Franklin Faces Charges of FraudFeb 5, 2004 | San Francisco Chronicle
San Mateo's Franklin Resources, one of the country's biggest and most respected mutual fund companies, was charged with fraud Wednesday for secretly allowing a wealthy Las Vegas investor to frequently trade in and out of its mutual funds in exchange for agreeing to park $10 million in a Franklin hedge fund.
Massachusetts Secretary of State William Galvin, who filed the charges, called the deal a "blatant quid pro quo" that gave special treatment to a high roller at the expense of average investors.
Galvin's complaint said Franklin allowed Daniel Calugar, president of Security Brokerage, to frequently trade shares in the mutual fund, despite strict rules in its written prospectus that bar investors from short-term trading, also known as market timing. Many firms ban the practice because it can drive up funds' expenses and hurt other investors.
In addition, Galvin's complaint said investigators uncovered e-mail indicating some of the firm's senior executives went along with the arrangement to keep the struggling hedge fund afloat.
"It's very disturbing,'' said Galvin, who is pressing Franklin to return any profits from the deal to investors and pay an unspecified administrative fine.
Although dozens of investment firms have been accused of misleading investors of giving special treatment to fat cats, this marks the first time that a Bay Area firm has been formally charged with fraud.
In November, two San Francisco firms, Fremont Investment Advisors and Charles Schwab Corp., acknowledged employees allowed some investors to engaging in rapid trading, contrary to their written policies. Neither has been sued by regulators so far.
Wednesday's charges could also potentially spell more bad news for Franklin if spooked investors decide to move their money to other firms, as many did when Galvin and other officials sued Putnam Investments in Boston for fraud.
Indeed, the California Public Employees' Retirement System, the nation's largest pension fund, is already planning to consider whether to end its contract with Franklin on Feb. 17. Franklin manages $780 million in U.S. stocks for CalPERS.
"I wouldn't be surprised if there are some redemptions," said Dan Culloton, a fund analyst for Morningstar in Chicago.
However, he was quick to add that he didn't think the reaction would be as severe as it was with Putnam, the first firm charged with fraud in the recent sweep of the mutual fund industry. Investors withdrew $54 billion from Putnam in the fourth quarter, about a fifth of its total assets. "Anytime an executive at a fund company is accused of breaking their fiduciary duty, it is very serious," Culloton said.
Franklin shares dipped 91 cents to $56.65 after the charges were announced.
In a statement, Franklin, the country's fourth-largest mutual fund firm and owner of the Franklin Templeton funds, said the arrangement was proposed by an unnamed officer of a subsidiary three years ago, but the deal "was unauthorized and was rejected by management."
Franklin spokeswoman Lisa Gallegos declined to say who opposed the deal or why it went forward anyway.
According to Galvin's complaint, Franklin executive William Post worked out a deal in 2001 to allow Calugar, a wealthy investor from Las Vegas, to rapidly trade up to $45 million in Franklin's mutual funds, in exchange for investing $10 million in a Franklin hedge fund.
Calugar, a well-known market timer, also struck similar deals with other investment firms that have been caught up in the mutual fund trading scandal. They include Alliance Capital Management and Massachusetts Financial Services, according to a separate suit filed against Calugar by the Securities and Exchange Commission.
Galvin's office cited a series of internal Franklin e-mails to show that Post, a former portfolio manager and senior vice president at Franklin Templeton Trust Co., and other high-level employees were aware of the arrangement. Post left the firm in December.
One e-mail suggests that Charles "Chuck" Johnson, the firm's then co- president and son of Franklin Chairman Charles B. Johnson, may have personally approved the deal.
The Aug. 28, 2001, e-mail from Philip Bensen, one of the firm's top sales executives, said Calugar "somehow got in touch with Chuck Johnson. While we don't know what was agreed to completely, Chuck agreed to accept this client's money in various funds and a hedge fund."
Chuck Johnson resigned in 2002 after he was arrested for beating his wife.
A separate Aug. 17 e-mail from Calugar, the Las Vegas investor, said he was aware that Post had discussed the market timing arrangement with Greg Johnson, now Franklin's co-chief executive.
Not everyone at Franklin approved of the arrangement. Tom Johnson, who worked in sales for Franklin/Templeton Distributors said in one e-mail: "Based on everything I've heard, let's pass. ...We do not want timing money." Another executive warned, "It doesn't pass the smell test."
As recently as November, Franklin executives denied allowing any market timing deals at all. "We've done our own investigations around portfolio managers to make sure we don't have any excessive trading behavior,'' Johnson said in an interview with The Chronicle. "At this stage, we're pretty confident that we don't."
Moreover, Johnson, who was promoted to co-CEO in January, said the company had repeatedly refused to accept deals from investors interested in rapid trading in exchange for investing large amounts of money in other funds.
"Our policy is not to accept those (deals), and we've turned away a lot of business,'' he said.
In a filing in December, however, Franklin disclosed that it had put three employees on leave for suspected improper trading, including two for rapidly trading in and out of their 401(k) funds. But Franklin refused to give any details about why the third person was suspended.
"This is extremely damaging ... coming this late in the trading scandal, '' said Roy Weitz, who runs the FundAlarm.com Web site, which monitors the mutual fund industry. "They had plenty of time to do their own investigation and come clean."