As the saying goes, “bad facts make bad law.” But, depending upon the outcome of Janus Capital Group, Inc. v. First Derivative Traders, it may well be that bad funds will make good law.
The facts and issues underlying the Janus case are complex. Indeed, during oral argument on December 7, 2010, an exasperated Supreme Court Justice, Stephen Breyer implored Petitioners’ counsel: “[Y]ou have to explain it to me more. I'm not being difficult. I understand this less well than you think I do, and I want to know.”
Yet there is hope. After combing through the lower court opinion and Supreme Court briefs and listening closely to oral argument, things seem less opaque. The purpose of this post, then, is to share this effort -- to set out the case as simply as possible, articulate the points of confusion and project how the Court might rule in this case and the resulting implications.
The Stock Price Decline in 2003
On September 4, 2003, as described in the Respondent’s Brief, the stock price of Janus Capital Group, Inc. (“JCG”) declined by nearly 13%. And, by September 26, by nearly 24%. Why did the stock price plummet? The precipitating event occurred on September 3, when the Attorney General of New York alleged that illegal trading had taken place at big name mutual fund families, including Janus. The press release estimated that these “widespread illegal trading schemes . . .potentially cost mutual fund shareholders billions of dollars annually.”
Were Janus Fund Operators Two-Faced, Giving Big Players Special Treatment?
In time, it was revealed that the that operators of the Janus mutual funds (JCG and its wholly-owned subsidiary Janus Capital Management LLC) had between 2001 and 2003, allegedly given special treatment to 12 special investors and “lied” about it. Ordinary investors had to play by the rules set out in the official prospectus for the mutual funds. In contrast, the dozen favorite big investors struck secret deals.
For example, the dozen special investors were allowed to break the no market-timing rules. Market-timing can entail frequent round-trip purchases and sales of mutual fund shares. Investors hand over cash one day and in a matter of a day or days receive it back from the fund manager. The purpose of market-timing is to exploit the differences between the price of the mutual fund shares and the price of the underlying portfolio securities held by the mutual fund.
The pricing differences can most apparently occur with funds that invest in foreign securities. This is because most mutual funds calculate the share price (net asset value – or NAV) as of 4:00 pm (New York Time). The numerator for the NAV is the total value (total prices) of the securities and cash held in the portfolio (less liabilities) and the denominator, the total number of mutual fund shares outstanding. The prices used in the calculation are as of the time when trading closes on the New York stock exchanges. With such mutual funds, investors who put a purchase order in before 4:00 pm on a Wednesday, for example, will be issued shares at the NAV calculated using 4:00 pm prices on Wednesday. Investors who put their order in after 4:00 p.m. will be issued shares at the next available NAV, calculated as of 4:00 pm on Thursday. This is known as forward pricing. As part of the mutual fund scandals uncovered by the New York Attorney General, some fund families were allowing “late trading.” That was the practice of allowing some favorite investors to get an advantage by placing orders after the NAV was struck.
Market-timing is related, but slightly different from late trading. Let’s return to the example of a mutual fund with a portfolio of foreign securities. By Wednesday at 4:00 pm, foreign exchanges might have been closed for many hours. For example, Tokyo would have closed at 1 a.m. E.T. on Wednesday and with plans to reopen at 7 p.m. E.T. This means that when calculating the NAV on Wednesday as of 4:00 p.m., “stale” prices will used for foreign securities, such as those on the Tokyo exchange. Suppose if on Wednesday morning in NY, there’s news that would lead to the conclusion that particular foreign stocks or group of foreign stocks from one geographic region are going to rise. In that situation, a market-timer would place an order on Wednesday before 4 to buy mutual fund shares in a fund that specializes in the region. Since the share price calculated at 4 would have “low” prices for the foreign stocks, the market-timer would get a deal. Similarly, market-timers would place redemptions orders, to pull out money on a day when it was clear that the foreign stocks were overvalued at the most recent closing, many, many hours earlier.