"I think you should investigate mutual
funds," said a clearly nervous female
The anonymous phone message, left with a staff
lawyer for New York Attorney General Eliot
L. Spitzer, touched off an intense investigation
of the mutual fund industry in the summer of
2003. Spitzer, the ambitious prosecutor who
had just nailed Wall Street investment banks
for sending out biased stock research to investors,
was looking for a new target. The $7 trillion
mutual fund industry, which had been largely
scandal-free for decades, was ripe for exploration,
especially given the fees they charge investors
for handling their money.
What follows is an inside look at how that
investigation developed, based on interviews
with Spitzer, his team and his adversaries.
* * *
"Doesn't this woman ever answer her phone?"
Noreen Harrington thought to herself in early
June 2003 as she tried once again to reach
a live person at Spitzer's shop. This was positively
the last time she was going to call. She had
already left one cryptic message about mutual
funds, and if the office couldn't follow it,
that was Spitzer's problem. Harrington wanted
to clear her conscience, but not enough to
leave her number. Surely, five or six attempts
to get through were enough.
Surprised when lawyer Lydie Pierre-Louis actually
picked up the line, Harrington blurted out,
"I'm that woman who was calling you about
"Oh, I'm so glad you called," Harrington
remembered Pierre-Louis saying. "We really
want to look into this, but we don't understand
it. We want you to come in."
No way, Harrington thought. "I can explain
it on the phone," she said and started
talking in rapid-fire Wall Street fashion about
"capacity," "market timing"
and after-hours trading. Pierre-Louis was encouraging
but sounded confused. Here Harrington was,
reporting what she thought was a crime -- that
small investors were being ripped off by hedge
funds making improper mutual fund trades --
and the lawyer on the other end of the line
didn't seem to get it. Eventually, Harrington
was persuaded that she was going to have to
do more, so she agreed to come into the office.
But when the day came, Harrington almost didn't
make it through the lobby of 120 Broadway,
the Lower Manhattan building that housed Spitzer's
operations. So nervous that she hadn't even
put the appointment in her datebook, she grew
agitated when she was forced to stand in line
to check in with security and almost walked
out. Upstairs, Spitzer's lawyers were nearly
as anxious. Could she be for real?
They peered down the hall at the elevators,
waiting for the first glance of their tipster.
When Harrington walked off the elevator, the
excitement in the room was palpable. Trim,
neatly dressed, with well-groomed graying hair,
Harrington looked every inch the former Goldman
Sachs trader that she said she was. "That
doesn't look like a nut to me," deputy
Investment Protection Bureau chief Roger Waldman
said, half to himself.
It took the lawyers several interviews to
understand and piece together Harrington's
story. But in essence, here was what she had
to say: She had been working for Edward J.
Stern, the younger son of one of New York's
richest and toughest business magnates, Leonard
Stern, who had built a $3 billion fortune out
of pet supplies and real estate. Since 2001,
Harrington had helped the Stern family invest
its money in a variety of outside hedge funds,
largely unregulated investment pools aimed
at wealthy people.
Her tip concerned another part of Eddie Stern's
business, two internal hedge funds -- known
collectively as Canary Capital Management --
that sought to make money by engaging in a
practice known as market timing. In English,
that meant they were trying to exploit the
fact that stock prices changed all the time
but mutual funds were priced just once a day.
They would move millions of dollars into a
particular mutual fund whenever they thought
its prices were "stale" -- lagging
behind the actual value of the underlying assets
-- and then sell their shares as soon as the
fund price caught up, usually within a few
Dozens of hedge funds were trying this strategy,
and many mutual fund managers hated them because
the sudden inflows and outflows increased costs
and cut into profits for long-term investors.
The Canary team stood out from the pack --
it earned a return of more than 25 percent
in 2001, a year in which the standard stock
indexes all declined.
One evening in 2002, when Harrington happened
to be working late, she watched the Canary
team begin to celebrate a big score. "We
just picked off this fund," Harrington
remembered a trader crowing as the group crowded
around a computer terminal they referred to
as "the box." The whole scene seemed
odd to her. Same-day mutual fund trading was
supposed to stop at 4 p.m. This was well into
the evening. "Who are you trading with?
Japan?" she asked. No one answered.
Now on the alert for odd behavior, Harrington
noticed that the Canary traders routinely wrote
order tickets in the hours between 4 p.m. and
8 p.m. She also began to wonder if the trading
was connected to a call Stern had asked her
to make to Goldman earlier that year. Eddie
wanted to make frequent trades in and out of
Goldman's mutual funds, but the honchos there
had turned him down. Stern had hoped Harrington
could find him another way in.
No dice. "Noreen, you can't do that;
it's illegal," Harrington's pals at Goldman
had said. "We can't have that kind of
turnover in our funds."
She tried to sleuth discreetly. Fellow employee
James Nesfield, a former trader now in North
Carolina, told her his job was to find "capacity,"
funds where Stern's team could make their enormous
investments and then pull out within days without
having to pay a fee, usually known as a redemption
That kind of cat-and-mouse game sounded wrong,
so Harrington went directly to Eddie Stern.
"Is this legal?" she asked. A lithe
and smooth-talking Haverford graduate who could
ooze charm when he wanted to, Eddie sidestepped
the question. "If the regulators ever
look at it, they'll want the mutual funds,
not me," he assured Harrington.
By Labor Day 2002, Harrington had left the
Stern family business, but she initially kept
quiet. She believed Stern's trading was an
isolated problem, and she wasn't inclined to
jeopardize her own future on Wall Street by
rocking the boat. But her next job, with a
private investment boutique, brought her into
contact with lots of hedge fund managers who
openly engaged in market timing. When she asked
them about after-hours trading, they tended
to tiptoe around the subject rather than reject
the idea outright.
She also began to focus on the harm Stern
was doing. In April 2003, Harrington's sister,
Mary Ellen Corrigan, was so appalled by the
shrinking value of her 401(k) retirement account
that she sent Noreen a copy of her statement,
accompanied by a bitter joke: "I guess
I'll have to work forever." On the statement,
Harrington recognized the names of several
fund companies that she knew had been granting
Stern special trading privileges.
She realized with a start that she had been
working for a reverse Robin Hood. "Money
isn't created," she observed. "It's
taken from one person to another. [Stern was
making money off] people who had no money."
'A Man on a Mission'
By late May 2003, Harrington was convinced
she had to do something. "I'm a senior
person in the industry. We're supposed to police
ourselves. I don't want people to think we're
all crooks," she remembered thinking.
But where should she go? For the past few months,
the papers had been full of articles about
Spitzer and his ambitious "global settlement"
that had reformed Wall Street stock research.
"He had a profile in the paper that was
clear; he was a man on a mission," she
The more one of Spitzer's lawyers, David Brown,
thought about Harrington's story, the odder
it seemed. Why would fund companies allow Stern
the privileges Harrington had described? Market
timing increased expenses, cutting into returns
for long-term investors. Harrington had a ready
answer for the fund managers' duplicity: "For
the fees, of course," she explained.
Fund companies made money by charging customers
a management fee based on a percentage of the
assets they invested, and as a fund company's
funds grew, so did its income. Market timers,
in exchange for permission to jump in and out
of individual funds, would usually agree to
park a certain amount of cash with the fund
company overall, generating a steady stream
Brown set his law school interns to work,
looking for information that would help bolster
Harrington's story. One of them hit pay dirt,
a mutual fund Internet chat room where investors
trolled for "timing capacity" and
promised to "pay top dollar." Among
the many messages was a November 2002 exchange
in which a Seth Fox at email@example.com
announced he was "Looking for timers who
need Capacity" and received a Nov. 24
reply from an firstname.lastname@example.org. "Run
a very large timing pool. $2 Bn. Call me if
this is for real. Don't waste my time if it
isn't. ES." Both the phone number and
the e-mail address traced back to the Stern
family offices in Secaucus, N.J.
On June 30, 2003, Brown was ready to send
out subpoenas. He called Nesfield's North Carolina
home first and asked if he would accept a subpoena.
Nesfield, who no longer worked for Stern, immediately
called his former employer, partly to give
him a heads-up and partly to find out if Stern
would get him a lawyer.
Stern told Nesfield he was on his own. So
the North Carolinian called Brown back and
asked what the attorney general's office wanted.
"I didn't do anything wrong," Nesfield
reasoned. "So why am I going to act like
I did? Spitzer has a reputation for doing the
right thing." Nesfield then threw 16 boxes
of documents and his laptop -- filled with
trading records -- into the back of his Ford
F-150 pickup and drove the nearly 500 miles
The Trader Comes In
After getting Nesfield's story, Spitzer's
lawyers turned to Andrew Goodwin, a former
Canary portfolio manager, who came to their
offices with his lawyer. A short and solidly
built redhead, Goodwin had been Canary's whiz
kid, setting up the computer programs that
used statistical models to determine when Stern's
team should put its money in or pull it out.
He also had been forced out of Canary in December
2001 over a dispute about the way he had handled
an e-mail containing salary information. Now
the investigators had a former insider who
could confirm Harrington's allegations.
Much of what Goodwin said also appeared in
the documents that were rolling into the office
of America, Janus Capital Management and
the other fund families that Brown had subpoenaed.
But it was the 11 hours of interviews with
Goodwin that brought these operations to life.
"Absent him stepping up and saying, 'It
is real,' I think we still would have had some
doubts about the case at that time," Brown
recalled. "I was absolutely astounded
that the mutual funds would allow this."
As Brown reconstructed events, Canary traders
had made hundreds of after-hours mutual fund
trades through Bank of America, at first manual
trades they phoned in to a broker named Theodore
C. Sihpol III and then through Canary's own
dedicated computer terminal, which allowed
the hedge fund staff to enter trades directly
into Bank of America's clearing system until
6:30 p.m. -- this was the "box" that
Harrington had seen. To Spitzer's team, the
manual trades sounded blatantly deceptive.
Sometime before 4 p.m., Canary would call Sihpol
with a list of proposed trades, and the broker
would write them down on order tickets stamped
before 4 p.m. Then, after the markets closed,
a Canary employee would call back and tell
Sihpol which trades the fund wanted put through,
and the broker would put the other order tickets
into the wastebasket. (Sihpol was later acquitted
of criminal charges but settled with the Securities
and Exchange Commission.)
Goodwin had been anxious about the legality
of the late trades long before Spitzer's office
called. But Stern brushed off his concerns,
saying, "I have an expert SEC lawyer who
has confirmed that the mutual funds don't like
it but we can do it." Eventually, the
young trader demanded and received a written
guarantee that Canary would cover his legal
costs if he were sued for his role in the hedge
fund's mutual fund trades.
Even as they interviewed Stern's former employees,
Spitzer's lawyers were also applying the screws
to the fund companies and the brokers who had
worked with Stern. Fresh from the stock analyst
investigation, Spitzer felt that the office
needed to keep up the pressure and not allow
the investigation to lag.
Unlike the investment banks that had been
the Spitzer team's last target, the Stern family
took the attorney general's office seriously
from the outset. Eddie hired Gary Naftalis,
a top Manhattan criminal defense attorney who
quickly realized the danger his client was
in. Though late trading had never been prosecuted,
New York's Martin Act of 1921 was so broad
that it would probably allow Spitzer to bring
criminal charges against Stern.
Within weeks, Naftalis made clear to Spitzer
that Stern was interested in a deal. From Spitzer's
point of view, Stern had much to offer. He
had the goods on dozens of mutual fund firms
When Eddie Stern finally showed up in Spitzer's
office on Aug. 5, he was a far cry from the
confident son of privilege who had assured
Harrington and Goodwin that they had nothing
to fear from the regulators. Visibly nervous,
Stern lingered in the doorway of the Investment
Protection Bureau's 23rd-floor conference room,
as if resisting his lawyer's plan for him come
in and tell all. When asked questions, he mumbled,
looked down and began to sweat.
Naftalis had negotiated a "queen for
a day" arrangement, which meant that nothing
Stern said to Spitzer's team could be used
against him in court unless he lied. But that
didn't stop Spitzer's staff from asking the
"Did you do late trading?" they
"Yes," Stern replied, his body hunched
over, his arms crossed across his chest and
his hands cupping his elbows.
The Tennis Deal
Negotiating the outlines of a settlement did
not take long. The two sides agreed that Canary
would make a total payment of $40 million --
$30 million in restitution to investors in
the mutual funds in which Canary had made improper
trades and a $10 million penalty -- and Spitzer
would agree not to go after the investors who
had profited from Canary's trades, including
Stern's family and friends. Stern himself was
banned from managing mutual fund investments
for anyone other than members of his family.
But as Labor Day weekend approached, the deal
started coming apart as disagreements arose
over the details. Spitzer had been getting
briefings from his team, who wanted to get
the Stern settlement done, then move on to
the mutual funds with the momentum of one deal
under their belts and the credibility to press
for structural reform.
Spitzer was in North Carolina watching the
U.S. Open tennis tournament on television.
He sent word to the Canary defense team that
if they couldn't work out a deal by the time
the match finished, all bets were off. Finally,
between 10 and 11 p.m., he and Naftalis were
able to cut through the clutter. The were ready
to fax each other final language.
But the fax machine at Spitzer's beach house
had broken down. He went down the street to
a local deli.
"They wondered who I was," Spitzer
recalled, but they let him use the fax machine
anyway. As a result, the settlement papers
that sparked one of the biggest scandals in
the history of the mutual fund industry were
all stamped "Tommy's Market."