New Jersey Officials Charge Three with Market Timing

TRENTON, N.J. (HedgeWorld.com)--Three former traders in the Fort Lee, N.J., office of Merrill Lynch Pierce Fenner & Smith Inc. have had their securities trading registration revoked by the New Jersey Bureau of Securities and also face allegations of market timing from the New Jersey Attorney General's office in connection with trades they made on behalf of the hedge fund Millennium Partners LP.

The three men--Christopher Chung, William Savino and Kevin Brunnock--worked together as financial advisers at the former UBS PaineWebber Inc., now UBS Financial Services Inc. There, one of their clients was Millennium Partners LP, a hedge fund previously implicated in mutual fund market timing. In January 2002, the three went to work for Merrill Lynch in its Fort Lee office. They brought Millennium Partners with them as a client and continued placing the same market-timing trades they had been making for the fund while at UBS, according to an administrative complaint from the New Jersey Attorney General's office.

Between January and April of 2002, the trio made some 3,700 mutual fund trades for Millennium, according to the complaint. Many of the trades were held for fewer than five business days, a classic form of market timing, or making rapid trades into and out of mutual fund shares to take advantage of short-term price movements. By October 2003, when Merrill fired the three men, they had placed some 12,500 trades for Millennium in more than 500 mutual funds. They also timed shares of mutual fund sub-accounts in variable annuity insurance contracts that were purchased on behalf of Millennium Partners employees, according to the complaint.

"These three financial advisers cheated small investors to benefit their large corporate client and enrich themselves," said New Jersey Attorney General Peter C. Harvey in a statement. "They market-timed mutual funds that were intended to provide relatively stable, long-term investments for ordinary people planning for retirement or their children's college tuition."

Merrill Lynch recently agreed to pay a US$10 million penalty to the State of New Jersey and US$3.5 million to the State of Connecticut to settle market-timing allegations involving the three men and Millennium. The firm had policies that prohibited market timing, but the three men, termed the "CBS Group" in the New Jersey complaint, allegedly hid their timing by using multiple accounts in different names for the same client to split up trades and by transferring or "journaling" fund investments from accounts at Merrill Lynch to accounts at the mutual fund companies and then back to different accounts at Merrill Lynch, in this way avoiding fees and detection.

The three also switched among different mutual funds, including mutual fund sub-accounts that were part of variable annuity insurance contracts. In their complaint against Merrill Lynch, state officials said the firm didn't do enough to prevent the market timing once it had identified that it was taking place.

The three men allegedly carried on market timing for Millennium Partners for three years at both UBS and Merrill Lynch. The complaint also asks for civil penalties from each of the men ranging from US$10,000 for the first violation of state securities law and US$20,000 for each subsequent violation.

Variable annuities are life insurance contracts that promise to pay the holder a certain amount at a certain time, usually retirement. Payments from variable annuities fluctuate based on the value of an underlying portfolio of securities--in many cases, mutual funds.

Variable annuities can be attractive to traders looking to disguise market timing. Instead of buying and selling mutual fund shares directly, timers submit orders to the insurance companies to transfer assets between various mutual fund sub-accounts within the annuity. The insurance companies aggregate the orders and submit them to mutual fund companies. The fund companies do not know the identities of the end investors, making it harder to identify market timers.

In the 60-page complaint, New Jersey officials laid out how Messrs. Chung, Brunnock and Savino worked with Millennium trader Stephen B. Markovitz to disguise Millennium's market timing and help it avoid paying various fees for its trades. In one recorded telephone conversation, Mr. Chung is heard explaining to Messrs. Markovitz and Savino how to formulate trades so as to avoid the kind of journaling that would lead to detection and to Millennium owing fees for its trades.

Previously, when Merrill Lynch officials had discovered the CBS Group's market timing on behalf of Millennium, they retraced the steps, calculated the fees and charged them to Millennium, passing on the money collected to the mutual funds that were subjected to the market timing. It also told the CBS Group not to journal assets in the future. The group found a way to comply but still market-time the mutual funds, according to a transcript of a telephone call in the complaint.

"This is a gray area in which we haven't done this before," Mr. Chung told Messrs. Savino and Markovitz on the phone, according to the complaint. That gray area involved buying and selling mutual fund shares in the same accounts, instead of journaling. "?? 1/2 [S]o there is no journaling or anything like that. So we are not doing something that they told us not to do."

In response, Mr. Markovitz said, "We, um, normally we journal, right?"

"Absolutely, this is a new tricky-dicky area," Mr. Chung replied.

"This is a new tricky because they told you not to journal?" Mr. Markovitz asked.

"Yeah, so we bought them in the A accounts and we are actually selling them in the A accounts, but we have them in the MLUA [Merrill Lynch Unlimited Advantage platform, a wrap account for which Merrill Lynch charged clients a fee based on of the assets managed for the client and out of which financial advisers were paid] subsequent to that," Mr. Chung said, with laughter then heard on the line, according to the state's transcript of the call. "If it works, then later on down the road, we'll f--ing MLUA the B accounts ... If this does in fact work ..."

"We can just f--ing buy A shares, then MLUA the accounts and not even journal anything," Mr. Savino chimed in, laughing with Mr. Chung, according to the transcript. "So, don't think we're not deviant m--f--ers and we don't want to explore that for you, all right? Don't think we're not trying to be creative."

"Deviancy at its best," Mr. Chung added.

"I'm with you," Mr. Markovitz said.

CClair@HedgeWorld.com

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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