A mutual fund advisor that has outspokenly bemoaned the corporate scandals plaguing Wall Street this year, even put its weight behind the movement to leverage fund assets to pressure public corporations into reform, has been fined by the Securities and Exchange Commission for improper disclosure.
Davis Selected Advisers of New York was fined $10,000 by the SEC this month for failing to tell investors in its Davis Growth Opportunity Fund that the firm had been garnering stellar returns by investing in initial public stock offerings (IPOs). The SEC also ordered the firm, which neither admitted nor denied guilt as part of a settlement, to cease and desist the violation of federal reporting laws. In May, the fund changed its name to the Davis Opportunity Fund.
The SEC said that in 1999 and 2000, the fund engaged in a practice known as "IPO flipping," or buying newly issued stocks, especially highly anticipated ones, and selling them either the same day or the next. The practice is legal, but the SEC said that Davis failed to inform its investors that much of the fund's gains resulted from the short-term positions. Such disclosure, the SEC said, is required under the Investment Company Act of 1940.
Ken Eich, Davis' chief operating officer, said his firm "had no intent to deceive investors."
"We could have chosen to litigate," he said, "but for $10,000, there are better things we can do with our time. This not a case about the way we allocated IPOs," he continued. "It's simply a question of disclosing the impact of the IPO trading."
Davis' Opportunity Fund posted incredible gains in 1999 and 2000, a time when technology companies were going public in droves and investors were snatching up the shares as quickly as companies could issue them. In 1999, Davis' Opportunity Fund gained more than $6.7 million, or 22% of its total $30.6 million annual increase, from taking short-term positions in IPOs. In 2000, the fund gained nearly half of its total $15.1 million increase from the practice, the SEC said.
Now, the fund has posted year-to-date returns of negative 16.86%, according to Chicago fund tracker Morningstar. Its assets under management total $203 million. The firm manages eight funds, all growth, income or growth and income products, with more than $40 billion in assets, according to the Davis Web site.
Davis' settlement with the SEC comes at a time when public companies, such as Enron, WorldCom and Global Crossing, have been accused of deceiving shareholders, thereby sparking panic among investors. In fact, Christopher Davis, the Opportunity Fund's portfolio manager, has been widely quoted in the press as supporting corporate governance reform. News reports from early summer said that Davis supported an effort by Vanguard Group founder John Bogle to use funds' broad asset holdings to pressure companies into reforming disclosure practices.
In a letter to Business Week magazine published in July, Davis said his firm has "a strong interest in improving the corrupt system of executive compensation that plagues much of corporate America," and that "the formation of a group of reform-minded institutional investors could serve to advance the cause of corporate governance." That said, his letter also rebuked the magazine for implying that Davis was affiliated with any formal group of fund companies that might impose such pressure.
But, ironically, the SEC said that the Opportunity Fund's prospectus mislead investors. The fund's prospectus says that the fund invests primarily in stocks "purchased at reasonable prices" that are held "for the long term." In reality, many of the fund's stock positions lasted only hours, the SEC said.
In addition, the SEC said that the disclosure documents Davis released to shareholders "did not contain any specific disclosure regarding [the firm's] IPO trading..."
Randall Lee, director of the SEC's Pacific Regional Office, said that his office's ruling underscores that an investment advisor must "ensure that it adequately discloses to mutual fund shareholders the fund's investment strategy and the source of investment returns."
Asked if Davis' settlement with the SEC might tarnish his firm's reputation as a shareholder advocate, Eich said, "This is not a major event."
The IPO Trail
In fact, this is not the first time a fund complex has been fined over the question of disclosing IPO trades during the raging bull market of the late 1990s. In September of 1999, the SEC fined Van Kampen Investment Advisory Corp. $100,000 and its chief investment officer $25,000 for failing to disclose the impact of investing in IPOs on its Van Kampen Growth Fund [see MFMN 11/13/99]. And in 2000, the SEC fined The Dreyfus Corp. $950,000 and one of its portfolio managers $50,000 for failing to disclose to investors that its Dreyfus Aggressive Growth Fund (DAG) owed impressive returns to trading in popular IPOs [see MFMN 5/15/00].
"Dreyfus did not disclose the large impact of the IPO investments, though it was questionable whether DAG could replicate its prior performance through continuing to invest in IPOs as the fund grew larger," according to an SEC document dated May 10, 2000. In addition, the document said that Dreyfus continued to advertise the fund's tremendous returns, even as its performance declined.
Indeed, the SEC's main concern in such cases is that funds may not be able to replicate the same strategies, and so those strategies should be made crystal clear to investors, said David Butowsky, who served as chief enforcement attorney at the SEC during the 1970s and is now an attorney with the New York firm Mayer, Brown, Rowe & Maw.
Since the cases began popping up in the 1990s, the fund industry has occasionally tried to get the SEC to clarify disclosure procedures that can help fund companies avoid what Butowsky called "the Van Kampen" trap.
But Butowsky said that the SEC's guidelines are clear enough: Simply disclose the fund's investment strategy to investors. "I don't think it's such a tough issue," he said.