As the big Wall Street investment banks have already discovered to their cost, America’s fund managers are learning that once the regulators start scrutinising industry practices, one discovery tends to lead to another. When Eliot Spitzer, New York’s attorney-general, and William Galvin, Massachusetts’ state regulator, started to poke around the trading practices of the mutual fund industry, the big players reacted indignantly. But the scandal has spread quickly. On Monday November 3rd, Lawrence Lasser was ousted as chief executive of Putnam Investments following a probe into so-called “market-timing” (frequent trading to take advantage of old prices) at the Boston-based fund manager. The same day, officials from the Securities and Exchange Commission (SEC), America’s top securities regulator, told lawmakers in Washington that as many as one in ten top fund-management groups and more than a quarter of brokers may have allowed, or even encouraged, clients to engage in illegal “late trading”. The regulatory scrutiny is bound to lead to an overhaul of industry practices, including more transparency in fees and more of an arm’s length relationship between fund trustees and fund managers. This, in turn, is likely to reduce the industry’s fat profit margins.
Putnam’s Mr Lasser was one of the giants of America’s $7 trillion fund management industry. He was chief executive of Putnam for 18 years and had increased its funds under management sevenfold since 1990. He was best known for aggressively pushing high-growth funds, though under him Putnam struggled during the technology bust. In spite of this, Mr Lasser was one of the industry’s best-paid executives, collecting $130m over the past five years. Despite being pushed out, he may be in line for a further hefty pay-off — of close to $90m, according to some reports. Any settlement may depend on what happens to the charges against Putnam. Both federal and state regulators have accused the company of allowing clients and even managers to engage in market-timing, which Putnam prohibits, according to its prospectus. Two managers have been accused of fraud. Putnam denies wrongdoing. Nevertheless, investors have been withdrawing their money in the billions.
Mr Lasser is not the first casualty of the scandal, nor is he likely to be the last. Over the past few weeks, Bank of America has sacked the head of its mutual fund arm, and Alliance Capital and Prudential have fired staff after conducting their own probes. On Tuesday, the SEC brought fraud charges relating to market-timing trades against five former Prudential brokers and a branch manager. Two days earlier, Richard Strong, the founder and chairman of Strong Mutual Funds, had stepped down after investigators in Mr Spitzer’s office accused him of engaging in market-timing, generating profits of $600,000. However, Mr Strong has retained his role at Strong Capital Management, the firm responsible for the day-to-day management of Strong Funds. A spokesman for Mr Spitzer said Mr Strong’s resignation from the fund board alone was “inadequate”, adding that the investigation into Strong was “open and ongoing”.
According to testimony from the SEC on Capitol Hill on Monday, trading abuses go right across the industry. Stephen Cutler, the SEC’s enforcement director, said that more than 80% of fund managers allowed intermediaries to send orders in after the stockmarket shuts at 4pm New York time. Though not illegal, this does allow corrupt brokers to hide illegal late trades in a batch of otherwise legitimate trades. The advantage of late trading is that it allows select clients to trade at an old price, using the benefit of new information, at the expense of other shareholders. Mr Cutler said that almost a third of intermediaries “indicate that they assisted market-timers in some way”. Separately, the National Association of Securities Dealers revealed that investors had not received an estimated $86m of volume discounts to which they were entitled during 2001 and 2002. Regulators are planning to bring enforcement actions against some two dozen brokers for this overcharging.
There is no way that the industry will emerge unscathed from this regulatory scrutiny. Mr Spitzer, who extracted $1.4 billion from investment banks for alleged conflicts of interest between their research and banking arms, has said he intends to get fund managers to repay all fees earned in funds engaged in dubious trading practices. The SEC, which was made to look flat-footed by Mr Spitzer during the investment-banking probes, will not want to be left behind. Mr Cutler told lawmakers: “As my colleagues and I have gathered evidence of one betrayal after another, the feeling I’m left with is one of outrage.” But the SEC and Mr Spitzer differ in their prescriptions.
Mr Spitzer’s prescriptions address a problem highlighted by Warren Buffett, America’s best-known investor and a persistent critic of the mutual fund industry. In the 2002 annual report of his Berkshire Hathaway investment company, Mr Buffett declared: “…for the most part, a monkey will type out a Shakespeare play before an ‘ independent’ mutual fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance.” Mr Spitzer wants to see fund chairmen and boards who are truly independent of the company that manages the fund, and who will seek truly competing bids. And the fees charged would be properly disclosed.
The SEC is more concerned about trading abuses. Its proposals would aim to eliminate much of the incentive for market-timing by, for example, having fair valuation, so that prices do not go stale and thus cannot be manipulated as they are now. The SEC advocates a hard 4pm deadline, after which trading would take place at the next day’s price.
On Capitol Hill, Richard Baker, a Louisiana Republican, has been working for months on a bill that would impose a variety of onerous new requirements on the industry. Not surprisingly, this legislation has suddenly attracted lots of interest and may even be broadened. And America is not alone in seeking tougher regulation. In Britain, the government has hinted that it would like to see funds disclose their voting records. As any Wall Street investment banker will tell you, if you let abuses spread to the point where they are pretty much standard practice, regulators will inevitably go for the jugular when they find you out.