What's Up with Payouts from the Market-Timing Scandal?

Remember the mutual fund market-timing scandal? It's not quite over yet.

No, there aren't new revelations as far as I can see. We're just waiting for fund companies to make their payments to fundholders. Then it will really be over. Although the scandal broke about three years ago when New York attorney general Eliot Spitzer revealed he had uncovered late trading and inappropriate market-timing going on at major fund companies, no fundholders have been compensated through payouts yet.

Finding out the current status of the settlements isn't easy. About the only information I could find on the Web from 2006 was a statement on Janus' site from April.

Those fund investors who stuck with the misbehaving fund companies have been benefiting from the lower expense ratios that Spitzer forced on the firms. However, the other half of the settlements, the restitution payments to shareholders who owned the funds when market-timing and other bad stuff happened, has yet to be completed.

A short refresher for new investors who weren't tracking the fund scandal: Although the phrase "market-timing" has stuck, the scandal really encompassed a wide range of unethical and sometimes illegal activities that hurt fund investors but lined the pockets of fund company executives and hedge funds. There was late trading, frequent trading, inappropriate fee markups, and time zone arbitrage, and one firm even gave daily portfolios to hedge funds so that they could front run the funds (buying and selling just before the fund did).

All of these activities hurt investors over different time periods, so each settlement required that an independent specialist be hired to figure out how much the damage was, when it occurred, and who should be compensated. Each one of those is a tough problem to solve--especially figuring out who should be compensated. A fund company can easily track down people who own its funds directly, but people also own funds through 401(k)s and intermediaries such as brokers. In those cases the fund company might not have the records, and some small 401(k) providers might not even have records themselves of who owned what on a date six years ago.

In short, it took a while for the specialists to sift through all their data and make their recommendations to the SEC. Now, many of those reports have been filed with the SEC, and the SEC is in the process of reviewing them. SEC officials have said they hope to finish their review of the first batch of reports by the end of September. If they do, then investors affected may get their money in December or the first quarter of 2007.

Another wrinkle still left out there is that the IRS hasn't ruled yet on whether these payouts will be taxable. I would think that because many of these activities occurred during the bear market--when funds were losing money--that this is mostly just a return of principal, but what do I know?

What Should Affected Investors Do?
The settlements require that the money be paid out to all investors who were harmed. Thus, the vast majority of you shouldn't have to do anything. However, given the difficulty of tracking down investors in small 401(k) plans, I'd imagine there are a few people who will be missed. In that case, you might want to check with the 401(k) provider or the fund company to see if they have your name after the SEC approves the settlements.

What Should Investors Do with the Money?
I don't have any money coming to me from the settlements, but if I did I might use it to buy a compact disc or a book. If you get more than most, maybe you could buy a sweater. Don't get your hopes up that you'll be getting a big fat check. In most cases the damage was a small percentage of assets. That might not jibe with the losses you suffered, but those likely would have been due mostly to the bear market--not timing, etc.

Lessons from the Settlement
We've written a lot about what the scandal said about the fund industry, its values, and the gaps in regulatory oversight. But here's a thought on the practical side of the lessons of settlement handling. The forced fee cuts are a much faster and cost-effective way to compensate investors for wrongdoing than restitution payments. The first cuts came in early 2004, but we're still waiting for payouts. True, the flaw in fee cuts is that an investor might not still be in the fund, but at least many of them got compensated quickly. If the payouts were eliminated the fee cuts could be even larger. Maybe a good standard would be to require fee cuts for cases in which the damage is less than 5% of assets; that way, people who were really burned still would get cash payouts, while smaller amounts of damages could be remedied with fast and simple fee reductions.