Mutually Assured Destruction II: New York Eliot Spitzer’s Campaign for the Governorship

by | Sep 11, 2003

The mutual fund scandal that erupted last week is the latest front in vigilante New York Eliot Spitzer’s campaign to climb to the governorship over as many ruined careers as possible. Here are some thoughts on where it could lead. Are there abuses of trading after the close in 401(k) plans or mutual-fund marketplaces? Probably […]

The mutual fund scandal that erupted last week is the latest front in vigilante New York Eliot Spitzer’s campaign to climb to the governorship over as many ruined careers as possible. Here are some thoughts on where it could lead.

Are there abuses of trading after the close in 401(k) plans or mutual-fund marketplaces? Probably not much, if any — but it’s an under-regulated part of the system and overzealous investigators will realize the potential is there and maybe find something.

And here’s another one. It’s a well-kept secret of the mutual-fund industry that daily fund net asset values don’t accurately reflect the true value of the fund’s holdings. Because of the necessity to provide the NAV within hours of the market close, most funds calculate NAVs using today’s prices applied against yesterday’s portfolio holdings. This creates another opportunity for effectively trading after the close for investors who have inside information about fund holdings, as apparently was the case with the hedge fund involved in the scandal.

If an investigation ends up characterizing these longstanding and widespread micro-abuses as crimes, the price to the industry could be a lot higher than just a stiff fine paid to Eliot Spitzer, or even the endless plaintiff litigation that would no doubt follow. For one thing, there would be massive reputation damage to the fund industry that would set it back decades. And that would spill over into a distrust of the market overall.

But here’s the worst-case nuclear-winter scenario that I’m sure fund-industry executives are talking about secretly right now — and hoping that no one will mention in public. Well, here goes.

The whole mutual-fund industry is based on a tax exemption — and that exemption could be put at risk in a widespread investigation. You don’t think much about it, because if you hold a mutual fund outside an IRA or 401(k), you’re paying taxes every year on its dividends and capital gains (unless it invests entirely in municipal bonds, of course). But the fund itself is tax exempt. Unlike other corporations — and a corporation is what a mutual fund actually is — a mutual fund itself does not pay taxes.

To earn the exemption, a fund must comply with applicable provisions of the Internal Revenue Code . The critical provision here is that all fund shareholders must be treated completely equally. The whole point of this week’s scandal is that certain funds have apparently not been doing that. If the Internal Revenue Service so chose, it could yank the funds’ exemptions — and it could do the same for any fund found to be treating its shareholders unequally in any future investigation.

A mutual fund that loses its tax exemption is, effectively, sentenced to death. Investors would desert funds in droves, and choose instead to hold individual stocks. Why be taxed twice when you can just be taxed once?

But it gets worse. What if the IRS were to rule that a fund had been treating investors unequally for a long period — and seek back taxes and penalties? Technically the fund itself would be liable, and it might be a liability that could more than wipe out all the fund’s assets. Think about the case of a fallen-angel technology fund that racked up big profits in the late 1990s, but now is only a fraction of its former size? The taxes and penalties could be larger than all the assets currently in the fund.

As a practical matter, the fund itself would probably not end up paying the back taxes and penalties. Any mutual-fund company that wanted to stay in the business would no doubt decide to step up to the plate and pay. But the bill could run to billions, and could deal a blow to some fund companies from which it would take years to recover.

How likely is that worst-case scenario? Not very. But I bring it up to make sure you know even the remote risks that are lurking out there.

And I have another reason, too. In a world that sometimes seems full of corporate crooks, our first impulse is to shout “hang ’em high” and applaud the regulators and the states attorneys general as they all rush in to prosecute at the same time. But a little of that goes a long way. What starts out as enforcement can easily turn into a lynch mob.

So now, as the prosecutorial posse goes after the mutual-fund outlaws, be careful before you cheer them on. Watch carefully to see if the abuses they uncover are substantive — and whether it costs more to fix them than it did to live with them. And let’s all take care that we don’t pay the highest price of all: blundering in with guns blazing, and inadvertently destroying the industry that has done a better job than any other to bring ordinary people into the investor class.

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Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

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