The Securities and Exchange Commission has unearthed yet a new type of mutual fund market timing, charging an Urbana, Ill.-based Internet day trader with three counts of violating exchange laws. The case further underscores the Commission's heightened scrutiny of the fund industry.
Thomas E. Edgar, a 65-year-old aerospace industry retiree, is accused of a manipulative trading practice known as "marking the close," or placing orders right before the close of the market in order to influence the closing price. On about 119 occasions over the course of four years, Edgar allegedly placed buy and sell orders on closed-end mutual funds averaging 100 to 200 shares at or near the close of the trading day. Just after placing these orders, Edgar submitted limit orders for the next day, either to sell shares at higher prices or purchase shares at lower prices. The SEC said Edgar priced these orders at the closing market value to ensure that his orders would be executed ahead of any others.
Although Edgar's orders were much smaller than the average 2,000 shares he held on most of the closed-end funds he owned, it is possible he placed the smaller orders to mask his activity. Edgar did not retain counsel and was unreachable for comment at press time.
Edgar agreed to pay a $35,000 fine, according to Dan Gregus, assistant regional director of the Midwest Regional Office of the SEC in Chicago.
In the past, some closed-end funds have faced SEC scrutiny for what is popularly known as portfolio pumping, where portfolio managers buy up fund shares near the end of a reporting quarter to bolster the fund's bottom line, but the practice of marking the close by individuals is relatively obscure.
"I haven't heard of individual investors doing so, but [the SEC action] is probably a result of the heightened scrutiny," said Burton Greenwald, president of the fund consulting firm B.J. Greenwald Associates. "And anybody doing that would have to be a large player. One hundred to 200 shares is not a lot of action." That's especially true for hyper-active day traders, who typically hold their positions for a very short time and often close out all of their positions by the end of the day.
"I'm unsure what he's done wrong," added Joan Boros, an attorney with the firm of Jordan Burt in Washington. "That's what day traders do. They wait until the last minute. Unless there are other circumstances, he's not stopped from doing that."
Edgar, however, employed a form of market timing that SEC officials say is unique to the closed-end fund industry. All of the closed-end funds Edgar manipulated are traded on the New York Stock Exchange. Although SEC officials declined to name which closed-end funds or sectors Edgar manipulated, the lawsuit provides details on how his scheme worked.
Between August 1999 and October 2003, Edgar marked the close of more than a dozen closed-end funds. He carried out this scheme in two ways. First, Edgar marked the close to increase his profit from the sale of closed-end fund shares that he owned. An investor who purchases shares of a closed-end fund has agreed to have taken a long position, according to the SEC lawsuit. Edgar established himself as a long investor, according to the Commission, because he held an average of 2,000 shares in each of the closed-end funds. However, his daily trading activity was contrary to his long positions and was a form of manipulating and timing the market, according to the SEC.
Edgar typically placed these marking-the-close orders within a few minutes of the market's 4 p.m. closing bell. The execution of the additional market buy orders resulted in an increase to the closing price of the fund.
The next trading day, Edgar would enter a limit order before the open of the market at or near the price at which he had marked the close, thereby influencing the opening price. He always tried to be, and usually was according to SEC investigators, the first trade of the day after he marked the close. In nearly every instance when he marked the close in this fashion, Edgar sold his shares at a profit the following day.
At other times, the SEC contends, Edgar marked the close to benefit from short positions he held in closed-end funds. In these cases, Edgar purchased shares to cover his short positions at a lower price. Edgar used two trading accounts to carry out this aspect of his scheme, the SEC alleges. In one of his trading accounts, Edgar would establish a short position of at least 1,000 shares in a closed-end fund. In a second account, he would then buy about 100 shares of the same closed-end fund. Within several minutes of the close of the market, Edgar would place a market order to sell the 100 shares that he purchased earlier in the day. The execution of those sell orders resulted in a decrease to the closing price of the fund. In nearly every instance when he marked the close in that fashion, the SEC says, Edgar covered his short positions the following day at a lower price.
"Very simply, what he did was he influenced the price one day and took advantage of it the next," Gregus said. "He's guilty of violating the anti-fraud provisions of the closed-end mutual fund industry."
Gregus declined to expand on how the SEC was alerted to Edgar's trading scheme, but noted that the regulator works closely with the NASD to identify trading impropriety and also maintains a staff of field examiners who visit brokerage firms. Gregus also declined to elaborate on the extent of Edgar's windfall, but said the $35,000 penalty represents a "negotiated amount that ensures that Edgar does not profit from his actions."