Feb. 5–Regulators charged the nation’s fourth-largest mutual-fund company, Franklin Resources of San Mateo, with fraud Wednesday for permitting an unethical arrangement in 2001 that enriched topexecutives and select clients at the expense of average investors.
Massachusetts regulators charged that Franklin defrauded investors by allowing a wealthy Las Vegas investor to essentially skim profits from Franklin’s Small Cap Growth Fund, in violation of Franklin’s policies.
The charges bring home to the upper echelon of the Bay Area’s largest fund company an industrywide scandal that has felled executives at numerous mutual-fund companies nationwide. The scandals have also spurred a rash of regulatory changes and shaken investors’ faith.
More than half of U.S. households invest in the $7 trillion mutual-fund industry, many in brokerage accounts or through 401(k) or retirement accounts.
“This case illustrates yet again another mutual-fund company putting profits over its fiduciary duty to act in the best interests of its long-term shareholder clients,” the complaint said.
Former Franklin executive William N. Post II, who headed a special investing division of Franklin Templeton at the time, allegedly solicited the investor and approved the arrangement, although he was not named as a respondent in the complaint. Post couldn’t be reached for comment, but the complaint noted that he has denied authorizing or knowing about the improper arrangement.
The complaint also alleged that other top executives at the company — including Charles E. “Chuck” Johnson, eldest son of Franklin’s current chairman, who took a leave of absence from the firm in 2002 — knew about the arrangement.
Franklin issued a statement Wednesday saying the 2001 arrangement was “unauthorized” and “rejected by management.” The statement added that the firm is confident no investors were harmed. Spokeswoman Lisa Gallegos did not elaborate on why the trading occurred despite management’s rejection.
Regulators say the Franklin case is yet another indicator that shareholders aren’t the first concern for the nation’s largest fund companies, as they should be.
“If the firm was engaged in what’s clearly illegal conduct, that says something about whether you can trust that firm with your money,” said Mercer Bullard, a former Securities and Exchange Commission lawyer who is now a professor at the University of Mississippi School of Law.
The alleged arrangement involved “market timing,” a practice that has been under intense scrutiny by regulators lately. In many cases nationwide, fund companies allowed select investors to make quick in-and-out trades in certain mutual funds, in violation of their own investor-protection policies. That jacked up expenses for other investors and eroded returns in other ways, regulators charge.
In return for the right to market-time, the select investors often agreed to park large sums of money in other accounts at the fund companies, boosting their assets under management.
In the Franklin case, a wealthy investor allegedly got a special dispensation from Franklin executives to market-time by buying and selling up to $45 million worth of shares in what is now the $9 billion Franklin Templeton Small-Mid Cap Fund.
In return, the investor — Daniel Calugar, described in the complaint as a “known market timer” from Las Vegas — allegedly agreed to invest $10 million in a fledgling hedge fund run by a separate investment unit of Franklin.
Market-timing is not typically illegal, but Bullard said that recruiting an investor to a hedge fund by allowing him to market-time a mutual fund probably violates securities laws.
A lawyer for Calugar, who was charged with fraud by the Securities and Exchange Commission last year for widespread market-timing activities, said he had no comment.
The complaint implies that Johnson, the son of Franklin Chairman Charles B. Johnson and co-president of Franklin at the time, permitted the firm to accept money from Calugar despite objections to the scheme from some Franklin executives including Peter Jones, president of Franklin’s fund-selling division.
Calugar “somehow got in touch with Chuck Johnson,” according to an Aug. 28, 2001 e-mail from a sales manager, Philip Bensen, to Jones. “Chuck agreed to accept this client’s money in various funds and a hedge fund.”
Chuck Johnson could not be reached through attorneys or an e-mail. He took a leave of absence from the firm in October 2002 after being charged with a felony for a domestic-assault incident.
Post, who later became the president and chief executive of the Northern California offices of Franklin’s broker-dealer, Templeton/Franklin Investment Services, resigned from Franklin in December.
The charges against Franklin were filed Wednesday by Massachusetts Secretary of the Commonwealth William Galvin, who has also brought charges against another top mutual-fund company, Putnam Investments.
Franklin, which manages more than $300 billion in assets, had revealed in recent months that several regulators including Galvin, the Securities and Exchange Commission, and the California and New York attorneys general were probing them for possible abuses.
To date, Putnam and Franklin are the largest fund families to be stung by the spreading scandal afflicting the fund industry. None of the three largest — Fidelity, Vanguard and American Funds — has been implicated.
Several fund experts said they still have extensive questions about what went on at Franklin — including who knew what, and when.
“I found their disclosures on their Web site and their earnings call to be inadequate,” said Dan Culloton, an analyst at fund-rating company Morningstar.
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