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January 01, 2004 at 02:00 AM
The mutual fund scandal seems likely to usher in regulatory reform that goes beyond the late traders and market timers, beyond the hedge funds and fund managers who enriched themselves through insider trading, and beyond the fund companies themselves that were complicit in unethical behavior. The scandal seems likely to change the way independent broker/ dealers conduct their business, and it is likely to affect the way many B/Ds price themselves to reps, i.e., your payouts.
Like it or not, undisclosed dealings between B/Ds and fund companies are going to end. The dirty little secret of the independent broker/dealer business, which is arguably not so secret, not so little, and not so dirty, is that independent B/Ds derive much of their revenue from mutual fund company shelf space arrangements. In fact, that idea–of making money by giving marketing access to a field force of reps–is commonly applied beyond funds to other products and services that reps need, separate account platforms, software vendors, and other services and products. These arrangements help allow a B/D to offer 95% or 100% payouts. The B/D, instead of relying totally on money paid to them by their reps, also relies on revenue from these marketing deals. These marketing arrangements subsidize rep payouts.
Regulatory reform that many observers expect to be imposed as a result of the spreading fund scandal, however, seems likely to spell an end or, at a minimum, a curtailment to these undisclosed payments fund companies make to independent B/Ds. B/Ds and fund companies are likely in the future to be required to disclose these arrangements. That dose of transparency could lead to a repricing by B/Ds. If they can no longer get revenue on these fund company marketing deals, a key revenue source for many B/Ds, then they’ll need to lower payouts and, effectively, raise the price reps must pay for their service.
B/D executives, while acknowledging that sweeping reform and greater disclosure are likely, make a strong case that it’s unfair, and that it won’t even help investors. It’s fair to say that many B/D executives and reps would not welcome reform, but their voices are likely to be drowned out by the cry for fuller disclosure.
The Shape of Reform
As regulators and lawmakers contemplate reforms to be enacted, even as the fund investigation widens and ensnares more firms, a public discussion about the shape of the reforms and how they might affect the independent advisor industry is wise for B/Ds and reps. Personally, I think fuller disclosure of these marketing arrangements is a good idea. But that’s my personal bias. I’m a reporter. I like everything out in the open. I believe that advisors can’t build trust and long-term relationships when a part of the terms with their customers is not disclosed, and that advisors should be on the same side as investors and investor protection. Those notions are probably a lot more reflective of where rulemakers are headed and what the public will demand in the coming weeks and months as the cries for reform grow stronger. This column should facilitate that public discussion, even if it agitates some of my friends in the industry.
First, it must be said that, when it comes to ethics, independent B/Ds own moral high ground that the wirehouses generally cannot yet reach. Independent reps can be proud of that fact, and leverage it in marketing, sales, and trust-building.
Wirehouses sell house brands, their own mutual funds, rather than other fund families. They double dip, making money not just on the sale but on the management and operation of the fund. That’s best for the brokerage house. Often, when the wirehouse makes more by selling one product, the broker also makes more on the sale. Wirehouses also cut lucrative deals with fund companies to sell their products, and as part of that deal a broker’s compensation may be materially higher for selling those favored funds than it is for sales of other funds. And then there are directed brokerage commission deals that fund companies give to wirehouses. These are key differences between independent reps and wirehouse reps, and customers would seem to have a right to know about these differences.
For independent B/Ds, fund company marketing deals are not as objectionable but do raise some questions. Some of the fund companies pay B/Ds an annual fee based on assets under management with the B/D’s reps. In some cases, the B/D gets paid by a fund company to sponsor a conference, a golf outing, or a luncheon speaker. Ads in newsletters, ads in e-mails, and easy access to the reps at B/D gatherings–fund companies thus buy influence. Is that okay? Should that be disclosed to clients? In fact, should those terms be disclosed to reps?
Most executives at independent B/Ds make a case against it. And I have to admit that, despite my personal bias toward full disclosure, they make a convincing case.
Jeff Auld, for instance, president and CEO of NEXT Financial Group in Houston, is clearly an honest man trying to do the right thing in running his B/D. “NEXT has selling agreements with 110 fund companies,” says Auld. “And if an advisor comes to me and tells me that we are missing a good fund, we’ll have 111. With anything that we do in terms of commission payout or payments, never do we bias or in any way influence the sale of one product over another.”
Joe Deitch, chairman and CEO of Commonwealth Financial Network in Waltham, Massachusetts, says there are practical reasons the industry has moved to shelf space deals, and there is nothing deceptive about it. “Say a brokerage firm with no intention of being deceptive or unfair is having a conference for its reps, and there is booth space for 10 fund companies,” says Deitch. “There are thousands of funds and hundreds may want space at a booth. Do you give it to the biggest funds? The ones with the best three-month track record? The best three-year record? Do you sell the booths to the highest bidders? Should there be a lottery?”
As a consequence, Deitch says, B/Ds must come up with a short list of fund families. “It’s just a matter of being practical,” he says. “Ultimately, though, it comes down to good judgment and not abusing the system.”
“Is the brokerage firm merely selling space to the highest bidders or is the B/D adding other incentives?” he says. “That’s the issue: Where does the B/D draw the line?” And Deitch says the “truly” independent B/Ds are not the problem. “Brokerage firms and other institutions owned by product manufacturers who influence their agents and customers, overtly and covertly, have more serious disclosure issues,” he says.
Access, Not Guarantees
Auld says he understands why fuller disclosure might be needed when a rep gets compensated better for selling one fund than another. But the marketing deals NEXT makes with fund companies is totally different.
“I would like to be able to tell a fund company to sponsor our conference or advertise in our newsletter and that they’ll be the best-selling mutual fund in our firm,” says Auld. “But the truth is, it isn’t necessarily so. And I can show you where a fund company that has almost made no effort to get a booth, sponsor anything, and that spends the least amount of marketing dollars with NEXT, is the number-one-selling fund company with our advisors.”
“I can no more guarantee that being a sponsor of my conference or advertising in my newsletter will give the mutual fund company results than your magazine’s ad sales department can guarantee that running a full-page ad on the inside cover of your magazine will create direct results,” Auld says.
