Mutual Fund Companies Slow to Respond to Crisis
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Holmes Report

Mutual Fund Companies Slow to Respond to Crisis

There has been little sign of leadership from the industry. The companies under fire appear to have been in reactive mode; those not yet tainted by the scandal appear to believe that keeping their heads down is the best approach.

Paul Holmes

It started, as these things often do, with an announcement by New York attorney general Elliot Spitzer.

In September, Spitzer charged that several mutual-fund firms allowed a hedge fund to book millions of dollars in profits at other clients’ expense through improper trades. Canary Capital Partners, a fund led by Edward Stern, agreed to pay $40 million to settle charges, although it did not admit or deny wrongdoing.

That triggered an investigation by the Securities & Exchange Commission and by several states, and the scandal widened. Bank of America fired several employees for their role in the Canary Capital incident, and Bank One announced an internal probe after learning that employees may have helped Canary “market time” trades.

(Market timing is one of the abuses brought to light by the probe. Investors make rapid trades of mutual-fund shares, which depletes other shareholders’ returns. Though the practice is not in itself illegal, most fund firms have policies in place to discourage timing. The other problem is late trading, which occurs when an investor buys fund shares at a given day’s price after the close. Late trading is illegal because it allows the trader to profit from information not available to others.)

The scandal has since engulfed some of the biggest names in the mutual fund industry. Janus Capital fired several employees who believed there was nothing wrong with market timing, and accepted the resignation of a senior executive who had authorized rapid trading. Charles Schwab says an in-house investigation found evidence of market timing and possibly also late trading. And Putnam Investments became the first mutual fund firm charges in the scandal, settling with the SEC over rapid trading, although Spitzer’s office continues its own investigation into the firm.

In the past week, Congress has announced plans to introduce legislation that could increase the criminal penalties associated with the abuses, and force increased disclosure; the cofounders of Pilgrim Baxter were accused of civil fraud and breach of their fiduciary responsibility; and Wal-Mart became the latest large company to announce it was dropping one of the tainted funds from its 401(k) plan, severing all ties with Putnam. 

To many observers, the crisis appears to be spinning out of control.

“The pervading perception stemming from news coverage of latest scandals is that mutual funds are no longer a trustworthy place for individual investors,” says Ed Orgon, president of financial communications specialist The Torrenzano Group. “The industry and individual companies are not taking control of how they are perceived—the first rule of communications during times of crisis or significant challenges.”

Says Larry Kamer, who heads the crisis and issues management practice at Manning Selvage & Lee, “What is peculiar about this scandal is the deafening silence from the mutual funds community that a problem genuinely exists, that it may exist within their firms because it was so widespread, and that the authorities are looking into this problem for a reason.”

There has been little sign of leadership from the industry. The companies under fire appear to have been in reactive mode; those not yet tainted by the scandal appear to believe that keeping their heads down is the best approach.

“While we haven’t seen anyone proactively take a leadership role on this issue, it’s clear that some firms have handled the charges better than others,” says Hollis Rafkin-Sax, vice chairman of Financial Dynamics U.S. “As soon as it became apparent that market timing and late trading were widespread infractions, not limited to ‘ a few bad apples’, no firm was willing to put themselves on the line for fear that something would be uncovered.

“Understandably, no one wanted to definitively state that there were no abuses at their firm or in their funds, but most could and should have loudly pledged their continued commitment to investors for fair and equal treatment. Any issues or malpractices later discovered should be addressed accordingly and in keeping with stated policies.”

Most communications specialists, and some astute industry observers, see the need for a more aggressive response.

“Don’t confuse the sum of money involved with the seriousness of the issue,” says Don Phillips, managing director at investment research firm Morningstar. “It isn’t the amount taken from investors, but the breach of fiduciary responsibility that’s at the heart of these scandals. On this score, there can be no gray area. Your people were either acting in shareholders’ best interests or they weren’t.

“If not, it doesn’t matter how valuable the employees have been in building your firm—they have to go. The money management business is built on trust; it’s by far the most valuable asset your firm has. A money management shop can survive the departure of even the most talented employees, but it can never withstand a soiled reputation.”

So several firms, including Janus, which brought in a former SEC division director to review its practices, have launched their own investigations.

“In general it does appear that the industry and individual funds have been slow to respond, with many being completely reactive up to this point,” says Rick Nelson, managing director at Cleveland-based Dix & Eaton. “However, some funds are not waiting for the regulators to swoop down on them and are stepping forward by announcing the results of their own proactive internal investigations and follow up actions. That is something more funds should and are likely to be doing.”

Public relations experts are divided on where the leadership is coming from.

“There is no leader per se of the $7 trillion mutual fund industry, says Orgon. “To date, only Merrill Lynch CEO Stan O’Neal has stepped forward to define the core issue as ‘trust’ and his firm has been quick to investigate improper activity and discipline or dismiss employees who violate its policies.”

Kamer says a review of mutual fund company websites indicates that they “will acknowledge that the New York attorney general or the SEC are looking into a problem, or that they have been asked to provide information, but I don’t see a lot of them saying ‘we have a real problem in this industry, and, even though it is isolated, we are going to deal with it, government investigation or not.’

“I think the leadership test here is a simple one: which companies are disclosing information that no one is forcing them to disclose or taking action that no one is forcing them to take? Look for the managers and boards that are seeking to get out in front of the problem and not simply respond to long-overdue demands. Most of the communication that we’ve seen over the past few weeks is the result of a legal gun pointed at the head of mutual fund companies.”

One exception, he says, is Charles Schwab. He points to letter from CEO David Pottruck to the firm’s employees, sent on November 16 and posted the next day to the company’s website.

“It’s a simple and clear explanation of the problem. It explains that Schwab looked into it, and indeed, found isolated cases of wrongdoing. It then discusses them. It provides some perspective on the relatively small number of incidents. Then it closes on a note of core values. I’ve reviewed a lot of fund and financial institution web sites. None of them talk about the company’s ‘moral compass.’ And certainly none set the Pottruck standard: ‘Our oversight systems cannot be content with 99.99 percent. We need perfection.’”

But even Pottruck’s statement won’t appease the industry’s critics, since it appears to ascribe late trading to an excess of zeal for customer service: “We believe that our culture—with so much emphasis on client service—could have influenced our employees in doing these substitutions since none of our employees earn commission payments on these trades. But let’s be absolutely clear, client service cannot be an excuse for not following industry regulations.”

Lewis Sanders, chief executive officer of Alliance Capital Management, is another industry leader to take a stand. “The particular practices that are under scrutiny by the authorities were inconsistent with the reputation and traditions of our firm,” he says. “But those practices occurred nonetheless and some of our mutual fund clients were hurt; we did not live up to our obligation to protect them. Such conduct has no place at Alliance Capital.

“We are moving swiftly to correct these flaws, but such steps are just the beginning of what must be done. Our retail mutual fund business must be restructured, repositioned, and its culture remade entirely.
All with just one goal in mind: To restore trust in our firm, an imperative in this business. It is earned by an unswerving commitment to putting clients’ interests above all else in every situation; by ensuring that fair and equitable treatment of all clients remains an inviolate principle; and most fundamentally, by providing sound investment advice, even if that means, at times, not being in sync with the fashions of the moment.”

It is unlikely, however, that the industry will be allowed to police itself. Already, the calls for stricter regulatory oversight are growing louder. 

“Expect more hearings on Capital Hill and a long round of investigations, allegations, potential prosecutions and mega-buck settlements as this crisis continues to unwind,” says Orgon. “We are already seeing regulatory and legislative reaction. The House passed its version of a bill on mutual fund reform and the SEC has announced a December 3 meeting to consider new fund trading rules.”

One issue that complicates things is the role of the crusading Spitzer, empowered by the fact that the SEC was not doing its job. Not for the first time, Spitzer has upstaged Congress and the SEC, say Rafkin-Sax and her Financial Dynamics colleague, Gordon McCoun, and legislators and regulators are perceived as having fallen asleep at the switch.

“Given that the fund industry has demonstrated a total inability or willingness to police itself, regulators must appear to take steps to restore confidence in the financial system. What perhaps is negotiable is the extent and reach of the regulation finally adopted. If firms, or better still an industry coalition was willing to step forward and proactively raise the bar on disclosure, transparency, governance, and oversight, some argue that may temper the harshness of the eventual regulations.”

If the legislative reaction to the corporate scandals of two years ago is any indication, the reaction to this scandal is likely to be both swift and ill-considered.

“In this environment, and given the other corporate and Wall Street scandals, legislative and regulatory action is a guarantee,” says Nelson. “However, as with any politicized situation, there is likely to be an over reaction and overkill for the magnitude of the actual problem. Certainly some trading activities will be restricted, additional disclosure will be required and improved corporate governance requirement will be imposed on fund management and their boards.”

Although stricter oversight seems inevitable, it seems likely that there will be winners and losers in the mutual fund industry. Indeed, many clients are already shifting investments out of funds tainted by scandal and into other funds—even though such shifts result in additional fees (which may themselves be subject to Spitzer’s scrutiny if tainted firms make money off fleeing customers).

“Some investors, reacting in a knee-jerk fashion, will switch or desert mutual funds,” says Nelson. Although he warns, “This will come at a transaction and opportunity cost to the investor.”

Putnam has lost $21 billion in assets since being named in an SEC investigation last month, and Spitzer is calling for complete disgorgement of all fees earned during the time in which improper behavior took place in a fund. But the cost of disgorgement may be minor next to the potential cost of class-action suits, Phillips warns.

But it seems clear that investors will keep most of their money in the market.

“It is interesting to note that the mutual fund scandals have not broken investor’s psychology,” says Rafkin-Sax. “While investors are fleeing tainted funds, especially public sector pension and retirement funds, they are not pulling out of the market altogether.” In fact according to a recent CIBC report, there was a net flow of money into equity funds over the past five weeks. Says Rafkin-Sax, “What we are seeing is a reshuffling of the deck and jockeying among the funds.”

Among the big potential winners are the socially responsible investment funds, which have not been accused of any wrong-doing.

 “I am not aware of any SRI firms that have been implicated of late trading or market timing, “ said Tim Smith, president of the Social Investment. SRI mutual funds tend to take long positions through buy-and-hold strategies, which distances them from the vagaries of short-term trading schemes. And Smith says the SRI community’s insulation from the scandal may stem in part from its ethical underpinnings.

“This situation has provided them with an opportunity to speak to one of their core values as a community and, in so doing, perhaps take a whack at those who view these funds as marginal or ‘not serious,’” says Kamer.

Other companies will need to take dramatic steps to improve their governance practices.

“An internal compliance officer, a stronger fund board, a corporate ombudsman are all worth considering,” says Phillips. “As you make these changes, you need to communicate openly and honestly with shareholders, regulators, and staff. Don’t hide from the media; you need to show investors that you take these issues seriously and are taking bold actions to address them. Treat your fund shareholders like business partners. Tell them fully what happened, what steps have been taken to correct the situation, and what steps will be taken to ensure this will never happen again.”

According to Rafkin-Sax, “The recent crises have hinged on two fundamental issues: conflicts of interest and the lack of a level playing field. It’s not easy to change that dynamic but the redress demanded by clients, investors, employees, business partners, and regulators will be greater disclosure of policies and practices and a renewed commitment and demonstration of fair and equitable treatment of all investors.”

Rafkin-Sax says mutual fund companies need to:
· Engage in a vulnerability audit to uncover any abuses, or discrepancies between stated policies and existing practices.
· Establish the necessary checks and balances to prevent a future occurrence or the appearance of such and publicly articulate actions taken to vet policies, review compliance and strengthen procedures
· Consider a third party review of their governance structure—boards, charters, processes, policies and practices
· Communicate management’s concern and level of seriousness to all key stakeholders on a real time basis

“They need to take charge of the issue,” says Orgon. “New leaders must emerge who will squarely address the issues raised and embrace the changes needed to restore investor faith in the mutual fund industry. Make no mistake, this is an industry-wide problem and trust must be rebuilt over time. Performance and a commitment to frequent, and consistently forthright communications are the only cure. This cannot be a transaction. One set of actions won’t fix it.”

Says Nelson, “Each fund should quickly perform appropriate internal reviews of their policies and whether or not those policies have been adhered to. Then they should proactively communicate the results of such studies. That investigation would then naturally lead to the opportunity to reiterate and/or establish appropriate investor-sensitive policies and procedures.”

In addition, there are significant opportunities in the area of board make-up, governance and
oversight, he says. “Though the mutual fund industry organizations could and should play a major role in getting out in front of the issues, each individual fund family also needs to act to protect its own reputation
and credibility.”

At the same time, Orgon says, the industry “should not be defensive about making money. They are entitled. However, they should clearly communicate to their investors how their funds work, how they are compensated, and how safeguard they have put in place protect their specific investors and the investing public in general.”

Ultimately, however, it comes down to values.

“The key to repairing frayed relationships and broken trust is an acknowledgement that all roads lead to core values,” says Kamer. “The values upon which this industry is based—that is, empowering and looking out for the individual investor—have been shaken. Moving forward, the leadership vacuum is going to be filled by companies that speak directly to core values.”

The most important question, Phillips says, is: “What was it about your firm’s culture that allowed this to happen? Do you hire the right kind of people? Do they have the right values? Don’t confuse greed with talent. Top professionals are motivated by the ability to do great work and be part of something bigger than themselves. The best money management firms have a deep-rooted sense of purpose. Have you created a firm with a purpose or have you merely gathered a lot of highly compensated stock jockeys?”

But to convince the investing public that its stated values are meaningful, the industry needs to go beyond mealy-mouthed statements about compliance.

“Now is not the time to settle for communications that stops at explaining how the company in question is cooperating with government investigators,” says Kamer, who believes much of the industry’s public relations efforts to this point have stressed compliance. “Smart investors, employees, and other stakeholders know that these companies don’t have a choice. No one ever puts out a statement that says, ‘No, we’re not cooperating.’ Cooperation with a legal mandate is no substitute for leadership and it does not go very far in reassuring stakeholders that the company is committed to responsible behavior moving forward.”

The scandal is not the death-knell for the industry, but it is a wake-up call.

“In the long run, investor confidence can be soothed or restored,” Nelson says. “The combination of thoughtful regulation and legislation—if that is possible—and proactive and constructive fund family and industry actions and communications should go a long way to restoring confidence.”

“Finally,” says Orgon, “an up market will do wonders to restore confidence. Regardless of market conditions, however, investors need to be informed on the steps funds intend to make to ensure that their investments are judiciously safeguarded, and educate them on the benefits and quality of the individual funds and the people who manage them.”


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