Fund Settlements May Fall Short for Investors
The California state treasury so far is $7 million richer for Atty. Gen. Bill Lockyer’s probe of alleged mutual fund fraud.
Lockyer’s office also has collected $6 million to cover its investigative costs.
But what fund investors are getting for all of this is harder to discern. There isn’t much money coming back their way, and new state-ordered fund disclosure requirements may do little to fix what’s really wrong.
With his settlement last week of a complaint against San Mateo, Calif.-based Franklin Resources Inc., the nation’s fourth-largest fund company, Lockyer now has two cases under his belt. The first was a complaint he settled with the Pimco-brand mutual funds in September.
The “fund scandal,” of course, has become a blanket phrase for all sorts of industry practices that have been exposed over the last 14 months. In the beginning, the headlines were mostly about short-term trading games some funds permitted in their portfolios to the potential detriment of long-term investors.
New York Atty. Gen. Eliot Spitzer was the first regulator to uncover industry abuses. Then a host of other state attorneys general jumped in, along with the Securities and Exchange Commission.
Lockyer entered the fray this year, armed with a new state law that expanded his authority in securities fraud cases. Rather than focus on fund-trading schemes, however, Lockyer zeroed in on something that ought to be much closer to home for many investors: how fund companies pay brokerages to sell their products, and the conflicts of interest that can arise because of those payments.
As an investor, you may never know whether your fund lost money because some slick trader was moving in and out of the portfolio for short-term profit. But if a broker sold you an inferior fund simply because his company earned more than it would from selling you a better fund, the hurt may be very real -- and measurable -- over time.
Worse, the money paid to brokerages in some cases came from fund assets, making it a direct expense for fund shareholders.
Because so-called pay-to-play, or shelf-space, deals have become common between fund companies and brokerages over the last decade, Lockyer had fertile ground to plow.
When he announced his investigation in January, the attorney general said he would initially focus on three big California fund operations: Franklin; the marketing unit of Newport Beach-based Pimco (short for Pacific Investment Management Co., a unit of German insurance giant Allianz); and Los Angeles-based Capital Group Cos., which manages the American Funds.
But with two of those three investigations concluded, investors may find the results somewhat underwhelming:
* The Pimco group agreed to pay a $5-million civil penalty to the state and $4 million to cover Lockyer’s investigative costs. No investor restitution was ordered by the state.
By contrast, the SEC, which jointly pursued the Pimco probe with Lockyer’s office, ordered Pimco to pay a $5-million penalty to the U.S. Treasury and also negotiated a $6.6-million reimbursement payment to be made by the Pimco group to seven of its stock funds.
That $6.6 million was the amount Pimco saved itself by using fund assets to cover certain shelf-space payments to brokerages, the SEC said.
(The Pimco cases focused on its relatively obscure stock funds managed from the East Coast; the group’s well-known bond funds in Newport Beach weren’t named in either the state or federal investigation.)
* Franklin agreed to pay California a $2-million civil penalty, $2 million for Lockyer’s costs and $14 million in restitution to Franklin funds that have incurred costs for shelf-space agreements.
Franklin will hire an independent consultant to decide which funds should get some of the $14 million. But investors in Franklin funds shouldn’t hold their breath hoping for a windfall to their portfolios: The assets in the company’s long-term (stock and bond) funds total more than $200 billion. The math isn’t encouraging in terms of spreading that $14 million around.
In any case, the money would simply go back to the funds; there won’t be direct payments to any investors.
The SEC also is expected to reach a settlement with Franklin soon over shelf-space payments. The Times previously reported that the deal with the SEC would be for an amount similar to the state settlement.
As is typical in civil securities fraud settlements, neither Pimco nor Franklin has admitted or denied wrongdoing.
Wall Street appears to be quite relieved by the outcomes. Franklin’s own shares declined through much of the summer as the state and SEC investigations progressed. But since August the stock has soared from about $47 to $62.30 by Friday on the New York Stock Exchange.
To put the shelf-space settlement numbers in further perspective, Franklin agreed in August to pay $50 million to settle SEC charges that it allowed favored investors to engage in trading schemes in its funds.
And last week, Gary Pilgrim and Harold Baxter, the founders of the Pilgrim, Baxter & Associates fund company in Wayne, Pa., agreed to pay $80 million each to settle abusive-trading charges brought by the SEC. They’ll also be barred for life from the securities business.
To the fund industry, the relatively mild penalties involved so far in shelf-space investigations are a vindication of sorts. The industry has contended that regulators have known all along about shelf-space payments and that the arrangements were disclosed in official filings each year with the SEC.
The industry often has defended the payments as “educational costs,” meaning money spent to educate brokers about specific funds via brochures or seminars. And the payments don’t look like much, on the surface -- typically, $20 or so to a brokerage per $10,000 of fund share sales.
But the industry’s harshest critics say shelf-space payments are bribes, pure and simple. Pay, and your fund gets special consideration by brokers as they pick out investments for clients; don’t pay, and your fund gets little or no consideration.
Regulators aren’t trying to prove that the arrangements amounted to bribery. And they don’t seem to be trying to find individual cases of investor harm. Instead, both the SEC and Lockyer have based their shelf-space fraud charges on technical grounds: They allege that the fund companies failed to adequately disclose the agreements to investors.
What is “adequate disclosure”? It’s whatever regulators now say it is.
It’s on this basis that Lockyer contends that he is performing the investor-protection role required of him under California law. Under his settlements with Pimco and Franklin, the companies have agreed to voluntarily provide more detail about their pay-to-play agreements with brokerages. The information is expected to be published in fund prospectuses or in the “statements of additional information,” fund documents that investors ought to read but, unfortunately, generally don’t.
“Basically, it’s the simple idea of full disclosure,” Lockyer said in an interview last week.
That is noble enough, as far as it goes. The problem is it doesn’t go very far.
Lockyer said he agreed that adding many more pages to a prospectus would be less effective than forcing brokers, as they’re selling a fund to a client, to clearly explain what the broker and his firm receive for selling that particular fund compared with others.
“It would be better if there was a way for people to get easily understandable disclosure at the point of sale,” Lockyer said.
But he has no authority to order those kinds of changes. That’s up to the SEC -- which is, in fact, mulling how to beef up what brokers must tell clients.
Which raises the question of whether California, in its pay-to-play probe, has truly pushed the envelope in terms of investor protection or has merely reinforced what was coming at the federal level anyway.
Lockyer offers no apology for pursuing these cases. But as far as what he wants from the fund industry and what he thinks the SEC wants, “we think we’re basically doing the same kind of thing,” he said.
Tom Petruno can be reached at tom.petruno@latimes.com.
