The 2003 Mutual Funds Scandal
February 23, 2004
Yves Blechner
Dai Nguyen
Jide Olateju
Mutual Fund Scandal Timeline
•
Sept. 3 - New York Attorney General Eliot Spitzer
announces a probe into hedge fund Canary Capital
Partners LLC and four mutual funds over suspected
trading abuses
•
Bank of America Corp.'s ,Banc One Funds, Strong Capital
Management Inc. and Janus Capital Group Inc involved
•
Sept. 30 - Alliance Capital (the largest publicly traded
U.S. fund company) suspends two executives after
finding conflicts of interest related to mutual fund
trading.
•
Oct. 1 - 12 stockbrokers and managers at Prudential
forced to resign after an internal investigation finds
evidence of improper mutual fund trading.
Mutual Fund Scandal Timeline
•
Oct. 2 - A former trader for Millennium Partners, a $4
billion hedge fund, pleads guilty to securities fraud
•
Oct. 2 - Smith Barney fires a broker for canceling mutual
fund trades after the market's close, an illegal practice
being probed by New York and federal regulators
•
Oct. 7 - Bank of America pledges to set up a restitution
fund for holders of its Nations Funds harmed by Canary
activities
Oct. 15 - James Connelly (Fred Alger Management Inc.),
pleads guilty to criminal charges of evidence tampering
relating to illegal trading of mutual fund shares
•
Mutual Fund Fraud Types
• Late-Trading
– Bank of America, CIBC World Markets
•
Market Timing
– Putnam, Invesco, Alliance Capital Management
•
Overcharging
– Prudential Securities
Late Trading
•
•
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Allowing favored investors to trade after market-closing
Investors can take advantage of post-market-closing
events not reflected in the mutual fund share price (set at
the time of market-closing)
Prohibited by New York law and SEC regulations
Bank of America
•
•
•
BOA Broker Sihpol allowed Canary Capital Partners to
engage in late trading of BOA mutual funds
NY State Attorney Spitzer and SEC’s Cutler issued state
criminal and federal civil charges against Sihpol
Sihpol surrendered his passport
Market Timing
•
Detrimental to long-term shareholders:
– Rapid and repeated trading of mutual fund shares can take
advantage of inefficient pricing of mutual fund shares
– Transaction costs for the fund increase
– The stated portfolio management strategy can be disrupted
– A fund can be required to maintain elevated cash positions
•
Result:
– Possible unwanted taxable capital gains for fund
shareholders
– Lower long-term performance
•
These consequences are borne by ALL shareholders
Market Timing: Putnam
•
Kamshad & Scott: Repeated short-term trading of
Putnam mutual funds
– had investment-decision responsibilities for most of those
funds
– traded in their personal accounts
•
•
•
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Engaged in approx. 35 round-trip trades each
Bought and sold shares within short time period
(Kamshad: 13 days on avg., Scott often on consecutive
days)
Traded large amounts of mutual fund shares (often worth
millions of dollars)
Realized “hundreds of thousands of dollars in gains”
(SEC)
Continued to engage in short-term trading after verbal
and written warnings
Putnam: Detection & Resolution
•
Detection:
– Minimal controls against short-term trading by Putnam
professionals
– In 2000: Senior execs. learned of “large & frequent” shortterm trades -> issued warnings
– April 2002: Amended the Advisor Code of Ethics
– October 2003: Issued a press release disclosing the shortterm trading activities
•
Resolution:
– Putnam agreed to the entry of an order in SEC’s
administrative proceeding
– Agreed to undertake reforms
Market Timing: Invesco
• Registered in Delaware, HQ in Denver, CO
•
Investment advisor since 1957
•
Up to $48 billion of funds under management in Mutual
funds
• As much as 46 (open-ended) mutual funds
Invesco: Fraud Scheme
•
Secretly accepted funds from market timers to enhance
the management fees earned by Invesco Funds Group,
Inc
•
Market timing could detrimental to long term
shareholders of the mutual funds
•
Prospectus stated that exchanges between funds by
investors would be limited to four per year
Violated fiduciary duty by arrangements that enabling
certain traders, engage in active trading of Invesco
mutual funds in pursuit of so called "market timing"
strategies
Failed to inform them that this market timing was being
allowed.
Invesco Leadership (Cunningham) realized that market
timing hurt ordinary mutual fund investors.
•
•
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SEC Pronouncements - Resolution
•
Permanent injunction prohibiting future violations
• Perform accounting of fees received due to market
timers
•
Disgorge all ill-gotten gains related to violations
•
For Cunningham, all benefits derived from his
employment (salary, bonuses, stock, and remuneration
or compensation of any kind)
•
Third tier civil money penalties for each separate
violation of law
•
Permanent ban from serving or acting with respect to
any registered investment company
•
Other equitable relief that is just and proper.
Market Timing: Alliance Capital
•
Alliance Capital allowed some investors to market time
certain Alliance mutual funds in exchange for long-term
investments (“sticky assets”) in the funds.
– Daniel Calugar, owner of Security Brokerage, was Alliance’s
single biggest market timer.
– Alliance reaped additional management fees.
– Calugar is facing civil fraud charges.
•
Alliance, without admitting or denying wrongdoing,
settled a SEC enforcement action. The terms:
– Payment of $250MM, consisting of $150MM in disgorgement
and $100MM in penalties.
– All monies will be returned to investors harmed by Alliance’s
actions.
– The settlement was a record payment for this type of
violation.
•
Alliance agreed to reduce management fees on its
mutual funds by 20% over a 5-yr. period (about $350MM).
– The SEC did not require Alliance to reduce fees as part of
the settlement.
Overcharging: Prudential Securities
•
•
Selling Class B shares without informing investors that
they could receive breakpoint discounts if they
purchased Class A shares.
Two Prudential Securities employees alleged to have
engaged in improper sales of mutual fund shares.
– Litigation against Ostrowski and Harris is still pending.
•
Prudential Securities settled an enforcement action by
the SEC finding that the company had inadequate
systems to monitor sales of different classes of mutual
fund shares.
– Prudential agreed to pay $82,000 in disgorgement and
prejudgment interest to be returned to affected investors
and a $300,000 civil penalty.
Personal Fraud Story
• Nigerian E-mails
• Courtesy of The 419 Coalition
1.
2.
3.
4.
5.
•
NEVER
NEVER
NEVER
NEVER
NEVER
pay anything up front for ANY reason.
extend credit for ANY reason.
do ANYTHING until their check clears.
expect ANY help from the Nigerian Government.
rely on YOUR Government to bail you out.
http://home.rica.net/alphae/419coal/
Resolution
• Economic and Financial Crimes Commission
• Warnings on every bank website.
• Nigerian Investment Promotion Council
• Trial of suspected Kingpins
Resolution
Defendants Emmanuel Ofolue (L) Emmanuel Nwude, former director of Union
Bank (C) and Amaka Martina Anajemba (R) sit during their trial for fraud, in Abuja
February 11, 2004. . Five Nigerians are on trial in Abuja accused of defrauding a
Brazilian bank of $242 million in the 1990s