ovember 4, 2003

Extensive Flaws at Mutual Funds Cited at Hearing

WASHINGTON, Nov. 3 — The mutual fund industry, plagued by a series of recent scandals, was battered on Monday by new details of widespread trading abuses, the removal of the top executive at a big fund company and the disclosure by federal regulators that the industry faced an imminent wave of government lawsuits.

The scandals also produced their first senior government casualty when Juan M. Marcelino, the head of the New England regional office of the Securities and Exchange Commission for the last 10 years, said he would step down amid criticism that his office failed to investigate promptly a whistle-blower's accusations in March about problems at Putnam Investments.

Putnam, the nation's fifth-largest fund company, said on Monday that its chief executive, Lawrence J. Lasser, would be leaving in the wake of recent accusations by federal and state prosecutors of civil fraud by the company.

As a result of those accusations, six states and New York City have told their public pension funds to stop using Putnam as a fund manager, and others are considering similar moves.

On Capitol Hill, where federal and state officials testified on Monday at a Senate hearing on the mutual fund industry, lawmakers have begun to call for significant changes in regulating the industry — which is in its greatest turmoil since it came under federal oversight more than 60 years ago.

Mutual funds, which manage money on behalf of their shareholders by buying and selling stocks and bonds, control some $7 trillion in investments for 95 million investors, and the industry's reputation as a haven for unsophisticated and small investors has taken a beating.

Several lawmakers have introduced legislation that would require directors of mutual funds, including board chairmen, to be more independent from the management of the funds. But federal and state officials and other experts said on Monday that the problems were not with the regulations but with lax enforcement of existing rules.

Eliot Spitzer, the New York State attorney general, who has moved more aggressively and quickly against the funds than his federal counterparts, attributed the problems to complacent directors — a shortcoming that has also troubled some of the nation's largest corporations and the New York Stock Exchange. Mr. Spitzer said that in future settlements with funds, he would demand that the penalties for serious infractions include returning fees to investors.

"We have opened up a window into a morass of problems," Mr. Spitzer said at the Senate hearing. "This is a window into what has been foggy, murky and impossible to understand."

Stephen M. Cutler, the head of the S.E.C.'s enforcement division, said at the same hearing, by a Senate Governmental Affairs subcommittee that investigations and a recent survey had found widespread suspicious trading practices. They ranged from overcharging many customers to giving preferential treatment to the largest ones, including confidential market information.

"The `unholy trinity' of illegal late trading, abusive market timing and related self-dealing practices that have recently come to light are matters that affect us all," Mr. Cutler asserted. "And they go right to the heart of the trust — the covenant, if you will — between mutual fund and other securities professionals and the individual investor. As my colleagues and I have gathered evidence of one betrayal after another, the feeling I'm left with is one of outrage."

Mr. Cutler also said more than 25 percent of brokerage firms that sell mutual funds and 10 percent of the funds surveyed had permitted customers to engage in late trading that may have been improper. Such trading involves buying or selling shares of a fund at the 4 p.m. closing price at some point later in the day.

Documents from nearly one-third of the brokerage firms, he said, indicated that they might have helped customers engage in possibly improper trades by such methods as concealing their clients' identities through special accounts.

He said that more than 30 percent of the fund companies had disclosed information about their portfolios selectively, to certain shareholders, giving them the ability to place advantageous trades.

Mr. Cutler and Mary L. Schapiro, the top regulator at NASD, said a joint inquiry had uncovered that at least one in five investors in Class A shares of mutual funds — those that impose a sales charge upfront — were not given discounts on large trades and, as a result, were overcharged an average of $243 each in the last two years — a total of at least $86 million.

Mr. Cutler said that "a significant number of brokerage firms" would receive notification this week that they were likely to face agency charges of securities law violations for overcharging customers. The firms were obliged to provide the customers with discounts for buying shares above certain limits, but failed to, Mr. Cutler and Ms. Schapiro said.

Ms. Schapiro said that about two dozen brokerage firms would be accused of failing to provide discounts to mutual fund investors. "There was pretty systemic failure," she said.

While only three senators appeared at today's subcommittee hearing, there is deep interest in the issue in Congress. Both the Republican chairman and the ranking Democrat on the full Senate Governmental Affairs Committee criticized the S.E.C. for not moving sooner or acting before problems were brought to its attention by Mr. Spitzer.

Senator Susan M. Collins, the Maine Republican who heads the committee, said, "I question why the Securities and Exchange Commission, which has regulatory responsibility for the mutual funds and their broker-dealers, has failed to detect these practices, to impose appropriate restrictions on them, or to penalize those who appear to be misusing investors money."

The senior Democrat on the committee, Senator Joseph I. Lieberman of Connecticut, issued a similar statement.

"The S.E.C. was far too late to the table in addressing these problems," Mr. Lieberman said in a letter to William H. Donaldson, the S.E.C. chairman. "Now that the problems have come to light," Mr. Lieberman wrote, "I am once again left to wonder: why did the watchdogs fail to bark?

Mr. Cutler acknowledged that the commission should have acted more promptly against Putnam. In March, a Putnam employee reported that some union members were day-trading Putnam funds in their 401(k) plans — moving money in or out within a single day — in ways that other investors could not.

Mr. Cutler said the agency could not always handle such complaints when it receives an average of 1,000 tips a day.

"Do I wish that we'd have brought the Putnam case two months ago instead of two weeks ago?" he asked. "You bet I do."

The Boston office of the S.E.C. had neglected a tip from a whistle-blower in March about problems at Putnam Investments — which prompted the informant, an employee at a Putnam telephone call center — to take his information to Massachusetts securities regulators. They have since made a major case against the company based on the tip; other accusations of improper trading practices by Putnam have also been made recently by the commission.

The S.E.C. said Mr. Marcelino, the head of its New England office, had decided to step aside, "given the recent press coverage of certain matters involving the Boston office, to minimize any further distractions for his staff as they continue the critical work of the office."

Three officials said Mr. Marcelino had been forced to resign by Mr. Cutler after Mr. Cutler became dissatisfied with his account of the incident.

Mr. Marcelino, who in nearly 20 years of service at the commission has received several agency awards for distinguished service, did not respond to calls left at his home and office for comment. Mr. Cutler, in an interview this afternoon, said Mr. Marcelino had made a "personal decision after a distinguished career to step down and I have to respect that."