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Breach Of Trust


Last August, 170 employees in the mutual-fund section of the Securities & Exchange Commission started packing their belongings. They were forced to decamp to an SEC annex to relieve overcrowding at agency headquarters in downtown Washington. The building was just four blocks away, but the new digs felt like Siberia to the staff. The Investment Management Div., as it's called, is hugely important: It protects $7 trillion invested by some 91 million Americans. Yet in the SEC's pecking order, it has long ranked near the bottom. The move seemed to confirm that. The one consolation: The disruption took place in the dog days of August, when most East Coasters head for the beach.

Most, but not all. Unbeknownst to the SEC, New York Attorney General Eliot Spitzer's staff was unpacking boxes -- though not their own. They had received shipments of subpoenaed documents from mutual funds and hedge funds and worked over the Labor Day weekend so that Spitzer could spring his first charges of abusive trading against hedge fund Canary Capital Partners LLC on Sept. 3. The case ignited one of the biggest financial scandals in U.S. history, which has so far implicated 15 mutual funds, 12 brokerage firms, 4 banks, and dozens of individuals. The list reads like a who's who of the fund world.

With so much chicanery taking place, why was Washington caught flat-footed? The answer goes far beyond the chronic underfunding of the SEC by Congress. The truth is more complex. The SEC put too much trust in mutual funds to do the right thing. The agency failed to look deeply enough at industry practices to detect patterns of abuse. At the same time, a highly persuasive and aggressive trade association -- of 400 fund complexes that make up the Investment Company Institute -- for years overpowered or co-opted most attempts to tighten fund regulation. Congress, cowed by an industry with a 60-year record of serving small investors (marred by only a few minor scandals), kept its distance. Even now, with funds and their executives facing charges of fraud, the ICI has been able to talk the House of Representatives out of requiring that fund boards be chaired by independent outsiders.

In 2000, the onset of the most vicious bear market since the Great Depression set the stage for the worst abuses by the mutual-fund industry. Squeezed by competition for dwindling investor dollars, funds started to worry more about selling their products than boosting investors' returns. Many fund companies began to resort to shady practices, such as ignoring their own policies against rapid in-and-out trading in exchange for lucrative fees from large investors. After all, with Washington blindfolding itself, what were the chances of getting caught? More and more, the funds depended on brokers and other intermediaries -- especially lightly regulated hedge funds -- to gather the assets they needed to earn the fees that pay managers' salaries and expenses. Such dependence on outsiders made it harder for funds to enforce policies against abusive trading.

Put it all together -- light regulation, a savvy trade association, a compliant Congress, a declining market, and frantic competition over a shrinking investment pie -- and you get the witches' brew of unsavory business practices now being uncovered. It was a disaster waiting to happen.

FUNDS' FRIEND

The ICI's success in manipulating Washington is pivotal to understanding what went wrong. Current and former SEC officials now concede that they were lulled by a false sense of security into a relationship with the ICI that bore all the earmarks of a friendly partnership: One side rarely acted without the other's consent. "From my heart," says Arthur Levitt Jr., the SEC's chairman from 1993 until 2001, "I really thought these people [at the ICI] cared a lot about their reputations and would do anything to keep the industry's image pristine."

The ICI may look puny on K Street, where Washington's power brokers congregate. It doesn't employ armies of lobbyists like mortgage giant Fannie Mae (FNM). Nor can it rally dozens of members in every congressional district, as can the National Association of Realtors. The $803,000 the ICI gave in the 2002 election cycle and the first nine months of 2003 put it in 11th place among financial-services donors -- way behind first-place Goldman, Sachs & Co. (GS), which donated $3.5 million, according to the Center for Responsive Politics.

Instead, the ICI has built its clout by claiming to speak for millions of shareholders with their 401(k)s, college funds, and personal savings. It's true that those shareholders help shoulder the ICI's $37 million annual budget: Fund companies tap fund assets, which are owned by shareholders, for a portion of their ICI dues. (An ICI spokesman says the group doesn't know exactly how much shareholders pay.) But in reality, the ICI represents the companies that create, run, and sell funds. When the interests of fund managers and fund investors have clashed, the ICI has almost invariably sided with the managers.

The industry's persuasive powers prevailed even when the SEC saw storm clouds gathering. In 1997, Barry P. Barbash, then the SEC's director of investment management, had a chance to nip the practice of market timing in the bud. Market-timers exploit the fact that funds set prices once a day -- after U.S. markets close at 4 p.m. Trouble is, the prices of European or Japanese stocks that funds hold can be up to 15 hours out of date by then. If news events or U.S. market gains are likely to move the stocks sharply when foreign markets open, market-timers can lock in near-automatic profits.

Barbash had an answer. He considered forcing funds to put more realistic prices on international funds by using guideposts such as foreign stocks traded in the U.S. An SEC study showed that market-timers had milked 2% of assets from some funds in late October, 1997, during the Asian financial crisis. The SEC also learned that, despite an SEC policy encouraging funds to update their prices after significant market events, only a few funds adjusted all their shares, while some did nothing. But in the end, according to an SEC source, Barbash capitulated to arguments from fund companies and other SEC staff that market timing was a passing fad and that funds would make adjustments without an SEC mandate.

"CULTURE OF OPAQUENESS"

Barbash's successor and current division head, Paul F. Roye, tried to put an end to market timing in 2001. But his strategy proved ineffective. He had his chief counsel send a letter to the ICI stating that funds must use fair-value pricing after "significant events." Many funds interpreted that to mean they need to adjust overseas prices only on days when the stock market rises or falls by 3% -- a rare occurrence. Besides, the SEC letter was viewed as a paper tiger: One SEC commissioner concedes that the agency would be unlikely to punish a fund for not following recommendations in a staff letter. "We should have done more," this commissioner says.

The SEC is finally closing the gap. On Dec. 3, it called for funds to adopt fair-value prices after market-moving events. But critics say the SEC has not gone far enough. "The SEC needs to take a stand that fair-value pricing should be done every day, with every fund," says John M.R. Chalmers, associate finance professor at the University of Oregon.

The SEC also backed down in the face of ICI pressure on fee disclosure. Both Levitt and his predecessor, Richard C. Breeden, wanted to make it easier for investors to understand how much they were charged. Both concluded that investors needed individual statements showing in dollars and cents what fees they are paying to a fund on a monthly or quarterly basis. The information would replace the confusing semiannual reports that show expenses as a percentage of fund assets.

The ICI persuaded the SEC to drop the idea before it published a formal proposal, arguing that shareholders are given enough information already and wouldn't understand the numbers anyway. What's more, it argued, powerful intermediaries such as brokerage firms, which sell the bulk of funds, objected to the cost of new technology needed to calculate the data. One former SEC official says he was frustrated by the "culture of opaqueness" in the fund industry. "You can see it in proposal after proposal that got watered down. [Funds] can provide monthly performance data, but they can't seem to multiply that to give you actual fees." Even now, the ICI is lobbying Congress not to include individual statements in any fund-reform package.

Sometimes it seems the SEC and the ICI work so closely together that they forget where one's job begins and the other's ends, says a former SEC official. In 2000, the ex-official's client, a group of European investment trusts, sought SEC permission to register in the U.S. The funds had to demonstrate that their home-country regulation was as tough as the SEC's. In a meeting with Roye to review the application, the ex-official was flabbergasted when Roye asked: "Have you checked with the ICI on this?" Roye says he was only warning that the ICI could request a hearing and drag the application through court appeals as they had once before in the 1980s.

Both Roye and Barbash dispute the idea that they were co-opted by the industry. They helped Levitt impose several new rules, such as requiring that a majority of fund directors be independent of the management company and insisting that funds publish aftertax returns in their prospectuses. Roye points to recent proposals adopted over the ICI's fierce objections, including forcing fund companies to reveal how they vote the shares they own in corporate proxy battles. For its part, the ICI insists that it often argued for strong SEC oversight.

Yet Levitt concedes that the SEC could have done more. "Looking back, there are many areas where I should have regulated," he says. Levitt may have compounded the problem when he moved mutual-fund inspectors into a separate Office of Compliance Inspections & Examinations in 1995. "I think that left the division somewhat divorced from what was going on in the outside world," says Barbash.

So regulators were already far behind when the bear market changed the rules of the game in 2000. Years of prosperity had left the industry overcrowded, with too many funds chasing too few investors. Big firms siphoned off most of the new money, leaving smaller rivals floundering. Fidelity Investments, Vanguard Group, and Capital Research & Management's American Funds together captured more than 58% of the net new cash flow into the industry in 2001, according to Boston's Financial Research. Janus Capital Group Inc. (JNS), once a bull-market darling whose assets peaked at $330 billion, saw investors yank nearly $24 billion out in 2001 and 2002. Fee income dropped 26%, to $1.1 billion.

DESPERATION TACTICS

The scramble for new revenues fostered unsavory business practices. One source was hedge funds, whose assets ballooned from $488 billion in 2000 to more than $687 billion today, according to Chicago's Hedge Fund Research Inc. Hedge funds considered mutual funds a perfect medium for trading because most can be bought and sold without a transaction fee. At first, mutual funds spurned this hot money. But when some hedge funds offered to park assets in other funds for long periods in return for special privileges, mutual funds couldn't resist. Firms that barred market timing looked the other way when hedge funds traded rapidly. Others allowed hedge funds to place late trades -- the illegal practice of accepting fund orders after the 4 p.m. cutoff.

Managers at Denver-based Invesco Funds Group Inc., for example, allegedly encouraged some growth-fund managers to allow market-timers to trade up to 5% of their funds in the spring of 2002. "They were desperate for asset growth," a former employee says. On Dec. 2, the SEC and Spitzer filed civil fraud charges against the company and its chief executive for allowing a scheme involving $900 million in market-timing trades. Invesco plans to fight the charges.

Hedge funds weren't the only new players. As their wealth soared in the 1990s, more and more investors turned to brokers and financial planners to manage their money. Many fund families followed suit, switching from direct sales of no-load funds to broker-sold funds with sales charges. Funds also paid Wall Street firms a percentage of sales, supposedly to cover training and other costs -- but also to induce brokers to push their funds more than those of rivals. Investors paid dearly for this cozy arrangement: Fund companies passed on promotion costs through so-called 12(b)(1) fees, and brokerage firms charged hefty sales loads. By 2002, brokers, financial planners, and other third parties accounted for nearly 90% of mutual-fund sales.

But there's a flip side. When shares are sold through outsiders, the fund family has a hard time identifying its clients precisely because all orders from the same source are lumped together in one omnibus account. That wrinkle led to questionable trading practices. Security Trust Co. (STC), a Phoenix bank that bundled together buy and sell orders for some 400 mutual funds and forwarded them after the market's close each day, allegedly operated five accounts for Canary Capital. STC then placed Canary's trades through one of the accounts, rotating them so that mutual funds wouldn't detect their origin. Three former top STC execs were charged with grand larceny and securities fraud on Nov. 25. The lawyer for ex-CEO Grant Seeger says her client "did nothing illegal." Calls to the others were not returned. STC's primary regulator, the Office of the Comptroller of the Currency, plans to dissolve the bank.

Changes in retirement plans -- particularly innovations in 401(k) plans -- also provided fuel for the scandal. Just a decade ago, participants had few funds to choose from and were limited to one trade each quarter, notes Michael Weddell, a retirement consultant at Watson Wyatt Worldwide (WW). Now, the average plan offers 14 choices, and most participants can trade daily. But those same innovations paved the way for abuses, such as market timing by 401(k) participants.

AVOIDING SCRUTINY

By 2002, a growing number of funds had begun to test the ethical boundaries. Regulators had an inkling of what was happening. In speeches, Roye urged industry leaders to observe high standards, maintain internal controls, and avoid overpaying brokers in return for orders -- all issues now central to the unfolding scandal.

But the ICI persisted in its efforts to avoid scrutiny. In the spring of 2002, reports circulated that the SEC was exploring the idea of a self-regulatory organization, like the National Association of Securities Dealers, for funds. ICI President Matthew P. Fink -- whose $1.16 million compensation package puts him at No. 11 on National Journal's 2002 list of best-paid association heads -- argued that funds didn't want any intermediaries between themselves and the SEC. Thanks in large part to the ICI's opposition, the idea died quickly.

One of the ICI's favorite tactics for blunting reform is to embrace the idea of a new law or rule in public but oppose the measure in private (or seek special conditions that open big loopholes). The ICI did just that with the Sarbanes-Oxley corporate-reform law of 2002. As big investors, funds favored the bill's crackdown on accounting that inflates corporate profits. But the ICI made sure key provisions of the law did not apply to funds. Unlike other companies, funds won't be forced to establish strict internal controls, verified by outside auditors. This requirement, if it applied to funds, could eventually halt the type of abuses recently uncovered.

Until the fund scandal, the ICI was enjoying similar success in weakening mutual-fund reform legislation by Representative Richard H. Baker (R-La.). Throughout the spring and summer of 2003, the ICI fought to keep the bill bottled up in Baker's Financial Services subcommittee. It insisted legislation wasn't needed and opposed specific sections as costly to investors and regulatory overkill. At the time, says ICI President Fink, "we didn't know this [abusive trading] was going on. We don't ask [funds] to tell us what's going on in their business."

An ICI official who did not want to be named says the group "agreed with many of Baker's policy objectives" but thought the SEC was able to handle any concerns through rulemaking. Once the scandal broke, the official says, the ICI switched sides and supported the measure. "It's inaccurate to say we opposed the bill throughout the process." Indeed, after Baker's bill passed the House by a 418-2 vote on Nov. 19, ICI Chairman Paul G. Haaga proclaimed on national television: "We supported these proposals."

Baker sees it differently: "There's no question but that the ICI lobbied to stop this bill at every opportunity with anyone in a decision-making role," including House Majority Leader Tom DeLay (R-Tex.). E-mails to congressional offices from ICI chief lobbyist Dan F.G. Crowley support Baker's version. On Oct. 8 -- five weeks into the scandal -- Crowley circulated a memo saying that "legislation is unnecessary and inadvisable at this time." And as late as Nov. 3, a House leadership aide e-mailed Crowley that it would be "wise for ICI to reconsider its unsustainable position of opposition to [the Baker bill] and give an unconditional endorsement of the legislation, with the understanding that there will be strengthening amendments."

Soon afterward, the ICI did throw its weight behind the bill. The group says most of the sections it disagreed with were either deleted or scaled back. The most important of those: The call for fund chairmen to be independent of the advisory company, a provision the ICI fought hard to kill. Fink says it's no panacea to have an outsider as chairman, pointing out that four of the nine fund companies implicated in the scandal by that time had independent chairmen. And, he adds, independent chairmen can be ineffective, because company insiders with far more knowledge about a fund's inner workings can isolate an outsider.

The real reason the ICI opposes mandatory independent chairmen, says a longtime industry lawyer, is that it's dominated by large fund complexes such as Fidelity, a unit of FMR Corp., and Vanguard. If the rule passed, Vanguard Chairman John J. Brennan would have to step down as chairman of all 188 of Vanguard's U.S. funds, while Fidelity Chairman Edward C. "Ned" Johnson III would have to step down from chairing 266 out of 342 Fidelity funds. Fink denies this. He says he spoke to Brennan about the measure, but not to Johnson.

SHOCKED INTO ACTION

Historically, the ICI has been known as a Democratic lobby. Its Hill ties are largely with liberal Democrats, such as Massachusetts Representative Barney Frank, whose state is home to fund giants MFS, Fidelity, and Putnam. To get the independent-chairman clause deleted from the Baker bill, the ICI turned to Frank. In a July 23 Financial Services Committee meeting, he said the requirement "is counterproductive, impractical, and unnecessary." Frank says that he was opposing only that provision and that he voted for the bill in committee and on the House floor. Furthermore, he says, he was on guard against retaliation by House Republicans after the ICI got into a public tiff with Committee Chairman Michael G. Oxley (R-Ohio), who had complained that the group didn't employ enough GOP lobbyists.

After that spat, the ICI moved to get better access to the GOP. In August, it registered to hold a fund-raiser for four Republican lawmakers who sit on the Financial Services Committee -- just two weeks after the panel had voted to water down Baker's bill. The Oct. 2 event netted about $92,000. It was held on the same day as an ICI executive committee meeting, says an ICI spokesman, so the group's top policymakers could mingle with the lawmakers who oversee them. Among the contributors: at least five fund companies, or their parents, implicated in the scandal. The ICI spokesman says there is no connection between the contributions and Baker's bill, which the ICI thought would never advance to the House floor. After all, he says, in late July, Baker himself had urged the SEC to adopt rules that would make the legislation moot.

An even tougher version of the Baker bill is expected to move in January in the Senate, where the industry's lobbying prospects look very grim. The requirement for independent fund-board chairs, for one, will probably be restored. And it could be many years before the ICI can win back its once- sterling reputation on Capitol Hill -- or regain the clout that it long enjoyed.

A humbled SEC has been shocked into action. "What has occurred has involved a grievous betrayal of trust," SEC Commissioner Harvey J. Goldschmid said on Dec. 3 as the agency voted to force funds to have chief compliance officers who report to the board. The SEC also proposed that fund orders must be received by the fund at 4 p.m. to get that day's price. And in January, the agency will consider new governance rules, such as requiring independent chairmen for fund boards. Meanwhile, it is also subjecting fund companies to white-glove examinations and bringing numerous enforcement actions.

But the SEC's toughest job will be to prove that it has learned the hard lesson of what happens when regulators trust an industry to monitor itself. For decades, mutual funds were left alone because they convinced enough people that they were squeaky clean and had shareholders' interests at heart. But it turns out that mutual funds marched to the same greedy drummer as Wall Street's analysts, Corporate America's executives, and the Big Five's accountants. The SEC and Congress alike failed to see that. By Paula Dwyer

With Amy Borrus in Washington and Lauren Young in New York


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