Why investors are sold inferior funds

Ever wonder why your stockbroker or insurance agent was so insistent that you buy mutual funds from a specific fund family? It may have been because they were paid more to sell those funds. Your sales agent may have even gotten a free trip to the Caribbean for convincing you to invest. The practice is called revenue sharing or “pay to play” and is common. Although not illegal, some companies have been recommending specific funds?even funds that are inferior, according to critics—without revealing the practice to clients as required.

Last month Edward D. Jones & Co., which has the largest national network of sales offices and bills itself as a folksy alternative to Wall Street brokerages, agreed to pay $75 million to settle charges of secret revenue sharing arrangements. The Securities and Exchange Commission and two other securities regulators accepted the settlement, but California’s attorney general continues to push a lawsuit accusing Jones of failing to tell investors about the arrangements and then selling them inferior mutual funds.

Attorney General Bill Lockyer’s suit is revealing because it includes internal memos from Edward D. Jones outlining the practice and e-mails from brokers in the field who objected to it. Although there are hundreds of companies that manage mutual funds, just seven preferred companies made up 98% of mutual fund sales to customers of Edward Jones, Lockyer’s suit alleges. Fifty percent of the total came from American Funds alone, it added. The suit claims Jones collected $300 million in “secret payments” from American, Federated, Goldman Sachs, Hartford, Lord Abbett, Putnam, and Van Kampen. Internal sales documents included in the lawsuit show that Edward Jones ran incentive campaigns to ensure that brokers sold funds from the seven companies and no others. Brokers were allowed to accumulate “points” towards free vacations in Switzerland and the Caribbean during 2002 by selling from the seven preferred fund families.

Some brokers objected to the practice. In one e-mail, an unnamed broker referred to company headquarters in St. Louis and wrote: “After thinking about it and remembering how secretive St. Louis has been about how this works for us, I’ve come to believe that ‘kickback’ describes this deal better than the term ‘revenue sharing.'” Another broker complained that contest points awarded only on preferred funds meant he might be influenced to sell those funds rather than other, more appropriate products. “If I understand this new policy correctly we could be heading down a dangerous path,” he wrote. Another broker questioned the company’s ethics: “Could outsiders look at this and say that mutual fund companies pay Edward Jones for preferential treatment? Would it look suspicious that over 90% of our fund sales go to preferred fund families… Could you please address this and the ethics of it?” Yet another broker anticipated the upcoming investigation by regulators: “Seeing that our preferred list of vendors is one of the smallest in the industry & that we have heavy monetary motivation to sell off of that, how will regulators look at that in light of the recent mutual fund scandal?” he asked.

As part of its settlement with the SEC, Edward Jones must disclose specifics of its revenue sharing agreements soon. Meanwhile, one veteran Jones broker summed up his feelings: “I have been in this business almost 20 years and I have always felt that we have way too many conflicts of interest.”