2003 mutual fund scandal

The mutual fund scandal of 2003 was the result of the discovery of illegal late trading and market timing practices on the part of certain hedge fund and mutual fund companies.

On September 3, 2003, New York Attorney General Eliot Spitzer announced the issuance of a complaint against New Jersey hedge fund company Canary Capital Partners LLC, charging that they had engaged in "late trading" in collusion with Bank of America's Nations Funds. Bank of America is charged with permitting Canary to purchase mutual fund shares, after the markets had closed, at the closing price for that day. Spitzer's investigation was initiated after his office received a ten-minute June 2003 phone call from a Wall Street worker alerting them to an instance of the late trading problem.

In the United States, mutual fund prices are set once daily at 4:00 p.m. Eastern time. "Late trading" occurs when traders are allowed to purchase fund shares after 4:00 p.m. at that day's closing price. Under law, most mutual fund trades received after 4:00 p.m. must be executed at the following day's closing price, but because some orders placed before 4:00 p.m. cannot be executed until after 4:00 p.m., brokers can collude with investors and submit post-4:00 p.m. trades as if they had been placed before 4:00 p.m.

Such trades can be made with information about after-hours market developments in other countries, for example. Traders would buy in at the previous day's close, and sell at the next day's close for a likely profit. This practice hurt long-term buy-and-hold investors in the mutual fund, who experienced a continued drain in the fund's net asset value.

Late trading was not a new phenomenon. Prior to 1968, most mutual funds used "backward pricing," in which the fund could be bought at the previous closing price. Thus, traders could purchase mutual funds on a day when the market was up, at the previous day's lower closing price, and then sell at the purchase date's closing price for a guaranteed profit. To prevent the exploitation of backward pricing, the SEC issued Rule 22c-1, requiring forward pricing of mutual fund transactions. This rule was enforced by randomly checking timestamps on orders, but intentional falsification of timestamps was difficult to catch.

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