Scandal-Harmed Fundholders: Is Your Check in the Mail?

Rip. That's the sound of more than $1.8 billion worth of checks being cut for fund shareholders hurt by the mutual fund scandals of 2003 and 2004. Nearly four years later, investors now are being compensated for damage done by unethical trading. Determining how to compensate harmed shareholders proved to be a Herculean task.

In case you weren't following the fund scandals, it boiled down to fund company executives striking deals that allowed some investors (such as hedge funds) to make otherwise-prohibited short-term trades that paid off for the select customers and led to higher profits for the fund company--all at the expense of regular fund shareholders like you and me. The scandal encompassed a wide range of dishonest practices including market-timing, late trading, and front-running.

Many of the fund companies embroiled in the scandal have reformed by firing wrongdoers, beefing up compliance, and reconfiguring their sales practices. More importantly, some have begun to shift their corporate cultures so they're focused on fiduciary duties rather than simply complying with the letter of the law. Meanwhile, others have done the bare minimum required by regulators. We've been keeping close tabs on how stewardship-related issues have been shaking out in our  Morningstar Stewardship Grades for mutual funds.

Status of the Payouts
While some fund companies were quick to embrace reforms, restoration payouts owed to investors have been slow in coming. That's not because fund companies have been dragging their feet. In fact, most fund companies agreed to the aggregate payouts when they settled charges with the SEC back in 2004. Since then, the responsibility for devising a plan to distribute the money has been in the hands of independent distribution consultants. First, each IDC is charged with devising a plan to distribute the money fairly. Then, the IDCs post the plan to the SEC's Web site for public comment. After the SEC has approved the plan, payouts can begin.

The reason it took so long to come up with the distribution plans is because investors buy and sell funds every day, so the consultants had to determine damages for each day and match them to records of who owned the fund on that day. To complicate matters, many third-party records, particularly those of 401(k)s, were often short on detail. To top it all off, the SEC and the IRS had to decide how to tax the restoration payments, so there was a bureaucratic hold up, too.

In the table below, we provide a rundown that shows where different fund companies stand in the process.

The Status of Mutual Fund Settlements
Fund Complex	Proposed Plan of Distribution Released?	Total Payout
AIM/INVESCO (Click here for more information)	No, expected on or after June 29, 2007.	$375 million
Banc of America/Nations Funds (Click here for more information)	No, expected on or after August 2007.	$375 million
Banc One (subseq. acquired by Chase) (Click here for more information)	Plan approved by SEC in May 2007.	$50 million
Columbia (Click here for more information)	Plan approved by SEC in May 2007.	$50 million
Federated (Click here for more information)	No, expected on or after Aug. 31, 2007.	$72 million
Franklin (Click here for more information)	Yes; now accepting comments	$50 million
Janus (Click here for more information)	Yes; now accepting comments	$100 million
MFS (Click here for more information)	Yes; in SEC review.	$175 million
Pilgrim & Baxter (PBHG Funds) (Click here for more information)	Plan approved by SEC in November 2006.	$250 million
Putnam (Click here for more information)	Yes; in SEC review.	$98 million
RS (Click here for more information)	Yes; now accepting comment letters	$25 million
Strong (subseq. acquired by Wells Fargo Funds) (Click here for more information)	No; expected on or after June 1, 2007.	$140 million
Waddell & Reed	No; expected date not available.	$77 million
Data was compiled from fund company Web sites as well as the SEC's Web site

How the Plans Work
We haven't gone through each proposal with a fine-toothed comb, but we did find some commonalities across the different plans. To analyze the harm caused by market-timing, for example, the IDCs highlighted two main ways the investors were hurt. The first was the dilution caused by the extra cash a fund held as large accounts rapidly traded in and out. Had all of that cash not been sloshing around, more of the portfolio could have been invested in securities. The IDCs found there was an opportunity cost to holding cash to deal with market-timing flows.

The second main loss came from incremental trading costs. If the portfolio manager opted to invest the market-timing money in securities rather than keeping it in cash, the fund was subject to administrative and trading costs that would not have otherwise been incurred. The IDCs generally estimated those daily or quarterly costs and then allocated the proportional amount of the payout to those investors who were unwittingly disadvantaged.

Who's Getting Big Payouts?
How much investors will receive from fund companies varies widely. The wrongdoing that took place at Pilgrim & Baxter's PBHG funds was more egregious than at other shops and that's reflected in the amount of money that shareholders are getting. (PBHG funds have since taken on the Old Mutual name.) Although PBHG and its two founders settled with the SEC without admitting or denying wrongdoing, the independent consultant found that market-timing was much more than just an isolated incident by a few parties. The IDC identified 2,063 market-timers in PBHG Technology and Communication Fund, for example, for a total dollar volume of trades equaling $27 billion. And the market-timing was most profound at the PBHG Growth Fund where the IDC found that excess profits earned by market-timers in that fund alone amounted to roughly $165 million, or 68.1% of the overall losses. In addition, PBHG's founders were accused of providing daily portfolios to hedge funds in which they invested, thus allowing the hedge funds to front-run PBHG's trades--a practice much more damaging than market-timing.

PBHG's total payout amounts to $267 million, which is going to be split among 384,000 or so account holders. Thus, the average payout per shareholder amounts to roughly $688. That figure can vary widely based on factors such as the specific fund owned, when it was owned, and the size of the position. Adding insult to injury, PBHG's funds imploded during the bear market, and shareholders' restitution payments may be little consolation for that.

Tiny Payments Returned to Fund
Investors entitled to a payout of less than $10 will get nothing. We think the $10 cutoff makes economic sense because for a $2 payoff, for example, it could cost much more than $2 to track down the right shareholder and send the check. That money will instead be placed back in the funds in proportion to the estimated damages. For example, roughly two thirds of affected Janus fund shareholders are entitled to less than $10 each and won't get a dime unless they still own the funds, in which case they'll benefit because that money will flow back to the funds. We estimate that roughly $2.6 million will go back to each of the seven affected Janus funds. That won't move the needle for some of the larger funds where market-timing wasn't very egregious, including  Janus Overseas (JAOSX), but it will be meaningful for Janus Adviser Worldwide , which may get an amount equal to 0.55% or so of its most recent net assets.

And for those Janus shareholders who pass the $10 hurdle and owned the funds directly (not through a third party or retirement account), the average payout amounts to roughly $55.

What to Expect If You Think You're Due a Payment
First off, don't get too excited. As we mentioned, you may get very little or nothing at all. It's important to note that the job of getting the money to the right shareholders rests with the fund companies and the firms picked to administer the plan. And they are all required to make a reasonable effort to track you down using tax identification numbers and other means. Even so, not all of the shareholders will be easy to find, especially those in omnibus accounts. If you think you may be hard to track down or if you have questions about your payout, click on the link in the table above next to the relevant fund family to access the distribution plan, frequently asked questions, and contact information.