A Senate panel heard more testimony Thursday from regulators on what’s needed to clean up the $7 trillion mutual fund industry, as New York Attorney General Eliot Spitzer said criminal charges would probably be brought against some firms. The testimony came after state and federal regulators filed civil charges against founders of the Pilgrim-Baxter fund family, alleging improper trading.
Criminal charges would go beyond the spate of civil actions that Spitzer, other state regulators and the Securities and Exchange Commission have been lodging against big mutual fund and investment firms in recent weeks.
“It’s fair to presume that there will be criminal cases brought,” Spitzer testified at a hearing of the Senate Banking Committee.
Spitzer and SEC Enforcement Director Stephen Cutler, who appeared with him, played down their recent public differences over pursuit of fund trading abuses and the SEC’s civil settlement with big fund company Putnam Investments.
They spoke the same day that Spitzer’s office and the SEC charged the founders of the Pilgrim-Baxter fund family, Gary L. Pilgrim and Harold J. Baxter, with improper trading of their funds to benefit themselves and friends at the expense of longer-term shareholders.
Those civil actions were the first time since the industry scandal became public in early September that fund company leaders had been directly charged in connection with illegal trading practices.
Previously, regulators had taken action against two former Putnam Investments portfolio managers, as well as the firm, but Putnam’s executives were not directly accused.
According to the complaint, the trading arrangements netted more than $13 million in profits, including $3.9 million for Pilgrim alone.
“The top managers of this mutual fund lost their ethical compass and were unable to distinguish between what was in their shareholders’ interest and their own interest,” Spitzer said in a news release.
Responding to the scandal, the House moved quickly Wednesday to adopt legislation cracking down on mutual fund abuses and providing more information for investors. But lawmakers of both parties agree that substantial work is needed before a final reform measure can be enacted.
Even the principal author of the House measure, Rep. Richard Baker, R-La., said further changes are needed for Congress to send President Bush “the strongest possible reform bill.”
The House’s 418-2 vote came as industry problems spread, with more big-name companies cited for allowing special trading deals that disadvantage ordinary investors and a money stampede continuing out of tainted funds. Lawmakers approved the measure after brief debate.
Treasury Secretary John Snow, who had cautioned earlier in the week that Congress should be careful that any legislation not drive up the cost of investing, said Thursday that the administration supported the basic thrust of the House-passed bill.
“Mutual funds are an extraordinarily important part of the financial structure of this country,” Snow said in an interview with the Associated Press. “We must maintain trust and confidence in our capital markets and in the instruments of our capital markets like mutual funds.”
The legislation that sped through the House would impose new curbs on fund trading abuses, make directors on company boards more independent from fund managers and require companies to disclose more information to investors about fees and fund operations.
It still needs approval in the Senate, where several different versions have been proposed. No action is expected before next year.
Democrats complained on the House floor that the bill was incomplete because it did not strengthen enforcement powers of the SEC and state securities regulators, yet they voted for the measure.
At the same time, Federal Reserve Chairman Alan Greenspan and Snow have cautioned Congress against passing mutual fund changes that could cost investors more in fees and diminished returns.
The issues raised could become sticking points in the Senate.
Dozens of fund companies have been subpoenaed by the SEC, the states of Massachusetts and New York and other regulators.
Putnam and Canary Capital, a hedge fund operator, have agreed to settlements with the SEC.
Authorities have also accused individuals at Fred Alger & Co., Bank of America and Millennium Partners of improper trading. They also have indicated charges are likely against Alliance Capital and Richard Strong, the founder of the Strong mutual fund company, who has acknowledged making short-term trades.
According to papers filed Thursday, Pilgrim, his wife and two other partners established the Appalachian Trails hedge fund, which was permitted to conduct extensive in-and-out trading of Pilgrim Baxter funds — in violation of its rules that limit rapid trading.
The practice, known as market timing, is not illegal, but is prohibited at most funds because it skims profits from longer-term shareholders.
The charges also allege that clients of Wall Street Discount, a brokerage run by a close friend of Baxter, were provided with non-public information about the portfolio holdings of Pilgrim-Baxter funds — a process that facilitated the market timing and generated significant profits for those customers.
The arrangements that were engineered or permitted by Pilgrim and Baxter came at a time when their own portfolio managers were complaining that market timing was having a negative impact on returns for typical shareholders and officials banned other market timers, according to Spitzer.
Pilgrim-Baxter officials estimated that market timers held $466 million in assets in the flagship PBHG Growth Fund in late 2001. This accounted for more 14 percent of the fund.
Wayne, Pa.-based Pilgrim Baxter is owned by London-based Old Mutual PLC. As of Sept. 30, Pilgrim Baxter managed a total of $7.4 billion.
Putnam overflows
As investors continued to withdraw billions of dollars, Putnam Investments moved to try to stem the outflow by saying it will slap heavy fees on traders who make quick trades in its funds.
Karnig Durgarian, Putnam’s chief of operations, wrote to all 401(k) retirement account investors this week to warn anyone caught moving in and out of Putnam’s international equities funds and some bond funds within 90 days will be charged a 1 percent redemption fee.
Boston-based Putnam has long prohibited so-called market timing, but 401(k) plan investors have never been charged a fee. Putnam also said more than a dozen members of Boilermakers Local 5 in New York conducted short-term trading in their 401(k) accounts.
Regulators are also investigating trades made by Putnam’s top lawyer, William Woolverton. The company has said Woolverton’s trades cannot be termed market timing.
In the first two weeks of November, Putnam’s assets under management shrunk by nearly 8 percent to $256 billion, Marsh & McLennan, the firm’s parent, said in a securities filing released this week.
The Associated Press and Reuters contributed to this report.