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late trading, market timing, investor welfare, mutual fund, direct action, class action, derivative action, individual recovery


Revised version of this paper was published in the Journal of Business and Technology Law under the title ""Who Should Recover What for Late Trading and Market Timing?"


This article focuses on the mutual fund trading scandals that came to light in late 2003 and in particular on the remedy that should be available to injured mutual fund investors. First, I describe mutual fund structure and the trading process for mutual fund shares. Second, I show how late trading and market timing can extract value from a fund and harm the interests of non-trading fund investors. Third, I discuss the factors that gave rise to these abuses and regulatory changes that would prevent a recurrence. Finally, I address the issues raised by the numerous private stockholder actions prompted by abusive trading in mutual fund shares. In particular, I focus on the question whether such claims are direct or derivative. The primary injury that arises from abusive trading is one that falls first on the fund as a fund. Such practices reduce the value of the fund. Non-trading fund investors lose because the value of fund shares declines, which is the classic badge of a derivative action in an ordinary business corporation. Thus at first blush, it would seem that investor claims should be characterized as derivative. It is arguable, however, that the harm suffered by fund investors is direct because of the contractual rights that individual fund investors have as against the fund. Specifically, mutual fund investors have the right to cash out at net asset value per share (NAV). Thus, although the harm suffered from abusive trading results in a reduction in the value of fund shares, fund investors suffer this harm directly because of their contractual right to cash out on demand. The problem with viewing mutual fund investor claims as direct rather than derivative, however, is that it suggests (1) that only those fund investors who sold their shares during the fraud period should be permitted to recover and (2) that the fund itself might be held liable to those who sold their fund shares during the fraud period, which would compound the loses of holdover investors. These problems can be avoided if the fund maintains an action for the benefit of all fund investors (whether on its own or in connection with a derivative action). But this solution gives rise to the problem that recovery by the fund may lead to a windfall for newcomer fund investors and even to speculation by buyers seeking to take part in the recovery. There is a simple solution to these problems. The windfall problem can be avoided by distributing additional fund shares -- rather than cash -- to fund investors who held shares at the time the trading abuses occurred. This remedy would dilute away any gain that could be captured by newcomers. Moreover, it should be relatively cheap and easy to effect this remedy on the basis of existing fund records. Holdover fund investors would have new shares or fractions thereof added to their accounts. Those who sold their fund shares during the fraud period would have their accounts constructively reopened to receive new shares as compensation (which shares could then be redeemed for cash). This remedy would avoid the need to issue thousands of small checks and would afford the fund itself the ability to invest the recovered funds. Thus, this remedy should be attractive both to fund investors and to funds themselves. Although the remedy proposed is neither a conventional derivative action nor a conventional class action, it turns out that FRCP 23(b)(2) authorizes a class action for final injunctive relief (rather than for damages payable to the plaintiff class) that appears to fit quite nicely.