By Amey Stone
Nancy Smith knows securities regulation. She has spent most of the past 20 years steeped in the subject, first serving as counsel for a House Finance subcommittee, then as director of New Mexico's state-securities agency, and from 1994-99 directing the Securities & Exchange Commission's Office of Investor Education & Assistance under Chairman Arthur Levitt. Lately she's consulting with businesses about compliance issues.
Despite her experience with past financial scandals, even Smith was taken aback by the latest one sweeping through the mutual-fund industry. Like many regulators, she thought the fund industry's business model –- where firms are compensated based on assets under management –- meant their interests were closely allied with shareholders and that would discourage fraud. Not so, she now realizes, since holes in the way fund-trading systems are set up allowed insiders to profit handsomely at shareholders' expense.
Smith now believes the only way investors can be fully protected against fraud is if companies are required by law to beef up their own compliance systems and adopt sophisticated technology to monitor trading. (One of her current clients is Mantas, a Fairfax (Va.) company that makes trading-compliance and fraud-detection software, and would likely benefit from such regulation.) Smith spoke with me recently about the how this fraud is already reshaping the fund industry and what should happen next. Edited excerpts of our conversation follow:
Q: What was your reaction when you first heard about New York Attorney General Eliot Spitzer's investigation into abusive trading practices in the mutual-fund industry?
A:I was shocked by what he uncovered, and I don't consider myself naive by any stretch. I know a lot of regulators were amazed by the brazenness of the activity and the fact that so many people were involved. This is a systemic problem. We're not talking about just a few bad apples.
Q: Why was it such a surprise, especially since scandal has touched so many aspects of the financial world in the past two years?
A:I think a lot of regulators had the impression that the mutual-fund industry was above this kind of thing. It had that reputation partly because it seemed like the structure of the industry had investor interests better aligned with fund-company interests and partly because it had remained above the fray during the accounting and research analyst scandals. People were lulled into a false sense of security.
Q: What is it about the structure of the industry that allowed such widespread abuses to take place?
A:It turns out that the attraction for fund companies of having "sticky assets" [large deposits made by market timers that would not be traded] and increased management fees was so great that some firms were willing to allow major customers to market-time their funds. There was a monetary interest that pitted large investors against smaller investors.
We're also finding there are lots of problems in the corporate-governance structure of funds. Where were boards of directors and the companies' compliance arms? The SEC just proposed a rule this week that funds and investment advisers have to have chief compliance officers in place who will look for violations.
Another major problem with the structure is that you have a whole set of intermediaries in the fund industry that were actually putting the orders through that were unregulated. You can't have trading or compliance operating on an honor system.
I would love to say there was some grander cause for this problem, but it all gets down to how trades are processed. The systems for trading funds were riddled with opportunities to exploit weaknesses. By Amey Stone
Q: What regulatory solutions do you favor?
A:We need to change trading practices that allow firms to put customer orders in batches and send them all at once to the fund companies. That makes it very hard for funds and boards and intermediaries to track what's going on. At the end of the day, what you have is a system where you can't follow the money because you can't follow the data.
The industry has to come to grips with the fact that trading has to be transparent. The only effective way to police trading activity is if you record it electronically, analyze it, and look for suspicious activity and links between seemingly unrelated accounts.
Fund companies can use the same technology that market timers used to uncover arbitrage opportunities to protect their shareholders. This technology is available, and it needs to be applied to protect investors. Without that, we will end up with overly restrictive rules, like having a hard close of 4 p.m. for fund trading. That would cause a lot of hardship on individual investors.
Q: Sounds like you're not in favor of the 4 p.m. deadline proposed by the SEC on Dec. 3?
A:The problem is that it may not give firms enough time to process orders [so investors may be required to submit orders far earlier, especially for trading in 401(k) plans]. The SEC is asking for comment on whether technology and systems are currently robust enough so that orders could be placed up until 4 p.m.
I think we will go to a hard close initially [that means investors have to submit orders earlier than that in many cases], and then work our way toward a technology solution that gives investors flexibility to submit orders up until 4 p.m.
Q: Do you favor the adoption of other SEC proposals being considered?
A:I think the rule requiring fund companies to name a chief compliance officer that reports directly to the board is a step in the right direction. Better disclosure in the prospectus of market-timing policies and boosting board independence also makes sense.
Q: Do you think these reforms will work, and if so, how will the industry change as a result?
A:It's hard to tell. A lot of the strength of reforms rests in how they're implemented. The devil is in the details. There has been a betrayal of trust that is huge. So I think the mutual-fund industry's relationship with regulators will be much different going forward.
Life has definitely changed for mutual-fund directors. They are going to be under a lot more scrutiny. Hopefully, fund companies will adopt sophisticated technology to deal with these issues and monitor what's going on.
Q: What other changes are under way?
A:Institutional investors are certainly becoming more active. That protects not only their shareholders but benefits the investing public at large. So I think that's a very healthy development. All this publicity is an investor-education campaign. People are learning a lot more about fees and how fees can lead to conflicts of interest. I think it has been an eye-opener, not only for regulators but also for the investing public.
Q: What's the legal end game for this scandal? Will we see a global settlement like we saw with the Wall Street research scandal?
A:Right now, it seems to be proceeding on a case-by-case basis. Also, firms have been very aggressive about finding out if they have problems, firing employees, and implementing remedial measures very quickly -- even before regulators came in in some cases.
Most firms announced they're going to reimburse investors for any losses, so that's a good move in terms of making sure the incentive to sue is not there. People are moving quickly to take action, and that's a good sign.
Q: So far, investors aren't moving quickly –- at least when it comes to moving assets out of funds. Should they be?
A:When you have a rising market, obviously people want to participate. But I think people are noticing which fund companies are involved, and they are disgusted. This could have a more subtle long-term effect than people selling their funds right away. Longer term, they can seek out firms that have stellar reputations. So we'll see more firms compete on basis of strength of compliance.
For now, investors should be very conscious of fund fees and how much they're paying for investments. They also now have an opportunity to speak out, to let their views be known. Call your financial firms or send a comment letter to the SEC.
Q: They listen?
A:I've seen it with other rules that were adopted. There's no doubt that when investors get involved and make comments, it makes a difference.
Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column