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Schwab Discloses Improper Fund Trades

Nov 14, 2003 | AP

Charles Schwab Corp. disclosed Friday that a handful of its mutual funds engaged in improper trading practices, becoming the first major discount brokerage linked to an industrywide scandal.

The inappropriate trades, which allowed institutional investors to rapidly trade in and out of mutual funds at the expense of longer-term shareholders, occurred in the Excelsior family managed by Schwab's U.S. Trust subsidiary, the company said in its quarterly shareholder report.

A "limited number" of trades in Schwab's broader mutual fund service, which includes offerings managed by the company and other vendors, may have been improperly processed after the weekday closing time of 4 p.m. EST, the company said.

With the disclosures, Schwab joins a lengthening list of prominent investment companies including Putnam Investments and Strong Financial Corp. that have acknowledged trading breaches that treated mutual fund shareholders unequally.

The betrayal felt by Schwab customers may run especially deep because the brokerage has always marketed a "squeaky clean image" while railing against rampant conflicts of interest at its rivals, Lehman Brothers analyst Mark Constant said in a note issued Friday.

"With (Schwab) aggressively promoting their self-professed objectivity and focus on the interests of individual investors they would seem to be far more vulnerable to a potential media and/or regulatory frenzy in this situation," Constant wrote.

Indeed, revelations of abuses at other fund companies have prompted mutual fund shareholders to pull billions of dollars from accounts at several other tainted investment companies, raising worries that Schwab may face a similar backlash although with the list of fund companies implicated in the scandal growing daily, investors may be hard-pressed to find an untarnished alternative. Federal and state authorities have subpoenaed dozens of fund companies, and have indicated criminal or civil charges could be filed in at least some cases.

"There are still ways to find ethical companies out there," said Moringstar mutual fund analyst Dan Culloton. "But it's certainly ironic that a company that positioned itself as a champion for the small investor is now caught up in this."

The unsettling news about Schwab's improper trading emerged the same day the company released a bit of encouraging news the company's net inflow into its stock and bond mutual funds totaled $2.65 billion in October, the highest monthly volume since March 2002.

Schwab ended October with 7.6 million customer accounts, holding $913 billion in assets.

The mutual fund industry's troubles stem from the "incredibly rogue behaviors" of a few misguided executives and money managers, David Pottruck, Schwab's chief executive, said during an interview Thursday with The Associated Press. Pottruck didn't specifically address the problems in Schwab's mutual funds.

"These scandals hurt the public's confidence in the system," Pottruck said. "None of us should be surprised by that, and all of us should be disappointed by that."

U.S. Trust uncovered its troubling trading patterns in an internal investigation prompted by inquiries from the Securities and Exchange Commission and New York Attorney General Elliot Spitzer, who has been spearheading a broad examination of the mutual fund industry.

Much of the scrutiny has focused on "market timing" a practice that enables privileged investors to reap short-term profits while lowering the returns of fellow shareholders.

Market timing is not illegal but most funds prohibit it. Regulators have said companies that allowed selective market timing, despite policies against it, committed fraud.

U.S. Trust's internal investigation uncovered "informal arrangements" allowing a few institutional investors to engage in short-term trading, said company spokeswoman Allison Kellogg. The deals were made with "junior" U.S. Trust employees and involved six or seven of the Excelsior family's 28 funds, Kellogg said. She declined to identify the problem funds. The funds have about $12 billion in assets and 68,000 accountholders.

U.S. Trust examined trades during a 10-year period, Kellogg said. Schwab acquired U.S. Trust, which caters to wealthy individuals, 3 1/2 years ago for $3.2 billion in stock.

Schwab is still analyzing the after-hours activity in the mutual funds offered under its brand name, spokesman Greg Gable said. Any trades entered after 4 p.m. EST would violate company policy and be considered improper, Gable said. It wouldn't be problem, though, if employees were merely processing orders after the 4 p.m. deadline, Gable said.

The review encompasses a small fraction of the millions of trades made through funds managed by Schwab and other vendors, Gable said. There is no evidence that Schwab employees profited from the questionable activity, Gable said.

In Thursday's interview, Pottruck said the problems facing the mutual fund industry can be addressed by stricter enforcement of existing rules.

"And that's just not by regulators, but also by the companies, making sure their own procedures are tightly followed and monitored," Pottruck said. "We all could learn to do a better job."

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