Jonathan Katz, Secretary
Re: Proposed Rule: Amendments to Rules Governing Pricing of Mutual Fund Shares, File No. S7-27-03
To the Commissioners:
I submit this comment letter on the above-captioned rule proposal. I was previously the Commission's Assistant General Counsel for Market Regulation, and later I was General Counsel for a major national broker-dealer that was one a pioneer in establishing mutual fund supermarkets. I submit this comment letter solely on my on behalf, and not on behalf of any client, my law firm, or any partners or associates at my law firm.
Late trading of mutual funds violates well-established existing law. The Commission, state securities regulators, and state and federal criminal authorities can and should be appropriately harsh in sanctioning firms and individuals that intentionally allow mutual fund orders to be placed after the close of trading for the purpose of arbitraging that day's calculated net asset value. Such sanctions, together with a rigorous Commission examination program, will effectively deter future violations of the late trading rules. The fact that until the past six months, the Commission had never inspected anyone for late trading, much less sanctioned anyone for late trading, goes far to explain the current mutual fund scandal.
The reason late trading is harmful, and the reason late trading is illegal, is because late trading gives some traders an unfair informational advantage over all other market participants. When a few traders are permitted to place orders with knowledge of events occurring after the close of trading (for example, the issuance of post-closing earnings releases), they will be able to profit systematically at the expense of other market participants who must place their orders without that knowledge.
The fundamental and fatal problem with the Commission's proposal here is that it would have the effect of institutionalizing exactly this kind of informational advantage. Today, the overwhelming majority of ordinary retail investors place their mutual fund orders through brokerage firms or 401(k) plans. Under the Commission's proposal, ordinary retail investors who invest through brokerage firms will have to place their orders some two hours before market close in order to get that day's NAV. 401(k) participants will have to place their orders even earlier (possibly even the previous day). By contrast, large sophisticated institutional investors will be able to open accounts and establish electronic linkages directly with multiple mutual fund companies, and therefore will be able to place their mutual fund trades right up until 4:00 PM. This proposal will put retail investors at a permanent and substantial disadvantage.1
Often market-moving news occurs in the final two hours of trading. The events of January 28, 2004, when the Federal Reserve Board issued a statement at 2:00 PM EST changing its interest rate outlook, is a perfect (but not uncommon) example. The Fed's announcement moved all major stock index averages by several percent in the final two hours of trading. Under the Commission's proposal, ordinary retail investors trading through brokerage firms would have had to place all mutual fund orders for the day before that news became public. Sophisticated institutional investors, who had already established accounts and direct electronic links with mutual fund companies, could have traded based on that information until 4:00 PM.
If you give sophisticated institutional investors a systematic informational advantage over ordinary retail investors, the institutional investors will be able to profit based on that informational advantage. The Commission's proposal will create arbitrage opportunities far more pervasive and far more harmful than the relatively rare late trading opportunities that a few bad actors were able to exploit under the existing rules.2
I do not mean to suggest that late trading is not a problem or that no regulatory response is required. I support the Commission's proposed alternative approach: (1) electronic time stamping of orders to ensure that they are received by intermediaries (such as broker-dealers) before 4:00 PM, (2) annual sworn certifications by intermediaries of their procedures to ensure that no orders are accepted after 4:00 PM, and (3) annual independent audits of the intermediaries' procedures to ensure that the procedures to prevent late trading are effective and are being followed. I suggest an important fourth prong to this approach - regular Commission inspections of the mutual fund order-entry procedures of all intermediaries permitted to accept orders up to 4:00 PM and transmit them to fund companies thereafter. Even for non-broker-dealer intermediaries (such as banks and 401(k) plan providers), since the intermediaries are acting as agent of Commission-registered funds when they accept orders on behalf of those funds, I believe the Commission can legitimately condition the right to process trades after 4:00 PM on consent to Commission inspections. This approach will be effective in preventing late trading, without creating any of the systematic informational disadvantage to ordinary retail investors that the Commission's preferred proposal would create.
Until a few years ago, the homepage of the SEC's website prominently featured a quote from former SEC Chairman and Supreme Court Justice William O. Douglas: "We are the investor's advocate." Today, that quote no longer appears. This proposal perhaps illustrates why the Commission felt the quote needed to be removed - the proposal advocated by the Commission will systematically and permanently harm ordinary retail investors. I urge the Commission to reverse course, adopt its more sensible alternative, and allow all investors to remain on a level playing field with regard to mutual fund order-entry cutoffs.
W. Hardy Callcott