A former executive at Canadian Imperial Bank of Commerce was arrested yesterday and slapped with criminal charges for allegedly bankrolling clients who participated in an illegal mutual fund trading scheme.
Paul Flynn, who served as a managing director in CIBC's U.S. arbitrage business before leaving the bank in December, was charged with five felonies by New York State Attorney-General Eliot Spitzer. If convicted on two counts of grand larceny, he could face up to 25 years in state prison.
Mr. Flynn arranged financing for a pair of hedge funds -- Canary Capital Partners LLC and Samaritan Asset Management -- that engaged in late-trading and "deceptive" market-timing practices, according to regulatory allegations. Mr. Spitzer's office accused Mr. Flynn of "stealing" more than $1-million (U.S.) from mutual fund investors by providing the financial backing for these trades.
The 46-year-old Canadian is also facing a related civil suit from the U.S. Securities and Exchange Commission, which has been conducting a joint investigation into the matter.
The SEC filed fraud charges against Mr. Flynn yesterday afternoon, claiming he "substantially assisted" his hedge fund clients and knew they were making improper trades.
Mr. Spitzer and the SEC are also considering filing charges against CIBC, and possibly other executives, in the coming weeks, according to people familiar with the matter. The regulators believe CIBC provided up to $1-billion in financial backing to hedge funds that made improper trades. An enforcement action would mean more bad news for CIBC, which less than two months ago agreed to pay $80-million to settle allegations by the SEC that it "aided and abetted" the accounting fraud at collapsed energy trader Enron Corp.
"Our investigation has demonstrated that it took many players in the industry to make these schemes work," Mr. Spitzer said in a statement, referring to Mr. Flynn. "This is the first case against someone who arranged financing so that late traders and timers could conduct illegal activities.
"This prosecution sends the message that those who arrange funding for illegal trading will be held accountable, as are those who make the trades."
The charges against Mr. Flynn represent a further widening of the regulatory inquiry into the $7-trillion U.S. mutual fund industry. Both Mr. Spitzer and the SEC have indicated they are expanding their focus somewhat and beginning to pursue banks or other financial institutions that may have backed fraudulent trading in mutual fund shares.
"We are committed to punishing not just those who engaged in the trading, but also those who facilitated it," Stephen Cutler, the SEC's director of enforcement, said in a statement. "Bankers, by providing financing to their hedge fund clients, now join the list of brokers, traders and mutual fund advisers who have been charged with participating in unlawful mutual fund trading."
Robert Waite, a spokesman for CIBC, said the bank is co-operating with Mr. Spitzer's office and other regulators, but declined to elaborate.
Mr. Flynn was arrested early yesterday morning near his home in Larchmont, an affluent suburb of New York. He was then taken to the Criminal Court in Manhattan, where he was formally arraigned on the charges. His lawyer, David Gendelman, declined to comment on the matter.
The Flynns live in a house neighbours describe as modest compared with so-called McMansions built in the area in recent years.
"They're nice people. I like them, trust them. I can't believe there's a problem," said Paul Turovsky, who lives across the street.
He found them "delightful" as neighbours. "I've lived across the street from them for 10 years. I knew they were Canadians. I know they have family in Canada they love to go visit."
The SEC alleges that between 2001and 2003, Mr. Flynn arranged financing for the two hedge funds through a CIBC affiliate, Canadian Imperial Holdings Inc. The financing deals, which consisted of loan agreements and structured "swap" transactions, meant that hedge funds only had to foot one-third of the cost of buying mutual fund shares -- the remainder was financed by the bank.
"[Mr.]Flynn knew or was reckless in not knowing that the hedge funds were engaging in late trading and deceptive market timing," the regulator claimed.
Massachusetts Financial Services Co. operated one of the mutual funds that was undermined by the illegal trading, according to the regulators. MFS, a unit of Sun Life Financial Inc., is expected to reach its own settlement with U.S. regulators this week over allegations it allowed market timing in some of its larger funds, contrary to policies laid out in the fund prospectuses. Sun Life has already taken a $211-million (Canadian) charge to cover the costs of a potential agreement.
The SEC and Mr. Spitzer claim that Mr. Flynn knew the hedge funds were placing their improper trades through Security Trust Co., an electronic trade processor that has already run afoul of the two regulators. In 2001, he allegedly circulated a memo within CIBC explaining that Security Trust used several tactics that could help hedge funds and other institutional investors disguise market timing and late trading.
"The company allows our clients to submit trades in a number of methods to reduce the chance that they would appear to be timing a specific mutual fund," he stated in an excerpt from the memo released by the regulators.
He goes on to detail a handful of these strategies, including the use of different tax identification numbers, which could be used to conceal the improper trading from the mutual funds.
Between May and September of last year, approximately 99 per cent of Canary's trades through Security Trust were made after the 4 p.m. deadline, and 82 per cent were sent in between 6 p.m. and 9 p.m.
Market timing, as opposed to late trading, is not illegal, but is often prohibited by major mutual fund companies. Market timers make frequent short-term trades in a mutual fund, hoping to cash in on minor discrepancies between the posted price of a mutual fund and the actual assets owned by the fund. The "in and out" trading can raise administrative costs and hurt returns to investors, regulators claim.
The SEC and Mr. Spitzer filed suits against Security Trust and three of its former executives in November, accusing them of participating in fraudulent late-trading and market-timing "schemes" orchestrated by a number of hedge funds.
Mr. Flynn, who is said to have begun his career with CIBC in 1991at the bank's Toronto office, is one of a handful of traders that has left the bank's U.S. operations in the past two months. All of them had ties to CIBC's hedge fund financing business, which has been scaled down in light of the recent controversy. CIBC said it no longer backs hedge fund companies that employ market-timing tactics.
A spokesman for the SEC declined to comment, but acknowledged they are also continuing their probe.
The news did not seem to bother investors. CIBC's shares slipped only modestly on the Toronto Stock Exchange yesterday, dropping 13 cents to $67.23.
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