Mutual / Hedge Funds Corrupt ??????Spitzer sets sights on funds
N.Y. attorney general probe includes Janus, Strong
By Luisa Beltran, CBS.MarketWatch.com
Last Update: 7:30 PM ET Sept. 3, 2003
NEW YORK (CBS.MW) -- Fresh from his showdown with Wall Street investment firms, New York State Attorney Eliot Spitzer on Wednesday turned his guns on the mutual fund industry.
Spitzer announced a potentially far-reaching probe of fraud and securities violations involving five companies, one of which - Bank of America - he said was "essentially being bought off."
Spitzer also announced a $40 million settlement with hedge fund Canary Capital Partners LLC.
Canary will pay $30 million in restitution as well as a $10 million penalty and has agreed to cooperate in Spitzer's investigation of the fund industry.
"The full extent of this complicated fraud is not yet known," Spitzer said in a statement. "But one thing is clear: The mutual-fund industry operates on a double standard. Certain companies and individuals have been given the opportunity to manipulate the system."
According to the complaint filed in New York State Supreme Court, Bank of America's Nations Funds, Janus Capital Corp., Strong Capital Management and Bank One Corp.'s Banc One Fund took part in wider schemes that allegedly bilked small investors out of tens of millions of dollars.
Spitzer said there is no formal complaint currently against the mutual funds, but he added that his office is continuing to investigate.
"There are many entities and actors involved in both sides," Spitzer said at a press conference Wednesday. "Our conversations will continue."
The investigation
Spitzer began scrutinizing the fund industry earlier this year. He called the settlement with Canary a "first step" in an investigation that will take some time.
From 1999 to 2003, according to settlement papers, Canary engaged in fraudulent schemes involving hedge funds.
Among the trading violations were deliberate late trades prohibited to regular investors. The daily price of mutual funds is calculated once a day, usually at 4 p.m. Eastern time. Any orders placed after 4 p.m. are supposed to use the following day's price.
Canary allegedly agreed with certain financial institutions, such as Bank of America, that orders placed after 4 p.m. would receive that day's price, according to court papers filed in the Supreme Court of the state of New York.
Secaucus, N.J.-based Canary obtained special trading opportunities with the leading fund firms by promising to make substantial investments in various funds managed by the institutions, Spitzer said.
Canary's most extensive late-trading relationship was with Bank of America, the complaint said.
Bank of America installed special computer equipment in Canary's offices that allowed it to buy and sell B of A mutual funds, including Nations Funds, at their 4 p.m. prices until 6:30 p.m. "In return, Canary agreed to leave millions of dollars in Bank of America's bond funds on a long-term basis," the court papers said.
The mutual-fund firms, Spitzer said, allowed the schemes because of the fees they pulled in. At one point, B of A broker Theodore Sihpol calculated that the bank was raking in $2.25 million yearly, according to an e-mail cited in court papers.
"Bank of America, in return for the fees it got, violated its fiduciary duty and was essentially being bought off," Spitzer said.
Kunal Kapoor, associate director of mutual fund analysis at MorningStar, said that the most serious allegations were against Nations Funds. If true, the mutual fund allowed Canary to trade after 4 p.m., while small investors were prohibited, Kapoor said.
"Mutual funds are supposed to be the one area where there is a level playing field between the big guys and the small guys," he said. "It really looks like this hasn't been the case."
Cooperating
The lawsuit specifically names Edward Stern, a managing member of Canary Investment Management, with arranging the schemes to benefit his firm. Stern is the son of Leonard Stern, who ranked 80th on Forbes magazine's 2002 list of richest Americans with about $2.2 billion.
Stern has reached a preliminary settlement and has agreed to not trade in mutual funds or manage public funds for 10 years, a Spitzer spokesman said.
Janus, in a statement, announced that it was cooperating with Spitzer's investigation. "Janus is reviewing the complaint closely and is committed to ensuring that the company continues to act in the best interest of Janus fund shareholders," the company said.
Janus (JNS: news, chart, profile) shares fell 5.5 percent to end at $16.88 Wednesday afternoon as Spitzer detailed allegations of the wrongdoing against it and other mutual-fund businesses.
Merrill Lynch analyst Guy Moskowksi said the sell-off of Janus shares was overdone. "It is important to note that Janus is not implicated in any of the post-4 p.m. NAV activity," Moskowski said. See full story.
Strong Funds and Bank of America also said they were cooperating with the investigation. Bank of America (BAC: news, chart, profile) shares fell 63 cents to close at $78 Wednesday. Bank One (ONE: news, chart, profile) also promised cooperation; its shares ended the day down 9 cents at $39.97.
"We are looking into the issues raised by allegations against the hedge fund," said Julie Crothers, spokeswoman for Bank One's One Group Mutual Funds. "We will cooperate fully with the attorney general's office."
Spitzer said he welcomed the involvement of the Securities and Exchange Commission, which had not been part of the current probe. "We would welcome working with them," Spitzer said.
SEC Chairman William Donaldson called the alleged conduct reprehensible. The SEC is looking into whether the $600 billion hedge industry needs stiffer regulations to stem conflicts of interest between hedge funds and mutual funds, among other things. See full story.
"Today's action further illustrates the importance of the SEC's ongoing review of both hedge funds and mutual funds and the SEC's upcoming recommendations regarding improvements and increased disclosure requirements for both," Donaldson said.
Rep. Richard Baker, D-La., applauded Spitzer's actions. "We should all be outraged to learn about fraud like this, and I commend the attorney general for helping to shine a bright light on the murky world of mutual-fund fees," said Baker, chairman of a House subcommittee that reviews capital markets.
Investors fleeced of billions
Academic research estimates that mutual-fund shareholders lose billions of dollars each year to trading abuses, Spitzer said.
Besides illegal after-hours trading, Spitzer's investigation uncovered improper exploitation of market swings between mutual funds and hedge funds at the expense of "ordinary long-term investors."
Where late trading is prohibited by federal regulators because, in Spitzer's words, "it allows a favored investor to take advantage of post-market closing events not reflected in the share price set at the close of the market," timing is a banned investment technique that employs day trades in and out of mutual funds.
Timing, too, has a "detrimental" effect on long-term shareholders, Spitzer said.
"Mutual-fund companies state in their prospectuses that they discourage or prohibit these practices, but evidence ... shows that mutual-fund managers permitted favored individuals and companies to engage in such trading in exchange for payments and other inducements," Spitzer said.
The move marks the latest effort by Spitzer to focus on conflicts of interest on Wall Street. In April, Spitzer, along with other regulators including the Securities and Exchange Commission, clinched a landmark $1.4 billion settlement with investment banks to clean up Wall Street research. See full story.
With William Galvin, Massachusetts' secretary of commonwealth, Spitzer recently announced a probe of Morgan Stanley's fund practices. In August, Massachusetts unveiled civil charges against Morgan Stanley (MWD: news, chart, profile) for encouraging brokers to sell in-house funds over third-party investments.