Experts: Mutual Funds Riddled with Abuse
Mutual fund boards have "utterly failed the investor."
- Eliot Spitzer, New York attorney general
Milwaukee Journal Sentinel
Federal regulators promised to unleash a number of enforcement actions, suggesting that problems in the $7 trillion industry are much more widespread than first thought.
The hearing ventured well beyond the trading abuses at the root of the current scandal. Topics of discussion included the size of the management fees charged to investors, as well as what critics said is the core conflict of interest between managers and shareholders posed by the "incestuous" governance structure of most mutual funds.
Illinois Republican Peter Fitzgerald, chairman of the hearing, called mutual funds "the world's largest skimming operation."
New York Attorney General Eliot Spitzer said the boards of mutual funds have "utterly failed the investor." He said excessive management fees cost the investing public far more money than the illegal or questionable trading practices that he and others are investigating.
Among Spitzer's targets is Richard S. Strong, chairman of Strong Capital Management Inc., the Menomonee Falls mutual fund company. He is under investigation on suspicion of improper trading in his firm's funds.
John Bogle, founder of the Vanguard Group of mutual funds and a longtime critic of industry practices, called recent revelations about trading abuses "a small tip of an enormous iceberg of conflict."
He said, "I love the mutual fund industry, but we've lost our way and must return to our proud heritage."
Lower management fees would save investors "tens of billions. . . year after year," Bogle said.Trading abuses widespread
Federal regulators reported on the preliminary findings of a compulsory survey of brokerage firms and mutual fund companies concerning trading abuses.
One illegal abuse, known as late trading, involves orders placed after the market is closed. Another, known as market timing - what Richard Strong is accused of doing - involves short-term, rapid trades. It's not by itself illegal, but can benefit one group of shareholders at the expense of another. Many funds claim in their prospectuses to discourage market timing.
In the survey, more than a quarter of brokers and dealers reported cases of late trading, in which customers were allowed to place orders after the 4 p.m. close but still receive the 4 p.m. price. In such trades, a customer can benefit from market trends that occur after the price is set and trading is supposed to close.
About two-thirds of brokers and dealers said they were aware of market-timing activities by their customers, according to Stephen Cutler, who heads the enforcement division of the Securities and Exchange Commission.
Cutler said the current scandal involves "one betrayal after another," an "unholy trinity" of late trading, market timing and what he called "self-dealing," or insider trading.
The scandal became public when Spitzer said on Sept. 3 that four mutual fund companies, including Strong, enabled hedge fund Canary Capital Management to make short-term trades in their mutual funds.
The SEC, the federal Justice Department and authorities in other states have since joined the investigation. More than 30 investment company officials have been suspended or lost their jobs.
The most prominent, Putnam Investments Chief Executive Lawrence J. Lasser, resigned Monday. Putnam and two of its former fund executives have been charged with fraud in connection with improper trading.
Massachusetts regulators and the SEC plan today to bring civil securities fraud charges against two former managers of Prudential Securities' Boston office and three former brokers there on accusations of improper mutual fund trading, sources familiar with the investigations told the Washington Post.
"Many more enforcement actions will follow," Cutler said.
After the witnesses made their statements, Fitzgerald turned to Cutler and asked, "We're talking about serious, wholesale criminal violations coming to light, aren't we, Mr. Cutler?"
Cutler declined to echo that, but responded, "I certainly share your concerns 100 percent."
The SEC also came under fire from senators who questioned why certain behavior went unchallenged for years.
Maine Republican Susan Collins, chairwoman of the Governmental Affairs Committee, wondered "why the Securities and Exchange Commission, which has regulatory responsibility for the mutual funds and their broker-dealers, has failed to detect these practices, to impose appropriate restrictions on them, or to penalize those who appear to be misusing investors' money."
Connecticut Democrat Joseph Lieberman, who was not at the hearing, released a letter he sent to the SEC attacking the agency, asking, "Why did the watchdogs fail to bark?"
SEC official Paul Roye told the committee that "We're committed to rooting out this problem."
Of the regulatory initiatives the SEC is planning, he said, "No reform . . . is off the table."
The central role mutual funds have come to play for middle-class investors, with 95 million people owning funds worth nearly $7 trillion, was noted repeatedly at the hearing.
The industry's scandal-free image was long-standing. But Fitzgerald said a "monster" had been created that was overdue for review, oversight and structural reform.
Beyond the newly publicized abuses, he said the "big picture" is of an "institutionalized conflict of interest" in which fund directors are the "insiders" of investment advisory firms that are paid to manage the funds.
Spitzer said the original law that covers governance of mutual funds "makes Swiss cheese look like a solid wall" and is ripe for reform.
Bogle said "profound conflicts of interest exist between fund managers and fund shareholders," because large fees and practices such as market timing might benefit managers but cost shareholders.