More Phonies Betting On the Ponies One in 10 Mutual Funds Guilty of Late Trading
November 10, 2003
Fund industry executives who thought they might dodge the scandal bullet had their odds reduced drastically last week.
As regulators made their way to Capitol Hill last week to testify before lawmakers, Stephen Cutler, the Securities and Exchange Commission's enforcement director, delivered one high and tight to the shaken industry.
The practice of late trading, which New York State Attorney General Eliot Spitzer likened to betting on a horserace after it's over, is apparently much more prevalent than those in the industry have previously acknowledged, according to Cutler's testimony before Congress.
As many as 10% of mutual fund firms and 25% of brokerages took part in late trading activity, according to preliminary data from SEC inquiries.
Throughout most of the investigation, the focus has remained on the relationships between market timers and fund companies.
Much more outrageous were the actions of late traders, who blatantly broke the law. These individuals were painted as rogues by the mutual fund industry, acting on their own - a few bad seeds. "It's one of those areas where nobody would have believed anybody would do this because it's so illegal," said Don Cassidy, a senior analyst at Lipper. "It's the extreme tip of the iceberg, it's like a new disease that nobody knew existed. But now that regulators know what it is, they will work to make sure it doesn't happen again."
However, they don't have the vaccine as of yet, and the disease appears to be spreading rapidly.
As part of its investigation, the SEC sent information requests to 88 of the largest fund companies in the country and 34 brokerage firms, including all of the registered prime brokers. The Commission also sent similar requests to insurance companies that sell mutual funds via variable annuities last week.
The startling responses - more than 25% of brokerage firms have placed orders at that day's NAV after the 4 p.m. deadline - have prompted the SEC to send sent staff members to conduct on-site inspections at dozens of firms.
It is obvious from Cutler's statements that the scope of this investigation is widening greatly. Two broker/dealers allowed customers to place orders up until 4:15 p.m., while another broker/dealer firm allowed customers to cancel orders between the closing time and 4:15 p.m., Cutler testified.
One broker/dealer firm allowed customers to trade a full 30 minutes after the close, while yet another one permitted customers to confirm orders 45 minutes after the bell. Another broker/dealer even permitted customers to place orders up until 5:30 p.m.
Additionally, about 10% of the e-mails submitted from responding mutual funds contained references to situations that possibly involve late-trading activity, Cutler said.
"Late trading is fundamentally worse than market timing because of what it is," said Robert Knuts, a partner in the government investigations department of Day, Berry & Howard and a former senior trial counsel and an assistant regional director for the SEC.
While the indications so far of late trading are not a good sign, they may not be as damning as they appear, Knuts said, noting that Cutler took special precaution to indicate that late trading is not necessarily connected to payoffs.
There are other instances in which late trading can occur, such when an order is accepted after the cutoff due to a misplaced order ticket, Knuts noted. "It remains to be seen whether or not the SEC will find all of this activity illegal."
However, last week, a person briefed on pending late-trading charges against Prudential said brokers had doctored order tickets purposely in order to get their trades in under the wire.
"A lot of it comes down to greed. When people see easy money out there, they are willing to do anything for it," said Jonathan Boersma, vice president at the Association for Investment Management and Research.
The Investment Company Institute and the SEC have both come out with proposals to curb these activities (see related story, page 8).
Move over Theodore Sihpol III. Your jail cell could get crowded. Sihpol, the Bank of America broker facing up to 25 years in prison on one count of grand larceny and four more years on one count of fraud for his role in a late trading scheme at BoA, may be getting company.
"I think the people who are the most at risk [of going to jail] are the people, who as part of the scheme, destroyed documents and created fictional records," Knuts said. "That goes right to the heart of the securities industries. To the extent that those people altered records, their actions go beyond just late trading."
So far in the investigation, mutual fund companies Bank of America, Federated Investors, Fred Alger Management, Morgan Stanley and Prudential Securities are under the gun, as well as hedge funds Canary Capital and Millennium Partners. Smith Barney also found late trading issues in its own internal investigation.
And, in an overall broadening of this investigation, Cutler said in his testimony last week that the SEC is looking at another potentially abusive practice in which fund companies appear to have disclosed portfolio information in circumstances that provided certain advantages to select investors - somewhat similar to an insider trading issue.
The SEC is "actively looking at two situations in which funds dramatically manipulated their net asset values in a manner that raises serious questions about the funds' pricing methodologies," Cutler said.
Knuts said the expansion of the investigation is a natural progression. "You will inevitably create new leads to track down once one witness begins to cooperate," he said.
And on and on the questioning and the depositions continue...
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