Mutual Fund Regulation and Issues

1. Mutual Fund Regulationand Issues Chapter 2

2. HISTORICAL PERSPECTIVE • Since its beginnings around 70 years ago, the open-end fund industry has largely avoided major legal troubles until the past few years. To start the discussion, it is useful for the reader to understand what might explain such a long period of relative legal and regulatory calm. Some explanatory power would seem to be related to the open-end product’s unique characteristics, namely its self-liquidating feature and its simple (all equity) capital structure.

3. Open-end portfolio managers generally cannot use leverage (borrowed money) to magnify fund returns, and if investors are not happy with a fund’s performance, they can redeem funds at net asset value (NAV) on a daily basis. Many of the largest problems in finance, whether personal investments or corporate matters, typically trace to one or two basic issues: high leverage and/or (low) liquidity. The reader can take note of the 2008 implosion of the real estate market to find both aspects.

4. Highly leveraged investors (e.g., those making a zero down payment on a house) bought highly illiquid assets (real estate). When the value of these assets began to fall, buyers were quickly in a negative equity scenario. Eventually, there were no buyers, and an economic catastrophe ensued. This panic soon spread to the stock market. In the last few months of 2008, investors had a taste of stock market panic not unlike what happened in the Crash of 1929. Most major indexes lost about 40 percent over just a few months’ time in late 2008, and daily stock price volatility was extremely high.

5. A number of the titans of modern finance, including Lehman Brothers, Bear Stearns, and Merrill Lynch, have either failed or been forced to merge in order to avoid failure. The major automakers stand on the brink of collapse. Think about how much more frightening this would be if, in a period of rapidly falling stock prices, investors could not find any other investors with whom to trade. Closed-end funds (those offering a fixed number of shares) were more popular than open-end funds until the Crash of 1929. Often closed-end funds would lever themselves.

6. Many continue that practice to this day. During the Crash, investors suffered from a lack of disclosure about fund leverage combined with an inability to sell since the (closed-end) fund itself did not stand ready to purchase and redeem shares each day (as an open-end fund would have). A panic ensued. In contrast, open-end funds must offer daily liquidity, so the funds themselves tend to hold more liquid securities than closed-end funds.

7. Despite the panic, investors in open-end funds could redeem their shares from the open-end company. This brought investors comfort and arguably formed the foundation for the popularity of the open-end product that continues to this day. The stock market implosion of late 2008 has brought back some of the same types of investor behaviors as the Crash of 1929, so a historical perspective on regulation may take on a heightened level of interest for contemporary readers.

8. Following the Crash of 1929, the federal government began to put a structure into place to address the underlying problems in securities markets, including mutual funds. In the paragraphs that follow, this chapter lays out that fundamental structure as it applies to open-end funds. The goal is to give the reader a sense of the overall regulatory framework. The sections that follow focus in more detail on a few issues that have been of increased interest in the past few years.

9. REGULATION OF OPEN-END FUNDS • The Securities Act of 1933 pertains to open-end funds as it requires registration if the fund intends to offer shares to the public. The broad goal of this act was to protect investors from fraudulent sales and misrepresentations by those selling shares. The act requires funds to provide a prospectus that discloses the key aspects of the fund. Open-end funds also typically provide additional disclosure in a Statement of Additional Information.

10. While some of the elements of required disclosure have been well settled for decades, several disclosure topics remain a lively topic of debate. As this chapter’s introductory story illustrates, required fund performance disclosure is one area that is still controversial. Disclosures about fund management (advisory), marketing and distribution (12b-1) fees, and other costs (such as brokerage fees) also remain hot topics.

11. While there is lively policy debate about disclosure requirements in several areas, it is clear that funds’ failure to follow their prospectus can be very costly. For example, some funds’ selective failure to enforce trading restrictions spelled out in their prospectus was the major legal “hammer” in the mutual fund market timing scandal, which is discussed in more detail later in this chapter.

12. The Securities Exchange Act of 1934 also impacts open-end mutual funds. This act focuses on regulating the trading of securities, requiring various types of record keeping, qualifications, and business practices for broker-dealers. In open-end funds, these rules pertain mainly to funds’ distributors and transfer agents. The latter are involved with a number of the interactions that a shareholder has with the fund, including account maintenance, processing of trades, dividend and capital gains payments, and document transfer (Gremillion, 2005, p. 233).

13. While the 1933 and 1934 Securities Acts apply to open-end funds as well as to other financial products, the Investment Advisory Act of 1940 targets the investment management industry more directly. The Investment Advisory Act requires those advising mutual funds to register with the Securities and Exchange Commission (SEC). The act also regulates the contract between the investment adviser and funds.

14. Some of the key contractual provisions are those that specify a maximum contract length between adviser and fund (two years), those that give the fund the ability to terminate the agreement (with at least 60 days’ notice), and those that require the approval of a majority of the outside directors for adviser–fund contract renewal. For those readers desiring more details, Gremillion (2005) is an excellent resource.

15. The Investment Company Act of 1940 is the major piece of legislation pertaining to open-end mutual funds. The SEC describes the scope and intent of the act quite nicely on itsWeb page (www.sec.gov/about/laws.shtml): This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public.

16. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of the Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments.

17. This quotation captures the overall philosophy of the Investment Company Act, which is based on disclosure. The emphasis is on those areas of operation where there could be a conflict of interest between the adviser and the investor. The next paragraphs highlight a few of those areas in the law. Some tie to the more in-depth discussion of contemporary issues in subsequent sections.

18. At the outset, the reader should recognize that the Investment Company Act carves out a special category for the open-end mutual fund. The open-end fund is deemed an open-end management company because of the investor’s ability to redeem shares of the fund for cash upon request. This distinction matters as it goes to a fundamental characteristic of the open-end fund and one that distinguishes it from other investment structures: its self-liquidating nature.

19. The open-end management company characterization also is important because the rules for open-and closed-end management companies (as well as for other types of investment companies) also differ in other dimensions. • The Investment Company Act of 1940 covers five primary areas of open-end operations: fund management, sales practices, investment advisory fees, fund capital structures, and financial statements and accounting (Sjostrom, 2006).

20. Within each of these areas, particular sections are devoted to issues where there are potential conflicts of interest between fund management and investors. For example, section 10 requires the fund to provide detailed statements of its policies and structure. This section also outlines the requirement that at least 40 percent of the fund’s directors not be “interested persons” in the fund. These are the “independent” directors. If the fund is to have various sorts of exemptions from other requirements under the act, then a majority (greater than 50 percent) of the directors must be independent.

21. Section 13 of the act gives shareholders the right to vote on certain matters, including a change in investment policy. Section 15 of the act requires a written investment contract, which is negotiated by the adviser and the independent directors. Section 17 prohibits affiliated transactions, so the advisers or other service providers cannot conduct financial transactions with the fund. This section also requires that securities be held in custody and that those who have access to securities or cash be adequately bonded.

22. In addition, governance is accomplished by the section 12 requirement that the fund’s annual reports be audited by an independent party. Usually this is an accounting firm (e.g., Ernst & Young). As was discussed in Chapter 1, open-end funds cannot issue senior securities (e.g., debt in an equity fund). That prohibition is contained in sections 12 and 18 of the act. • This sampling of provisions illustrates some of the ways that the 1940 Investment Company Act addresses conflicts of interest between investors and fund managers.

23. For example, suppose that open-end funds could freely borrow money. If the fund manager were paid as a percentage of assets under management, perhaps the manager would be inclined to overleverage the fund and increase risk. Assessing the potential for a conflict of interest is a useful approach to consider any regulatory issue under the scope of the act. • Having built a foundation for open-end fund regulation, this chapter now turns to discussing a few regulatory issues that have been in the headlines in the recent past.

24. RECENT REGULATORY ISSUESIN OPEN-END FUNDS • The open-end mutual fund’s self-liquidating feature, the ability for investors to buy and sell shares each day at NAV, has brought about several regulatory challenges. This feature sets up two kinds of investors in a fund: those who buy and sell (trade) a lot (even daily) and those who buy and hold funds for long periods (i.e., they might go years without trading). The fund management and regulatory challenges in open-end funds often involve striking a reasonable balance in the interests of these two groups.

25. Consider for a moment that those who want to hold funds for long periods are “sheep” and those that want to trade funds daily are “wolves.” Suppose further that those who want to trade in and out of the fund in short intervals harm fund performance and/or impose a burden on fund management. Ideally, the sheep need to be protected from the risks associated with wolves’ behavior, or at least be adequately warned about them.

26. Howcould the sheep be protected fromthe wolves? • One way is to limit trading, either via individual fund rules (such as those in a fund prospectus that limit number of round-trip [buy-and-sell] trades per year by an investor, e.g.) and/or by regulatory fiat, such as a mandatory fee imposed for sales of fund shares held for only short periods of time.

27. These sound appealing until one recognizes that trading limits or costs reduce liquidity for all investors, even some of the “innocent” sheep who might want to trade based on a change in their investment circumstances. Plus limits on liquidity raise the cost for all investors to get out of the fund and, if high enough, could trap the investors with a poorly performing manager. Trading restrictions are one regulatory area where conflicts of interests between investors and fund managers, as well as those between investors themselves, remain an ongoing challenge.

28. NAV Pricing and Trading Policies • Every investment product structure has strengths and weaknesses, and the open-end fund is no exception. So where would the open-end fund be vulnerable? • Consider the daily self-liquidation feature. The fund itself stands ready to buy and sell to individual shareholders at NAV each day. Consider that a fund can hold billions of dollars in assets, made up of thousands of individual accounts. Given its size alone, such a large fund presents an interesting target for fraud.

29. What if an individual can take a small amount of money from a very large number of other individuals? In this case, the amount taken from each individual is so small as to make it unnoticeable or not worth pursuing a remedy even if noticed. If the target number of victims is large enough, then the scam artist can make a lot of money, even if the per-victim rate is very small.

30. The words fund and target were used in the same sentence on purpose. As Ciccotello, Edelen, Greene, and Hodges (2002) state: “Suppose that the calculated NAV were to deviate systematically and predictably from the value of the fund’s underlying assets.” Assume further that mutual fund trading technology allows rapid order submission for large numbers of shares each day. Together, these are a mix for trouble.

31. If a trader could take systematic advantage of predictability in movements of a fund’s NAV and trade large amounts of shares daily, that trader could trade at favorable prices. In the context of an open-end fund, that would translate into wealth taken by the trading shareholders and extracted from buy-and-hold shareholders. Hence, the one takes from the many, and typically in small amounts each day.

32. How could the NAV be biased? As it turns out, pricing of open-end fund shares is not a new problem, having vexed regulators from the birth of open-end funds in the 1920s. Many of the early problems were due to rules that priced the fund shares before the orders to buy or sell at that price were made (backward pricing). Responding to what it perceived to be widespread abuses that resulted from this practice, the SEC adopted Rule 22c-1 in 1968. Reversing what had been the norm (backward pricing), Rule 22c-1 requires funds to adopt a forward-pricing rule in which they sell or redeem shares at the NAV that is first computed after the order is received.

33. Backward pricing is an example of a broader issue of traders being able to buy or sell at a “stale” NAV. That is, the price at which the investor could buy or sell the fund (the NAV) did not reflect all market information when the trader executed the trade. So a stale price trader had an advantage somewhat like placing a bet on a horse race after watching the race. Problems with stale prices are worse in open-end funds that are domiciled in one location but hold assets that are traded on markets in other countries (Bhargava, Bose, and Dubofsky, 1998).

34. Consider the situation with a U.S.-domiciled fund that holds international (say, stocks traded on Asian exchanges) assets. When the fund computes its price as of 4:00 P.M. Eastern Standard Time (EST), most Asian markets are closed. The prices of those Asian stocks have not changed to reflect market movements in the United States during that day. As such, they are “stale” prices (Chalmers, Edelen, and Kadlec, 2001).

35. Academic research has shown that prices in international markets tend to follow U.S. moves the following day, thus opening up a pattern for trading in U.S. mutual funds that can “dilute” buy-and-hold shareholders while rewarding the stale price traders (Greene and Ciccotello, 2006; Greene and Hodges, 2002). The problem became extreme in the case when markets are highly volatile, as in the late 1990s in Asian markets.

36. On Tuesday, October 28, 1997, the Hong Kong market index declined about 14 percent, following the previous day’s decline on the New York Stock Exchange. Later on Tuesday, October 28, the New York market rallied. U.S. funds holding Hong Kong securities were now faced with a dilemma: Should they compute NAV from the Tuesday closing prices in Hong Kong? That would seem to be a stale price. In that scenario, some funds concluded that the closing prices in Hong Kong did not represent “fair value” and calculated their funds’ NAV based on another method.

37. For the purposes of calculating value, the Investment Company Act of 1940 divides securities into two classes. Where securities have “readily available” market quotations, “current market value” should be used. Current market value is generally accepted to be a security’s last quoted sales price on a national exchange. Where securities do not have a “readily available” market quotation, “fair value” should be used. The fund’s board of directors has the power to determine “fair value” in good faith. As detailed in Ciccotello et al. (2002), the SEC has made a number of recent attempts to clarify the use of fair value in terms of both application and disclosure.

38. Fund Pricing and the (Late) Trading Scandal • OnLabor Day weekend in September 2003, thenNewYork Attorney General Elliott Spitzer broke the Canary trading scandal (Masters, 2003; State of New York, 2003). The Canary hedge fund attacked the open-end structure’s self-liquidating feature in an innovative manner. While international funds were known to have vulnerability to market timing trades due to links between markets as just described, domestic funds (holding domestic securities) were thought to be (relatively) safe frommarket timing trades because their prices were not stale.

39. At 4:00 P.M., for example, when the stock fund computed its NAV using closing prices, these were the 4:00 P.M. prices of the stocks in the fund. Among Canary’s innovations were the alleged submissions of orders as late as 9:00 P.M. EST to buy or sell at the 4:00 P.M. price. Often the submissions of orders would relate to moves in the after-market (post− 4:00 P.M.) futures market. In effect, Canary had transformed a domestic fund into an international fund in terms of staleness.

40. Being able to trade at 9:00 P.M. for a 4:00 P.M. price is valuable. The price move from 4:00 P.M. to 9:00 P.M. today can shed light on the market move tomorrow just as the movements in the U.S. stock market today can shed light on international stock market moves tomorrow. In a domestic fund, the odds of predicting the next day’s market return (as either positive or negative) are roughly 50 percent, the flip of a fair coin, if one trades at 4:00 P.M. today

41. With the five-hour after-market advantage today, the odds of correctly predicting a positive or negative market return tomorrow become closer to 66 percent. If one conducts 100 round trips in a fund a year using $100M per buy order, and one is right 66 percent of the time (next day), this lucrative (although illegal) operation for the trader can be quite damaging to the buy-and-hold shareholder (Damato, 2003; Hulbert, 2003).

42. Canary allegedly submitted late orders under several (false) pretenses, including masquerading as a qualified pension investor (which at that time could submit late orders due to the time lag for bundling all of the individual orders together). This abuse and the concern for the anonymity of bundled orders have led the SEC to adopt more stringent order submission guidelines. In December 2003 the SEC proposed: amendments dictating that an order to purchase or redeem fund shares would receive the current day’s price only if the fund, its designated transfer agent, or a registered securities clearing agency receives the order by the time that the fund establishes for calculating its net asset value. The amendments are designed to prevent unlawful late trading in fund shares (See SEC, Amendments to Rules Governing Pricing of Mutual Fund Shares, 2003).

43. In sum, the rules surrounding enforcement of prospectus trading limits, fair valuation of fund shares, and timely order submission have become much more important in an era where large (and sometimes bundled) trades can be submitted electronically through various channels to the open-end fund (Ciccotello et al., 2002).

44. CURRENT REGULATORY ISSUES IN FUNDS • The mutual fund market timing scandal went beyond the escapades of the Canary hedge fund. Over the period from 2003 to 2006, regulators implicated a number of other late traders and mutual fund families in the scandal. In some of these cases, the mutual fund had made explicit special arrangements for certain investors to trade in excess of stated prospectus limits. Often this was done in exchange for that investor’s agreement to put buy-and-hold (sticky assets) cash into other funds in the family.

45. In other cases, the market timers had no explicit agreement with the fund but nevertheless traded in and out of funds by switching accounts or by taking on other “cloaking” devices. Regulators often alleged that these timers were “tolerated” by the family, although there were circumstances where timers were kicked out of funds (by the fund’s “timing police”) for their trading behavior. As a result of this timing phenomenon, fund families did (in general) step up their awareness of investor trading practices.

46. The market timing scandal was a big deal. Over $2 billion to date has been placed in settlement funds for disbursement to open-end fund shareholders who were harmed by market timing trades. Market timing was the largest scandal ever to hit the open-end fund industry, and it has had several regulatory spillovers. Recall that the major goal of the 1940 Act is to address areas of conflict of interest between investors and fund managers. Allowing preferential trading rights (in violation of prospectus limits) to some investors in return for sticky assets looks like such a conflict of interest.

47. The “timing” of the market timing scandal is also informative as to the nature of the conflict-of-interest issues at hand. Some of the leading “creative” investors with strategies to market time (or late trade in) funds made their pitch to funds in years 2001 and 2002. Recall that by late 2002, the market had dropped about 25 percent (based on the Dow Jones index) and over 50 percent (based on the Nasdaqindex) since early 2000. Mutual funds advisory fees are normally assessed a flat percentage of assets under management.

48. With declining asset values and flat percentage fees, the amount of money that the fund manager gets to manage the fund goes down—even if no investors pull their money out of the fund. If asset values fall 50 percent, then revenues to the fund manager are down significantly—indeed, exactly 50 percent if that management (advisory) fee is a flat percentage of assets. So a market timer’s promises to add sticky assets to one fund in exchange for the ability to trade in excess of prospectus limits in another made for an interesting business proposition for some fund managers in this period, when management fees were down.

49. These market timing offers set off quite a struggle in some fund families between compliance personnel and marketing (sales) managers. The former argued that the deal would violate prospectus (harming buy-and-hold shareholders); the latter looked at more of the revenue upside—and perhaps thought that market timing in a domestic fund would not hurt shareholders anyway since the NAV was not stale. It is apparent in some cases that the sales side won the battle, although the war ended up being a different story.

50. For the reader, the important point is to see the clear conflict of interest between shareholders in the fund (especially those who buy and hold shares) and fund management in this matter. How could this happen? Why weren’t shareholders’ interests protected by the board of directors? One pressure point in the 1940 Investment Company Act to deal with conflicts of interest like this is the structure of the mutual fund board of directors. Recall from earlier in the chapter that most mutual fund boards have a simple majority of independent (disinterested) directors.