Fund kickback deals underscore need for board vigilance

Your Funds

Your Money

November 07, 2006|By Charles Jaffe | Charles Jaffe,MarketWatch

The similarities between a mutual fund board of directors and an 82-year-old Ohio widow aren't obvious, but they help to explain the latest industry scandal and how investors should react to the latest round of trouble.

The scandal came to light at the end of October, with published reports that the Securities and Exchange Commission is investigating more than two dozen fund companies for allegedly accepting hundreds of millions of dollars in kickbacks from a firm that handled their back-room operations.

The probe was sparked by a $21 million settlement that regulators reached in September with Bisys Fund Services Inc., which provides administrative services for funds. Bisys doled out some $230 million in rebates from its fees, according to the SEC, and the regulators are now pursuing fund companies that entered those illicit deals.

Effectively, the fund firms - and the names have not been released, but Bisys customers are mostly smaller names with an emphasis on banks - agreed to sweetheart deals where Bisys was overpaid, and then rebated some of its booty.

The funds' stated expense ratios were correct, in terms of what the customer paid out, but they would have been lower without the special "arrangement."

It's another black eye for the industry, and you can assume that more firms and funds will be dragged into the mix in the coming weeks and months. Regulators aren't talking, but insiders suggest that the administrative services business is extremely competitive, as is the fund game itself; if one provider was giving a rebate, you can bet fund firms demanded something similar from others.

The continuing probes are not likely to nail the industry's biggest names, because they typically handle most administrative functions in-house (perhaps because it's cheaper than paying up to get a kickback).

Expect fast settlements, with the service providers paying fines, and the fund firms agreeing to reduce expense ratios for a period of several years. While there may be disgorgement of the illicit proceeds of the deals, restitution is unlikely, because this is more about failing to say where the money was going than about charging outrageous, over-the-top expense ratios.

Once expense ratios are lowered as punishment, expect fund boards to be loathe to let them go back to pre-scandal levels.

The reason for that brings us back to how fund directors are similar to the Ohio widow.

In mid-September, the Associated Press told the story of Ester Strogen, who started leasing two black, rotary telephones - you moved the dial with your fingers - more than 40 years ago. She paid rent to use the phones the whole time, paying $29.10 a month until her two granddaughters put a stop to it.

All told, the phones cost her more than $14,000.

Strogen is far from alone (stories like this actually are fairly common); there are plenty of situations where the customer is satisfied with the item they're using and the cost they're paying for it, so they never do any price comparisons and never find out that something newer, better and cheaper is available.

The same can be said for fund directors, because they seldom renegotiate servicing deals or put them out for new bids. Companies getting a servicing contract are practically winning a lifetime annuity, which is precisely why they'd create a kickback deal if it would give them a chance of grabbing a contract and keeping it.

Industry watchers and critics are saying that this latest scandal is a sign that funds need independent directors. In 2004, in reaction to the last round of scandals, the SEC approved a rule that would have required that 75 percent of board members, including the chairman, be independent of the fund company. The rule was challenged in court, and overturned on procedural grounds. In April, the SEC put the rule back out for comment but has taken no action.

While this kickback deal might revive talk of the rule, board composition was not the problem here.

Most bank funds already have an independent chairman, so this shows that the independent chair is no better than a lead trustee if management fails to make adequate and proper disclosures. Without the right information, no board can truly protect shareholders.

What all boards will learn from this experience is that shareholders - and regulators - expect them to be different from the widow with the old phone, and to make sure they routinely get the best execution, putting services out to bid rather than simply extending old deals.

jaffe@marketwatch.com

Charles Jaffe, a senior columnist for MarketWatch, also can be reached at Box 70, Cohasset, MA 02025-0070.

Baltimore Sun Articles
|
|
|
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.