U.S. Chamber of Commerce
February 6, 2004
Jonathan G. Katz
Re: File No. S7-27-03 - Proposed Rule: Amendments to Rules Governing Pricing of Mutual Fund Shares
On behalf of the U.S. Chamber of Commerce, we submit this letter in response to the request for comments on the proposed amendments to Rule 22c-1 under the Investment Company Act which were released by the Securities and Exchange Commission ("SEC") on December 11, 2003. The U.S. Chamber of Commerce is the world's largest business federation representing more than three million businesses and organizations of every size, sector and region, with substantial membership is all 50 states. These comments have been developed with the input of member companies potentially affected by the proposed amendment.
The purpose of the proposed amendment is to stop late trading violations that have recently been discovered. Currently, mutual fund orders must be received by either a retail dealer or an intermediary by 4:00 pm to receive that day's price. To discourage further incidences of late trading, the proposed amendment requires that trades received by the mutual fund, the fund's primary agent, or a registered clearing agency by 4:00 pm receive that day's trading price. Consequently, trades received by an intermediary must be fully processed and sent to a mutual fund company, or other authorized entity described above, by 4:00 pm in order to receive that day's trading price. While the Chamber encourages an appropriate and timely resolution to the late trading abuses, we believe that, for the reasons detailed below, the proposed amendment imposes an undue and unnecessary hardship upon retirement plan participants and plan sponsors.
Plan Participants are Disadvantaged by the SEC's Rules
The proposed amendment significantly disadvantages retirement plan participants by relegating the majority of them to next-day trading status. Most retirement plans use an intermediary to process mutual fund orders for the plan. Intermediaries generally require 2 to 4 hours to process orders from retirement plans. The lag in time is due not only to ensuring the accuracy of the order, but also to ensuring compliance with that plan's unique requirements, qualification rules under the Internal Revenue Code ("Code") and the laws of the Employee Retirement Income Security Act ("ERISA"). For example, if a participant sends a request to redeem mutual fund shares, the intermediary will verify the following ERISA, Code, and plan requirements:
These checks occur in addition to routine checks for accuracy. This process is repeated for each individual order that the intermediary receives from the plan each day. These verifications must be made to ensure that the order complies with the rules of the plan, the Code and ERISA. Consequently, even with improved systems, there will still be a lag in processing for plan participants because their orders require verifications and checks not required for other mutual fund orders.
To satisfy the proposed amendment that the order be received by a mutual fund company by 4:00 pm in order to get that day's price, the intermediary will have to stop taking orders 2 to 4 hours before 4:00 pm. On the East Coast, participants would have maybe half a day to place an order, while on the West Coast participants would have an hour or two to place an order to receive that day's trading price. Effectively, the majority of plan participants would be relegated to next day trading.
Some have stated that plan participants would not be unduly harmed if they were relegated to next day trading because they are long-term investors. This argument, however, overlooks the fact that even long-term investors buy and sell shares during the course of holding their investments. As a matter of fact, plan participants are encouraged to rebalance their portfolios at least annually (and preferably as often as quarterly) to ensure that their investment choices remain balanced. Also participants are encouraged to shift their investments to correlate with life changes, such as nearing retirement age. Furthermore, these decisions to buy and sell shares are made at one point in time. Consequently, at the point in time that a plan participant decides to buy or sell, they would not receive the same pricing benefit as other mutual fund investors.
The most dramatic demonstration of this disadvantage is to compare a plan participant to a mutual fund shareholder the day before the tragic terrorist attacks on the United States. On September 10, 2001, at 2:00 pm EST both people place an order to redeem shares in the same mutual fund. The non-participant's order goes straight to the mutual fund company and he gets the price of the shares on Sept. 10. The plan participant however, places his order through an intermediary. Because of the necessary preparation time, the intermediary cannot process the trade in time and the participant receives the next day's price. In this case, the "next" day is Sept. 17 and the value of the mutual fund shares has fallen significantly. The only difference between the two people is that one is a plan participant and the other is not. Thus, one person has received a greater return on his or her investment, not because of planning, research, or even luck, but because of a rule that imposes a disadvantage on one person over the other.
Less drastic examples still demonstrates the disadvantage to plan participants. Sally holds $25,000 worth of Fund QRS in her retirement portfolio and $2,000 worth of the same fund in her brokerage account. At 2:30 pm, she hears that the portfolio manager of Fund QRS has been terminated because of improper trading activity in the funds she holds. She places orders to sell the Fund from both her 401(k) plan and her brokerage account. Because of different cut-off times, she is told that the sell order for her brokerage account will be executed at that day's price, but that her sell order within her 401(k) plan cannot be executed until the next day's price. The fund, as expected, suffers a downturn, and it is Sally's retirement account that is impacted despite the fact that she was aware of the situation, wanted to avoid the loss, and the market was still open at the time.
In another example of an ordinary plan transaction, a plan participant calls his or her intermediary at 11:00 am PST to rebalance their retirement investments. The intermediary requires 3 hours to process trades and therefore only orders received before 1:00 pm EST (and 10:00 am PST) will receive that day's trading price. Therefore, the plan participant is already too late to receive that day's trading price for their mutual fund orders. In addition, because rebalancing requires that some shares be bought and some shares be sold, this transaction could require several days to complete as the intermediary must wait for each day's trading price before completing the next step of the transaction. Thus, for an ordinary rebalancing transaction that the plan participant is encouraged to engage in at least annually (if not quarterly), the participant is disadvantaged by not receiving the same day's trading price for her transaction.
We do not believe that the SEC intended to disadvantage plan participants in this way. Even though plan participants are long-term investors, their decisions and transactions are impacted by daily occurrences and should not be negatively impacted by an SEC rule that makes them second-class investors.
Plan Fiduciaries Would Contend with an Unreasonable Burden
ERISA mandates that plan fiduciaries must exercise prudence and discharge to their responsibilities solely in the interest of plan participants. If they fail to properly discharge their fiduciary duties, they risk bearing liability for losses resulting from their failure. ERISA also requires that plan fiduciaries ensure that investment options are sufficiently diversified so as to minimize the risk of large losses. Without the proposed amendment, these duties generally work in tandem. The SEC proposal, however, creates a potential conflict for plan fiduciaries.
The proposed amendment will inevitably limit plan fiduciaries' ability to comply with the ERISA fiduciary diversification and prudence requirements for the following reasons: this rule would provide those products and those firms that offer only proprietary funds a significant competitive advantage as trades, purchases and liquidations will still be able to be made at "same day" pricing while the non-proprietary funds won't have this capability. A plan fiduciary may determine that participants are unduly disadvantaged by the restricted order requirements of the non-proprietary funds and that such restrictions are not prudent. However, by switching to proprietary funds, the fiduciary may feel that the investment choices are not diverse enough (since only the mutual funds owned by a bundled provider will be able to maintain an advantage under the proposed amendment). In this situation, a plan fiduciary may feel that he cannot satisfy one fiduciary duty without sacrificing the other. This decision places plan fiduciaries in an impossible situation.
In addition, for the reasons mentioned above, the proposed amendment increases the risks of complaints and lawsuits against the plan fiduciaries. If a fiduciary decides to move to a bundled provider in order to enable participants to get same day pricing and thereby protect the economic interest of plan participants, some participants may feel that their investment choices are not diverse enough. On the other hand, if a fiduciary stays with the unbundled services provider to provide maximum diversity, some participants may feel that they are being economically disadvantaged. In either situation, the fiduciary's ability to satisfy both duties is diminished and, consequently, the risk of liability is substantially increased. Similar to the disadvantaged plan participant, this situation arises not because of market forces, or lack of knowledge, but only because the proposed amendment creates an untenable dilemma.
The Proposal Encourages an Anti-Competitive Environment
The proposed amendment could encourage plans to use bundled providers and encourage participants to trade in the shares of the mutual funds owned by the bundled provider. Thus, the SEC proposal would create two tiers of anti-competitiveness within the retirement plan investment market.
First, the proposed amendment may encourage the use of bundled providers, which not only encourages an anti-competitive market, but also counters current industry trends. There is a growing movement in the retirement plan industry toward offering "open architecture" or "open brokerage windows" that allow plan participants to trade across a broad array of equities, mutual funds and other investment vehicles. In the mutual fund context, one of the best advantages of this open architecture is that it allows participants to compare a number of funds from a number of different fund families quickly and easily, using the parameters that are most important to them-historical performance, fees, management style and portfolio turnover, among others. As discussed above, if the proposed amendment is implemented, plan fiduciaries may determine that it is in the best interest of plan participants to move to a bundled provider. Thus, because of the proposal, the only intermediaries that could continue to effectively compete in the retirement plan market would be those that are bundled with a mutual fund. Consequently, unbundled providers would be driven out of the market place.
Second, the proposed amendment discourages competition among the mutual funds offered through a bundled provider. Because the bundled intermediary would still have to comply with the proposed amendment, only the orders placed for mutual funds owned by the bundled provider would be able to receive the same day's trading price until 4:00 pm. The timing for other mutual fund orders would be shortened in order to meet the processing requirements. Therefore, even though a bundled provider may offer mutual funds from other companies, plan participants would still be disadvantaged relative to other mutual fund traders unless they trade in the mutual funds owned by the bundled provider. Consequently, the proposed amendment would encourage participants to trade in particular mutual funds in order to avoid being disadvantaged. If competition in the mutual fund industry was severely reduced, higher investment management fees could result.
Again, in this instance, competition (or lack thereof) is not driven by market conditions or provider performance, but solely by the proposed amendment. The effects of the proposed amendment would become a significant factor for decision-makers in choosing among service providers and mutual funds.
Further Alternatives Must be Considered
In the retirement plan arena, the proposed amendment makes plan participants second-class investors, imposes unreasonable burdens on plan fiduciaries, and encourages a less competitive investment market. While we support the effort to curtail the illegal practice of late trading in the industry, we do not believe that unduly burdening participants and plan fiduciaries serves that goal. There are already laws in place to deal with late trading and creating more laws that negatively impact the innocent will not stop those who continue to trade illegally. We cannot emphasize enough our desire that the SEC use its power to enforce the laws and rules already in place in order to protect those who have been and continue to follow the law.
There are several ideas being considered that may help the SEC in its enforcement efforts. In October, the House passed H.R. 2420, which was introduced by Representative Baker (LA). This bill requires that all trades be received by 4 pm at either a mutual fund company or at an intermediary. This legislation would require the intermediaries to implement tamper-proof, verifiable systems and procedures to prevent late trading and subject such procedures to annual audits. Similar legislation has been introduced in the Senate. Also, there are ideas of securing carve-outs or exemptions from the proposed amendment for employer-provided retirement plans. For example, liquidation transactions might not meet the expectations of plan participants if they are subject to the requirements of the proposed amendment. A liquidation transaction involves a distribution for retirement, a loan, or a hardship withdrawal. In all of these instances, plan participants depend upon the distribution for a certain purpose and any change in the expected amount of the liquidation could upset the plans of the participant. For this reason, allowing liquidation transactions to receive the same day's trading price if it is sent to any intermediary before 4:00 pm would alleviate undue anxiety to plan participants. Another idea, referred to as the "Smart 4," builds upon the proposed amendment and would require any entity that wishes to receive orders up until 4:00 pm to implement certain technological and procedural processes. The SEC or its designee would have to certify that the entity-a mutual fund company, an intermediary, or a transfer agent-has met the requirements before it could be permitted to receive orders until 4:00 pm that would receive the same day's trading price. Any entity that chooses not to comply would operate under the proposed amendment.
All of these alternatives, however, still raise concerns among different parties about issues such as jurisdiction, the practicalities of implementation, and the fairness of the rules. These alternatives and the concerns surrounding them demonstrate that there are many issues still to consider. The Chamber believes that all dealers of mutual funds, including mutual fund companies, should be subject to the same set of rules and restrictions, particularly since evidence of abuse was found within the mutual fund companies. Rather than singling out or favoring certain service providers and fund families, we recommend that the use of technology be given serious consideration. As we understand, the technological capability exists and can be readily implemented to ensure a tamper-proof timing system that would ensure that investors are making mutual fund purchases in compliance with the rules governing such purchases and the integrity of information within the trade, as well as the timing of the trade.
Our members will be impacted in different ways by whatever proposal is eventually adopted and, while there may not be agreement on a final answer at this point, there is definitely a consensus that drastic changes should not be made without careful and deliberate consideration of the impact of such changes and the availability of alternatives.
The integrity of the mutual fund industry is important to the employer-provided retirement plan system. The Chamber fully condemns those parties that have acted illegally in these recent scandals and encourages action that will deter such activities in the future. At the same time, it is of paramount importance that rules and requirements imposed upon governing the practices of the mutual fund industry be given careful consideration for their potential impact upon retirement plan sponsors and participants.
We sincerely appreciate your consideration of these comments.