Investors Deserve an Intolerant SEC

Mr. Spitzer's recent allegations share a common theme with those he successfully leveled against conflicted Wall Street research analysts earlier this year, as well as the SEC's case against the NASD in 1996, and the Treasury auction scandal in the early 1990s. All reflect a significant weakness in the SEC's enforcement philosophy. The SEC staff does not have a culture of actively seeking to identify and preempt broad categories of misconduct based on fundamental operational and economic problems in the securities industry.

A Deficient Enforcement Culture

Some, but not all, of Mr. Spitzer's allegations are a case in point. His late-trading allegations, for example, probably do not reflect a failure of the SEC enforcement staff. The late-trading allegations took industry insiders and SEC attorneys alike by surprise. There has been no evidence that late trading is an industrywide problem, and it reflects no failure by the SEC that this fraud was first uncovered by someone else.

The allegations of funds using stale prices are a different matter. This fraud, which I call arbitrage pricing, has been widespread and well-known for years. Over three years ago, I published two articles in TheStreet.com explaining how arbitrageurs cheat fund shareholders by exploiting stale prices. Both articles were cited in Mr. Spitzer's complaint, and these articles were not the only ones that had identified the problem. A number of hedge fund managers were known to be making a good living engaging in fund arbitrage. Published academic studies showed that fund shareholders lose billions of dollars annually to arbitrage pricing.

The SEC itself studied the practice and found that "large numbers" of arbitrageurs had made risk-free profits at the expense of fund shareholders. The SEC has not made its findings public, but you can find an analysis based on the SEC's methodology in my June 10, 2000 article.

Despite years of mounting evidence that fund arbitrage was widespread and pernicious, the SEC took no action. The SEC never brought an enforcement action against a fund for using stale prices, thereby sending the message that it did not consider inaccurate pricing to be a major concern. This message was reinforced when the SEC failed to take action against the fund manager or directors of two Heartland municipal bond funds that in October 2000 lost 44% and 70%, respectively, of their net asset value in a single day because the funds' shares had been mispriced. (Check out these stories: SEC May Hold Independent Directors Responsible for Heartland Debacle; Heartland Fiasco Shows Need for Conflict of Interest Rules, and Two Muni Funds Pay the Price for Extreme Risk.) William Nasgovitz, who settled private claims for $14 million ($10 million of which was paid by his insurer), still runs the fund's managing entity, and three of the four independent directors are still in place. (The fourth resigned only late last year.)