Aren’t charges at Strong due?

It’s been almost 3 months since first accusation

By KATHLEEN GALLAGHER AND PAUL GORES kgallagher@journalsentinel.com

Sunday, November 23, 2003

New York Attorney General Eliot Spitzer told a congressional committee earlier this month that Richard S. Strong’s alleged improper trades in and out of shares of his company’s mutual funds were “Exhibit A” in the dereliction of duty by mutual fund directors.

The question no one is asking is, “Where exactly is Exhibit A?”

It’s been nearly three months since Spitzer first implicated Strong Capital Management Inc. for giving a New Jersey hedge fund special opportunities other shareholders didn’t have to trade in certain Strong funds. It’s been nearly four weeks since Spitzer leaked to the press his plans to take action against Richard Strong based on allegations of improper short-term trading of his company’s mutual funds.

Strong lost $933 million of assets between early September, when Spitzer first mentioned the firm, and Oct. 31. Richard Strong, the company’s founder and chairman, was tied with Martha Stewart in CNBC.com’s online “biggest scoundrel” of the year survey as of Friday, and his company landed a spot as the three of clubs in the coming second edition of Parody Productions’ Wall Street Most Wanted deck of playing cards that is sold at www.wallstreetmostwanted.com.

What have Strong and and its founder done to deserve all that?

Something, maybe — but it’s not clear what.

Questions abound

Spitzer has produced some evidence: Exhibit 5 to his lawsuit against Canary Capital Partners LLC showed e-mails and lists suggesting unnamed Strong employees paved the way for Canary’s trades so they wouldn’t get rejected for “flipping.” And at least four times, Strong provided Canary with lists of holdings in four of its fund portfolios over a period when shareholders got them only once.

The evidence suggests Strong had different rules for certain clients than others. It raises serious questions for investors about whether the firm violated its fiduciary responsibility and ignored the whole premise of a mutual fund: that all investors are treated the same.

The allegations against Strong, however, weren’t the worst ones made against the mutual fund industry. It took Spitzer’s Oct. 29 leak suggesting Richard Strong made trades in his firm’s funds to the detriment of other shareholders to catapult Strong onto center stage in the growing mutual fund industry scandal.

The lack of a formal accusation or any hard evidence didn’t stop anyone: Richard Strong is now a prominent figure in the mutual fund industry scandal.

Questions abound. Is there any proof Strong did anything criminal or unethical? Is Spitzer acting ethically and appropriately, and within his authority as New York attorney general, in suggesting he plans to take action against Strong or his company?

Many Strong investors are angry because they believe Richard Strong stole not only their trust but their money — and did it in an unethical, perhaps illegal, way.

“If he knew a way to make money, why wasn’t he making it for me?” asked Terri Thompson, who had money invested at Strong and is the director of the Knight-Bagehot Fellowship in Economics and Business Journalism at Columbia University.

Thompson, though, couldn’t explain what Richard Strong did.

That lack of clarity has several local money managers scratching their heads. As one of them, who asked not to be named, put it: “Explain to me how Dick Strong gamed the system.”

Strong focused his trading on funds that invested in small and midsize companies, making more than two dozen in-and-out trades each year, The Wall Street Journal reported on Oct. 30, citing unnamed investigators. Some, but not the majority of the trades, were of very short duration, covering the course of only a few days, the newspaper said.

Richard Strong said in a statement he does not believe his transactions were disruptive to the funds, and he committed to personally compensate the funds for any financial losses they may have experienced as a result of those transactions.

But that information leads to speculation, rather than certainty, about what Strong did.

To take advantage of pricing inefficiencies, a market timer would have to find a fund with a good number of stocks whose bid price is higher than the “stale” price, which is the price determined by the last trade in the stock.

In that situation, the timer could buy shares knowing the price would catch up with the rising market later, providing a profit to the timer that otherwise would have gone to the fund’s longer-term shareholders.

‘What’s the point?’

Mark Ready says he doesn’t think Strong could have been taking advantage of pricing inefficiencies in any of his firm’s domestic funds. Even the smallest one — Strong U.S. Emerging Growth Fund — has a median market capitalization of $50 million to $150 million.

Ready, an associate professor of finance at the University of Wisconsin-Madison who worked for a year on regulatory issues at the SEC and who specializes in market structure, looked at a sample of companies with market caps in that range for the first six months of 2002. On a typical day, 90% of those stocks have a trade after 1:30 p.m., and 75% have a trade after 2:30 p.m.

“Accordingly, it looks like the ‘stale price’ form of market timing would be very tough in this type of fund,” Ready said.

Nor does it appear that Strong was making a lot of extremely rapid trades, buying on one day and selling on the next. He only had six to nine next-day trades during the period in question, said his lawyer, Stanley S. Arkin.

“In every one of the next-day trades, he lost money,” Arkin said.

Some suspect Strong could have taken advantage of pricing inefficiencies in the firm’s international funds, the type of fund that often has such opportunities. But during the 6 1/2-year period in question, Strong didn’t make more than four trades in his firm’s international funds, Arkin said.

There are certainly other ways Strong could have profited from trading in his own funds, but the available information doesn’t provide any clues about whether he employed them.

Needs to see details

“While I can imagine many ways — what’s the point of imagining,” Ready said. “The next thing to see is the detail behind the $600,000 calculation.”

News reports have suggested Richard Strong netted at least $600,000 in profits.

Strong’s trades occurred in from nine to 13 accounts with a total value of about $6 million, Arkin said.

“There were no two sets of rules: One for Dick Strong and one for others,” Arkin said. Strong’s trading was open to the firm’s portfolio managers, people in its compliance and accounting departments, and on its trading desk, he added.

In fact, the compliance department once rejected one of Strong’s trades, Arkin said.

“In my view, there’s no way there’s any crime committed here by Dick,” he said.

The system will ultimately judge that. And even if Strong didn’t do anything criminal, there may be ethical questions involving his trades.

“It’s very possible that this market timing thing — when we really look at it in the cold light of day, not the panic of Enron – – we might say, ‘What’s the big deal?’ ” said Michael Josephson, a lawyer and former law professor who is president and chief executive officer of the Josephson Institute of Ethics in Los Angeles.

Could Strong have been making trades in his own funds that weren’t illegal or unethical?

Strong, according to peers who have observed his investment activities over the years, tends to make big market bets based on macro-economic news.

“Anybody who knows Dick Strong knows the guy makes macro bets,” said Timothy P. Reiland, chairman and chief financial officer of Madison-based Musicnotes Inc. and formerly investment research director at now-defunct Cleary Gull Reiland & McDevitt.

Reiland’s view jibes with that of F. Jon Baranko, managing director of Strong’s institutional business and its former head equity trader.

In a meeting last week with the Milwaukee County Pension Board, Baranko said Strong, influenced by investment losses in the 1970s, tries to be in the market when it’s going up and out of it when it’s going down.

Strong applies that same absolute return style, where turnover can be as high as 800%, to his personal portfolios, Baranko said.

“In retrospect, he probably should have looked at it and isolated his activity within some sort of blind trust or something like that. But it is what it is,” Baranko said.

“I don’t believe there was any intent on his part to defraud investors. I don’t believe there was any sort of arbitrage opportunity that was available to him that wasn’t available to any of our other investors.”

Time will tell whether Eliot Spitzer is going to publicly argue anything different.

Dave Umhoefer of the Journal Sentinel staff contributed to this report.

SCANDAL TIMELINE

Since Sept. 3, when New York Attorney General Eliot Spitzer accused four investment firms — including Strong Capital Management Inc. — of improper trading, news articles based on leaks have focused additional attention on company founder and Chairman Richard S. Strong.

Here is a look at allegations that have surfaced from sources other than public releases of information by Spitzer’s office. Neither the company nor Strong himself have been officially charged with wrongdoing.

OCT. 29

Headline by The Associated Press: “AP Exclusive: Authorities looking at Strong chairman in mutual fund investigation, source says”

Sources: A source “familiar with the matter” who spoke on the condition of anonymity.

The Associated Press said Spitzer was investigating whether Richard Strong made improper trades that benefited himself, his friends and family. A similar story appeared that day in The Washington Post, using unnamed sources.

OCT. 30

Headline in USA Today: “Mutual fund chairman Strong could face charges”

Sources: Sources close to the investigation.

USA Today said Spitzer was weighing the possibility of charging Richard Strong with defrauding investors. The newspaper reported that during a five-year period ending in 2002, trading records subpoenaed by Spitzer’s office suggest Strong made at least $600,000 for himself, friends and family by engaging in rapid, market-timed trading designed to exploit inefficiencies in funds that specialize in small and midsize companies.

Headline in The Wall Street Journal: “Probe hits Strong chairman”

Sources: Investigators familiar with the firm’s trading activities.

The Wall Street Journal also reported that day that Richard Strong was suspected of engaging in improper, short-term trading of his firm’s mutual funds, netting at least $600,000 in profits for himself and others.

NOV. 11

Headline in The Wall Street Journal: “Strong Capital faces precipice — criminal charges could be filed against founder for fund moves”

Sources: People familiar with the matter.

The newspaper reported Spitzer’s office “is giving serious consideration” to filing criminal charges against Richard Strong for allegedly personally profiting from improper trading in the mutual funds that his company runs. The story went on to say Strong ultimately could be forced to sell the company.

NOV. 18

Headline by CNBC (from transcript): “Eliot Spitzer allegedly investigating whether mutual fund company engaged in the practice of front running”

Sources: A “source close to Spitzer”

CNBC News said investigators were looking at whether Richard Strong took personal positions in individual stocks knowing his funds were about to take even bigger positions — a practice known as front running. The source stressed Spitzer’s office was only investigating the allegations so far, and no decision had been made on whether to charge Strong.