From MarketWatch, online at:
http://www.marketwatch.com/news/story.a ... &minisite=
FUND REFORM HITS THE COURTS
9/19/2005 6:59:00 PM
By Paul B. Farrell
6:59 PM ET Sep 19, 2005
ARROYO GRANDE, Calif. (MarketWatch) -- The fund industry has finally met its match:
Federal trial judges. They can't be bought off by special-interest lobbyists. In the
coming year they will preside over trials guaranteed to reform the fund industry.
FundDirections, a magazine for trustees, directors and other insiders, recently
reported that a "new, aggressive and savvy plaintiffs' bar, including attorneys who
participated in huge settlements won against the tobacco industry, are now
methodically working on a nationwide scale" to challenge the fund industry.
So, as University of South Carolina Law School Prof. John Freeman, a former SEC
attorney, succinctly put it: "Fund insiders are now running scared. Their
special-interest lobby can control Congress, the SEC and the White House, but they
can't buy the judges." And the judges don't like what they see.
The background of this incredible turn of events is fascinating: For many decades
fund managers have had powerful lobbyists who won special protections from Congress,
the SEC and the White House. In fact, since the passage of the Investment Company Act
of 1940, fund-industry insiders have taken it for granted that they can run $8
trillion fund industry with impunity, putting their own personal interests ahead of
the fiduciary duties of America's 95 million small investors.
So after the Senate killed the Mutual Fund Reform Act in early 2004 I felt that the
fund industry's lobby was so powerful, so bullet-proof, that nothing could penetrate
and reform it. So when I reviewed two new books by highly respected critics exposing
corruption in the industry, it wasn't with any hope they would trigger change.
Fund industry is a 'colossal failure'
-----------------------------------------------------------------------
One book was "The Battle for the Soul of Capitalism," by Vanguard's founder Jack
Bogle. His arguments were familiar, after years of reading his speeches and books.
The second was "Unconventional Success" by David Swensen, the amazingly successful
manager of the Yale University endowment fund (16.1% average annual returns since
1982!). Swensen originally set out to share his experience with average investor.
However, he finally concluded that investors would never be able to use his
strategies.
Worse yet, Swensen concluded that fund industry conflicts of interest "lead to
behaviors that line the pockets of mutual fund managers at the expense of the
individual investor;" that the "colossal failure of the fund industry carries serious
implications for society, particularly regarding retirement security for America's
workers;" and that the industry is "seriously impairing the level of resources
available to support future generations." A brutal indictment.
Two powerful attacks by highly respected experts. Unfortunately, these two books
merely repeated criticisms we've heard many times before from big guns like former
SEC chairman Arthur Levitt in "Take on the Street," and other high-profile critics.
We heard the same indictments, to no avail, during the 2003-04 congressional
hearings from Sen. Peter Fitzgerald, author of the Fund Reform Act of 2004, and other
critics: Fitzgerald said "the fund industry is the world's largest skimming
operation, a $7 trillion trough from which fund managers, brokers and other insiders
are steadily siphoning off an excessive slice of the nation's household, college and
retirement savings."
But that didn't matter! The industry dodged the bullet anyway. Fitzgerald was
trumped by the fund industry's special interest "conspiracy," as Bogle called it.
After months of hearings, Sen. Richard Shelby, chairman of the Senate Banking
Committee, dismissed the reform legislation: "We must be sensitive to the current
political environment, in which I believe it will be very difficult to pass a bill."
SEC run by little Chihuahuas
-----------------------------------------------------------------------
When the Senate killed the reform bill, it handed the responsibility back to the
SEC. But since the SEC, like Congress, is also controlled by special interests, that
was like throwing the fox back into the henhouse: SEC "professionals are dedicated to
protecting the industry's managers, and the industry's managers have an agenda that
does not place the fund shareholders first," says Freeman. "The SEC has failed mutual
fund investors. [They are] a Chihuahua watchdog, not the Doberman that shareholders
need."
So my initial reaction was: So what. Unfortunately, even two great books by Bogle
and Swensen will have little effect. The industry lobby is so powerful, protected by
a conspiracy of friends in high places in Congress, the SEC and the White House,
these books will be old news in a week.
But then I learned the fund-reform movement had shifted to the federal courts, and
suddenly, massive changes are almost certain! The industry is in for huge reforms. So
fund insiders are running scared because they can't buy off trial judges as they can
Congress and the SEC. They are facing a full-court press rivaling the attack on the
tobacco industry.
According to Freeman, in the next year you can expect to see more than two dozen
cases going to trial in federal courts all over America, against Fidelity, Federated,
Franklin-Templeton, MFS, AIM and others. This is significant because they're based on
a totally new legal strategy: For two decades excessive-fee cases never got to trial.
Industry lawyers routinely got them dismissed based on the Gartenberg vs. Merrill
Lynch ruling that essentially said if a fund's expenses were in line with the
expenses of similar funds, the fees could not be excessive (no matter how high!).
But now federal judges are letting these new cases go to trial based on a new
theory: Plaintiffs argue that the fund industry's explosive growth has generated
economies of scale that fund managers are not sharing with all investors. Instead,
the benefits are shared primarily with larger investors, or favored institutional
clients, or simply pocketed by insiders, all of which is a violation of the fiduciary
duties imposed by the 1940 act.
Ironically, when the Senate avoided responsibility by passing the ball back to the
harmless Chihuahuas at the SEC, it didn't realize it was also turning loose a couple
dozen Dobermans in the plaintiff bar. And the Dobermans started attacking.
Bottom line: The Federal judiciary is now going to do what Congress, the SEC and the
White House have long refused to do: Reform a corrupt mutual fund industry.