WASHINGTON -- It was known as the Boilermaker Hour. Every day, between 3 p.m. and 4 p.m., select officials of the Boilermakers Union would flood the Boston offices of mutual fund giant Putnam Investments with orders to buy and sell units of the International Voyageur Fund held in their retirement accounts, according to allegations by Massachusetts.
One day, they'd bulk up. The next, they'd cash out. In less than three years, some made as many as 500 of these rapid-fire trades, earning up to $1-million (U.S.) apiece in profits by exploiting the awkward way mutual funds are priced, officials allege.
There was internal griping at Putnam about the day trading. But top executives, including former chief executive officer Lawrence Lasser, turned a blind eye, prosecutors said. Worse, the scheme was apparently so tantalizing that six Putnam fund managers joined the people from the union officials and began actively trading in their own fund.
Welcome to the lucrative world of market timing, a practice that was largely unknown to most of the 95 million Americans who have money socked away in mutual funds. Unknown, that is, until regulators in New York and Massachusetts recently blew the lid off rampant trading abuses, insider deals and pricing hocus pocus throughout the industry that may be robbing the least sophisticated investors of billions of dollars a year.
The trading by the Boilermakers Union officials, which was not in itself illegal, is detailed in a complaint filed last week in civil fraud charges brought by the state of Massachusetts against Putnam and two top traders.
"This is no longer a case of one or two . . . bad apples selling the entire crate. It is beginning to appear as though the entire crate is rotten," New York State Attorney-General Eliot Spitzer told a U.S. congressional committee this week.
"We have to come to the conclusion that the problems are structural. They are systemic."
Peter Fitzgerald, chairman of the U.S. Senate governmental affairs subcommittee on financial management, went even further, complaining that the mutual fund industry has "disintegrated into the world's largest skimming operation."
At Putnam, the fifth largest of more than 800 U.S. mutual fund companies, the scandal has already cost Mr. Lasser his job, triggered billions of dollars in investor defections and left a stain on its once-sterling reputation.
And every day, it seems, there are troubling new allegations and avenues of investigation for regulators and prosecutors to pursue.
Dozens of mutual fund companies have had documents subpoenaed. Some of the biggest names in the industry have already been dragged into the investigation, including Putnam, Janus Capital Group Inc., Bank of America, Prudential Securities Inc., Strong Capital Management, Alliance Capital Management Holding and Bank One Corp. Putnam's Mr. Lasser is among more than 30 executives who have quit, been fired or forced out. Across the United States, lawyers are preparing class-action lawsuits that could eventually bring down some funds.
Securities and Exchange Commission chairman William Donaldson said yesterday that regulators are moving quickly to curb abuses in the $7-trillion mutual fund industry.
Speaking to the Securities Industry Association, he promised the SEC will meet in a few weeks to consider setting a strict 4 p.m. EST deadline for orders to buy and sell mutual funds, effectively eliminating illegal late trading. He said the SEC may also require mutual funds to impose a 2-per-cent penalty on short-term traders, provide investors with explicit disclosure of policies, and designate a chief compliance officer to oversee problems.
And in Washington, Congress is talking about a major regulatory overhaul to root out the excesses in the industry.
Flashback to December, 2001, in the chaotic weeks after the collapse of Enron Corp. Attention then was centred on the murky world of energy trading -- a business far removed from the everyday lives of most investors. Unless you directly owned Enron stock, the scandal seemed worlds away.
Since then, every corner of the U.S. financial services industry has been systematically probed and exposed. From energy trading, the focus shifted to accounting, corporate governance, hedge funds, executive compensation, insider trading, Wall Street research and self-regulatory agencies such as the New York Stock Exchange. Now, the scandal has come home to Main Street. Half of all U.S. families have money in funds, which were long considered a relatively safe haven for small investors.
"Given the problems of the last couple of years, going after the mutual fund industry was the obvious next step," said Lawrence Mitchell, a business law professor at George Washington University and author of the book, Corporate Irresponsibility: America's Newest Export.
"It was under-regulated. Everybody who looked closely at the industry knew that average investors were getting screwed, but it wasn't being investigated."
Inside Putnam, a lot of people knew the little guy was getting a raw deal. Repeated internal complaints and controls were ignored, according to Massachusetts' 25-page civil complaint, because the trading was seen as a way to keep the Boilermakers Union from moving its $100-million retirement account -- a quid pro quo for a nice piece of business.
"The [union officials] can call in whenever they want," a Putnam official told prosecutors, according to the complaint. "They can trade whenever they want and they can call in a quarter to four in the afternoon, put through a trade, and keep doing it day after day to be able to capitalize on their gains in the international funds."
William Galvin, Secretary of the Commonwealth of Massachusetts and the state's top regulator, said Putnam managers were part of a web of "active connivance" and a pervasive "see-no-evil attitude."
But the highly lucrative trading allegedly made easy for the union officials was out of bounds to other investors. Indeed, the Voyageur fund's public prospectus, handed out to unitholders and filed with the complaint, suggested that managers aggressively combat market timing.
"In order to limit excessive exchange activity and promote the best interests of the fund, the fund imposes a redemption fee of one per cent of the total exchange amount on exchanges of shares held less than 90 days," the prospectus noted, warning that it could cut off day traders at any time if the trades negatively affected the fund.
But the rules didn't apply to the so-called 401(k) registered retirement plans, like those of the union officials, the complaint says.
Foreign funds, such as Voyageur, are particularly susceptible to a technique known as "time zone arbitrage." By 4 p.m., when mutual funds set their daily per unit net asset value, or NAV, a lot has already happened that can move the following day's price. The Japanese market has already been closed for 14 hours, and in that time Wall Street might have crashed, the yen could have soared or Sony Corp. might have issued a dire profit warning. Armed with that kind of market-moving information, the union officials could readily time the market for profit.
Think this kind of alleged behaviour is rare or without cost? Think again.
Testifying before a congressional committee this week, U.S. Securities and Exchange Commission officials reported that half of the 88 largest mutual fund companies have acknowledged their staff have sanctioned late trading by investors. Nearly 30 per cent of major brokerages told the SEC that they facilitated market timers by setting up special accounts to hide traders' identities or breaking up unusually large orders that would otherwise raise red flags at mutual funds. One in seven brokerage firms reported knowing that their clients were involved in market timing, the SEC reported.
"What begins to emerge is an image of two distinct sets of rules -- one for insiders and one for everybody else -- a set of rules for those who are big enough to play, because they know who to call, how to craft a separate agreement, at the expense of the small investor whom they are supposed to be protecting," Mr. Spitzer told the U.S. House of Representatives financial services committee this week.
In and of itself, market timing is not illegal. But if fund managers are looking out for the best interests of unitholders, they wouldn't let it happen. In an internal document quoted in the complaint, Putnam acknowledged that timing may inflate transaction costs, generate taxable capital gains if managers need to sell holdings to meet redemptions, force the fund to keep higher-than-normal cash positions, disrupt portfolio management strategies and hurt long-term investors.
Add up the net cost to fund holders, and soon you're talking about big money. Market timing alone may cut up to one percentage point per year, or $5-billion, off mutual fund returns.
"While some investors may shrug that off, it can do great damage to long-term compounding, if it is continuous," pointed out Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania.
Take an investor who puts $10,000 a year into a mutual fund, expecting to earn an average 8 per cent return per year. A loss of one percentage point per year represents nearly $50,000 over 20 years, Prof. Siegel said.
Peter Kugi, 38, manager of an electronic publishing company in Milwaukee is so bitter about losses in his son's college trust fund that he joined a class-action lawsuit against several leading mutual fund companies.
"I really felt let down," Mr. Kugi said. "For those of us who aren't millionaires, we're counting on someone to manage our money."
John Pollock of Hillsboro, Ore., another mutual fund investor, is more circumspect about the scandal. He and his wife rode the stock market boom in the 1990s, and since 2001, their portfolio has been cut in half.
"I believe that it's about the truth and I believe the truth hasn't been marketed," said Mr. Pollock, a leadership trainer who has bought mutual funds for he and his wife.
"We benefited from the lying and cheating, but now we're losing."
Even before the recent string of mutual fund scandals, the U.S. House of Representatives was working on tougher rules for the industry. Richard Baker, chairman of the capital markets subcommittee, said the string of recent scandals suggests those efforts aren't enough to shield investors from fraud and other abuses.
"In light of the events that have occurred . . . it is clear to me that my legislation needs to be strengthened," Mr. Baker acknowledged this week.
The original bill would have forced clearer disclosure of potential conflicts of interest and fees, including mutual fund trading costs, compensation of managers, non-monetary or "soft dollar" commissions paid to brokers, financial links between funds and their advisers and proxy voting policies.
Industry critics and state regulators, such as Mr. Spitzer and Mr. Galvin, also want Congress to force mutual fund companies to hire compliance officers, appoint independent boards of directors, obtain multiple bids on advisory and management contracts plus fully disclose all hidden operating costs and fees. Others want soft dollar commissions banned outright.
John Bogle, founder and former chief executive officer of mutual fund giant Vanguard Group, said that for all its talk about serving Main Street investors, the mutual fund industry has for too long structured itself to promote the interests of fund managers over the investors that own their funds.
"It is time to put investors in the driver's seat of fund governance, and give them a fair shake," Mr. Bogle said.
Monday: Janet McFarland on Canada's need for an Eliot Spitzer
© 2007 The Globe and Mail. All rights reserved.
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