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In the 1980s, the defense industry was the subject of public scrutiny. Then came the savings and loan and health care scandals. And most recently, the Enron and WorldCom collapses placed intense heat on public companies. But since Labor Day, the corporate scandal du jour has centered on the world of mutual funds. For the past two months, investment management lawyers have been exceptionally busy advising clients about the fast-paced investigation that started in New York and has picked up steam in the Securities and Exchange Commission. On Sept. 3, New York Attorney General Eliot Spitzer announced that he had uncovered evidence of widespread illegal trading schemes that potentially cost mutual fund shareholders billions of dollars. Spitzer’s investigation focused on two practices: “late trading” and “market timing.” SEC chairman William Donaldson soon chimed in on Spitzer’s findings and culminated an investigation last month by filing the commission’s first case against a large mutual fund company, Putnam Investments. The SEC has sought records from, and had personnel make visits to, mutual fund companies. The commission has also promised rulemaking proposals designed to keep the questionable practices from recurring. “We’ve been really affected,” said Pepper Hamilton 40 Act partner Joe Del Raso. “We don’t have a homogenized 40 Act practice, so we’ve put together a team of lawyers [from various practice areas] to provide assistance to our clients. Our [40 Act] group is working at full capacity, and we’re still looking to expand because this is just the first wave of the investigation.” Del Raso said in addition to 40 Act lawyers, Pepper Hamilton has called on its six SEC alums and its contingent of white-collar defense litigators to help advise its mutual fund clients. “We moved pretty quickly,” Del Raso said. “We contacted third-party administrators and brokers [to discuss procedures involving late trading and market timing.] We recommended that [mutual fund] boards call unscheduled meetings where third-party administrators give reports. We want to make sure that our clients are following up with their fiduciary duties.” Of the two practices that have come under scrutiny, late trading is considered far more serious because it is illegal, whereas market timing is not. Late trading refers to the practice of placing orders to buy or sell mutual funds after they are valued daily at 4 p.m. (Eastern Standard Time). Late buyers receive the price based on the value set as of 4 p.m. although normally they are supposed to get the next day’s price. This mechanism allows late buyers to earn big profits by taking advantage of late news that the average trader cannot act on. Drinker Biddle & Reath 40 Act partner Audrey Talley said that late trading has been extremely difficult for lawyers to handle because many of the infractions have been committed by third-party brokers or administrators. “What can a fund do except get representations from third parties that they are following the law and not late trading,” Talley asked. Market timing deals with short-term trading of mutual fund shares designed to exploit inefficiencies in the way mutual fund companies price their shares. For instance, if an investor sees that the price of a fund has become stale and no longer reflects the value of its stocks, he or she will buy at the stale price and sell soon after at an updated price. Talley said that although technically legal market timing becomes particularly sticky if a fund company says in its prospectus that it does not allow for market timing but then allows certain shareholders to do it. “We’ve worked jointly [with Drinker Biddle's white-collar litigators] to put in place operating procedures to ferret out this behavior,” Talley said. “This is all new to us and the industry, which, through all the other corporate scandals, has always said that it’s squeaky clean. And people just gave them the benefit of the doubt that they were telling the truth until Spitzer began his investigation.” Dechert partner David Howard said white-collar defense litigators at his firm have been involved in representing clients connected to the mutual fund probe. Howard, who has defended clients from the recent Enron and Rite Aid corporate scandals, said most of his time is still consumed by representing clients connected to scandals involving public company governance. But the past two months have brought an influx of requests for assistance from Dechert’s mutual fund practice. “There’s really no difference [between the mutual fund investigation] and any other government investigation,” Howard said. “It’s the same basic rules. Every case rises and falls on its own facts. And the advice we give [mutual fund clients] is the same. Once an investigation begins, how you respond is critical. If you do something like destroy documents, you’re going to get yourself and your company in more trouble.”

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