Qestions: What elements of unfairness (fraud, manipulation, unequal information, or unequal bargaining power) were evident in Richard Strong and Canarys use of market timing strategies? Please explain how long term mutual fund investors and overall financial markets could be negatively impacted by these strategies. Why would they be considered unethical? How might a utilitarian argue that this firing is unethical? What might a follower of virtue ethics say about this case?

Case: When Richard S. Strong founded Strong Capital Management (SCM) in 1974, he wanted it to be the Nordstroms of the financial industry, believing that this store provided the very best customer service. With this goal in mind, he built SCM into an investment company that by 2004 managed $33.8 billion in mutual fund and pension investments. In that year, though, SCM and Richard Strong came under scrutiny by the Securities and Exchange Commission (SEC) and the New York Attorney General for permitting market timingnot only by an outside investor but by Mr. Strong himself.

(Market Timing): Although stocks are difficult to predict, some investors make money by market timing, which is selling stocks within a few days of buying. Market timers are able to exploit inefficiencies in the market that occur when new publicly available information has not yet been reflected in stock prices. Such inefficient or stale prices are especially common with foreign stocks because of the large time difference between markets. Mutual funds are attractive to market timers because, unlike trades of individual stocks, which incur a brokers fee, many mutual funds charge little or nothing to put money in and take it out since they receive their return from a management fee on the amount invested. Rapid in-and-out trading (called round trips) hurts long-term mutual fund investors in several ways. For one, if a fund rises from the day before, when the market timers investment was made, and the trader cashes out quickly, the effect is to dilute the return to the other investors in a fund. If the market timers infusion of cash has not yet been invested in stocks, the earnings of the fund are due entirely to the money provided by the other investors. The market timer thus contributes nothing to the holdings that generate a funds earnings, and yet by putting millions of dollars into a fund for a day or two, the market timer gets a portion of that return. In addition, large inflows and outflows add trading and overhead costs, and if a fund manager has to sell stocks when a market timer withdraws funds, this could trigger taxable capital gains for all fund investors. Market timing is not illegal, but most mutual funds discourage or prohibit the practice because of the harm to long-term investors. SCM, like most mutual fund companies, encouraged long-term holding of five years or more and advised that market timing does not work. Beginning in 1997, SCM warned shareholders that frequent traders could be banned: Since an excessive number of exchanges may be detrimental to the Funds, each Fund reserves the right to discontinue the exchange privilege of any shareholder who makes more than five exchanges in a year or three exchanges in a calendar quarter. Like most other mutual fund companies, SCM also had timing police, who monitored trading activity for frequent activity, and from 1998 through 2003, hundreds of market timers were identified and barred from investing in Strong funds. When it was discovered that some SCM employees were market timing in their own accounts, the company issued a clear directive that the Strong funds were not to be used for short-term trading and that violators could have their trading privileges restricted.

(Company Policy): Any activity by SCM employees that would harm fund shareholders was also prohibited by the companys code of ethics, which was distributed to all employees. In his introduction to the code, Richard Strong summed up the three most important principles for dealing with clients: You must deal with our clients fairly and in good faith; You must never put the interests of our firm ahead of the interests of our clients; and You must never compromise your personal ethics or integrity, or give the appearance that you may have done so. Moreover, as chairman and chief investment officer of SCM and as chairman of the board of directors of the 27 investment companies that managed the 71 SCM mutual funds, Richard Strong had a fiduciary duty to serve the interests of all shareholders in the SCM family of funds. A fiduciary duty prohibits a person in a position of trust from gaining a benefit at the expense of those to whom the duty is owed.

(The Violations): Despite the companys policy on market timing, the code of ethics, and a fiduciary duty, Richard Strong engaged in market timing in SCM mutual funds, making 1,400 quick trades between 1998 and 2003, including 22 round trips in 1998 in a fund for which he was also a portfolio manager. In 2000, SCMs timing police detected the chairmans trading activity, and the general counsel spoke to him, noting that his trading was inconsistent with the companys stated position on market timing and its treatment of other market timers. After agreeing to quit market timing, he increased his activity, making a record 510 trades in 2001. In total, he netted $1.8 million and obtained higher returns than ordinary investors in the same SCM funds. In late 2002, Mr. Strong was presented with another opportunity. Canary Capital, a hedge fund headed by Edward J. Stern, sought permission to make market-timing trades in SCM funds. In return, Canary would make large investments in other SCM funds, including SCMs own hedge fund. Between 2000 and 2003, market timing in mutual funds and also late tradingan illegal activity in which traders were permitted to place orders after the official 4:00 p.m. close of the marketbecame epidemic, and Canary was one of the biggest operators. An SEC survey of the 88 largest fund companies found that half admitted to allowing market timers in their funds. By one estimate, market timing during this period cost long-term mutual fund investors $5 billion a year, which reduced the return to other investors by 1 percentage point. Hedge funds like Canary sought an agreement (called a capacity arrangement) to make a certain number of trades involving an agreed-upon amount of money during a fixed period of time. In return, the hedge fund would turn over a large amount of money (called a sticky asset) to be managed by the investment company. Canary had obtained a capacity arrangement with a large number of investment companies and banks, including Pimco Advisors, Alliance Capital Management, Invesco, Bank One, and, most famously, Bank of America, which provided Canary with its own computer terminal to place late trades. In addition, Canary gained access to the list of stock holdings in these companies mutual funds. This information, which was provided to other investors only twice a year, was essential for determining how a fund would perform. In 2001 and 2002, Canary was making so much money and attracting so many new investors that it was finding it more difficult to obtain sufficient capacity, that is, mutual funds that would permit market-timing trades. This success led to the firms downfall. In an effort to get the attention of Goldman Sachs, Canary hired a former employee, Noreen Harrington. Goldman Sachs was uninterested, and Harrington left in dismay when she discovered how Canarys money was made. She was not intending to blow the whistle until her sister complained about how much money she was losing in her mutual fund and how she would never be able to retire. I didnt think about this from the bottom up until then, Harrington said. A telephone call to the New York State Attorney Generals office started the investigation that eventually led to Richard Strong.