The Mutual Fund Trading Scandals: Implications for CPAs and Their Clients

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EXECUTIVE SUMMARY

* SINCE THE FIRST MAJOR MARKET-TIMING and late-trading scandal broke, a barrage of federal and state enforcement actions against funds has followed.

* LATE-TRADING IS ILLEGAL UNDER FEDERAL securities laws and some state statutes. It occurs when a mutual fund or intermediary permits an investor to purchase fund shares after the day's net asset value is calculated, as though the purchase order were placed earlier in the day.

* THE SEC HAS ADOPTED A NEW RULE requiring a fund to disclose in its prospectus and statement of additional information its market-timing risks; policies and procedures adopted, if any, by the board of directors, aimed at deterring market-timing; and any arrangement that permits it.

* THE SEC HAS PROPOSED A NEW RULE that generally would require all mutual fund trades to be placed by a "hard 4 p.m." Eastern time deadline.

* IN CONTRAST TO LATE-TRADING, MARKET-TIMING is not illegal per se. Problems arise, however, when the timing of trades violates the disclosures in the prospectus. This can cause so many buys and sells that the costs escalate and the fund is disrupted, to the detriment of its long-term shareholders.

Amid the financial accounting frauds and Wall Street's investment banking-analyst scandal, mutual funds stood out as an industry that played by the rules. The recent mutual fund trading scandals, however, have changed that perception.

Since the first major market-timing and late-trading scandal broke just over a year ago, there's been a barrage of federal and state enforcement actions against investment advisers who advise mutual funds. Many investment advisers serving mutual funds have been accused of fraud, and the SEC has issued a wave of new rules aimed at safeguarding shareholder investments. As fiduciaries, investment advisers should understand not only how the fund trading scandals operated, but the effects of the resulting investigations and regulations on the mutual fund investments they recommend. To learn how CPAs have dealt with client concerns about the scandals, see "When Investor Trust Is Shaken," page 38.

HOW MUTUAL FUNDS ARE STRUCTURED

Open-end investment companies, commonly known as mutual funds, do not issue shares in their funds for resale to other potential shareholders. Instead the shares must be purchased from, and sold back to, the fund itself.

Mutual funds are unusually structured. Most do not have employees but are overseen by boards of directors that, among other things, approve contracts with service providers to perform essential fund operations. The board typically approves contracts with an investment adviser to make appropriate investment decisions for the fund's portfolio, a transfer agent to administer shareholder purchases and redemptions of fund shares, and a principal underwriter to oversee the distribution of shares and payments for distribution, usually through intermediaries such as broker-dealers, banks and employee-benefit-plan administrators.

Placing oversight responsibility for a fund's proper operation with the board is not always simple. Frequently, the investment adviser organizes or sponsors the fund and recruits its board members. In practice this relationship has created a conflict of interest between the adviser and the fund under which the adviser sometimes has acted in its own self-interest at the expense of shareholders. According to the financial press, many of the participants in the fund trading scandals were executives, portfolio managers and employees of the investment adviser who personally participated in the fund trading scandals and made illegal profits, or permitted favored shareholders to do so in return for lucrative business arrangements.

PRICING FUND SHARES

Using accrual accounting principles, a fund calculates daily its expenses, the value of investments held in its portfolio and the number of fund shares outstanding. …