State alleges investment firm fraud

Galvin says failing fund gave false assurances

"They misled people and kept people in the fund." - William F. Galvin

Massachusetts Secretary of State William F. Galvin yesterday accused a New York investment firm of fraud for allegedly misleading investors over the safety a $62 billion money market mutual fund while company officials worked desperately behind the scenes to stem a tidal wave of panic selling.

The firm is Reserve Management Co., one of the founders of the money market mutual fund industry. During the credit crisis last September, its giant Primary fund became the first of its kind in more than a decade to reduce its value below the industry standard of $1 a share, adding to widespread fears that not even the safest vehicles were immune from the panic then sweeping the financial system.

The firm's initial problems were triggered by Lehman Brothers Holdings Inc. entering bankruptcy protection on Sunday, Sept. 14. Reserve's Primary fund held $785 million of Lehman debt, around 1.2 percent of the fund's assets. Over the next 24 hours nervous Primary fund investors demanded as much as $24 billion back from Reserve.

Despite being unable to keep up with demands for cash, Galvin said, Reserve Management falsely reassured investors throughout the crisis that it would keep the fund's net asset value at $1 per share. Unable to sell enough securities in the fund, and unable to find a lender to help, Reserve was forced to "break the buck," and reduced Primary's value to 97 cents a share on Sept. 16. That meant investors stood to lose 3 cents on every $1 they gave to Reserve.

A Reserve spokeswoman said the company would not comment on the complaint.

Galvin also alleged that as the crisis grew, Reserve Management failed to return shareholder money on a first-come, first-serve basis, instead redeeming accounts for big, favored clients first. He said Bear Stearns, the bankrupt Wall Street brokerage, went to the top of the list with its demand to cash out $1 billion worth of money market mutual fund shares. Other big institutions were also moved ahead to get their money back.

"They misled people and kept people in the fund," Galvin said. "Perhaps most egregiously, they allowed special investors" to get out more easily. "It makes it more offensive and outrageous."

A spokesman for Galvin said that at the time, the Primary fund had 566 shareholders from Massachusetts, with a combined $2.13 billion invested. In bringing civil charges against Reserve, Galvin is seeking restitution for the Massachusetts investors in Primary fund, a censure of Reserve's brokerage operation, and an undetermined fine.

Last month, Reserve disclosed the Securities and Exchange Commission might charge it with violating securities laws and bring actions against senior executives. An SEC spokesman declined to comment.

Since September Reserve has been slowly returning money to shareholders, who to this day are still owed about 20 cents on the dollar.

Meanwhile, Reserve company documents included in Galvin's complaint, including internal e-mails and minutes of the fund trustees' meetings, detail the nonstop actions of employees to find a way to issue refunds to shareholders, and still keep Primary's value at $1 a share.

A loss on the fund's Lehman holdings would have been a setback, but not a disaster. Reserve's bigger challenge was persuading shareholders to remain confident in the fund. Requests for large redemptions would force Reserve to sell other holdings, which included short-term company loans, government debt, and bank certificates of deposits, at a time when panicky markets had little appetite for those securities.

Galvin said Reserve Management misled investors by telling them the company would protect the value of the fund "to whatever degree necessary."

By midday Sept. 15, with fund redemptions at $16.5 billion, fund trustees authorized Reserve executives to approach the SEC about a so-called capital support agreement, backstop financing that would protect Primary fund.

To the public, Reserve Management sent messages of unwavering support for the Primary Fund's $1-per-share value. Galvin's suit included examples of employees telling clients a capital support arrangement was all set, awaiting government approval, Galvin said.

But there was no such financial backstop in place that afternoon. By the morning of Sept. 16, when fund trustees resumed meeting, the situation had worsened: Requests for redemptions had increased to $24.6 billion, and Reserve president Bruce Bent II told the board the chance they could raise enough money to keep the fund's value at $1 seemed "unlikely," according to minutes of the meeting provided by Galvin.

In fact, the Primary fund was able to repay only $10.7 billion, relying mostly on a credit line from its custodian, State Street Corp. of Boston. When investors inquired about the status of their redemptions, Galvin said, some Reserve executives claimed that the company had sufficient funds and that any delays were the fault of State Street. A State Street official declined to comment yesterday.

Running out of options, Reserve officials made last-ditch calls for help. They rang Timothy Geithner, president of the New York branch of the Federal Reserve, for emergency help. The call was returned by two underlings who told them not to hold much hope. Trustees even discussed turning over the money market fund to another firm or selling the management company but took no action.

By 3:45 p.m. on Sept. 16, shareholders' requests were up to $40 billion. With no financing in site, the trustees determined the Primary fund was no longer a going concern.

At the end of that day, Reserve Management said Primary fund had completely written off the value of its Lehman Brothers securities and would not be able to immediately return all the money shareholders had requested. The fund has since returned $40.4 billion with shareholders still owed about $11 billion.

Steven Syre can be reached at syre@globe.com. Ross Kerber can be reached at Kerber@globe.com