NEW YORK — If it weren’t against the law, a trading scheme that prosecutors say enriched a hedge fund firm and exposed the seamy side of the mutual fund business would be considered a can’t-missinvestment strategy.
In its early stages, the scheme, which prosecutors compare to betting on a horse race after the horses have crossed the finish line, depended on low-tech tools: faxes, handwritten trade orders, phones and — most important — the clock.
Prosecutors say it was a simple fraud concocted by hedge fund firm Canary Capital Partners and made possible by certain mutual fund companies that played along even though they knew the scheme ran afoul of the law and industry regulations.
Eliot Spitzer, the attorney general of New York, on Wednesday charged that some of the mutual fund industry’s biggest players were involved in illegal trading practices, a bombshell that tarnished the fund industry’s image.
Until now, the $6.8 trillion industry, which caters to buy-and-hold individual investors, had a relatively clean public image. This scandal could involve more than 30 fund companies.
So far, only Canary has been charged, and it settled without admitting or denying guilt. It is cooperating with investigators, as are the fund companies named in the complaint. Spitzer’s complaint targets Canary’s trading practices with four companies: Strong Financial, Janus Capital, Bank One and Bank of America.
The details surrounding Bank of America’s alleged wrongdoing get to the heart of how individual investors suffered again in the name of greed.
One illegal practice that Spitzer says Bank of America and Canary engaged in, called ”late trading,” particularly raised his ire. Mutual fund shares are priced once a day at the close of stock trading, based on the closing prices of the stocks in the fund’s portfolio. Late trading is when an investor places an order to buy fund shares after 4 p.m. ET and gets the shares at that day’s closing 4 p.m. price, or net asset value (NAV). That violates a 1968 law that ensures a level playing field for all investors based on ”forward pricing.” Simply, the law says an investor must buy before 4 p.m. to get that day’s price.
In the complaint, Spitzer details how he says the prohibited practice was executed by Canary over a three-year period with the help of mutual funds marketed by Bank of America.
The scheme normally began prior to the 4 p.m. close of stock trading in New York, the complaint says. Canary would fax or e-mail a series of ”proposed” fund trades to Bank of America broker Theodore Sihpol, according to the complaint. It says Sihpol, or a member of his team, would then fill out the order ticket, stamp the pre-4 p.m. time on it and set it aside to await further instructions that evening.
That delay is what Spitzer says gave Canary an unfair advantage. It gave traders a chance to see if earnings announcements or any market-moving news broke after the close that could affect the next day’s price movement of the funds for which they had placed orders.
In essence, Bank of America would have been giving Canary a chance to make an after-hours purchase if the hedge fund thought it could make money the next day by selling the shares at a profit, a strategy known as ”arbitrage.” Mom and pop investors have no such opportunity and, therefore, never get to enjoy such a potentially profitable trading edge.
The complaint says the scheme was consummated each day sometime after the stock market closed at 4 p.m., when Canary would phone Sihpol and tell him whether to fill or cancel the proposed order. If Canary still wanted the transaction to go through, the order — with its pre-close time stamp — was sent to Bank of America’s funds clearing department for processing at that day’s closing NAV. If Canary canceled the order, Sihpol or others at the bank would destroy the order ticket as if it never existed, the complaint says.
Bank of America spokesman Bob Stickler says the bank has assembled a special team to gather all the facts: ”We are working with a great sense of urgency, and when we get those facts we will take the appropriate action.”
The mastermind behind the illegal activity, prosecutors say, is Edward Stern, 38. Stern is the son of Leonard Stern, the 80th richest person in the USA, according to <I>Forbes</I>. Leonard Stern’s father inherited a canary business from his German immigrant father, Max, and turned it into Hartz Mountain, a family-owned pet supply business with 1,500 products. Leonard Stern also branched heavily into publishing and real estate, holdings that include Manhattan’s Soho Grand and Tribeca Grand hotels.
Edward, who was president of Hartz until 2000, began trading on a small scale with private money in the late 1990s. After the family sold part of Hartz Mountain in late 2000, he began to do what he had always longed to do: run a hedge fund. Hedge funds are loosely regulated investment pools geared toward the wealthy. The complaint says Stern began running money full time in or around 2000.
Under Stern’s leadership, Canary also profited from a practice known as ”market timing.” The complaint says Canary arranged deals with fund companies to allow it to dart in and out of funds in an attempt to exploit short-term moves in the fund’s underlying value. Such a tactic, while not illegal, is frowned upon by fund companies, which often include passages in their prospectuses stating that they won’t tolerate timers.
And market timing hurts long-term shareholders by diluting their returns and resulting in higher trading costs. A fund’s performance may also be hurt by the fact that fund managers must hold more cash to meet the redemptions caused by the timers’ trades.
Prosecutors say the Canary hedge fund wasn’t the only one profiting from the arrangement. According to the complaint, Canary invested millions in the bank’s bond funds, generating fees for Bank of America and other fund companies. Such an inducement is referred to as ”sticky assets.”
”Fund managers have succumbed to temptation and allowed investors in the target funds <B> . . . </B> in exchange for additional money in their own pockets,” the complaint says.
Canary’s dealings with Bank of America date to 2001. The relationship became so cozy that Bank of America allegedly gave Canary the OK to market-time several of its funds. The complaint also accuses Bank of America of installing electronic trading systems at Canary’s office that enabled it to trade the bank’s Nations family of funds, and hundreds of other funds, for 2 1/2 half hours after the market closed. Throughout 2001, 2002 and up until the investigation in July, Canary placed ”late orders for hundreds of mutual funds,” the complaint says. Bank of America also allegedly extended Canary a $300 million line of credit to finance its trading.
Sihpol, the Bank of America broker who deals mainly with high net-worth clients, was said to have landed Stern as a client and arranged for Stern to meet with higher-level executives at Bank of America. The complaint says Sihpol first met with Stern at the hedge fund’s offices in Secaucus, N.J., back in April 2001. Sihpol then invited Stern to come to the bank’s New York offices later that month to explain his proposal. It is at that meeting that Bank of America offered to set Canary up with the electronic clearing system that would allow it to directly place trades up until 6:30 p.m., the complaint says.
Sihpol summarized the meeting in an April 16, 2001, e-mail to his superior, Charles Bryceland. The memo stated that ”initially it was contemplated that Bank of America would permit Canary to time $20 million to $30 million in Nations Funds <B> . . . </B> (and that) Canary would make a ”sticky” asset investment of the same amount of money in Nations bond funds.”
In a letter dated May 1, 2001, Canary sent Sihpol a letter confirming that the hedge fund planned to commit ”sticky” assets with Bank of America. ”It is our intention,” the letter read, ”to commit ‘permanent’ capital to Nations funds.”
The deal was cemented, prosecutors say, when Sihpol got the OK from Banc of America Capital Management, the investment manager for Nations funds. Sihpol sent Robert Gordon, then co-president of BACAP, an e-mail on May 3, 2001, advising him of the specific funds Canary wanted to time. He also asked for help in getting a list of the targeted funds’ portfolios to assist Canary in their timing efforts.
Later that day, Gordon forwarded an e-mail giving Canary a special ”market timing dispensation” to the BACAP’s ”timing police.” So the people who were supposed to police timing were told to look the other way, prosecutors say.
In 2002, with Canary’s timing still underway, Nations Funds added language in its prospectus noting the harmful effect of timing and steps it would take to protect shareholders.
The end game neared in May when a disgruntled BACAP employee complained ”vociferously” to the timing police about the damage being caused to funds by Canary’s timing. It wasn’t until Canary received a subpoena from the attorney general’s office that the hedge fund’s timing of Nations Funds ceased.
On July 3 BACAP’s timing police announced that all of Canary’s ”sticky” money had left the bank.
