When New York Attorney General Eliot Spitzer first announced charges in early September for improper trading in mutual funds, many prominent fund families insisted that they were not complicit, but rather innocent victims of rapacious trading by hedge funds. Since then, the scandal has spread, suggesting they're wrong: Nine mutual-fund companies have become entangled in the probe, and on Oct. 16, one fund executive pleaded guilty to obstructing justice.
Now, Massachusetts Secretary of State William F. Galvin is jumping into the fray: For the first time, he is bringing charges against a mutual-fund company itself. He plans to file civil securities fraud charges against Boston-based Putnam Investments Inc. for allegedly letting investors frequently trade mutual-fund shares in their retirement accounts using a practice called market timing. A Putnam spokesman denies the charges.
Galvin's allegations concern trades made by individual investors in Putnam mutual funds held within their 401(k) accounts; Putnam administered those 401(k)s. Until now, such retirement plans, which provide $1 trillion of the $7 trillion in assets that mutual funds manage, had been untouched by the probe. And a law-enforcement source tells BusinessWeek that Spitzer, too, is looking into questionable trading in 401(k)s. The issue: Did mutual funds fail to enforce rules against rapid trading by 401(k) plan participants? "The funds are trying to portray this as isolated, and we don't believe that's the case," Galvin says.
Nor is it the end of the bad news for the fund industry. The Bay State prosecutor is investigating allegations that employees at some of the country's most prestigious fund groups -- Fidelity Investments, Franklin Resources, and Morgan Stanley -- actively helped large institutional investors avoid the internal checks that mutual funds have set up to nab frequent traders. And unlike Spitzer, who tends to settle cases out-of-court and collect multimillion-dollar fines, Galvin wants to sue for damages. "We're not doing this minuet of bow and curtsy," he says. "They think practices can be resolved by simply saying 'gee, we won't do it again.' That's not acceptable."
Just how deep the problems are for the fund industry remains to be seen, but for troubled Putnam, the charges couldn't come at a worse time. The nation's fifth-largest fund group has been battered by poor performance and redemptions since 2000. Investors pulled out $10 billion last year and another $8 billion through August. Assets under management have fallen to $272 billion, from $425 billion in mid-2000. Making matters worse, many of Putnam's best fund managers have decamped in recent years.
Putnam acknowledges it stopped two 401(k) plans from market timing. But in a third instance it was unable to halt individual investors, trading in their union pension plan, until it shut off access to two international funds in late September. And as of Dec. 1, Putnam will start charging fees for excessive trading.
Why did Putnam take so long to clamp down? One theory put forth by Galvin: Putnam allowed trades to go on so that it wouldn't lose management fees should the union take its money elsewhere. Not so, say Putnam officials, who point out that they administered only $40 million for the union. "If they had left us as a result, it would have been insignificant," says John Brown, head of institutional management for Putnam.
Now, Galvin has Fidelity, Franklin, and Morgan Stanley in his sights. He recently subpoenaed one person at each regarding trades by brokers at another firm. The subpoenaed employees are "wholesalers" who peddle their group's funds to large institutions.
Based on allegations made in depositions by the outside brokers, Galvin is investigating whether the fund salespeople helped them evade internal alarms intended to alert a fund to market timing. Investigators are looking at whether the salesforce advised market-timers, for instance, to keep trades under a certain dollar limit or number per week to avoid detection. A Fidelity spokeswoman says the firm has simply been asked for information. Franklin denies wrongdoing and Morgan Stanley says its policy is to discourage market timing.
If such allegations are borne out, the damage to Fidelity and the other funds could be significant. "The fund industry is being shaken at its roots," says James Lowell, who is the editor of Fidelity Investor, an independent newsletter that covers Fidelity funds. The fines could run up into the millions, but tarnished reputations could prove far more costly. By Faith Arner in Boston and Paula Dwyer in Washington