Wall Street is easing into its favorite summer pastime: spreading deal rumors. Following a research report in late May that Merrill Lynch & Co. (MER ) may consider selling part of its asset-management operations, the Street was buzzing with talk that it was on the verge of shedding its mutual-fund business to Baltimore financial-services firm Legg Mason Inc. (LM ).
Just another Wall Street rumor? Perhaps not entirely. Both Merrill and Legg Mason declined to comment on the speculation. Yet there is at least one good reason why Merrill and other brokerage firms might want to overhaul their mutual-fund businesses in the future. With Securities & Exchange Commission Chairman William H. Donaldson pushing for new rules aimed at providing greater safeguards for mutual-fund investors, brokerages worry that implementing them will cost billions of dollars.
Under the proposed new rules, which are likely to go into effect toward the end of the year, brokers would be required to disclose in full the fees they are paid for selling any fund. The idea is to alert investors when brokers push in-house or favored funds at the expense of others that might be cheaper or more suitable.
Sounds simple, but it's not. Implementing the new rules will require elaborate computer systems and increased manpower to track, distribute, and monitor the labyrinthine payment arrangements brokerages have with hundreds of fund families. Even by conservative SEC estimates, the price to the securities industry will be roughly $9 billion in the first year and $7 billion a year after that.
The new regs are likely to spur a shakeout among brokerages that are in the fund business. Smaller firms that can't absorb the costs of compliance, as well as larger firms that aren't deeply committed to asset management, will probably stop managing mutual funds altogether. Even those brokerages that decide to continue to run their own funds will scramble to figure out how best to minimize the costs. Some will try to improve their appeal by offering only their best funds or by building up "no-load," or low-fee, offerings. Poorly performing "me-too" funds will be closed down, combined with others, or sold off.
The speculation surrounding Merrill points to the struggle brokerages face keeping in-house mutual-fund operations. Although Wall Street likes the steady fee income from funds, it is under fierce SEC scrutiny because the business is rife with conflicts of interest. Last November, Morgan Stanley (MWD ) shelled out $50 million to settle charges by the SEC and the NASD that it misled investors by not disclosing fees the firm and its brokers received to sell funds from certain mutual-fund families. Morgan Stanley neither confirmed nor denied the charges. And in May, Citigroup (C ) and Merrill Lynch were hit with class actions alleging that they paid undisclosed incentives to get brokers to sell in-house funds. Citigroup says the suit is without merit, and intends to fight it. Merrill spokesman Mark Herr says: "There is no truth to the allegations."
In hopes of heading off the new regs, brokerages warn that the costs of implementation are much greater than the SEC estimates and will fall to retail investors. What's more, investors could end up with fewer funds to buy, the industry argues. Nonsense, say industry critics. For one thing, better disclosure of fees will have the effect of lowering costs, since competitors will be quick to highlight more attractive deals. "Right now, we don't have effective price competition," says Barbara Roper, head of investor protection at the Consumer Federation of America. And if better information forces brokerages to shut down their dud funds or improve them, that's hardly a bad thing for investors. At the very least, they will finally know what they're paying for.
By Emily Thornton in New York, with Amy Borrus in Washington