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  1. 1. D&O/E&O – Is There Any Good News? Michael P. Morabito XL Professional - Hartford 2004 Casualty Loss Reserve Seminar Las Vegas, Nevada – September 13, 2004 Mutual Funds Under Scrutiny: Market Timing/Late Trading
  2. 2. What is Market Timing? <ul><li>Exploitation of mutual fund pricing mechanism </li></ul><ul><li>Calculating “NAV” – 4:00 p.m. EST </li></ul><ul><li>“ Stale Prices” and Time Zone Arbitrage </li></ul><ul><li>Not illegal per se; but could violate terms in prospectus </li></ul>
  3. 3. What is Late Trading? <ul><li>Forward Pricing Rule – Rule 22c-1 of Investment Company Act of 1940 </li></ul><ul><li>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 </li></ul><ul><li>Unlike market timing, late trading is illegal </li></ul>
  4. 4. SEC Survey of Mutual Fund Late Trading/Market Timing ¹ <ul><li>More than 25% of broker-dealers surveyed allowed customers to confirm or place orders after 4:00 p.m. EST </li></ul><ul><li>Almost 70% of broker-dealers reported being aware of timing activities by their customers </li></ul><ul><li>Documents provided by almost 30% of responding broker-dealers indicate that they assisted market timers in some way </li></ul><ul><li>50% of responding mutual fund groups appear to have had arrangements that allowed select customers to market time </li></ul>¹ Cutler, 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)
  5. 5. Current Prosecutorial Landscape <ul><li>Roughly 300 class action and derivative lawsuits filed against 18 mutual fund companies </li></ul><ul><li>SEC investigations and inquiries are ongoing </li></ul><ul><li>State agency and regulatory bodies conducting investigations </li></ul>
  6. 6. Financial Impact to Investors <ul><li>“ Dilution” of returns to long-term investors </li></ul><ul><li> ( See Exhibit A) </li></ul><ul><ul><ul><ul><li>According to one study ² , long-term shareholders lose approximately $5 billion per year as a result of market timers </li></ul></ul></ul></ul><ul><li>Added transactions costs passed on to funds </li></ul><ul><li>Drag on fund performance caused by larger cash positions </li></ul>² Zitzewitz, Eric (2002). Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds , (Research Paper No. 1749).
  7. 7. Settlements with Regulators <ul><li>So far, nine mutual fund companies have agreed to pay $2.5 billion dollars to settle with regulators </li></ul><ul><li>Penalties; Disgorgement/Restitution; Fee Reductions </li></ul><ul><li>Non-Reimbursement provisions of agreements </li></ul>
  8. 8. Settlements with Regulators Examples <ul><li>Alliance Capital Management </li></ul><ul><li>$100M Penalty </li></ul><ul><li>$150M Restitution/Disgorgement </li></ul><ul><li>$350M Future Fee Reductions </li></ul><ul><li>Massachusetts Financial Services </li></ul><ul><li>$50M Penalty </li></ul><ul><li>$175M Restitution/Disgorgement </li></ul><ul><li>$125M Future Fee Reductions </li></ul>
  9. 9. Coverage Issues for D&O/E&O Insurers <ul><li>Certain investigations/SEC inquiries may not constitute “Claims” </li></ul><ul><li>Disgorgement/Restitution </li></ul><ul><li>“ Loss” excludes civil fines/penalties </li></ul><ul><li>Intentional wrongful conduct/fraud exclusion </li></ul><ul><li>Unfair profit or advantage exclusion </li></ul><ul><li>Insurance application exclusion </li></ul><ul><li>Rescission as a last resort </li></ul>
  10. 10. Direction of Civil Litigation <ul><li>Damages issue at the forefront </li></ul><ul><li>How will plaintiffs justify additional damages on top of what is being paid to regulators? </li></ul>
  11. 11. Is there any good news? …maybe <ul><li>Highly litigious climate of investment banking industry is not likely to subside any time soon: </li></ul><ul><ul><ul><ul><li>IPO Laddering litigation continues </li></ul></ul></ul></ul><ul><ul><ul><ul><li>“Soft Dollar”/12b-1 Fee litigation and </li></ul></ul></ul></ul><ul><ul><ul><ul><li>investigations </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Market Timing/Late Trading litigation only in its infancy </li></ul></ul></ul></ul>
  12. 12. Is there any good news? Well…maybe <ul><li>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. </li></ul>
  13. 13. Is there any good news? …maybe <ul><li>SEC Proposed Reforms governing mutual fund management may provide additional protection to investors going forward: </li></ul><ul><ul><ul><ul><li>4:00 p.m. EST “Hard Close” </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Mandatory 2% Early Redemption Fee </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Disclosure of market timing policies, potential harm of frequent trading to investors in marketing materials </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Establishment of “fair value pricing” policies </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Greater degree of mutual fund board independence: 75% v. majority </li></ul></ul></ul></ul>
  14. 14. What can you do? <ul><li>Talk to your underwriters </li></ul><ul><ul><ul><ul><li>Policies Primary or Excess </li></ul></ul></ul></ul><ul><ul><ul><ul><li>What are attachment points </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Applicable Retentions </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Other insurance </li></ul></ul></ul></ul><ul><li>Talk to your claims department </li></ul><ul><ul><ul><ul><li>Regulatory developments </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Status of civil litigation </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Nature of settlements </li></ul></ul></ul></ul><ul><li>Independently monitor developments </li></ul>
  15. 15. 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.
  16. 16. 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.