If Eliot Spitzer is right about the culpability of four money management companies and a third-party administrator in permitting market timing and late trading in mutual funds by a hedge fund, investors will be swift to mete out punishment.
That will come in the form of outflows of retail, defined contribution plan and defined benefit plan assets, and class-action lawsuits by both retail and institutional investors.
Retail clients already have begun their exodus. Institutional clients likely will follow after more details emerge from the investigations by Mr. Spitzer, the New York attorney general; the Securities and Exchange Commission; and others.
Consultant Ted Disabato said he already has heard "from clients calling with righteous indignation about this matter." Mr. Disabato said one threatened to fire a money manager named in Mr. Spitzer's complaint "on the spot" if the trading abuse allegations are true. Mr. Disabato, president of Disabato Associates LLC, Chicago, wouldn't name the client.
Other consultants, including Russell LaBarge, principal at Strategic Capital Investment Advisors Inc., Oak Brook, Ill., are anticipating questions from pension clients and upcoming pension fund board meetings, where the topic will be a hot one with trustees.
Mr. Spitzer alleged in a complaint about Secaucus, N.J.-based Canary Capital Partners LLC, two of its affiliates, and the managing principal, Edward J. Stern, that four firms permitted Canary to market time within their mutual fund families, including many funds that are widely used by 401(k) plans. The firms were Bank of America Corp. Charlotte, N.C., which managed about $310 billion as of Dec. 31; Bank One Corp., Chicago, which managed about $176 billion as of July 31; Janus Capital Group Inc., Denver, which handled about $152 billion as of Aug. 31; and Strong Financial Corp., Menomonee Falls, Wis., with $42.1 billion as of July 31.
Mr. Spitzer also alleged that Security Trust Co., Phoenix, gave permission to perform market timing using shares of the 5,200 mutual funds on its trading platform. Security Trust provides same-day trade clearance for 40 third-party 401(k) administrators.
The four money management companies and Security Trust have not been charged with criminal wrongdoing. In a settlement with the New York attorney general's office, Canary agreed to pay $30 million in restitution and a $10 million penalty.
Officials at all four money management companies declined to comment specifically about the allegations, referring questions to their press statements. In those statements, all said they are cooperating fully with authorities.
All but Strong said they have hired independent firms to evaluate their trading practices and compliance and would make appropriate restitution if it is proven that investors were damaged by trading irregularities within their mutual funds. Bank of America and Bank One said disciplinary action would be taken if employees were found to have knowingly violated internal policies and processes.
The three Bank of America employees Mr. Spitzer accused of facilitating Canary's market timing and late trading activities have left the firm, said a source who requested anonymity. Gone are Robert H. Gordon, chief executive officer and president of Banc of America Capital Management LLC, New York; Charles D. Bryceland, head of B of A's brokerage and private-banking office for New York high-net-worth individuals; and a broker, Theodore C. Silpol III.
Firm hired to audit
Nancy Murphy, vice president of marketing and business development at Security Trust, said an outside firm has been hired to audit the firm's practices for the period Canary was a client to quantify whether plan participants were harmed. She also said Security Trust officials "haven't done anything wrong."
But plan sponsors are having a hard time believing statements like Ms. Murphy's. Benefits attorneys said as fiduciaries, plan sponsors have a duty to be suspicious and to question their vendors' trading practices.
Judith M. Johnson, executive director of the $1.2 billion Minneapolis Employees' Retirement Fund, said she finds the situation "distressing. It's been keeping me awake at night."
Strong is Minneapolis Employees' longest-running money manager; for more than a decade, star growth-stock manager Dick Weiss has managed about $70.4 million in active small-capitalization core stocks for the Minneapolis plan. Ms. Johnson said she's been in touch with her client service representative at Strong, and "they swear they didn't allow Canary to late trade, but their answer wasn't (good) enough for me."
Ms. Johnson said she is going to ask the plan's consultant, Ennis Knupp + Associates, Chicago, to prepare a detailed report about whether the internal controls and risk management systems in place at Strong are sufficient. She said she also will ask Ennis Knupp to cast a critical eye over the business risk Strong faces.
"If they lose a lot of retail accounts because of this, what will the impact be on institutional investors both in mutual funds and separate accounts?" she asked.
Although Ms. Johnson must wait for board approval before terminating Strong, she has already moved her personal investments out of Strong and Janus funds. "What does it say about my ethics if I stay in funds that would do this to shareholders?" she asked.
Plan sponsors like Ms. Johnson have "an affirmative duty to look out for the best interests of plan participants. Plan sponsors can't blindly believe what they read in the press releases and client letters of these firms. They have to ask questions, to drill their managers and possibly to take action," said Fred Reisch, managing director and head of the pension practice at Reisch Luftman McDaniel & Reicher PC, Los Angeles.
Plan executives "could not be reasonably expected to know that these things were happening," said Marcia W. Wagner, founding partner, Wagner Law Group, Boston. But "once they found out, it is their duty to make inquiries of providers and to get absolute assurance that everything is in compliance" or find themselves with significant liability exposure as a fiduciary under the Employee Retirement Income Security Act, Ms. Wagner said.
"These kind of self-interested conflicts (of money managers) are exactly what ERISA was enacted to prevent. This is pure ERISA 404 (stuff). In fact, it's ERISA 101," Ms. Wagner said.
Ms. Wagner, whose firm specializes in ERISA issues, said she has been contacted by plaintiff attorneys representing plan sponsors, who are contemplating bringing suits but are holding off until the facts are clear. Once they are, "it could be significant if an ERISA attorney gets hold of this. It could result in some very interesting litigation, if it all goes as (Mr.) Spitzer wants it to," she said.
Litigation notwithstanding, plan sponsors may need to act fast to replace the four asset management companies to avoid further damage to participants' 401(k) account balances, Mr. Reisch said.
"Who gets hurt if there's an exodus of IRAs, trust, individuals and family offices? Those who leave first or last? In fact, it's those who stay who are hurt most by the cost of transactions. If you're invested in a mutual fund with a declining asset base that's having to sell a lot of securities to meet redemptions, the only choice is to leave. There are so many good choices out there, there's no advantage to hanging around. There's no doubt in my mind that these firms will lose significant amounts of money," Mr. Reisch said.
Despite the huge amount of publicity and potential client losses for the four money managers named in Mr. Spitzer's complaint against Canary Capital, industry consultants doubt Mr. Spitzer's allegations against the four money management will have a long-term impact.
"Unfortunately, in our experience, these types of scandals tend to only have transient effects. Two years from now, we will probably look back and not see much change in terms of institutional investors' practices," said Glenn Davis, partner, Eager & Davis LLC, Louisville, Ky.
"No one will remember"
Said Peter H. Starr, principal of an eponymous mutual fund consulting firm in Boston: "The overall impact of losses will probably be in thousands of cents per person, not in the thousands of dollars. Washington will grab it and make some attempts at legislation, but in six to nine months, no one will remember this."
Still, he predicted that the money management industry, caught with more than a little egg on its face, will be moving en masse to perform hurried internal housework in the next few months to be able to reassure institutional and retail clients that their trading operations are squeaky clean.