Is the Mutual Fund Issue Abuses, or Is It Fees?

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Is the Mutual Fund Issue Abuses, or Is It Fees?

By Floyd Norris, The New York Times

November 19, 2003

The coming battle over mutual fund regulation may well end up focusing not on trading abuses, which are now the subject of regulatory action, but on the fees and costs that funds charge investors.

Much may hinge on who will make the decisions on how the rules will change.

William H. Donaldson, the chairman of the Securities and Exchange Commission, yesterday laid firm claim to mutual fund turf, and in the process voiced disapproval of the possibility that state regulators like Eliot Spitzer, the New York attorney general, might try to set new rules.

If Mr. Donaldson gets his way, the likely results will be a lowering of fees and more disclosure of what investors are paying.

That probably will reduce the profitability of the fund industry while increasing the returns for those who invest in the funds.

It is not clear if Mr. Spitzer will be content to offer suggestions and criticisms, while deferring to the S.E.C. in the end, or whether he will try to mandate reforms through negotiated settlements of civil, or even criminal charges, brought against mutual fund companies.

Nor is it clear whether Congress will be content to let the S.E.C. act, or whether legislation will be passed regarding fees.

In testimony before the Senate Banking Committee yesterday, Mr. Donaldson indicated that the commission would bring more disciplinary actions over the issue of payment for "shelf space,'' in which funds pay brokerage firms to push their funds. That was part of the case against Morgan Stanley that was settled with the S.E.C. on Monday.

"Morgan Stanley's customers did not know about these special shelf-space payments, nor in many cases did they know that the payments were coming out of the very funds into which these investors were putting their savings," Mr. Donaldson told the Senate committee.

He added that the S.E.C. was now investigating such payments at 15 brokerage firms "to determine exactly what payments are being made by funds, the form of those payments, the shelf space benefits that broker-dealers provide, and most importantly, just what these firms tell their investors about these practices." He said the commission was also "looking very closely at the mutual fund companies themselves," hinting they might face suits over the same payments.

The issue of fund fees, particularly their disclosure, had been pending at the S.E.C. for some time, with an expectation that new rules would be developed. But until the Morgan Stanley action the commission had not taken disciplinary action.

The fee issue was inserted into the debate over trading abuses by Mr. Spitzer, who criticized the commission for reaching a partial settlement with Putnam Investments without doing anything about fees.

In an Op-Ed article that appeared in The New York Times on Monday, Mr. Spitzer denounced the "exorbitant fees" that Putnam charged and said the settlement "does not address the manner in which the fees charged to investors are calculated.''

"Nor," he added, "does it require the fund to inform investors exactly how much they are being charged - or even provide a structure that will create market pressure to reduce those fees."

Mr. Donaldson responded to that argument in his own op-ed article, published in The Wall Street Journal yesterday, in which he said Putnam's violations did not involve fees.

"Those lacking rule-making authority seem to want to shoehorn the consideration of the fee-disclosure issues into the settlement of lawsuits about other subjects," Mr. Donaldson wrote. "But we should not use the threat of civil or criminal prosecution to extract concessions that have nothing to do with the alleged violations of the law."

Mr. Spitzer, in an interview yesterday, said Mr. Donaldson was taking too narrow a view in separating excessive fees from trading abuses. "They really should be viewed as a set of issues that are woven together by the common thread of failed mutual fund governance," he said. The S.E.C.'s solution, Mr. Donaldson indicated in his testimony, is likely to be much better disclosure of fees and other costs. He promised S.E.C. action next month to require better disclosure of costs in confirmation statements sent to investors when they buy fund shares, but set no date for consideration of actions on other cost-related issues, like the use of "soft-dollar" commissions to buy services or the practice of using commissions to "facilitate the sale and distribution of fund shares."

Better disclosure would probably cause some money to move to lower-cost funds, but it is worth noting that institutional investors, who presumably understand what they are doing, in recent years have put much more money into hedge funds, where fees are very high, in hopes of earning higher returns. Even well-informed individuals might make similar choices among mutual funds.

While the S.E.C. may well force boards to explain the fees that they negotiate with fund managers, it is unlikely it will go as far as imposing a "most-favored nation" rule that would require them to offer services to funds for prices no higher than those charged to other accounts.

Mr. Spitzer, in the interview yesterday, agreed that he lacked the power to regulate the fund industry and said it was unlikely that he would ever threaten criminal charges against a company that had settled a civil case with the S.E.C. Some in the industry have privately voiced fears that he would use such a threat to try to become a de facto rule maker.

Instead, Mr. Spitzer, who in his article on Monday said the commission's settlement with Putnam had "short-changed" investors, said he had worked closely with the S.E.C. and expected that to continue.

"Given the inherent difficulty, the degree of teamwork, I think, is pretty good," he said.