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The principal industry justification for the existence of a front-end load is that some persons need the stimulus to savings which prepaid sales charges provide. If persons wishing to subject themselves to a penalty provision for the discipline which they believe it will give them are to be permitted to do so, they should do so consciously and voluntarily, with an awareness of the alternative forms of mutual fund investment. At present, a high percentage of investors in contractual plans are unaware of the existence of accumulation plans which do not involve a front-end load, some of them with completion insurance and some with low initial and continuing payments. They should not subject themselves to the front-end load unwittingly or for lack of a clear alternative. If the front-end load is not to be prohibited, any fundamental alteration of its structure should be combined with a requirement that any mutual fund sales organization offering a front-end load contractual plan to any person simultaneously, offer such person the opportunity to purchase shares of the same underlying fund under a level-load voluntary plan, but otherwise on substantially the same terms. Such a provision would not, of course, compel any contractual plan sponsor to offer voluntary plans on an uneconomic basis. It would, however, preclude the offering of contractual plans except on a basis reasonably calculated to insure that the purchaser of a contractual plan had made a conscious election to impose a penalty upon himself in the event of his failure to make the required payments.
The Special Study concludes and recommends:
1. The study was not concerned with and has not attempted to evaluate the merits of mutual fund shares as an investment medium, and nothing contained in this report should be construed as an endorsement of criticism of investment company shares generally, or of those of any particular company, or as a basis for purchasing or redeeming any such shares. However, certain factors peculiar to the mutual fund industry create pressures toward undesirable selling practices. Evidence suggests the existence of such practices to an unfortunate degree. Industry representatives and the NASD, in consultation with the Commission, should jointly undertake a program designed to eliminate such tactics and devices through the adoption of interpretations of the Rules of Fair Practice. The further development of secondary supervisory controls by industry members is desirable, and the NASD should increase its activities in the surveillance of selling practices outside of the area of advertising and sales literature. As recommended in chapter II, membership in the NASD or another registered securities association should be required of all mutual fund selling organizations, and any such association should be required to maintain standards equivalent to those adopted by the NASD in accordance with this recommendation. Reference is also made to the recommendations in chapter II concerning the qualification and registration of salesmen.
2. Prospectus requirements should be further refined to assure that basic information is brought clearly and conspicuously to the attention of the prospective investor. The Commission should require a summary on the cover, or as prominently as possible at the beginning of each prospectus, of the sales charges, expense
ratios, advisory fees, performance objectives, and other basic information, and should require disclosure of any special or extra compensation arrangements for the sale of particular funds by mutual fund salesmen or of the fact that the salesman can only offer a particular fund or funds. It should amend the Statement of Policy to require that tables which are used to reflect results of plan completions also indicate performance records of plan investors. It should also consider an exercise of its rulemaking power to define deceptive practices in connection with recommendations of switches from one mutual fund to another.
3. In conjunction with its comprehensive program of study of the investment company industry, the Commission should recommend to the Congress legislation amending the present provisions of the Investment Company Act of 1940 which relate to contractual plans. Consideration should be given to the abolition of any future front-end load. If it should be concluded that such aboli. tion is not called for, such legislation should both substantially limit the amount and method of application of any such load and prohibit the offering of front-end-load contractual plans by any mutual fund sales organization without the simultaneous offering of a level-load voluntary plan for shares of the same fund and (except for prepayment of selling charges) on substantially the same basis.
PART C. RECIPROCAL BUSINESS—THE PROBLEMS OF ALLOCATING
MUTUAL FUND PORTFOLIO BROKERAGE Reciprocity, or “doing business with people who do business with you,” is an accepted custom of the business world in general and the securities industry is no exception. In the mutual fund industry, however, it takes on a unique characteristic. While it is the mutual funds themselves whose portfolio transactions provide the brokerage which constitutes the currency of reciprocity, its principal beneficiaries are not the funds but their investment advisers and principal underwriters.
The unusual structure of reciprocal business practices in the mutual fund industry traces principally to the minimum commission rate schedule of the New York Stock Exchange and its antirebate rule. The large volume of transactions executed by mutual funds in the exchange market are sufficiently profitable to the member firms which handle them that these firms are willing to do so for 40 percent of the amount to which the commission rate entitles them. Since the balance of 60 percent cannot be returned to the funds themselves without violating exchange rules, the executing broker-dealers pay give-ups, as instructed by the funds or their investment advisers, to other member firms. The firms to which the give-ups are paid are those which have rendered services in some way related to the fund, their advisers or underwriters. The principal service so rewarded is the sale of fund shares; others include such things as rendering statistical or research services or providing wire facilities. The funds do not profit from the sale of their shares and they pay an advisory fee--geared to their size-for the investment advice they receive from their advisers. The rewards of reciprocity thus flow to the broker-dealers who have primarily benefited the advisers and their frequently related principal underwriters rather than to the funds.
While the rules of the New York Stock Exchange have created the particular character of reciprocal business in the mutual fund industry, the problems are not confined to the community of NYSE firms. Nonmember firms are as eager for additional compensation for their sales of fund shares as are member firms. As a result there have developed intricate patterns which permit them to share the large amounts of brokerage generated by the funds. Firms which are members of regional exchanges are enabled to participate through transactions on those exchanges in dually traded securities executed by firms with dual memberships. For firms which are members of no exchange the problem is more difficult. Sometimes they are rewarded by participating in a selling group in a primary or secondary offering of a security to be purchased or sold by the rewarding fund. More often they are required to take their compensation in kind rather than cash through a service give-up from a NYSE member firm of sales promotional or training materials. On occasion they may receive over-the-counter give-ups, directly or through a device known as interpositioning. Such over-the-counter give-ups, including interpositioning, raise serious questions of conflicts of interest, however, since in the over-the-counter markets where no minimum commission structure exists there is no reason why fund shareholders rather than secondary broker-dealers should not be entitled to the benefits of quantity discounts.
The existence of substantial sums of fund portfolio brokerage available as extra compensation for the sale of fund shares can lead to undesirable sales pressures by fund retailers. Competitive demands or a desire to increase investment advisory fees can lead to portfolio churning by investment advisers. Both possibilities have concerned industry representatives in recent years.
Ultimately the solution of the problems lies at their source: the NYSE minimum commission rate schedule. So long as the funds cannot themselves benefit from the economies created by their mass purchasing power, the complexities and potential problems of the third party beneficiary system will continue. Various problems in connection with the Exchange's rate structure are discussed in chapter VI, but it is appropriate to observe in connection with this review of reciprocal patterns of mutual fund brokerage allocations that in the consideration of any revision of the rate structure the question of introducing some form of volume discount should be high on the agenda.
Granting that the existing commission framework may explain many of the existing patterns of reciprocity, there are some which it cannot justify. There is no reason for funds or the regulatory agencies to countenance give-ups in the over-the-counter market. The NASD should outlaw participation in them by its members and discipline such violators as come to its attention. The prohibition should cover overthe-counter transactions in listed securities as well as unlisted ones, and should be designed to prohibit its evasion by deliberate resort to a market for the purpose of taking advantage of a minimum commission rate structure.
The Special Study concludes and recommends:
1. The pattern of reciprocal business in the mutual fund industry is unique. The economies of the volume of securities transactions generated by the mass purchasing power of the funds for the most part are of minor benefit to the funds themselves. The primary beneficiaries are their investment advisers and their frequently related principal underwriters, who to a large extent use reciprocity to reward the sales efforts of fund retailers, thereby increasing their own rewards. The use by fund advisers of investment advice and research provided by brokerage firms in return for fund brokerage, without diminution of their investment advisory fees, is another indication of the manner in which they are the primary beneficiaries of reciprocal business. This unbalanced reciprocal structure is a direct outgrowth of a minimum commission rate structure which prohibts volume discounts and rebates. In the broad study of the commission rate structure recommended to the Commission in chapter VI-I, appropriate consideration should be given to the desirability and appropriate form of a volume discount from the viewpoint of mutual funds.
2. While some reciprocal practices in the mutual fund industry are justifiable under the existing commission structure, the overthe-counter give-up in its various forms, including interpositioning, is in flagrant conflict with the duty of a fund and its adviser to obtain best terms in its securities transactions unless the advantages of any such give-up can be clearly demonstrated. The NĀSD should amend its Rules of Fair Practice to prohibit the practice among its members in over-the-counter transactions in any security. The Commission should consider the issuance of a Statement of Policy on the subject.
3. Mutual fund directors and those who transact portfolio business for them are primarily obligated to obtain the best available terms in such transactions for the benefit of fund shareholders without regard to the reciprocal business aspects of the transaction, and to see that the funds themselves receive the maximum benefits available from any such reciprocal business. The choice of market for portfolio transactions should be made exclusively from the point of view of these obligations, and not on the basis of rewarding broker-dealers for their sales of fund shares or for other services. The NASD and the Investment Company Institute should promulgate rules and standards of conduct designed to assure that the primary obligations to fund shareholders in the handling of fund portfolio transactions are recognized and enforced.
PART D. INSIDER TRANSACTIONS IN PORTFOLIO SECURITIES The nature and extent of trading by those having access to inside information on mutual fund portfolio transactions, the policies of the investment company complexes concerning such trading, and the implementation of such policies were examined by the Special Study in relation to the portfolio transactions of 28 representative mutual funds whose assets at December 31, 1961, aggregated $5.2 billion. In its survey of insider trading the study attempted to determine the extent to which situations of potential conflict exist in the industry, without for the most part characterizing the manner in which they have been resolved. In the light of the high position of trust of the persons and companies covered by the survey, however, the overall industry figures on industry insider trading are significant. As many as 14.4 percent of all persons and companies included in the survey had traded in securities during the same period as the fund, and 8.0 percent traded within 15 days prior to the fund. Over a brief 7-month period, at least 30 percent of the access persons and companies traded in fund portfolio securities.
From a more detailed discussion of the transactions relating to five out of eight funds selected for more intensive study, it also becomes clear that fairly extensive trading in mutual fund portfolio securities by insiders takes place. The specific situations described vary considerably in quantities and relative prices, degree of relationship between fund transactions and individual transactions, and possible motivations or explanations. There are, however, several instances where insiders' transactions seem to have been clearly designed to benefit from related fund transactions.
The survey demonstrates broad industry awareness of the problems raised by the conflict of interest which may exist when an individual or entity privy to the mutual fund's investment recommendations and decisions engages in trading for his or its own account in securities purchased or sold by the fund. Taking advantage of inside information in advance of fund transactions for personal gain is widely regarded in the industry as unethical. Overwhelmingly, the funds and their investment advisers reported the existence of policies which reflected in one way or another their awareness of the ethical problems involved.
However, despite widespread existence and application of policies, there are substantial variations in the policies themselves and the manner in which they are enforced. Some of those examined were vague, broad, and equivocal, while others were firm and clear. It was somewhat surprising, in view of the extent of trading by insiders reported to the study, that only one fund indicated knowledge of any violation of its policies, and that was said to be inadvertent. The vagueness of some policies and the variety of others suggest considerable disagreement in the industry as to the nature and extent of obligations in this area.
The results of the survey indicate that considerably more attention to the subject of insider trading is called for on the part of the mutual fund industry and the Commission. The situation calls both for clarification and implementation of higher standards for the industry.
The Special Study concludes and recommends:
1. Each registered investment company should be required to adopt a written policy covering insider trading, and provisions for its implementation, which are satisfactory to the Commission, and should be required to report any violations of policy to the Commission. The minimum standards for such a policy which would be acceptable to the Commission should include: (a) Coverage of all officers, directors, substantial stockholders, and advisory employees of the investment company, its investment adviser, and principal underwriter, but with appropriate recogni