The Securities and Exchange Commission will propose restrictions on trading in the $7 trillion mutual fund industry by the end of November and consider new rules on funds’ governance as lawmakers, investors and state regulators criticize the agency’s oversight.
“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.
Regulators are considering the most sweeping overhaul of mutual fund rules since the 1940 law that set up the industry. New York Attorney General Eliot Spitzer uncovered evidence that favored investors were allowed to make improper trades that diluted the returns of others. Spitzer said “heads should roll” at the SEC for missing the wrongdoing.
Spitzer is considering criminal charges against Strong Capital Management Chairman Richard Strong, said Juanita Scarlett, a spokeswoman for the attorney general. This week, Massachusetts regulators and the SEC charged Putnam Investments, the fifth-largest U.S. mutual fund company, with securities fraud.
Three committees in Congress have called hearings into what Senate Banking Committee Chairman Richard Shelby, R-Ala., called the fund industry’s “growing scandal.”
Half of 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,” SEC Commissioner Harvey Goldschmid said. “Given what we’ve seen, we’re undoubtedly going to do a lot, and we have to.”
On Friday, pension funds in Pennsylvania, Iowa and Rhode Island fired Putnam Investments. They joined Massachusetts, New York and Vermont pension officials, as well as some universities, who are taking their business away from Putnam following accusations by regulators that four of its fund managers engaged in personal short-term investing at clients’ expense. In just two days, public pension funds have announced plans to pull at least $4.4 billion out of the company, which lists $272 billion in assets under management.
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 Monday in the Senate, Spitzer will call for similar reforms, a person familiar with the situation said.
Goldschmid, in an interview, said he is concerned about mutual fund governance. While funds’ boards are required to have at least 40 percent independent directors, the chairman of the board is often the fund company’s chief executive. That may need to change, he said.
“There should be an independent chairman of the fund board,” Goldschmid said. “We need a fund governance where those independent directors, which constitute a majority in almost all funds, are active and scrutinizing conflicts of interest with particular care.”
Regulators are seeking to stop two types of trading abuses “market timing” and “late trading.” The first item the SEC will propose is barring mutual fund companies from accepting orders from brokers after 4 p.m. to prevent illegal late trading.
Market timing involves making short-term trades in a mutual fund to take advantage of pricing discrepancies in underlying fund investments. Because the practice can raise a fund’s transaction costs and dilute the gains of long-term holders, funds often discourage investors from engaging in market timing.
Late trading, which is illegal, occurs when favored investors are allowed to make trades after the fund has stopped accepting orders. The late traders are given that day’s price, which is no longer available to others, allowing them to take advantage of news that will move prices the next day.
The internal memo prepared for Donaldson sketches out a timetable for SEC action on new rules. Along with the ban on trades after 4 p.m., the SEC will consider rules by the end of November requiring funds to explicitly disclose their policies on market timing and to have procedures to prevent late trading.
By January, the agency 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.
Spitzer may try to use settlements with Strong and other funds to force changes in the way they operate that would then serve as models for reform in the industry, the person said.
The SEC’s Division of Investment Management, which oversees regulation of the mutual fund business, “has always been a little bit of a red-haired stepchild at the SEC,” said Mark Radke, a securities lawyer and former chief of staff to then-SEC Chairman Harvey Pitt.
The SEC has also long viewed the mutual fund industry as relatively clean, Radke said.
“One of the problems the SEC has is, it’s now got to impose rules on activity that pretty much nobody expected anybody in the mutual fund business would do,” Radke said. “The mutual fund industry was widely regarded as holding itself to very high standards. They had to appeal to moms and pops, and look like the safest places to put money away for the college fund.”
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