Revenue sharing OK if it’s disclosed, SEC tells court

The Securities and Exchange Commission has weighed in on a long festering class action suit involving several brokerage houses over whether payments to brokers constituted kickbacks.

The question is how money market mutual funds pay brokers to invest client money in their portfolios when they create sweep accounts, and how the client should be informed about payments between two.

The agency dealt a blow to the case of individual investors who are suing Quick & Reilly Inc., Bear Stearns & Co., Pershing Division of Donaldson Lufkin Jenrette Securities and FMR Corp.’s National Financial Services Corp.

In a brief requested by the Second U.S. Circuit Court of Appeals in New York, the SEC wrote that brokers need only disclose the payments they get from fund companies if a fund’s prospectus does not make the disclosure. However, the SEC left the door open for the court to still rule there was fraud in this particular case.

The brief marks the first time the agency has interpreted its rules in such cases. It adds weight to three earlier decisions to dismiss the case by the federal district court in Manhattan, after its initial filing in 1997.

In their complaint, the plaintiffs charge that the brokerage firms committed fraud by moving their clients’ money from “sweep accounts” into mutual funds that made payments to the brokers. In sweep accounts money is moved into money market funds to generate interest while it is not invested in other securities.

money from funds

“Brokers are given money by the money market funds in order to induce them to get customers to put their money into the funds,” says Stuart Wechsler, a partner with Wechsler Harwood Halebian & Feffer LLP in New York, who represented the plaintiffs in the class action.

“That is a secret kickback because it’s an undisclosed payment of cash,” Mr. Wechsler maintains.

“Because of the kickback, the [money market funds] that pay the biggest kickback pay a great deal less to the investor,” he says, adding that the funds typically paid the customer 0.55%, or 10% to 15% of the funds’ total yield, less than similar funds.

“There is existing law that says you must disclose material information about any conflict of interest you have,” Mr. Wechsler says, and he believes the defendants violated those requirements.

read the prospectus

The SEC, agreeing with earlier district court rulings, said disclosure by the brokerages was adequate because the companies sent clients money market fund prospectuses.

The plaintiffs had contended that specific disclosure should have been made with each transaction.

“The plaintiffs expressly opted to have as a service to them their money swept into a money market fund, and [they] chose the particular fund,” says James Benedict, managing partner at Clifford Chance Rogers & Wells LLC in New York, which represents National Financial Services.

“They were then provided with a prospectus from that fund setting forth all of the pertinent fees,” he continues.

“For the plaintiffs to then bring a fraud case claiming that they didn’t know those fees is patently without any merit.”

Mr. Wechsler acknowledges that the SEC brief hurts his clients’ case, but he notes that in the final pages of the brief, the SEC does not totally rule out the possibility that the brokerages committed fraud.

He cites this paragraph in the SEC statement:

“The existence of the payments and some information about them was disclosed in the prospectuses, so the issue is whether the difference between the information that was disclosed and the greater information that plaintiffs claim should have been disclosed is material.