On Sept. 3, 2003, Canary Capital came clean over its market-timing and late-trading abuses. Now, nineteen months, four days and billions of dollars in penalties later, regulators continue to uncover malfeasance in a scandal that never seems to end.
The trading abuses have become increasingly less dramatic and the penalties correspondingly smaller, but it's still left fund companies, brokers, investors and industry watchers to wonder how far the pendulum must swing, as well as who might get swept up next.
Fund executives, brace yourselves.
The Securities and Exchange Commission, NASD and state attorney generals are probably going to continue to press charges against additional fund companies for sales practices and conflicts of interest through the end of this year, leading industry attorneys say. Just last week, Nuveen Investments indicated the SEC is looking into $2.8 million in overcharged performance fees, while two U.S. attorney generals are investigating a smattering of issues, including market timing, directed brokerage, revenue sharing, performance advertising, holdings liquidity and selective holdings disclosure.
New York Attorney General Eliot Spitzer isn't finished, either. While experts think Spitzer is dedicating resources elsewhere, he is ready to jump in with both feet at a moment's notice, particularly if there's a chance to steal a few headlines.
Among the issues still on regulators' minds are quid pro quo sales practices, according to TowerGroup. They're also zealous about trading practices, including best execution, fair valuation and soft dollars, along with operational risk controls and what they believe to be excessive fees.
"We're not at some point just going to eliminate greed. There are always going to be temptations for people to cheat if it's going to line their pockets," observed Paul Roye, outgoing director of the investment management division at the SEC. "There are some inherent conflicts and you can try to mitigate those, but you're never going to get to a situation where everything is conflict-free."
Investigations by the SEC and NASD have now crept into a wide variety of lucrative sales practices in the industry that have been standard operating procedure for years. Most notably, the Commission hit broker Edward Jones with a $75 million penalty late last year for not disclosing revenue sharing from a select group of mutual fund families, while the NASD charged American Funds with paying out $100 million in preferential brokerage commissions.
Those two cases, and the American Funds charge in particular, have drawn the ire of many within the industry. Some insiders say regulators, in a fit to catch up with the scope of the scandal, are now pressing too hard. Some go as far as to say that the SEC and the NASD are practicing ex post facto law by criminalizing conduct that was legal when it was originally performed. The Edward Jones wrongdoing dates back to at least 2000 and the American Funds wrongdoing occurred between 2001 and 2003. Although the NASD has had an anti-reciprocal rule on its books since 1973, it wasn't until last year that the SEC passed its directed brokerage rule.
However, "just because something has been deemed industry practice does not mean it can't be found to be unlawful conduct," said Marc Powers, a former SEC branch chief and head of securities litigation and regulatory enforcement practice at the law firm of Baker & Hostetler in New York. He cited the $850 million case against insurance giant Marsh & McLellan, which fell into Spitzer's net for steering business to insurers with the highest placement payments.
"The playing field is constantly changing. There has been continual movement of the ground beneath our feet, and people must adjust their business practices and ask, Are we conducting our business ethically and not risking to come too close to the edge of illegality?'" Powers explained.
Regulators, however, have cemented guidelines that many in the industry argue are overdue. For instance, in addition to enhanced disclosure of market- timing policies, fair valuation and portfolio holdings disclosure, the SEC has also ordered fund companies to draw comprehensive compliance procedures, conduct annual reviews of those procedures, appoint a chief compliance officer and adopt a code of ethics. And on top of its directed brokerage rule, the SEC has ordered that funds add an independent chairman and increase its ratio of independent board members to 75% by Jan. 16, 2006.
Other proposals have met skepticism, namely, a hard 4 p.m. close to the trading day that's designed to fully eliminate late trading and, to further curb market timing, a mandatory redemption fee of 2% on the sale of fund shares within five days of the original investment. A broker/dealer rule encouraging greater disclosure to investors about potential conflicts of interest and registration for hedge fund advisors have also been suggested.
In recent weeks, the SEC has stepped back from those proposals, including a retreat from mandatory redemption fees to make them voluntary.
"Have the SEC and the NASD been playing catch-up?" asked Nancy Van Sant, a director at the Miami law firm of Sacher Zelman Van Sant Paul Beiley Hartman Rolnick & Waldman and former investigation and enforcement chief in the SEC's southeast region office. "I'm afraid the answer is yes."
And as Spitzer turns his attention to insurance industry reform and fulfilling what Van Sant calls the "Teddy Roosevelt trust-busting" path to the state governor's seat and perhaps even the presidency, the SEC and NASD are left to perform mop-up duty in discretionary areas where the difference between right and wrong isn't entirely clear.
"There's a lot of dissention at the Commission table right now on a lot of issues, on hedge fund regulations [and] on virtually every issue that is up there, which is pretty unusual. I think, with the Sarbanes-Oxley Act, Congress gave a mandate the Commission couldn't ignore, and when you get into these more discretionary areas, there's a lot of debate. But I think the SEC is backing off a number of issues. They came out gung-ho and are now moving backwards, perhaps because of industry pressure," she said.
Van Sant stopped short of suggesting, however, that the SEC's investigation and rulemaking is entirely over.
"I think they're going to start looking at sales practices on a more minute level, at an individual practice level. There are probably practices out there like late trading that most of us don't even know about. I continue to be surprised, but as long as you have people being called to task for this, particularly in a criminal context, those people are going to continue to rat out the rest of the industry," she said.
Marc Dorfman, an attorney at Foley & Lardner in Washington, just wishes state and federal regulators had been on the same page at the outset of the scandal, which probably could have resolved the mess much sooner.
"Both the industry and the investing public would be better served had there been cooperation rather than competition," he said.
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