Now, mutual funds don't have to feel quite so lonely. The Securities and Exchange Commission and New York Attorney General Eliot Spitzer have settled their first market-timing case against variable annuity issuers, with fines and disgorgement totaling $20 million.
A blend of insurance and securities, variable annuities fall under the regulatory scrutiny of the SEC, and the agency has now charged subsidiaries of Conseco of Carmel, Ind., and Inviva of New York, with securities fraud for inadequate disclosure of market-timing activity in their variable annuities. Both companies neither admitted to nor denied the allegations of the settlement. The charges revolve around activity involving $120 million in market-timing assets in approximately 100 contracts from late 1999 through September 2003.
Conseco has agreed to pay $7.5 million in disgorgement and $7.5 million in civil penalties, but $10 million of that is subject to approval of the bankruptcy court. Inviva has agreed to pay $3.5 million in disgorgement and $1.5 million in civil penalties and will hire independent compliance and distribution consultants for at least two years.
The case involves both companies because Conseco sold its variable annuity business to Inviva in September, 2002. Inviva retained the variable annuity product line and, according to the charges, Conseco's policy of catering to market-timing hedge fund clients, often in defiance of the mutual funds that managed its sub-accounts. Secaucus, N.J.-based Canary Capital Partners, infamously implicated in similar mutual fund cases, was one of the hedge fund clients, investing $25 million in five Conseco annuities. The suit does not name any of the mutual funds, however.
Annuities appeal to hedge funds and other market timers because, although they are unable to take advantage of the tax benefits, they are able to make trades virtually anonymously. Therefore, the sub-account's sub-advisor, usually a mutual fund, can have a difficult time detecting or tracing the source of the money movement.
Some variable annuities are designed for market timers or have certain funds designated for rapid trading, but in these cases, explicit language in prospectuses alerts all investors of the risks and costs of timing. In fact, the hedge funds could have chosen just such a contract, Conseco Advisor, which offers six sub-accounts from Rydex Investments of Rockville, Md., as opposed to the 56 available in the other contracts. Rydex specializes in portfolios that can be rapidly traded without incurring excess fees that harm other investors in the funds. Juanita Brown, vice president of insurance services at Associated Securities Corp., a Los Angeles-based broker/dealer, says contracts can be specifically designed to allow clients to trade with abandon without hurting other investors.
Indeed, the existence of Conseco Advisor was material to the case. "It certainly indicated to us that they knew [the ability to freely market time] was a feature that some people would want and others would not want," said Kay Lackey, assistant regional director of the SEC's Northeast Regional Office.
However, instead of promoting the Advisor contract, the SEC claims, both companies knowingly sold the Monument and Advantage Plus variable annuities to hedge funds intent on market timing despite the fact that the prospectuses explicitly stated that the annuities were not for professional market-timing organizations. Both contracts reserved the right to limit or charge for excessive trades, but Conseco and Inviva failed to invoke their right to restrict timing activity by the hedge fund clients.
The Monument variable annuity was a middle-market product intended for individual investors between the ages of 51 and 70, and the average investor placed $50,000 in the product. However, assets from market timers dominated the product, at times constituting over 90% of the assets. The problem was primarily a failure of disclosure, Lackey said. Other investors were not warned that the carriers were marketing these contracts to individuals interested in market timing, and they were not made aware of the risks or potential costs associated with this activity.
The insurers' involvement with market timing went beyond a sin of omission. Conseco identified those fund companies that would or would not allow timing activity in their funds. According to the SEC's settlement, at least three fund complexes complained to Conseco about timing activity and demanded that the carrier monitor and curtail excessive trading, with one company closing its European fund to Conseco's investors. In response to the complaints, Conseco attempted to steer its market-timing clients away from such funds to fund complexes that were amenable to timing. The companies established ground rules about the allowable dollar volume of aggregate trades as well as the size of individual trades, which Conseco employees then tried to mediate when the trading orders came in from registered representatives and clients.
However, establishing this protocol did not keep clients from attempting to time portfolios that were off limits, and the only thing that stood in their way was the carrier's vigilance. But instead of evicting the offenders from the contract altogether, the carrier often helped them by letting them know how to evade detection by keeping the size of their trades small enough.
This was especially a problem when one fund complex that operated an emerging markets portfolio let Inviva know that it had to decrease its timing capacity from $50 million to $30 million. Meanwhile, clients began migrating to other portfolios, including a worldwide growth portfolio that had not agreed to timing.
In an e-mail, Inviva's director of sales and marketing described the subsequent trading activity as "a bit of a juggle," due to the sensitivity of international funds. The executive also recognized market timing as a sales opportunity, suggesting to another employee, "We should probably put together a list of funds people want to use that won't let us and go tour the fund [companies] explaining how it is a harmless and cheap way to take in some money."
Clearly, some of the mutual fund complexes also violated the terms of their prospectuses by allowing timing activity for some clients. Lackey said that she could not comment on whether those firms are also under investigation, but she did say that the SEC "has brought cases against various mutual funds."
So, it seems, the first action against variable annuity issuers does not mean the end of trouble for the mutual fund industry.