SEC weighs in on mutual fund reform

Changes would focus on independent directors

By KEN MORITSUGU Knight Ridder Newspapers

Tuesday, January 13, 2004

Washington — Federal regulators and lawmakers want to reinforce what many industry experts say has been a failed line of defense for mutual fund investors: the funds’ boards of directors.

Just as the board at Enron failed to detect complex accounting frauds, the boards of several mutual funds failed to prevent questionable or illegal trading practices that harmed investors. Some industry critics also blame fund boards for signing off on high fees that ate into investors’ returns.

“Mutual fund companies have boards of directors who are supposed to fulfill their fiduciary obligations toward their investors,” said Sen. Susan Collins (R-Maine) at a hearing on mutual funds last fall.

“And yet, these abuses occur over and over again. The system is obviously flawed.”

This week, the federal Securities and Exchange Commission will take up proposals to overhaul fund boards, mainly by increasing the clout of their independent directors, those without ties to the funds’ management. The proposed changes include requiring that boards be chaired by an independent director and that three-fourths of a board’s members be outsiders.

The commission, at a meeting on Wednesday, also is expected to take aim at the role of financial advisers in the mutual fund scandal.

The SEC plans to propose rules that would force brokers to reveal to investors any hidden sales charges, as well as incentives brokers may get to push selected mutual funds. Under existing laws, Morgan Stanley DW Inc. has been fined $50 million for failing to disclose information to clients about fee arrangements involving funds the firm preferred.

Crackdown on brokers

The proposal is part of a broader attempt to crack down on brokers who direct clients to invest in certain mutual funds, whether or not doing so in the client’s interest, because selling those funds is more profitable for the broker.

For fund boards, their failure to protect investors wasn’t always caused by a lack of will; sometimes, they were out of the loop.

In two high-profile cases — Denver-based Invesco Funds Group and Boston-based Putnam Investment Management — the SEC alleged that the fund companies kept a questionable practice known as market timing hidden from their own independent directors.

In market timing, short-term investors make money by taking advantage of the disparity between the price of a mutual fund — which is set once a day — and the changing value of the stocks or bonds held by the fund. The market timer buys a mutual fund when it’s underpriced and sells it the next day, after the price has been raised to reflect the rising value of its holdings.

The practice, while not illegal, can erode the value of a fund for long-term investors. Mutual fund companies ran afoul of the law when they permitted select clients to market time or engaged in the practice themselves, while claiming in fund documents that they discouraged it.

In September, New York Attorney General Eliot Spitzer said Menomonee Falls-based Strong Financial Corp. had allowed a hedge fund to make improper trades. Spitzer later accused Richard Strong of personally profiting from improper trading in his company’s mutual funds.

Strong has said his trading was not disruptive to the funds, and Spitzer has not filed criminal or civil charges against him or the company. With investors pulling money out of Strong funds, Strong resigned Dec. 2 as chairman and chief executive officer.

Reports last week said Strong is now weighing offers to purchase the company from seven companies that survived an initial round of bidding.

The SEC proposal is expected to give independent directors the authority to hire their own staff.

The commission already has adopted a rule requiring that funds hire independent compliance officers who report directly to the board.