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March|April 2004
A Course of Inaction By John C. Coffee Jr.
Expiration Date By Jessica Sachs
Expiration Date By Jessica Sachs
The Big Fix By Daniel A. Nathan
Readers Respond: Justice Blackmun

A Course of Inaction

Where was the SEC when the mutual fund scandal happened?

By John C. Coffee Jr.

THE FIRST WAVE OF SCANDALS CAME IN 2001. Beginning with the fall of Enron, a host of similar cases of accounting irregularity quickly followed, most involving overstated earnings and understated liabilities. These events culminated in 2002 with WorldCom's record-setting bankruptcy and the passage of the Sarbanes-Oxley Act. Later that year, a second wave erupted, this time involving securities analysts, who New York attorney general Eliot Spitzer showed had behaved more like cheerleaders than objective umpires. Barely had these scandals been resolved—with a $1.4 billion settlement and complex institutional reforms to protect the independence of analysts—when a new and even more surprising controversy exploded in 2003. Mutual funds, long the cleanest sector of the financial industry, were shown to have systematically subordinated the interests of public investors to those of insiders and privileged large traders through practices known as "late trading" and "market timing." It was an outsider, Spitzer, who twice found the smoking gun and who was critical of the SEC's more lenient handling of each case.

In the waves of financial scandals that have now crested three years in a row, the common denominator has been failure by the gatekeepers of corporate governance who are expected to serve investors as watchdogs, but have often proved more the loyal lapdogs of those who controlled their compensation. In the first wave, auditors acquiesced in reckless accounting policies at the insistence of corporate managers, who rewarded them with lucrative consulting contracts; in the second wave, securities analysts obeyed the demands of the investment bankers at their firms, who largely subsidized their compensation, to upgrade their ratings of the firm's clients. In the most recent wave, the investment managers who run mutual funds appear to have assisted large investors (typically, hedge funds) in skimming gains that rightfully belonged to their traditional customers, small investors.

The rapid succession of these scandals raises a more fundamental question: Where was the SEC? Why has it been unable, with its large staff and resources, to find the wrongdoing that Spitzer twice uncovered in successive years with only 15 lawyers? Why has Spitzer responded swiftly to whistle-blowers ignored or discounted by the SEC? Why are the SEC and Spitzer quarreling over the terms of the settlements that each has been negotiating with various defendants in this controversy? To be sure, adopting a profile of being tougher than the SEC may further Spitzer's political ambitions, but this does not mean that he is wrong to suggest that the SEC has been too soft—that it has, to a degree, been "captured" by the politically powerful mutual fund industry.

The practices at issue fit a familiar pattern of corporate governance dysfunction. In the real world, no hedge fund or other large trader actually "loots" a fund, embezzles assets, or engages in other clear-cut forms of larceny. Rather, pennies are effectively stolen from millions over an extended period, as conflicts of interest are masked from public investors. The fullest academic study of market timing estimates its cost to long-term mutual fund shareholders at $4.9 billion a year. But if such legally dubious practices have been so pervasive and have had such a high aggregate cost, why didn't the SEC react earlier? The reasons are instructive, and they imply that if someone like Spitzer did not exist, he would need to be invented. Some measure of regulatory competition may be necessary to protect the public from the danger that federal agencies, even prestigious ones like the SEC, may be captured or stalemated by interest groups and their lobbies. State attorneys general are not the only actors who can play this fail-safe role, but they are probably the best positioned.

IN OPEN-END MUTUAL FUNDS, unlike corporations or closed-end funds, buyers and sellers do not trade shares with each other in securities markets. Rather, all trades are with the fund itself, with the investor either buying shares from the fund or redeeming them at the fund's per-share net asset value, or NAV. By SEC rule, the fund's NAV is determined each trading day by valuing its portfolio securities, typically at 4 p.m. Eastern Standard Time, which is the moment when the New York Stock Exchange closes. All purchases or sales made that day will occur at this price, and orders received after 4 p.m. are supposed to be executed at the next trading day's NAV.

To understand the motivation for late trading, imagine that the Federal Reserve Board announces a reduction in interest rates at 5 p.m., after the market closed. Now, an investor would be eager at 6 p.m. to buy the fund's shares at the 4 p.m. closing price, because it is predictable that stock prices will open significantly higher the next day. Thus, if a crooked investor can convince his broker to certify to the mutual fund that the broker received the customer's order before 4 p.m., the investor has rigged the system in his favor. It's much like betting on yesterday's races, as Eliot Spitzer has said. The losers in this charade are the long-term shareholders in the fund, whose gains are diluted by the appearance of the late-trading customer who has taken no real risk but will share pro rata in the fund's increased NAV when it is computed the next day.

Market timing involves a similar but somewhat grayer procedure, which at bottom also depends on exploiting out-of-date prices that new information has made obsolete. Many specialized mutual funds invest heavily in foreign securities, debt securities, or thinly traded small-cap stocks, in all of which current prices may not be available. The simplest example is an international mutual fund that invests heavily in foreign stocks that trade in different time zones; the relevant market for these stocks may close as much as 15 hours ahead of U.S. markets. As a result, when the 4 p.m. valuation point is reached in the United States, stocks on these foreign exchanges may not have traded for up to 15 hours, and the use of their last closing price in the foreign market (say, Tokyo) introduces an inherently stale price into the computation of the fund's NAV. If U.S. or other markets have risen since the closing of the foreign market, it is a good bet that the foreign market will also move upward when it opens again.

This very predictable tendency explains the art of stale-price arbitrage. Smart-money investors will buy mutual funds that invest heavily in foreign stocks on those days when the U.S. market rises, because they can safely anticipate that these funds' NAV will be significantly higher on the next day, when the foreign market will also rise. If they buy at 3:30 p.m. on Thursday, knowing that U.S. markets have risen, they can redeem their fund shares the next morning and be cashed out at the increased 4 p.m. price on Friday.

According to Professor Eric Zitzewitz of Stanford Business School, the leading scholar of market timing, such quick in-and-out trading in mutual funds permits arbitrageurs to earn excess returns of between 35 and 70 percent per year in international funds and up to 25 percent in small-cap equity stocks. This extraordinary rate of return comes at the expense of long-term mutual fund holders, who suffer two distinct injuries: Their gains are diluted because they must be shared with these in-and-out arbitrageurs, and their funds must maintain an artificially high cash level in their portfolios to handle the predictable redemptions a day or so later from these short-term investors. Market timers seldom invest capital that the fund can profitably put to use.

Predictably, mutual funds do not like market timing, and they can restrict it by a variety of means, including special redemption fees for short-term trades or transfer restrictions limiting the number of trades that the investor can make within a defined period. But these defensive measures are imperfect for two reasons: First, if there has been a major development in the markets, the smart-money investor can afford to pay a 2-percent penalty redemption fee (which is the most the SEC permits) in order to exploit stale prices; or, the investor can avoid any penalty by holding its fund shares for the requisite holding period. Second, whatever the protections the fund announces it will employ to discourage market timing, the mutual fund can selectively waive them for large investors whose investments it wants to attract.

Why would it do so? Mutual fund managers are paid an annual percentage of the average assets under management. The mutual fund might rationally discourage market timing by a retail investor seeking to make a quick $10,000 investment, but waive the same rules for a hedge fund willing to invest $50 million. Alternatively, a large investor might agree to place other funds under the long-term management of the fund's investment advisor if the fund would permit it to engage in market timing. Whatever the particular inducement, the pattern is one in which the mutual fund's investment advisor receives an implicit bribe for permitting sophisticated investors to exploit retail investors.

This self-interest of the fund manager may explain the most disturbing fact about the mutual fund crisis. Although it is relatively simple to protect a fund against market timing, only a minority of funds took steps before the crisis to make their funds "arbitrage proof." According to Zitzewitz's study, only 30 percent of international stock funds (the most vulnerable category of funds) had installed measures to discourage stale-price arbitrage as of mid-2002. The rest, it seems, were happy—quietly, to be sure—to invite such arbitrage.

STALE-PRICE ARBITRAGE HAS BEEN UNDERSTOOD FOR 20 YEARS. Yet it apparently did not start being used on a large scale until around 1998, and it has risen exponentially since then. Why? An initial answer is that competition among funds intensified during the late 1990s. From 1995 to 2002, the number of mutual funds jumped from 5,725 to 8,256. As the industry grew, it became both more specialized and more competitive. Competition pressured firms to acquiesce in market timing. If a fund refused to permit market timing, large investors could simply shift their funds to a more accommodating competitor. Thus began the proverbial race to the bottom, because the more ethical a fund's management was, the less attractive the fund became to smart money.

A second factor was the rise of hedge funds and investment advisors in the 1990s as major competitors to mutual funds and the consequent slowing of mutual fund growth. This further intensified the competition for the same investors' funds. More importantly, hedge funds became the quintessential short-term trader that could practice stale-price arbitrage on a large scale and that could reward acquiescent fund managers by making very large, if short-term, investments in their funds.

The most important factor underlying the explosion in stale-price arbitrage was the collapse of the stock market bubble in early 2000. From the spring of 2000 until the fall of 2002, all market indices plunged. The smart money became less interested in making long-term investments in a declining and volatile market; instead, in-and-out arbitrage became a more attractive investment strategy. Only small investors bought and held.

As a result, the dilution of long-term shareholders in international mutual funds because of stale-price arbitrage appears to have doubled between 1998-99 and 2001. For the most vulnerable group of international funds, this annual dilution rate came to exceed 2.3 percent of assets in 2001.

All this did not escape the attention of the SEC. As stale-price arbitrage accelerated, the SEC sent a letter in April 2001 to the Investment Company Institute (ICI), the principal mutual fund industry trade group and lobby. The letter advised mutual funds that they could not rely on the last closing price for securities in foreign markets if some "significant event (i.e., an event that will affect the value of a portfolio security) has occurred after the foreign exchange or market has closed, but before the fund's NAV calculation." If such an event has happened, then "the fund must value the security pursuant to a fair value pricing methodology." For example, the fund might look to the trading price of American Depository Receipts, or ADRs, of the same issuer, which often trade in the U.S. market. (These ADRs may represent anywhere from a fractional share to multiple shares of the foreign stock, which are held by U.S. banks, and their trading price provides a simple arithmetic basis for determining the current fair valuation of the foreign stock.)

Fair valuing is exactly the right answer; the best way to restrict stale-price arbitrage is to insist that each fund use current prices to value its portfolio. But the SEC did not insist on or seek to enforce its policy. Although the SEC has consistently maintained that fair valuing of a fund's foreign securities is necessary, it has left it up to each individual fund to determine in good faith when "significant events" have occurred that necessitate use of a later price or a different valuation methodology. Studying the response of the industry to the SEC's policy statement, Zitzewitz found in late 2002 that "the majority of international funds have not fair valued on even a single day in the May 2001- September 2002 period." In short, while the industry could protect its investors, the majority of the most vulnerable funds chose not to do so.

HOW COULD THE INDUSTRY EFFECTIVELY IGNORE THE SEC'S POSITION? As a large bureaucracy overseeing several thousand mutual funds, the SEC usually implements its policies for mutual funds through compliance inspections rather than enforcement proceedings. As of 2001, the typical fund was inspected (on a predictable rotating basis) less than once every five years. Even then, if noncompliance with SEC's "fair valuing" interpretation were found, the rules were sufficiently imprecise that any penalty would likely be modest and imposed without publicity. In all likelihood, the fund would simply have to promise to do better in the future.

In addition, the ICI mounted a political campaign and issued an elaborate white paper in 2002, defending the right of a fund in good faith to rely on the closing market price in the foreign market and resisting any obligation to predict future value. Joining the fray on the side of their clients, the committee on mutual fund law of the Association of the Bar of the City of New York, which is prominent in the securities law field, warned the SEC's staff that it had no "basis to contest the good faith of directors in making fair value determinations." Members of Congress also wrote critical letters to the SEC.

For an overworked agency, this coalition of trade and bar groups, industry lawyers, and the legislators that they funded represented a powerful antagonist, able to mobilize great political pressure and closely connected to the SEC's then chairman, the less-than-activist Harvey Pitt. In consequence, the SEC staff in late 2001 appears to have backed away from its earlier insistence on fair valuing, not abandoning its policy on a formal level but lowering the profile of its position and ceasing to interpret it in ways that constrained fund managers.

In fairness, the SEC staff probably did not know that insiders at some funds were deeply engaged in arbitraging their own funds' stale prices. Yet this was because the SEC had exempted mutual fund personnel from any obligation to report to the agency their trading in their own funds, whereas they did have to report trading in other stocks. Ultimately, because no public outcry had arisen and because the issue was too complex for the public to understand—absent a vivid "poster boy" case of abuse—the SEC staff took the politically expedient course of inaction, neither abandoning their policy preference for fair valuing nor enforcing it meaningfully.

To a considerable degree, this episode parallels the more public battle between former SEC chairman Arthur Levitt and the accounting industry in the late 1990s, when Levitt sought to restrict auditors from marketing consulting services to audit clients. The SEC's goal was to limit a conflict of interest that could cause (and probably did cause) auditors to be less vigilant. But the accounting industry went to Congress and threatened the SEC's budget, causing Levitt's reform proposals to be watered down. In the case of mutual funds, much less of a threat was necessary because the issue of stale-price arbitrage had never made its way to the top of the SEC's agenda. But in both cases, the lobbies won.

Attorney General Spitzer has criticized the SEC's policy of accommodation with the mutual fund industry, and CalPERS, the nation's largest public pension fund, has recently made similar criticisms about the SEC's acquiescent attitude toward the New York Stock Exchange. Deep down, what is at work here is less a formal policy of accommodation than the habitual response of overworked bureaucrats operating in an esoteric and insular field of law that the public does not understand and that is dominated by a powerful lobby playing the role of the 600-pound gorilla. Add to this mix a rapidly revolving door between the SEC and private legal practice, and SEC staffers tend to learn that, unless an issue has become high profile, it is best not to rock the boat. Efforts to expand the law only gain a staffer the reputation of a troublesome dissident and interfere with his ability to return to private practice with an enhanced resume.

IN MID-2003, THE MUTUAL FUND WORLD'S QUIET EQUILIBRIUM was profoundly disrupted when Spitzer brought charges under New York law against Canary Capital Partners, a hedge fund that had systematically engaged in late trading and market timing while parking money with major mutual fund managers to obtain a waiver of their restrictions on market timing. Now, the SEC responded with alacrity, perhaps because they had already been burnt in 2002 when they reacted slowly and equivocally to Spitzer's initial attacks on securities analysts.

When Spitzer publicly criticized the SEC for its lenient settlement of charges involving the Putnam Funds, the old rivalry quickly reappeared. From Spitzer's perspective, the SEC had settled too cheaply because the deal did not impose meaningful penalties on any individual officers or directors of Putnam, left unresolved what the financial penalty to the company would be, and did not require Putnam to admit its responsibility.

What explains the SEC's seemingly lenient disposition? Unlike Spitzer, the SEC has to worry about hundreds of potential mutual fund cases, which collectively represent a logistical nightmare for an understaffed agency that has long been denied an adequate budget. The SEC often attempts to devise a settlement template that it can use over and over with only minor variations. From the SEC's perspective, it need not worry greatly about imposing significant financial damages on wrongdoers, expecting the plaintiff's bar to follow in its wake and exact financial retribution through class actions.

Neither side in this debate is necessarily right or wrong, but Spitzer's tougher approach has clearly had an impact on the SEC. Following his criticisms of the Putnam settlement (which did not resolve the financial penalty to be imposed), the SEC insisted that Alliance Capital pay a $250 million penalty, a near-record fine and in all likelihood a precedent for future penalties. While the SEC will deny that Spitzer influenced the agency, competition usually spurs the contenders to greater activism, and here it appears to have made the SEC more demanding.

Another cause of SEC passivity may have been the fear that harsh penalties and rhetorical condemnations would produce an undesirable "run on the funds," leading to massive withdrawals from the mutual fund industry. Similar concerns often prompt bank regulators to subordinate consumer protection to the goal of protecting bank solvency. To a degree, a "run" has already happened, as Putnam had over $32 billion in redemptions just during the month of November, representing approximately 12 percent of the funds then under its management. But rather than being undesirable, a run on some funds may be the optimal sanction. The latest evidence suggests that investors' money is not being withdrawn from the mutual fund sector, but rather transferred from "bad" funds to "good" ones. Some funds, most notably Fidelity and Vanguard, have long made assiduous efforts to "fair value" their funds on a continuing, even hourly basis. This is the simplest and the best way to "arbitrage proof" a fund—by insuring that its NAV never depends on stale prices. In the end, consumer sovereignty may yet reign, because mutual fund shareholders can generally move their investments among funds at relatively low cost.

Ultimately, two unexpected lessons emerge from this dark chapter in financial cupidity. First, corporate governance does count. Zitzewitz found that the funds that did the least to protect their shareholders from market timing were also the funds that had the highest proportion of inside directors on their boards. Even if independent directors may have done little that was visible, those funds with lower percentages of independent directors experienced greater abuse; hence, the presence of a high percentage of independent directors does seem to correlate with better protection.

Second, duplication may be desirable. The coexistence of state and federal securities regulators has often been criticized by the industry as inefficient and burdensome. But a degree of competition may be as healthy for regulators as it is for businesses. Without Eliot Spitzer, there is little reason to believe that either the securities analyst scandal or the mutual fund scandal would have come to light.

Hurrah for competition!

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and the director of its Center on Corporate Governance.

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