On Sept. 3, 2003, then New York State Attorney General Elliot Spitzer filed a complaint against New Jersey based hedge fund, Canary Capital Partners. The complaint alleged that Canary Capital entered into illegal agreements with multiple, nationally known mutual fund companies to defraud investors. Here we'll take a look at what Canary Capital did, how it affected investors and why they were caught off guard.

SEE: The Biggest Stock Scams Of All Time

The Issues
The fraud involved the following two issues:

Late trading is an illegal practice that the U.S. Securities and Exchange Commission (SEC) defines as "placing orders to buy or redeem mutual fund shares after the time a mutual fund has calculated its net asset value (NAV), usually 4pm EST, but receiving the price based on the prior NAV already determined that day." Canary Capital traders would listen to news that was released after the market closed and then use that information to make buy and sell decisions.

SEE: The SEC: A Brief History Of Regulation

For example, if IBM released an announcement at 4:05pm EST about record earnings, the traders at Canary Capital assumed that the price of IBM's stock would rise when the market opened for business the next day and close higher at the end of the trading day. Canary Capital would identify a mutual fund that had a large position in IBM and then contact the fund company to make a purchase. Canary Capital locked in guaranteed profits by trading after the market. Making numerous trades in this manner resulted in astronomical profits.

Market timing is an effort to predict the up or down direction in which the financial markets will move in order to make profitable trades. This practice is not illegal, but many mutual fund companies specifically forbid it in their prospectuses by mandating that a fund cannot be bought and sold within a certain time period, such as 30 days. Banning market timing makes it easier for mutual fund managers to manage their portfolios because the portfolios won't be subject to the rapid influx and outflow of cash necessary to facilitate short-term trades. Banning the practice also keeps the fund's trading costs down. The same fund companies that wrote prospectuses forbidding market timing permitted Canary Capital to engage in the practice. While not illegal, permitting some investors to engage in this practice while excluding others is certainly unethical.

How It Hurt Small Investors
The practices that Canary Capital and its partners in crime engaged in cost investors a lot of money. According to Stanford economist Eric Zitzewitz, late trading alone may cost shareholders as much as $400 million in a year. Because all investors in a fund share in the cost of the fund's transactions, the rapid-fire trading involved in market timing spreads costs across all the fund's investors. Canary Capital and other large institutional investors profited from these behaviors, leaving long-term mutual fund investors with the bill.

Why It Happened
Edward Julius Stern sold his HartzMountain pet supplies business for $300 million and used his money to form Canary Capital. He entered into agreements with many of the nation's top mutual fund companies and defrauded their own investors in order to profit from the large amounts of money Canary placed with them. One of the companies, Security Trust, entered into a secretive 4% profit-sharing deal with Canary in exchange for facilitating such trades. Other fund companies, such as PIMCO, agreed to permit a specified number of illegal trades in exchange for $25 million in long-term billable assets from Canary. While PIMCO shareholders paid for Canary's trades, PIMCO earned fees on the $25 million it managed on Canary's behalf in funds that did not engage in the illegal activities and it charged management fees to all of the investors in the funds that Canary was defrauding. While Canary became the focus of attention, its practices were widespread, involving many of the industry's major players. A survey conducted by the SEC revealed that half of the nation's largest fund companies admitted to engaging in market timing and a quarter admitted to engaging in late trading. Greed was a lure that few could resist.

The Bottom Line
Many fund companies were assessed fines and penalties that were returned to fund shareholders who shared in the increased costs incurred from the improper practices. Canary Capital paid $40 million to settle Spitzer's charges. The firm was permitted to state that it made "no admission of wrongdoing." Despite this claim, the scandal tarnished the image of the mutual fund business; what many perceived as a sector of the financial services industry that provided opportunities for the "little guy" turned out to be just as susceptible to corruption.

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