The Blame Shifts Around on Late Trades, Market Timing
September 15, 2003
Tongues are wagging and fingers are pointing.
In light of New York State Attorney General Eliot Spitzer's shocking allegations that four mutual fund companies knowingly allowed a hedge fund manager to execute illegal after-hours trades and engage in an elaborate market-timing scheme, industry players are wondering who fell asleep at the wheel? Who at the fund companies and at the Securities and Exchange Commission missed spotting this train wreck?
Should the responsibility for uncovering or policing fall to top executives or the compliance staff at fund advisory companies? SEC examiners? The fund group's transfer agent? The independent auditors? What about the independent fund directors?
According to various sources, that very question has caused introspection among many of the fund industry's players who are evaluating their policies and responsibilities, and are only now testing the current systems of checks and balances for cracks. Despite the urge to pass the buck, it may end up that no one faction could have suspected these activities were occurring, except the parties involved.
It All Came Down to Money'
Neither one rogue fund executive nor one rogue hedge fund manager would have been able to carry out the alleged illicit and illegal trades all by him or herself, said one fund industry executive. There would have had to been complicity among a chain of people at the mutual fund firm and perhaps elsewhere. "There would have to have been processes in place," he added.
In the end, "it all came down to money, and fees," said one top-level auditing executive and former SEC accountant. "The under-the-table deal, essentially, was, If you permit me to play the game, then I will park this money with you.' If anyone at the fund group is at fault, their days are numbered," he added.
But you cannot use a broad brush to paint all fund executives as greed-driven, the auditor added, noting that a hedge fund approached his own fund company with such a deal. "We simply said, No thank you.'"
Another nagging question is why did fund executives believe their actions would go unnoticed? Wouldn't the fund companies' compliance officers spot trouble?
Compliance staffs must oversee that all fund policies and procedures are followed, said one fund industry attorney. However, not all compliance officers scrutinize the details of trading, but they should, he added. "These were deliberate acts of fraud on the marketplace," the lawyer added.
Where Was the SEC?
What about the SEC examiners? Lori Richards, director of the SEC's office of compliance inspections and examinations, vowed in an October 2002 speech that SEC examiners would inspect every SEC-registered investment adviser every two to four years. But in those inspections, the SEC isn't necessarily looking at each and every share trade that's executed at a mutual fund firm, sources said.
Ironically, in a speech Richards gave this past April, she detailed the SEC's top 10 list of fund compliance problems, failure to disclose material facts, and failure to have effective internal controls were noted as the top two deficiencies. "We find disclosure deficiencies in 70% of our exams," she said.
The SEC has now asked the industry's top 80 mutual fund complexes to report information on their policies and practices relating to market timing and late trading. While these practices may not have been high on the SEC's list of procedures to review during exams in the past, these will now become top priorities, industry experts said. The SEC declined comment.
What about the independent auditors? Should they have sleuthed out clues? Then again, how do auditors know if there is a fraud being committed? That's the question many of the audit firms are grappling with right now, said a partner at a leading accounting firm in charge of auditing.
"The easiest way to hide [fraud] is to do it through a third party," which no auditor would have detected, he said. As proof of this, the SEC and Spitzer's investigations are now turning to fund transfer agents, trust companies and broker/dealers. "It's much more difficult to find trading abuses in a [brokerage] omnibus account," the auditor said.
"Unless the auditors did a spot check on fund [trades], which they don't do often, would they have caught" the abuse, the fund attorney agreed.
As for the role of transfer agents in allowing late-day trading, that absolutely requires a complicit trading platform, top executives at a leading transfer agency said.
As for market timing, transfer agents can typically catch some timing tricks or report suspect activity back to the fund complex, these executives noted. The real challenge is when market timing is masked within a trading platform, where trades are processed automatically, they said.