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?
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Exploitation of mutual fund pricing mechanism
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Calculating “NAV” – 4:00 p.m. EST
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“Stale Prices” and Time Zone Arbitrage
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Not illegal per se; but could violate terms in
prospectus
2
What is Late Trading?
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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

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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 broker-dealers
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

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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

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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:


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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:
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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
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What can you do?
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Talk to your underwriters
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Talk to your claims department
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Policies Primary or Excess
What are attachment points
Applicable Retentions
Other insurance
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