EXECUTIVE
SUMMARY |
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.
|
HOW MUTUAL FUNDS ARE STRUCTURED
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.
PRICING FUND SHARES
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.
THE CANARY SINGS
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 ( www.sec.gov
) 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 (
www.oag.state.ny.us ), which has
played a major role in many cases even
outside the state, and the National
Association of Securities Dealers ( www.nasd.org
), which is investigating the role
of broker-dealers in fund trading
scandals.
|
LATE-TRADING
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
”).
MARKET-TIMING
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.
IMPLICATIONS FOR CPAs
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.
FUNDS CHARGED IN THE SCANDALS
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.
OUT OF THE ASHES
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. |