Charles Joseph Kerns Sr. is the kind of guy a lot of people in south Florida would like to sock right in the mouth. He is, by all accounts, a crook of many talents, a grifter who steals as casually as you and I brush our teeth in the morning. He is in his mid-sixties, a square-headed man with a bad toupee who steals with a practiced finesse, and steals from just about everybody who has made the mistake of crossing his path. “This was the worthless check written by Charles J. Kerns as earnest money for my house.” That’s the caption to a photo of a five-thousand-dollar rubber check that appears on charleskerns.com, which one of his victims designed as a less-than-loving tribute to Charles J. Kerns Sr. In the early part of the millennium, Kerns found a new method of accumulating victims. He took the path of many career criminals and joined the brokerage business, via a firm in Boca Raton called Geek Securities.
In several cases that churned their way through the federal courts of Miami during 2004, Kerns and the operators of Geek Securities were convicted of various crimes and sentenced to prison terms of varying severity. For Kerns it was a throw-away-the-key twenty-seven years. The charges in the Geek Securities cases were the usual Boca-brokerage sliminess. There was sale of unregistered securities, a stock-loan scam—and also something really bad. “THIRTY-SIX COUNT INDICTMENT CHARGES MUTUAL FUND MARKET TIMING AND LATE TRADING SCHEME” was the title of a press release that was issued by the Office of the U.S. Attorney for the Southern District of Florida on June 24, 2004.
Kerns and his co-thieves, the owners of Geek Securities, were playing an essential role in the regulatory process. They were serving very admirably as clay ducks in the latest Wall Street shooting match, the Mutual Fund Late Trading Scandal. Kerns himself didn’t do any of that late-trading stuff. That wasn’t his style. He was an old-fashioned worthless-paper-pusher. But he had fallen in with some bad company. As the Miami federal prosecutor pointed out in a press release, these were “the first federal court criminal convictions for mutual fund ‘market timing’ and ‘late trading’ in the nation.”
Selling unregistered securities and otherwise ripping off investors in a straightforward fashion—in the sense of actually taking their money—won’t get most regulators and law-enforcement people out of bed nowadays. But if you get caught up in the Mutual Fund Scandal—well, you had better put your bondsman on speed-dial and feed the goldfish before leaving the house every morning. Getting hooked up with a bunch of mutual fund late traders was the biggest mistake of Charles J. Kerns’s miserable life. He should have gone down to Little Havana and hooked up with methamphetamine dealers instead.
So far in this book our self-regulatory pyramid has been in a state of repose, calmly snoozing away while investors are ripped off. But now you get a chance to see our regulators aroused, motivated, and in motion. The Mutual Fund Scandals, encompassing late trading, market timing, and allied forms of misconduct, are an area of endeavor about which our regulators have been as busy as a turkey farm in November, axes flying. Unless you’ve been orbiting Venus for most of the past few years, you probably know that there is such a thing as the Mutual Fund Scandals, and you probably know that they are bad, based on all that has appeared in the media and the sheer volume of publicized bloviating on the subject. Even so, you may not be too certain as to the exact nature of the scandalous conduct in these particular scandals, whether your fund was involved, and what if anything you should do about it. You’ve probably noticed that the term late trading has been tossed around a lot, and since people are being thrown in the clink for it, you might reasonably assume that it is pretty awful.
It is probably just as well if you haven’t paid close attention and don’t know what all this Mutual Fund Scandals stuff is all about. Because when you sit down and take a close look at this crusade du jour of the self-regulatory pyramid, you are likely to get mad. And you won’t be mad for reasons that the self-regulatory pyramid wants you to be mad.
Let’s go back to D-Day in what the Wall Street Journal described as the launching of a “new front in allegations of financial-market abuses,” September 3, 2003. New York Attorney General Eliot Spitzer charged “that a hedge-fund manager arranged with several prominent mutual-fund companies to improperly trade their fund shares—some after the market’s close—reaping tens of millions of dollars in profits at the expense of individual investors.” So said the front page of the Journal the following day, and the front pages of the nation’s newspapers were similarly alive with this new species of Wall Street greed.
It was startling for several reasons. A scandal in, say, the hedge fund industry would be far less jarring. Hedge funds, which are supposed to be private partnerships for the wealthy, * are mysterious—if you want to reach for an inappropriate adjective, as people often do when dealing with money, you might even say “sexy.” You expect adventurous and “sexy” areas of the financial business, such as investment banking in the eighties, to have occasional scandals. But mutual funds are about as sexy as your maiden aunt, the one with the parakeet. They have carefully nurtured a reputation for blandness and scrupulous hygiene amid the general filth and cursedness of Wall Street. The fund industry, hewing closely to the wisdom of Hillel the Elder—“If I am not for myself, who will be for me?”—was always the first to admit that it had this reputation, and that it was well deserved.
Fund managers and their trade association, the Investment Company Institute, worked hard to ensure that word of their reputation echoed through the hills and valleys of the fund-buying heartland. After all, what’s the point of a great reputation if nobody knows about it? If you praise a mutual fund executive in the middle of the forest and nobody hears you, is he really praised? Fund-industry executives, mindful of this age-old metaphysical dilemma, worked hard to ensure that the world knew about their reputation by making speeches and generating essays about their great reputation, and then issuing press releases pointing out what they had pointed out in speeches and essays.
The worse the news from the rest of the financial world, the more grotesque the scandals, the greater the swelling in the fund industry’s pride. In October 2002, ICI chairman Paul G. Haaga Jr. made the following bold observation that was transmitted throughout the world: “The mutual fund industry’s reputation is its most important asset. Strict regulation and the industry’s adherence to the highest possible voluntary standards have helped us avoid major scandals.” It was, he said, a “stellar record.”
By 2003, when corporate scandals that were mere polyps in 2001 and 2002 rose up out of the earth and roared like creatures in a bad science fiction movie, the fund industry was serene. As in the late 1980s, when insider trading and junk bond scandals were alienating the population, the mutual fund industry was an island of goodness and decency. Mutual funds were once more dodging the raindrops of the storm, Mother Teresas with toll-free numbers.
In an address to the ICI’s annual Mutual Fund and Investment Management Conference, held on March 31, 2003, in suitably clean and lush Palm Desert, California, ICI president Matthew P. Fink counted off the ways in which the fund industry was selflessly, without a thought to its own welfare, serving the investors of America. In a recitation that brought to mind the repetitious rhythms of the Amidah of Jewish liturgy and other prayers familiar to the faithful of all religions, Fink davened again and again,
“We are serving shareholders well because…”
“We are serving shareholders well because…”
Chief among his exhortations to the Higher Power (whatever media were in attendance) was this one:
“We are serving shareholders well because the interests of those who manage mutual funds are so well aligned with the interests of those who invest in mutual funds.” Amen.
This was not the usual self-congratulatory bullshit you find in any conference in any industry, in which the well-heeled periodically gather to give thanks, to administer to the spirit, to sanctify the mission that provides the livelihood and pays the green fees. This was more the kind of mass self-hypnosis that you’d see in Kim Jong Il’s North Korea—a relentless immersion in propaganda that was effective and believed by all, including the ones who were supposed to know better. The mutual fund industry was so virtuous in the eyes of the media that the Strong mutual fund group (later pilloried in the fund scandal) and the ICI both sponsored journalism awards for years and no one in the press blinked an eye. *
No brokerage could have gotten away with putting its name on a journalism award. Mutual funds were different. Every financial journalist knew that mutual funds were virtuous, scandal-free, boring. “The mutual fund industry has avoided the abusive practices that betrayed investors in other parts of the marketplace,” said Fink in his keynote address out there in Palm Desert.
Even after D-Day, the press rarely deviated from that line—that the industry’s record was clean, an unparalleled record of trust that had just been abruptly fouled, as if by a passing car driving through a mud puddle. Business Week expressed the zeitgeist in December 2003, saying in an article entitled “Breach of Trust” that the fund industry was, in effect, a victim of overzealous sales practices prompted by the bear market. “In 2000, the onset of the most vicious bear market since the Great Depression set the stage for the worst abuses by the mutual fund industry,” said the article. “Many fund companies began resorting to shady practices” because they were “squeezed by competition for dwindling investor dollars.” (An interesting excuse, by the way. In your business, does a competitive squeeze send you out to the 7-Eleven with a ski mask and a.357 Magnum?) Congress, the magazine said, was browbeaten by cunning fund lobbyists into keeping its distance from an industry that had a “60-year record of serving small investors (marred by only a few minor scandals).”
That was all over now, or such was the judgment of the media and the conventional wisdom. The regulators were on the case, and were competing with one another to knock fund-industry heads together. Bill Donaldson swiftly rose to the occasion, proposing various rules and saying the right things. The SEC began to sue, in competition with Spitzer, who raised the stakes a notch by convening a grand jury and actually indicting people instead of just suing them as he usually did. Prosecutors throughout the country took up the challenge. A kind of sweepstakes began for the greatest number of mutual fund late-trader scalps.
Regulators were reacting to genuine feelings of shock that swept over the country when the Mutual Fund Scandals commenced. Dick Grasso had just been shown to have pillaged the pride and joy of American capitalism, and he would be dead meat by the fall of 2003. Then came new-sounding allegations of improprieties in the supposedly squeaky-clean fund industry. How tragic it would have been, this fall from grace—if it really had been a fall, and if there really had been much grace to begin with.
Amid all the hubbub, some fundamental facts concerning mutual funds had been overlooked—such as the factual basis, or lack thereof, for that glorious reputation. As is often the case in a fast-moving news event, the media found itself parroting pap such as “sixty-year scandal-free record.”
In fact, the mutual fund business did not have a clean history, and for most of its existence it did not even have a reputation for having a clean history. What it had was a reputation for having a reputation for having a clean history.
The mutual fund industry was (and is) in the same awkward position as Ebenezer Scrooge on Christmas Eve, haunted by the Ghost of Mutual Funds Past, Present, and Future. It’s an industry with a dreary, smarmy history dating back to the period just after the First World War. The earliest fundlike outfits, which were similar to today’s closed-end funds, were established in Boston in 1924. Since their origins go back so far, it’s actually not a sixty-year record of anything, but rather an eighty-year record of…what?
Let’s see what their reputation was in 1982, their actual almost-sixty-year point in selflessly serving the American public. In that year, in a book entitled Regulation by Prosecution: The Securities and Exchange Commission vs. Corporate America, a former SEC commissioner named Roberta S. Karmel commented on the reputation of the mutual fund industry. At the time, deregulatory fever was sweeping the nation, and the glory of free markets was returning to center stage in Washington. Here was Karmel’s take on possible fund deregulation:
“Significant reform of investment company regulation, by either Congress or the SEC, will be difficult,” she said. “The public has historically feared and distrusted the fund industry, and with some good reason. The Investment Company Act [of 1940] and its various amendments were passed in response to perceived abuses.” (Emphasis added.)
So here we have an outspoken advocate of deregulation saying in 1982, when the fund industry really had a sixty-year record, that mutual funds not only had a lousy reputation but a lousy reputation “for good reason.” And why? What’s this stuff about “perceived abuses”? Why were they perceived so vividly that Congress had to pass a bunch of laws in response?
What Karmel was talking about, this perception problem that beset the fund industry for three-quarters of its existence, involved stuff that was a lot worse than the stuff that is at the center of the Mutual Fund Scandals.
That phrase she used for the title of her book, “regulation by prosecution,” certainly applies to the mutual fund industry in its recent scandal. The fund industry, though heavily regulated, has not been regulated in a way that has kept fund managers from turning into slightly better-groomed versions of the sun-kissed grifters at Geek Securities. What makes the whole thing even messier is this: The fund abuses that affect you the most are not the ones that have been getting the headlines. All this late-trading stuff you’ve been reading about is about as old as the fund industry itself, and was allowed to fester because the fund industry wanted it to fester.
Let’s take a close look at those phrases you keep hearing, late trading and market timing. They make it sound as if someone has a hand in the till.
It’s a mighty big till, after all. At last count, some $8.2 trillion was held by the eight thousand or so mutual funds in the United States. That counts the whole gamut—funds holding stocks, bonds, and money market funds. Even if you narrow that down to stock funds, that brings the number down to a measly $4.4 trillion. A lot of mischief can happen when you are dealing with that kind of money, particularly when it is your money and you aren’t around to watch it. As you’ll be seeing in the next chapters, there certainly is a whole lot of mischief going on in the fund business. However, the very worst abuses haven’t made the cut. Sorry, but the stuff that really hurts you failed to make it through the tryouts and never were placed on the official roster of the Mutual Fund Scandals—that is to say, not as enshrined by the media and officially constituted by Spitzer, the SEC, and the rest of the self-regulatory pyramid.
Whenever someone talks about a scandal sweeping over Wall Street, there are questions you need to ask: “Who gets hurt?” and “How?” You then need to haul out a copy of Les Misérables. Okay, the Cliffs Notes will do.
You need to be skeptical when regulators stop acting like amiable high school substitute teachers and start imitating Inspector Javert. You want Inspector Javert pursuing Landru, not Jean Valjean. You want prosecutors, ambitious state attorneys general, and the SEC to use their limited resources against the people who are out to rob you. When I say “rob,” I am invoking Sunday School morality, not the finer points of the securities laws. Concepts like “lie,” “cheat,” “bribe,” “overcharge,” and “steal.”
Unless you can persuade the self-regulatory pyramid and law enforcement to get their priorities straight, you’ll be cursed by what I call the Reverse Rationality Theorem of Wall Street Crime and Punishment:
Just because something is terrible doesn’t mean that it will be punished, and just because something is being punished doesn’t mean that it is terrible.
The Mutual Fund Scandal is the best example you can find of the Reverse Rationality Theorem of Wall Street Crime and Punishment in full bloom of sheer stupidity.
The clay ducks in the fund-scandal penny arcade, be they Geek Securities or Putnam or Strong or Janus, are not being fined or yelled at or arrested because of any of the Sunday School concepts noted above. A fund scandal is not comparable to an accounting scandal, either the ones that result in indictments or the ones that result in an SEC wrist slap or a financial-statement fix-it called a restatement. When you read “accounting irregularities,” what you are really reading is “they lied.” That’s the thing about the Dick Grasso scandal that should bug you. He didn’t lie or steal. He followed the rules and looked both ways before he crossed the street as he turned that building into a piggy bank. Calling a CEO being overpaid, however piggishly, a “scandal” distorts the term. Grasso’s arbitration system was a scandal. Grasso’s paycheck was not.
The Mutual Fund Scandal did not involve lying, cheating, or stealing. It involved trading. It wasn’t a good thing, and the people involved should definitely have been caught and penalized. However, don’t believe for a second that this was a terrible thing that arose all of a sudden and required the self-regulatory pyramid to drop everything and turn its attention to it. A perfectly accurate way of defining the conduct that everybody is upset about is “how the funds have done business since Adam and Eve shacked up at Eden Community College.”
The relevant, naughty practices at issue have two names—late trading and market timing—but they both involve the same kind of thing, which is buying fund shares at stale prices. That’s it, as far as scandalous conduct is concerned. One of those things, market timing, isn’t necessarily illegal.
As told by the media, the first day of the Mutual Fund Scandal was September 3, 2003. But that’s not true. I can’t tell you when Day One took place because that’s wedged somewhere in the distant mists of time, at the dawn of the mutual fund industry in the days when Harold Lloyd was the number one movie star. Today’s Mutual Fund Scandal is just another name for a trading method that was a legitimate practice in the fund business for almost five decades, from the early 1920s until 1968, and which remained commonplace right up to the fund-scandal D-Day. For all those years, traders took advantage of flaws in the way fund shares were priced. Evidently the fund industry has never figured out a way of pricing fund shares without you being screwed.
That’s right, folks. Over the past eighty years, the mutual fund business hasn’t gotten the kinks straightened out about how to charge for their wares, even though the timing issue has been an invitation to mischief. You might think that maybe the fund industry wanted the mischief to continue, or didn’t care one way or the other. You’d be right.
Here’s the “problem”:
When you buy into a U.S. mutual fund today, shares are priced at four P.M. New York time, when the markets close. But that’s not how it was in the old days. Prior to 1968, funds engaged in what was known then as “backward pricing,” which meant that you bought shares today at prices set at the close of trading yesterday.
When you bought shares in a fund in the old days, the price was automatically “stale.” Backward pricing made the paperwork easier for the fund companies, at shareholder expense, while at the same time giving a bunch of fortunate people an opportunity to print money. These unnamed lucky cusses—“unnamed” because so few of them were caught doing it—made nice, riskless profits if they happened to work for the funds or were big customers of the funds or had pals at the fund companies.
If the market advanced nicely on a Tuesday, all you had to do was buy into the fund on the cheap late that day, when you knew the market (and your fund) would end the day with a nice advance over Monday’s prices. Then on Wednesday you’d sell at Tuesday’s prices to lock in your gain. Easy!
Ordinary people couldn’t do that, because in those days the sales “loads”—sales charges, sometimes exceeding 8.5 percent—would have chewed away at any such trading. “Insiders and favored customers, however, often could purchase fund shares without paying sales loads,” said a 1992 SEC history of the fund industry.
Such hijinks beset the fund industry during the carefree, modestly regulated 1920s and 1930s. In 1940, six years after erection of the self-regulatory pyramid, Congress finally got around to regulating the fund industry by passing the Investment Company Act of 1940. This was designed to fix all the problems that beset funds. And boy, were there problems. Trading on stale prices was just one of them. An SEC study of the fund industry, ordered by Congress in 1935, found that the mutual funds of the time were an absolute mess:
Before passage of the Investment Company Act of 1940] to an alarming extent investment companies had been operated in the interests of their managers and to the detriment of investors. A high incidence of recklessness and improvidence was also noted. Insiders often viewed investment companies as sources of capital for business ventures of their own and as captive markets for unsalable securities that they, the insiders, wished to convert into cash. Controlling persons frequently took unfair advantage of the companies in other ways, often using broad exculpatory clauses to insulate them from liability for their wrongdoing.
Outright larceny and embezzlement were not uncommon. Managers were able to buy investment company shares for less than net asset value, thus enriching themselves at the shareholders’ expense. In addition, reports to shareholders were often misleading and deceptive. Controlling positions in investment companies—represented by special classes of stock or by advisory contracts—were bought and sold without the consent, or even the knowledge, of public shareholders. Basic investment policies were changed without shareholder approval. The advisory contracts themselves were often long term and either noncancellable or cancellable only upon the payment of a substantial penalty by the company. Sales loads were as high as 20 percent. Management fees charged in connection with contractual plans sometimes bore no relationship to any actual managerial services.
Whew! Sounds like something from the Old Testament, maybe the part where the children of Israel make a Golden Calf, and Charlton Heston throws the tablets at them. Licentiousness! Debauchery! Congress certainly had its hands full. Still, it would be simple enough to tackle stale pricing and what regulators gently called the “riskless” trading that it encouraged. All they had to do was price shares at the closing prices on the day they were bought—what is known as “forward pricing.”
That would have been a simple solution, which is probably why it didn’t happen. The SEC’s 1992 history of the fund industry describes what happened next: “The Commission could have cured riskless trading [that is, late trading] by requiring forward pricing. The industry, however, vigorously resisted.”
So that was that. Instead, as a “compromise,” the 1940 act included a rule requiring all customers to be charged the same sales load. That made it verboten for funds to be sold to some customers without loads and other customers with loads. That might have solved the problem, and probably seemed like a good idea at the time. However, many funds stopped charging loads over the years, and some funds just looked the other way and didn’t charge loads to favored customers. Either way, traders could take advantage of stale prices.
A former SEC fund regulator named Karl C. Smeltzer, looking back on the era in an oral history for the SEC Historical Society that he dictated in 2004, noted that well into the 1960s it was “possible for sophisticated investors and professional traders to purchase mutual fund shares in a rising market at the last, previously determined, net asset value.” Karl called this a “system, unintended by regulators, which could result in the dilution of the shares of buy and hold investors already in a fund.” In other words, what you had going on here was a Mutual Fund Scandal, albeit without all the Sturm und Drang and embarrassing headlines.
Karl recounted that he and his colleagues, all conscientious career civil servants, put their heads together. “A group of us involved in the regulation of mutual funds urged the Commission to meet the above problem by adopting what we called the forward pricing of shares.” Well, better late than never. The SEC adopted forward pricing in October 1968. That ought to fix it.
To enforce the new forward-pricing system, mutual fund examiners like Karl would randomly check time-stamping of orders to see to it that the prices were determined at the “next determined net asset value.” That should have eliminated the entire problem of stale price trading—in theory. In practice, pals of the traders at the fund companies changed the date on the time-stamping machines. “Of course, improper, intentional back time-stamping could occur, and it can be even more difficult to detect today with orders recorded by electronic systems,” said Karl.
Wait a second. If a fund is priced at four P.M., when the market closes, what could possibly be the point of buying a fund after four P.M. and backdate stamping the trade so that it seemed to be before four P.M.?
The reason is that a good deal of market-moving news takes place after four. That’s late trading, and it is definitely illegal. But something very similar isn’t illegal. Overseas mutual funds are priced along with domestic funds at four o’clock New York time, but are based on share prices when the overseas markets close—fourteen hours earlier, in the case of Japan. A lot can happen in fourteen hours to affect the price of Japanese stocks. So overseas fund prices often become stale while people are snoring in Japan.
If you buy shares in Japanese funds on a day when stuff happens in the United States to boost the Japanese funds, and sell the following day at elevated prices to make a riskless profit, what you have done is called “market timing.” You will note, by the way, that this phrase is a misnomer. More accurate would be “stale-price trading.” Though it’s legal, it hurts long-term investors, and to do it in any volume, you have got to have a pal at the fund who will relax rules that restrict the amount of in-and-out trading that customers can do. That’s how the fund companies get in hot water, because stuff like that can violate the law.
Fred Alger Management, a very prestigious firm, ripped its reputation to shreds by allowing late trading. That’s a shame, when you think about it. If the public knew the crummy history of the fund industry on the subject of stale-price trading, there wouldn’t have been all that much disappointment.
Looking back in the midst of the Mutual Fund Spitzerama, Karl Smeltzer expressed surprise that the media hadn’t noticed that late trading was a problem that had been the subject of hand wringing so many years before. He noted that trading on stale prices was “a problem which was supposed to have been resolved by [the 1968 rule change]. I have seen no references to that in recent financial news or publications on the matter.”
Oh, well. Just another lost opportunity in the 1960s (imagine if we had all bought into Berkshire Hathaway?). Still, you would think that somebody might have noticed when stale-price trading reared its head during the intervening three and a half decades.
Such as October 28, 1997. On that day, the Asian markets took a nosedive. By the end of trading in New York, while Asians were just starting to wake up, the U.S. market recovered. That was expected to make the Asian markets recover as well. Sure enough, if you bought an Asian fund at the stale, low price, you could turn around and sell at a quick, riskless profit the following day. Yep, just as Grandpappy might have done back in the 1930s, if you chose the right parents. This was legal, but not very nice, market timing.
Let’s turn to Barry Barbash of Enron-exemption fame to see what happened next. He was head of the SEC’s Investment Management division under Arthur Levitt. Barbash decided to address the problem in the Levitt manner, which was to give a speech. On December 4, 1997, he addressed the 1997 ICI Securities Law Procedures Conference in Washington. The theme of the speech was nostalgia.
“In the face of the impending millennium,” said Barbash, “much of America these days seems to be looking backward.” Teenagers were wearing bell-bottoms again. It was really something. Continuing to stroll down memory lane, well into his speech Barbash came to the point. He reminded his audience of fund hacks and lawyers that “during the Wonder Years of the 1960s, the Commission took one of its most decisive actions ever in regulating mutual funds”—Rule 22c-1, which abolished backward pricing.
Barbash went on to gently remind his listeners that backward pricing “encouraged questionable sales and trading practices in fund shares.” In 1981 the SEC had encouraged—but did not, God forbid, require—funds to price shares at “fair market value” when fresh prices were not available. Some Asian funds did that. Some didn’t. Therefore, some traders who hoped to make a quick killing on the Asian markets on October 28 were disappointed. The SOBs used fresh prices! Didn’t let them turn a profit at the expense of other shareholders. So they complained—how’s this for chutzpah—to the SEC!
The SEC responded by launching an examination of the affected funds. “Our review was completed last week and many of our findings are noteworthy,” Barbash told the fund officials. “A striking finding of our recent exams, particularly in view of the Commission’s policy goals in adopting Rule 22c-1, was the extent to which fund investors in October appear to have speculated in the shares of funds investing in Asian securities.” He was clearly shocked—shocked!—that this had taken place. “We need to undertake a broader and more comprehensive analysis of fund pricing issues,” said Barbash.
At this point the SEC swung into action. An SEC lawyer wrote a long and very polite letter to the chief counsel of the ICI, Craig S. Tyle, on December 9,1999. Douglas Scheidt, chief counsel of the SEC’s Investment Management division, politely pointed out that it would be very, very nice if the funds would think seriously about using fair value pricing.
Fund boards, he said, had a “good faith obligation” to see that fund prices were fair—not that there was any heavy lifting involved. “A board,” he said, “would need to have comparatively little involvement in the valuation process in order to satisfy its good faith obligation.” Scheidt concluded with a threat: “We will consider whether to provide additional guidance on pricing issues in the future. We would appreciate your sharing this letter with your members.” The threat of still more correspondence from an SEC lawyer is, of course, usually enough to bring even the most recalcitrant malefactor to heel.
You can just imagine the kind of shock waves that this letter set off in the fund industry: There may be more letters! Oh, no! Oddly, the fund industry proved resilient to this heavy-handed bullying. (Perhaps they didn’t believe there would be more letters? We can only guess.) So the SEC made good on its earlier threat, and wrote a letter. In April 2001, Scheidt wrote Tyle again. This time, Scheidt hauled out a big gun—he used boldface.
“The Failure to Determine the Fair Value of Portfolio Securities Following Significant Events May Result in Dilution,” said Scheidt.
The boldface did not work. The fund industry didn’t do anything, and neither did the SEC, under either Harvey Pitt or Bill Donaldson. Trading on stale prices continued, was examined periodically in academic studies that nobody noticed, and continued to fester. According to studies at Stanford University, trading on stale prices (market timing) had resulted in losses to long-term investors of $4 billion a year, while trading at night and back stamping of orders (late trading) had resulted in losses of $400 million. Those $4 billion/$400 million annual losses were achieved by, as the Scheidt letter indicated, “diluting” the value of fund shares.
That is not a lot of gobbledygook—it is a very real diminution in the value of fund shares, caused by all the trading I’ve described. But let’s not go nuts about this, folks. It is bad—and backdating orders is rotten stuff—but it is not the kind of stealing that happens when some broker calls you and lies to you about a stock. It is not the kind of thing that happens when you buy shares in a company that has been fibbing in its financial statements, driving up share prices to boost the value of executive stock options. It is not, in other words, stealing. It’s the kind of thing that might have caused a stern letter to be sent to your parents, but you wouldn’t have been drummed out of Sunday School. Even so, when the Mutual Fund Scandals exploded on the financial scene, it seemed to be the worst thing that you could do with your clothes on. It wasn’t.
You couldn’t blame Spitzer—he needed an issue, and that was his issue. He needed something he could use to embarrass Bill Donaldson. He succeeded. True, he could have used an issue that was of more importance to investors, but his heart was in the right place. Besides, there’s no question that he preserved investor confidence in the fund industry, and investor confidence in the fund industry is important—to the fund industry. If you don’t have confidence in the fund industry, you won’t give them your money.
That’s the fun part of running a mutual fund, by the way. Taking your money.