Sep. 4–A private hedge fund said yesterday it agreed to pay $40 million as part of a government settlement involving alleged illegal trading schemes, the first step in what state Attorney GeneralEliot Spitzer promised would be a crackdown on “widespread” unlawful mutual fund practices.
Spitzer yesterday alleged that prominent mutual funds had given preferential treatment to Canary Capital Partners, a Secaucus, N.J.-based hedge fund that has an office in Manhattan, by allowing it to engage in practices involving trades made after a market closes.
Canary Capital, which Spitzer said had $1 billion under management at its peak, will pay $30 million in restitution and a $10 million penalty “to avoid protracted and complex litigation,” the company, which admitted no wrongdoing, said in a statement. The firm is managed by Edward Stern, son of billionaire Leonard Stern, a longtime member of Forbes’ list of the world’s 400 richest people, the former owner of the Village Voice and Hartz Mountain pet supplies and the man whose name adorns New York University’s business school.
Spitzer identified two practices in which he accused Canary Capital and four prominent mutual funds — Bank of America’s Nations Funds, Banc One, Janus and Strong — of engaging. One, he called “late trading,” or buying shares at their closing price but making the trades after the market already has closed, which is illegal because it allows investors to take advantage of knowledge not reflected in the share price set at the market’s close. Spitzer compared such a practice to allowing someone to bet on a horse race after the winner already is known.
The other, “market timing,” occurs when an investor buys shares of a fund at the 4 p.m. closing price with the knowledge that the price doesn’t accurately reflect the value of the stocks in the fund. The shares are often sold the following day, exploiting the fund for short-term gains at the expense of long-term investors. Although not illegal, the funds that Spitzer cited all state in their prospectuses that they discourage or prohibit such practices, yet they gave Canary preferential treatment in allowing the hedge fund to violate the policies in return for some of the gains, Spitzer alleged.
While he declined to detail the next steps in the investigation, Spitzer said the settlement marked just the first step of the investigation.
“We believe it is very widespread,” he said. “I don’t want to predict what actions we will take. We’re beginning conversations with many mutual fund families and we’ll proceed apace.”
The four named funds have said they’re assisting in the attorney general’s investigation.
“We are cooperating fully with Mr. Spitzer’s office on this matter,” said Alexandra Trower, Bank of America Nations Fund spokeswoman.
Spitzer’s focus on mutual funds is a “distressing event” for the industry, said Chris Wloszczyna, a spokesman for the Investment Company Institute, a large mutual fund trade group. He said the industry has worked hard to earn the trust of investors and is built on the foundation that “all investors are treated equally.”
If Spitzer’s allegations are true, the transgressions amount to the hedge fund effectively bribing mutual funds to relax or ignore their own policies, said John Coffee, a professor of securities law at Columbia University.
“In the case of favored customers, it’s a fiduciary breach by the mutual funds,” Coffee said. Spitzer “has not just found bad things done by the hedge fund, which are small and anonymous, he found bad things they were doing with prominent mutual funds.”
In April, Spitzer announced a preliminary, $1.4 billion settlement of conflict of interest charges against Wall Street analysts and investment banks.
In a statement yesterday, Securities and Exchange Commission chairman William Donaldson called the financial firms’ alleged conduct “reprehensible” and said there was “no place” for it in the markets.
“As we have stated in announcing our current and ongoing study of hedge funds, there is too much money at stake for us to know as little as we do about these funds, in particular, and how they operate,” Donaldson said. “Concurrently, the broad participation by individual investors into mutual funds requires that we do everything possible to understand, anticipate and address areas where there is the potential for abuse and fraud.”
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