Most mutual fund prospectuses are about as lively as the Manhattan phone directory, and twice as long. Many investors ignore them. Still, it’s the only place you can get the 411 on a fund’s expenses,investment strategy, management and performance.
But allegations that some fund companies granted special privileges to large investors have prompted some investors to question whether they can believe what they read. New York Attorney General Eliot Spitzer has accused Bank of America, Bank One, Janus Capital and Strong Investments of allowing Canary Capital, a hedge fund, to engage in frequent trading — known as market timing — in funds that prohibited such trading in their prospectuses.
Attorneys for individual investors have filed dozens of class-action lawsuits against the fund companies named in Spitzer’s lawsuit. They say the fund companies violated their fiduciary duty to investors when they allowed favored customers to make rapid-fire trades, which can dampen long-term investors’ returns.
The federal law governing mutual funds prohibits them from including false or misleading information in their prospectuses, says Seth Ottensoser, an attorney at Bernstein Liebhard & Lifshitz in New York, which has filed lawsuits against the fund companies.
”It’s illegal to have any misrepresentations or omissions in a prospectus or document related to mutual funds,” he says. ”If you say you’re going to discourage market timing, and market timing occurs, that’s breaking the law.”
Ottensoser acknowledges that the lawsuits may be breaking new legal turf. ”These are very innovative cases, affecting the mutual fund industry as a whole,” he says.
Restrictions on frequent trading in fund prospectuses are relatively new and were originally designed to protect fund companies from lawsuits by market timers, says Barry Barbash, a partner at Shearman & Sterling and former Securities and Exchange Commission attorney.
<B>Potential roadblocks
</B> In the late 1990s, funds saw an increase in market timing, particularly among investors in international funds, Barbash says. Investors were exploiting time-zone differences between foreign and U.S. markets to make a quick profit. When fund companies tried to eject the timers, the investors sued, arguing that fund companies had no authority to limit their trading activity.
Courts eventually ruled fund companies that included restrictions on frequent trading in their prospectuses could banish market timers, Barbash says.
Proving that mutual fund companies violated the law won’t be easy, securities experts say. Potential problems:
<B> * </B><B>Fuzzy language.</B> Many fund companies that restrict frequent trading stop short of saying they’ll always punish market timers. More often, their prospectuses say the funds ”may” penalize investors for frequent trading, or state that as a matter of policy, the fund discourages market timing. ”To the extent there’s any kind of ambiguity, that disclosure will be used as a defense” against investor lawsuits, says Alexander Bono, a securities lawyer for Blank Rome in Philadelphia.
Some prospectuses give fund companies room to make exceptions to their market timing rules in specific circumstances, Barbash says. For example, a fund company might want the flexibility to allow an institutional investor to trade more frequently, particularly if the fund determines it won’t harm other investors, he says. ”Market timing in and of itself is clearly not illegal,” he says. ”What’s illegal is market timing in a situation where a fund says unequivocally it’s not going to be allowed.”
<B> * </B><B>Proving injury.</B> To win damages, investors’ attorneys will have to show that misrepresentations in the fund’s prospectuses caused investors to lose money, says Elliot Klayman, an associate professor of business law at Ohio State University. That won’t be easy, he says. Even if the investors lost money during the period in question, attorneys will have to show that the losses stemmed from market timing, rather than fluctuations in the market, Klayman says.
While the fund companies have declined to comment on the lawsuits, recent letters to shareholders downplay the impact of Canary’s trades. In a Sept. 26 letter to shareholders, Strong Investments contended that the transactions by Canary Capital in four Strong funds didn’t disrupt the fund managers’ investment strategies. The letter also notes that the four funds typically have high turnover, which is disclosed in their prospectuses.
Likewise, a Sept. 30 Janus letter to shareholders contends that the market timing involved just 0.25% of the fund company’s assets.
Janus has hired an outside firm to evaluate whether fund investors were affected by short-term trading, spokesman Blair Johnson says. If the company determines investors were harmed, it will provide restitution, he says.
Shareholder attorneys, meanwhile, are expected to argue that market timing diverts fund assets away from long-term investors and increases the fund’s administrative costs.
<B>Reforms ahead
</B> Resolving the class-action lawsuits, which will probably be consolidated, could take years. But in the meantime, the Spitzer investigation could trigger changes in the fund industry that will benefit the hardy investors who read prospectuses.
Regulators will probably pressure fund companies to provide investors with more information about their market timing policies, in language they can understand, securities lawyers say. Funds that allow market timing under certain circumstances may be required to explain those exceptions, Bono says.
If an investor understands a fund’s market timing policies, ”They can make a reasonable choice,” he adds. ”They know what they’re getting into.”
