The $7-trillion U.S. mutual fund industry was under siege. Everyone from TV talking heads to sage investor Warren Buffett was pointing out its shortcomings.
"It makes me wonder what life would be like if we'd actually done something wrong," Paul G. Haaga Jr., chairman of the Investment Company Institute, the industry's main trade group, told a membership meeting in Washington, D.C.
That was in May. Haaga and the rest of the industry scarcely could have imagined what would transpire four months later.
Since Sept. 3, state and federal regulators have launched a barrage of charges against the fund business, alleging wrongdoing on a scale that has left industry veterans mortified and the public stunned. Many more cases are expected to be filed in coming months. The House and Senate this week will hold hearings on the spreading scandal.
Just as memories of the corporate frauds that began with Enron Corp. in 2001 may have begun to fade, the fund debacle is providing average investors with another reason to believe they can't get a fair shake from Wall Street.
In recent years, the fund industry had become used to criticism over its fees, portfolio performance and sales practices. But regulators now say they are uncovering outright fraud and cheating by fund executives, and a blatant disregard for what is supposed to be the hallmark of mutual fund management: that the client's interests rise above all others.
The crisis is virtually certain to lead to significant changes in the business -- possibly including the demise of one or more major firms, some experts say.
Regulators' principal focus has been on illegal or improper trading of fund shares either that fund companies allowed for favored investors or that fund managers engaged in for their personal accounts. In all cases, the trading had the potential to cut into the returns of long-term investors in the funds.
Worst May Not Be Over
It's far from clear that the worst is over: Of the 88 fund companies and brokerage firms queried by the Securities and Exchange Commission in its industrywide probe during the last two months, preliminary responses show that as many as half the fund firms have let at least one investor improperly engage in "market timing" of shares, meaning rapid buying and selling.
New York Atty. Gen. Eliot Spitzer fired the first salvo on Sept. 3 when he accused a hedge fund, Canary Capital Partners, of scheming with four mutual fund companies to make market-timing trades. He also charged Canary with "late trading," meaning that fund buy or sell orders were submitted after markets had closed for the day, yet Canary was given that day's closing prices.
"Timing and late trading are more widespread than anyone could have imagined and are causing injury to the tune of billions of dollars for individual investors," Spitzer said last week. "It has become increasingly clear that the mutual fund industry has failed to police itself."
Until last week, regulators had filed formal charges only against fund company individuals alleged to have broken the law -- a broker in Bank of America Corp.'s fund business, for example, and the fund unit chief at Fred Alger Management.
But the stakes for the industry were raised considerably on Tuesday, when the SEC and the state of Massachusetts filed civil securities fraud charges against Putnam Investments, the fifth-largest fund firm. Regulators alleged that Putnam allowed average investors to be cheated by failing to halt market-timing abuses, including by portfolio managers for their own enrichment and by some aggressive retirement account investors.
And on Thursday, Spitzer warned Strong Capital Management Inc. and its founder, Richard Strong, that they could face criminal fraud charges. Strong's independent directors issued a statement saying they had "become aware of active trading of the Strong Funds by employees including Richard Strong" and promised an investigation.
Boston-based Putnam has denied any wrongdoing. Yet by Friday, public pension funds in states including Iowa, Pennsylvania and Rhode Island had fired the firm as an asset manager, yanking billions of dollars.
That points up the serious risk for fund companies embroiled in the scandal, even if they proclaim innocence: They could undergo death by a thousand cuts as angry investors pull their money out.
Investor Susanna Munro, a 33-year-old accountant in Los Angeles, said she dumped her Janus Balanced fund recently after purchasing shares regularly since 1997. Janus Capital Group Inc. is one of the fund companies Canary Capital is alleged to have used for market timing.
"At the end of the day the trading scandal didn't cost me much money," Munro said, "but it's just the principle of it: A large institutional investor gets to trade after-hours or make special 'timing' trades and make even more money. That's not very equitable."
Criminal charges against a fund company could be a death warrant, in the same way that the conviction of accounting giant Arthur Andersen in 2002 on criminal fraud charges stemming from the Enron case destroyed the auditing firm.
For the industry overall, the root question is: What went wrong? The fund business had prided itself on being largely scandal-free since it was created in 1940.
A Taste for Fees
Critics say that as assets ballooned in the 1990s, many fund companies became addicted to fast growth, which brought in ever-rising management fees. When the bull market for stocks hit a wall in 2000, growth became a more difficult game, and many fund firms scrambled to find new business.
The timing arrangements with Canary Capital, Spitzer said, were driven by Canary's promise to give the fund firms other fee-generating business.
Said manager Ron Muhlenkamp, who founded Pittsburgh-based Muhlenkamp Fund in 1988: "Some [fund company] people thought their job was to bring in assets, period."
He called that a short-sighted and counterproductive view, especially when favors are granted to short-term traders: "You're hurting good customers for someone who would go across the street for a nickel. To run a business that way is stupid."
Sheer greed, fueled by the late 1990s bull market, also may have led some fund managers to put their own interests ahead of their investors, critics say.
Richard Strong already was one of the richest men in the country -- worth an estimated $800 million -- but he found time in the late '90s to engage in market-timing trades in Strong Funds to earn at least $600,000 more, Spitzer's office said.
While not revealing details, Spitzer said his probe has turned up evidence that executives at other funds also engaged in personal market timing. Typically, fund companies try to discourage average investors from timing.
"There are other management-level people who have been doing this," Spitzer said.
Yet the fund scandal is about more than personal enrichment of portfolio managers. The investigations into market timing and late trading also have revealed long-festering structural problems involving the industry's heavy reliance on intermediaries, such as brokers and company-sponsored retirement plans, for distribution of fund shares. That increasingly has limited the control the funds have over assets they manage.
"Market timers go into 401(k) plans precisely because those accounts are tax-deferred and because they are hidden" from the view of fund watchdogs, said Matthew P. Fink, president of the Investment Company Institute.
How to Clean Up
The challenge now for regulators, and for the industry, is how to clean up the abuses without ruining a business that has allowed 95 million Americans to invest their savings with relative ease, and usually for the long run.
"This is a $7-trillion industry. Do we really want to put that at risk?" said Tom Curran, a former securities fraud prosecutor who now practices white-collar criminal defense at Edwards & Angell in New York.
He believes that it's imperative that state and federal regulators adopt a "cogent, comprehensive approach" to disciplining the industry and ordering reforms. But that may be difficult because of a continuing feud between Spitzer and the SEC, which flared anew last week as Spitzer accused the agency of being asleep on the job.
Some analysts have raised the prospect of a "global settlement" between the fund industry and state and federal regulators, along the lines of a reform package that 10 major brokerages sealed in the spring to settle charges of widespread abusive practices during the bull market.
Some basic fund industry reforms seem certain. The Investment Company Institute last week recommended that the SEC order a strict 4 p.m. Eastern time deadline for fund orders to be received by fund firms, to "slam the late-trading window shut," in Haaga's words. That deadline had become porous in recent years.
To limit market-timing abuses, the institute recommended that all funds charge investors a mandatory minimum fee of 2% if they sell a stock or bond fund within five days of purchase.
Haaga, who also is an executive at Los Angeles-based Capital Research & Management, parent of the American Funds group, said the industry understands the gravity of the challenge it faces to restore investors' confidence that their interests come first.
"As soon as shareholders don't come first," he said, "mutual funds won't be the investment of choice, and we won't deserve to be."
Friedman and Petruno reported from Los Angeles, Hamilton from New York.