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A Year of Charges, Reforms for Funds

Regulators Imposed Fines, Crafted New Rules

By Brooke A. Masters
Washington Post Staff Writer
Wednesday, September 1, 2004; Page E01

NEW YORK -- Just a year ago this week, New York Attorney General Eliot L. Spitzer shook the financial services industry -- and investor confidence -- by revealing that four big-name mutual fund companies had cut secret deals allowing a New Jersey hedge fund to profit from short-term trading at the expense of ordinary investors.

Before Spitzer's charges, the $7.4 trillion mutual fund industry -- the country's single most important vehicle for retirement and education savings -- had appeared to be a safe harbor for ordinary investors, sheltered from the types of financial scandals that helped wipe out shareholder equity in such companies as Enron Corp. and WorldCom Inc.


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The Securities and Exchange Commission and other regulators followed Spitzer's initiative with investigations into a growing list of abuses. Allegations of promised discounts that failed to materialize, tainted advice from brokers, and portfolio managers who preyed on their own funds helped spread the unease.

Since then, six mutual fund and brokerage officials have been indicted for wrongdoing, and regulators have sued or settled civil complaints with a score more. A dozen fund companies and brokerage firms have shelled out nearly $2.5 billion in fines, penalties and restitution, and seven of them have also signed agreements with Spitzer to cut their future fees by more than $800 million over five years.

Investors have pulled money out of some of the scandal-tarnished firms -- Janus Capital Group Inc., Strong Capital Management Inc. and Putnam Investments were among the big losers -- while new cash poured into the big firms that emerged largely unscathed, including Vanguard Group Inc., Fidelity Investments and American Funds Distributors Inc.

"At the one-year mark we have made greater progress than I thought we would at confronting these issues," Spitzer said.

Four congressional committees have held hearings, and the SEC has passed or proposed new rules covering fund governance, pricing and disclosure.

The industry also has begun implementing changes. More than 500 funds, many of them not linked to the scandal, cut their fees in the year ended July 31 -- almost twice as many as in the year before, according to Lipper Inc., which analyzes mutual funds. Just yesterday, for instance, Fidelity announced it was cutting fees on five index funds.

And the industry's main trade group, the Investment Company Institute (ICI), often viewed by consumer advocates as a major roadblock to reform, has an entirely new leadership and has supported some of the big changes, even as it tried to moderate their effects.

Federal, state and industry regulators say that they believe they have uncovered the worst of the abuses and that most of the really large cases have already been settled. Congress, too, seems to be moving away from investigating the scandal to making sure that the reforms are succeeding in cleaning it up.

"This scandal is basically over. The public has a very short attention span," said Bentley College finance professor Leonard Rosenthal. Still, he said Spitzer's revelations did the public and regulators a service. "It was important for people to find out that this industry that claimed to be scandal-free did not have clean hands. It helped expose all the dirty legal secrets" such as high management fees and undisclosed payments to brokers, he said.

The scandal broke Sept. 3, 2003, when Spitzer charged a hedge fund with "late trading" and "market timing" -- placing same-day orders after the official 4 p.m. deadline and making short-term investments that exploit differences between a fund's daily price and the value of its holdings.

Further investigation revealed that other hedge funds, other major investors and some fund company officials were engaging in similar trading and that fund companies including Alliance Capital Management LP, Bank of America Corp. and Franklin Capital Corp. had failed to stop the predatory trading. In some cases, they profited from allowing it to go forward.

Since then the SEC and Spitzer have collected about $2 billion in fines and restitution that will eventually go to investors in the victimized funds, though that process is expected to take months or even years because of the complexities in calculating who lost exactly how much money.

The NASD, which regulates brokers, also got involved, penalizing brokers who helped the hedge funds engage in timing and bringing cases against firms that overcharged mutual fund customers by failing to tell them about commission discounts or steering them into buying a type of share that carried higher commissions.

"I would suspect there will be more cases . . . [but] the issues have been pretty well fleshed out," said Barry R. Goldsmith, NASD's enforcement chief.

Investors voted with their feet. In the first 11 months after Spitzer's first press conference, companies touched by the scandal experienced net withdrawals of $155.6 billion while the rest of the industry has experienced net inflows of $124.6 billion, according to Lipper.

Regulatory reforms have gone far beyond the trading abuses that touched off the scandal. The SEC now requires fund boards to have independent chairmen, betting that an independent director in that role would be more likely to challenge deals that appear to work against the interests of most fund investors. The commission has also banned "directed brokerage" -- the practice by mutual fund companies of sending brokers extra business as a reward for selling mutual fund shares to retail customers. It was a system, regulators said, that encouraged brokers to sell particular funds to as many investors as possible, whether or not they were the best options for specific individuals. The commission is also considering whether to require more detailed disclosure of funds' transaction costs and payments to brokers.

SEC Chairman William H. Donaldson also set a deadline of the end of the year for dealing with proposals to enforce the 4 p.m. share-buying deadline and institute a mandatory 2 percent fee for short-term investors.

University of Mississippi law professor Mercer E. Bullard argues that the fund scandal has followed a traditional Washington trajectory: "You have a scandal, and you get things done that you've always wanted to do," he said. "It's ironic. The proposals that are most closely related to the scandal haven't been approved," he said, referring to the 4 p.m. deadline and the 2 percent fee proposals.

The SEC began investigating the directed brokerage problem months before Spitzer's revelations, but its findings got far more coverage because of the ongoing scandal. And Rep. Richard H. Baker (R-La.), who chairs the House subcommittee on capital markets, originally proposed the independent chairman idea only to see it voted down in committee right before the scandal broke.

When Baker first called for reforms in early 2003, he said, "we were met by industry representatives saying, 'Why us? Why now? There's no reason.' Almost the same individuals were saying a year later, 'We've got to get this fixed right now.' "

Paul Schott Stevens, the new president of the ICI, agrees that his industry realizes the atmosphere has changed. "Even the firms that have not been touched by [the scandal] understand that people's reputations are linked. . . . Investor trust is a very fragile thing that needs to be conserved," he said.

Still, academics and consumer advocates say most investors remain woefully uninformed about the performance and costs of the funds they choose. And Spitzer argues that too many fund boards of directors allow the management companies to charge too much for their services.

Spitzer insisted that his settlements with fund companies include promises of reduced fees, but the SEC commissioners explicitly rejected that approach, saying they thought it came close to price-fixing. Instead, the commission and Baker have focused on making sure investors get clear, upfront information about fees and other expenses and on requiring fund boards to justify management fees they approve.

Partly as a result of all these changes, Spitzer and his staff say they are moving on. They say they feel comfortable that the federal regulators who set policy for the industry are on top of trading problems and that fund directors are on notice that they can't rubber-stamp high fees.

"We jump-started the focus on mutual fund misbehavior so it's possible for us to focus elsewhere," Spitzer said.

At the SEC, Paul F. Roye, who heads the division that regulates mutual funds, said regulatory changes, combined with a major budget increase, mean the commission staff is better-positioned to catch and prevent future abuses. An SEC task force is considering whether to require mutual funds to report data to the SEC more frequently.

"Until the current budget cycle, we didn't have any money. We could keep the lights on but we couldn't invest in technology. Now we can think about, if we get more information reported in, getting technology to analyze it," Roye said.

Baker said he too will keep watch on the industry, probably with annual hearings on whether there is need for further reform. "The world is a better place today" because of the scandal and reform, he said. But "the dynamic is different than it ever has been before. When you have working families with substantial capital at risk and they are looking to us to make sure the system is fair, [Congress] has to respond."


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