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For the Fund Business, What Went Wrong?

As fraud allegations mushroom, damaging investors' confidence, the industry may face dramatic changes.

November 02, 2003|Josh Friedman, Tom Petruno and Walter Hamilton | Times Staff Writers

The $7-trillion U.S. mutual fund industry was under siege. Everyone from TV talking heads to sage investor Warren Buffett was pointing out its shortcomings.

"It makes me wonder what life would be like if we'd actually done something wrong," Paul G. Haaga Jr., chairman of the Investment Company Institute, the industry's main trade group, told a membership meeting in Washington, D.C.

That was in May. Haaga and the rest of the industry scarcely could have imagined what would transpire four months later.

Since Sept. 3, state and federal regulators have launched a barrage of charges against the fund business, alleging wrongdoing on a scale that has left industry veterans mortified and the public stunned. Many more cases are expected to be filed in coming months. The House and Senate this week will hold hearings on the spreading scandal.

Just as memories of the corporate frauds that began with Enron Corp. in 2001 may have begun to fade, the fund debacle is providing average investors with another reason to believe they can't get a fair shake from Wall Street.

In recent years, the fund industry had become used to criticism over its fees, portfolio performance and sales practices. But regulators now say they are uncovering outright fraud and cheating by fund executives, and a blatant disregard for what is supposed to be the hallmark of mutual fund management: that the client's interests rise above all others.

The crisis is virtually certain to lead to significant changes in the business -- possibly including the demise of one or more major firms, some experts say.

Regulators' principal focus has been on illegal or improper trading of fund shares either that fund companies allowed for favored investors or that fund managers engaged in for their personal accounts. In all cases, the trading had the potential to cut into the returns of long-term investors in the funds.

Worst May Not Be Over

It's far from clear that the worst is over: Of the 88 fund companies and brokerage firms queried by the Securities and Exchange Commission in its industrywide probe during the last two months, preliminary responses show that as many as half the fund firms have let at least one investor improperly engage in "market timing" of shares, meaning rapid buying and selling.

New York Atty. Gen. Eliot Spitzer fired the first salvo on Sept. 3 when he accused a hedge fund, Canary Capital Partners, of scheming with four mutual fund companies to make market-timing trades. He also charged Canary with "late trading," meaning that fund buy or sell orders were submitted after markets had closed for the day, yet Canary was given that day's closing prices.

"Timing and late trading are more widespread than anyone could have imagined and are causing injury to the tune of billions of dollars for individual investors," Spitzer said last week. "It has become increasingly clear that the mutual fund industry has failed to police itself."

Until last week, regulators had filed formal charges only against fund company individuals alleged to have broken the law -- a broker in Bank of America Corp.'s fund business, for example, and the fund unit chief at Fred Alger Management.

But the stakes for the industry were raised considerably on Tuesday, when the SEC and the state of Massachusetts filed civil securities fraud charges against Putnam Investments, the fifth-largest fund firm. Regulators alleged that Putnam allowed average investors to be cheated by failing to halt market-timing abuses, including by portfolio managers for their own enrichment and by some aggressive retirement account investors.

And on Thursday, Spitzer warned Strong Capital Management Inc. and its founder, Richard Strong, that they could face criminal fraud charges. Strong's independent directors issued a statement saying they had "become aware of active trading of the Strong Funds by employees including Richard Strong" and promised an investigation.

Boston-based Putnam has denied any wrongdoing. Yet by Friday, public pension funds in states including Iowa, Pennsylvania and Rhode Island had fired the firm as an asset manager, yanking billions of dollars.

That points up the serious risk for fund companies embroiled in the scandal, even if they proclaim innocence: They could undergo death by a thousand cuts as angry investors pull their money out.

Investor Susanna Munro, a 33-year-old accountant in Los Angeles, said she dumped her Janus Balanced fund recently after purchasing shares regularly since 1997. Janus Capital Group Inc. is one of the fund companies Canary Capital is alleged to have used for market timing.

"At the end of the day the trading scandal didn't cost me much money," Munro said, "but it's just the principle of it: A large institutional investor gets to trade after-hours or make special 'timing' trades and make even more money. That's not very equitable."

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