March 5, 2021

Economix: A Lie That Was ‘Literally True’

Remember market timing?



Notions on high and low finance.

That was a financial scandal before Wall Street brought on the collapse of the economy. Some mutual funds allowed favored customers to trade mutual funds based on stale prices. In many cases, this involved funds that invest in foreign securities, where a lot of news may have happened after the stocks stopped trading in their home countries but before the 4 p.m. New York deadline. The effect is to transfer money from other investors in the fund to the market timers.

One example was the Gabelli Global Growth Fund, known as GGGF, run by Marc Gabelli, the son of Mario Gabelli, the founder of the Gabelli Funds. He told the fund’s board that the fund was diligently seeking to stop investors from market timing, and that was true, with one not-so-minor exception. He allowed a favored hedge fund to do it hundreds of times. That fund made money in the fund; other investors lost money. The hedge fund effectively paid off Gabelli by investing in a Gabelli hedge fund.

When market timing became an issue in 2003, the fund reassured investors that management was on the case, in a memo signed by Bruce Alpert, the chief operating officer of Gabelli Funds, that said market timers were really scalpers:

For more than two years, scalpers have been identified and restricted or banned from making further trades. Purchases from accounts with a history of frequent trades were rejected. . . . While these procedures were in place they did not completely eliminate all timers.

The Securities and Exchange Commission filed a civil suit against Mr. Gabelli and Mr. Alpert, only to have a federal judge, Deborah Batts, dismiss the suit. That judge concluded the letter was “literally true,” and thus not misleading. After all, some market traders were blocked, and the funds admitted that some succeeded.

On Monday the United States Court of Appeals for the Second Circuit reversed that decision, in a ruling by another district judge, Ned Rakoff, who was temporarily sitting on the appellate court:

“The law is well settled, however, that so-called “half truths” — literally true statements that create a materially misleading impression — will support claims for securities fraud.”

Judge Rakoff concluded that “a reasonable investor reading the Memorandum would conclude that the Adviser had attempted in good faith to reduce or eliminate GGGF market timing across the board, whereas, as Alpert well knew but failed to disclose, the Adviser had expressly agreed to let one major investor . . . engage in a very large amount of GGGF market timing.”

The case will thus be able to go to trial. But I find it amazing that this appeal was necessary. Given the facts as alleged by the S.E.C. (and the judge has to assume they are accurate in considering a dismissal motion), it is hard to imagine a less absurd conclusion than the one reached by Judge Batts.

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