Why It's Open Season on Mutual Funds

The SEC is demanding more disclosure--and oversight

In last year's sordid parade of financial scandals, the one player missing was the mutual-fund industry. Compared with Wall Street, funds have a clean, investor-friendly reputation. But suddenly, the funds have become a target for regulators and lawmakers. The shell-shocked funds and their lobbying arm, the Investment Company Institute (ICI), are wondering what hit them.

The answer: a lot all at once. On Jan. 23, the Securities & Exchange Commission overruled the industry's objections when it ordered funds to start disclosing how they vote in corporate proxy contests. The SEC is also pushing funds to reveal every quarter which stocks they own, instead of every six months. Next up: two new SEC proposals aimed at tightening oversight of funds. At a Feb. 4 meeting, the agency will propose that every mutual fund adopt stiffer internal controls and designate a compliance officer. And the commission will debate an even bolder idea of whether to create a self-regulatory body to oversee the $6.6 trillion fund industry.

SEC sources say outgoing Chairman Harvey L. Pitt, with an eye on his legacy, is dusting off old ideas in hopes of showing his willingness to crack down on a former client, the ICI. "He's trying to say: `Look, these were my clients, too. Let me show you how many times I can hammer them,"' according to a former SEC official. And in times of tight budgets, the SEC has considered creating a self-regulatory organization (SRO) that could both pay for itself by levying fees on funds and relieve the agency of the burden of examining investment companies. Indeed, SEC officials argue that funds need closer supervision than the overburdened agency can provide. "We can't be everywhere at all times," says Paul F. Roye, director of the SEC'S Investment Management Div. "We're trying to avoid problems that we've seen in other areas." Moving routine examinations of funds to a third party--whether it's an SRO or, as the SEC is also considering, auditors or insurers--would free the SEC to focus its limited resources on the most troublesome practices. Shareholder activists say the call to beef up controls is long overdue. "This is directed at small fund complexes, where there's greater potential for abuse," says Mercer Bullard, president of shareholder advocacy group Fund Democracy.

That's fine with most big funds that already have compliance systems. But they're balking at a new layer of regulation. "Direct government regulation of mutual funds by the SEC is the superior model," says ICI spokesman Chris Wloszczyna. And SROs have hardly covered themselves with glory. Witness the accounting industry's failed disciplinary system for auditors or the National Association of Securities Dealers' slow response to analyst conflicts.

With Pitt pushing the notion of a new regulator, lobbyists figure the idea will vanish when he does, in February. But that won't cure the ICI's longer-term problems on Capitol Hill. House Financial Services Committee Chairman Michael G. Oxley (R-Ohio) will hold the funds' feet to the fire in hearings he plans into the fees they charge investors. He's also singled out funds for hiding their costs by paying inflated commissions to brokers. The funds are supposed to buy research with those "soft dollars." But they're sometimes diverted to buy software, computers, and even cars for managers. Such conflicts, says Oxley, "may be a contributing factor to poor mutual-fund performance--well below market averages." John C. Bogle, founder of giant Vanguard Group Inc., agrees with him. Closer scrutiny of fund fees is "long overdue," he says. "The economies of scale, which are staggering in this industry, aren't being shared with fund owners."

Oxley also has a personal gripe with ICI. Lobbyists say he is incensed by the group's close ties with Hill Democrats. Whenever a fund issue comes up, says one, "the ICI runs to Democratic staffers" on committees that oversaw the industry before Oxley's panel was created in 2001. The ICI says it has great relations with lawmakers on both sides of the aisle.

Fund companies are hoping ICI will work these connections harder. But as long as investors' 401(k) balances stay in the dumps, the scrutiny of funds--and the barrage of regulation--aren't likely to end. Until then, the funds need every friend they can find.

By Amy Borrus and Mike McNamee in Washington

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