Lawmakers Lash Out as Debacle Spreads
Members of Congress and law enforcement officials Monday blasted the $7-trillion mutual fund industry for betraying the public, amid new evidence that many financial firms had engaged in improper trading that siphoned profits from small fund investors.
The Securities and Exchange Commission, making a number of disclosures, told lawmakers that more than one-fourth of major brokerage firms examined by the agency had allowed favored investors to illegally trade funds after the stock market had been closed for the day.
“As my colleagues and I have gathered evidence of one betrayal after another, the feeling I’m left with is one of outrage,” Stephen M. Cutler, the SEC’s director of enforcement, told a Senate hearing that was noteworthy for its harsh denunciations of an industry once viewed as a haven for average investors.
Cutler’s testimony preceded an appearance by New York Atty. Gen. Eliot Spitzer, who told lawmakers that he would insist that fund companies return any fees they gained through allowing wrongful trading practices, despite the financial pain that such sanctions may cause the firms.
Also on Monday, the chief executive of Boston-based fund giant Putnam Investments quit; the company had been charged last week with securities fraud. And in an unusual move that demonstrated the high-profile stakes of the fund scandal, an SEC official in Boston resigned after widespread criticism that his office had failed to listen to a mutual fund whistle-blower.
Cutler’s revelations on Capitol Hill indicated that the breadth of wrongdoing involving the fund industry was broader than previously thought. In particular, the new information suggested that Wall Street brokerage firms, which had been swamped by a wave of scandals in recent years, might be deeply involved in the mutual fund mess as well.
The comments from Cutler and Spitzer seemed to guarantee that fund companies and brokerages would be hit with a barrage of enforcement actions and lawsuits that would dominate headlines for months. The disclosures also suggested that deep changes would be coming to the way the fund industry operates and treats its customers.
Investigations are underway at the state and federal levels, and sentiment is soaring in Congress for reform legislation.
“Getting to the bottom line here, we’re talking about serious, wholesale criminal violations coming to light, aren’t we, Mr. Cutler?” asked Sen. Peter G. Fitzgerald (R-Ill.), chairman of the Senate Governmental Affairs subcommittee on financial management, which held the hearing.
Cutler responded: “I certainly share your concerns 100%.”
According to Cutler, the SEC examined records at 34 brokerage firms and found that almost 30% had assisted clients in performing market-timing trades, and almost 70% were aware of customers who had attempted to do so. Market timing involves rapidly trading in and out of mutual funds and is usually legal, but hurts long-term investors by driving up transaction costs.
Regulators are concerned that brokerages, which serve as intermediaries that receive buy and sell orders from customers and transmit them to fund companies, may have helped facilitate improper trading.
Cutler revealed that more than one-quarter of the brokerages surveyed let customers engage in late trading -- the illegal practice of accepting buy and sell orders after the 4 p.m. Eastern time deadline, but at the same day’s closing price, rather than the next day’s price. One firm accepted such orders as late as 5:30 p.m., Cutler said.
More than four-fifths of fund companies told the SEC that they had allowed brokerages and other intermediaries to send orders in after 4 p.m., but the vast majority of them said they were unaware of late-trading abuses by brokerages.
The SEC review also found that more than 30% of the mutual funds surveyed had acknowledged disclosing information about their portfolios in a way that may have given some shareholders an edge.
Cutler didn’t reveal the names of any of the firms involved in the SEC’s survey.
Regulators are trying to determine how much fund companies knew of the activities of the brokerages. Even if fund firms didn’t know of specific wrongdoing, regulators are investigating whether they suspected wrongdoing by brokerages but didn’t act.
In some cases, the brokerages worked hard to shield their timing roles from fund firms, but in other ways their activity was plain to see. Employees at three brokerages split large fund orders into smaller trades to escape detection by fund companies, Cutler said. But four firms said they had advertised timing services and openly solicited potential clients.
It was New York’s Spitzer, rather than the SEC, who lit the match on the mutual fund scandals two months ago with revelations of abuses involving four fund firms and hedge fund Canary Capital Partners. On Monday, Cutler sought to deflect criticism of his agency by pointing out that the SEC already had formally notified “a major financial institution” that it would be charged with abuses.
“The commission’s investigation of mutual fund trading abuses is continuing on multiple fronts,” he said. “I can safely predict many more enforcement actions will follow.”
Lawmakers responded angrily to the latest round of revelations about the fund industry, which previously had enjoyed a near-spotless reputation.
“The mutual fund industry is now the world’s largest skimming operation -- a $7-trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings,” Fitzgerald complained at one point.
The industry scrambled Monday to limit what has become a public relations debacle, with its official spokesman pledging to cooperate with reforms, including a strict ban on late trading.
“The bedrock principle of the mutual fund industry is that the interests of mutual fund investors always come first,” Matthew P. Fink, president of the Investment Company Institute, told the panel.
Investigations by the SEC, New York, Massachusetts and the NASD, which regulates brokers, have targeted dozens of companies, although it is not at all clear how many will ultimately be found to have broken the law. So far, charges have been filed against one fund firm -- Putnam -- and several individuals.
The SEC and NASD said Monday they were requiring almost 450 securities firms to tell customers they might be eligible for refunds totaling $86 million on some mutual fund commission charges. The refunds would go to investors who should have received certain volume discounts, known as breakpoints, when buying fund shares through brokerages. The average refund would be $243.
In his testimony, Spitzer offered blistering criticism of members of funds’ boards of directors for passively allowing improper behavior rather than serving as watchdogs.
“Boards never ask the hard questions,” Spitzer said, later telling reporters that “with any minimal effort,” board members at fund companies would have detected the problems.
Spitzer also said that he would insist, as a condition of his office settling any charges with the fund industry, that fund firms give back fees generated by wrongful practices.
“This number will be big. It will impose pain, and it should,” he said.
Lawmakers also demanded changes. Rep. Richard H. Baker (R-La.), chairman of a House Financial Services subcommittee, recalled in his written testimony that earlier this year some members had derided his effort to pass a mutual fund reform law as an unneeded bid to put out “phantom fires.”
Baker said he planned to make his legislation tougher, noting that “recent disclosures ... have proven these fires to be quite real, and like any dangerous blaze, prone to spreading.”
Said Sen. Susan M. Collins (R-Maine) a member of the Senate panel: “Clearly, something must be done to protect mutual fund investors, whether it is through legislation, tougher enforcement actions, stronger regulations or all three.”
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Peterson reported from Washington, Hamilton from Los Angeles.
