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NOVEMBER 10, 2003
The Coming Mutual-Fund Reforms As mutual-fund abuses mount, regulators and lawmakers promise tough new rules For decades, the mutual-fund industry used its squeaky-clean record as a shield against new rules and congressional scrutiny. But with the fund-trading scandal spreading throughout the industry, that defense falls flat. Lawmakers and state and federal regulators are now itching to overhaul the industry, in the same way they put Corporate America through the reform wringer last year. Coming soon: tough new rules from the Securities & Exchange Commission, a round of klieg-light hearings on Capitol Hill, and maybe even far-reaching legislation similar to the Sarbanes-Oxley Act that followed the 2002 plague of corporate scandals. Says SEC Commissioner Harvey J. Goldschmid: "This industry generally says, 'Leave it to us.' I think we're past that now. We've got to be a lot more aggressive in protecting investors." Regulators are alarmed by the extent of the abuses. In reviews of 88 fund companies controlling 90% of the industry's $7 trillion in assets, the SEC found that half allowed at least one large investor to engage in market-timing -- a practice whereby investors buy fund shares at outdated prices and then sell them a day or two later. Though market-timing isn't always illegal, it cuts the returns of long-term shareholders. And by allowing only certain investors to engage in the practice, funds may be violating securities laws. A study by fund consultants Lipper Inc. shows that shares in almost a quarter of 126 international funds changed hands completely in the previous 12 months -- a strong sign of market-timing. The scandal is also enmeshing insurance companies selling variable annuities, policies that let investors pay their premiums to mutual funds. The SEC is probing whether insurers enforced their own rules against market-timing. "The problem isn't limited to a firm here or a person there," says SEC Enforcement Director Stephen M. Cutler. "We are finding a disturbing amount of misconduct." Regulators also are uncovering more instances of late trading. This happens when funds, brokers, or insurers allow investors to trade fund shares at that day's closing price even though the orders came in after the official 4 p.m. New York time cutoff. Late trading is illegal. And the agency is developing new cases against mutual funds in which hedge funds have paid fees for a sneak peek at their portfolio holdings. The hedge funds then use the information to buy or sell stocks before the mutual fund does, potentially moving prices against the mutual fund and damaging the interests of its shareholders. The fund scandal has even intruded into the 2004 Presidential election: On Oct. 28, Democratic candidate Senator Joe Lieberman (D-Conn.) proposed reforms, including increasing the number of independent directors and better disclosure of the fees funds pay brokerage firms to sell their products. Shell-shocked fund companies are scrambling to get ahead of the unfolding debacle. "You could've pushed me over with a feather when the first late-trading charges were announced" in early September, says Paul G. Haaga Jr., chairman of the industry trade group Investment Company Institute. "Now I'm almost numb hearing [it] again and again." "RIPE FOR REFORM" Companies are hiring outside auditors to investigate whether abuses occurred in any of their funds. They're reviewing rules with brokers who sell their funds and with transfer agencies that process trades. Seven fund groups so far have pledged to make up any losses to shareholders. And fund boards have been holding emergency meetings and demanding explanations from management. Industry lobbyists, meanwhile, are urging lawmakers to let the SEC handle the cleanup and not pass new laws. "I'm hoping it is regulatory, not legislative," says John J. Brennan, chairman and chief executive of Vanguard Group Inc. He's not likely to get his wish. Republican lawmakers are hustling to crack down before fund misdeeds become an embarrassing campaign issue. "Maybe we need the equivalent of a Sarbanes-Oxley bill directed at the mutual-fund industry," says Senator Peter G. Fitzgerald (R-Ill.), who will chair a Nov. 3 Senate governmental affairs subcommittee hearing. "The industry is ripe for reform." His star-studded witness list includes New York Attorney General Eliot Spitzer, whose case against hedge fund Canary Capital Partners LLC in early September alerted investors and the SEC to market-timing and late-trading abuses. On Nov. 4, Representative Richard H. Baker (R-La.), who chairs a House subcommittee that oversees capital markets, plans to grill executives of major fund companies. Baker, sponsor of a bill that would force funds to disclose more information about fees, plans to sharpen his proposal to require chairmen of fund boards to be independent of management. "Ultimately it's a question of governance," says Baker. Not to be outdone, the SEC will soon issue its own reform package. To curb late trading, it's likely to require that funds receive orders to buy or sell shares no later than 4 p.m. for investors to get that day's price. Currently, back-office delays mean that brokers often forward orders to a fund long after 4 p.m., enabling them to hide illegal late trades in a bundle of on-time trades. But the industry has resisted this change because it would force 401(k) plans to impose trading deadlines on employees as early as 9 a.m. in California. To discourage in-and-out trading by fund managers for their personal accounts, the SEC may make them hold fund shares for a minimum of six months. Also under discussion: raising the 2% ceiling on redemption fees that funds are allowed to charge investors, and making such fees mandatory. Much of Washington's focus in coming months will be on governance, particularly the failure of fund directors to protect shareholders' interests. Don Phillips, president of fund-rating service Morningstar Inc., says sleepy boards "are the biggest problem." To fix that, the SEC may soon require funds to name a compliance officer who reports to the board. FOLLOWING EVERY LEAD Indeed, in the latest joint SEC-state regulator case, filed on Oct. 28 against Putnam Investment Management LLC, enforcers allege that Putnam failed to notify its board of numerous market-timing violations by managers of the funds they oversee. While most of the suspect trades took place years ago, some occurred as late as March, 2003 -- contradicting earlier Putnam assertions that it had corrected the problem in 2000. Putnam, the country's fifth-largest fund company and the first to be charged in the mushrooming scandal, also was cited for failing to prevent market-timing in several of its international funds. Putnam denies wrongdoing but is in settlement talks with the SEC. With the lid off the scandal, regulators are following up every lead. While the SEC's Boston office failed to pursue a whistleblower's tip in March about some of the Putnam abuses, Cutler personally instigated part of the Putnam case after receiving a tip from a separate source. Now, 10 of 11 regional offices have active fund investigations under way, and many have multiple cases. An industry that exploited its pristine image and its stewardship of the Investor Class's money to deflect tough oversight may have sowed the seeds of its current problems. "The scandal-free mantra made all of us drop our guard a bit," says a top SEC official. "That has to change." Now, there's every sign that it will.  By Paula Dwyer and Amy Borrus in Washington, with Lauren Young in New York
BW MALL
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