TCS Daily

How to Handle the Scandal

By Gil Weinreich - October 21, 2003 12:00 AM

Alas, a new financial scandal has exploded in our midst, causing mayhem in the marketplace, as wounded investors are forced to once again tiptoe over shards of broken trust. Most surprising, the claim of responsibility comes from an unexpected quarter -- the mutual fund industry, heretofore thought of as a friend of innocent shareholders.


It remains to be seen how widespread are the abuses, which to date have been linked to Bank of America's Nations Funds, Bank One's One Group Funds, Janus Funds, Strong Funds, Alliance Capital, Fred Alger Management and several brokerage firms that facilitated the illicit trading. But the allegations, which center on illegal late trading in the case of Bank of America and in improper market timing by BofA and the other firms, are certain to prolong the crisis of trust that is inhibiting a sustained market revival.


Because the facts and terminology used to describe this latest and other financial scandals can be abstruse and conceptually abstract, it is worth re-examining what conflicts of interest and financial fraud are, so that we can better visualize how investors are harmed.


Taking Advantage of the Blind


Unethical business practices go by a large number of names -- bribery, counterfeiting, embezzlement, identity theft, insider trading, insurance fraud, kickbacks, money laundering and so forth. But they all boil down to taking advantage of someone's figurative blindness.


Exploiting the blindness of someone who cannot see what is going on in a transaction goes under the rubric of conflicts of interest. For example, a financial firm that sells securities to investors who expect the firm to make objective recommendations has a conflict if that same firm receives fees from corporate clients who expect only positive recommendations. Similarly, in this latest fund scandal, shareholders expected their funds to maximize shareholder value even while the funds were diluting the value of fund shares in order to reap hefty asset-based fees from hedge funds that parked tens of millions of dollars with their partners in crime.


Another metaphor to describe a different type of unethical business conduct is distorting the vision of someone so he cannot see what is really going on, which gives you a more intuitive understanding of what fraud is.


A research report that makes a shaky company look like a sound investment by exaggerating its potential or minimizing its drawbacks would fit this category. Here the customer has been blinded to the company's faults through intentional misleading. Similarly, all of the companies embroiled in the fund scandal issued prospectuses that appeared to disallow market timing. But the appearance they deceptively created masked the ugly reality of their actual practice of conspiring with Canary Capital Partners, Millennium Partners or Veras Investment Partners -- three hedge funds accused of illicit trading -- to earn money at their shareholders' expense.


In all of these examples, financial firms exploited their customers' blindness or distorted their vision to earn money for themselves. Rather than serving their customers, the firms leveraged their customers to earn revenue in a crooked way.


How do we know these practices are unethical? There is a simple test: Would the other party mind? Chances are an investor would mind the dilutive effect of market-timing trades, which one expert has estimated could cost up to 2 percent of assets a year -- or $2,000 on a $100,000 investment, according to a recent report in The Wall Street Journal. And public investors would mind, indeed did mind, learning that stocks touted by analysts were described glowingly on CNBC or in research reports and less flatteringly in corporate e-mail communications.


To put all of this in another context, financially savvy investment professionals who are ignorant of auto repair would mind if they knew their mechanic was giving a false diagnosis of the car's troubles or was lending out the unwitting customer's car as a loaner to other customers.


No Free Lunch


So far, New York attorney-general Eliot Spitzer has filed criminal charges against one Bank of America broker and has obtained guilty pleas from a former top mutual fund executive with Fred Alger Management and from a former trader from hedge fund Millennium Partners. Time will tell whether the other implicated firms represent just the tip of the iceberg -- and whether the public will continue to invest in the affected fund firms. Indeed, the question as to whether or not to liquidate such holdings has touched off a mini-controversy in itself.


Fund research firm Morningstar triggered the debate in September with a call for investors to consider selling their holdings in the four fund families initially fingered in Spitzer's investigation. In contrast, rival research firm Standard & Poor's urged a more cautious approach, suggesting that investors hold tight until more details of Mr. Spitzer's investigation emerge. Next, Janus CEO Mark Whiston entered the fray, blasting Morningstar -- with no hint of irony -- for "recklessness and irresponsibility" in making its sell recommendation before a full analysis of all the facts.


Personally, I'm with Morningstar on this one. Although under our system of law one is presumed innocent until proven guilty, market participants can and should make ethical judgments and leave legal ones to the courts. But first, we can dispense with the question as to whether any monies parked in these funds are safe. In all likelihood, they are. By law, fund assets are held by a separate custodian. Unless there is a major run by worried investors on fund assets, causing massive redemptions in excess of the fund's cash holdings, it is hard to see how investors will be adversely affected by remaining in the affected funds (assuming the improprieties have stopped).


A second question is more fundamental. Can these fund managers be trusted to handle investors' monies going forward? Absent a massive housecleaning, I would not be inclined to trust these firms with my investments. They have already shown a propensity to put the firm's interests ahead of those of their shareholders. Although Bank of America has fired a number of senior managers, at least one very senior executive who was reportedly aware of the scam remains in place. And Janus' Whiston would have been more convincing in his letter to Morningstar if the firm strongly denied the charges, fired key senior executives or at least sounded ashamed. Rather, his combative reply bespoke an attitude of "recklessness and irresponsibility."


The great economist Milton Friedman astutely remarked that there is no free lunch, by which he meant that even things that are apparently free are paid for in some way. Likewise, there is no ethical free lunch. The millions of dollars in asset-based fees that the mutual fund firms earned at their shareholders' expense has come at the steep cost of the firms' reputations. Even if the firms had not been caught, a price would be paid in a morally desensitized management that would be tempted again and again to cut ethical corners, imperiling the firm at a later date.


Without ethics, business is like a Hobbesian state of nature in which "man is a wolf to man," to cite a Roman proverb that Thomas Hobbes used to describe man's natural tendency to act only in his own interests. When this occurs with enough regularity, trust in the marketplace weakens and companies and economies inevitably decline. Thanks to a few rogues in the top ranks of several fund companies, we will be waiting a while longer before actors in the marketplace lose their fear of being robbed blind.


Gil Weinreich is the editor of Research magazine and can be reached through his website,

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