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SEC to Probe Mutual Funds Over Undisclosed Payments

By Stephen Labaton

The New York Times -- WASHINGTON

Federal officials announced a new front in the investigations into the mutual fund industry on Tuesday, saying they had uncovered widespread instances of brokers receiving undisclosed payments for steering investors toward specific funds.

Officials at the Securities and Exchange Commission described a kind of mutual fund payola -- arrangements in which a significant number of brokerage firms and mutual funds have provided cash and other compensation to the brokerage houses that sell fund shares. The findings come from a nine-month examination of 15 of the largest Wall Street brokerage firms by the SEC.

In one particularly prevalent form of compensation, SEC officials said, the funds have steered the trading of the stock in their portfolios to brokerage houses that, in exchange for the trading business, would promote the funds to their brokerage clients.

Such arrangements between fund companies and brokerage houses can be legal, if they are fully disclosed to investors. The problem in too many cases, SEC officials said, is that investors in the mutual funds have been kept in the dark about such payments and the fact that their brokers have a financial interest in promoting a particular fund. The officials said that federal securities laws and the industry’s own rules require both the brokers and the funds to disclose such conflicts of interest.

The officials compared the issue to the conflicts that became prevalent during the market boom, when stock analysts were writing ostensibly objective reports about e-companies that were giving investment banking business to the analysts’ firms.

“A customer has a right to know what the incentives are when the selling broker recommends a particular fund family,” said Stephen M. Cutler, the head of the SEC’s enforcement division. He said the agency had recently opened eight investigations of broker-dealers and 12 of mutual fund families for failing to adequately disclose such arrangements. “Even if it is the best performing fund, a customer has a right to know whether a broker received anything for recommending that fund transaction.”

Inadequate disclosure of payments by the fund companies to the brokerage houses has long been suspected, but for years the issue had been largely ignored by securities regulators.

Last April, though, SEC inspectors began to focus more intensely on such practices during examinations of mutual funds and Wall Street brokerage firms. The inquiries were a response to evidence that some funds were using brokerage firms to execute stock trades in their portfolios even though there were less expensive trading alternatives, officials said. But the inquiries gained urgency after regulators began last September to focus on trading practices and corporate governance at the mutual fund companies.

Having focused on brokerage houses so far, officials said, the agency is now beginning to look more closely at the funds.

Details of the examinations remained somewhat sketchy, as the commission declined to identify which brokers and funds may have been involved. But Tuesday’s announcement elevated the mutual fund scandal to a new level, one that has the potential to directly affect millions of investors.