It's open season on the mutual fund industry, as New York State Attorney General Eliot Spitzer's probe of mutual fund trading practices has triggered a barrage of investor lawsuits.
The complaints are based on evidence that mutual funds took part in trading schemes that exploited a loophole in the way mutual funds are priced. Last week, Bernstein Liebhard & Lifshitz of New York filed claims against the four companies implicated in the Spitzer probe: Janus Capital, Bank One, Bank of America and Strong Financial.
The suit charges the defendants neglected their fiduciary responsibility to their customers in exchange for higher fees and other forms of compensation. Essentially, they are accused of inviting large institutional investors to time the market or move in and out of positions freely at the expense of the fund's long-term individual investors. Market timing, while not illegal, is not consistent with the best interests of a fund's investors. Additionally, the firms are accused of participating in illegal late trading, which allows preferred customers to trade after the market closes but still receive that day's price. The claims are seeking class-action status.
Spitzer fired the first shot at a press conference earlier this month, blaming fund companies for allowing hedge fund Canary Capital Partners to take advantage of post-market events not reflected in the share price at the end of the trading session.
"This allowed Canary and other mutual fund investors who engaged in the same wrongful course of conduct to capitalize on post-4 p.m. information while those who bought mutual fund shares lawfully could not," Bernstein Liebhard said in a statement.
As a result, Canary enjoyed a substantial arbitrage profit that would have been otherwise passed on to the fund's investors. When it redeemed its shares and claimed the profit, the fund manager was forced to sell some stock or use cash, which formerly belonged to the fund's investors, to give Canary its payout. In return, Canary parked its money in the funds' money market funds, which meant fatter commissions and fees for the firms.
Meanwhile, in a class action complaint filed in a California district court last Wednesday, Weiss & Yourman, a law firm with offices in New York and Los Angeles, charged that Bank of America allowed large institutional clients to illegally execute trades after the closing bell and engage in lucrative market-timing trades. The class action suit is being brought on behalf of investor Leann Lin and all individuals who purchased shares in Bank of America's Nations Funds between May 1, 2001 and July 3, 2003. Weiss & Yourman would not comment on how much money it expects to win for its clients.
During that time frame, the defendant allegedly provided false and misleading information in its prospectuses and registration statements by failing to disclose that it was allowing at least one hedge fund to clandestinely engage in both late trading and market timing. The smoking gun in the case is a number of interoffice e-mails that provide details of these covert operations. For example, Robert Gordon, chief executive of Banc of America Capital Management sent an e-mail to Richard DeMartini, president of Bank of America's asset management business, detailing how the firm planned to request a commitment of $20 million from Canary in return for market timing. Bank of America wanted the commitments after it launched a new principal-protection fund, which would serve as depository for the sticky money.
As alleged in Spitzer's original complaint, Bank of America went so far as to set up special computer equipment in Canary's office that allowed it to buy and sell its Nations Funds and hundreds of other funds well after the close. A similar suit was brought against Janus in a Colorado State court for improper trading practices including trading behind the bell.
"It's an unfortunate wake-up call that mutual fund managers are in business for their shareholders, not their investors," said Gary Gensler, former undersecretary of the Treasury Department and author of The Great Mutual Fund Trap. "It's unfortunate that the pressures on managers are to raise more assets rather than to do the best job for investors." Gensler believes that there's bound to be other firms that have allowed market timing in their funds. But he said that late trading treads so clearly across the line one would hope that firms with decent compliance departments would have put a stop to it.
An Inexact Science
These types of trading schemes violate the forward pricing laws that were introduced back in 1968. The average mutual fund investor doesn't know the exact price at which their orders will be executed at the time they place their orders, as a fund's net asset value is calculated after the close. Forward pricing ensures fairness because those who buy during the day prior to a positive announcement reap the benefits, while those who buy after the announcement are not entitled to share in that profit. Their purchase order is based on the following day's NAV after the market has digested the news. Trading after-hours using stale prices creates an opportunity to realize an arbitrage profit. That is where these preferred customers were cleaning up.
"I knew market timing was going on and how extensive it was, so it really didn't come as much of a surprise," said Eric Zitzewitz, an assistant economics professor at Stanford University's Graduate School of Business. A research paper he co-authored on arbitrage-proofing mutual funds was contained in Spitzer's complaint. "I was quite shocked by the late trading because it is so clearly and egregiously illegal in a way that everyone in the industry understands. It is such a clear violation that people deserve to go to jail." Zitzewitz estimates that our nation's mutual funds lose $4 billion each year to timers.
Even a single trader, using the simplest market timing strategy on international funds, could generate a neat profit of $3 million a year, said Geert Rouwenhorst, a professor of finance at the Yale School of Management. The way it works is if the markets are higher now than they were yesterday, based on these prices, a trader could buy a mutual fund and sell Japanese stock to lock in the profit, thus capitalizing on time-zone differences. Any downside risk in his mutual fund portfolio would be offset by his futures position.
Using such a strategy, an international arbitrageur could outperform the other investors in an international fund by 30% or more a year, he said. "Although there are relatively small pricing errors each day, say a dime off each day, over a year's time, that's a lot of dimes," he said.
Most firms have a system of checks and balances in place in order to discourage market timing, such as imposing redemption fees and trading limits. Still, there is no uniform defense mechanism out there, so how aggressively these measures are applied varies from firm to firm.
Fair value is another defense against market timing. Zitzewitz said he is baffled by the fact that the industry is so reluctant to use a fair value system, opting instead to pursue solutions that don't deny market timing to everybody. The only explanation that makes any sense at all is that mutual funds allow market timing in exchange for some sort of compensation, he said. "It will be interesting to see what a fair calculation of the losses will amount to," Rouwenhorst said.
One way to stamp out market timing, Rouwenhorst suggested, would be for companies to publish statistics of the amount of short-term trading that exists in their funds. Gensler believes that the problem lies with independent directors, who sit on anywhere from 80 to 150 boards and pretend to fulfill their fiduciary duty. "They are largely rubber stamps," he said.
In response to the intense scrutiny from regulators and investors, Janus and Bank of America each issued statements saying they plan to pay restitution to investors from the fees they received from these discretionary arrangements. Janus went a step further and hired an outside auditor to evaluate the impact of these arrangements. The Denver-based company also tried to soften the blow by saying that market timers comprise a mere 0.5% of its total assets under management and that it has implemented short-term redemption fees on many of its funds to dissuade frequent traders.
With investor confidence already terribly shaken from a three-year bear market, the collapse of Enron and the analyst research scandal, the allegations put forth by Spitzer could steer investors toward alternative investment vehicles. "It's hard to make the case why you should be paying extra for an actively managed mutual fund," Zitzewitz said.
"It leaves the investor to [conclude] the industry is based on a false premise and [that they] would be better off in an index fund or exchanged-traded fund," Gensler said.
Mercer Bullard, founder of shareholder advocacy group Fund Democracy, argues that the Securities and Exchange Commission, not the fund industry, is primarily responsible for the scandal. "The SEC never brought an enforcement action against a fund for using stale prices, thereby sending the message that it did not consider inaccurate pricing to be a major concern," he said. That is not to say that mutual funds were kept in the dark about these shady dealings with arbitrageurs. On the contrary, it seems they were leaving the light on for them.
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