Targeting Mutual Funds

In last month's article, we pointed out that successful enforcement efforts against investment banks have emboldened state and federal authorities to target mutual funds – a fact that has been borne out in the national press over the past few weeks. More precisely, the funds' investment advisers are the targets. We believe regulators' inquiries will most likely examine two general categories, fund administration and marketing. Last month's article discussed fund administration; the following concentrates on trade allocations, and advertising and marketing.

Trade Allocations

Trade allocation issues arise when funds conduct bunched trades. For example, an adviser might conduct trades that benefit more than one fund and intentionally delay apportioning the shares. This delay allows the adviser to allocate trades to favored funds based upon subsequent market movements (this scheme is commonly called “cherry picking”). A fund may also manipulate the pricing of bunched trades by allocating the shares without using the average price paid, thereby allotting a more favorable price to favored funds. Compliance advisers should educate fund managers to these risks, and ensure that fund managers have a truthful, ethical, coherent explanation for their trade allocations that is consistent with the documents. Managers should have this explanation in mind before they allocate trades, not grasp for one after the fact, once the subpoena has arrived.

Front Running

The individual fund manager's behavior can attract regulators' attention as well. In front running, a fund manager may buy certain stocks for his or her personal portfolio before directing the fund to purchase bulk shares of the same stock. The fund's subsequent purchases run-up the value of the manager's personal shares.

Securities regulations require investment advisers to maintain adequate records of personal securities transactions to prevent these conflicts of interest. These records must include the amount of shares for each transaction, the date and nature of the trade, the price at which the security was bought or sold, and the name of the broker. All personal securities transactions must be reported no more than 10 days after the end of the calendar quarter in which the transaction occurred. The problem, of course, is that it is easier to keep such records than to use them. Compliance staff should review trading records periodically and examine unusual trades or patterns. Companies that establish compliance procedures only to ignore them earn a special wrath from prosecutors.

Advertising and Marketing

Investment advisers are prohibited from making misleading statements or omitting material facts in advertising funds to investors. For example, advertisements must not use testimonials, client endorsements, or any implication that the SEC recommends or approves a fund. Furthermore, securities regulations limit the use of graphs or charts in marketing the fund as well as representations of service charges and the adviser's qualifications. Regulators are especially vigilant about the use of specific, past, profitable investments without including all past investments, both good and bad.

Clients look to past performance as the leading criterion for future investing. The SEC, therefore, carefully monitors performance claims in fund advertising. For example, regulators look for misleading advertising of performance results that include only selected profitable investments or selected profitable periods. Furthermore, regulators watch for funds representing that their performance claims comply with the Performance Presentation Standards of the Association of Investment Managers and Research (AIMR). The SEC does not use AIMR standards to judge performance claims, and so touting AIMR compliance may mislead investors into thinking it is within SEC standards. Regulators have focused on advertisements that compare a fund's performance and strategy with an inappropriate index, distorts the fund's total assets or misrepresents the investment adviser's credentials or years of experience. Investment advisers must maintain records that substantiate all performance claims. Regulators find that the most reliable records are third-party records, such as brokerage or custodian statements.

Pursuant to the securities laws, funds must report their performance over a specified time, typically 1-, 5- and 10-year periods. Economists have claimed that some investment advisers manipulate trades at the end of a reporting period so they can temporarily boost results in a way that overstates the fund's true performance. For example, just prior to the end of a reporting period, a fund could buy the stock of an issuer it already owns to boost the value of its holdings. By dumping risky stocks and buying government securities and blue chip stocks, an investment adviser may distort the composition of the fund's portfolio near the end of a reporting period so as to appear more conservative.

Though many of the behaviors that can give rise to enforcement actions involve high-level decision making, such as investment strategy or disclosure issues, others may arise from the actions of individual brokers and others who market mutual funds. For example, brokers who churn trades between mutual fund accounts that charge loads will certainly fall within regulatory purview. On a broader level, issues may arise for funds that charge reduced loads or fees at certain break points, ie, investments that exceed a certain threshold pay lower fees. Regulators may claim that funds need to aggregate a client's trades over a period of time.

Conclusion

Congress is presently considering legislation that, if enacted, would impose even greater disclosure and regulatory requirements on mutual funds. House Resolution 2420 would apply many of the reforms of the Sarbanes-Oxley Act to mutual funds. Reforms would include new audit committee standards, increased accountability of mutual-fund directors, increased disclosure to investors, and increased fee transparency. The bill would require investment advisers to disclose soft-dollar arrangements, as well as other brokerage arrangements that may raise a conflict of interest. The proposed legislation will add further requirements with which regulators and prosecutors can build their cases against mutual funds.

In last month's article, we pointed out that successful enforcement efforts against investment banks have emboldened state and federal authorities to target mutual funds – a fact that has been borne out in the national press over the past few weeks. More precisely, the funds' investment advisers are the targets. We believe regulators' inquiries will most likely examine two general categories, fund administration and marketing. Last month's article discussed fund administration; the following concentrates on trade allocations, and advertising and marketing.

Trade Allocations

Trade allocation issues arise when funds conduct bunched trades. For example, an adviser might conduct trades that benefit more than one fund and intentionally delay apportioning the shares. This delay allows the adviser to allocate trades to favored funds based upon subsequent market movements (this scheme is commonly called “cherry picking”). A fund may also manipulate the pricing of bunched trades by allocating the shares without using the average price paid, thereby allotting a more favorable price to favored funds. Compliance advisers should educate fund managers to these risks, and ensure that fund managers have a truthful, ethical, coherent explanation for their trade allocations that is consistent with the documents. Managers should have this explanation in mind before they allocate trades, not grasp for one after the fact, once the subpoena has arrived.

Front Running

The individual fund manager's behavior can attract regulators' attention as well. In front running, a fund manager may buy certain stocks for his or her personal portfolio before directing the fund to purchase bulk shares of the same stock. The fund's subsequent purchases run-up the value of the manager's personal shares.

Securities regulations require investment advisers to maintain adequate records of personal securities transactions to prevent these conflicts of interest. These records must include the amount of shares for each transaction, the date and nature of the trade, the price at which the security was bought or sold, and the name of the broker. All personal securities transactions must be reported no more than 10 days after the end of the calendar quarter in which the transaction occurred. The problem, of course, is that it is easier to keep such records than to use them. Compliance staff should review trading records periodically and examine unusual trades or patterns. Companies that establish compliance procedures only to ignore them earn a special wrath from prosecutors.

Advertising and Marketing

Investment advisers are prohibited from making misleading statements or omitting material facts in advertising funds to investors. For example, advertisements must not use testimonials, client endorsements, or any implication that the SEC recommends or approves a fund. Furthermore, securities regulations limit the use of graphs or charts in marketing the fund as well as representations of service charges and the adviser's qualifications. Regulators are especially vigilant about the use of specific, past, profitable investments without including all past investments, both good and bad.

Clients look to past performance as the leading criterion for future investing. The SEC, therefore, carefully monitors performance claims in fund advertising. For example, regulators look for misleading advertising of performance results that include only selected profitable investments or selected profitable periods. Furthermore, regulators watch for funds representing that their performance claims comply with the Performance Presentation Standards of the Association of Investment Managers and Research (AIMR). The SEC does not use AIMR standards to judge performance claims, and so touting AIMR compliance may mislead investors into thinking it is within SEC standards. Regulators have focused on advertisements that compare a fund's performance and strategy with an inappropriate index, distorts the fund's total assets or misrepresents the investment adviser's credentials or years of experience. Investment advisers must maintain records that substantiate all performance claims. Regulators find that the most reliable records are third-party records, such as brokerage or custodian statements.

Pursuant to the securities laws, funds must report their performance over a specified time, typically 1-, 5- and 10-year periods. Economists have claimed that some investment advisers manipulate trades at the end of a reporting period so they can temporarily boost results in a way that overstates the fund's true performance. For example, just prior to the end of a reporting period, a fund could buy the stock of an issuer it already owns to boost the value of its holdings. By dumping risky stocks and buying government securities and blue chip stocks, an investment adviser may distort the composition of the fund's portfolio near the end of a reporting period so as to appear more conservative.

Though many of the behaviors that can give rise to enforcement actions involve high-level decision making, such as investment strategy or disclosure issues, others may arise from the actions of individual brokers and others who market mutual funds. For example, brokers who churn trades between mutual fund accounts that charge loads will certainly fall within regulatory purview. On a broader level, issues may arise for funds that charge reduced loads or fees at certain break points, ie, investments that exceed a certain threshold pay lower fees. Regulators may claim that funds need to aggregate a client's trades over a period of time.

Conclusion

Congress is presently considering legislation that, if enacted, would impose even greater disclosure and regulatory requirements on mutual funds. House Resolution 2420 would apply many of the reforms of the Sarbanes-Oxley Act to mutual funds. Reforms would include new audit committee standards, increased accountability of mutual-fund directors, increased disclosure to investors, and increased fee transparency. The bill would require investment advisers to disclose soft-dollar arrangements, as well as other brokerage arrangements that may raise a conflict of interest. The proposed legislation will add further requirements with which regulators and prosecutors can build their cases against mutual funds.