Delta Data Software, Inc.

February 5, 2004

Submitted Electronically to

Jonathon G. Katz
Secretary, Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549

Re: Proposed Amendments to Rules Governing Pricing of Mutual Fund Shares. (Release No. IC-26288; File No. S7-27-03)

Dear Mr. Katz:

This letter comments on the proposed amendments to rule 22c-1 under the Investment Company Act of 1940, as amended (the "Investment Company Act"), which governs the pricing of mutual fund shares. The proposed rule amendments would impose a "hard" 4 p.m. cut-off for submitting purchase and sale orders for mutual fund shares to a designated fund transfer agent or registered clearing agency (e.g., Fund/SERV).

Delta Data Software, Inc. is a primary supplier of mutual fund processing systems to the financial industry, with installed systems processing approximately 25% of the dollar volume of all retirement industry fund trades daily through the NSCC. For over six years, we have been intimately involved in improving the control, integrity, and auditability of the trading process while simultaneously improving the efficiencies and reducing the errors and costs involved in the trading, reconciliation and settlement activities. We respectfully submit our comments in an effort to improve the understanding of how current, existing technology can be rapidly and economically deployed to prevent illicit late trading activities or to discover any such illicit trades in a timely manner.

We will not address the reasons for avoiding a 4:00 PM hard close, as other industry organizations with far more direct knowledge regarding the impact of implementing the several currently proposed 4:00 PM cut-off alternatives are presenting their views on the difficulties and cost to be incurred should one of those alternatives be mandated. We will confine our comments to addressing how a 4:00 PM hard close can be avoided while concurrently ensuring the integrity of the trading process and retaining all of the efficiencies gained by the technological advance largely adopted by the financial industry over the past seven years.

Highlights of A Proposed Approach to Ensure Integrity and to Reestablish Credibility in The Mutual Fund Trading Operations of Financial Institutions

The process proposed in this document, which was discussed in overview with Director Paul Roye and his staff at the SEC as part of the SPARK preliminary presentation to the SEC Investment Management Division in October, is an approach that can be used to ensure that, (a) any unauthorized late trades cannot be placed by an unauthorized person or by an authorized person acting alone; and, (b) all trades originated or modified after the daily cut-off time will be prominently displayed in daily reports to the compliance officer; and, (c) will be fully traceable and auditable by outside auditors and examiners in a list of all trades originated after the daily cut-off for mutual fund order, all orders cancelled after the daily cut-off, and all orders changed in any manner after the daily cut-off.


Virtually all bank and trust companies which trade mutual funds have one or more primary customer account systems where the daily trade activity is posted to the customer accounts. These primary systems are typically under tight security and are operated with proper division of responsibilities and supervision. Mutual fund trade orders may be originated in these systems under good control processes. In addition, there are typically other systems that interface electronically to these primary systems, such as internet trading systems, Voice response trading systems and other customer order systems for use by internal bank customer service personnel, trust officers, and other authorized personnel. These additional systems also have good security to preclude unauthorized personnel from entering trades.

All of these systems, that is, the primary systems and all the additional customer order originating systems that update the primary systems, apply date-time stamps to the orders that are electronically originated at the time the order is entered into the system. Since the date-time placed on the order is controlled by the application software, the only way a dishonest operator can tamper with the date-time stamp on an electronically-originated order is to tamper with the electronic clock that feeds the date-time information to the application software. In most large institutions, the systems clocks are unavailable to anyone except authorized information technology personnel, and the system clock integrity should be reliable. However, we have proposed that if the integrity of the clock is at question, the use of special clocks with encrypted date-time information to supply the date-time information to all applications that are used in the mutual fund trading process.

However, the weakest point today in the mutual fund trading process is the preprocessing and transmitting of mutual fund trade orders. It is during this processing that manual trade orders may be prepared (legitimately) to correct mistakes discovered in the validation processing. Also, many organizations do not have straight-through- processing of mutual fund trade orders from point of origin to submission to the fund company. Without straight-through processing, there is are opportunities for unscrupulous operators to manipulate the actual trade information sent to the fund companies. We believe that the current methods of after-hours processing of trades and transmission of trades need significant improvement, and we are certain that the deficiencies in the current methods can be readily corrected within a reasonable time period and at affordable expense.

Critical Controls.

The minimum controls necessary to assure compliance with the laws relating to late trading of mutual funds securities through internal controls and audits and examinations must include controls in the areas listed below.

  1. Valid, Legitimate Customer Accounts, Properly Classified.

  2. Date-Time Stamps Of All Transactions, Applied With Integrity.

  3. Control Over The Timely Cut-off Of Participant Instructions

  4. Traceability And Auditability Of Every Transaction From Point Of Origination Through Receipt By Fund Company.

  5. Absolute control (including verifiability) of the integrity of the trade data, in both the active databases and in the archived databases to ensure that:

    1. No records have been altered;

    2. All records originally generated by the trading systems are in the database; and,

    3. No records other than the original records have been added to the database.

  6. Strict Control Over All Exception Orders.

  7. Effective Daily Share Position And Cash Reconciliation Processes.

  8. Comprehensive Pricing Controls, Including The Application Of Prices To Pending Trades.

Valid Customer Account.

The first line of defense in the ability to trace any potential inappropriate activity is to have proper controls over the establishment and maintenance of customer accounts and fund company accounts.

  1. Each trade order placed should be identified with a known, valid customer account at the originating institution, and each customer account should be identified with an appropriate account at the Fund Company.

  2. No trade should be allowed without such a customer account association. Any aggregated trade to an omnibus or super-omnibus account at the fund company should be traceable to all the individual trades that were aggregated, and each of those disaggregated trades should be identified with its own customer account. Each exception trade should be associated with a customer account at the institution. `Covering' trades against `house accounts' should be carefully reviewed and cleared each day by a senior compliance officer or executive.

  3. There should be tight control over the customer accounts that are available for trading activity. Such controls should include appropriate separation of duties, supervisory control, and documentation of account authorization and account identification. For qualified plans, the federal identification number of the plan should be retained and validated against DOL records.

  4. There should be tight control over the securities that are authorized for trading in the customer account. These should be established using controls similar to those required for customer account maintenance and appropriate documentation authorizing such investments should be permanently retained with the customer account documentation.

Date-Timestamps Of All Transactions, Applied With Integrity.

Virtually all commercial recordkeeping systems place an electronic date-time stamp on each transaction record that is originated by the system. These systems retain the originating date-time stamps throughout the entire processing cycle of the system, so that it is easy to investigate the trading activity of an individual going back through the whole history of the account on the system. These systems also place a unique transaction ID on the transaction record. These are useful for audit and examination purposes when looking at the recordkeeping system by itself.

However, not all systems verify that the date-time stamp on a record is compliant with the 4:00 PM ET cut-off when processing the updates to the system for the end of the trading day. The integrity for this process is normally controlled by enforcing the policies and procedures established by the institution for such activity. This enforcement is auditable, since most systems also affix the date-time stamp of the posting process that updated the system following the trade order generation. A report showing all transactions with an origination date-time stamp after 4:00 PM for trades posted to account on or before that same posting date would show potential late trading activity.

Additionally, the date-time stamp applied by the recordkeeping is ultimately derived by the computer clock on the hosting computer. It is possible to manipulate the applied date-time stamp by manipulating the computer clock. In large institutions, this is not practical because the main computers are under the control of major IT organizations and their clocks are not easily manipulated. However, in a small shop, there is nothing other than the employee integrity to control this manipulation of the computer clock. For this reason, less a priori reliance can be place on the integrity of the date-timestamp as it is applied today.

However, a number of different technologies exist today for applying tamper-proof, verified accurate date-timestamps. Some of these will be briefly described later in this paper.

Control Over The Timely Cut-off Of Investor Instructions

All commercial Voice Response Units and Web-based application for participant financial instructions have date-timestamp of participant activity. In addition, these systems all update separate transaction databases that are used to update the primary recordkeeping database at 4:00 PM ET each day.

The control over the 4:00 PM ET cut-off is normally the result of a process initiated either automatically by a controlling computer routine or it is initiated by an established administrative process that is applied consistently within the organization. It is important that internal control and audit programs assure that these daily cut-offs are made in a timely manner each day. Clearly, a better approach would be for these cut-offs to be systematically controlled by the computer systems used to process the transactions, using tamper-proof timestamps to initiate and document the cut-off activity.

Traceability And Auditability Of Every Transaction From Point Of Origination Through Receipt By Fund Company.

The ability to aggregate trade orders has been an important part of the advances made in efficiency and economics during the past five years. However, one instance of the late trading abuses recently discovered involved aggregating manual trades for hedge fund accounts with electronic trades from pension plan accounts, with all the aggregated trades placed in the same omnibus account at the fund company.

Many large financial firms maintain `super-omnibus' accounts at the fund companies, where trades for retail accounts are aggregated with trades for pension plan accounts, endowment accounts, personal trust accounts, etc. Without prejudice as to whether such `super-omnibus' accounts should be discouraged, it is essential for proper control and examination purposes that these aggregated trades and their resultant single trade be fully traceable in both directions; that the history of these transactions be maintained indefinitely; and, that the audit program include a testing of this integrity.

There are a number of institutions which act as intermediaries for trading for smaller firms. These intermediaries include trust companies, securities firms and clearing firms. Many of these intermediaries may not have transactional traceability either within their own institution or across their clients' systems. This represents a break in the audit chain which needs to be corrected.

Control Over Exception Trades, Correcting Trades, Trade Cancellations, Etc.

  1. In the course of preparing hundreds of thousands of transactions each day, it is inevitable that some mistakes or errors will occur. These errors are usually discovered either from the exception reports generated after the main nightly processing run or after the trade reject reports are received from the NSCC or from the fund company. While it is economically important to allow the post-4:00 PM origination of correcting trades to remedy these errors, the submission of any trade which is originated by the trading institution post-4:00PM must be subject to extremely tight control.

  2. Such correcting trades must first be identified either with a specific customer account or with an existing erroneous trade that is identified with a specific customer account.

  3. The correcting trade must be identified as a correcting trade and must have supervisory approval before being submitted for execution.

  4. The correcting trade must be documented with a clear and comprehensive description of the nature of the error being corrected.

  5. All correcting trades and their documentation must be reviewed within 24 hours of execution by an independent compliance officer or senior operations officer, and that review must be indicated in writing.

Control and Verification of Control Of Trade Database Records.

For the compliance review, audit and regulatory review processes to be reliable, it is essential that the integrity of all of the original trade data be controlled and that the control be verifiable. The control process over the original trade records must ensure that no records can be altered after trades are submitted, that no records can be added to the database after the daily processing cycle, and that no trade records can be removed from the database. In addition, there must be a means for verifying that these controls are working and for readily and easily detecting any tampering in a timely manner.

Effective Daily Share Position and Cash Reconciliation Processes.

The daily share and cash reconciliation process is an integral part of the control program. This is the process where the positions at the fund companies on a specific date are reconciled to the corresponding positions on the primary recordkeeping systems. It would be very easy to camouflage short-term late day trading by showing a reconciling item on an unauthorized purchase and then clearing the item with the sale of the position, without ever posting the item to the recordkeeping system. The primary systems that create the trade orders post those orders to the customer accounts at the end of the daily processing cycle. The trade orders are forwarded to the fund companies and are executed and confirmed back to the institution. The fund company's transfer agent then posts these trades to the institution's accounts at the fund company and forwards a file of the resultant fund account positions to the institution. This file from the fund company is usually received on the second day following the trading.

On a day-to-day basis, the position reported by the fund company and the related position(s) recorded on the institution's recordkeeping system are frequently different. These differences result from a number of reasons, including:

  • timing differences between the processing cycles of the transfer agencies and those of the recordkeeper ( the second-day situation shown above);

  • exception trades that were sent to the fund company after the recordkeeping system was posted for the day (hence posted to the recordkeeping account the day following the day regular orders were posted) and may have been posted to the fund company account on the same day as the regular orders;

  • timing differences between when reinvested dividend and income share purchases are recorded on the fund company's accounts compared to when they are posted to the recordkeeper's accounts;

  • small differences in the number of shares purchased by reinvested dividends as computed by the fund company transfer agent compared to the number calculated by the recordkeeping system. (these are typically resolved within one or two days of purchase, but are reconciling items until resolved.);

  • orders called in directly to the fund company representative for various reasons, which may be posted to the transfer agent system on a different day that when posted to the recordkeeping system;

  • orders posted to the recordkeeping system on the day of trading, but rejected by the fund company for any of several reasons;

  • Various other reasons.

Many firms match cleared trades one-for-one with trades placed and reconcile their positions trade-by-trade on a daily basis. Many other firms simply keep a rolling list of unmatched trades and reconcile these differences in detail only once or twice a month. It is important to assure that each share position reconciliation is backed up by a detailed trade-for-trade matching for reconciling items, and that this reconciliation be explained and be reviewed by appropriate supervisory or compliance personnel. As stated at the beginning of this section, without proper daily position reconciliation reviews, it would be very easy to camouflage short-term late day trading by showing a reconciling item on an unauthorized purchase and then clearing the item with the sale of the position, without ever posting the item to the recordkeeping system.

Comprehensive Pricing Controls, Including The Application Of Prices To Pending Trades.

Sometimes, errors are not discovered until two or more days after the trading has occurred for a particular account. Correction of such errors always involves a correcting set of trades with resultant gains or losses. Typically, the gains are attributable to the customer account, but the losses are borne by the recordkeeper. While we are unaware of any illicit activity exploiting this area of activity, it would be possible for an insider to deliberately misprice a series of trades in an account owned by a collaborator and subsequently place a correcting trade order to either close out a loss position with the loss attributed to the recordkeeper institution or capture the gain for the collaborator account. Systematic controls should be applied to disclose any irregular pricing actions.

Use Of Technology To Improve Mutual Fund Trade Processing.

We believe that a combination of technology; proper internal controls, procedures, supervision, internal compliance oversight and security; and, independent outside audit and compliance review will ensure a the integrity of the processing and trading environment that exists today and will preserve the economic efficiencies and service levels that the customers of the U.S. financial industry. The proposals below are all essential to the proposed approach. There are additional features we will propose, but these are more detailed than appropriate for this document.

Trading and Trade Processing Systems (Includes Mutual Fund Company Transfer Agent Systems)

The first and most important area for the proper application of technology is the series of computer applications used to originate and process trades. These systems must have comprehensive user security, input and change controls, exception handling procedures, archival capabilities, audit trails, separation of duties, supervisory controls and compliance reporting designed into the core system. And, equally importantly, departmental procedures must be in place to properly utilize the system-based controls. In most large institutions, this combination of good systems and procedures and compliance review should be adequate to ensure the integrity of the trade processing.

However, there are additional economical technologies that can be incorporated to further ensure the integrity of the process. These include the use of tamper-proof date-timestamps, and the use of hashing algorithms and digital signatures to verify that the content of the transaction data has not been altered in any illegitimate manner.

There are a number of commercially available tamperproof date-timestamp products that can be economically incorporated into the trading and trade processing systems. There are also a number of commercial vendors of economical products that use various encryption and digital signature approaches to verify that the content of the data has not been altered and to identify any data that has been altered. Incorporation of such technology into the trading and trade processing systems should also be also economically modest.

We propose that all mutual fund trade orders be originated electronically in one or more controlled systems. In addition, we propose that all mutual funds trades be transmitted electronically, using straight-through-processing technology whenever possible, and we further propose that, without exception, all mutual funds trades submitted to the fund company after the daily cut-off period must have been originated in a controlled straight-through-processing environment and must be submitted electronically to the fund company from the controlled environment. Any mutual fund orders not originated and transmitted from such a controlled electronic environment must be received at the fund company or its authorized, registered clearing firm prior to the daily cut-off time. We further propose that the systems used to accomplish this processing have the following basic control features regardless of whether encryption techniques are also incorporated.

  1. Every order placed with a mutual fund company should be originated electronically in a controlled trading system included in the straight-through-processing environment. No orders should be allowed to be entered or placed in any manner other than through a controlled straight-through processing environment. Orders that are to be faxed or telephoned directly to a fund company must be subsequently originated in a controlled electronic environment and reported in a separate financial control area of fund company. Because of the proven lack of integrity in this area of trade entry, and because there are no tamper-proof audit trails that can be used to trace these trades to the point of origin, we believe that there should be a requirement that any orders entered directly by the fund company should be input into the fund company's system before the daily trading cut-off time (typically, 4:00 PM ET).

  2. Each system should apply a tamper-proof date-timestamp on each order processed for each stage of processing. Each system in the straight-through-processing chain should validate that the tamper-proof date-timestamp of each transaction it is forwarded from prior systems is in compliance with the standards for its stage of processing.

  3. Each system should apply a unique transaction ID to each order processed in such a manner that every order is traceable from origination to final disposal. Specifically, when more than one system is used in processing an order, each system subsequent to the first must have the capability to provide an audit trail tracing each order processed on that system to the transaction on the system prior and to the related transaction on the subsequent system. In addition, this information shall be readily available upon demand and all information shall be archived for seven years or such other time as deemed appropriate, but no less than five years.

  4. Each system should verify as a matter of routine daily processing that all transaction ID's issued by the system are actually contained within the system's transaction database and that no other transaction records are in the database. Reports evidencing these verification runs should be routed directly to the appropriate compliance officer in a timely manner each day.

  5. Each trade transaction record and each trade-related record should have a further encryption code applied which is constructed from the primary trade data and which can be used to verify that the data in the record has not been altered in any way. In addition, each trade order file resulting from all of the records included in such trade order submission should also carry an encrypted code that can be used to verify that no tampering or alteration took place between the origination of the trades and the submission of the trade order.

  6. All consolidated orders shall be traceable to the orders included in the consolidation and every order included in a consolidated order shall be traceable to the disposition of the final consolidated order. That is, all individual orders should be fully traceable throughout multiple consolidation and grouping processing, and the systems should be capable of disaggregating all consolidated orders into the individual orders comprising the consolidated orders at each step of the process.

  7. All correcting orders should be automatically placed on hold until supervisory approval is applied to the order.

  8. The system should require that all correcting orders have sufficient description of the cause of the correction included in the electronic records of the correction transaction. These transactions should show the date-time of the correction, the person making the correction and the person approving the correction.

  9. All correcting orders should be fully disclosed to the compliance officers as a matter of daily compliance reporting.

  10. Confirmations of every trade order should be matched to the original trade within the controlled electronic systems. All unconfirmed orders should be reviewed daily and the review filed with the compliance officer. All mutual fund trade orders remaining unconfirmed more than three days must be reported to the compliance officer on the fourth day, along with all relevant information pertaining to the order. Similar procedures should be followed for confirmations that are materially different from the originating order.

  11. All corrected and all adjusted orders should be traced to the related account and validated as compliant orders by an independent financial control group at the originating firm.

  12. Reports of all correcting orders should be available to auditors and compliance personnel at all times in such a form that the examiner can readily and easily trace the correction to the account(s) affected.

Internal Controls and Procedures and Oversight..

There should be sufficient internals controls, supervision, security, and compliance oversight to preclude any individual from subverting the late-day trading regulations. In addition, there should be sufficient separation of duties to routinely protect against collusion among individuals within the organization. There should also be sufficient and daily oversight and substantial review by the compliance department to assure that the controls are working as planned.

Outside Audit and Compliance Review.

The audit programs and the compliance review programs should be expanded to examine and validate that the entire process contains necessary and sufficient controls and processes to ensure integrity in the mutual funds trading process. Independent auditors knowledgeable about the mutual fund processing environment should examine the processes and audit the historical data to validate that the controls are working in a manner to prevent abuse and to discover abuse when present.


There should be a requirement that all individuals involved in the trading process sign an affidavit periodically that they understand the regulations and that they have complied fully with the regulations, and they should be required to disclose each incident that may have been nonconforming. Each supervisor with approval authority for trade order changes or corrections should be required to report periodically on the frequency of changes and corrections, and these reports and the underlying trade information should be reviewed and critiqued by both internal compliance and audit personnel and by outside auditors and compliance examiners. Each compliance officer should prepare a report periodically evidencing that the exception trading process has been properly reviewed for compliance purposes and the exceptions should be reviewed independently by the compliance department for patterns that may suggest inappropriate activity.

* * * * * *

In conclusion, we know that the technology exists today to ensure the integrity of the mutual fund trading process with verifiable 4:00 PM cut-off of trade origination without resorting to a hard 4:00 PM ET cut-off for trade processing and submission, for those firms which adopt the approach proposed in this letter or an equivalent approach. In addition, we are prepared to demonstrate that this technology is available, and is effective, and can be readily deployed.

We appreciate your taking the time to study our position. We hope that these comments are helpful. We will be glad to answer your additional questions and provide any additional information that may be helpful to you. Please feel free to call me (303-680-7006) or Burton Keller (706-323-1497, ext 145) if you have questions or comments.

Very truly yours,

David Hayes

J. David Hayes
Delta Data Software, Inc.