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11/03/2003

KERRY TAKES AIM AT LATE TRADING AND MARKET-TIMING SCHEMES WITH MUTUAL FUND INVESTOR PROTECTION ACT

“This outrageous type of fraud lowers the value of mutual fund shares, taking retirement funds away from hardworking American families. It will not be tolerated,” says Kerry

WASHINGTON, DC – Senator John Kerry (D-Mass.) today unveiled his proposal to protect average investors from late trading and the market timing of mutual fund shares. The Mutual Fund Investor Protection Act will increase penalties for those convicted of such schemes and update federal securities laws to curb these abuses.
“Illegal and unethical mutual fund trading has no place in our financial markets,” said Kerry. “My proposal is a clear warning to anyone who even attempts to line their own pockets by exploiting everyday investors. This outrageous type of fraud lowers the value of mutual fund shares, taking retirement funds away from hardworking American families. It will not be tolerated.” Today, mutual funds are valued once a day (called Net Asset Value or NAV), usually at 4 p.m. ET, when the New York market closes. Since the prices are updated only once per day, mutual funds are more likely to be the target of attempts to manipulate the sudden changes in the marketplace.

Late trading involves purchasing mutual fund shares at the 4 p.m. price after the market closes. It is similar to betting today on yesterday’s horse races since it allows a favored investor to take advantage of post-market-closing events (like the announcement of corporate earnings) not reflected in the share price set at the close of the market. Late trading is prohibited by the Martin Act and SEC regulations.

Market timing exploits the unique way that mutual funds set their prices. While it is not illegal, most mutual fund companies assure investors that such practices are discouraged and that they are working to prevent fund timing. Quick-turnaround traders routinely try to trade in and out of certain mutual funds in order to exploit the inefficient way mutual funds price their shares. A typical example of market timing occurs when a U.S. mutual fund owns Japanese shares. Because of the time difference, the Japanese market closes at 2 a.m. ET. When the mutual fund uses the closing prices of the Japanese shares of their fund to arrive at the daily NAV, that price information is 14 hours old. If there have been positive market moves during the New York trading day that will cause the Japanese market to rise later when it opens, the stale (14-hour-old) Japanese prices will not reflect them and the mutual fund’s NAV will be artificially low. On such a day, a trader who buys the Japanese fund at the “stale” price is virtually assured of a profit, which can be realized the next day by immediately selling. That profit dilutes the value of shares held by long-term investors.

Nearly 95 million Americans have invested approximately $7 trillion in 8,300 U.S.-based mutual funds. The majority of U.S. households owning mutual funds have moderate incomes. Fifty-seven percent of households owning funds have incomes between $25,000 and $75,000, while seven percent of households owning funds have incomes under $25,000. The number of U.S. households owning individual stocks instead of mutual funds declined 4.9 percent between 1999 and 2002. Eighty nine percent of U.S. equity investors owned stock in mutual funds in January 2002, while 49 percent owned individual stock directly. (The Investment Company Institute report “Fundamentals Investment Company Institute Research in Brief: U.S. Household Ownership of Mutual Funds in 2002”; October 2002)

A summary of Kerry’s Mutual Fund Investor Protection Act follows.

SENATOR JOHN KERRY’S MUTUAL FUND INVESTOR PROTECTION ACT

§ Requires that all mutual fund companies receive an order prior to the time the fund prices its share for an investor to receive that day’s price;

§ Increases the penalties and jail time for current laws related to late trading such as: violating Section 17(a) of the Securities Act relating to defrauding the offer or sale of securities, violating Section 10(b) of the Exchange Act in connection with the purchase or sale of securities; violating Section 17(a) of the Exchange Act for failing to keep current and appropriate records of brokerage transactions, violating Section 22(c) of the Investment Company Act, which requires underwriters and dealers to sell and redeem fund shares at a price based on current Net Asset Value (NAV);

§ Includes violations of late trading laws as an offense under the Racketeer Influenced and Corrupt Organization (RICO) provisions as part of the Organized Crime Control Act of 1970;

§ Requires each mutual fund prospectus to explicitly disclose market timing policies and procedures to stop abuse, and;

§ Increases penalties for including fraudulent information on mutual fund prospectus.

Background In a September 2003 complaint, the New York Attorney General alleged that Canary Capital Partners, a New Jersey hedge fund, engaged in illegal and unethical trading in mutual funds, such as late trading and market timing. Canary allegedly entered into agreements with four major mutual fund companies (Bank of America’s Nation Funds, Bank One’s One Group funds, Janus and Strong) to make illegal trades in exchange for Canary placing millions of dollars into their funds. While Canary Capital Partners did not admit to or deny any guilt, the company paid $40 million in fines to settle the charges. Since the New York complaint was issued, the Bank of America has set up a fund to reimburse its shareholders hurt by improper trades it processed for Canary Capital Partners.

A preliminary investigation by the SEC found that half of the 88 mutual fund companies and brokerage firms had arrangements with one or more investors allowing them to trade in and out of shares (market timing). These arrangements occurred even though about half of the fund companies have policies specifically barring market timing. In addition, many fund companies appear to have provided information about their stock holdings to big investors to help them profit from securities being bought or sold by the fund. (New York Times, 10/25/03)

Last week, regulators accused Putnam Investments and two of its fund managers of civil securities fraud, accusing Putnam of allowing its fund managers to practice market timing. Massachusetts pension fund trustees have voted to sever the fund’s relationship with Putnam Investments which had previously managed $1.7 billion in state pension funds. (Reuters, 10/30/03)