Litigators Take Aim at Timers, Funds
September 15, 2003
It's open season on the mutual fund industry, as New York State Attorney General Eliot Spitzer's probe of mutual fund trading practices has triggered a barrage of investor lawsuits.
The complaints are based on evidence that mutual funds took part in trading schemes that exploited a loophole in the way mutual funds are priced. Last week, Bernstein Liebhard & Lifshitz of New York filed claims against the four companies implicated in the Spitzer probe: Janus Capital, Bank One, Bank of America and Strong Financial.
The suit charges the defendants neglected their fiduciary responsibility to their customers in exchange for higher fees and other forms of compensation. Essentially, they are accused of inviting large institutional investors to time the market or move in and out of positions freely at the expense of the fund's long-term individual investors. Market timing, while not illegal, is not consistent with the best interests of a fund's investors. Additionally, the firms are accused of participating in illegal late trading, which allows preferred customers to trade after the market closes but still receive that day's price. The claims are seeking class-action status.
Spitzer fired the first shot at a press conference earlier this month, blaming fund companies for allowing hedge fund Canary Capital Partners to take advantage of post-market events not reflected in the share price at the end of the trading session.
"This allowed Canary and other mutual fund investors who engaged in the same wrongful course of conduct to capitalize on post-4 p.m. information while those who bought mutual fund shares lawfully could not," Bernstein Liebhard said in a statement.
As a result, Canary enjoyed a substantial arbitrage profit that would have been otherwise passed on to the fund's investors. When it redeemed its shares and claimed the profit, the fund manager was forced to sell some stock or use cash, which formerly belonged to the fund's investors, to give Canary its payout. In return, Canary parked its money in the funds' money market funds, which meant fatter commissions and fees for the firms.
Meanwhile, in a class action complaint filed in a California district court last Wednesday, Weiss & Yourman, a law firm with offices in New York and Los Angeles, charged that Bank of America allowed large institutional clients to illegally execute trades after the closing bell and engage in lucrative market-timing trades. The class action suit is being brought on behalf of investor Leann Lin and all individuals who purchased shares in Bank of America's Nations Funds between May 1, 2001 and July 3, 2003. Weiss & Yourman would not comment on how much money it expects to win for its clients.
During that time frame, the defendant allegedly provided false and misleading information in its prospectuses and registration statements by failing to disclose that it was allowing at least one hedge fund to clandestinely engage in both late trading and market timing. The smoking gun in the case is a number of interoffice e-mails that provide details of these covert operations. For example, Robert Gordon, chief executive of Banc of America Capital Management sent an e-mail to Richard DeMartini, president of Bank of America's asset management business, detailing how the firm planned to request a commitment of $20 million from Canary in return for market timing. Bank of America wanted the commitments after it launched a new principal-protection fund, which would serve as depository for the sticky money.
As alleged in Spitzer's original complaint, Bank of America went so far as to set up special computer equipment in Canary's office that allowed it to buy and sell its Nations Funds and hundreds of other funds well after the close. A similar suit was brought against Janus in a Colorado State court for improper trading practices including trading behind the bell.
"It's an unfortunate wake-up call that mutual fund managers are in business for their shareholders, not their investors," said Gary Gensler, former undersecretary of the Treasury Department and author of The Great Mutual Fund Trap. "It's unfortunate that the pressures on managers are to raise more assets rather than to do the best job for investors." Gensler believes that there's bound to be other firms that have allowed market timing in their funds. But he said that late trading treads so clearly across the line one would hope that firms with decent compliance departments would have put a stop to it.
An Inexact Science