Sep. 12–Investor confidence is an early victim of New York Attorney General Eliot Spitzer’s mutual fund investigation which shows that money talks even in Everyman’s investing vehicle.
The fraud probe, disclosed by Spitzer last week, will drive more investors to use independent investment advisers instead of dealing directly with mutual funds, which were created for the ordinary investor.
There are other shoes to drop in the investigation, as well. Mutual funds and transaction processors, many of them in the Philadelphia area, are likely to spend more time and money screening trades.
Spitzer’s probe also could spark more fundamental changes as prosecutors investigate who in the fund industry knew about illegal transactions and when they knew it. The heart of the investigation involves trading in mutual fund shares by a favored customer at prices and times not available to small investors.
In a complaint filed Sept. 3, Spitzer alleges that brokerage firms and fund companies allowed Canary Capital Partners L.L.C., an unregulated investment fund for wealthy clients, to complete investing transactions after the market closed. Spitzer called it the equivalent of placing bets after the horses crossed the finish line.
“There will be greater focus on activities that make sure that trades pass the smell test,” said Geoff Bobroff, a consultant in East Greenwich, RI.
That examination will spread the impact to less visible players in the mutual fund industry. SEI Investments Co., Oaks, Montgomery County, keeps records for financial planners, for example. PFPC, a Wilmington subsidiary of PNC Financial Services Group, keeps records for mutual fund companies.
Both companies say they screen trades for abuses of the kind alleged by Spitzer, and that they have not been subpoenaed.
Vanguard Group, the nation’s second-largest fund company, has the local spotlight for the moment. Spitzer has subpoenaed documents and information from the Malvern fund giant, which enjoys a reputation of fair dealing.
Subpoenas do not indicate wrongdoing, and Vanguard has not been accused by Spitzer. “Certainly, if Vanguard were implicated, that would shake everything,” said Gary Shatsky, a New York financial planner.
Investor confidence has been rocked repeatedly by abusive mutual fund sales practices, said Shatsky.
“People are being rudely awakened and rewakened,” he said. “That’s why independent advisers, and fee-only advisers in particular, are finding their phones ringing.” He advocates charging flat fees for financial advice rather than commissions, which rise with increased trading activity.
Direct sales by mutual fund companies dropped to 13 percent of all fund trading in 2002, down from 23 percent in 1990, according the Investment Company Institute, the fund trade group, in part because investors want independent advice.
Vanguard is the exception. It describes itself as “primarily” engaged in direct sales to investors while declining to give figures.
In earlier investigations, the Securities and Exchange Commission alleged that brokerage firms sold expensive classes of mutual fund shares without disclosing that the fund company offered discounted commissions on others.
Meanwhile, Spitzer and his counterpart in Massachusetts allege that brokerage firms paid incentives to sales representatives to push certain funds.
In the latest probe, Spitzer alleges that brokerages helped Canary, a New Jersey hedge fund, to make trades that the mutual fund said were prohibited in its disclosures to investors.
The question of whether the fund company is culpable depends on the circumstances, said Allan Mostoff, a securities lawyer at Dechert LLP in Washington. Regulators would frown if a fund company said one thing in its prospectus but didn’t enforce its policies, he said.
To assess their legal exposure, fund companies also are reexamining sales relationships that increasingly cede control to the outside representatives.
In many cases, investment advisers, trust companies, retirement plan administrators and brokerages take over record-keeping functions from the fund company. After matching buy and sell orders from their own clients, these firms, which stand between the investor and the fund company, present a single combined buy or sell order to the fund company to balance their books. These aggregated orders limit the fund company’s ability to monitor trades.
“There are transparency problems,” said Arthur Gabinet, head of the SEC office in Philadelphia. “Spitzer has uncorked a bottle we’ll be drinking from for a long time.”
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SEIC, PNC,
