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Spitzer's Saber Rattling Prompts Fund Reform Bill

WASHINGTON - The crusade against mutual funds for ripping off customers is reaping benefits as Congress prepares to draft new legislation to curtail trading abuses and protect shareholders.

Testifying at a series of hearings before both the Senate and House of Representatives last week, bulldog New York Attorney General Eliot Spitzer continued to thunder away at the fund industry for its egregious and widespread abuses.

"It is a cesspool," Spitzer said, regarding the wave of improprieties his office has uncovered since launching a full-scale investigation into mutual fund trading practices in September. His vigorous pursuit of firms that have allowed market timing and late trading in their funds has prompted legislators to consider revising a bill that would clean up the fund industry.

Sen. Daniel Akaka (D- Hawaii) indicated he will be working closely with Rep. Richard Baker (R- La.), chairman of the House Subcommittee on Capital Markets, on drafting a bipartisan bill to restore public trust in mutual funds. The bill will aim to build on reforms detailed in the Mutual Fund Transparency and Integrity Act, or Baker Bill, which passed in the House earlier this year, but ultimately stalled in the Senate.

Spitzer's probe has brought to light a morass of conflict of interest in the fund industry, as more than a dozen mutual fund companies have been implicated, and one firm, Putnam Investments of Boston, has been formally charged with securities fraud. New York brokerage Prudential Securities was also slapped with charges that former brokers and branch managers at its Boston office engaged in improper trading.

Richard Strong, chairman and CEO of Strong Financial of Menomonee Falls, Wis., is currently facing an investigation by state and federal regulators after admitting to trading in his own accounts. Spitzer insisted that the scandal is more than just a few bad apples but rather, "The whole crate of apples is rotten." The SEC estimates that at least 10% of mutual fund complexes are guilty of late trading and that more than half of them have market-timing arrangements in place.

The Unholy Trinity'

Spitzer promised stiff penalties for the firms found guilty of late trading, market timing and self-dealing, or what Stephen Cutler, director of enforcement at the Securities and Exchange Commission, dubbed the "unholy trinity." Spitzer called for the complete disgorgement of losses along with any fees retained as a result of their dereliction of fiduciary duty. "This number will be big, it will impose pain, and it should," he boomed.

In terms of identifying what constitutes criminal behavior, Spitzer said that if a firm knowingly permitted market timing and accepted payment for it, it will be charged. When asked if the investing public will be satisfied with the punishment the offenders receive, Spitzer snapped that his job is not to make people happy but rather to prosecute the offenders. He declined to comment on whether the offenders would see any real jail time but assured that he is not done yet. "There will be more cases," Spitzer told Money Management Executive.

Another sticking point for Spitzer was that, by charging excessive fees, funds are not delivering on their promise of an economy of scale. He noted that mutual fund assets grew 60 times between 1980 and 2000, but fund fees grew by 90 times during that time frame. Shareholders, on average, pay 25 basis points more for advisory services than pension funds pay, despite receiving near identical services. In fact, a 25-point reduction in the advisory fees that all mutual fund shareholders pay would result in a staggering savings to investors of more than $10 billion annually.

Despite the overwhelming evidence of impropriety, Spitzer stopped short of recommending that investors dump shares in mutual funds. "That would be a mistake," he said. Rather, he proposed a series of reforms that would revamp the way funds are structured.

A key provision of Spitzer's proposed reforms is the inclusion of a "favorite nations" clause in fund contracts that would prevent advisory firms from charging them fees in excess of those paid by pension funds. Another action step he endorsed was requiring funds to negotiate advisory and management fees by obtaining multiple bids. Requiring funds to have independent directors and an independent chairman was also high on his list.

Skimming the Till

Sen. Peter Fitzgerald (R-Ill.), chairman of the Senate Subcommittee on Financial Management, the Budget and International Security, expressed similar concerns about how mutual funds are organized and managed. Many fund directors are also insiders at the firm, he argued, and federal law not only allows such an incestuous relationship but also codifies it. The combination of an ambiguous fee structure, abusive trading practices and government policies that channel money into funds has turned the industry into a "monster" that does not adequately represent shareholder interests, Fitzgerald said.