Corporate Governance

Will Bad Funds Make Good Law?: Janus v. First Derivative Traders Part II

By Jennifer S. Taub

The market-timing stories are much more than allegations. According to the 4th Circuit, Petitioners Janus Capital Group, Inc. ('JCG') and Janus Capital Management, LLC ('JCM') have admitted that they "had, for years, entered into secret arrangements to allow several hedge funds to engage in market timing transactions in various Janus Funds." According to the SEC, one of the largest of the dozen special investors was permitted to make 500 trades totaling over $2.5 billion in purchases over less than two years, between 2001 and 2003. This market-timer kept as much as $263 million invested in Janus mutual funds in 2003.

And, it is clear, according to the 4th Circuit, 'The prospectuses for a number of the individual Janus funds stated that the funds had policies of discouraging market timing and that the funds engaged in measures to deter such behavior.'  Thus, the operators of Janus funds were two-faced, promising one practice, but allowing another.

Indeed counsel for Janus group Petitioners at oral argument stated that '[T]he policy says funds are not intended for market timing. The adviser allowed 12 traders to trade frequently.'

Does Market-Timing Harm Ordinary Fund Investors?

These trading practices can be very lucrative for the market-timers. However, they can interfere significantly with the fund portfolio managers. The behavior can dilute the value of the fund shares for ordinary, long-term investors.  As the 4th Circuit noted:

'Market timing has the potential to harm other fund investors by diluting the value of shares, increasing transaction costs, reducing investment opportunities for the fund, and producing negative tax consequences.'

Janus fund investors lost millions of dollars across 7 different funds due to these practices. And, as detailed below, were compensated through a $100 million settlement entered into between JCM and the Securities and Exchange Commission.

In addition to promising to prohibit market-timing, many of the Janus fund prospectuses assured investors that redemption fees would be charged to those accounts that withdrew cash from the fund after very recently investing. And, JCG charged those redemption fees for many of the Janus mutual fund investors. However, certain special investors were not charged redemption fees.

The no-market-timing-allowed language in the prospectuses was designed to attract long-term investors. The incentive to let some investors break the rules was that these big investors would promise to only trade rapidly with a small amount of money and would keep a much larger portion, in the hundreds of millions of dollars for the longer term in the Janus mutual funds.  Keeping the money in the fund meant bigger management fees for the Janus fund operator – JCG and JCM.

In other words, there were two sets of rules. One set of rules applied to ordinary investors who if they engaged in market-timing or rapid trading would have to pay fees for redemptions and/or would be blocked from the fast trading practices or even have their accounts closed. However, another set of hidden rules applied to the dozen big, favored investors. JCG through its subsidiaries secretly had fees waived and were not stopped from engaging in the trading that benefited them and hurt other fund investors.

And, most importantly for this case, owners of stock in the parent company JCG, had reason to believe that in running its mutual funds, JCG played by the rules set out in the prospectuses that it wrote for the funds it created, marketed, operated and controlled. 

Full post as published by The Race to the Bottom on January 11, 2011 (boomark / email).