Friday, November 30, 2012

Win-Win-Win-Win becomes Lose

Win-Win-Win-Win becomes Lose

Yesterday I described a fantastic business opportunity for a big bank. An investor traded in and out of the firm’s mutual funds, including trades executed after-hours, while using a bit of its own capital and a loan from the bank.  The investor was a hedge fund called Canary, and the bank was Bank of America.  Over more than two years beginning in 2001, Canary executed 8,300 trades in and out of Nations Funds, BoA’s mutual funds. 

Bolt-Ons (2008)

As I mentioned yesterday, the bank earned all sorts of fees from this relationship.  Bank of America Capital Partners (BACAP), the advisor to the fund, earned $4.1 million in fees on Canary’s trades.  BACAP also earned another $267,000 in management fees from the assets invested by Canary in other funds.  The bank’s mutual fund distributor earned $113,000.  BA Securities, the broker, earned $7 million executing other stock trades for Canary.  And Bank of America’s private bank earned about $1 million from providing between $75 million and $125 million in credit to Canary so it could make its timing and late trades using the borrowed funds. 

How come we know all these details?  Bank of America was forced to settle with the SEC in 2004, pay a fine of $235 million, and roll back fees for 5 years.  The late day trades were simply illegal.  Canary wasn’t profiting from the markets, it was simply taking profits that belonged to mutual fund investors.  The market timing trades weren’t illegal per se.  Rather, the short-term trades violated fund policies established by the mutual fund board, and BACAP failed to tell the board about the thousands of trades executed by Canary.  Bank of America had a lame excuse for failing to inform the mutual fund board.  The bank claimed that it would have violated client confidentiality.  Canary’s frenetic activity cost the regular investors a great deal.  Thanks to the hedge fund, the effected mutual funds had excessively high turnover (lots of transaction costs) and unusually large short-term capital gains, all of which were borne by the mutual fund investors.

How did the SEC find out about this transgression?  An employee of Canary named Noreen Harrington tipped off New York State Attorney General Elliot Spitzer, who quickly discovered that a bunch of mutual funds were permitting Canary and a few other hedge funds to engage in these practices.  Before long, the SEC and Attorney General were digging through emails.  Bank of America was far from alone in granting a hedge fund special access to its funds.  Alliance Capital, Bank One, Invesco, Janus Funds, and Putnam were among the large fund complexes caught up in the scandal.  In fact, Bank of America got hit twice because it acquired Fleet Financial, whose mutual fund, Columbia, had been doing the same thing.  

Two culprits deserve special mention.  Both these individuals were icons of the money management business.  Gary Pilgrim was a highly successful growth investor who founded Baxter, Pilgrim, and Associates, and Richard Strong was an equally successful value investor who established Strong Capital.  As it turns out, Mr. Strong had been market timing his own mutual fund, in addition to permitting Canary to engage in the practice.  And Mr. Pilgrim had allowed a hedge fund to trade his funds in which he had a 45% stake.

Having worked in a large financial conglomerate, I can envision how the pressure from senior management pushed executives to enter into these improper relationships.  I’m sure they were desperate to achieve their profit plan.  It’s harder to understand Messrs. Strong’s or Pilgrim’s motivation.  These guys were rich beyond their wildest dreams.  Perhaps it is the amoral environment of money management that led them to screw their clients in order to make themselves just a little bit richer.

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