“Putnam Investments is dropping its practice of rewarding brokers who sell more of the company’s products by directing commissions to their firms, a way of doing business that has recently drawn scrutiny from federal regulators,” writes John Hechinger in today’s Wall Street Journal.

“John A. Hill, chairman of the Putnam funds’ board of trustees, which represents fund shareholders, disclosed the planned switch in a letter last week to Securities and Exchange Commission Chairman William Donaldson. The move comes at a time when Putnam, the first mutual-fund firm charged in the fund-trading scandal, is seeking to restore its reputation and stem investor defections.”

“The shift by Putnam, a unit of Marsh & McLennan Cos., also coincides with a broadening focus by regulators on sales practices in the mutual-fund business. For years, mutual-fund companies have rewarded brokerage firms that sell large amounts of their funds by steering trading business to those brokerage firms, a practice called ‘directed brokerage.’ It is legal for a mutual fund to consider a broker’s record of selling its products when deciding where to direct commissions, as long as the broker is providing ‘best execution’ of trades, or prices in line with those of other brokers. It is illegal if there is a set quid-pro-quo between the broker and mutual fund in which commissions are traded for extra business. “

“Last week, in settling a suit against Morgan Stanley, the Securities and Exchange Commission and the National Association of Securities Dealers charged that Morgan Stanley failed to disclose that it was receiving extra commissions for selling certain mutual funds. After the settlement, Morgan Stanley said that it had such arrangements with 16 firms, including Boston-based Putnam, the nation’s fifth-largest fund firm. Morgan Stanley paid $50 million to settle. The company neither admitted nor denied wrongdoing. In his letter to Mr. Donaldson, Mr. Hill of Putnam said the practice created ‘potential conflicts of interest’ between Putnam and its shareholders, saying it was often difficult to determine whether a broker was really offering best execution on trades. Mr. Hill, an independent director who doesn’t work for Putnam, also urged Mr. Donaldson either to restrict or end the practice on an industrywide basis.”

” ‘We believe that eliminating this long-standing potential conflict of interest in the mutual-fund industry would serve the interests of all mutual-fund shareholders and urge the commission to make Putnam’s new policy the industry standard,’ wrote Mr. Hill, who said he believed Putnam practices didn’t violate any regulations. Mr. Hill is vice chairman and managing director of First Reserve Corp., a private-equity buyout firm specializing in energy investments.”

“An SEC spokesman said Mr. Donaldson doesn’t comment on correspondence. Robert Plaze, associate director for the SEC’s division of investment management, said, ” ‘We are closely examining this area and are preparing further guidance.’ ” Mr. Hill’s letter comes as Putnam Investments’ assets have dropped $30 billion in the past three weeks after facing state and federal civil-fraud charges last month related to fund trading. Putnam acknowledged that six fund managers engaged in short-term trading of Putnam funds in their personal accounts that hurt long-term shareholders.”