Could securities lending be the mutual fund industry's next ticking time bomb?

Lori Richards, director of the office of compliance, inspections and examinations at the Securities and Exchange Commission has warned investment companies that the SEC will be examining mutual fund securities-lending practices. Further, the Commission is going to be taking a far closer look at funds' trading, sales and conflict-of-interest practices.

Richards wasn't kidding. The Bank of New York, Dreyfus and State Street Corp., are reportedly under the SEC's microscope for their securities-lending practices. Although spokespeople for BONY and State Street declined comment, Patrice Kozlowski, a spokeswoman for Dreyfus, said: "Dreyfus is confident that the securities-lending services it receives are provided in an appropriate manner. On that basis, [the firm] has cooperated fully with the Securities and Exchange Commission in its review of securities-lending practices in the mutual fund industry."

Richards would not confirm or deny that securities-lending practices at the three firms are under review, but she told MME the Commission wants to make sure lending agents are not overcompensated for their role in short-sale arrangements with hedge funds or other large investors. Mutual funds typically earn about two basis points annually from securities lending.

"We are looking at the lending activities of mutual funds to see if the money is coming back to the shareholders of the funds," Richards said. "We want to make sure the lending agent agreements are in compliance with the law."

Richards said that although mutual funds hire independent auditors to go over their books, annual financial reports fail to disclose details about securities-lending income. "Auditors should be looking at securities-lending practices," she said. "We are not seeing it in the mutual fund filings. Auditors need to look hard and make sure the funds are in compliance."

Anthony Sabino, associate professor of law at the Tobin College of Business at St. John's University in New York, said the move to check securities-lending practices is part of a broad-based effort by the SEC. It aims to zero in on adequate disclosure of all aspects of the mutual fund business.

"It is hard to say if [the SEC] will uncover any wrongdoing," he said. "But some financial maneuvers may not be appropriate because some may be bending the rules. This is a large move by the SEC to revamp disclosure of mutual funds. It affects other areas such as trading and sales practices and disclosure of all fees."

Standard Operating Procedure

Nonetheless, securities-lending by mutual funds is a standard industry practice. Mutual funds typically reinvest the income back into the fund. Or they may use the income to lower fund expenses. Short sellers are required to put up securities as collateral for borrowed securities. Any profits due to gains in the value of the collateral when a transaction is unwound are split between the lending agent and the mutual fund.

Overall, securities-lending markets are in excess of $700 billion, according to a report by Goldman Sachs of New York. Based on Goldman's data, MME estimates that investment companies derive over $1 billion in income from securities lending for their funds.

James Atkinson, president of the Guinness-Atkinson Funds of Woodland Hills, Calif., said that his securities-lending arrangements called for his funds to get 60% of the income from securities lending. The income was then used to lower fund expenses. But he stopped lending securities five years ago over concerns that a stock market meltdown could seriously diminish the value of the collateral.

"It is a complex transaction," he said. "The board of directors makes the decision to lend securities. The income isn't that much today. It's not worth the time and effort."

Mercer Bullard, president of Fund Democracy of Oxford, Miss., said that in the past, the SEC has never questioned securities lending even though it can be very lucrative to large fund complexes. "A large fund group can earn hundreds of millions of dollars in additional income for their funds," said Bullard, a former assistant chief counsel in the SEC's division of investment management.

Bullard suspects the SEC's examinations may be related to the following problems:

* The failure of the fund group to get an exemption for its affiliate to handle the short-sale transactions. For example, if the mutual fund division uses its parent company's security-lending division, it must file for an exemption with the SEC.

* Affiliates or agents who are overcompensated for the transaction. As a result, mutual fund shareholders do not get the appropriate amount of income generated from securities lending from their fund.

* Illegal activity if a fund isn't reinvesting the proceeds back into their funds.

In addition, there may have been some whistleblowers, Bullard said. "In the past, the SEC has not made much effort to enforce the rules. If a fund is engaged in securities lending and the proceeds are not paid back to the fund, it is a violation of federal securities law. It is fraud."

Bruce Bent, president of the Reserve Funds of New York, suspects that the SEC is attempting to cover all bases in the wake of the recent mutual fund improprieties involving market-timing abuse.

"I can't believe it is a big issue," Bent said. "I would be surprised if the [SEC] finds anything. Maybe the SEC does not want to be embarrassed by another Eliot Spitzer investigation. Securities lending has been practiced for years. It is a safe and good source of revenue for fund investors."

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