Mutual funds, NSMIA and the state securities regulators – When do state enforcement remedies become improper regulation?

Abstract

On September 3, 2003, New York Attorney General Eliot Spitzer announced what quickly became the gravest scandal in the mutual fund industry in the 65 years since Congress passed the Investment Company Act of 1940. Spitzer’s office discovered that some hedge funds had been permitted to trade shares of open‐end mutual funds after that day’s net asset value (NAV) for those mutual funds had been set (typically at 4:00 PM eastern time). This practice allowed the hedge funds to profit based on corporate news announcements released after that time, and therefore not reflected in the mutual funds’ daily NAV. Moreover, Spitzer disclosed that some mutual fund advisers had only selectively enforced the stated limits in their prospectuses on frequent trading, or market timing, of those mutual funds. In some cases, mutual fund advisers had permitted selected investors to conduct frequent trading in mutual funds in return for investments (sometimes referred to as “sticky assets”) in other investment vehicles, or had permitted frequent trading by officers of the adviser itself. And some mutual fund advisers had selectively disclosed information about portfolio holdings of the funds to hedge funds that used that information to arbitrage the mutual funds’ positions. This was the second major securities industry scandal uncovered by Spitzer’s office in just two years. In 2002, Spitzer’s office uncovered the research analyst independence scandal that culminated in a global settlement with the country’s major investment banks. Spitzer’s 15‐person Securities Bureau appeared more nimble and better informed than the thousands of staff members at the Securities and Exchange Commission, the federal agency charged with regulating the mutual fund industry. The SEC ‐ already under fire for the unprecedented wave of corporate and brokerage industry scandals that led to adoption of the Sarbanes‐Oxley Act ‐ had to endure yet another round of vocal public criticism.