updated 1/30/2004 9:33:40 AM ET 2004-01-30T14:33:40

The staff of the Securities and Exchange Commission will recommend that the agency ban mutual fund companies from making special payments to brokerages for steering clients toward certain funds, according to an SEC official.

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The recommendation goes beyond a recent SEC proposal to require that fund companies disclose such special arrangements to investors because they create a conflict of interest. An investigation by the agency found that the practice was rampant in the mutual fund industry and frequently undisclosed _ prompting officials to express outrage.

"We have concluded ... that this is an area where it creates distortions in a way that adversely impacts fund investors," Paul Roye, the head of the SEC division that oversees the fund industry, said Thursday in a telephone interview. "This is one of the areas where we think that the conflicts and distortions are so dramatic that it ought to be banned altogether."

Investors can be hurt by the practice by being pushed into buying higher-cost or more poorly performing funds because brokers are rewarded for doing so, not because the funds are suitable for the investors.

Roye said the staff planned to present the proposal to the five SEC commissioners for a vote in February.

It is one of the most radical proposals advanced to date affecting Wall Street brokerages and the mutual fund industry, which has been ensnared in a scandal since revelations in September of trading practices that favor some big investors to the detriment of ordinary shareholders. Since then, top executives of several big fund companies have been charged; dozens of companies are under investigation.

SEC Chairman William Donaldson is believed to support the move as a way to rebuild confidence in the fund industry among the 95 million Americans _ half of all households _ who entrust some $7 trillion to it. The proposal could, however, face opposition from other commissioners.

Stephen Cutler, the SEC's top enforcement official, disclosed recently that the agency is investigating numerous cases in which brokerage firms may have failed to fully disclose that they pushed clients to buy certain mutual funds in exchange for payments from the fund companies.

An SEC inspection of brokerages that sell mutual funds found that 14 of 15 received cash from funds' investment advisers and two-thirds accepted payments in the form of commissions on fund trades, a practice known as revenue sharing. In return for the payments, 13 of the 15 brokerage firms appear to have favored the affected funds by giving them greater visibility on their Web sites and in promotional materials sent to customers, SEC officials said.

The inspection found that for every $100,000 in sales to customers of favored funds, brokers pocketed between $50 and $400.

In November, major brokerage Morgan Stanley agreed to pay a $50 million civil fine and change its practices in a settlement with the SEC and the National Association of Securities Dealers for an alleged "firm-wide failure" to fully disclose potential conflicts of interest. Morgan Stanley also agreed last fall to pay a $2 million fine to settle the NASD's allegations that it held prohibited sales contests _ offering tickets to Britney Spears concerts and the NBA finals _ to push its brokers to sell in-house mutual funds and certain annuities.

The House in November overwhelmingly passed legislation requiring, among other things, mutual fund companies to disclose more information about fees and operations. The measure as written does not ban incentive payments from fund companies to brokers. The Senate is expected to act on its own version of such proposals early this year.

Copyright 2004 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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