Regulators filed civil fraud charges against the two founders of the Pilgrim Baxter mutual fund family Thursday, saying they made millions for themselves and friends in an improper trading schemethat harmed other fund shareholders.
Gary Pilgrim and Howard Baxter were accused by the Securities and Exchange Commission and New York’s attorney general of defrauding investors by allowing selected customers to make in-and-out trades prohibited by fund policy.
The civil charges mark the first time fund company leadership has been directly charged in a trading scandal that has rapidly spread across the $7 trillion fund industry. Previously, regulators had taken action against two former Putnam Investments portfolio managers, as well as the firm, but Putnam’s top executives were not directly accused.
Authorities said it appears Gary Pilgrim benefited the most financially from the trades, while Baxter broke the law by allowing them. One trading arrangement netted more than $13 million in profits, including $3.9 million for Gary Pilgrim, according to the SEC complaint.
The agencies said they will seek restitution for investors as well as financial penalties. The New York state complaint also seeks the return of all management fees earned by the Pilgrim Baxter during the alleged wrongdoing – which it estimates at $250 million.
“There will be enormous fines,” New York State Attorney General Eliot Spitzer told The Associated Press. “This was such a gross violation of their fiduciary duties.”
The move comes a week after both Pilgrim and Baxter were ousted from Pilgrim Baxter & Associates, which manages the PBHG fund family, because of improper trading.
In a statement Thursday, Pilgrim Baxter & Associates stressed that both men have left the company and that it is cooperating with the investigation, although it does not agree with everything in the complaints. Last week, the company said Gary Pilgrim would turn over personal profits he received from the improper trading and the company would reimburse the fund all related management fees.
Charles Walker, an attorney who represents both men, did not return calls for comment on Thursday.
The charges are the latest wrinkle in a widespread investigation by the SEC, the states of Massachusetts and New York and other regulators.
Putnam and Canary Capital, a hedge fund operator, have agreed to settlements for fund-related wrongdoing.
Authorities have also accused some individuals at Fred Alger & Co., Bank of America and Millennium Partners of improper trading. They also have indicated charges are likely against Alliance Capital for improper trading, as well as Richard S. Strong, the founder of the Strong mutual fund company, who has acknowledged making short-term trades to benefit himself and his family.
According to Thursday’s filings, Gary Pilgrim, his wife, hedge fund manager Michael Christiani and a fourth unidentified individual established the Appalachian Trails hedge fund, which was permitted to conduct extensive in-and-out trading of PBHGs funds in 2000 and 2001, about the time the bull market soured.
The practice, known as market timing is not illegal, but had been formally prohibited by the fund family because it skims profits from longer-term shareholders.
The charges also allege that clients of Wall Street Discount, a brokerage run by Alan Lederfeind, a close friend of Baxter, were provided with nonpublic information about the portfolio holdings of PBHG funds – a process which facilitated the market timing and generated significant profits for these customers.
Neither Christiani nor Lederfeind have been charged, though Spitzer said more charges are possible.
The arrangements that were engineered or permitted by Gary Pilgrim and Baxter came at a time when the funds’ own portfolio managers were complaining that market timing was having a negative effect on returns for typical shareholders and other market timers were ordered to stop.
The complaint cites an e-mail in which Gary Pilgrim suggested giving market timers “the boot” because they hurt shareholders and probably are “not even in our business interests.”
Appalachian and Wall Street Discount continued to time funds through the end of 2001.
In 2000 and 2001, Appalachian made nearly 100 exchanges into and out of the PBHG Growth Fund, trades that helped net $13.9 million in profits, the AG’s complaint said. A long-term investor in the same fund would have lost over 60 percent of his investment during that time, according to the complaint.
PBHG officials estimated that market timers held $466 million in assets in the flagship PBHG Growth Fund in late 2001 – or more than 14 percent of the fund, according to court papers.
“Pilgrim Baxter’s mutual fund investors deserved much better; their trust was abused,” said Stephen M. Cutler, director of the SEC’s enforcement division.
Roy Smith, professor of finance at the Stern School at New York University, said the charges raised the possibility that PBHG funds would suffer withdrawals from unhappy investors.
“Those who are named in cases like this are going to be punished by investors,” he said.
Wayne, Pa.-based Pilgrim Baxter, which is owned by London-based Old Mutual PLC, managed $7.4 billion as of Sept. 30.
Putnam Investments has lost more than $22 billion in assets it managed since reports of its trading activities became public in late October and continues to lose business. On Thursday, DaimlerChrysler AG’s Chrysler division dropped Putnam Investment funds from its retirement plan offerings. California and Oregon pension funds also dismissed Putnam this week.
