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Alliance Struggles To Reach Settlement

Deal with regulators may be a model for mutual fund firms


In January 2002, the head of mutual fund sales at Alliance Capital Management LP wrote an e-mail to the firm’s president, the vice chairman of its board and other top managers that laid out a stark quid pro quo: The nation’s largest publicly traded money-management firm would allow a Las Vegas investor to make trades in its mutual funds of a type that the company normally prohibited.

In exchange, the investor would park $51 million in three Alliance hedge funds, allowing the company to earn lucrative management fees.

Just in case the executives had any qualms about the exchange, the e-mail from Michael J. Laughlin noted that firm Chairman “Bruce Calvert is okay with this.â€

The discovery of the e-mail and others like it have brought Alliance into the crosshairs of the aggressive state and federal investigations of mutual funds. The contents of the e-mail were confirmed by three sources.

New York state Attorney General Eliot L. Spitzer is pushing Alliance to accept a settlement that could be a model for other funds, including a large fine, changes in management and fund practices, and the most controversial an agreement to lower fees charged to mutual fund investors.

Last week Alliance offered to try to settle the anticipated charges, sources familiar with the negotiations said. The company has been eager to reach a settlement, in part out of fear that a drawn-out investigation could drive away customers, especially large institutional investors such as pension funds, which make up the major part of its business, according to sources.

Spokesmen for Alliance, the Securities and Exchange Commission and Spitzer’s office all declined to comment on possible settlement talks. But Alliance has already acknowledged publicly that it will almost certainly face regulatory action and has set aside $190 million to cover possible fines, lawsuits and investor restitution.

Chief executive Lewis A. Sanders was openly contrite at a Merrill Lynch investor conference in November. The mutual fund business “is an industry in need of reform, and we at Alliance are in need of repair in this important business,†he said. “Our retail mutual fund business must be restructured, repositioned, and its culture remade entirely.â€

Alliance is facing regulatory action for allegedly misleading customers about the way it handled market timing, according to three sources. Market timing in the context of the mutual fund probes means quick in-and-out trades by investors seeking to profit when mutual fund share prices lag behind underlying values.

Most funds say they discourage timing because the practice, although legal, raises expenses and cuts into returns for long-term customers. Alliance was no exception. Alliance’s growth fund prospectuses stated, “you should consider an investment in the fund as a long-term investment. Funds reserve the right to restrict purchases or sales when there appears to be evidence of a pattern of frequent purchases and sales made in response to short-term considerations.â€

But investigators say the firm secretly had a formal process for dealing with big customers who wanted to employ market timing. Investors who agreed to leave large amounts of money in Alliance hedge funds were permitted to engage in market timing in specific mutual funds. Hedge fund management fees can be 10 times as high as mutual fund fees, plus the firm gets a share of any profits the hedge fund makes.

The sources said Alliance employees also shared inside information about the funds’ holdings with at least two big customers. Such sharing would have made it easier for the timers to hedge their short-term investments and determine when the funds’ shares were undervalued. It may also violate laws banning insider trading.

A close look at the money moving in and out of several Alliance funds supports the view that the firm was permitting an enormous amount of short-term trading, securities analysts said.

The A shares of Alliance Technology Fund and the Premier Growth Fund, which the Las Vegas investor, Daniel Calugar, and others were allegedly allowed to jump in and out of, had annual turnovers of 820 percent and 320 percent respectively in 2002, according to the data firm Lipper Inc. In June 2002 alone, the Technology Fund overall experienced 30 percent turnover, according to, which analyzes fund data. Turnover is a measure of redemptions compared with assets.

The mutual fund trade group, the Investment Company Institute, considers 75 percent turnover in a calendar year strong evidence that a fund was being used by timers.

Sources said Calugar, who traded through his own firm, Security Brokerage Inc., came to Alliance in May of 2001 through a hedge fund sales executive who left Alliance about six months later. In January 2002, the head of hedge fund sales, Charles Schaffran, inherited the account and raised questions about the arrangement. That’s when Laughlin, the mutual fund chief, sent his e-mail to upper-level management, including then-firm President John D. Carifa and Roger Hertog, who is still vice chairman of Alliance’s board.

Calugar remained an active mutual fund trader until June, when he suddenly pulled out all of his money from that part of Alliance, two sources said. He shut down his brokerage firm in late September, after Spitzer’s probe became public, and could not be located for comment. He remains an investor in Alliance’s hedge funds, the sources said. Both Laughlin and Carifa were forced out last month.

The apparent arrangement and the high-level approval it received “is pretty awful. It reflects on the integrity of Alliance and it’s going on at the highest levels,†said University of Texas law professor Henry T.C. Hu. “They were trading off money that belonged to mutual fund shareholders to get money in hedge fund fees.â€

The company is under pressure to resolve the probe as soon as possible for fear of losing the institutional clients that are its bread and butter, legal analysts said. The California Public Employees’ Retirement System will decide on Monday whether to pull $1.5 billion of its assets from the firm’s management.

Alliance had $456 billion in assets under management as of the end of November, including $257 billion from pension funds and other institutional clients.

But sources familiar with Alliance’s efforts to reach a deal with Spitzer and the SEC said negotiations have been stormy. The regulators, the sources said, are pushing for more high-level heads to roll, and Spitzer’s office in particular wants any deal to cover more than just the trading practices that got Alliance into trouble.

Spitzer already has said publicly that he will seek to force mutual fund companies to lower their fees as part of any settlement, and he criticized an earlier SEC settlement with Putnam Investments for failing to address the issue.

Alliance would be a fat target for such an effort. Among the 20 largest fund companies, Alliance has the highest average fee for equity funds 2.09 percent and the second-highest fee for funds overall, 1.63 percent, according to Lipper. By contrast, Vanguard Investment’s average overall fee is 0.19 percent.

The firm is also being sued by a group of disgruntled investors who say the firm illegally charged individual mutual fund customers far more for the same services than it charged institutional clients, such as pension funds. The lawsuit alleges that Alliance charged 0.93 percent for “advisory services†to its Premier Growth Fund customers, but provided the same services to another mutual fund company for only 0.30 percent.

The lawsuit also alleges that Alliance has increased fees as its asset base has grown, even though it may have profited from economies of scale.

Spitzer told Congress there was a “nexus†between high fees and improper trading because “both consequences of a governance structure that permitted managers to enrich themselves at the expense of investors.â€

“The desire for increased fees led managers and directors to abandon their duty to investors and to condone improper and illegal activity,†Spitzer said. “Common sense demands that we at least inquire whether the desire for increased fees also resulted in fee agreements and charges that were improper.â€

Sources said demands for lower fees also have come up in negotiations with several other fund companies, including Strong Investments. The Wisconsin firm has acknowledged that its founder, Richard S. Strong, is under investigation for his personal trading, but neither he nor the company has been charged with wrongdoing.

Top SEC officials are not as avid as Spitzer to address the issue of fees in a settlement, having said as recently as last month that the issue should be addressed, instead, by industry-wide regulation.

As a result, negotiations among Alliance, Spitzer and the SEC are still very delicate, the sources said. There could be a deal as soon as next week, but talks also could drag into the new year, two sources said

Spitzer’s determination to bring fees into the equation has raised concerns at the SEC and among outside lawyers, who say that the issue is at best tangentially related to the conduct that got Alliance in trouble.

“It’s a very dangerous place to be. You don’t go out there and find some misconduct just to make regulatory changes,†said former SEC attorney Gregory S. Bruch. Requiring a firm to lower future fees across the board “is essentially providing a windfall for the people who come afterward.â€

The proposal also smacks of price controls, say critics who argue that the market might be better served if investors were simply given clearer information about fees and allowed to make their own decisions. The SEC has several fee disclosure proposals pending, including one that would tell investors each year how much of every $1,000 invested was diverted to fees — using real dollars and cents rather than percentages.

“We should not use the threat of civil or criminal prosecution to extract concessions that have nothing to do with the alleged violations of the law,†SEC Chairman William H. Donaldson told Congress last month.

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