New York Atty. Gen. Eliot Spitzer’s office has notified mutual fund giant Strong Capital Management Inc. and its founder, Richard Strong, that they may face criminal fraud charges related to improper fund trading, a person close to the matter said Thursday.
The possibility of criminal action came as the founder said he would consider stepping down as head of the firm amid revelations that he engaged in the so-called market timing of Strong mutual funds, one of the key abuses at the heart of the worst scandal in mutual fund history.
“If it becomes appropriate, I would be prepared to step aside to enable new leadership to bring new energies to this company,” Strong, 61, said in a statement. A spokeswoman for the Menomonee Falls, Wis.-based company declined to comment further.
A criminal indictment of the firm would mark the first such action against a company in the mushrooming fund scandal, and the first against any financial services firm in the various scandals that have engulfed Wall Street in recent years.
However, it is unclear whether any criminal charges will in fact be brought against either Strong or the company he founded almost 30 years ago, and Spitzer said in an interview Thursday that he had not yet decided what steps he would take.
“We have said to everybody that we have ruled absolutely nothing out at this point,” Spitzer said.
The consideration of criminal charges follows Spitzer’s disclosure that Strong engaged in market timing of his own funds, thus making him the highest-ranking executive implicated in a scandal that grows wider by the day.
Industry observers were shocked this week when state and federal regulators filed civil securities-fraud charges against Putnam Investments and two of its portfolio managers over alleged market timing by the managers.
“If you told me a couple of weeks ago that you’d have a couple of fund managers at Putnam timing their own funds, I’d say that’s bad enough but it must stop there,” said Roy Weitz, a fund industry watchdog from Tarzana who runs the Fund Alarm.com Web site. “Now, to have the head of a company timing his own funds, it’s hard to imagine it could get worse than that.”
In another potential criminal action, Putnam disclosed Thursday that it had received a subpoena for documents from the U.S. attorney’s office in Manhattan.
Strong Capital said that its founder would reimburse the funds for any losses caused by his activities and that it was undertaking several reforms, including an expansion of its board of directors and the hiring of David Ruder, a former chairman of the Securities and Exchange Commission, to tighten its compliance policies.
Though Strong pledged to reimburse the funds and resign if necessary, the company also struck a defensive tone. It said that Richard Strong didn’t believe his trading was “disruptive to the funds,” citing “only a small number” of “next-day transactions.”
The statement stopped short of what Spitzer’s office had expected: an admission from Strong that his trading was improper, setting the stage for possible settlement negotiations.
Darren Dopp, a Spitzer spokesman, declined to comment late Thursday.
Spitzer’s office also is considering taking action against one other Strong executive, a portfolio manager who was timing one of the company’s funds, according to a person familiar with the matter. The company discovered the improper activity and barred the manager from trading the fund for personal profit, the source said.
Market timing involves the rapid purchase and sale of mutual fund shares in hopes of profiting from short-term market swings.
Though the practice is not illegal, Strong and many other fund companies discourage small investors from such trading, saying the profits are made at the expense of fellow shareholders.
A fund company executive who engaged in market timing while prohibiting other shareholders from doing the same could have violated securities laws.
Strong Capital has told Spitzer’s office that Richard Strong earned about $600,000 dating back to the late 1990s through market timing, but recently backed away from that estimate, a source said. Strong’s timing profits in the late 1990s may have exceeded $1 million, but the strategy appears to have cost him some of those returns during the recent bear market.
According to Forbes magazine, Strong is one of the richest men in the country, with a net worth estimated at $850 million.
“These people who control mutual funds are doing very well financially,” Spitzer said, “so why the necessity to go beyond what was there and play fast and loose with the rules?”
Strong’s timing eluded detection by the company’s so-called timing police, who monitor such activity, a source said. Much of Strong’s timing involved small-cap and mid-cap stock funds, the source said, and very little was done in international funds, which are a common target of market timers and were being closely monitored by the firm.
Strong Capital ranks 40th among U.S. mutual fund firms, with $28 billion in fund assets. The company manages billions more in private accounts.
Also Thursday, SEC Chairman William H. Donaldson told Congress that his agency should have done a better job overseeing the $7-trillion mutual fund industry and detecting trading abuses that may have harmed long-term investors.
“There’s no doubt about the fact that we can improve our methodology,” Donaldson told the House Financial Services subcommittee on capital markets. “We probably have not had the issue of market timing as high in our priorities as we should have.”
The SEC has lagged behind Spitzer in uncovering mutual fund trading abuses.
“We believe as a result of the net we cast, that the market timing and late trading issues are quite widespread,” Donaldson testified. “We’re still gathering data on this, but I think it’s more widespread than we originally anticipated.”
Commenting on the SEC’s oversight lapses, Spitzer said “heads should roll” at the SEC office responsible for mutual fund supervision.
While agreeing that the SEC’s oversight should have been more thorough, Donaldson said regulatory agencies should not criticize one another. “This should not be a competitive situation between regulators,” he said. “The spectacle of one regulatory agency criticizing another is not healthy.”
Bloomberg News was used in compiling this report.
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The threat of legal action against Strong Capital Management Inc. and its founder, Richard Strong, marks the third time in the last decade the firm has had run-ins with regulators. A summary:
July 1994 -- Strong and his firm were sanctioned by the Securities and Exchange Commission for allegedly making improper trades among the firm’s funds in the late 1980s and not disclosing conflicts of interest to investors. The company paid $444,300 to three of its funds as reimbursement but did not admit wrongdoing. The SEC also alleged that Richard Strong bought and sold securities for his own accounts at the same time the firm was recommending the securities to private money management clients.
June 1996 -- The firm agreed to pay $5.9 million to 101 pension plans to settle a U.S. Department of Labor lawsuit involving allegations related to the late-1980s trades in the 1994 SEC complaint.
September 2003 -- Strong was one of four mutual fund companies named by New York Atty. Gen. Eliot Spitzer in his investigation of improper trading in the fund industry.
Sources: Milwaukee Journal Sentinel, Times research
Los Angeles Times