A headache for the mutual fund industry has developed into a migraine as Putnam Investments and two of its portfolio managers have been accused of market timing their own funds.

Massachusetts regulators and the Securities and Exchange Commission each filed securities fraud charges against the Boston-based fund shop last week, marking the first indictment in the widening market-timing scandal. The move is the latest in a string of allegations against fund firms for trading abuses involving international funds, an effort spearheaded by New York State Attorney General Eliot Spitzer. Under his direction, 88 mutual fund firms have received subpoenas regarding market timing and late trading. Roughly half of those firms admitted to having arrangements with one or more investors allowing them to move nimbly in and out of funds.

The civil actions allege that Putnam knowingly allowed market timing in its international mutual funds while failing to provide adequate disclosure of these practices in its prospectuses.

The Kicker

The real kicker for Putnam is that it knew that two of its managing directors and portfolio managers, Justin Scott and Omid Kamshad, were timing their own funds and took no remedial action. Scott and Kamshad used their investment expertise and responsibility to gain access to non-public information such as current portfolio holdings, valuations and transactions, the complaint said.

"Self-dealing is antithetical to the responsibilities investment advisors and their employees owe to mutual fund investors," said Stephen Cutler, director of the SEC division of enforcement.

Putnam responded to the allegations by issuing a statement saying that its compliance systems were not perfect, an obvious understatement. Still, the company maintained that it did not act fraudulently and has been cooperating fully with regulators. Putnam stresses that it did not receive any financial benefit from the timing arrangements and no late trading took place. The company promised to restore any losses that resulted from employee trading activity, and it will begin incurring a 1% short-term redemption fee on all of its global and international funds. Putnam did not return phone calls seeking further comment.

Putnam, a unit of Marsh and McLennan, conceded that it knew about the timing back in 2000, when it warned the two managers to curb their activities. Still, timing in those funds continued up until this year, according to the complaint. In fact, it wasn't until last week that Scott and Kamshad were given their walking papers, after it became clear that regulators were filing formal charges. Other investment professionals at the firm, including two that also traded in their own accounts, have been implicated in the complaint but not formally charged. All individuals named in the complaint "are on leave from Putnam and will no longer be managing money," the company said.

Nevertheless, the fact that the managers showed such blatant disregard for their fiduciary duty, yet the firm took no action, is indicative of how deep this scandal runs.

Joe Millionaire

The smoking guns in the case are a series of internal e-mails describing the nature of the trades and the dollar amounts that were exchanged. In particular, regulators pointed to round-trip trading activity in one of Putnam's retirement plans used by Boilermakers Union, Local 5, of New York. At least 28 members of the labor union made between 150 to 500 trades over a three-year period. One laborer racked up a million dollars by timing the Putnam Voyager Fund. Overall, each plan participant took in at least $100,000 during that time frame.

According to an e-mail exchange in December 2002, the 28 Boilermakers made up 2.9% of the total number of participants but represented 20% of the assets. Those same 28 individuals represented 99% of the exchanges in the Voyager fund, 99% of the exchanges in the International Growth fund and 98% of the exchanges in money market accounts.

"It's cheating," Massachusetts Secretary of the Commonwealth William Galvin told reporters at a press conference. "It's about creating a separate category of investors, who took advantage of the circumstances of market timing to the detriment of the average investor."

This raises the question about what the firm's compliance officers were doing while this illicit trading was taking place. There are two likely scenarios: One, the head of compliance brought it to the attention of management and was silenced, or the officer kept his mouth shut because he knew it would be an unpopular opinion. In either case, there was a gaping hole in the compliance system at Putnam and, in turn, turning a blind eye to market timing became the part of its culture.

"The problem is that there's no senior person at the board level who carries the voice and responsibility of audit or compliance," said Andrew Clark, senior analyst at Lipper of New York, a Reuters company. "Even if one were to raise an issue to the highest levels, there's no board representative. It has long been a mistake and continues to be a mistake." Clark went on to say that increasing the number of independent directors who serve on boards should be one of the top priorities for the fund industry (see related story, page 2). In terms of the fallout from this episode, he said that it is likely more folks will seek out a financial planner to actively monitor their investments.

That raises another question about why the SEC wasn't a more vigilant watchdog for fund shareholders. Peter Scannell, a former call center employee at Putnam, blew the whistle on the Boilermaker scheme back in February 2003, but his voice fell on deaf ears. A man sporting a Boilermaker sweatshirt subsequently assaulted Scannell with a brick outside his car, warning him to keep his mouth shut (see news item, page 4). When the case was eventually brought to the attention of Massachusetts regulators, they moved swiftly to issue a subpoena.

"I don't think the SEC is serious about looking out for the small investor," said Gary Gensler, former Undersecretary of the Treasury and author of The Great Mutual Fund Trap (see MME 10/14/02). "They address these things with modest proposals, [and] refuse to address themselves to the problem."

Gensler believes that the problem of market timing stems from failings of the current corporate governance structure. The SEC needs to address the problem by implementing new rules regarding the role and responsibilities of mutual fund directors, he said.

Market timing infects about half of the mutual fund industry, Money Management Executive has learned. In order to stamp out market timing, Gensler recommends that firms take their business elsewhere. For example, Nations Funds should fire Bank of America and seek an alternative provider, he said.

Until we see that tactic, expect the hits to keep on coming.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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