A recent Supreme Court of Canada decision may result in new information showing how a couple of mutual fund management companies got involved in allowing some investors to benefit at the expense of others by using market-timing strategies.
Last month the Court ruled that a class action suit against mutual fund management companies AIC Ltd. and CI Mutual Funds Inc. may proceed. AIC already paid out $58.8 million to investors while CI paid out $49.3 million as part of deals with the Ontario Securities Commission in 2004 and 2005 that saw a total of $205.6 million paid to investors by the two companies as well as AGF Funds Inc., Franklin Templeton Investments Corp. and IG Investment Management Ltd..
The companies had allowed some investors in certain mutual funds to make multi-million-dollar profits at the expense of other investors in the late 1990s and early 2000s through what are called market-timing strategies.
Market-timing strategies take advantage of the difference in prices between two markets. For example, a Canadian mutual fund investing in Japanese stocks would be priced at 4 p.m. eastern time. However, the fund's unit value would be based on closing prices in Tokyo 14 hours earlier. Any positive news about the Japanese market released after the close would be reflected in the Canadian fund's unit value on the following day. Short-term traders would make money by buying the fund on the first day and selling on the next.
Frequent short-term trading harms a fund because there are substantial transaction costs involved and the profits made by the short-term traders are at the expense of long-term investors in the funds. The Investment Industry Regulatory Organization of Canada (then called the Investment Dealers Association) stated in its disciplinary action covering brokers involved in market timing that one dealer "executed in excess of 3900 market timing trades on behalf of Client A. The value of the aggregate transactions of Client A ranged from $500,000 to $54,800,000. The average hold period with respect to a given mutual fund position in Client A's account was fewer than 5 days."
While market timing isn't illegal, fund managers have a duty to protect the best interests of their funds. Fund companies generally do this by imposing short-term trading fees or simply refusing to accept such accounts. Indeed, the equity funds in question were supposed to charge fees of 2% to 3% on redemptions made within 90 days of purchase, with the fees going to the fund rather than the manager.
The plaintiffs' position in the new class action suit is that the settlements with the OSC fell short of what should have been paid to investors. The defendants' position is that the settlements with the OSC compensated the millions of investors.
In a news release, Rochon Genova LLP, the investors' lawyers, said that the decision means that corporations can no longer shelter behind a regulatory investigation into their conduct.
From my perspective the real consequences, if the case doesn't settle and goes to court, are that investors and the fund industry might learn some of the things that weren't covered by the OSC in its settlement documents. The key missing element is the identity of the individuals responsible. Similarly, the Investment Dealers Association omitted names in its decision on the brokers involved in short-term trading.
I assume that at some point in the proceedings the plaintiffs' lawyers will be asking questions such as who in the fund management companies approved the short-term trading practices and whether the compliance officers or other senior officers were aware of what was happening. I also assume they will ask who was responsible for waiving the fees that were supposed to be in place to discourage short-term trading and who initiated the practice. I expect they will also ask on what basis the fund companies justified the practice.
Market timing was not a widespread industry practice. The OSC sent letters to 105 fund companies in 2003 asking them to confirm they had effective policies to detect and prevent trading abuses such as late trading and market timing. Late trading was found not to be an issue, but the five companies were subsequently called on the carpet over market timing.
(Market timing is no longer an issue because the industry moved to a "fair-pricing" model, which adjusts fund unit prices to reflect changes in value of the fund's foreign holdings.)
IG Investment Management, Franklin Templeton and AGF Funds were defendants in the class action suit but they settled in 2010, paying a total of $11.3 million -- chump change compared with what the plaintiffs are asking and what all five companies paid investors under their agreement with the OSC.
The court decision notes that the plaintiffs' expert's best estimate of losses were $192.6 million for AIC's investors and $349.3 million for CI's investors.
Whether the case goes to court or is settled is a flip of the coin. And if there are settlements I suspect they will be more generous than the $11.3 million settlement noted.
Part of the settlement agreements with the OSC called for the companies to put into place "procedures to prevent and detect frequent-trading market timing that could reasonably be expected to be harmful to the respondents' mutual funds and unitholders of those funds."
A consequence of the market timing scandal was National Instrument 81-107, which requires each investment fund to have an Independent Review Committee that looks at every perceived conflict of interest by the fund manager. The IRC's job is to provide the fund manager with a recommendation that the manager must consider.
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