Compensation Practices for Retail Sale of Mutual Funds: the Need for Transparency and Disclosure
FORDHAM JOURNAL OF
CORPORATE & FINANCIAL LAW
Fordham Journal of Corporate & Financial Law
John Howat 0
Linda Reidy 0
0 John Howat, PhD Associate Professor of Finance University of Wisconsin-Whitewater , USA
Linda Reid, JD
Assistant Professor of Law,
University of Wisconsin-Whitewater
Mutual fund firms, also known as investment companies or
investment trusts, buy and sell stocks, bonds, and other securities.2 A
fund raises money to make its purchases by selling shares in itself. The
fund pools the money of many investors—its shareholders—to invest in
the securities.3 Those securities are professionally managed by fund
managers on behalf of the shareholders. After the trading costs and
expenses of managing and administering the fund are subtracted, the
earnings realized by the fund on its investment portfolio are paid out
1. Technically, a mutual fund is an open-end management company registered
with the Securities and Exchange Commission (“SEC” or “Commission”) under the
Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 to -64 (2005) [hereinafter the
Investment Company Act]. An “open-end company” is a management company that
issues a redeemable security. 15 U.S.C. § 80a-5(a)(1) (2005).
2. Mutual fund firms are also known as mutual fund complexes and mutual fund
companies. For the purposes of consistency in this paper, we refer to them as mutual
fund firms or funds, and to the persons who manage the funds as mutual fund managers
or fund managers.
3. The term redeemable security is defined in Section 2(a)(32) of the Investment
Company Act to mean a security the terms of which entitles the holder, upon
presentation “to receive approximately his proportionate share of the issuer’s current net
assets, or the cash equivalent thereof.” 15 U.S.C. § 80a-2(a)(32) (2005).
pro-rata to the fund’s shareholders. Shareholders may also realize
investment gains by selling (or redeeming) their shares back to the fund
at the shares’ net asset value (the total value of the fund’s assets divided
by the number of shares outstanding).
Mutual funds have recently become increasingly popular vehicles
for individual investors in the United States. In 1980 there were 564
funds with assets totaling $134.8 billion.4 As of the end of December
2005 there were 7,977 funds with combined assets of $8.905 trillion.5
Similarly, in 1980, 4.6 million households owned mutual fund shares,
representing only 5.7% of all households in the United States.6 As of
2005, 91 million individuals in 54 million households (nearly half of all
households) owned mutual funds.7 It should be noted that the majority
of household investments in mutual funds occur through employee
retirement plans.8 A healthy percentage, however, is purchased by the
investors themselves, and of those purchases, more than 80% are made
through financial professionals.9
Individual investors can purchase mutual fund shares on the retail
market in one of two ways, either directly from the fund, or through an
intermediary seller. In the first case, investors purchase
“directmarketed funds” via phone, mail, or the internet. In the second instance,
the fund’s underwriter acts as a wholesaler or distributor to an
intermediary firm, (e.g. a brokerage firm, an asset management
company, a financial planning firm, an insurance agency, or a bank)
which in turn sells to the individual investor via a sales force.10 Some
brokerage firms also sell their own private-label funds.
The typical retail shopper who purchases shares through a financial
adviser will be given a fund prospectus. The prospectus includes
information regarding the investment objective of the fund, the historical
4. Investment Company Institute, 2006 Investment Company Fact Book 71 (46th
ed. 2006), available at http://www.ici.org/stats/mf/2006_factbook.pdf.
6. Id. at 47.
8. See id. at 50.
10. For the purpose of consistency in this paper, we refer to these salespersons as
investment advisers. The term advisor is also proper and is used by several professional
organizations. In specific instances we use the terms brokerage firms and brokers.
Brokers and other financial advisers will have the NASD Series 6 license, which allows
them to sell mutual fund products. Many will also have the NASD Series 7 license,
which allows them to sell securities.
investment performance of the fund, and the costs and expenses the
shareholder will pay. The compensation received by the financial
adviser for recommending or selling the shares is included in the fee
table in the prospectus; however, in most cases it is not identified
explicitly. Adviser compensation information is required to be
presented explicitly in the Statement of Additional Information (SAI).
The SAI must also include a description of potential conflicts of interest
which the adviser’s method of compensation might create. Notable,
however, is the fact that the SAI is provided to the potential shareholders
only if they specifically request it.
Brokerage firms and the various financial advisers who sell mutual
funds to retail purchasers may be compensated in a variety of ways,
including (1) loads, or sales charges paid directly by the purchaser; (2)
marketing fees, also known as 12b-111 fees; and (3) fund servicing and
operating expenses.12 Both 12b-1 and fund expense fees are paid out of
the assets of the fund, and thus are ultimately paid by the shareholders.
Payments from each of these sources compensate financial advising
firms and their personnel for providing a wide range of services,
including the administering of shareholder records, processing
transactions, training the advisers who sell the funds, and investor
education. While fund firms assert that these services provide advisers
and investors with valuable benefits, others, including regulators,
criticize the lack of transparency in brokerage firm compensation, since
it is practically impossible for investors to know precisely if, and how,
financial advisers are paid out of fund assets.
Financial adviser compensation is often augmented by enhanced
compensation arrangements, such as directed brokerage, soft dollar
commissions, revenue sharing, and differential cash compensation, each
of which has been the source of criticism in recent years, due to potential
conflicts of interest inherent in the practices, and the lack of disclosure
of the practices to investors. This paper examines the practices and
recommends changes to reduce, if not eliminate, the potential harm to
investors inherent in their use.
11. Rule 12b was promulgated under the Securities Exchange Act of 1934
(codified as amended at 15 U.S.C. §§ 78a-lll (2005)) [hereinafter the Securities
Exchange Act]. See discussion infra Part III.B for a detailed discussion of 12b-1 fees.
12. See generally Susan S. Krawczyk, Compensation Practices for Retail Sales of
Mutual Funds, 4 J. INVESTMENT COMPLIANCE 27 (2004) (discussing compensation
practices in detail).
II. ENHANCED COMPENSATION PRACTICES
A. Directed Brokerage
In directed brokerage arrangements, mutual funds channel trades to
brokers who promise to promote those funds in exchange for
commissions on the mutual fund’s stock and bond transactions. Put
another way, in directed brokerage, a mutual fund typically promises to
buy a certain amount of brokerage services from a broker-dealer who in
turn agrees to promote that mutual fund to investors. Critics level two
charges against directed brokerage: (1) the practice can lead a broker to
recommend mutual funds that are not in his client’s best interest; and (2)
it can lead a fund firm to select a broker based on increasing its sales,
rather than on getting the best execution of its trades. That can lead to
high trading costs being passed to fund shareholders.
As is discussed in Parts III.B and III.D.3 of this paper, the
Securities and Exchange Commission (the “SEC”) and the National
Association of Securities Dealers, Inc. (the “NASD”) banned the
practice of directed brokerage in 2004, because of its potential for
creating conflicts of interest by generating incentives for fund managers
to direct fund transactions to firms who were encouraging sales of their
funds, rather than to the firms that could provide the best execution or
price on fund transactions.
B. Soft Dollar Practices
The SEC is currently examining the practice of soft dollar
commissions. Soft dollars refer to an arrangement whereby fund
managers direct fund trades through a particular brokerage firm in
exchange for brokerage services, including investment research. Fund
managers typically use soft dollar payments to pay for investment
research because, by doing so, they are able to hide the costs of research
in brokerage commissions, when those costs would ordinarily be paid
out of fund assets. Transaction costs, including soft dollar commissions,
are not included in a fund’s expense ratio, because accounting principles
dictate that they be included as part of the cost basis of securities
purchased or subtracted from the net proceeds of securities sold.
For example, suppose Fund A pays for research by adding to its
management fee, which is disclosed in the prospectus fee table. Fund B
pays for the same research with soft dollars, commissions paid to the
brokerage firm providing the research. Those costs do not appear in the
fee table. Instead, those costs are part of the fund’s transactions costs,
which are typically disclosed in the Statement of Additional Information
(“SAI”). Thus, to most investors, Fund B appears to have a lower
expense ratio than Fund A. In reality, the costs charged by the fund and
paid by the investor are the same.
Supporters of the practice maintain that soft dollar payments benefit
shareholders by giving small fund advisers access to valuable research,
thereby enhancing the competitiveness and price efficiency of small
mutual funds. Opponents criticize the lack of transparency and
oversight in soft dollar arrangements. They also argue that soft dollar
compensation can create conflicts of interest for fund managers, because
the fund managers may be motivated to select brokers based on their
research services rather than on the speed or price of trade execution for
There currently exists a safe harbor rule that allows fund managers
to use client funds to purchase “brokerage and research services” for
their managed accounts under certain circumstances without breaching
their fiduciary duties to clients.13 Under Section 28(e) of the Securities
Exchange Act of 1934 as amended, mutual fund firms may pay higher
than normally allowed commissions if the fund firm deems the higher
commission is in the best interest of the fund.14 If it participates in soft
dollar practices outside the safe harbor, however, it may be subject to
liability for breach of fiduciary duty to clients.
Critics of soft dollar practices have advocated repealing Section
28(e), or outlawing soft-dollar transactions altogether. Others have
called for greater oversight and stricter definitions of what can and
cannot be bought with soft dollars. As discussed in Part III.D.4 of this
paper, the SEC has recently issued a release containing interpretative
guidance as to which soft dollar practices are within the scope of the
safe harbor established by Section 28(e).
C. Revenue Sharing and Shelf-Space Practices
Most, if not all, mutual funds make payments to brokerage firms
that sell the funds’ shares. As the SEC defines it, revenue sharing
13. See Securities Acts Amendments of 1975, Pub. L. No. 94–29, 89 Stat. 97
14. See id.
occurs when a fund manager agrees to pay a brokerage firm cash
compensation not otherwise disclosed in the prospectus fee table to
promote the mutual fund to the broker’s clients. This type of payment
creates a clear conflict of interest by introducing a new factor for an
investment adviser to consider—his or her company’s own financial
profit—when deciding which mutual funds to recommend to an investor.
These payments are often referred to as buying “shelf space” at the
broker-dealer firm. In some cases, the fund manager may describe those
payments as reimbursing the brokerage firm for expenses it incurs in
selling the shares. The payments, regardless of whether they are labeled
reimbursements or otherwise, may give the brokerage firm a greater
incentive to sell the shares of that fund or an affiliate, rather than the
shares of funds that don’t make such payments.
The SEC is reviewing the disclosure of these so-called
revenuesharing deals. Regulators are looking particularly closely at revenue
sharing and shelf space arrangements because of the financial incentives
they may create for brokers to recommend one fund over another.15
While brokers argue that spotlighting a particular fund is no guarantee of
sales, others say that compensating brokers for promoting a fund may
not be in the best interest of the firms’ clients.16
D. Differential Cash Compensation
Differential cash compensation is the practice of paying sales
representatives higher cash compensation for sales of proprietary and
“partnered funds.” Proprietary funds are those offered by the sales
representative’s employer (e.g. brokerage firm or insurance company).
Partnered funds are those offered by firms that have an agreement with
the sales representative’s employer to promote those funds in exchange
for cash payments. According to Financial Research Corporation
estimates, in 2003 the fifty largest fund companies in the United States
paid securities firms roughly $1.5 billion annually to distribute their
15. See generally CONFIRMATION REQUIREMENTS AND POINT OF SALE DISCLOSURE
REQUIREMENTS FOR TRANSACTIONS IN CERTAIN MUTUAL FUNDS AND OTHER
SECURITIES, AND OTHER CONFIRMATION REQUIREMENT AMENDMENTS, AND
AMENDMENTS TO THE REGISTRATION FORM FOR MUTUAL FUNDS, 69 Fed. Reg. 6438-01,
6451 (Feb. 10, 2004).
17. Deloitte Development, 2005 Global Securities Industry Outlook: 2005 Top 10
Differential cash compensation is currently not prohibited under
applicable rules and regulations, but critics charge that, like other types
of enhanced compensation arrangements, they create a potential conflict
of interest when a securities firm recommends mutual funds and the
commission relationship is not adequately disclosed to investors. Even
if there is adequate disclosure, the potential conflict of interest remains,
and investors must be aware of that.
III. THE EVOLUTION OF COMPENSATION PRACTICES
Compensation practices for mutual funds have evolved over time.
Prior to 1980, compensation to the sellers of fund shares was primarily
accomplished through front-end load charges. By the late 1990s,
compensation arrangements generally entailed several methods, and the
investor usually had a choice in the methods applied. The key change
was the approval of 12b-1 plans, which allow for the payment of
marketing and distribution expenses from fund assets. These plans
allow for both different share classes within a particular fund, and the
practice of revenue sharing.
A. A Brief History of Mutual Funds and National Association of
Securities Dealers, Inc.
The first pooled funds were introduced in the United States in the
1890s.18 In 1924, the Massachusetts Investors Trust became the first
open-end mutual fund.19 Shortly thereafter, in response to the 1929
stock market crash, Congress passed the Securities Act of 193320 and the
Securities Exchange Act of 1934.21 The 1933 and 1934 acts require,
among other things, that investment funds be registered with the
Securities and Exchange Commission and that prospective fund
investors be provided with a prospectus. In 1934, Congress also passed
Issues, at 5, available at http://www.deloitte.com/dtt/cda/doc/content/dtt_financial
services_topten2005-securities_013105(3).pdf (last visited Mar. 23, 2007).
18. K. Geert Rouwenhorst, The Origins of Mutual Funds 17
(Yale Sch. of Mgmt.,
Int’l Center for Fin., Working Paper No. 04-48, 2004)
, available at
http://ssrn.com/abstract=636146 (last visited Mar. 23, 2007).
20. 15 U.S.C. §§ 77a-aa (2005).
21. 15 U.S.C. §§ 78a-lll (2005).
the National Industrial Recovery Act (the “NIRA”).22 The act called for
industrial self-regulation and declared that codes of fair competition—
for the protection of consumers, competitors, and employers—were to
be drafted for the various industries of the country.23 In 1935, the U.S.
Supreme Court invalidated the compulsory-code system, ruling that the
NIRA improperly delegated legislative powers to the executive and that
the provisions of the poultry code at issue in the case did not constitute a
regulation of interstate commerce.24
The the NASD grew out of the Investment Bankers Code
Committee (the “IBCC”) formed by the investment banking business
under the NIRA.25 When the NIRA was declared unconstitutional, the
IBCC was continued on a voluntary basis, becoming the Investment
Bankers Conference Committee, its function to be one of discussion and
conference with federal agencies looking toward the establishment of an
organization to preserve and formalize the values of the code.26 A
successor organization known as the Investment Bankers Conference,
Inc. (the “IBC”) was established to proceed more formally towards the
objective of a legal entity empowered to administer rules promoting
“high standards of commercial honor.”27 An important objective of the
IBC was the development of a plan of self-regulation for
over-thecounter markets.28 By November of 1937, the SEC and an IBC
governing committee prepared the draft of legislation to accomplish the
self-regulatory objective.29 The bill, known as the Maloney Act, was
signed into law in 1938.30 The NASD, the successor to the IBC, was
registered by the SEC as a national securities association under section
15A of the 1934 Securities Exchange Act.31
The NASD is currently the world’s leading private-sector provider
of financial regulatory services. Under U.S. law, every securities firm
22. Ch. 90, 48 Stat. 195 (1933).
24. Schechter Poultry Corp. v. United States, 295 U.S. 495, 550 (1935).
25. Fulton, Wallace H., The Origin of the NASD, 1933-1939: The OTC Market’s
Venture Into Self-Regulation, at http://www.people.hbs.edu/aperold/resource/ISR/
Teaching%20Note/AKS%20-%20History%20of%20the%20NASD.doc (last visited
Mar. 23, 2007).
31. Fulton, supra note 25, at 1.
doing business with the American public must register with NASD.32
The NASD registers securities firms, writes rules to govern their
behavior, examines them for compliance and, when necessary, brings
enforcement actions against those who break those rules.
Approximately 5,100 brokerage firms and more than 660,000
stockbrokers and registered representatives currently fall under the
jurisdiction of the NASD.33
B. The Evolution of Rule 12b-1
In 1940, Congress enacted the Investment Company Act of 1940
(the “1940 Act”),34 which is the principal statute under which the mutual
fund industry is regulated today. The 1940 Act seeks to prevent abuses
through mandating disclosure regarding an investment company’s
structure, operations, financial condition and policies when shares of the
investment company are initially offered to the public and, thereafter, on
a regular periodic basis.35 Investment companies typically register their
securities with the SEC under the 1933 Act and their companies under
the 1940 Act.36 Investment advisers use Form ADV to register as an
investment adviser with the SEC.
The provisions in the 1940 Act govern, among other things,
transactions between the investment company and its affiliates (e.g.,
investment advisers to the investment company), purchases and sales of
investment company shares and the responsibilities of the investment
company’s directors or trustees.37
32. NASD Rules and Regulations, available at http://www.nasd.com/Rules
Regulation/index.htm?ssSourceNodeId=9 (last visited Mar. 27, 2007).
33. About NASD, available at http://www.nasd.com/AboutNASD/index.htm (last
visited Mar. 16, 2007).
34. See 15 U.S.C. §§ 80a-1 to -64 (2005).
35. NASD website, available at http://www.nasd.com/web/idcplg?IdcService=SS_
36. Investment advisers use Form ADV to register with the SEC. Generally, an
investment adviser that manages $25 million or more in client assets must register with
the SEC. Advisers that manage less than $25 million must register with the state
securities regulator where the adviser’s principal place of business is located. Form
ADV also is used for state registration. Form ADV has two parts. Part I contains
information about the adviser’s education, business and an adviser’s disciplinary history
within the last ten years. Part II includes information on an adviser’s services, fees and
37. See NASD website, supra note 35.
The 1940 Act bans the use of fund assets to pay for the distribution
of a fund’s shares.38 However, in the late 1970s, mutual funds
experienced a significant and steady outflow of cash from redemptions
of shares.39 This left the remaining shareholders to pay the fixed costs of
the funds as the costs were spread over fewer shareholders.
The fund industry lobbied for the use of fund assets to pay for
distribution costs and persuaded the SEC to pass Rule 12b-140 in
October 1980. The rule permits funds to pay the costs of marketing and
distribution of fund shares as long as they are properly disclosed and
regulated. The annual fee is included in the fund’s reported expense
ratio. Since 1980, the total of these fees has grown from a few million to
over $10 billion in 2004.41 This is due in part to the rapid growth of
mutual fund assets, but is also due to the significant drop in front-end
loads, both in terms of size (the typical load has dropped from 8% in
1980 to 5% today) and in terms of the percentage of funds which charge
a front-end load.42
Although it was initially meant as a short-term solution to the high
level of net redemptions in the 1970s, Rule 12b-1 is largely responsible
for the class system of funds used today. A fund will often have various
classes of shares that differ in their commission structures.43 For
example, one class might have a high initial sales commission and a
small (usually .25%) annual fee paid for by a 12b-1 plan, while another
class might have a small initial sales commission and a large (perhaps
1.0%) annual 12b-1 fee. The expense ratio of a fund typically includes
three components: an advisory fee, administrative fee (such as legal and
accounting costs) and 12b-1 fees. For multiple class shares, the advisory
fee is always the same across classes. Administrative fees and 12b-1 fees
can vary across classes although the administrative fee is often the same.
The selection of share class by an investor typically depends on the
expected holding period. An investor with a short expected holding
period might find it beneficial to buy shares with no up-front fee but
high annual fees. A long-term investor does better with shares that have
a large initial fee but small annual fees.
There are two important differences between load fees and 12b-1
fees besides the obvious one-time fee versus annual fee. First, they differ
in the level of transparency. The load charge is clearly stated in the
confirmation statement that the investor receives from the fund or the
broker who sold the shares. On the other hand, the investor is never
explicitly told the amount of the 12b-1 fees—it is neatly buried in the
expense ratio. Second, loads are a fixed amount charged at the account
level, and each investor pays only for his or her costs. 12b-1 fees are
charged at the fund level, and investors may pay for other investors’
costs. The aggregate amount that investors pay increases as their holding
period increases and as the asset level rises. Because the fees are
deducted at the fund level, some investors subsidize the costs of other
investors. For example, small accounts typically cost more, as a percent
of the account size, than large accounts; and yet both investors pay the
There is also a crucial difference between brokerage commissions
and both load fees and 12b-1 fees in terms of transparency.
Commissions are not even disclosed in the expense ratio. When the fund
purchases a security the commission is added to the cost basis of the
asset, and when a security is sold the commission is deducted from the
proceeds of the sale. Assuming a security is bought and sold for a gain,
the profit for shareholders is the net profit after deducting the
commissions on both the purchase and the sale. The total of all
commissions is disclosed as a lump sum (usually labeled as transactions
costs) in the SAI which is typically delivered to a shareholder only if
requested. Thus, directed brokerage payments and soft dollar
commissions are quite unlikely to be uncovered by the vast majority of
A recent survey by the Investment Company Institute (the “ICI”)
showed that funds use most of the 12b-1 fees to compensate financial
advisers for assisting fund investors before and after they purchase fund
shares.44 Only a small fraction of the fees are used for advertising and
promotion.45 Thus, the primary use of revenues raised through 12b-1
44. Supra note 41, at 1.
fees is to create incentives for advisers to distribute the fund shares,
making advisers the main beneficiaries of 12b-1 plans.
On August 14, 2004, the SEC adopted amendments to Rule 12b
prohibiting the use of fund brokerage to compensate broker-dealers for
selling fund shares.46 New Rule 12b-1(h)(2) permits a fund to use
brokers selling its shares to execute transactions in its portfolio securities
only if the fund or its adviser has implemented policies and procedures
designed to ensure that the selection of selling brokers for portfolio
securities transactions is not influenced by considerations about the sale
of fund shares.47 The rule and correlating NASD Rule 2830(k) are
discussed in further detail in Part III.D.3 of this paper.
C. Congressional Initiatives
The poor performance of mutual funds in the early 2000s, partially
as a result of the collapse of the technology bubble and the slowdown in
the world economy, led to intense scrutiny of the mutual fund industry
by many, including Congress.48 Criticism focused, in part, on the
transparency of fund fees and costs, and specifically the practices of
directed brokerage, revenue sharing and soft dollars.49
In early 2003, the House Subcommittee on Capital Markets,
Insurance and Government Sponsored Enterprises held hearings on
mutual fund practices, including mutual fund fee and cost disclosure
issues, sales practices and governance. On June 11, 2003, Representative
Richard H. Baker and twenty-three co-sponsors introduced H.R. 2420
(the “Mutual Fund Integrity and Fee Transparency Act of 2003”)
Among other things, H.R. 2420 required the SEC to require disclosure
of a number of items and required the adviser to submit an annual report
to the fund directors on revenue sharing, directed brokerage and soft
dollars.51 It imposed a fiduciary duty on the fund directors to supervise
the arrangements.52 H.R. 2420 also required brokers to disclose
information about differential compensation and conflicts of interest
associated with the broker’s sale of a particular fund, along with
information about commissions that may be charged based on the class
of shares the investor has purchased.53
By mid-summer, however, efforts to pass H.R. 2420 had stalled.54
The bill died for a lack of support in the House and the inability to even
find a sponsor in the Senate. Instead, the House Subcommittee directed
its efforts to having the SEC deal with the matters addressed by H.R.
2420 through rulemaking.55
Following market timing, late trading scandals, and subsequent
prosecutions by New York Attorney General Eliot Spitzer, Congress
renewed its efforts at mutual fund reform. The House passed a beefed up
version of H.R. 2420 on November 19, 2003 by a vote of 418-2.56
Among other things, H.R. 2420 contained additional detailed provisions
regarding the disclosure of mutual fund fees, obligations regarding
distribution and soft dollar arrangements.
The following bills were introduced in the Senate in the 108th
S.1882, the “Mutual Fund Transparency Act of 2003”
introduced on November 5, 2003 by Senator Daniel K.
S.1971, the “Mutual Fund Investor Confidence Restoration
Act,” introduced on November 25, 2003 by Senators Jon
Corzine (D-NJ) and Christopher Dodd (D-CT);58
S.1958, the “Mutual Fund Investors Protection Act,”
introduced on November 29, 2003 by Senators John Kerry
(D-MA) and Edward Kennedy (D-MA);59
Cong., 2003, available at
http://thomas.loc.gov/cgiCong., 2003, available at
Cong., 2003, available at
http://thomas.loc.gov/cgi• S.2509, the “Mutual Fund Reform Act of 2004,” introduced
on February 10, 2004 by Senators Peter Fitzgerald (R-IL),
Carl Levin (D-MI) and Susan Collins (R-ME).60
• S.2497, the “Small Investor Protection Act of 2004,”
introduced on June 3, 2004 by Senator Joe Lieberman
Each of the bills contained provisions to reform mutual fund sales
practices by eliminating certain types of compensation arrangements,
including 12b-1 fees, soft dollars, directed brokerage, and revenue
sharing arrangements. None of the bills made it out of committee.
On May 16, 2005 Senator Daniel Akaka (D-HA) introduced
S.1037, the “Mutual Fund Transparency Act of 2005,” in the 109th
Congress.62 Among other things, the proposed bill requires broker
point-of-sale disclosure regarding revenue sharing and differential cash
D. Recent SEC and NASD Reforms
A wide range of mutual fund reform initiatives have also been
undertaken by the NASD and SEC in the past few years, certain of
which specifically address mutual fund enhanced compensation
arrangements. These initiatives have resulted in significant changes in
the way in which mutual funds, fund directors, and investment advisers
1. Code of Ethics
On May 26, 2004, the SEC adopted a rule requiring registered
investment advisers to establish, maintain, and enforce a written code of
ethics.64 Specifically, Rule 204A-1 requires that the code of ethics
contain, at a minimum, a standard of business conduct that the adviser
60. S. 2059, 108th Cong., 2003, available at
61. S. 2497, 108th Cong. (2003), available at
62. S. 1037, 109th Cong. (2003), available at
64. SEC Investment Adviser Code of Ethics, 17 C.F.R. §§ 270, 275, 279 (IA-2256)
(2004), available at http://www.sec.gov/rules/final/ia-2256.htm.
requires of its “supervised persons” as defined in Section 202(a)(25) of
the Investment Advisers Act of 1940.65 The standard must reflect the
fiduciary obligations of the investment adviser and supervised persons.
Although it might have gone without saying, the rule also
specifically requires that supervised persons comply with applicable
federal securities laws such as the Securities Act of 1933,66 the
Securities Exchange Act of 1934,67 the Sarbanes-Oxley Act of 2002,68
the Investment Company Act of 1940,69 the Advisers Act,70 Title V of
the Gramm-Leach-Bliley Act,71 and the Bank Secrecy Act.72
Amendments to SEC Rule 204-2(a) also require SEC-registered
investment advisers to retain as “required records” code of ethics
violations and their disposition; records concerning personal securities
transactions by certain advisory personnel; and evidence in the form of
an acknowledgement that supervised persons received a copy of the
code of ethics.73
As part of its adoption of new Rule 204A-1, the SEC also made an
amendment to Form ADV, the form advisers use to register with the
SEC.74 The change requires investment advisers to describe their code
of ethics on Schedule F of their registrations.75 It also requires
investment advisers to indicate that they will provide a copy to any
client or prospective client upon request.76
2. Disclosure Requirements
On August 18, 2004, the SEC finalized new disclosure
requirements for mutual funds.77 The requirements became effective for
mutual fund registration filings after February 28, 2005.78 The rules are
designed to achieve increased information about fund portfolio
managers, including their identity, incentives, potential conflicts of
interest, other accounts they manage, compensation structure and
ownership of securities in accounts they manage. Among others, the
following disclosures are required:79
• A mutual fund must identify in its prospectus each
individual who is a “portfolio manager.”
• A mutual fund must provide information in its SAI
regarding other accounts managed by any of its portfolio
managers, including a description of any material conflicts
of interest that may arise in connection with simultaneously
managing the portfolio and other accounts.
• A mutual fund must disclose in its SAI the structure of, and
the method used to determine, the compensation of each
• A mutual fund must disclose each portfolio manager’s
ownership of securities in the fund. This disclosure is also
to be made in the SAI.80
3. Directed Brokerage
Also on August 18, 2004, the SEC amended Rule 12b-1 to prohibit
the practice of directed brokerage, a practice the Commission stated
“poses significant conflicts of interests and may be harmful to funds and
fund shareholders.”81 Rule 12b-1(h)(1) prohibits funds from
compensating a broker-dealer for promoting or selling fund shares by
directing brokerage transactions to that broker.82 The prohibition
applies both to directing transactions to selling brokers, and to indirectly
compensating selling brokers by participation in “step-out” and related
Investment Companies, 69 Fed. Reg. 33-8458 (Aug. 27, 2004) available at
81. See 17 C.F.R. § 240 (2004).
82. Id. at § 270.12b-1(h)(1). The rule prohibits funds from financing distribution
of fund shares through the direction of any service related to effecting a fund brokerage
transaction, including performing or arranging for the performance of any function
related to processing a brokerage transaction. The prohibition reaches transactions
executed by government securities dealers and municipal securities dealers.
arrangements whereby the selling broker receives a portion of the
commission.83 “The ban extends to any payment, including any
commission, mark-up, mark-down, or other fee (or portion of another
fee) received or to be received from the fund’s portfolio transactions
effected through any broker or dealer.”84
From the broker-dealer’s perspective, directed brokerage activities
are subject to NASD Rule 2830(k).85 Effective February 14, 2005, Rule
2830(k) was amended to prohibit the practice.86 Prior to amendment,
Rule 2830(k) prohibited NASD members from favoring the sale of
shares of any investment company on the basis of brokerage
commissions received or expected to be received from any source,
including the investment company.87 However, subparagraph (7)(B) of
the rule allowed an NASD member, subject to the requirements of best
execution, to sell the shares of, or act as an underwriter for, an
investment company where that investment company “follows a policy,
disclosed in its prospectus, of considering sales of shares of the
investment company as a factor in the selection of broker/dealers to
execute portfolio transactions . . . .”88
The NASD proposed to strike subparagraph (k)(7)(B) and add a
new subparagraph, designated (k)(2), which will prohibit NASD
members from selling the shares of, or acting as underwriter for, any
[I]f the member knows or has reason to know that such investment
company, or an investment adviser or principal underwriter of the
company, has a written or oral agreement or understanding under
which the company directs or is expected to direct portfolio
securities transactions (or any commission, markup or other
remuneration resulting from any such transaction) to a broker or a
dealer in consideration for the promotion or sale of shares issued by
the company or any other registered investment company.89
83. Id. at § 270.12b-1(h)(1)(ii). The prohibition also extends to circumstances in
which two funds cooperate to direct brokerage commissions to the selling broker of the
other fund. See Section 48 under the Investment Company Act (making it unlawful for a
person to do indirectly what the person could not do directly).
84. See 69 Fed. Reg. 33-8458.
85. NASD, R. 2830(k).
86. See Smith, supra note 50.
88. NASD, R. 2830(k)(7)(B).
89. Self-Regulatory Organizations; Notice of Filing of Proposed R. Change by
The NASD noted in its description of the proposed rule change that
proposed new subparagraph (k)(2) “would add an objective proscription,
in that the broker-dealer’s intent to favor or disfavor a particular fund
would not be relevant to that prohibition.”90 In approving the
amendment in December of 2004, the SEC noted that “[o]ne important
purpose of Rule 2830(k) is to help eliminate conflicts of interest in the
sale of investment company securities, and the proposed rule change
will improve NASD’s ability to achieve this objective.” 91
The SEC, NASD, and certain states have actively brought
enforcement proceedings against firms engaged in directed brokerage
activities. In 2005, the NASD set records for the number of new
enforcement actions brought and the amount of fines collected for
violation of the directed brokerage rules.92 That year, the NASD settled
twenty-seven cases against retail firms for providing preferential
treatment to select mutual funds in exchange for brokerage business, in
violation of its Anti-Reciprocal Rule. In total, the firms paid nearly $55
million in fines.93
4. Soft Dollar Practices
As discussed in Part II.B. below, Section 28(e) of the 1934 Act
provides a “safe harbor” allowing fund managers to use client funds to
purchase “brokerage and research services” for their managed accounts
under certain circumstances. On July 18, 2006, the SEC published final
interpretive guidance (“The Release”) regarding the use of “soft
dollars.”94 The Release clarifies the circumstances under which fund
managers may use client commissions to pay for brokerage and research
Nat’l Ass’n of Securities Dealers, Inc. Relating to Investment Company Portfolio
Transactions, 69 Fed. Reg. 64609 (proposed Sept. 17, 2004).
90. Id. at 64611 n.5.
91. Id. at 64611.
92. News Release, NASD, NASD: 2005 in Review (Dec. 27, 2005), available at
94. Guidance Regarding Client Commission Practices Under Section 28(e) of the
Securities Exchange Act of 1934, 17 C.F.R. § 241 (2006), Exchange Act Release No.
34-54165, File No. S7-13-06 (July 24, 2006), available at http://www.sec.gov/
R.s/interp/2006/34-54165.pdf. The Release affirms most of the positions taken by the
Commission in the proposed release issued in October 2005 (the Proposed Release) and
is intended to replace Sections II and III of the Commission’s 1986 interpretive release
(the 1986 Release) but is not intended to replace any other section of the 1986 Release.
services under the soft dollars safe harbor and specifically addresses four
issues: (1) when do “brokerage or research services” fall within the safe
harbor, (2) what constitutes “eligible research,” (3) what constitutes
“eligible brokerage services” and (4) what is the appropriate treatment
for “mixed-use” items.95 The Release sets forth a three-part test to
determine whether brokerage and research services fall within the safe
harbor. They must: (1) acquire “eligible” research products and
brokerage services, (2) use those products and services lawfully and
appropriately and (3) make a good-faith determination that the
commissions they are paying are reasonable in light of the value of the
products and services they are receiving.96
Significantly, the Release denotes a departure with respect to
equipment, such as computer hardware, now considered outside the safe
harbor, even if used in connection with research.97 It also definitively
excludes “mass-marketed publications” from safe harbor eligibility.98
Additionally, the SEC has articulated an interpretative standard under
which products and services not clearly constituting research are eligible
for the safe harbor if they “reflect the expression of reasoning or
knowledge relating to” the components of the definition of research in
IV. CODES OF ETHICS AND OTHER STANDARDS GOVERNING
SELLERS OF MUTUAL FUNDS
In addition to being governed by SEC and NASD regulations, many
financial advisers, whether broker-dealers, financial planners, insurance
agents, or bank representatives, are members of professional
organizations and subscribe to a particular code of ethics. Typically,
these codes have disclosure and conflict of interest provisions, many of
which are relevant to the retail sale of mutual funds. Financial advisers,
thus, are subject to scrutiny from several quarters. It is hoped that if
dubious practices are employed by any type of financial adviser, and
reported, at least one of the institutions having oversight will recognize
the inappropriate nature of the practice and take action to stop it. Given
the recent mutual fund scandals and number of prosecutions for
violations of mutual fund rules, the effectiveness of self-policing by
these institutions has been called into question of late.100
A. Certified Financial Planners
Certified Financial Planners (“CFPs”) operate under the Code of
Ethics and Professional Responsibility and Financial Planning Practice
Standards adopted by Certified Financial Planner Board of Standards,
Inc. (the “CFP Board”). According to the CFP Board, all persons whom
it has recognized and certified to use the CFP designation are obligated
“not only to comply with the mandates and requirements of all
applicable laws and regulations but also to take responsibility to act in
an ethical and professionally responsible manner in all professional
services and activities.”101
The CFP Code of Ethics consists of two parts: Part I consists of the
Principles and Part II the Rules.102 The Principles are “statements
expressing in general terms the ethical and professional ideals that CFP
Board designees are expected to display in their professional
activities.”103 The seven articulated principles are: (1) Integrity, (2)
Objectivity, (3) Competence, (4) Fairness, (5) Confidentiality, (6)
Professionalism, and (7) Diligence.104 The CFP Board describes the
Principles as “aspirational in character,” but “intended to provide a
source of guidance” for CFPs, and comments follow each Principle and
further explain the meaning of the Principle.105 The Principles are
accompanied by rules that “describe the standards of ethical and
professionally responsible conduct expected of [CFPs] in particular
For example, Principle 1—“Integrity”—states: “A CFP Board
designee shall offer and provide professional services with integrity.”107
The comments to the principle maintain, inter alia, that “[i]ntegrity
demands honesty and candor which must not be subordinated to
personal gain and advantage.”108 Coordinating Rule 102 requires that,
“[i]n the course of professional activities, a CFP Board designee shall
not engage in conduct involving dishonesty, fraud, deceit or
misrepresentation, or knowingly make a false or misleading statement to
a client, employer, employee, professional colleague, governmental or
other regulatory body or official, or any other person or entity.”109
Principle 4—”Fairness”—and the accompanying Rules are
especially relevant to the retail sale of mutual funds and the potential
conflicts of interest herein addressed. It requires that CFPs perform their
professional services “in a manner that is fair and reasonable to clients,
principals, partners and employers, and shall disclose conflict(s) of
interest in providing such services.” 110 The comments state:
Fairness requires impartiality, intellectual honesty and disclosure of
conflict(s) of interest. It involves a subordination of one’s own
feelings, prejudices and desires so as to achieve a proper balance of
conflicting interests. Fairness is treating others in the same fashion
that you would want to be treated and is an essential trait of any
Rule 402 requires a CFP in a “financial planning engagement [to
make] timely written disclosure of all material information relative to
the professional relationship.” 112 Further, “in all circumstances and
prior to the engagement,” the CFP must disclose in writing conflict(s) of
interest and sources of compensation.113 The CFP must also “inform the
client or prospective client of his/her right to ask at any time for
information about the compensation of the [CFP].”114
There exists a safe harbor provision for CFPs who provide clients
or prospective clients with certain written disclosures using SEC Form
ADV or similar disclosure documents. The form must include:
• A statement that in reasonable detail discloses (as
applicable) conflict(s) of interest and source(s) of, and any
contingencies or other aspects material to, the CFP Board
• A statement describing material agency or employment
relationships a CFP Board designee (or firm) has with third
parties and the nature of compensation resulting from such
• A statement informing the client or prospective client of
his/her right to ask at any time for information about the
compensation of the CFP Board designee.115
Rule 403 of the CFP Code of Ethics states that “[u]pon request by a
client or prospective client, the [CFP] in a financial planning
engagement shall communicate in reasonable detail the requested
compensation information related to the financial planning engagement,
including compensation derived from implementation.”116 Rule 404
mandates that disclosures required under Rule 402 shall be offered at
least annually for current clients, and provided if requested.117
Principle 6 – “Professionalism” – bears upon the matter of
selfpolicing. It states that “[a CFP’s] conduct in all matters shall reflect
credit upon the profession.”118 Generally, Rule 603 requires the CFP
who has “non-confidential knowledge” (defined as “no substantial
doubt”) that another CFP Board designee has committed a violation of
the CFP Code of Ethics “which raises substantial questions as to the
designee’s honesty, trustworthiness or fitness” to promptly inform the
CFP Board.119 Rule 604 requires the CFP with non-confidential
Code of Ethics and Responsibility: Rules, supra note 109, R. 603.
knowledge which raises a substantial question of unprofessional,
fraudulent or illegal conduct by another CFP or other financial
professional to “promptly inform the appropriate regulatory and/or
professional disciplinary body.”120 Rule 605 requires the CFP who has
reason to suspect illegal conduct within his or her organization to “make
timely disclosure of the available evidence” to his or her “immediate
supervisor and/or partners or co-owners.”121 Further, “if the [CFP] is
convinced that illegal conduct exists within [his own] organization, and
that appropriate measures are not taken to remedy the situation, the
[CFP] shall, where appropriate, alert the appropriate regulatory
authorities . . . in a timely manner.”122
The CFP Code has formal disciplinary procedures in place and
several possible forms of discipline defined. The disciplinary
procedures were designed to ensure a fair and reasonable process. The
steps in that process are:
(1) Receipt of a written request for investigation.
(2) Investigation of the complaint by CFP Board Staff Counsel.
(3) Determination of probable cause by CFP Board Staff Counsel.
(4) Formation of a hearing panel to review all evidence from both
(5) Submission of hearing panel findings to the Board of
Professional Review, which renders a decision.
(6) The aggrieved may petition the decision to the Board of
The possible forms of discipline are: a private written censure, a
public letter of admonition, suspension for up to five years, and
permanent revocation of the CFP designation.124 Notably, the CFP
Board recently proposed significant changes to its Code of Ethics and
Professional Responsibility and Financial Planning Practice Standards,
Elimination of the written notice informing clients of their
right to ask at any time for information about the CFP’s
sources of compensation, and an annual offer of disclosure
of important information about the CFP;
• Elimination of a current requirement that CFPs report
infractions of the Code of Ethics by other CFPs; and
• Creation of a new fiduciary standard for all certificants, but
allowing use of a lower standard if set forth in the client
The comment period ended September 25, 2006.126
B. Financial Planning Association
The Financial Planning Association (FPA) was created by the union
of the International Association for Financial Planning (IAFP) and the
Institute of Certified Financial Planners (ICFP).127 The FPA’s
“individual members include financial planners, accountants, attorneys,
bankers, charitable giving specialists, insurance agents, stockbrokers,
money managers, investment consultants, broker-dealer and corporate
executives, and others.”128 The FPA has nearly 30,000 financial
planners, allied professionals and organizations that advance the
financial planning process.129 Members of the FPA are mandated to
adhere to the FPA Code of Ethics.130 The “FPA’s Ethics Committee is
charged by its Board of Directors with reviewing alleged violations of
the FPA Code of Ethics and advising staff on ways to enhance
awareness by FPA members of their obligations under the Code.”131
According to the FPA, its guidelines capture the essence of the Certified
Financial Planners Board of Standards Code, addressed above, but make
the FPA Code applicable to all FPA members whether or not they are
also CFPs.132 It employs the same seven principles, but does not include
the associated rules that the CFP Code puts forth.133
C. Chartered Financial Analyst Institute134
The Chartered Financial Analyst Institute (the “CFA Institute”)
includes 89,981 individual voting members in 130 countries.135
Individual members either hold the Chartered Financial Analyst (the
“CFA”) designation or are active in the investment business.136 All
members must abide by the CFA Institute’s Code of Ethics and
Standards of Professional Conduct.137 The latest Code of Ethics and
Standards of Professional Conduct became effective January 1, 2006.138
Violations may result in disciplinary sanctions by the CFA Institute:139
All alleged violations of the code and standards are investigated by
the designated officer (a regular member of CFA Institute appointed
by the CFA Institute Board of Governors). Upon completion of an
investigation, if the designated officer determines a violation of the
code and standards occurred, the designated officer recommends a
disciplinary sanction. The [CFA] member . . . may accept the
designated officer’s recommendation or proceed to a Hearing
Potential sanctions include revocation of membership and the right
/about/Princ.s/ethics.cfm (last visited Mar. 23, 2007).
133. Id. at Princ. 1.
134. Formerly known as the Association for Investment Management and Research.
135. CFA Institute, About Us, http://www.cfainstitute.org/aboutus/index.html (last
visited Mar. 23, 2007).
136. CFA Inst., About Us: Membership, http://www.cfainstitute.org/aboutus/
overview/index.html (last visited Mar. 23, 2007).
138. CFA Inst., Code of Ethics and Standards of Professional Conduct,
http://www.cfainstitute.org/centre/ethics/code (last visited Mar. 23, 2007).
139. CFA Inst., CODE OF ETHICS AND STANDARDS OF PROFESSIONAL CONDUCT:
PREAMBLE, http://www.cfainstitute.org/centre/ethics/code/pdf/english_code.pdf (last
visited Mar. 23, 2007).
140. CFA Inst., Disciplinary Procedures: Procedure, http://cfainstitute.org/aboutus/
conduct/complaint/discipline.html (last visited Mar. 23, 2007).
to use the CFA designation.141
The CFA Institute Code of Ethics requires members to:
• Act with integrity, competence, diligence, respect, and in an
ethical manner with the public, clients, prospective clients,
employers, employees, colleagues in the investment
profession, and other participants in the global capital
• Place the integrity of the investment profession and the
interests of clients above their own personal interests.143
• Use reasonable care and exercise independent professional
judgment when conducting investment analysis, making
investment recommendations, taking investment actions,
and engaging in other professional activities.144
• Practice and encourage others to practice in a professional
and ethical manner that will reflect credit on themselves and
• Promote the integrity of, and uphold the rules governing,
• Maintain and improve their professional competence and
strive to maintain and improve the competence of other
There are seven sections of the CFA Institute Standards of
Professional Conduct: I. Professionalism; II. Integrity of Capital
Markets; III. Duties to Clients; IV. Duties to Employers; V. Investment
Analysis, Recommendations, and Action; VI. Conflicts of Interest; and
VII. Responsibilities as a CFA Institute Member or CFA Candidate.148
As its name suggests, Section VI is particularly applicable to the retail
sale of mutual funds and the conflicts of interest addressed in this paper,
especially subsections A and C:
142. CFA Inst., CODE OF ETHICS AND STANDARDS OF PROFESSIONAL CONDUCT:
THE CODE OF ETHICS, available at
http://www.cfainstitute.org/centre/ethics/code/pdf/english_code.pdf (last visited Mar.
148. Supra note 142.
A. Disclosure of Conflicts. Members and Candidates must make
full and fair disclosure of all matters that could reasonably be
expected to impair their independence and objectivity or interfere
with respective duties to their clients, prospective clients, and
employers. Members and Candidates must ensure that such
disclosures are prominent, are delivered in plain language, and
communicate the relevant information effectively. 149
C. Referral Fees. Members and Candidates must disclose to their
employer, clients, and prospective clients, as appropriate, any
compensation, consideration, or benefit received from, or paid to,
others for the recommendation of products or services. 150
D. American Institute of Certified Public Accountants
Certified Public Accountants (CPAs) are bound by the Code of
Professional Conduct of the American Institute of Certified Public
Accountants. Like the CFP Code, the American Institute of Certified
Public Accountants (AICPA) Code consists of two sections: (1) the
Principles; and (2) the Rules.151 The Principles provide the framework
for the Rules that govern the performance of professional services by
members.152 “Compliance with the Code of Professional Conduct . . .
depends primarily on members’ understanding and voluntary actions,
secondarily on reinforcement by peers and public opinion, and
ultimately on disciplinary proceedings, when necessary, against
members who fail to comply with the Rules.”153 The Rule most relevant
to compensation for mutual fund sales is 503(b) which requires a
member in public practice who is not prohibited from receiving
commissions and “who is paid or expects to be paid a commission, [to]
disclose that fact to any person or entity to whom the member
recommends or refers a product or service to which the commission
149. Id. at VI. Conflicts of Interest.
151. Am. Inst. of Certified Pub. Accountants, AICPA CODE OF PROFESSIONAL
CONDUCT: COMPOSITION, APPLICABILITY, AND COMPLIANCE (2006), available at
relates.”154 Other similar professional organizations include the Institute
of Certified Bankers and the National Association of Insurance and
Financial Advisors (LUTC, FSS, ChFC, and CLU designations).
V. RECOMMENDATIONS FOR CHANGE
The SEC, NASD, Congress, and the mutual fund industry are
investigating ways to provide better and more standardized disclosure of
mutual fund fees and expenses. Many experts argue that clearer
disclosure of fund fees will not only help investors make better-informed
decisions, but will improve price competitiveness within the industry.
In early 2004, the NASD formed the Mutual Fund Task Force to
consider issues relating to distribution arrangements, portfolio
transaction costs, and soft dollar payments. 155 The Task Force was
comprised of industry executives representing mutual fund management
companies and broker-dealers, and representatives of the academic and
legal communities.156 The Task Force concluded that,
[m]any of the developments in distribution payments since the
adoption of Rule 12b-1 have benefited investors by allowing them to
choose to pay distribution costs up-front, over time, or when fund
shares are redeemed. At the same time, the variety and complexity
of these choices, and the fact that many distribution costs are
incurred at the fund level, may tend to obscure the extent of these
costs and the incentives that they may create.157
The Task Force suggested “that the most important changes that the
[SEC] should consider are those that make the costs and potential
conflicts associated with mutual fund distribution more visible to the
retail investor.”158 The Task Force also recommended that visibility be
increased by the requirement that a short, easy-to-understand document
be made available to investors at the point of sale.159 Dubbed the
154. Am. Inst. of Certified Pub. Accountants, AICPA CODE OF PROFESSIONAL
CONDUCT R. 503(b) (2006), available at http://www.aicpa.org/about/code/sec500.htm.
155. NASD, REPORT OF THE MUTUAL FUND TASK FORCE: MUTUAL FUND
DISTRIBUTION 1, available at http://www.nasd.com/web/groups/R.s_regs/documents/
R.s_regs/nasdw_013690.pdf (last visited Mar. 27, 2007).
157. Id. at 2.
“Profile Plus,”160 it is a two-page document that includes key
characteristics of the fund and all fees and expenses of the fund,
including the costs and potential conflicts associated with mutual fund
Page one contains a statement describing the fund’s principal
investment strategies and principal investment risks.162 It also includes
charts detailing the fund’s total return over the past ten years, “and a
chart that shows average annual return of the fund over the past 1-, 5-,
and 10-year periods.”163 Page two focuses on “the costs associated with
fund ownership and possible conflicts of interest.”164 It includes a “Fees
and Expenses” table that would “show the total fees and expenses paid
by a shareholder - both transaction fees and fund operating expenses
based on the fund’s current prospectus.”165 The costs are to be presented
both in dollars and as a percentage, based on hypothetical investments of
$1,000, $50,000 and $100,000.166 In addition, the fund’s total
“operating expenses is not to be presented as a single number, and not
broken down into components.”167 The Task Force believes that
investors are interested mainly in the total amount of fees they pay rather
than in a detailed breakdown of the various components.168 Page two
also provides an explanation of “portfolio transaction costs and portfolio
Another major section on page two is titled “Potential Conflicts of
Interest.”170 It provides information about revenue sharing and
differential compensation arrangements through two “yes/no”
questions.171 The first is, “Does the fund or its affiliates pay XYZ Firm
extra to promote this Fund over other similar funds?”172 If the answer is
yes, an investor can click on a hyperlink to additional information about
the revenue sharing payments received by the broker/dealer.173 The
second question is, “Does XYZ Firm pay its personnel more for selling
this Fund than for selling other similar funds?”174 Again, if the answer
is yes, the investor can access a hyperlink to additional information
about the differential compensation arrangements that the broker-dealer
has with its registered representatives.175
The Task Force also recommended that all broker-dealers be
required to provide the Profile Plus, dealer disclosure statement, and the
fund’s prospectus on their web sites.176 It further recommended that a
registered representative refer the investor to the Profile Plus at the time
that the representative makes a recommendation to invest in a particular
fund, stating that the Profile Plus contains important information
concerning costs and potential conflicts of interest.177 In November
2004, the Commission proposed an “access equals delivery” approach to
prospectus delivery, under which investors would be presumed to have
access to the internet, and issuers and intermediaries could satisfy their
delivery requirements by posting the required information on their
It is obvious that something needs to be done to eliminate, or at
least to reduce, the conflicts of interest that have been created by
revenue sharing, directed brokerage, differential compensation, and soft
dollar commissions. It appears there are two alternatives, either to make
the practices illegal, as the SEC recently did with directed brokerage, or
to make those practices more transparent, so that investors are aware of
the potential for conflicts of interest. The Profile Plus document
developed and recommended by the NASD’s Mutual Fund Taskforce
does a good job of divulging the information that investors need in order
to uncover and understand the potential conflicts.
The approval of 12b-1 fees in 1980 made revenue sharing and
differential compensation possible. It also led to the formation of
different classes of mutual fund shares, which allows investors to choose
the way they pay the fees associated with mutual fund investment. That
represents an advantage for potential shareholders, which we feel
overcomes the associated costs, and the conflicts of interest for financial
advisers. Certainly those practices need to be disclosed to a greater
extent, and the Profile Plus does that.
Both directed brokerage and soft dollar payments involve payments
to brokerage firms in the form of commissions for executing portfolio
transactions in exchange for recommending the funds to clients or for
providing services (most commonly investment research). These
payments are thus hidden in the overall transaction costs of the fund, and
would not be apparent to the vast majority of investors. On the other
hand, revenue sharing and differential cash compensation are part of the
fund’s 12b-1 plan, and are clearly payments made in exchange for
recommending the fund to investors.
Each of the four practices involves the potential for conflicts of
interest, but in directed brokerage and soft dollar payments, the
payments are made in the form of commissions and it is difficult to
separate the part of the commission that represents payment for
recommending the fund from the payment for the execution of trades.
With revenue sharing and differential compensation, there is no question
as to what the payments represent. Thus the potential conflict of interest
is more transparent.
Some feel, however, that disclosure is not enough. In 2004, Senator
Carl Levin (D-Michigan) stated,
Even if an investor is clearly told that his or her broker is getting
paid to promote a mutual fund, the investor is left wondering
whether the broker’s recommendation is based on the mutual fund’s
merits or the broker’s financial benefit. Disclosure does not resolve
the conflict; it allows revenue sharing payments to continue to
undermine objective investment advice. The better course of action
is to ban revenue sharing from the mutual fund marketplace.179
Our feeling is that if an investor is “left wondering” whether the
broker’s recommendation is unbiased, he or she should raise the issue
with the broker. If the broker’s response is unsatisfactory, the investor
should find another broker. If a sufficient number of investors do this,
179. Ending Conflicts of Interest at Mutual Funds: The Mutual Fund Reform Act:
Hearing Before the Senate Committee on Banking, Housing and Urban Affairs, 108th
Cong. (2004) (statement of Sen. Carl Levin), available at http://www.senate.gov/~levin
revenue sharing will be eliminated from the marketplace by making the
funds and brokers who engage in the practice uncompetitive with those
that do not.
Our recommendations are for soft dollar commissions to be
eliminated, just like directed brokerage. Those costs are too easily
hidden from investors. But revenue sharing and differential
compensation should be allowed to continue as long as the Profile Plus
and the associated recommendations of the taskforce are implemented.
While it is tempting to recommend outlawing those practices as well
because they do create the potential for conflicts of interest, we feel the
transparency of those practices makes their cost acceptable, given the
benefit that different classes of funds provide in allowing investors to
choose the way that they pay the costs associated with mutual fund
38. Id .
39. Lori Walsh , U.S. Securities and Exchange Commission, The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Return, at 6, available at http://ftp.sec.gov/rules/proposed/s70904/lwalsh042604.pdf. (last visited Mar . 19 , 2007 ).
40. 17 C.F.R. § 270 .12b- 1 ( 2005 ).
41. INV. CO. INST., How Mutual Funds Use 12b-1 Fees , Fundamentals: Investment Company Institute Research in Brief, Vol. 14 , No. 2 , p. 2 ( 2005 ), available at http://www.ici.org/statements/fundamentals/fm-v14n2. pdf .
42. Supra note 4, at 4.
43. Supra note 39, at 5.
46. SEC Prohibition on the Use of Brokerage Commissions to Finance Distribution , 17 C.F.R. § 270 ( 2004 ), available at http://www.sec.gov/rules/final/ic26591.htm.
47. Id .
48. See Thomas R. Smith , Jr. , Sidley Austin Brown and Wood, Mutual Funds Under Fire: Developments Since January 1 , 2003 (Jul. 1 , 2005 ), at 1, available at http://www.sidley.com/db30/cgi-bin/pubs/TRS%20Chronology% 20 - % 20VERSION% 2012 %20070105.pdf.
49. Id .
50. Thomas R. Smith , Jr. , Mutual Funds Under Fire: Reform Initiatives, 7 J. OF INV. COMPLIANCE 4 ( 2006 ).
65. 15 U.S.C. § 80b ( 2004 ).
66. 15 U.S.C. § 77a- aa ( 2005 ).
67. 15 U.S.C. § 78a- mm ( 2005 ).
68. Pub . L. 107 - 204 , 116 Stat. 745 ( 2002 ).
69. 15 U.S.C. § 80a ( 2005 ).
70. 15 U.S.C. § 80b ( 2004 ).
71. Pub . L. No. 106 - 102 , 113 Stat. 1338 ( 1999 ).
72. 31 U.S.C. §§ 5311 - 14 ; 5316 - 32 ( 2001 ).
73. See generally Investment Advisor Code of Ethics, supra note 64.
74. CONNECTICUT BANKING COMMISSION , Investment Advisory Codes of Ethics (Feb . 2005 ) available at http://www.ct.gov/dob/cwp/view.asp?a= 2252 &dobNAV_GID = 162 &q= 299220 .
75. Id .
76. Id .
77. SEC Disclosure Regarding Portfolio Managers of Registered Management 100 . Beginning in 2003, many of the biggest fund companies, including Janus Capital Group Inc. and Invesco Funds Group Inc., were charged by regulators with allowing some investors to make unorthodox trades that hurt the funds' long-term shareholders. At the same time, Wall Street firms were charged with withholding commission discounts from mutual-fund investors who had been eligible for the discounts . See Eleanor Laise , How to Check Up on Your Mutual Fund-New Web Tools Help Investors Take Advantage of Flood of Data Now Required by Regulators, WALL ST . J., Dec . 14 , 2005 , at D1 (discussing the ability of consumers to monitor mutual fund institutions).
101. Certified Fin . Planner Bd. of Standards , Code of Ethics and Professional Responsibility, available at http://www.cfp.net/learn/ethics. asp (last visited Mar . 23 , 2007 ).
102. Id .
103. Id .
104. Certified Fin . Planner Bd. of Standards , Code of Ethics and Professional Responsibility: Principles, available at http://www.cfp.net/learn/ethicsPrinc.s. asp (last visited Mar . 23 , 2007 ).
105. See Code of Ethics and Professional Responsibility, supra note 101.
106. Id .
107. Supra note 104.
108. Id .
109. Certified Fin . Planner Bd. of Standards , Code of Ethics and Responsibility: Rules, http://www.cfp.net/learn/ethicsR.s. asp (visited last Mar . 23 , 2007 ).
110. See Code of Ethics and Professional Responsibility: Principles, supra note 104, at 4.
111. Id .
112. Code of Ethics and Responsibility: Rules, supra note 109, at R. 402 .
120. Id . at R. 604 .
121. Id . at R. 605 .
122. Id .
123. Certified Fin . Planner Bd. of Standards , Disciplinary Procedures: Disciplinary Process and Procedures, available at http://www.cfp.net/learn/procedures. asp (last visited Mar . 23 , 2007 ).
124. Id . at Forms of Discipline.
125. See generally Certified Fin . Planner Bd. of Standards , Exposure Draft, available at http://www.cfp.net/Downloads/Attachment_A.pdf (last visited Mar . 27 , 2007 ); see generally Certified Fin . Planner Bd. of Standards , Exposure Draft Overview, available at http://www.cfp.net/Downloads/Overview.pdf (last visited Mar . 27 , 2007 ). For Financial Planning Association member comments regarding the CFP proposed changes see Financial Planning Association website at http://www.fpanet.org/member/ ethicsresponse. cfm (last visited Mar . 27 , 2007 ).
126. Certified Fin . Planner Bd. of Standards, Exposure Draft of Proposed Revisions to CFP Board's Ethical Standards: Comment Period Ends Sept . 25 , 2006 , CFP Bd . News (Sept. 7 , 2006 ) available at http://www.cfp.net/certificants/boardreport_ 9_ 2006 .asp.
127. Fin . Planning Ass'n, FPA Overview , available at http://www.fpanet.org/global/ about/overview.cfm (last visited Mar . 23 , 2007 ).
128. Fin . Planning Ass'n , About FPA , available at http://www.fpanet.org/ member/about/index. cfm (last visited Mar . 23 , 2007 ).
129. Fin . Planning Ass'n, Institutional Membership , available at http://www.fpanet. org/member/membership/corporate/instindex. cfm (last visited Mar . 23 , 2007 ).
130. Supra note 128.
131. See Fin. Planning Ass'n , Code of Ethics, http://www.fpanet.org/member