Research firm being probed by SEC

Morningstar says inquiry stems from incorrect data published on mutual fund

Returns of Top Flight overstated

September 25, 2004|By BLOOMBERG NEWS

CHICAGO - Morningstar Inc., a U.S. research firm used by 3 million investors to decide what mutual funds to buy, said yesterday that the Securities and Exchange Commission is investigating the company for publishing incorrect performance data for a fund.

The SEC may sue the firm, founded 20 years ago by Joseph Mansueto, for violating securities laws, Morningstar said. The company said it overstated the returns of the Rock Canyon Top Flight Fund from March 12 to March 23.

Morningstar said the regulator may be concerned with how long it took to correct the information. John Freeman, a law professor at the University of South Carolina, said the firm's retirement planning and investment services units are registered as investment advisers, which means the SEC may be able to hold Morningstar liable for deceiving investors.

"The SEC's position is that it has jurisdiction over any false statements made in connection with securities transactions, and the question here will be the closeness of the connection between anything Morningstar said and anything that investors did as a result," said David Becker, a former SEC general counsel who is now a partner at Cleary, Gottlieb, Steen & Hamilton, a law firm in Washington.

The investigation comes as Morningstar is preparing for an initial public offering. In May, the firm said in an SEC filing that it planned to raise as much as $100 million through an IPO. Morningstar has been unprofitable for four of the past five years, the filing said. In 2003, it reported a net loss of $11.9 million after compensation-related expenses of $29 million. Revenue last year rose 27 percent to $139.5 million.

Morningstar's brush with regulators also comes a year after New York Attorney General Eliot Spitzer began his probe of alleged improper trading and sales practices in the $7.4 trillion mutual fund industry. The company has recommended that investors sell shares of funds managed by some of the companies ensnared in the investigation, including Janus Capital Group Inc.

Morningstar's "five-star" fund-rating designations influence what mutual fund investors buy. In the first half of this year, funds with four- and five-star rankings attracted a net $143 billion, and lesser-rated funds suffered net withdrawals of $12 billion, according to data from Financial Research Corp. in Boston. Last year, 96 percent of net fund sales went to top-rated funds, FRC said.

"We try to be open and honest in all of our communications, and so we try to share the facts as we know them, and if we are ever critical of fund companies, we should be held to that same standard," Mansueto said in an interview.

SEC spokesman John Nester declined to comment on the inquiry or answer questions about what type of authority the SEC has over publishers of financial information.

Three Morningstar subsidiaries are registered as investment advisers with the SEC and operate independently from other areas of Morningstar. The matter under investigation concerns a part of the company that isn't an SEC-registered entity, Mansueto said.

Top Flight is "a hedge fund in a mutual fund wrapper" and has $18.9 million in assets, its manager, Jonathan Ferrell, said in an interview.

The fund uses an investing technique that involves moving into fast-rising stocks and selling them quickly as markets change, Ferrell said. It had a turnover rate of 2,686 percent in the six months ending March 31, according to a semiannual report to shareholders filed with the SEC.

The data problem arose from the accounting of a short-term capital gain that was paid to fund shareholders in December, Ferrell wrote in a letter to the SEC on March 25 in response to a request for information. Morningstar and Lipper, a unit of Reuters PLC, correctly reported fund returns that included the gain, Ferrell said.

Some sites that use data from Morningstar and Lipper, including CBS MarketWatch, incorrectly presented the capital gains payout as a decline in the fund's total value. To fix that problem, Ferrell said, he sent all of the data providers a chart of the fund's actual and adjusted daily values.

Morningstar changed its information based on the chart and mistakenly showed a 25 percent increase in value on the date of the fund's capital-gains distribution, Ferrell said.

Ferrell said he and the fund's transfer agent, Mutual Shareholder Services, contacted Morningstar to tell them that the revised data were wrong. Mutual called three times without getting a response.

For as long as four weeks, Morningstar incorrectly showed Top Flight as the top performer in its category, Ferrell said.

The SEC contacted Morningstar about the incorrect data March 23. The company was served with a Wells notice, indicating that the SEC's staff was recommending civil action, on May 24.

SEC spokesman John Heine declined to comment.

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