Statements on Introduced Bills and Joint Resolutions S.1958

CONGRESSIONAL RECORD
SENATE
PAGE S15983
Nov. 25, 2003

Statements on Introduced Bills and Joint Resolutions S.1958

By Mr. DASCHLE (for Mr. KERRY (for himself and Mr. KENNEDY)):

S. 1958. A bill to prevent the practice of late trading by mutual funds, and for other purposes; to the Committee on Banking, Housing, and Urban Affairs.

(At the request of Mr. DASCHLE, the following statement was ordered to be printed in the RECORD.)

Mr. KERRY. Mr. President, as the world's largest economy, I believe the United States must have the fairest, most transparent and efficient financial markets in the world. Our financial services companies must live up to the highest standards of accountability. This is critical to ensure that the United States remains strong, competitive and safe in the global economy. Unfortunately, recent reports of late trading and market timing have brought into question whether mutual fund companies have lived up to the highest standards of accountability. They have also shown that the Bush Administration failed to provide effective oversight and examination of mutual fund companies, while poorly enforcing our securities laws. The inaction of the Bush Administration has dangerously eroded the trust and confidence of the American people in mutual funds and may have allowed mutual fund companies and big investors to engage in fraudulent behavior against individuals and pension funds.

New York and Massachusetts regulators have uncovered a scheme in which some of America's top mutual fund companies let big investors profit illegally at the expense of small investors with so-called "late trades" and "market timing." The scam appears to be widespread. Today, roughly half of all American households own mutual funds either directly or through a retirement account or pension fund. It's been reported that as much as one quarter of mutual fund companies may be involved in late trading and market timing and that such schemes may cost investors as much as $5 billion annually.
In a late trade, big investors purchase mutual fund shares after the close of the market but at the closing price, allowing them to take advantage of late-breaking financial news. A mutual fund manager might allow a big investor to buy shares in a technology fund at the 4 p.m. close price after learning at 5 p.m. that a major technology company has reported unexpectedly strong earnings. The investor is almost guaranteed a profit when the market opens the following day and share prices climb. In return for this illegal access, the big investor might pledge to continue to invest in the fund.

Market timing exploits the unique way that mutual funds set their prices. While it is not illegal, most mutual fund companies assure investors that they discourage such practices and that they are working to prevent fund timing. Under a market timing trade, big investors trade in and out of certain mutual funds in order to exploit the inefficient way mutual funds price their shares and ensure a profit.

In 2002, individuals who invested in mutual funds paid approximately $70 billion in advisory and management fees, an average of more than $700 per investor. There is a significant disparity between the rate of advisory fees charged to mutual fund investors and the rate paid by institutional investors, even though they provide the similar services. Currently, mutual fund managers are under no obligation to negotiate advisory and management fees that are in the best interest of their shareholders. In some instances, mutual fund managers has a financial relationship with the contractor which receives a no-bid contract from the same mutual fund.

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In a September 2003 complaint, New York Attorney General Spitzer alleged that Canary Capital Partners, a New Jersey hedge fund, engaged in illegal and unethical trading in mutual funds, such as late trading and market timing. After the New York State complaint, the SEC ordered a preliminary investigation, which found that half of the 88 mutual fund companies and brokerage firms had arrangements to make market-timing trades. These arrangements occurred even though about half of the fund companies have policies specifically barring market timing. Other investigations of mutual fund companies have begun, and it appears as though many mutual fund companies have been involved directly or indirectly in late trading and market-timing schemes.

I am very concerned that the actions of the SEC in response to the State investigations of late trading and market timing have been inadequate and show a bias in favor of mutual fund companies at the expense of small investors.

For example, earlier this year the SEC conducted a four-month investigation of Putnam Investments' record keeping, internal controls, and ability to comply with Federal securities laws. During that review, a Putnam employee informed the SEC that the company had failed to stop improper market-timing trades. Despite the tip, SEC examiners did not identify any problems with market timing in its report on Putnam. The Putnam employee, after being rejected by the SEC, brought the same information to the Massachusetts Secretary of State's office, which began an investigation. Only after the Commonwealth of Massachusetts began an investigation did the SEC begin its own investigation of market timing at Putnam. In October, both the Commonwealth of Massachusetts and the SEC charged Putnam with securities fraud, only months after the SEC gave Putnam a clean bill of health. Only a few weeks later, Putnam reached a partial settlement of the securities fraud charges with the SEC which did not include the Commonwealth of Massachusetts. Under the settlement, Putnam agrees to make restitution only for losses to investors attributable to excessive short-term and market-timing trading by its employees and to make structural reforms. Under the agreement, Putnam neither admitted nor denied wrongdoing and the SEC still has not investigated whether outside investors were engaged in market-timing activities. New York Attorney General Eliot Spitzer said that Putnam's agreement with the SEC does not address crucial issues involving restitution to fund holders, fees and penalties. William Galvin, the Massachusetts Secretary of State said that the agreement clearly demonstrates that the SEC is more interested in protecting the mutual fund industry than the average investor.

These actions by the SEC highlight a fundamental problem in the Bush Administration's hands-off approach to regulating financial markets and the danger it poses to small investors and the national economy.

Compounding this danger and lack of responsible leadership, President Bush has repeatedly nominated individuals to important economic positions notable for their corporate sympathies. The President selected a lobbyist for financial deregulation as the chief regulator of the federal mortgage lender Freddie Mac. His first SEC chairman was an accounting industry who was forced to resign in a storm of public outrage over his lenient treatment of his former business.

Even after the accounting scandals that felled Enron and WorldCom, it was last year's Democratic Senate that pushed to enact an historic corporate reform law and the President who joined the effort only once its passage was all but ensured. It was state attorneys general who exposed dubious conflicts of interest at brokerage houses. And when energy companies gauged ratepayers in the West through questionable trades, the Administration sat on its hands for months.

The message from the White House to the regulatory agencies, in actions if not words, is don't ask and don't tell when it comes to protecting investors and consumers.

Justice demands that we fully prosecute Wall Street insiders that steal from Americans saving for retirement, education or simply a brighter future. And we can only hope to revive our economy if we restore investor confidence in the markets so that capital flows to business growth and job creation.

To stop the erosion of trust in our financial markets and to help restore the American investor's faith in the mutual fund industry, I am introducing the Mutual Fund Investor Protection Act to update federal securities laws to curb late-trading and market-timing abuses and institute new limits on mutual fund fees paid by investors.

The actions by the SEC show that it is incapable of protecting investors from securities fraud by mutual fund companies and will not prosecute this type of fraud to the full extent of the law. Therefore, we must take the day-to-day oversight of mutual funds away from the SEC and develop a new Mutual Fund Oversight Board to provide oversight, examination and enforcement of mutual funds. This new board will be similar to the Public Company Accounting Oversight Board developed in the Sarbanes-Oxley Act. It will be charged with identifying potential problems in the mutual fund industry and ensuring that fund boards are actively addressing these problems-before they spread. It would promulgate guidance regarding current regulatory issues and best practices regarding how to deal with them, and it would examine mutual funds to ensure that they are taking necessary steps to protect shareholders. The Board itself would determine how to provide an adequate and reliable source of funding for its investigations.

I believe that every investor has the right to know how much their mutual fund takes away from their investment to pay for advisory, management, and investment service fees. Under this legislation, each investor will receive in their statement a regular accounting as to what types of fees they are paying to invest in their mutual fund. This will help investors shop around and find the mutual funds that have the lowest fees. Mutual funds will have to respond to the changing marketplace and only charge fees that are absolutely necessary to the management of the fund. Also, this legislation requires mutual fund managers to negotiate fee contracts that are reasonable and in their investors' best interest and to report on any significant or material business or professional relationship with companies that the mutual fund provides contracts. Finally, the bill requires each mutual fund to hire a compliance officer to ensure that the mutual fund complies with all relevant laws and makes sure that they provide any information on scams to the independent mutual fund directors to stop abuse. Taken together, these provisions will help investors by making it much more difficult for mutual funds to charge unreasonable and unnecessary fees.

Today, mutual funds are valued once a day, called the Net Asset Value or NAV, usually at 4 p.m. EST, when the New York market closes. The bill will require that all mutual fund companies receive an order prior to the time the fund sets a share price or NAV for an investor to receive that day's price. This will make it much more difficult for big investors to use brokers to send in trades after the 4 p.m. deadline.

We should include late-trading laws as an offense under the Racketeer Influenced and Corrupt Organization (RICO) provisions of the criminal code. First used to prosecute the Mob, RICO should now be used to stop and punish organized crime on Wall Street. This will help limit mutual fund employees and big investors from attempting to defraud small investors. It will also help investors who lose money due to late-trading schemes to recover treble damages, costs and attorneys' fees.

The SEC recently found that many mutual fund companies and brokerage firms had arrangements with big investors allowing them to make market-timing trades even though these fund companies have policies specifically barring market timing. My legislation bars mutual fund employees from engaging in market timing trades. It requires each mutual fund prospectus to explicitly disclose market-timing policies and procedures to stop abuse. Then, it increases penalties for mutual funds which do not follow their own policies and procedures to limit abuse.

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In order to help stop mutual fund abuse, this legislation increases the penalties and jail time for current securities laws including: defrauding the offer or sale of securities, failing to keep current and appropriate records of brokerage transactions, and not selling or redeeming fund shares at a price based on current Net Asset Value (NAV). These changes will make criminals think twice before committing violations of securities laws. The proceeds of the additional fines collected by this legislation will be put into a fund to assist the victims of their crimes.

Today, individual mutual funds are effectively dominated by their advisers. My legislation strengthens the influence of independent directors on fund boards by requiring that independent directors comprise at least three-quarters of the board. It will also require mutual funds to have an independent chairman with the authority and ability to demand and receive all information from the fund advisory and management companies. This will increase the voice investors have in fund management and limit mutual fund abuses.

By developing a new structure to provide appropriate oversight and enforcement mechanisms to fight abuse in the mutual fund industry, this legislation restores the confidence of investors in mutual funds. Ultimately, investor confidence will increase investment and enhance economic growth. I ask all my colleagues to support this legislation.·