P ORTER M EMORANDUM W RIGHT M ORRIS & A RTHUR LLP Attorneys and - - PDF document

PORTER WRIGHT MORRIS & ARTHUR LLP

Attorneys and Counselors at Law

MEMORANDUM

To: Clients and Friends of Porter, Wright, Morris & Arthur LLP From: Mark B. Koogler, Esq. Date: November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues This memorandum summarizes the various investigations and initiatives in the mutual fund industry arising from the recent claims of widespread late trading and market timing practices and abuses of investors in mutual funds. Market Timing and Late Trading Investigations of Mutual Funds The New York Attorney General filed a complaint on September 3, 2003 alleging a fraudulent scheme involving “late trading” and “market timing” of mutual funds by a hedge fund, Canary Capital Partners

• LLC. Since then, various mutual fund complexes have been conducting their own internal

investigations or accused by third parties of participating in or not discouraging similar improprieties. The Securities and Exchange Commission (“SEC”), the National Association of Securities Dealers (“NASD”) and the Investment Company Institute (“ICI”)1 have recommended various actions be taken by their respective constituencies to assure that mutual funds meet their fiduciary standards to their shareholders and uphold the public trust. Late Trading Late trading is a violation of the federal securities laws governing forward pricing which requires the redeemable securities of investment companies be sold and redeemed at a price based on the net asset value of the fund computed after the receipt of orders to purchase. Late trading occurs if an order placed after the time the fund’s net asset value is computed receives that prior-calculated per-share price.2

1 The ICI is the national association of the American investment company industry, with over 9,000 members which, in

aggregate, have assets of approximately $6.857 trillion (approximately 95% of the total industry assets and 90.2 million individual shareholders).

2 Investment Company Act Rule 22c-1(a) generally requires that redeemable securities of investment companies be sold and

redeemed at a price based on the net asset value (“NAV”) of the fund computed after the receipt of orders to purchase (generally known as “forward pricing”). NAVs are calculated after the market closes, generally as of 4:00 p.m. Eastern time, the normal close of regular trading on the New York Stock Exchange. Under the forward pricing requirements, any orders

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 2 As stated in the New York Attorney General’s complaint, the importance of forward pricing protection “becomes clear when, for example, there is an event after 4:00 p.m. (like an unexpectedly positive corporate earnings announcement) that makes it highly probable that the market for the stocks in a given fund will open sharply higher the next day. Forward pricing ensures fairness: those who bought the fund during the day, before the information came

• ut, will enjoy a gain. Those who buy shares in the fund after the announcement are not

supposed to share in this profit. Their purchase order should receive the NAV set at the end of the day, when the market will have digested the news and reflected its impact in (1) higher prices for the stock held by the fund and therefore (2) a higher NAV for the fund.”3 Market Timing Market timing is an investment strategy that often involves the frequent buying and selling of securities, usually stocks or stock mutual funds. The objective is to achieve a short-term profit by quickly entering and exiting the market in anticipation of prices rising or falling. Determining what constitutes market timing may be in the eye of the beholder as active management of mutual fund accounts, for example, may appear on first blush to be a market timing device. However, market timing is generally viewed not as the active management of an account per se, but instead as “an investment technique involving short- term, ‘in and out’ trading of mutual fund shares.”4 Market timing is not illegal but some funds disclose in their prospectus that they do not permit market timing or that they may take steps to discourage it. Steps taken by mutual funds to restrict market timing include (i) imposing redemption fees for short-term trading; (ii) restricting frequent trading during particular periods of time; (iii) modifying exchange privileges; and (iv) identifying market timers and restricting their trading privileges or expelling them from a fund. In his complaint against Canary Capital, the New York Attorney General noted that the named mutual fund complexes5 never disclosed in their prospectuses the arrangements by which the funds would receive more assets or “sticky assets”6 in exchange for the right to time. “On the contrary, many of the relevant mutual fund prospectuses

placed by investors after 4:00 p.m. Eastern time must be priced at the next day’s price. Late trading occurs if an investor places an order after 4:00 p.m. Eastern time, but receives the per-share price calculated as of 4:00 p.m. Eastern that day.

3 Paragraph 16 of Complaint, State of New York v. Canary Capital Partners, LLC, Canary Investment Management, LLC,

Canary Capital Partners, LTD and Edward J. Stern.

4 Paragraph 11, Complaint, State of New York v. Canary Capital Partners, LLC, Canary Investment Management, LLC,

Canary Capital Partners, LTD and Edward J. Stern.

5 See Section B.6., with respect to Nations Fund, Section F., with respect to One Group, Section G., with respect to Janus, and

G., with respect to Strong, Complaint, State of New York v. Canary Capital Partners, LLC, Canary Investment Management, LLC, Canary Capital Partners, LTD and Edward J. Stern.

6 These are typically long-term investments made not in the mutual fund in which market timing is permitted, but in one of

the fund manager’s financial vehicles (e.g., a bond fund or hedge fund run by the manager) that assures a steady flow of fees to the manager.

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 3 contained materially misleading statements assuring investors that the fund managers discouraged and worked to prevent mutual fund timing.”7 Regulatory and Industry Response to New York Attorney General Investigation On September 4, 2003, SEC Chairman William H. Donaldson sent the ICI a letter indicating that the SEC's examination and enforcement staffs were conducting an investigation into the types of abuses alleged by the New York Attorney General. The letter requested that the ICI write to its membership regarding certain responsibilities and policies related to market timing and late trading. In response to Chairman Donaldson's request, on September 5, 2003, ICI President Matthew P. Fink wrote to ICI members urging them immediately to:

• seek assurances from selling broker-dealers and other intermediaries that they are following all

relevant rules, regulations, and internal policies regarding the timely handling of mutual fund

• rders; and
• review the sufficiency of market timing and fair valuation policies and procedures for addressing

concerns in this area. In its reply to Chairman Donaldson's request, the ICI promised to "do all that we can to make it clear that such behavior is intolerable and inexcusable."8 On September 25, 2003, the Executive Committee of the Board of Governors of the ICI issued a public statement9 regarding its investigations into market timing and late trading involving mutual funds to reinforce its commitment to taking whatever steps are needed to ensure the fiduciary duties owed to mutual fund shareholders are fulfilled. In reaffirming that shareholders’ interests come first, the ICI stated that the alleged business practices are “inconsistent with this obligation, incompatible with mutual funds’ duty to treat shareholders fairly and equitably, and intolerable if mutual funds are to serve individual investors as effectively in the future as they have in the past.” In addition, the Executive Committee pledged the assistance of the ICI with the efforts of the SEC and

• ther government officials to take whatever steps are necessary to ensure, at a minimum, that the

following initial policy objectives are met:

• Every mutual fund and every intermediary should be required to take any steps needed to

provide reasonable assurance that existing legal prohibitions regarding the late trading of mutual funds shares are strictly adhered to.

7 Paragraph 34, Complaint, State of New York v. Canary Capital Partners, LLC, Canary Investment Management, LLC,

Canary Capital Partners, LTD and Edward J. Stern.

8 Letter dated September 5, 2003 from ICI President Mathew P. Fink to Chairman William H. Donaldson of the SEC. 9 Statement of the Executive Committee of the Board of Governors of the ICI on the Fiduciary Obligations of Mutual Funds

to Individual Shareholders Regarding Late Trading, Market Timing, and Related Issues.

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 4

• No mutual fund should ever permit an individual or institutional investor to engage in otherwise

proscribed trading activity in exchange for compensation or the provision of similar benefits to the fund's adviser or other fund affiliate.

• No mutual fund should ever selectively release non-public information regarding its portfolio

investments in a manner that is harmful to some or all of the fund's shareholders. In September, the NASD sent a Special Notice to Members (03-50) reminding its members that late trading violates NASD Rule 2110 and Investment Company Act Rule 22c-1(a) and that knowingly or recklessly facilitating market timing may violate NASD Rule 2110 and the federal securities laws. The Notice to Members (1) reminded members of their responsibility to ensure that they have policies and procedures reasonably designed to detect and prevent the occurrence of mutual fund transactions that would violate NASD Rule 2110 and the federal securities laws; and (2) directed each member firm executing mutual fund sales and redemptions to review its policies and procedures to assure that they are adequate with respect to late trading and market timing. In addition, members were reminded that they must have in place policies and procedures reasonably designed to detect and prevent collusion with mutual funds to facilitate market timing transactions in situations where the mutual fund and/or its affiliated persons have represented that they have taken steps to protect investors from market timers. On October 9, 2003, the Chairman of the SEC announced that the staff is preparing new rules and amendments designed to prevent late trading abuses and to curb market timing abuses.

• Proposed SEC Rules and Rule Amendments Regarding Late Trading:
• Proposed amendments will be designed to prevent the circumvention of forward pricing

requirements for purchases and redemptions of fund shares, including the possibility of requiring the fund, instead of an intermediary, to receive the order prior to the time the fund prices its shares for an investor to receive that day’s price.

• Proposed amendments may require funds to have additional procedures and controls in place to

prevent late trading and ensure compliance with the new pricing requirements.

• Proposed Rules and Form Amendments Regarding Market Timing:
• Rules may require explicit disclosure in fund offering documents of market timing policies and

procedures.

• Rules may require funds to have procedures to comply with representations regarding market

timing policies and procedures.

• Rules will emphasize the obligation of funds to fair value their securities under certain

circumstances to minimize market timing arbitrage opportunities.

• Rules will reinforce the obligation of fund directors to consider the adequacy and effectiveness
• f fund market timing practices and procedures.

A significant number of mutual fund firms have undertaken internal reviews of their practices. In some cases, funds, such as Janus and One Group, have publicly stated that they will make shareholders whole

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 5 in the event their reviews conclude that abuses took place. In other cases, the funds, such as Nations Funds and One Group, have fired executives and brokers who permitted or participated in late trading or market timing activities (the latter in violation of their restrictions or prohibitions on the same). On October 23, 2003, Smith Barney, the brokerage arm of Citigroup Corp., fired four brokers for “inappropriate behavior related to market-timing.” On November 2, 2003, Richard S. Strong, the founder of Strong Mutual Funds, resigned as chairman of the fund’s board of directors after the New York Attorney General stated that he would take criminal action against Mr. Strong and others at the Strong Mutual Funds for the improper trading of Strong shares. Despite these internal reviews by mutual fund firms, government regulators have followed in the footsteps of the New York Attorney General and initiated their own proceedings. On October 28, 2003, the SEC and the Massachusetts Securities Division commenced administrative proceedings10 against Putnam Investment Management (“Putnam”)11 for market timing violations.12 Market timing by mutual fund shareholders is against Putnam’s stated policy. Since at least January 2000, Putnam’s prospectus for the Putnam International Voyager Fund13 contained the following language: “The exchange privilege is not intended as a vehicle for short-term trading. Excessive exchange activity may interfere with portfolio management and have an adverse effect on all shareholders. In order to limit excessive exchange activity and otherwise promote the best interest of the fund, the fund imposes a redemption fee of 1.00% of the total exchange amount (calculated at market value) on exchanges of shares held less than 90

• days. The fund also reserves the right to revise or terminate the exchange privilege, limit

the amount or number or exchanges or reject any exchange. The fund into which you would like to exchange may also reject your exchange. These actions may apply to all shareholders or only to those shareholders who exchanges Putnam Management determines are likely to have a negative effect on the fund or other Putnam funds.”14 The Massachusetts administrative complaint15 noted that “in a separate section of the prospectus, management has chosen not to impose this redemption fee for ‘certain omnibus accounts, including

10 The SEC claims Putnam’s actions violate Sections 204A, 206(1) and 206(2) of the Investment Advisers Act of 1940 and

Section 17(j) of the Investment Company Act of 1940 and Rule 17j-1(c) thereunder and that it failed to supervise under Section 203 of the Advisers Act. The Massachusetts Securities Division claims Putnam’s actions violate the anti-fraud provisions of the Massachusetts Uniform Securities Act and the regulations promulgated thereunder.

11 Putnam, the fifth largest mutual fund complex in the United States, has $272 billion of assets under management, with

more than 100 mutual funds and 12 million shareholders and 401(k) participants.

12 Two senior portfolio managers were also named in the Massachusetts proceeding and were the subject of a separate SEC

civil injunctive action in federal court.

13 Now known as the Putnam International Capital Opportunities Fund. 14 See Paragraph 23, Administrative Complaint, In the Matter of Putnam Investment Management, Inc., Putnam Investment

Management, LLC, Omid Kamshad, Justin M. Scott.

15 The issues with respect to 401(k) plan market timing that were raised by the Massachusetts Securities Division in its

administrative complaint were not raised by the SEC in its administrative order.

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 6 401(k) plans,…’ (See Exhibit 1, Voyager prospectus, p. 15).”16 The Massachusetts administrative complaint charged that Putnam had an obligation to enforce its restrictions on market timing against all shareholders, including defined contribution/401(k) plan participants. The Massachusetts administrative complaint alleged that Putnam was on notice regarding market timing activity from two defined contribution/401(k) plans and had not taken steps to impose trading restrictions on the plan participants. At least 28 participants from a single plan,17 identified by Putnam in March 2000 as a market timing account, were permitted to market time Putnam international and

• ther mutual funds, anywhere from 150-500 trades over a three year period. “Each individual profited

from over $100,000 to over 1 million in the three year period. One Putnam employee stated that the trading activity of the Boilermakers was so prolific that 3 to 4 p.m. was known as ‘boilermaker hour” within Putnam’s Norwood, Massachusetts office.”18 Even though Putnam had identified specified plan participants as market timers, it failed to restrict or eliminate this activity for over three years. The Massachusetts Securities Division claimed that Putnam’s failure is an “egregious violation of its fiduciary duty to its shareholders and resulted in a fraud or deceit perpetrated on the shareholders.”19 From Putnam’s standpoint, the defined contribution/401(k) plans had substantial investments in the Putnam funds and had insisted on liberal exchange privileges for their participants. It remains to be seen how strong Putnam’s argument is that its decision to allow market timing by some of these participants was in the best interest of the funds. On November 3, 2003, Lawrence J. Lasser, the chief executive

• fficer of Putnam, resigned.

The late trading and market timing issues making their way through the mutual fund industry and regulators have now been raised at the level of Presidential politics. On October 28, 2003, Democratic candidate Joseph Lieberman issued The Lieberman Mutual Fund Reform Plan, designed to create a proactive enforcement environment within the SEC, better corporate governance among mutual fund boards of directors, and more disclosure to mutual fund shareholders. Lieberman’s plan proposes to:

• Create an Office of Investor at the SEC to protect the interests of average investors;
• Toughen enforcement to crack down on shady trading;20
• Strengthen the independence of mutual fund directors;21
• Provide greater transparency so investors are aware of the rules and fees of mutual funds; 22and

16 See Paragraph 24, Administrative Complaint, In the Matter of Putnam Investment Management, Inc., Putnam Investment

Management, LLC, Omid Kamshad, Justin M. Scott.

17 The Boilermakers Local Lodge No. 5 Taft-Hartley Plan. 18 See II. Summary, Administrative Complaint, In the Matter of Putnam Investment Management, Inc., Putnam Investment

Management, LLC, Omid Kamshad, Justin M. Scott.

19 See Paragraph 91, Administrative Complaint, In the Matter of Putnam Investment Management, Inc., Putnam Investment

Management, LLC, Omid Kamshad, Justin M. Scott.

20 Steps will include regular SEC compliance reviews and audits of mutual funds and require the appointment of compliance

• fficers who report directly to the board of directors, tightened trading deadlines, and toughened rules against market timing.

21 To better ensure serving the interests of shareholders, Lieberman proposes to raise the share of independent directors from

• ne-half to a two-thirds supermajority, require all members of a nominating committee to be independent, and limit the

number of mutual fund boards on which an individual may serve.

22 Lieberman proposes requiring full disclosure of all fees, expenses and after-tax returns of mutual funds.

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 7

• End conflicts of interest that lead to double dealing.23

Although as President, many of Lieberman’s proposals would be outside his immediate control, these issues may be raised among the Presidential candidates and receive greater scrutiny and attention. Similarly, as attention continues to be drawn to an industry with 95 million customers, one should expect more initiatives to be taken by mutual fund regulators and, unfortunately, more disclosures of abuse of the public trust by mutual fund complexes. On October 30, 2003, the ICI recommended three fundamental reforms to be undertaken by the SEC and individual mutual funds to combat late trading and market timing abuses.24 The ICI will call for these reforms in testimony before Congress the week of November 3, 2003 as part of its efforts to rebuild investor confidence in the mutual fund industry. The call for reforms includes:

• A firm 4:00 p.m. deadline for all mutual fund trades to be reported to mutual fund companies.

This practice, if accepted, would, in the opinion of ICI Chairman Paul Haaga, “substantially alter longstanding business practices … [t]he firm 4:00 pm deadline represents all that can be done to slam the late trading window shut. We intend and are committed to doing everything possible to keep this window shut and permanently locked.”25

• A mandatory, industry-wide minimum 2% redemption fee on the sale of virtually all mutual

funds (other than money market funds) for a minimum of 5 days following purchases. The ICI believes a uniform, industry-wide minimum requirement is necessary to ensure that the fee’s deterrent effect would be felt in the many omnibus accounts that mutual funds do not control.

• With respect to short-term purchases and sales by senior fund personnel, ICI members should

clarify or amend their codes of ethics to include oversight of all trading activity in mutual funds

• ffered or sponsored by the company. James S. Riepe, a member of the ICI Executive

Committee, supports this reform as he believes the recently revealed trading reports of mutual fund executives in their company’s own funds “is an inexcusable and intolerable violation of mutual funds’ core ethic of putting shareholder interests above all else.”26 The mutual fund industry continues to be battered. On November 3, 2003, federal and state officials testified in favor of significant changes in the regulation of mutual funds at a Senate hearing. Late trading, abusive market timing and self-dealing are all leading the mutual fund industry down the path taken by the public companies that led to the enactment of the Sarbanes-Oxley Act of 2002. The SEC and ICI will be required to become more aggressive in their enforcement and oversight initiatives and the public should expect more of the same for the foreseeable future.

23 Lieberman proposes banning broker sales contests and quotas and demanding disclosure of revenue-sharing arrangements. 24 ICI Statement dated October 30, 2003, entitled “Mutual Fund Leaders Call for Fundamental Reforms to Address Trading

Abuses.”

25 ICI Statement dated October 30, 2003, entitled “Mutual Fund Leaders Call for Fundamental Reforms to Address Trading

Abuses.”

26 ICI Statement dated October 30, 2003, entitled “Mutual Fund Leaders Call for Fundamental Reforms to Address Trading

Abuses.”

November 4, 2003 Re: Mutual Fund Industry Late Trading and Market Timing Issues Page 8 Should you have any questions concerning the matters set forth in this memorandum, please feel free to contact Mark Koogler by telephone at (614) 227-2133 or via e-mail at mkoogler@porterwright.com. MBK:mbk

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