Alliance Deal Sets Alarming Precedent
December 22, 2003
The mutual fund scandal took a surprising turn last week when Alliance Capital Management agreed to lower management fees on its funds as part of a landmark $600 million settlement that could set an alarming precedent.
Alliance will cut fees by 20% and keep them frozen at that level for the next five years - a $350 million value - as part of its settlement with New York Attorney General Eliot Spitzer for engaging in abusive trading practices that ripped off long-term shareholders in its funds.
The firm also has agreed to hire an executive to oversee its fee structure and evaluate fees according to the level of fees charged to institutional investors, the costs of providing services and Alliance's overall profit margins. The move comes on the heels of an investigation that revealed extensive market timing arrangements and cost two senior executives their jobs. Alliance fired President and CEO John Carifa and mutual fund head Michael Laughlin last month.
The probe revealed that senior executives at Alliance had authorized complex timing arrangements with 18 broker dealers and hedge fund operators in exchange for new assets that generated hefty management fees. One e-mail suggested that Alliance Chairman Bruce Calvert knew about timing arrangements made with Daniel Calugar, a Las Vegas broker, in several Alliance funds. These clandestine deals contradicted the policies outlined in the prospectuses of its funds.
The New York-based fund firm will also pay a $250 million fine that will be used to repay investors harmed by the illicit trading in Alliance funds. The penalty, negotiated jointly with the Securities and Exchange Commission and the attorney general's office, marks the largest fine ever paid by a fund company.
The reduction in fees, however, was the handiwork of Spitzer, who insists that he would not have signed anything unless slashing fees was on the table. The fee cut is expected to save investors $350 million over the next five years.
"This settlement will fundamentally alter the way this company is run," Spitzer said. "Instead of favoring managers, the company will now focus on the interests of investors by eliminating harmful market timing and reducing fees for all shareholders."
But the fee provision of the deal has raised concerns from industry experts about how fees should be set.
"This isn't the right way for fees to be determined. They should be determined by the marketplace," said Don Phillips, managing director at Chicago-based fund tracker Morningstar. "This is the kind of thing Spitzer is delighted to come away with because it positions him as a fee buster, a Robin Hood-type character. The reality of this is that Alliance ought to be thinking about lowering fees, anyway."
Indeed, Alliance charges an average of 77 basis points in management fees for its equity funds, compared with an industry average of 65 basis points, according New York-based research firm Lipper. So paring fees would really just put Alliance in line with industry norms. It stands to reason then that a firm that has been tainted by the scandal would no longer be able to justify charging a 20% premium to the market.
Spitzer criticized the SEC for its settlement with Putnam Investments of Boston last month because it did not include a provision for reducing fees. The SEC, on the other hand, believes that independent fund boards operating in a competitive market should negotiate fees and that the government should not interfere. The SEC argued that the deal benefits future Alliance customers while requiring the victims of the scandal to stay invested with the company to reap the benefits.
"Dictating to fund companies what they should be charging in their investment management contracts under the guise of trying to force settlements is not a good thing," said Joseph Del Raso, a partner at Philadelphia law firm Pepper & Hamilton, who represents fund boards.
Alliance Says Uncle'
What is truly surprising is that Alliance was so quick to concede on the fee issue, a move that could potentially be the blueprint for future settlements. "They're settling because their exposure is gigantic," said Max Rottersman, president and founder of FundExpenses.com, a New York research firm that analyzes fund costs for institutional clients. He estimates that for the past four years Alliance funds that were market timed took in more than $1.2 billion in advisory fees. "Spitzer said boo, and Alliance [peed] their pants," Rottersman said.
At press time, Alliance had not returned phone calls seeking comment. Spitzer's office also did not return calls seeking comment.
Rottersman believes the industry has embarked on an irreversible course because once a fund company admits that fees are an important component of investors' mutual fund selection, they'll have to address themselves to the issue (see "Scandal Squeeze Moves on to Fees," MME 12/8/03).