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Mutual fund industry under scrutiny.

Allegations of improper and illegal trading at a umber of prominent money management companies have left the mutual fund industry reeling in what can only be described as its own version of recent corporate governance scandals. According to a recent report by Sanford C. Bernstein & Co. securities analyst Brad Hintz, the widening scandal could cost the mutual fund industry more than $1 billion--between $400 million and $600 million to settle charges by various regulators and nearly another $600 million to settle the class-action lawsuits expected to stem from this debacle.

Some major firms are already feeling the heat. Alliance Capital Management--Sanford C. Bernstein's owner--has fired two of its senior money management executives and took a $190 million charge against third quarter earnings to cover shareholder restitution and litigation costs. This comes in light of possible impending enforcement action by both the Securities and Exchange Commission and the New York state attorney general.

Bernstein is hardly alone. Bear Stearns Cos. has been subpoenaed by federal prosecutors and the SEC and may face criminal charges. Other New York-area companies, such as Citigroup, Fred Alger Management, Merrill Lynch, Morgan Stanley and Prudential Financial have also been implicated in similar scandals. Most firms are expected to settle charges by regulators to save their reputation, but dealing with the inevitable investor lawsuits will likely prove to be more troublesome.

Perhaps the most lasting effect of this scandal, however, has been the legislation it has spawned. According to U.S. Representative Rahm Emanuel (D-IL), a member of the Financial Services Committee, mutual fired directors and managers have abandoned their fiduciary duties and failed to protect middle-class investors' interests. "It is time for Congress, working in concert with the SEC, to pass tough new rules to eliminate abuses and protect investors," Emanuel said last November, shortly before the House of Representatives overwhelmingly passed the Mutual Funds Integrity and Fee Transparency Act of 2003.

Originally introduced in June 2003 by Rep. Richard H. Baker (R-LA), the final version of the Act includes a number of provisions that will address market timing and late trading practices, such as:

* requiring fund and investment advisers as well as principal underwriters to adopt codes of ethics to prevent abusive transaction practices

* permitting redemption fees in excess of 2 percent

* establishing standards for fair valuation

* prohibiting individuals to serve as a portfolio manager to both a mutual fund and a hedge fund

* prohibiting short-term trading in fund shares with a fund, its adviser and its principal underwriter

The Act also requires mutual funds to provide investors with increased amounts of information regarding fees, such as estimated operating expenses based on a hypothetical $1,000 investment. Furthermore, the Act will require funds to disclose all directed brokerages, revenue sharing and any other special trading arrangements.

Meanwhile, Rep. Baker has predicted that in the current Congressional session, which began late last month, further legislation of the mutual land industry is highly likely. According to Baker, investment regulations were rewritten more than 60 years ago, and that recent scandals---which included insiders trading outside of regular hours to gain an advantage over ordinary investors--are proof that it is time for the legislators to step in once more.

As extensive as the House's actions may have been, the Senate will, probably take up even more stringent legislation. Both the House and the Senate are expected to reach a compromise on mutual fund oversight legislation shortly after the Senate acts. Alter that, it will be a new era for the mutual fund industry as it learns to cope with its new regulatory oversight. More importantly, this legislation again proves, just as Sarbanes-Oxley did, that if the financial services industries can not police themselves, then the federal government--backed by sufficient outcry from everyday investors will do it for them.

Bill Coffin is RM's editor in chief.
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Title Annotation:Rules & Regulations
Author:Coffin, Bill
Publication:Risk Management
Geographic Code:1USA
Date:Feb 1, 2004
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