How High Can Costs Go?

Mutual fund distribution has never been more crucial. Nor has it ever been so expensive.

Mutual fund distribution has never been more crucial. Nor has it ever been so expensive.

By Rich Blake
May 2001
Institutional Investor Magazine

Mutual fund distribution has never been more crucial. Nor has it ever been so expensive. But as costs grow, so do questions surrounding “revenue-sharing,” a controversial way of paying brokerage firms for sales.

Stroll down the aisle of any American supermarket and take a close look at the shelves. There at eye level sits Ivory Snow or Tide detergent or Bounty paper towels. How they got so prominent a placement is no accident - or mystery - but a basic fact of consumer marketing. Procter & Gamble Co. and its rivals eagerly pay for the privilege, shelling out hundreds of millions of dollars a year for prime shelf space to entice customers and boost market share.

If it works for soap, why not mutual funds?

In this case, the Procter & Gambles are the mutual fund companies, and the Safeways are financial intermediaries, most often big brokerage houses like Merrill Lynch & Co. or Citigroup’s Salomon Smith Barney. Crudely put, the fund companies are paying ever-growing tariffs to those intermediaries to move their merchandise. All that sell through brokerages pay something; increasingly some pay quite a bit extra for the financial marketing equivalent of eye-level shelf space - access to brokers and salespeople to educate and cajole, wine and dine them, to sell the funds.

Few fund investors even know this goes on. But the payments - made to the brokerage firms, not to the brokers, and known euphemistically as revenue-sharing - have become an essential facet of the business. Although legal, they are increasingly controversial. Institutional Investor has learned that the payments have now drawn the attention of the Securities and Exchange Commission.

“Paying for distribution does raise questions,” says Douglas Schiedt, associate director of the SEC’s division of investment management. “We are taking a look to see whether more disclosure is necessary.”

And though many fund company executives defend the practice, there is evidence that a backlash is brewing. “Revenue-sharing payments have gotten so out of control that a lot of fund executives at small and midsize firms actually want to see regulators step in and put an end to it,” says Matthew McGinness, a consultant at Boston-based Cerulli Associates.

The sums involved are enormous. According to estimates by Boston-based strategic consulting firm Financial Research Corp., fund sponsors, mostly load players such as Franklin Resources, Putnam Investments and AIM Management Group, pay the Merrill Lynches of the world as much as $2 billion a year. By comparison, mutual fund companies spent $515 million on advertising in 2000, calculates FRC. It estimates that revenue-sharing fees have more than doubled in the past five years. “Revenue-sharing is considered the dirty little secret of the mutual fund industry,” says Neil Bathon, FRC’s founder and president. “Nobody likes to talk about it, but the reality is that it has become a major expense.”

The remarkable upsurge of revenue-sharing, which did not exist a decade ago, underscores a dramatic change in the mutual fund business. Even as the rising tide of the bull market lifted all yachts, certain fundamentals of the industry deteriorated. Now, in the grip of a nasty bear market, many mutual fund executives are struggling to keep their firms above water. With revenues shrinking as assets under management decline because of redemptions and poor performance, fund companies are caught in a classic squeeze as their costs continue to ratchet up.

“The cost of distribution is rising. Revenue-sharing is an increasingly large part of it, and it’s a cost that wasn’t there ten years ago,” says Lawrence Lasser, president of Putnam. “These deals have been protected and made worthwhile by the dramatic rise in assets. Now we see things starting to go the other way.”

Last month one public fund company after another began reporting lower earnings and falling operating margins. These announcements were accompanied by the grim news of layoffs - 4 percent of staff at Putnam, 24 percent at Janus Capital Corp. - and other cutbacks.

“The market has taken away a whole lot of revenue in a short period of time, and no company can reduce expenses that fast,” moans Edward Bernard, chief of retail sales and distribution for T. Rowe Price Associates. His firm saw operating margins drop in the first quarter to 32 percent, down from 41 percent a year ago.

A key underlying cause of this drop at T. Rowe Price, as well as at other companies, is the spiraling cost of distribution. A decade ago most funds were no-load and were sold directly to consumers through newspaper and radio ads and toll-free numbers. Today direct sellers are adding load funds to sell through brokerages, fund supermarkets and financial planners. In the past five years, the proportion of all funds sold by intermediaries

has soared from 60 to 80 percent, according to estimates by New York-based research firm Strategic Insight. Brokerage channels account for an increasingly big share of these sales - 45 percent last year, up from 32 percent in 1998, estimates FRC.

Today’s cost-squeeze stems in large part from the extraordinary success that mutual funds enjoyed in the 1990s as they became staples of consumer savings, igniting ever-fiercer competition. Shoppers can now rummage through 8,433 mutual funds, up from 3,086 a decade ago; even in last year’s wretched market, 221 new funds were launched.

To cut through this clutter, funds need strong performance and solid brand names. But in an era of open architecture - when just about everyone seems willing to peddle just about everyone else’s products - they also need a lot of help selling their wares. That has never been more true than it is today: February and March saw the first back-to-back months of net equity fund outflows since August and September 1990, after Iraq’s invasion of Kuwait. In March alone stock funds suffered a record-setting $20.6 billion in outflows. Hence the reliance on intermediaries and revenue-sharing.

“Simply having performance isn’t enough any more,” says Putnam’s Lasser. “Good numbers don’t sell themselves.”

As a result, just about every major fund family, including companies that have clung to direct sales, has embraced intermediary channels. In January Zurich Scudder Investments slapped sales loads on its entire lineup of 30 Scudder funds; Strong Capital Management added charges to six of its retail funds earmarked for distribution through brokerages. Both Janus and T. Rowe Price, historically major direct sellers, have been spending heavily to plug some of their funds into brokerage firm-sponsored mutual fund wrap programs and 401(k) platforms. Then there’s Waddell & Reed Financial, which has long relied on its own distribution network of 3,000 sales reps, mostly in the Midwest. Even it is selectively moving into brokerage channels for the first time. “We know the cost dynamics and are trying to approach distribution partners where it makes economic sense,” explains Thomas Butch, the company’s chief marketing executive.

Increasingly powerful, brokerages have used their leverage to exact ever-higher tolls. Technically compensation for any service connected to fund distribution - such as technology, annual meetings, special events, sales conferences and training seminars - revenue-sharing is simply money that fund companies pay brokerage houses to get access to their brokers. It’s a tab for renting the retail sales armies that most mutual fund companies don’t have.

For additional money, fund companies can buy their way onto the lists of “preferred” providers that most brokerage houses maintain. Often limited to a dozen or fewer fund companies, these lists are confidential and never revealed to the buying public or even to a firm’s brokers, though astute sales reps can figure them out. Preferred status carries real advantages: In some cases, the wholesale marketers of the fund companies can get virtually unfettered access to brokerage sales forces to convince them to sell their funds.

Revenue-sharing is just part of the cost. Distribution is the second-biggest expense for fund companies - after compensation. But a big chunk of that budget goes toward wholesale marketing costs. To reach intermediary channels, fund companies need to employ scores of high-paid marketers who, in effect, sell to the sellers. According to FRC, a fund company spends on average some $50 million a year compensating these sales executives.

For the intermediaries, all this money is manna from heaven. Revenue-sharing, paid in hard or soft dollars, comes in addition to the ordinary loads and sales commissions - typically 5 percent, and split between salesperson and firm. And it also comes on top of any so-called 12b-1 fees that fund companies are permitted to charge for marketing and distribution; as it is, the 12b-1 fee is gobbled up by the brokerage firms.

Loads, commissions and 12b-1 charges come right out of the fund shareholders’ pockets. Revenue-sharing comes straight off the fund companies’ bottom lines. When markets soared through the late 1990s and into 2000, no one complained too loudly. In good times, mutual funds enjoy extraordinary economics, collecting fees on ever-rising assets that have to be gathered only once. But there’s nothing like a bear market to make people growl.

Consider the cost pileup at Stilwell Financial, parent of fallen industry darling Janus. Even as assets at Stilwell fell to $205 billion from $324 billion about a year ago, the company spent heavily to get plugged into fund supermarkets, brokerage wrap programs and 401(k) platforms. In 2000 Stilwell shelled out $315 million on third-party distribution - more than double the $143 million it spent in 1999. In this year’s first quarter, Stilwell tempered its spending but still spent a substantial $66 million, down 9 percent from a year earlier. Revenues, meanwhile, dropped by 18 percent year over year.

Stilwell has company in feeling squeezed. The $215 billion load-giant Franklin Resources saw its revenues fall 6 percent in the first quarter compared with the same quarter a year ago. At the same time, operating expenses dropped by only 2 percent. “Underwriting and distribution expenses” were to blame, according to a company statement. The firm’s distribution margin - net under-writing and distribution fees less net underwriting and distribution expenses - fell from 11 percent a year ago to 9 percent in this year’s first quarter. Alliance Capital’s distribution margin fell from 22 percent in the fourth quarter of 2000 to 12 percent in the first quarter of this year.

“It’s one of those things that keep you up at night,” says Greg Johnson, president of Franklin’s U.S. retail and institutional arm. “Everybody knows there’s far more investment management capacity and limited distribution, and that in tough times distributors are known to squeeze suppliers.”

The squeeze may be hardest on small and midsize firms, adding more pressure for consolidation. Their profit margins have begun to lag those of their bigger rivals; three years ago the small firms were more profitable. In 1999 fund families with assets of $20 billion to $50 billion reported a median operating margin of 28.2 percent, a steep drop from the 38.5 percent average in 1998, according to West Conshohocken, Pennsylvania-based industry consulting firm Investment Counseling. Firms with assets of more than $50 billion posted a median margin of 35.2 percent in 1999, down slightly from 37 percent in 1998. “Distribution costs are rising, and the midsize money management firms are having to eat those costs,” says Mustafa Soylemez, an analyst at Investment Counseling.

“It used to be that only the major brokerages would charge for shelf space, but recently it has become more prevalent across all the channels - everyone is charging,” says Victor Ugolyn, CEO of $7 billion-in-assets Enterprise Group of Funds. “It’s tougher for the smaller firms to get in the door. But these deals are part of the business.”

There is, however, a growing debate about the propriety of these revenue-sharing arrangements, which inside the industry are intentionally opaque and to the outside world are all but invisible. The critical question: Does an investor have a right to know whether his broker or financial adviser, whose independent judgment he trusts, is possibly recommending a mutual fund in part because the fund company has paid the broker’s or adviser’s firm a substantial distribution fee?

Last year Paul Roye, director of the SEC’s division of investment management, directed his staff to advise whether additional disclosure should be required. No report has yet surfaced, though the SEC has commented in a related lawsuit.

“It’s pay to play, no question,” says a former top executive at one of the biggest mutual fund companies. “And it’s starting to stink.”

Not surprisingly, one of the most prominent critics of revenue-sharing is Jack Brennan, CEO of Vanguard Group, which has hung on to its pure no-load status and never made any payments to brokerages. “No one is forcing these companies to strike arrangements. The fact that brokers want to be compensated is not surprising,” he says. “The question is whether the clients should be informed that the funds they are being placed in are providing brokerage firms extra compensation. I think they should.”

Responds William Rittling, director of nonproprietary fund sales at Merrill Lynch: “For a distributor to assign costs to organizations who benefit from their infrastructure is not an unreasonable business proposition. Do the fund companies want to pay less? Yeah, sure. And they don’t have to pay if they don’t want to. For them, it’s a simple business decision, simple math.”

Mutual fund math has certainly changed over the years. Back in the late ‘70s and early ‘80s, selling funds was a straightforward business. No-load firms followed a simple business model, selling their wares, overwhelmingly money market funds, directly to consumers tired of low passbook rates at their local banks. Fund companies invested in marketing and advertising campaigns to build their brands, taking orders on toll-free telephone networks or by mail. Load funds, for which fund investors paid brokers an 8.5 percent sales commission, offered consumers a more expensive investment choice.

But as the stock market began its historic ascent in August 1982, the game changed. Equity funds took off, eclipsing money market and bond funds by 1991. And the number of funds exploded. In 1983, for example, the industry sold about 1,026 funds. By 1990 that total topped 3,000.

Those twin forces - the shift to stock funds and the proliferation of products - made it far more difficult for no-load funds to merely take out ads in The Wall Street Journal and wait for their phones to ring. Consumers were overwhelmed by choices, and direct sellers found it harder and harder to get their attention.

The two no-load giants, Fidelity Investments and Vanguard, flourished thanks to their powerful brand names - just as, thanks to its performance, Janus did in the late 1990s. But most other no-load families struggled.

No-load funds needed a new route to reach their potential customers - their own financial intermediaries - and they found it with the 1992 opening of Schwab’s OneSource. The fund supermarket, whose sales took off almost at once, emerged as a powerful new distribution channel, even as the success of the Schwab mart blurred the distinction between load and no-load funds. At Schwab, and later at other fund supermarkets, such as those run by Fidelity and TD Waterhouse, investors could buy top-performing funds, both load and no-load, without paying a brokerage sales commission. At the beginning, fund companies paid Schwab a fee of about 25 basis points on assets sold, to get into Schwab’s no-transaction-fee program. Before long, Schwab had increased the toll to 35 basis points.

Mainstream brokers woke up. They quickly calculated that if Schwab could exact a toll from fund families, they could do the same. Another factor played a part: The SEC began frowning on a common practice at brokerage firms, in which individual brokers received substantial incentives, including higher commissions and sales quotas, to sell in-house funds. The biggest wire houses - with the notable exception of Dean Witter Reynolds - began to distribute a higher percentage of outside funds. In 1996 roughly 22 percent of total fund net flows went to wire house brokerage firms’ proprietary funds, according to Cerulli Associates. Two years later that percentage had fallen to just 3 percent, and last year the flows were negative.

Brokerages began moving more money away from transaction-based activities and into wrap accounts - long-term, asset-based fee programs featuring funds. So at the same time that the load players jumped into no-load supermarket channels, no-load players such as T. Rowe Price and Janus were plugging into broker-sold wrap programs that allowed the investor to access a range of fund products for a single asset-based fee.

Schwab’s success helped shift the industry toward the “open architecture” model. Whereas mutual fund providers had once struck exclusive arrangements with particular distributors, now every channel became fair game. To compete, fund companies needed to be in every channel. With thousands of funds and just a handful of national full-service brokerages, wire houses like Merrill, PaineWebber and Smith Barney held the upper hand.

“The brokerage firms know they are a scarce resource,” says Guy Moszkowski, a Salomon Smith Barney analyst covering money management and brokerage firms. “So in recent years they have been able to extract more money from fund managers. That will only go up; and the reality is, managers can’t do anything about it.”

The first step in cementing a deal between the brokerages and fund managers is what’s known as a selling-group agreement. This is a legally binding contract among the brokerage house, the underwriter or sponsor of the fund and the fund manager. For fund companies, one measure of success in a world of open architecture is the number of signed selling-group agreements it holds. For example, Conseco Capital Management, which got into the game only three years ago, boasts that it has formed about 200 selling-group agreements with brokerages and banks.

The selling-group contract defines the terms of the relationship, such as which funds will be sold - in other words, which goods the store will stock. But just having something in inventory doesn’t mean it’s going to sell; the merchandise needs to move off the shelves.

Just as fund companies need to cut through the clutter of all the funds available for sale, they must also attract the attention of the average salesperson, who might familiarize himself with just a handful of funds among hundreds in any given asset category. (There are, for example, more than 800 large-cap growth funds, according to Morningstar.) Brokers need to be motivated; and to get the chance to motivate them, fund companies must first motivate the brokers’ employers.

That’s where revenue-sharing comes in. If it pays enough, the fund company can get amazing - and rewarding - access to the brokerage sales force. Even fund giant Fidelity has aggressively stepped up wholesaling efforts for its broker-sold funds, which were launched in 1986 but doubled in number and in assets during the past four years.

“To be on the preferred lists, to gain access, you have to pay,” says Michael Kellogg, head of distribution at Fidelity Investments Institutional Services, which distributes the adviser-sold funds at Fidelity. These funds account for about $60 billion of the firm’s roughly $900 billion in assets under management. “The cost to distribute through the large brokerage firm has been going up, but it’s not unreasonable; otherwise we wouldn’t pay it.”

Neither Kellogg nor any other fund company executive interviewed for this story would specify how much he pays, or to what brokerages. Revenue-sharing takes place in a gray world, with minimal disclosure. Brokerages and fund managers appear to want to keep it that way, in part to prevent firms from exchanging information and possibly getting better terms. As a result, there is little hard information about pricing and terms, and much scuttlebutt.

One example: It’s widely rumored among jealous fund company executives that Capital Research and Management Co., does not make revenue-sharing payments for its top-performing, and broker-sold, American Funds. Not true, says CRM president James Rothenberg: “Contrary to what people think, we do make these payments - just not on the same level as most other firms.”

The structures of the selling-group agreements vary, depending on the levels of access accorded, as well as the type of program that a fund company wants to be in - direct mutual fund sales versus wrap programs, for example. The revenue-sharing deals are done sotto voce; the specific terms kept confidential. Rarely are they even committed to writing. Fund companies pay their tabs through a mix of hard and soft dollars. Says FRC consultant Gavin Quill, “This information is something of a closely guarded secret.”

The SEC refers to this type of remuneration as “non-12b-1 payments"; and because the money does not come from shareholder assets, there is no legal limit on what fund companies can pay. “There’s no mandate that the payments have to be disclosed,” points out James Folwell, a consultant with Cerulli Associates. “Different brokerage firms strike different deals with different fund companies, and you don’t want anyone doing any comparison shopping. You don’t put a sticker price on a used car in a lot - you see what the market will pay.”

To the extent that funds do disclose payments, they keep the details to a minimum. A 1995 Alliance Capital Management fund prospectus, for example, refers to “substantial monies” paid to broker-dealers and other financial intermediaries “for their distribution assistance.” “There is no real standard fee,” says Cerulli’s Folwell. “It might be based on a percentage of assets or gross sales, or it might be a straight dollar amount.” The extra payments were traditionally set as a percentage of gross fund sales, but increasingly they are pegged to a percentage of fund assets under management at the brokerage firm. The payments can include up-front hard dollars earmarked for special events, though fund companies are frequently asked to write additional checks to brokerage firms for sales conferences and training seminars.

Brokerage firms may also require fund companies to direct certain minimal amounts of brokerage business their way on a quarterly basis. According to a former mutual fund executive, the soft-dollar payments are sometimes referred to as “marketing credits,” because the fund manager is effectively providing directed commission revenue that is supposed to be earmarked by the brokerage firm for shared marketing expenses.

“There are squishy aspects to this,” says Folwell. “You could pay the brokers with a combination of a check for hard dollars and directed brokerage. Some brokerages want hard dollars. It always varies.”

Adds Richard Phillips, a securities lawyer with Washington, D.C.-based Kirkpatrick & Lockhart: “It’s perfectly legal for a fund manager to pay money for shelf space. The companies would prefer not to pay, but this is the cost of doing business.”

How high is this “cost of doing business”? FRC’s educated estimate: Some funds pay brokerages and financial supermarkets as much as 40 basis points for each net new dollar in assets. That’s up from an estimated 10 to 15 basis points five years ago. “The cost of plugging into the brokerage firms has substantially increased,” consultant Quill says.

FRC figures that revenue-sharing represents a fund company’s second-largest distribution expense. The No. 1 component: compensating a fund’s sales force, which averages about $50 million for a $60 billion fund group.

Merrill’s Rittling declines to comment on the specifics of his firm’s selling agreements, but he concedes that the cost of doing business with Merrill has risen considerably over the past three years. But then, Merrill can command top dollar. Rittling holds the keys to direct mutual fund sales by 15,000 brokers worldwide, and no army of brokers sells more funds than does Merrill. Of the $340 billion in fund sales through brokerages in 1999, Merrill accounted for roughly 20 percent. Analysts estimate that the firm accounted for the same share in 2000.

One clear sign of the firm’s clout: In August 1996 Merrill sent a letter to fund managers stating that the firm expected to be compensated at a rate not lower than that of any other brokerage. Vendors must pay “maximum dealer compensation offered or paid to any seller,” the letter stated. “Because we believe that our superior service is deserving of compensation at the highest level, we are asking you to agree to [these] terms.”

“Merrill basically sent out the message that it expects a most-favored-nation status,” says Burton Greenwald, a mutual fund consultant based in Philadelphia. “Everybody wants to get into the Merrill system. There’s just not room for everybody; so Merrill can be selective, and it can demand more from the providers.”

Merrill Lynch has signed approximately 100 selling agreements with mutual fund companies. Once a year, usually in December or January, Rittling will invite top mutual fund sales executives to come in for an assessment of the previous year’s program. According to one former fund sales executive, Rittling, who holds court in his office in Princeton, New Jersey, tends to be blunt. “He’ll give you a review of the past year, he’ll tell you how the funds are doing, whether they are in the top five or ten in terms of sales,” the executive says. “Eventually, he will say, ‘If you want to continue to be one of our premier providers, here’s what it’s going to cost.’ He’s pretty straightforward.”

During one such meeting a year ago, says the former fund executive, Rittling asked for $600,000 up front to cover conferences and sales meetings, plus 25 basis points on each net new dollar, as well as 10 additional basis points on ongoing assets. “It’s pretty much take it or leave it,” the executive says.

Rittling insists that Merrill has a level playing field, and many industry members agree that the firm does not offer preferential treatment to any of the 100 fund companies with which it does business. Once in the door, fund companies gain access to Merrill’s regional brokerage offices across the country to host training seminars and sales conferences.

That’s not how it works elsewhere. Other brokerage firms set up distinct tiers of access and privilege for the fund companies on their rosters. Second-tier funds sign revenue-sharing deals; but for the most exclusive entry to a brokerage sales force, a handful of funds pay for preferred status.

A second-tier fund company might be allowed to call on a brokerage’s branch offices a few times a year; but a preferred firm typically enjoys nearly unlimited access, an invaluable asset that allows fund company wholesalers to drop off literature, mingle with brokers and schmooze the branch managers, whose support is critical.

Preferred status at Salomon Smith Barney, well-informed sources report, is granted to AIM, Alliance, American Funds, Franklin Templeton, John Hancock Funds, Lord, Abbett & Co., MFS Investment Management, Oppenheimer Funds, Putnam and Van Kampen Funds. It means unlimited access to branch offices for grass-roots wholesaling as well as some active support from managers in pushing the product. Second-tier firms that do not have preferred status pay the basic revenue-sharing tithe, but they do not get any extra boost from branch managers and receive only limited access to the sales troops. “It’s just harder to get in the door unless you have preferred status,” says Keith Hartstein, Hancock’s director of sales and marketing.

A client will often trust his broker to select funds, and, as long as the performance is competitive, the broker is apt to routinely direct business to funds with which he is most familiar. Strong personal rapport between the fund wholesaler and the broker can often be the deciding factor when there are many options from which to choose.

“Brokers recommend funds for different reasons, but you’d be surprised at how important the goodies and perks are - the shirts, golf balls, trips,” as one veteran broker at a major wire house puts it. “With so many of these funds so similar, you wind up doing a lot of business with the guys who take care of you.”

Brokers may sell funds that don’t appear on their firms’ preferred lists. But they are far more likely to sell the names they know - and those are almost certainly funds that have paid the most to get the brokers’ attention. Edward D. Jones, for example, has selling agreements with about 100 fund companies, but the seven that are on its preferred list account for 90 percent of the firm’s $5 billion in annual fund sales, according to Cerulli Associates.

One industry statistic testifies to the power of the brokerages’ preferred lists. Nearly all of the ten largest broker-sold fund families - AIM, Alliance, American Funds, Fidelity, Franklin Templeton, Kemper Funds, MFS, Oppenheimer, Putnam and Van Kampen (which together account for 74 percent of broker-sold-fund assets) - pay for preferred status at the largest wire houses. Only three of these fund families - Alliance, American and Van Kampen - rank among Lipper’s ten best-performing fund families over the past five years.

The brokerages approach their preferred lists in different ways. Prudential Investments sports an A-list of 11 elite fund providers, or “strategic connections partners,” from among the nearly 100 fund companies with which it does business. These 11 are featured in a major marketing promotion that began this year. To pay for their preferred status, the fund companies are reportedly being asked by Prudential to begin to make revenue-sharing payments based on a percentage of their fund assets under management at the firm, not gross sales. In exchange, the funds’ wholesalers will be able to participate in quarterly and annual sales meetings.

PaineWebber keeps 16 firms on its select list. Six fund companies participate in the Morgan Stanley program, reportedly paying a traditional 25-basis-point 12b-1 fee and an annual 15-basis-point asset-based fee. That last charge is considered aggressive by wire house standards because it kicks in immediately and continues in perpetuity.

Revenue-sharing agreements between fund companies and brokerage firms have historically covered traditional fund sales, but there are other channels within each brokerage firm, including mutual fund and separate-account wrap products, variable-annuity wrap products and 401(k) platforms. Each channel usually falls under a different unit or division of the brokerage firm, and access to each comes at a separate price.

Salomon Smith Barney recently consolidated its dealings with outside fund managers. Where, previously, nonproprietary fund sales, the wrap program and annuities had each been headed up by a different executive, the activities are now under one distinct area managed by Jerry Hampton, who formerly ran only the annuity business. “These agreements are evolving from covering a single product toward a more consolidated relationship,” says Cerulli’s Folwell. “Some brokerage firms will have single points of contact for product lines.”

Whether the access to different channels comes ö la carte or on a pay-one-price basis, it doesn’t come cheap. Salomon’s mutual fund wrap program involves some 40 fund companies, which last year were asked to pony up $65,000 apiece to cover costs of annual and quarterly due-diligence meetings, five events in all, in which brokers were educated on the funds and the asset classes in which they invested. Usually these are weeklong seminars at warm-weather locations, during which a group of 100 to 200 of the top-producing brokers are invited to learn and listen to presentations made by fund executives - not to mention, play golf and schmooze.

FACING DECLINING CASH FLOWS INTO MUTUAL funds, companies believe they must pay up for prime shelf space. Things may get worse before they get better. “Distribution is so critical to fund companies as a source of growth that there is a possibility that it’s worth even more than what the brokerage firms are charging,” says Salomon’s Moszkowski. “In that case, the broker could get even more of the spoils.”

Just the same, Paul Hondros, CEO of Villanova Capital, the money management arm of Nationwide Financial, thinks that some fund companies may elect to do a little pruning. When times are good, sharing a few million a year with your best distributors is no big deal,” he says. “But when times are rough, as in the past six months, you’ll start to see fund companies be more selective as far as who they partner up with, because the revenues won’t be there to pay everyone.” But, adds Hondros, who once oversaw Fidelity’s distribution strategy, “the national wire houses will continue to command these payments because their revenues are down and they are looking for every ounce of profit they can get. They could squeeze the fund companies. Certainly they won’t be any cheaper to deal with.”

And if costs keep going up, only the biggest - not necessarily the best-performing - fund sponsors may be assured of shelf space.

When is revenue-sharing a conflict of interest?

How much should investors be told about the financial arrangements that their brokers have made with the companies whose mutual funds those brokers recommend?

That question figured prominently in a class-action lawsuit filed in August 1995 by a Manhattan attorney, Robert Strougo, and six other investors. The plaintiffs accused a handful of brokerages - Bear, Stearns & Co.; Donaldson, Lufkin & Jenrette and its Pershing division; Merrill Lynch & Co.; National Financial Services; and Smith Barney - of sweeping cash into subpar money market funds that were selected by the brokerage firms because the funds’ advisers were providing them with compensation. The money market funds were managed by Alliance Capital Management and Fidelity Investments.

The ostensible legal issue: Were the advisers’ payments properly disclosed under securities laws?

In the end, the defendants prevailed. In July 2000 the U.S. Second Circuit Court of Appeals for the Southern District of New York upheld a 1997 District Court ruling that dismissed the case. The lower court concluded that the arrangements between the brokers and the fund companies were properly, if vaguely, disclosed in fund prospectuses and that the plaintiffs did not prove a willful attempt to deceive shareholders.

Had the plaintiffs won, fund company payments to brokerage firms would no doubt have come under assault. But the issue will likely be resurrected. “When the market goes down, the warts start to show,” says Stuart Wechsler, the lead attorney for the plaintiffs in the Strougo case.

In that case, says Wechsler, the key legal issue became whether the brokerage firms “were intentionally putting clients in underperforming money market funds in exchange for extra compensation from fund companies.” To make his argument, Wechsler had to demonstrate that the broker-dealers violated Rule 10b-10 of the Securities Exchange Act of 1934. Rule 10-b10 requires a brokerage to inform its customers of any remuneration from third parties made in connection with a customer transaction.

The plaintiffs alleged that the funds made two types of payments to the brokerage firms: Rule 12b-1 fees paid from fund assets and non-12b-1 fees paid by the fund advisers from their own resources. Section 12b of the Investment Company Act prohibits mutual funds from using shareholder assets to pay distribution expenses. However, the statute does allow fund companies to use up to 100 basis points of a 12b-1 fee to defray certain distribution costs, such as advertising and promotional materials. The law does not define what fund companies can pay brokers for distribution expenses out of their own pockets: The sky’s the limit.

In the class-action case, the arrangement involved disclosed 12b-1 payments to the brokerages on the assets of the shares that they gathered, as well as additional payments that were only vaguely explained. The Alliance prospectuses, for example, disclosed that the firm paid brokerages “significant amounts from the adviser’s own resources” for distribution expenses.

When the Second Circuit Court of Appeals upheld the lower-court judgment last year, it asked the Securities and Exchange Commission for its opinion on the interpretation of Rule 10b-10. The SEC filed an amicus brief, stating that “we believe that the disclosure of both the 12b-1 fees and the non-12b-1 fees in the prospectuses meets the requirement of the rule.”

But, the SEC brief continued, “We are not saying that this is necessarily all the disclosure about these types of fees that should be required as a matter of policy, only that the disclosure made here satisfies the existing rule.” The SEC has directed its staff to recommend whether additional disclosure is needed.

Meanwhile, SEC staffers are reportedly being lobbied aggressively by the Investment Company Institute to basically leave well enough alone. The ICI made clear its stance in a May 8, 2000, letter to the SEC from ICI general counsel Craig Tyle, that read in part: Rule 10b-10 “should provide that the payments by the investment adviser or principal underwriter of an investment company to a broker-dealer who sells the investment company’s shares need not be disclosed in specific detail on a confirmation.”

A class-action litigator naturally offers a different perspective. Says Wechsler: “The fund companies do not word these prospectuses so intentionally vague as a way to save ink; it’s buried in there to begin with, and it doesn’t tell you who is paying whom and how much. To me, that’s not disclosure, and an undisclosed payment in my book is called a kickback.”

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