Fund Managers Face Enforcement Actions And Regulatory Reforms

Thursday, April 1, 2004 - 01:00
Alexandra K. Alberstadt

New York's Attorney General sent shock waves through the mutual fund world when it brought charges against a hedge fund and its managing principal, alleging their involvement in fraudulent mutual fund trading activity. The Attorney General claimed that several leading mutual fund management companies were "complicit" in this trading and violated fiduciary duties owed to their customers. In the aftermath of these allegations, several fund managers have settled enforcement actions, while Congress and the Securities and Exchange Commission have proposed sweeping regulatory reforms.

This article summarizes the issues raised by the Attorney General's complaint, the dramatic fallout that followed, and issues facing mutual fund directors in light of these events.


Acting on a tip, Eliot Spitzer, New York's Attorney General, confidentially investigated the relationship between a hedge fund and some mutual funds in the spring of 2003. On September 3, 2003, the Attorney General sued the hedge fund and its managing principal, alleging fraudulent schemes involving trading mutual fund shares. Simultaneously, the hedge fund and its managing principal, without admitting any wrongdoing, agreed to settle the case for $40 million in restitution and fines, and cooperate with the Attorney General's investigation.

What did the Attorney General accuse the hedge fund of doing? The Attorney General claimed that the hedge fund and its managing principal, with the complicity of mutual fund managers, engaged in "late day trading" of mutual fund shares and "timing" of mutual fund trades.

What is late day trading? Late day trading means placing orders to buy or sell mutual fund shares on a given day after the fund calculates its net asset value ("NAV") for that day, typically at 4:00 p.m. Eastern time, and still receiving that day's NAV. According to the Attorney General, late day trading circumvents forward pricing and provides a significant advantage: it is like "betting today on yesterday's horse race."

Were the mutual fund managers involved with the late day trading scheme? The Attorney General accused several mutual fund managers of encouraging the late day trading practice. The complaint charged that certain mutual fund managers gave the hedge fund current lists of complete portfolio holdings, and let the hedge fund place trades after 4:00 p.m. with knowledge of how the mutual fund performed that day. The complaint also alleged that the hedge fund created a complex "fool-proof" arbitrage system: using lists of portfolio security positions, they created derivative instruments and effectively "shorted" the fund's portfolio, profiting on declining NAVs. The hedge fund allegedly borrowed money from affiliates of a manager to fund this trading strategy.

What is market timing? "Market timing" is short-term trading of mutual fund shares designed to exploit inherent inefficiencies in the way that mutual funds determine their NAV. While market timing is not illegal, it allegedly harms long-term shareholders. Accordingly, mutual funds typically state that they monitor transactions and discourage this practice.

Were mutual fund managers involved with the market timing strategy? The Attorney General accused mutual fund management companies of encouraging market timing strategies, despite their potential to harm long-term fund shareholders. The complaint alleged that fund managers tolerated market timing because the hedge fund agreed to invest large amounts of money (which generated management fees) and to make long-term investments in non-mutual fund products or to invest on a long-term basis in other, less volatile mutual funds or investment products ("sticky assets"). The Attorney General claimed that the fund managers did not disclose these arrangements, and that prospectuses erroneously stated that the funds discouraged market timing.

SEC Rulemaking Initiatives

The SEC proposed and adopted several new regulations, and more certainly will follow.

Late day trading and market timing. The SEC proposed a "hard" close, requiring a fund (or its primary transfer agent or Fund/SERV) to receive orders no later than the time the fund establishes for calculating its NAV in order to receive that day's price. Intermediaries would have to collect and transmit orders to buy and sell fund shares earlier in the day if shareholders are to receive that day's NAV.

Market timing, selective portfolio disclosure and fair value pricing. The SEC proposed rules that would require funds to disclose more details about their policies on market timing, selective disclosure of portfolio composition and fair value pricing practices, especially about the exceptions to their policies in these areas. New final rules require funds to disclose portfolio holdings quarterly, instead of semi-annually.

Mandatory redemption fee. The SEC proposed rules that would require funds to impose a two percent redemption fee on shareholders who redeem or exchange shares within five days after purchase. The fee would apply to shares held in omnibus accounts, but would not apply to funds designed for market timers.

Compliance programs. New final rules require funds and advisers to appoint a chief compliance officer ("CCO"), accountable to fund boards. Independent directors must approve the CCO's compensation, and the CCO can only be fired with board consent. Funds must adopt comprehensive compliance policies and procedures that address, at a minimum, market timing, late day trading, and selective disclosure of portfolio holdings. Funds and advisers must comply by October 5, 2004.

Breakpoint sales charge discounts. After discovering that many purchasers did not receive correct sales charge "breakpoint" discounts, NASD adopted a new rule requiring improved breakpoint compliance, and both the SEC and NASD required fund companies to determine whether they owe refunds to customers. Proposed SEC rules would require funds to disclose more details about arrangements that result in reduced sales loads, and the particular information that shareholders must provide to obtain a breakpoint discount.
Fund governance. The SEC proposed rules designed to strengthen director independence. At least 75 percent of a fund's directors would have to be independent and fund boards would have to designate an independent chairman. Boards would have to undergo annual self-evaluations, considering among other things, committee structures and the total number of funds they oversee. Independent directors would meet separately each quarter, and could hire their own staff. Funds would keep records of information boards use to determine that management fees were appropriate.

Investment adviser code of ethics. New SEC rules require investment advisers to establish codes of ethics reflecting their fiduciary obligations. Adviser codes of ethics must be reasonably designed to keep secure any material nonpublic information about securities recommendations, client holdings and transactions. Some personnel will have to report their personal trades to a compliance officer. The SEC urged advisers to consider restricted lists, blackout periods, "short-swing" trading limitations, and duplicate trade confirmations for personal trades.

Confirmations and point of sale disclosures. Two SEC-proposed rules would require broker-dealers, at the point of sale, to disclose distribution related costs. These costs would include sales loads, the amount of the sales load paid to the broker-dealer, estimated asset-based fees and sales charges shareholders can expect to pay in the following year, the maximum amount of any deferred sales load chargeable if shares are not held for at least one year, and revenue-sharing payments or brokerage commissions paid by the distributor. The rules would require additional disclosures on periodic statements.

Fund brokerage. The SEC proposed rule changes that would prohibit funds from using brokerage commissions to compensate broker-dealers for selling fund shares and from considering fund sales in selecting brokers.

Dollar-based fee disclosures. New SEC rules require funds to disclose fund expenses borne by shareholders, including costs in dollars associated with a $1,000 investment based on actual expenses and the actual expense ratio for the period, assuming a 5 percent annual return.
Enforcement Initiatives

Bank of America. Without admitting or denying the allegations, Bank of America settled SEC charges that it permitted improper market timing in exchange for "sticky assets." Bank of America will pay $250 million in restitution and $125 million in fines, and eight fund directors are expected to resign within a year.

Putnam Investment Management. Without admitting or denying the allegations, Putnam settled SEC charges that it allowed its own employees to improperly market time proprietary funds. Putnam agreed to comply with the SEC's proposed governance rules, and some additional limitations that are more restrictive than the standards proposed by the SEC or Congress. Monetary fines will be determined later. Although the New York Attorney General criticized this settlement for not including a fee reduction, this settlement incorporated elements of the new rules and proposals that go beyond current regulatory requirements.

Alliance Capital Management. Without admitting or denying the allegations, Alliance settled SEC charges that it allowed market timing in exchange for fee-generating "sticky assets." Alliance will pay $250 million in restitution to shareholders of the affected funds, consisting of $150 million in disgorgement and $100 million in penalties. Alliance also accepted compliance and fund governance reforms, including a 75 percent independent board and trustee elections every five years. Alliance settled separately with New York's Attorney General, and agreed to reduce its management fees by 20 percent for at least five years. The SEC declined to negotiate lower fees, stating that decisions relating to fees were better left to informed consumers, independent directors, and the free market.

Other actions. Other actions include: (late trading and market timing); Fleet/Columbia, MFS, Franklin Resources, Prudential Securities Inc. and Invesco Funds Group (market timing); State Street (for failing to detect "blocked" market timers' transactions); PIMCo, Pilgrim Baxter & Associates (market timing and portfolio composition disclosures); Morgan Stanley DW Inc. (revenue sharing, and sales contests); and Security Trust Company, N.A. (late trading). Security Trust Company has since been closed and deregistered and is currently in liquidation.
Legislative Initiatives

Under several proposed bills, funds would be required to increase the number of independent directors and only independent directors could serve as chairs of fund boards and board committees. The bills would also impose new fiduciary duties, increase disclosure obligations, especially with respect to distribution arrangements, revenue sharing and "soft dollars," and establish a new system of compliance certifications.
The bills contain a hodge-podge of other provisions: repealing Rule 12b-1; prohibiting "revenue sharing" arrangements; barring registered fund portfolio managers from managing unregistered pools; raising penalties for civil and criminal violations; making pricing violations into racketeering offenses; requiring regular director elections, more disclosure about portfolio manager compensation, share ownership, broker compensation methods and amounts, and more explicit disclosure about particular fees and expenses mutual funds incur. Several of the bills would create a new mutual fund regulator, like the Public Company Accounting Oversight Board created by the Sarbanes-Oxley Act of 2002.

What Next?

In the wake of the burgeoning mutual fund scandals, regulators and the press are questioning whether mutual fund directors are doing enough to protect the interests of shareholders. Diligent fund directors should ask what they could have done differently and how they can fulfill their fiduciary duties going forward.

To be sure, fund directors should expect increased scrutiny of their oversight of late day trading, market timing and fair value pricing, and their own independence, among other things. Moreover, fund directors likely will be forced to defend their compensation in the face of criticism from the press and others who claim that fund trustees are "ineffectual" and have been asleep at the switch.

Perhaps, most significantly, these developments represent a shift to a new regulatory environment. Funds, their directors and their service providers should become accustomed to this new environment and focus on compliance process and procedures.

Jay G. Baris is a Partner and Alexandra K. Alberstadt is an Associate of Kramer Levin Naftalis & Frankel LLP. Members of the firm have represented or represent some of the parties mentioned in this article.

Please email the authors at and with questions about this article.