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Spitzer's Strategy: One Fund at a Time

Nov 7, 2003 | BusinessWeek

What do conflicted research analysts have in common with mutual-fund directors and managers? Plenty, says New York Attorney General Eliot Spitzer.

On Nov. 3, Spitzer told the Senate Governmental Affairs Committee that there are "striking parallels" between the rampant conflicts of interest revealed in his ongoing mutual-fund investigations and those uncovered by his earlier probe of Wall Street research analysts.

Like analysts, he said, mutual-fund directors' interests haven't been aligned with those of retail investors. Some analysts misled investors to please investment bankers who held sway over their compensation. Similarly, "mutual-fund directors rarely, if ever, negotiated lower fees or changed advisers because that would be contrary to the interest of the fund advisers and managers," Spitzer told Congress.

Perhaps that's why, after his testimony, lawyers in the investment-management industry, of which mutual funds are a part, started exchanging e-mail to explore the possibility of a global settlement similar to the massive deal Spitzer reached with investment banks last December. The rumors of such a deal have fed on wishful thinking in a worried mutual-fund industry, which just wants to get this scandal behind it.

LOPPED HEADS. Spitzer raised the possibility of separate settlements with companies during his testimony, and regulators are considering settling with Strong Funds and Alliance Capital Management, according to sources close to investigations. But Spitzer told BusinessWeek that there will be many more civil and criminal cases before he's ready to consider an industrywide deal. "We're talking about an enormous number of cases that have to be made before we know the depth of the problem," says Spitzer. Some are already quite strong, he says.

Apparently, much wrongdoing remains to be rooted out. In just two months, Spitzer and other state regulators have identified abuses that go straight to the top of major mutual-fund outfits. On Nov. 3, Putnam Investment's chief executive, Lawrence J. Lasser, called it quits after regulators sued the company and two of its portfolio managers for fraud. Putnam denies wrongdoing.

At the weekend, Richard S. Strong resigned as chairman of Strong Funds after allegations that he made improper trades over several years in the funds that he founded. Additional individual charges, some criminal, are in the works.

LAPSE OF FAITH. Moreover, the fund violations tend to be more clear-cut than those of analysts. Placing late orders of mutual-fund shares after stock markets close at 4 p.m. is illegal, plain and simple. Market-timing trades, while not illegal, clearly harm investors and violate most mutual funds' prospectuses.

No wonder the mutual-fund industry's reaction to Spitzer's charges has been very different from securities firms' long, drawn-out fight against his allegations. Investment banks are still denying any wrongdoing as they battle investors in arbitration cases. By contrast, most funds have been quick to confess their faults and say they'll make up for investors' losses.

That's a positive sign. But this will undoubtedly be a long-term process. Major structural reforms that align the interests of fund managers and directors with shareholders are clearly necessary to restore investors' faith in the industry. As a start, Spitzer called for requiring funds to have truly independent boards and chairmen as well as to demonstrate that they have negotiated advisory and management fees in the best interest of shareholders.

Unlike the analyst case, adopting new rules and legislation may turn out to be the fastest way to deal with the mutual-fund morass. "When we're dealing with the analyst settlement, we were dealing with 10 firms. There are roughly 4,000 [domestic equity] mutual funds. And hundreds upon hundreds of firms will have some problems," observes John Coffee, professor of securities law at Columbia University. "Rule making will be quicker than trying to get several thousand mutual funds to agree on something."

WEALTH OF SINS. So don't look for a global settlement anytime soon. Barry Barbash, a partner at Sherman & Sterling and former head of investment management at the Securities & Exchange Commission, points out that an industrywide settlement could be difficult since the types of improper trading have been so varied. One option might be to strike several big settlements, each dealing with firms involved in a specific type of offense. But a Big Bang deal that resolves the legal issues in one fell swoop isn't in the cards.

In the meantime, Spitzer, the SEC, and state regulators will pursue a steady stream of cases, rather than rush to any conclusive settlement. Mutual funds, securities firms, and trust companies should prepare for a colder-than-normal winter.


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