Savvy Prosecutors Lead California Fund Probe

When Tom Greene walks the offices at the state Department of Justice these days, colleagues often ask about the controversy swirling around the nation’s $7.4-trillion mutual fund industry.

Greene, the chief assistant attorney general, is among 95 million Americans who invest in the funds. But there are three California-based names you won’t find in his portfolio: Pimco, Franklin and American.

“Happily not,” Greene said with a smile.

Greene, 56, was recently tapped by Atty. Gen. Bill Lockyer to head the state’s investigation of mutual fund sales practices -- starting with Pacific Investment Management Co., or Pimco, of Newport Beach; Capital Group Cos. in Los Angeles, which runs the American Funds; and Franklin Resources Inc. of San Mateo.

Lockyer believes these and other mutual fund firms may have defrauded California investors by failing to disclose deals in which brokers got compensation to recommend their funds.

Going up against these corporations could be a daunting task. Pimco, American Funds and Franklin are three of the five biggest firms in the business, with heretofore sterling reputations and a total of more than $1 trillion in assets. They could argue that they were following long-standing industry guidelines, or that disclosure obligations regarding sales incentives should fall mainly with the brokers who meet with clients face to face, experts say.

“The fund companies are going to hire the best and the brightest lawyers, and if the stakes are high enough they are not going to roll over,” said corporate defense attorney Al Fishman of Tesler, Sandmann & Fishman in San Francisco.

Pimco said its disclosures were in line with federal regulations and declined to comment further. Capital Group said only that it was cooperating with Lockyer’s probe. Franklin, which was charged with civil fraud last week in a separate case, also declined to comment.

Lockyer was given expanded authority to pursue securities fraud under a new state law that took effect Jan. 1. He has vowed to devote as many of his department’s 1,100 lawyers as needed to the mutual fund team -- even if it meant shifting resources from the energy task force and other operations.

Lockyer got no extra funding to go with his expanded jurisdiction, however, and Greene acknowledged that the investigation was starting with a “handful” of staffers. Greene’s second in command is Mark Breckler, a deputy attorney general who has worked with Greene in cases involving Microsoft Corp. and energy traders.

“We will pursue all leads we find and do whatever it takes to understand this matter,” Breckler, 51, said during an interview with Greene at their modest offices in downtown Sacramento. “Savers depend on the integrity of mutual funds.”

The fund scandal erupted in early September, when New York Atty. Gen. Eliot Spitzer alleged widespread trading abuses in the industry. The Securities and Exchange Commission and other states followed with probes of their own, examining fund sales arrangements as well as trading.

About 30 financial services companies have been implicated in the scandal. Four fund firms have been charged with wrongdoing and more than 60 executives have been fired.

California’s focus is not on late trading or market timing, the practices that have drawn the most attention. Instead, Lockyer is targeting something he considers more insidious: mutual funds paying brokers for “shelf space,” or spots on a list of preferred funds offered to the brokerage’s clients, without properly disclosing those deals to investors. Most funds are distributed through brokers or other third parties, rather than sold directly to investors.

On Jan. 2, Lockyer’s office subpoenaed Pimco, Capital and Franklin, demanding internal documents related to fund sales. As the investigation unfolds, the office probably will look at other targets too, including brokerages.

Pimco, American Funds and Franklin were chosen as a starting point, Greene said, when their names surfaced in the case brought by the SEC in November against brokerage Morgan Stanley over its shelf-space deals. The three were among 15 mutual fund families in Morgan Stanley’s so-called Partners Program, whereby brokers and branch managers were paid extra commissions to recommend the “preferred” funds.

Morgan Stanley agreed to pay $50 million to settle charges that it failed to disclose the sales incentives to fund investors or to inform them of the availability of certain fee discounts, but none of the fund companies were charged.

Separately, Massachusetts last week filed civil fraud charges against Franklin alleging that the firm allowed a well-heeled investor to time its mutual funds in exchange for investing in the firm’s hedge funds. Franklin said its shareholders weren’t harmed by the deal but said it would work with Massachusetts regulators to resolve that case.

Regarding their shelf-space deals with Morgan Stanley and others, the three fund companies have said they followed long-standing disclosure guidelines established by the SEC.

Indeed, some lawyers wonder whether the attorney general is taking on the right target.

Brokers and financial advisors who meet face to face with investors at the point of sale, they say, have the ultimate duty to fully disclose whether their mutual fund recommendations might be influenced by financial incentives. For years, the SEC has signed off on fund prospectuses and official statements of additional information that touch on shelf-space arrangements in the vaguest terms, if at all.

“There hasn’t been much guidance to fund management companies, their lawyers or directors as to how much specificity should go into the disclosures,” said attorney Julie Allecta, whose San Francisco firm, Paul, Hastings, Janofsy & Walker, represents the three fund companies on various matters but has not been retained specifically to assist in their responses to the Lockyer subpoenas.

“I think the correct approach would be to improve the disclosure requirements first and then prosecute those who fail to meet the new standard,” Allecta said.

Breckler and Greene argue that funds have a duty to not mislead investors by omitting material facts.

“Mutual funds prepare the prospectuses and statements of additional information, they get the money and they’re trusted to use it properly,” Breckler said. “It seems to me to make abundant sense to understand their role, in addition to the role of broker-dealers.”

Greene said the state hoped to benefit from two sources of evidence that have been windfalls in other big cases: whistle-blowers and e-mail.

“We’re getting help from people who know about unlawful conduct,” Greene said of whistle-blowers, declining to elaborate.

Greene called e-mail “the litigation gift that keeps on giving,” as frank exchanges are preserved on an electronic record. “Most investigations of this type turn on how decisions are made in a large institution,” he said.

Colleagues call Greene and Breckler savvy prosecutors.

Greene, who unwinds after hours in an online poetry discussion group, has become a go-to guy for Lockyer.

In 2001, he moved to Washington for eight months to coordinate the Microsoft litigation efforts of 11 states including California. In 2002, he jump-started California’s energy probe when he was asked to reorganize the department’s task force. Greene, who still heads the energy team, led negotiations with El Paso Corp. that resulted in a $1.7-billion settlement.

“Tom is well regarded as a prosecutor -- balanced, intelligent and committed to his public responsibilities,” said Andrea Ordin, a former colleague and now a partner with Morgan, Lewis & Bockius in Los Angeles.

Breckler, said Fishman, “is the kind of guy who enjoys an esoteric issue like this, where there’s more to the case than just chasing down the facts. This may require a creative application of the law, and Mark won’t be afraid to do that.”

For both veteran prosecutors, their career paths became clear early on.

When Breckler was 10, he got to watch his father, an Encino surgeon, in the operating room one day, stitching a patient’s head.

“The room got warm, then it got black,” Breckler remembers. When young Mark came to, his dad drove him straight home. “He looked at me with disgust and said, ‘Go to law school.’ ”

After majoring in criminology at UC Berkeley, he did just that, graduating from San Fernando Valley College of Law.

Greene was steered toward a legal career as well.

His dad, a Sacramento cop, used to come home cursing whenever he was cross-examined in court by a crafty defense attorney, Greene recalls. “He thought as long as you were a prosecutor, that was a very good thing to be.”

Breckler, who, like Greene, is married and has two kids, said he also dabbled in mutual funds -- but even before the scandal broke, he was not a Pimco, American Funds or Franklin shareholder. Whereas Greene said it was sheer happenstance that he avoided the three fund families in his portfolio, Breckler cited his conservative investing bent.

“I am a saver by nature and only have a little bit of mutual funds in my 401(k), for the action,” Breckler said. “I like FDIC-insured bank accounts.”