Another casualty was added to the growing list of mutual fund criminals last Tuesday as a New York bank executive was hauled off in handcuffs for allegedly arranging $1 billion in financing for illegal mutual fund trades.
Paul Flynn, former managing director of equity investments at Canadian Imperial Bank of Commerce, was arrested near his home in Larchmont, N.Y., by officials from the office of New York Attorney General Eliot Spitzer. The 46-year old stock trader has been charged with five felonies for allegedly providing the financing for hedge funds that engaged in late trading and market timing of mutual fund shares.
The criminal complaint notes that Flynn "knew or was reckless in not knowing" about these trading improprieties. The list of charges includes two counts of grand larceny in the first degree, a class B felony; two counts of "violation of business law" and one count of "scheme to defraud."
As a result of his involvement in the trading scheme, Flynn is said to have pocketed more than $1 million that otherwise would have gone to the long-term shareholders in the funds that were timed. The action marks the first arrest related to banks' financing of mutual fund trades executed by hedge funds. If convicted of grand larceny, Flynn faces up to 25 years in prison.
At the arraignment in a Manhattan criminal court, Judge Larry Stevens deemed Flynn a flight risk, thereby forcing him to relinquish his passport to his lawyer and advised him to remain in New York.
"Our investigation has demonstrated that it took many players in the industry to make these schemes work," Spitzer said in a prepared statement. "This is the first case against someone who arranged financing so that late traders and timers could conduct illegal activities. This prosecution sends the message that those who arrange funding for illegal trading will be held accountable, as are those who make the trades."
Other cases that demonstrate the illicit relationship between investment banking funding and mutual funds and hedge funds are expected to be filed by Spitzer's office in the coming months. Bank of America was named in the original complaint filed against Canary Capital Partners last September for its role in financing similar schemes.
In a related action, the Securities and Exchange Commission brought civil charges against Flynn alleging he "willfully aided and abetted" the illegal late trades and deceptive market timing practices. "We are committed to punishing not just those who engaged in the trading, but also those who facilitated it," said Stephen Cutler, director of the SEC's division of enforcement.
The SEC has not brought any federal charges against Flynn, but if the allegations ring true, he will face stiff civil penalties, which could include hefty fines, disgorgement of any ill-gotten gains and possibly a lifetime ban from investment companies and the securities industry.
Karen Pennington, assistant regional director at the SEC's New York office, told Money Management Executive that the agency will continue to investigate CIBC and its employees, suggesting that Flynn did not act alone and may not be the only CIBC employee to be formally charged. Fraud charges are expected to be brought against CIBC in the coming weeks, according to a New York Times report citing those familiar with the matter.
The news comes after Flynn and another trader, Jeff Haas, were fired by CIBC in December as a result of an internal review of its trading operations. Robert Deutsch, a managing director who oversaw the two traders, and Keith Weillner, an attorney who worked closely with Flynn have also left the firm. Flynn's attorney, David Gendelman, could not be reached for comment.
According to the New York criminal complaint, "Flynn negotiated and structured swaps and loan agreements that provided the hedge funds with leverage of at least three to one to trade in mutual fund shares." Swaps are a hedging tool used to get around problems of exchange controls, and many hedge funds often use them because they behave like loans but prove to be more tax efficient.
Two of Flynn's hedge fund clients named in the complaint were Canary and Samaritan Asset Management. The two hedge funds placed trades through an electronic trading platform at clearing firm Security Trust Co.
Among the mutual funds that were timed in the scheme were the $4.9 billion MFS Emerging Growth Fund and the $9.3 billion Artisan International Fund.
In a memo kept as part of a 2001 due diligence review of Security Trust, Flynn explicitly outlined the benefits of its platform with respect to market-timing capabilities including submitting trades after the 4 p.m. close: "[A] pricing list is prepared by the company and submitted to our clients, who are then able to run their timing models against actual closing prices instead of the previous day before they submit trades."
The memo further explained the various methods used to mask the true nature of the trades thereby slipping past market-timing controls. The methods include traditional account-specific fund investing to keep account balances small, using different tax identification numbers to rotate ownership of the funds and "piggy-backing" 401(k) and retirement savings accounts.
In November, the SEC and the Office of the Comptroller of the Currency ordered the dissolution of Security Trust by March 31. The move came after Spitzer filed felony criminal charges against the former chief executive of Security Trust and two other ex-executives.
The CIBC trading desk reportedly has been linked to fund clients of Oppenheimer & Co. broker and former CIBC broker Michael Sassano, who regulators believe is a key player in the broadening mutual fund scandal. Although Sassano has not yet been charged with any wrongdoing, Spitzer's office has subpoenaed records from Oppenheimer to learn more about how Sassano made roughly $10 million a year in commissions by linking hedge funds with market-timed mutual funds. He remains a "person of interest" in the eyes of regulators.
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