There was no place of refuge for tainted mutual fund shop Pilgrim Baxter & Associates, as the company last Monday agreed to a $100 million settlement with regulators for engaging in abusive trading practices.

Under the terms of the deal, a joint effort by the Securities and Exchange Commission and New York Attorney General Eliot Spitzer, Pilgrim Baxter must reimburse harmed investors to the tune of $40 million and pay an additional $50 million in fines.

Slashing Prices

In a separate agreement with Spitzer's office, Pilgrim Baxter must lower management fees by 3.16% over the next five years, a reduction totaling $10 million. While the overall number may look small in comparison to some of the huge settlements we've seen previously in the scandal, the fine levied against the firm is actually greater than MFS and Bank of America when assets under management are taken into account.

"Pilgrim Baxter was an early and popular haven for some of the best known and most active market timers," said Ari Gabinet, district administrator of the Commission's Philadelphia office, in a prepared statement. "It's a large penalty for a firm of this size, one that balances the size of the firm against the amount of harm and the nature of the conduct."

In accordance with the settlement, the Wayne, Pa.-based fund complex is cooperating fully with regulators' ongoing efforts to prosecute the firm's ousted principals and founders of the PBHG funds Gary Pilgrim and Harold Baxter, who could be hit with criminal fraud charges.

Gabinet noted that the Commission staff was careful not to go overboard with the civil penalties. "If you put $150 million on the back of Pilgrim Baxter, you might not have a Pilgrim Baxter when you're done," he said in a telephone interview. He further added that the company has a lot of work ahead of it to try to attract investors back to Pilgrim Baxter funds. When asked if the scandal and subsequent settlement would kill the company's brand, Gabinet replied, "It's on oxygen." Gabinet is currently investigating at least a dozen other market-timing and late-trading cases.

Another stipulation of the settlement is that Pilgrim Baxter is required to implement a series of reforms including enhanced disclosure of fees and expenses, new standards for board independence and greater board and investment advisor accountability. The firm must also hire a senior officer whose responsibility is to ensure that its fees are reasonable and negotiated at arm's length.

Regulators brought the case against Pilgrim Baxter after discovering that from at least June 1998 through December 2001, the company allowed hedge fund Appalachian Trails to rapidly trade in and out of three PBHG funds, activity that was in direct conflict with the language of the prospectuses. The firm also struck a deal with brokerage Wall Street Discount Corp. that enabled its clients to market time PBHG funds. The kicker with the Appalachian arrangement was that Mr. Pilgrim held a substantial stake in Appalachian, an egregious conflict of interest. Pilgrim Baxter also provided WSDC customers with sensitive portfolio information, which was then used to facilitate the market-timing trades.

Magic Number

Spitzer once again managed to grab the spotlight by including a fee reduction as part of the settlement, an authority granted to the savvy attorney general under New York's Martin Act. But some suggest that he has gone too far in his efforts to clean up the fund industry and that perhaps, given the waning appeal of the scandal in the mainstream press, Spitzer is looking to further his political agenda by making an example out of Pilgrim Baxter.

"What really irritates me is that this is a number Spitzer just pulled out of a hat," said Max Rottersman, founder of, a New York research firm that examines fees for institutional clients "The 3.16% is totally arbitrary."

He argues that Spitzer came up with the $10 million figure to make the settlement an even $100 million, then used backwards logic to justify the amount. After arbitrarily pegging the fee cut at $10 million, Rottersman said, Spitzer took the roughly $70 million in management fees minus the expense waivers and multiplied it by five. Next, he suspects, Spitzer divided the number by 10 million to arrive at a percentage. The 3.16% of each PBHG fund was then calculated to add up to $2 million per year. Rottersman further suggested that had the SEC settlement been $88 million, Spitzer would have found a way to manipulate the numbers to reach the $100 million mark. "What they did is backtracked it from the $10 million, which is wrong," he said. (see chart showing the Pilgrim Baxter funds that will have their fees reduced, page 14).

A couple of the funds are not actually profitable, so to lower their expense ratios essentially is like taking money out of a bankrupt fund's pocket, Rottersman pointed out. He believes the best way to determine a fee reduction is to evaluate Pilgrim Baxter fund fees based on the industry average of companies similar in size. Fees should then be brought down to the complex-wide industry average or ratcheted down a notch below the average as punishment.

"This case proves that Spitzer doesn't really care about understanding the industry or doing anything in a logical fashion," he said. "He picks his targets, he picks his numbers, and he picks his punishments. He's judge, jury and hangman all in one."

A spokesperson for Spitzer's office, Paul Larrabee, told Money Management Executive there was no set mathematical formula for calculating fee reductions. He said that they take into account the amount the company would have profited, the nature of the transgression and the size of the company as a whole. Ultimately, it ends up in a negotiation. "We want the retail consumer to benefit in a way that is closer to that of the institutional [investor]," Larrabee said.

Set to Stand Trial

As for Mr. Pilgrim and Mr. Baxter, Larrabee declined to comment on the specifics of the case but conceded, "Neither is precluded from criminal prosecution at this time." The two men are set to stand trial in February 2006. Pilgrim Baxter has submitted a request to U.S. District Judge Harvey Bartle II that all depositions and related documents be kept from public view. Their attorneys could not be reached for comment at press time.

Old Mutual of South Africa, Pilgrim Baxter's parent company, reportedly expressed its dismay with the settlement and has said publicly it supports the prosecution of founders Pilgrim and Baxter. Pilgrim Baxter spokesperson Tucker Hewes declined comment.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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