Scandal Sullies Franklin Templeton's Reputation

Like a teacher who catches a good student passing exam answers to a classmate, we're very disappointed with Franklin Templeton Investments.

The firm has been implicated in the ever-widening mutual fund trading scandal. Its transgressions do not seem to rise to the level of malfeasance we have seen at other firms and do not warrant action on the part of current or prospective shareholders. Still, the allegations sully the record of what has been a reputable and responsible fund family.

The Situation
The allegations are surprising. Massachusetts securities regulators say Franklin let Las Vegas hedge fund manger Daniel Calugar market-time the  Franklin Small-Mid Cap Growth Fund (FRSGX) in return for a $10 million investment in a Franklin-sponsored fund of hedge funds. Franklin never disclosed the arrangement, which violated prospectus language barring frequent trading in the fund, according to the complaint.

But that's not all. Franklin also disclosed in late 2003 that some current and former employees--two of whom have been placed on leave--had made questionable trades in their 401(k) accounts. The Securities and Exchange Commission also could file its own market-timing charges against the firm, and state and federal authorities are investigating the complex's distribution and sales practices.

Franklin stands accused of disconcerting behavior, but based on what we know so far, its actions were not as egregious as those of other families caught up in the controversy. Invesco Funds allowed rapid trading in at least 10 of its funds, even though compliance officers and portfolio managers said the rapid trading hurt shareholders. Timing money at times accounted for up to $1 billion of Invesco's assets, according to state and federal complaints. At the peak of their activity at AllianceBernstein, market-timers had more than $600 million in a number of the family's funds.

Franklin's Response
Meanwhile Franklin points out that the trading activity was limited to three round-trip trades of $20 million in one fund in the fall of 2001 and that the firm never made a concerted effort to solicit money from market-timers besides Calugar. Indeed, the family claims to have rejected roughly $3 billion in timing money since 2000, when it first began toughening its market-timing stance. The firm also contends its agreement with Calugar did not harm shareholders because the amount traded was a fraction of the Small-Mid Growth Fund's total assets and cash position, and Calugar lost $700,000 on his trades.

There is evidence that top executives, including members of the Johnson family that founded Franklin and control much of the company's stock, knew of the timing arrangement. Franklin argues, however, that current co-CEO Greg Johnson rejected Calugar's request for additional market-timing capacity in exchange for bigger hedge fund investments. Franklin also disciplined William Post, the executive who cut the timing deal with Calugar. (Post was put on administrative leave in December 2003, and he resigned before the end of the month.) The firm also has embarked on a series of reforms. It has tightened its prospectus language and practices regarding market-timing, imposed redemption fees on all its funds, and stopped using trading commissions to pay broker/dealers for fund distribution.

Our Take
Allowing Calugar market-timing capacity in one Franklin fund while he invested in one of the firm's hedge funds was a bad decision, regardless of whether Calugar made money or not. If nothing else, the appearance of a conflict of interest and the potential of harm to Small-Mid Cap Growth shareholders should have set off alarm bells.

It is encouraging, though, that Franklin's timing relationship with Calugar was short (he stopped trading the Small-Mid Growth fund about a month after he started in September 2001 and withdrew from the hedge fund about a year later) and that the family did not let it get out of control. It's also reassuring that Franklin has promised to repay shareholders for any harm done, is in settlement talks with state and federal authorities, and has gotten tougher on market-timers.

Until it became mired in the trading imbroglio, we had no major problems with Franklin. It doesn't have a reputation for rolling out trendy funds. Nearly all of the family's stock and bond funds have expense ratios below the average for their respective categories, or at least below other broker-sold funds. Managers with above-average tenure run most of Franklin's portfolios. Most of the firm's funds employ sober investing styles that make them no more volatile, as measured by standard deviation, and no less tax efficient than their peers. A majority of Franklin funds rank in the top half of their respective categories over the trailing one-, three-, five-, and 10-year periods ending in January. And the firm also is home to many skilled investors, such as  Mutual Shares (MUTHX) manager David Winters. In short, Morningstar historically has thought well of Franklin, which is reflected in the fact that three of its funds are among our  Analyst Picks and none of them are pans.

Franklin is not out of hot water yet, and the charges leveled against the firm so far certainly detract from its overall appeal. Nevertheless, while there is cause to be wary of Franklin, we don't think investors should reject the firm's offerings out of hand because of its involvement in the fund-industry scandal.