Spitzer Fund Abuse Probe Pumps Out More Subpoenas

September 5, 2003 (PLANSPONSOR.com) - The New York state attorney general's office has expanded its latest probe into improper trading - market timing - by subpoenaing records from a number of large hedge funds and mutual fund companies.

Subpoenas seeking data about mutual fund trading activity went to The Vanguard Group, the nation’s second-largest fund company measured by assets (behind Fidelity Investments), and Invesco Funds Group, a unit of Amvescap PLC, another large fund group, according to a Wall Street Journal report. Also getting a call for documents was Millennium Management LLC, a hedge fund with $4 billion in assets.  Millennium, Vanguard and Invesco told the Journal they were cooperating in the probe.

There is also word that the US Securities and Exchange Commission (SEC) is ramping up its investigation.

So far, only one hedge fund has been charged with any wrongdoing. But in reaching a settlement Wednesday with Canary Capital Partners LLP, New York Attorney General Eliot Spitzer said additional cases alleging abuses in fund trading were almost a certainty.

In the complaint, filed this week in a New York state court, Spitzer accused Canary of arranging with Bank of America Corp. to do mutual fund trading after the market had closed and then moving the shares the next day for a profit.

Spitzer also accused Canary in the complaint of frequent in-and-out “timing trades” at the mutual funds, which, for example, take advantage of differences between closing prices of stocks overseas and the mutual fund’s later closing value. While this activity isn’t against the law, most mutual-fund companies prohibit it as costly to other fund investors. Canary settled the charges and agreed to pay $40 million in fines and restitution, without admitting to any wrongdoing.

While just four mutual-fund companies are currently named as part of Spitzer’s lawsuit, Canary potentially had access to trading with thousands of different funds through the facilities of Security Trust Co. of Phoenix, according to the Journal. STC provides an electronic system to handle mutual-fund trades for participants in retirement plans as well as institutional investors and financial advisers.

Spitzer alleged that STC gave Canary the ability to trade funds as late as 9 p.m. Eastern time at prices that shouldn’t have been available after the 4 p.m. close of market trading. Such trades were so profitable to Canary that STC eventually demanded and received 4% of Canary’s gains, Spitzer charged.

Grant Seeger, STC chief executive, declined to comment on the details of the attorney general’s lawsuit to the Journal, except to say that STC was fully cooperating with the investigation. STC wasn’t charged with any wrongdoing in Spitzer’s complaint.

On Wednesday,   Spitzer contended that four mutual-fund groups — units of Bank of America and Bank One Corp. as well as Janus Capital Group Inc. and Strong Capital Management Inc. — agreed to give Canary manager, Edward Stern preferential treatment, allowing Canary to buy and sell fund shares at prices not available to other investors.

None of the fund companies were charged with any wrongdoing. Two types of trading violations were alleged: Late trading, or buying mutual-fund shares after the market close at that day’s closing price; and timing, which involves taking advantage of market-moving events after the close of the market, when the funds’ daily price is set based on the net-asset value of the portfolio.

Also in the Journal report was word that the SEC plans to send letters to mutual funds holding about 75% of assets under management in the US to inquire about their practices on market-timing and their fund-trading practices in general, according to people familiar with the matter. Similar letters will be sent to some registered brokers who sell mutual funds to investors, they said.

But the SEC insisted it hasn't been caught unaware about problems in the hedge- and mutual-fund industries, although officials said the agency hadn't been looking into the market-timing problems alleged by Spitzer in his complaint against Canary and Stern.

SEC enforcement chief Stephen Cutler Thursday praised Spitzer's aggressive action in pursuing the mutual-fund case, telling the Journal that there is room for both federal and state regulators to act in investors' best interest. "God bless Eliot. He got the tip, and he pursued it," Cutler said after announcing an enforcement action against a major securities firm, Goldman Sachs Group Inc. "I view what Eliot did as for the benefit of the investing public."

Targets: Subpoenas Received

In confirming it had received a subpoena for information, a spokesman for Millennium, one of the largest hedge funds, told the Journal that the firm "did not engage in after-hours trading as described in that complaint" by Spitzer. As one of its numerous strategies, Millennium does do permissible timing trades in mutual-fund shares, allocating as much as $1 billion to that arcane trading area, according to people familiar with the fund. At times, the strategy returned 25% and accounted for as much as $250 million in profits, a huge part of the fund's performance, these unidentified sources told the Journal.

Invesco runs several funds in which Stern placed late trades to buy and sell, according to a copy of one evening's orders obtained by Spitzer's office. On the evening of January 13, Stern placed late trades through Bank of America's trading system for the Invesco Health Sciences and Invesco Dynamics funds. He also placed orders for the Alliance Growth and Income Fund and the MFS Research Fund , the document shows. The fact that Stern bought and sold shares of funds didn't automatically mean that he had agreements with those companies to engage in these timing trades.

The Bank of America system would enable his fund to trade with any of the hundreds of funds in the system. However, investigators say that large and frequent trades would likely gt spotted by the fund companies. A spokesman for AIM Investments, an Amvescap subsidiary whose affiliates include the Invesco Funds group, said that Invesco was contacted by New York officials "in connection with its inquiry on certain mutual-fund industry practices." But the company declined to comment on specific trades and said it is a company policy not to comment on legal matters. The spokesman said Invesco is cooperating with the inquiry.

Vanguard's spokesman said the company recently received a subpoena but declined to comment further. A spokesman for MFS Investment Management and Alliance Capital Management Holding LP declined to comment.

Ongoing SEC Mutal and Hedge Fund Probes

The SEC has been focusing on potential abuses in the mutual-fund and hedge-fund industries for several months. But the agency has been looking more broadly at conflicts of interest and whether investors are getting adequate information from funds. In fact, the SEC is expected to issue new rules aimed at improving disclosure and curbing fraud in coming weeks (See  SEC Widens Hedge Fund ProbeSources: Fund Probe Uncovers Widespread Discount Problems  ).

One area of heavy focus for the SEC has been determining whether conflicts exist in the way Wall Street brokerage firms are compensated when selling mutual funds.

The SEC, which requested documents from more than 15 brokerage firms, has discovered such conflicts, including undisclosed incentives given to brokers in exchange for selling particular funds over others, according to people familiar with the probe.

A separate investigation into hedge funds has also been tracking how those investment vehicles work and the relationships that the funds have with brokerage firms. The commission, which plans to release its hedge-fund report by the end of the month, is expected to require hedge funds or their investment advisers to register with the SEC. Right now, hedge funds aren't regulated by the SEC, though the agency can pursue fraud cases against them.

Meanwhile, the Massachusetts Securities Division, which has been investigating mutual-fund sales practices at brokerage firm Morgan Stanley, said it was also looking into instances of market-timing at Prudential Financial Inc.'s Prudential Securities. At issue is whether Prudential brokers in the Boston office were timing mutual funds and then evading fund companies' efforts to block their rapid trading by switching internal identification numbers that are used to track which brokers are placing the trades.