FUND-BROKER INCEST: GUESS IT’S ALL RELATIVE, JUDGING BY DEBATE; REGULATOR, PREDECESSOR SPLIT ON INDUSTRY PLAN TO PERMIT TRADES WITHIN SAME CORPORATE FAMILY

As the debate over the brokerage industry’s proposal to legalize transactions between mutual funds and affiliated broker-dealers continues to rage, the top fund regulator and one of his predecessors find themselves on opposite sides.

The proposal by the Securities Industry Association would allow brokerages to sell their own securities to affiliated funds if prices could be readily determined to ensure that they reflect market values.

Under current law, funds affiliated with market makers are forced either not to buy at all, or to buy from other brokers, who may end up buying from the affiliate.

The fund has to pay more, brokerage advocates insist, “and investors will be hurt.” Those in the mutual fund industry concede that some opportunities may be missed, but they worry about “all the baggage that comes along for the ride.”

Paul Roye, director of the Securities and Exchange Commission’s Division of Investment Management, is firmly on the side of the status quo. He warned those attending the Investment Company Institute’s general membership meeting in Washington last month that ending the prohibition has the “potential to open the door to overreaching, self-dealing and the other abusive practices that prompted enactment of the statute.”

His predecessor, Marianne Smythe, who headed the division from 1990 to 1993, sees things differently. She says the proposed revisions are warranted because mergers have reduced the number of independent broker-dealers, making it more difficult for fund companies to find better prices. Ms. Smythe now represents securities outfits as a partner in the Washington law firm Wilmer Cutler & Pickering.

“You have a lot of prominent broker-dealers who have large asset management companies that are managed separately,” she says. “It’s not like you have some guy in the same shop doing both. These are large companies with large bureaucracies that would make the federal government blush.”

While the law prevents bad trades from happening, she acknowledges, it also prevents good trades: “Mainly what it prevents is competition.”

Few cases have been brought by the SEC involving violations of the prohibition since it was included in the Investment Company Act of 1940. “It’s kind of like a prophylactic provision,” says David Levine, senior adviser to the SEC’s director of enforcement. “A lot of people do not engage in these transactions because they know they can’t.”

A rare case was brought by the agency’s Los Angeles office last September against Concord Growth Corp., a commercial finance company in Palo Alto, Calif., and its founder, Reid Rutherford.

In a settlement in which they neither denied nor admitted the charges, the company and Mr. Rutherford, who also acted as a director of the fund, paid fines totaling $15,000 for selling Concord’s asset-backed securities to its own mutual fund affiliate, the Target Income Fund in Glendora, Calif. Neither the company nor its lawyer could be reached for comment.

Mr. Roye says problems caused by the law should be dealt with by regulatory changes.

Burton Fendelman, vice president and director of compliance policies and procedures at Citigroup’s Citibank, says there are instances in which a related SIA proposal could enable investment advisers to save their clients money by allowing the purchase of securities owned by affiliated brokers through prior approval by the client — eliminating the requirement for permission on each transaction.

“We may have securities in position,” says Mr. Fendelman. “We can’t deal with a client directly. We have to go out to another broker and do it on an agency basis, and there may be another cost there. We’re not getting a wholesale price; we’re buying at the regular market price from the other broker. We could go to the client and ask for permission, but by the time that’s done the market could be away from you, especially in wrap fee programs where you’ve got multiple clients that you’re trading for at the same time.”

The SEC is working on new regulations to deal with the concerns raised by the brokerage industry, and Mr. Roye says a proposal may be issued this summer. In an April speech to the SIA’s legal and compliance seminar in Boca Raton, Fla., SEC Chairman Arthur Levitt said that “it might be appropriate” to allow advisers to make such transactions if the securities are easy to price.

‘all that baggage’

Price is the factor driving the debate over purchases by fund affiliates, of course.

Under current law, says SIA general counsel Stuart Kaswell, “the mutual fund buying will have to pay more because the major player in the market for that particular security can’t participate. The fund will pay more and investors will be hurt.”

Paul Haaga, executive vice president of Los Angeles-based Capital Research and Management Co., concedes that in some instances, beneficial transactions might be prevented. “The problem,” he emphasizes, “is all the baggage.”

“If this kind of transaction is available when it is the best opportunity, it’s also available when it’s not the best opportunity,” adds Mr. Haaga, whose company manages the $300 billion-asset American Funds.