In the summer of 2002, as Congress was grappling with how to clean up Corporate America's shady financial practices, mutual-fund industry lobbyists beseeched lawmakers to exempt their corner of the financial-services industry. Lulled by the funds' six decades of scandal-free operation, Congress obliged, for the most part, excusing funds from the more onerous provisions of the Sarbanes-Oxley corporate reform law. But mutual funds won't be off the hook for long. Now that they are embroiled in a spreading scandal of their own, the hammer is coming down. The legislative, regulatory, and market reforms in the works could add up to an overhaul as sweeping as Sarbanes-Oxley -- with an even more immediate impact on American investors.
For now, it's the big fiduciaries -- particularly the state treasurers, pension fund trustees, and 401(k) plan overseers who have billions invested with fund companies -- who are doing the most to shake up the mutual-fund industry. But Congress, too, is steaming ahead, even as Federal Reserve Chairman Alan Greenspan and Treasury Secretary John W. Snow caution against reform that goes too far. On Nov. 19, the House of Representatives overwhelmingly approved a package of reforms sponsored by Capital Markets Subcommittee Chairman Richard H. Baker (R-La.). Senate Democrats are urging stronger measures.
Racing Congress to the finish line, Securities & Exchange Commission Chairman William H. Donaldson says his agency on Dec. 3 will consider new rules to halt trading abuses such as market-timing, a practice in which investors buy fund shares at outdated prices and sell them a day or two later. And in January, the SEC will take up measures to strengthen fund boards, give fund investors better information about portfolio holdings, and require portfolio managers to reveal their own trades in funds.
DOZENS OF PROBES
Will it be enough? While the SEC was caught flat-footed when the first fund-trading abuses were revealed on Sept. 3 by New York Attorney General Eliot Spitzer, the agency now has dozens of active investigations into fund abuses, as do Spitzer and other state prosecutors. The SEC is also probing unsavory fund-sales practices by brokerage firms. And in addition to cracking down on trading abuses, the SEC is also finally tackling the mutual-fund industry's opaque fees and weak governance. The multi-pronged attack by the SEC, Congress, and state money managers still has some gaps. But the combination could bring about a top-to-bottom housecleaning of the industry.
While Washington's moves are garnering the headlines, the strongest push appears to be coming from state treasurers and other fiduciaries, who have begun to put their leverage to work. Their reform agenda goes beyond curbs on market timing and late trading -- the illegal late-day buying and selling of fund shares after the markets close. Pension trustees also want to force funds to disclose more hidden fees and to shop for lower-priced investment-advisory services. "This is an instance when large fiduciaries have to take matters into their own hands," says Mark Anson, chief investment officer at California Public Employees' Retirement System (CalPERS), which commands $154 billion in assets.
PENSION FUND CLOUT
Such institutions have good reason to worry. In just 10 weeks, what started as misbehavior by a little-known hedge fund in cahoots with a handful of dishonest brokers and mutual-fund managers has ballooned into an industrywide scandal. Already, 15 mutual-fund companies, 12 brokerage firms, three hedge funds, and dozens of executives have been implicated. And on Nov. 20, the SEC was expected to bring civil fraud charges against Pilgrim Baxter & Associates Ltd., which runs the PBHG fund family, and co-founders Gary L. Pilgrim and Harold J. Baxter. The case will allege that the co-founders allowed a hedge fund partially owned by Gary Pilgrim to make rapid trades in PBHG funds. A lawyer for the firm and the two company officials, both of whom resigned in mid-November, did not return phone calls.
Yet the industry shakeup now unfolding holds out the promise of real reforms. The SEC's Dec. 3 rule proposals will require that funds receive orders to buy or sell shares no later than 4 p.m., in order to curb late trading. Commissioners also will adopt rules requiring funds to have written compliance policies and a compliance officer who reports to the fund's board of directors. Also likely: stronger curbs to deter fund managers from giving favored investors a peek at portfolio holdings, including prosecution for insider trading. And in January, the SEC will propose a raft of governance changes, including requiring 75% of fund directors and the board chairman to be independent of the fund management company.
Congress has other items on its list. Baker's bill, for example, would force funds to disclose such hidden costs as shelf-space payments to induce brokers to sell some funds over others. He also would require them to reveal soft-dollar payments, the excess commissions that fund advisers use to purchase research and other products. And Baker would prohibit individual fund managers from overseeing hedge funds.
While the SEC and Congress are moving fast, it could be months before their reforms take effect. Big state fiduciaries aren't waiting. On Nov. 17, North Carolina State Treasurer Richard H. Moore told nine fund companies that manage the state's $2.3 billion 401(k) plan and its $56 billion pension plan that they must adopt a package of reforms if they want to keep the state's business.
Moore's ambitious agenda includes requiring fund managers to disclose information about fees in dollars, rather than listing them as a percentage of assets, the current practice. He also wants fund managers to charge 401(k) investors fees similar to those charged the big pension pools. Says Moore: "We're saying to the funds that handle our money, 'Why don't you do a better job of disclosure and customer service? If you want to stay in our family of funds, I want to know what you have to say about these changes."'
Other state pension heavyweights are considering similar action. CalPERs is reviewing the ethics codes and compliance procedures of all 66 money managers with whom it does business, and may craft its own investor-protection guidelines. CalPERS is among the investors who have withdrawn some $21 billion in assets from Putnam.
State treasurers who oversee so-called 529 college-savings funds are also moving swiftly to protect these plans. Wisconsin State Treasurer Jack C. Voight is asking the state legislature to give Wisconsin investors a tax benefit if they place their funds with college plans other than home-state Strong Capital Management Inc. That seems bizarre, but Strong is the only fund company currently with a state tax break. So even though Spitzer has alleged that founder Richard S. Strong traded against his own funds, the state can't rip up Strong Capital's contract to manage the plan through 2006. It can, however, invite out-of-state competition. Richard Strong has denied wrongdoing but still promises to repay investors for their losses due to his trades.
CREEPING FEE ESCALATION
Despite the broad reform push, there's clearly more work to be done. Fixing the basic flaw of mutual-fund boards -- that they hire, but don't control, the fund adviser -- isn't on anyone's to-do list, but it should be. And while adding more independent directors is all the rage, that may not make much difference, says Gary Gensler, former Treasury official and co-author of The Great Mutual Fund Trap. Outside directors already have a duty to weigh investment adviser fees, he says. But the SEC only requires them to determine if such fees are "reasonable" -- a standard that a 1982 court ruling defined as in line with what other funds pay. That has led to a creeping escalation in fund management fees ever since. "Congress and the SEC need to issue a clearer definition of fees and put more meat on the word 'reasonable,"' says Gensler.
Brokers need new rules, too. Now, says Louis S. Harvey, president of Dalbar Inc., a financial market-research firm based in Boston, funds don't compete on price. "We have a price-fixed system where funds set the price and the consumer pays the price no matter what," says Harvey. More disclosure may not help, since few investors read their fund documents. A better solution: Congress could impose a fiduciary duty on brokers, requiring them to shop for funds that offer attractive returns at lower prices.
In the end, the $7 trillion fund industry, with all its legendary clout, will be hard-pressed to blunt reforms. At this point, the best mutual-fund leaders can hope for is that the coming changes help restore confidence in their tarnished industry. By Amy Borrus and Paula Dwyer in Washington, with Lauren Young in New York