WASHINGTON - The crusade against mutual funds for ripping off customers is reaping benefits as Congress prepares to draft new legislation to curtail trading abuses and protect shareholders.

Testifying at a series of hearings before both the Senate and House of Representatives last week, bulldog New York Attorney General Eliot Spitzer continued to thunder away at the fund industry for its egregious and widespread abuses.

"It is a cesspool," Spitzer said, regarding the wave of improprieties his office has uncovered since launching a full-scale investigation into mutual fund trading practices in September. His vigorous pursuit of firms that have allowed market timing and late trading in their funds has prompted legislators to consider revising a bill that would clean up the fund industry.

Sen. Daniel Akaka (D- Hawaii) indicated he will be working closely with Rep. Richard Baker (R- La.), chairman of the House Subcommittee on Capital Markets, on drafting a bipartisan bill to restore public trust in mutual funds. The bill will aim to build on reforms detailed in the Mutual Fund Transparency and Integrity Act, or Baker Bill, which passed in the House earlier this year, but ultimately stalled in the Senate.

Spitzer's probe has brought to light a morass of conflict of interest in the fund industry, as more than a dozen mutual fund companies have been implicated, and one firm, Putnam Investments of Boston, has been formally charged with securities fraud. New York brokerage Prudential Securities was also slapped with charges that former brokers and branch managers at its Boston office engaged in improper trading.

Richard Strong, chairman and CEO of Strong Financial of Menomonee Falls, Wis., is currently facing an investigation by state and federal regulators after admitting to trading in his own accounts. Spitzer insisted that the scandal is more than just a few bad apples but rather, "The whole crate of apples is rotten." The SEC estimates that at least 10% of mutual fund complexes are guilty of late trading and that more than half of them have market-timing arrangements in place.

The Unholy Trinity'

Spitzer promised stiff penalties for the firms found guilty of late trading, market timing and self-dealing, or what Stephen Cutler, director of enforcement at the Securities and Exchange Commission, dubbed the "unholy trinity." Spitzer called for the complete disgorgement of losses along with any fees retained as a result of their dereliction of fiduciary duty. "This number will be big, it will impose pain, and it should," he boomed.

In terms of identifying what constitutes criminal behavior, Spitzer said that if a firm knowingly permitted market timing and accepted payment for it, it will be charged. When asked if the investing public will be satisfied with the punishment the offenders receive, Spitzer snapped that his job is not to make people happy but rather to prosecute the offenders. He declined to comment on whether the offenders would see any real jail time but assured that he is not done yet. "There will be more cases," Spitzer told Money Management Executive.

Another sticking point for Spitzer was that, by charging excessive fees, funds are not delivering on their promise of an economy of scale. He noted that mutual fund assets grew 60 times between 1980 and 2000, but fund fees grew by 90 times during that time frame. Shareholders, on average, pay 25 basis points more for advisory services than pension funds pay, despite receiving near identical services. In fact, a 25-point reduction in the advisory fees that all mutual fund shareholders pay would result in a staggering savings to investors of more than $10 billion annually.

Despite the overwhelming evidence of impropriety, Spitzer stopped short of recommending that investors dump shares in mutual funds. "That would be a mistake," he said. Rather, he proposed a series of reforms that would revamp the way funds are structured.

A key provision of Spitzer's proposed reforms is the inclusion of a "favorite nations" clause in fund contracts that would prevent advisory firms from charging them fees in excess of those paid by pension funds. Another action step he endorsed was requiring funds to negotiate advisory and management fees by obtaining multiple bids. Requiring funds to have independent directors and an independent chairman was also high on his list.

Skimming the Till

Sen. Peter Fitzgerald (R-Ill.), chairman of the Senate Subcommittee on Financial Management, the Budget and International Security, expressed similar concerns about how mutual funds are organized and managed. Many fund directors are also insiders at the firm, he argued, and federal law not only allows such an incestuous relationship but also codifies it. The combination of an ambiguous fee structure, abusive trading practices and government policies that channel money into funds has turned the industry into a "monster" that does not adequately represent shareholder interests, Fitzgerald said.

"The mutual fund industry is now the world's largest skimming operation - a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings," Fitzgerald said.

But fund firms were not the only target of the slings and arrows of state regulators and lawmakers last week. The SEC took its share of lumps for its inability to effectively catch what have been described as obvious cases of fraud. Spitzer pointed out these illicit trading practices are the product of a systemic failure of compliance and has repeatedly told the press that the SEC was asleep at the switch.

Juan Marcelino, head of the SEC's Boston regional office, announced his resignation last Monday after enduring withering criticism for not acting on a tip from a whistleblower at Putnam. Massachusetts' top regulator, William Galvin, later discovered that Putnam knowingly allowed at least two of its portfolio managers to time their own funds. Additionally, Putnam allowed at least 28 members of the Boilermakers Local 5 union to rapidly trade in and out of its funds, racking up millions of dollars in profits. "For too long, a culture of compromise and accommodation has overwhelmed enforcement efforts," Galvin said.

Despite admitting that he regretted not catching certain instances of fraud, Cutler defended the SEC's position by saying that it has imposed 679 enforcement actions in 2003, more than double the number of actions taken two years ago. These have resulted in $1.5 billion in recovered losses. It has also brought enforcement actions against 16 chief executives and the New York Stock Exchange. He believes that his unit is doing a good job given the 200,000 complaints it receives each year and the resource constraints under which it operates. "We have to be everywhere in the marketplace," Cutler said.

The SEC proposed mandatory redemption fees for all short-term trading, with a minimum of 2%; expanding options to delay exchanges; and allowing funds to return gains from short-term trading to the fund.

The seething criticism from Spitzer's office continues to be that the SEC was behind the eight ball on market timing and late trading. A week prior to the hearings, he called for the head of Paul Roye, the SEC's director of investment management, who also delivered testimony.

But Spitzer kept a civil tongue during the hearings, saying that he was merely expressing frustration that the abuses were not caught sooner and that he welcomes the opportunity to work together. He also maintained that the SEC will continue to be the primary regulator for the securities industry.

But don't be fooled by his gracious words, because the truth is that Spitzer doesn't plan to bow out to federal regulators, especially considering he may run for governor of New York in 2006, as some analysts have speculated.

Presumably, this is what is holding up legislation in Congress that would further empower the SEC. The Securities Fraud Deterrence and Investor Restitution Act would make it significantly more difficult for state cops to police the securities beat. The pro-investor bill includes a provision that would restrict state regulators from taking enforcement actions against financial services firms. Advocates of states' rights have labeled this provision a "poison pill" that would effectively sabotage early detection of securities fraud. After all, it was Spitzer and Galvin who brought mutual fund misdeeds to light and not the SEC.

Around the Horn

The scandal has successfully brought to light serious flaws in the system, but the question remains as to what steps should be taken to remedy them. Industry officials and shareholder advocates also had their turn at bat. "The way that funds are sold and managed reveals a culture that thrives on hype, promotes short-term trading and withholds important information," testified Arthur Levitt, former chairman of the SEC.

Levitt proposed that the fund industry proactively ban performance advertising, elect an independent chairman in each fund, forbid active trading of funds by managers and draft legislation to protect shareholders.

Mercer Bullard, founder of Fund Democracy and assistant law professor at the University of Mississippi, proposed forming a Mutual Fund Oversight Board, a special task force designed to monitor the activities of fund firms and their boards (see MME 11/3/03). Don Phillips, director of research at Chicago-based research firm Morningstar, doesn't think structural change is necessary but that several improvements should be made including how costs and fees are communicated to shareholders, the makeup of the board and a better pricing mechanism to remove the potential for arbitrage.

Meanwhile, the Investment Company Institute endorsed three reforms it believes would slam the door on late trading and market timing (see related story, 8).

It is still unclear which proposed reforms will end up in the final draft of the new bill, as the debate continues to be whether to revamp the entire structure of the fund industry or simply address the most recent allegations. But as the scandal widens, it will become increasingly difficult to argue the latter.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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