A Pile of Reasons

As one A.G. Edwards financial advisor sees it, regulators and broker/dealer management have gone overboard with mutual fund disclosure. Take the case of the B-share class of mutual funds. “Right now, B shares are the baddest guys on the Street, the steroids of the industry,” says the advisor, who asked that his name not be printed. “[The industry] has tightened a noose around brokers who use them and have put us on a forced migration away from them.”

For certain small investors who don't qualify for breakpoints and intend to hold a fund for years, B shares can represent the cheaper option and actually be the best choice. But at A.G. Edwards and elsewhere, clients can be forgiven for thinking that B shares would ever make sense. The “B-share disclosure form and checklist” that clients must sign “is specifically designed to make it a pain in the butt to sell B shares,” he says. “I call it the ‘I'm-a-dumb-sh*t’ letter,” the advisor says of the form. “After the presentation, the clients have to sign off on this thing that basically says, ‘I realize that I'm going into an inferior product with higher expenses, but I am going to do it anyway.’”

In a ‘B’ Fall

Not surprisingly, sales of B shares have collapsed. In 2004, A shares of equity funds had net inflows of $63 billion, while B shares had net withdrawals of $32 billion, according to the Financial Research Corp. Total assets in B shares, now amount to $271 billion, a tiny speck compared to the total equity fund universe of $4.2 trillion. Since many B shares automatically convert to A shares after certain periods, some observers believe that B shares will soon be extinct. (See table on page 41.) “Taking away choices from consumers is never a good idea,” says the Edwards advisor.

A.G. Edwards instituted the B-share letter in January. It's just one example of how regulatory pressure is forcing b/ds to change the way their reps present mutual fund investments to clients. Indeed, over the past year, the change has been dramatic. Most reps are pushing around a lot more paper, and there may be still more to come. For now, b/ds are taking their cues from NASD member recommendations and recent regulatory settlements, but more specific guidance is on its way. On March 1, the SEC resubmitted a proposed rule that would require reps to offer specific information about costs and conflicts of interest related to distribution of mutual funds, 529 college savings plans and variable insurance products. Analysts expect the rule will be finalized this year.

Reps aren't too happy about the deluge of paperwork — B-share and switch letters, prospectus receipts and 1035 exchanges. “It's almost to the point where they're making it difficult to do business,” says one Morgan Stanley broker who manages over $100 million in retail assets. “I would suggest it's probably 20 percent to 30 percent more time spent on paperwork. That's a lot more administrative work to do the same amount of revenue.” Some clients are confused, he adds. A number of them have called him up to ask about new cost items that are being included on transaction confirmations, like surrender charges, even though these were discussed in client meetings.

The amount of paperwork is fast approaching the level of documentation for a mortgage, says Lon Dolber, CEO of American Portfolios, an independent b/d based in Holbrook, N.Y. Confronted with a sheaf of legal documents, he says, consumers “turn to their advisors and ask, ‘What should I do?’” He adds, “The mindset that more paperwork will protect the consumer is not necessarily true. The b/d must examine all of its transactions to ensure clients' objectives and suitability are being met.”

B/ds say they're spending a lot of extra time and effort on disclosure too. “We have to establish new procedures, create technology to support the procedures and assign staff to make sure the procedures are executed,” says David Spinar, vice president and chief compliance officer of Securities America, an independent b/d based in Omaha, Neb. “It's a cascade that hits multiple parts of the organization.”

Breaking Point

If the proposed SEC disclosure rule passes in its current form, b/ds will be required to generate a point-of-sale document with both standardized and transaction-specific disclosures about sales loads, breakpoints and annual sales costs by category — including 12b-1 fees. The SEC is also considering whether to require that point-of-sale documents include information on revenue-sharing deals, including sources of payment and amounts, or simply a Web site and 800 number where this information can be found.

The Securities Industry Association estimates that the industrywide cost of the proposed point-of-sale and confirmation disclosures could come to $5.4 billion the first year and $7 billion a year after that. This is greater than the U.S. brokerage industry's total annual profits of $1.2 billion from mutual funds in 2002, the SIA says.

Much of the added disclosure b/ds have already put in place, in advance of an SEC ruling, is related to share classes and breakpoints — sales charge discounts applied to A-share purchases after certain investment thresholds are met. It used to be that a prospectus receipt from a client was enough to prove appropriate disclosure of the advantages and disadvantages of A, B and C shares, says Securities America's Spinar.

But over the past few years, the NASD has fined numerous b/ds for selling B shares to investors who could have gotten breakpoint discounts in A shares, and for failing to provide the discounts even when investors did buy A shares. (The NASD says most of the breakpoint failures appeared to be mistakes and were not intended to defraud.) As a result, the NASD recommended last year that reps keep records of their efforts to inform investors of breakpoint opportunities and to find out about their clients' eligible accounts.

There is also a multipart form that brokers call a “switch letter” that is required whenever a rep wants to move some of a client's assets out of one fund family and into another. This letter is meant to show that the client understands he might lose breakpoint privileges and/or the ability to get payment of a new sales load waived, something many fund companies offer when an investor transfers assets within the fund company.

Some b/ds are putting automated systems in place to cut down on the share-class paperwork and ensure that share-class mistakes aren't made. Linsco/Private Ledger says it will have its system up and running by this summer. “It probably cost over $1 million to create,” says Esther Stearns, chief operating officer at LPL. “But mutual funds are a very important part of our product mix here.”

Still, one lawyer says some reps have entirely given up on load funds. “At American Express Financial Advisors, the amount of paperwork those guys have to do to sell a mutual fund requires a tremendous amount of time,” says Chad Weaver, an attorney at Edgerton & Weaver in Hermosa Beach, Calif., who represents a number of b/d clients. “A lot of these guys are going to wrap accounts, going to NAV and no-loads.” This may also be part of a larger move in the industry away from commission-based products and towards fee-based business. Most registered investment advisors (RIAs) already avoid load funds all together, so for them, the added share-class disclosures aren't a hassle.

More Biggies

Other big items on b/d disclosure checklists are revenue-sharing deals and 12b-1 fees. Revenue sharing has been a common practice in the industry for years: Mutual fund companies pay fees to get on b/ds' “preferred” fund lists, which can give them better access to brokers through marketing materials, conferences and educational programs.

In November 2003, Morgan Stanley agreed to pay $50 million to settle charges that it failed to adequately disclose the details of its revenue-sharing agreements to investors. Then in December 2004, Edward Jones agreed to pay $75 million to settle similar charges. Jones had selling arrangements with 240 fund companies, but the seven funds on its preferred list typically accounted for 95 percent or more of the broker's annual fund sales. The bonuses of individual brokers were partly based on sales of these funds, and the deals were lucrative for the firm: In 2004, Edward Jones received $82.4 million in revenue-sharing payments.

As a result of these regulatory actions, Morgan Stanley and Edward Jones now have detailed information about their revenue-sharing deals on their Web sites. Morgan Stanley discloses a range of payments it charges the funds on its preferred list, whereas Edward Jones discloses the exact sums it charges each fund company. Jones also discloses details about its revenue-sharing agreements in a letter, which goes out with all mutual fund confirmations.

Several other major firms, like Merrill Lynch, UBS and Smith Barney have followed suit with disclosures about their own deals. But most of them have been careful not to release actual payment amounts. Benjamin Poor, an analyst at Boston-based Cerulli Associates, says he expects they will wait to provide these details — and to create point-of-sale or confirmation documents with this kind of information — until the SEC's proposed disclosure rule is finalized.

“If you do something voluntary, you could put yourself at a competitive disadvantage,” says Poor.

As for 12b-1 fees, a few b/ds have added Web site disclosure on the amounts of fees they receive and what they are used for, but few, if any, have begun voluntarily disclosing this information at the point of sale. Created in 1980 to help small fund companies pay for marketing, 12b-1 fees now are used mostly for third-party research and account administration. Critics say the fees are misused and, because they are not prominently disclosed, hide the true cost of investing in mutual funds. But 12b-1 fees, unlike revenue-sharing agreements, have always been included in fund prospectuses and can be found in Morningstar's fund research. According to industry estimates, the mutual fund industry charges $13 billion annually in 12b-1 fees, which are then funneled back to individual brokers.

For fee-only registered investment advisors, the additional disclosure requirements won't hurt. Charles Foster, partner at Blankinship & Foster in Del Mar, Calif., says he always recommends no-load mutual funds and avoids 12b-1 fees and revenue-sharing deals whenever he can. “The whole fiasco has brought new awareness to what has gone on for a decade and longer,” he says. “Even though it's hurt, it's been really healthier.”

Vanishing B shares