By Brooke A. Masters and Carrie Johnson
Washington Post Staff Writers
Tuesday, August 29, 2006
A subsidiary of insurance giant Prudential Financial Inc. agreed yesterday to pay $600 million in fines and restitution to avoid being prosecuted on charges that it helped favored customers make improper mutual fund trades.
The settlement is one of the last and biggest to stem from the 2003 mutual fund scandal uncovered by New York Attorney General Eliot L. Spitzer and the first to include federal criminal charges.
Spitzer's revelations that mutual fund firms had cut secret deals with big investors known as hedge funds shook the $9.3 trillion industry and sparked a host of investigations. Over the past three years, the Securities and Exchange Commission has brought more than 90 civil cases involving market timing and late-trading abuses and has collected more than $3 billion that will be returned to investors, SEC enforcement director Linda Chatman Thomsen said at a news conference announcing the Prudential settlement.
Prudential's brokerage subsidiary, now known as Prudential Equity Group LLC, admitted criminal wrongdoing, but prosecutors agreed to drop the charges if the firm stayed out of trouble for five years. The company said it had set aside sufficient reserves to cover the $600 million payment, but the size is significant. Prudential's financial services businesses reported a second-quarter profit of $424 million.
Three former employees of Prudential's Boston office also pleaded guilty to federal criminal charges of inventing identities and accounts to help customers circumvent rules against market timing -- industry slang for rapid in-and-out investments in mutual funds. Prudential's management received more than 1,000 letters and e-mails complaining about the improper trades but failed to address the problem or discipline the brokers involved, Thomsen said.
Market timers exploit the fact that mutual funds are priced once a day. They buy a fund when they think the constantly fluctuating value of its underlying stocks is greater than the once-a-day price reflects and then sell it a few days later.
Many fund companies forbid the practice because the rapid turnover cuts into long-term returns by forcing managers to keep more of their funds' assets in cash and also because the rapid turnover can make it hard to stay focused on an investment strategy.
The payment is the largest by a single company to resolve market-timing charges, Deputy U.S. Attorney General Paul J. McNulty said. In 2004, Bank of America Corp. agreed to pay $675 million, including fee cuts, to settle allegations of improper market timing and illegal after-hours trades, but that settlement also covered allegations against FleetBoston Financial Corp., with which it had just merged.
McNulty said the Prudential scheme was particularly egregious because mutual fund investments, the main way Americans save for retirement and education, "have become a necessity" and "represent a large portion of the life savings of the average American."
Under the terms of the deal, Prudential Financial will be required to make periodic reports about its compliance with securities regulation to its audit committee and to Michael J. Sullivan, the U.S. attorney in Boston, who said yesterday that the deceptive practices "undermined the integrity and utility of the automated, standardized mutual fund trading system."
Of the $600 million payment, $300 million will go to the U.S. Treasury; $270 million will go into a fund controlled by the SEC and ultimately will be returned to investors; $25 million will go into a Postal Inspection Service consumer fraud fund; and $5 million will go to Massachusetts, which took a lead role in bringing the case against Prudential in 2003.
The settlement "points up the importance of scrutiny of the industry," said Massachusetts Secretary of the Commonwealth William F. Galvin. "This was pretty notorious."
Prudential chairman and chief executive Arthur F. Ryan said in a statement, "we take these matters very seriously and regret the conduct of some former employees that led to this problem."
Between 1999 and June 2003, authorities said, Prudential brokers used false accounts and phony identities to help their hedge fund clients evade detection by the mutual fund companies that were trying to crack down on the frequent trades.
The brokers used more than 750 customer accounts to process transactions, including more than 100 for one client alone, securities regulators said. At least two dozen brokers at Prudential took part in the scheme, which reaped $57 million in commissions for the company between 2001 and 2003. The hedge fund clients profited by more than $100 million during that period, according to court papers.
SEC officials also filed a separate, civil lawsuit against four former Prudential brokers in federal district court in New York yesterday. A related market-timing case against six other onetime Prudential employees was lodged nearly three years ago.
Law enforcement authorities said the criminal investigation continues into other unnamed people and entities that may have taken part in the abusive practices. Thomsen said the agency "still has some matters in the hopper." Still, she said, "my view is we will see far less of this conduct on an ongoing basis."
Deferred prosecution arrangements such as the one Prudential agreed to have become increasingly common, as regulators and prosecutors have sought to punish corporate wrongdoing that involves more than just a few individuals. Since accounting firm Arthur Andersen's 2002 indictment and subsequent collapse, prosecutors have been reluctant to press charges against large public companies for fear of putting them out of business. This is the second time Prudential has struck a deferred prosecution deal: In 1994, it paid $330 million in restitution to avoid prosecution on charges of defrauding 100,000 investors through the sale of limited partnerships.
"It's great to see the government stepping up and getting substantial settlement sums," said James D. Cox, a professor at Duke University School of Law. "The problem in these cases is, the wrongdoing is clear, but it's very impressionistic what the damages are. The task for government regulators is, at what level does it say 'ouch' with enough force? I think $600 million comes close to a very loud 'ouch.' "
Cox pointed out that courts have been reluctant to allow investors to proceed with private lawsuits stemming from after-market trading practices. That makes regulatory action all the more important, he said.
"It's really heartening to see government doing what government ought to do . . . which is step up and take ill-gotten gains from those who have misbehaved."