Initial Ruminations on Insider Trading in the Mutual Fund Scandal
by Allan Horwich

First we had the Enron scandal—which soon became shorthand for all manner of accounting legerdemain. Then we had the analyst scandal: conflicts of interest between the research and the investment banking departments of major Wall Street firms that resulted in biased stock recommendations. Now we have the mutual fund scandal: late trading, market timing, and who knows what else in the way of apparent abuses and excesses favoring hedge funds, other clout-heavy investors, and fund managers themselves to the disadvantage of long-term investors in retirement and personal investment accounts. (The preceding statements, as with many others in this article, could be festooned with copious footnotes. The reader is understood to be sufficiently familiar with these developments and most of the legal principles discussed so that this piece need not be weighed down with the traditional scholarly apparatus.)

There has been occasional mention of the loaded term “insider trading” in connection with the unfolding mutual fund scandal.¹ This article is an inquiry into the extent to which traditional theories of unlawful insider trading (i.e., trading on the basis of material non-public information) are or are not implicated in what has thus far come to light, in order to help focus the analysis on meaningful concepts rather than highly charged rhetoric. There are more questions than answers in what follows. The underlying concern is to avoid broadening the scope of “unlawful insider trading” to reach behavior that violates other prohibitions. Those who would expand the concept to address a new evil may fail to recognize the implications for other, perhaps lawful, types of securities transactions.

The Nature of the Timing Issue

At this writing, a handful of cases have been filed, principally by New York Attorney General Spitzer and the SEC, against persons affiliated with mutual funds or those who allegedly abused mutual funds.² These early cases have focused on two infractions: late trading, in which fund purchasers were allowed to purchase shares at the closing net asset value of the fund after that price has been determined, thus effectively buying securities at an historical rather than current market price; and market timing. Market timing is the behavior that may theoretically have involved unlawful insider trading, although the early cases do not allege unlawful insider trading per se.

Attorney General Spitzer’s complaint against one fund group contains a cogent explanation of market timing:

[Q]uick-turnaround traders routinely tried to trade in and out of certain mutual funds in order to exploit inefficiencies in the way the funds price their shares . . . .

This strategy works only because some funds use “stale” prices to calculate the value of securities held in the fund’s portfolio. These prices are “stale” because they do not necessarily reflect the “fair value” of such securities as of the time the NAV is calculated.³

Specifically, a mutual fund manager pricing shares at 4:00 p.m. Eastern time uses the most recent closing price of all securities in the portfolio including, notably, stocks traded in Japan, where the market closes at 2:00 a.m. New York time, fourteen hours earlier. If there were positive market moves during the New York trading day, then traders may expect the Japanese market to rise when it opens. The Japanese prices used to calculate the fund’s NAV do not reflect these anticipated market moves, meaning the fund’s NAV may be artificially low. Put another way, the NAV does not reflect the true value of some of the stocks the fund holds; these price determinations of fund shares are “inefficient” because they do not reflect all publicly available information. In these circumstances, a trader who buys a mutual fund with Japanese stocks priced at the “stale” price has a substantial probability of realizing a profit by placing his buy order just prior to 4:00 p.m. Eastern time (before the NAV is calculated) and selling the next day (after the NAV has increased, if in fact the foreign stocks rose in price).

When a fund is heavily invested in foreign securities, market timing in the form of time-zone arbitrage is not based on any non-public information.

This strategy is known as “time zone arbitrage.” Taking advantage of this kind of short term arbitrage repeatedly in a single mutual fund is called “timing” the fund.⁴ Many mutual funds state in their prospectuses that they prohibit repeated timing transactions. Many also employ techniques or impose charges, such as back-end loads, to detect and deter timing.⁵

The gravamen of many of the claims that have been brought arising out of market timing is that privileged investors were allowed to engage in market timing contrary to a fund’s explicit policies and to the detriment of long-term shareholders. Frequent trading may impose high transaction costs on the fund: the fund may pay commissions to buy and sell portfolio securities in order to invest the cash infusion of, or to meet the redemption requirements of, a short term trader; the fund may sell portfolio securities to meet redemptions, leading to realization of taxable capital gains or losses, which are borne by the long-term investors and not the short-term traders, who themselves do not hold the funds at the record date for reporting gains and losses as taxable events; funds may hold larger than normal cash positions and thus not be fully invested in a rising market so they can meet the redemption demands of market timers; and funds may be forced to buy underlying securities as the market is rising, or sell into a falling market, as a result of trading by the timers.⁶ New York has alleged that in virtually every instance of market timing, the market timer profits at the expense of long-term investors as the “timer steps in at the last moment and takes part of the buy-and-hold investors’ upside when the market goes up, so the next day’s NAV is reduced for those who are still in the fund.”⁷

The critical question is whether market timing based on non-public portfolio information violates Rule 10b-5.

When a fund is heavily invested in foreign securities, market timing in the form of time zone arbitrage is not based on any non-public information. On the contrary, it is based on two very well known facts: the general nature of the fund’s portfolio and the day’s events on Wall Street that may affect overseas markets.

Timing Based on Non-Public Information

The kind of market timing that gives rise to thoughts of unlawful insider trading is based on information about a fund’s portfolio that is not public. Mutual funds are required to disclose the composition of their portfolios every six months.⁸ Portfolios change, however, between public reports. Thus, a person who is given access to more current detailed portfolio information may be able to engage in more fully informed market timing trades.

There is one fairly straightforward manner in which this unsavory form of timing can occur. When a fund has acquired a new or increased position in a foreign stock and bullish information is released regarding that stock after the close of its principal market, the disclosure will not be reflected in the closing price on the foreign market and will not be factored into the fund’s NAV set at the next 4:00 p.m. New York close. This allows the market timing investor who is privy to non-public information regarding changes in a fund’s portfolio to benefit from the “bump” in the value of the mutual fund stock arising out of the next day’s trading in the foreign markets. By liquidating his position in the mutual fund the next day, a market timer can reap some of that profit at the expense of long term fund investors.

The Insider Trading Question

The critical question is whether market timing based on non-public portfolio information violates Rule 10b-5. As a general matter, a violation of Rule 10b-5 must contain an element of deception or manipulation.⁹ Trading in mutual funds, however, inherently involves trading with the fund itself; there is no trading of fund shares—buying or selling —in the secondary market. It is axiomatic under the securities laws that you cannot deceive someone who knows the information on which you are basing your trade. This, after all, is the essence of the “disclose or abstain” concept at the heart of insider trading law.¹⁰ In other words, the seller—in this case, the fund—is not “deceived” when the person purchasing and then redeeming the shares is basing the trading decision on a combination of information about the fund’s portfolio, which of course the fund “knows,” and public information regarding a particular security.

Is There Deception?

On first impression, this kind of transaction seems comparable to an insider of a corporation buying stock from the corporation at the current market price when there is favorable material non-public information about the company known to the purchaser and the corporation itself but, obviously, not reflected in the market price. Ordinarily, this is not a violation of Rule 10b-5 because there has been no deception. It is an altogether separate question whether the insider breaches a fiduciary duty to the corporation by selling stock at the open market price knowing that price does not reflect all material facts. As the Supreme Court held some years ago, however, in the absence of deception, a breach of fiduciary duty is not a violation of Rule 10b-5.¹¹

In the case of a fund, this begs the question whether there is nevertheless deception because the fund’s Board of Directors has not, with full disclosure, approved the transaction that takes advantage of the fund (or at least of the fund shareholders). As alleged in a number of the complaints filed recently by regulators, market timing in contravention of stated fund policies has been carried out without the concurrence of the fund directors (most significantly the independent directors) and with the alleged complicity of the investment adviser—the entity that actually makes the portfolio decisions for the fund under an investment advisory agreement. In reality, it is the advisor—not the fund Board— that has real-time information regarding the portfolio, not to mention significant influence, if not control, over compliance with trading restrictions in the securities of the fund.

Some cases under Rule 10b-5 have at least suggested that an issuer of securities is deceived in violation of Rule 10b-5 when a transaction is entered into with the corporation where the board is either uninformed or is deceived.¹² It is yet to be determined whether market-timing transactions that are based on non-public information regarding the composition of a fund’s portfolio involve deception in this sense. If there is “deception,” this activity also may be insider trading under the classical theory, which prohibits trading in the securities of the issuer by insiders or by insiders’ tippees.¹³

Does the Classical Theory Apply?

There is at least one respect in which trading in mutual fund shares differs from the type of corporate transaction just described. Unlike the ordinary business corporation, a mutual fund— an “open end investment company”—is continuously selling and redeeming shares. Thus, these transactions with timers who are privy to the fund’s portfolio are not one-off trades where someone makes a conscious decision on behalf of the seller (the fund) to sell the shares at a particular price to a particular buyer. On the contrary, the fund has no choice but to sell. The shares are sold to the timer as one of perhaps thousands of fund share purchasers that day at an arithmetically determined price. Moreover, unlike the typical unlawful insider purchase, the timer’s profit is realized in an offsetting redemption directly with the seller itself, not in the open market with a stranger. It is at the back end of the trade where the fund arguably has a choice— to refuse to honor the timer’s redemption request because it violates fund policy.

[T]here are a number of departures from the paradigm insider trading scenario.

Finally, it is accepted that it is the other holders, not the fund itself, who are damaged by the timer’s trading. Again, this is because the fund “knows” its shares are mispriced, but it sells them at that price anyway. That is, even if the individual directors did not know of the improper disclosure of the composition of the fund’s portfolio to the timer, they did knowingly condone in principle sales at a share price that was inherently wrong. Thus, there are a number of departures from the paradigm insider trading scenario that raise questions about whether a timer’s transactions are within the rubric of unlawful classical insider trading.

Does the Misappropriation Theory Apply?

The alternative to the classical theory of insider trading is the misappropriation theory adopted by the Supreme Court in United States v. O’Hagan.¹⁴ Under this theory, a purchaser of securities violates Rule 10b-5 when it deceives the source of the information by misappropriating the information without making disclosure to the source (this is the necessary element of “deception”) and then trades, typically but not necessarily in the open market (thereby satisfying the “in connection with the purchase or sale of a security” element of Rule 10b-5).¹⁵ Under O’Hagan, deception is avoided if prior disclosure is made to the source of the information that the information is going to be used for an unauthorized purpose.¹⁶

The misappropriation theory rests on deception in the use of non-public information where the user does so in breach of a duty to the source of the information. This duty may arise out of a number of relationships, such as employer employee and a confidential relationship of the type now described in Rule 10b5-2. It is doubtful the market timer has any such relationship to the fund. The investment adviser, however, which typically is the source of the market timer’s nonpublic portfolio information, manifestly does owe fiduciary duties to the fund. Accordingly, the adviser’s use of the information without prior disclosure to the fund would be deception, and passing it on to the market timer may render the market timer an unlawful tippee.¹⁷

[I]s it really unlawful misappropriation to trade with the source of the information while exploiting that counterparty’s own information?

This analysis raises the question whether the adviser could disclose to someone associated with the fund in a managerial capacity who is independent of the adviser that the adviser intended to provide portfolio information to a third party. Would that disclosure preclude application of the O’Hagan misappropriation theory? This may seem silly, but O’Hagan’s “disclosure is enough to avoid misappropriation” concept is equally bizarre. (There is no indication in the recent mutual fund cases that any attempt at exculpatory disclosure was made, however.) Or, to avoid the impact of O’Hagan, would it be necessary to make disclosure to the full fund board, to assure that disclosure was made to parties who were undeniably independent of the adviser?

Another interesting wrinkle in the possible application of the misappropriation theory is that, as in the analysis under the classical theory, the securities trade is necessarily with the source of the information, not in the open market with a party who lacks knowledge of the misappropriated portfolio information. True, O’Hagan is not dependent on deception of the other party to the trade. But is it really unlawful misappropriation to trade with the source of the information while exploiting that counterparty’s own information? Moreover, does it matter that the fund essentially has an open offer to sell to all comers and is contractually obligated to redeem on demand? That is, where the counterparty has no choice but to trade, are all the elements of insider trading present? The analogy here is to a stock option that was issued long ago with a predetermined exercise price. The optionee has the right to exercise at any time, and the grantor has no choice about whether to honor the exercise. Arguably there is no unlawful insider trading when the optionee exercises the option, even if he or she does so on the basis of misappropriated information.

The Nature of the Government Claims Thus Far

To date Rule 10b-5 and its analogous provision under the Investment Advisors Act (Section 206) have been invoked in charges against market-timers largely without the rhetoric of “insider trading.” It is not entirely clear how the regulatory authorities understand those provisions of law to have been violated under the facts alleged in the various complaints, none of which has been resolved through contested litigation. The SEC’s complaint against Scott and Kamshad suggests the advisor defendants violated Section 206 by misrepresenting to the shareholders the “advisability” of investing in a fund that was being used by insider market timers.¹⁸ The remedy sought, however, was disgorgement— akin to an insider trading remedy—not the damage done to the shareholders (unless those are thought to be equivalent).¹⁹ The Pilgram Baxter Complaint suggests that the ill-gotten gains of the timers are only part of the damage suffered by the long-term investors.²⁰

Moreover, the SEC has charged an advisory firm with a violation of Section 204A of the Advisors Act, which requires an adviser to establish, maintain, and enforce procedures to prevent the misuse of material non-public information by the adviser and associated persons.²¹ The firm agreed to prohibit market timing by employees and to compensate shareholders for losses attributable to, among other factors, market timing.²² All of this suggests that remedies from the realm of insider trading are only part of the picture.

The question remains, nevertheless, whether market timing is properly viewed as a species of insider trading, or whether other concepts of securities fraud and breach of fiduciary duty, under the common law or governing statutes, are sufficient to address the kind of market timing that has thus far been the subject of governmental proceedings.

Notes

1. See, e.g., Masters, “Fund Scandal in New Territory; Definition of ‘Insider Trading’ Broadens,” THE WASH. POST E01 (Nov. 7, 2003), available at 2003 WL 62229170; Morgenson, “Inside Putnam: Reform or Damage Control?,” THE N.Y. TIMES Sec. 3, p. 1 (Dec. 7, 2003).>

2. Crimmins, Gourevitch & Del Raso, “The Mutual Fund Probes— What We Can Tell So Far” 35 BNA SEC. REG. & L. REP. 1834 (Nov. 3, 2003), is a comprehensive summary of the initial cases, with extensive citations.

3. Complaint, State of New York v. Pilgrim Baxter & Associates, Ltd., et al., N.Y. Sup. Ct. (Nov. 20, 2003), at ¶¶ 24-25, available at <www.oag.state.ny.us/press/2003/nov/pilgrim_baxter.pdf>.

4. Id. at ¶ 25.

5. Not all mutual funds prohibit or limit market timing. Some funds openly allow it, such as some of the Rydex Series funds.

6. See, e.g., Pilgrim Baxter Complaint, supra note 3, at ¶¶ 28-29. The Kinetics Internet Fund claims that market timers benefit long-term holders in a bear market because the fund will maintain a cash position to meet the redemption requests of market timers, and being less than fully invested in a down market is beneficial. McDonald, “Fund Says Market Timing Could Help Shareholders,” THE WALL ST. J. ONLINE (Nov. 18, 2003).

7. Pilgrim Baxter Complaint, supra note 3, at ¶ 27. At the same time, advisers may be induced to allow market timing because the timer “offers the [fund] manager more assets in exchange for the right to time,” thereby increasing the manager’s fee (typically a percentage of assets under management). Id. at ¶ 33.

8. SEC Rule 30b1-1 under the Investment Company Act, Form NSAR, and Item 12-12 of Regulation S-X. This information must be filed within sixty days after the close of the six-month period, so the information is often quite stale by the time it is filed. For larger funds, disclosure is also made quarterly on Schedule 13F, but those are not filed until 45 days after the end of the quarter.

9. Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 474 (1977).

10. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968).

11. Santa Fe, supra note 9, 430 U.S. at 474-75.

12. See, e.g., Goldberg v. Meridor, 567 F.2d 209 (2d Cir. 1977). Thus, a crucial allegation in the SEC’s complaint against Scott and Kamshad is that the trading by executives of the fund’s investment adviser based on non-public portfolio information was not disclosed “to fund boards or to fund shareholders.” See Complaint, SEC v. Scott and Kamshad, No. 03-12082-EFH (D. Mass., Oct. 28, 2003) at ¶¶ 2, 17, 32, available at <www.sec.gov/litigation/complaints/comp18428.htm>.

13. Dirks v. SEC, 463 U.S. 646, 659 (1983) (insiders are “forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they also may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain”).

14. 521 U.S. 642 (1997).

15. Id. at 652.

16. Id. at 654-55. It is noteworthy that the element of deception in O’Hagan is abrogated merely by the disclosure to the source of the information; there is no requirement that the source approve the use. The Court suggested that in these circumstances the source of the information could protect itself by obtaining an injunction against the use of the information on the ground that its use constituted a breach of duty. Id. at 659 n.9.

17. While the law here is not settled, it has been held that in order to be an unlawful tippee under the misappropriation theory, the tippee must know the tipper breached a duty to the source of the information. United States v. Falcone, 257 F.2d 226, 234 (2d Cir. 2001).

18. See supra note 12, at ¶ 39.

19. Id. at Part II.

20. See supra note 3, at ¶¶ 28-29.

21. In re Putnam Investment Management LLC, IA Release 2192 (Nov. 13, 2003), at ¶ 32, available at <www.sec.gov/litigation/admin/IA-2192.htm>. In State of New York v. Invesco Funds Group, New York seeks recovery of all fees received by the fund manager as well as losses sustained by investors. N.Y. Sp. Ct. (Dec. 2, 2003), at ¶ 3, available at <www.oag.state.ny.us/press/2003/dec/invesco_complaint.pdf>. The SEC seeks similar relief in SEC v. Invesco Funds Group, D. Col. (Dec. 2, 2003), available at <www.sec.gov./litigation/complaint/comp18482.htm>. This complaint does not, however, allege a violation of Section 204A.

22. IA Release 2192, supra note 21, at Part IV.C-E.

About The Author

Allan Horwich (ahorwich@schiffhardin.com) is a partner in the Chicago office of Schiff Hardin & Waite and Senior Lecturer, Northwestern University School of Law.