SEC charges money market fund with fraud

Operators of Reserve Primary Fund charged with misleading investors about its vulnerability in wake of Lehman Brothers collapse.

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NEW YORK (CNNMoney.com) -- The Securities and Exchange Commission has filed fraud charges against the operators of the Reserve Primary Fund for failing to provide important information to investors and trustees about the fund's exposure to Lehman Brothers.

By bringing the case, the agency is trying to get the company to release the $3.5 billion it is withholding from shareholders until all lawsuits against the company are resolved.

The money market fund "broke the buck" on Sept. 16, the day after Lehman Brothers filed for bankruptcy, meaning its net asset value fell below $1 a share. Investors seek out money market funds as conservative investments because they are designed to maintain their $1 per share value. Companies also rely on them to purchase short-term corporate debt.

The Primary Fund, however, held $785 million in Lehman-issued securities, which lost most of their worth in the bankruptcy, the SEC said. This dragged down the fund's net asset value.

The agency says that the Reserve Management Company Inc., its chairman Bruce Bent Sr., vice chairman and president Bruce Bent II and Resrv Partners Inc. misled investors and "significantly understated" the volume of redemption requests. They also failed to provide trustees with accurate information about the value of the Lehman securities.

Reserve also said it would provide the money needed to maintain the fund's share value when it "had no such intention," according to regulators.

"Fund managers have serious obligations to keep their trustees and investors informed in both good times and bad, and cannot choose to reveal only favorable facts," said James Clarkson, acting director of the SEC's New York regional office.

The company said in a statement that it intends to defend itself vigorously.

"Since we created the money fund in 1970 we have operated and grown our business by putting our shareholders' interests first," said Bruce Bent Sr. "The Lehman Brothers Bankruptcy filing created an unforeseeable and out-of-control condition for many parties and the results were serious...We remain confident that we acted in the best interest of our shareholders."

There are at least 29 different lawsuits pending against the company, according to the SEC. The agency hopes to bring all claimants together in this case and have it settled together.

The Primary Fund is currently being liquidated. Last month, the company said about $46.1 billion, or approximately 90% of fund assets as of Sept. 15, 2008, has been returned to investors. Approximately $4.5 billion remains in the fund, which once had a value of $60 billion.

The fund's independent trustees, who oversee its operations, said in a statement that they would work with the agency.

"The trustees will continue to fully cooperate with the Securities and Exchange Commission to expedite the distribution of the remaining assets to shareholders and to ensure that all decisions are made in the shareholders' best interest," the trustees said.

The meltdown

The fund's troubles added to the turmoil that roiled Wall Street that week. Not only did Lehman Brothers collapse on Sept. 15, but the federal government stepped in to save AIG (AIG, Fortune 500) with an $85 billion injection and then announced a $700 billion rescue of the American financial industry.

Executives at Reserve, which pioneered the money market fund, hid the fact that Lehman Brother's bankruptcy had pulled the Primary Fund's net asset value below $1 that day, according to the SEC. Already spooked by Wall Street's gyrations, investors rushed to pull out $24.6 billion from the fund, but Reserve only had the money to cover $10.7 billion.

It wasn't until 4 p.m. the next day that the company announced that the fund's value was 97 cents per share.

The Primary Fund's problems led to a run on money market funds in general, forcing the federal government to step in by week's end. The Treasury said it would insure up to $50 billion in money-market fund investments at financial companies that pay a fee to participate in the program. The initiative guarantees that the funds' value does not fall below the standard $1 a share. At the same time, the Fed took steps to stabilize the debt products in which money-market funds invest.

The exodus ended about two weeks later, though investors shifted to more conservative money market funds that invest in government debt, rather than the short-term corporate debt that Primary Fund had in its portfolio. Assets of government money market funds increased in 2008 by more than $700 billion or 90%, while assets of prime funds, which invest in corporate commercial paper, declined by $55 billion or 3%, according to the SEC.

Still, the crisis has led the SEC to reconsider its regulation of the industry.

"In light of the events of last fall, it is essential that the SEC comprehensively re-examine the money market fund regulatory regime, said SEC Chairman Mary Schapiro in a speech to mutual fund directors Monday. "We should do so with a view toward enabling money market funds to afford investors the relatively safe and liquid investment that they expect from an SEC-registered money market fund." To top of page

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