The Securities and Exchange Commission

[thepennyking]

Wall Street's rogue mutual fund traders now have more to fear than the wrath of New York Attorney General Eliot Spitzer.

Last week, federal prosecutors in New York shocked securities experts by filing criminal charges against three brokerage executives who were involved in helping hedge funds market-time shares of mutual funds.

The charges against the former top executives of Mutuals.com, a Dallas brokerage, are the first to allege that mutual fund market-timing -- a theoretically legitimate arbitrage strategy -- can be a crime in certain circumstances. The case has defense lawyers fearing that prosecutors now may be gunning for other brokers who engaged in the practice.

In charging Richard Sapio, Eric McDonald and Michele Leftwich with securities fraud, prosecutors allege the "defendants engaged in a number of deceptive and fraudulent practices designed to conceal the identity" of the firm's hedge fund customers and their trading activity.

Prosecutors contend the Mutuals.com execs resorted to the deception after a number of mutual funds told them to stop market-timing because it was hurting long-term investors. Specifically, they allege the defendants conspired to evade detection by setting up multiple accounts and incorporating two affiliated brokerages to make their trades.

Sources familiar with the investigation said one of the clients that Mutuals.com did market-timing for was Veras Investment Partners.

Until now, state prosecutors in Spitzer's office and regulators at the Securities and Exchange Commission have spared brokers criminal prosecution. In the scandal's highest-profile broker case, regulators filed civil fraud charges against a group of Prudential Securities brokers alleged to have used deception to conceal their clients' abusive trading activity. The criminal charges against the Mutuals.com executives mirror those, but come with criminal penalties
Before last week's development, the only brokers, traders or mutual fund officials facing criminal charges were ones who allegedly had some connection to late-trading -- a practice in which favored investors are allowed to buy mutual fund shares that were priced prior to the emergence of market-moving news.


Now, even plain-vanilla market-timers could face criminal prosecution. Federal prosecutors in Massachusetts, sources said, are getting closer to filing criminal charges against the several former Prudential brokers who allegedly used deception to conceal their market-timing activity.

A source familiar with the investigation said Spitzer's office also hasn't ruled out filing criminal charges over market-timing, especially in cases involving egregious conduct. (Prudential is jointly owned by Wachovia (WB:NYSE - news - research) and Prudential Financial (PRU:NYSE - news - research) .)

Defense lawyers, however, say prosecutors make a big leap trying to turn market-timing into a crime.

"With each case, the regulators seem to be walking farther out on the limb," said James Walden, a partner with O'Melveny & Meyers in New York and a former federal prosecutor. "The prosecutors will have an extremely difficult time convincing a jury that market-timing is provable securities fraud without allegations of late-trading."

What prosecutors contend is deception, Walden says, arguably can be characterized as an attempt by savvy brokers and traders to "exploit gray areas of the system."

Indeed, if prosecutors intend to turn the gray areas surrounding market-timing into a crime, there could be plenty of criminal cases to pursue.

That's because using techniques such as multiple accounts was a standard operating strategy for market-timers trying to evade detection by the so-called "timing cops" -- employees mutual fund companies relied on to stop abusive trading.

"I didn't even think of that as illegal. That's how common it was," says James Nesfield, a mutual fund consultant who helped find market-timing opportunities for Canary Capital Partners, another hedge fund at the center of the inquiry.

One thing that often gets overshadowed in the mutual fund scandal is that many fund companies did try to deter market-timers. The problem is that many timing cops weren't particularly good at their jobs, and the mutual fund companies didn't consider deterring market-timing a high priority.


The lax enforcement meant it didn't take much subterfuge for market-timers to evade detection. It's one reason most market-timers didn't negotiate the kind of special trading arrangements that regulators have highlighted in settlements with several mutual fund companies, including Alliance Capital (AC:NYSE - news - research) and FleetBoston Financial's (FBF:NYSE - news - research) Columbia Funds.

"Most of it wasn't negotiated," says Nesfield. "It was a lot easier to change account names than call up a mutual fund company."

In fact, market-timers contend that most of the things they did to avoid detection, while possibly shady and unethical, were perfectly legal.

In a possible preview of their defense to the criminal charges, the defendants in the Mutuals.com case call the SEC an example of "strained" regulatory enforcement.

In court papers seeking the dismissal of the SEC action, lawyers for the brokerage executives accuse regulators of targeting them because market-timing is now seen as "extremely unpopular and politically incorrect in the current environment." The defendants contend the "SEC attempts to contort a series of legal acts into a fraudulent scheme."

By Matthew Goldstein
TheStreet.com Senior Writer