On Sept. 3, 2003, then New York State Attorney General Elliot Spitzer filed a complaint against New Jersey based hedge fund. Canary Capital Partners. The complaint alleged that Canary Capital entered into illegal agreements with multiple, nationally known mutual fund companies to defraud investors. Here we’ll take a look at what Canary Capital did, how it affected investors and why they were caught off guard.

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The Issues

The fraud involved the following two issues:

Late trading is an illegal practice that the U.S. Securities and Exchange Commission (SEC) defines as placing orders to buy or redeem mutual fund shares after the time a mutual fund has calculated its net asset value (NAV), usually 4pm EST, but receiving the price based on the prior NAV already determined that day. Canary Capital traders would listen to news that was released after the market closed and then use that information to make buy and sell decisions.

For example, if IBM released an announcement at 4:05pm EST about record earnings, the traders at Canary Capital assumed that the price of IBM’s stock would rise when the market opened for business the next day and close higher at the end of the trading day. Canary Capital would identify a mutual fund that had a large position in IBM and then contact the fund company to make a purchase. Canary Capital locked in guaranteed profits by trading after the market. Making numerous trades in this manner resulted in astronomical profits.

Market timing is an effort to predict the up or down direction in which the financial markets will move in order to make profitable trades. This practice is not illegal, but many mutual fund companies specifically forbid it in their prospectuses by mandating that a fund cannot be bought and sold within a certain time period, such as 30 days. Banning market timing makes it easier for mutual fund managers to manage their portfolios because the portfolios won’t be subject to the rapid influx and outflow of cash necessary to facilitate short-term trades. Banning the practice also keeps the fund’s trading costs down. The same fund companies that wrote prospectuses forbidding market timing permitted Canary Capital to engage in the practice. While not illegal, permitting some investors to engage in this practice while excluding others is certainly unethical.