Little scrutiny of funds by SEC

Commissioner admits agency never checked mutual fund practices

U.S. investments at $7 trillion

Donaldson details reforms, risk assessment office to catch future problems

November 19, 2003|By Eileen Ambrose | Eileen Ambrose,SUN STAFF

Securities and Exchange Commissioner William H. Donaldson confessed yesterday that for years his agency had failed to check funds to catch wrongdoing like late trading or market timing, practices used to steal millions from small investors.

"For too long, the commission has found itself in a position of reacting to market problems, rather than anticipating them," Donaldson told Senate Banking Committee members. "Clearly we can improve the effectiveness of the way we go about things."

Donaldson rebutted criticism of how the Securities and Exchange Commission was handling a widening scandal over fund practices and fielded questions about turf fights between state and federal regulators.

But in an explicit acknowledgement that the agency's regulatory effort had fallen short, he outlined a detailed list of steps the SEC would take in coming weeks to reassure mutual fund investors.

About 95 million investors, representing more than half of U.S. households, own mutual funds. The funds - with assets totaling $7 trillion - have become the popular choice for small investors.

Committee members were sharply critical.

"It has become apparent that many of the questionable fund practices that are now being examined are not the result of a few bad actors, but are long-standing industry practices that have largely gone unregulated and are not well-disclosed to, or understood by, most investors," said Sen. Richard C. Shelby, the Republican Banking Committee chairman from Alabama.

"Mutual fund abuses simply did not receive adequate attention from the SEC," Shelby said.

"We must determine whether new laws, new regulations or more effective enforcement of existing regulations, or all of the above, are needed," said Democratic Sen. Paul S. Sarbanes of Maryland.

Donaldson dismissed the suggestion, however, that a new agency was needed to oversee the fund industry. "Everything is on the table on how we address the problem," he said.

Shelby questioned Donaldson about criticism that the SEC settled an investigation into market timing at Boston-based fund giant Putnam Investments too quickly and with insufficient punishment.

Donaldson said, "The criticism is misguided and misinformed, and it obscures the settlement's fundamental significance." The settlement addressed the specific allegations of market timing and a failure by fund officials to disclose problems to directors, he said.

The SEC acted quickly to protect Putnam's current shareholders from being hurt by heavy redemptions as investors bail out of Putnam shares, Donaldson said. Since allegations of market timing surfaced last month, the company's assets under management fell $21 billion to about $256 billion.

Sarbanes asked if the SEC was behind a push for legislation in Congress that would limit oversight of financial markets by state regulators.

New York Attorney General Eliot Spitzer and Massachusetts Secretary of the Commonwealth William Galvin have criticized the SEC settlement with Putnam.

In an apparent allusion to Spitzer, Donaldson said it's counter-productive for some regulators to publicly criticize the SEC's efforts.

He said he would continue working with state regulators, but "when it comes to writing rules, it's got to be our responsibility."

Treasury Secretary John W. Snow and Federal Reserve Chairman Alan Greenspan cautioned in letters to Congress yesterday that too-stringent reforms could end up costing investors more in fees and diminished returns.

The funds scandal surfaced in early September when Spitzer settled with a hedge fund accused of market timing and late trading in some big-name mutual fund companies.

Late trading is illegal. Still, some funds have allowed traders to take advantage of late-breaking news by trading in fund shares after the 4 p.m. close of the securities markets.

Market timing isn't illegal, but funds often prohibit the practice of traders jumping in and out to take advantage of short-term price movements - skimming off profits that would have gone to long-term investors.

"Ever since then, we have been getting additional disturbing revelations," Sarbanes said.

Donaldson said the commission will consider a series of reforms at a meeting on Dec. 3. Most importantly, they would:

Require that buy and sell orders be received by a fund or its agents no later than 4 p.m.

Require funds that prohibit market timing to provide greater disclosure of the rules and to have procedures outlining what the fund does to keep market timers out.

Review recommendations to curb self-dealing by portfolio managers who market time in their own funds.

Consider new rules to ensure that funds have strong compliance programs.

Donaldson also proposed creating an SEC office of risk assessment to quickly identify fraud or questionable activities.

The SEC chief said the recently identified problems underscore the need for independent board of directors for the funds, and the commission expects to review recommendations to achieve independent boards in January.

Also in January, the commission will likely consider requiring funds to disclose fees in "dollars and cents," rather than percentages, and make it easier for investors to know what they are paying in fees.

The commission also plans to improve disclosure so investors know how much brokers benefit if they buy a certain fund.

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