Mutual funds--the next big thing.

The next big issue Congress will tackle in 2004 will be mutual fund abuses. By now, you have seen daily news stories about "market timing" and "late trading" abuses at brokerage firms and mutual funds, and the response from regulators and industry regarding the need for reforms. Congress is also looking into mutual fund abuses, and several bills have been introduced, but time is running out for this Congressional session.

At issue are charges of market timing (short-term trading to take advantage of prices on foreign markets) and late trading (allowing a trade to be processed after the day's 4 p.m. deadline for trades).

Market timing may not be illegal, but it is certainly unethical, because it hurts long-term shareholders; as a result, the practice is discouraged by most funds. However, allegations have been made that some brokerages and mutual funds have publicly stated that they discourage market timing, but then have turned around and actually assisted larger clients, including hedge funds, time the markets. This activity may rise to the level of illegality.

Late trading, however, clearly is illegal. Late trading occurs when a mutual fund manager allows a trader to buy or sell shares of the fund at the 4 p.m. closing price, at say 7 p.m., instead of at the next day's closing price. If a major stock-moving event occurs after the close of trading, the late trader can profit.

On October 30, the House Financial Services Capital Markets Subcommittee held a hearing to discuss market structure issues and, more particularly, mutual fund abuses. The Committee heard from Securities and Exchange Commission Chairman William Donaldson about the current state of affairs within the mutual fund industry; he acknowledged that market timing and late trading practices seem to be "quite widespread"--more than originally anticipated. That said, the SEC does not know how widespread the practice of market timing in fund managers' personal accounts may be. Donaldson also announced that the SEC is "very deliberately" investigating the matter, and that specific market proposals may not be made for months.

The Investment Company Institute (ICI), the industry group that represents mutual funds, also testified during the House hearing and made several recommendations to restore and reinforce investor confidence. ICI has recommended the following:

Late Trading--Require that all purchase and redemption orders be received no later than 4 p.m., when the funds set the price for their shares.

Market Timing--Require funds to have more formalized market-timing policies; emphasize the obligation funds have to fairly value their securities under certain circumstances; and reinforce board oversight of market-timing policies and procedures.

Other industry groups, like the Profit Sharing/401(k) Council of America, have responded to the ICI proposal by saying that the additional disclosures proposed are good, but that the 4 p.m. "hard close" proposals will place 401(k) participants at a disadvantage relative to other investors. There is also concern that a company that uses a bundled service package, in which one vendor provides plan administration and investment funds, would have an advantage in this scenario relative to a company using an unbundled service package.

Congress is eager to jump into the discussion, but time is growing short for this year. In addition to the hearing on October 30, the House Financial Services Committee passed a bill (H.R. 2420) on November 4 designed to improve the transparency of fees and costs that mutual fund investors incur, as well as improve mutual funds' corporate governance. At this point, the House legislation is awaiting further consideration, but it will not become law this year.

The Senate also is weighing a bill (S.1822) that would improve the corporate governance of mutual funds through additional disclosures of financial relationships between brokers and mutual fund companies. However, due to time constraints on the Congressional schedule, this legislation will not be considered this year.

All the stars are aligned for a major overhaul of the mutual fund industry in 2004. Congress, the SEC and New York Attorney General Eliot Spitzer are continuing their investigations, while the mutual fund industry prepares for the storm. This coming year should see major discussions about corporate policies and corporate governance within the mutual fund arena.

Bob Shepler ([e-mail]) is Director of Federal Affairs for FEI and is based in FEI's office in Washington, D.C.