|Daniel P. Barry is a member of the MBA New Lawyers Section Council and practices in securities and investment law at Baring Asset Management, Inc. in Boston.
An era of increased scrutiny of corporate governance is upon us, and state and federal regulators are now turning their attention to well-known fund firms for allowing, and, in some cases, encouraging certain shareholders to engage in a practice called "market timing." While the practice is not strictly illegal, it raises many ethical concerns, raising the question of what corporate fiduciaries have been doing while the practice has been ongoing. Market timing refers to the practice of short-term trading of mutual fund ("fund") shares, with the objective of exploiting forward pricing requirements.1
Responding to concerns about market timing behavior, in mid to late 2003, the Securities and Exchange Commission ("SEC") subpoenaed 88 of the largest mutual fund complexes in the country, half of which have already reported to have had at least one arrangement allowing for market timing by an investor.2
In a complaint brought against Boston's Putnam Investments LLC,3
the SEC charged the investment advisor with improper market timing, contending that the practice of market timing violates the anti-fraud provisions under Section 206 of the Investment Advisors Act of 1940 ("Advisors Act"). Under the landmark ruling in SEC v. Capital Gains Research Bureau, Inc.4
advisors owe a fiduciary duty to their clients under Section 206. Now, Congress is weighing in and is considering broadening House Resolution 2420, the Funds Integrity and Fee Transparency Act of 2003, to require funds to disclose, as they must disclose fund objectives, their market timing policies. This proposed legislation may help eliminate abuses in the future, but avoids the question evaluated by this article: Whether fund fiduciaries should have detected and prevented market timing activity under existing law? This article posits that the answer is "yes."
An examination of the responsibilities of a fund's board of directors under long-standing legal doctrine suggests that the "watchdogs" were napping while market timers lined their pockets at the expense of other shareholders.
A mutual fund's organization - An overview
An understanding of how mutual funds and their boards are organized is necessary to appreciate the full extent of the failures of those tasked with fund oversight. A mutual fund often is organized as a corporation under state law and, as such, is governed by a board of directors. Although it resembles a typical corporation, a fund generally has few or no employees.
The fund contracts for all of the services it needs, including the services of an investment advisor. Considered a delegate of the investment company's management functions, responsibilities of the advisor are set forth in the investment management agreement with the fund. The investment advisor selects portfolio investments in compliance with the investment objectives of the fund, places portfolio orders with broker-dealers and ensures the fund conforms to the federal securities and tax laws.
A fund's board is normally comprised of representatives from the investment advisor, which is normally affiliated with the fund, and independent directors. Mutual funds, and to a certain extent their investment advisors, are regulated by the Investment Company Act of 1940 ("1940 Act"). Congress enacted Section 10 of the 1940 Act with the realization that mutual funds require greater independent oversight in light of the control exercised by advisors and the inherent conflicts of interest created between a fund and its affiliated advisor to the potential detriment of shareholders. Hence, Section 10 of the 1940 Act mandates that 40 percent of the directors of a mutual fund be independent of the investment advisor. Due to the unique nature of the relationship between an advisor and a mutual fund, the board of directors is obligated to look after the interests of shareholders and to oversee the fund's investment advisor. Hence, the directors are commonly referred to as "independent watchdogs."5
In many respects a fund's board must discharge its responsibilities much like a board of an operating company, although the potential for conflicts requires special attention. The Report of the Advisory Group on Best Practices for Fund Directors,6 prepared under the auspices of the Investment Company Institute in early 1999, best summarized the salient responsibilities borne by mutual fund directors in this respect:
[T]he fundamental responsibility of fund directors is to ensure that the fund's shareholders receive the benefits and services to which they are fairly entitled, both as a matter of law (e.g., resulting from the advisor's fiduciary duty to the fund and specific requirements of the Act) and in accordance with investor expectations reasonably created by the fund's prospectus and other disclosure documents. Within this context, it is the responsibility of the fund's board to evaluate the performance of the fund's investment advisor and that of its other service providers on the basis of what is best for shareholders and to apply that same standard in evaluating any proposals for change in fund operations or expenses. On those occasions where the interests of the advisor and fund shareholders diverge, the fund's directors and, in particular, the independent directors, must effectively represent the interests of the fund and its shareholders.
Within the context described above, the responsibilities of a fund's board of directors are derived from the common law duty of loyalty and duty of care, and explicit obligations set forth in the 1940 Act.
Duty of care and duty of loyalty
Both independent directors and affiliated directors of a mutual fund are fiduciaries and owe the fund and its shareholders special responsibilities that apply when making business decisions on behalf of the fund. In particular, the directors owe the fund and its shareholders the fiduciary duties of loyalty and care. The duty of loyalty prohibits self-dealing and forbids directors from using their position of trust and confidence to further their own interests.
The duty of care generally requires directors to perform their duties in good faith, in a manner reasonably believed to be in the best interests of the fund and with that degree of care that an ordinarily prudent person in a like position would exercise under similar circumstances.7 The duty of care requires that directors keep adequately informed on pertinent matters, apply their business judgment to appropriate matters and reach reasonable decisions. The duties of loyalty and care are simply the basic common law duties that help guide the decision-making process. The board is also subject to explicit obligations set forth in the 1940 Act, the most important of which is approval of the investment management agreement
Approval of the investment management agreement
Under Section 15 of the 1940 Act, the investment management agreement must be approved initially and upon renewal by a majority of the fund's outstanding voting securities and by a majority of the board of directors, including a majority of the fund's directors who are not parties to the advisory contract or interested persons of a party to the contract. After its initial term of two years, the investment management agreement must be approved annually.
The annual approval of the investment management agreement is a key undertaking for the directors. In evaluating the terms of the investment management agreement, directors are required to request and evaluate, and the advisor is required to furnish, certain information. This includes information about investment performance, compensation, brokerage and portfolio transactions and overall fund expenses and expense ratios. The annual approval provides ample opportunity for the board to ferret out abusive management by the advisor and ensure the interests of fund shareholders are maximized with respect to the services provided by the investment advisor.
The evolving market timing scandal
With a basic understanding of a fund's organization and the duties and responsibilities of its board of directors, the next logical questions are: What is market timing? Does market timing hurt fund shareholders and, if so, is the board of directors in a position to detect and prevent this practice?
As stated previously, market timing is the practice of excessive short-term trading of mutual fund shares in order to exploit the forward pricing requirements mutual funds use. Forward pricing requires funds to price their shares, based upon the value of the underlying securities, once a day at 4 p.m. EST. The price shareholders pay for fund shares is the net asset value (NAV), calculated based on the market value of the securities in the fund. Fund shares do not trade on the secondary market and are redeemable, meaning that shareholders normally sell their shares back to the fund at the fund's NAV.
Market timing is most prevalent in U.S.-based funds that hold foreign shares (e.g., international funds) because foreign markets close before the U.S. market. The market timer realizes that when the U.S. market closes up on a given day, then foreign markets are likely to rise the following day. The market timer buys shares of the fund by locking in a price of the fund that holds foreign securities reflecting stale prices. The discrepancy between the stale price of the underlying foreign shares and the value assigned to the fund shares at the end of the day translates into a quick profit when the market timer cashes out of the fund the next day.
The effect of market timing on shareholders has yet to be quantified, but the SEC noted that it hurts long-term shareholders in those funds in several important respects.8 First, market timing dilutes fund assets. Dilution occurs when fund shares are overpriced and redeeming market timers receive proceeds based on the overvalued shares. The fund may be required to sell securities to raise cash or it may pay for redemptions out of its cash reserves, both of which ultimately diminish fund assets. Second, market timing increases transaction costs by subjecting the fund to excessive trading activity. Third, market-timing behavior can disrupt the fund's stated portfolio management strategy, requiring a fund to maintain an elevated cash position and resulting in lost opportunity costs. In each of these cases the costs associated with market timing are borne by all shareholders, not just those market timers who are walking away with the quick profit.
One may argue that, irrespective of the duties of the board as outlined above, it is difficult if not impossible for the board to ferret out market-timing behavior. However, in its 2003 investigation, the SEC discovered that more than 30 percent of the 88 fund firms subpoenaed have disclosed portfolio information indicating that certain fund shareholders possessed the ability to make advantageous decisions to place orders for fund shares. This information was available to the boards of the firms subpoenaed, a point that suggests that market timing is far more prevalent than initially thought and that fund boards are turning a blind-eye to this activity in their own funds. Boards should consider whether they have avoided asking tough questions of their investment advisors relating to their fiduciary duty. Had the directors of the subpoenaed boards revisited the core duties of loyalty, care and careful compliance with provisions of the 1940 Act, the prevalence of market timing uncovered by the SEC might not have been so great.
The job of the independent director becomes most challenging on those occasions when the director suspects that a manager may have engaged in illegal or improper conduct. However, independent directors have an obligation to detect such conduct even when no suspicion exists. Paul Brountas, one of the nation's leading experts on the subject of corporate governance and the author of Boardroom Excellence, A Common Sense Perspective on Corporate Governance, recommends that directors have the courage and ability to challenge in dispatching their duties: "A board cannot be effective unless its members possess and exercise good judgment, are financially literate, are able and willing to assume responsibility, and have the courage to say 'no' to management when it proposes actions or policies that subordinate the interests of the stockholders to the interests of management or otherwise serve to reduce rather than enhance stockholder value."9 Despite the prevalence of market-timing behavior and its acceptance by affiliated directors, had independent directors asked the necessary questions, they would have concluded that market timing subordinates the interests of shareholders to the investment advisor and ultimately reduces shareholder value.
Reform legislation is not the answer. The board of directors for a mutual fund, under already existing law, has an enormous responsibility to ensure that shareholders' money is invested in a manner consistent with fiduciary principles and statutory law. Indeed, directors' responsibilities far exceed the basic tenets summarized above. In a commonly referred to standard, Justice Cardozo described the duties of a fiduciary as "something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate."10 The board of directors of funds in which market timing has occurred, and more importantly the independent directors dubbed the "independent watchdogs," have failed to discharge their duties at the most fundamental levels. Board members must ask probing questions of the investment advisor and be vigilant in protecting the interests of fund shareholders. Shareholders must demand that directors go beyond what is minimally required to ferret out abusive practices and demand that directors treat their responsibilities as the "punctilio of an honor the most sensitive."
1. See Rules 22c-1 and 2a-4 of the 1940 Act. [back]
2. See Oral Statement Concerning Recent Commission Activity to Combat Misconduct Relating to Mutual Funds, by Stephen M. Cutler, director, Division of Enforcement, U.S. Securities and Exchange Commission, before the Senate Subcommittee on Financial Management, the Budget, and International Security, Committee on Governmental Affairs. Nov. 3, 2003.[back]
3. Securities and Exchange Commission Administrative Proceeding, File No. 3-11317 (Oct. 28, 2003).[back]
4. 375 U.S. 18 (1963). [back]
5. See e.g., Tannenbaum v. Zeller 552 F.2d 402, 406 (2d Cir.), cert. denied, 434 U.S. 934 (1977).[back]
6. See p. 9, Report of the Advisory Group on Best Practices for Fund Directors, Enhancing a Culture of Indpendence and Effectiveness, Investment Company Institute (June 24, 1999).[back]
7. See, e.g., Section 2-405 of the Maryland Corporations and Associations Code.[back]
8. SEC v. Justin M. Scott and Omid Kamshad, Civil Action No. 03-12082-EFH (D.Mass.).[back]
9. Paul P. Brountas, Boardroom Excellence, A Common Sense Perspective on Corporate Governance, Massachusetts Continuing Legal Education, Inc. (2003), p.28.[back]
10. Meinhard v. Salmon, 249 N.Y. 458 (1928).[back]