Mutual Funds Face Future Regs

The mutual fund scandals center on five key areas: failure to apply breakpoints, late trading, market timing, brokers' conflicts of interest and the all encompassing breach of trust.

Mutual funds are the preferred investment vehicle of mainstream America. According to latest statistics from the Investment Company Institute, mutual funds, totaling just shy of $8 trillion, are owned by 53.3 million U.S. households and represent 22 percent of U.S. retirement assets. Until recently, the structure of the industry and its products provided a sense of security in the integrity of the mutual fund market. That's why the discovery of questionable and in some cases egregious practices occurring in the mutual fund industry met with such shock and a sense of betrayal.

In response, regulators, litigators and legislators have released a deluge of thoughtfully calculated proposals and reactionary rhetoric and saddled the industry with fines and settlements estimated at more than $2.6 billion. In addition, a number of legislative and regulatory proposals are being considered. The mutual fund scandals center on five key areas: failure to apply breakpoints, late trading, market timing, brokers' conflicts of interest and the all encompassing breach of trust.

Failure to Apply Breakpoints. Investors are often eligible for sales discounts as they hit specified asset levels or rights of accumulation. These entitlements were not always applied for a variety of reasons occasionally intentional but often inadvertent.

Late Trading. Forward pricing requires trades to be placed before valuation of portfolios occurs (typically 4:00 p.m. Eastern time). Intermediaries have been permitted the flexibility of sending trades later so that they could allow their clients to trade through 4:00 p.m. and then consolidate trades and coordinate the transmission of transactions to the fund companies. This flexibility was illegally exploited in a number of cases to allow individuals and firms to profit from information available after the market closed.

Market Timing. While currently not illegal, market timing is often prohibited by funds as outlined in a firm's prospectus. Allowing market timing where it violates a fund prospectus can be construed as a violation of the fiduciary responsibilities of funds to shareholders, and applying the prospectus inconsistently across shareholders is a violation of investment laws. The timing of mutual fund pricing and limited application of fair value pricing created real or perceived opportunities for arbitrage that might occur to the detriment of long-term investors.

Brokers' Conflicts of Interest. This issue has two components:

The "direction" of mutual-fund portfolio trades to brokers in return for shelf space among the distributed fund products.

Additional compensation provided to specific firms or to specific products as a sales incentive

Breach of Trust. The net effect of the transgressions described here has been the perception that the oversight of the industry is woefully inadequate and regulators or legislators must rectify the inherent conflicts between the interests of fund companies and those of their shareholders.

The regulatory and legislative response to these issues has come on top of the myriad of other issues facing the broader asset management industry. Let's not forget, the industry is still working through USA PATRIOT Act, Sarbanes-Oxley, e-mail and instant message storage requirements under 17a-4, soft-dollars, proxy voting and the list goes on. These have led TowerGroup to put regulatory and legislative issues as the number one business driver for the asset management industry. The subsequent technology implications are as varied as they are complex. It has been a long time since there has been such a pervasive need for third-party technology to help firms meet their regulatory obligations and mitigate the reputation risk associated with the failure to meet these obligations.

Mutual Fund Compliance Challenge