EXECUTIVE SUMMARY

* SINCE THE FIRST MAJOR MARKET-TIMING and late-trading scandal broke, a barrage of federal and state enforcement actions against funds has followed.

* LATE-TRADING IS ILLEGAL UNDER FEDERAL securities laws and some state statutes. It occurs when a mutual fund or intermediary permits an investor to purchase fund shares after the day's net asset value is calculated, as though the purchase order were placed earlier in the day.

* THE SEC HAS ADOPTED A NEW RULE requiring a fund to disclose in its prospectus and statement of additional information its market-timing risks; policies and procedures adopted, if any, by the board of directors, aimed at deterring market-timing; and any arrangement that permits it.

* THE SEC HAS PROPOSED A NEW RULE that generally would require all mutual fund trades to be placed by a "hard 4 p.m." Eastern time deadline.

* IN CONTRAST TO LATE-TRADING, MARKET-TIMING is not illegal per se. Problems arise, however, when the timing of trades violates the disclosures in the prospectus. This can cause so many buys and sells that the costs escalate and the fund is disrupted, to the detriment of its long-term shareholders.

Amid the financial accounting frauds and Wall Street's investment banking-analyst scandal, mutual funds stood out as an industry that played by the rules. The recent mutual fund trading scandals, however, have changed that perception.

Since the first major market-timing and late-trading scandal broke just over a year ago, there's been a barrage of federal and state enforcement actions against investment advisers who advise mutual funds. Many investment advisers serving mutual funds have been accused of fraud, and the SEC has issued a wave of new rules aimed at safeguarding shareholder investments. As fiduciaries, investment advisers should understand not only how the fund trading scandals operated, but the effects of the resulting investigations and regulations on the mutual fund investments they recommend. To learn how CPAs have dealt with client concerns about the scandals, see "When Investor Trust Is Shaken," page 38.

HOW MUTUAL FUNDS ARE STRUCTURED

Open-end investment companies, commonly known as mutual funds, do not issue shares in their funds for resale to other potential shareholders. Instead the shares must be purchased from, and sold back to, the fund itself.

Mutual funds are unusually structured. Most do not have employees but are overseen by boards of directors that, among other things, approve contracts with service providers to perform essential fund operations. The board typically approves contracts with an investment adviser to make appropriate investment decisions for the fund's portfolio, a transfer agent to administer shareholder purchases and redemptions of fund shares, and a principal underwriter to oversee the distribution of shares and payments for distribution, usually through intermediaries such as broker-dealers, banks and employee-benefit-plan administrators.

Placing oversight responsibility for a fund's proper operation with the board is not always simple. Frequently, the investment adviser organizes or sponsors the fund and recruits its board members. In practice this relationship has created a conflict of interest between the adviser and the fund under which the adviser sometimes has acted in its own self-interest at the expense of shareholders. According to the financial press, many of the participants in the fund trading scandals were executives, portfolio managers and employees of the investment adviser who personally participated in the fund trading scandals and made illegal profits, or permitted favored shareholders to do so in return for lucrative business arrangements.

PRICING FUND SHARES

Using accrual accounting principles, a fund calculates daily its expenses, the value of investments held in its portfolio and the number of fund shares outstanding. Generally, the fund's daily accrued costs are netted against the fund portfolio's value (including cash) to determine the fund's net asset value, which then is divided by the number of outstanding shares to arrive at the per-share net asset value, or NAV.

Typically, NAV calculations take place at 4 p.m. Eastern time every day the securities markets are open for business. The timing of the NAV creates a unique pricing dynamic. If an order to purchase or sell a fund share comes in at 10 a.m., that shareholder will not know the price until after 4 p.m.

THE CANARY SINGS

For decades this NAV methodology contributed to the mutual fund industry's reputation for reliability and honesty--until the "Canary" sang. The fund trading scandal broke when New York State Attorney General Eliot Spitzer filed charges against, among others, Canary Capital Partners LLC, a hedge fund manager, and some of its affiliates. The Canary case complaint rocked the industry by including allegations that certain mutual funds, with the help of intermediaries, had allowed late-trading, market-timing, or both. Since Canary, major investment adviser firms under contract to mutual funds have been charged with a variety of schemes, including some involving portfolio managers and founders of investment advisory firms.

Consistent with their fiduciary duty to clients, investment advisers should research federal and state records and fund filings to determine whether any of the mutual funds they have recommended to their clients are under investigation or charged with fraudulent activities, (see "Finding Funds Charged with Fraud," at right) or whether any shareholder class-action lawsuits have been filed. Advisers also should consider contacting the fund directly to get that information.

LATE-TRADING

Late-trading is illegal under federal securities laws as well as certain state statutes. It occurs when a mutual fund or intermediary permits an investor to purchase fund shares "late," after the day's NAV has been calculated, as though the purchase order had been placed before the NAV was calculated. For example, late-trading permits the investor to learn information after 4 p.m.--about public, potentially market-moving information (for example, key earnings releases, industry trend announcements and interest rate changes)--that more than likely will cause the next day's NAV to increase. In essence the late-trader is permitted to capitalize on new information by turning back the clock and placing a trade as though it had been placed before learning the new information. Once the market-moving news is reflected in the fund's share price and correspondingly increases the fund's NAV, the investor can sell the fund shares at a profit.

Late-trading requires the cooperation of the fund itself or an intermediary who assists in distributing fund shares. For example, the Canary case complaint alleged that Bank of America provided Canary with a trading terminal that made it possible to purchase or redeem shares of hundreds of different mutual funds at the trading day's NAV up until 6:30 p.m. In return, Canary agreed to maintain substantial deposits in fee-bearing Bank of America accounts.

The Canary case complaint also alleged that a little-known uninsured national banking association called Security Trust Co., an intermediary commonly used by third-party administrators of employee benefit plans to consolidate participant's mutual fund trades, also permitted Canary to late-trade through its accounts with mutual funds--as late as 9 p.m.

Broker-dealers also played a key role in allowing investors to late-trade. Some were time-stamping fund purchase orders before the day's NAV was set, but holding them back until some potential market-moving information was available after the market's 4 p.m. close. Then the investor would tell the broker-dealer whether to fully process the order or tear it up, depending on whether the information was likely to cause an increase or decrease in the next day's NAV.

In response to late-trading, the SEC has proposed a rule that would generally require all mutual fund trades to be placed by a "hard 4 p.m." Eastern time deadline. Public comments on this proposed rule have noted that this might require advisers operating in time zones other than Eastern time to place their trades much earlier in the day, before certain corporate releases, government economic data or relevant market information is readily available. Advisers should be watchful for any SEC action on this issue (see "New Regulations," page 35).

MARKET-TIMING