Nov. 4–A bipartisan chorus of senators called yesterday for sweeping reforms of the $7 trillion mutual fund industry, accusing fund directors of rampant conflicts of interest and taking federalregulators to task for failing to detect management abuses that cost small investors billions of dollars in profits.

In a packed hearing room, a Senate Governmental Affairs subcommittee heard more than three hours of testimony from industry officials and federal and state regulators, who described an industry that has routinely allowed big investors to profit from preferential trading schemes and fund advisors to cash in on unchecked management fees.

“The mutual fund industry is now the world’s largest skimming operation — a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings,” said Sen. Peter G. Fitzgerald, the Illinois Republican at yesterday’s hearing.

As the scandal enveloping the industry grows, Fitzgerald and other lawmakers have proposed legislation that would call for more accountability of mutual fund directors, require greater disclosure of fees and put a stop to questionable trading practices that have tarnished the industry’s image as a safe haven for everyday investors.

John Bogle, founder of the Vanguard Group, a giant Pennsylvania mutual fund company, called the trading scandals “just a small tip of an enormous iceberg.” A longtime industry critic, Bogle has only recently found an audience for his concerns about industry abuses.

“We have opened up a window into a morass of conflict of interest,” said New York Attorney General Eliot Spitzer, whose investigation of the industry prompted lawmakers to launch their own probe.

Two months ago, Spitzer, who attended yesterday’s hearing, accused several large mutual fund companies of giving a large hedge fund preferential treatment by allowing it to make after-hours trades and use in-an-out trading techniques to gain an advantage over other investors.

Late trading allows an investor to place trades after the 4 p.m. closing bell, giving them an unfair advantage over other investors because they can act on late corporate news while others can’t. Market timing, which is not illegal, is when investors trade in and out of funds rapidly, a practice that can raise fund costs and hurt a fund’s performance over time.

Yesterday, Spitzer railed against the industry, saying it has been charging investors excessive fees while mutual fund directors look the other way. He said mutual funds often pay a quarter of a percentage more in advisory fees than pension funds, even though both types of funds are managed by the same companies. A reduction of that amount would result in a $10 billion annual savings to investors, he said.

Similarly, the management fees charged to investors keeps climbing even as the industry’s assets have exploded in size. “Where are the economies of scale that have been promised year after year by this industry?” he asked.

Spitzer joined federal regulators in criticizing mutual fund directors, saying there is an inherent conflict of interest in the way the boards are structured because many directors are affiliated with the advisory firms they are charged with overseeing. The result is that directors often allow fund management firms to pump up fees at the expense of investors.

He hinted that more allegations are likely to come out of his expanding probe and that firms caught engaging in questionable activity must be forced to repay investors for fees they received while abuses occurred. “This number will be big, it will impose pain, and it should,” he said.

After the hearing, Spitzer, surrounded by reporters, said the “entire governing structure of the mutual fund industry needs to be considered and revised.”

“You have every possible permutation of wrongdoing,” he said. “It is a cesspool and it is an industry that has for too long said, ‘We are pure. How dare you attack the virtues that we bring to the table.’ They are going to get the comeuppance they deserve based upon on their years of failing to police themselves.”

Industry officials acknowledged the need for reform and pledged cooperation.

“I am outraged at the shocking betrayal of trust,” said Matthew Fink, president of the Investment Company Institute, which represents the mutual fund industry. “We want to rebuild trust, renew public confidence. Every type of reform is … on the table.”

He said the trade group backs a Securities and Exchange Commission proposal to curb late trading by setting a 4 p.m. deadline for all mutual fund trades. Any trades placed by an investor or an intermediary after that time would be based on the next day’s price. The group also urged the SEC to require a minimum 2 percent redemption fee on the sale of all mutual funds for a minimum of five days after their purchase. Such fees would discourage market timing.

Stephen Cutler, the SEC’s enforcement director, told senators yesterday that his agency is aggressively pursuing those who may have hurt investors by engaging in late trading, market timing or other illegal activity that hurts investors.

The National Association of Securities Dealers, the brokerage industry watch-dog, echoed those comments, saying it has brought 60 enforcement cases this year involving the mutual funds industry.

As part of its continuing inquiry, Cutler said the agency has requested information from 88 of the largest mutual fund companies and 34 broker-dealers. A survey found that a quarter of the largest broker-dealers polled said they had helped customers place mutual fund orders after the 4 p.m. market close, a violation of rules against late-trading. And nearly 70 percent were aware that some customers engaged in market timing.

Lawmakers expressed surprise at the widespread abuses spelled out by regulators.

“I question why the Securities and Exchange Commission, which has regulatory responsibility for the mutual funds and their broker-dealers, has failed to detect these practices, to impose appropriate restrictions on them or to penalize those who appear to be misusing investors’ money,” said Sen. Susan M. Collins, R-Maine, who heads the committee holding yesterday’s hearing.

Sen. Joseph Lieberman, D-Conn., wrote a stinging letter to SEC Chairman William Donaldson demanding that the SEC provide details of how it plans to stop trading abuses and restore credibility to the industry.

“The looting has already begun,” wrote Lieberman, a committee member who also is running for president. “Now we must prevent it from continuing.”

Fallout from the investing scandals continued yesterday as Juan Marcelino, head of the SEC’s Boston office, which has been criticized for being slow to crack down on abusive industry practices, said he will resign.

Lawrence J. Lasser, chief executive of Putnam Investments, the Boston-based mutual fund company, said he will step down after the company was hit with civil fraud charges by Massachusetts securities regulators and the SEC.

Richard Strong, chairman of Strong Mutual Funds, resigned Sunday after he allegedly made hundreds of thousands of dollars at the expense of investors through improper short-term trading in his company’s own mutual funds. Strong will continue as a director and chief executive of Strong Capital Management, which is the investment adviser to the mutual fund company.

By Paul Adams and Bill Atkinson

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