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News September 13, 2004 Issue

SEC Bans Fund Brokerage for Distribution Arrangements

After December 13, it will be unlawful to direct any business related to executing or processing your fundsí trades to a broker or dealer to reward them for selling or promoting your fundís shares.

The new ban prohibits funds from directing "portfolio securities transactions" to compensate selling brokers. The SECís adopting release additionally states that the ban applies to the direction of "any service" related to effecting fund trades, "including performing . . . any function related to processing a brokerage transaction."

And you can forget about stepping out portions of fund trades to reward selling broker-dealers. Clearing up any doubt remaining after the SECís open meeting, the adopting release stated that the prohibition "applies both to directing transactions to selling brokers, and to indirectly compensating selling brokers by participation in step-out and similar arrangements in which the selling broker receives a portion of the commission."

Nearly all broker-sold funds (or their advisers) will have to adopt new policies and procedures "reasonably designed" to prevent the folks who select the fundís brokers and dealers from "taking into account" the sale or promotion of the fund (or for that matter, any fund) when making those selections. The procedures also have to prevent the fund, its adviser(s), and principal underwriter from entering into any agreement ó formal or informal ó under which the fund directs trades or other compensation to a broker or dealer for selling the fund (or any other fund).

Letís put this into context: the new procedures must be designed to prevent Fund Aís manager, when making brokerage allocation decisions, from considering how well Broker X has done selling: 1) Fund Aís shares, 2) shares of its sister fund, Fund B; or even 3) unaffiliated Fund Zís shares (as in, "Hey, they did a real good job pushing our competitorís funds. Maybe they can do the same for us.") The procedures also have to prevent Fund Aís manager from entering into an agreement to direct Fund A trades or trade-related compensation to Broker X for selling Fund Aís, Bís, or Zís shares.

The new procedures must be approved by the fundís board, including a majority of independent directors, and be in place by December 13. Helpfully, the SEC said that funds may make corresponding changes to their registration statements at the time of their next regularly scheduled amendment.

In the adopting release, but not in the rule, the SEC said that the procedures should be incorporated into a fundís new compliance program. Fund CCOs should "assure themselves that the required procedures are in place as well as any others that they believe are reasonably necessary" to prevent violation of the ban on fund directed brokerage arrangements. In addition, fund compliance officers "should monitor the operation of the policies and procedures, and should consider periodic testing of brokerage allocations to determine whether there is a significant correlation between sales and the direction of brokerage that may suggest the existence of informal arrangements in violation of the rule."

During the agencyís open meeting, SEC associate director Robert Plaze said that SEC examiners will be looking at the new policies and procedures to determine "the direction the trading desk receives from management on how to trade shares." To that end, trading desk procedures should state that sales of the firmís or other firmís mutual funds may not be taken into consideration when selecting brokers or dealers for the firmís approved list, or when selecting amongst brokers already on the list. An explicit procedure that fund distribution not be taken into consideration when making brokerage allocation decisions "will go along away to create certainty that this is being complied with," said Plaze.

Another tip: firms should adopt procedures banning fund marketing personnel from discussing the performance of brokers or dealers in selling the firmís mutual fundsí shares (as well as shares of other mutual funds) with trading desk personnel and any member of the firmís best execution committee. Plaze said that examiners will be checking to confirm the absence of communications between the trading desk and the fund marketers about fund sales efforts.

During the open meeting, Commissioner Cynthia Glassman said she supported the rule, but asked how the SEC would determine whether a fund is executing trades through a selling broker for the right reasons (because the broker provides best execution) or wrong reasons. She said she could envision a situation where a particular broker is very good at both selling the fund shares as well as executing trades, and therefore correspondingly is responsible for a high proportion of both. "How would the fund convince you and [OCIE] that it was not in violation of this prohibition if thatís what was occurring?" she asked.

"A correlation would suggest circumstantial evidence that demonstrates the need to investigate further," replied Plaze. "It would not, I believe, determine guilt in that circumstance." He said that the correlation would give OCIE "the signal that perhaps they should talk to the brokers on the other side of the transaction" and dig deeper. And, noted Plaze, a suspicious correlation is not just that a particular broker sells a lot and trades a lot, "itís that over time, brokerage goes down and sales go down, or brokerage goes up and sales go up."

Plaze also noted that after December 13, SEC examiners will be looking at the role that the CCO plays in assuring that the fund complex is in compliance with the rule: "Has the chief compliance officer reviewed the policies and procedures? Has he met with the brokers? Does he understand what the policies and procedures are? Do the participants on the trading desk understand?" CCOs, said Plaze, should "from time to time test to determine whether thereís a correlation between the allocation of brokerage and sales, to determine whether in fact there are informal agreements that cannot be discovered simply by looking at the paper trail."

The SEC declined to provide a safe harbor as some commenters had requested. But it provided some comfort by acknowledging that "many funds are likely to find that, for some portfolio transactions, the broker-dealer who can provide best execution also distributes the fundís shares" and that "there will be some instances in which funds will execute portfolio securities transactions through their selling brokers."

The SEC deferred consideration of other changes to Rule 12b-1, noting that it had received 1,650 comments on the "concept release" portion of its February 2004 directed brokerage proposal. The SEC said it is evaluating "whether and how to amend the rule further."

A corresponding rule change by the NASD (repeal of NASD Rule 2830(k)) is under review by the SEC. The NASD amendment will require brokers to have their own policies and procedures designed to ensure that formal and informal fund brokerage-for-distribution arrangements do not exist.†