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Morningstar Data Mix-Up Prompts Probe

Having watched a number of mutual fund companies mishandle inquiries from securities regulators for the past 12 months, fund-tracking firm Morningstar knew what to do when faced with its own brush with the law.

The Chicago-based research firm announced plans last week to upgrade its procedures used to collect fund data on the heels of a Securities and Exchange Commission investigation to determine whether the company should face civil charges for failing to correct inaccurate information published on its Web site. News of the probe comes at an inopportune time for Morningstar, which plans to take the firm public later this year.

"We sincerely regret that this error occurred," Morningstar Chairman Joseph Mansueto wrote in a letter to customers. "To prevent a similar problem, and as part of our ongoing effort to continually improve our processes, [we are] increasing our communication efforts and centralizing lines of reporting for data questions or errors; augmenting the stringent rule we already have in place; and improving our data-analyst training."

Morningstar took an aggressive stance on fund companies tied to the trading scandal unearthed by Eliot Spitzer last Fall, issuing sell recommendations on some of the nation's biggest fund shops for market-timing abuses. The panning of the tainted firms, particularly Janus Capital of Denver, caused quite a bit of consternation on the part of fund executives, as many of them were already struggling to cope with substantial outflows. Ironically, Morningstar has now found itself in the SEC's crosshairs.

On Feb. 27, Morningstar published inaccurate information for the $20 million Rock Canyon Top Flight Fund for nearly a month. Top Flight is a mutual fund that behaves like a hedge fund in that it moves in and out of stocks quickly, sporting a 2,686% turnover rate. The nimble fund paid a short-term capital gain to investors in December 2003, prompting a handful of financial Web sites to incorrectly report the payout as a decline in the fund's total value. Morningstar, however, did not fall into that trap, having reported the data correctly the first time.

But the problem for Morningstar began when an employee of the transfer agent for Rock Canyon Top Flight sent an e-mail to a Morningstar analyst containing a chart of the fund's actual and adjusted daily averages, erroneously depicting a 25% spike in value as of the date of the capital gains distribution. That robust gain pole vaulted the fund to the top slot in Morningstar's small blend fund category. Notching the top spot on the company's list of top-performing funds often serves as a boon for getting new money in the door.

On March 12, the transfer agency alerted Morningstar about the inflated returns, but the numbers were not corrected until two days after the SEC contacted it on March 23. The reason for the delay was the transfer agent attached the same exact file it had sent in February. When Morningstar moved to change the data, the transfer agent again pointed to the adjusted NAVs, leaving the firm little recourse but to leave the data unchanged. Jonathan Ferrell, portfolio manager of the Top Flight fund, wrote the SEC about what had transpired, saying that even after Morningstar acknowledged the mistake, it was not treated as a high priority and several calls placed to Morningstar were not returned.

Subsequently, Morningstar received a Wells notice from the SEC on May 24, informing the data provider that it could be held liable for deceiving investors. While the SEC does not have explicit jurisdiction over research providers, the agency told Morningstar that if it was reckless in its handling of the data, then a civil suit could be brought against the firm. Morningstar was surprised to learn that a single data error could be interpreted as a securities violation, but said it plans to cooperate fully with regulators on the matter.

Although Ferrell was displeased with Morningstar for its slow reaction to the problem, he believes the company acted in good faith and had no intent to deceive investors. Typically, the SEC will bring an enforcement action when the investors have been harmed by a company's actions. In this instance, no investor purchased the fund during the period in which returns were overstated. Mansueto wrote in his letter to customers, "We believe the heart of the SEC's concern relates to our timeliness in correcting the data during the nine business days from March 12 to March 23."

Despite what seems to be a very minor mistake, the timing of the probe couldn't be worse for Morningstar, which filed for a $100 million initial public offering in May, saying it plans to use the new cash to expand its business through acquisitions and joint ventures. It also plans to expand operations overseas, according to its preliminary prospectus. It is too soon to determine how far the SEC will push the envelope on this matter or whether it will impact its pending IPO. Morningstar declined comment on the IPO and the SEC investigation. When asked to provide a historical perspective on data miscues at Morningstar, the firm also declined.