2003 Mutual Fund Scandal Settlements and Trials

In 2003, a major mutual fund scandal rocked the financial industry, leading to numerous settlements and trials. The scandal involved several major investment firms and their involvement in timing the market and insider trading.

The Securities and Exchange Commission (SEC) was instrumental in uncovering the scandal, which led to the resignation of several high-ranking executives. The SEC's investigation revealed widespread abuse of trading rules and a culture of corruption within the firms.

Several major firms were involved in the scandal, including Alliance Capital Management, Janus Capital Group, and Putnam Investments. These firms agreed to pay billions of dollars in fines and penalties as part of their settlements with the SEC.

The mutual fund scandal was a major issue in 2003, with the New York attorney general, Eliot Spitzer, leading the investigation into mutual fund trading abuses. His office probably would bring criminal charges against some companies in especially egregious cases.

Spitzer testified at a hearing of the Senate Banking Committee that it's fair to presume there will be criminal cases brought. This was a significant development in the scandal, as it marked a shift from civil actions to potential criminal charges.

The SEC and state regulators had been lodging civil actions against big mutual fund and investment firms in recent weeks. This included charging the founders of the Pilgrim-Baxter fund family, Gary L. Pilgrim and Harold J. Baxter, with improper trading of their funds to benefit themselves and friends at the expense of longer-term shareholders.

The House moved quickly to adopt legislation cracking down on mutual fund abuses and providing more information for investors. The legislation passed with a vote of 418-2.

Treasury Secretary John Snow supported the basic thrust of the House-passed bill, saying that mutual funds are an important part of the financial structure of the country. He emphasized the need to maintain trust and confidence in the capital markets and in the instruments of those markets, like mutual funds.

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The 2003 mutual fund scandal had severe consequences, with management companies facing billions of dollars in penalties. A total of $2.3 billion in civil penalties and disgorgement was levied by the SEC and state officials.

Several top executives paid a steep price, with a total of about $220 million in disgorgement and civil penalties. Aggregate penalties for other less-senior employees were less than $5 million.

The New York Attorney General's settlements also included very large management fee reductions, which were negotiated as part of the settlements.

Nearly all of the fund firms charged by Spitzer with allowing market timing or late trading had settled with his office and the SEC between mid-2004 and mid-2005.

A notable exception was J. W. Seligman, which chose to sue Spitzer in Federal court after their talks broke down in September 2005.

The case against Theodore Sihpol, III, a broker with Bank of America who introduced Canary Capital to the bank, ended in a hung jury in August 2005, with Spitzer deciding not to retry Sihpol.

In a separate case, Spitzer's office reached a plea bargain with three executives charged with fraud for financing Canary and assisting its improper trading in mutual funds in September 2005.

The United States Second Circuit reversed the District Court in United States Security Commission v O`Malley on 19 May 2014, finding that there was no consistent rule prohibiting traders from engaging in market timing.

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Smaller losses for poor performers? It's a possibility, but the evidence suggests otherwise. The estimated coefficients from equation (10) that apply to the middle of the returns distribution show a significant flow response to relative returns. However, for funds in the bottom quintile, the response was smaller, but only by 4 to 6 percent.

The flow response to relative returns in the bottom quintile was smaller than in the middle quintiles. This means that even the poorest-performing mutual funds had a lot to lose in making arrangements with abusive traders. The managers of these funds had a significant incentive to perform well and avoid poor returns.

The estimated coefficients suggest that the lasting effect of performance losses is striking. Once incurred, poor returns can be expected to weigh on net flows for several years. This is why managers of mutual funds should strive to maintain good performance and avoid poor returns.

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The 2003 mutual fund scandal had a significant financial impact on investors and the industry as a whole. Management companies' revenues from collusion with abusive traders were estimated to be $1.7 billion per year.

Shareholders suffered losses of $10.4 billion annually due to abusive trading arrangements, which were split among abusive traders, management companies, and administrative costs. This highlights the need for stricter regulations to prevent such practices.

Official penalties imposed on management companies provided a measure of the dilution damage done to mutual fund shareholders, with the penalties serving as an upper-bound for prosecutors' and regulators' estimates.

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Official penalties imposed on management companies provide some insight into the magnitude of the revenues from arrangements that allowed trading abuses. The penalties, excluding fee reductions, totaled $2.3 billion.

Management companies paid a significant portion of these penalties, with $1.35 billion in disgorgement paid by management companies alone. Disgorgement totals should be a measure of management company revenues from collusive arrangements.

The SEC Rules of Practice state that disgorgement should serve as a deterrent to violations, rather than compensate injured investors. This implies that disgorgement totals should be a direct measure of ill-gotten gains.

The total penalties, including fee reductions, were adjusted to $2.6 billion by subtracting the $5 million in penalties levied on non-executive employees. Penalties paid by senior executives were included in this total.

The present value of the penalties alone surpassed that of the estimated revenues generated by the abusive-trading arrangements. However, the market penalties, or revenues lost due to poor performance and reputation-related net redemptions, dwarfed the official penalties.

Management companies likely collected less than 20 percent of the estimated total dilution profits shared by abusive traders and management companies. Disgorgement represented 60 percent of total penalties imposed.

Management companies' share of abusive-trading gains ranged from 2% to 43%, with most earning less than 10% of the profits from trading abuses.

According to table 5, management companies' average share of abusive-trading gains was 12.0%, which adjusts to 12.4% when accounting for internal market timing.

A high estimate for management companies' revenue from agreements with abusive traders is $528 million per year, based on disgorgement and restitution payments.

Management companies likely collected less than 20% of the total dilution profits shared by abusive traders and management companies.

Disgorgement, a portion of the total penalties, should be a direct measure of the ill-gotten gains of management companies, according to SEC rules.

The estimated revenue from abusive-trading arrangements is $1.7 billion per year, derived from multiplying shareholder losses by 16.6% and assuming no deadweight loss.

Management companies obtained small shares of the gains from abusive trading, often less than 10%, due to the nature of the arrangements and the fact that many tainted fund families tolerated trading abuses by timers without special arrangements.

Here's a summary of estimated management company revenue from abusive-trading arrangements:

The 2003 mutual fund scandal had a significant impact on the investment world. Many investors lost money due to the improper trading practices of some mutual fund companies.

The Securities and Exchange Commission (SEC) took action against several mutual fund companies, including Alliance Capital Management, Bank of America, and Putnam Investments. They were accused of allowing favored clients to trade in and out of funds at the worst possible times.

The scandal led to a decline in investor confidence in the mutual fund industry.

Investors who held mutual funds at tainted families were initially thought to be less sensitive to past performance, which would have provided little incentive to prevent abusive trading arrangements.

However, research suggests that these investors were actually more responsive to past performance, with a larger flow sensitivity to relative returns than the overall sample.

This increased sensitivity should have provided strong incentives against arrangements with abusive traders, due to the expected performance losses that tainted families faced.

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Investors at tainted families were actually more responsive to past performance than the general sample, which suggests they were more likely to take action against poorly performing funds.

Research found that the flow response to relative returns in the bottom quintile was smaller than in the middle quintiles, but only by 4 to 6 percent.

The estimated flow sensitivity to relative returns was larger for funds at tainted families than for the full sample, indicating that these investors were more likely to react to poor performance.

This means that even the poorest-performing mutual funds had a lot to lose in making arrangements with abusive traders, and the expected performance losses should have provided strong incentives against such arrangements.

Private Civil Litigation was a significant consequence for mutual fund management companies involved in market timing scandals. As of this writing, 17 mutual fund firms were embroiled in private litigation.

These lawsuits were filed by investors who had suffered losses due to the market timing activities. The plaintiffs were seeking compensation for their losses.

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Mutual fund firms that were sued included those that had colluded with market timers. Settlement amounts were confidential, so the costs were not publicly disclosed.

Investors who had lost money in these scandals were seeking justice through the courts. None of the mutual fund firms had settled with the plaintiffs at the time of this writing.

The 2003 mutual fund scandal was a complex web of deceit, but it all started with a simple idea: to make money by cheating. Mutual fund companies were accused of engaging in illegal practices to boost their performance.

One of the main culprits was a company called Alliance Capital, which was found to have used market timing and late trading to inflate their returns. This meant that they allowed certain investors to buy and sell shares at the end of the day, after the market had closed, to make a profit.

The scandal also involved a lack of transparency, as mutual fund companies failed to disclose their practices to investors. This made it difficult for investors to make informed decisions about their investments.

The SEC took action, charging several companies and individuals with violating securities laws. Fines and penalties were imposed, but the damage had already been done.

Previous research estimated losses to buy-and-hold investors due to market timing and late trading, with some papers focusing on specific mutual fund families and others using broader categories of funds.

The costs of abusive trading to investors were substantial, with estimates ranging from 0.15 to 3 percentage points per year in losses, depending on the type of fund and the time period considered.

In contrast, estimates of management companies' revenues from trading arrangements were rough and difficult to obtain, but one study suggested that the total gains from such trades were likely much lower than the costs of abusive trading.

Official penalties imposed on management companies provided some clues about the magnitude of the revenues from arrangements that allowed trading abuses, with the penalties appearing to be an upper-bound for prosecutors' and regulators' estimates of the dilution damage done to mutual fund shareholders.

A related possibility is that the effects of poor performance on flow were overstated, but even if so, the losses computed from estimated coefficients that would apply to low-quintile funds were still substantial, and not nearly enough for a management company with poorly performing funds to justify collusion with abusive traders.

Here's a rough breakdown of the estimated costs and revenues of trading arrangements:

It's worth noting that even if the revenues from trading arrangements were substantial, they were still likely much lower than the costs of abusive trading to investors.

The 2003 mutual fund scandal was a major financial controversy that shook the industry. Criminal charges were likely to be brought against some companies in especially egregious cases.

Attorney General Eliot Spitzer and SEC Enforcement Director Stephen Cutler downplayed their public differences over pursuing fund trading abuses. However, they did charge the founders of the Pilgrim-Baxter fund family, Gary L. Pilgrim and Harold J. Baxter, with improper trading practices.

This was the first time since the scandal became public that fund company leaders had been directly charged. The House quickly responded by adopting legislation to crack down on mutual fund abuses.

The legislation would impose new curbs on fund trading abuses and require companies to disclose more information to investors. It also made directors on company boards more independent from fund managers.

The administration supported the basic thrust of the bill, citing the importance of maintaining trust and confidence in the capital markets. However, Democrats complained that the bill was incomplete and didn't strengthen enforcement powers.

Federal Reserve Chairman Alan Greenspan and Treasury Secretary John Snow cautioned Congress against passing changes that could cost investors more in fees and diminished returns. The issues raised could become sticking points in the Senate.

Mutual fund directors and officers care intensely about practices that lower the fund's value and have every financial incentive to maximize the firm's value. They would likely take steps to end market timing once it was discovered.

Funds have indeed taken steps to end market timing, firing or pressuring resignations from those who broke the rules by encouraging it. Long-term investors have also moved their investments elsewhere.

Employers have dropped funds where alleged abuses occurred from the list of investment options available to employee 401(k) retirement plans. This shows that the market can self-correct.

Market timing is perfectly legal, but funds do not want it, just like casinos do not want card counting. Fund management has every incentive to prevent market timing.

The press divides mutual-fund stories into two categories, but both refer to the same phenomenon stemming from mutual fund features.