The SEC has suffered a pair of setbacks in its attempts to discourage intermediaries from recommending that their clients sell funds after holding them for only a short time and then use the proceeds to buy new, hot-performing funds.
In separate decisions late last month, two of the agency's administrative law judges held that intermediaries who switched investors out of funds after holding periods of as short as 16 months, did not violate federal securities laws. Indeed, in one case, the judge ruled that some switches that Richard Hoffman, a registered representative of Palm, Pa., admitted were improper, were inadvertent mistakes and did not violate federal law.
Judge Carol Fox Foelak, in a decision Jan. 27, emphatically rejected a suggestion from an SEC expert witness in the case against Hoffman that short-term trading of mutual funds is defined as anything less than a five-year holding period. Evidence that Hoffman moved investors from one fund to another after holding periods ranging from 16 months to more than two years was not enough to prove the SEC's claims that Hoffman improperly switched the investors, Foelak wrote.
"Indeed, it is common knowledge that mutual fund investors are turning over their holdings more rapidly than in the past and changing funds according to past performance or future expectations," Foelak wrote.
SEC administrative law Judge James T. Kelly reached the same conclusion in a decision he issued Jan. 31. The SEC's enforcement division failed to prove allegations that Michael Flanagan, a registered representative in Seal Beach, Calif., had improperly switched a client from one similar fund to another, Kelly ruled. The SEC failed to show Flanagan engaged in a pattern of switching, a fact which Kelly found to be significant in evaluating the SEC's allegations.
Switching was a small part of the Flanagan case, which primarily was about sales practices relating to mutual fund B-shares. The SEC prevailed on its claims related to improper B-share sales practices. (See related story page 3)
In analyzing the SEC's switching allegations against Flanagan, Kelly said that the agency has never stated which factors among a handful are the most important in identifying improper switching. It is unclear if all of the factors - including the length of time an investor holds a fund, the amount of the sales commission to the registered representative and a loss of profits for the investor - or just some of the factors are necessary to prove illegal switching, Kelly said.
The ambiguity about what constitutes improper switching has vexed mutual fund industry lawyers, who have closely followed both the Hoffman and Flanagan cases.
"There really isn't an affirmative guideline about what is improper," said Hoffman's lawyer, Alexander D. Bono of Blank Rome Comisky & McCauley LLP of Philadelphia. "The Commission and regulators ought to step up to the plate" and set a clear standard defining what constitutes improper switching.
The standard may not be clear to lawyers, but the perils of switching are unambiguous to Arthur Levitt, chairman of the SEC. Levitt warned investors about the dangers of jumping from one mutual fund to another in search of hot performance in a statement and accompanying investor education guide the agency made public Jan. 24. Levitt warned investors to scrutinize such factors as sales charges before jumping from one fund to another.
"Buy and Hold' Beats Switching In and Out of Funds," the SEC said in the headline of its Jan. 24 statement.
The Hoffman case may be an instance of the SEC trying to lead investors where they do not want to go at a time when the market is hot and outstanding performance advertising is widely circulated. Witnesses in the Hoffman case testified that they switched funds seeking better performance. Indeed, some of the SEC's own investor witnesses testified that they wanted to switch funds and were angry with the SEC for bringing the case, Foelak said.
A Hoffman client testified that his "reason for making the change was the potential for better performance," Foelak said. The investor "is offended by the proceeding against Hoffman," she said.
Another Hoffman client "commented negatively about the proceeding against Hoffman, stating her belief that no customer had complained about him and that he does not have a crystal ball,'" Foelak said.
The SEC viewed the investors' anger with the proceeding as consistent with the enforcement division's claims that Hoffman did not fully explain the costs and effects of mutual fund switching to investors, said the SEC lawyers who participated in the trial.
The enforcement division alleged that Hoffman violated federal securities laws by failing to disclose important facts about the costs and effects of switching - allegations Foelak rejected. Investor anger at the SEC was consistent with the enforcement division's allegations that the investors did not understand the effects of the switching transactions they engaged in, said William S. Dixon, an SEC enforcement lawyer.
Some of the witnesses "were more upset with us than him," Dixon said.
It was unclear last week if the enforcement division would appeal Foelak's decision, SEC lawyers said. The enforcement division can appeal the decision to the SEC's five commissioners.
Previous SEC switching cases have found violations when mutual fund holding periods were 11 months and shorter, Foelak said. Hoffman's customers held funds longer than that - 16 months to more than two years - and were told of the cost of the transactions, she said.
"The Commission has never held that switching mutual funds after holding periods like those in this case is short-term trading or improper switching," Foelak said.
In addition, the commissions that Hoffman earned from the switching in the case constituted "an insignificant portion" of his business, Foelak said. She did not disclose a commission total or percentage associated with the switching. Foelak examined transactions involving 14 of Hoffman's clients. The alleged violations occurred between July 1, 1993 and Dec. 31, 1994.
Foelak also exonerated the chief compliance officer at Hoffman's firm, FSC Securities Corp. of Atlanta, Ga. The SEC's enforcement division failed to prove that Kirk Montgomery failed reasonably to supervise Hoffman, Foelak said.
The holding periods of mutual fund shareholders are a matter of some debate and a great deal of interest among mutual fund companies and broker/dealers. Fund companies benefit, the longer investors hold their shares. Broker/dealers and their registered representatives potentially can earn more in fees when investors switch among funds.
Broker/dealers such as Edward Jones of St. Louis, Mo. and Waddell & Reed of Overland Park, Kan. have built their reputations in part by encouraging shareholders to buy and hold their mutual fund investments. Mutual fund supermarkets and some funds and fund groups have imposed redemption fees on investors who sell their funds within months of buying them.
The Investment Company Institute maintains no industry-wide data on individual investor holding periods, a spokesperson said last week. Individual companies, however, track holding periods of shareholders. Some broker/dealers who sell funds impose an added revenue-sharing charge on so-called aged assets, assets which remain in place for a period of longer than three or four years, according to fund executives and consultants.