The

NASD

proposed a new rule Thursday that would require increased disclosure on hidden incentives that securities firms and brokers receive from fund companies to choose certain mutual funds over others for their clients.

The NASD, or National Association of Securities Dealers, is a not-for-profit organization for securities firms that, under federal law, requires essentially all securities firms in the U.S. to be members. The NASD looks out for the best interests of all members and the securities business. This includes efforts to protect member firms from increased government regulation by setting rules to prevent abuses by member firms -- call it pre-emptive regulations to stop the painful government regulations that have historically resulted after corruption and abuses in the industry have come to light.

While many investors are familiar with mutual fund sales loads, most have no idea that funds offer additional incentives to brokers who sell their wares, an issue the NASD wants to shed some light on.

Sales loads are commissions used to pay brokers as compensation. The payments are how brokers and other registered dealers make money selling load mutual funds. Loads typically are 5.75%. An investor who puts $10,000 into a load fund actually only puts $9,425 into the fund and pays a sales commission of $575. All sales loads are currently disclosed in a funds prospectus, even obscure level loads designed to disguise the fact that a fund is a load fund in the first place.

The assumption when buying a load fund is that the investor is paying for expert advice in choosing the best funds. Many investors aren't comfortable with making their own investment decisions, which is why load funds exist alongside no-load funds that can be purchased without paying a commission.

The presumption is that the investor is paying for objective, expert advice -- most load funds pay 5.75%, so the broker must be choosing the best among the load funds for the investor. In practice, as the proposed NASD rule implies, the broker may just be choosing the funds that pay the most beyond the regular load.

Call it mutual fund payola, after the system in which record labels paid DJs to play certain songs and created disincentives for them to objectively choose the best songs. But as the nation's retirement money is at stake, this is an exponentially more serious situation.

With the proposed rule, the NASD will let fund investors see, or at least become more aware of, certain payoffs that funds give brokers beyond the load. The rule is specifically aimed at two areas of incentives: shelf space fees and perks that go beyond the load sales incentives.

Shelf space fees are the slotting fees of the brokerage industry. Large supermarket chains routinely charge companies like

Coca-Cola

"slotting fees" for prominent display and shelf space. Brokers have a similar scheme in which a fund company would need to make a large payment to get on the list of funds that clients of the broker can buy -- regardless of whether the broker actually sells any of the funds. Load funds that don't pay the fees -- no matter how good they are as investments -- won't be available to customers of the broker even if they pay the usual 5.75% load. Call them RC Cola funds.

Beyond the load sales incentives are additional commissions or perks paid to the brokerage firm or the selling broker above the normal sales commissions all load funds will pay. In supermarkets, food companies will pay supermarkets to promote certain items or offer them at a discount. In a similar vein, a broker selling certain funds that are paying out extra commissions would receive more money than a broker selling another fund.

The fund companies make these payments to brokers out of pocket or, even more questionably, by directing trades to certain brokers. Funds routinely overpay commissions on stock trades with fund assets to generate so-called soft dollars, which can be used, among other things, to pay brokers for these types of product-placement deals. Other investors in a fund bear these costs as the fund directs trades to brokers at above-market rates to create the necessary incentives.

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The proposed rule will require brokers to disclose in writing to clients before making a sale:

1) That a fund's fees and expenses are available in the funds prospectus

2) That a fund's polices toward such incentive payments is disclosed in the fund's Statement of Additional Information, or SAI

3) Whether the broker receives cash compensation beyond that disclosed in the prospectus for making a sale and the nature of this compensation

4) A list of the funds that pay the firm these fees in order of size

5) Whether the brokers receive different compensation from different funds, the nature of these payments, and a list of the favored funds making the payments

While the proposed rule primarily deals with load funds and the registered representatives of securities firms that sell load funds, it could apply to no-load funds in some cases.

Schwab

(SCH)

receives different payment schemes from different mutual funds available on its OneSource fund supermarket. Funds pay Schwab slotting fees for placement on the system, and some funds pay higher fees as a percentage of assets sold by Schwab.

The NASD has no intentions to halt or limit any of the payoff practices; it just wants investors to know they exist.

Such disclosure could alert investors to the fact that the broker may not be acting in the client's best interests when choosing among load funds. This is similar to requiring investment banks to disclose any investment-banking relationships that may influence their stock research.

Fortunately for the brokerage industry, regulators feel disclosure is the solution to most evils, instead of actually stopping them altogether. All the investors who read fund SAIs would probably agree. That's if you can find any to ask. Most investors have never seen an SAI, and wouldn't understand what they are reading if directed to inspect the long document that funds make available only upon request.

Jonas Max Ferris is co-founder of

MAXfunds.com, a fund research and analysis company, and partner in an investment advisor offering managed accounts in mutual funds. He welcomes column critiques, comments or baseless accusations at

jferris@maxfunds.com.