By Brooke A. Masters
Washington Post Staff Writer
Thursday, September 4, 2003; E1
Several major mutual fund families cut special deals that allowed a New Jersey hedge fund to profit illegally from quick trades at the expense of ordinary buy-and-hold investors, New York Attorney General Eliot L. Spitzer said today as he announced that the hedge fund and its managers had agreed to pay $40 million in fines and restitution.
Spitzer alleged that Bank of America Corp., Janus Capital Group Inc., Strong Capital Management Inc. and Bank One Corp. all gave the hedge fund run by Edward J. Stern special trading opportunities in exchange for his promises to make substantial investments in their fund families. Stern, 38, is the son of a wealthy real estate magnate, and his Canary Capital Management LLC was started with family money.
Spitzer first drew national attention and irked the Securities and Exchange by attacking long-ignored conflicts of interest at the major investment banks. He recently turned his attention to mutual funds.
"This is a huge black eye for the mutual fund industry," said Leonard Rosenthal, a finance professor at Bentley College in Massachusetts.
Matthew P. Fink, president of the Investment Company Institute, the mutual fund industry's largest trade group, said in an interview that "if the allegations are true, they are pretty damning."
"We've always supported tough laws and strict enforcement," he added.
SEC Chairman William H. Donaldson said in a statement that the alleged conduct "is reprehensible and there is no place for it in our markets."
According to a 44-page complaint filed in New York state court, Bank of America allowed Stern to skirt a 1968 law that requires investors who buy mutual funds after 4 p.m. to pay the next day's price. This "late trading" allowed Stern to purchase mutual fund shares after major market announcements at prices that were set before the news broke.
"It's like betting on a horse race that ended yesterday. You know who won," Spitzer said in an interview.
In addition, the other fund families -- and Bank of America -- allowed Stern to exploit a loophole in the rules governing international mutual funds, Spitzer said. The practice of "timing" - - using time differences to make short-term profits -- is not illegal, but most funds say in their prospectuses that they discourage it because it siphons profits from other investors.
Spokesmen for the fund families, which have not been charged with wrongdoing, said they are cooperating with Spitzer's office and declined to comment further.
Stern's spokesman said in a statement that the fund, which had $730 million in assets at its peak, "decided to enter into a settlement to avoid protracted and complex litigation" and "admits no wrongdoing." Stern has agreed to cooperate with Spitzer and to stay out of trading mutual funds for 10 years. Spitzer's office is also working with other cooperating witnesses, officials said.
Nearly 95 million Americans -- including about half of all households -- own mutual fund shares, according to the Investment Company Institute. Many investors who lost money when the technology bubble burst were irate when they learned analysts had privately disparaged the stocks they publicly touted.
Now Spitzer's investigation suggests that some funds were winking at the practice of timing in exchange for financial considerations.
According to the complaint, the fund companies all had rules and statements in their prospectuses that purportedly discouraged timing. But the funds gave Canary explicit exemptions to time their funds in exchange for guaranteed investments. Mutual fund managers are paid a percentage based on the assets under management.
A Janus manager explained in an internal e-mail, "I have no interest in building a business around market timers, but at the same time I do not want to turn away $10-$20m!," according to the complaint.
Georgia State University finance professor Jason Greene said his 2001 study of timing found that the practice costs ordinary investors in international funds between 0.5 and 1 percent per year. Timers profit because mutual funds are valued once a day, at the close of business in the home country. They can take advantage of the time difference -- it is a trading day in Tokyo when it is night time in New York -- and the fact that international stock markets tend to follow U.S. markets. Thus, if investors expect Japanese stocks to rise overnight, they can buy an international fund priced in New York at 4 p.m. on Thursday and then sell the next day when the fund shares are repriced on Friday, making a quick profit.
"These mutual funds weren't just failing to enforce the rules that protect buy-and-hold investors. They were actually in bed" with the timers, said Greene. "It's the old story: The small investor is left holding the bag."
Meanwhile, industry officials predicted that Spitzer's announcement would exacerbate tensions between state and federal regulators that were apparent earlier this year as the two groups negotiated April's landmark $1.4 billion settlement with 10 major investment banks.
"This is another example of the competition between the regulators. . . . I'm sure they're burning up at the SEC right now," said an official at one of the major Wall Street firms who spoke on the condition of anonymity.
SEC spokesman Herb Perone said that the commission's own yearlong review of hedge funds is expected to be finished this fall. He noted that the staff has also been making recommendations for new mutual fund disclosure rules. Over the last three years, the SEC has brought 36 enforcement actions against hedge funds and 183 involving mutual funds and investment advisers, Perone said.
John C. Bogle, founder of Vanguard and a frequent industry critic, called Spitzer's allegations "a major scandal."
"Attorney General Spitzer ought to be in line for the mutual fund investor's medal of honor," he said. "We need people to clean this place up."
Staff researcher Richard Drezen contributed to this report.
