State said to probe fund firm's policies

Market-timing eyed at Putnam

By Andrew Caffrey and Scott Bernard Nelson, Globe Staff, 10/21/2003

Massachusetts Secretary of State William F. Galvin plans to charge Putnam Investments with civil securities fraud within the next few days, say two people involved in the investigation. The charges would ensnare one of Boston's largest mutual fund firms in a burgeoning probe into abusive practices in the fund industry.

Galvin and New York Attorney General Eliot Spitzer have moved aggressively in the last two months against the mutual fund industry, which had largely avoided the lawsuits and scandals that have plagued corporate America and the securities industry since the Internet bubble burst in early 2000. Spitzer, in particular, has shown that certain big investors received preferential treatment at some fund houses, undermining investors' faith that the rules apply equally to all shareholders. Formal complaints against Putnam, the nation's fifth-largest fund family, would suggest that the scope of the inquiries is widening.

Investigators are probing whether the trading practice known as market timing -- trading quickly into and out of funds, to take advantage of short-term price fluctuations -- was being employed by small-time individual investors as well as by sophisticated brokerage houses. The two people involved in the investigation said the state Securities Division, which Galvin oversees, intends to charge Putnam with at least two counts of securities fraud. One count would allege the company let individuals trade rapidly in and out of their mutual fund accounts -- despite company policies that prohibit excessive trading. A second would allege that Putnam failed to treat shareholders equally, by allowing some to market-time their accounts, and not others.

The state is expected to allege that by not upholding its policies, Putnam in effect said one thing and did another as well as treated its customers unequally. The state is expected to argue that both would constitute civil fraud in Massachusetts.

Under Massachusetts law, each violation carries a penalty of up to $25,000. It's not known how many violations the state hopes to document. In a statement, Putnam said that "any accusation of improper behavior related to market timing across our client base is simply not true. We recently completed a thorough review of market timing in our mutual funds as far back from 1998 to the present and have determined that nothing illegal occurred during that period."

Putnam said it learned of the pending complaint against the firm late yesterday.

The Massachusetts investigation of Putnam funds concerns mutual fund accounts of members of several New York trade unions and workers involved in the cleanup of the US government's Hanford nuclear waste site in Washington state, according to a subpoena Galvin's office issued to Putnam last month, a copy of which was obtained by the Globe.

The subpoena demanded documents covering the period from Jan. 1, 2000, to the present related to its administration of investment funds for the Boilermakers Union, Local No. 5, in New York; the Joint Industry Board of Electrical Industry, which manages some benefits for union electricians in New York; and Fluor Hanford Inc., a unit of the California engineering and construction firm Fluor Corp. that runs the retirement plan for more than 11,000 employees from about 10 companies working on the cleanup of the polluted US nuclear reservation in Washington state.

The state has also asked that Putnam produce account records of 11 individual investors, though it does not identify where the 11 worked.

The subpoena doesn't indicate whether the three organizations or their plan members are targets of investigators.

While market timing isn't technically illegal, Putnam, like many other many mutual fund companies, said it strongly discourages such frequent trading because it raises expenses and lowers investment returns for all shareholders.

Prospectuses for Putnam's funds warn that the company "reserves the right to revise or terminate" trading privileges "in order to limit excessive exchange activity and otherwise to promote the best interest of the fund."

The crux of the Massachusetts investigation is whether Putnam allowed certain mutual fund holders to trade frequently -- while refusing to let others do the same.

Putnam said it moved to stop such trading whenever it discovered it. The company said its investigation reviewed the accounts of "millions" of individual investors.

"The number of individuals who attempted to market time Putnam funds was minimal during that period of time, and Putnam achieved a success rate of 99.98 percent in preventing market-timing activity," Putnam said.

Yesterday, a spokesman for Fluor said that members of its retirement plan had been frequently trading in their Putnam accounts, but that the company put a stop to it last year.

"There were some changes made. People can't trade on a daily basis or can't make transactions on a daily basis. There had been some issues around that," said Fluor spokesman Jerry Holloway.

As to how widespread such trading was, Holloway said, "We're talking a very small number of people."

An official of the electricians' Joint Industry Board declined to comment yesterday.

In its statement yesterday, Putnam said it "worked closely" with Fluor, as well as with the electricians unions, "to identify and eliminate market timing when we detected it," by adding trading restrictions to the members' accounts.

Putnam said that market timing by members of the Fluor retirement plan stopped in August 2002, while market timing by union electricians was thwarted in April 2000.

Putnam said it "faced certain difficulties curbing excessive trading" by members of the boilermakers local, however. One problem, Putnam officials said, is that a mutual fund company has little direct control over the individual investors in a company-sponsored or union-sponsored retirement plan. Its contract is with the plan sponsor -- in these cases, the boilermakers union, the electricians unions, and Fluor Hanford.

"We can't reach through and force anything on the participants without the plan's sponsor's authorization," said John Brown, head of institutional management at Putnam. Unless the plan sponsor "instructs us in writing, we can't take direct action against the underlying participants from doing whatever they're doing."

Putnam officials said that representatives of the boilermakers local told them they, too, were powerless to stop the trading because the individual investors are union members, rather than employees over whom they would have more control. In September, after more than two years of fruitless negotiation, Putnam said, it shut off access to two international mutual funds to all members of the local, or about 1,000 investors.

Galvin subpoenaed Putnam Sept. 11.

One member of the boilermakers union who is cited in the Massachusetts subpoena, David Henderson, said yesterday that he "moved money occasionally, which was consistent with our plan rules. Our plans rules are we can move the money wherever we want, once a day."

Among the funds that Henderson said he traded into and out of is Putnam's International Voyager fund, one of five funds Massachusetts is seeking information about. (Putnam recently renamed it the International Capital Opportunities Fund.) It was also one of two international funds that Putnam closed to boilermakers members last month.

Henderson declined to specify how often he traded, saying:

"It depends on the market. I moved the money because I thought I had a better advantage. It's my hobby. I study trading."

Asked whether he profited, Henderson said he made "a couple of bucks."

An official at the boilermakers local, Joseph Gregorio, said the union would have "no way of knowing" whether its members were market timing. He declined to comment further.

Yesterday, Putnam said that it would impose a 1 percent redemption fee on frequent trades in 401(k) retirement plans "to further inhibit market timing activity."

Last month, Spitzer, the New York attorney general, reached a $40 million settlement with a New Jersey hedge fund and its principal, Edward J. Stern, for "two fraudulent schemes" to market-time and to trade after closing hours in mutual funds of four investment companies.

And as his investigation has widened throughout the industry, Spitzer on Thursday won a guilty plea from James P. Connelly Jr., the former chief mutual fund officer at the respected New York firm Fred Alger & Co. The charge was tampering with evidence, a felony punishable by up to four years in state prison.

A spokesman for Galvin declined to comment yesterday.

But last month, in disclosing that his office had issued the Putnam subpoena, Galvin said, "We have probable cause to believe there are significant problems."

Andrew Caffrey can be reached at caffrey@globe.com; Scott Bernard Nelson, at nelson@globe.com.