Those who have maintained the holier-than-thou attitude of the mutual fund industry and have believed that this scandal, too, shall pass, shouldn't kid themselves. It's time for the industry to turn in its halo.
New York State Attorney General Eliot Spitzer has maintained that the developments in his investigation involving corrupt deals between hedge funds and mutual funds is moving at a speed he has never seen before. Heads will roll, Spitzer has promised. Corporate crooks will be put behind bars for significant amounts of time, he's boasted.
Those who know Spitzer expect tough talk. However, New York's top regulator is not the only one talking about serious retribution.
"The industry has tried to say that this is not widespread," said Mercer Bullard, shareholder activist and former assistant chief counsel at the Securities and Exchange Commission. "I think we've reached a point where the number of firms implicated in one aspect or another indicates [the scandal] is widespread.
"In the complaint, you already have Janus, Bank of America, Bank One and Strong. Since then, you've had Merrill, Prudential, Alger and Alliance - all implicated one way or another. By anyone's definition, this is widespread in terms of the number of firms involved. And I think the number will continue to grow."
More than 80 firms in total have been subpoenaed. It is still unclear to what extent investors were harmed, although an academic report included in Spitzer's complaint indicated that market timing could diminish returns by 2%.
"The myth that the industry has somehow been a blessed industry where scandal could never happen or would never happen, is just out the window," said Don Phillips, managing director of Morningstar in Chicago. Phillips said there are two ways one could look at the developments: "The pessimistic view is, My God, this is just sprawling out of control.' Spitzer has basically said as much; this is going off in ways he didn't even anticipate.
"The more positive view is that the industry takes this extremely seriously and is rushing to clean up its act and purge any unethical behavior out of its system as quickly as possible."
However, Phillips added, market timing is moderately well spread out within the industry. There is some gray area as to what constitutes timing and when it is disadvantageous to long-term shareholders.
Kathryn Barland, a senior research analyst at Lipper, New York, believes the scandal is huge. Barland, who has worked in the enforcement division at the SEC and listing qualifications at Nasdaq, said it has been very frustrating for regulators dealing with the mutual fund industry in light of the opposition the industry gave to proxy voting disclosure, fees and expense disclosure, and even the Patriot Act. The industry has steadfastly maintained it has been flawless for 60 years and has questioned why regulators are pointing their fingers at them, Barland noted.
"I think it's beautiful that Eliot Spitzer has blown this thing wide open and made all those political arguments irrelevant. [He has] shown very clearly there is a problem in the mutual fund industry," she said.
However, not everyone is convinced of doom and gloom. "I think it's probably relatively limited," said Jeff McClure, a certified financial planner and author of The Personal Wealth Coach: Creating and Rebuilding Invested Wealth in the 21st Century. "When you look at the actual dollar damage that has been calculated, for example, by Bank of America, it's a relatively small number. Coming at the tail end of some of the other scandals, this will clean itself up rather quickly."
"Even the most serious and pessimistic view of this is that there are [only] a handful of funds doing this [involving] people at low levels" in most cases, McClure said.
Ed Moed, managing partner and co-founder of Peppercom, an international strategic communications firm headquartered in New York that specializes in crisis management for financial services firms, said the keys for firms involved in the scandal are: 1) unity among a firm's multiple departments, including sales, advertising, and legal, coming together to develop a united front and game plan; 2) persistence in cleaning up the wrongdoing; and 3) communicating that progress to shareholders.
"You can have a badly damaged reputation, but it's what you continue to do for the weeks and months after that to continue getting your house in order and communicating and being transparent and showing that you care that will get your reputation back."
In other words, the fund companies that have preemptively fired executives involved in the scandal, most notably the head of Bank of America's mutual fund business, may have done a very smart thing. As well, Janus CEO Mark Whiston may have been wise in sending out a detailed mea culpa to shareholders saying the firm had uncovered 12 market-timing arrangements with clients, but that all of them had been terminated and that they had involved only 0.25% of the firm's assets.
Moed cited Firestone as a prime example of how a firm can, over time, come back from a big scandal, just as the tire giant did with the monumental recall of its tires. Just one year after the whole ruckus, the firm had its best earnings, Moed said. In fact, Janus' stock at deadline had risen 7% since Whiston issued his missive on Sept. 30.
For fund companies that have discovered wrongdoing in their shops on their own, Moed said, transparency is the key. While they will have to bear the brunt of negative publicity in the short run, they must be open with regulators and investors in order to clean up the mess. Firms "need to take immediate action and deal with the offenders internally," even if it means firing them, he said. "They need to come forward and say, We're not going to stand for this.'"
Damage Control
For those that already had their dirty laundry aired in front of the entire world, such as Janus, there are still ways to minimize the damage, particularly the personal letter that Whiston sent out to shareholders emphasizing how Janus is cooperating with regulators. Although this in itself is not going to solve the firm's problems, it will be an early step back towards trustworthiness and regaining its reputation.
For firms like Fidelity and Franklin, which at this point have just been subpoenaed, they still should be proactive in their approach, Moed advised. He stopped short of calling it damage control, but said that there is definitely a fire in the industry and that firms need to make sure they aren't fueling it in any way. At this point, now that Spitzer has subpoenaed 80 firms, virtually every firm in the industry needs to be prepared to receive a subpoena - and for what may happen as a result, Moed said.
Bullard suggested that firms that find wrongdoing in their own shops should appoint a truly independent investigator to find out what the harm to the fund was and who was responsible for it. "When somebody at the highest levels of the firm, such as [Rich] DeMartini, [head of asset management of BoA], has actual knowledge of the fraud, they should be fired."
Bullard also said that the real question is whether there will be any meaningful repayment to shareholders. "Simply declaring that you are going to have a restitution fund, tells you nothing about whether there will be anything in it," he said.
Morningstar's Phillips said firms' course of actions should be clear: "You are much better taking control of this yourself than having Eliot Spitzer putting your internal e-mails out there for the whole world to see. Clearly, waiting for Spitzer to do his work and then holding a press conference presenting all of his evidence against you is a disastrous strategy."
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