Oct. 5–The economy is strengthening. Profits have greatly improved. Chief financial officers report that they’re more optimistic than they’ve been in a year. For the first time since 2000, stockprices have moved up steadily. Employment could use some help, but at least unemployment is holding steady.
I want to say we’re getting back to normal. The recovery is plugging along. But as an investor, I can’t get my eyes off the regulators.
The news brings a scandal a day or more from Wall Street or from mutual funds. None of the stories are insignificant.
You may think what’s emerging now, the second wave of Wall Street corruption, is too complex. It won’t touch you. You’re not in a hedge fund, so why care?
It all touches investors. A culture of rules that can be nudged to fit the situation, when we’re talking about other people’s money, is dangerous.
Your pennies become someone else’s millions far too easily. Profits you should have had for staying the course as a long-term investor get eaten by the short-term traders.
Investor confidence can’t recover as long as shady trading is easy to do.
You want to get into a mutual fund after it’s closed for the day? If you’re the right person and you know the right broker, you can do it.
Word of that sort of broker, somehow, moves from Boca Raton to New York.
“In early 2000, Canary began to engage in late trading,” says the complaint filed by New York Attorney General Eliot Spitzer against the hedge fund manager Canary Capital Partners.
“Its first opportunity came in the form of an agreement with Kaplan & Co. Securities Inc., a broker dealer located in Boca Raton, Florida, which Canary approached after hearing that it provided late trading.”
Kaplan President Jed Kaplan didn’t return two calls requesting comment. Canary, without admitting or denying the charges, agreed to pay $40 million to settle Spitzer’s charges. Kaplan was not named by Spitzer’s office as a party to the settlement.
According to e-mails released by Spitzer, the proposal from Kaplan was to market-time Bank of America’s Nations Large Cap Index Fund. The trades would range from $5 million to $10 million. They’d be limited to one a month.
It appears, from the tone of the e-mail, that market timing is an ordinary strategy.
It must be.
While market timing is not illegal, it is expressly discouraged by the majority of mutual fund companies. (Rydex and Profunds are the exception, offering funds designed for those who want the risks of jumping in and out of markets). Many fund companies claim to guard the doors against this practice, because market timers raise costs for all investors and shrink profits available to long-term shareholders.
Separately, late trading is illegal. And when you use an illegal method — late trading — to implement a strategy — market timing — that hurts long-term shareholders, you have an ugly situation.
Here’s a simple version of how late trading works: Mutual funds settle their prices at 4 p.m. Investors who place trades after that time get tomorrow’s price.
The scandal is focused around funds that ignored those rules in special deals with market timers.
Let’s say news is announced or some development in trading overseas leads the market timer to believe that the U.S. market will rise tomorrow. The market timer, in what’s called late trading, is allowed to buy the fund after 4 p.m. at today’s price.
This is illegal under Securities and Exchange Commission rules.
This rogue then sells his shares tomorrow, when the U.S. market opens higher. He takes his profit and leaves. Because he’s taken his, there’s less profit left for the long-term shareholders.
“Obviously, it dilutes the gains, because the late trader comes in for the large gains but he does not share in the small gains or, for that matter, in the losses with other shareholders,” said Leo Guzman, head of Guzman & Co. in Miami. “It’s a very unfair bet. In a sense, it is shooting fish in a barrel.”
The e-mailer, whose name is not revealed in Spitzer’s documents, received a reply from a superior that the “stated policy for the Funds” was that “we do not allow market timing activity.”
Bunk. Somehow, it happened anyway.
Another, less publicized scandal made the news last week, as well.
Let’s say that you decide to sell your stock for $10. You put in your sell order, and your broker finds someone, a specialist in Chicago, to take it. But when the order goes through, the specialist who promised you $10 pays you only $9.90. The SEC said the exchange would only be alerted to this sort of practice if someone called in to complain.
I made up the numbers. The example, however, is based on what the Securities and Exchange Commission last week said it had discovered at the Chicago Stock Exchange. They are violations of what’s called the firm quote rule. And one person did this 37 times in one year.
The same specialist, also 37 times in the same year, traded ahead of customer orders. As soon as he received your buy or sell order and knew what price you hoped to get or were willing to pay, the specialist did his own buying or selling of that same stock before he executed your order. You probably could have gotten a better price if he’d let you go first.
The Chicago exchange didn’t discipline this specialist, whose name the SEC did not reveal. It didn’t stop his unethical trades, even after more than 100 times of doing the wrong thing.
So the SEC stepped in, now — after the violations had gone on for three years.
How widespread is this chicanery? Peter Chen, the Securities and Exchange Commission’s point person on this issue, would only say that the violations were “extensive” and went beyond this one person whose example was cited.
The Chicago and Boca stories weren’t even the biggest of the week.
While you may argue that what’s coming out now is good for cleaning up the market’s ills, I’m still naive enough to be surprised.
And I would hope that anyone on Wall Street with an ounce of ethics is glad that the regulators are finally awake — and very busy.
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