Most investors are aware of the secret agreements that enabled a handful of savvy traders to run abusive trading strategies in many of the country's best-known mutual funds. Now, a newly filed complaint suggests that the efforts of stockbrokers acting on behalf of would-be market-timers and late traders were more pervasive than previously believed, often representing a second, unwelcome front for funds that had friendly timing agreements in place with other clients. The Securities and Exchange Commission, in one of the most detailed civil complaints yet filed against any defendant in the mutual fund investigation, alleges that five former Prudential ( PRU) brokers defrauded 52 fund companies by making more than $1.3 billion in market-timing trades over three years. The complaint details the brokers' efforts to hide behind dozens of false accounts to conceal abusive trading and circumvent attempts to root them out. The SEC, which was ordered last month by a federal judge to expand on a complaint it first filed in November, contends that all of the fund companies were victims of the brokers and in many instances took steps to try and stop them from doing more trades. The irony is that some of the victimized fund families -- Janus ( JNS), Alliance Capital ( AC), Franklin Templeton ( BEN) and Marsh & McClennan's ( MMC) Putnam Investments -- are ones that were either charged by the SEC and New York Attorney General Eliot Spitzer with knowingly allowing traders to market-time shares of their funds, or are under investigation. The complaint also alleges, for the first time, that some funds sold by Fidelity Investments, the nation's biggest mutual fund company, also were timed. The Fidelity funds were timed despite a series of steps taken by the Boston-based firm to keep abusive traders out of its funds, if not necessarily the
funds of other companies that were sold on Fidelity's big mutual fund trading platform. If anything, the new 67-page complaint, which includes hundreds of pages of exhibits, demonstrates just how widely practiced market-timing was in the mutual fund industry, and the lengths to which some traders and brokers would go to score easy profits. It also shows how the complaints from fund companies to a brokerage, in this case Prudential, could fall on deaf ears.
In April 2002, officials from AIM Funds sent an email to Prudential complaining about the abusive tactics by the firm's brokers. AIM wrote: "What we have seen scares us. It appears certain representatives are changing account registrations, tax ID numbers and branch and rep numbers in an effort to time AIM funds. All of these accounts have been stopped, but each day, 'new' ones pop up." In December, the SEC and Spitzer charged that AIM's sister company, Invesco Funds, with "fraudulently accepting investments by dozens of market-timers in Invesco mutual funds" in order to enhance its management fees. Both Invesco and AIM are divisions of Amvescap ( AVZ). Market-timing, a strategy that tries to take advantage of pricing discrepancies between U.S. and foreign markets, is one of the two main trading abuses that regulators have focused on in the mutual fund probe. While timing is legal, the frequent trades can dilute the value of a mutual fund's assets and incur added administrative costs. Most fund companies say they take steps to prohibit the practice, though regulators have charged that many of them knowingly violated their own policies. The complaint also sheds new light on the activities of the former brokers, who were led by Martin Druffner. The 35-year-old broker allegedly was the mastermind behind the scheme that generated $5.2 million in trading commissions for the brokers. The SEC alleges that Druffner's personal take was about $3.2 million. "The broker defendants profits handsomely from their misconduct," regulators allege. Druffner's group allegedly schemed to place thousands of market-timing trades for seven hedge funds: Chronos Asset Management of Cambridge, Mass.; U.K.-based Headstart Advisors; London-based Pentagon Capital Management; Illinois-based Ritchie Capital; Jemmco Advisers of New York City; Global Analytical Capital of Salem, Mass.; and Summa Capital, also of Salem, Mass. The hedge funds received financing to place their market-timing bets from a variety of foreign banks, including Toronto-based Canadian Imperial Bank of Commerce ( BCM), France's Credit Lyonnais, Germany's Dresdner Bank and Swiss-based Zurich Capital.
Four of those hedge funds, Chronos, Headstart, Pentagon and Jemmco, were referred to Druffner by his college buddy, Oppenheimer's ( OPY) Michael Sassano, one of Wall Street's most successful market-timing brokers, according to regulators and people familiar with the inquiry. Sassano regularly referred customers to Druffner while Oppenheimer was still owned by CIBC, one of the banks that provided funding the hedge funds. Sassano, himself the subject of an investigation by the SEC and other regulatory agencies, isn't named in the complaint, nor has he been charged with any wrongdoing. But people familiar with the investigation say regulators have made inquiries into Sassano's customer referrals to Druffner, since the brokers worked for rival firms, even though they were friends on a personal level. Michael Collora, an attorney for Druffner, and another defendant, Skifter Ajro, says his clients did nothing wrong and "adhered to the letter of any bloc imposed by a mutual fund." He says, "there is no statute, regulation or case forbidding" market-timing. But regulators portray Druffner and his colleagues as being almost ruthless on behalf of their customers, often using multiple accounts to place identical trades in shares of the same mutual fund. The multiple accounts "all bore fictitious entities that had no relation to the client's actual name." The SEC also contends the hedge funds were aware of the brokers deceitful strategies and "exchanged emails" discussing their plans. "By splitting up a client's transactions into numerous smaller components, submitted under fictitious names using different (broker identification) numbers, the brokers significantly increased the chances that the transactions would evade detection by the fund companies," the complaint says. The SEC contends the market-timing didn't end until after Wachovia ( WB) reached an agreement to buy a majority stake in Prudential Securities from Prudential Financial ( PRU) in summer 2003.