The Watchdog, the Whistle-blower, & the Making of a $7Trillion Scandal

Late last summer, Matt Nestor, the director of the Massachusetts Securities Division, got an unexpected phone call from Michael Collora, a respected Boston defense attorney. Collora told him he was representing a former employee of Putnam Investments who had information about the firm that he wanted to share with the agency. A lieutenant to Secretary of the Commonwealth William Galvin, who has taken an increasingly tough line in policing the state's massive financial services industry, Nestor eagerly agreed to a meeting. “I know Collora-he wouldn't contact me with something that is just ludicrous on its face,” says Nestor, who has a bulldog build, dimpled chin, brown hair, and a hard-nosed style honed during his years as a Suffolk County prosecutor. That notion, though accurate, wouldn't make what he was about to hear any less shocking.

Nestor sat down with the whistleblower in Collora's office near South Station on Thursday morning, September 11. The man's name was Peter Scannell, and before joining Putnam he had waited tables in the North End.

The temptations of the restaurant business had threatened his recovery from alcoholism, so he'd gotten a job processing orders for mutual fund shares in a facility Putnam operates in a nondescript Norwood office park.

Soon after settling into his cubicle, Scannell told Nestor, he'd become troubled by the orders from union members-including those of the Boilermakers Local No. 5 in Floral Park, New York-that flooded the call center in the late afternoons. The trades seemed to reflect a practice known as market timing: When U.S. stocks surged, the boilermakers bought into funds composed of foreign companies-which had finished trading-before prices for those funds were set at 4 p.m. They were betting that the international markets would follow Wall Street's trajectory the next day, scoring them a quick profit.

Although market timing is legal, it can erode the gains of long-term investors. Putnam, like most mutual fund firms, has internal policies meant to prevent it. Yet Scannell told Nestor that his bosses had dismissed the concerns he raised about the practice. On January 30, 2002, he informed a supervisor he would no longer accept orders from market timers. Two days later, he attended his Sunday night Alcoholics Anonymous meeting at a church in Quincy. He arrived early and waited in his Volvo, sleet from a winter storm pinging off the hood. Suddenly, according to a report Scannell filed with police, a large, bearded man in a Yankees cap and “Boilermakers Local 5” sweatshirt emerged from the darkness, dragged him out of the car, and beat him over the head with a brick.

Undeterred, Scannell marched into the Boston office of the Securities and Exchange Commission last April. Five months went by. The agency didn't act on his tip. So here he was, turning his allegations over to Nestor. And, yes, he said: He had documents that backed up his claims.

Nestor exudes restless energy, and has a habit of drumming his fingers during conversation. He listens with equal intensity. While Scannell talked-and talked-Nestor paid attention both to what he said and how he said it. “He wasn't nervous. He wasn't agitated,” says Nestor. “I knew he was right.”

By the time the interview was over, nearly four hours had passed. Nestor thanked Scannell and headed back to his office in the McCormack Building on Beacon Hill. His investigators had already spent the previous six months checking into allegedly deceptive mutual fund sales pitches at Morgan Stanley. They'd just opened a file on improper fund trading at Prudential Securities. Now they were about to add a case against Putnam, the country's fifth-largest mutual fund firm and, after Fidelity, the second biggest in Boston. It was already starting to sink in with Nestor: This would be a blockbuster. On the walk back, he turned to his chief of enforcement, Bryan Lantagne, who'd sat in on the meeting with Scannell.

“Holy shit,” he said. When he got back to his desk, he called his boss, Bill Galvin. Before the day was out, one of the biggest legal cases in the history of the $7 trillion mutual fund industry was under way.

You can be forgiven-even if you are one of the 95 million people who invest in mutual funds-for having paid little attention to the industry until the ongoing rash of misdeeds hit the papers. Mutual funds, after all, are designed to be boring, and for most of their 80-year history they've served that purpose with aplomb. The first mutual fund, Massachusetts Investors Trust (now MFS Investment Management), was established in Boston on March 21, 1924, by three brokers looking to minimize risk, maximize returns, and diversify their holdings at a time when a single share of General Electric cost more than $230. The concept gained popularity after early funds weathered the Great Depression better than individual stocks, rode the post-World War II boom into the mainstream, and through it all remained an enterprise as punctilious as its hometown.

The seeds of the scandal that has rippled through the industry and now reached MFS itself (which also allegedly practiced market timing) were not sown until the boom years of the 1990s. While retail banks slashed savings account rates, skyrocketing tech stocks lured new investors to Wall Street, prompting families who wanted both a piece of the rally and an incubator for their nest eggs to stash their money in mutual funds. Over the past decade, the industry has nearly quadrupled in size; today, roughly 8,300 funds manage $7 trillion for investors. And along the way, the business has become less George Bailey, more Gordon Gekko. “What happened is that a small, somewhat staid industry grew into a very large industry, and the aggressive trading common on Wall Street started to be applied in mutual fund firms,” says John Sten, a Greenberg, Traurig attorney who heads the local chapter of the SEC Historical Society. “As more and more people became more and more sophisticated, they were going to take advantage of the loopholes.”

While mutual funds were changing, so too was their watchdog in Boston, which, with $900 billion in assets under management, remains the industry's hub. By a quirk of the Massachusetts constitution, responsibility for enforcing the state's securities laws falls not to the attorney general, as is typically the case, but to the secretary of the Commonwealth, a position otherwise charged with such duties as certifying voting returns and giving tours of the State House. Galvin, however, has devoted the backroom savvy, penchant for publicity, and taste for ruthlessness that marked his 16 years in the legislature-where he earned the nickname “Prince of Darkness”-to transforming the post into a platform for raising broad policy issues and, while he's at it, his own profile.

Since winning the office in 1994, Galvin has made bold and occasionally creative use of its powers. While filling in for a vacationing Paul Cellucci five years ago, the conservative Democrat used his time as acting governor to file an emergency bill meant to coerce HMOs into providing prescription drug coverage to older patients. He has gone after predatory mortgage companies and what he described as “unconscionably excessive” milk prices, and when Mitt Romney released only an online version of his 2004 budget proposal as a cost-saving measure, Galvin created an innovative new revenue source-he printed paper copies, bound them, and sold them at the State House bookstore (another operation under his purview) for $15. Throughout his two terms, Galvin has instilled the same proactive approach in his Securities Division. The revamped agency led the national crackdown on day-trading shops that lured clients with misleading promises of huge incomes, landing Galvin an appearance on 60 Minutes. It later played a vital role in New York Attorney General Eliot Spitzer's probe of Wall Street analysts by building the fraud charges against Credit Suisse First Boston (CSFB).

When the Securities Division got a tip from a Morgan Stanley employee last March-the company was allegedly using a high-pressure sales contest to push in-house mutual funds on unsuspecting customers-Galvin was handed an opportunity for which he was ideally suited. “For many people, if not most, mutual funds are the bank of necessity. That being the case, our office has a greater responsibility,” he says. But it wasn't until Putnam stumbled into his sights that Galvin got the information he needed to turn what could have been a series of dreary regulatory inquiries into a stirring populist crusade.

After Nestor told Galvin what he'd learned about Putnam, he and his deputies raced to draft a subpoena demanding records from the firm. A clerk hand-delivered it to the company's sleek Post Office Square high-rise that same afternoon.

The Securities Division operates on a budget of $2 million and with a staff of just 29. During the CSFB case, Nestor had to hire a team of law students to sift through the 500,000 company e-mails the agency collected in search of proof that the firm's stock analysts maintained “buy” ratings on certain companies-specifically, companies doing business with CSFB's investment banking arm-even though they knew those shares were tanking. Because Scannell told Nestor exactly where to look, the Putnam documents required far less spadework. Nestor nonetheless instructed his staff to maintain a tight line of inquiry. “If you investigate everything, you wind up litigating nothing,” he says. “We regularly meet and ask 'Where are you going with this?' The person handling the case can't make that decision. They're too invested.”

What Nestor's investigators needed was confirmation that the boilermakers had indeed been market timing in violation of Putnam's prospectus. They determined that in the last three years, at least 28 of the union's members made between 150 and 500 trades, scoring gains of up to $1 million each. The investigators also zeroed in on two e-mails from the firm's internal monitors: It appeared they'd been aware of the troublesome activity since the spring of 2000. Putnam had failed to stop transactions its own prospectus purported to ban.

During his time as a state representative, Galvin had an office on the same floor as the State House bureau of the Boston Globe. Political insiders still marvel at how adroitly he works the press. On October 21 of last year, the Globe, citing “two people involved in the investigation,” reported that the Securities Division was close to filing a complaint against Putnam. The company, responding to the leak, insisted market timing within its funds was “minimal.” Galvin pounced. “We are very troubled by what we see, and their attitude is not helpful,” he told the Globe the next day. “They're still trying to mitigate instead of acknowledge what they've done.”

As Galvin smacked Putnam in the papers, his deputies were preparing the final element of their case. They knew the market timing was concentrated in Putnam's foreign equities funds. Now they wanted the trading records of the executives who oversaw those units.

Putnam shuns the celebrity-stock-picker system that made Peter Lynch a household name during his tenure at Fidelity; during the mid 1990s, this top-down approach enabled the firm to outperform its crosstown rival. But any portfolio manager who posts a 93 percent gain, as Putnam international investment chiefs Omid Kamshad and Justin Scott did with International Voyager in 1999 (a year in which they more than doubled the value of another fund), is going to attain star status. At the height of the dotcom rally, Kamshad and Scott each earned more than $10 million a year. After Putnam, weighed down by an overreliance on those now- plummeting tech stocks, started to sputter in 2000, their group emerged as one of the firm's few bright spots.

As it happened, between 1998 and 2000, Kamshad and Scott were also allegedly using their personal accounts to make short-term trades in the funds under their care. (Lawyers for both men declined to comment for this story.) One of Kamshad's trades netted a profit of $79,000, according to Putnam trading records-for him, about a month's pay. “One of the great ironies of this,” says Joseph Franco, a professor at Suffolk University Law School, “is that they put their reputations at risk for what was really just chump change.”

Putnam warned the managers in 2000 to stop their inappropriate trading, but it allegedly neither disciplined them nor ordered them to return the profits. Now the firm had received a new subpoena from Nestor pertaining to those very records. Rather than wait for the Securities Division to discover its indiscretions, Putnam forced Kamshad and Scott, along with four other employees accused of similar transgressions, to leave the firm, then launched what would prove an ineffective attempt at damage control.

On Thursday, October 23, before it had answered Galvin's subpoenas, Putnam voluntarily went to the Globe with its side of the story. The disclosure succeeded only in provoking Galvin to faster action. “The trigger for me was that they'd left these people in charge of pilfering their own fund,” says Galvin. “Once those facts were confirmed to our satisfaction, I called Stephen Cutler, director of enforcement at the SEC,” which had by then launched its own probe of the company. “I told him, 'We're going to file. If you'd like to join us, you could do so now.'” They agreed to separately charge Putnam the following Tuesday.

On the evening of Sunday, November 2-three days after the Massachusetts pension board pulled $1.8 billion out of Putnam, sparking an exodus by other states-several of the firm's senior officers huddled at the Four Seasons with board members of its parent company, Marsh & McLennan. They decided to ask Putnam's autocratic CEO, Lawrence Lasser, to step down. Next to fall was Juan Marcelino, head of the SEC's Boston bureau. The aftershocks had only just begun.

For months, the Securities Divi-sion had been putting in late nights and working weekends; one investigator's desk was so blanketed with papers, it resembled a snow fort. The grueling pace continued. In its investigation of Prudential's Boston office, which resulted in charges filed last month, the state had uncovered an apparent market-timing scheme carried out by the brokerage, two hedge funds, and wholesalers from several mutual funds. As in the Putnam case, Nestor tapped his best writer, Gina Gombar, to coauthor the complaint; the final document reads like an indictment of the mutual fund industry itself. Although the division had already taken legal action against Morgan Stanley for its mutual fund sales contest, it also sought individual sanctions against the manager of the firm's defunct Back Bay office, who in his zeal to win ran his operation like a cross between boot camp and a frat house. Between strategy sessions with Nestor, Galvin jetted to congressional hearings in Washington, where he joined Spitzer-who was in the midst of his own splashy mutual fund cases-in demanding sweeping reforms.

Meanwhile, Putnam and the SEC were working to hammer out a deal. Soon after the departures of Lasser and Marce-lino, the organizations worked out a partial settlement of the fraud charges against the firm. The agreement required Putnam to reimburse investors harmed by its employees' market-timing trades, institute tough-er safeguards, and pay a civil penalty. “The way we look at it, we got everything we wanted,” says Peter Bresnan, interim head of the SEC's Boston office, who emphasizes that the agency is still investigating Putnam. “We thought it was important to move quickly because we wanted to give shareholders restitution as soon as possible-the order provides that it's going to be paid within 195 days. We preferred not to argue it out in court for a year, so the problem gets fixed now.”

Around 7:30 on the evening of November 12, the SEC called Nestor at his home in Reading and informed him it was about to announce a deal with Putnam. Did the state want in? The news blind-sided Nestor. He conferred with Galvin, who wanted to know if the settlement included language indicating that Putnam acknowledged its wrongdoing. When Galvin learned it didn't, he gave Nestor his answer: “No. A firm no.”

The type of no-admit, no-deny settlement the SEC struck with Putnam is standard operating procedure for regulators; the Securities Division had agreed to such arrangements in other cases, including the CSFB probe. But the next day, Galvin blasted the federal regulators. “The SEC seems far more concerned about making nice with the industry than they are in protecting investors,” he told Bloomberg News. “It's the same old story: There's no admission of guilt, they're going to make some changes, and back out they go.” Galvin added that Putnam wasn't off the hook and threatened additional market-timing charges against it. Another “person involved in the investigation” fingered one potential target-Putnam's general counsel, William Woolverton-by name.

“These constant leaks of people and firms who are being subpoenaed casts a cloud before there's any finding, and that's not good law enforcement,” one highly placed critic responds angrily. “I think it's outrageous.” Appropriate or not, the disclosures kept Galvin's quarry under fire. As business columnists and lawmakers bashed the SEC and Putnam, the firm struggled to plug its leaky balance sheet. Despite a personal plea from Putnam's new CEO, Ed Haldeman, the influential California Public Employees Retirement System pulled its money out of the firm. So did pension boards in New York, Pennsylvania, Rhode Island, and Iowa, and 401(k) administrators at Wal-Mart, Merck, and Revlon. When Putnam's troubles started, it was managing $277 billion. A month later, it had lost $32 billion, or a little less than the entire gross domestic product of Kuwait. The FBI and the U.S. Attorney's Office in Boston are also reportedly looking into criminal charges against the firm.

Even before Putnam settled with the SEC, Galvin indicated he had no interest in a similar resolution of the case. Now he can't afford it politically. Putnam, for its part, has a powerful incentive for fighting any outcome that blames it for defrauding investors. “The reason defendants like to avoid declaring guilt is that it gives them the ability to argue in a civil case that they've never admitted they did anything wrong. Any time a defendant admits wrongdoing, it certainly helps private plaintiffs,” says Michael Pucillo, a partner in the Boston-based law firm of Berman, DeValerio, Pease, Tabacco, Burt & Pucillo, which has filed one of at least 23 class-action suits Putnam faces. Some observers worry that if Galvin squeezes Putnam long enough-a task at which he's already proven remarkably adept-the firm's 5,000 Massachusetts employees could suffer the same fate as their counterparts at Arthur Andersen, which imploded after a few of its accountants were implicated in the financial hocus-pocus at Enron. “I certainly think Galvin has taken an appropriate position going after these funds,” a prominent Democrat observes. “But I just wonder: What is the end game? How do you declare victory? In the number of headlines? By establishing policies where investors are better protected? Or is it driving a large Massachusetts employer out of business? I'm concerned you're going to see a very large company blown out of the water, and I don't know if that's in the best interest of our citizens.”

Sitting in a conference room tucked behind the State House bookstore-a room he has had specially outfitted for news conferences-Galvin says he's sensitive to the collateral economic damage his salvos on the mutual fund industry could cause. But he insists he's just doing his job. “Am I concerned? Of course I am. But if I were in charge of regulating the healthy sale of foods in Massachusetts, and a supermarket was selling rancid products, and I knew about it, I couldn't say, 'You know what? I don't want to see those cashiers put out of work, so I'd better let the store continue doing what it's doing,'” he says. “There are people of very high integrity working in the mutual fund industry, and it is capable of fixing its problems. But this industry will only survive in the long run if it operates within the principles of trust. You can't simply walk away.”

Meanwhile, up on the 17th floor of the McCormack Building, the search for the next damning document continues. Brown cardboard boxes stuffed with mutual fund records are stacked along the hallways, under desks, atop overburdened file cabinets-anywhere the Securities Division can find space. Several contain material collected in the unit's latest inquiry, an examination of mutual fund wholesalers, which began as an offshoot of its Prudential case. The wholesalers flog the funds to brokerages and other major buyers, and Nestor and Galvin think some may have tipped off those customers about the best ways to avoid their firms' market-timing detectors. If this theory proves correct, it would expose the industry to a whole new front of attack.

Nestor is still deciding whether to bring in another group of law students to dig through the material or to parcel the task out to regulators in other states, who are eager to help. He points to a box of evidence stowed in a makeshift storage area. It's still taped shut. “We haven't even cracked this one yet,” he says.