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Attorney General Lockyer Launches Investigation of Fraudulent Sales Practices by Mutual Funds

Probe Marks First Use of Expanded Authority Under New State Law
Friday, January 2, 2004
Contact: (415) 703-5837

(SACRAMENTO) – Attorney General Bill Lockyer today launched an investigation into whether mutual funds have defrauded California investors by failing to disclose deals under which broker-dealers receive compensation to recommend particular mutual funds.

"Our laws governing securities transactions rest on a simple principle: Investors must be told the truth, the whole truth," said Lockyer. "That's not just a lofty goal. It's a legal duty. The working men and women and retirees of California have the right to be fully informed when they make investment decisions that affect their lives and futures. When secrets are kept from them, that right is violated."

The investigation marks Lockyer's first use of a new law he sponsored, SB 434, which expands the Attorney General's authority in securities fraud cases. The statute gives Lockyer the ability to respond to the trading scandal that has engulfed the nation's $7 trillion mutual fund industry.

SB 434, which took effect New Year's Day, grants the Attorney General concurrent jurisdiction with the Commissioner of Corporations to investigate violations of the state Corporate Securities Law (CSL) and to bring civil enforcement actions for such violations.

"I sponsored SB 434 because I believe it is important that the state's top law enforcement officer have clear, sufficient authority to help fight abuses that harm investors and the marketplace," said Lockyer. "While the initiation of an investigation does not mean the targets have violated the law, this action demonstrates I will aggressively use that authority."

The initial subjects of Lockyer's probe are three large California-based mutual funds. Ultimately, the investigation could expand to include other mutual funds, as well as broker-dealers who sell mutual fund investments to consumers. "They're the counter-parties to these arrangements," Lockyer said of broker-dealers.

In a recent case involving failure to disclose compensation agreements with mutual funds, the prominent Wall Street brokerage firm of Morgan Stanley DW, Inc. agreed to pay $50 million in civil penalties and investor restitution to resolve an enforcement action brought by the U.S. Securities and Exchange Commission (SEC). Some 15 mutual funds were implicated in the case, but not named as defendants.

The practice targeted by Lockyer's probe is known in the industry as "selling shelf space." The phrase refers to spots on broker-dealers' list of recommended buys which mutual funds secure by paying broker-dealers cash or commissions.

Failure to disclose such arrangements could violate CSL provisions that prohibit fraudulent sale of securities. Both mutual funds and broker-dealers could be liable for such violations. Potential remedies under the CSL could include investor restitution, disgorgement of ill-gotten profits, damages and a maximum civil penalty of $25,000 per violation. The key legal question in such cases is whether a reasonable investor would consider the undisclosed information important to know in making an investment decision.

The mutual fund scandal also has involved other abuses, such as "market timing" and "late trading." Market timing refers to the rapid buying and selling of mutual fund shares. It is not illegal. But it increases costs for investors, and some mutual funds tell investors they prohibit the practice. Late trading is illegal and refers to buying or selling shares after the market closes, at the closing price, with the knowledge that market forces will bring a higher price the next day.

Lockyer's probe currently is not focused on these other trading abuses. The "shelf space" problem, he explained, has broader implications for investors. "We're going after fraud at the front end," said Lockyer. "Misleading investors strikes at the heart of our laws and the consumer protections those laws provide."

Employees of mutual funds or broker-dealers who have knowledge of securities law violations by their companies should contact the Attorney General's Whistleblower Hotline at 800-952-5225 (for California residents) or 916-322-3360 (for out-of-state residents). Consumers are encouraged to file complaints with the Attorney General's Office by writing to P.O. Box 94255, Sacramento, CA 94244-2550, or by using the online form available at http://www.ag.ca.gov/consumers/mailform.htm .

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