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

P ORTER M EMORANDUM W RIGHT M ORRIS & A RTHUR LLP Attorneys and Counselors at Law 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 out, 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 complexes 5 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 orders; 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 statement 9 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 other 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.