Back-office technology is now emerging as having played a role in the fund scandal, requiring fund companies to take a fresh look at their clearing systems.
New York Attorney General Eliot Spitzer's complaint against Canary Capital for conducting questionable trades in Bank of America Corp.'s mutual funds refers to "state-of-the-art" systems the bank's clearing unit, Banc of America Broker/Dealer Services, installed at the hedge fund.
But sources said that the software was more likely fairly old technology originating at one of the largest providers of trade-processing systems. Its installation at Canary highlights how important it is for back-office providers like clearing firms to guard against providing order-enabling technology to the wrong types of customers, they said.
The complaint discusses the "electronic ADP system," which sources in the clearing industry said probably refers to Automatic Data Processing's mutual funds routing system (MFRS). The processing giant's Web site describes MFRS as an order-entry vehicle for no-load mutual fund orders that gives users the ability to hold shares in an omnibus account with the fund. An ADP spokeswoman said that "because the SEC is involved," the company would not comment.
Omnibus accounts have been an important factor in many of the current fund-related issues because they net all the mutual fund orders and, in the process, eliminate customer-related information.
The MFRS software is said by sources to date back to the 1980s, and has few functions to control when or how trades are conducted, leaving those decisions largely to the user. The former head of a clearing firm said that MFRS was designed for use by a broker/dealer's order room, and that clearing firms have provided it to broker/dealer correspondents to use in that capacity. He added that an order-entry system with few controls is appropriate to give to broker/dealers, since they are registered at the Securities and Exchange Commission and are required to follow applicable regulations regarding trades.
On the other hand, the source said, an order-entry system allowing a firm's licensed brokers to enter trades typically has more controls, at least above a certain volume of trading, to enable the broker/dealer to monitor for questionable trading activity. A system permitting unregistered, unlicensed customers to enter orders into their personal accounts should have multiple checks and edits to control the types of trades and allow the broker/dealer to monitor those trades, the source said.
According to the complaint, executives at BoA's clearing unit agreed to give Canary, an unregistered customer, uncontrolled access to its mutual fund processing system, allowing it to submit orders without the bank's broker/dealer monitoring for transgressions.
Jonathon K. Lagemann, a principal with Lagemann Law Offices, could not cite a specific incident in which a clearer or other financial firm was successfully charged with providing inappropriate technology to customers. However, he described BoA's clearing unit's actions as contrary to securities law.
"If you want to place an order, you're supposed to be an agent of a registered broker/dealer. If a clearing firm allows unregistered customers to enter trades directly, and not through the broker/dealer, then you have a regulatory problem [because] it's knowingly allowing violations to occur," Lagemann said.
That alleged violation may explain why, in addition to a $375 million fine, the March agreement with the SEC required the bank to divest its clearing unit. The indictment against former BoA broker Theodore Sihpol charged he arranged to provide Canary with the ADP system in order to enter mutual fund trades as late as 8:30 p.m., and that he was the bank's go-between to Canary. BoA allegedly gave Canary permission to time the bank's Nations Funds mutual fund family, provided the hedge fund with $300 million in credit to finance those trades, and sold Canary short positions as the market dropped.
Mutual fund trades submitted after 4 p.m. based on the same day's price are widely viewed as illegal. However, Sihpol's attorney, C. Evan Stewart at Brown Raysman Millstein Felder & Steiner, said regulations do not mention a specific time and instead refer to setting the funds' net asset value, which is established once a day, usually well after 4 p.m.
Stewart also argued that Sihpol has been unfairly singled out from among a range of BoA executives involved in providing services to Canary.
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