It’s been four decades since the go-go years of the late 1960s, when hot mutual funds captured the imagination of investors by reporting performance that was too good to be true.
It’s been so long that Bank of America seems to have forgotten what happened. In a case now pending involving hedge fund fraud, the bank has told a federal judge that it was its standard practice to allow funds to value investments in the same ways that were discredited back then.
The case involves one of the first hedge fund frauds to gain wide attention, that of the Lancer funds run by Michael Lauer until they collapsed in 2003. Those funds invested in penny stocks, including restricted shares that could not be traded. The restricted shares were valued at the same price as freely traded shares.
Eventually, the funds blew up. Mr. Lauer is under indictment, scheduled to go on trial next year. At the request of the Securities and Exchange Commission, a federal judge in Florida has ordered him to repay ill-gotten gains of $62 million, but don’t expect the check to be sent anytime soon.
Investors in the hedge funds sued everyone in sight, including Bank of America , which was the hedge fund group’s prime broker and was involved in sending out account statements that included the funds’ fraudulent asset values.
In a ruling last week, Judge Shira A. Scheindlin of United States District Court in New York refused to dismiss the case, meaning it will go to trial unless it is settled.
According to her decision, it was “standard procedure” at Bank of America Securities “to enter data about restricted stock with the same ticker in the same way as the trading stock unless otherwise instructed by the client.” By doing so, the restricted shares automatically were valued at the same price.
According to the judge, a Lancer fund bought restricted stock in one company for a bit more than four cents a share and told Bank of America to record them as being worth $1.50 each, which it did. The result was that a $1.7 million investment was shown as rising 3,384 percent, to $60 million.
All this sounds like a tale from the late 1960s, as recorded in John Brooks’s classic book, “The Go-Go Years.”
In 1968, the Mates Fund, run by Fred Mates, bought 300,000 shares of restricted stock in a small conglomerate called Omega Equities, which was then selling in the over-the-counter market for $24 a share. The Mates Fund paid only $3.25 a share — a price that turned out to be a lot more than the shares were really worth.
Mr. Mates valued the shares at $16 each, a one-third discount from the public market price. “It will be noted,” Mr. Brooks wrote, “that this was almost five times as much as he had just paid for them. With no change in the market price of Omega stock, then, and with no particular good news as to Omega’s business prospects, the Mates Fund had made what appeared on the books it displayed proudly to the investing public to be an investment yielding an instant profit of almost 500 percent.”
In 1968, that was, amazingly enough, standard procedure in the mutual fund industry. Mr. Mates’s investment became notorious because it had helped his fund become the best performing fund in 1968, up 168 percent, until the S.E.C. suspended trading in Omega because it suspected fraud. The Mates Fund had to suspend redemptions and slash the value of the shares.
The next year, the S.E.C. made clear that restricted stock could not be valued in that way.
Now, 40 years later, Bank of America seems to have argued that doing such a thing was normal operating practice. Mr. Mates had at least valued the restricted shares at prices lower than the publicly traded shares; Mr. Lauer did not even do that. Mr. Mates’s instant profit of 400 percent — Mr. Brooks got the arithmetic wrong — is positively modest when compared with the profit Mr. Lauer posted.
I say the bank seems to have made that argument because the judge says that was the bank’s argument. Normally, I would have consulted the bank filings to see if there was some nuance that distinguished what it was doing from what happened during the bad old days. But the bank filed its legal arguments under seal, so that the public is not allowed to read them.
Neither the bank’s lawyers nor its spokesman would discuss the case or what was in its legal memorandum.
Secrecy seems to be something of a legal hallmark of the Bank of America these days. In the company’s other brush with a federal judge in Manhattan, Judge Jed S. Rakoff refused to approve a settlement between the bank and the S.E.C. over a lack of disclosure in its merger proxy with Merrill Lynch last year. That proxy reported that Merrill could not pay bonuses without Bank of America’s approval, but failed to mention that such approval had been granted.
Judge Rakoff was infuriated by many aspects of the case, including the bank’s unwillingness to part with information. “It is noteworthy,” he wrote, “that, in all the papers protesting its innocence, Bank of America never actually provides the court with the particularized facts that the court requested, such as precisely how the proxy statement was prepared, exactly who made the relevant decisions.”
The judge wants the case to be tried in February, but few think that will happen. Perhaps the bank will appeal the ruling, or perhaps the S.E.C. will drop the suit and reopen the investigation.
For the S.E.C., perhaps the most significant aspect of the judge’s opinion is its frontal assault on the commission’s practice of holding companies, rather than executives, responsible for corporate violations of securities laws. In this case, the bank was to pay a $33 million penalty, but no individuals were charged.
The proposed settlement, the judge wrote, “is not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality, in that it proposes the shareholders who were the victims of the bank’s alleged misconduct now pay the penalty for that misconduct.”
In the real world, that is what often happens in any case. Companies often indemnify officers and directors, particularly when fraud is not proved. Even if the commission did win a judgment against the bank’s chief executive, Kenneth D. Lewis, or some other executive, the chances are the company — and its shareholders — would end up footing the bill.
My suspicion is that the S.E.C. fears that this case is not a strong one, and that the bank may prevail with its argument that it followed normal practice in deciding what to disclose. If I am right, it is easy to understand why the commission was happy to establish a precedent that the lack of disclosure was not permissible, even if it could not identify the people who made the decision. As for the bank, it wanted to put the whole thing behind it. Hence the settlement.
It appears such a neat resolution will not be possible.
There is another aspect to Judge Rakoff’s actions that aroused some note, at least to those with long memories. Some years ago, he presided over the WorldCom case, and forced the S.E.C. to get a larger penalty than it originally agreed to take from that company, which had been destroyed by a vast accounting fraud.
And who paid that? It was not the shareholders; they had already been wiped out. It was the creditors, the people who had lent WorldCom money. If such an outcome did not “comport with the most elementary notions of justice and morality,” it did not seem to bother the judge at the time.