Long-term returns

In settling Securities and Exchange Commission charges of abusive trading, 11 mutual fund companies have agreed to pay about $3 billion in restitution to their shareholders (not including promises to lower fees). In most cases, the shareholders lost out because the mutual funds’ portfolio managers had to set aside larger-than-normal amounts of cash to meet the frequent withdrawals of traders who were allowed to dart in and out of the funds in search of quick profits. Holding the money in low-yield cash equivalents can hurt a fund’s overall returns for its long-term investors. But figuring out who’s entitled to what isn’t going to be easy.

Restitution plans are to be filed with the SEC anywhere from 175 to 235 days after a settlement agreement is signed; already extensions have been given. Janus Capital Group has until April 11, 2005, to file its plan. At Putnam Investments an initial deadline of October has been indefinitely extended. Says a Putnam spokeswoman, “We cannot forecast the completion date now, but we are working on a mutually agreeable timeline with the SEC.” How long it will take the commission to approve the plans or ask for modifications is anyone’s guess.

As part of their settlements, the mutual fund firms negotiated with the SEC an estimate of the scope of damages to shareholders. In some cases, such as the $375 million settlement by Amvescap’s Aim and Invesco funds units, the estimate was based on a list of specific relationships with market timers -- in Invesco’s case there were 40 -- detailing the number of annual exchanges permitted and the dollar volume of trading capacity. In other cases, such as Putnam’s $55 million settlement, there were no explicit agreements between fund companies and market-timing traders.

In their pacts with the SEC, the mutual fund companies agreed to name independent distribution consultants, whose selection the commission must approve, to draw up the restitution plans.

Among the fund company appointments: Alliance Capital chose Professor Marshall Blume of the University of Pennsylvania’s Wharton School, Massachusetts Finacial Services Co. chose Professor John Coates of Harvard Law School, Putnam selected Professor Peter Tufano of Harvard Business School, and Pilgrim Baxter & Associates named Professor Kenneth Lehn of University of Pittsburgh’s Katz Graduate School of Business (see table).

The independent consultants were not involved in the discussions between the fund companies and the SEC that led to the settlements. But as part of their research to produce a fair restitution plan, they may suggest that the size of a settlement needs to be increased -- that more money should be set aside to fairly compensate shareholders for the losses they suffered.

To review the mutual fund companies’ choices of consultants, the SEC has hired Virginia Commonwealth University Professor David Dubofsky, who is on leave as chairman of the finance department. Dubofsky will also review the restitution plans, once they are filed with the SEC.

Even as the consultants begin their work, class-action litigation against mutual fund companies is making its way through the courts. In February 2004 seven multidistrict suits were consolidated in front of four judges in the U.S. District Court in Maryland, led by Judge J. Frederick Motz. The plaintiffs, represented by Deborah Clark-Weintraub and David Bershad of Milberg Weiss Bershad & Schulman, will try to persuade the courts to up the payout to shareholders.

“It is currently our opinion that damages exceed those specified in the SEC agreements,” says Bershad. “We believe it’s wise for the fund companies to open their books, to bring this to a more rapid conclusion.”

The judges hearing the cases are encouraging the independent consultants to carefully evaluate the size of the various settlements. In a June 14 letter to all parties to the litigation, Judge Motz wrote, “We also want you to focus on the total amount of recoverable damages and the effect of any settlements or restitution agreements that may have been reached.”

The independent distribution consultants face a twofold challenge: to explain how the rapid trading worked and to propose how to distribute the settlement money.

As the consultants are well aware, no law prohibits rapid trading. But in many cases, the fund companies and the traders violated the permissible trading practices explicitly outlined in the funds’ prospectuses.

Detailing exactly how the trading worked is most straightforward when the market timers had a special arrangement with a fund; this was the case for Alliance Capital Management, Columbia Management Advisors, Franklin Templeton, Fremont Investment Advisors, Invesco/ AIM, Janus, Pilgrim Baxter, Pimco Equity Advisors Capital, RS Investment Management and Strong Capital Management. But it’s less easily measured in the absence of explicit agreements.

After the consultants estimate the gains that accrued to market timers, they will evaluate any action taken by portfolio managers to accommodate the rapid trading, specifically examining the amount of cash that was held to enable the market timers to buy and sell quickly. The cash positions can then be compared with those of peer funds and with the fund’s own historical pattern of cash holdings. “If there were big differences and no other reason for the discrepancy, we would ask questions,” says Bradley Massam, the Ernst & Young partner who heads the firm’s investigative and dispute services practice and is consulting on restitution plans.

The critical and difficult calculation: determining the opportunity cost of keeping the incremental cash out of the market for a specified period. Was cash held to accommodate market timers or for some other reason? “This is where substantial judgment is required,” explains Massam.

In determining who should get what, the independent distribution consultant will run into the mutual fund market’s structural peculiarities, some of which enabled market-timing to occur in the first place. Among them are so-called omnibus, or aggregated, accounts that are created by banks, broker-dealers and retirement fund administrators, who net their clients’ trades before forwarding them to the mutual fund firms. In this way, the activity of any one investor is obscured. The independent distribution consultants will thus have to get information from these third parties to determine which shareholders are entitled to what. “It’s something these intermediaries hadn’t bargained for,” notes the University of Pittsburgh’s Lehn.

Nevertheless, precedents do exist for this kind of fact-gathering. Attorney Bershad points to the securities litigation against Lucent Technologies in which the court approved a roughly $600 million settlement of charges that company management breached its fiduciary duties and wasted corporate assets through improper accounting and revenue recognition. Bershad also cites the Nasdaq settlement approved by the courts in November 1998 in which 37 market makers settled, for about $1 billion, charges of conspiring to boost spreads.

In the Lucent and Nasdaq cases, the banks, broker-dealers and retirement fund administrators passed claims forms on to their clients, the underlying investors, allowing them to file their claims individually. In other cases, the intermediaries filed claims on behalf of their clients and then subdivided the claim payments when they were made.

Whether those precedents will apply in the fund-trading cases remains up in the air -- like so much else in the restitution saga.