Focus to Shift in Fund Probes

Round 1 of the mutual fund industry scandal, the storm over abusive trading practices, is coming to a close.

Round 2 is expected this summer and promises to pack more punch with small investors -- because it will focus on whether the industry and major brokerages have been in unholy alliances to push certain funds.

For state and federal regulators, the new legal cases they are pursuing are likely to involve alleged industry wrongdoing that is more complicated, and harder to prove, than the accusations of market timing and other improper trading that have been in the headlines for the last nine months.

Round 2 also may see the spotlight shift from East Coast fund companies to West Coast giants, including Los Angeles-based Capital Group Cos., which manages the American Funds, and San Mateo, Calif.-based Franklin Resources Inc., which manages funds under the Franklin and Templeton brand names.

California Atty. Gen. Bill Lockyer this year launched an intensive investigation of sales practices at Capital Group, Franklin and at Newport Beach-based bond titan Pacific Investment Management Co., the Allianz subsidiary known as Pimco. Lockyer is looking broadly at the issue of “pay to play,” or payments fund companies gave brokers to tout their products.

The Securities and Exchange Commission also is focusing significant resources on pay-to-play investigations, say people familiar with the probes.

Since September, when New York Atty. Gen. Eliot Spitzer stunned the $7.5-trillion fund industry with the first allegations of widespread wrongdoing, the primary focus has been on improper trading of fund shares by some clients at the expense of average investors.

One major charge was that favored clients were allowed to engage in market timing, or in-and-out trades that attempted to profit from short-term market moves. Such trading can constitute fraud if fund companies permitted some investors to do it, perhaps in return for other fee-producing business, in violation of their own fund policies.

Spitzer has settled abusive-trading charges with East Coast fund companies Alliance Capital Management Holding, Bank of America Corp. and Massachusetts Financial Services Co., as well as with Denver-based Janus Capital Group Inc. and Strong Capital Management Co. in Menomonee Falls, Wis. The SEC also was a party to those settlements.

Last week, New Jersey Atty. Gen. Peter C. Harvey settled an improper-trading suit his office had brought against Pimco and its sister firm PEA Capital in New York.

PEA Capital agreed to pay $18 million to New Jersey without admitting wrongdoing. But Harvey dropped the charges against Pimco.

Although some trading cases remain to be settled, fund executives and industry regulators say that phase of the scandal is winding down and isn’t expected to produce dramatic new revelations.

Among individual investors, the trading abuses have sparked outrage, but actual dollar losses often have been hard to peg.

The upcoming legal action against the industry may be more likely to strike a nerve with average investors, because it may call into question why a broker or other financial advisor sold them a particular fund.

“We made a decision that we would focus on pay-to-play because we thought it had a broader impact on investors,” said Tom Dresslar, a spokesman for Lockyer in Sacramento.

In Round 2, state and federal regulators are expected to try to show that many fund companies have had special sales arrangements with brokerages that weren’t fully or properly disclosed to investors.

Those arrangements had the potential to cause brokers to sell clients funds that weren’t necessarily in the investors’ best interest, fund industry critics say. Instead, some brokers may simply have favored the funds that provided the biggest kickbacks to their firms, critics say.

The agreements, known as revenue sharing, typically have involved either direct financial payments from fund companies to brokerages or compensation in the form of stock or bond trading business that generated commissions for the brokerages. The deals have become increasingly common in the last decade.

In defending the practice, some fund and brokerage industry executives have made an analogy to payments that consumer-product companies make to retailers for premier shelf space. They also have said the payments help support the cost of educating brokers about the merits of particular funds.

But critics say the arrangements mean there is severe conflict-of-interest risk in brokers’ sales of funds -- and that major fund companies have sought to obscure the arrangements to avoid a backlash.

“Does a fund have to tell you that they are paying off somebody who is ostensibly giving you objective advice? I think so,” said Mercer Bullard, head of investor advocacy group Fund Democracy Inc. in Oxford, Miss.

For regulators, proving fraudulent behavior by fund companies in pay-to-play cases is no slam-dunk.

The industry’s main defense has been that the SEC was satisfied with the often vague revenue-sharing disclosures in the fine print given to investors.

“Revenue sharing and most of what is going on in fund distribution has been well known to the SEC and other regulators who were interested,” said Richard Phillips, a securities lawyer with Kirkpatrick & Lockhart in San Francisco.

Capital Group, Franklin and Pimco have declined to discuss regulators’ investigations of their practices. The companies have said they have followed SEC disclosure requirements.

Sources say the SEC is wrestling with the issue of how to allege wrongdoing by fund companies without in effect indicting itself for having signed off on fund disclosure documents for years.

As is its custom, the agency declined to discuss its investigations.

The SEC has reached one settlement in a revenue-sharing case with a fund company: On March 31, Massachusetts Financial agreed to pay $50 million to settle allegations that management didn’t tell its fund trustees or investors enough about sales deals it had with brokerages.

Although the company disclosed the sales arrangements, the firm “did not adequately communicate to fund trustees and shareholders the conflicts that may arise out of such arrangements,” MFS said in announcing the settlement.

The case, which got relatively little publicity, suggested a possible avenue of attack by the SEC in alleging wrongdoing. But some fund industry executives take the view that MFS settled the revenue-sharing case as an aside, since it already was paying $350 million to settle improper-trading charges with Spitzer and the SEC.

An MFS spokesman in Boston declined to comment.

On the brokerage side, the SEC in November reached a $50-million settlement with Morgan Stanley over allegations that the firm didn’t properly disclose to investors the sales incentives it received to push certain funds.

But a pending lawsuit against Morgan Stanley by Massachusetts’ chief securities regulator, William Galvin, on the same issue was pared down by a hearing officer in May.

The ruling said Galvin had no basis under Massachusetts law to argue that brokerages were required to disclose payments they received from fund companies.

However, the hearing officer said Galvin could argue that Morgan Stanley failed to disclose potential conflicts of interest that stemmed from its sales practices. Galvin spokesman Brian McNiff said the Morgan Stanley case would proceed on that basis.

California could become the main testing ground for legal challenges to pay-to-play disclosures by fund companies.

The SEC and Lockyer’s office are working together on the revenue-sharing probes of Capital Group, Franklin Resources and Pimco. As three of the biggest companies in the industry, the firms have substantial legal teams devoted to defending their practices and their reputations.

The next few months may determine whether the two regulators have enough evidence to bring cases against the California companies and others, legal analysts say.

Although Lockyer and the SEC are coordinating their investigations, it is possible that Lockyer could attempt to bring charges under California fraud laws, and the SEC could decide against joining the case, sources say.

Instead, the SEC could opt against alleging previous wrongdoing and focus on writing rules that would strengthen fund companies’ disclosure requirements on revenue-sharing agreements.

In any case, new rule-making on disclosure of pay-to-play arrangements is a virtual certainty. The SEC already has proposed a number of rule changes, and the NASD, the brokerage industry’s self-regulatory group formerly known as the National Assn. of Securities Dealers, last month said it would form a task group to suggest additional changes in fund sales practices and disclosure.