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On Sept. 3, New York State Attorney General Eliot Spitzer announced a $40 million settlement with Canary Capital Partners LLC (a multimillion-dollar hedge fund), Canary Investment Management LLC, Canary Capital Partners Ltd. and the managing principal, Edward Stern, for fraudulent trading of mutual fund shares. Because of suggestions that such schemes are widespread, the news has triggered a flurry of media attention and, more notably, significant regulatory inquiries, criminal probes and private class actions. The media and regulatory buzz is not unlike attention to Spitzer’s investigation of Wall Street research. That 2001 investigation led to sweeping industry-wide reform, with 10 Wall Street securities firms agreeing to pay $1.4 billion in fines in April 2002. The recent investigations and lawsuits mark the beginning of yet another chapter in the ongoing scrutiny of investment practices. The ‘Canary’ complaint and settlement In a complaint filed in New York state court, Spitzer described two fraudulent mutual fund trading schemes between 1999 and 2003: “late trading” and “market timing.” New York v. Canary Capital Partners LLC, No. 402830/03 (N.Y. Sup. Ct.). Unlike stocks, mutual funds are valued only once a day, at the close of trading at 4 p.m. Eastern time. An investor purchases shares at the net asset value (NAV) of the fund at the close of the day’s trading. Under rules promulgated under the Investment Company Act, orders placed after 4 p.m. must be processed at the following day’s NAV. This requirement is known as “forward pricing.” Late trading occurs when a purchaser places a post-closing order and buys at that day’s NAV, unlawfully receiving a benefit that other investors are denied. Spitzer described the advantage as betting on a horse race after the race. The late trader takes advantage of any post-market closing news, which is not to be reflected in the NAV until the following day. Market timing likewise allows an investor to take advantage of market news. Unlike late trading, market timing is not illegal, but it is publicly disfavored and mutual fund companies disclose to customers that they guard against such practices. The most common example involves trades of funds that hold international stocks. Since some international markets close much earlier than the U.S. market, those foreign stock prices, which will affect the fund’s NAV, may grow stale. A market timer would attempt to take advantage of such stale NAVs, hoping to capture a move in the market reflected in the following day’s trading. Some funds state in their prospectuses that they prohibit timing trades. Others have “timing police” who target and seek to prevent such trades. Despite the illegality of late trading and assurances by mutual funds that they do not allow market timing, Spitzer alleged that Canary, successfully, and with the consent of several prominent funds, engaged in both practices. Although not naming them as defendants, the complaint identified several large mutual fund families as participants in those schemes. Allegedly, these funds agreed to allow late trading and market timing in exchange for assets being committed to family funds for a longer period, so called sticky assets. Since fund managers are compensated according to total assets under management, they stand to gain from such commitments, regardless of whether fund investors are harmed by late or timed trades. Spitzer’s complaint is particularly detailed as against Bank of America, describing e-mails between Canary and the mutual fund that document agreements for late trade or timing privileges in exchange for sticky assets. The complaint also identified complicit securities firms. The harm from these practices is difficult to quantify-an issue that may present itself in suits against alleged perpetrators of late trading or timing schemes. In theory, investors are harmed because late traders and market timers take a share of profits that would otherwise be preserved for long-term investors. Harm may also result from increased volatility or transaction fees. Regulators have suggested that losses are in the billions. Although not admitting to any unlawful trades or wrongdoing, the Canary defendants agreed to pay $30 million in restitution and a $10 million penalty. The hedge fund and its officers also consented to future cooperation in Spitzer’s ongoing investigation of mutual funds. In addition to investigating the mutual funds, since the settlement, Spitzer has subpoenaed other large hedge funds, as well as other mutual fund family complexes. In September and October, he brought criminal charges against several individuals, including former employees of Bank of America, Millennium Partners and Fred Alger and Co. In addition, state and federal investigators in Massachusetts brought civil fraud charges against Putnam Investments and two of its former fund managers on Oct. 28. Looking more broadly, the Securities and Exchange Commission (SEC) announced a rule-making initiative in October focusing on market-timing and late-trading policies and practices. Other criminal actions are expected. Allegations about late trading and timing may be new, but the buzzwords surrounding the investigations are not. The SEC has been conducting a fact-finding mission to review hedge fund practices since June 2002. In May 2003, in an SEC hedge fund roundtable considering a range of issues about how hedge funds are managed and regulated, SEC Chairman William H. Donaldson described the commission’s concerns as “ensur[ing] investor protection and . . . focusing on issues such as . . . transparency, risk management, conflicts of interest, and fraud.” See www.sec.gov/spotlight/hedgefunds/ hedge1trans.txt. In a press release following Spitzer’s Sept. 3 announcement, Donaldson expressed similar sentiments: “[T]he broad participation by individual investors in mutual funds requires that we do everything possible to understand, anticipate and address areas where there is the potential for abuse and fraud.” See www.sec.gov/news/press/2003-106.htm. The underlying theme is again integrity or, more precisely, the lack of it and the need to restore it. Hedge funds remain on the target list, but mutual funds, which control trillions of investors’ dollars and have been praised as solid vehicles for small, long-term investors, have joined them in the hot seat. Just one day after Spitzer announced his office’s settlement with Canary, and despite prompt announcements by Bank of America and Janus Capital Group that investors would be made whole if losses were confirmed, mutual fund purchasers demanded answers and restitution in court. Investors in both the Janus and Strong Capital Management Inc. funds filed class actions in state court in Wisconsin and Colorado. Both actions allege that the mutual fund families breached fiduciary duties owed to the class. Federal securities class actions have been filed against all four fund families named in Spitzer’s Canary complaint in various jurisdictions, including the Central District of California and the Southern District of New York. As investigations and litigation continue, further scrutiny seems certain. At best, one can hope for efficient coordination and consolidation. State and federal regulators are cooperating Some cooperation between federal and state regulators is already under way. Spitzer; James Comey, the U.S. attorney for the Southern District of New York; and the SEC met soon after the Canary settlement. More significantly, Donaldson announced a 12-member task force initiative to recommend improvements in communication and coordination for high-profile cases. Although civil litigation is spread out in state and federal courts throughout the nation, plaintiffs or defendants may ultimately seek consolidation as they face tricky issues of proving losses associated with late trading and timing. Those parties in the federal suits, at least, could seek to consolidate the actions for pretrial purposes through the panel for multidistrict litigation. Civil defendants in state courts may seek to remove the actions to federal jurisdictions to join in such consolidation. In their pledge to ascertain whether investors suffered losses, the mutual fund families will likely conduct internal investigations and cooperate with regulators. Bank of America has already fired several employees allegedly connected to the Canary scheme, including Robert Gordon, who ran its mutual fund division, and Charles Bryceland, who headed the bank’s brokerage and private-banking office and apparently wrote a January 2002 e-mail describing the relationship with Canary as “profitable” (yet another cautionary tale of e-mails as potent evidence of wrongdoing). Despite such efforts, the funds face significant hurdles, as investment research firm Morningstar Inc. recommended that investors sell holdings in the four targeted firms. The newly revealed schemes may also influence SEC proposals already under way. An existing SEC proposal, which calls for more frequent disclosures of funds’ portfolios, is arguably strengthened by evidence that Canary had ready access to that information even though most shareholders infrequently receive full portfolio information. By SEC rule, it is distributed to them only twice a year. Questions about “fair-value pricing” may again become a hot topic. Fair-value pricing allows a fund to base its NAV not on stale closing prices of international stocks but on values calculated in light of significant market events post-closing. In 2001, the SEC asked the fund industry to adopt fair-value pricing for significant events to prevent market timers from taking advantage of stale valuations. While funds now have fair-value pricing policies, the practice has been criticized as a potentially subjective departure from objective prices, and it is unclear how frequently funds substitute fair values for closing prices. Patti Roer and Joellen Valentine are associates in the Stamford, Conn., office of Wiggin & Dana.

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