1. A Green Light for the Mutual Fund Red Light District
You've got to hand it to the hardworking folks in the mutual fund industry: Even in a holiday-shortened week, they managed to squeeze in some bad news.
(Which reminds us: We're still accepting entries for
our latest reader contest: "How to Fix What's Broken in Mutual Funds." If you've got any oddball, outlandish, bizarre and/or unworkable ideas about how to prevent late trading, market-timing, lax oversight and/or incompetent management of mutual funds, send them to the research lab in care of
firstname.lastname@example.org. The winner will receive the gratitude of all mankind. Plus a free book.)
Anyway, this week's depressing disclosure about mutual funds -- which we at the Five Dumbest Things Research Lab used to think were level-playing-field, equal-opportunity-type investments -- came from
The fund giant, a subsidiary of
, announced Monday evening that the staffs of both the
Securities and Exchange Commission
and New York Attorney General Eliot Spitzer have told Invesco
they intend to recommend civil enforcement actions against Invesco "based on market-timing activities by certain investors in its mutual fund shares."
But here, we think, is the interesting part. Keeping in mind that mutual fund companies generally limit market-timed trading of their shares -- or at least say they do -- Invesco disclosed Monday its novel strategy "to protect Funds from harmful short-term activity."
And what was that strategy? Why, it was to permit short-term activity.
Yes, Invesco evidently decided it was a losing game to out-and-out forbid market-timing, which it refers to as "investment models calling for frequent asset allocation."
Instead, Invesco "determined it could better control certain asset allocators and momentum investors by restricting them to certain funds, which, in its judgment, would not be adversely affected by their activities," the company said Monday. "This was done after consultation with investment professionals and included restrictions and limitations designed to protect the Funds and their shareholders."
Hmmm. Here we have someone controlling activity that could be harmful to the community at large by limiting such activity to a particular, tightly regulated area.
You know, maybe that's not so Dumb after all. You can gamble in the U.S., but only in Las Vegas, Atlantic City or some Indian reservation somewhere. You can visit a prostitute, but only in certain counties in Nevada. You can buy a six-pack of beer in Pennsylvania, but only from a bar.
Of course, the next question raised by all these policies is whether the restricted activity should be permitted at all. Is market-timing somewhere in the realm of beer, gambling and prostitution? Or should it be grouped with smoking crack cocaine -- an activity that's pretty much illegal everywhere?
Unfortunately, we at the lab don't have the answers to this one. Just the questions.
2. Peeling Away the Lawyers at Enron
Actually, we spent most of our time at the lab this week reading about
Specifically, we waded through the fourth and final report from Neal Batson, the examiner appointed by a judge to investigate what exactly went so spectacularly wrong at Enron.
Enron, for those of you who have tried to put it out of your mind, was the hubristic energy trading company that solemnly epitomized the hard-charging New Economy -- until it collapsed in a puddle of sham transactions and shoddy bookkeeping in 2001.
Despite all the ugly details that have already spilled out of Enron, there were plenty of new ones in the Batson report.
For starters, we used to think that having a lawyer on staff would help a company avoid illegal behavior.
As we learned from the Batson report, Enron had about 250 lawyers on staff. 250! That's more than one for every 100 employees Enron had at its peak. Most of them had between eight and 17 years of experience
they joined Enron. And those numbers don't include the "hundreds of outside law firms" Enron engaged.
So what did all those lawyers do to keep Enron out of suspect transactions? Or to properly disclose what Enron was up to?
Not much, according to the report. For example, when Enron did deals with related parties and needed a lawyer's opinion as to whether the transaction was a "true sale" as opposed to a loan, the lawyers came up with something called a "true issuance" letter instead.
The true issuance letter wasn't the same thing as the true sale letter, but it was treated as such to provide the illusion of approval for smoke-and-mirrors transactions. The ritual was sort of like demanding someone's passport before he enters the country, but waving him through once he shows you a library card.
And when Enron whistleblower Sherron Watkins in 2001 suggested an investigation of suspect financial transactions, she specifically pointed out that Enron's favorite law firm, Vinson & Elkins, shouldn't do the investigating, since it had advised Enron on the transactions. So who did Enron's general counsel engage to investigate the transactions? Vinson & Elkins.
3. Extra Credit Suisse First Boston
Not that this will be any surprise, but Wall Street fell down on the job, too.
For example, Batson's report paints a depressing picture of Credit Suisse First Boston, which did banking work for Enron and was home to equity analyst Curt Launer, an Enron bull who had a strong buy on the stock until days before the company's Chapter 11 filing.
Launer and his research weren't necessarily problematic, according to Batson. After all, plenty of analysts were die-hard bullish on Enron.
No, the problem was how CSFB treated fixed-income analyst Jill Sakol, who wasn't quite so fond of the company.
Some of Sakol's Enron research was edited by a CSFB investment banker to present a more positive view of the company's debt, says Batson. Sakol, says Batson, was discouraged from publishing her progressively negative assessment of Enron even though she was warning CSFB bond traders of her concerns.
Elsewhere, an internal CSFB memo, dated October 2001, noted that Launer maintained a strong buy on Enron's stock -- while stating in the next paragraph that CSFB's internal credit team had decided that the firm's Enron-related credit exposure of $625 million "needs to be reduced to $500 million by the end of October."
"The Examiner Report's conclusions with respect to CSFB are based on aselective reading of the record," a CSFB spokesman said. "A fair reading of the entire record shows that those conclusions are unfounded."
Still, one might conclude, says Batson, that CSFB tried to bolster Enron and its stock by issuing positive research, while simultaneously basing its own investment decisions on more negative research.
4. Junior Analyst Miss
It turns out that Sakol wasn't the only Enron bear at CSFB. As we read in footnote No. 123 in Appendix F of the Batson report, another one was Andrew DeVries, an equity analyst at CSFB who evidently worked under Launer.
A month before Launer dropped his strong buy on Enron, here's what DeVries emailed to a buddy at J.P. Morgan:
Correct me if I'm wrong, but you have been speaking to a member of the coverage team at CSFB who has specifically told you NOT TO BUY it but to STAY AWAY from it all the way down from $45?
And here's what his buddy emailed back:
hey, how has your rating helped clients???
You're telling me one thing but clients a different story??? a little shady if you ask me.....strap it on, man!!! take a stand!!! afraid to lose the banking business??? are you an investment banker or equity research analyst???
Now, we don't look at this exchange as proof of misdeeds by DeVries, or by Launer. We don't know to whom on the CSFB team, if anyone, DeVries communicated this bearish opinion. Perhaps Launer engaged in a spirited, thought-provoking debate with DeVries, then overruled him. We weren't able to reach DeVries for comment.
What these emails do, however, is confirm our suspicions that a lot of folks knew, but no one told. For a lot of folks in the Enron universe, the company's collapse was no surprise. People saw it coming. They just didn't speak up.
5. Andersen of a Gun
Speaking of not speaking up, let's not forget Andersen. The defunct auditor's lax oversight of Enron, constant capitulation over accounting standards and lackadaisical attitude toward educating Enron's board about financial risk all enabled Enron to build its Potemkin village of a company.
As early as 1999, a senior Andersen accountant knew there was something fishy about the off-balance-sheet entities Enron was setting up. "Setting aside the accounting, idea of a venture entity managed by CFO is terrible from a business point of view," the accountant wrote to an Andersen partner. "Conflicts of interest galore. Why would any director in his or her right mind ever approve such a scheme?"
As Batson notes, accountants aren't responsible for their clients' business decisions. But there's no indication that Andersen disclosed the nature of these internally expressed concerns, or their intensity.
Two years later, the chief of staff of then-Enron Chairman Ken Lay had some useful advice for his boss. "We should do the economically rational thing in every transaction and business and let the chips fall where they may," wrote Steven Kean in an email. "Instead of tying ourselves in a knot about managing earnings or write downs or avoiding an asset sale because it's on the books for more than the market, we should just make the rational economic decision. ... If we make the economically rational decisions over and over, the stock price will come along."
Great idea. Too bad no one thought of it earlier.