The Great Mutual Fund Clean Up That Almost Happened
The great mutual fund clean up appears to be petering out. Increasingly it appears that industry efforts to frustrate reform initiatives will be successful. We predict the legislature will ultimately defer to the SEC and the SEC will resume its ineffectual regulation of the industry.
Let’s review the facts:
First, at some point in time, if not already, Eliot Spitzer and other state officials will lose interest in exposing mutual fund wrongdoing. Spitzer was able to uncover so much malfeasance so quickly because it is rampant throughout the industry. All Spitzer had to do to surpass the SEC (and we do not mean to minimize his enormous contribution) was to establish an open-door policy, welcome whistle-blowing industry insiders and listen. When we met with Spitzer’s staff, we were surprised with their limited knowledge of mutual fund regulation. But what they lacked in knowledge they more than made up for in willingness to pursue allegations of wrongdoing and enforcement of the applicable laws. The SEC, on the other hand, has tremendous knowledge of mutual fund practices and regulation yet perennially fails to act. It’s as if the Commission knows about mutual fund wrongdoing but believes (or is persuaded by the industry) that no one is really being harmed.
While it may not be apparent, Spitzer’s investigations have shown that many of the investor protections central to the mutual fund regulatory scheme are not working. His investigations have focused upon a limited number of arcane practices, however, what he has uncovered is pervasive disregard for investors. It is now abundantly clear that mutual funds are operated primarily to benefit their advisers and fund boards have utterly failed as watchdogs. As we indicated in our testimony before the Senate Banking Committee recently, the costs to investors is staggering. Skimming by the mutual fund industry is a significant factor in explaining why the nation’s retirement savers are approaching retirement with far lesser assets than they envisioned.
Second, Spitzer has not, in the past nine months, succeeded in addressing more than twenty years of mutual fund wrongdoing. He only scratched the surface. As we testified, many other abuses such as personal trading by portfolio managers, underwriters parking investment banking client stock in affiliated mutual funds, payment of Investment Company Institute fees from fund assets, have yet to surface as concerns. Virtually every aspect of mutual fund operations needs to be carefully examined by eyes that are less forgiving than the SEC’s.
When we met with Spitzer’s staff we suggested they review the “deficiency” letters issued by the SEC over the past five years in connection with the Commission’s mutual fund inspection program in order to determine whether they agreed with the SEC’s manner of resolving regulatory deficiencies the Commission staff uncovered. An effective regulator could spend years simply revisiting transgressions the Commission has already identified but failed to appropriately address.
Third, legislators are not sufficiently knowledgeable of the arcane world of mutual funds to recommend meaningful change. Further, due to intense industry lobbying efforts, they are not prepared to undertake a serious, comprehensive review of the weaknesses in the mutual fund industry. During our testimony we were amazed that the Senate Banking Committee was willing to allow industry insiders to claim ignorance regarding simple matters such as the cost of executing a securities trade. If the Committee cannot find an answer to the question of the cost of execution, it will never be able to grasp the extent to which funds pay excessive commissions and fund boards fail to monitor trading costs. Our simple suggestion: Require industry insiders to take an oath before testifying.
Fourth, the SEC will be no more effective in the future than it has been in the past. The reform measures the SEC has endorsed to address the scandals that have surfaced are preposterous. At the heart of the problem is the fact that the Commission continues to believe the legal fictions incorporated in the Investment Company Act of 1940, the federal statute that regulates mutual funds. The reality is that, regardless of what the statute provides mutual fund directors handpicked by fund advisers will rarely, if ever, be truly independent. You can change the definition of “independent,” require a greater percentage of “independent” directors on mutual fund boards but, at the end of the day, nothing will change. We can assure you that no consumer/investor advocate will EVER appear on a mutual fund board.
The SEC proposal that funds be required to hire compliance directors that will report directly to fund boards is equally fanciful. A Commission spokesperson was recently quoted as saying that “Any compliance director that doesn’t do his job will risk ruining his career.” We can assure you that any mutual fund compliance director that DOES his job and rats on an adviser will risk ruining his career. Again, the SEC seems to be living in a fantasy world where whistleblowers are rewarded.
In summary, mutual fund investors should not be lulled into believing that any meaningful new protections will emerge. The industry has not been cleaned-up and will soon return to business-as-usual. However, a bell once rung cannot be un-rung. Investors now have more information than ever available to them as a result of the mutual fund scandals. The public has gained familiarity with theories of mutual fund malfeasance that previously had not been discussed. Investors now know that funds are not inherently safe and that they should always be on the alert for self-dealing by advisers, brokers and other intermediaries. Investors should seek to identify the “hidden financial incentives” related to every investment service they purchase.
Thankfully, reforms may provide investors with a better understanding of the costs related to investing in funds. Cost information alone should expose some of the industry’s greediest firms. Greater disclosure of the costs related to investing in funds will likely be the one significant benefit arising from the scandals.
As The Ratings Firms Soundly Slept
Finally, little attention has been paid to the failure of the so-called mutual fund ratings firms to predict any of the scandals. Over the years these firms have followed a course of avoidance of critical commentary on the industry and have crafted their ratings to provide maximum marketing value to funds. Catering to the industry in pursuit of profits, integrity and accountability to investors was abandoned. Investors who have relied upon these firms’ ratings have generally been disappointed. Today these firms are advising investors regarding a host of legal, ethical and operational mutual fund issues that they are simply unqualified to comment upon. Already they are telling investors it is safe to return to funds that admitted to serious wrongdoing only a few months ago. Investors hopefully will remember these so-called rating firms should not be unduly relied upon. They failed to anticipate the last scandals and they cannot be relied upon to predict the next.
Update From Dow Jones Business News
Chattanooga Probes Pension Work by UBS, Morgan Stanley By Arden Dale 22 April 2004
(c) 2004 Dow Jones & Company, Inc.
NEW YORK -- The city of Chattanooga, Tenn., has hired an investigator to review the way UBS AG's (UBS) UBS Financial Services and Morgan Stanley (MWD) acted in their role as consultants to its $180 million pension fund in recent years. The move comes as the Securities and Exchange Commission is looking into possible conflicts of interest in the pension-consulting business.
UBS Financial, then known as UBS PaineWebber, advised the Chattanooga fund between 1996 and 2000, and Morgan Stanley held the position from 2000 to 2003. Both firms declined to comment on the current review.
David Eichenthal, Chattanooga city finance director and chairman of the pension-fund board, said the city has retained former SEC attorney Edward A.H. Siedle to look into the firms' activities during the period in question. The probe began several months ago and is expected to conclude by the end of the year.
"The purpose of the review is to go back and look at the plan's prior performance as part of an overall effort of the board to take stock," said Mr. Eichenthal.
He said most of the seven-member board of the general pension plan of the city of Chattanooga have been appointed within the past year or two. The fund covers city employees, excluding police and firemen. Like most public funds, it sustained significant losses in recent years due to market conditions, but has rebounded in 2004.
Mr. Eichenthal declined to comment on the exact nature of the review, but said Mr. Siedle's work with a nearby pension prompted the city to hire him. Specifically, Mr. Siedle had a hand in winning one of the few known settlements related to conflicts of interest in the pension-consulting arena, a $10.3 million payment by UBS to the Metropolitan Government of Nashville and Davidson County in 2002. UBS was a consultant to Nashville's pension fund.
"We were aware of his work in Nashville and with some other funds, and we thought he would be appropriate for the type of review we were looking for," said Mr. Eichenthal. Mr. Siedle started the Nashville probe after a KPMG LLP report to the city raised a number of concerns about possible conflicts of interest. For example, it noted that UBS was paid by Nashville in brokerage commissions, and had "provided the board with misleading information, resulting in board decisions that generated higher commissions."
Alleged conflicts by consultants can take several forms, but they all come back to the powerful influence consultants wield over investment officials at pension funds. These officials - mostly at public funds - rely heavily on their consultants as the gatekeepers who tell them which money managers to hire. In turn, the argument goes, money managers feel pressure to "pay to play," or give kickbacks of various forms to consultants in return for recommendations to pension boards.
A big concern is that some consultants may direct above-market brokerage trades to their affiliates, collecting so-called "soft dollar" payments that can add up to huge sums that go unreported as revenue.
"Most of the major wirehouses have an elite core of high-producing brokers that they hold out to the public as being pension experts," said Mr. Siedle, who confirmed the review but declined to disclose details.
Mr. Siedle now owns Benchmark Financial Services, an Ocean Ridge, Fla., company, which he describes as a broker-dealer that provides investment-banking services, securities trading and specialized consulting, or investigative work. He said he has been getting more calls from city and state pension funds since the SEC began looking into pension consulting. The SEC initiated its look with a Dec. 12 letter to many investment-advisory f irms, seeking a wide range of information on their activities during the period between Jan. 1, 2002, and Nov. 30, 2003. The SEC said it is "examining the practices, compensation arrangements and disclosures of consultants that provide services to sponsors of defined-benefit and defined-contribution pension plans or other market participants."
Of particular interest to the SEC are "practices with respect to advice regarding the selection of investment advisers to manage plan assets; selection of other service providers such as administrators, custodians, investment research firms and broker-dealers; and services other than investment consulting provided to plan sponsors, investment advisors and mutual funds."
Lori A. Richards, director of the SEC's office of compliance inspections and examinations, said earlier this month that the examination is continuing but didn't give a time frame for completing it.
Nearly half of all pension-plan sponsors with $100 million or more use investment consultants, according to a 2003 survey by Nelson Information, a division of Thomson Financial. Marsh & McLennan Cos. (MMC) Mercer Investment Consulting Inc., Callan Associates Inc., Russell Investment Group, Wilshire Associates and Segal Advisors Inc. are among leaders in the field.