Tipster Set Fund Scandal Snowballing

Brown set his law school interns to work, looking for information that would help bolster Harrington's story. One of them hit pay dirt, a mutual fund Internet chat room where investors trolled for "timing capacity" and promised to "pay top dollar." Among the many messages was a November 2002 exchange in which a Seth Fox at fundtiming@hotmail.com announced he was "Looking for timers who need Capacity" and received a Nov. 24 reply from an ejstern@canarycapital.com. "Run a very large timing pool. $2 Bn. Call me if this is for real. Don't waste my time if it isn't. ES." Both the phone number and the e-mail address traced back to the Stern family offices in Secaucus, N.J.

On June 30, 2003, Brown was ready to send out subpoenas. He called Nesfield's North Carolina home first and asked if he would accept a subpoena. Nesfield, who no longer worked for Stern, immediately called his former employer, partly to give him a heads-up and partly to find out if Stern would get him a lawyer.

Stern told Nesfield he was on his own. So the North Carolinian called Brown back and asked what the attorney general's office wanted. "I didn't do anything wrong," Nesfield reasoned. "So why am I going to act like I did? Spitzer has a reputation for doing the right thing." Nesfield then threw 16 boxes of documents and his laptop -- filled with trading records -- into the back of his Ford F-150 pickup and drove the nearly 500 miles to Manhattan.

The Trader Comes In

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After getting Nesfield's story, Spitzer's lawyers turned to Andrew Goodwin, a former Canary portfolio manager, who came to their offices with his lawyer. A short and solidly built redhead, Goodwin had been Canary's whiz kid, setting up the computer programs that used statistical models to determine when Stern's team should put its money in or pull it out. He also had been forced out of Canary in December 2001 over a dispute about the way he had handled an e-mail containing salary information. Now the investigators had a former insider who could confirm Harrington's allegations.

Much of what Goodwin said also appeared in the documents that were rolling into the office from Bank of America, Janus Capital Management and the other fund families that Brown had subpoenaed. But it was the 11 hours of interviews with Goodwin that brought these operations to life.

"Absent him stepping up and saying, 'It is real,' I think we still would have had some doubts about the case at that time," Brown recalled. "I was absolutely astounded that the mutual funds would allow this."

As Brown reconstructed events, Canary traders had made hundreds of after-hours mutual fund trades through Bank of America, at first manual trades they phoned in to a broker named Theodore C. Sihpol III and then through Canary's own dedicated computer terminal, which allowed the hedge fund staff to enter trades directly into Bank of America's clearing system until 6:30 p.m. -- this was the "box" that Harrington had seen. To Spitzer's team, the manual trades sounded blatantly deceptive. Sometime before 4 p.m., Canary would call Sihpol with a list of proposed trades, and the broker would write them down on order tickets stamped before 4 p.m. Then, after the markets closed, a Canary employee would call back and tell Sihpol which trades the fund wanted put through, and the broker would put the other order tickets into the wastebasket. (Sihpol was later acquitted of criminal charges but settled with the Securities and Exchange Commission.)

Goodwin had been anxious about the legality of the late trades long before Spitzer's office called. But Stern brushed off his concerns, saying, "I have an expert SEC lawyer who has confirmed that the mutual funds don't like it but we can do it." Eventually, the young trader demanded and received a written guarantee that Canary would cover his legal costs if he were sued for his role in the hedge fund's mutual fund trades.

Even as they interviewed Stern's former employees, Spitzer's lawyers were also applying the screws to the fund companies and the brokers who had worked with Stern. Fresh from the stock analyst investigation, Spitzer felt that the office needed to keep up the pressure and not allow the investigation to lag.

Unlike the investment banks that had been the Spitzer team's last target, the Stern family took the attorney general's office seriously from the outset. Eddie hired Gary Naftalis, a top Manhattan criminal defense attorney who quickly realized the danger his client was in. Though late trading had never been prosecuted, New York's Martin Act of 1921 was so broad that it would probably allow Spitzer to bring criminal charges against Stern.

Within weeks, Naftalis made clear to Spitzer that Stern was interested in a deal. From Spitzer's point of view, Stern had much to offer. He had the goods on dozens of mutual fund firms and brokerages.

When Eddie Stern finally showed up in Spitzer's office on Aug. 5, he was a far cry from the confident son of privilege who had assured Harrington and Goodwin that they had nothing to fear from the regulators. Visibly nervous, Stern lingered in the doorway of the Investment Protection Bureau's 23rd-floor conference room, as if resisting his lawyer's plan for him come in and tell all. When asked questions, he mumbled, looked down and began to sweat.