The Scandal That Walked in the Front Door

Sigh ... yet another fund scandal.

The latest is a growing scandal around kickbacks paid to fund companies by  Bisys , a third party that provides a wide range of mutual fund back-office services, such as accounting, shareholder report production, and transfer-agency services. Bisys settled charges with the SEC, but The Wall Street Journal reported that the SEC has now turned its attention to 27 mutual fund companies that may have accepted kickbacks. At this point, we don't know how many, if any, of those fund companies will actually face charges from the SEC.

Regulators say that the way the kickbacks worked is that Bisys would overcharge fund investors for its services and then kickback to the fund company money that rightly belonged to fund investors. Similar to other fund scandals such as market-timing, late trading, front running, and overcharging for transfer-agency fees, the amounts involved were small when viewed in terms of their effect on individual shareholders, but hefty when summed up. In this case Bisys paid $230 million in kickbacks from 1999 through June 2004, according to the SEC.

In addition, another service provider,  SEI Investments (SEIC), disclosed in its 10-Q filing that the SEC is investigating it for similar-sounding practices: "We have responded and are currently responding to various regulatory examinations, inquiries and requests. One of these regulatory requests and inquiries relate to the payment by certain of our subsidiaries of expenses related to the marketing and distribution of shares of certain mutual fund clients of our fund administration and distribution business. As a result of these examinations, inquiries and requests, we are generally implementing changes and reviewing our compliance procedures and business operations. These activities resulted in an increased level of general and administrative costs."

How'd they get away with it? Well, it appears that independent directors were kept in the dark on the matter. Perhaps inside directors knew about it but didn't share that information with independent directors. Or maybe Bisys kept the board in the dark. After all, one of Bisys' services is providing the chief compliance officer to a fund board. Talk about conflict of interest.

Regardless of who knew about the Bisys kickbacks, fund companies clearly violated their fiduciary duty to fundholders by pocketing money that belonged to them. Some of the market-timing was in a gray area, but this was not.

So far the SEC has not named the fund companies involved, but The Wall Street Journal wrote that  AmSouth Bancorporation  is the Adviser A named in documents. Adviser A allegedly demanded millions in kickbacks in return for the contracts. In 2005, AmSouth received word that it was being investigated and shortly thereafter it sold its funds to Pioneer. Pioneer reports that only a few salespeople and a bond-fund manager were retained in the acquisition, so we don't believe that the AmSouth executives behind the deal are now at Pioneer.

We have found language similar to AmSouth's disclosure in filings from Pacific Capital Funds advised by the Bank of Hawaii: "In addition, the Funds' administrator, BISYS Fund Services Ohio, Inc., is currently the subject of an SEC investigation related to its past payment of certain marketing and other expenses with respect to certain of its mutual fund clients, including the Funds. Based on management's review and consideration of the matter to date, management does not believe the Funds' financial statements would be adversely impacted as a result of this investigation."

In addition, BNY Hamilton Funds (of Bank of New York) disclosed this: "One of these investigations, by the U.S. Securities and Exchange Commission ("SEC"), concerns the relationship between: (1) the BNY Hamilton Funds, Inc., a family of mutual funds; (2) the Company, which acts as the investment adviser to the Hamilton Funds and provides certain other services; and (3) a third-party service provider that acts as administrator and principal underwriter of the Hamilton Funds. This investigation principally concerns the appropriateness of certain expenditures made in connection with marketing and distribution of the Hamilton Funds."

Time to Clean House
In the market-timing scandal, we saw a wide range of fund employees involved. In some cases, hedge funds hoodwinked lower-level employees into allowing timing, while in others, top brass was up to their ears in the scandal. In this case, though, it seems quite likely that these deals must have been cut by mid- to high-level employees. Making matters worse, it was from a service provider that walked in the front door right to the executive suite.

Those who signed off on kickbacks were knowingly violating their fiduciary duty to fund shareholders, so we urge the SEC, the fund companies involved, and fund boards to ensure that none of those people remain employed at the fund company--especially any inside directors who knew but kept mum about it.

More Transparency Needed
Mutual fund boards are set up to be the arbiters of fund contracts because of the obvious conflicts involved when fund companies negotiate fund service contracts. Yet this case and the case of Smith Barney--where transfer-agent fees were marked up but hidden from directors--illustrate the point that independent directors are not getting enough information.

They should be privy to all discussions about key contracts rather than have the fund company sort things out and hand the whole package into the board for a thumbs up or thumbs down. The board needs to hear from service providers what they're offering and open up the process to additional bidders to make sure they are getting the best deal for fundholders.

I don't know if it should fall to the chief compliance officer or not, but someone needs to be charged with delivering all the information on service contacts to fund boards so that they can make an informed decision.

What It Means for Investors
The good news is that you aren't losing any money to these deals today. Moreover, if your fund was part of the kickbacks, your fund's expense ratio was presumably reported accurately. It's just that it was higher than it should have been.

Initial indications are that most of the affected fund companies were smaller, often bank-run, funds, so this scandal appears likely to have affected fewer investors than the timing scandal. However, we can't be sure this won't open up new lines of investigation at other service providers.

In our Stewardship Grades we keep tabs on fund-board performance, fund culture, and a number of other important measures of stewardship that can affect your bottom line. We will update our Stewardship Grades for each fund when any important developments occur. In the case of under-the-table kickbacks, it's unlikely that there would be a sign for us to spot, but funds that have a range of stewardship problems are certainly more likely to get caught in a scandal such as this.

A Broader Issue on Costs
I've written a number of times about how the fund industry has grown sevenfold over the past 20 years yet expense ratios have barely fallen at all. Given the tremendous productivity improvements that technological advances have brought the rest of the world, it makes me wonder where fundholders' economies of scale are.

Here's an illustration of how fund companies have kept those efficiencies to themselves. You have a service provider set to slash its fee by 75%, but the fund company decides to keep paying the old rate and make the service provider kickback the markup to it. There are legal ways to do this, too, such as keeping service functions in-house and marking up the prices a lot so that service areas become huge hidden profit centers.

This is why the industry needs greater transparency of fees. Then fund companies can compete in the open for a fair profit rather than building up a bunch of hidden profit centers to make exorbitant gains at fundholders' expense. As it is, lots of different fees can be bundled into management and transfer-agency fee disclosure so that outsiders can't make an apples-to-apples comparison.