Updated from 1:38 p.m. EST
Paul Flynn, a former
Canadian Imperial Bank of Commerce
executive who regulators believe helped arrange $1 billion in financing used by hedge funds for potentially illegal mutual fund trades, was arrested Tuesday and charged with fraud and grand larceny.
Flynn was arrested at his home in Larchmont, N.Y., by authorities attached to New York Attorney General Eliot Spitzer for violations under the Martin Act, a 1921 state law governing securities sales. The law has been an all-purpose legal tool in Spitzer's campaign to clean up Wall Street, most famously deployed in his September 2002 suit seeking the return of $1.5 billion in stock proceeds from former
Chief Executive Bernard Ebbers.
Flynn was arraigned Tuesday afternoon in state criminal court in New York City.
Securities and Exchange Commission
, in administrative complaint, alleged that CIBC assisted hedge fund clients in "engaging in late trading and deceptive market timing of mutual fund shares.''
The SEC, in the complaint, contends Flynn ''knew or was reckless in not knowing'' that the hedge funds were engaging in late trading and deceptive market timing.
"This case should alert management at financialinstitutions that they will be held directly accountable when they knowingly finance fraud," said Mark Schonfeld, associate director of the SEC's Northeast regional office.
As previously reported by
, regulators believe Flynn's group had a significant role in financing the hedge fund clients of
Oppenheimer & Co.
broker Michael Sassano,
said by regulators and securities industry sources to be a central figure in the probe of mutual fund market-timing. Sassano was a top-performing broker at CIBC before it sold the Oppenheimer division in early 2002.
In a move that could be related to the CIBC investigation, a source said Massachusetts regulators two weeks ago served Sassano with a subpoena seeking to take his testimony in the market-timing scandal. Sassano was previously named but not charged in a Massachusetts action against several
brokers and has
ties to numerous players in the burgeoning scandal.
Flynn's attorney, David Gendelman, declined to comment. A spokesman for Spitzer also declined to comment. A person answering the phone at Flynn's home said she did not know where the former investment banker was. She said she did not know if he had been arrested.
The arrest of Flynn is a significant turn in the investigation into the $7 trillion mutual fund industry because CIBC was allegedly the biggest financier of hedge funds engaged in market-timing and late-trading. The bank is believed to be in advanced settlement talks with Spitzer's offices and the SEC.
"Our investigation has demonstrated that it took many players in the industry to make these schemes work,'' said Spitzer.
Stephen Forbes, a spokesman for CIBC, said the bank has been cooperating with authorities from the outset of the investigation. The bank's outside counsel, Jonathan Polkes, also was unavailable.
Market-timing and late-trading are the two main types of inappropriate mutual fund trading being investigated in the sprawling inquiry that encompasses dozens of mutual fund companies, brokerages and hedge funds.
Flynn ran the hedge fund financing operation at CIBC with Jeffrey Haas. Both were let go by the Toronto bank in December, along with an in-house attorney who reviewed their financing deals. They were followed out the door this month by their supervisor, Robert Deutsch, CIBC's former head of U.S. arbitrage and derivatives trading.
Joel Cohen, the attorney for Deutsch, said his client has been in contact with Spitzer and the SEC, but declined to comment beyond that. An attorney for Haas couldn't be reached for comment.
Sources previously told
that Flynn's group at CIBC specialized in credit derivatives, most commonly "total return swaps," a popular leverage tool in the hedge fund world. Hedge funds favor the vehicle, in which the economic performance of a specified asset is exchanged for cash payments pegged to a benchmark, because they act like loans with a more favorable tax treatment. The group also provided standard margin loans.
Sources said the total return swaps enabled hedge funds to invest several times as much money as they normally could have. The SEC, in its complaint, alleged that Flynn negotiated and structured swaps and loan agreements that provided the hedge funds with leverage of at least 3:1 to trade in mutual fund shares.
Regulators believe the $1 billion in CIBC financing enabled a select group of hedge funds to make big profits from market-timing mutual fund shares and possibly other improper trading activities. CIBC, meanwhile, was able to book highly profitable loans to clients whose risk was limited by the relatively sure-thing nature of their objectionable trading strategies.
Sources familiar with the investigation by the SEC and Spitzer's office said much of the $1 billion went to bankroll the hedge fund clients of Sassano, the Oppenheimer & Co. stockbroker who turned mutual fund market-timing into a $10-million-a-year gold mine for himself.
Some of Sassano's customers, according to regulators and sources, included
Chronos Asset Management
of Cambridge, Mass.; British-based
Head Start Advisors
Pentagon Capital Management
; and Illinois-based
Samaritan Asset Management
. Sassano also was an investor in
Atlantique Captial Advisors
, a Garden City, N.Y., fund that specialized in the market-timing that Sassano helped start.
Ira Lee Sorkin, an attorney for Sassano, said he had not heard about Flynn's arrest.
For now, regulators and prosecutors, are only identifying two of the hedge funds,
Canary Capital Partners
and Samaritan, that received financing from CIBC to make improper trades. But sources say more than a dozen hedge funds got CIBC money. It was Spitzer's $40 million settlement with Canary, a New Jersey hedge fund run by Edward Stern, that broke open the mutual fund investigation in early September.
The SEC also charged that Flynn knew that some of the hedge funds he was financing made illegal late trades through an electronic platform set up by
, the Phoenix-based trust bank that regulators are shutting down because of its involvement in the mutual fund trading scandal. Security Trust enabled Canary, Samaritan and other unnamed hedge funds to engage in late-trading and market-timing.
The SEC said Flynn even prepared a memorandum discussing the benefits of the Security Trust platform. In the memo, Flynn specifically referred to the platform as a: "Same Day/Late Day Trading Platform.''