Mutual Funds Under The Microscope

New York Attorney General Eliot Spitzer, who has made headlines investigating Wall Street investment firms, has shifted the spotlight to the mutual fund industry.

At a news conference Wednesday, Spitzer announced a settlement with a hedge fund he says received unfair trading privileges at several big name mutual fund companies in an illegal arrangement investigators say is widespread and could be costing small investors billions of dollars.

The New York Attorney General said that under the terms of the settlement, the multimillion dollar hedge fund Canary Capital Partners LLC, and its managers, have agreed to pay a $10 million penalty and $30 million in restitution for illegal profits generated from unlawful trading.

In exchange for big money investments, Spitzer said, several mutual funds bent the rules applied to most investors and allowed Canary to make after-hours trades and short-term "in and out" deals. Canary allegedly arranged to make such trades with several leading mutual fund families - including Bank of America's Nations Funds, Janus Capital Corp., Strong Capital Management and Bank One Corp.'s Banc One Fund.

All four mutual fund companies named in Spitzer's complaint against Canary issued statements Wednesday saying they are cooperating with the investigation.

While saying that no formal charges have been brought against the mutual funds, Spitzer emphasized that his investigation, begun earlier this year, will continue and it is "a near certainty" that other mutual and hedge funds will be named.

The probe has "opened up a window on some of the practices used by the mutual funds that are detrimental to mom and pop investors," said Spitzer.

Late trading involves purchasing mutual fund shares at the 4 p.m. price after the market closes - a practice equivalent to "betting on a horse race after the horses have crossed the finish line," Spitzer said. Late trading is prohibited by New York's Martin Act and Securities and Exchange Commission regulations.

Under the settlement's terms, Canary did not admit or deny wrongdoing, and its officers agreed to cooperate with the investigation of the mutual fund industry. A statement from the firm said it agreed to the settlement "to avoid protracted and complex litigation."

Court papers filed by Spitzer's office charge that Canary agreed with certain financial institutions, such as Bank of America, that orders placed after 4 p.m. would nonetheless receive that day's price.

The New York attorney general says the Secaucus, N.J.-based firm obtained special trading opportunities with leading fund firms by promising to make substantial investments in various funds managed by the institutions.

Court papers state that Canary's most extensive late-trading relationship was with Bank of America. The complaint alleges that Bank of America installed special computer equipment in Canary's offices allowing it to buy and sell B. of A. mutual funds, including Nations Funds, at their 4 p.m. prices until 6:30 p.m.

"In return, Canary agreed to leave millions of dollars in Bank of America's bond funds on a long-term basis," the court papers said.

The lawsuit specifically accuses Edward Stern, a managing member of Canary Investment Management, of arranging the schemes to benefit his firm. Stern is the son of Leonard Stern, who ranked 80th on Forbes magazine's 2002 list of richest Americans with about $2.2 billion.

Spitzer says Stern has reached a preliminary settlement and has agreed that for the next ten years, he will not trade in mutual funds or manage public funds.

Also Wednesday, a source at Massachusetts Secretary of State William Galvin's office said that regulators there are investigating allegedly similar activity at Prudential Securities' Boston office.

Prudential spokesman Darrell Oliver said the company "had no information about any investigation."

Mutual fund companies state in their prospectuses that they discourage or prohibit "late trading" and short-term "market timing" by large investors. But investigators at the New York Attorney General's office say they have found evidence that some mutual fund managers have permitted certain companies to conduct such trades in exchange for payments and other inducements.

As he announced his investigation Wednesday, Spitzer displayed e-mails and documents in which the firms discussed the schemes. In an April 2nd e-mail exchange over whether questionable trades should be allowed, a senior official at Janus wrote, "I have no interest in building a business around market timers, but at the same time I do not want to turn away $10-$20 million. How big is the ... deal?"

According to Spitzer, the fees garnered by the mutual funds in return for allowing the trades were substantial - Bank of America documents showed the firm estimated it made $2.25 million per year from such relationships.

The New York attorney general also said academic research has estimated that mutual fund shareholders lose billions annually due to such trading abuses.

Timing is an investment technique involving short-term, "in and out" trading of mutual fund shares, which has a detrimental effect on the long-term shareholders for whom mutual funds are designed.

"To allow people in after the gates have closed, when everyone else has to get back in line for the next day, is clearly not fair," said Don Phillips, managing director of fund-tracker Morningstar Inc.

"It's also likely not a case of some rogue employee's practices," he said. "There had to be people very high up who knew what was going on. This is a real black eye for the fund industry."

SEC Chairman William Donaldson condemned the alleged misconduct as "reprehensible" and said it underscores the importance of the agency's current probe into whether the $600 billion hedge industry needs stiffer regulations to guard against conflicts-of-interest between hedge funds and mutual funds.

"There is too much money at stake for us to know as little as we know about these funds, in particular and how they operate," said Donaldson.
CBS MarketWatch reports the SEC says its recommendations on possible reform, based on a yearlong study, are expected to be made public sometime this fall.

Steve Strecker, a mutual fund investor who lives in Salem, Ore., said he is pleased regulators are moving to police the industry, but believes it will take harsh penalties to truly root out fraud.

"The real question from my perspective as an investor, and I'm the one who's getting shafted here, is are they going to throw the book at these guys?" said Strecker, 57, a retired technology executive. "If you're really going to control this kind of stuff, people are going to have to do hard time ... I think if they did that, a lot of this game-playing would just disappear."