An unusual food fight has broken out between the New York Attorney General and Massachusetts securities regulators, on one side, and the SEC, on the other, with the former criticizing the SEC’s settlement with Putnam Investments as both overly lenient and premature. Although the Putnam settlement involves some useful governance reforms and a still unspecified civil penalty, it neither requires Putnam to admit liability, nor does it impose any sanction on the various Putnam executives who made repeated, in-and-out trades in their own funds that diluted their own investors. It is thus the typical “Go-And-Sin-No-More” SEC settlement that state regulators consider a mere “slap on the wrist.” Moreover, because the Putnam settlement may well prove a prototype for other soon-to-be-announced settlements with a host of other firms where market timing trades by insiders and favored customers appear to have been endemic, a serious public policy issue arises as to whether the SEC is being too soft.
But what more can or should the SEC do? Let’s begin with what the SEC has been alleging. To this point, the SEC’s criticism of market timing has been relatively gentle; market timing, it has told the press, is not necessarily illegal, but it can conflict with the terms of mutual fund prospectuses, which represent to fund investors that the fund will discourage market timing trades. Yet this position ducks a deeper question: Does such trading also amount to insider trading? If so, could the investment adviser to the mutual fund sometimes be liable as the tipper on trades in the fund made by large customers to whom it reveals the fund’s portfolio? So far, the SEC has carefully avoided suggesting that “market timing” could constitute insider trading. This euphemistic hesitation may be the result of a desire to accommodate the mutual fund industry (as some state regulators have suggested), simple bureaucratic inertia (always a problem at the SEC), or doctrinal obstacles (which, as discussed below, arguably also exist).
Accordingly, this column will successively consider: (1) when market timing should amount to insider trading; (2) the empirical evidence about market timing and the injuries it inflicts for investors; (3) the SEC’s equivocal response to this evidence since 2001; and finally (4) the possible penalties and reforms that the SEC, or its more aggressive state rivals, should seek.
Is it Insider Trading?
The typical example of “market timing” involves a mutual fund with large holdings in foreign stocks. If these foreign stocks trade only abroad, and if the foreign market closes well before the U.S. market, then foreign stock prices will be stale by the 4:00 p.m. point at which the mutual fund must determine its daily Net Asset Value (“NAV”). Knowing that these prices are stale, an investor can buy the mutual fund shares just before the 4:00 p.m. deadline if the investor believes the stale market price undervalues the foreign stock. The investor thereby arbitrages the difference between the fund’s stated “NAV” and its actual value, locking in a gain that the investor could not likely obtain by buying the foreign stock when it resumed trading. At first glance, this practice does not look like insider trading because the price of the foreign stock, and the fact that it is stale, is public information. Nonetheless, material nonpublic information is being exploited here: The material nonpublic information is the extent to which the fund’s portfolio is heavily invested in certain foreign stocks. If this information is used by an employee of the investment adviser, or by a customer of the investment adviser who is selectively shown the fund’s portfolio by the investment adviser, then we arguably have a case of insider trading under Dirks v. SEC.1 To be sure, Dirks does require that the tipper receive a direct or indirect “personal benefit” in return for its disclosure to the tippee2, but this requirement seems easily satisfied if, for example, the tippee is a hedge fund or money manager who parked funds with the investment adviser in order to obtain information about the mutual fund’s portfolio.
Still, a further complexity surrounds the mutual fund context that is caused by the lack of a secondary market in the case of “open end” mutual funds. Investors buy and redeem shares with the mutual fund itself, and not with each other. Thus, arguably there is no informational imbalance when the tipped investor buys mutual fund shares from the mutual fund in order to exploit stock prices, because both the fund and the tipped investor have the same information. Viewed in the light most charitable to the SEC, this factor could explain what has caused the SEC to avoid any use of the phrase “insider trading” in its recent statements about market timing.
The fact there is a parity of information between the fund and the tipped investor should not, however, imply that Rule 10b-5 has not been violated. All the classic elements of a Dirks violation are present: (1) a purchase or sale of securities, (2) based on the use of material, nonpublic information, and (3) involving a fiduciary breach in which a personal benefit was conferred on the tipper. Alternatively, in some cases, the investment adviser might be said to have manipulated the market by maintaining the fund’s NAV at an artificially low level by failing to properly value the foreign stock at its fair value. Either way, because the majority of mutual fund investors have not traded contemporaneously with the defendants, they could not directly sue the defendants under Rule 10b-5, but they may be able to sue derivatively on behalf of the fund, which did trade. In any event, the SEC and the U.S. Attorney could prosecute such trading on either theory, confident that it produces real injury to investors.
In this light, the failure of the SEC to bring or even threaten insider trading charges is disturbing. It seems consistent with the critics’ view that the SEC was “captured” by the mutual fund industry. Indeed, there is one striking fact that corroborates this assessment. Even if the selective tipping of hedge funds and other clients does not constitute insider trading, it would certainly violate Regulation FD, which prohibits selective disclosure, but for the revealing fact that Regulation FD specifically exempts open end mutual funds.3 Put simply, the mutual fund industry received a carefully crafted immunity from selective disclosure that no other industry sector or class of issuers received. Nor was this unique. A similar broad exemption applicable to mutual funds was created under Section 16(b) of the Securities Exchange Act of 1934.4
Particularly in light of its compromised recent history, the SEC should bring insider trading charges in cases where the trading defendant is either an officer or employee of the investment adviser or a client of the adviser who parked assets with, and thus conferred a “personal benefit” on, the investment adviser. If the SEC loses, it could respond, as it has done in other recent cases, by adopting a rule defining the conduct to be insider trading. Rules 10b5-1 and 10b5-2 are specific examples of how the SEC can salvage a regulatory victory, even if it suffers a litigation defeat.5 Similarly, Rule 10b5-3 could define it to be a manipulative and deceptive practice to buy mutual fund shares based on material nonpublic information about the fund’s portfolio. What the SEC cannot fairly do, however, is sit passively, ignoring this problem.
Prosecutors face less of a problem than the SEC. They can easily indict under the mail and wire fraud statutes the insider who trades on or who leaks confidential business information to enable others to trade. In Carpenter v. United States,6 a unanimous Supreme Court found that an agent who tipped the contents of a newspaper column to confederates who traded in advance of the column’s appearance was liable (along with his confederates) because he deprived his employer of “exclusive possession” of that confidential information. On this basis, the investment adviser who selectively reveals portfolio information to large funds to receive side benefits from those clients is similarly breaching the fiduciary duty it owes to the fund.
What Rules Are Needed?
“Market timing” is a misnomer, which obscures the real underlying behavior. The actual phenomenon driving the current scandal is stale-price arbitrage. By trading in mutual funds to exploit predictably stale prices, investors appear to earn 35 to 70 percent returns in international funds and only a slightly more modest 10 to 25 percent returns in small-cap equity, high-yield debt, and convertible bond funds.7 These high returns are obtained, however, by diluting the long-term, buy-and-hold shareholders to whom mutual funds typically market their products. Symptomatically, dilution of the long-term shareholder has been growing in recent years, up in the case of the international equity funds from 56 basis points in 1998–1999 to 114 basis points in 2001. In the case of regionally focused international funds, the annual loss is now estimated to be 2.3 percent of the fund’s assets per year.8 All told across all fund classes, long term shareholders are losing about $5 billion per year.9
Although the practice of stale-price arbitraging has accelerated since 1998, only a minority of funds have sought to arbitrage-proof themselves. Among international funds, which are the most vulnerable, only 30 percent had adopted short-term trading fees by mid-2002.10 Worse, the SEC has to date temporized about whether funds have a duty to protect their long term shareholders from dilution. In fact, a variety of defensive tactics are feasible: (1) short-term trading or redemption fees; (2) restrictions on trading frequency; and (3) fair value pricing techniques that mark-to-market the estimated prices of foreign stocks throughout the trading day by using the nearest comparable stock prices. In 2001, the SEC properly advised the Investment Company Institute (“ICI”) that, in the case of foreign securities, “a fund must evaluate whether a significant event (i.e., an event that will affect the value of a portfolio security) has occurred after the foreign exchange or market has closed, but before the fund’s NAV calculation.”11 In such an event, it indicated the fund could not use the stale price in determining its NAV. This was a sensible, if partial, step in the right direction, but the industry fiercely resisted the SEC’s efforts. As usual, the bar associations were even more intemperate in their criticisms to the SEC. As happened throughout the 1990s, the SEC retreated. Industry newsletters reported that Paul Roye, the director of the SEC’s Investment Management Division, backed down under pressure from the SEC’s 2001 no action letter to the ICI, which had recommended updating foreign stocks for post-market closing significant developments, but which had been written by a subordinate.12
In overview, this was deja vu all over again. The mutual fund industry’s success in forcing the SEC to back away from its limited effort in 2001 to introduce fair pricing for foreign stocks seems highly reminiscent of the auditing industry’s similar success a few years earlier in forcing the SEC to abandon its initial efforts to restrict the consulting services that auditors could market to their audit clients. SEC reform efforts directed at auditors encountered fierce political resistance in Congress—until Enron. But, by some surveys, the mutual fund industry is the second largest political donor.13 Still, just as after Enron, the accounting firms suddenly lost their political influence. That same moment may have arrived for mutual funds.
Real reform requires the mandating of fair pricing methodologies. The best funds—Fidelity and Vanguard—already use these techniques. Not surprisingly, those that have done the least to arbitrage proof their funds are those that have the highest expense ratios and the highest proportion of insiders on their boards.14 These funds systematically dilute their investors, but the industry will nonetheless predictably continue to resist fair value pricing and favor instead easier reforms, such as redemption fees and transfer restrictions. The reforms are also useful, but second best to the one answer that stops stale price arbitrage at its source by ending stale prices.
What Should Regulators Do?
Whether or not the SEC decides belatedly to recognized that insider trading is occurring, there are other steps that should be pursued and that Congress should demand. A first such step should be to amend Regulation FD to delete its exemption for open-ended mutual funds. Similarly, the exemption under Section 16(b) is overbroad. So long as Regulation FD openly permits selective disclosure by mutual funds that cost fund shareholders an estimated $5 billion a year, New York Attorney General Spitzer is entitled to describe the SEC as a “captured” agency.
Attorney General Spitzer has suggested a Draconian penalty for investment advisers that permit stale-price arbitrage: they should forfeit, he argues, their management fees. Possibly, he has read the September 16, 2003 decision of the Second Circuit in Phansalkar v. Andersen, Weinroth & Co.15 That decision reads New York’s “faithless servant rule” to require a highly punitive forfeiture of all employee or agent compensation received after a significant act of disloyalty. The Second Circuit’s decision reversed a district court decision that had limited the forfeiture to only the compensation received for the transaction in which the agent was disloyal. Although New York law does not apply to most mutual funds, which tend to be organized under Maryland or Massachusetts law, New York law may often apply to the advisory contract between the mutual fund and its investment advisers. Hence, there are real penalties that regulators can threaten.
Based on Phansalkar, it appears that courts today are ready to be tough on fiduciary misconduct. The open question is whether the SEC is also.
- 463 U.S. 646 (1983)
- Id. at 663-664.
- See Regulation FD, Rule 101(b) (defining issues not to include any investment company other than a closed-end investment company), 17 CFR 243.101(b).
- See Rule 16b-1, 17 C.F.R. 240.16b-1.
- Rule 10b5-1 was a response to decisions that had found that the defendant must be shown to have “used,” rather than simply “possessed” nonpublic information. Rule 10b-2 reversed the decision in United States v. Chestman, 947 F.2d 551 (2d Cir. 1991) (en banc), which held that a husband did not owe a fiduciary duty to his wife for purposes of insider trading law.
- 484 U.S. 19 (1987).
- See Eric Zitzewitz, “Who Cares About Shareholders?: Arbitrage Proofing Mutual Funds,” Stanford Graduate School of Business Research Paper No. 1749 (Oct. 2002).
- Id. at 2.
- Id. at 33.
- See Letter to Craig S. Tyle, General Counsel, Investment Company Institute, from Douglas Scheidt, Chief Counsel, Investment Management Division, dated April 30, 2001, 2001 SEC No-Act. LEXIS 543.
- See Alison Sahoo, “SEC’s Roye Tries to Clear Up Valuation Quagmire,” Ignites.com (August 31, 2001)
- See Zitzewitz, supra note 7, at 32.
- Id. at 34-35.
- 344 F.3d 184 (2d Cir. 2002); see also Murray v. Beard, 102 N.Y. 505, 7 N.E. 553 (1886); see also, Western Elec. Co. v. Brenner, 41 N.Y. 291, 295, 392 N.Y.S. 2d 409 (1977); Feiger v. Iral Jewelry Ltd., 41 N.Y. 2d 928, 394 N.Y.S. 2d 626 (1977).