Can You Trust Your Fund Company?


First it was the accountants, then the analysts and investment bankers. Is the mutual-fund industry rife with conflicts of interest, too?

That's the central charge of a campaign by the AFL-CIO, which is demanding reforms in the name of union members who are shareholders because of the billions of dollars invested through their retirement and other benefit plans. Labor argues that because mutual funds compete for companies' benefit business, including 401(k) plans, the funds kowtow to management while failing to vote proxies in the best interests of the millions of shareholders they represent.

MOOD FOR REFORM. In late July, the AFL-CIO made its case at a rally in Boston, the home of leading mutual-fund company Fidelity. The union's goal is to force Fidelity and other funds, which together control 21% of all publicly traded shares in the U.S., to tell their shareholders how they vote on proxies. The AFL-CIO, which has been pushing the issue with the Securities & Exchange Commission since 2000, is trying to capitalize on the current mood for reform.

"This is a core conflict of interest on Wall Street," charges William Patterson, head of the AFL-CIO Office of Investments. "Fidelity gets paid to run 401(k)s for companies like Enron, so it won't vote against their interests." Fidelity Chief of Administration David Weinstein says Fidelity makes proxy decisions based only on shareholder interests.

The shareholder activist campaign is part of Labor's larger effort to alter the rubber-stamp approach to investing that's common among many institutional stockholders. The union's argument, which has gained support after the recent spate of corporate scandals, is that institutions such as pension and mutual funds uncritically vote with management on everything from poison pills to huge executive pay plans.

"QUIET DIPLOMACY." Fidelity's Weinstein insists that his company has no conflicts and shouldn't tell its investors how their shares are voted in proxy contests. His reasoning: Fidelity is such a large shareholder at many companies that its public airing of differences with management could hurt the stock price. Better to practice "quiet diplomacy," he says. Eric Roiter, Fidelity's general counsel, also points out that it is Fidelity's policy to always vote against management on three items: antitakeover measures, excessively dilutive stock option plans, and plush golden parachutes for departing executives.

The mutual funds also contend that comparing them with conflict-plagued Wall Street analysts is unfair. Federal securities laws governing mutual funds address a wide range of potential conflicts of interest between mutual-fund shareholders and the companies that manage the funds, including proxy votes. The law essentially says that mutual funds have a fiduciary obligation to vote proxies in their shareholders' best interests. In addition, funds have independent boards of directors that are supposed to monitor the fairness of proxy voting. Wall Street analysts have no fiduciary obligation to investors, nor do they face independent checks on their performance.

Plenty of experts don't buy these arguments. They say the mutual funds routinely vote with management -- a point Fidelity's general counsel recently confirmed in testimony before a New York Stock Exchange committee. And the woes of the stock market have heightened the potential for conflict. Like many large mutual funds, Fidelity has been trying to cut its dependence on money earned for managing individuals' investments, which fluctuates with stock prices, and concentrate more on such fee-based services as helping companies run 401(k)s and other benefit plans.

STOCK OPTIONS -- AGAIN. For example, Fidelity earned $2 million in 1999 (the last data available from Labor Dept. filings), for helping Tyco run $2.8 billion worth of 401(k) and other benefit funds. Fidelity is also the troubled company's second-largest institutional investor, owning 5.3% of Tyco's stock. "It's quite clear that [mutual] funds have to be very cautious in voting against their own [401(k)] clients," says John Bogle, founder of rival Vanguard Group.

A growth area for Fidelity is administering stock-option plans -- the same plans Roiter says Fidelity will vote against if they're too dilutive to shareholders. That means Fidelity could find itself voting against a plan it gets paid to administer.

Fidelity has large contracts to handle employee programs for companies such as Philip Morris, Ford, General Motors, and Shell. Overall, more than half of Fidelity's $9.8 billion in operating revenues last year came from such fee-based services, according to its current annual report. These fees, of course, are paid by the companies -- which could be ones in which Fidelity is a shareholder on behalf of its mutual-fund investors.

NOT-SO-OPEN BOOKS. Money managers that invest traditional defined-benefit pensions are required by government regulation to disclose their proxy votes. Many mutual funds, including Fidelity, manage some pension-fund money. Weinstein says Fidelity discloses its proxy votes on such funds only because it's required to. That attitude doesn't sit well with Barry Barbash, who oversaw the mutual-fund industry as the SEC's director of investment management and now is an industry lawyer. "Clients should have a right to know how a money manager votes," Barbash says.

Spurred on by the AFL-CIO, the SEC is looking at the issue of mutual-funds' proxy voting disclosures. It's not clear what steps, if any, the agency will take. But with shareholders up in arms these days, the industry may face growing pressure to open its voting record to scrutiny. By Aaron Bernstein in Washington and Geoffrey Smith in Boston


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