Schwab finds improper trading in funds

SEC, state regulators may fight over enforcement turf

By LANDON THOMAS JR. New York Times

Saturday, November 15, 2003

Charles Schwab, the discount broker that revolutionized the mutual fund industry, said Friday that it had uncovered evidence of improper mutual fund trading in both its supermarket of funds and a fund family of a subsidiary, U.S. Trust.

Through an internal investigation, Schwab has found its sales force may have allowed professional investors like hedge funds to trade mutual fund shares after the market closed and to engage in short-term trading of its Excelsior funds, a fund family of U.S. Trust, a spokesman for the company said Friday.

The Schwab news comes a day after the PBHG fund group forced out its co-founders because of improprieties in fund trading and after Putnam Investments agreed to make a host of changes in its business practices to settle a suit with federal regulators.

American Express, Legg Mason and Wachovia also said they had been subpoenaed in the widening mutual fund investigations that have already led to the departures of key executives at Bank of America, Putnam and Menomonee Falls-based Strong Capital Management Inc.

Putnam still a target

New York state regulators and the Securities and Exchange Commission are investigating Schwab, along with many other companies. But a rift between them appears to be growing wider, as they disagree over whether to reach quick resolutions or push for tougher punishment to restore investor confidence. As the scandal spreads to many companies, an escalating turf war could become a drain on resources, with regulators unleashing competitive lawsuits.

A day after federal regulators reached a settlement with Putnam Investments, the New York attorney general, Eliot Spitzer, said Friday that his investigation of Putnam was continuing and that he was not close to a settlement with the fund company. A Massachusetts regulator said he too would continue to pursue a case against Putnam.

The investigation of trading abuses at Schwab may be a crucial testing ground to determine whether state and federal regulators can cast aside professional and procedural differences. Both groups say they wish to protect investors who have suffered at the hands of mutual funds that made special trading arrangements for prized institutional clients.

In a speech in Albany, N.Y., on Friday, Spitzer, whose investigation of collusive fund trading abuses prompted the SEC’s entry, described the commission’s recent settlement with Putnam as duplicitous and questioned whether his office would be able to work with the SEC in the future.

“Every rock you turn over in this industry you find vermin,” Spitzer said. “The SEC has not turned over a pebble. They just don’t know how to negotiate a meaningful resolution.”

Spitzer used his own leverage as a prosecutor to force the investment banking industry to pay $1.4 billion and to agree to changes in how it does business in a joint settlement with the SEC. He now contends that the SEC may be missing a similar opportunity to force change in the $7 trillion mutual fund industry, change that could lead to lower fees and increased disclosure.

Acting without state officials, the SEC and Putnam settled a complaint that the company allowed its employees to trade rapidly in and out of its funds. Regulators say the practice, called market timing, is not in the best interest of long-term shareholders. Under a partial settlement, the fund company, a unit of Marsh & McLennan based in Boston, agreed to a number of governance reforms, including the addition of independent directors and the restriction of employee fund trades.

It did not reach an agreement yet on a fine, though Putnam did admit guilt for the purposes of a penalty. The amount of money lost by investors will help determine the penalty, and though it may have been only pennies per share for individuals, it may have amounted to substantial profits for those favored clients allowed to conduct market timing.

For Spitzer, the promised changes at Putnam are window dressing; he says that Putnam should be forced to return the excessive fees it charged investors.

SEC defends settlement

On Friday, Stephen Cutler, the director of the SEC’s enforcement division, defended the Putnam settlement, arguing that the widespread evidence of trading abuses necessitated quicker settlements.

“I feel an urgency,” Cutler said. “The widespread misconduct needs to be addressed now. The prosecutor and I may not see eye to eye, but we do share the same goal in protecting the investor.”

Schwab, through its vast supermarket, offers individual investors the opportunity to invest in more than 2,000 mutual funds, and in many ways it is the nexus of the many-faceted relationship between fund companies and the small investor.

Any evidence that illegal fund trading occurred at this level is sure to come as a shock to the 3.5 million Schwab clients who browse through its marketplace looking for the right fund to buy.

A spokesman said on Friday that an internal investigation of more than 34 million fund trades found that a small number of mutual fund trades may have been processed after 4 p.m., and some professional investors may have been allowed to change orders after the end of the day’s trading.