D&O/E&O – Is There Any Good News?
Mutual Funds Under Scrutiny: Market Timing/Late Trading
Michael P. Morabito
XL Professional - Hartford
2004 Casualty Loss Reserve Seminar
Las Vegas, Nevada – September 13, 2004
1
What is Market Timing?

Exploitation of mutual fund pricing
mechanism

Calculating “NAV” – 4:00 p.m. EST

“Stale Prices” and Time Zone Arbitrage

Not illegal per se; but could violate terms in
prospectus
2
What is Late Trading?

Forward Pricing Rule – Rule 22c-1 of
Investment Company Act of 1940

When a trader is permitted to place an order
after 4:00 p.m. EST and have that order filled
at that day’s NAV, that trader has engaged in
late trading

Unlike market timing, late trading is illegal
3
SEC Survey of Mutual Fund
Late Trading/Market Timing¹

More than 25% of broker-dealers surveyed allowed customers to
confirm or place orders after 4:00 p.m. EST

Almost 70% of broker-dealers reported being aware of timing
activities by their customers

Documents provided by almost 30% of responding brokerdealers indicate that they assisted market timers in some way

50% of responding mutual fund groups appear to have had
arrangements that allowed select customers to market time
¹Cutler, Stephen (November 3, 2003). Testimony Concerning Recent Commission
Activity To Combat Misconduct Relating to Mutual Funds. (Reporting on results of
preliminary SEC survey of 34 broker-dealers and 88 mutual fund complexes)
4
Current Prosecutorial Landscape

Roughly 300 class action and derivative
lawsuits filed against 18 mutual fund
companies

SEC investigations and inquiries are ongoing

State agency and regulatory bodies
conducting investigations
5
Financial Impact to Investors

“Dilution” of returns to long-term investors
(See Exhibit A)
– According to one study², long-term shareholders lose
approximately $5 billion per year as a result of market
timers

Added transactions costs passed on to funds

Drag on fund performance caused by larger
cash positions
²Zitzewitz, Eric (2002). Who Cares About Shareholders? Arbitrage-Proofing Mutual
Funds, (Research Paper No. 1749).
6
Settlements with Regulators

So far, nine mutual fund companies have
agreed to pay $2.5 billion dollars to settle
with regulators

Penalties; Disgorgement/Restitution; Fee
Reductions

Non-Reimbursement provisions of
agreements
7
Settlements with Regulators
Examples

Alliance Capital Management
$100M Penalty
$150M Restitution/Disgorgement
$350M Future Fee Reductions

Massachusetts Financial Services
$50M Penalty
$175M Restitution/Disgorgement
$125M Future Fee Reductions
8
Coverage Issues for
D&O/E&O Insurers

Certain investigations/SEC inquiries may not
constitute “Claims”

Disgorgement/Restitution

“Loss” excludes civil fines/penalties

Intentional wrongful conduct/fraud exclusion

Unfair profit or advantage exclusion

Insurance application exclusion

Rescission as a last resort
9
Direction of Civil Litigation

Damages issue at the forefront

How will plaintiffs justify additional damages
on top of what is being paid to regulators?
10
Is there any good news?
…maybe
Highly litigious climate of investment
banking industry is not likely to subside
any time soon:
– IPO Laddering litigation continues
– “Soft Dollar”/12b-1 Fee litigation and
investigations
– Market Timing/Late Trading litigation only in its
infancy
11
Is there any good news?
Well…maybe
While the market timing/late trading
matters are still the preliminary stages,
initial indications suggest these matters
may not be another E&O insurance
catastrophe.
12
Is there any good news?
…maybe
SEC Proposed Reforms governing mutual
fund management may provide additional
protection to investors going forward:
– 4:00 p.m. EST “Hard Close”
– Mandatory 2% Early Redemption Fee
– Disclosure of market timing policies, potential
harm of frequent trading to investors in marketing
materials
– Establishment of “fair value pricing” policies
– Greater degree of mutual fund board
independence: 75% v. majority
13
What can you do?

Talk to your underwriters
–
–
–
–

Policies Primary or Excess
What are attachment points
Applicable Retentions
Other insurance
Talk to your claims department
– Regulatory developments
– Status of civil litigation
– Nature of settlements

Independently monitor developments
14
Exhibit A
Example of Market Timing
Below is an example of the dilution effect of market timing from Yale professor of finance K.
Geert Rouwenhorst, as set forth in Jeanne Sahadi’s September 4, 2003 article from
CNN/Money entitled “How Scandal May Bilk Mom & Pop”:
Say a mutual fund investing in European stocks has four long-term shareholders who
each own one share. The fund’s net asset value per share (set once a day at the close
of trade in New York) is $10 on Monday. So the total value of the fund is $40 ($10 per
share x 4 shareholders).
At 2 p.m. EST Monday, good news about various holdings in the fund comes out, news
that is likely to push share prices higher by 25 percent when trading resumes in Europe
Tuesday. But your fund’s NAV Monday doesn’t yet reflect this good news because it’s
based on share prices at the close of European trade, which occurs several hours
before Wall Street shuts down.
The fund’s shareholders might expect their NAV to rise 25 percent on Tuesday to $12.50
a share. Then the fund’s total value would be $50 ($12.50 per share x 4 shareholders).
But they’ll get less if a market timer or late trader steps in.
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Exhibit A (Cont.)
Example of Market Timing
Here’s how: Say the trader senses prices will go up and decides to buy a share of the
fund at Monday’s NAV of $10.
Tuesday rolls around, and sure enough European prices rise and so does the fund’s
NAV. With the trader’s late-day investment Monday plus the boost in share price, the
fund’s total value comes to $60 ($50 after 25 percent rise in share price + $10 cash
investment from the trader).
With the trader, there are now five shareholders in the fund, so each fund share is now
worth $12 ($60/5), instead of the $12.50 the four original shareholders were expecting.
The trader will sell his share on Tuesday for $12, booking a $2 profit. That’s the
equivalent of 50 cents a shareholder – which is the same amount forfeited by each of
the original shareholders because of the trader’s actions.
In other words, instead of getting the 25 percent increase in NAV they were expecting,
the shareholders only see a 20 percent increase.
16