WASHINGTON - Testifying before the Senate Banking Committee last week, SEC Chairman William Donaldson called for the formation of a new risk assessment unit to circumvent abuses in mutual funds and other investments.

He also called for a greater representation of independent directors on fund boards, including the chairman, and reiterated his call for a chief compliance officer.

Defending his agency's much-criticized, unilateral settlement with Putnam Investments, Donaldson stressed it is only a "partial settlement" in investigations that will be ongoing.

But when pressed by Banking Committee Chairman Richard C. Shelby (R-Ala.) as to how the mutual fund industry could be filled with such "illicit collusion" and "financial schemes," Donaldson and his counterpart at the Investment Company Institute said the authorities never thought to look for market timing or late-trading abuses.

"Innocent or dumb as I was, these issues blindsided me," said Matthew Fink, ICI president. "Late trading never occurred to me, and that any fund group sold the right to market time as a quid pro quo -- it's incredible. No one at the SEC or the NASD thought this was going on."

"Were they blind?" Shelby rejoined, as he and the other Senators repeatedly did throughout the hearing.

"You sit at the top of the pyramid of your industries, with reports now coming out that these practices were an open secret," challenged Sen. Paul Sarbanes (D-Md.). "What was going on?"

Fink admitted that the ICI became aware of market timing in 2001, but not whether it was abusive. "You didn't look closely enough," Shelby quipped.

One bombshell that Fink dropped during the hearing is the ICI's backing for prison terms for those who violated criminal laws.

"I am appalled by the circumstances that caused you to convene this hearing," he said. "I am outraged by the shocking betrayal of trust exhibited by some in the mutual fund industry."

Fink said he also regretted reiterating so many times over the course of his 32 years at the ICI how the 1940 Act, the genesis of the mutual fund industry, had been such a basis of integrity that it hadn't needed any major alterations in these 63 years since.

An Investor's Bill of Rights

Donaldson reiterated some of the measures he and the ICI have put forth in recent weeks to correct mutual fund trading abuses, namely a firm 4 p.m. deadline and a 2% redemption fee for trades within three to five days of a fund purchase.

But he went further last week, saying that the boards of mutual funds should have an independent chairman and 75% to 80% of its members also unaffiliated with a fund. This marked a major concession by the SEC, although it did not broach investors' rights to vote their own slate of trustees, which shareholder advocates have been calling for.

Besides these proposals, the SEC chairman set forth a number of new proposals, one of the foremost being an eight-point mutual fund investor's bill of rights, the last of which assures investors: "Aggressive enforcement actions will be taken when there are violations of the federal securities laws."

Examination Sweep

Further, the SEC is conducting an examination sweep of 15 broker/dealers, and in January, the Commission is going to ask for dollars-and-cents fee disclosure. It will also work to provide investors "insight into management and other fees for a fund," including 12b-1 fees, B shares, revenue sharing, premium shelf space and soft dollars, Donaldson said. Clearly, this is a major concession to the glaring national spotlight the SEC now finds itself under, since the fund industry has vigorously fought it on these points in the past.

The SEC is also going to form an office of risk assessment to join the efforts of its divisions of investment management, inspections and enforcement. The office will detect areas of fraud or abuse yet uncovered, and the Commission is also going to ask senior regulators to oversee the handling of the more than 1,000 tips a day.

Additionally, the SEC has joined with the National Association of Securities Dealers to form an omnibus task force and is forming another special task force to cooperate with state regulators and industry groups.

Alluding to New York Attorney General Eliot Spitzer's harsh criticism of the SEC's settlement with Putnam, Shelby noted how the settlement "doesn't force Putnam to change its fee structure or disgorge fees. Some have said you missed the opportunity to create an opportunity for reform," Shelby said, to which Donaldson answered, the Commission wanted to resolve Putnam's woes quickly in light of the massive redemptions of the past few weeks. In the last two weeks alone, Putnam has lost $21 billion, or 7.6% of its $277 billion of assets under management.

When Donaldson concluded that he hoped such measures "will stimulate fund leadership to come to us," once again, he set himself up for further jabs. "I hope you will go after the culprits" and not expect them to come willingly, Shelby mocked.

Concern Throughout the Nation'

The Senators stressed the severity of the situation, not only for the 95 million investors who have entrusted $7 trillion of their retirement and families' money to mutual funds, but also how those investments have fueled the capital markets and infrastructure of the nation. Indeed, they said, mutual funds are a vital part of the U.S. economy.

"Deeply disturbing practices involving a growing number of funds [have caused] concerns [to] mount throughout the nation," Sarbanes said. "The revelations are eroding investor confidence."

Jack Reed (D-RI) called the fund scandal "a profound breach of trust, an existential problem."

Whatever needs to be done to stem the tide, to empower the SEC to create new rules and regulations and beef up its inspections, will be provided, Shelby vowed.

Editor's Note: Look for more on the Senate fund hearings in next week's issue of Money Management Executive:

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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