Alert April 08, 2008

Federal District Court Rules Variable Insurance Contract Issuer May Restrict Contract Owner Market-Timing Activities

On March 31, 2008, the United States District Court for the Eastern District of Pennsylvania (the “Court”) ruled after trial that the insurance company issuer (the “Issuer”) of a $50 million variable life insurance contract (the “Contract”) was not required to permit the Contract owner (the “Market Timer”) to engage in market timing of the Contract’s mutual fund investment options.  The Market Timer has previously sued, on behalf of himself and certain affiliated entities, a number of variable insurance contract issuers, including Aetna, Allstate, Hartford, John Hancock, Phoenix Life, Prudential, and ReliaStar.  The Market Timer’s investment and litigation strategies have been profiled in The Wall Street Journal and elsewhere.

Background.  Under a variable insurance contract, the contract owner allocates account value of the contract among a variety of underlying mutual funds.  In part because of the tax advantaged status of variable insurance contracts, market timers – investors that make frequent purchases and sales of mutual funds to take advantage of short-term market changes and, in some instances, to exploit inefficiencies in fund pricing – have sometimes used variable life insurance and variable annuity contracts as the vehicle for their market-timing activities.  According the to SEC, market timing, although not illegal per se, can harm other fund shareholders because (a) it can dilute the value of their shares, if the market timer is exploiting pricing inefficiencies, (b) it can disrupt the management of the fund’s investment portfolio, and (c) it can cause the targeted fund to incur costs borne by other shareholders to accommodate the market timer’s frequent buying and selling of shares.  Most mutual funds have adopted procedures to restrict market timing.  Most issuers of variable insurance contracts have adopted similar procedures and have added language to the insurance contracts themselves expressly authorizing the issuer to restrict market timing.  Older variable insurance contracts – for example, many contracts issued before 2003 – are less likely, however, to include such language.

The Market Timer, who owns or controls a registered broker-dealer and a registered investment adviser, invests on behalf of himself, certain affiliated entities, and his clients.  Prior to 2003, the Market Timer purchased from different issuers a number of variable life insurance contracts with an aggregate coverage amount well in excess of $100 million.  The Market Timer typically sought assurances before purchase that he could continue his market timing activities.  Years later, when the contract issuers sought to restrict market timing, the Market Timer filed lawsuits against a number of them to enforce his alleged market-timing rights, with a considerable degree of success.

The Dispute.  In early 2004, the Issuer adopted new procedures restricting market timing in its variable insurance contracts.  The Issuer brought a declaratory judgment action against the Market Timer seeking declaratory relief that the new restrictions did not violate the Market Timer’s contractual rights.  The Market Timer counterclaimed for breach of contract and sought damages and injunctive relief.  The Market Timer contended that the Issuer knew that the Market Timer purchased the Contract in order to market time, that the new restrictions frustrated the contractual purpose, and that the Contract did not permit the Issuer to impose such restrictions.

The Court’s Decision.  After a ten-day trial on the merits that concluded in March 2008, the Court entered judgment in favor of the Issuer.  In a detailed 61-page decision, the Court held that the Contract did not grant the Market Timer the right to market time, and furthermore that the Market Timer was aware at the time of Contract formation in 1997 that the Issuer reserved the right to restrict the Market Timer’s ability to trade.  Accordingly, the Court granted the Issuer declaratory relief and rejected the Market Timer’s counterclaim.

Prudential v. Paul Prusky, et al., 2008 U.S. Dist. LEXIS 26330 (E.D. Pa. March 31, 2008).  Goodwin Procter LLP was trial counsel for the Issuer.