Mutual fund sales practices are coming under increased scrutiny, asillustrated by the

NASD's recentproposal for rules requiring disclosure of incentives thatbrokers often get when choosing certain funds for clients.

It's just too bad the proposed rules didn't exist a few years ago. Ifthey had, they might have prevented the

Morgan Stanley

(MWD)

conflict that'scurrently brewing in the Boston area. Massachusetts regulators last weeklaunched a complaint alleging that Morgan committed fraud under statesecurities acts, saying brokers in the region used aggressive salestactics akin to those in a "used-car lot." The practices included contests and cash rewards for selling the most proprietary mutual funds to investors -- and threats of pink slips if results didn't pass muster.

(For more detailed examples of Morgan's enterprising sales tactics, click here.)

Morgan's incentives weren't disclosed, and that left hapless investors with the impression that brokers were working in their best interest and nottrying to meet aggressive sales quotas for specific securities. In astatement released last Monday, Morgan noted that rules requiringdisclosure of certain potential conflicts of interest in fund sales hadn'tbeen proposed by the NASD until this month.

So why aren't stronger rules against shady sales practicesalready in place? One reason may be the pressure the financial industry hasput on regulators to stop more specific rules aimed at the types ofconflicts of interest that allegedly took place at Morgan.

Last week, NASD Senior Vice President Thomas Selman said in an interviewthat the new proposed rules "clear up" older rules. Fortunately for theNASD, the current environment allows regulators a little more leeway intightening up rules to protect investors, now that investor abuses fromrecent years have come to light.

After the NASD's release last week proposing the new disclosure rules,the Investment Company Institute, the trade group of the mutual fundindustry, was quoted in a

Reuters

article as saying, "We think it's very good for mutual fund shareholders, because it will give them more information about the incentives that brokers may receive when selling mutual funds." The ICI added that it "certainly look

s forward to working with the NASD to get this sort of improved disclosure available to the people."

This represents a bit of a flip-flop for the ICI. In a letter two yearsago, the ICI wrote to the NASD, "The Institute continues to maintain thatthe NASD should refrain from adopting rules that have the practical effectof requiring disclosure to be made in mutual fund prospectuses."

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In 1999, the NASD had proposed similar rules to those it pitched lastweek. Among other things, the rules were aimed at prohibiting payments ofhigher payout ratios for sales of proprietary investment company products.The rules also were directed at barring single-security sales contests. Theproposed rules specifically left out earlier proposals limiting cashincentives -- proposals that were shot down by the securities industry.

In the 1999 proposed rules, the NASD explained why it backed down onthe issue of limiting cash incentives. "In response to comments received on an earlier version of the Non-Cash Compensation Rules that would have imposed substantive prohibitions on cash compensation, NASD Regulation decided to delete those provisions pertaining to cash compensation."

The NASD has been trying to clean up mutual fund sales practices sinceat least 1997, if not earlier. The efforts came on the heels of the "TullyReport," which was released in 1995 after the then-chairman of the

Securities and Exchange Commission

, ArthurLevitt, wanted more information about questionable sales and compensationpractices throughout the securities business -- practices that could createconflicts of interest.

The report was named after Merrill Lynch Chairman Daniel P. Tully, whochaired the committee. One of the conclusions was that there shouldn't becontests tied to the sale of specific products, as was the case in theMorgan branch in Massachusetts, in apparent violation of firm policy. Theoverriding conclusion of the Tully report was that the securities industryshould more closely align the interests of firms and representatives withthose of customers.

One group that has strongly opposed any such specific rules is theSecurities Industry Association, or SIA, an industry group representing the shared interests of more than 600 securities firms.

In a letter to the NASD regarding a proposed rule in 1997 that wouldlimit cash incentives, members of the Investment Company Committee of theSIA wrote, "While most agree that payment and receipt of cash compensationcould lead to potential conflicts of interest, there has been no evidenceof widespread abuses regarding cash compensation in connection with thesale of securities, including investment company securities

mutual funds. ... This lack of systemic abuse leads the Committee to believe that the current regulatory structure, whereby all potential conflicts of interest are addressed using a broad-spectrum approach, is working well."

The letter went on to explain that the current industry structure"offers a workable construct that mandates the protection of customerinterests, while allowing firms the flexibility to create the education andsales incentives that meet their business needs."

Tell that to the customers of the Morgan Stanley Back Bay office, thetarget of the complaint from Massachusetts regulators. At that office,according to the complaint, the "flexibility to create sales incentives"meant clients became pawns in an effort by brokers to sell the most sharesof the Morgan Stanley Allocator Fund and other proprietary products to winprize money.

These events bring new meaning to Morgan Stanley's slogan, "One client at a time."

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.