NEW YORK - New York Attorney General Eliot Spitzer's crackdown on alleged illegal trading schemes by four mutual fund companies with a hedge fund could wreak havoc on the mutual fund industry's insistence on its squeaky-clean image. The thought of fund companies cutting deals with arbitrageurs and market timers may be hard for investors to swallow. And if this potentially multi-billion-dollar practice is as widespread as Spitzer believes, it could have serious implications beyond the four firms named: Bank One Corp., Bank of America's Nations Funds, Janus Capital and Strong Capital.
"I think it's probably the most damning news we have heard about the fund industry in a while," said Kunal Kapoor, associate director of mutual fund analysis at Morningstar of Chicago.
"This is likely to get significant mainstream press and could bring increased asset management regulation chatter, which had recently begun to die down. Further, we don't believe for a second that [this] is an isolated case and expect to hear of more incidents as Spitzer does his thing," said Glenn Schorr, an analyst with UBS.
Roy Weitz, industry critic and publisher of FundAlarm.com, said this has the makings of the first major scandal in the industry and enforcers may have the smoking gun they need to prosecute. "The conduct alleged in the complaint is reprehensible and there is no place for it in our markets," said Securities and Exchange Commission Chairman William H. Donaldson, in a statement.
At issue here are two very specific activities that are generally detrimental to the interests of long-term mutual fund shareholders: late trading and market timing. A number of fund firms have violated the law by allowing certain investors to buy a fund at that day's closing price well into the evening hours, which is also known as late trading, Spitzer said at a press conference last Wednesday. In so doing, they shrugged their fiduciary responsibility to shareholders in order to line their own pockets, Spitzer said.
Late trading is prohibited by the Martin Act and Securities and Exchange Commission. "Late-day trading is like being permitted to bet on yesterday's horse races. You know who is going to win and even after the race is over, you're permitted to place a bet that will guarantee you make money," Spitzer said.
The investigation is looking into how mutual fund companies not only failed to prevent these activities, but how they actually were knowing accomplices that facilitated the acts in some cases and planned to profit from the events at the direct expense of their long-term shareholders.
At one point, Spitzer said bluntly, Bank of America was being "bought off." Spitzer held the conference to announce an action and $40 million settlement against hedge fund firm Canary Capital Partners, two related entities and Edward J. Stern, the managing principal of those entities. With the settlement, Stern has agreed to give his full cooperation to the investigation. Spitzer emphasized that the settlement was merely the first step in a larger investigation.
While Spitzer would not detail whether he expects to bring a monetary settlement against these firms and declined to characterize how widespread this problem is, he did say that jail time is a possibility for those found of wrongdoing. The Investment Company Institute was fairly quiet on the topic, issuing a brief statement, reading, in part, that "mutual funds and the ICI support strict compliance with and vigorous enforcement of the law on behalf of mutual fund shareholders." Several of the firms mentioned in the complaint offered one-line responses, indicating that they are fully cooperating with the attorney general's office.
"We have evidence of more widespread late-day trading than I would have ever suspected before we began this investigation, so I am startled that is the case," Spitzer said.
Spitzer said fees are at the root of the devilish deals. "The fees that were garnered by the mutual funds in return for this blatantly illegal behavior were very substantial." The Bank of America claimed it was making $2.25 million a year from these relationships, Spitzer said. "The reality, unfortunately, is that when the hedge funds went to the mutual funds and said, We would like to time your mutual funds,' rather than saying, No,' the mutual funds said, How much will you pay us?,'" Spitzer said.
Richard Garland, Janus International's chief executive officer, received an e-mail from a co-worker earlier this year asking him about accepting business from market timers, according to the attorney general's complaint. "I have no interest in building a business around market timers," Garland wrote, "but at the same time, I do not want to turn away $10 million to $20 million." He later gave the go-ahead for a deal worth as much as $50 million in April. The agreement was never finalized, though.
Exactly how prevalent these practices are in the industry, Spitzer wouldn't say. However, others think it's big. "I suspect this is pretty widespread," Weitz said. "I can't imagine that Strong and Janus are the only ones that are doing this."
Mercer Bullard, founder of shareholder advocacy group Fund Democracy, agreed. "When you use a stale price," which allows arbitrageurs to benefit from price discrepancies, "you do it knowingly or you do it recklessly. It's surprising to see mutual fund managers act so carelessly," Bullard said.
"These are some very large mutual fund complexes that a lot of people have their money with and they are not fly-by-night operators," Kapoor said. "If the charges are true, what they have done is completely unacceptable. This invariably undermines the principles of being a steward of someone else's capital."
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