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Viewpoint: Heartland Fiasco Shows Need for Conflict-of-Interest Rules

A sweetheart transaction with pension funds draws scrutiny.


recent collapse of two

Heartland Advisors

muni-bond funds brought home to many investors the potential danger of investing in high-yield, or junk, bonds. But there's another, perhaps more important, lesson there about the dangers of sweetheart transactions between mutual funds and associated companies.

In September, shortly before their problems became public, the two Heartland funds,


High Yield Municipal and


Short-Duration High Yield Municipal, sold a portfolio of distressed bonds to the

State of Wisconsin Investment Board

, or SWIB. Heartland and its founder and president, William Nasgovitz, guaranteed SWIB a 20% annual return and return of principal.

It appears the deal was the brainchild of SWIB's chairman, Jon Hammes, who also happens to be on the board of both muni funds. According to published reports, Hammes told Nasgovitz that SWIB might be interested in a deal and told him who to call at SWIB. The deal was consummated at an emergency SWIB meeting on Sept. 27. (Hammes did not return calls this week asking for comment.)

The sale appears not to have broken any conflict-of-interest laws, which in any case are riddled with loopholes. But as the financial services industry prepares to mount a campaign to further water down these laws, it serves as a timely reminder of why


saw the need to establish them in the first place.


The deal with SWIB appears to have been a desperate attempt by Milwaukee-based Heartland to raise cash for the two faltering funds and thereby avoid having to unload securities at fire-sale prices to meet redemption requests. The funds received the cash on Sept. 29, apparently too late to avoid having to liquidate part of its portfolio. The day before, Heartland repriced the Short Duration Fund and the High Yield Fund, dropping their

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net asset values 2% and 8%, respectively. The same day, the funds announced the resignation of portfolio co-manager, Thomas Conlin. On Oct. 13, the funds were repriced again, this time reducing their net asset values 70% and 44%, and sticking their shareholders with a $62 million aggregate loss.

No one is claiming the deal with SWIB caused the funds' collapse. But shareholders saddled with the drastic losses surely have the right to ask whether they were further victimized by a disadvantageous transaction with SWIB.

There's no clear answer to that question. The drastic markdown of the funds' values after the SWIB deal was completed suggests SWIB might have paid more than the bonds were worth. But Heartland's and Nasgovitz's generous guarantee of principal and interest might indicate that SWIB had the upper hand and made the most of it.

Hammes might have sensed SWIB could profit from Heartland's desperate situation, and, as a Heartland fund director, was in a position to bring about the deal. Indeed, comments by SWIB's chief legal counsel, Keith Johnson, support that view. "To a certain extent, we almost took advantage of

Heartland," Johnson told the

Milwaukee Journal Sentinel


But the funds found a loophole in the affiliated-transaction rules that gets SWIB off the hook. Though Hammes is clearly an affiliate of the funds, the restrictions are triggered only if SWIB is an affiliate of Hammes. The key is whether Hammes exercised a "controlling influence" over SWIB. Chairman Hammes and five other members of the nine-member SWIB were appointed by Wisconsin's governor. Although this may be taken by some to be strong evidence of Hammes' controlling influence over SWIB, the law says he is not considered to control SWIB solely due to his position as its chairman. And SWIB counsel Johnson says that Hammes did not participate in negotiations and abstained from voting.

So this carefully lawyered deal appears to pass legal muster. Nonetheless, it represents exactly the kind of conflict-ridden fund transaction that Congress intended to prevent.

Loopholes Could Grow Wider

But don't hold your breath waiting for Congress to close the gaping loopholes in affiliated-transaction prohibitions. In fact, if the securities industry has its way, these important investor protections will be watered down further.

Affiliated-transaction rules have been the bane of the securities industry for years. As large financial services firms aggressively built up their fund offerings during the 1990s, they increasingly chafed under laws that prevented them from using captive fund clients as customers for other parts of their businesses.

Last year, the financial services firms' trade group, the

Securities Industry Association

, launched an assault on the ban on affiliated transactions with funds. The same financial services conglomerates whose exploitation of their funds in the 1920s and 1930s was the reason these rules were created, argued that the time had come to let them back into the mutual fund cookie jar.

This attack was put down in part by a firm response from Paul Roye, head of the

Securities and Exchange Commission's

fund division, who issued a harsh reminder that before the rules existed, "underwriters of securities formed funds into which they could dump underwritings ...

dealers in securities formed funds into which they could dump their inventories ...

and banks formed funds in order to make loans to them."

The industry remains undaunted, however, and appears to be preparing for yet another assault on the core protections afforded mutual fund shareholders. At a recent celebration of the 60th anniversary of President

Franklin Roosevelt's

enactment of the federal statute governing mutual funds, Robert Pozen, president of

Fidelity Investments

, targeted revisions to the same affiliated-transaction rules as a top regulatory priority. At the same conference, Barry Barbash, former director of the SEC's funds division, threatened that if the SEC did not loosen up the affiliated-transaction rules, the industry would take the issue to Congress. Echoing Barbash's remark was Matthew Fink, president of the

Investment Company Institute

, the trade organization for fund management companies.

Despite his tough stance in 1999, Roye may be feeling pressure to compromise in order to avoid a worse result in Congress. Under constant industry pressure, the SEC has created 13 loopholes from the affiliated-transaction prohibitions, and it annually grants dozens of exemptions from these rules to individual firms. The SEC's mutual fund rule-making group is "undertaking a review of the need for rules that would permit certain other affiliated transactions," says Roye.

Thus, with an activist, pro-investor SEC chairman, Arthur Levitt, preparing to step aside, and a Republican-appointee increasingly

likely to replace him, the industry is poised to rally against fund shareholder protections in 2001. It appears that the lessons and risks of Depression-era financial conglomeration may have been forgotten by lawmakers. Soon, the lesson of the Heartland funds may be forgotten as well.

Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md.