Mutual fund reform gathers steam in U.S.

…the mutual fund industry has become a "study in institutionalized conflicts of interest."…"Unfortunately, the mutual fund industry has disintegrated into the world's largest skimming operation,"…

The Globe and Mail
November 4, 2003

Mutual fund reform gathers steam in U.S.
Regulators, politicians and industry critics call for overhaul to root out trading abuses
Barrie McKenna

WASHINGTON — Momentum is building in the United States for a sweeping overhaul of the $7-trillion (U.S.) mutual fund industry as a widening conflict-of-interest scandal has forced the resignation of the head of the country's fifth-largest fund.

As a U.S. congressional committee opened hearings into the scandal yesterday, regulators, politicians and industry critics called for key reforms to root out trading abuses, enhance corporate governance and rein in fees paid by 95 million mutual fund investors.

The hearings began as Putnam Investments announced that it had ousted chief executive officer Lawrence Lasser following civil fraud charges against the company and a string of customer defections that have stripped more than $4-billion in assets from the fund.

"The kind of conduct that occurred has no place at Putnam," insisted Jeffrey Greenberg, chairman and CEO of Marsh & McLennan Cos. Inc., parent of Putnam, the fifth-largest U.S. family of funds.

Mr. Lasser, who resigned under pressure, joins 30 other industry executives who have been fired, suspended or forced to quit since New York Attorney-General Eliot Spitzer launched a probe two months ago into abusive insider trading practices, such as market timing and late trading.

On Sunday, chairman and founder Richard Strong quit Strong Mutual Funds of Menomonee Falls, Wis., amid a flurry of federal and state probes into questionable trades he has admitted to making in the company's own funds.

The industry is now facing multiple criminal and civil probes by state regulators and the U.S. Securities and Exchange Commission. The SEC and Massachusetts securities regulators are expected to file civil fraud charges today against five former Prudential Securities brokers.

But the regulatory crackdown is moving well beyond the specific trading abuses uncovered by Mr. Spitzer to encompass allegations of inflated fees and flawed corporate governance.

Mr. Spitzer's investigation began in early September with a $40-million settlement with an obscure New Jersey hedge fund, Canary Capital Partners, which specialized in short-term trading of some popular mutual funds.

Peter Fitzgerald, chairman of the financial management subcommittee of the Senate governmental affairs committee, complained that the mutual fund industry has become a "study in institutionalized conflicts of interest."

Those conflicts — caused by a dearth of independent directors and unhealthy ties between funds and their hired management companies — have allowed mutual funds to charge grossly inflated fees, he said.

"Unfortunately, the mutual fund industry has disintegrated into the world's largest skimming operation," said Mr. Fitzgerald, who vowed to work with the House of Representatives to craft a bipartisan reform bill. "The mutual fund industry has grown into a $7-trillion monster that too many people are leeching off."

Mr. Fitzgerald said he's poised to introduce a bill that would require three-quarters of all directors to be independent, compel funds to put their management contracts out to competitive tender and force full disclosure of all fees and trading costs.

"Whether it's ready or not, the mutual fund industry needs to be reformed," said Mr. Fitzgerald, warning that the industry would likely fight the legislation.

The furor over mutual funds in the United States is in sharp contrast to Canada, where regulators have promised to look into possible mutual fund trading abuses. But so far, no complaints have been filed and there's apparently no push for a regulatory crackdown.

Mr. Spitzer told the hearing that excessive fees by mutual fund companies may be costing U.S. mutual fund investors as much as $10-billion a year.

He based the estimate on the fact that mutual funds often pay management fees that are a quarter percentage point higher than large pension funds pay.

"The fees paid by mutual funds — or, more precisely, the fees that are paid by mutual fund shareholders — seem to defy the laws of economics," Mr. Spitzer told the subcommittee.

He said the industry paid out $70-billion in management and advisory fees in 2002, and that those fees have been growing much faster than the total assets Americans are socking away in mutual funds.

The root problem in the mutual fund industry is the same as with the other corporate scandals of the past two years — boards of directors aren't asking the hard questions because they are caught in conflicts of interest, Mr. Spitzer said.

"There has been a complete failure of the fiduciary obligations of those who sit on the boards," he said.

Mr. Spitzer also vowed to make mutual fund companies that are guilty of illegal insider trades forfeit all of the fees they pocketed during the period of the offences.

The penalty "will be big, it will impose pain, and it should," he said.

SEC enforcement director Stephen Cutler told the committee that trading abuses are far more pervasive than regulators first thought. An SEC survey found that 10 per cent of 88 top mutual fund companies may have been involved in illegal trading.

Likewise, a quarter of 34 large brokerage firms acknowledged allowing mutual fund customers to place late trades. U.S. and Canadian law prohibit trades made after the 4 p.m. market close to enjoy the same-day price.

Nearly a third of the brokers and half the mutual fund companies also admitted to helping customers engage in "market timing," which lets investors take advantage of outdated pricing for underlying securities in mutual funds. While not illegal, market timing is publicly denounced by most mutual fund companies.

"The commission's investigation of mutual fund trading abuses is continuing on multiple fronts," Mr. Cutler told the committee. "I can safely predict many more enforcement actions will follow." The SEC is drafting a new rule that would force mutual fund companies to provide better disclosure of their market timing policies.

Mr. Cutler also defended the SEC against charges by critics that it was slow to focus on problems in the mutual fund industry in spite of years of widespread allegations of abuses.


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