Mutual Fund Outrage Keeps Growing

By John Waggoner, Christine Dugas and Thomas A. Fogarty, USA TODAY

Nov - 2003

Regulators are turning over every rock in the mutual fund industry, and they don't like what's seeping out. "It's a cesspool," says New York Attorney General Eliot Spitzer. In Boston, new charges surfaced against former Prudential Securities employees, the head of Putnam Investments was forced out, and a Securities and Exchange Commission official resigned. At Senate hearings Monday, regulators blasted the fund industry for the widening trading scandal, as well as shady sales practices.

Monday's hearings were no one-day ritual congressional flogging, after which it's all business as usual. Mutual fund trading abuses are more widespread than first suspected. Proposed new laws will be tough. And the crackdown on funds and fund executives is just starting. "I can safely predict that many more enforcement actions will follow," says Stephen Cutler, the SEC's chief enforcement officer.

For the mutual fund industry, the scandals mean lawsuits and possibly oblivion for some companies. For regulators, they mean new laws — and, perhaps, bigger enforcement staffs. For individuals, the effects are far-reaching and complex. Some investors may turn their backs on funds entirely. All will have to cope with new rules for buying and selling funds. And even with new laws and vigorous enforcement, investors may never entirely trust their funds again.

Bombshell after bombshell

Ever since Spitzer rocked the fund world in early September with allegations of trading abuses, new revelations just keep coming.

Most recent: Massachusetts securities regulators today filed civil securities fraud charges against five former Prudential Securities employees. The regulators accused three former Prudential brokers and two former branch managers of engaging in a fraudulent market-timing scheme to make money for themselves at the expense of mutual fund shareholders.

Regulators say Prudential knew about the activity but failed to stop it. Prudential received an incredible influx of about 30,000 warnings and termination letters from fund companies during the past year but took no action, regulators allege.

The SEC has filed similar charges.

There could be even more market-timing allegations ahead. The SEC surveyed the 88 largest mutual fund firms for violations last month. Cutler says half the fund companies had market-timing agreements with favored clients. Market timing is rapid, in-and-out trading to take advantage of differences between the fund's share price, which is set once a day, and current market conditions. It's not illegal, but most fund companies have policies against it.

Spitzer ignited the scandal when he settled in September with Canary Capital, a hedge fund, for mutual fund trading abuses. Four fund companies — Janus Capital, Strong Financial, Bank of America and Bank One — were implicated.

They weren't doing it alone. Thirty percent of the brokerage firms the SEC surveyed helped clients mask market-timing trades, either by breaking up big orders or creating special accounts to hide identities. And 70% of brokerages knew that some clients were market-timing funds.

Even worse, 10% of the fund companies surveyed may have allowed late trading, according to preliminary results from the SEC's survey. Late trading is when customers put in a trade after the funds' 4 p.m. ET cutoff but get the pre-4 p.m. price. It's like betting after the race is over, and it's illegal. The SEC survey showed that 25% of brokerage companies allowed late trading. Three fund companies had late-trading arrangements with clients.

But Monday's revelations didn't stop there.

• The National Association of Securities Dealers and the SEC cracked down on widespread abuses in mutual fund sales practices, saying brokerage firms overcharged investors on sales charges, or loads. The NASD says the average overcharge was $243 and that some investors were gouged for as much as $10,000. NASD estimates that at least $86 million is owed to investors for 2001 and 2002.

• The SEC says 30% of fund companies disclosed details about their portfolio holdings to favored customers. Armed with the knowledge of what funds are doing, those customers could buy or sell along with the fund and make outsized profits. The industry has been fighting against increased portfolio disclosure to ordinary investors for years.

The NASD is also looking at payments from fund companies to be on brokerage firms' recommended lists. Investors who buy those funds usually aren't told about such payments.

Remedies: Off with their heads

The question now: How to fix the fund industry? Heads are already rolling.

Lawrence Lasser, CEO of Putnam Investments and one of the most lavishly paid executives in the industry, was fired Monday. Richard Strong, CEO of Strong Financial, stepped down as chairman of Strong Mutual Funds. He is still CEO of Strong Financial.

And Juan Marcelino, head of the SEC's Boston office, resigned Monday. Marcelino had been tipped about Putnam's market-timing activities but didn't act on it. Massachusetts Secretary of the Commonwealth William Galvin brought the charges against Putnam.

But the industry's problems won't be solved by personnel changes. Both the SEC and the Investment Company Institute have proposed tough rules to end late trading and market timing. (Related chart: The root of the problem, and possible ways to combat it)

Among the issues highlighted at the hearing for possible legislation or regulation:

•Board independence. Mutual funds are structured so that a board of directors oversees a series of contracts with service providers, including the company that manages the fund's assets. Commonly, those executives hold the chairmanship and seats on the board. Industry critic Mercer Bullard, a University of Mississippi law professor, urged the Senate panel to require that board chairmen be independent of the service providers.

•Regulatory structure. The scandal underscores the inability of an overworked and underfunded SEC to regulate funds. "Market timing has been an issue for at least a decade," says Richard Sauer, partner in the Washington law offices of Vinson & Elkins. "You couldn't swing a dead cat in the mutual fund industry without hitting a market timer." Bullard recommended creation of a separate federal oversight board financed by assessments on the industry.

•Competitive bidding. Mutual fund investors are nearly assured that high fees will reduce their long-term returns, said Sen. Peter Fitzgerald, R-Ill., who chaired Monday's hearings. He says he will push for a requirement that contracts for managing a fund's assets be occasionally put out for competitive bids.

No quick fix

Fixing the fund industry won't be easy, in part because there's no agreement on the best way to do it.

For example, retirement plan experts say the Investment Company Institute proposals to end late trading would hurt workers and put many retirement providers at a disadvantage. Currently, 401(k) plan participants must make trades by the 4 p.m. deadline, but the plan administrators can take extra time after the deadline to collect the trades and forward them to the fund companies.

The result of the new deadline for retirement plans: It could take three or more days to process a trade that now takes one day, says David Hand, president of Hand Benefits & Trust in Houston. "There will be more opportunity for abuse" by mutual fund managers and insiders who could make advance trades based on knowledge of upcoming retirement plan shifts, he says. Figuring out how to compensate shareholders' losses in the trading scandal won't be easy, either. "It will be grist for 100 Ph.D. dissertations in economics the next few years," Sauer says.

Spitzer says he won't settle with funds unless they can ensure a compliance program that will catch abuses. They will also have to disgorge profits from illicit trading — and give up management fees from the funds for the period the abuses occurred. "The number will be big and will impose pain," he says.

He's also pushing hard for funds to lower fees. At the hearing Monday, he said funds overcharge customers by a quarter of a percent per year. He figures that's $10 billion out of investors' pockets each year. "We don't believe funds have negotiated aggressively to keep fees down," Spitzer says.

The House, which held hearings into the fund industry this summer, will hold more hearings this week. Any new SEC regulations will have to be put out for public comment before they're enacted. Fitzgerald said comprehensive mutual fund legislation is unlikely this year because Congress will adjourn soon. Investigations by state and federal authorities could drag on for months.

One thing regulators agree is clear: The industry must be fixed. "Individual investors have a right to expect fair treatment, and quite simply, they have not gotten it," says the SEC's Cutler.


** Editors note:

From: The Journal Of The Committee On Monetary And Economic Reform.


And let no condescending thought cross a Canadian mind, that there are few or no investigations of crime in our financial circles. That is only because the cover-up is almost absolute. Especially, on the victims of brokerages in modest margin accounts. Try contacting the Ontario Security Commission to complain about your bank-broker having taken the crudest advantage of you in your margin account, and you will get a voice message:

“If you have a complaint against your broker, contact a lawyer.”

They know and the bank knows that a lawyer will cost you more than your not inconsiderable loss. Margin accounts – the field of the little guy – are open game for the banks especially when they themselves are the trouble.

But then perhaps you should not have been in the stock market on margin? But isn’t our financial system – particularly the bank – broker – underwriters – derivative boutiques itself on margin? Currently at a leverage of about 380 to one.

William Krehm