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News September 20, 2004 Issue

I've Got My Own Martin Act And I'm Not Afraid To Use It!

NSMIA, Schismia.

Last week, California attorney general Bill Lockyer attempted to impose a new disclosure requirement on all mutual funds doing business in California: if Lockyer had his way, funds would be required to describe in their prospectuses or SAIs the specific services they obtain from selling broker-dealers in exchange for hard dollar revenue sharing payments paid by the fundís adviser or distributor.

In a September 15 complaint filed by Lockyer against PIMCO fundsí principal underwriter, PA Distributor (PAD), Lockyer claimed that PAD committed fraud under California law by failing to disclose (via the PIMCO fundsí prospectuses and SAIs) that it paid hard dollar revenue sharing payments out of its profits in exchange for various services provided by selling broker-dealers. The services included things such as the fundsí placement on preferred fund lists and on the brokersí intranet websites, as well as PADís obtaining access to the brokersí registered representatives. The complaint also charged PAD with entering into inadequately disclosed directed brokerage for distribution arrangements.

PAD agreed to settle Lockyerís case for $9 million. It also settled an undisclosed directed brokerage for fund distribution case by the SEC for $11.6 million.

Relative to other settlements, such as the $225 million paid by MFS in February to settle its directed brokerage case with the SEC, the PAD settlement is "a pretty small number," said Morgan Lewis partner Dick Grant. "Maybe itís a reflection that things are just settling down." (No pun intended, weíre sure).

As part of its settlement with California, PAD agreed to disclose to current and prospective fund investors the shelf space payments it makes to selling broker-dealers, and the services those payments buy. It also agreed to attempt to enter into written shelf space agreements with the selling broker-dealers.

Hmmm . . . we can see the concerns raised by using fund directed brokerage (an asset of the fund) for distribution (which benefits the adviser). But how can the failure to disclose distribution services paid for out of an adviserís own legitimate profits be fraud?

Under one theory, since the fund complex effectively created a conflict of interest between the broker selling the funds (who arguably is incentivized, or as the SEC recently put it, Ďcorrupted,í by the revenue sharing payment to push the funds over others) and the brokerís customer, the fund complex has the obligation to disclose the brokerís conflict. As Fund Democracy and other consumer groups put it in a joint April 2004 comment letter to the SEC on the pending fund confirm and point-of-sale proposal: "When a fund knows that brokers may recommend its shares over the shares of other funds because the fundís manager is making additional incentive payments to brokers, and that brokersí recommendations to purchase that fund are therefore biased and may even be unsuitable, the federal securities laws demand the prominent disclosure of such highly material information in the fund prospectus." After all, they said, "the fund is equally responsible for creating, and thus disclosing, the relevant conflict of interest."

Thatís one way of looking at it.

But consider this: the SEC, in its fund confirm and point-of-sale proposal, put the onus squarely on broker-dealers to disclose the details of revenue sharing payments.

Under the proposal, if someone in a fund complex makes revenue sharing payments, the funds would have to disclose that fact in their prospectuses. However, the fund would not have to disclose the amount paid under the arrangement, nor would it have to trot down the specific services provided, as Lockyer seems to have contemplated. Instead, the fund would disclose that specific information about those payments is included in the confirm (or periodic statement) or point-of-sale document provided by the selling broker. The ICI has supported this approach, saying in its comment letter that "it is neither necessary nor appropriate to require more detailed disclosure concerning revenue sharing arrangements in the prospectus."

Interestingly, for all its discussion of the ills of directed brokerage, the SEC apparently has not cast any dispersions on the practice of advisers or fund distributors making hard dollar revenue sharing payments. Indeed, in last monthís adopting release banning fund directed brokerage, the SEC noted that one consequence of the new rule might be that "advisers may be required to increase the payments that they make to broker-dealers out of their own assets, which are likely to cause advisersí costs to rise." It noted that an increase in management fees would have to be approved by fund shareholders. But it didnít say boo about enhanced disclosure of hard dollar revenue sharing payments, much less indicate that failure to disclose them with specificity would constitute fraud.

So why has Lockyer been able to find fraud where others havenít?

Earlier this year, the California legislature amended the stateís corporation code to provide Lockyer with authority that, as his staff has claimed, exceeds that of Eliot Spitzerís under New Yorkís Martin Act. In a press release announcing the PAD settlement, Lockyer claimed that his investigation "has helped expose shelf-space agreements as a universal practice" in the fund industry, and has helped put an end "to the most egregious arrangements, such as directed brokerage." (Never mind the shockwaves caused by the SECís November 2003 case against Morgan Stanley, which put the entire fund industry on notice that SEC Chairman Donaldson didnít take kindly to fund brokerage for distribution.)

"In this climate, an aggressive regulator who wants to stake out a position like that may be able to make it stick because the industry has been in a defensive position for some time," said Morgan Lewisís Grant. "Every regulation looks like a good regulation and every accusation seems to shift the burden of proof to the industry."

Why did PAD agree to the new disclosure requirements? One senior investment management attorney pointed out that when a firm is involved in settlement negotiations, it might agree to things that it would not ordinarily agree to. For example, he said, in the Spitzer settlements, funds agreed to reduce fees, which had nothing to do with the trading abuses.

Added the attorney: "I think it is quite clear that a state cannot impose prospectus or SAI requirements on a mutual fund, and they canít do it through the enforcement process any more than they can through rulemaking." He noted that under NSMIA, the only possible way a state can impose new disclosure requirements is to claim that failure to do so is fraud. "Obviously," he added, "that is a somewhat elastic concept." The attorney added that it is clear that the specific disclosure of hard dollar revenue sharing payments is not required under current federal law, and that the SECís point-of-sale proposal contemplates that brokers will provide the relevant disclosure. Questioning Lockyerís approach to disclosure of hard dollar payments, he added: "If that single issue were litigated, I think any attorney general would be in a very tough position."