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Behind the Mutual-Fund Probe: Three Informants Opened Up

Henny Sender and Gregory Zuckerman, The Wall Street Journal

December 9, 2003

The investigation rocking the mutual-fund industry began with a phone call in June by a 20-year Wall Street veteran that lasted 10 minutes.

Noreen Harrington, calling from her apartment near New York's financial district, asked to be connected to a lawyer in the office of New York Attorney General Eliot Spitzer. Several times she got voice mail and didn't leave a number, she says. But one day, an assistant attorney general picked up.

Without identifying herself, Ms. Harrington, 47 years old, told the junior attorney something unusual about her former boss, Edward J. Stern -- who ran a fund for wealthy investors and whose family controls a $3 billion business empire. Mr. Stern, she said, had bought and sold mutual funds after the 4 p.m. close of trading -- but still got the 4 p.m. prices, letting him take advantage of late, market-moving news.

Ms. Harrington's call set off a chain reaction, leading to two other informants, who helped Mr. Spitzer and his team open a far-reaching probe of the $7 trillion mutual-fund industry. At least 25 financial firms so far have been enmeshed in it. Two traders have pleaded guilty and are awaiting sentencing.

The identity of the tipsters has been a closely guarded secret on Wall Street. Each worked for the Stern investment business at one time, though each appears to have had a different motivation for talking to investigators. The second informant, James Nesfield, 45, was a consultant to Canary Capital, Mr. Stern's trading unit. Mr. Nesfield, who now lives on the North Carolina Outer Banks, where he sometimes helps man fishing boats, says that after being contacted by investigators, he spoke to them out of remorse and fear of prosecution. Andrew Goodwin, 33, was a former Canary trader who had worked by Mr. Stern's side and, according to others, believed his future was at risk if he didn't cooperate.

Ms. Harrington's hesitant call was well-timed. Just a few weeks earlier, Mr. Spitzer had hired David Brown, a 45-year-old Wall Street lawyer, to work in the Investor Protection Bureau. Mr. Brown already was concerned about mutual funds. In a job interview with Mr. Spitzer, Mr. Brown says, he was asked where the next scandal would come from. Recalling a 2001 article from a University of Iowa legal journal about conflicts on mutual-fund boards, he shot back: "Mutual funds."

Quarterbacking a team of 15 lawyers, Mr. Brown began digging up information to see if Ms. Harrington's tip would bear out. The first hint that it might: an obscure chat room, Mutual Fundsnet.com. Mr. Stern last year posted a response on the site to someone offering investors the opportunity to buy and sell shares of mutual funds after the 4 p.m. close of trading.

Mr. Brown was dubious that mutual funds would let anyone do that. He walked upstairs to Mr. Spitzer's office. "This can't really be happening," he recalls saying to his boss. "They can't be doing this out in the open, right?" Mr. Spitzer encouraged him to keep working on it. "Keep pounding," the attorney general called out as Mr. Brown turned to leave, according to people familiar with the matter. As the trail grew warmer, Mr. Spitzer encouraged Mr. Brown even more, saying, "I smell indictments."

The tipsters helped expose the two improprieties in the mutual-fund scandal: late trading and active, in-and-out trading of fund shares, often called "market timing." What made mutual funds a target is that they are priced only once a day, at a specific time, unlike stocks. That feature provided opportunities for privileged traders who knew how to game the system.

Of the two improprieties, the more-serious is late trading. Mutual-fund shares generally are priced at 4 p.m. An order placed after that isn't supposed to be filled until 4 p.m. the following day. But a late trader is able to enter an order after 4 and still get that day's 4 o'clock price -- thus taking advantage of any late news that is likely to move stocks up or down the following day. This is illegal.

Both practices hurt other investors in a mutual fund. That's because these investors don't get quite as large a share of the mutual fund's gains as they should. The late trader or market timer, in effect, jumps in and snares an outsize portion of the gains. The practices also hurt regular investors in other ways, such as by driving up a fund's trading costs.

A few days after calling anonymously, Ms. Harrington walked into the attorney general's office and identified herself. Mr. Brown saw that Ms. Harrington had credibility on Wall Street. She had worked at Goldman Sachs for 11 years as a managing director on the bond desk, where she was in charge of sales to hedge funds -- private-investment pools for the wealthy. She also had spent time running emerging-markets trading for Barclays Bank PLC. In 1997, Euromoney, a trade publication, named her one of its top 50 women in worldwide finance.

Ms. Harrington joined the Stern family business in 2001. She had no direct involvement in the trades: Her job was to dole out money from the family empire to other investment funds. Though she didn't work directly for Canary Capital, she says she learned of Mr. Stern's rapid trading. She thought this was questionable but in a gray area. Then, she says, she noticed orders being handed in late.

A flash point came when she suggested to Mr. Stern that he remove Canary's 401(k) program from a fund company because it was underperforming. She says Mr. Stern refused, explaining that the firm allowed him to trade its funds frequently.

Ms. Harrington says she repeatedly complained to Mr. Stern that he was taking advantage of other mutual-fund investors. Mr. Stern ignored her, she says. "I asked how could this be right? I put in my two cents many times," Ms. Harrington says. "But he didn't have to listen to me, and he didn't. He said the onus was on the mutual funds, and if the regulators ever looked at it, they would go after the mutual-fund companies." Ms. Harrington says she left the organization last year, unhappy about Mr. Stern's activities. She adds that she wanted a more challenging job.

An attorney for Mr. Stern, Gary Naftalis, says Ms. Harrington never complained about Mr. Stern's trading. "Ms. Harrington's termination had nothing to do with mutual-fund trading. She didn't quit in disgust over any mutual-fund trading. Indeed, she was an investor and limited partner in Canary Partners and received economic benefits from the trading," he says.

"Eddie Stern and Canary," the lawyer adds, "have been cooperating with the investigation and have been totally candid throughout."

Asked about the Stern lawyer's account, Ms. Harrington said she left by mutual agreement, adding: "They were not enamored with me. People are never enamored with people who ask questions." As for investing in Canary, she says every senior staffer was required to do so. A spokesman for Canary says that isn't the case.

Months after she left, Ms. Harrington decided to talk. She says she didn't go to the Securities and Exchange Commission because she wasn't confident the agency would follow up on her allegations. She says she trusted Mr. Spitzer's team, which had just finished its big investigation of Wall Street research analysts, with 10 firms settling for $1.4 billion. And she respected Mr. Brown, who had also worked at Goldman Sachs.

As Mr. Brown and his staff dug deeper, in late June they got a big break. A summer intern from New York University working for Mr. Brown tracked down someone who appeared frequently on the Internet chat room used by Mr. Stern. It was Mr. Nesfield, who went by "Jimbo" in his posting.

Mr. Nesfield wasn't a typical Wall Streeter. He grew up in the South Bronx, the son of a transit worker and union organizer, and dropped out of college at State University of New York at Stony Brook. He says he studied for the priesthood when he was in high school. One of his first jobs was in the municipal-bond vault in the innards of Paine Webber, a firm later bought by UBS AG.

Canary hired Mr. Nesfield as a consultant, he says. His job was to help find mutual-fund companies willing to let Canary trade their funds actively, a practice many mutual funds discourage. Mr. Nesfield was particularly helpful because he had mastered details of how the "back office," or trade-processing, systems work on Wall Street. On behalf of Mr. Stern, Mr. Nesfield approached mutual funds directly, often writing e-mails to their heads of marketing.

Within days of being recruited, Mr. Nesfield says, he located Phoenix-based Security Trust Co. This is a firm that Mr. Spitzer's office alleged, in the complaint against Canary, played a role in making mutual funds available to Mr. Stern for late trading in exchange for fees amounting to 4% of proceeds. Regulators have demanded that Security Trust dissolve itself, and Security Trust has said it will cooperate with authorities to do so.

Mr. Stern asked Mr. Nesfield to agree to work only for Canary, at $50 an hour. The formula eventually was changed to a commission of less than 1% of the funds he was able to place with mutual-fund companies. Mr. Nesfield estimates he made $300,000 in the years he worked with Mr. Stern.

In the first week of July, Mr. Brown sent a subpoena to Mr. Nesfield's home fax machine. To Mr. Brown's surprise, Mr. Nesfield called him back. At first he was evasive, telling Mr. Brown that "late trading" was an urban myth, according to the investigator. "Market timing is what you should look into," Mr. Nesfield said, referring to the rapid, in-and-out trading of mutual-fund shares.

Mr. Nesfield says he phoned Mr. Stern to discuss strategy on how to deal with the investigators. "We should work together" on dealing with the New York attorney general's office, Mr. Nesfield says he told Mr. Stern.

"Get your own attorney," he says Mr. Stern replied.

Mr. Stern later received a subpoena from Mr. Brown's office, based on information both Ms. Harrington and Mr. Nesfield supplied the attorney general's office, as well as the Web site, according to Mr. Brown. Meanwhile, based on his conversation with Mr. Nesfield, Mr. Brown instructed his staff to draw up new subpoenas, which he sent to dozens of mutual funds and hedge funds, asking them about their trading.

Mr. Brown drew up a second subpoena and sent it to Mr. Nesfield's home. Mr. Nesfield didn't have an attorney and was sobered by the prosecutor's quick action. "I thought, 'Whoa, I better not mess with the Brahmins,' " Mr. Nesfield says. He says he also began to have second thoughts about whether Mr. Stern's trading was proper and decided that aiding Mr. Brown was the right thing to do.

The investigators "really didn't know much about what they were talking about," Mr. Nesfield recalls in an interview. "So I decided to help them."

One reason for his change of heart: Mr. Brown had established a bond with Mr. Nesfield. "He is like me," says the chain-smoking Mr. Nesfield. "He lived in New Jersey. So did I. We both home-school our kids."

The two men are also quite different. Mr. Brown grew up in a tony Connecticut suburb, the son of a lawyer at a blue-chip law firm. But when Mr. Brown told Mr. Nesfield that he wanted to meet him, Mr. Nesfield complied.

On July 22, Mr. Nesfield threw 13 cartons of documents containing Canary's trading records into his Ford pickup and drove seven hours to New York. Alone with Mr. Brown, in a stuffy conference room in the state attorney general's office adorned with an "I Love New York" tourist poster, Mr. Nesfield talked from 10 a.m. until late afternoon. Eyeing the investigator across a wooden conference table, Mr. Nesfield explained the arcane world of mutual-fund trading. In the beginning, Mr. Brown threatened Mr. Nesfield with the possibility of jail time. By the end of the conversation, though, as Mr. Nesfield revealed everything he knew, Mr. Brown became his confessor. Mr. Brown stopped threatening him with jail time. Mr. Nesfield "is on the side of the angels," says Mr. Brown.

Mr. Nesfield told how mutual-fund managers gave Mr. Stern more-timely information on their holdings than most investors got and let Mr. Stern submit orders after 4 p.m. without paying the next day's price. In exchange, he said, Mr. Stern promised to keep some money with the mutual-fund company to swell its assets under management. That helps a fund and its manager, whose fees depend on that figure.

Mr. Nesfield also told Mr. Brown that some fund firms allowed Mr. Stern and others to buy and sell their funds frequently, that is, engage in "market timing." In March 2003, Mr. Nesfield sent an inquiry to Janus Capital Group Inc. "I am looking for a point of contact to negotiate market-timing capacity on behalf of a large private account," he wrote. He asked "Is there a way that the restrictions ... can be lifted for a long term cash allocation...? A spokesman for Janus, which hasn't been charged by regulators, says the firm plans to make full restitution to investors hurt by these activities.

Mr. Nesfield also cited some other hedge funds, among them Millennium Partners L.P. Last month, Mr. Spitzer's office filed criminal charges against a senior Millennium trader relating to alleged after-hours trading. Lawyers for Millennium and the trader declined to comment.

Though many mutual funds profess to oppose rapid in-and-out trading, Mr. Nesfield says that "I'd call and get in." In saying in their prospectuses that they oppose such trading, "What they really mean is that they don't want small timers," he says. "If they say no, it just means you haven't found the right person to ask."

Mr. Nesfield says he believed that he wasn't doing anything illegal. "I didn't place the trades," he says. And even now, he is ambivalent about his role. "People say it is a bad thing and you helped, but I say it is not as clear-cut as you perceive," he says. "Morally, everyone is guilty. I kept one eye closed." Besides, he says, "Who am I to question Eddie Stern?"

In talking to the investigator, Mr. Nesfield spoke quickly, and Mr. Brown tried to scribble it all down on a white legal pad without pausing for lunch. "He had so much information, we couldn't take it all in," Mr. Brown recalls. At the end of the long day with Mr. Brown, Mr. Nesfield burst into tears. "Please don't hurt them" he begged Mr. Brown, referring to the Stern family. Mr. Nesfield says that even though he felt the Sterns hadn't paid him well, he felt a certain loyalty to the family and admired their charitable donations.

With six children, Mr. Nesfield worries that he might go to jail. And he fears that someone who lost money as a result of his disclosures might take revenge.

As much as Mr. Nesfield knew about Canary, he wasn't an insider. Mr. Brown still needed someone who could explain how Mr. Stern's operation worked. Ms. Harrington and Mr. Nesfield say they steered prosecutors to Mr. Goodwin. He had worked in the Canary trading room for several years, side by side with Mr. Stern conducting the mutual-fund trades.

Mr. Stern had recruited Mr. Goodwin, a New Yorker and Harvard graduate, from a rival hedge fund in 2000. Mr. Goodwin left in late 2001 following a dispute with Mr. Stern over a computer file, according to people close to the matter. Mr. Brown sent Mr. Goodwin a subpoena in mid-July, and then called him directly, saying he wanted to talk to him about Canary. Mr. Goodwin responded, "I can't talk to you right now," and hung up, according to a person with knowledge of the call.

When Mr. Goodwin's lawyer returned the call, Mr. Brown put the pressure on. Over the next few days, Mr. Goodwin began to worry about going to prison unless he cooperated, according to a friend.

Deciding to cooperate, Mr. Goodwin described the inner working of the hedge fund and Mr. Stern's role in executing the trades. He also told Mr. Brown Bank of America was cooperative in helping Mr. Stern do improper mutual-fund trading. Mr. Goodwin detailed how late trading worked, providing confirmation to some of the initial tips of Ms. Harrington and Mr. Nesfield. Mr. Nesfield had used so much industry lingo that it was only when Mr. Brown interviewed Mr. Goodwin that he could make sense of it all, Mr. Brown recalls.

Mr. Goodwin declines to comment on the trading, citing pending class-action suits by investors against Canary. He recently moved to Miami Beach. He has told some people he wants out of the financial world.

By the time Mr. Brown interviewed Mr. Stern, in early August, the investigator had a lot of information. He quickly won Mr. Stern's cooperation and began gathering evidence on other firms to break open the investigation. One of the first pieces of information Mr. Stern provided was an agreement with Bank of America appearing to allow Mr. Stern to trade mutual funds half an hour after the 4 p.m. close of trading and still get the 4 p.m. price. The bank has fired employees who dealt directly with Mr. Stern. A spokesman for the bank says it has been cooperating in the investigation and launched its own probe.

On Sept. 3, less than three months after Ms. Harrington's phone call, Mr. Spitzer's office filed a civil complaint against Canary in a New York state court, written by Mr. Brown, and announced a $40 million settlement with Mr. Stern. Mr. Stern neither denied nor admitted wrongdoing.

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