Oral Statement Concerning Recent Commission Activity to Combat Misconduct Relating to Mutual Funds

Stephen M. Cutler

Director, Division of Enforcement
U.S. Securities and Exchange Commission

Before the Senate Subcommittee on Financial Management, the Budget, and International Security, Committee on Governmental Affairs

November 3, 2003

Chairman Fitzgerald, Ranking Member Akaka, and distinguished members of the Subcommittee:

Good morning. Thank you for inviting me to testify today on behalf of the Securities and Exchange Commission concerning abuses relating to the sale and operation of mutual funds. More than 95 million Americans are invested in mutual funds. For that reason, 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. 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. And I feel that not just as a prosecutor, but as a citizen and member of the investing public.

It is intolerable when investment professionals — who are duty-bound to serve their customers' interests — instead serve their own. The conduct we have seen is antithetical to the duties that mutual funds, investment advisers, brokerage firms, and their employees owe to fund shareholders. Individual investors have a right to expect fair treatment, and quite simply, they have not gotten it. Along with the other regulators sitting at this table, the SEC is fully committed to ensuring that those responsible for betraying the trust of mutual fund shareholders are held accountable and brought to justice.

Indeed, that process has begun, starting of course with Mr. Spitzer's action against the Canary Partners hedge fund firm and its principal, Edward Stern. Since then, the Commission has brought five enforcement actions involving fraud against mutual fund investors. In each one, the Commission's staff has worked in close coordination with State regulators, including my distinguished co-panelists, Mr. Spitzer and Mr. Galvin. I'll touch on each of the cases very briefly.

On September 16, the Commission filed a civil action against Theodore Sihpol, Canary's primary contact at Bank of America Securities. We allege that Sihpol played a key role in enabling certain hedge funds to engage in late trading — that is, putting in orders after 4 p.m. but receiving the old, 4 p.m. price. On the same day the Commission commenced its action, the New York Attorney General filed a two-count criminal complaint charging Sihpol with larceny and securities fraud.

Less than three weeks later, the Commission and the New York Attorney General again announced parallel criminal and civil actions, this time against Steven B. Markovitz, formerly an executive and senior trader with the prominent hedge fund firm Millennium Partners. According to the criminal charges and the SEC findings, Markovitz engaged in late trading on behalf of his firm. In partial settlement of the SEC's action, Markovitz agreed to be permanently barred from associating with an investment adviser or from working in any capacity with or for a registered investment company.

In the first action against a mutual fund executive for permitting abusive market timing, on October 16, the Commission and the New York Attorney General announced the arrest, conviction, and lifetime industry bar of James P. Connelly, Jr., former Vice Chairman of Fred Alger & Company. Market timing, of course, refers to the practice of excessive short-term buying and selling of mutual fund shares in order to exploit inefficiencies in mutual fund pricing. In its administrative order, the SEC found that Connelly had approved agreements that, contrary to Alger's prospectus disclosure, permitted select investors to market time certain mutual funds — in some cases, in exchange for the timers leaving at least 20% of their investments at Alger in buy-and-hold positions. The Commission's order bars Connelly from the industry and imposes a $400,000 civil penalty.

Most recently, on October 28, in conjunction with the Secretary of Massachusetts, the Commission brought enforcement actions against Putnam Investment Management and two former Putnam portfolio managers, Justin M. Scott and Omid Kamshad, in connection with Scott and Kamshad's personal trading in Putnam mutual funds. We alleged that Scott and Kamshad market timed the very Putnam funds they managed, and that Putnam failed to take adequate steps to prevent or disclose their self dealing activity or that of other Putnam personnel who engaged in excessive short-term trading of Putnam funds.

I think I can safely predict that many more enforcement actions will follow. We are currently conducting a broad-based inquiry of late trading, market timing and related self-dealing practices. On September 4, the Commission staff sent detailed, compulsory information requests to 88 of the largest mutual fund complexes in the country and 34 brokerage firms, including all of the country's registered prime brokers. And just last week, we sent similar requests to insurance companies that sell mutual funds in the form of variable annuities. Based on the responses to these requests, Commission staff have been dispatched to conduct onsite inspections and interviews and further investigation at dozens of firms.

Although we are continuing to receive and analyze the responsive information, I would like to highlight some of the most troubling items. I must emphasize that these are only preliminary, and are the subject of continued, active investigation.

First, on the subject of late trading:

• More than 25% of responding brokerage firms reported that customers have received 4 p.m. prices for orders placed or confirmed after 4 p.m.
   
• Emails submitted by approximately 10% of the responding mutual funds contained references to situations that possibly involved late trading.
   
• Three fund groups reported, or the information provided indicated, that their staffs had approved a late-trading arrangement with an investor.

Second, on the matter of market timing:

• We have already reported that 50% of responding fund groups appear to have had at least one arrangement allowing for market timing by an investor.
   
• But in addition to that, documents provided by almost 30% of responding brokerage firms indicate that they may have assisted market timers in some way, such as by breaking up large orders or setting up special accounts to conceal their own or their clients' identities — a practice sometimes called "cloning" — to avoid detection by mutual funds that sought to prevent abusive market timing.
   
• Further, almost 70% of responding brokerage firms reported being aware of timing activities by their customers.

Finally, let me mention another potentially abusive practice that has gotten our attention — the selective sharing of mutual fund portfolio information:

• More than 30% of responding fund companies appear to have disclosed portfolio information in circumstances that may have provided certain fund shareholders the ability to make advantageous decisions to place orders for fund shares.

The Commission's staff is following up on all of these situations closely, along with my colleagues at the table.

Let me also point out that we are also actively engaged in enforcement and examination activities in four other important areas involving mutual funds — some of which I know that Mary Schapiro will address:

• The first area is mutual fund sales practices and fee disclosures. In particular, we are looking at just what prospective mutual fund investors are being told about revenue sharing arrangements and other incentives doled out by mutual fund management companies and mutual funds themselves to brokerage firms who agree to feature their funds. We are looking at whether there is adequate disclosure of the source and nature of such payments — and the fact that they may increase costs to investors as well as create conflicts of interest between investors and the financial professionals with whom they deal. In one case involving a major financial institution, we have already issued a Wells notice of the staff's intention to recommend what I think would be first-of-their-kind charges to the Commission.
   
• Our second area of focus is the sale of different classes of shares in the same mutual fund. Very frequently, a fund will have issued two or more classes of shares, commonly referred to as A shares, B shares, and so on. Each class will have a different fee structure associated with it. In the last six months we have brought enforcement actions against two brokerage firms, Prudential Securities and IFG Network, in connection with the alleged recommendations that customers purchase one class of shares when the firm should have been recommending another.
   
• The third area is the abuse of so-called "breakpoints." That's a fancy term for what are in essence volume discounts available to investors who make large purchases of mutual fund shares. Quite simply, we have found numerous instances in which it appears that brokerage firms did not give investors the discounts to which they were entitled. This week, together with the NASD, we will be issuing Wells notices to a significant number of brokerage firms for their failure in this regard.
   
• The final area is the pricing of mutual funds beyond the context of market timing. We are actively looking at two situations in which funds dramatically wrote down their Net Asset Values in a manner that raises serious questions about the funds' pricing methodologies.

Before I conclude, I'd like to take a moment to address press reports that, several months ago, an employee in Putnam's call-operator unit told our Boston office that individual union members were day-trading Putnam funds in their 401(k) plan. Do I wish that we'd have brought the Putnam case two months ago instead of two weeks ago? Of course I do.

You know, the SEC receives on the order of 1000 communications from the public in the form of complaints, tips, emails, letters and questions every working day. That's more than 200,000 a year. We've made and are continuing to make changes in how we handle these — including giving more expeditious treatment to those that raise enforcement issues and instituting a monthly review of the disposition of each enforcement-related matter by the Division's senior management. Tips from whistleblowers are critical to our program. In fact, the investigation of personal trading at Putnam — which is what we ultimately sued Putnam for — was launched when we received a tip in that area just a few weeks ago.

Speaking more generally, I am proud of the Commission's record in the enforcement arena. In our just-concluded fiscal year, the Commission brought 679 enforcement cases involving just about every conceivable type of securities violation. That's a 40% jump from just two years ago. We accomplished this dramatic increase with almost no increase in resources. And included in our most recent year's totals are some extraordinary efforts on behalf of the investing public: $1.5 billion in disgorgement and penalties designated for return to investors using Sarbanes-Oxley Fair Funds; 60 enforcement actions against public company CEOs; nearly 40 emergency asset freezes and TROs to protect investors' money on a real-time basis; groundbreaking and important cases against brokerage firms and banks for their roles in the Enron debacle; the first-ever case against a mutual fund management company for its failure to disclose a conflict of interest in the voting of its funds' proxies; a first-of-its-kind case against a major insurance company for aiding and abetting an issuer's financial statement fraud; multiple cases alleging violations of the Commission's new selective disclosure rule; the largest civil penalty ever obtained in a securities fraud case; and dozens of financial reporting cases involving Fortune 500 companies and their auditors. The dedication, commitment and professionalism of our Enforcement staff are second to none.

With Congress' help, we have now begun to see additional resources. With more people and better technology, our mandate from Chairman Donaldson is to more proactively identify problems and to "look around the corner" for the next fraud or abuse. With respect to mutual funds, I know that the agency's routine inspection and examination efforts will be improved by adding new staff, increasing the frequency of examinations, and digging deeper into fund operations.

We are working aggressively on behalf of America's investors to ferret out and punish wrongdoers wherever they may appear in our securities markets — including in the mutual fund area.

And at the same time that the Commission is looking back to identify and punish past misconduct, the Commission has been engaged in a comprehensive regulatory response designed to prevent problems of this kind from occurring in the first place. My colleague Paul Roye, Director of that Division, will discuss those initiatives.

Thank you, and I would be happy to answer any questions you may have.

http://www.sec.gov/news/testimony/ts110303smcoral.htm