Since the dawn of regulation of mutual funds in America (1940) until early in the new millennium, the fund industry enjoyed a largely underserved reputation for responsible stewardship and high integrity. While I remain the only mutual fund compliance director in history to ever turn whistleblower, I can assure you that my counterparts at fund complexes have long been aware of widespread industry abuses but choose to do nothing.
With the new millennium, cracks in the industry’s Veneer of Virtue began to surface and spread massively.
The mutual fund scandals of 2003 commenced with revelations of arcane illegal late trading and market timing practices on the part of certain hedge and mutual fund companies. New York Attorney General Eliot Spitzer initiated the investigations into these abuses but the SEC, charged with regulation of the fund industry, swiftly followed in his wake.
In addition to illegal late trading, market timing, then personal trading “front-running” violations, investors soon learned for the first time that mutual fund families made payments to brokerages recommending their shares—kick-backs politely referred to as “revenue sharing” by fund insiders. These payments, which were not properly disclosed to investors, resulted in regulatory actions and litigations involving dozens of brokerages.
Today, as a result of increased disclosure prompted by regulators almost two decades ago, it is widely known that mutual fund companies make certain payments to certain financial intermediaries that recommend, or support, sales of their shares.
For example, brokerage Edward Jones discloses the firm “receives payments known as revenue sharing from certain mutual fund companies, 529 plan program managers and insurance companies. Virtually all of Edward Jones’ transactions relating to mutual funds, 529 plans and annuity products involve product partners that pay revenue sharing to Edward Jones.”
Jones acknowledges that “receipt of revenue sharing payments creates a potential conflict of interest in the form of an additional financial incentive and financial benefit to the firm, its financial advisors and equity owners in connection with the sale of products from these product partners. For the year ended December 31, 2018, Edward Jones received revenue sharing payments of approximately $205.9 million from mutual fund and 529 product partners and $7.0 million from annuity product partners.”
Given the revenue sharing received by this single regional brokerage is in excess of $200 million, mutual fund payments to intermediaries globally likely amount to tens of billions.
However, industry disclosure to investors of compensation arrangements with mutual funds, including but not limited to so-called “revenue sharing” is far from complete, as well as woefully inadequate for the protection of investors.
Not adequately disclosed to investors:
· The widely-divergent amounts of all payments;
· The names of the dozens of types of payments (e.g., revenue sharing, 12b-1, sub- transfer agent, administrative, shareholder servicing, data analytics, and infrastructure fees);
· The services supposedly provided to mutual funds in exchange for such payments;
· The parties to whom payments are made; and
· The conflicts of interest/potential harm to investors related to such payments.
Most sinister of all, indirect payments—payments based upon aggregate assets at intermediaries, calculated on an omnibus basis—are cleverly concealed. They’re not disclosed at all and, when asked, fund firms and intermediaries fraudulently deny the existence of such indirect compensation.
Mutual fund secret payments related to retirement plans and investment advisory accounts—kick-backs to recordkeeper, administrator, trustee, and custodian intermediaries—raise additional regulatory concerns due to the heightened fiduciary standards that apply, as well as Employee Retirement Income and Security Act (ERISA) prohibitions.
In my forensic investigations I have found it commonplace for recordkeepers, administrators, trustees, and custodians to enter into agreements with mutual fund companies to keep confidential any payments between them—for example, to withhold from pension boards and participants information related to payments based upon pensioners’ assets and pocket dollars rightfully belonging to pensions.
For pension fiduciaries diligently investigating whether any such secret payment arrangements exist, it becomes an elaborate game of cat-and-mouse.
Retirement plan intermediaries are supposed to safeguard assets—that’s their legal duty. Instead, my investigations reveal that these firms that have been entrusted with retirement assets routinely scheme to conceal and pocket retirement plan dollars which should be credited to pensions and participants.
Add widespread industry secret payment schemes between mutual funds and retirement plan intermediaries—siphoning tens of billions from plans—to the list of reasons pensions globally are struggling.