In the month since Eliot Spitzer aimed his cleanup crusade at improper trading in mutual funds, one crucial sector of the financial industry has escaped charges: mutual funds. The New York Attorney General has uncovered alleged wrongdoing by hedge funds, brokers, and traders -- all vital cogs in the selling and administration of mutual funds. But the $7 trillion industry, while tarred in the headlines, has largely escaped the charges that are wracking its customers and business partners.
Not for much longer. Enforcement officials say their wide-ranging probe is uncovering abuses that will soon go straight to the heart of the fund industry. Upcoming cases will show that mutual funds were active participants in two of the three major types of wrongdoing that investigators have brought to light.
That isn't all. BusinessWeek has learned the Securities & Exchange Commission has found that some mutual funds are selectively disclosing their portfolio holdings to hedge funds, which then trade on the info. The agency, which has joined Spitzer's probe with brio, is considering bringing insider-trading charges against the funds involved.
Moreover, the SEC is mulling an aggressive legal strategy that could result in fraud charges against mutual funds for the practice known as market timing, or the rapid trading of a fund. Since the probe began, securities lawyers have maintained that most funds would be insulated from such charges unless they violated a stated policy banning rapid trades. But the agency will probably argue that even those who didn't explicitly ban such trades violated their fiduciary duties to other shareholders.
The Spitzer-SEC hunt, which has resulted in dozens of leading mutual-fund companies being hit with subpoenas, has turned up evidence that trading abuses are more widespread than originally thought, officials say. The legal fallout from the probe could even wipe out some smaller brokerage firms. "Whether it's [in] hedge funds, broker-dealers, trust companies, or mutual funds," Spitzer told BusinessWeek, "we're going to have to ensure that trading [cannot be permitted when it's] contrary to the interests of those whose benefit is supposed to be paramount."
The most potentially explosive new charge: The SEC has discovered some mutual funds have selectively disclosed portfolio holdings to hedge funds and other investors, a practice one official termed "nefarious." Current rules require funds to reveal what's in their portfolios twice annually. But when the SEC early this year proposed funds make quarterly disclosures, the industry fought back, saying that would allow hedge funds to divine their investment strategies -- and trade the stocks needed to implement those strategies ahead of the mutual fund. Such front-running would boost the funds' costs by driving stock prices up or down before they could adjust their portfolios, the industry argued.
Turns out, an SEC official says, some funds have given hedge funds a sneak peek of their holdings -- a green light to front-run. Enforcement Director Stephen M. Cutler, on Oct. 8 said the SEC is weighing insider-trading charges against those who allowed or engaged in such trades.
Still, the investigation has brought some good news for the industry. So far, the funds themselves don't appear to have been involved in late-day trading. Late trading occurs when a major investor, such as a hedge fund, illegally buys or sells mutual-fund shares after 4 p.m. at the price set when the market closed. By law, orders for fund shares entered after 4 p.m. should be priced at the next day's closing.
Spitzer's probe has shown that most late trading involves illicit deals among hedge funds, Wall Street brokers, and the transfer agents that handle funds' back-office paperwork after the 4 p.m. deadline. On Oct. 2, Steven B. Markovitz, a former trader at hedge fund Millennium Partners LP, pleaded guilty to criminal charges brought by Spitzer and settled civil charges by the SEC involving such late trades. Earlier, Spitzer and the SEC leveled similar charges against Bank of America broker Theodore C. Sihpol III, who pleaded not guilty. More such joint actions are expected in coming weeks.
That hardly leaves mutual funds unscathed. Spitzer and the SEC will probably bring civil charges against numerous funds for allowing market-timing -- the moving of large amounts of money in and out of a fund in short order. Timers can profit handsomely from short-term gaps between a fund's value and the prices of the stocks it holds. This is especially true for those with international stocks, which trade on exchanges that close up to 12 hours earlier than U.S. markets, making their prices stale by the 4 p.m. New York close. The problem: Other shareholders get short shrift when funds sell off good investments or hold extra cash to pay back the timers. Shareholder returns also decline because market timing raises mutual funds' own trading costs. "For the most part, late-trading appears to be stopping at the [mutual funds'] shore," says a top SEC official, "but the timing stuff washes right up on the beach." The result is likely to be disgorgement of significant amounts of money as restitution, says one official.
More bad news: Industry leaders believe even if some funds were complicit in market timing, regulators will only go after funds that violated their own explicit policies. No, says an SEC source. The SEC is mulling bringing cases even when a fund hasn't banned market timing. The reasoning: Under the Investment Company Act of 1940, funds must treat all shareholders the same. If a fund adviser gives favored treatment to a big investor in exchange for a benefit, such as an extra fee, the fund is in conflict with other shareholders. That may violate the act's requirement that all shareholders receive equal treatment and that conflicts be fully disclosed.
Exposure of these wide-ranging abuses could slam the entire financial-services industry. Representative Richard H. Baker (R-La.), chairman of a House panel with jurisdiction over capital markets, plans to rewrite previously offered mutual-fund reform legislation. New revelations, he says, "have started a fresh discussion of what reforms are needed. The industry's defense was 'we've done nothing wrong,' but it seems that's not so."
Other lawmakers may try to erect barriers between banking and investment services torn down in 1999. After all, many late-trading and market-timing problems take place at large, full-service Wall Street firms, where firewalls between the sales desks on the banking side and fund managers on the investment side have broken down in the race for higher commissions and fees. Already, close to two dozen brokers have been fired by such firms as Merrill Lynch, Citigroup, Prudential, and Bank of America.
Fund directors, too, are in the eye of the storm. Some critics insist that the law governing mutual funds must be amended so that fund boards take more responsibility for the advisory companies that manage funds. Before it's all over, this octopus-like probe is likely to reach far beyond the financial institutions directly caught in the dragnet. By Paula Dwyer in Washington and Emily Thornton, with Mara Der Hovanesian, in New York