Did Lawyers Sign Off on Late Trading?

Mutual funds and brokers are increasingly leaning on an advice-of-counsel defense.
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Prosecutors on the hunt for scofflaws in the mutual fund trading scandal are hearing a common rallying cry from some potential defendants: "My lawyer said it was OK."

People familiar with the investigation said hedge fund traders, brokers and fund managers under scrutiny are telling investigators that their corporate lawyers signed off on their allegedly improper trading activity.

In effect, some of those under investigation contend they have a so-called advice-of-counsel defense. It's a strategy that's often employed in corporate crime cases, because it makes it difficult for prosecutors to prove a person had the necessary criminal intent to break the law.

Said one corporate lawyer, who is familiar with the investigation but didn't want to be identified, "In theory the advice of counsel is a good defense because it shows a person had no intent to commit a crime."

An emerging advice-of-counsel defense could prove especially problematic for the investigation into allegations of late trading, an activity in which a mutual fund company permits a favored customer to buy shares that were priced prior to the release of market-moving news.

Late trading has emerged as one of the most serious offenses prosecutors and regulators are examining in the quickly expanding investigation into the $7 trillion mutual fund industry. New York Attorney General Eliot Spitzer, who is leading the investigation, contends that after-hours trading is a crime and has compared it to betting on a horse race after the winner has crossed the finish line.

So far, allegations of late trading have surfaced in investigations of

Bank of America

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, Fred Alger Management, Security Trust and three hedge funds: Canary Capital Management, Millennium Partners and Veras Investment Partners.

Other fund companies, such as

Marsh & McLennan's

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Putnam Investments, Prudential Securities,




Bank One

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Alliance Capital

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, are being investigated over allegations of market timing -- a trading infraction that appears more likely to result in civil charges.

For now, Spitzer's office seems to be brushing off the possibility of an advice-of-counsel defense doing harm to its investigation of late trading. A Spitzer spokesman said: "Illegal behavior is illegal regardless of who might be giving counsel otherwise."

But people familiar with the investigation said a number of high-powered lawyers have written legal opinions for their brokerage clients saying the prohibition on late trading is not as clear-cut as it's been made out to be.

This might explain why prosecutors and regulators are finding that late trading in mutual fund shares is far more common than anyone thought. The

Securities and Exchange Commission

has found that 25% of the 34 largest brokerage firms it recently surveyed allowed customers to engage in late trading in some situations. But interestingly, the SEC said it hasn't determined yet whether these late trades necessarily violated federal securities regulations.

The legal opinions, meanwhile, are said to focus on what some see as a potential loophole in the securities regulation that's supposed to prohibit late trading -- the "price forward rule." These opinions point out that the regulation never states that all orders to buy or sell mutual fund shares must be submitted to the fund company by the 4 p.m. close of the trading day.

This omission in the price forward rule may leave the door open for some late trading through a broker intermediary, as long as it takes place before a mutual fund company calculates that day's net asset value, or NAV, for the shares of a particular fund. Many mutual funds don't actually calculate the NAVs for their funds until 5:30 p.m., or 90 minutes after the 4 p.m. close.

An attorney familiar with this legal thinking said that because few mutual funds are actually priced at 4 p.m., it's debatable whether that's the true deadline for submitting all orders to buy and sell.

Indeed, the mutual fund industry itself implicitly has acknowledged that the price forward rule prohibition on late trading may not be as airtight as prosecutors contend.

In response to the trading scandal, the Investment Company Institute, the lobbying arm of the mutual fund industry, is recommending that the SEC amend the price forward rule and other relevant trading regulations to "to support a firm 4 p.m. deadline for all mutual fund trades to be reported to mutual fund companies." This firm 4 p.m. deadline for submitting and executing trades would effectively close the 90-minute window that some lawyers contend exist under the current rule.

But even if the current price forward rule allows for a 90-minute late-trading window, an advice-of-counsel defense may not be a panacea for brokers and fund managers being investigated by prosecutors. The defense falls apart if the defendant misrepresents his intentions to his lawyer.

In fact, people familiar with the investigation said they aren't aware of any lawyers giving the green light to trading after 5:30 p.m. Yet, as the mutual fund scandal already has shown, some hedge funds -- Canary, for instance -- were indeed making trades well after 5:30 p.m.

"If you do not fit those set of facts, the legal opinion is of no value to you as a defense," said an attorney familiar with the investigation.