Mutual Funds: No Moss on This Mess


By Amey Stone As financial dust-ups go, the mutual-fund scandal has its share of pyrotechnics. It erupted with a bang on Sept. 3, when New York Attorney General Eliot Spitzer filed his initial complaint alleging that a hedge fund and four prominent mutual-fund firms had engaged in illegal or unethical trading deals. Ever since, the fireworks have grown louder.

Within just three months, more than a dozen fund companies have been implicated, a major fund middleman has been put out of business, several top executives are battling fraud charges, and both Congress and the Securities & Exchange Commission are honing new regulations.

TARDY PRECEDENT. Concern grows as more prominent fund outfits have been drawn deeper into the scandal. On Dec. 3, the SEC and Spitzer's office announced civil fraud charges against Denver's INVESCO Funds Group and its chief executive for allegedly breaching their fiduciary duty to shareholders by allowing market-timing in their funds (see BW Online, 12/1/03, "Invesco May Be in the Crosshairs"). And on the same day, amid allegations that he engaged in short-term trading, Richard Strong resigned as chairman and CEO of Strong Financial, the mutual fund company he founded, which was among the first firms implicated in the scandal.

The speed at which the government has brought or resolved cases against the fund industry contrasts sharply with other recent financial scandals. Consider that, with the exception of Enron's former Chief Financial Officer Andrew Fastow, no other top exec from the once-high-flying energy trader has been charged yet by federal prosecutors -- years after its implosion shredded billions in market value.

Yet, the founders of PBHG Funds, a venerable mutual-fund company, are already facing civil charges. In a span of a few months, James Connelly Jr., former head of mutual funds at Fred Alger & Co., has been arrested, convicted, and barred for life from the industry for tampering with the investigation into his firm's trading practices (he pled guilty).

CLEARLY ILLEGAL. Spitzer's probe into conflicts of interest between investment banking and research divisions at Wall Street firms directly and indirectly cost plenty of bankers and analysts their jobs -- but heads never rolled at the top of most of those firms as they have in the fund scandal. It took just days following the New York AG's initial compliant for fund firms he named to significantly reshuffle their top ranks and for their boards of directors to promise restitution to shareholders. Other fund companies, such as Alliance Capital, suspended executives before prosecutors named them.

Institutional investors, too, have reacted much faster to the fund fiasco than to earlier episodes. The research scandal aroused little ire from institutional fund managers (who always knew Wall Street research was tainted), but they have been fleeing named fund companies in droves -- and are now calling for reforms even ahead of proposed new regulations (see BW, 12/1/03, "The Critical Battle for Fund Reform").

What's going on here? Although the schemes fund traders used are often hard to understand, they aren't murky from a legal perspective. Fund companies have a clear fiduciary duty to put the interests of shareholders ahead of their own. Trading in funds after the market's 4 p.m.close is illegal. And fund firms are supposed to follow the guidelines issued in their prospectuses, which, at most outfits, discouraged market-timing.

INCENTIVE FOR SPEED. "Convictions of Enron defendants require pulling together a pretty complicated case. But these [mutual-fund] frauds are pretty simple. It's not so hard to make a case," says Mercer Bullard, president of advocacy group Fund Democracy -- particularly when it involves trading after the 4 p.m. deadline. Adds Bullard: "Many of these violations are so unambiguous."

Spitzer made a similar point in his statement announcing charges against INVESCO: "The evidence in this case speaks for itself," he says. "Top managers knew market-timing was harming buy-and-hold investors, but they condoned and facilitated it because it was a lucrative source of management-fee revenues."

Fund companies implicated in the probe also have an incentive to act quickly in hopes of putting the scandal behind them and regaining shareholders' trust. Putnam Investments has already reached a settlement with the SEC over improper-trading charges. "For compelling business reasons, fund companies have the motivation to clear things up very quickly," says Dallas Salisbury, president of the Employee Benefit Research Institute.

SOMETHING TO PROVE. That's why some are making the case that they didn't engage in late trading, which clearly flouts the law, even if they did allow select cases of market-timing, which is questionable but not necessarily illegal -- depending on the wording in their prospectus, says Sherrie Savett, chairperson of the securities litigation department at law firm Berger & Montague in Philadelphia.

Federal regulators have their own reasons for acting quickly. Spitzer, who has already stepped on plenty of toes in pursuing the research scandals at brokerage firms, beat the feds to the punch once again on the fund scandal. Now, a more proactive SEC wants to show it has some fight as well, says Salisbury.

Congress also wants to move swiftly to shore up damaged public trust. According to a Dec. 2 release from the Investment Company Institute, a mutual-fund trade group, a July survey found that 48% of U.S. households own funds. That's 54 million households, or 91 million individuals (all figures are down slightly from 2002) -- and a total of $7.2 trillion in assets. Mercifully, the damage so far to individual investors has been minimal, however (see BW Online, 11/10/03, "Scared by the Mutual-Fund Scandal?").

PLAINTIFFS' SLOG. No one wants to see the fund scandal lead to a stock-market meltdown -- and so far, so good. The Dow Jones industrial average has risen about 350 points during the past three months of industry turmoil, and flows of new cash into mutual funds are at back up to levels last seen in the late 1990s.

Savett does point out one area where the wheels of justice are slow to turn: the civil suits individuals are bringing against fund outfits. Those cases are in suspension while procedural issues are being adjudicated, she says. So while the industry and regulators work fast in an effort to clean up the mess, private plaintiffs are facing the same slog through the legal system they typically do. Plenty of fireworks, yes, but lots of effort to keep the explosions under control. Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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