Reform may hurt investors the most

Scandal: New legislation for mutual fund companies might leave shareholders with a worse deal.

November 23, 2003|By Gerri Leder and Libby Dubick | Gerri Leder and Libby Dubick,SPECIAL TO THE SUN

The recent revelations of wrongdoing at mutual fund companies have left shareholders rattled at best and betrayed at worst. But while calculating the cost of these activities, they should also give a thought to the cost of reform and what's next.

The mutual fund scandal covers a multitude of sins from the venial to the mortal.

The charges include:

After-hours trading. Accepting orders to buy or sell mutual fund shares after 4:00 p.m. EST, when the U.S. stock market closes.

Market-timing or short-term trading. Permitting selected investors to trade in and out of a fund as much as once a day, when the prospectus says market timing will be discouraged or prohibited.

Trading by senior fund-personnel for their own accounts. Short-term trading of company funds by portfolio managers and others despite a fund's policy against it, and potential detriment to fund shareholders.

Payment for placement. Paying fees to brokerage firms for preferred fund status without disclosing the fees to potential buyers.

Failure to pay breakpoints. Failing to pay shareholders discounts they are entitled to based on their accumulated purchases in the funds.

Selective disclosure of portfolio holdings. Fund managers informing certain investors (usually institutions) of the portfolio's contents without releasing the same information to the public.

Some of these activities skirt the edge of fair dealing, while others are strictly forbidden by regulation. Yet there is no sense of proportionality when they are discussed.

Indeed, the industry was declared "the world's largest skimming operation" by Republican Sen. Peter Fitzgerald of Illinois. But painting all companies as villains does a disservice to the companies that strive to do well by shareholders, and it misleads the public.

While the government may not have been watching the industry very closely before, it is now. Members of Congress are crafting reform legislation in an effort to make the industry more accountable to investors. The Securities and Exchange Commission has begun to formalize rule changes as it reaches the first multimillion-dollar settlements with some of the early comers in the scandal.

The new rules will be directed at disclosure and at many of the practices uncovered in the investigation. Market-timing is not necessarily illegal, but funds whose prospectuses prohibit the practice will be held to account. Brokerage firms and fund companies will have to disclose fee-sharing arrangements to fund purchasers. Late trading and selective disclosure of portfolio holdings are prohibited by securities regulations, and additional steps are being considered to curb these practices. The SEC also is considering moves that would require a fund or its designated agent to receive a buy or sell order before 4:00 p.m. to get that day's price.

Those are only some of the proposals. This all sounds pretty good until we think back to the last time the government stepped in to solve a regulatory problem. Remember the SEC settlement that required firms to separate research and investment banking? In the process of routing out potential conflicts, investors have gotten less: fewer analysts, fewer companies and industries covered, and a noticeable decline in written research products.

And many of the transgressions in the mutual fund scandal already were deemed improper. Can the government also hope to regulate poor judgment?

Investors want to separate harsh reality from hyperbole, the sloppy bookkeeping from the willful abuses of trust.

Lawyers for the fund companies are counseling "No comment," creating an information vacuum. The financial advisers and customer service staff are not speaking up as the drama unfolds.

It is not a smart course of action, but it's understandable. Class action lawsuits have been filed, and trial lawyers are trolling for plaintiffs to fuel their cases with sufficient numbers.

Lost in the vacuum is the fact that mutual funds have created wealth for a generation of baby boomers and many of their parents.

Funds provide access to some of the finest money managers in the world for an investment as small as $2,500. Does a problem with management mean 95 million shareholders are wrong?

Mutual funds have been the investment of choice for employer retirement plans, but with new regulations, plan participants could end up with the short end of the stick.

Because plans require a great deal of bookkeeping, third-party administrators (TPAs) usually handle orders. The TPAs bundle the day's orders, or trades, and pass them to the mutual fund companies for execution. The fund companies execute the trades and pass the prices back to the TPAs, who update the participants' accounts. This can take all night.

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