The rapidly spreading scandal over favoritism in mutual fund trading is shaking the industry and has prompted Congress and federal and state regulators to push for the biggest overhaul of the system in more than 50 years.
Dozens of companies have confessed to the Securities and Exchange Commission that they had special short-term trading deals with some customers. Half a dozen securities firms have said some employees broke laws against after-hours trading. And top executives at two major fund companies Putnam Investments and Strong Financial Corp. allegedly profited personally at the expense of their investors.
New York state Attorney General Eliot L. Spitzer and SEC enforcement director Stephen M. Cutler said in interviews that they have more cases coming against brokers and fund managers, and against hedge funds largely unregulated investment pools of wealthy investors that allegedly received special treatment by the mutual fund managers. The NASD, which regulates brokers, has opened more than 30 investigations of securities firms that sell mutual funds, sources said.
Spitzer and others investigating the industry say it is becoming clear that the trading practices not only were widespread and improper, but also directly harmed ordinary long-term investors. At the same time short-term traders extracted profits that would have gone to other investors in the fund, they also drove up mutual fund costs with their quick in-and-out trades.
“It wouldn’t surprise me if there are shareholders who lost 5 to 10 percent a year,” said University of Mississippi law professor Mercer E. Bullard, who runs a shareholder advocacy group.
The investigations of mutual funds, which hold about $7 trillion in assets, stand out from the other Wall Street scandals since the stock market bubble popped three years ago, because it involves the part of the financial world that most directly affects individuals.
Investigations of accounting, investment banks and corporate boardrooms have shaken investor confidence, and the collapse of individual stocks has hurt some investors’ portfolios. But malfeasance at mutual funds reaches much deeper into the nation’s pocketbooks. More than 95 million Americans, and half of all the nation’s households, own shares of mutual funds, the main investment vehicle for the middle class and a growing instrument of savings for retirement and college tuition.
“For many years, people who invested on Wall Street were the wealthy. Now 50 percent of all households have [mutual fund] investments. Those are voters. This resonates with Congress,” said Rep. Richard H. Baker (R-La.), who has been pushing for mutual fund reforms since last spring. “The window of opportunity is larger and so is the obligation to act.”
The investigation became public just eight weeks ago, when Spitzer alleged in a civil complaint that four major fund companies had allowed a New Jersey hedge fund to engage in two kinds of trading “late trading” and “market timing” to the detriment of other investors. Since then Spitzer has filed criminal charges against two people accused of breaking a 1968 law that requires mutual fund orders placed after 4 p.m. to be executed at the next day’s price. Late trading illegally allows investors to benefit from developments announced after the New York markets close.
Market timing seeks to exploit the fact that fund prices are set only once a day, while stock prices change constantly as they are traded around the world. While the practice is not illegal, fund companies say they discourage it because it cuts overall returns. But more than 40 fund companies have acknowledged to the SEC that they allowed select customers to market-time, which may violate disclosure rules. Last week investigators went further, alleging that top executives at two fund companies profited personally from timing their own funds.
The SEC and Massachusetts regulators charged Putnam Investments and two of its former portfolio managers with securities fraud because the managers allegedly timed their own funds. And the chairman and founder of Strong Financial Inc. is under investigation by Spitzer and the SEC for timing his own firm’s funds. Richard S. Strong has said he doesn’t believe his trading was “disruptive” but promised to reimburse investors if they lost money because of it.
The speed with which the scandal has moved through the mutual fund industry and the widespread nature of the apparent violations prompted a round of public soul-searching and promises for reform aimed at stopping improper and illegal trading, improving governance at the fund companies and making sure regulators are not caught flat-footed again.
“Small investors have been victimized for too long by unscrupulous behavior on the part of fund managers,” Spitzer said. “The regulatory structure that should have picked that up, didn’t. We need to create a new regulatory environment that protects small investors against the games that have been played.”
So far, investors have stuck with mutual funds, although some of the fund families implicated in the investigation are losing customers. The four fund companies named in Spitzer’s first complaint saw net outflows of 1.85 percent ($7.9 billion) in September five times the outflow rate of 0.36 percent for the rest of the industry, according to the mutual funds research company Lipper Inc. Several state pension funds are moving to drop Putnam. But the booming stock market and the complex nature of the scandal have helped mute the scandal’s effects, analysts have said.
Individual investors who got lower returns because of improper trading probably don’t even know it yet, analysts said. “It’s not like the investors got shot. Instead they got bled. [The cheating] took a little vial out every month,” said Conrad S. Ciccotello, a business professor at Georgia State University. “Over time that’s a lot.”
Advocates and regulators said the apparently widespread yet largely invisible nature of the secret deals is precisely why reform is needed.
“If the government doesn’t regulate, the public is going to be left unprotected, and not only unprotected, unaware,” said Sen. Joseph I. Lieberman (D-Conn.), who proposed a mutual funds reform plan last week. “If there’s a feeling that there’s not a cop on the economic beat, people will lose confidence in the market.” House and Senate committees are planning hearings on the mutual fund industry this week.
SEC Chairman William H. Donaldson acknowledged last week that oversight of the industry could be improved. The SEC staff is working on possible reforms, said Paul F. Roye, director of the SEC’s division of investment management.
Ideas for change include requiring each fund company to hire a chief compliance officer, who would police trading practices and report directly to the funds’ boards. The SEC staff also is considering removing the economic incentive for market timing by requiring funds to update prices for mutual funds when rapid market movements render current prices out of date.
The proposed changes also would require all mutual fund orders to be at fund companies by 4 p.m. each trading day. Some brokers were turning in late orders but falsely claiming the customer had put them in by 4 p.m.
Also being considered are two measures to discourage investors from getting in and out of funds frequently. One would slow the process of redeeming shares so investors would have to wait longer for their money. The other would charge a 2 percent redemption fee for shares sold within five days of purchase.
“If you can take the profit out, the incentive for market timing goes away,” Roye said. But, he added, most of the proposals would also make it harder for ordinary investors to get their money easily. “It’s a balancing act: inconvenience to investors and cutting down on fraud. There are going to be some judgment calls,” he said.
The SEC and NASD also are considering proposals to require that brokers tell their clients when they or their companies get extra commissions or other rewards for pushing particular products. Some of the information is already available, but the new rules could require direct conversations between brokers and their clients about commissions, something that rarely happens now.
Even industry officials acknowledge that quick action may be necessary. “Investor confidence will ultimately depend on how we respond [to the scandals],” said Timothy Forde, vice president of the Investment Company Institute, the major mutual fund trade group. On Thursday the institute said it would support the 4 p.m. deadline for filing orders for mutual funds and a 2 percent fee on very frequent trades.
Baker, chairman of the House Financial Services subcommittee on capital markets, is pushing to increase the independence of the boards of mutual funds by requiring more independent directors and an independent chairman.
Lieberman, who is running for president, proposed Tuesday, among other things, to limit the number of funds a director can oversee. Fund companies generally use the same board for all of their funds, which cuts costs but means that a single director may supervise as many as 250 funds.
If federal authorities do not act, Spitzer and Massachusetts Secretary of the Commonwealth William Francis Galvin, who brought the Putnam case with the SEC, will push individual firms for changes whenever they bring a case, they said.
“It is no longer good enough to pay a fine and say ‘we won’t do it again,’ ” Galvin said. “I don’t want to put them out of business, but if you can’t play by the rules, you shouldn’t be in financial services.”
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