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New York State Attorney General's Case aga

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NEW YORK (–Eliot Spitzer, New York State Attorney General, alleges that Canary Capital Partners LLC, a firm with offices in Secaucus, N.J., and New York City, engaged in fraudulent schemes from 1999 to 2003 that made it tens of millions of dollars at the expense of mutual fund investors.

The New York State Attorney General announced a US$40 million settlement with Canary Capital this morning. The firm is cooperating in a broad investigation into illegal practices by large mutual fund companies Previous HedgeWorld Story.

Following the announcement, Securities and Exchange Commission Chairman William H. Donaldson said, “The conduct alleged in the complaint is reprehensible and there is no place for it in our markets. Today’s action further illustrates the importance of the SEC’s ongoing review of both hedge funds and mutual funds and the SEC’s upcoming recommendations regarding improvements and increased disclosure requirements for both. As we have stated in announcing our current and ongoing study of hedge funds, there is too much money at stake for us to know as little as we do about these funds, in particular, and how they operate. Concurrently, the broad participation by individual investors in mutual funds requires that we do everything possible to understand, anticipate and address areas where there is the potential for abuse and fraud.”

Mr. Spitzer said that Canary manager Edward Stern had special relationships with Bank of America, Janus Capital Corp., Banc One, Strong Capital Management and many other mutual fund companies, which allowed him to use allegedly illegal trading strategies.

Mr. Stern was able to buy mutual fund stocks after closing time and engage in short-term trades that exploited inefficiencies in the way these shares are priced. These practices variously violated SEC rules, New York state law and mutual fund prospectuses, Mr. Spitzer claims.

Mr. Stern invested in hedge funds managed by others and ran two funds of his own, according to a complaint filed with the Supreme Court of the State of New York. After trading with private money starting July 1998, Mr. Stern started raising capital from non-family investors in September 2000. The Canary vehicles, one U.S.-based and the other offshore, were devoted to trading and timing mutual funds.

In 2000, Canary returned net 49.5%. By early 2001, the firm had US$184 million in assets. At the end of that year, assets had grown to US$400 million. The funds returned 28.5% in 2001. In 2002, assets increased to US$730 million, and investors made 15%.

But in the first five months of 2003, returns were disappointing at 1.5%. In May 2003, Mr. Stern returned all funds to outside investors. “We hope that you considered the ride to be a good one,” he wrote in a letter announcing this decision. As of July 2003, his firm had received US$40 million in management and performance fees.

Timing Capacity

Mr. Spitzer said that Mr. Stern evolved and improved his trading strategies to achieve these above-market results by relying on negotiated private deals. Early in his money management career he followed a simple timing method of buying a small-cap technology fund when the market was going up and selling it when the market began to decline. He had an understanding with a senior fund executive that allowed him to do this.

Through the years Canary searched for such opportunities and even engaged a consultant devoted exclusively to looking for timing capacity, the complaint says. By July 2003, the firm had negotiated, directly or through intermediaries, timing capacity agreements with around 30 mutual fund families, many involving quid pro quo “sticky asset” investments in the funds.

Mr. Stern also conducted below radar trades that are difficult for the target mutual funds to detect. Bank of America and Security Trust Co., an Arizona trust administrator, intermediated such trades in addition to facilitating late trading. Canary also relied on other brokers such as Kaplan & Co. Securities Inc. and JB Oxford & Co. for late trading.

But the hedge fund manager’s most extensive relationship was with Bank of America, the complaint says. Starting in 2001, the bank set Canary up with a state-of-the-art late trading platform, allowing it to trade late in hundreds of mutual funds offered to the bank’s customers; gave it permission to time its own Nations mutual funds; provided US$300 million of credit to finance the trading; and sold derivative short positions.

“In the process, Canary became one of Bank of America’s largest customers,” according to the prosecutor. This relationship was mutually beneficial to Canary and various parts of the bank. Theodore Sihpol III, a broker at Banc of America Securities, coordinated all the activity. At one time Mr. Sihpol commented that Canary’s requests were “a bit unorthodox,” but stated that the manager was willing to play by the guidelines and pay for value added.

Procedures Canary was allowed to use violated SEC rules and the Nations Funds prospectus and were never disclosed to mutual fund shareholders. Timing privileges given to Canary were controversial within the bank, according to e-mail messages obtained by Mr. Spitzer’s office. One employee complained that this client was doing extremely short-term trades in and out of a Nations midcap index fund, sometimes holding only a day, and the cost was being borne by other fund shareholders.

In early July 2003, Canary received a subpoena from the New York Attorney General and stopped timing Nations Funds. At that time, the bank’s “timing police,” which was supposed to stop abuses, noticed that Canary’s sticky assets had left the bank.

Canary has agreed to make restitution of US$30 million in illegal profits and pay a $10 million penalty. Mr. Stern and his employees are providing the prosecutor with evidence in an ongoing investigation of the mutual fund industry.

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