The Ontario securities Commission’s final report into the mutual fund market-timing scandal, released in March, fails to answer the questions that have dogged the settlement from the start: why did only five of the 20 fund companies that suffered market-timing trades pay the price and why did none of the traders?

OSC chairman David Brown gave answers to both questions in a recent speech. The OSC went after the five fund managers who were the worst offenders and whose clients suffered the most, he told to the Economic Club of Toronto. It didn’t pursue the market-timing traders who made the bulk of the profit because they didn’t actually break any rules.

The Street, however, isn’t completely satisfied with those answers. There is some feeling that the OSC should have gone after all the companies whose funds were used by market-timers, particularly as the settlements aimed to return money to investors. “Going after the other 15 [fund companies] was straightforward, and the penalties would have been proportionate,” says one senior securities lawyer.

The OSC’s report attempts to show why the commission drew the line where it did. It specifies the three areas of risk ratings which the commission applied to each of the 20 firms that faced the third and final phase of the probe: market-timers’ profits, fees earned by fund managers by allowing market-timing and volume of redemptions.
Brown says the sanctioned firms — AGF Funds Inc., AIC Ltd., CI Mutual Funds Inc., I.G. Investment Management Ltd. and Franklin Templeton Investment Corp. —
stood out from the pack as markedly riskier.

“Five fund managers stood out in clear contrast,” he says. “The average risk rating for market-timers’ profits for those five was three times as high as the rest. The average risk rating for gross management fees from allowing this activity earned by those referred was four times as high as the rest.
The average risk rating for volume of redemptions for them was almost three-and-a-half times as great as the others. The average total risk rating was three-and-a-half times as high.”

This is true, but if you play around with the numbers in the report, you’ll be able to make a similarly compelling argument for more firms to face sanctions.

For example, if you calculate average risk scores for the top eight companies, rather than just the top five, you’ll find a similar disparity between the top eight and the remaining 12 — the average risk rating for both market-timers’ profits and fees earned from market-timing is 3.3 times as high for the top eight as it is for the rest; the average risk rating for redemption volume is 3.6 times as high as the rest, and the average total risk rating is 3.4 times as high. Or simply divide the list in half and take the averages for the top 10 and bottom 10 companies. The average risk rating for market-timers’ profits is 3.5 times higher for the Top 10, 2.8 times higher for fees earned from market-timing and 3.1 times higher for volume of redemptions. And the Top 10’s total risk rating is 3.1 times higher.

Dividing line

The point is that if these risk scores are to be used as a dividing line between the firms that deserve sanctions and those that don’t, it is clear the line could have been drawn in a number of different places.

Based on the risk-scoring data alone, Toronto securities lawyer Phil Anisman says the commission could have gone after two or three more fund firms than it did. But, he notes, what the report doesn’t reveal is whether there were other factors that influenced the OSC’s decision to focus on the five, instead of six or eight. For example, did any of the other 15 firms have agreements to allow market-timing?

In his speech, Brown said the 15 unnamed firms “identified market-timing at an early stage and shut it down with negligible harm to investors.”

If the 15 fund companies were spared enforcement action because they moved to defend unitholders’ interests, that was not the case with the traders who made market-timing profits. Indeed, they were spared despite their determination to exploit unitholders.

As Brown noted in his speech, the market-timers didn’t profit by simply making smarter investment decisions than most unitholders: “This was a case in which some knowledgeable investors exploited the system to make more money at the expense of others. By taking advantage of the difference between the stale value and an expected price movement of a fund the following day, and trading in anticipation of those price movements, they were able to make gains. Those gains could only come at the expense of every other investor in the fund.”