COMMENTARY: THE SEC SHOULD KEEP FUND MANAGERS HONEST
After weeks of embarrassment for Dreyfus Corp., the Schonberg affair is finally dying down. Michael L. Schonberg has been put on paid leave while at least three investigations--including the FBI--probe his personal ownership of penny stocks purchased by his two "aggressive growth" funds. But no amount of investigating will resolve the thorniest question raised by this mess: Should the Securities and Exchange Commission require that personal trading by fund managers be disclosed, restricted--or banned entirely?
Well, it seems that this issue is about to be dealt with by the SEC. In the next month or so, the agency is expected to act on a three-year-old proposal to change Rule 17j-1, which governs personal trading by fund managers. As currently written, the rule is a prime example of do-nothing regulation. All it requires is that fund companies adopt codes of ethics "reasonably necessary" to prevent "fraudulent, deceptive, or manipulative acts" when fund managers trade stocks held by their funds. Yep--that's all. Fund managers are allowed to buy and sell the shares of companies held by their funds, even illiquid shares of tiny penny stocks. Only their consciences--and ethics codes--are there to guide them. And as the Schonberg affair illustrates, both can fail to avert questionable conduct.
Don't expect a regulatory juggernaut. The SEC-proposed rule change, which is wending its way through the agency, has the enthusiastic support of the mutual-fund industry. And for good reason--it is little more than a ringing endorsement of the status quo. Under the rule being proposed, fund boards would be given responsibility over their funds' ethics rules and would be provided with periodic reports on personal trading by fund managers. The ethics codes would be filed with the SEC and would be available for perusal by the public. Prospectuses would have to note that the funds have ethics codes and disclose whether they permit fund managers to buy stocks that are owned by their funds. Also, fund managers would have to report their holdings when they join a fund.
It sounds good but in fact would do precious little. To begin with, the SEC expects too much from fund boards, which are hardly the Ralph Naders of investing and don't even approach their corporate cousins in activism. And no wonder--fund directors often don't even have a personal stake in their funds. The other "new" proposal, which requires fund managers to report their holdings when they start working, is really old hat. Most funds already have that requirement. No, the status quo needs to be changed, not ratified. The changes that should be made by the SEC fall into a couple of broad categories:
-- Disclosure The SEC proposal is ridiculously timid on this subject. Fund customers have a right to know if fund managers own the same stocks their funds buy. Why not put it right in the prospectuses, semi-annual reports, and annual reports? Why not publish the ethics rules as well? Fund customers should not have to go to the SEC to obtain such vital information.
-- Personal Trading The SEC won't have to worry about disclosure at all if it simply bites the bullet and severely restricts personal trading. A total ban is not necessary--and may not even be permitted by law, says Robert E. Plaze, associate director of the SEC's investment management division. Indeed, there's no reason money-market fund managers should be prohibited from buying money-market securities. But strict limits are needed for the vast majority of fund managers, and the SEC should set them.
If fund managers want to play the market, they should be required to buy their own funds. Buying stocks that might be considered by their own funds is simply too prone to conflicts of interest. So if the manager of a gold fund wants to play the gold market, he or she should do that via his or her fund--and not some gold-mining stock. And there should be a strict prohibition against fund managers' obtaining "cheap stock" in private placements of any company, whether or not their funds can buy it--another issue that is raised by the Schonberg affair.
The SEC's Plaze stresses that passing a rule will not, by itself, prevent improper trading by fund managers. He correctly observes that enforcement of the securities laws is the other major tool in the SEC's arsenal. But in reassessing Rule 17j-1, the SEC has a golden opportunity to take the lead--and not pass the buck to the fund industry. It shouldn't let that opportunity slip by.By Gary Weiss