A big offshore investment fund, beyond the easy reach of US regulators, starts pumping huge amounts of cash into American mutual funds.
Fund managers are accused of catering to this powerful investor at the expense of ordinary shareholders. Regulators scramble to attack the problem.
That, of course, is the outline of the drama that opened in September last year when Canary Capital Partners, an unregulated offshore hedge fund, was accused of using its financial muscle to get "market timing" privileges from fund managers that were not available to small investors.
But an almost identical scandal swept the fund business in the mid-1960s -- except that, back then, the role of the hedge fund was played by an impish scoundrel named Bernie Cornfeld. Those looking for remedies for the current scandal may find the Cornfeld tale instructive.
Cornfeld, who had frequent run-ins with regulators before his death in 1995, was best known for creating the first "fund of funds," a superfund that invested only in other mutual funds.
By 1964, that unregistered offshore fund was plowing hundreds of millions of dollars into domestic mutual funds. That made Bernie -- no one called him "Mr Cornfeld" with a straight face -- the most powerful, and worrisome, investor in the mutual fund world.
The smell of hot money was Bernie's eau de Cologne, and unregulated offshore status suited him best.
Federal law barred any regulated fund from owning more than 3 percent of any other fund, but by operating offshore, Bernie was exempt from that limit. By 1965, his fund of funds owned half of one popular mutual fund, and almost 30 percent of another.
It had big stakes in a fund run by Sir John Templeton, in the Wellington fund and in several Fidelity funds. That gave Bernie much more power over American mutual funds than regulators said he, or anyone, should have.
The Securities and Exchange Commission's solution, in a report to Congress in May 1967, was a proposal to prohibit the fund-of-funds concept entirely and to bar any fund, offshore or not, from investing in other American funds.
Bernie had left the American market to settle SEC charges, but regulators still had good -- indeed, prescient -- reasons to seek permanent change.
They worried about any single big investor exerting "undue influence" over the fund managers. And they fretted that mutual funds would have to hold such large amounts of cash to accommodate such investors that returns for other shareholders would suffer. These concerns, of course, mirror the issues raised by "market timing" hedge funds today.
In 1969, after Senator John Sparkman intervened to "grandfather in" a small existing fund called First Multifund of America, the SEC was forced to backpedal. While insisting that it still opposed the whole idea of a "fund of funds," it ultimately agreed to congressional amendments allowing unregulated funds to buy up to 3 percent of a regulated fund -- a limit that did not deter today's market-timing abuses at all.
Since then, even those weaker Cornfeld-inspired protections have eroded. The ban on the fund-of-funds concept has been lifted. And along the way, the very idea of building a fence to protect mom and pop's mutual funds from hedge funds and other Bernie-style investors was largely forgotten.
Should that fence be built today? Some former regulators say that the notion is worth considering.
The mutual fund is "fundamentally a retail product for the middle-income, average investor," said Richard Breeden, a former chairman of the SEC.
When hedge funds aim their cash in fire-hose fashion at the same funds that cater to smaller investors, "it puts a lot of pressure on the system," he said.
And building a fence would be preferable to the often-discussed notion of regulating hedge funds, said Kathryn McGrath, a lawyer and former federal fund regulator.
But, curiously, whether hedge funds and other institutional pools of unregulated cash should continue to have access to the mutual funds that cater to retail investors of modest means is not one of the questions that either regulators or lawmakers are asking in response to today's scandal. Somewhere, surely, Bernie Cornfeld is smiling.
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