Mutual Funds Claims Update by shimeiyan1


									  The Mutual Fund Crisis – Past,
Present and Future Exposures to the
  Professional Liability Insurance
Market Timing and Late Trading
What Generally Occurred
    Regulatory investigations revealed there was a cottage
    industry catering to:

   Market Timing
       The practice of short term buying and selling of mutual
        fund shares in order to exploit inefficiencies in mutual
        fund pricing
   Late Trading
       Shares in mutual funds are purchased after hours at the
        share price at the close of the stock market with
        knowledge of post-closing events which may impact the
        share price at the next day's opening of the market
   Result
       Increase trading costs, lower returns, and an adverse
        impact for long-term investors
Consequences of Mutual Funds allowing
Market Timing and Late Trading
 Regulatory Actions and Settlements
 Reforms and changes to fees and other
  industry practices
 Displacement of business and executives
 Private Class Actions by fund-holders
 Private Class Actions by parent company
Regulatory Settlements
   To date, regulatory settlements have
    grown to a total of $2.918 billion,
    consisting of:
       $925 million in future fee concessions
       $1.993 billion in restitution and penalty
        assessments earmarked for payment to mutual
        fund-holders who incurred loss through late
        trading or market timing
Regulatory Settlements (millions)
  Bank One
    Putnam                                            Rest. & Penalty
       MFS                                            Future fees
     B of A

               0   50   100 150 200 250 300 350 400 450 500 550 600
Regulatory Settlements (by type)
 Bank One
                                                        Future fees
    B of A

              0   50 100 150 200 250 300 350 400 450 500 550 600
Regulatory Settlements (penalty v. restitution)
      Janus                                           Penalty
     B of A

               0   50   100   150   200   250   300   350     400
    Penalty relative to restitution, where available. (Bad
     actor indicator?)
    Penalties, in addition to restitution funds, are
     earmarked under Sarbox 308/SEC Rule 1100 to be paid
     to “investors who were harmed by the violation.”
SEC Alliance Order of 12/18/03
“Disgorgement” required
   Provides that in the event investor losses
    exceed funds paid, Alliance agreed to top
    off to allow for “full satisfaction.”

   “In the event that full satisfaction of item
    (i) would require a payment of more than
    $200 million, Alliance Capital agrees that
    it will increase the disgorgement portion of
    its payment obligation by [that] amount.”
SEC Putnam Order 11/13/03
“Restitution” required
   Putnam order required that “Independent
    Assessment Consultant shall calculate the
    monetary amount necessary to fairly
    compensate Putnam funds’ shareholders
    for losses attributable to excessive short-
    term trading and market timing trading

   Subsequent calculation yielded $10 million
SEC MFS Order 2/5/04 –
“Disgorgement” required
   Independent Distribution Consultant was to
    develop a plan “to compensate fairly and
    proportionately the funds shareholders for losses
    attributable to late trading and market timing
    trading activity ...”

   Order also provides that the Plan “shall provide
    for fund investors to receive, in order of priority,
    (i) their aliquot share of losses suffered by the
    fund due to late trading and market timing
    activity, and (ii) a proportionate share of advisory
    fees paid by such fund during the period of such
    late trading.”
Penalty Offset Provision
   E.g., Invesco - “To preserve the deterrent effect
    of the civil penalties, Respondents . . . agree that
    they shall not, after offset or reduction in any
    Related Investor Action based on Respondent’s
    payment of disgorgement in this action, further
    benefit by offset or reduction of any part of
    Respondents payment of civil penalties in this
    action (“Penalty Offset”). If the court in any
    Related Civil Action grants such Penalty Offset,
    Respondents agree that they shall . . . pay the
    amount of the Penalty Offset to the US Treasury.
    Such a payment shall not be deemed an
    additional civil penalty . . . ”
Industry Developments
   Fees

          1800 funds have lowered fees over the last year (aside
           from the regulatory settlements)

   Reforms and changes to industry practices

          Compliance Officer – funds must have compliance chiefs
           who report to the board
          Board composition – chairman and at least 75% of the
           board must be independent
          Directed brokerage – steering fund’s trading business to
           brokers who promote the funds is prohibited
          Additional disclosure requirements
Industry Developments
   Displacement of well-known executives

           Lawrence Lasser (Putnam)
           Harold Baxter, Gary Pilgrim (Pilgrim Baxter)
           Richard Strong (Strong Financial)

   Winning v. Losing Fund families

           Janus – net withdrawals of $10 billion through July 2004
           MFS - net withdrawals of $4.2 billion through July 2004
           Fidelity Investments – net increase of $14.1 billion (v. $7.4)
           Vanguard – net increase of $29.2 billion (v. $13)
Private Class Actions – Putative Classes

    Class (Direct) Plaintiffs
        Mutual Fund Purchasers
        Mutual Fund Shareholders
    Derivative Plaintiffs
        Mutual Fund Shareholders
        Parent of Fund Family Shareholders
Universe of Parties
    Plaintiffs
        Putative Classes
    Defendants
        Fund Family Entities (includes Trustees and
        Market Timers/Late Traders
        Brokers/other facilitators
        Trusts/other Clearing Platforms
        Third Party Financiers of Timing/Late
         Trading activity
Claims Asserted
   Basic facts -- Funds increased assets under
    management by:
      Entering into undisclosed agreements with select
       customers and/or brokers (or other intermediaries)
       to permit Market Timing and/or Late Trading
       Otherwise permitting Market Timing and/or Late
        Trading activity in the Funds
   Alleged Benefits to Fund Family Defendants
      Increased asset base increases revenues by upping
        management/advisory fees
       “Sticky assets” - generate fees, increase asset base
        and must remain static – a quid pro quo for allowing
        Timing and/or Late Trading
Claims Asserted (cont’d)
    Misrepresentations/Omissions in
        Funds’ prospectuses contain disclosure of
         fund policy to prohibit/discourage
         excessive/abusive trading
             may/will reject if exceed X trades/year
             may/will impose redemption fees if exceed X
        Funds were portrayed as long-term (e.g.
         retirement) investments
        Market Timing/Late Trading was activity not
         disclosed to ordinary investors
Alleged Harm to Plaintiffs
  Dilution of profits to long term holders
   because Timers entered Funds when
   they predicted a profitable event
  Losses disproportionately fall on long-
   term holders because Timers got out of
   the market before a predicted loss
   would hit the Funds
  Forced sale of Fund assets at
   inopportune times due to Timer activity
        Often en masse redemptions due to
         similarity of Timers’ models
Alleged Harm to Plaintiffs (cont’d)
    Increased costs created by Timer
        Possible taxable capital gains
        Increased transaction costs
  Disparate treatment (e.g., waiver of
   redemption fees/frequency of exchanges
   and redemptions)
  Questions about harm to Fund holders,
   especially if timers lost money
Securities (1933) Act Claims
  Section 11
  Section 12(a)(2)
        Recessionary remedy
    Section 15
        Control person liability against fund
         advisors, trustees, parents and individuals
Exchange (1934) Act Claims

    Section 10(b)
        Rule 10b-5(a) & (c)
             Deceptive course of conduct/fraudulent scheme
        Rule 10b-5(b)
             Untrue statement of fact/material omission
    Section 20(a)
        Control person liability against fund
         advisors, trustees, parents and individuals
Investment Company Act of 1940
   Section 34(a)
       Prohibits false prospectus statements and material
       No express private right of action
   Section 36(a)
       Action against directors, officers and advisors for
        breach of fiduciary duty
       No express private right of action
   Section 36(b)
       Also a breach of duty claim
       Express private right of action
   Section 48
       Allows for Control Person liability
State Law/Other Claims
 Breach of Fiduciary Duty/Constructive
 Aiding and Abetting Breach of Fiduciary
 Unjust Enrichment
Status of MDL Proceedings

   February 20, 2004 - MDL Panel Transfer
   Organization of Plaintiffs’ counsel / Lead
    Plaintiff issues:
   Cases consolidated, by Fund Family,
    before 4 Judges in the District of
   Consolidated Complaints filed on
    September 29, 2004
Multidistrict Litigation
   Judge J. Frederick Motz, overseeing the
    consolidated actions:

       “Nobody should expect to get rich off this
       case . . . If there is any recovery, the great
       bulk of the recovery should go to those
       injured, not to their lawyers, particularly in
       light of the fact that so much of the
       underlying investigative work has already
       been done by public authorities.”
Multidistrict Litigation
   Issue to be briefed – Whether the
    regulatory settlements will be offset
    against the potential damages in the
    private class actions lawsuits?
Professional Liability Coverage
 Regulatory settlements specifically bar
  recovery of arguably both restitution and
 Definition of “Loss?”
 Defense Expenses (which have been
  reported running $2+ million per month
  on some of the noted insureds)
 Vigilant Ins. Co. v. Credit Suisse First
  Boston Corporation applicable?
 Expenses to administer?
Prohibition of insurance recovery
 Settlement template by SEC and NYAG
  stipulate that the fund families will not
  seek insurance reimbursement for the
  disgorgement component of their
  regulatory settlements (Spitzer initiative;
  followed by the SEC).
 Defense Expenses – no prohibition in the
  settlement agreements
 Vigilant Ins. Co. v. Credit Suisse First
  Boston Corporation applicable?
Next Wave of Claims?
 Conflicted promotion of proprietary funds
 Directed brokerage of trading
 Soft dollar commissions arrangements
  with brokers
 Excessive fees
 Failure to pay breakpoint discounts

To top