Investors Deserve an Intolerant SEC

The SEC Response

If the SEC's response to Mr. Spitzer's announcement is any indication, however, then there is no reason to expect improvement. SEC Chairman William Donaldson stated that Mr. Spitzer's action illustrated the "importance of the SEC's ongoing review of both hedge funds and mutual funds and the SEC's upcoming recommendations regarding improvements and increased disclosure requirements for both."

First, this is not a hedge fund scandal, but a mutual fund scandal, and what's needed is action, not more "ongoing reviews." Second, the action needed has nothing to do with fund disclosure requirements. Mr. Spitzer's action shows that investors need enforcement, not more disclosure.

Perhaps even more telling is Mr. Donaldson's comment that "there is too much money at stake for us to know as little as we do about [hedge] funds, in particular, and how they operate." Mr. Donaldson's mistaken view that we should be worried about hedge funds shows that the SEC knows "little" about them. If mutual fund managers feel free to conspire with investors -- whether or not they are hedge funds -- to cheat the funds' shareholders, nothing new that the SEC learns about hedge funds will protect fund shareholders. There is nothing in the nature of hedge funds that was necessary to perpetrate the frauds alleged by Mr. Spitzer. Indeed, you need only read popular Internet bulletin boards on investing to find that arbitrage pricing is a game played by hedge funds and retail investors alike.

None of this suggests that the SEC will fail to follow-up on the fraud uncovered by Mr. Spitzer. The SEC enforcement staff will follow up, and with vigor and competence unmatched among federal enforcers.

But will it recognize and act on the warnings signs of the next scandal? The SEC's inaction with respect to the Strong fund ad described above suggests that it will not. The Strong ad is an extreme example of a number of ads that have touted bond funds' recent returns without adequately disclosing that, like the hot Internet funds of the late 1990s, these funds may be money losers going forward. The SEC enforcement staff is failing to anticipate the role that misleading ads will have played in shareholders' losses in bond funds resulting from a precipitous rise in interest rates.

Another potentially damaging, systemic issue is funds' increasing purchases of IPOs from fund affiliates. In 1997, the SEC substantially increased the amount of IPOs that funds could buy from their underwriter affiliates -- the same underwriters who were charged in this year's Spitzer settlement with Wall Street. Did these underwriters use their funds to as a captive market during the Internet boom, thereby harming fund shareholders? The SEC can't answer this question because it hasn't tracked the effect of the rule. Perhaps the rule has had no adverse effect at all, but it would be no surprise to see an academic study released that showed that Wall Street underwriters used the rule to take advantage of their funds, thereby igniting another scandal and providing another opportunity for Mr. Spitzer to eat the SEC's lunch.

As the fund industry is no doubt realizing, the SEC enforcement staff's weaknesses pose as great a risk to the fund industry as to fund investors. Unlike much of the financial services industry, the fund industry has an honest reputation that can be destroyed by occurrences of widespread fraud, and that reputation has been the single greatest factor in the industry's growth. The mutual fund brand is now more at risk than ever before, and it cannot be saved without the restoration of an effective enforcement culture at the SEC.