Unfinished Business from the Fund Scandal

It has been 17 months since Eliot Spitzer turned the fund industry on its head by announcing he had found evidence of market-timing and late trading in mutual funds by hedge fund Canary Capital. So now, let's take a step back and see where we stand.

In some ways, it's surprising to see the extent of what's still left to do, yet in other ways, it's remarkable how much this scandal has transformed the industry. Some fund companies are changing dramatically for the better, as they rediscover their shareholders and recommit themselves to ethical behavior. Firms including Putnam and AllianceBernstein are very different places because they've taken a number of shareholder-friendly steps, including cutting fees.  In addition, the Securities and Exchange Commission has introduced some important new disclosure rules, including a requirement that managers divulge their own investments in the funds they oversee as well as their bonus structure. Additionally, the SEC has mandated an increase in a fund's required percentage of independent directors to 75%, and the SEC and National Association of Securities Dealers are conducting a cleanup of some bad sales practices, such as directed brokerage, which is now banned.

Although Spitzer can't make rules, he too has forced some important changes, including the removal of some of the worst offenders from the business and big fee cuts that will last well after most of us have forgotten about Canary.

But despite these meaningful strides, there's some important business left to wrap up on a few fronts.

Settlement Issues
By now many fund companies entangled in the scandal have reached agreements with regulators on settlements that will compensate shareholders for losses due to market-timing and/or late trading. However, I'm not aware of a single dollar that has been paid as part of these settlements. It's not that fund companies are dragging their feet. It's just extremely difficult to figure out how to track down and accurately compensate all the affected investors.

For example, assume a market-timing deal went on for 12 months. In that case, you'd have to assess how much damage was done over that period and the exact dates it happened. And it gets even more complicated to assess the impact of that market-timing on an individual-investor basis, because fundholders are buying or selling the fund every day. On top of that, it's a bear to track down all of the affected shareholders because so many invested through omnibus accounts in which brokerages simply collect the money of all their clients in the fund and send the net inflow to the fund company at the end of the day without specifying who the individual shareholders are. Further, many companies don't keep such detailed records that they can say precisely who in their 401(k) plan would have owned the XYZ Fund over a certain period.

Most likely we'll see some payouts this year as independent consultants complete their studies and submit recommendations to the SEC on how to make the payments.

On the plus side, nearly all the expense ratio cuts that fund companies agreed to have taken effect and are providing real benefits to those still in the funds.

Fund Companies Still on the Hot Seat
A surprisingly large number of companies caught up in the scandal have not yet reached final settlements with regulators. Heartland is perhaps the only fund company known to be fighting its charges, so it seems that most of the remainder are waiting for regulators to make time for them, although it's tough to be sure from the outside. It's also possible that regulators will not require settlements from all of those whose names have popped up because the regulators don't consider their transgressions serious enough or the evidence may not be strong enough.

Remarkably, Nations Funds, one of the firms that set all this in motion because of its late-trading and market-timing activities in association with Canary Capital, has not yet reached a final settlement. Nations and Columbia reached a preliminary settlement just before their parent companies merged in the summer of 2004, but it still hasn't been finalized. Moreover, Evergreen, Scudder, Federated, ING, Alger, Excelsior, and Seligman also have yet to settle.

Big Issues Remain for the SEC
In addition to a host of outstanding settlements, regulators have yet to finalize regulations that would definitively wipe out the late trading and market-timing that were at the heart of the fund scandal. The best defense against late trading is a hard close that bars trades that haven't reached fund companies by the close of trading on the New York Stock Exchange. The best way to inhibit market-timing is to assess redemption fees for short-term trading. The SEC has proposed both measures but is still wrangling with the financial-services industry over their adoption. A big force pushing against these remedies are brokerages, which don't want to have to update their fund-trading technology to be comparable with their stock-trading technology. However, Fidelity is pushing firms to enforce its own redemption fees in the meantime.

Although not central to the scandal, the SEC also ought to continue to focus more on conflicts of interest on the sales side of funds. Revenue sharing at both full-service and discount brokers has choked off competition on price. If this practice were banned, funds would compete on a level playing field, and they'd have more room to cut expenses because they wouldn't be loaded down with big 12b-1 fees. Furthermore, 12b-1 fees in general are a topic worth revisiting, as they are used in a way that is quite different from their intended purpose.

Moreover, the examination of sales practices has highlighted the fact that brokers are treated like fiduciaries in some regards but not in others. It may be time for the SEC to wade into this and decide whether they are or are not, and adjust some rules for consistency.