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News October 2, 2006 Issue

Service Provider Kickback Scandal Looms Over Fund Industry

Just when you thought it was safe to talk about what you do
for a living Ö

Last weekís settled SEC enforcement action against BISYS Fund Services is sending shudders through the investment management industry.

While the case involves mutual-fund specific circumstances, its broader implications are worthy of note by all investment advisers. Simply put: If you recommend that your clients hire a service provider, and you receive some benefit from that recommendation, you had better ó at a minimum ó make full disclosure of that benefit to your clients.

The SECís September 26 order alleged that BISYS entered into undisclosed "side agreements" with fund advisers, whereby BISYS agreed to use a portion of the administration fees it received from the fund to reimburse the adviser for marketing and non-marketing expenses. In return, the adviser agreed to recommend that its fund board approve BISYS as a service provider.

The boards were told that BISYS would use a portion of its administration fee to promote the fund. However, the SEC alleged, they were not informed about the existence of the side agreements, or that their fundís adviser and BISYS had entered into a side agreement before the adviser recommended that the board approve BISYS. Consequentially, the marketing fees reimbursed by BISYS were not covered under the fundís 12b-1 plans.

The SEC also alleged that BISYS entered into securities lending agreements with the funds, pursuant to which the funds paid an "excessive fee" to BISYS. Part of that fee, alleged the SEC, was used to pay the adviser for "purported" consulting services. "At its core, the consulting agreement was merely a vehicle to pay money otherwise due to the [funds] from the securities lending program to [the adviser]," the SEC alleged.

To settle charges that it aided and abetted the advisersí fraud, and other charges, BISYS agreed to pay $21 million, including a $10 million civil money penalty. The company also agreed to hire an independent consultant to review its policies and procedures governing the receipt of revenue and payment of expenses associated with its administrative, fund accounting, and distribution services. BISYS was not directly charged with fraud.

"We are glad to have reached closure on this issue so that we can move forward to build and strengthen our business," said BISYS president Fred Naddaff, in a statement. "We have implemented industry-leading best practices to ensure compliance with the highest legal and ethical standards."

Several industry lawyers noted that the SECís order echoed themes raised by the SECís June 2005 Citigroup case. In that proceeding, the SEC alleged that Citigroup allegedly set up a transfer agent to service its mutual funds, but then turn turned around and hired the Citigroup fundsí previous transfer agent to perform virtually the same services it always had, albeit at significantly lower rates. Citigroup allegedly kept the difference as profit. "Itís the same concept," noted one investment management lawyer. "Itís right on point."

The case also evokes memories of the initial Canary complaint, which foreshadowed the market timing scandal that shook the fund industry. The SECís order stated that BISYS was continuing "to cooperate with the Commission in future proceedings." And, ominously, the SECís press release stated that "the Commissionís investigation is continuing."

Clearly, other shoes are going to drop. The question is, how many.

The SECís order alleged that BISYS aided and abetted fraud violations by no fewer than twenty-seven mutual fund advisers. The SEC alleged, with alarming specificity, that twelve of the agreements were written and fifteen were oral.

If the alleged conduct was simply limited to BISYS, the fallout might not be that bad. Several industry lawyers noted that the companyís client base consists of smaller, bank-oriented fund groups, rather than the "big names" of the fund industry, as one lawyer put it.

The bad news, however, is that itís not just BISYS. According to one industry source, the SEC is aware of similar fee arrangements at other fund administrators. "They have found generally similar fact patterns in other contexts," he said.

Still, despite its potentially broader scope, the service provider scandal (can anyone think of a better name?) is not expected to rock the fund industry the way the market timing scandal did.

First and foremost, the case against BISYS has been expected: The company has been disclosing the existence of the pending SEC enforcement action for over a year. Moreover, it has been well-known throughout the industry that the Commission has been scrutinizing fund service providers, as evidenced by the SECís mini-sweep in this area two years ago. In contrast, noted one law firm partner, the market timing scandal "broke out of the clear blue."

Another industry observer agreed that the BISYS case, and any subsequent cases, will have "less of an impact" than the market timing scandal. "I donít think itís going to have nearly the PR value," he said. "People have been sort of scandal saturated." He expressed hope that the SEC would not bring an "unfolding series" of enforcement cases (although, he added, "I donít rule that out.") The SEC "knows whatís out there," he said. "This isnít necessarily a tip of the iceberg situation. This may be a good part of the iceberg."

But there will be consequences. "There are higher standards that people are going to be subject to now," said the industry observer. The question is not just "Who are we paying and how much?" Instead, he explained, the question is also "Is any part of this payment going to some other fiduciary of the fund?" In the past, he noted, people may not have focused on that issue. Now, however, if there is any undisclosed benefit to the adviser from a service provider arrangement, "there is a potential for trouble." In his view, the take-away lesson from the BISYS case is that without disclosure to boards about a fee rebate to the adviser, the adviser is at risk, regardless of whether the fee rebate may have benefited the funds. In light of the case, boards will be asking for information on any side arrangements with fund service providers. "Tell them, even if they donít ask," he added.

"Iím sure there was more than one company involved here," noted the law firm partner. "It wouldnít surprise me if there were others out there, because the business is competitive. A certain type of activity engaged in by one company is a pattern that is likely to be followed by others." However, he concurred that the fallout "probably will be not as extensive" as that from the market timing scandal. Here, he predicted, the SEC "will get its message out" through this case and perhaps others. "My guess would be weíll see other cases," he said, but there "wonít be as much fanfare." And, he added, the SEC is unlikely to propose new regulations to address the conduct.

The law firm partner suggested that advisers go back and review their service provider arrangements. The fact pattern described in the BISYS case "is a reflection of the way business was done," he said. "The SEC is basically taking a look at it now with a little bit of 20/20 hindsight and suggesting that the way business was done was not appropriate." The practical lesson, he said, is that "everyone is going to look really carefully at these arrangements," he said. It will be "yet another burden placed on boards."

The investment management lawyer agreed that boards will be stepping up their review of service provider arrangements. In his view, an adviser should inform the board about "everything."

He also emphasized that the fund industry is a regulated business and that individuals operating in that environment should be aware of that fact. "If you are in the business, you need to know about fund assets for distribution," he noted. The side deals in the BISYS case, he said, seemed to allow the advisers to "essentially move cash around that they couldnít get lawfully out of the fundsí assets." Advisers, he said, should "know better than that." He suggested that part of the problem might have stemmed from a lack of regulatory awareness. "You have to have people involved in the process that understand the regulations," he said. "You canít have some jack-of-all-trades signing off on these agreements."