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John C. Coffee Jr.

As the fog slowly lifts from the still developing mutual fund scandal, three things have become clear: First, market timing imposes extraordinary costs on ordinary shareholders, costs that Stanford Business Professor Eric Zitzewitz estimates at $4.9 billion a year in terms of the dilution they suffer. Second, mutual funds could have taken a variety of easily feasible steps to protect themselves from market timing, but they did not. Third and most surprising, the Securities and Exchange Commission (SEC) could have insisted on steps that would have effectively prevented market timing, but again, it did not. Instead, it repeatedly backed off of reforms that it had proposed, because of industry opposition. Even in the belated reforms that the SEC has now proposed in December 2003, it has still been unwilling to directly proscribe manipulative practices that seem functionally equivalent to insider trading. Rather, it is pursuing a more indirect and softer disclosure strategy that asks mutual funds to disclose the extent to which they engage in selective disclosure of their portfolios to privileged investors and the circumstances under which they will “fair value” portfolio securities. All of this lends support to New York Attorney General Eliot Spitzer’s diagnosis that, at least in the context of investment company regulation, a “culture of accommodation” has led the SEC to defer excessively to industry interests. ‘Market timing’ is a practice that exploits stale prices To understand what reforms are needed, it is useful to begin by focusing on what makes “market timing” possible. Essentially, “market timing” is a form of arbitrage that seeks to exploit stale prices. All open-end mutual funds must value their portfolios each day, typically at 4 p.m. Eastern time, when the markets close. See SEC Rule 22c-1, 17 C.F.R. 240.22c-1. All purchases or redemptions made during the prior 24 hours are transacted at the net asset value (NAV) per share determined at that time. But suppose that the 4 p.m. price undervalues the fund? Then it would be in the interests of the “smart money” investor to buy at that cheap price and then redeem those shares at the next day’s price when the fund had eventually adjusted its NAV to reflect market developments. Why would a fund be slow to incorporate market developments into its NAV? The best illustration is an international stock fund that is heavily invested in foreign equities. Because these foreign stocks trade in foreign markets that may have been closed for up to 15 hours when the 4 p.m. valuation point is reached here, their closing prices in those markets will often be stale. Thus, if there have been significant market developments in the United States or elsewhere in the interim, it is usually predictable which way those foreign stocks will move when they open for trading abroad in a few more hours. This predictability makes the practice of stale-price arbitrage both possible and highly profitable. Zitzewitz has shown that arbitrageurs pursuing market timing strategies can earn excess returns of between 35% and 70% annually investing in international funds, and up to 25% per year investing in small-cap equity funds. But the cost of their success falls on other shareholders, who suffer two distinct injuries: Their own gains are diluted because they must be shared with these in-and-out arbitrageurs, and their mutual funds must maintain an artificially high cash level in their portfolios to handle the predictable redemptions when these arbitrageurs seek to cash out a day or two later. Zitzewitz estimates this dilution alone to be 2.3% annually for the more vulnerable international stock funds. But such damage could easily be prevented by a variety of simple techniques. For example, the fund could impose a 2% mandatory redemption fee applicable to short-term, in-and-out trades; or it could simply restrict the number of such trades it will allow an investor to make over a given time period. Best of all, it can engage in “fair-value pricing” by which it estimates the fair value of the foreign security when it determines its 4 p.m. NAV, rather than relying on the stale closing price in the foreign market. Some funds do all these things, but most do not. The extent to which most funds accommodated, rather than discouraged, market timing is staggering. When the scandal broke last year, the SEC’s staff surveyed 88 major mutual fund families that accounted for more than 90% of the industry’s assets under management. Fifty percent of those reporting acknowledged that they had entered into arrangements with at least some large investors to facilitate market timing transactions by them. Even more surprising, more than 30% of those surveyed acknowledged privately disclosing their funds’ portfolio holdings to certain shareholders. Such tipping makes market timing almost foolproof. At first glance, such conduct might seem to amount to selective disclosure in violation of Regulation FD. But it does not. Symptomatically, Regulation FD contains an exemption so that its general prohibition of selective disclosure does not apply to open-end mutual funds. See SEC Rule 101(b), 17 C.F.R. 243.101(b). Because of another overbroad exemption, the SEC never learned that mutual fund officers and employees were often systematically arbitraging their own funds. Although mutual fund employees are required to report their trading in individual stocks to the SEC in order to minimize the risk of “front running,” they are not required to report their trading in their own funds. Thinking that it was desirable that these employees “eat their own cooking,” the SEC did not realize that there could be too much of a good thing. The breadth of these exemptions is testimony to the success of the Investment Company Institute, one of the ablest lobbyists in Washington. The appropriate answers to these abuses seem obvious: First, prohibit selective disclosure by mutual funds of their portfolio holdings; second, require fair-value pricing so that funds cannot quietly invite market timing by using “stale” closing prices from foreign exchanges. But this is not what the SEC is proposing to do. Instead, in Securities Act Release 33-8343 and Investment Company Act Release No. IC-26299, each released in late December, the SEC has only proposed, much more modestly, to require additional disclosures about a mutual fund’s policies and procedures with regard to market timing and to mandate that the fund explain both the circumstances under which it will use fair-value pricing and the effects of such pricing. The simpler course would have been to amend Regulation FD to eliminate its exclusion for open-end mutual funds. Why, after all, should mutual funds simply disclose their policies about a practice-selective disclosure-that all other public companies are forbidden to engage in? No justification for this exemption has ever been provided; nor is one apparent. If mutual funds wish to disclose their portfolio holdings to some, let them disclose the same information publicly to all. The SEC’s approach toward fair-value pricing seems equally timid and equivocal. For roughly 20 years, the SEC has emphasized that when market quotations for a portfolio security are not currently available (as in the case when the home-country market is closed as of 4 p.m. Eastern time), a mutual fund is required to calculate its NAV by using the fair value of that security, as determined by the fund’s board in good faith. In 1999 and again in 2001, the Division of Investment Management issued interpretive letters to the Investment Company Institute that stressed the obligation of funds to use a fair-value pricing methodology when there had been a “significant development” following the closing of a foreign market. See, e.g., Letter from Douglas Scheidt, associate director and chief counsel, SEC Division of Investment Management to Craig S. Tyle, general counsel, ICI, 2001 SEC No-Act Lexis 543 (April 30, 2001). But at no time has the SEC been willing to define what constitutes a “significant development.” As a result, the SEC has stated a noble principle, but effectively abandoned it through lack of enforcement or interpretation. The industry, in turn, argues that the mutual fund’s board possesses business judgment discretion in determining what constitutes a “significant development” and when to use fair-value procedures. As a result, most of the funds that are most vulnerable to market timing simply do not use fair-value pricing. Surveying the period from May 2001 to September 2002, Zitzewitz found that the majority of international stock funds had not fair valued their portfolios on even a single day. This should not be a surprise. Letting prices go stale is a way of attracting hedge fund investments in the fund. The probable effect of the SEC’s new requirement What will be the impact of the SEC’s new requirement that each fund disclose in its prospectus the circumstances under which it will use fair-value pricing and the effects thereof? Predictably, lawyers will draft long and opaque disclosures describing a wide variety of circumstances. None of this will be meaningful or transparent to most investors. For the near future, market timing will disappear because it represents commercial suicide for any mutual fund to continue to acquiesce in it. But a few years from now, memories will fade, and mutual funds may begin again to compete for the “smart money” of hedge funds and money managers; these investors love stale prices and abhor fair valuing. What should the SEC do? A first step would be to define “significant event” in concrete, quantifiable terms. Even a 1% or 2% general price rise in market prices after the closing of a foreign market can be arbitraged. If the SEC must depend on a disclosure approach, it should develop a measure of staleness and require disclosure of how many times a year a fund’s NAV included stale prices. Investors would then learn which funds were most characterized by the stale prices that invited arbitrage. This would be a disclosure that carried meaning. John C. Coffee Jr. is the Adolf A. Berle professor of law at Columbia Law School and director of the Columbia Law School Center on Corporate Governance.

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