Tipster Set Fund Scandal Snowballing

By Brooke A. Masters
Washington Post Staff Writer
Sunday, July 23, 2006

"I think you should investigate mutual funds," said a clearly nervous female voice.

The anonymous phone message, left with a staff lawyer for New York Attorney General Eliot L. Spitzer, touched off an intense investigation of the mutual fund industry in the summer of 2003. Spitzer, the ambitious prosecutor who had just nailed Wall Street investment banks for sending out biased stock research to investors, was looking for a new target. The $7 trillion mutual fund industry, which had been largely scandal-free for decades, was ripe for exploration, especially given the fees they charge investors for handling their money.

What follows is an inside look at how that investigation developed, based on interviews with Spitzer, his team and his adversaries.

* * *

"Doesn't this woman ever answer her phone?" Noreen Harrington thought to herself in early June 2003 as she tried once again to reach a live person at Spitzer's shop. This was positively the last time she was going to call. She had already left one cryptic message about mutual funds, and if the office couldn't follow it, that was Spitzer's problem. Harrington wanted to clear her conscience, but not enough to leave her number. Surely, five or six attempts to get through were enough.

Surprised when lawyer Lydie Pierre-Louis actually picked up the line, Harrington blurted out, "I'm that woman who was calling you about mutual funds."

"Oh, I'm so glad you called," Harrington remembered Pierre-Louis saying. "We really want to look into this, but we don't understand it. We want you to come in."

No way, Harrington thought. "I can explain it on the phone," she said and started talking in rapid-fire Wall Street fashion about "capacity," "market timing" and after-hours trading. Pierre-Louis was encouraging but sounded confused. Here Harrington was, reporting what she thought was a crime -- that small investors were being ripped off by hedge funds making improper mutual fund trades -- and the lawyer on the other end of the line didn't seem to get it. Eventually, Harrington was persuaded that she was going to have to do more, so she agreed to come into the office.

But when the day came, Harrington almost didn't make it through the lobby of 120 Broadway, the Lower Manhattan building that housed Spitzer's operations. So nervous that she hadn't even put the appointment in her datebook, she grew agitated when she was forced to stand in line to check in with security and almost walked out. Upstairs, Spitzer's lawyers were nearly as anxious. Could she be for real?

They peered down the hall at the elevators, waiting for the first glance of their tipster. When Harrington walked off the elevator, the excitement in the room was palpable. Trim, neatly dressed, with well-groomed graying hair, Harrington looked every inch the former Goldman Sachs trader that she said she was. "That doesn't look like a nut to me," deputy Investment Protection Bureau chief Roger Waldman said, half to himself.

It took the lawyers several interviews to understand and piece together Harrington's story. But in essence, here was what she had to say: She had been working for Edward J. Stern, the younger son of one of New York's richest and toughest business magnates, Leonard Stern, who had built a $3 billion fortune out of pet supplies and real estate. Since 2001, Harrington had helped the Stern family invest its money in a variety of outside hedge funds, largely unregulated investment pools aimed at wealthy people.

Her tip concerned another part of Eddie Stern's business, two internal hedge funds -- known collectively as Canary Capital Management -- that sought to make money by engaging in a practice known as market timing. In English, that meant they were trying to exploit the fact that stock prices changed all the time but mutual funds were priced just once a day. They would move millions of dollars into a particular mutual fund whenever they thought its prices were "stale" -- lagging behind the actual value of the underlying assets -- and then sell their shares as soon as the fund price caught up, usually within a few days.

CONTINUED     1              >

© 2006 The Washington Post Company