On Sept. 3, in an energy-infused press conference, Spitzer said "illegal trading schemes" allowed at least one hedge fund to buy mutual-fund shares at prices that were not available to most other investors. The attorney general announced a $40 million settlement with the hedge fund, Canary Capital Partners LLC, and its managing principal, Edward J. Stern. Stern, the son of real estate magnate and billionaire philanthropist Leonard Stern, did not admit or deny wrongdoing. Spitzer continues to probe mutual funds on the other side of its trades. "It's the first shock to the fund industry in 60-some years," says John Collins, a spokesman for the Investment Company Institute, a Washington (D.C). fund industry trade group. "If these charges prove true, there has been a breach of law that cuts close to the heart of what protects all mutual-fund shareholders."
But while Spitzer continues to grab headlines, many wonder: Where is the Securities & Exchange Commission? The SEC has made clear it wants mutual funds to give investors more information about fees, portfolio turnover rates, revenue-sharing payments to brokerage firms, and the compensation of portfolio managers. In January it proposed some new regulations, and in June it put out a 120-page report on the industry's practices. In late July, the House Financial Services Committee passed a bill that would make most of those changes and more. Now, expectations are high that Spitzer's big splash will spur the SEC to adopt those measures quickly, and perhaps more.
But if greater transparency is always helpful, that alone is unlikely to stop the sorts of illegal practices Spitzer alleges. And probing mutual funds hasn't been a top priority at the SEC, although its caseload is up. Says Mercer Bullard, a law professor at the University of Mississippi and founder of Fund Democracy, a mutual-fund advocate: "The real failure has been on the enforcement side. The SEC has done nothing to show that it really means business."
Spitzer's case against Canary was based on a tip that came his way -- and he was able to move fast because he faces fewer procedural hurdles than the SEC does. "Spitzer continues to trump the SEC in major new areas of investigation.... He's making an obvious effort to beat the SEC to the prosecutorial deadline," says Seth T. Taube, a former SEC prosecutor who now chairs the securities litigation practice of McCarter & English, a Newark (N.J.) law firm.
The SEC applauded Spitzer's big score -- but wondered why he pursued the case without clueing them in. "We've been looking at mutual-fund sales practices for a number of months," says one official. "Collectively, we have limited resources in which to look under every rock; perhaps we could be more efficient with a little more coordination."
Spitzer's complaint against Canary Capital should put to rest any idea that the mutual-fund industry is a pristine, ethical world in which little watchdogging is needed. The complaint alleges that Canary was allowed to trade certain mutual funds after the market closed, exploiting market swings. "Late trading," as it's sometimes called, is prohibited by New York State's Martin Act and SEC regulations because it allows select investors to take advantage of events that occur after the market has closed and are not figured into the funds' net asset value (NAV). Spitzer described the practice as "being permitted to bet on yesterday's horse race."
The hedge fund was also allowed to engage in "timing" mutual funds -- doing short-term "in and out" trades, based on previous NAVs. This harms buy-and-hold investors. Spitzer called this type of trading "akin to playing a casino with loaded dice."
What was in it for the mutual funds? Plenty. Canary plowed millions in assets into the mutual funds in exchange for the right to engage in timing. The hedge fund also offered to pay higher management fees than other customers. And it invested in accounts called "sticky assets" -- typically long-term investments in other financial vehicles managed by the mutual fund, such as bond funds, "that assured a steady flow of fees to the manager," according to the complaint.
Mutual-fund firms named in Spitzer's complaint are among some of the most respected: the Bank of America's Nations Funds (BAC
), Strong Capital Management, Bank One (ONE
) and Janus Group. All say they are cooperating fully with the AG's office. Says Russel Kinnel, Morningstar's director of fund analysis: "One of the reasons that funds are so popular is the perception that they're very ethical -- they supposedly treat the little guy like the big guy. But clearly, they haven't done that here."
Ironically, hedge funds have taken most of the heat from regulators and in the press of late. Some insiders say that to take the focus off them, hedge-fund managers have been "ratting out" their mutual-fund brethren. "Hardly anyone has a clue about all the games mutual funds play -- it's all about the big bad hedge funds," says one manager.
Spitzer would not comment on any pending settlement with the mutual-fund firms and no charges have been filed. But Canary will be required to return $30 million in profits reaped from illegal trading and pay an additional $10 million fine. Moreover, the AG says this issue is far from over: "There are many other institutions involved in timing. It's just Day One of this investigation." Given Spitzer's track record, it could be remembered as D-Day for mutual-fund companies. By Marcia Vickers, with Mara Der Hovanesian in New York and Amy Borrus in Washington