Industry Is Unlikely to Have S&L-Type; Troubles

This recession will be remembered for shaking the nation’s financial industry to its core. First the savings and loans got in trouble, then the banks and finally even the insurance companies.

Fortunately, mutual fund companies show no signs of becoming the next domino. The business remains generally healthy and, more to the point, offers a different set of protections for investors. Obviously, you can lose money if your fund’s stock or bond holdings decline in price. But there’s little chance of loss stemming from fraud, scandal or bankruptcy involving the management company itself.

That’s a key distinction. By transferring investment risk to shareholders, mutual fund companies have been able to sidestep many of the problems plaguing their financial cousins.

In addition, the legal structure and heavy regulation of mutual funds offer key safeguards. A fund is a separate corporation or trust that’s owned by its hundreds or thousands of shareholders, not by the firm that runs it. The only formal link with the management company is through a contract that must be renewed, says Matthew P. Fink, general counsel of the Investment Company Institute and the trade group’s upcoming president.

Consequently, the fund’s assets--stocks, bonds and cash--are not kept in the drawers of the management company, which usually also serves as the investment adviser. Rather, they’re placed in the custody of an independent third party, typically a bank. “We do not have easy access to our shareholders’ ” money, says Charles J. Tennes, a vice president of GIT Investment Funds in Arlington, Va. “We have authority to buy and sell securities on their behalf, but the assets are held by someone else.”

As another safeguard, each fund features a board of directors or trustees, who are charged with keeping tabs on the management company and renewing its contract. If the management firm was going broke, the directors would liquidate or merge the fund or find another outfit to run it, explains Paul Robertson, general counsel for United Services Funds in San Antonio. “These contracts are terminable on 60 days’ notice for no reason at all,” he says.

According to federal regulations, at least 40% of all board members must be independent of the management company. But just how independent are these unaffiliated directors? Aren’t they chummy with management’s own representatives on the board?

Many undoubtably are. Yet they have a strong motivation to act in the best interests of shareholders, since they can be held personally liable. The directors are elected by shareholders, are paid with shareholder money and can be sued for ignoring their fiduciary duties. At GIT, for example, the independent board members have their own securities lawyer, who attends all meetings, Tennes says. If all that’s not enough, many independent directors are themselves fund shareholders.

As further protection, the management company and other affiliated parties can’t engage in certain types of transactions with a fund. For example, the investment adviser can’t dump its own stock and bond holdings by selling them to the fund, says Fink. Nor can an adviser with a brokerage arm charge the fund excessive commissions for conducting trades. “This is designed to prevent self-dealing and keep the adviser from lining its pockets with brokerage commissions,” Robertson explains.

These conflict-of-interest provisions are often called the heart of the Investment Company Act, the 1940 legislation that established the modern code for regulating mutual funds. Though the Securities and Exchange Commission is reviewing the act and will undoubtably make changes, perhaps later this year, Fink doesn’t think that it will alter the basic checks and balances.

Bob Pozen, general counsel and managing director of Fidelity Investments in Boston, believes that there are more fundamental reasons besides the structural safeguards for lack of scandal in the industry. First, he says, funds must stand ready to redeem investor shares upon demand. That forces them to stick with assets for which there’s a liquid market. Second, funds must value their holdings every day, a process known as “marking to market.”

“I feel one of the big problems with insurance companies is that they didn’t mark to market their assets daily,” he says. “They were able to go a long time before anybody realized they had a problem. You can’t do that with mutual funds. You know the problems immediately.”

Despite the safeguards, a handful of fund companies do occasionally get into trouble.

For example, the SEC has been battling Charles Steadman of Steadman Security Corp. in court for years on various charges arising from a failure to register under state blue-sky laws, according to David Horowitz, regional trial counsel for the SEC in Philadelphia. The SEC earlier this year won an injunction that could bar Steadman from serving as a fund adviser.

And last year, the SEC banished the head of tiny SFT Funds from the business after charging that he sold illiquid stock in a personal company to four SFT portfolios at inflated prices. Also in 1990, regulators from New York and Massachusetts sued First Investors group for fraudulent sales practices, alleging that it had understated the risks of two junk bond portfolios.

In all three cases, the affected funds have been closed to new investors pending resolution of the conflicts.

The Hub and Its Spokes

Although it’s tempting to think of a mutual fund as a monolithic entity, that’s not really accurate. Various functions--investing, recordkeeping, safekeeping and others--are split among two or more companies. Some observers describe the relationship in terms of a wheel with a hub and spokes. At the hub is the fund itself, organized as a separate corporation or trust. At each spoke is a separate service firm, including the following key parties:

* The management company: Runs the fund’s daily operations. Usually is the same entity that created the fund. Often is the same firm that serves as investment adviser.

* The investment adviser: Buys and sells stocks or bonds and otherwise oversees the portfolio.

* The distributor: Sells fund shares, either directly to the public or through a brokerage. When you request a prospectus and sales literature, you deal with the distributor.

* The custodian: Physically safeguards the securities and other assets of a fund, without taking a role in the investment decisions. To discourage foul play, an independent party, usually a bank, serves in this capacity.

* The transfer agent: Keeps track of purchase and redemption requests from shareholders and maintains other shareholder records.

Each of these parties collects a fee for its services. However, actual ownership of the fund rests with the hundreds or thousands of shareholders, who are represented by the board of directors or trustees.