Division of Investment Management:
November 13, 2002 Letter to Investment Company Institute
re: Delayed Exchange of Fund Shares
Investment Company Act of 1940-Section 11(a) and Rule 22c-1
Investment Company Institute
November 13, 2002
Response of the Office of Chief Counsel
Division Of Investment Management
Investment Company Institute
Your letter dated October 28, 2002, requests that we concur with your view that a registered open-end investment company ("fund") may, consistent with Section 11(a) of the Investment Company Act of 1940 ("1940 Act"), offer its shareholders the opportunity to exchange their shares of the fund for the shares of another fund on a specified delayed basis.
Section 11(a) of the 1940 Act generally makes it unlawful for any fund or its principal underwriter to make an offer to exchange the fund's shares for the shares of another fund on any basis other than the "relative net asset values of the respective securities to be exchanged . . .." 1 The section further provides that, for purposes of Section 11(a), net asset value means:
the net asset value which is in effect for the purpose of determining the price at which the securities, or class or series of securities involved, are offered for sale to the public either (1) at the time of the receipt by the offeror of the acceptance of the offer or (2) at such later time as is specified in the offer (emphasis added).
You argue that, consistent with Section 11(a), a fund may offer its shareholders the opportunity to exchange their shares of the fund for the shares of another fund on a specified delayed basis, so long as the offer is fully and clearly disclosed in the prospectus of the fund making the offer. You state that such an exchange offer would provide that any exchange order2 would be executed at the relative net asset values of the respective fund shares, calculated at a specified time that is later than the time that those funds next calculate their net asset values.3
We agree that a fund may, consistent with Section 11(a), make an exchange offer on a specified delayed basis, so long as the offer is fully and clearly disclosed in the fund's prospectus.4 Thus, for example, we believe that a fund could make an offer to exchange its shares for the shares of another fund on a specified delayed basis pursuant to which all exchange orders received before the fund calculates its net asset value on any business day would be executed at the relative net asset values of the funds calculated on the next business day. If these funds calculate their net asset values as of 4:00 p.m., any exchange order received before 4:00 p.m. on Monday would be executed at the relative net asset values of the funds calculated on Tuesday.
As another example, a fund could make an offer to exchange its shares for the shares of another fund on a specified delayed basis pursuant to which all exchange orders received after 2:30 p.m. on any business day would be executed at the relative net asset values of the funds calculated on the next business day. If these funds calculate their net asset values as of 4:00 p.m., any exchange order received at 3:00 p.m. on Monday would be executed at the relative net asset values of the funds calculated as of 4:00 p.m. on Tuesday.
In either example, the transactions would be effected in a manner that is consistent with the forward-pricing provisions of the 1940 Act.5 We note that you have not asked for our views on whether a fund may make an exchange offer pursuant to which the fund specifies that only the net asset value of the other fund will be calculated on a delayed basis.6 We question, however, whether such an exchange offer would be consistent with the 1940 Act.
Jana M. Cayne
1 Section 11(a) also provides that an offer of exchange may be made at other than the relative net asset values if the terms of the offer have been submitted to and approved by the Commission or are in accordance with such rules and regulations as the Commission may have prescribed. See, e.g., Rule 11a-3 under the 1940 Act.
2 For purposes of this letter, an exchange order is composed of simultaneous orders to redeem shares of one fund and purchase shares of another fund using the proceeds of the redemption.
3 You state that an exchange offer made on a specified delayed basis would affect the timing of transactions covered by the exchange offer; it would not impair a shareholder's ability to separately purchase or redeem fund shares at the net asset value next computed after the purchase or redemption order is received.
4 We expect a fund that offers to exchange its shares on a specified delayed basis will provide its existing shareholders with a separate written notice explaining the change to the fund's exchange offer before implementing such offer.
5 See Section 11(a) and Rule 22c-1 under the 1940 Act.
6 For example, a fund might be interested in specifying that it would execute the redemption side of an exchange order at the redeeming fund's net asset value next calculated after the fund receives the exchange order, but that it would execute the purchase side of the exchange order at the selling fund's net asset value calculated two business days later.
[Investment Company Institute letterhead]
October 28, 2002
Mr. Paul F. Roye
Division of Investment Management
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Dear Mr. Roye:
As you know, market timing activity involving mutual funds, particularly those funds that invest in foreign securities, has received increased attention recently. Most market timing activity is disruptive to the efficient management of portfolios and contrary to the interests of longer-term shareholders. For this reason, fund groups have sought to employ a number of methods to try to deter market timing, such as imposing redemption fees, limiting frequent trading, and conditioning exchange privileges.
The Investment Company Institute1 is writing with respect to the last of these methods and, in particular, to request that the staff confirm that funds may institute delayed exchange policies. Under a delayed exchange policy, exchange transactions2 would be executed on a specified delayed basis (e.g., the next business day after the exchange request is received).3 Such a policy could be implemented in more than one way. Some funds may adopt a policy under which only those exchange requests received late in the day that involve funds that are a common target for market timers, such as international funds or Asia-Pacific regional funds, will be delayed. Other funds might have a broader or narrower policy, depending on the funds' specific circumstances. In any event, the terms of a delayed exchange policy would be fully disclosed to shareholders in fund prospectuses.
Importantly, while a delayed exchange policy would affect the timing of transactions covered by the policy, it would not impair a shareholder's ability to either purchase or redeem fund shares at the net asset value next computed after the order is received.
Delaying an exchange transaction can help to deter harmful market timing, since market timing relies on effecting transactions on specific days to take advantage of perceived market conditions. Some funds may find this approach to be more targeted than, and thus preferable to, the imposition of redemption fees or the outright suspension of exchange privileges. Moreover, fund shareholders who are not market timers might also find this approach to be preferable to such other alternatives. As with any practice that deters market timing, delaying exchanges can help to ensure that both a fund's redeeming shareholders and those remaining in the fund are treated fairly.
For the reasons discussed below, we believe that delayed exchange policies are consistent with the requirements of and policies underlying the Investment Company Act of 1940.
Most fund groups provide shareholders the ability to exchange shares of one fund for shares of another fund. These exchange privileges are provided as a benefit to shareholders and are not required by the Investment Company Act. Therefore, in providing an exchange privilege, funds are able to define the terms of that privilege, subject to the restrictions in Section 11(a) of the Investment Company Act, discussed below. For example, funds may confer exchange privileges only with respect to shares that have been held for a specified period of time, and/or restrict the number of permitted exchanges, and/or reserve the right to suspend exchange privileges for identified market timers. Similarly, funds should be able to delay the execution of exchange transactions.
Section 11(a) governs exchange offers by registered investment companies and their principal underwriters. The purpose of Section 11(a) is to prevent "switching" - the practice of inducing shareholders of one fund to exchange their shares for those of a different fund primarily to exact additional selling or other charges.4 To this end, Section 11(a) prohibits exchange offers at other than relative net asset value, unless the terms of the offer have been approved in advance by the SEC or the exchange is made pursuant to rules adopted by the SEC.5 For these purposes, Section 11(a) defines "net asset value" as:
The net asset value which is in effect for the purpose of determining the price at which the securities, or class or series of securities involved, are offered for sale to the public either (1) at the time of the receipt by the offeror of the acceptance of the offer or (2) at such later time as is specified in the offer.
As the highlighted language demonstrates, Section 11(a) clearly contemplates that a fund's exchange policy may specify an execution time later than the next net asset value calculated after the exchange order is received, so long as the policy is clearly disclosed in the fund's prospectus.
In addition, delayed exchange transactions are consistent with Rule 22c-1 under the Investment Company Act. Rule 22c-1 requires funds to follow a forward-pricing procedure under which each purchase or redemption order is executed by the fund at the net asset value next computed after the order is received. At the time the rule was adopted, many funds were using backward-looking pricing systems. The SEC adopted Rule 22c-1 to address its concern that backward pricing could lead to significant dilution of the investments of existing fund shareholders. Delaying an exchange transaction would not result in backward pricing. Instead, a fund's shares would always be priced at the next computed net asset value after the time specified in the fund's exchange policy, consistent with Rule 22c-1. 6
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The Institute appreciates your consideration of this request. If you have any questions about these matters or need any additional information, please contact me at (202) 326-5815 or Bob Grohowski at (202) 371-5430.
Very truly yours,
Craig S. Tyle
cc: Douglas J. Scheidt, Associate Director
Office of the Associate Director (Chief Counsel)
1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,982 open-end investment companies ("mutual funds"), 513 closed-end investment companies and 6 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.373 trillion, accounting for approximately 95% of total industry assets, and over 90.2 million individual shareholders.
2 An exchange allows a shareholder to simultaneously request that all or a portion of the shares of one fund be redeemed and shares of another fund be purchased using the redemption proceeds as payment.
3 For example, assume that a fund complex that, under normal circumstances, prices its funds as of 4:00 p.m. has adopted a delayed exchange policy pursuant to which exchange requests received after 2:30 p.m. would be executed on the next business day. Pursuant to this policy, an exchange request received at 3:00 p.m. on Monday would be executed using NAVs calculated on Tuesday. In all instances, even where one of the funds involved calculates its NAV as of a time other than 4:00 p.m., the exchange transaction will be forward-priced at the next computed net asset value after the time specified in the fund's exchange policy, consistent with Rule 22c-1.
4 See H. Rep. No. 76-2639, at 8 (1940).
5 Rule 11a-3 permits a fund or its principal underwriter to charge exchanging shareholders a sales load on the acquired security, a redemption fee, an administrative fee, or any combination of the foregoing, provided certain conditions are met. A delayed exchange policy does not raise any issues under Rule 11a-3.
6 The staff of the Division of Investment Management previously declined to take a no-action position under Rule 22c-1 with respect to a fund's proposal to delay the execution of purchase orders received between 12:00 noon and 4:00 p.m. until the next business day. Dreyfus Index Fund (pub. avail. Sept. 21, 1987). The Dreyfus letter was limited to the application of Rule 22c-1 to delayed purchases of fund shares and did not discuss delayed exchanges. This distinction is important because Rule 22c-1 specifically requires funds to execute purchase or redemption orders at the next computed net asset value after such orders are received, but does not specifically reference exchanges. By contrast, as indicated above, Section 11(a) specifically contemplates that in the case of exchange transactions, funds may provide for an execution time later than the next calculation of net asset value after the exchange order is received. Moreover, as noted above, a shareholder in a fund that adopted a policy of delaying exchanges would still be able to purchase (or redeem) shares of the fund directly (i.e., not as part of an exchange) at the next computed net asset value after the order is received. Therefore, the proposed delayed exchange policies discussed herein do not contravene the staff's position in the Dreyfus letter.