WHAT DOGS CAN TEACH US ABOUT SECURITIES REGULATION: Why Fining Two Mutual Funds For "Window Dressing" Was A Mistake

By FRANK PARTNOY

Monday, Aug. 20, 2001

Critics of U.S. securities regulation should be hounding the Securities and Exchange Commission for imposing these fines. And anyone who owns stocks should be yowling at the SEC's apparent naiveté in dealing with companies that cook their books.

The SEC Finally Catches the Scent

The SEC seemed surprised to discover that "window dressing" occurs. But in fact, it is commonplace. And the "culprits" are not merely a few mutual funds. They include most major corporations.

Why is window dressing so omnipresent? Because the incentives to do it are too seductive to resist.

Imagine that you run a fund. Your performance is judged as of December 31. On that day, you decide to buy even more of a given stock that the fund already owns, hoping to pump up the stock's price, at least temporarily. The value blips upward, and the fund's performance for the year looks great. Shareholders are happy; you get a big bonus. Of course, there's that New Year's Day hangover, when the artificially inflated price dips back to its former level, but you decide you can worry about that later.

I believe window dressing is a direct and logical result of U.S. securities regulation, which requires end-of-quarter reporting. Major U.S. companies are required to disclose all material facts, including financial information, four times a year. That requirement naturally creates incentives to engage in window dressing, and virtually guarantees that most corporations will dress up their financial statements each quarter.

My Dog, Fletch: A Canine with the Mind of A Mutual Fund Manager

The easiest way to understand why is not to think from the perspective of a securities regulator, but rather from that of a dog.

When I'm watching over my yellow lab, Fletch, he is angelic, with the I-would-never-do-that gaze of a well-trained canine. But the second I leave the house, he's on the sofa, shredding another of my daughter's Teletubbies or eating a loaf of bread. Several high-quality Saturday evening television programs have documented the array of doggy misdeeds that occur when owners are away. Of course, most dog owners know this, and take precautions accordingly.

In this respect, at least, mutual fund managers are no different from dogs. When left unattended, they will be quite naughty — betting the farm, hiding losses, and manipulating prices. That's why the securities laws force funds to make disclosures about their investments.

However, because the laws require only quarterly disclosure, the funds have an incentive to misbehave during each quarter. They borrow too much or buy riskier investments than they should and then, at the end of the quarter, pump up the value of those investments. It was this type of portfolio pumping that led the SEC to act last Friday.

If you are not a securities lawyer or fund manager, you might think it sounds foolish to "look in" on a fund only once a quarter. And you might think it imprudent for regulators to tell fund managers precisely when they will be looking. It's not difficult to predict how any animal — human or dog — would respond to such incentives. How fast would you drive at night if cops ran speed traps only during the lunch hour?

Yet much of securities law is based on this notion of forced periodic disclosure. And this notion applies not only to mutual funds, but also to most large companies in the U.S. If you own stock in a U.S. company, it is more likely than not that the company is required by law to make certain disclosures — but only once every three months.

Pavlov's Dog and the Incentive Effects of Quarterly Disclosure

Consider the incentives created by these periodic requirements, which apply to all major corporations, not only to mutual funds. With some exceptions, material facts are disclosed to investors only at the end of a quarter. In turn, those disclosures drive the price of the stock.

Investors and analysts wait eagerly for quarterly earnings information and, to the extent that information is new, the stock price reacts immediately. Accordingly, if disclosure is more favorable and/or if performance numbers are higher, the stock price will go up. For managers with a fiduciary duty to maximize value for stockholders — and, more importantly, with bonuses and stock options that depend on the stock price — it is imperative that the quarterly numbers be as good as they can be.

Of course, some companies don't engage in window dressing, just as some dogs have never chewed a shoe. But in most of corporate America, it's playtime in between quarters. Pavlov's bell rings at quarter's-end, which becomes a time to shift revenues or costs, to push taxes or losses off into the future, or even to manipulate the price of stock.

When I worked as a derivatives salesman at Morgan Stanley, for example, my bosses said they routinely reduced their borrowings at the end of a quarter, only to increase them immediately thereafter. A cleaned-up company has higher ratings and greater investor interest, even if things are not as tidy for the other 361 days of the year.

Such practices are commonplace, and are a logical and expected result of mandatory periodic disclosure rules. When the SEC is away, the companies will play. Some might find these practices disturbing, but could anyone really be surprised? If so, that person's dog is probably licking a dessert plate as you read this.

A Problem with Periodic Disclosure Itself?

The debate about the merits of mandatory disclosure continues in the legal academy, but one issue that few scholars even consider — perhaps because it is so obvious — is the perverse incentive effect of forced quarterly disclosure. Many academics and practitioners are aware of "window dressing" practices, and to the extent that they consider them, it seems to me the majority opinion is that they are a necessary evil in a system of periodic mandatory disclosure.

If that is the case, should the periodic disclosure system itself be changed? Probably not, for there are few attractive alternatives to modern U.S. securities regulation. And the benefits of the current system seem to exceed the costs.

Some scholars advocate relying on companies to disclose material facts voluntarily, rather than forcing them to do so. But many others worry that companies will hide too much bad news, and that the markets will be less efficient as investors are forced to expend resources to uncover the truth about financial statements.

With improvements in technology, a continuous disclosure system might be possible, but most companies would be reluctant to show competitors too much information about their daily business functions.

The length of the three-month mandatory term could be shortened or lengthened, but it is difficult to know how much would be gained from monthly or biannual reporting, for example. And as long as reporting is periodic, the "window dressing" problem will remain: All that will change is when window dressing occurs.

Surprise, Surprise for the SEC

I had always assumed lawyers at the SEC — like most academics and practitioners — were aware of "window dressing" practices, and of how widespread they are. I assumed, also, that SEC lawyers nevertheless implicitly allowed these practices because they would be too difficult or costly to police, or because of a policy decision that they really did not cause any harm.

But recent press coverage of the August fines suggests, to the contrary, that folks at the SEC were shocked, shocked, to discover that window dressing commonly occurs. They brought cases against ABN Amro and Oechsle, only after the division of investment management was alerted that the practice was going on "to some extent." Gregory S. Bruch, an SEC enforcement attorney, was quoted as saying the SEC is concerned with any end-of-quarter conduct like this and will be looking very closely at it in the future.

The SEC's apparent misimpression as to the extent of window dressing may mean the two fines imposed last week are misguided. Slapping the wrists of a few funds by imposing minor fines, with no principals serving jail time, is unfair: Why were these funds picked out for punishment?

Punishing a few is also unlikely to deter the many others who engage in the same practices, unless fines are commensurate with the gains from window dressing. And there are no signs that the SEC intends a huge increase in the prosecution of such cases in the future, or that it would have the funds to do so if it wanted.

Publicizing a handful of prosecutions, as the SEC has done, is also misleading, for it sends a false signal that the misdeeds are under control, when in fact the practice is rampant.

Finally, the SEC's naïve attitude, in itself, is troubling. Were some SEC commissioners previously unaware of the extent of window dressing? Have enforcement lawyers at the SEC just now caught the scent? Will the SEC apply the same standards to corporations as it recently applied to mutual funds? And, perhaps most importantly, does Harvey Pitt, the new SEC Commissioner, have a dog?


Frank Partnoy is Professor of Law at the University of San Diego, and is the author of F.I.A.S.C.O.: Blood in the Water on Wall Street (W.W. Norton 1997).

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