Industry-wide late processing of mutual fund trades has some in the industry worried. The practice is commonplace and perfectly legal, so why the concern?

Facing the biggest scandal in the history of the industry, late processing can sound an awful lot like late trading to the average Joe investor and the industry is worried about its image. Late trading, which is at the heart of New York Attorney General Eliot Spitzer's probe, is out and out illegal and has been described by many as an egregious abuse by the firms accused of undertaking these practices.

Late trading allows select investors a chance to place an order at the earlier closing price, but after market-altering events have taken place. It gives them an unfair advantage other investors do not have. Late processing is something very different. It is simply taking orders that were received before the close of the market and placing them in the system after 4 p.m.

"The problem is that you hear late trading and assume that anything that's done after 4 p.m. is by definition wrong" said Brian Pears, head equity trader at Victory Capital Management, the asset management arm of KeyCorp Bank in Cleveland.

Earlier this month, panelists and attendees at the Investment Company Institute's Tax and Accounting Conference emphasized the importance of making the differences between the two practices known to the public. The talk was of promoting integrity and not letting a few bad seeds such as Janus and Bank of America spoil the whole crop.

However, the public has read press accounts and heard soundbytes of politicians and enforcers talking up the abuses. The financial services world seems mired in one scandal after another and many are fearing a rush to judgment.

Rightfully so, given that Morningstar of Chicago recently recommended investors consider bailing from funds run by those implicated in the initial complaint/settlement with hedge fund Canary Capital Partners. "We think that New York Attorney General Eliot Spitzer's recent allegations of trading misdeeds at Bank of America, Janus, Strong and Bank One should prompt investors to consider selling their stakes in funds run by those firms," Morningstar wrote in a special report published earlier this month. Furthermore, without any official charges being brought yet, Brian Portnoy, a Morningstar analyst, said in a piece on the firm's Web site that the evidence against the unfab four is "sufficiently damning" to justify its call to exit the funds.

Late, Not Lazy

"Late processing is a recognition that the order is received by the broker, prior to the 4 p.m. deadline," said Burton Greenwald, president of consulting firm B.J. Greenwald & Associates in Philadelphia. "But, in transmitting the order and getting the order processed, there can be delays because of the logistics. You have a huge problem in collecting orders from many locations and processing those orders. It's just the mechanics. The key there is there is an order trail."

"Processing after 4 o'clock is necessary," said Don Boteler, vice president of operations at the Investment Company Institute. "All of the trade activity takes place up until 4 o'clock and it takes time for all the various entities involved to assemble trade files, transmit them through the various parties, get cleared and settled and confirmed back. This is an ordinary securities industry process."

He said the rules are in place and they just need to be observed. "It's a strong system and it's been built and enhanced since the mid-1980s when it was installed, but there are always opportunities to improve things."

However, one of those ways is not to force fund firms to process trades only during the hours the markets are open, says Victory Capital's Pears. "If you said you can only contribute or remove funds during market hours you would never have this problem, and if the goal was only to manage the business rather than to make things as convenient as possible for your customers, that would be a possibility. Market hours close at 4 o'clock, but that certainly isn't the close of business hours for most people. I don't think it's practical to tell people they have this six-and-a-half hour window even though that would eliminate any possibility of pulling this off."

"The danger in abandoning the idea that you can process things late is that you could negatively impact fund shareholders the next morning."

The Fallout

"I'm sure the ICI is trying to design three or four options for a PR campaign," said Ralph Verni, a consultant in Sudbury, Mass., and former president and CEO of State Street Research & Management. "Some heroes have been tarnished."

However, he said the industry needs to assess the damage before deciding on a game plan. "I would guess that most industry people are sort of in the same place I am at. They are wondering if this is five bad apples? Is it a bushel? Is it a truckload? Most are making sure something bad hasn't gone on in their own shop. There's a hesitancy against saying anything until we understand exactly what we have here."

The industry will put safeguards in place and publicize those moves, according to Doug Charney, a certified portfolio manager with Wachovia Securities. Trades will be double checked to make sure they are done at the right time and for the correct price. "It will be another layer of regulation and the firms are going to tighten up to make sure it doesn't happen again."

Despite the fact that many think the developments uncovered in Spitzer's investigation are isolated incidents, industry watchers think firms are going to have to be more diligent in tightening all of their controls.

"The industry has a reputation issue now," Greenwald said. Firms need to make sure all the processes are in place to ensure equality in the industry. He said to try and explain to the public the difference between late trading and late processing is a "futile task. More important is to try and convey to the public that the fund industry does not favor anyone and treats all investors, small and large, equally."

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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