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The man in the white hat

Fidelity veteran Robert Pozen is working overtime to restore the good name of MFS. Can he do the same for the entire mutual fund industry?

Sitting in the study of his Boston condominium a week before Christmas last year, Robert Pozen picked up the phone to call his friend Jeffrey Shames. "How are you holding up?" he asked.

It was no idle question. Two months earlier Shames had lost his wife to breast cancer after a lengthy battle. And the Securities and Exchange Commission was breathing down his neck, investigating Massachusetts Financial Services Co., the giant mutual fund company of which he was chairman, over charges that the firm inadequately disclosed its policy of allowing some market timing of its funds.

The 49-year-old Shames, who had relinquished the CEO title the year before, told Pozen that he was determined to retire once the SEC matter was resolved, to care for his 11-year-old daughter, an only child. He suggested, as he had before, that Pozen, 58, the well-known former general counsel and vice chairman of Fidelity Investments, then just teaching a course at Harvard Law School, might join MFS. After the pair hashed over the possibility, Shames urged Pozen to stay in touch.

A month later Pozen returned home from a vacation in Thailand and called his friend again, only to learn that the SEC had intensified its probe. "Let's meet," Shames said. "Things have heated up."

Indeed they had. The next few days marked one of the most intense and traumatic times in the firm's history. Even as the old friends huddled to discuss in what role and under what terms Pozen might join the company -- he also met with Donald Stewart, CEO of MFS's parent, Sun Life Financial of Canada -- MFS hammered out a tough settlement with regulators. On February 5, MFS, without admitting or denying guilt, agreed to pay $225 million to settle civil fraud charges brought by the SEC, while promising in a separate deal with New York State Attorney General Eliot Spitzer to cut its fund fees by $125 million over the next five years. The SEC suspended MFS's CEO, John Ballen, and its chief investment officer, Kevin Parke, from the financial services industry for nine and six months, respectively, and barred them from ever serving as senior officers of MFS. With these matters behind him, Shames resigned on February 9. He was succeeded by Pozen; popular fixed-income boss Robert Manning, 40, rose to CEO.

For MFS, the proud descendant of the Massachusetts Investors Trust, the inventor of the mutual fund, it was a costly and humbling fall. No one understood that better than Pozen, called out of retirement to help restore a former competitor's reputation and livelihood.

Yet for Pozen, the challenge was irresistible. A sharp lawyer with a nose for a business opportunity, he would finally get to snare the top job, long an unlikely outcome at family-controlled Fidelity, where Abigail Johnson, daughter of the firm's chairman, Edward (Ned) Johnson III, has been the odds-on successor for years. Highly regarded for his clear thinking and unimpeachable reputation for integrity, Pozen owns a wide-ranging, hands-on knowledge of the business that few can match. He literally wrote the book on mutual funds (The Mutual Funds Business, MIT Press, 1998).

"I had such tremendous respect for Jeff and for the MFS organization," says Pozen. "It's the oldest fund company, and one of the best. I knew I could make a difference at a difficult time." (See box at left.)

As the public face of MFS, Pozen confronts a daunting task: restoring investors' shaken faith not only in MFS but also, by extension, in the whole mutual fund industry -- which, after all, was built as much on trust as on performance. He and Manning join a cadre of new leaders at scandal-tarred money management organizations -- David Bullock at Pilgrim Baxter & Associates, Charles Haldeman at Putnam Investments, Lewis Sanders at Alliance Capital Management, Steven Scheid at Janus Capital Investments -- who are cutting fees, reshaping their boards of directors and focusing on shareholder protections in an effort to reassure a skeptical public that it can again place its confidence, as well as its money, with the big mutual fund companies. They are the men in the white hats come to rescue a tarnished industry.

MFS, like other mutual fund companies, must meet new SEC rules that, among other things, require funds to appoint independent chairmen, disclose more about their market-timing restrictions and report to the agency what they're doing to protect their shareholders. The SEC has also cracked down on controversial but common business practices, notably telling funds to end the use of directed brokerage -- that is, paying trading commissions to brokers in exchange for distribution of their funds.

Pozen and Manning work in a close and complementary partnership, the former's reserve balancing the latter's outgoing personality. Manning focuses on investment management, operations, finance and marketing; Pozen handles legal and regulatory matters and public relations and deals with the MFS board. Initially, Pozen signed on as nonexecutive chairman, but in June he, Manning and the Sun Life directors agreed that the title of chairman would more accurately reflect the hands-on role he had assumed. "It was key that we strictly define our roles so as not to send any mixed messages," says Pozen.

Manning adds, "Bob Pozen is someone who speaks his mind, and that's how I am too."

Under Pozen, the no-nonsense securities lawyer, MFS is very much in the vanguard of the industry's Augean cleanup effort. For a start, Pozen serves as one of a half dozen members on an elite NASD committee advising the SEC on mutual fund reforms -- other members include Vanguard Group CEO Jack Brennan and T. Rowe Price Group vice chairman James Riepe. But the MFS chairman is on his own crusade to restore the industry's good name. He is bolstering controls, candidly describing fund practices -- and leaning on Wall Street for lower trading commissions for fund customers. In the process he is winning praise from veteran industry watchers.

"Bob Pozen is exactly what the mutual fund industry needs right now," contends Kurt Cerulli, founder and president of Boston-based investment consulting firm Cerulli Associates. "He's leading by example."

Pozen wasted little time cleaning house. Slicing to the heart of MFS's SEC troubles, he and Manning in late March acted to deter market timers by slapping a 2 percent fee on exchanges and redemptions made within 30 days on purchases of shares in any of the firm's 65 retail funds, excluding its three money market funds. MFS had already imposed a 2 percent redemption fee on exchanges and redemptions made within five days for its international, global and high-yield funds. "You can't just say, 'We here at MFS put shareholders first.' You have to show you mean it," Pozen says.

The SEC, meanwhile, appeared in early October to be backing away from a proposal to require all funds to impose 2 percent fees on shares sold within five days of purchase.

The SEC has required funds to have a chief compliance officer reporting to the board, but even before that ruling Pozen and Manning had created just such a senior-level watchdog post. They readily agreed that the ideal person to be MFS's chief regulatory officer was Maria Dwyer, 46, who had been head of compliance at the firm for a couple of years in the mid-1990s before joining Fidelity as treasurer of mutual funds. Manning and Pozen lured her back in early March. Dwyer, an attorney, is a commanding executive who will hold MFS to the highest ethical standards, Pozen says, noting that "she has gone through all internal controls from top to bottom." And where necessary, she has tightened up controls. Dwyer reports: "We've increased our focus on monitoring and deterring market timing. We're committed to achieving industry best practices."

Underscoring his commitment to compliance reform, Pozen named a new general counsel, tapping seasoned securities lawyer Jeffrey Carp, 47, in March. Carp had been a senior partner at Hale and Dorr, a leading Boston law firm that merged with Washington-based Wilmer Cutler Pickering in May. (MFS's former general counsel, Stephen Cavan, departed.)

Transparency -- and accountability -- have become watchwords at MFS. Along with Franklin Advisers, Janus and Putnam, MFS urged a break with entrenched industry practice, declaring in a March 16 conference call with reporters that it would abandon the use of "soft dollars," i.e., allowing brokers to direct some of MFS's trading commissions to third parties to pay for research and market data. Pozen predicts that the SEC will ban the use of soft dollars for products or services that do not make a "significant intellectual contribution" to the investment process. MFS now pays cash for data feeds and Bloomberg and Reuters terminals.

Pozen does not go quite so far as Fidelity Investments, which advocates separating commission payments for execution, research, capital commitment and other services. "I'm against unbundling," he says. "You can't put a price on capital commitment. Nor can you easily value access to a global analyst network."

Pozen elected to disclose in quarterly reports what MFS pays from its own account (not in the form of brokerage commissions) to compensate brokers for selling its funds. For instance, the firm pays Merrill Lynch & Co. the equivalent of 0.1 percent of the assets that Merrill's brokers direct to MFS's funds. Several brokerages, including Merrill Lynch Investment Managers, Smith Barney Citigroup and Wachovia Securities, disclose, on their Web sites or in client brochures, payments received from fund companies as part of sales agreements.

Further, the chairman recast MFS's quarterly fund reports so that shareholders can see clearly what they are paying in expenses -- in dollars, not in basis points. Eventually, Pozen says, he would like trading costs, not just portfolio turnover rates, spelled out in annual reports. "The more information, the better," he says.

But his most telling campaign has been his struggle to break out of a Wall Street stranglehold: the nickel-a-share institutional commission rate. Like other large asset managers, MFS was able to get Wall Street to direct, or "step out," one penny of the official 5-cent commission to pay providers of third-party research. That brought MFS's effective per-share commission rate to 4 cents. So when Pozen decided to stop directing that penny a share to third parties, he vowed to reduce MFS's official commission cost to 4 cents.

He says he has spoken with Merrill CEO E. Stanley O'Neal and Goldman, Sachs & Co. CEO Henry Paulson Jr. and also had extensive meetings with heads of research and trading at all the major sell-side firms. "Discussions have been constructive," Pozen asserts. "Everyone in the securities business realizes that the world is changing." Pressure to lower the 5-cents-a-share commission rate will only intensify. How does Pozen rate his chances of success? "Let's just say we hope to be closer to 4 cents a share by the end of the year," he says.

Pozen may want to add a chapter or two to his mutual fund textbook after his MFS experience. Winning back the respect of investors is only one of his and Manning's urgent chores. The pair must contend with a chastened Sun Life board of directors that can be counted on to scrutinize their actions. Moreover, the SEC's new ban on directed brokerage makes the cost of marketing retail mutual funds that much more onerous. As MFS cuts its portfolio management fees in keeping with the Spitzer settlement, profit margins will be squeezed. All this is taking place as active managers face greater pressure to outperform index funds and to avoid being shown up by hot hedge funds.

"Mistakes were made at MFS, but the company is fundamentally sound," says Pozen. Assets totaled $137 billion as of June 30, up slightly from $128 billion a year ago. Nevertheless, MFS suffered net retail outflows of $1.2 billion in this year's first quarter and $2.9 billion in the second quarter. Although MFS's fund performance has been solid across most asset classes, it remains decidedly subpar in the firm's signature category: large-cap growth. Pretax margins have held steady at 19 percent, as they were before the scandal, but Smith Barney Citigroup analyst Colin Devine projects that after hitting that number in the third quarter, "margins will then get squeezed" as the costs of compliance and the impact of lower fees kick in.

The investment process at MFS is very much Manning's domain. The CEO, who has always been an especially well liked figure at the firm, used some of his political capital when he orchestrated a modest shake-up among research analysts and portfolio managers. "We had some brutally honest heart-to-hearts with our staff," Manning says. "Some people decided that it was best to pursue other opportunities." The CEO also promoted several analysts to portfolio manager while bolstering the size of the research staff. At the same time he has tightened risk controls, monitoring portfolio weightings across all MFS funds.

Not surprisingly, Manning is focusing closely on the flagship MFS Large-Cap Growth fund, a critically important symbol of the firm. For the three years ended June 30, the portfolio trailed the Russell 1000 growth index by 2.7 percentage points (­6.4 percent for MFS versus ­3.7 percent for the index). But this year through August, performance has improved as the portfolio declined 2.8 percent, versus a 3.6 percent drop for the Russell index.

While Manning's moves have been well received by most MFS clients, bad publicity has nevertheless taken its toll as several pension clients have fired the firm this year. On February 20 the Illinois Teachers' Retirement System pulled a $664 million large-cap mandate. Jon Bauman, the plan's executive director, says he urged the Illinois board to dismiss MFS not only because of lackluster performance but also because the SEC settlement allowed ex-CEO Ballen and ex-CIO Parke to return to the firm. "That played heavily into our recommendation that MFS be dismissed," says Bauman.

A few weeks after the Illinois dismissal, Pozen and Manning made the tough decision to bar Ballen and Parke from coming back to MFS in any capacity. "It became clear from the feedback we got from our large clients that the best course was that they not return," Pozen says.

MFS recently won a global equity assignment from the Frank Russell manager-of-managers program, splitting about $400 million with two other firms. But MFS has also lost a number of smaller accounts in the past few months, including defined contribution assignments from the Hartford Municipal Employees' Retirement System and the Louisiana Deferred Compensation Plan.

Still, Pozen's many admirers are confident that he -- and MFS staffers -- will ultimately prevail in restoring the firm to investors' good graces. "If you have a problem in need of solving," says Robert Reynolds, Fidelity's chief operating officer, "then Bob Pozen is the man you want on the job."

ROBERT POZEN GREW UP IN GRITTY, WORKING-class Bridgeport, Connecticut, the second of three sons. His father was a traveling salesman of men's clothes; his mother worked part time as a bookkeeper. Pozen won a scholarship to Harvard College, graduating summa cum laude in 1968 with an interdisciplinary major in economics, politics and philosophy. After traveling in Africa and the Middle East for a year on a Knox Fellowship, he went to Yale Law School, also on scholarship, and earned his degree in 1972. He stayed on at Yale to add a doctorate in law in 1973. His thesis became the basis of his 1973 book, The Role of State Enterprises in Africa, which examines the problems of quasistate businesses in furthering economic development in Africa.

Pozen took a teaching job at New York University School of Law in 1974. But after three years he quit to join the SEC as an associate general counsel, litigating many of the earliest cases interpreting the agency's then-new rules on tender offers. In 1981, Pozen became a partner at Washington, D.C.­based Caplin & Drysdale, which specializes in tax law. He started the firm's thriving financial institutions department.

In 1981, Pozen's brother, Michael, a Boston cardiologist, died of a heart attack at age 36. Pozen began spending more time in the Boston area, and in 1987 he decided to move there with his family to help his brother's widow raise her two young sons. Through a headhunter, he landed the impressive job as Fidelity's counsel and bought a house in the leafy suburb of Newton.

Within a few years Pozen had become a managing director of Fidelity and taken on the role of senior counselor to CEO Ned Johnson. In the early 1990s the pair worked closely together developing new business, especially overseas. Among other initiatives, they launched retail operations in Japan and Canada and introduced a well-received charitable gift fund. Fidelity's non-U.S. assets tripled during Pozen's tenure.

In the mid-1990s, however, Johnson was preoccupied with other matters. The performance of several Fidelity funds, notably the flagship Magellan Fund, had begun to deteriorate. Under celebrated stock picker Peter Lynch, Magellan had consistently outperformed the Standard & Poor's 500 stock index from 1977 to 1990. Assets had soared. Lynch's successor, Jeffrey Vinik, did well for several years, but in 1995 he made a major move into bonds -- just before interest rates rose. Magellan's returns collapsed, and Vinik left Fidelity in June 1996 to run his own hedge fund. Around this time Fidelity, long known for low employee turnover, lost several respected portfolio managers.

In April 1997, Johnson asked Pozen to help right the ship, naming him president of Fidelity Management & Research, which oversees the firm's retail funds as the core investment arm of Fidelity Investments. As a 51-year-old lawyer who had never run a portfolio, Pozen struck many as a surprising choice for so pivotal an investment post. "At first the fact that a lawyer had taken over the investment department didn't sit well," admits Ileen Jacobs, then head of human resources at Fidelity. "But it wasn't long before Bob had won everyone over with his fresh thinking." For instance, Pozen, sending a message that shareholders come first, took over from fund managers the responsibility of deciding when to close Fidelity funds to new investors. He then did so with four large funds.

Pozen benefited as much as any portfolio manager from serendipitous timing. The bull market was heating up when he took over, and during his four years as FMR president, Fidelity's assets almost doubled, to more than $1 trillion in 2000.

He liked his job. The work was stimulating, and he found his co-workers engaging. But his last name wasn't spelled J-o-h-n-s-o-n. Pozen recognized that he could not realistically aspire to become the next CEO of what was, after all, a family firm.

In April 2001, Pozen walked into Johnson's office and told the Fidelity chief that he would be leaving the firm. The two men agreed that he would stay on until the end of the year. Pozen turned to public service when President George W. Bush named him to his Social Security Commission that May, and the following January, Pozen accepted a long-standing offer to teach corporate governance at Harvard Law School.

The Social Security Commission issued its report in the spring of 2002, proposing several reforms of the system, including private savings accounts. At the start of 2003, Massachusetts Governor Mitt Romney offered Pozen the position of economic development director for the state. He accepted but continued to teach at Harvard Law. Over the next 12 months, Pozen helped Romney close a $3 billion deficit in the state's $22 billion budget. After eliminating several tax loopholes, Romney managed to balance the budget without raising taxes. Pozen also played a leading role in the governor's battle to recapitalize the state's unemployment insurance fund.

"Pozen was able to come up with creative solutions to some difficult problems," says Renee Fry, chief of staff for the Bay State's executive officer of economic development.

Toward the end of 2003, Pozen was ready for a new challenge. He gave his notice to the governor, and a few weeks later he was talking to Shames.

In his years at Fidelity, Pozen, like many in the money management industry, had come to admire the strong MFS culture, which valued teamwork and inspired loyalty. When he came to work at MFS headquarters, he quickly saw that many employees experienced the SEC settlement as something close to a personal failure.

"No one was angrier about what happened than MFS employees," Pozen says. "These are people who prided themselves on the high ethical standards of their company."

Shames and Ballen first became responsible for upholding those standards as senior managers back in 1987. That October the firm's widely admired head of equities, Alden (Auggie) Johnson, died of cancer, just three days after Black Monday. Almost literally on his deathbed, Johnson told MFS's then-CEO, Dick Bailey, that an ambitious, charismatic 32-year-old portfolio manager named Jeffrey Shames should succeed him as equity chief. Bailey concurred. That same year John Ballen, a sharp 28-year-old equity analyst, became head of research.

Tragedy struck MFS again a little more than a decade later when Bailey's successor as CEO, Keith Brodkin, died of an embolism a few weeks after undergoing open-heart surgery. In March 1998 the board tapped Shames, who had become president, to lead the firm as chairman and CEO. Six months later Shames named Ballen president.

Shames pressed forward with a campaign to push MFS deep into the institutional market. It was a rousing success: The firm's pension assets increased from practically nothing in 1990 to $31 billion in 2001 (Institutional Investor, December 2001). "I'd like to think we're just beginning to catch up," Shames said at the time.

With a brace of young leaders -- Shames, Ballen and CIO Parke were all in their 40s -- and strong portfolio performance, MFS flourished in 2001 as the bear market settled in. For Shames, work was a welcome distraction from his wife's battle with breast cancer. But when her condition deteriorated in 2002, he turned the CEO reins over to Ballen.

"At this level your heart has to be 100 percent in it," Shames says. "Mine just wasn't."

Thus it was on Ballen's watch that MFS negotiated its settlement with government regulators.

According to the SEC, MFS allowed market timing in certain funds from late 1999, when Shames was still CEO, through October 2003. In certain other funds, including its international and high-yield portfolios, MFS discouraged market timing by imposing fees on redemptions made within five days. In market timing, a professional investor, like a hedge fund, trades rapidly in and out of a fund to exploit the fact that, because of inefficiencies, the net asset value of a fund does not necessarily reflect the exact market value of the stocks owned by the fund.

In July 2001 then-president Ballen promulgated a new internal company policy that explicitly permitted such activity, but only in 11 MFS funds, which became known as unrestricted funds. Because the 11 were large and highly liquid domestic stock funds, in theory market timing would have minimal impact on regular shareholders. The policy of allowing some market timing was not disclosed in the funds' prospectuses.

The policy authorizing market timing in the unrestricted funds continued even after April 2002, when MFS issued revised prospectuses for all of its mutual funds, including the 11, that contained this statement: "MFS does not permit market timing or other excessive trading practices that may disrupt portfolio management strategies and harm fund performance."

Perhaps MFS reasoned that market timing in the 11 funds would not harm fund performance and thus was consistent with the terms of the prospectuses. Ballen declines to comment. Pozen, for his part, confines his remarks to his own tenure at MFS. The SEC took the position that MFS's timing policy contradicted the language of its prospectuses.

Pozen and Manning must fight on several fronts to revive MFS, working to deliver strong investment performance and to preserve a modicum of profitability. That's no easy task with management fees reduced, compliance costs growing and -- now that directed brokerage is verboten -- the price of distribution costs rising. Yet in everything they do, Pozen and Manning vow to hold MFS to the highest ethical standards.

Says Pozen, "As the industry deals with fund reforms, MFS has a chance to be a leader."

Pozen: 'More than a full-time job'

It's the worst nightmare of every mutual fund company's general counsel: Some real (or perceived) transgression brings down the wrath of the Securities and Exchange Commission and results in a huge fine and harsh sanctions. As the longtime top lawyer for Fidelity Investments, Robert Pozen never had to contend with that daunting scenario. But in February the Yale Law School­educated Pozen, 58, was hired by another giant Boston mutual fund firm, scandal-stained Massachusetts Financial Services Co., to help repair the damage from its $225 million settlement with the SEC (and separate $125 million settlement with New York State Attorney General Eliot Spitzer) over allegedly failing to adequately disclose market timing of its funds. Pozen talked with Contributor Rich Blake about the challenges that MFS -- and the entire mutual fund industry -- face in restoring investors' trust.

Institutional Investor: When MFS chairman Jeffrey Shames was recruiting you, did you think, "Do I really need this headache?"

Pozen: Well, I can tell you my wife was all for it, seeing as how MFS's Back Bay office is a five- or ten-minute walk from where we live. But the key was meeting [CEO] Rob Manning. He was so personable and candid that I was very interested in working with him. I've always had a tremendous amount of respect for MFS and its culture.

Can you restore MFS to its former prestige?

As far as I'm concerned, we have put the issues behind us and we are nearly back to our former position. I'm just one person on a team of very talented people, and we all are working together. I think I've made a contribution, but I do not go around telling everybody what to do. It doesn't work that way at MFS.

Why was your title changed from nonexecutive chairman to chairman?

At first my role was going to be something less hands-on, more consultative and behind-the-scenes, and I was going to continue teaching courses at Harvard. But we discovered early on that dealing with the regulatory issues and the boards and the public is a full-time job -- more than a full-time job, really -- so the title change was to reflect the broader nature of my role.

MFS appointed independent directors before the SEC began requiring fund companies to do so. Therefore does the ruling make a meaningful difference to MFS?

Independent directors have comprised three fourths of the MFS board since 2003, and the chairman has been independent since then. Furthermore, the board has been advised by independent counsel. All of these measures contribute to an atmosphere in which shareholders' interests are placed ahead of the interests of the company.

MFS has taken a leading role in adopting soft-dollar reforms. Where do you see the SEC ultimately coming down on this issue?

The SEC is going to narrow the safe harbor in Section 28(e) [a 1975 amendment to the 1934 Exchange Act] and should begin by banning the use of soft dollars that do not make a "significant intellectual contribution" to the investment process. The SEC's 1986 interpretation of Section 28(e) opened the door to using soft dollars for many products and services, such as newspaper subscriptions and pure data feeds that are readily available for cash. On the full-service side of Wall Street, I do not believe that we are going to see unbundling of commissions.

Do you favor unbundling?

No, to the contrary, I'm against it. You can't put a price on capital commitment, which is a key component of the bundled rate. Nor can you easily value access to a global analyst network. I'd like to see the industry take a hard look at what's being received for its nickel per share [commission].

Is the worst over for the mutual fund industry?

The industry is likely to face another year of tough times in terms of regulatory scrutiny. Although Congress won't pass any laws, there are a lot of new rules coming out of the SEC. But the mutual fund will continue to be a very attractive way to invest for most Americans.