Mutual fund industry is scandal-free no more

By John Waggoner, USA TODAY

Throughout the corporate scandals of the past few years, the mutual fund industry has long touted its scandal-free reputation. It can’t do that any more.

The charges leveled by New York Attorney General Eliot Spitzer against Canary Capital Partners, a hedge fund, implicate large, well-known companies such as Bank of America, Banc One, Janus Capital and Strong Investments in illegal activities that dwarf the industry’s earlier scandals. (Related story: Spitzer: Illegal trading schemes pollute mutual fund industry )

Canary Capital Partners, run by Edward Stern, didn’t admit wrongdoing, but agreed to a $40 million settlement. Hedge funds are loosely regulated investment pools for the wealthy. Spitzer charged that Canary and the fund companies engaged in:

Late trading. Canary had a deal with Bank of America that let the hedge fund buy mutual funds after 4 p.m. ET, but get the fund’s share price for that day. An investor must buy before 4 p.m. to get that day’s price. A purchase after 4 p.m. gets the next day’s price.

The agreement gave Canary the advantage of being able to buy at the 4 p.m. price with knowledge of post-close developments such as unexpected earnings news that could influence the fund’s share price the next day. Canary was guaranteed a quick gain the next day. It’s like being permitted to bet on yesterday’s horse races, Spitzer said Wednesday.

Spitzer alleged that the Bank of America installed software at Canary allowing it to buy and sell Bank of America’s Nations Funds and hundreds of other funds at the 4 p.m. closing price until about 6:30 p.m. An Arizona company, STC, allegedly allowed Canary to trade funds until 9 p.m. ET. Bank of America says it’s cooperating with the investigation.

Market timing. Janus and Strong allegedly allowed Canary to buy several of their funds one day, then sell them the next, a practice known as market timing. In return, Spitzer said Canary made big investments in those firms’ other funds. Market timing isn’t a guaranteed profit. But most funds bar individuals from doing it. The February 2002 prospectus for Janus Income Funds says, The funds are not intended for market timing or excessive trading.

How were investors hurt? Canary enjoyed advantages that small investors didn’t. Even worse, big movements of money in and out of a fund make it difficult to manage and could force a fund to sell stocks the manager would prefer to keep. That hurts returns.

In the complaint, Spitzer displayed e-mails from fund executives that show how willing they were to bend and break rules for additional profit. For example, a Janus employee wrote to Richard Garland, CEO of Janus International, expressing alarm about the volume of market timing activity in Janus funds.

Garland 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!

At Bank of America, Robert Gordon, co-president of the company’s Capital Management division, forwarded an e-mail to senior managers and some portfolio managers. He wrote: I’ve spoken to a number of you about this day-trading exception. The account is the Stern family, a significant and growing GCIB/Bank relationship. Also, nice incentive of matching funds in the Short-Intmdt. Gov’t fund. thanks, and let me know if there are any issues. Gordon is also on the executive committee of the Investment Company Institute, the mutual fund industry’s trade organization.

The industry has had a few, relatively small recent scandals:

In April, the Securities and Exchange Commission fined fund manager Ron Baron $500,000 on charges he manipulated shares of Southern Union.

In October 2000, Heartland High-Yield fell 70% because of mispriced bonds and ultimately wound up in SEC receivership.

But if those practices in the New York complaint are widespread, it could jar investors’ faith in the $6.3 trillion in mutual funds. These are major allegations, shake-the-foundations kind of stuff, says Roy Weitz, editor of Fundalarm.com.