Out of the 283 million Americans, 95 million have investments in mutual
funds, crucial savings for many to sustain them in their retirement
years.
The Investment Company Act of 1940 made clear that mutual funds were
to be "organized, operated, and managed" for the benefit of
the shareholders, rather than for the benefit of their "officers,
directors, investment advisers, and underwriters (distributors)."
The vast majority of the steadily growing number of shareholders apparently
believed that the funds to which they entrusted their hard-earned savings
worked to produce for them the highest possible gains.
Few investors seem to have suspected that mutual funds could be exploited
to the detriment of their shareholders. That, however, is precisely
what happened when fund employees-- how many, nobody knows as yet--bought
or sold shares after the 4 p.m. closing on trading days when they knew
what fund positions to add or drop for certain gains. The traders call
that market timing, but it is actually a violation of the trading rules
at the expense of their unsuspecting clients.
It was a $40 million judgment against the hedge fund Canary Capital
Partners that led New York Attorney General Eliot Spitzer to inquire
into the prevalence of market timing and other practices damaging to
fund investors. On September 3, he filed his first criminal complaint
against a mutual fund that permitted market-timing.
Subsequently, Spitzer's office also became aware of numerous fund managers
assessing excessive management fees and extending kickbacks to banks
and financial advisers steering clients to their companies. Alliance
Capital, American Express, Bank One, Bear Stearns, Citigroup, Federated
Investors, Janus, Legg Mason, Loomis Sayles, Merrill Lynch, Morgan Stanley,
Pilgrim Baxter, Putnam, Schwab, Security Trust, Strong, and Wachovia
are among the better known fund traders that have either admitted, or
are now being investigated for, theft amounting to billions of dollars
over many years.
What is known so far about the corruption in the mutual fund industry
teaches investors essentially the same lessons they should have learned
from the recent cases of massive fraud in other sectors of corporate
America. We simply can no longer assume that every company and every
employee will be honest and have the shareholders' benefit uppermost
in mind. We also cannot assume that the responsible government agencies
diligently exercise their oversight responsibilities to protect citizens
from financial fraud.
Some institutional investors reacted to the news about illegal market
timing by promptly withdrawing their holdings from the funds involved.
Putnam lost $21 billion in assets since the story of its violations
broke. Such a response serves as the most immediately effective corrective,
but it cannot be the only one.
It is not enough for the violators of the rules to fire the responsible
employees. The unscrupulous funds must be compelled to return their
ill-gotten gains to the investors to whom they belong.
Even more important are the structural changes the government needs
to legislate. To make mutual funds truly mutual, elected shareholders
with appropriate expertise--not managers and advisers--ought to hold
the majority of the seats on the boards of directors. No board member
should have a financial conflict of interest, and no director should
sit on more than one board.
The annual reports should have to spell out in non-technical language
how and why the directors have arrived at fund fees and employee remuneration.
The Securities and Exchange Commission, moreover, needs to prevent further
violations of trading rules with increased oversight.
If investors cannot trust their money managers, the whole investment
industry and the nation's monetary and fiscal structure are in trouble.
Regrettably, lack of vigilance on the part of investors also has contributed
to tempting the greediest of corporate America's operators to make billions
dishonestly. Mutual funds in particular require mutual involvement from
both managers and owners.