SEC: Enforcement to Be Reckoned With
The portfolio police are out in force these days, and they’re finding much to quibble about in the way mutual fund companies run their operations.
Inspectors from the Securities and Exchange Commission are spending more time than ever in fund company offices--examining documents, interviewing key policymakers and otherwise observing the way these businesses are run.
The increased oversight is a reflection of the rapid growth in the fund industry, which now counts two of every five American households as customers.
“Mutual funds largely are scandal-free, but we need to follow the money, because that’s where the potential abuses are greatest,” Colleen Mahoney, deputy director of the SEC’s Division of Enforcement, said at a recent industry conference in Palm Desert.
Fund companies have generally earned a well-deserved reputation for complying with the many federal laws that govern them, but their record isn’t perfect. Roughly 80% of SEC inspections result in a “deficiency letter” or complaint about certain practices, said Lori Richards, director of the SEC’s Office of Compliance Inspections and Examinations, who also spoke at the event.
Is such a high figure cause for alarm?
Richards doesn’t think so. “Examiners comment on all types of problems, some of which are quite minor,” she said. “That rate does not indicate widespread disregard for the law.”
Most deficiencies are quickly resolved by changes adopted by fund families, and sometimes the SEC drops a complaint after discussing the matter with company executives. Only about 5% of complaints are referred to the SEC’s Division of Enforcement for further examination, and in only a fraction of these does the SEC take legal action.
Here are the chief types of problems the SEC is looking for these days:
* “Soft-dollar” abuses. Some fund companies receive research reports and other goods or services from brokerages by directing trades their way. Fund shareholders don’t necessarily benefit from this, yet these costs are built into the commission price shareholders ultimately pay. This presents a potential for a conflict of interest because portfolio managers have a duty to execute trades at the most favorable costs. The SEC is currently studying the extent of soft-dollar practices.
* Inequitable apportioning of trades. Managers are supposed to apportion attractive investments--say, shares of a promising initial public offering--equitably among their mutual funds and other accounts, but sometimes certain funds, for any of a number of reasons, are given short shrift.
* Sales practices involving variable-annuity companies. Of particular interest are situations in which firms, through their salespeople, persuade investors to drop their existing contracts and purchase substitutes that are more costly or not suitable.
* Improper personal trading by portfolio managers. One of the more egregious violations involves what’s known as front-running, whereby managers buy shares in a stock for their own accounts before they purchase them for their funds.
* Exaggerated performance claims. The SEC monitors for accuracy the total return results cited by fund companies and other money managers in their advertising and marketing literature.
The SEC will pursue enforcement actions when it has reason to believe proper controls or procedures are not in place.
For example, the agency took action against Janus Capital of Denver when a portfolio manager, Ronald Speaker, made a $16,000 profit on a personal bond trade upon spotting a discrepancy in dealer quotes. Speaker passed up the same trade for his fund, Janus Flexible Income. He was fined and suspended, and Janus was fined for not having sufficient supervising policies in place.
What does all this mean to you as an individual investor? First, be aware that shareholders generally don’t hear about SEC oversight efforts until they reach the disciplinary stage.
“Deficiency letters are sent to the fund’s management company and to its board, but these are not public documents,” said Richards. “Only if we [subsequently] bring an enforcement action does the situation become public.”
Meaning: “If you have received a notice of inspection and are trying to decide what to do, you have waited too long,” Robert Zack, associate general counsel for Oppenheimer Funds in New York, told the gathering of fund industry executives.
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Mutual Fund Investigations
The Securities and Exchange Commission monitors mutual fund companies to make sure they are complying with federal regulations. Here are some key facts about the process:
* The SEC aims to inspect all fund companies at least once every five years. The current average is 3.1 years.
* The agency in 1996 inspected fund companies managing 2,294 separate funds with $708 billion in combined assets.
* About 80% of inspections result in “deficiency letters.” But only about 5% of the problems are serious enough to refer to the SEC’s Division of Enforcement for further investigation.
* About 9% of the inspections were for “cause,” meaning the SEC had a reason--stemming from a newspaper article, customer complaint or other source--to suspect a problem.
