Growing fund scandal brings calls for reform

Regulatory overhaul may be most sweeping in industry’s history

By LISA SINGHANIA Associated Press

Saturday, November 1, 2003

New York — The mutual funds scandal has taken on a new, potentially much more damaging dimension with accusations that fund managers and top executives engaged in their own improper trading at the expense of other customers.

The allegation that even someone as highly placed as Richard Strong, founder of the Strong Financial mutual fund family, was involved has infuriated investors and is a serious black mark against the $7 trillion industry, which long has enjoyed a squeaky- clean reputation.

Now, regulators are considering the most sweeping overhaul of mutual fund rules since the 1940 law that set up the industry.

The U.S. Securities and Exchange Commission, New York Attorney General Eliot Spitzer and the industry’s trade association all say they will push for new rules to govern mutual funds.

“No regulatory reform — be it structural reform, fund governance or board composition — is off the table,” said an internal memo prepared for SEC Chairman William Donaldson. He has promised to respond to the spreading scandal with regulations to be proposed this month.

The issue is being watched closely: Half of all U.S. households invest in mutual funds, which bill themselves as a place for small investors to put their retirement and other savings.

“This is where American families put their money,” said SEC Commissioner Harvey Goldschmid. “Given what we’ve seen, we’re undoubtedly going to do a lot, and we have to.”

Among the changes the SEC is considering are new governance standards for mutual funds, including a requirement that the chairman of the board be an outsider.

In testimony scheduled for Monday in the U.S. Senate, Spitzer will call for similar governance reforms, a person familiar with the situation said.

Testifying before a House Financial Services subcommittee this week, Donaldson said the SEC should have done a better job uncovering improper mutual fund trading.

“We probably have not had the issue of market timing as high in our priorities as we should have,” he said.

Trade association busy

Meanwhile, the fund industry’s trade association, the Investment Company Institute, is also proposing new governance regulations.

The institute has asked the SEC to require that all orders to purchase or sell fund shares reach fund companies, not brokerage firms or other intermediaries, by 4 p.m. Eastern to receive that day’s price. Shares of mutual funds, which hold mixtures of stocks and bonds, are priced once a day after the American financial markets close.

Enforcing that deadline would prevent the intermediaries from claiming that orders placed after 4 p.m. deserved the day’s closing price. Spitzer’s investigation found that a hedge fund, Canary Capital Partners, had been getting such special treatment for its trading of funds managed by Bank of America.

To discourage rapid trading of fund shares, the institute also recommended that fund companies charge a 2% redemption fee on any sale of fund shares within five days of purchase.

Some hedge funds and individual investors try to take advantage of pricing anomalies in funds, especially those that buy foreign securities, by jumping in and out of them frequently, a practice known as market timing. Many fund companies insist that they discourage market timing, but investigators have found that some fund managers and other investors were profiting from such trades.

The third, less concrete, proposal would be for fund companies to amend their ethics codes to require more scrutiny of trading by their senior employees.

“Our commitment to righting the wrongs that arise from these investigations comes with no caveats, limitations or qualifications,” said Paul G. Haaga Jr., chairman of the institute. “We said, ‘Everything is on the table to protect fund shareholders,’ and we mean it.”

Along with the ban on trades after 4 p.m. Eastern, the SEC will consider rules by the end of November requiring funds to explicitly disclose their policies on market timing.

Disclosing expenses

By January, the SEC will consider final rules that would require mutual funds to disclose the dollar amount of fund expenses an investor pays on a hypothetical investment, for example $10,000.

Some critics contend that the key to restoring investor confidence in fund companies is to give more power to independent board members and their overseers.

“The current mutual fund scandal demonstrates a systemic breakdown in compliance in the mutual fund industry that necessitates structural reforms in the way that mutual fund boards are regulated,” said Mercer Bullard, a lawyer who used to work for the SEC and now heads Fund Democracy, a shareholder advocacy group.

He said he would propose during Senate testimony Monday that mutual fund boards have independent chairmen and that three- quarters of their members be independent and stand for election every five years. He said he also would call for term limits of 15 years for fund directors.

The New York Times and Bloomberg News contributed to this report.

CLOSING THE WINDOW FOR ABUSES

The Investment Company Institute, a fund industry trade group, has proposed three measures to deal with trading practices that have recently come under scrutiny:

— A firm 4 p.m. trade deadline.

No longer would brokers, benefits managers and others who get orders from customers during the day be allowed to submit them in the evening for execution at the former daily price after a new one has been calculated. Prosecutors call the practice a clerical convenience that was improperly exploited by favored clients at some funds to turn a profit.

— A mandatory fee for short-term trading.

Except for money-market funds and others specifically designed for short-term trading, all funds would be required to levy a charge of at least 2% on redemptions of shares within five days of purchase, with all proceeds added to the fund’s assets. The fee would be meant to discourage in-and-out trading of fund shares and compensate other fund shareholders for the costs they bear because of such trading.

— More scrutiny of fund managers’ personal trading.

Fund management companies would be called upon to amend their codes of ethics to include more scrutiny of trading by their senior employees for their own accounts. Some fund company executives have been accused of profiting personally from rapid in-and-out trading in the shares of the funds they oversee.

Source: The New York Times