Schwab’s Role in Mutual Fund Probe Adds New Dimension

-By John Shipman, Dow Jones Newswires; 201-938-5171; john.shipman@dowjones.com

(Kathy Chu, Yuka Hayashi, Jane Kim and Kaja Whitehouse contributed to this article.)

NEW YORK — The impact of the mutual-fund probe may finally be hitting home on Main Street.

Since New York Attorney General Eliot Spitzer first announced the wide-ranging investigation into mutual-fund share-trading practices, several fund firms have disclosed that they may have allowed select investors to trade rapidly in and out of funds – a strategy known as market timing – or allowed some to place trades after hours, in violation of securities law.

But the disclosure Friday that Charles Schwab Corp. (SCH) found instances of market timing – and possibly late trading – in its own firm ups the ante, since the firm is built around giving the average person an entree into investing. Not only is Schwab one of the marquee discount brokers, it is also a fund supermarket, giving investors a wide range of choices in funds. And it is a name that has generally been associated with trust and stability.

“This is a company that built its franchise on gaining the trust of the average Joe investor,” said Mike Ford-Taggart, an analyst who covers Schwab for investment researcher Morningstar Inc.

“The bottom line,” he said, “is it will test client loyalty.”

Indeed, Lehman Brothers analyst Mark Constant believes Schwab’s promotion of its image as objective and its focus on investors’ interests could increase scrutiny of the firm by regulators and the media.

In a note Friday, Constant called the firm’s “squeaky-clean image” questionable, and said that image “is at far greater risk as this investigation plays out, with the media attention likely to be amplified.” Constant doesn’t own Schwab’s stock and Lehman disclosed no current investment banking business with Schwab.

Schwab has given just scant details, released early Friday in a filing with the Securities and Exchange Commission. Prompted by inquiries from regulators, Schwab conducted an internal review of its operations, and found market-timing arrangements with a “small number of parties.” Such arrangements affected six or seven of its U.S. Trust unit’s Excelsior funds, and have since been terminated.

Schwab also said, separate from any activities at U.S. Trust, that it found a “limited number of instances” where fund orders may have been entered or processed after the 4 p.m. market close.

The company didn’t give any indication as to which funds offered on the platform were used as market-timing vehicles, including whether they were Schwab-brand funds or third-party funds.

“We don’t have details yet on which funds may have been affected,” said Schwab spokesman Greg Gable. “But it’s an extremely small number of instances that we are investigating.”

In some ways, Schwab was destined to be brought into the scandal, at least tangentially, since it offers such a wide range of funds and dozens of mutual-fund companies have already said they have been subpoenaed for information from Spitzer, the SEC or other regulators. Schwab’s mutual-fund supermarket is among the largest of its kind, offering more than 2,000 mutual funds. As of the end of September, investors had $362 billion in total assets invested through the system. Of that amount, $155 billion were in Schwab group’s proprietary funds, while the rest are funds from third-party providers.

“What surprises me is that this is the first time a financial warehouse is being named,” said Donald Trone, president of the Foundation for Fiduciary Studies, a Sewickley, Pa., organization that develops fiduciary standards for trustees, investment committees and advisors. “I would have expected this issue to come up sooner because of the vast volume of mutual-fund trades that (financial warehouses) handle on a daily basis.”

But Schwab’s name carries such heft in the market that the new disclosure runs the risk of making many investors nervous and it comes at a time when the average investor is just starting to pay close attention to the widening scandal.

“This (probe) finally seems to be reaching a critical mass,” said David Yeske, president of the Financial Planning Association, an Atlanta organization with 29,000 members. “Up until now, my clients seemed to be unaware of what’s going on, but just in the last week or so, we seem to have crossed the threshold where there’s heightened awareness of what’s going on. It’s the drip, drip, drip effect of the issue being in the paper everyday.”

There are some factors in Schwab’s favor. For one thing, investors may have scandal fatigue already, even if they are only tuning into the investigations. A sampling of customer opinions at Charles Schwab’s Wall Street branch office seemed to indicate investors are taking the market-timing and late-trading news in stride, mostly since they believe the same types of activities happen at most firms.

“My perception of all these (firms) is the same,” said Brooklyn resident Jay Sonin. “They’re scoundrels.”

For now, the market-timing activity seems limited to Schwab’s U.S. Trust unit, which caters to high-net-worth individuals. Schwab’s “everyman” investor typically isn’t exposed to that part of the firm’s business, said Jim Gargan, a retired New Yorker.

That could be a key distinction, said George Walper, president of Chicago research firm Spectrum Group. “Schwab clearly is a very well-known brand,” he said. But if wrongdoing only happened at U.S. Trust, “that may not affect the brand,” Gargan said.

Then there’s Charles Schwab himself. The firm’s squeaky-clean image has been driven largely by the personal touch of the man whose name is on the front door. Charles Schwab has been a vocal spokesman for both his company and smart investing in general, and that personal touch may be what ultimately allows Schwab to bounce back faster than its peers, said Don Cassidy, senior analyst with Lipper Inc. in Denver.

Charles Schwab will be able to “use some of his personal charisma to have fireside chats with people, tell them what (the firm) has done to take care of it,” Cassidy said.

It happens all the time in politics, Cassidy noted. “If you have pre-existing credibility, you can pull it off,” he said.