Mutual Fund Firms Face Favoritism Probe

New York Atty. Gen. Eliot Spitzer put the $6.9-trillion mutual fund business in his crosshairs Wednesday, accusing four major fund firms of letting a privileged client engage in improper trading that, industrywide, may cost ordinary investors billions of dollars a year.

One of the alleged schemes involved unlawful, after-the-bell trading in fund shares that Spitzer likened to “being permitted to bet on yesterday’s horse race.” Another involved funds allowing short-term trading tactics that are discouraged for individual investors.

Although Spitzer named only four mutual fund groups -- Bank of America’s Nations Funds, Banc One funds, Janus Capital Group and Strong Capital Management -- he said at a news conference that he is investigating “many entities akin” to those four and that his probe “will radiate out in many different ways.”

Wednesday’s surprise announcement was another bombshell lobbed at Wall Street by Spitzer, a state official who has been both praised for his aggressive, pro-investor prosecutions and attacked for invading the regulatory turf of the Securities and Exchange Commission and other federal authorities.

Experts said the new probe could hasten legal and regulatory reforms of the mutual fund industry that already are in the works.

As part of his investigation, Spitzer on Wednesday announced a $40-million settlement with hedge-fund group Canary Capital Partners, two Canary business units and Canary’s managing partner, Edward J. Stern.

Stern, 38, is a son of Manhattan real-estate mogul Leonard N. Stern and a grandson of Max Stern, founder of the Hartz Mountain pet-supply fortune.

Hedge funds are lightly regulated private investment pools whose investors typically are very wealthy individuals or institutions such as pension funds or insurance firms.

While not admitting wrongdoing, Stern agreed to a $10-million fine for improper trading by his hedge fund, plus $30 million in restitution of its alleged illegal profits. Spitzer said Stern is cooperating in the widening probe.

Canary said in a written statement that it agreed to the settlement to “avoid protracted and complex litigation.”

The mutual fund firms named in the Canary court filing have not been formally charged with anything, but Spitzer said the announcement marked “day one” in his plans to halt fund-industry abuses.

Canary’s trading activities with the fund companies, which allegedly took place between 1999 and July of this year, were described in a 44-page complaint and a book-thick packet of private e-mails and other supporting documents.

Besides the four named firms, Spitzer’s office had subpoenaed documents from five or six other fund companies at the beginning of his probe, according to a person familiar with the matter. And on Tuesday, Spitzer sent subpoenas to “a number of additional firms,” the source said.

Spitzer sent out the new information demands on Tuesday because he feared that doing so after Wednesday’s news broke could give the other firms time to destroy relevant documents, the source said.

It was Spitzer who spearheaded the year-long state and federal probe of conflicts of interest among Wall Street brokerage analysts, resulting in this spring’s $1.4-billion settlement with 10 prominent securities firms. That probe also relied heavily on damaging e-mails retrieved from employee files.

The latest investigation has the potential to be just as volcanic, as it allegedly involves a profound violation of the contract between Main Street America and its most popular investment vehicle. Mutual funds, as Spitzer put it, long have been regarded as “a safe harbor for mom and pop investors,” and are owned by 95 million people.

But Canary was able to bend fund-industry rules, and profit at other investors’ expense, by agreeing to bring other fee-generating business to the fund companies, Spitzer said.

Roy Weitz, editor of the Los Angeles-based Web site FundAlarm.com, said the news could push lawmakers to clamp down on the fund business.

“One of the claims the fund industry could always make was that there have been no major scandals -- that has been its best argument against regulation,” Weitz said. “But with major names like Janus and Strong involved, this case could open up the floodgates.”

A House committee passed a bill in July that, among other reforms, would require fund companies to provide more information about the fees they charge investors and adopt a code of ethics. The bill faces an uncertain future in the full House and does not have a sponsor in the Senate. But Spitzer’s probe could galvanize support for the measure, some securities industry experts said Wednesday.

The Spitzer case strikes at one of the tenets of the fund industry: that all investors, no matter how small, should be treated fairly.

According to the complaint, Canary was allowed to engage in two types of trading that victimized ordinary mutual fund investors: “late trading” and “market timing.”

Late trading, which is prohibited by New York law and SEC regulations, means buying or selling fund shares after the market closes at 4 p.m. EDT but still receiving the current-day price. Investors who enter fund orders after 4 p.m. are supposed to get the price that is effective at the following day’s market close.

During the long stock-market slump that began in early 2000, Canary used the late-trading opportunity to profit from collapsing fund values, even as ordinary investors were losing money, Spitzer said.

According to the complaint, Bank of America not only allowed Canary to regularly engage in late trading of funds but set up a special computer program to facilitate the practice.

Under the deal, Canary could receive the current-day price until 6:30 p.m. EDT, giving the hedge fund a 2 1/2-hour window to exploit news that broke after the close of the stock market.

In return, Canary brought millions of dollars in other business to Bank of America, the complaint said.

A January 2002 e-mail from a Bank of America officer, recapping the firm’s extensive agreement to allow Canary to trade BofA funds in return for other business, said: “Thanks to all team members who have contributed to this profitable relationship and for thinking across divisional lines to make money for the firm.”

Security Trust Co., an Arizona firm mainly serving retirement plans, struck a similar deal with Canary that granted it late-trading access to hundreds of mutual funds until 9 p.m. EDT. In exchange, STC received 4% of Canary’s trading profits, the complaint states.

In the portion of the complaint that alleges market timing abuses, Spitzer said Canary’s trading in funds sold by Bank One, Janus Capital and Strong Capital, as well as those of Bank of America, contradicted the fund companies’ stated policies against encouraging investors to jump in and out of funds in an attempt to profit from short-term swings in the market.

The mutual fund industry has long advised individuals to be buy-and-hold investors, and to eschew trying to time short-term market swings.

Market timing isn’t illegal. But timers can hurt long-term investors in a fund by forcing the fund manager to buy or sell stocks on a short-term basis -- incurring costs such as brokerage commissions -- as money moves in or out of the portfolio.

For that reason, many fund companies regularly turn down money from short-term timers, Spitzer said. But the fund firms named in the complaint “arranged to give Canary and other market timers a pass” in return for doing other business with the funds that brought in management fees, Spitzer said.

In an e-mail exchange earlier this year between two Janus officers, for example, one raised concerns about allowing Canary to rapidly trade the firm’s funds. But the other officer replied: “I have no interest in building a business around market timers, but at the same time I do not want to turn away $10-$20m!”

The complaint also says that Strong Funds provided Canary with a “detailed breakdown” of the stocks it held in certain funds, which allowed Canary to engage in trading practices that involved betting against those stocks.

According to the complaint, Canary’s late-trading and market-timing profits came “dollar-for-dollar out of the pockets of the long-term investors.” In some cases fund companies allowed Canary to avoid paying short-term trading fees that are routinely charged to smaller investors who make such trades.

Paul G. Haaga Jr., executive vice president of L.A.-based fund giant Capital Research & Management and current chairman of the fund industry’s chief trade group, the Investment Company Institute, said that if proved, Spitzer’s allegations “are abhorrent and are completely against everything we stand for.”

But he also cautioned: “Let’s not assume yet that the whole mutual fund industry is tarred with this.”

Bank of America, Strong and Bank One declined to discuss the specifics of the allegations, and all said they are cooperating with the probe.

Denver-based Janus said it “is reviewing the complaint closely and is committed to ensuring that the company continues to act in the best interest of Janus shareholders.”

Security Trust could not be reached for comment.

It’s not known what other mutual fund companies Spitzer is probing. Fidelity Investments and Vanguard Group, the two biggest U.S. fund companies, said Wednesday they had not received a subpoena from Spitzer.

In a statement, SEC Chairman William Donaldson said the fund practices Spitzer described were “reprehensible.”

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Mulligan reported from New York, Petruno and Friedman from Los Angeles.Times staff writer Walter Hamilton in New York contributed to this report.