In his testimony before Congress this week,
Securities and Exchange Commission
Chief William Donaldson called for sweeping changes, saying "the time for excuses has long passed." Congress has responded: too little, too late.
Most industry observers concur: The SEC has spent years studying issues that have yet to be addressed. Fair-value pricing (a method of adjusting the value of fund shares that would incorporate after-market news and eliminate most opportunity for market-timing), for instance, has been on the table since 1997.
"Reform should come from the SEC, but Donaldson has demonstrated that he's not interested in real reform," said Mercer Bullard, securities law professor at the University of Mississippi and founder of fund-investor advocacy group Fund Democracy. "The risk is that Congress is a less expert body in this area. But the SEC has utterly failed to implement any changes, so it's time to take the risk of Congress fouling things up in order to achieve real reform."
So what does Congress propose, and when will we see such reform? And what steps are being taken in the meantime?
On Wednesday the House of Representatives voted overwhelmingly (418 to 2) to pass a bill that would restrict fund executives from market-timing their own funds, impose harsher penalties for abuses, force fund companies to disclose more information regarding fees and require that the chairmen of fund boards be wholly independent from the companies managing the funds.
The Senate is mired in discussions of several similar bills, and actual Congressional action will not likely happen this year. But the general displeasure with the SEC's efforts in this matter has been remarkable -- and not limited to Washington.
Several states have yanked their pension funds from the management of fund companies that have been tarnished by the scandal. While institutional clients (such as pension managers) don't actually have their assets invested in mutual funds, their accounts are often managed by the fund families. And the poor behavior of Putnam, a unit of
Marsh & McLennan
, in particular, has prompted the California Public Employees' Retirement System (Calpers) and the California State Teachers' Retirement System (Calstrs) to move their combined $1.5 billion in assets from Putnam's management. Massachusetts, Iowa and Rhode Island also have removed their pensions from Putnam.
Not content to wait for Congress or the SEC to improve compliance, pension managers -- long known for their advocacy on behalf of their investors -- have taken steps of their own to ensure money managers adhere to a stricter set of ethics and behavior.
North Carolina's state treasurer, Richard Moore, has issued "Mutual Fund Protection Principles" that the managers of the state's 401(k) plan for public employees is considering. Shareholder reforms include a mandatory annual statement of the charges, expressed in dollars, debited from each person's account, and a detailed management fee schedule. At least two-thirds of the fund's board of directors and the chair would need to be independent, and the portfolio manager's compensation would have to be clearly disclosed annually.
Calpers -- which is a pension fund rather than a 401(k) plan, so the money is not invested in actual mutual funds -- will set up a review of its money managers and develop an ethics and practices blueprint that managers must comply with to manage Calpers money.
Industry agitators have called for much stricter reforms. "The areas Donaldson outlined are the key areas, and a lot stronger than anyone thought possible," says Roy Weitz, publisher of
FundAlarm.com, an industry watchdog site. "But his suggestions can still be beefed up."
The SEC, for its part, said Tuesday that it plans to meet Dec. 3 to evaluate a raft of regulatory proposals that would prevent late trading and market-timing abuses. It also plans to address fund governance and disclosure issues. On Thursday, SEC Director of Enforcement Stephen Cutler testified before Congress as to several compliance proposals that would address misconduct in two broad areas -- concerning late trading and market-timing, and the issues of how sales fees are disclosed and assessed.
Particularly lacking in the SEC's plan, Weitz says, is any move to limit fund abuses of 12b-1 fees. These fees are ostensibly a marketing charge for new funds that should disappear once the fund has established itself -- but 12-b-1 fees really serve as little more than an additional expense that funds rarely eliminate.
"The absence of any mention of 12b-1 fees in Donaldson's testimony was noticeable," Weitz says. "If he really wanted to nail fund abuses shut, this is the chance to resolve the major issues."
New York State Attorney General Eliot Spitzer -- credited with bringing the late trading and market-timing abuses to light with his extensive and ongoing investigation -- testified before Congress on Thursday as to excessive fees imposed on individual investors.
"Some have questioned whether there is a nexus between the inquiry into fees that I am proposing and the investigation into the trading activities permitted by fund managers. The answer is yes," Spitzer said, according to the
. The fund company executives that allowed or engaged in the improper trading of fund shares did so largely to increase their fees.
In addition, Spitzer said, fund companies charged institutional clients far less for managing the same amount of money in retail accounts. Once again, Putnam's behavior was particularly egregious -- Spitzer said that retail fund investors were charged 40% more in management fees, amounting to $290 million a year.
Another issue that needs to be tackled is that of omnibus accounts, notes Lucas Garland, an analyst with Lipper, a Reuters company. When a broker/dealer has a 401(k) client, for instance, all the trades that occur in the 401(k) on any given day are bundled and issued as a single trade to the fund company. That lack of individual trading information, Garland says, puts fund companies at a disadvantage in spotting frequent or otherwise spurious trades that could be market-timing. It also means that funds rarely bother to identify breakpoints at which sales charges should be reduced. And, of course, it could easily conceal late trades.
Late trading is an illegal practice in which certain large investors are permitted to purchase fund shares after the market's close, but at the 4 p.m. price. As with all aspects of the law, though, there are shades of gray -- particularly surrounding the issue of whether the fund company has a window of time in which it can still accept orders from a broker/dealer after the market's close. (For more on the legal aspects, see
Did Lawyers Sign Off on Late Trading?).
The SEC is considering requiring that a fund -- not an intermediary such as a broker-dealer -- actually receive all fund orders by 4 p.m.; otherwise they'll be processed at the next day's price.
"We need systemic change," Garland says. "It's going to cost a lot of money and be a dramatic change in procedure. But it needs to happen."
Another change observers would like to see is a mandatory independent oversight board for funds -- a notion that has been picked up in two Senate bills.
The SEC's historic reluctance to issue any regulations on fair value pricing, 12b-1 fees and the like is largely political. But with the fund scandal breaking 10 months into Donaldson's tenure as chief, few expect his politics to change.
"He feels he needs to balance the interests of the industry and consumers, and this is where he comes down on that balance," Weitz says. "He's come a long way since late August, but it's unlikely the industry will get behind
these suggestions. And that means they're almost certainly not going to go further -- and they should."
The fund industry has decried too much regulation, largely on the grounds that it will cost investors. But even if that's true, Bullard says, the payoff for investors is still greater. "The creation of wealth for shareholders is the net test of all these regulations," he says. "If it costs them $1 million in the aggregate but prevents $10 million in losses due to bad behavior, it's worth it."