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Post date: September 3 2003

State Investigation Reveals Mutual Fund Fraud

Attorney General Spitzer announced today that his office has obtained evidence of widespread illegal trading schemes that potentially cost mutual fund shareholders billions of dollars annually .

Spitzer announced that one of the perpetrators of the schemes – a hedge fund and its managers – has agreed to make restitution $30 million in illegal profits generated from unlawful trading and pay a $10 million penalty. The agreement further commits the hedge fund and its officers and employees to continue to cooperate in the Attorney General's ongoing investigation of the mutual fund industry.

"The full extent of this complicated fraud is not yet known," Spitzer said. "But one thing is clear: The mutual fund industry operates on a double standard. Certain companies and individuals have been given the opportunity to manipulate the system. They make illegal after-hours trades and improperly exploit market swings in ways that harm ordinary long-term investors."

"My office will take all reasonable steps to ensure that the ill-gotten gains of those who engage in this conduct are returned to investors, that wrongdoers are held responsible, and that appropriate reforms are implemented to halt this egregious activity," the Attorney General said.

As part of an ongoing effort to protect small investors, Spitzer's office began an investigation of mutual fund trading practices earlier this year. The investigation quickly became focused on practices known as "late trading" and "market timing."

"Late trading" involves purchasing mutual fund shares at the 4:00 p.m. price after the market closes. Late trading is prohibited by the Martin Act and SEC regulations because it allows a favored investor to take advantage of post-market-closing events not reflected in the share price set at the close of the market.

"Allowing late trading is like allowing betting on a horse race after the horses have crossed the finish line," said Spitzer.

"Timing" is an investment technique involving short-term, "in and out" trading of mutual fund shares, which has a detrimental effect on the long-term shareholders for whom mutual fund investors are designed, such as retirees and other "buy and hold" investors. The technique is designed to exploit market inefficiencies when the "net asset value" or "NAV" price of the mutual fund shares – which is set at the 4:00 p.m. market close – does not reflect the current market value of the stocks held by the mutual fund. When a "market timer" buys mutual fund shares at the stale NAV, it realizes a profit when it sells those shares the next trading day or thereafter. That profit dilutes the value of shares held by long term investors.

Mutual fund companies state in their prospectuses that they discourage or prohibit these practices, but evidence uncovered by Spitzer's office shows that mutual fund managers permitted favored individuals and companies to engage in such trading in exchange for payments and other inducements.

"Allowing timing is like a casino saying that it prohibits loaded dice, but then allowing favored gamblers to use loaded dice, in return for a piece of the action," said Spitzer.

Mercer Bullard, a leading mutual fund advocate and securities law professor at the University of Mississippi, said: "These findings that prominent mutual fund managers colluded with hedge funds to pick the pockets of fund shareholders undermines the integrity of the fund industry and reminds us of the importance of state regulators' enforcement efforts in uncovering and fighting securities fraud."

Spitzer's office reached the $40 million settlement agreement with Canary Capital Partners, LLC – a multi-million dollar hedge fund – two Canary-related entities, and Edward J. Stern, the managing principal of those entities. Canary obtained special trading opportunities with leading mutual fund families – including Bank of America's Nations Funds, Banc One, Janus and Strong – pursuant to undisclosed agreements that involved substantial benefits for the fund management companies.

Academic research has estimated that mutual fund shareholders lose billions of dollars annually due to the trading abuses that are the subject of Attorney General Spitzer's ongoing investigation.

The settlement and investigation are being handled by Assistant Attorneys General David D. Brown, IV, Roger Waldman, Bruce Topman, Charles Caliendo, Marc Minor and Lydie Pierre-Louis of the Attorney General's Investment Protection Bureau.