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Senate fund reform offered

THE BALTIMORE SUN

Senate lawmakers proposed legislation yesterday that would drastically alter the economics of the $7.4 trillion mutual fund industry by repealing some fees and sales practices, while giving independent directors more power to hold down investors' costs .

The legislation represents a sweeping reform of the industry that goes well beyond what House lawmakers and the Securities and Exchange Commission have proposed in a bid to stem the widespread market timing and late-trading abuses that came to light after an investigation by New York Attorney General Eliot Spitzer last fall.

Sen. Peter G. Fitzgerald, an Illinois Republican, and other members of a Senate Governmental Affairs subcommittee proposed the bill after holding a series of hearings that highlighted what critics say are conflicts of interest that have contributed to spiraling costs and lower returns for the 95 million Americans who invest in mutual funds.

"By making it easier for shareholders to compare funds on an apples-to-apples basis, the bill would unleash competitive market forces that have until now been bottled up by an obscure and misleading disclosure regime," said Fitzgerald, who last year called the mutual fund industry "the world's largest skimming operation."

While industry officials already have advocated some of the proposed reforms, many provisions of the bill are likely to put Congress on a collision course with Wall Street as it struggles with how to address the mutual fund scandals that have tarnished some of the biggest names in the industry.

The legislation, which has bipartisan support in the Senate, would repeal rule 12b-1, a 24-year-old regulation that was supposed to be a temporary measure to help the then-struggling fund industry increase sales. The rule gave funds the ability to use shareholder assets to pay for sales and distribution costs. Today, a majority of mutual funds charge the annual fee, which Fitzgerald said ends up enriching brokers at the expense of shareholders.

The bill also would ban revenue sharing arrangements, in which fund companies pay brokers and financial advisors to push certain funds over others. An SEC study revealed last month that numerous firms paid such commissions without adequately disclosing the deals to shareholders.

Soft dollar arrangements, in which funds steer trading business to brokers in exchange for research, would be eliminated, as well. Funds would be required to disclose payments for research and other services separately. And directed brokerage arrangements, in which funds steer trading business to firms in exchange for help in selling their products, would be banned. Critics say the practice inflates costs to shareholders.

The bill also would require mutual funds to give investors an annual breakdown of the fees they paid in dollar terms.

The bill would mirror a proposed SEC rules that would require fund officials to adopt a code of ethics and require that fund chairmen and three-fourths of fund directors be independent.

The bill, which is one of four mutual fund reform bills that have been introduced in recent months, was co-sponsored by Sen. Carl Levin, a Michigan Democrat, and Susan Collins, a Maine Republican. The House passed its own reform legislation in November.

The Investment Company Institute, which represents the mutual fund industry, said the proposed legislation contains "ill-defined new legal standards that could change mutual funds' essential structure."

"These changes could produce major dislocations and unintended consequences that would deter innovation, diminish competition, breed litigation and - as a result - harm current and future generations of mutual fund shareholders," said Matthew P. Fink, president of the institute, in a statement.

But industry critics say the changes are needed in order to restore confidence in the industry.

At least 20 mutual fund companies are being investigated for various trading abuses. Yesterday, Franklin Resources Inc., the parent of Franklin Templeton Investments, said the SEC intends to recommend charging the company and two executives over its trading practices.

"It seems to me the writing is on the wall that these practices are going to go, and this is a bill that definitely moves it in the right direction," said John. C. Bogle, an outspoken industry critic and founder of mutual fund company Vanguard Group.

However, Bogle said the reforms should probably be phased in over time in order to avoid sending the industry into chaos.

"I think we ought to be a little circumspect in cutting away the foundation, lest the whole building fall down," he said.

But some industry analysts say the bill goes too far.

"He [Fitzgerald] probably under-appreciates the complexity of the issues and how reliant the industry is on some of these underlying practices," said Jeffrey Keil, a vice president for fund tracking firm Lipper Inc. in Denver.

Keil said that 12b-1 fees, revenue sharing and soft dollar arrangements should be reformed and reconstituted, but not eliminated altogether.

"There are some valid expenditures under 12b-1 that have some merit and shouldn't necessarily be abolished," he said.

Lawmakers face a challenge in convincing the industry to give up 12b-1 fees, which a majority of mutual funds charge their investors.

Fitzgerald said the fees have grown out of control. His bill would direct the SEC to repeal the fees, but allow fund advisers to use their advisory fees to pay for sales expenses. The provision would encourage fund managers to keep such costs down, since the expense will come out of their profits rather than shareholder assets, the bill's sponsors said.

But the ICI has argued that 12b-1 fees give investors a choice in how they pay for a fund's distribution expenses.

In the past, investors paid an upfront sales commission, or load, when buying mutual fund shares. By contrast, a 12b-1 fee is paid annually.

The SEC, which regulates the mutual fund industry, has proposed rules that would require funds to disclose revenue sharing agreements and make fees more transparent to shareholders. But it has not yet taken up the issue of 12b-1 fees.

SEC officials were still reviewing the legislation yesterday and couldn't comment on its contents.

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