The 2003 mutual fund scandal was the result of the discovery of illegal late trading and market timing practices on the part of certain hedge fund and mutual fund companies.
On September 3, 2003, New York Attorney General Eliot Spitzer announced the issuance of a complaint against New Jersey hedge fund company Canary Capital Partners LLC, charging that they had engaged in "late trading" in collusion with Bank of America's Nations Funds. Bank of America is charged with permitting Canary to purchase mutual fund shares, after the markets had closed, at the closing price for that day. Spitzer's investigation was initiated after his office received a ten-minute June 2003 phone call from a Wall Street worker alerting them to an instance of the late trading problem.
Canary Capital settled the complaint for US$40 million, while neither admitting nor denying guilt in the matter. Bank of America stated that it would compensate its mutual fund shareholders for losses incurred by way of the illegal transactions.
In the United States, mutual fund prices are set once daily at 4:00 p.m. Eastern time. "Late trading" occurs when traders are allowed to purchase fund shares after 4:00 p.m. at that day's closing price. Under law, most mutual fund trades received after 4:00 p.m. must be executed at the following day's closing price, but because some orders placed before 4:00 p.m. cannot be executed until after 4:00 p.m., brokers can collude with investors and submit post-4:00 p.m. trades as if they had been placed before 4:00 p.m. In 2003 several mutual fund companies and stock brokerage firms engaged in a trading practice which guaranteed profits for the stock brokerage firm’s insider managers and preferred customers.
To understand how this works, one needs to know how mutual funds shares are priced. Share values for mutual funds are not based upon bids from outside buyers. The price of a fund’s price was set in the evening based upon the value of the securities that it owned at the end of trading day, 4:00 PM Eastern Time. The law prohibited trading of mutual fund shares at any other price so the price set on Monday evening for a fund’s shares was available to anybody all day long on Tuesday until the market closed at 4:00 PM.
Pension funds and hedge funds are faced with unpredictable big inflows of cash on any given day. Their job is to put those funds to work as soon as possible.
Mutual funds were eager to take the money from these pension funds. The mutual fund’s management fees were based upon the amount of money (value of shares) held by the fund. More money held by the mutual fund meant more money at the end of the quarter for the fund’s managers. Pension managers had a legitimate problem with knowing just how much money they had to invest on any given day. There are changes from day to day as beneficiaries took withdrawals or employers made deposits.
An ostensibly harmless practice developed where mutual funds let it be known that they could be flexible about taking purchases at that morning’s price after the closing, even though that was prohibited by their rules. This was a matter of accommodating fund managers and encouraging them to trust that fund with their investment.
People were beginning to realize unanticipated uses for computer technology, in particular people realized they could track what was happening to the value of any mutual fund’s investments as quickly or even quicker than the mutual fund managers could using relatively simple spreadsheet programs. They realized that if permitted to buy after the close they could know what tomorrow’s price would be and provided they sold the shares tomorrow morning that they bought that evening would be guaranteed a profit, a profit that ordinary customers that played by the rules could not get. The trades involved small variances in price but because the buyers were purchasing millions of dollars in mutual fund shares the guaranteed profits for these insiders was significant and secure.
Such trades could be made with information about after-hours market developments in other countries, for example. Traders would buy in at the previous day's close, and sell at the next day's close for a likely profit. This practice hurt long-term buy-and-hold investors in the mutual fund, who experienced a continued drain in the fund's net asset value (or NAV).
Late trading was not a new phenomenon. Prior to 1968, most mutual funds used "backward pricing," in which the fund could be bought at the previous closing price. Thus, traders could purchase mutual funds on a day when the market was up, at the previous day's lower closing price, and then sell at the purchase date's closing price for a guaranteed profit.[1] To prevent the exploitation of backward pricing, the SEC issued Rule 22c-1,[2] requiring forward pricing of mutual fund transactions. This rule was enforced by randomly checking timestamps on orders, but intentional falsification of timestamps was difficult to catch.[3] In addition, New York's Martin Act can be interpreted to prohibit late trading as well, due to the unfair advantage the late trader gains over other traders.
Spitzer and later the U.S. Securities and Exchange Commission (SEC) also charged that major mutual fund groups such as Janus, Bank One's One Group, and Strong Capital Management and others facilitated "market timing" trading for favored clients.
Market timing is an investment strategy in which an investor tries to profit from short-term market cycles by trading into and out of market sectors as they heat up and cool off. In a novel interpretation of New York's Martin Act, Spitzer contended that fund firms committed fraud when they allowed some clients to trade more frequently than allowed in their fund documents and prospectus.
In many cases, funds bar or limit frequent trading because the practice may increase the cost of administering a mutual fund borne by all shareholders in the fund. Market timers also can make managing the fund more difficult since the fund may need to keep extra cash to meet liquidity demands of selling timers, although if timers are trading opposite flows of other investors, they can moderate cash fluctuations. Those funds that did not limit frequent trading in their prospectus—as well as a small number of funds that cater specifically to market timers—were not charged.
Spitzer contended that some advisors allowed market timers in order to increase their assets under management (fund advisors are paid based on the amount of assets in the fund).
The SEC is charged with the regulation of the mutual fund industry in the United States. Following the announcement of Spitzer's complaint, the SEC launched its own investigation of the matter which revealed the practice of "front running". The SEC claimed that certain mutual fund companies alerted favored customers or partners when one or more of a company's funds planned to buy or sell a large stock position. The partner was then in a position to trade shares of the stock in advance of the fund's trading. Since mutual funds tend to hold large positions in specific stocks, any large selling or buying by the fund often impacts the value of the stock, from which the partner could stand to benefit. According to the SEC, the practice of front-running may constitute insider trading.
By early November, investigations led to the resignation of the chairmen of Strong Mutual Funds and Putnam Investments, both major mutual fund companies. In the case of Strong, the chairman Richard Strong was charged with market-timing trading involving his own company's funds. In December, Invesco (market-timing) and Prudential Securities (widespread late trading) were added to the list of implicated fund companies.
Nearly all of the fund firms charged by Spitzer with allowing market timing or late trading had settled with his office and the SEC between mid-2004 and mid-2005.
One exception was J. W. Seligman, which chose in September 2005 to sue Spitzer in Federal court after their talks with Spitzer broke down. Seligman argued in its suit that Spitzer had overstepped his authority by attempting to oversee how Seligman's funds set their advisory fee and that the regulatory oversight of fees is left by Congress to the SEC. Separately, in August 2005 Spitzer lost the only trial arising from his investigations when a jury could not reach a verdict on all counts in a case brought against Theodore Sihpol, III, a broker with Bank of America who introduced Canary Capital to the bank. Though Spitzer threatened to retry Sihpol, he did not do so. In September 2005 Spitzer's office reached a plea bargain in a case brought against three executives charged with fraud for financing Canary and assisting its improper trading in mutual funds. That case against two Security Trust executives and one banker had appeared to be Spitzer's strongest, and the settlement seemed to reflect Spitzer's weakening hand in the wake of his defeat in the Sihpol case. The United States Second Circuit reversed the District Court In United States Security Commission v O`Malley on 19 May 2014 finding there was no consistent rule prohibiting Traders from engaging in market timing and therefore there was no requirement to disgorge profits made thereunder. This appeal related to a Rule 50 motion to dismiss on basis there was no credible evidence to leave to the jury as to breaching any duty of care and the Appeals Court Upheld same.