Charles Schwab Finds Questionable Trades
San Francisco-based investment giant Charles Schwab Corp. said Friday that it had uncovered evidence of possible improper or illegal trading in some of the 3,000 mutual funds it sells, bringing the deepening fund industry scandal to the doorstep of a firm that has long portrayed itself as a champion of individual investors.
Schwab said it found evidence of a “limited” amount of late trading by mutual fund customers -- the illegal practice of buying and selling fund shares after the stock market’s closing bell, but at that day’s closing prices.
In addition, a “small number of parties” were allowed to trade rapidly in and out of the Excelsior Funds run by Schwab’s New York-based U.S. Trust unit -- a practice the funds discourage because it can run up transaction costs and siphon profits from long-term investors.
The questionable trading was unearthed during an internal probe launched in September after the Securities and Exchange Commission and New York Atty. Gen. Eliot Spitzer asked Schwab to turn over records of mutual fund trades from January 2001 to June 2003. Schwab said two U.S. Trust employees had been fired for trying to destroy evidence sought by regulators.
The revelations added a new wrinkle to the scandal sweeping through the $7-trillion mutual fund industry. Schwab is one of the best-known brand names in the securities business, and it is the first “fund supermarket” to be implicated.
The news also came at an embarrassing time for Schwab: On Friday, the firm was wrapping up its annual conference for nearly 1,000 investment advisors in its hometown.
Schwab is only the 35th-largest manager of mutual fund assets, but its clout in the industry stems from its leading role as a distributor of other companies’ funds to individual investors. More than 5,500 independent financial advisors use the firm’s online fund-trading service, and the firm had 7.6 million customer accounts as of last month.
The 30-year-old company has crafted an image as a West Coast maverick taking on Wall Street. Founder Charles Schwab became a familiar face thanks in part to a series of folksy TV ads aimed at small investors. Last year the firm mocked Wall Street salesmanship in a commercial depicting a brokerage executive urging workers to hype a lousy stock with the cry: “Let’s put some lipstick on this pig!”
In a note to clients Friday, Lehman Bros. analyst Mark Constant said such posturing could backfire as the fund-trading investigation unfolds. Schwab’s “self-professed, yet clearly debatable, objectivity and focus on the interests of individual investors” leaves the company vulnerable to “a potential media and/or regulatory frenzy,” Constant wrote.
On the New York Stock Exchange on Friday, Schwab’s shares sank $1.06, or 8%, to $12.26.
Other analysts say it was hard to gauge the potential damage to Schwab’s reputation because the details of what occurred at the firm were sketchy.
“Almost everybody in the industry is going to get sideswiped by what’s gone on in the last couple of years,” said Geoff Bobroff, a fund industry consultant in East Warwick, R.I. “For Schwab, the question is whether this was just some transactional problem or whether there was really a fairness issue in the way different customers were treated.”
Schwab said it was unclear whether it had been a victim of traders who figured out how to gain an edge, or whether its employees knowingly had helped those investors to the detriment of others.
“A very small number of trades may have been entered incorrectly against our policies,” said Schwab spokesman Greg Gable. “We are still trying to figure out the nature of the operational glitches. There is no evidence of staff trying to profit from the trades.”
Gable declined to name the mutual funds involved in late trading or quantify the number of improper transactions, but he said the traders were “professional” rather than individual investors. He wouldn’t reveal whether the traders were hedge funds, institutions such as pension funds, or other large investors.
Schwab said Spitzer’s office had subpoenaed trading records from U.S. Trust, where the rapid fund trading, or “market timing,” had taken place.
Though market timing is not illegal, it can harm long-term investors by running up a fund’s trading costs, which are shared by all of the fund’s investors. Investigators found that some fund firms had allowed favored clients to engage in market timing trades at the same time they had been discouraging the practice by most other customers.
U.S. Trust spokeswoman Allison Kellogg said Friday that the two employees dismissed from the firm’s institutional mutual fund sales group were fired for allegedly trying to destroy electronic evidence, which was recovered and given to authorities. She said the pair allegedly were involved in making arrangements with “a handful of institutional clients” that traded about half a dozen of the funds. She declined to specify the funds or traders but said the clients were not part of a hedge fund.
At Schwab itself, no disciplinary action has been taken against any employees, although the internal review is continuing, Gable said. Schwab has “strengthened its policies and procedures” to ensure there are no further problems, Gable said, declining to elaborate.
Schwab is the latest company to be ensnared in the mutual fund scandal, which began more than two months ago and has tarnished the likes of Putnam Investments, Bank of America Corp. and Janus Capital Group Inc. Putnam is the only firm charged by regulators so far. More than 40 fund company employees, including former Putnam Chief Executive Lawrence Lasser, have been fired or suspended because of the probe.
In an internal memo Friday, Schwab CEO David Pottruck told employees that violations of fund trading policy were intolerable, regardless of whether any Schwab employees profited.
“The good news is that based on the analysis we have completed to date, the issues we have identified appear to be limited in scope,” Pottruck wrote. “But that is also the bad news, because having even limited instances happen here at Schwab is simply not acceptable.”
