First Trust Corporation
File No. S7-27-03:
Dear Mr. Katz:
First Trust Corporation ("First Trust") appreciates this opportunity to comment on the Securities and Exchange Commission's proposed amendments to the rules governing the pricing of mutual fund shares (the "Proposed Amendments").
First Trust, an FDIC-insured trust company organized pursuant to the banking laws of the state of Colorado, provides custodial and/or directed trustee services through its various business units and departments to financial intermediaries such as registered investment advisors ("RIAs"), third-party administrators of qualified retirement plans ("TPAs") and other financial representatives ("FRs"). First Trust refers to those business units that serve each type of financial intermediary as "business channels." First Trust administers over 270,000 retirement and custodial accounts for these financial intermediaries with assets totaling over $25 billion, and processes approximately 2.1 million mutual fund trades annually on behalf of its customers. First Trust has developed proprietary systems and established relationships with approximately 4,000 mutual funds to enable its financial intermediary customers to offer a wide range of investment choices to their individual investor clients. First Trust has been serving the financial intermediary market for over 40 years.
First Trust agrees that the SEC should take appropriate action to prevent illegal late trading in mutual fund shares and to provide a level playing field for all mutual fund investors. However, First Trust believes that the Proposed Amendments would result in significant unintended consequences - particularly for individual retail investors - and that the objectives of the Proposed Amendments can be achieved without such consequences.
Under the Proposed Amendments, intermediaries such as broker-dealers, banks and TPAs would be required to transmit trade orders to the mutual fund, its designated transfer agent or a registered clearing agency (e.g., the National Securities Clearing Corporation ("NSCC")) (collectively referred to hereafter as the "Fund" or "Funds") prior to the time established by the fund for calculating the current day's net asset value (the "Trading Cutoff," generally 4:00 PM EST) to obtain the same-day price. This requirement would create substantial disadvantages for all mutual fund investors, particularly those who invest in mutual funds through financial intermediaries, and would also substantially increase costs for the intermediaries themselves. Rather than adopt the Proposed Amendments, First Trust urges the SEC to adopt a rule that would permit intermediaries that meet certain minimum operating standards to obtain same-day pricing for orders received by the intermediary before the Trading Cutoff.
I. The Proposed Amendments would substantially harm individual investors and greatly increase costs to intermediaries.
1. Harm to investors
As noted in the preamble to the Proposed Amendments, the requirement that orders be submitted to a Fund by the Trading Cutoff in order to receive the same-day price would disadvantage all mutual fund investors, particularly that great majority of investors who purchase fund shares through intermediaries. These intermediaries aggregate trades received during the day and then transmit a single trade to the appropriate fund. This aggregation process may take an hour or more depending on the systems and resources of the particular intermediary. Under the current rules, intermediaries are allowed to accept trades from investors up to the Trading Cutoff and aggregate them after the Trading Cutoff for transmission to the Fund. Requiring the intermediary to transmit trades to the Funds prior to the Trading Cutoff would force intermediaries to use a portion of the trading day to aggregate trades. This would force intermediaries to establish substantially earlier cutoff times to allow for internal processing before submission to the Funds, which would in turn force investors using those intermediaries (including participants in participant-directed employee benefit plans) to communicate their trades to intermediaries early in the trading day. The practical effect of such earlier cutoff times would be to create a sub-class of investors who could not respond to developments in the market that occur late in the trading day. This sub-class represents no small number of investors: the Investment Company Institute estimates that 85-90% of mutual fund purchases are made through intermediaries such as First Trust's RIA, TPA and FR customers.
First Trust generally requires one to two hours of processing time to prepare all trades for a given day for transmittal to the Funds. Allowing an appropriate "cushion," (which is not required under the current system, but would be necessary under the Proposed Amendments) First Trust would be required to establish a cutoff between 1:00 PM and 2:00 PM EST - two to three hours prior to market close - in order to assure that trades could be transmitted to the Funds prior to the Trading Cutoff. In the case of participant-directed employee retirement plans, the problem is compounded: generally, a plan's recordkeeper accepts trades from individual participants up to the Trading Cutoff, then aggregates those trades after the Trading Cutoff for transmission to First Trust, which performs further processing prior to transmitting trades to the Funds. Under the current rule these trades are actually transmitted to the Funds late in the evening. Under the Proposed Amendments, participants may be required to transmit instructions to their plan recordkeeper by 12:00 PM EST or earlier in order to receive the same-day price. This means that investors, and retirement plan participants in particular, will be forced to make important investment decisions absent the benefit of any news or information that may come to light during the remainder of the trading day.
Individual investors attempting to avoid the disadvantage of a foreshortened trading day by trading directly with the Funds (rather than using an intermediary such as First Trust's RIA, TPA or FR customers) will face other disadvantages. For example, investors who by-pass these intermediaries will be afforded fewer investment choices. Many of First Trust's RIA, TPA and FR customers choose First Trust's administrative services because through First Trust they are able to offer their individual investor clients a wide range of mutual funds. In addition to having relationships with large fund complexes, First Trust has relationships with many small, independent funds. First Trust often establishes relationships with these smaller fund companies at the request of a TPA, RIA or FR intermediary so that the intermediary's clients can invest in those funds. The result of First Trust's relationships is investment flexibility and choice for the individual investor. Under the Proposed Amendments an investor seeking similar flexibility would be forced to establish accounts at each fund with which he or she wanted to invest. This effectively denies the investor flexibility and choice as it is unlikely that an individual investor will establish relationships with more than a few fund families. The Proposed Amendments would also have the unintended effect of discouraging individual investors from employing the services and advice of financial intermediaries, therefore giving up the advantage of receiving professional investment advice, information and assistance.
The burden of dealing directly with fund companies will not be limited to investors who choose not to use an intermediary. TPA, RIA and FR intermediaries who wish to avoid subjecting their clients to a shortened trading day would also be forced to bear the burden of establishing and maintaining relationships with each Fund into which their clients invest. Rather than do so, it is highly likely that these intermediaries would choose a few, or perhaps even a single, fund complex with which to do business. While the current system effectively levels the playing field between large fund complexes and small funds and fosters competition, the Proposed Amendments create an environment in which it is easy to envision large fund complexes competing for the business of the largest intermediaries, increasing the intermediaries' dependence on a few fund families. In addition, the barriers to entry for new, independent mutual funds would be formidable. Without access to RIA, TPA and FR investors, even those independent funds that did manage to achieve a toehold in the marketplace would be less able to effectively reach the individual investor and therefore be less likely to compete effectively for investor dollars. The end result is likely to be less competition among funds and, consequently, less choice for investors.
Rather than bolstering investor confidence in the mutual fund industry, each of these unintended effects - limiting investment choices for investors, discouraging investors from seeking professional guidance and chilling competition between large fund complexes and independent funds - serves to further undermine investor confidence.
2. Costs to intermediaries and others
The most significant cost to intermediaries, and the most difficult to quantify, will be the cost of lost business. As noted above, the Proposed Amendments will incent both individual investors and intermediaries like First Trust's RIA, TPA and FR customers to trade directly with mutual fund families in order to avoid disadvantages caused by the Proposed Amendments. As individual investors establish direct relationships with fund companies or forsake mutual funds for other investment products, RIA and FR intermediaries are likely to experience a decline in business. This decline will inevitably trickle down to the custodians and trustees who provide service to such intermediaries. Further, rather than employing third-party custodians or directed trustees such as First Trust, it is foreseeable that many RIA, TPA and FR intermediaries will migrate to the relatively few fund complexes that are also able to provide custodial or trustee services. It is impossible to estimate the effect that this would have on an intermediary like First Trust, but the effect is likely to be significant for each intermediary and quite large when taken in the aggregate.
Intermediaries like First Trust would not only face the prospect of losing customers, but would be forced to incur substantial costs to comply with the Proposed Amendments. As discussed, First Trust provides services to a number of different types of intermediaries. First Trust's systems and trading procedures vary slightly for each of these types of intermediaries. In order to meet the Trading Cutoff at the Funds for each type of intermediary, First Trust would be forced to effect changes to each of these systems and procedures. These efforts would include programming and development of technology, development or amendment of policies and procedures, development or amendment of related quality control procedures, and training and education. In addition, intermediaries like First Trust would face significant costs under the Proposed Amendments in an effort to mitigate disadvantages to investors by upgrading their technology and systems and revising processing procedures in an effort to establish internal cutoff times as close to the Trading Cutoff as possible for RIA, TPA and FR customers. Additional time and expense will be required if intermediaries are to be expected to implement these changes without experiencing sharp increases in trade processing errors or claims as new systems and processes are adopted. It is also important to note that no matter how efficient an intermediary's systems and processes become, the competitive inequities caused by the Proposed Amendments would never be fully cured because no system could be created that would permit order-taking by an intermediary right up to the Trading Cutoff.
As recognized by the SEC, the Proposed Amendments also create concerns regarding the processing capacity of NSCC itself. Under the current system, intermediaries are allowed to transmit trade files at intervals throughout the day and into the evening. These files are processed by the NSCC, which considers trades to be "received" only when its processing is complete. Under the Proposed Amendments, if an intermediary transmits a file at 3:55 PM EST, but the NSCC's processing isn't completed until 4:05, the trades would be considered late and would receive the next-day price. Because the Proposed Amendments would impose the same cutoff for everyone, it is likely that virtually all intermediaries would transmit trades at the same time (rather than throughout the day and evening), and that the increased volume would lengthen the NSCC's processing time, forcing intermediaries to establish even earlier cutoff times. The NSCC will be forced to upgrade its own systems and processes in order to mitigate this problem and will necessarily incur costs and expend resources to do so.
II. The SEC's concerns can be addressed without harming investors or imposing financial burdens on intermediaries.
First Trust believes that an approach substantially similar to that discussed by the SEC in its preamble to the Proposed Amendments provides adequate protections designed to prevent late trading without harming investors or imposing unnecessary costs on intermediaries. Specifically, that approach would ensure compliance with pricing rules by requiring that intermediaries like First Trust uniformly adopt certain safeguards to protect against late trading if they wish to obtain same-day pricing for orders received by them prior to the Trading Cutoff.
The approach discussed by the SEC in its preamble includes: (1) the application to all orders received of an electronic or physical timestamp that is "tamper-proof" (i.e. it cannot be altered or discarded once the order has been entered into the trading system); (2) provision by the intermediary of an annual certification that it has policies and procedures in place designed to prevent late trades; and (3) an annual independent audit.
1. Application of a tamper-proof time-stamp
As noted above, First Trust currently receives mutual fund trades through its various business channels in a variety of ways, including computer upload, telephone, and facsimile. These trades are then processed pursuant to systems requirements and procedures for the particular business channel in which they were received. Regardless of the business channel or method of receipt, virtually all of the orders received by First Trust are processed by one of First Trust's trading systems, each of which applies a time stamp indicating when the trade was entered into the system. Efforts to cancel or alter a trade that has been received by the trading system leave an auditable trail. Currently, some trades are received outside First Trust's electronic systems, and of those a small number are transmitted to the Funds outside First Trust's system.
It would be possible for First Trust to upgrade its systems and procedures to allow it to achieve the goal of applying a tamper-proof time stamp to all orders received. To achieve this, First Trust would require that all orders, regardless of business channel, be entered into the First Trust systems through a single electronic interface. This would be an internet-based application that would allow First Trust customers to enter mutual fund orders into the application, which would then feed them into First Trust's trading system. Trades received by First Trust via telephone, facsimile, or mail would be entered promptly into this same application by First Trust representatives. Every trade, to be processed by First Trust, would have to be entered into the application. Access to the First Trust system would be limited to users who are identified by First Trust's authentication system.
Every order entered into the internet application would be sent by that application to a database within First Trust's "trade engine." Each order would be time stamped upon receipt by the trade engine, and only orders bearing a trade engine time stamp before the Trading Cutoff would be sent for same-day execution. The trade engine would aggregate orders and send them to the appropriate Fund. Each order sent by the trade engine for execution would be stamped with the time that it was sent, and also with a "digest," which is a digital signature that ensures that the data sent matches that which is recorded in the database. The trade engine would automatically move trades entered after the Trading Cutoff into the following day's file for processing. The upgraded system and processes described here are in fact more robust versions of those used for the great majority of First Trust trades today, with enhancements not only to the system itself but to related processes and procedures.
Security features in the trade engine would allow the digest as well as the time stamp to be locked so that the data could only be altered by a system administrator with the authorization of at least one other designated First Trust employee. First Trust would expect to authorize only a very small number of system administrators and other designated employees. The trade engine would include an audit feature that would record any attempt by an administrator to alter the time stamp or digest, and the record created by this audit feature, as well as the original data, would be recorded and maintained on a non-volatile media (such as a write once, read many CD) that cannot be altered. Each of these safeguards would be fully auditable, and the system could be programmed to generate an exception report for any attempted or actual alteration of data.
This approach would also permit legitimate alterations to orders, such as the cancellation of an order that was placed erroneously, so long as such alterations occur prior to the Trading Cutoff.
2. Self- Certification Regarding Controls
First Trust recognizes the benefits of requiring intermediaries to provide self-certification regarding the sufficiency of their policies and procedures for preventing late trades. First Trust would gladly provide an annual certification that it has policies and procedures in place designed to prevent late trades. First Trust urges the SEC to adopt a rule that would provide intermediaries flexibility concerning the manner in which such certifications may be provided. It would pose a significant burden for First Trust and other intermediaries to provide separate individualized certifications to each of the fund families with which it maintains a relationship. Thus, we suggest that the rule permit intermediaries to provide "global" certifications through a form letter, central depository or internet posting. Further, First Trust's systems and controls would be subject to periodic review, allowing First Trust to identify trades, if any, that appear to have been placed after the Trading Cutoff and which were submitted to a fund or transfer agent for same-day pricing during the certification period. In addition to the self-certification requirement regarding the sufficiency of an intermediary's policies and procedures, First Trust urges that the SEC adopt a rule providing that the intermediary be allowed to separately report, in a writing to the applicable fund, as well as to the intermediary's federal functional regulator, the occurrence of and an explanation regarding any trade that appears to have been received after the Trading Cutoff and sent for same-day pricing.
3. Independent audit of controls
First Trust is regulated by the FDIC and the Colorado State Banking Commission, and its systems, procedures and internal controls are subject to audit by these entities on a regular basis. First Trust is also subject to periodic audit by an independent accounting firm. Finally, certain of First Trust's systems and business areas are subject to periodic SAS 70 audits. First Trust urges the SEC to consider permitting intermediaries that are otherwise regulated and examined by the SEC or the federal banking agencies to rely on those examinations to provide the protection sought by a requirement for an independent audit of the control function. The SEC should also consider permitting intermediaries to rely on a SAS-70 audit, or an enhanced SAS-70 audit, to fulfill this requirement. Finally, if an external audit requirement is established, intermediaries should be permitted to provide a single audit report that could be accessed by or provided to the chief compliance officer of a fund, rather than being required to generate separate individualized reports for each fund to which it submits trades.
The SEC has asked for additional comment regarding how it might police compliance with the above-described protections by those intermediaries which are not currently subject to the SEC's jurisdiction. It is First Trust's view that extending the SEC's jurisdiction to such intermediaries is unnecessary for a number of reasons. As described above, First Trust's systems and controls are already subject to review by its federal functional regulator, the FDIC, as well as by its state regulator. Such regulators should be relied on to examine entities under their jurisdiction for adequate internal controls and compliance with applicable law. Further, the key element of the protections outlined above is that intermediaries employ a "tamper-proof" system for order processing. So long as the existence and operation of such a system is the subject of periodic certification by the intermediary's management and periodic review and verification by regulators and qualified independent parties, the SEC's oversight should be unnecessary.
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We appreciate the SEC's willingness to consider alternative approaches to the Proposed Amendments and we urge the SEC not to adopt an approach that serves to disadvantage the majority of individual investors and forces intermediaries like First Trust to bear unreasonable financial and operating burdens. Any questions the staff may have regarding our comments should be directed to me at the number below, to Joanne Ratkai, First Trust's General Counsel, at (303) 294-5872 or to Cecelia Calaby at Shaw Pittman LLP, (202) 663-8984.
Executive Vice President
First Trust Corporation