No Oversight Of Mutual Funds By SEC, Chairman Admits

by Margie Burns

Sounding at times hesitant and tentative, Donaldson at times sounded almost overwhelmed, several times replying "I don't know" or "We're working on it" to questions.

But despite their professed ignorance of abuses that have become widespread over the past few years, the witnesses tried to convince skeptical members of the Banking Committee that the frauds in mutual funds management will be stopped, prosecuted, and prevented from recurring by self-regulation.

Committee Chairman Richard C. Shelby (R-Alabama) and Co-Chairman Paul Sarbanes (D-Maryland) began the hearing by outlining the extent of the mutual funds industry and the newly disclosed abuses. As they reminded the packed hearing room, the American mutual funds industry includes more than 95 million investors and manages $7 trillion in assets.

Sarbanes pointed out that "more than half of all American households own funds... millions of small investors -- savers -- entrust their savings to fund managers." As Sarbanes also pointed out, in recent years mutual funds have become a dominant mechanism for saving by small investors, who often "rely on mutual funds as an alternative to traditional savings accounts."

"It has become apparent that many of the questionable fund practices that are now being examined are not the result of a few bad actors, but are long-standing industry practices," Shelby said.

Illegal practices included selective disclosure about portfolios to chosen large investors, insider trading by fund managers themselves, "late trading," and "market timing." Market timing itself is not illegal by itself, but trading after the market close is. Combined, they mean that securities (usually mutual fund shares) were traded after the end of the trading day because insiders had information not available to the trading public. "We did not inspect for late trading, market timing, [not] for many years," Donaldson told the Senate Committee.

"We must determine whether new laws, new regulations or more effective enforcement of existing laws, or all of the above, are needed," Sarbanes said, listing a number of problem areas calling for "thorough examination." He pointed out that just the day before, the SEC had announced a $50 million settlement with Morgan Stanley: "The allegations in that case were that Morgan Stanley received incentives to push certain funds on investors instead of others."

To prevent future abuses, Donaldson called for setting up a new "Office of Risk Assessment," with a staff of five professionals to anticipate problems before they arise by analyzing data.

Both Shelby and Sarbanes, joined by other members of the Committee, repeatedly expressed willingness to appropriate money for the SEC to handle the mutual funds scandal. As Shelby said, "Chairman, we're going to give you the resources you need. We just want to know what you're going to do with those resources," he added, pointedly reminding Donaldson that the SEC had returned part of its appropriation from the previous year.

The SEC is just beginning to investigate the industry's top 88 companies, which manage the majority of assets controlled by the industry. There are over eight thousand mutual funds companies.

The other witnesses, Investment Company Institute president Matthew P. Fink and Marc E. Lackritz, president of the Securities Industry Association, repeatedly stated that their organizations were unaware of the widespread illegal trading and the conflicts of interest. Fink said, "We're trade association lobbyists. We don't go out and inspect our members... nobody at the Institute, the SEC, NASD had a clue that these things were going on." Asked whether the mutual funds industry itself was widely aware of how much late trading and other abuses were occurring, and Donaldson answered in the negative. Sarbanes raised a laugh when he said, "So this isn't a case like Claude Rains in Casablanca? -- you're not 'shocked, shocked,' to find that this was going on?" Donaldson, also laughing, said no.