Watchdogs zero in
Mutual funds are on the hot seat
New York State Attorney General Eliot Spitzer made a big splash last month when he said that his high-profile investigation into wrongdoing on Wall Street was zeroing in on a new target: the nation's mutual funds. As it turned out, Spitzer was not the only one exploring this turf. That very day, Massachusetts' top securities regulator, Secretary of State William F. Galvin, acknowledged he was conducting his own inquiry into mutual funds on the same basic issue - giving an unfair edge to big investors. "There are two sets of rules, one for the average citizen and one for the insiders," charged Galvin, in language that could have come out of Spitzer's mouth.
In the investment world, New York is number one and Spitzer is the top regulator. But if New York is Hertz, Massachusetts is Avis, a plucky number two that works hard to compete. In a series of investigations - into mutual funds, investment banking, and day trading - Galvin and his deputy, Matthew Nestor, have earned a reputation for their aggressive pursuit of investment fraud. "Massachusetts has been a real leader among states on issues that affect markets and investors," said Marc Beauchamp, until recently the executive director of the North American Securities Administrators Association, which represents securities regulators in all 50 states.
Like New York, Massachusetts has gone beyond the traditional domain of the states - crooked brokers, promoters of Ponzi schemes, and operators of no-name boiler rooms, or what Nestor calls the "B team" of the investment world. In the past year Galvin and Nestor have targeted big-name investment banks such as Morgan Stanley and Credit Suisse First Boston. In the mutual fund probe, the state has gathered information from Prudential Securities and Putnam Investments. Neither has been charged with any offense. Prudential last week asked five stockbrokers and a manager in its Boston office to resign following an internal investigation of mutual-fund trading.
"The fact that some of these companies are large and spend a lot of money telling us how reputable they are doesn't necessarily mean they are reputable," Galvin said.
Secretary of state for the past eight years, Galvin can sound like an old-time populist attacking the monied interests. When Morgan Stanley was fined $2 million by an industry regulatory body over its sale of mutual funds, Galvin said, "I'd call it a slap on the wrist, but it's more like a slap on the pinkie finger." Earlier Galvin said Morgan Stanley had "the kind of sales culture you'd expect at a used-car lot." For Galvin, an ambitious politician, the securities cases are a way of making headlines and reinforcing his image as a defender of the ordinary citizen.
Nestor, director of the Massachusetts Securities Division, is less quotable, but his basic take on his role is much the same as Galvin's: To make sure the average investor gets a fair shake in the marketplace. "The harm that can be done to people is dramatic," said Nestor, a former prosecutor. "If you lose your retirement fund or college savings, it is not like breaking a leg. In some cases you never recover."
Nestor, 38, is a local product. He grew up in Randolph, went to Boston College High School and BC Law School. He spent six years working in the Suffolk County district attorney's office before taking his current position. He likes the investigative nature of the work and the opportunity "to be on the side of the angels." Nestor has had better-paying offers from the private sector - he earns $108,000 a year - but he has not been tempted to leave. "I have the best job in America," he said. "We investigate Wall Street and corporate America for squeezing the little guy. How much fun is that?"
Nestor's office gets its leads when investors call up with complaints. Occasionally brokers call to inform on unethical colleagues. Because the office is small - the annual budget is only $2 million - Nestor has to rely on others, including the press, to generate leads. Securities lawyers complain that the press coverage of investigations sometimes exaggerates the nature of the problems.
"There have been instances where there has been noise over cases that were not terribly significant," said Michael Unger, an attorney with Rubin and Rudman. But in the next breath, Unger, a former regulator, said, "I can't be too critical. I did the same thing myself."
In 1997, Massachusetts joined with a number of other states in a crackdown on "microcap" fraud, a scheme that involved brokers who artificially pumped up the price of so-called penny stocks. The investigation led to the shutdown of several firms and the indictment of more than a dozen brokers.
In 1999, as the bull market drew in more investors, Massachusetts became the first state in the country to go after day trading. "Massachusetts put day trading on the map," said Beauchamp. Using computers, day traders buy and sell stocks at a rapid clip, hoping to make money on small movements in price. Day trading isn't illegal, but Massachusetts argued that the firms behind day trading were misleading gullible investors by promising they would make money. A study sponsored by regulators found that more than 90 percent of all day traders lost money. The collapse of stock prices in 2000 killed day trading, but by shining the spotlight on the practice, Massachusetts may have hastened the business's demise, say investment specialists.
Last year Spitzer jolted Wall Street when he charged that the research reports generated by Wall Street analysts were tainted. To win investment banking business, Spitzer said, Wall Street firms wrote glowing reports on companies they knew were flawed. To make his case, Spitzer produced damning e-mails in which analysts trashed stocks they were recommending to investors. Spitzer built cases against Merrill Lynch and Citigroup. Massachusetts used the same technique against Credit Suisse First Boston. Nestor hired 15 law students to pore through 500,000 e-mails. The e-mails showed that at least two Credit Suisse analysts issued "buy" recommendations on stocks about which they had serious misgivings. "These people were so blatant they hanged themselves," said Galvin. Last December Credit Suisse paid $150 million as part of an industry-wide deal to settle the research scandal.
Until recently the nation's mutual fund firms had managed to avoid the spotlight. This is no longer true. Last summer, Massachusetts accused Morgan Stanley of pushing investors to buy in-house mutual funds, without disclosing that the brokers had all sorts of incentives - from extra cash to free trips - to sell those funds. Said Nestor, "Imagine what you'd think if a broker said, `Buy this fund so I can win a trip to Florida.' " In a response filed two weeks ago, Morgan Stanley said Massachusetts had no rules specifically requiring disclosure of sales incentives.
In the past month, Massachusetts has been exploring whether mutual funds let big investors trade funds at the expense of smaller shareholders. Spitzer in September filed criminal charges against a former Bank of America broker as part of his own mutual fund probe.
The actions of New York, and to a lesser extent Massachusetts, have put state regulators on a collision course with Washington. The Securities and Exchange Commission has complained that the states are encroaching on its turf. In a recent speech SEC chairman William Donaldson extended an olive branch to state regulators, saying Washington and the states should cooperate. Even so, some members of Congress have been pushing legislation that would clip the wings of regulators at the state level.
"It's an attempt by the rats to put bells on the cats," said Galvin. "The securities industry finds us painfully effective." Marc Beauchamp, a fan of the Massachusetts operation and state regulators in general, says it is critical to keep the states in the game. Said Beauchamp: "They are good cops. They get to the crime scene before the feds."
Charles Stein can be reached at stein@globe.com. 