the mutual fund crisis – past, present and future exposures to the professional liability...
TRANSCRIPT
The Mutual Fund Crisis – Past, Present and Future
Exposures to the Professional Liability
Insurance Market
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
shareholders
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)
0 50 100 150 200 250 300 350 400 450 500 550 600
AllianceInvescoB of AFleet
JanusMFS
PutnamStrong
Bank OnePilgrim
FranklinPimcoS
Rest. & Penalty
Future fees
Regulatory Settlements (by type)
0 50 100 150 200 250 300 350 400 450 500 550 600
AllianceInvescoB of A
FleetJanusMFS
PutnamStrong
Bank OnePilgrim
FranklinPimcoS
RestitutionPenaltyFuture fees
Regulatory Settlements (penalty v. restitution)
0 50 100 150 200 250 300 350 400
Alliance
Fleet
B of A
Invesco
Janus
Strong
MFS
Putnam
Pilgrim
RestitutionPenalty
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 activity”
Subsequent calculation yielded $10 million result.
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 Parent)
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 Prospectuses 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
trades/year 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 trading 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 Claims Section 34(a)
Prohibits false prospectus statements and material omissions
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 Fraud
Aiding and Abetting Breach of Fiduciary Duty
Unjust Enrichment
Status of MDL Proceedings
February 20, 2004 - MDL Panel Transfer Order
Organization of Plaintiffs’ counsel / Lead Plaintiff issues:
Cases consolidated, by Fund Family, before 4 Judges in the District of Maryland
Consolidated Complaints filed onSeptember 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 penalties
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?