Speech by SEC Staff:
Redemption Fees for Redeemable Securities
Opening Statment at March 3, 2005 Open Meeting
Paul F. Roye
Director, Division of Investment Management
U.S. Securities and Exchange Commission
March 3, 2005
Thank you, Mr. Chairman. Good morning, Commissioners:
The Division of Investment Management is recommending today that you adopt new rule 22c-2 under the Investment Company Act. The rule would permit, but not require funds to impose a fee in connection with the redemption of fund shares. The rule is intended to allow funds to recoup the costs they incur as a result of short-term trading strategies, such as market timing. These costs include administrative and processing costs, as well as transaction costs from liquidating portfolio positions to meet redemptions. Short-term trading can also disrupt a fund’s stated portfolio management strategy, require maintenance of an elevated cash position, result in lost investment opportunities and adversely affect a fund’s performance.
Frequent traders include market timers, who attempt to purchase and redeem fund shares to take advantage of market movements they believe will occur in the future. Other types of market timers attempt to more directly take advantage of the fund's long-term shareholders by exploiting how funds calculate their net asset value. These "arbitrage market timers" buy and sell shares of funds if they believe that the fund's calculation of net asset value significantly lags behind the current value of a fund's portfolio securities, typically in international funds or other funds that invest in thinly traded securities. Over time, the long-term shareholders in a fund will, in effect, pay the costs of the short-term shareholders' transactions and have the value of their fund shares diluted through the activity of arbitrage market timers. Unfortunately, over the past year and a half, we have seen far too many instances of inappropriate market timing of fund shares.
The Commission has attacked the problem of abusive market timing on multiple fronts.
- Enforcement. First, the Commission has brought a series of enforcement actions against fund advisers that have facilitated market timing in violation of fund policies, as well as against broker-dealers and other intermediaries who have used elaborate schemes to conceal their customers’ market timing from funds that were trying to enforce their policies against such activity.
- Disclosure. Second, the Commission has required funds to disclose with more specificity in their disclosure documents the risks of short term trading of fund shares and the fund’s policies and procedures with respect to market timing, as well as the fund’s policies regarding fair value pricing of portfolio securities.
- Compliance. Third, the Commission required funds to adopt written policies and procedures reasonably designed to ensure compliance with the fund’s disclosed policies regarding market timing, including monitoring shareholder trades to determine the extent of market timing activity. The Commission also expects funds to adopt effective policies and procedures on fair value pricing, which can eliminate or minimize the opportunities for arbitrage market timing. Each of these policies is now overseen by a chief compliance officer reporting to a fund’s board of directors.
Last year you also proposed a rule that would have required funds to impose a mandatory two percent redemption fee on shares an investor redeemed within 5 days after purchase. At the time you noted that redemption fees were not the sole solution to preventing market timing, but that redemption fees, particularly when used in combination with measures such as fair value pricing, could be an effective deterrent to short term trading in fund shares.
We received approximately 400 comment letters on the proposal. Most investors did not like the proposed mandatory redemption fee and thought it would penalize many shareholders who were not engaged in market timing. Funds were divided on whether the Commission should adopt a rule mandating the imposition of redemption fees. With respect to omnibus accounts, funds and intermediaries generally recognized the need to address the persistent problem of excessive trading in omnibus accounts.
While we continue to believe that redemption fees are an important component to reducing or eliminating shareholder dilution that results from excessive short term trading, we are not recommending you adopt a rule requiring mandatory redemption fees. We are persuaded by commenters that not every fund needs a redemption fee, and those that do, may not need to impose a redemption fee of two percent.
Instead, we recommend that you adopt rule 22c-2, which would require a fund’s board of directors either to approve a redemption fee or to determine that a redemption fee is not necessary for the fund. Therefore, the rule would leave the decision regarding whether a redemption fee is appropriate to those in the best position to make that decision -- the fund directors.
While many funds currently rely on staff no action positions to impose a redemption fee, this rule would not simply codify the status quo. Instead, it would require every fund board to affirmatively consider whether a redemption fee is appropriate to protect the fund’s investors. The rule also would require funds to enter into written agreements with fund intermediaries that would enable funds to obtain data on shareholders who trade through omnibus accounts and require intermediaries to enforce the fund’s market timing restrictions against shareholders violating fund market timing policies through these accounts. We believe that these requirements will give funds the necessary information to monitor all trading activity in the fund, and tools to apply market-timing restrictions consistently to shareholders who invest directly with the fund, as well as shareholders who invest through omnibus accounts.
While we believe the voluntary redemption fee approach has significant advantages over a mandatory redemption fee, we are nonetheless concerned that it may not solve the most pressing problem that led us to recommend a mandatory fee, that fund intermediaries may continue to refuse to impose redemption fees on shareholders who own shares through omnibus accounts.
To address this problem, we recommend that you ask for additional comment on whether the Commission should adopt uniform parameters for a redemption fee. Under this approach, a fund would not be required to adopt a redemption fee, but if it did, the terms of the redemption fee would have to conform to certain standards. For example, we recommend you ask for comment on standards such as how to determine the duration of time the shareholder has held shares, i.e., FIFO or LIFO methodology; whether to permit an exception for a redemption of a small amount, or an exception for financial hardship. We believe that a uniform standard would decrease intermediaries’ costs of imposing redemption fees, and therefore encourage more intermediaries to assess them. A uniform standard would have the added benefit of allowing investors greater ability to compare the cost of investing in different funds, and promote greater certainty as to when to expect that a fund will impose a redemption fee.
In conclusion, we believe the rule we recommend you adopt today will be of significant benefit to funds in their effort to thwart abusive market timing activity. We also believe it is appropriate for the Commission to request additional comment on further steps the Commission might pursue to encourage intermediaries that sell fund shares to implement a fund’s redemption fee policies.
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I would like to thank the staff in the Division of Investment Management who worked on this rulemaking as well as acknowledge the assistance of Jonathan Sobokin and Harvey Westbrook in the Office of Economic Analysis, and Giovanni Prezioso, Arthur Laby, Uzma Wahhab, and Lori Price in the Office of General Counsel. Thank you and I will now turn it over to Penelope Saltzman to explain the details of the rule.