California Fund Firm Is Charged
Franklin Resources Inc. on Wednesday became the first California mutual fund company to be charged with wrongdoing in the widening fund industry scandal when Massachusetts accused the firm of securities fraud for allowing rapid in-and-out trading by a favored investor.
San Mateo-based Franklin, the largest publicly traded fund company and the fifth-biggest firm by assets, let Las Vegas investor Daniel Calugar make so-called market-timing trades totaling $45 million in exchange for investing $10 million in its hedge funds in September 2001, Secretary of the Commonwealth William Galvin alleged in a civil suit.
The state is seeking unspecified fines and a return of any profit from the arrangement.
“This case is another example of a mutual fund having one standard for the ordinary investor and an entirely different one for someone able to move millions and of millions of dollars through it in market-timing trades,” Galvin said.
The complaint alleges that in early 2001, Franklin Senior Vice President William Post, who was helping the firm secure outside financing to launch a line of hedge funds, courted Calugar and struck the deal allowing him to time the Franklin Small-Mid Cap Growth Fund, although that fund’s prospectus prohibited rapid trading. E-mails indicated that several high-ranking Franklin executives were aware of the deal, the complaint says.
Calugar, head of the now-defunct Security Brokerage Inc. and a well-known timer, wired $10 million to Franklin for its Franklin Templeton Strategic Growth hedge fund -- a stake constituting 59% of that fund’s assets, the complaint says. Three days later, Calugar’s firm opened an account with Franklin “for the sole purpose” of timing, Galvin has alleged.
In a statement, Franklin called the deal harmless, saying it involved only one client and three “round-trip” trades in and out of the stock fund.
“Franklin Resources’ first priority is to protect the best interests of our funds’ shareholders and our clients,” the company said, “and we are confident that none of them was harmed by these investments.... We are committed to working with Massachusetts regulators to resolve this situation in the best interests of our investors.”
Franklin, which managed $337 billion as of Dec. 31, said it also remained in talks with the Securities and Exchange Commission over the agency’s investigation of timing trades.
Post, who left Franklin in December, could not be reached for comment. Calugar, who was sued by the SEC in December for allegedly making improper trades at MFS Funds and Alliance Capital, also could not be reached.
Franklin is the fourth fund firm officially charged since the scandal broke Sept. 3, when New York Atty. Gen. Eliot Spitzer accused a hedge fund of market timing and late trading involving mutual funds from four companies. About 30 mutual fund firms and brokerages have been implicated, and more than 60 executives have been ousted.
The continuing litany of new fund cases threatens to undermine confidence in the industry, said Stephen Bainbridge, a UCLA securities law professor. Until now, investors have fled from individual funds and companies implicated in wrongdoing. But “the question is: Will a point come when investors give up on the industry as a whole rather than give up on individual funds?” Bainbridge said.
“As bad as Enron and WorldCom got, out of the thousands of publicly traded corporations there weren’t that many where we found serious fraud,” he said. With mutual funds, “it looks at the very least that it’s pervasive and it’s going to erode investor trust in the industry as a whole.”
Market timing is a technique for exploiting temporary discrepancies between a fund’s share price and the actual value of its underlying holdings. It isn’t necessarily illegal, but regulators say that if funds that have policies against timing permitted and profited from such trades, that could be a violation of securities laws.
Also, by making rapid trades in and out of funds, traders could dilute the gains of long-term shareholders and increase the funds’ transaction costs.
Henry Hu, a securities law expert at the University of Texas, said the case against Franklin may be strong because the fund’s prospectus clearly told investors that market timing was banned.
“Everything else held equal, if you say you prohibit market timing, as opposed to merely saying you discourage market timing, your [legal] vulnerability index goes up,” Hu said.
Galvin said the “outrageous” case also draws attention to a serious conflict of interest within the fund business.
“It brings into sharp focus the bigger question: Can you have hedge funds and mutual funds managed by the same company?” Galvin said. “We see time and again that the hedge funds are the beneficiaries of these arrangements, and their goals are not terribly consistent with the goals of mutual fund investors.”
