Anatomy of a mutual fund scandal

Separate complaints against Prudential's Martin Druffner offer a window into the scrutiny of fund industry.

Up the street from the Boston Marathon starting line lives Wall Street's latest alleged villain, Martin Druffner.

His half-million-dollar white colonial house, with a Mercedes sedan parked in the driveway, doesn't quite measure up to the golden lifestyle of Enron or Tyco executives. But in the world of the retail brokerage business, government regulators say Mr. Druffner made off like a bandit, thanks to alleged fraud involving mutual-fund trades.

The case, outlined in separate civil complaints Tuesday by the Securities and Exchange Commission and William Galvin, Massachusetts secretary of the Commonwealth, illustrates what investigators say has gone wrong in the usually staid world of mutual funds.

Up until a few months ago when a co-worker tipped off regulators, the operation run by Druffner and two subordinate traders was, investigators charge, more reminiscent of a massive con game: intentionally changing account numbers, misspelling names, and falsifying which branch was executing transactions.

What is even more eye-opening to many experts is that supervisors at Prudential allegedly looked the other way while industry insiders even offered advice about how to circumvent internal controls. "It certainly indicates they were not doing a good job at finding and correcting this activity," says Larry Soderquist, director of Vanderbilt University's Corporate and Securities Law Institute in Nashville, Tenn. "The mutual-fund industry and its managers have been fairly much asleep as to problems for many years."

According to documents in the Druffner case, he began gaming the system in 1998 after a friend from college referred a new client, Chronos Asset Management. The investment adviser, funded by the Canadian Imperial Bank of Commerce, was looking for a broker for mutual-fund transactions.

Chronos began what is termed "market timing" trading with Druffner, the documents say. This involves placing orders as close to 4 p.m. as possible. Since the trading day is almost complete and the markets' performance for that day is largely known, a mutual-fund buyer would have a slight advantage buying stocks. At the same time, frequent short-term trading increases costs for the funds, may force them to liquidate holdings to meet sudden redemptions, and disrupts strategies. For these reasons, most mutual funds, in their prospectuses, prohibit excessive trading and market timing.

But according to the documents, Druffner's clients increasingly practiced this type of trading. By 2001, he had hired two more brokers to handle the increased volume, which was producing $1.7 million in commissions. Before he was allowed to resign in September, commissions had reached $3 million, the highest in the Boston office and one of the highest in the Prudential network, according to the documents.

While trading was rising, so were complaints from the mutual funds whose shares were being bought and sold. According to court documents, the brokers received some 25,000 to 30,000 letters from these funds asking them to stop their practices.

In an internal Putnam Funds memo included in the court documents, one officer complained, "I'd like your help in having Prudential shut down this entire branch since it's obvious that they will continue to circumvent the controls we have in place."

Regulators say that to get around the controls, the Druffner group obtained 62 identification numbers to conceal who they were. Names were slightly changed. They made it appear orders were coming from branches in north Miami and the West Indies. At the same time, according to regulators, wholesalers who sell mutual funds to institutions and brokers wanted the lucrative trading to continue. They advised the Prudential brokers they could avoid detection through different strategies, among them executing trades before holidays when watchdogs were less vigilant.

In Druffner's Boston office, regulators say, the process took on an almost factory-like routine. Every day, each client would fax in 20 pages of trades. "However, these transactions were not active or live orders," says the complaint. Instead, the trades required a telephone call between 3 and 3:45 p.m. to implement the trading. Additional personnel were hired to assist in entering trades and exchanges.

The late-day trading became apparent to Prudential management, the state alleges. "Members of the Druffner Group were known market timers throughout Prudential management including the Druffner Group's branch managers, administrative manager, regional compliance officer, divisional risk officer, divisional compliance officer as well as the president," say the documents.

Daniel Rabinovitz, an attorney for three brokers, did not return calls to the Monitor. But he told the Associated Press that his clients had done nothing wrong. "How can it be deceptive if everybody knew about it?" he said.

In February of this year, Wachovia Securities bought a majority of Prudential's brokerage operations. According to court documents, in August, Druffner went to Wachovia offices in Richmond, Va., where he says he was told, "There is other timing going on at Wachovia and there should be business, same old business."

On Sept. 8, Wachovia adopted a uniform policy prohibiting mutual-fund market timing. A spokesman for Wachovia says they would have no comment on the specific charges. He did note that as part of their purchase agreement, any preexisting liabilities are the responsibility of Prudential Financial.

The complaints filed Tuesday may only be the start of legal fallout. The implicated brokers and managers could still face criminal charges for securities fraud in either state or federal court.

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