The Mutual Fund Trading Scandals

Implications for CPAs and their clients.

SINCE THE FIRST MAJOR MARKET-TIMING and late-trading scandal broke, a barrage of federal and state enforcement actions against funds has followed.

LATE-TRADING IS ILLEGAL UNDER FEDERAL securities laws and some state statutes. It occurs when a mutual fund or intermediary permits an investor to purchase fund shares after the day’s net asset value is calculated, as though the purchase order were placed earlier in the day.

THE SEC HAS ADOPTED A NEW RULE requiring a fund to disclose in its prospectus and statement of additional information its market-timing risks; policies and procedures adopted, if any, by the board of directors, aimed at deterring market-timing; and any arrangement that permits it.

THE SEC HAS PROPOSED A NEW RULE that generally would require all mutual fund trades to be placed by a “hard 4 p.m.” Eastern time deadline.

IN CONTRAST TO LATE-TRADING, MARKET-TIMING is not illegal per se. Problems arise, however, when the timing of trades violates the disclosures in the prospectus. This can cause so many buys and sells that the costs escalate and the fund is disrupted, to the detriment of its long-term shareholders.

Brian Carroll, CPA, is special counsel with the U.S. Securities and Exchange Commission in Philadelphia. He also is an adjunct professor at Rutgers University School of Law in Camden, New Jersey.

The U.S. Securities and Exchange Commission disclaims responsibility for any private publication or statement of any commission employee or commissioner. This article expresses the author’s views and does not necessarily reflect those of the commission, the commissioners or other members of the staff.

mid the financial accounting frauds and Wall Street’s investment banking-analyst scandal, mutual funds stood out as an industry that played by the rules. The recent mutual fund trading scandals, however, have changed that perception.

Since the first major market-timing and late-trading scandal broke just over a year ago, there’s been a barrage of federal and state enforcement actions against investment advisers who advise mutual funds. Many investment advisers serving mutual funds have been accused of fraud, and the SEC has issued a wave of new rules aimed at safeguarding shareholder investments. As fiduciaries, investment advisers should understand not only how the fund trading scandals operated, but the effects of the resulting investigations and regulations on the mutual fund investments they recommend. To learn how CPAs have dealt with client concerns about the scandals, see “ When Investor Trust Is Shaken.

Importance of the Industry

In the past 20 years, mutual fund assets have grown from under $400 billion to more than $7.5 trillion and become a vital component of the financial security of more than 95 million American investors.

Source: David M. Walker, Comptroller General of the United States, 2004.

Open-end investment companies, commonly known as mutual funds, do not issue shares in their funds for resale to other potential shareholders. Instead the shares must be purchased from, and sold back to, the fund itself.

Mutual funds are unusually structured. Most do not have employees but are overseen by boards of directors that, among other things, approve contracts with service providers to perform essential fund operations. The board typically approves contracts with an investment adviser to make appropriate investment decisions for the fund’s portfolio, a transfer agent to administer shareholder purchases and redemptions of fund shares, and a principal underwriter to oversee the distribution of shares and payments for distribution, usually through intermediaries such as broker-dealers, banks and employee-benefit-plan administrators.

Placing oversight responsibility for a fund’s proper operation with the board is not always simple. Frequently, the investment adviser organizes or sponsors the fund and recruits its board members. In practice this relationship has created a conflict of interest between the adviser and the fund under which the adviser sometimes has acted in its own self-interest at the expense of shareholders. According to the financial press, many of the participants in the fund trading scandals were executives, portfolio managers and employees of the investment adviser who personally participated in the fund trading scandals and made illegal profits, or permitted favored shareholders to do so in return for lucrative business arrangements.

Using accrual accounting principles, a fund calculates daily its expenses, the value of investments held in its portfolio and the number of fund shares outstanding. Generally, the fund’s daily accrued costs are netted against the fund portfolio’s value (including cash) to determine the fund’s net asset value, which then is divided by the number of outstanding shares to arrive at the per-share net asset value, or NAV.

Typically, NAV calculations take place at 4 p.m. Eastern time every day the securities markets are open for business. The timing of the NAV creates a unique pricing dynamic. If an order to purchase or sell a fund share comes in at 10 a.m., that shareholder will not know the price until after 4 p.m.

For decades this NAV methodology contributed to the mutual fund industry’s reputation for reliability and honesty—until the “Canary” sang. The fund trading scandal broke when New York State Attorney General Eliot Spitzer filed charges against, among others, Canary Capital Partners LLC, a hedge fund manager, and some of its affiliates. The Canary case complaint rocked the industry by including allegations that certain mutual funds, with the help of intermediaries, had allowed late-trading, market-timing, or both. Since Canary, major investment adviser firms under contract to mutual funds have been charged with a variety of schemes, including some involving portfolio managers and founders of investment advisory firms.

Consistent with their fiduciary duty to clients, investment advisers should research federal and state records and fund filings to determine whether any of the mutual funds they have recommended to their clients are under investigation or charged with fraudulent activities, (see “ Finding Funds Charged with Fraud ”) or whether any shareholder class-action lawsuits have been filed. Advisers also should consider contacting the fund directly to get that information.

Finding Funds Charged With Fraud

F ederal and state regulators are investigating and prosecuting participants in the mutual fund trading scandal. Federal regulators enforce, among other statutes, the Investment Company Act of 1940 and Investment Advisers Act of 1940. In some instances state laws provide a more flexible basis for prosecuting fraudulent conduct. The SEC ( ) is the primary federal agency investigating and civilly prosecuting violations of federal securities statutes. Advisers should check to see whether mutual funds they are recommending have been formally accused of market-timing or late-trading by visiting the SEC’s Web site and entering the fund’s name in its search engine. If a fund has, advisers should evaluate the nature of the fraud alleged as discussed in the article.

Advisers also should consider checking their local U.S. Attorney’s Office, which is part of the Department of Justice. Frequently, the state attorney general from the state where the fund is headquartered leads the state investigation. They also should check the Office of the New York State Attorney General ( ), which has played a major role in many cases even outside the state, and the National Association of Securities Dealers ( ), which is investigating the role of broker-dealers in fund trading scandals.

Late-trading is illegal under federal securities laws as well as certain state statutes. It occurs when a mutual fund or intermediary permits an investor to purchase fund shares “late,” after the day’s NAV has been calculated, as though the purchase order had been placed before the NAV was calculated. For example, late-trading permits the investor to learn information after 4 p.m.—about public, potentially market-moving information (for example, key earnings releases, industry trend announcements and interest rate changes)—that more than likely will cause the next day’s NAV to increase. In essence the late-trader is permitted to capitalize on new information by turning back the clock and placing a trade as though it had been placed before learning the new information. Once the market-moving news is reflected in the fund’s share price and correspondingly increases the fund’s NAV, the investor can sell the fund shares at a profit.

Late-trading requires the cooperation of the fund itself or an intermediary who assists in distributing fund shares. For example, the Canary case complaint alleged that Bank of America provided Canary with a trading terminal that made it possible to purchase or redeem shares of hundreds of different mutual funds at the trading day’s NAV up until 6:30 p.m. In return, Canary agreed to maintain substantial deposits in fee-bearing Bank of America accounts.

The Canary case complaint also alleged that a little-known uninsured national banking association called Security Trust Co., an intermediary commonly used by third-party administrators of employee benefit plans to consolidate participant’s mutual fund trades, also permitted Canary to late-trade through its accounts with mutual funds—as late as 9 p.m.

Broker-dealers also played a key role in allowing investors to late-trade. Some were time-stamping fund purchase orders before the day’s NAV was set, but holding them back until some potential market-moving information was available after the market’s 4 p.m. close. Then the investor would tell the broker-dealer whether to fully process the order or tear it up, depending on whether the information was likely to cause an increase or decrease in the next day’s NAV.

In response to late-trading, the SEC has proposed a rule that would generally require all mutual fund trades to be placed by a “hard 4 p.m.” Eastern time deadline. Public comments on this proposed rule have noted that this might require advisers operating in time zones other than Eastern time to place their trades much earlier in the day, before certain corporate releases, government economic data or relevant market information is readily available. Advisers should be watchful for any SEC action on this issue (see “ New Regulations ”).

New Regulations
The SEC has responded to the mutual fund trading scandals by promulgating a wide variety of new rules designed to prevent future scandals and disclose more information to shareholders and their investment advisers. These regulations are available at the SEC’s Web site ( ) under Regulatory Actions. Advisers should monitor both the Final Rules Releases and Proposed Rules sections because these rules directly affect investment decision making. Generally, the rules apply to SEC-registered investment advisers, regardless of whether they provide investment advice to a fund. Here are examples of final and proposed regulations:

Final Regulations
Investment Adviser Codes of Ethics.
Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies.
Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings.
Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies.
Compliance Programs of Investment Companies and Investment Advisers.
Investment Company Governance.
Disclosure regarding portfolio managers of registered management investment companies.

Mandatory Redemption Fees for Redeemable Fund Securities.
Amendments to Rules Governing Pricing of Mutual Fund Shares.

Source: SEC, .

The Canary case complaint also alleged market-timing—which, in contrast to late-trading, is not illegal per se. Some investors buy fund shares seeking to capitalize on information they think will affect a fund’s NAV, but which is not yet reflected in the NAV. For example, a fund investing in Japanese companies may value its securities based on a Japanese stock exchange price set at 2 a.m. Eastern time, when the fund’s NAV is calculated at 4 p.m. Investors may learn of certain public information (balance of trade data or currency fluctuations, for example) after the 2 a.m. exchange price is set, but before the 4 p.m. NAV calculation, that leads them to believe the 2 a.m. exchange price is too low. The investor then lawfully buys shares of a fund investing in the Japanese company’s security, hoping the next day’s exchange price will reflect this public information and the investor will sell the fund share at a profit.

As in the late-trading scandal, some investment advisers have permitted market-timing practices that violate the terms of a prospectus in exchange for the investor’s depositing substantial assets with the fund or an affiliated firm. From these “sticky assets” the investment adviser can charge fees and increase the amount of assets under management, a key factor for determining the investment adviser’s compensation.

Other advisers actively attempted to stop market-timers by assigning personnel to monitor investor-trading practices and enforce prohibitions against timing. Some brokerage and consulting firms, however, specialize in testing these fund “timing police” and informing willing investors of which funds were susceptible to market-timing. Since the Canary case, several firms have been prosecuted by regulators for assisting in market-timing, late-trading or both. Based on current investigations as reported in the press, market-timing has proven more widespread than late-trading.

Investment advisers should understand and make clear to clients that market-timing can dilute the value of fund shares held by long-term investors. First, the cash that enters the fund when market-timing investors purchase fund shares is available to the fund’s portfolio manager to invest only for a short period of time, until that investor redeems. As such, this short-term cash generally does not earn a return equal to the amount of money the market-timer takes out of the fund when he or she redeems the fund shares. Because of, for example, “stale” portfolio security pricing, the market-timer gains a windfall. Second, because market-timing causes a fund to maintain a large cash position to meet redemptions by market-timers, it may reduce the overall performance of the fund because the return on cash or highly liquid investments generally are relatively less than the return on fund portfolio investments. Third, market-timing typically increases the fund’s transaction costs, which may reduce the NAV. In order to meet market-timer redemptions, a portfolio manager may be forced to sell fund portfolio holdings, possibly at a loss. This higher portfolio turnover rate increases costs such as brokerage commissions and custodian fees on the portfolio transactions, which, again, may lower the NAV. Similarly, constant purchases and redemptions of shares may increase the fund’s transaction costs for processing its own shares. Finally, increased fund portfolio transactions may result in an unusually large amount of capital gains tax liability that would be incurred by shareholders.

Recently, the SEC adopted a new rule, Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings, requiring more detailed disclosures in different parts of the fund’s prospectus and statement of additional information. A fund now must describe market-timing risks, any policies and procedures adopted by the board of directors aimed at deterring market-timing, and any arrangement that permits it. In addition, the SEC has proposed a rule, Mandatory Redemption Fees for Redeemable Fund Securities, requiring, with certain exceptions, that funds require all shareholders to hold fund shares for five days or pay a 2% redemption fee. Before deciding to recommend that a client invest in a particular fund, investment advisers should familiarize themselves with fund disclosures to determine whether the fund is compatible with the client’s investment objectives and strategies.

Because an investment adviser bent on engaging in fund trading fraud may violate the fund’s disclosed policies and procedures, investment advisers may want to consider digging beyond these disclosures. Although very difficult to discern, more technical fund disclosures may reveal tell-tale signs of market timing. For example, the financial highlights section of the fund’s prospectus includes a “turnover rate” or “portfolio turnover rate,” designed to measure the number of fund portfolio transactions. By comparing the current rate with the fund’s historic rates, an adviser can roughly gauge whether the fund has increased the number of times it buys and sells portfolio securities. All things being equal, market-timing causes a substantial increase in the turnover rate, as a fund’s portfolio manager often is forced to buy and sell securities to raise cash to meet market-timing redemptions.

Investment advisers also should review the fund’s Form N-SAR, Semi-Annual Report for Registered Investment Companies, for potential fund abuses. Item 77 E of Form N-SAR requires a fund to describe any nonroutine litigation or legal proceedings against it, such as class-action lawsuits. The fund must list the court, date filed and principal parties to the action. Advisers should review this disclosure to determine whether any material legal proceeding has been filed against the fund and what the allegations mean to its clients.

AICPA Resource
Audit and Accounting Guide, Audits of Investment Companies, 2004 (paperback version available early 2005, # 012624JA).
Other Resources
Web sites . . . .

With the fund trading scandal touching so many investment advisers associated with major mutual funds, it is highly likely that an investment adviser has recommended or is considering investing in one of these funds. Before recommending a fund involved in the scandal, advisers should undertake a careful review of the facts. The adviser now must consider the effect of the charges, if any, on the fund.

Start by reviewing all publicly available documents discussing the fund’s role, including any civil complaints filed by regulators or shareholders, criminal indictments or settlement agreements. The scandal has revealed a wide range of questionable conduct by a variety of participants. So advisers should consider the position and role of the persons involved in the fraud; were they relatively low-level employees or senior executives who were responsible for setting the “tone at the top?” What was the scope of the conduct? Was it an isolated occurrence or systemic over a long period of time? Was it caused by a single lapse in internal controls or did top management override entire systems to illegally profit?

Next, advisers should assess what the fund has done to remedy the misconduct, either voluntarily or as part of a settlement. In connection with settlements regulators have required funds to change their governance structures, retain independence compliance professionals, increase reporting requirements to their fund’s audit committee, institute an ombudsman program and establish internal compliance control and code of ethics oversight committees. They should also consider contacting the investment adviser directly to ask questions, such as which personnel have been terminated and what voluntary measures, beyond the requirements of any settlement agreement, have been adopted, and check whether any key portfolio managers have decided to leave, as this could affect future fund performance. Advisers should stay abreast of financial press accounts of the fund’s future. Sometimes speculation on a possible acquisition has a way of becoming fact.

Finally, advisers should ascertain what shareholder compensation, if any, is available. Although late-trading presents a fairly clear-cut instance of fund losses, shareholder losses attributable to market-timing also can be considerable, and many regulatory settlements in market-timing investigations have set up programs to compensate harmed investors. An adviser should review settlement agreements to determine whether penalties, disgorgement of ill-gotten gains or restitution has been ordered and whether an independent distribution consultant must be retained by the fund to calculate and oversee shareholder payments. If appropriate, the adviser should consider contacting the fund on behalf of its clients. In contrast, as part of fund-trading-scandal settlements, some funds have lowered certain fund expenses (fees) across the board, which should increase the fund’s NAV. Advisers should research what funds have agreed to reduce expenses because these funds now may be an appropriate investment for certain clients.

Before deciding to recommend that a client invest in a particular fund, investment advisers should familiarize themselves with fund disclosures related to market-timing and mandatory redemption fees.

Investment advisers can dig beyond fund disclosures to detect market-timing by comparing a fund’s current portfolio turnover rate to the fund’s historic rate. Market-timing may cause a substantial increase in the turnover rate.

The SEC’s proposed new rule to prevent late-trading would require advisers operating in time zones other than Eastern to place their trades much earlier in the day. Some critics claim that certain corporate releases, government economic data or relevant market information may not be readily available when those trades are placed.

Before recommending a fund charged in a scandal, review all publicly available documents discussing the fund’s role, including any civil complaints filed by regulators or shareholders, criminal indictments or settlement agreements entered into by the fund.

The fund trading scandal is reshaping the mutual fund industry. Based on news reports, government fraud inquiries continue while the SEC promulgates new rules in response to the fruits of the investigations. With these changes in motion, advisers should renew their commitment to fulfilling their responsibilities when recommending mutual funds. Though some of these are outlined above, each investment decision implies its own set of questions, which the adviser should be prepared to answer.


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