It's Time for a Change at the SEC

The Putnam settlement shows new leadership is needed. Eliot Spitzer is the man for the job.
Publish date:

William Donaldson must go as head of the

Securities and Exchange Commission


Let's turn the job of cleaning up the mutual fund industry, custodian of $7 trillion that belongs to average Americans' savings efforts, over to New York Attorney General Eliot Spitzer.

For me, the SEC's announcement of a settlement with

Putnam Investments

was the last straw. This is how Donaldson's SEC cracks down on mutual fund companies that rip off their own investors?

On Nov. 13, the SEC let Putnam, one of the key scandal participants, off with a slap on the wrist. Putnam, whose egregious misdeeds we'll explore here, didn't even have to apologize or admit that it had done anything wrong.

By moving so quickly to a settlement, the SEC has chosen to put its own bureaucratic need to look like a leader above the interests of investors who have been, or will be, robbed.

That's not the kind of tough independence Donaldson promised when he took over as chairman of the SEC from the compromised Harvey Pitt. You can wait longer if you want to, but I have all the evidence I need that Donaldson isn't a man willing to take on the mutual fund industry, the

New York Stock Exchange

or CEOs who act like they own the companies they really just work for.

Time for Immediate Change

Get him out of there.

I don't care if Spitzer really is an ambitious publicity hound, as his detractors claim. Spitzer's undisguised design on higher office -- governor of New York, according to most political insiders -- gives him a personal stake in building a record of financial reform. And it's about time average investors had someone on their side who's motivated to go for the financial industry's jugular.

If you're not mad yet about the mutual fund scandals, I challenge you to read the SEC's administrative proceeding of Nov. 13 and keep your cool. (You can read the complete text of the SEC's

administrative proceeding on the SEC's Web site.)

The Putnam settlement very clearly lays out the market-timing of fund managers and managing directors at Putnam. Through this practice, they used inside information and rapid trading of fund shares, of the sort explicitly denied to the average fund investor, to reap millions of dollars in profit for themselves.

The SEC settlement says that after 2000 Putnam clearly knew that this kind of trading was taking place and failed to take adequate steps to stop it. In fact, according to the SEC, Putnam's management kept information about this short-term trading from the boards of directors and public shareholders in its funds.

And the punishment for all this wrongdoing that's so clear to the SEC? Putnam has promised to never, ever do this again. And it's going to hire some outsiders to make sure it doesn't. (There's a promise of restitution, amount unspecified, and a big fine from the SEC, amount again unspecified.)

Inside the Putnam Scandal

Want some specific examples of how these guys picked their customers' pockets? The administrative proceedings provide plenty.

There's Omid Kamshad, chief investment officer of international equity since early 2002. He managed seven portfolios with international holdings. Between 1998 and 2003, Kamshad engaged in at least 38 round-trip trades of Putnam fund shares, according to the SEC. On average he sold the shares only 13 trading days after buying them. Senior Putnam management learned of Kamshad's market-timing in January 2000, the SEC concludes, and asked him to stop. Despite saying he would, Kamshad kept trading. In March 2003, for example, he bought $850,000 in shares of Europe Equity, a fund he managed, and sold that position days later for a gain of about $80,000, according to the proceedings documents.

How did such short-term trading in mutual funds lead to profit like that? Here's how it worked: Mutual fund companies say they discourage quick in-and-out trading of their funds. U.S. mutual funds calculate their daily net asset values -- what a share of the fund is worth based on the closing prices of the investments it holds -- at 4 p.m. EST.

But because so many stocks and bonds trade infrequently and because, thanks to round-the-clock trading, international stocks trade at such different times of day, those 4 p.m. closing prices are often stale. That is, they don't reflect the up-to-the-minute prices of the assets held by the funds.

So any investor -- like the fund managers at Putnam -- who had detailed knowledge of precisely what stocks the funds held could make big bucks by trading on the difference between current prices and the "stale" prices of international stocks.

Of course, all that trading hurt the other investors in the fund because they had to pick up the cost of those frequent trades. Moreover, fund managers had to keep more of their assets in cash so that they could handle those big sell orders. And of course, part of the profit from all those stale prices should have gone into all shareholders' pockets instead of the wallets of just a few.

Total damage across the fund industry, according to the academics who have studied the problem, is somewhere around $5 billion annually.

Dubious Victory

Now, of course, this being a typical SEC settlement, Putnam didn't admit that it had actually done anything wrong. But it still agreed to make changes in its procedures. Here's what the SEC won for mutual fund investors:

    At least 75% of the members of the board of trustees for any Putnam fund must be independent as defined by the Investment Company Act of 1940, the basic enabling legislation that governs the fund industry. Unfortunately, the act's definition of "independent" is rather lax. For example, Neal Malicky counts as an independent director for Strong Capital Management, according to the act's definition. But the year he joined the board of the mutual fund, Malicky was the chancellor of Baldwin-Wallace College, the alma mater of Richard Strong, Strong Capital's CEO until his recent resignation for market-timing Strong funds. In 2000, Malicky's first full year as a board member, Strong gave between $2,500 and $5,000 to the college. Strong at least doubled his contributions in the next two years. The fact is, Strong Capital already had been forced to increase the size of its board from three to six, with at least five of six members to be independent, as a result of a 1994 settlement with the SEC. Yep, that worked.

    Putnam employees have to hold shares of any Putnam fund they buy for at least 90 days. (If it's a fund where the individual has portfolio management responsibility, the shares must be held for a year.) Well, at least that's less vague than the mid-2000 warning from Putnam to senior investment managers not to engage in "excessive short-term trading." At a minimum, any individual caught violating this rule would be forced to give back any profit. The settlement doesn't spell out any further or maximum punishment, and it gives Putnam "a reasonable time" to use "reasonable best efforts" to design an automated system to prevent such market-timing trades.

    Within 30 days, Putnam will hire an independent "assessment consultant" to determine the compensation due Putnam shareholders. The consultant must be acceptable to the SEC.

    Putnam also will hire an independent compliance consultant within 30 days to conduct a review of Putnam's policies, including but not limited to procedures designed to prevent market-timing. Putnam has to implement the recommendations of the independent consultant. This is certainly a step forward from the days when employee trading compliance was the purview of the human resources department. (As part of the settlement, it will now switch to the legal department.)

    At some point in the future, Putnam will have to pay fines to settle the civil charges brought by the SEC.

    What's missing? Oh, how about:

    • An admission of guilt or some expression of contrition.

    • A promise from the SEC to address the problem of stale prices that made this scandal possible to begin with. (The mutual fund industry actually has been asking for regulations on this issue.)

    • A definition of an independent director that has some meaning.

    • Securities-fraud charges against individuals and the company for saying in regulatory filings that they didn't permit market-timing when they did.

    • Jail time for the individuals who violated their fiduciary duty to investors.

    • At least some consideration of whether Putnam, or any other fund company involved in these scandals, should be allowed to continue as an investment company. If that were even on the table I think the settlement would look very different.

    But don't take my word that this is a crummy deal for investors. Listen to the reaction from Spitzer, as well as William Galvin, who oversees securities regulation in Putnam's home state of Massachusetts.

    Blasting the Agreement

    Galvin blasted the agreement. "For all the discussion about enforcement, when it comes to being serious, the SEC is more interested in hastily reaching accommodations with the industry than in resolving problems," Galvin told reporters. "I believe the industry is breathing a great sigh of relief."

    Galvin also announced that he was weighing a decision to file charges against Putnam's head lawyer, general counsel William Woolverton, for allegedly market-timing Putnam funds. (Putnam on Friday denied Woolverton had engaged in prohibited market-timing.) Spitzer, who hasn't filed charges against Putnam, was unusually concise: "If the SEC thinks this is adequate, then clearly they don't understand the issues."

    Maybe that's because the issues that concern investors about mutual funds aren't at the top of the SEC's list of worries. This deal has all the trappings of a bureaucracy deeply embarrassed at being caught asleep at the wheel trying to one-up its enforcement competitors. After all, the initial complaints against Putnam were brought to the SEC's Boston office, which proceeded to do nothing, until Galvin moved. A settlement with Putnam, even before the investigation is completed, would help bury that failure and asserts that the SEC is the agency really in charge of fixing this scandal.

    Bush, Are You Listening?

    Good luck. Galvin isn't going to let the Putnam case fade away without completing his work, even if the SEC is ready to close the book on Putnam. I'd expect more charges out of his office.

    Spitzer, meanwhile, has brought down two more big names in the world of mutual funds. On Nov. 13, Gary Pilgrim and Harold Baxter, founders of the PBHG family of funds, resigned in the face of Spitzer's investigation into market-timing in fund shares by hedge funds, including one where Pilgrim himself was an investor.

    "It's just one more example of a complete breach of fiduciary duty by the most senior executives in a mutual fund," Spitzer said.

    At least there's one guy that gets it. Unfortunately, he doesn't head the SEC. But that can be fixed.

    President Bush, Sen. Paul Sarbanes, Rep. Michael Oxley, are you listening?

    At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jim Jubak at