The Vanguard Group, Inc.
February 6, 2004
Jonathan G. Katz, Secretary
Re: Proposed Amendments to Rule 22c-1 Relating to
Dear Mr. Katz:
The Vanguard Group, Inc. ("Vanguard")1 appreciates the opportunity to comment on the Securities and Exchange Commission's recent proposal to amend rule 22c-1 under the Investment Company Act of 1940, which governs the pricing of mutual fund shares. The Commission's proposal would amend Rule 22c-1 to provide that an order to purchase or redeem fund shares would receive the current day's price only if the fund, its designated transfer agent, or a registered securities clearing agency receives the order by the time that the fund establishes for calculating its net asset value, typically 4 p.m. Eastern Time. 2
1. Reports of unlawful late trading by intermediaries and consequences.
As noted in the Proposing Release, investigations by Commission staff and state securities authorities revealed instances of late trading of mutual fund shares by intermediaries in violation of the Commission's fund pricing rules. The Commission's rules permit intermediaries to transmit purchase and redemption orders to mutual funds after 4 p.m. for receipt of the current day's price, provided those orders were received by the intermediary from underlying customers prior to 4 p.m. Unfortunately, it has been discovered that certain intermediaries engaged in illegal late trading by submitting mutual fund orders for current-day pricing that were not properly received from customers prior to the required 4 p.m. cutoff.
Intermediaries that are found to have engaged in unlawful late trading activities face serious business and legal consequences. These include market repercussions for their highly publicized illegal actions as well as civil and even criminal sanctions under federal and state laws, and possibly legal actions by funds to recover damages for breach of their intermediary agreements.3 Presumably, the market fallout and vigorous civil and criminal enforcement will be important deterrents to late trading by intermediaries in the future.
2. Commission's proposed rule and request for comments.
While intermediaries that engage in unlawful late trading face severe consequences, the Commission has determined that more must be done to eliminate the possibility of late trading and restore the trust and confidence of mutual fund investors. Vanguard applauds the Commission in its efforts to prevent late traders from unfairly and illegally profiting at the expense of other mutual fund investors.
To eliminate late trading through fund intermediaries, the Commission proposes to require that all purchase and redemption orders be received by the fund, a single transfer agent designated by the fund, or a registered clearing agency no later than 4 p.m. in order to receive the current day's price. Under this proposal, fund intermediaries would be required to submit orders to the fund before 4:00 p.m. to receive the current-day price, and orders submitted after the 4 p.m. close would receive the following day's price.
The Commission seeks comments on the costs associated with its proposal and whether they are justified by the benefits. The Commission also seeks comment on alternative proposals that would allow intermediaries to continue to submit orders to funds after 4:00 p.m. provided the intermediaries have adopted enhanced protections designed to prevent late trading.
1. Vanguard supports the Commission's proposal as a first step to eliminating intermediary late trading.
Vanguard agrees with the Commission that, in light of the findings of late trading by certain intermediaries, strong measures are needed to protect the interests of mutual fund investors. This matter is of great importance-and considerable complexity. There is a pressing need to eliminate as soon as practicable the possibility of late trading and restore the confidence of mutual fund investors. At the same time, however, that need must be balanced against the risk of imposing undue, unfair and unnecessary burdens on scores of intermediaries, including broker-dealers, banks, trust companies, and retirement plan recordkeepers, that properly process mutual fund trades on behalf of millions of underlying clients.
Vanguard believes that the Commission's proposal will enforce the "hard" 4 p.m. cutoff for mutual fund trades that Vanguard and others in the fund industry have so strongly advocated.4 As such, the proposal represents an appropriate and effective way to accomplish the immediate goal of eliminating late trading by fund intermediaries and restoring the confidence of mutual fund investors.5
2. Vanguard recommends that the Commission continue studying enhancements that would allow intermediaries to transmit current-day fund orders after 4 p.m.
As recognized in the Proposing Release, the Commission's proposal will likely require substantial and costly changes in the way fund intermediaries process fund orders. Intermediaries will need to make major upgrades to their computer systems and possibly other significant changes to their technological infrastructure. And intermediaries will likely need to require clients to submit their purchase and redemption orders several hours in advance of the 4 p.m. cutoff to allow intermediaries time to process the orders before submitting them to the fund.
The Commission's Proposing Release also recognizes that, in the case of firms that provide recordkeeping services for 401(k) and other defined-contribution retirement plans, many firms will be required to process fund purchase, exchange and redemption directions by participating employees on a next-day basis. This would undermine the improvements that have been made to daily valuation recordkeeping systems for retirement plan investments in mutual funds over the past twenty years.
Vanguard agrees with the Commission that, while the burdens on fund intermediaries of complying with the rule may be substantial, the burdens on most fund investors should be small since they tend to make longer-term investments. Nevertheless, Vanguard is concerned that sponsors of 401(k) and other defined-contribution retirement plans may not share that perspective. To the extent that the Commission's proposal necessitates next-day processing for mutual fund investments, certain 401(k) plan sponsors may respond by shifting their plan's investments from mutual funds to alternative products, such as collective trust funds and separate accounts, that are fully compatible with daily valuation recordkeeping systems but would not be subject to the Commission's fund pricing rules. Surely it would be an unfortunate consequence if a rule intended to protect mutual fund investors results in millions of participating employees in 401(k) plans being driven to investment products that are far less regulated than mutual funds.6
For these reasons, Vanguard recommends that the Commission carefully consider alternative proposals that would allow funds to authorize intermediaries to transmit current-day orders after 4:00 p.m. under strict conditions that would not expose the funds to any meaningful risks of unlawful late trading. Again, Vanguard supports the Commission's proposal as the first step to eliminating the possibility of illegal late trading in the immediate future and restoring the confidence of mutual fund investors. However, the Commission should continue to carefully consider alternative proposals that would protect mutual fund investors while avoiding the disruptions to intermediaries and potential disincentives to using regulated investment companies.
3. Vanguard recommends that, if the Commission allows intermediaries to transmit current-day orders after 4 p.m., the Commission should impose strict requirements to protect funds from unlawful late trading.
If the Commission should decide to allow funds to authorize intermediaries to transmit current-day orders after 4 p.m., Vanguard recommends that the Commission impose strict requirements on these arrangements to eliminate any significant risks of illegal late trading. In Vanguard's view, these requirements should include the following:
Vanguard believes that these additional requirements, combined with vigorous civil and criminal enforcement actions for violations of the Commission's fund pricing rules, would be effective in eliminating any meaningful risks of illegal late trading of fund shares by intermediaries.
4. Vanguard recommends that the Commission confirm the application of the amended rule to orders by 401(k) participants entered on defined-contribution recordkeeping systems maintained by designated transfer agents.
Vanguard believes that there are two important issues requiring clarification under the Commission's proposal with respect to mutual fund firms that provide recordkeeping services for 401(k) and other defined-contribution retirement plans. These issues are of immense importance, since participating employees have investments of well over $700 billion in 401(k) plans that are administered by mutual fund firms.
i) When the entity serving as the fund's designated transfer agent provides recordkeeping services for 401(k) plans, would receipt by that entity of directions by participating employees to purchase or redeem fund shares in their 401(k) accounts be considered orders received by the designated transfer agent for purposes of rule 22c-1?
Many mutual fund firms provide participant-level recordkeeping services for 401(k) and other defined-contribution retirement plans. These services generally require firms to maintain sophisticated defined-contribution recordkeeping systems, which are capable of establishing individual accounts for participating employees to reflect the different contribution types (employee pre-tax contributions, employer matching contributions, etc.) made to the plan on their behalf and the investment of those contributions in the investment options offered under the plan. It is commonplace for mutual fund firms to administer 401(k) plans that offer as investment options not only the firm's funds but also "outside" mutual funds sponsored by other fund firms (as well as other investments such as company stock, stable value investments, etc.).
It is Vanguard's understanding that most mutual fund firms maintain their defined-contribution recordkeeping system separate from their mutual fund shareholder accounting system (which maintains overall records of shareholder ownership). Since the defined-contribution recordkeeping system maintains records of participants' interests in their 401(k) plan accounts and the ownership interests of 401(k) plans in the funds, firms need only maintain omnibus accounts on their mutual fund shareholder accounting system for aggregate 401(k) plan holdings.
While the defined-contribution recordkeeping and mutual fund shareholder accounting systems may be separate systems, they are likely maintained by the same corporate entity that serves as the funds' designated transfer agent (or possibly an affiliated entity under the control of the designated transfer agent). Under current practices, it is possible that an order to purchase or redeem fund shares that is entered on the firm's defined-contribution recordkeeping system prior to 4 p.m. may not be reflected in the omnibus accounts on the firm's mutual fund shareholder accounting system until after 4 p.m.
The question raised is, if a fund's designated transfer agent receives and enters on its defined contribution recordkeeping system a direction by a participating employee to purchase or redeem fund shares in the participant's 401(k) plan account, would that be considered receipt of an order by the designated transfer agent within the meaning of proposed rule 22c-1(a)?
Vanguard submits that such a transaction literally satisfies the requirements of proposed rule 22c-1(a), since there is an order-i.e., a direction to purchase or redeem shares within the meaning of 22c-1(c)(3)-that is received by the entity serving as the fund's designated transfer agent. Since the principal objective of the proposed amendments to rule 22c-1 is to require the receipt of all fund orders by the fund's designated transfer agent (or Fund/SERV) by 4 p.m. to eliminate the possibility of late trading by third-party intermediaries and ensure the integrity of fund pricing, it should not make any difference whether the designated transfer agent receives the orders on its defined-contribution recordkeeping system or its mutual fund shareholder accounting system. The important point is receipt of the order by the entity that is in a position to verify that no late trades are submitted to the fund. It should not matter on which system the order is entered.
ii) When participating employees exchange amounts in their 401(k) plan accounts between a fund whose designated transfer agent is the plan's recordkeeper and an outside fund, may those exchanges be processed on a delayed, next-day basis if appropriate disclosures are made to participating employees?
As stated above, many mutual fund firms provide recordkeeping services for 401(k) plans that allow participating employees to invest not only in the firm's funds but also in outside mutual funds sponsored by other firms. In the case of outside mutual funds where the plan's recordkeeper is not the fund's designated transfer agent, it may be necessary under the proposed rule for the 401(k) plan to cut off participant directions at an earlier time in order to allow the recordkeeper time to process all purchase and redemption orders by participants and submit an aggregate purchase or redemption order to the outside fund's designated transfer agent (or Fund/SERV) by 4 p.m.
As a result, in the case of 401(k) plans administered by mutual fund firms that include outside funds, the plan may allow participating employees to enter current-day orders involving the recordkeeping firm's funds up to 4 p.m. but cut off orders involving outside funds at an earlier time. This in turn raises the question of how to treat directions by participating employees to exchange amounts between the recordkeeping firm's funds and outside funds that occur after the earlier cut-off time for the outside funds but prior to the 4 p.m. cut-off time for the recordkeeping firm's funds.
Vanguard would submit that in these situations it would be appropriate to process these types of exchange orders on a delayed, next-day basis if appropriate disclosures are made to participating employees. This would be consistent with previously expressed views of the Commission's staff on the ability of funds to make exchange offers on a specified delayed basis provided that there is full and clear disclosure. See Investment Company Institute (Pub. Avail. Nov. 13, 2002).
5. Vanguard recommends that the Commission expand the exception for conduit funds to include funds of funds within the same fund family.
The Commission's proposal includes an exception to the forward pricing requirements for conduit funds that rely on section 12(d)(1)(E) of the Investment Company Act. Vanguard strongly recommends that the Commission broaden this exception to cover funds of funds that are in the same fund family. Vanguard has eleven funds of funds, all of which invest in other Vanguard funds, but none of which rely on section 12(d)(1)(E).
Vanguard recommends that the Commission extend its current proposal to allow funds of funds registered under the Investment Company Act that invest in other registered funds within the same fund family to submit their orders based on the net asset value established by the other funds on the same day. This allowance should be granted to registered funds of funds within the same fund family regardless of whether they rely on a statutory exemption (such as sections 12(d)(1)(E) or (G)) or an exemptive order. Because an investor's order would have to be received by the fund of funds, its transfer agent or a registered clearing agency prior to 4 p.m., this broadened exception would not increase the potential for late trading.
6. Vanguard recommends that the Commission allow the fund's designated transfer agent to continue to hire service processors (for functions like lockbox services) who route processed orders after 4 p.m.
Vanguard recommends that the proposed rule be revised to continue to allow the fund's designated transfer agent to hire service processors to assist the transfer agent in carrying out its back office functions. Many fund transfer agents use banks or other service companies that are not registered as transfer agents solely to process incoming written orders and checks.
Vanguard urges the Commission to allow a fund's primary transfer agent to continue these "lockbox" arrangements since they do not raise any potential for late trading by intermediaries. These service providers are hired by the transfer agent to do its processing; they are not intermediaries that sell funds to clients. Allowing these arrangements to continue would provide flexibility to a fund's transfer agent and avoid forcing the lockbox processor to route all processed orders to the designated transfer agent for receipt by 4 p.m.
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Vanguard appreciates the opportunity to provide these comments on the Commission's proposal to amend rule 22c-1 governing the pricing of mutual fund shares. Vanguard would be happy to discuss these comments in greater detail with Commission staff or provide additional information that would assist the Commission in considering the proposed rule. Please do not hesitate to call me, or Sandra J. Burke, Senior Counsel, if you have any questions or would like additional information.
cc: John J. Brennan, Chairman and Chief Executive Officer