Banks in the mutual fund business got a jolt recently when the Securities and Exchange Commission brought sanctions against Bank of California for mispricing a money market fund it manages.

The disciplinary action -- believed to be the first ever against a bank-run mutual fund -- provided unmistakable evidence that the SEC is holding banks to a high standard as they become more involved in managing mutual funds.

The SEC said the San Francisco bank failed to recognize a severe deterioration in the value of some bonds that it carried in a tax-exempt money market portfolio. Poor internal controls to sloppy accounting, the SEC said.

The bank consented to a cease-and-desist order, but neither admitted nor denied wrongdoing. The bonds, with a face value of $1 million, dipped in price to $700,000, and the bank had to make up the difference.

Bank of California, like most its peers, has not been managing mutual funds for very long. It launched its High Mark funds in 1987.

Wake-Up Call

"The lesson we learned from this, although it's not one we weren't aware of, is that the SEC takes compliance seriously and wants banks to know that," said C. Christine Stuart, a spokeswoman for Bank of California.

Industry experts said other banks should pay heed and learn from the episode.

Mistakes "can happen when you have a small, newer organization," said Avi Nachmany of Strategic Insight, a New York consulting firm. "There are a lot of things you have to do right, and there is room for errors."

But some bankers were reluctant to ascribe too much importance to the Bank of California case.

Safeguards in Place

"There's an awful lot of misconception that if there's ever going to be an accident it will be at a bank," said Mark Williamson, senior vice president at NationsBank. "But the banks I know of are sophisticated and have layers of internal safeguards."

Nevertheless, the case shows that there are many ways a mutual fund manager can come under fire. Even if banks market mutual funds carefully and choose investments wisely, they won't be spared criticism if they fail to follow accounting procedures.

"Some banks may be under the misapprehension that being an investment adviser to a mutual fund is basically a riskless business. That's not the case," said a securities lawyer, who requested anonymity.

Banks that lose credibility as mutual fund managers could lose customers, too. And they can look forward to the SEC taking a very keen interest in their mutual fund activities, especially when it comes to mistakes.

In accepting the SEC sanctions, Bank of California agreed to correct practices that violated the mutual fund pricing and accounting provisions of the Investment Company Act.

No fines were levied, though the SEC has the authority to assess civil penalties of up to $500,000 per violation.

Controls to Be Improved

To avoid repeat incidents, Bank of California promised to clean up its internal controls, which the SEC criticized as inadequate "in that they allowed the pricing problem to occur and remain undetected for a substantial period of time."

At issue was the bank's alleged mispricing of bonds issued by the Phoenix Industrial Redevelopment Authority and guaranteed by Mutual Benefit Life Insurance Co.

Bank of California's High Mark tax-exempt money market fund held $1 million of these bonds, which lost almost half of their market value in the summer of 1991, when the New Jersey insurer was taken over by state insurance regulators.

The bank failed to discover and correct the accounting mistake, although it had several opportunities to do so, according to the SEC.

Informed of Problems

Winsbury Co., Bank of California's mutual fund administrator, apprised the bank of Mutual Benefit's difficulties before the insurer was seized, the SEC said.

But the bank failed to flag that the Phoenix bonds in the money market fund were backed by Mutual Benefit. Consequently, it reported that it had no Mutual Benefit bonds on its hands.

The bank acknowledges this, saying the portfolio managers who looked into the matter were not the same ones who had been on board when the bonds were purchased.

Once the insurer was seized, the bank's fund accounting department received lower quotes for the bonds from an outside pricing service, but treated this information as a "transmission error," the SEC said.

The bank laid the blame for this error on an employee who, it said, overrode the pricing information and continued carrying the bonds at a higher value. The employee later quit the bank, a spokeswoman said.

The trouble was ultimately revealed when the bank's custody department requested pricing information while exploring the possibility of exercising the bonds' put feature.

Because the bank mispriced the bonds, shares in its tax-exempt money market fund were worth only 99.36 cents - not the $1 at which they were traded, the SEC said.

Price stability is paramount with money market funds. By industry convention, all money market funds trade at a $1 net asset value, instead of fluctuating as equity and bond funds do.

Because of this implied guarantee, money market funds are considered by many to be among the safest investments, on a par with certificates of deposit.

The net asset value of a money market fund is something banks cannot "break" with impunity, said Debra McGinty-Poteet, senior vice president and a director at Bank of America, which also has proprietary funds. "It's like motherhood and apple pie," she said. Break the $1 price and "investors would be out of there in a minute."

That's the last thing any bank, including Bank of California, would want.

In a statement, Bank of California said that it acted "immediately and appropriately" once the problem was discovered and that "no fund holder was harmed."

The bank reported the incident to the SEC and the Office of the Comptroller of the Currency. The OCC was satisfied with the SEC's involvement and took no actions of its own, an OCC spokesman said.

But banks can hardly expect the incident to be ignored. "This makes people question the fund industry, and they may shy away from the smaller players, including banks," said David Nadig of Cerulli Associates, a Boston consulting firm. Mr. Nadig added that the incident could have industrywide ramifications. Even though a money market fund was involved, "mispricing of securities is an issue with every single fund," he said.

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