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| | Mutual Funds
Mom-and-pop investors cheated of 'billions'
Crusading attorney general says mutual fund companies allowed hedge funds to invest after-hours, raking in billions from the small investors who couldn't.
By Timothy Middleton
Small investors are once again the big losers in the latest scandal to rock Wall Street.
New York Attorney General Eliot Spitzer announced the filing of a complaint Wednesday against a New York-area hedge fund and four mutual fund companies, alleging they had engaged in illegal trading practices.
Eric Zitzewitz, a professor at the Stanford University School of Business, estimated the losses were at least $4 billion a year.
The implication of Spitzers complaint is that ordinary mutual fund shareholders were robbed of profits to which they were entitled when the hedge fund, Canary Capital Partners, was allowed to buy shares after market hours, a time when ordinary investors can't trade funds.
Spitzer asserted that Janus Capital Group (JNS, news, msgs), Strong Funds, Bank of America's (BAC, news, msgs) Nations Funds and Bank One (ONE, news, msgs) allowed Canary and related entities to profit unfairly on these after-hours fund trades. In return, the hedge fund made investments with some of the companies' other funds, generating fees for the companies.
'Betting on a horse that's already won'
The fund companies not only allowed the illegal trading but assisted Canary in various ways, Spitzer said: - Strong allowed after-hours trading in five of its funds in exchange for Canary setting up an $18 million brokerage account as well as investing in one of its own hedge funds.
- Bank of America installed special software in Canarys computer system so the firm could communicate directly with the bank. The company's business was worth $2.25 million a year in fees to the bank.
- Bank One created a special-purpose vehicle that allowed Canary to conduct trades.
Here's how the scheme worked: Many companies release their earnings reports after 4 p.m. ET, when a funds net asset value (NAV) is established. A favorable earnings surprise could cause the funds holdings to spurt in value, though the closing NAV wouldn't reflect that. Someone able to buy the fund at 6 p.m. at the closing price and then sell the next day would draw its profit from the earnings of the funds other shareholders.
Spitzer called this betting on a horse that has already won.
More targets likely, Spitzer says
The complaint announced Wednesday is the result of an eight-month investigation by Spitzer's office. In settling the complaint, Canary agreed to pay back $30 million in illegal profits generated from the trading and pay a $10 million penalty. Canary did not admit or deny wrongdoing. It also agreed to aid Spitzer's continuing probe of the mutual fund industry.
Spitzers office has been investigating the funds for some eight months.
In an interview on CNBC, Spitzer declined to say whether he would take action against the mutual fund companies. But he said it was a near certainty that other mutual fund companies would be named in the continuing investigation of the arbitrage practices. Mutual funds owe (money) to mom-and-pop investors all over the country, he said.
The mutual fund companies named said they were cooperating with Spitzers office.
The managing partner of Canary Investment Management is Edward Stern. He is the son of Leonard N. Stern, chairman and chief executive of Hartz Mountain Industries, a major real-estate development company that formerly owned the Hartz pet food concern.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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