Lack of Mutual Interest

Corporate Research E-Letter No. 41, November 2003


by Mafruza Khan

Over the last two years, the media has been replete with stories of accounting fraud, excessive executive compensation and other incidents of corporate malfeasance. Only one business seemed to remain untouched by corporate scandals -- mutual funds. Then the bubble burst about two and half months ago with New York Attorney General Eliot Spitzer announcing a settlement with investment firm Canary Capital Partners, a hedge fund, for transactions it had made with four mutual fund companies. Hedge funds are largely unregulated pools of money catering to wealthy investors. The four companies -- Nation's Fund/Bank of America, Bank One, Janus Capital and Strong Capital -- were secretly allowing major customers like Canary to engage in questionable short-term trading in return for bringing in other fee-generating business at the expense of their ordinary investors. All four are still under investigation by Spitzer and the Securities and Exchange Commission (SEC) and are expected to be hit with civil penalties and various charges related to illegal business practices. 

These findings are part of a larger investigation by Spitzer, the SEC and Massachusetts regulators of self-dealing and other trading practices by mutual fund companies that by some accounts cost investors about $5 billion a year. Companies indicted include industry leaders such as Putnam Investment Management, Pilgrim Baxter & Associates and Morgan Stanley. Morgan Stanley and Putnam have paid millions of dollars in settlement as well as agreeing to a number of governance related reforms. Pilgrim's two founders left the company after being accused by the SEC of defrauding investors. Gary Pilgrim has agreed to turn over personal profits and the company has agreed to reimburse all related management fees. Some large institutional investors have started to pull out of these funds. A September 19 (unscientific) Reader Survey by BusinessWeek of 430 readers found that readers are in favor of fines, firing and jail time for fund executives who are found guilty of breaking the law.


The 80-year old mutual funds business currently has an estimated 95 million Americans, or approximately 50 percent of all American households, invested in the $7 trillion industry. Only 20 years ago, it was valued at $134 billion, with approximately six percent of American households owning mutual fund shares. The number of funds during the same time has increased from 500 to 8,000. The industry controls about 10 percent of the nation's financial assets. According to former SEC chairman Arthur Levitt, mutual funds represent the very best vehicle from which the individual investor has access to markets. But unfortunately, the industry has taken advantage of this growth by allowing preferred clients to engage in prohibited trading practices at the expense of the average investor.


Market timing is being used as a broad term to describe the ways investors have been bilked by fund managers and brokers. Market timing per se is not illegal. It traditionally refers to shifting a portfolio from equities to cash with the goal of sidestepping a market decline, and then moving back into the equity market in anticipation of a rally. But market timing also encompasses prohibited or illegal practices such as the following:

  • Frequent Trading - Frequent trading of funds is prohibited because it raises brokerage costs, which are shared by all investors in a fund. If companies allowed this form of arbitrage or trading when they had rules to the contrary, then they could be guilty of violating securities laws.
  • Late Trading - Late trading, which involves allowing preferred clients to trade after the close of business hours at 4 pm Eastern Standard Time, is patently illegal. It is also unfair to other shareholders because it forces fund managers to make adjustments to the fund's cash position that can adversely affect other investors.
  • Stale Pricing - Stale pricing can be viewed as a specific form of market timing most commonly associated with trading in international stocks. Stale pricing refers to the practice of allowing certain investors to get today's price that funds use to calculate their net asset value even when the order is placed after the cutoff time of 4 pm. For international stocks, prices can be several hours out of date because of time difference. Investors who switch in and out of these funds frequently can thus realize substantial profits at the expense of long-term shareholders. This form of arbitraging is not illegal, but most mutual fund companies have rules that prohibit such trading as it hurts long-term shareholders.

The SEC charged Putnam, the fifth largest family of funds, with securities fraud for allowing two portfolio managers to engage in improper short-term trading in international equities, amongst other things. As with most other SEC settlements, the company has not admitted to any wrongdoing, but has agreed to take a series of steps to improve its governance and oversight of its operations, and will have to pay some financial penalty and restitution. The measures are expected to affect the entire Putnam Family of Funds, including 38 unaffiliated institutional portfolios with total assets of $272 billion, as well as its municipal bond funds. The SEC's hasty settlement with Putnam, however, has been criticized by state regulators as inadequate and has been called a "Band-Aid" approach by Spitzer. Current and former SEC officials say that the agency has been captive to the industry and that it has also been seriously understaffed and under-funded.

According to a recent SEC survey, one-fourth of the nation's largest brokerage houses were involved in helping clients engage in late trading, and half of the largest companies had arrangements that allowed certain customers to engage in market timing or frequent trading


Other than trading practices related to timing, the industry is also being rightly criticized for serious shortcomings such as: commission overcharges; breakpoints or instances where brokerage firms did not give investors the volume discounts to which they were entitled to when they purchased funds; lack of transparency and inadequate disclosure on issues such as fund pricing and executive compensation; lack of independent directors and totally interlocking boards; and soft dollar issues such as additional fees charged for broker-directed research and other related services.

On November 17 Morgan Stanley agreed to pay $25 million in civil penalties and $25 million in surrendered profits and interest to settle charges by the SEC. The Morgan Stanley settlement focuses on revenue sharing arrangements such as "shelf-space payments" in which fund companies pay brokerage houses extra compensation on Top of ordinary broker's commissions when brokers agree to feature them as preferred funds. The SEC complaint also alleges that Morgan Stanley failed to make necessary fee disclosures and that the firm's brokers improperly directed customers into a particular kind of high-commission mutual fund shares without disclosing that the class carried higher fees for the customer.

As part of its settlement with the SEC, Putnam has agreed to appointing an independent chairman, have at least 75 percent of its board members be independent, and appoint a chief compliance officer who will report to the board the firm's compliance with federal securities laws, fiduciary duties to shareholders and establish and maintain a code of ethics oversight committee and an internal controls compliance committee.

On November 19 the SEC proposed increasing the proportion of independent directors from 50 percent to 75 percent for all funds. Under current federal law, a majority of each fund's director must be independent; directors are also required to annually renegotiate a fund's contract with the financial company that provides it with management services. Unlike a publicly traded company, each mutual fund does not have its own independent board. Most funds usually have the same directors oversee all the funds they offer. The SEC is also pushing for use of plain English.


On November 19 the House voted 418-2 for a bill introduced by Representative Richard Baker  (R-La) that imposes new restrictions on short-term and other trading practices, requires disclosure of investor fees in dollars, disclosure of soft dollar arrangements and disclosure of compensation to brokerage firms for distribution of fund shares.

Mercer Bullard, a securities law professor at the University of Mississippi and founder of Fund Democracy, a non-profit organization promoting accountability and regulation of mutual funds, says that the big issue for the industry is disclosure and that it is critical that the SEC and Congress improve the transparency of the cost of owning funds. The Baker bill is critical towards that end for him because it requires that a fund's expense ratio include portfolio transaction costs and that the transaction confirmation show how much the broker got paid for promoting the funds.

The Baker bill still needs approval in the Senate, where several other bills have been proposed, including one supported by the industry's chief lobbying arm, the Investment Company Institute. That bill will seek to prevent late trading and frequent trading or market timing by imposing a fee on investors who jump in and out of funds. Critics point out that while such a fee would discourage frequent trading, it would also unfairly penalize shareholders who need to sell shares quickly because they have an emergency. The bill requires full disclosure of fees and equal access to information for all investors about fund portfolios. It also calls for corporate governance measure such as requiring funds to have a written code of ethics and an in-house compliance officer who would report to the fund's board of directors.

Senators Jon Corzine (D-NJ) and ChrisTopher Dodd (D-Conn) plan to introduce legislation that would apply to mutual funds some of the reforms that the Sarbanes-Oxley Act imposed to corporations. The bill includes requirements that the board chairmen and chief compliance officers of fund companies certify the accuracy of costs to investors in their funds' prospectuses. It also stipulates that two thirds of a fund's board, its chairman, the nominating committee and the audit committee must be independent.

Senators Daniel Akaka (D-Hawaii) and Peter Fitzgerald's  (R-Ill) proposed bill calls for disclosure of portfolio manager's fund holdings, adding brokerage commission to expenses and providing written notice of broker's compensation for selling funds.


As the preferred investment vehicle for 95 million Americans, including a majority of the middle class, the mutual funds industry cannot be allowed to exist without adequate oversight, disclosure and accountability. Investors who have been cheated need to be compensated. The money management industry is one of the most profitable businesses in the world, even in today's volatile market. The SEC, Congress, state and federal regulators and industry leaders need to rise to the occasion of restoring investor trust in the industry.