What Penalties Befit Fund Trading Scandal?

Some scandalous things have happened in the mutual fund industry.

Now, what price should fund companies pay to make amends?

The Securities and Exchange Commission took its first stab at answering that question last week, only to trigger cries of “Sellout!” from the agency’s two principal state regulatory rivals.

The SEC on Thursday struck a deal with Putnam Investment Management to settle charges that the Boston company defrauded investors by failing to stop abusive trading by some of the firm’s own fund managers.

Putnam was the first (and so far, only) fund company charged with wrongdoing in the widening scandal, and now is the first to settle, at least with the federal government.

Stephen M. Cutler, the SEC’s enforcement chief, said he won “very significant” reforms from Putnam involving extensive new oversight of its fund operations. There also will be a financial penalty, but Cutler said that would be determined later -- after the SEC gets a full accounting of what investors may have lost because of fund managers’ shenanigans at the firm.

That latter point ought to be key to the penalty question for the industry as a whole. The sentence meted out should fit the crime. But in the emotion of the moment, as nearly every day brings revelations of improper activities at more fund companies, it’s understandable if a hang-’em-high mentality is spreading among the public.

The SEC’s rivals may have helped to stoke that sentiment last week. New York Atty. Gen. Eliot Spitzer and Massachusetts’ chief securities regulator, William Galvin, both trashed the Putnam settlement, calling it premature and meek.

Spitzer termed the deal a “Band-Aid” on a fund industry problem that may need a tourniquet or even surgery.

Galvin, who like Spitzer is pursuing his own investigation of Putnam and other fund companies, said the settlement “shows the SEC is more interested in papering over wrongdoing than uncovering it.”

Issues of Admission

Galvin had a specific demand: He wanted Putnam, the fifth-biggest fund company by assets, to admit wrongdoing as part of any settlement.

Instead, as is standard in SEC cases, the company didn’t admit or deny the agency’s charges.

The SEC traditionally hasn’t forced the issue, in large part because of concerns that the resulting legal liability could sink a company that publicly concedes, “Yes, we did it.”

Marsh & McLennan Cos., Putnam’s parent firm, said on Friday that it was facing at least 18 shareholder lawsuits over alleged mutual fund trading abuses. In theory, a formal admission of wrongdoing would give shareholders’ lawyers more leverage in extracting substantial damages.

Galvin rejects the idea that financial services companies fear ruin in admitting guilt. “They don’t want to admit it because they’re arrogant,” he said.

Yet when Spitzer faced the same issue last year in negotiating a settlement with Wall Street’s biggest brokerage firms over their abusive practices during the bull market, he took the same route as the SEC in the Putnam case: The brokerages settled, and agreed to a total financial penalty of $1.4 billion, without admitting guilt.

Spitzer specifically said he did not want to risk putting a major brokerage out of business.

Has the mutual fund industry, by its conduct, held its average customers in greater contempt than the brokerage industry did in the late 1990s?

There is strong evidence that the brokerages manipulated the entire stock market during the Internet bubble, corrupted their research analysts and encouraged them to lie to investors, and doled out hot new stock offerings to favored clients in return for kickbacks.

By contrast, many fund companies so far appear to have been victims of lax internal controls that allowed some savvy investors (including insiders) to be opportunistic in making short-term fund trades that may have effectively skimmed profits from buy-and-hold investors and raised overall portfolio expenses.

Fred Isquith, a plaintiffs’ attorney at Wolf Haldenstein Adler Freeman & Herz in New York, noted that Putnam had already publicly admitted that its controls were flawed. The firm said it had long had a policy against improper “market timing” trades but had failed to stop them all in recent years, including some trades by two of its own fund managers (who have since been fired).

Negligent, or Willful?

As far as potential damages go, the issue is whether fund companies were merely negligent -- or willful, Isquith said.

“The open question is: To what degree did any of these fund companies establish [oversight] systems, and then close their eyes and allow their own guys to do this?” he said.

Some fund companies’ situations look more perilous than others’. At Strong Capital Management Inc., the firm’s chairman and founder, Richard S. Strong, has admitted that he engaged in market-timing trades in his own funds but says he didn’t view them as disruptive to the portfolios.

In the initial case that uncovered the scandal, Spitzer on Sept. 3 said a hedge fund, Canary Capital Partners, was able to make market-timing trades with four fund companies in return for bringing other fee- generating business to the firms (Bank of America Corp., Bank One Corp., Janus Capital Group Inc. and Strong Capital) .

A quid pro quo, if proved, could be costly to the companies. But so far, Spitzer hasn’t charged them with wrongdoing. As for Canary, it settled Spitzer’s charges -- without admitting or denying guilt.

Isquith and other attorneys say the question of the appropriate penalty for a fund company also must hinge on the actual damages sustained by the majority of fund investors because of the illegal or improper trading of a relative handful of people.

As far as market-timing activity goes, “whatever the total [damages are], because the trades were narrowly confined, I suspect it’s not a big deal” financially compared with the industry’s $7 trillion in assets, Isquith said.

If all of this sounds like a defense of the fund industry, it isn’t. It’s early in regulators’ investigations, and the conduct yet to be exposed may prove to be even more devastating to the industry’s image as a friend to the small investor.

But the wrongdoing that will be alleged in coming weeks and months will vary significantly from company to company. And so should the severity of the penalties that will be handed out.

The SEC’s Cutler said the settlement with Putnam wasn’t meant to be a template for deals with other fund companies.

Particular to This Case

“I don’t view it that way,” he said. “It addresses the particular conduct in this case.”

The SEC, Cutler said, wanted to start the ball rolling in terms of industry reforms that will reduce the chances that fund trading abuses can occur in the future.

It’s interesting that Spitzer late last week was focusing on an issue different from improper market-timing trades.

His beef with the SEC’s settlement with Putnam, he said, was that it didn’t encompass other reforms, particularly regarding the level of management fees fund companies charge investors and the disclosure of those fees.

But there is little question that those reforms are coming, either from the SEC or Congress or both. (Two reform bills have been introduced in the Senate, which until this month had shown little movement in that direction.)

It will help that Spitzer is pushing the process along, but the fee issue has been in some House lawmakers’ sights since well before the scandal broke.

As regulators wrestle with the appropriate penalties for fund company misconduct, it’s worth remembering that the marketplace may yet demand the most painful penalties.

The stocks of many publicly traded fund companies that have been implicated in the scandal have slumped since early September. The damage isn’t huge so far, but it could get there -- particularly if disgusted investors continue to pull their money from funds tainted by the affair.

Putnam saw a drop of $14 billion in assets in the first week of November, reducing its total to $263 billion.

In the court of public opinion, degrees of wrongdoing in the fund scandal may not matter much. A fund company whose name has been in the press enough may find that there is little it can do to stop investors from trickling out, or to attract new ones.

The fund firms may see that as grossly unfair, depending on their offenses. But that’s the cold reality.

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web: www.latimes.com/petruno.