MUTUAL FUNDS ARE AMERICANS' most trusted financial instrument. Roughly half of all households invest in them - to the tune of some $7 trillion.
No other financial vehicle even comes close.
So it came as a bolt from the blue early last month when New York Attorney General Eliot Spitzer announced his office had evidence of widespread illegal trading schemes "that potentially cost mutual-fund shareholders billions of dollars annually."
Should mutual-fund investors pull out and look for other places to put their money?
The short answer is no. Mutual-fund managers have a relatively clean record compared with brokers, investment bankers, or even insurance firms. But the spreading scandal should serve as a goad to mutual-fund firms to become even more vigilant.
Sadly, investors have become somewhat inured to corporate misbehavior. Trials of two high-profile executives, Frank Quattrone, a former investment banker of Credit Suisse First Boston, and Tyco International's former chief executive, L. Dennis Kozlowski, began in Manhattan last week. That's only the latest news on a string of misdeeds at the highest levels of business.
Fortunately, mutual-fund scandals are rare. Fund managers almost never get charged with cooking the books or with embezzlement, points out Tamar Frankel, a Boston University Law School expert. And they are sensitive to investors. They know their customers can quickly turn in their shares for cash if disenchanted. Should enough do so, managers get a pay cut or go out of business.
Mutual-fund managers do get criticized, or worse, for the fees and expenses charged their investors, or for advertising that exaggerates performance. "But I don't see an Enron," says Professor Frankel.
Mr. Spitzer's charges are, nonetheless, serious. "The mutual-fund industry operates on a double standard," the attorney general stated. "Certain companies and individuals have been given the opportunity to manipulate the system. They make illegal after-hours trades and improperly exploit market swings in ways that harm ordinary long-term investors."
He announced Sept. 3 a $40 million settlement agreement with Canary Capital Partners - a multimillion-dollar hedge fund, two Canary-related entities, and Edward Stern, the managing principal of these entities. Canary Capital, which admitted no wrongdoing, was charged with obtaining special trading opportunities with leading mutual fund companies, including Bank of America's Nations Funds, Banc One, Janus, and Strong.
Janus last week indicated it has ended relationships with 12 different clients, which allowed them to conduct rapid-fire trading. Not all did, though.
Spitzer's office says investigations are "ongoing." The SEC says it has sent "detailed information requests" to 80 of the nation's largest mutual-fund complexes, to prime brokerage firms, transfer agents, and large broker-dealers. So possibly more funds will face charges of "late trading" and "market timing."
"Late trading" involves the purchase of mutual-fund shares at the 4 p.m. closing price after the market has closed. Normally, transactions received after 4 p.m. are priced at the next trading day's 4 p.m. closing price. But the kind of "late trading" alleged by Spitzer allows a few favored investors to take advantage of events after the market close and still pay that day's 4 p.m. price. Spitzer likens it to allowing betting on a horse race after the horses have crossed the finish line.
"Timing" involves short-term, "in and out" trading of mutual-fund shares. It is not automatically illegal. If a fund's prospectus says it is not allowed, though, it becomes a regulatory issue. The practice can drive up trading costs.
Both techniques can hurt the value of shares held by long-term shareholders, including buy-and-hold retirees.
Whether their losses will amount to "billions of dollars," as Spitzer suggests, will depend on how many mutual funds were actually involved in such schemes. Fund managers may OK such practices in return for payments or for the equivalent - bringing in large chunks of investor money.
The inquiry has widened. The Massachusetts Securities division issued a subpoena to the Boston office of Prudential Securities Inc., to check whether it allowed improper trades. It sent letters to five other major mutual-fund groups, asking how they limit questionable or illegal trading practices.
Last week, a dozen stockbrokers and managers at Prudential Securities resigned under internal pressure.
Also, Alliance Capital Management Holding suspended two employees because of "conflicts of interest" in regard to rapid trades in mutual funds.
On Sept. 16, the Securities and Exchange Commission (SEC), the national regulatory body, joined with Spitzer in charging a Bank of America broker, Theodore Sihpol III, with state criminal and federal charges for his role in unlawful trading of mutual funds.
To the mutual-fund industry as a whole, its reputation as a safe investment vehicle is vital. "Shareholder confidence is every mutual fund's most precious asset," states Paul Haaga Jr., chairman of the industry's Investment Company Institute (ICI) in Washington.
Financial experts continue to regard mutual funds as suitable for ordinary investors, offering investment diversity in stocks, bonds, and other areas.
They are "still the financial vehicle of choice," says Mercer Bullard, head of Fund Democracy, a nonprofit advocate of shareholders' rights and interests.
Robert Shiller, a Yale University economist, figures the alleged scandals "are affecting only a small part of the industry. The rip-off wasn't enormous."
Indeed, he suspects the moves by the regulators may be a good thing, leading to a more sound industry.
The SEC on Sept. 24 approved more reform - new rules encouraging mutual funds to provide more complete disclosure in their advertisements so as to "convey more balanced information to prospective investors, particularly with respect to past performance."
To provide more timely information, mutual funds advertising performance will have to make available returns that are current to the most recent month-end by a toll-free or collect-telephone number or on a website.
In testimony to Congress last Tuesday, SEC Chairman William Donaldson announced a five-part plan to better regulate funds in regard to abusive trading practises. The ICI Friday set up two task forces to work with the SEC.