New York State attorney general Eliot L. Spitzer filed a legal complaint against Canary Capital Partners, a hedge fund, for fraudulent late trading and time-zone arbitrage, practices that favored select clients over ordinary customers. Investigators looked at twenty-five fund companies, which led to settlements with regulators totaling over $3.1 billion, private civil lawsuits, congressional hearings and legislative proposals, and U.S. Securities and Exchange Commission oversight reforms.
According to the Investment Company Institute, a mutual-fund trade group, nearly 48 percent of U.S. households were mutual-fund shareholders at the end of 2003. The total assets of mutual funds came to $7.4 trillion. Mutual-fund growth paralleled the movement in American retirement plans away from employer-managed and -defined benefits plans and toward employee-managed and -defined contribution plans.
New York State attorney general Eliot L. Spitzer announced in a complaint filed with the New York Supreme Court on September 3, 2003, that his office had obtained evidence of illegal trading practices of New Jersey-based Canary Capital Partners, a hedge fund. According to Spitzer, the company was found to have engaged in fraudulent late trading and time-zone arbitrage with four large mutual fund companies at the expense of its ordinary, long-term mutual-fund investors. Even before this announcement, the mutual-fund industry was being viewed with dissatisfaction. After the technology-stock bubble burst in 2000, the stock market entered a three-year bear market, and funds performed poorly. The following background discussion of the structure and operations of mutual funds will help clarify both the dissatisfaction by 2003 and the scandals that were uncovered.
Mutual funds, also known as open-end investment companies, are not run by fund employees; rather, they are overseen by a board of directors. This board contracts with service providers: the investment adviser (a management company that makes the portfolio decisions), the transfer agent (who administers purchases and redemptions of shares and keeps customer records), and the principal underwriter (who handles distribution of shares). The U.S. Securities and Exchange Commission (SEC) regulates mutual funds, primarily through rules and through its Office of Compliance Inspections and Examinations. The SEC also regulates the securities markets.
Mutual funds are designed to help their owners (the shareholders) pool their money, diversify their portfolios, and have access to expert management at a lower cost than they could as individuals. The preamble of the Investment Company Act of
Many analyses of the scandals point to the conflict of interest and objectives inherent in the governing structure of mutual funds. Investors (shareholders) want to maximize their returns on the money held in the funds. The investment adviser (management company) wants to maximize its profits. The investment adviser is paid a percentage of assets under management as its management fee. Prior to the scandals, funds had grown larger and larger. Fees charged to shareholders had increased, even though economies of scale should have reduced fund-management costs. The expense ratio of the average equity (stock) fund rose from 0.77 to 1.56 percent between 1959 and 2004.
Analyses of the scandals also pointed to SEC regulations requiring only that a majority of the fund directors be independent (that is, not connected to the fund adviser in the preceding five years). In addition, the board chair was not required to be independent. Critics pointed out that if a fund wanted to change advisers or negotiate lower fees, having a board chair who is affiliated with the adviser would be an inherent conflict.
Some of these issues were beginning to be investigated just before Spitzer’s announcement. In February, 2003, the SEC proposed new rules that would require every mutual fund and adviser to instate compliance policies that would prevent securities law violations and to appoint a chief compliance officer. In March, the U.S. House Subcommittee on Capital Markets held a hearing, the first of ten congressional hearings (none resulting in laws passed) between 2003 and 2005. This one focused on fees, sales practices, disclosure, and fund performance and governance.
The investigations that followed the September 3 complaint were brought (in various combinations) by Spitzer, the SEC, the National Association of Securities Dealers
Although several other practices were discussed in the hearings, reports, and media coverage surrounding the scandals, most of the charges brought involved two forms of arbitrage: late trading and stale pricing. Generally, arbitrage involves exploiting short-term price differences in a security to make a profit without risk. Late trading was performed by a small number of high-dollar, sophisticated investors who had a special relationship with intermediaries and the funds themselves. Stale-price, or time-zone, arbitrage, which exploits the prices of international stocks at the time foreign markets close, was well known and widely practiced by both large and small investors.
Coverage of the scandals often used the term “market timing”; this term can also mean rapid trading. By 2003, even many ordinary mutual fund shareholders were beginning to trade frequently. Although it did not reach the level of illegality, it certainly diluted returns for long-term shareholders, adding to the damage done by arbitrage. From 1950 to 1975, the average length of time investors held shares was twelve years; by 2002, it was two and a half years.
Morningstar, a mutual-fund rating and analysis company, identified hedge funds (which use risky investment methods to achieve large gains) as the source of most mutual fund arbitrage money and predicted that the scandals would lead to more regulation of them. Some hedge funds publicly listed “mutual fund timing” as their investment strategy. The SEC’s November, 2003, survey found that 50 percent of the eighty largest fund companies were secretly allowing timing by certain shareholders (undoubtedly including hedge funds) that was forbidden by their own prospectus disclosures.
Because many people were surprised that Spitzer, rather than the SEC or the NASD (which regulates broker-dealers), first uncovered the scandals, the U.S. Government Accountability Office (GAO) conducted an analysis of the SEC’s fund oversight program. Its April, 2005, report found that although the SEC made a good faith effort through its regulations to combat the known risks for arbitrage, it did not conduct examinations that might have uncovered this practice. Examinations are one of the SEC’s two primary oversight methods.
One measure of the impact of the scandals is the gain they afforded violators versus the loss to long-term shareholders. A research study by Eric Zitzewitz on stale-price arbitrage documented that this activity cost long-term shareholders $4.9 billion in 2001 and that the cost had doubled since 1998-1999.
Another measure is the cost to the funds themselves, as investors lost trust and withdrew their money. A research study calculated the losses suffered by the fifteen publicly traded mutual fund families investigated between September 3, 2003, and November 31, 2004. In the three days following the announcement of an investigation, funds lost, on average, $1.35 billion.
Numerous reforms were proposed or enacted as a result of the scandals. The SEC’s new rules required fund boards of directors to designate a chief compliance officer and to conduct annual self-assessments and mandate that funds have written policies and procedures reasonably designed to prevent violations of federal securities law. Other rules relate to the disclosure of expenses as a dollar amount, the prohibition of various forms of directed brokerage using 12b-1 fees, and enhanced disclosure to shareholders of arbitrage policies. The SEC expanded its surveillance program to focus more attention on preventing wrongdoing. It instituted risk-targeted minisweeps to gather information on specific mutual fund practices, which have included soft dollars, 12b-1 fees, and revenue sharing.
The Investment Company Institute’s Mutual Fund Fact Book shows that in 2007, $12.02 trillion was invested in eight thousand mutual funds owned by nearly 300,000 shareholders. Clearly, increasingly large amounts of the retirement and college savings of ordinary Americans are placed in mutual funds. Consumers represent two-thirds of the American economy. Thus, both the risks and the unfairness continue to grow when mutual funds are allowed to place corporate profits above their fiduciary responsibility to shareholders.
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Bogle, John C. “What Went Wrong in Mutual Fund America? The Triumph of Salesmanship over Stewardship.” In The Battle for the Soul of Capitalism. New Haven, Conn.: Yale University Press, 2005. Clear, readable, passionate discussion of the scandals and the mechanisms used to perpetrate them. -
MacDonald, Scott B., and Jane E. Hughes. Separating Fools from Their Money: A History of American Financial Scandals. New Brunswick, N.J.: Rutgers University Press, 2007. Explains the often complex business world in an easy-to-read format. Detailed history of American financial scandals and their main players, including Eliot Spitzer, whose work is the focus of an entire chapter. -
Smith, Thomas R., Jr. “Mutual Funds Under Fire: A Chronology of Developments Since January 1, 2003.” Journal of Investment Compliance 7, no. 1 (2006): 4-33. This comprehensive account describes events initiated by Spitzer, the SEC, the U.S. Congress, mutual fund industry groups, and others. -
Swensen, David F. “Hidden Causes of Poor Mutual-Fund Performance.” In Unconventional Success: A Fundamental Approach to Personal Investment. New York: Free Press, 2005. Carefully documented explanation of the practices underlying the scandals. Unflinching in its exposure and condemnation of regulators, lobbyists, and the funds themselves. -
Zitzewitz, Eric. “Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds.” Journal of Law, Economics, and Organization 19, no. 2 (2003): 245-280. Explains the mechanics of stale-price arbitrage and the extent to which it was known before the scandals.
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