Improper trading widespread, probe shows

Mutual fund firms get new scrutiny from regulators

By GRETCHEN MORGENSON AND LANDON THOMAS JR. New York Times

Saturday, October 25, 2003

An investigation by securities regulators has uncovered widespread improper trading of mutual fund shares at the nation’s largest fund companies and brokerage firms, an official at the Securities and Exchange Commission said Friday.

The SEC is investigating mutual funds in light of several recent disclosures that have shaken investor trust in the industry. A major focus of the investigation is determining how common it is for funds to allow certain investors to trade fund shares rapidly and capitalize on inefficiencies in share prices. The practice, known as market timing, is not illegal but is discouraged by many fund companies because it can interfere with management of a fund and can allow certain traders to profit unfairly at the expense of other, long-term fund shareholders.

The SEC official said that after sending out 88 letters to mutual fund companies and brokerage firms, the agency found that half of the fund companies had arrangements with one or more investors that allow them to trade in and out of shares. These arrangements occurred even though about half of the fund companies have policies specifically barring market timing, the official said.

In addition, many fund companies, the official said, appear to have provided information about their holdings to big investors, such as hedge funds. Such portfolio information could help these investors profit by trading the securities being bought or sold by the funds.

The SEC also found that a handful of brokerage firms allowed certain customers to make late-day trades in fund shares, possibly enabling them to profit from overnight price movements by allowing them to buy at the price before the market closed. The regulatory official expressed surprise at the findings and promised fast action against the companies.

The SEC’s investigation comes on the heels of one announced in September by Eliot Spitzer, the New York state attorney general, who uncovered market timing and late trading. So far, one mutual fund executive and another hedge fund trader have entered guilty pleas in that investigation.

William F. Galvin, the secretary of the commonwealth of Massachusetts, also has been investigating big fund companies, many of which are in that state. Galvin has led the investigation into practices at Putnam Investments, the nation’s fifth-largest fund company, which manages $272 billion for 12 million investors.

Putnam fires four

Officials at Putnam Investments said Friday that they fired four fund managers for making improper personal trades three years ago in shares of the funds they managed. Putnam fired the fund managers after fielding inquiries from The Boston Globe. The fund has confirmed that two additional fund managers engaged in market timing but that they are still employed by the firm.

Nancy Fisher, a Putnam spokeswoman, declined to identify the fund managers who were fired or the funds they ran, saying that those disclosures would be made soon.

Asked why Putnam had not fired the two fund managers found to have conducted market timing, Fisher explained that they had not traded in their own fund shares. “The consequence is different for those who were involved in trading in their own funds,” she said.

Putnam has said it would reimburse the funds in which managers traded improperly.

The fund’s board is led by John A. Hill, a managing director of First Reserve Corp., a private equity buyout firm. Hill said that the board is conducting its own investigation of the fund’s policies and practices.

In a statement to Putnam shareholders late Friday, Hill conceded that Putnam’s policies “have not been perfect.” But he said: “Putnam has assured the trustees that it has taken all steps necessary to ensure the effective management of the funds managed by the portfolio teams affected by these changes.”

He declined to comment further.

One question that the Putnam spokeswoman said she could not answer was whether the fund’s board had been advised of the market timing trades when Putnam officials learned of them in 2000. Under securities laws, a fund management company must adopt policies and procedures designed to prevent the misuse of non-public information, which such trading may involve, according to an SEC official. If such trading occurs in spite of the procedures, fund officials are supposed to alert the board of directors, which has a fiduciary duty to protect fund shareholders.

Likened to insider trading

Market timing by fund managers in their own shares is the functional equivalent of insider trading, the official said, adding, “The non-public information here may have been that the shares of the fund are mispriced.”

Meanwhile, a U.S. Senate panel has set a hearing into alleged trading abuses in the mutual fund industry to assess whether new laws are needed to protect investors.

“We must maintain vigilance over the integrity of the mutual fund industry,” said Sen. Peter Fitzgerald, an Illinois Republican and chairman of the Senate Governmental Affairs financial management subcommittee, who scheduled the hearing for Nov. 3.

Bloomberg News contributed to this report.