The mutual fund companies appeared to be struggling to protect their customers by trying to curb market timing trades by brokers at the Prudential Securities Boston branch office.
The funds sent as many as 30,000 warning letters to Prudential in the last year, according to regulators’ complaints filed Tuesday, complaining about brokers attempts to evade mutual fund prohibitions on market timing by creating dummy accounts and intentionally misspelling names.
But on closer examination, Tuesday’s state and federal actions against former Prudential employees may signal even more bad news for the embattled $7 trillion mutual fund industry, with its allegations that it was fund company employees who gave the brokers some of their best tips about how to keep the funds from catching them.
“It appears that there was some complicity not just among the people at Prudential but by the mutual funds as well,” said David Marder, a former Securities and Exchange Commission attorney now in private practice in Boston. “I think it’s a safe bet that the (mutual funds) are going to be on the horizon. What’s interesting about this action is that we could just be looking at the tip of the iceberg.”
Market timing is not illegal, but many fund companies prohibit it because it can skim profits from long-term investors. The SEC and Massachusetts Securities Division alleged in their filings that the techniques used by the brokers to avoid being detected by mutual funds amounted to civil fraud.
Those techniques allegedly included using different account numbers, trading in large-cap funds to avoid attracting attention, and even trading ahead of holiday weekends when monitoring might be lax.
The Massachusetts Securities Division alleged that some of those tips came from wholesalers, or mutual fund employees who sell to brokers and institutions, and who may have been too accommodating to prospective clients.
One broker told investigators “there were a lot of conversations with numerous different wholesalers that gave you different advice of how to place this type (market timing) business without creating a disruption.”
Neither Putnam nor any mutual funds were named as defendants in Tuesday’s filings, but they appeared to lay the groundwork for a potential future case against fund companies.
“Naturally there exists a conflict between the wholesalers, whose sole responsibility is to get as much money invested in the mutual fund as possible, and the mutual fund company, who has a fiduciary duty to make sure the money coming in will remain long-term and benefit the shareholders,” the Massachusetts complaint stated.
Said Marder, the former SEC attorney: “I’m guessing there’s going to be a whole series of investigations.”
The Wall Street Journal reported in Wednesday’s editions that the National Association of Securities Dealers also is investigating whether Prudential brokers engaged in late trading, which is illegal. The practice of late trading allows an order placed after 4 p.m. to receive the same day share price, even though orders received then are supposed to be executed at the next day’s price.
A Prudential spokesman told the newspaper that the firm is cooperating with the NASD probe.
Prudential is the latest company to have executives or employees implicated in the scandal, which already forced the departure of CEOs from two other firms, Strong Mutual Funds and Putnam Investments. And the scandal is likely to keep spreading: the SEC’s enforcement chief, Stephen Cutler, told Congress on Tuesday his agency will be notifying more companies this week that they face possible charges.
Prudential is now controlled by Wachovia Corp. and minority-owned by Prudential Financial. Wachovia said it has no liability for the actions under its acquisition agreement with Prudential earlier this year.
The SEC complaint names former brokers Martin J. Druffner, Justin F. Ficken, Skifter Ajro, John S. Peffer and Marc J. Bilotti and former branch manager Robert Shannon. The Massachusetts complaint names Druffner, Ficken, Ajro, Shannon and Michael Vanin, also a former branch manager.
Attorneys for the defendants said the complaints clearly showed Prudential approved and encouraged the behavior, and that individual employees shouldn’t be punished for following legal company policies.
“It strikes me as a pretty heavy-handed attempt by the regulators to hold employees accountable for a strategy that was approved by the highest levels of the company,” said Gary Crossen, an attorney for Vanin. “If they want to make a rule making market timing illegal, they should implement such a rule for the future and stop trying to hold people responsible for activity that was not illegal in the past.”
Daniel M. Rabinovitz, an attorney representing Druffner, Ficken and Ajro, said his clients were cooperating and had done nothing wrong. An attorney for Shannon did not immediately return a message seeking comment. Vanin left the company in 2001; the others resigned under pressure last month.
Prudential spokesman Jim Gordon said: “Our only comment is we have been and continue to cooperate fully with regulators.”