SEC May Now Face Burden of Proof

There have been many players in the 1-year-old mutual fund industry scandal, but basically just one script: Regulators investigate and bring charges, and the accused settle by agreeing to pay large fines and change their ways -- without admitting or denying guilt.

Now, two former executives of the Pimco mutual fund group have decided against following the script. They want to force the Securities and Exchange Commission to prove, in federal court, that they broke the law.

It’s a high-stakes gamble for the two men, Stephen J. Treadway and Kenneth W. Corba. By choosing to fight the government, they risk facing harsher penalties -- if found guilty -- than if they were to settle like most of their industry peers.

Going to court also would be a gamble for the SEC, which almost never is forced to take its cases that far.

In the agency’s yearlong investigation of fund industry practices, it has been able to use its discretion in bringing charges against some fund executives while leaving others unblemished. In other words, although the SEC always names a fund company when it alleges wrongdoing, it may or may not name people at a firm.

Similarly, the fines the SEC has assessed against fund companies and individuals have been all over the map. More than a few securities lawyers have wondered how regulators are arriving at the numbers.

In a trial, a judge or jury would decide whether the SEC has been accurately interpreting often gray areas of securities law in the varied civil judgments it has brought regarding allegedly improper or illegal fund practices.

The SEC also could be forced to address, at least on some level, the basic issue of fairness in its judgments.

“It’s an excellent question: How has the SEC made its charging decisions?” said Jacob Frenkel, a former SEC enforcement attorney who now is a partner at Smith Gambrell & Russell in Washington.

“There’s only one body that knows the answer to that, and that’s the SEC.”

For the highly profitable fund firms that have been implicated in the scandal, paying $20 million or $200 million may be less important than simply putting an end to bruising headlines.

For the individual executives charged, however, fairness isn’t some throwaway issue. Their careers often are ruined the instant they are named in an SEC suit. And how would they write up a resume after agreeing to a settlement and, as is often the case, a ban from the fund industry for a year or longer?

In the Pimco case, the company itself is expected this week to settle the SEC’s allegations of improper trading by paying $50 million in restitution to investors in its stock funds.

Pimco is best known for its bond mutual funds, based in Newport Beach. The bond unit wasn’t implicated in the case.

The SEC’s allegations center on decisions made at PEA Capital, which manages the Pimco stock funds, and at PA Distributors, a Pimco arm that oversaw retail mutual fund sales.

Corba, 51, was chief executive of PEA Capital in New York until he resigned in April. Treadway, 56, was chief executive of PA Distributors in Stamford, Conn., until he left in July.

The SEC’s suit, filed in May, accused the Pimco units and the two executives of defrauding their fund investors by allowing a favored client to engage in market-timing of certain stock funds from February 2002 to April 2003.

Any investor who has read a story or two since the fund scandals broke a year ago probably knows that market timing involves fast-paced trading that can siphon profits away from longer-term fund investors, in addition to raising portfolio operating costs.

Market timing isn’t illegal. But if a fund company quietly allows it for some investors, while banning others from the same practice, it can constitute fraud, according to the SEC.

In the Pimco case, the agency alleges that Corba and Treadway cut a deal with hedge fund Canary Capital Partners to trade Pimco stock funds, in exchange for other fee-generating investments by Canary in Pimco funds.

The case differs from others involving alleged market-timing deals in that the Pimco executives are accused of allowing just one investor -- Canary Capital -- to make short-term trades. Regulators have accused some fund companies of practically beating a path to the doors of dozens of wealthy clients, inviting them to become timers.

Attorneys for Corba and Treadway don’t dispute that Canary had a trading arrangement with Pimco funds. But in filings over the last few weeks in federal court in New York, the attorneys maintain that their clients broke no laws, and that therefore the SEC had no basis on which to charge them with fraud.

“Corba denies any wrongdoing whatsoever,” said his Boston-based attorney, James C. Rehnquist . (He is the son of U.S. Chief Justice William H. Rehnquist.)

“We’re going to trial,” said Treadway’s attorney, Alan Levine, in New York.

In motions the attorneys have filed to have the charges dismissed, there is considerable emphasis on what arguably are technical legal issues -- what some people might view as hair-splitting.

For example, in one court filing Levine asserts that Treadway could not have defrauded Pimco fund investors because “the [SEC] complaint contains no allegations that the funds actually suffered any harm, let alone significant harm.”

What’s more, Levine said, the Pimco funds’ policy permitted executives to use their discretion in allowing frequent trading. “Treadway appropriately exercised his discretion under the policy by terminating the [Canary] trading after he learned its true scope and determined that it could potentially harm the funds,” Levine said.

Rehnquist, in a court filing on Friday, made clear that the broader issue in the case is what he alleges is serious over-reaching by the SEC. “In an apparent fit of regulatory zeal fueled by the media blitz surrounding market timing in mutual funds, the SEC is attempting to stretch the securities laws beyond their limits,” he said.

Other attorneys have noted a significant distinction between the Pimco case and the market-timing case the SEC settled in August against San Mateo-based fund company Franklin Resources Inc.

The accusations of executive misconduct were similar in the Franklin case. But the SEC didn’t name, or charge, the executives involved -- even though, as one attorney noted, “somebody was responsible.”

Randall R. Lee, head of the SEC’s Los Angeles office, said that decisions about when to charge executives “are based solely on the evidence.” He said there were “significant differences” in the evidence involved in the Franklin and Pimco cases.

As for the prospect of Corba and Treadway forcing a trial, Lee said: “We believe the charges are fully supported by the evidence, and we are looking forward to presenting that evidence at trial.”

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Tom Petruno can be reached at [email protected].