Nov. 21–New York state and federal regulators filed civil fraud charges against mutual fund industry legends Gary Pilgrim and Harold Baxter Wednesday, turning up the heat on an expanding probe thathas been roiling the fund business for months.
The suits detail a raft of allegedly fraudulent behavior that is striking in both the amount of money involved and the extent to which such high-profile executives participated.
Pilgrim, Baxter and the firm they founded–Pilgrim Baxter & Associates Ltd.–were charged with allowing friends and a hedge fund partly owned by Pilgrim and his wife to churn hundreds of millions of dollars through their mutual funds at the expense of shareholders.
The Securities and Exchange Commission also accused Baxter with providing outsiders non-public information on securities in PBHG fund portfolios and charged both executives with breaching their fiduciary duty to shareholders in their funds.
“The allegations in our complaint describe a course of conduct that was unethical, illegal and just plain wrong,” Stephen Cutler, the SEC’s director of enforcement, said in a statement. “Pilgrim Baxter’s mutual fund investors deserved much better; their trust was abused.”
Lawyers for Pilgrim, Baxter and the firm did not respond to calls for comment.
Although other prominent fund executives have either been charged or have stepped down as a result of the broadening scandal, the Pilgrim suits represent the first time the top executives of a fund company have been charged formally with illegal trading that benefited them personally.
Richard Strong, the founder and 90-percent owner of Strong Financial in Menonomee Falls, Wis., has also been publicly accused of improper trading for his own account by New York Attorney General Eliot Spitzer. But so far, Strong has not been charged with anything formally and his attorney has insisted for weeks that the embattled fund chief has done nothing wrong.
Nevertheless, sources close to the Strong investigation said that both the SEC and Spitzer’s office plan to level charges soon but that Spitzer is taking his time, intent on proving a criminal case against Richard Strong. Congressional sources also say that several cases are brewing against other Chicago mutual fund complexes, including the one run by Bank One.
A Bank One spokesman said officials have no comment, but two Bank One asset-management executives stepped down in October.
By contrast, Merri Jo Gillette, associate district administrator of the SEC office in Philadelphia, said the Pilgrim Baxter suits were moved ahead quickly in the interest of protecting shareholders.
“We thought it was very important to investors to get as much information out there as possible,” Gillette said.
Pilgrim Baxter carved a reputation for itself during the 1990s as one of the highest-flying fund companies in the nation. Gary Pilgrim, especially, was considered one of the bull-market’s true gurus and his highly technical growth strategy drew lavish attention from the business press.
But during the downturn, Pilgrim’s portfolios fared poorly. And earlier this month, the Pilgrim Baxter board issued a statement saying an internal investigation had turned up evidence that Pilgrim, 63, and Baxter, 57, were involved in the sort of “market timing” trades that have been at the center of mutual fund scandal ensnaring dozens of firms.
Pilgrim was the firm’s chief investment officer. Baxter was the chief executive. Pilgrim Baxter is owned by insurer Old Mutual PLC of London.
Market timing involves moving into and out of funds quickly, hoping to exploit inefficiencies in the way mutual fund companies price their shares. Funds calculate their share price, or “net asset value,” only once a day–usually at 4 p.m. Eastern time. But that value sometimes reflects “stale” prices for the stocks the fund holds–one example being a Japanese stock that because of time-zone differences closed on local markets at 2 a.m. New York time.
If news in the U.S. markets appears likely to cause Japanese stock to rise overnight, an investor might be able to predict as much before the fund closes that day. If he buys the stock, and the Japanese company does rise, he can sell it for a tidy profit the next day
The strategy also works for small-company stocks that trade infrequently or have a limited number of shares, because their prices are often stale and can fluctuate widely. The PGHG Growth fund, which was managed by Pilgrim, traded in those kinds of stocks and it became a favorite target of market timers, according to the suits.
Market timing hurts shareholders because it distracts management and the timer’s profits come out of the pool reserved for the fund as a whole. Heavy transaction costs also boost fund expenses. For this reason, most fund companies — Pilgrim Baxter included — publicly discourage timers. In 1998, Pilgrim’s firm even instituted a special committee to track down and eject timers from its funds.
But the suits claim the firm’s “timing police” were told to ignore specific trading entities. One was a hedge fund called Appalachian Trails that was launched in 1995 by Connecticut investor Michael Christiani specifically to profit from a timing strategy in mutual funds. Starting that year, Pilgrim and his wife invested $1 million the fund, which grew to $28 million —-or 45 percent of the fund’s assets–by 2001.
Pilgrim and Baxter also allowed timing trades by the clients of a New York broker-dealer firm called Wall Street Discount Corp. (WSDC), which is owned by Alan Lederfeind, a long-time friend of Baxter’s. The SEC claims Baxter provided Lederfeind “material, non-public” information on the funds’ holdings, which his clients could use to trade against. Left to their own devices, Appalachian Trails and WSDC clients traded “feverishly” in PBHG funds, Spitzer’s complaint says.
Until now, revelations in the fund scandal indicated that money invested by market timers represented just a small portion of a mutual fund’s assets. But Spitzer’s complaint said that Pilgrim Baxter’s own analysis showed that short-term assets ballooned in its funds from 1998 until late 2001.
In July 2001, for instance, Gary Pilgrim’s PBHG Growth Fund had almost $500 million in short-term assets, or nearly 14 percent of the total. Appalachian Trails and WSDC routinely moved chunks of money topping $50 million between a PBHG money market fund and Pilgrim’s Growth fund.
In May 2000, Spitzer’s suit says, a PBHG fund manager complained in an email about having to manage the incessant flow of hot money.
“I’m not sure if this $100 MM is from Wall Street Discount,” the email said, “but it is really a disruptive amount of money. I wouldn’t keep hounding you about it if the size was not close to 10 percent of the total assets.”
The SEC suit estimates that Appalachian Trails netted $13 million in profits from PBHG trading in 2000 and 2001. Pilgrim’s share of that came to $3.9 million. Spitzer’s suit claims the firm itself raked in $250 million in fees managing the short-term money over a four-year period.
Shareholders, meanwhile, were left holding the bag. Not only did those profits and fees come directly out of their pockets, but the PBHG funds also suffered badly in the downturn. During the timeframe of Appalachain’s trading in 2000 and 2001, Spitzer’s suit says, PBHG Growth shareholders lost 60 percent and 26 percent, respectively.
Both suits seek to bar Pilgrim and Baxter from most aspects of the securities industry. They also seek an unspecified amount of restitution and penalties.
What impact these suits will have on the Strong investigation isn’t clear. But Spitzer has been outspoken about trying to make Richard Strong an example. So far, the Strong Financial board has acknowledged that the firm accepted market timing trades from a hedge fund called Canary Capital Partners. And it has admitted that Strong himself made trades for his own account in Strong mutual funds.
Strong’s attorney has maintained he has done nothing wrong.
Compounding Strong’s problems, however, is that unlike Pilgrim and Baxter, he owns 90 percent of his firm and has effective control over the whole operation.
For a prosecutor or regulator, said the SEC’s Gillette, “those are very compelling facts. Certainly the more ownership of a firm you have the more you’re going to profit from all of the ways a firm is going to profit.”
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