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Prison Sentences Needed to Stem Mutual Fund Abuses

Milwaukee Journal Sentinel Guest Opinion, November 16, 2003

The recent scandals surrounding mutual fund companies highlight the necessity for vigorous criminal prosecution and prison sentences for executives who engage in fraudulent activities. The executives at firms like Strong and Putnam who allegedly have violated or at least thumbed their noses at state and federal securities laws have done so with virtual impunity.

Richard S. Strong may face criminal charges for allegedly profiting from improper trading he conducted for himself, his family and friends, according to prosecutors. He resigned as chairman of Strong Mutual Funds, but remains chairman of Strong Capital Management. Putnam settled a securities fraud lawsuit over improper trading by fund managers by agreeing to implement reforms. It also fired Lawrence J. Lasser as chief executive of Putnam Funds.

One of the worst kept secrets in corporate America is that the penalties for getting caught with one’s hand in the cookie jar are nothing more than a monetary slap on the wrist and possible disgorgement of the ill-gotten gains. The prospect of prison time for those who defraud individual investors would change this perception and help prevent the types of abuses that allegedly occurred at mutual fund companies across the country.

The U.S. has a long history of such slaps on the wrist for violators of state and federal securities laws. In the past, the punishment for placing individual investors’ interests behind those of the mutual fund or brokerage firm has not fit the crime, which further emboldens others to engage in the same type of activity. Merrill Lynch research analysts knowingly disseminated inaccurate, misleading research reports on companies followed by the firm in order to generate investment banking fees, resulting in billions of dollars of investment losses for clients. The firm’s penalty was a $100 million fine, which is about one-third of its annual postage expense.

Xerox was accused by the Securities & Exchange Commission of engaging in a wide-ranging, four-year, $1.5 billion accounting fraud. The firm paid a $10 million fine without admitting any wrongdoing. Ernie Olde of Olde Discount, a brokerage firm, engaged in multiple fraudulent sales practices in the mid-1990s that helped him build a company he eventually sold to H&R Block for more than $700 million. Olde eventually paid a $4 million fine and served a 12-month suspension from the securities industry. As long as the SEC, the National Association of Securities Dealers and the criminal justice system view defrauding of individual investors different than street crime, the same types of abuses will continue unabated.

If $5 million is stolen from someone’s safe in their house, it is a virtual guarantee that the perpetrator will serve a significant prison sentence. If an executive at a mutual fund company converts the same amount of money spread across thousands of different investors through fraudulent or illegal sales practices, the executive will likely be fined and ordered to disgorge some of the ill-gotten gains. It is the equivalent of a bank robber being ordered to return $250,000 of the $500,000 he stole and then paying a $100,000 fine to prevent him from doing it again.

The primary method for avoiding future violations of state and federal securities laws at fund companies is vigorous criminal prosecutions of those responsible for the violations. If it becomes clear to mutual fund company executives who place their direct pecuniary interests ahead of those of their fund holders that the punishment is a probable prison sentence, this will severely curtail future criminal and fraudulent activity from occurring. The credible threat of prison time will send shock waves through corporate headquarters of mutual fund companies across the country.

With minimal penalties if they are caught, regulators who are sympathetic to their cause, and massive financial windfalls if successful, it is not surprising that so many individuals associated with the mutual fund industry are willing to place their financial interests ahead of those of their investors. Only the realistic threat of prison sentences for rational, highly educated, successful corporate executives will prevent these types of abuses from occurring in the future.

Andrew Stoltmann is a Chicago attorney and the author of “Investor Rights for the 21st Century.”

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