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Focus to Shift in Fund Probes

Regulators are turning attention from trading to sales practices, and the spotlight could move to West Coast firms.

June 07, 2004|Tom Petruno | Times Staff Writer

Round 1 of the mutual fund industry scandal, the storm over abusive trading practices, is coming to a close.

Round 2 is expected this summer and promises to pack more punch with small investors -- because it will focus on whether the industry and major brokerages have been in unholy alliances to push certain funds.

For state and federal regulators, the new legal cases they are pursuing are likely to involve alleged industry wrongdoing that is more complicated, and harder to prove, than the accusations of market timing and other improper trading that have been in the headlines for the last nine months.

Round 2 also may see the spotlight shift from East Coast fund companies to West Coast giants, including Los Angeles-based Capital Group Cos., which manages the American Funds, and San Mateo, Calif.-based Franklin Resources Inc., which manages funds under the Franklin and Templeton brand names.

California Atty. Gen. Bill Lockyer this year launched an intensive investigation of sales practices at Capital Group, Franklin and at Newport Beach-based bond titan Pacific Investment Management Co., the Allianz subsidiary known as Pimco. Lockyer is looking broadly at the issue of "pay to play," or payments fund companies gave brokers to tout their products.

The Securities and Exchange Commission also is focusing significant resources on pay-to-play investigations, say people familiar with the probes.

Since September, when New York Atty. Gen. Eliot Spitzer stunned the $7.5-trillion fund industry with the first allegations of widespread wrongdoing, the primary focus has been on improper trading of fund shares by some clients at the expense of average investors.

One major charge was that favored clients were allowed to engage in market timing, or in-and-out trades that attempted to profit from short-term market moves. Such trading can constitute fraud if fund companies permitted some investors to do it, perhaps in return for other fee-producing business, in violation of their own fund policies.

Spitzer has settled abusive-trading charges with East Coast fund companies Alliance Capital Management Holding, Bank of America Corp. and Massachusetts Financial Services Co., as well as with Denver-based Janus Capital Group Inc. and Strong Capital Management Co. in Menomonee Falls, Wis. The SEC also was a party to those settlements.

Last week, New Jersey Atty. Gen. Peter C. Harvey settled an improper-trading suit his office had brought against Pimco and its sister firm PEA Capital in New York.

PEA Capital agreed to pay $18 million to New Jersey without admitting wrongdoing. But Harvey dropped the charges against Pimco.

Although some trading cases remain to be settled, fund executives and industry regulators say that phase of the scandal is winding down and isn't expected to produce dramatic new revelations.

Among individual investors, the trading abuses have sparked outrage, but actual dollar losses often have been hard to peg.

The upcoming legal action against the industry may be more likely to strike a nerve with average investors, because it may call into question why a broker or other financial advisor sold them a particular fund.

"We made a decision that we would focus on pay-to-play because we thought it had a broader impact on investors," said Tom Dresslar, a spokesman for Lockyer in Sacramento.

In Round 2, state and federal regulators are expected to try to show that many fund companies have had special sales arrangements with brokerages that weren't fully or properly disclosed to investors.

Those arrangements had the potential to cause brokers to sell clients funds that weren't necessarily in the investors' best interest, fund industry critics say. Instead, some brokers may simply have favored the funds that provided the biggest kickbacks to their firms, critics say.

The agreements, known as revenue sharing, typically have involved either direct financial payments from fund companies to brokerages or compensation in the form of stock or bond trading business that generated commissions for the brokerages. The deals have become increasingly common in the last decade.

In defending the practice, some fund and brokerage industry executives have made an analogy to payments that consumer-product companies make to retailers for premier shelf space. They also have said the payments help support the cost of educating brokers about the merits of particular funds.

But critics say the arrangements mean there is severe conflict-of-interest risk in brokers' sales of funds -- and that major fund companies have sought to obscure the arrangements to avoid a backlash.

"Does a fund have to tell you that they are paying off somebody who is ostensibly giving you objective advice? I think so," said Mercer Bullard, head of investor advocacy group Fund Democracy Inc. in Oxford, Miss.

For regulators, proving fraudulent behavior by fund companies in pay-to-play cases is no slam-dunk.

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