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U.S. Securities and Exchange Commission

Statement by SEC Staff:
Statement at Open Commission Meeting


Paul F. Roye

Director, Division of Investment Management
U.S. Securities and Exchange Commission

SEC Headquarters
Washington, D.C.
December 3, 2003

Thank you Mr. Chairman and good morning Commissioners.

We on the staff share the Chairman's, and the Commission's, concern and outrage over recent events involving the mutual fund industry and those who sell fund shares. With over 95 million Americans invested in mutual funds, it is critical that we do all that we can to protect their investments; indeed, this is our mission. That is why we are pleased to recommend a package of rulemaking initiatives for the Commission to consider this morning to address the immediate concerns regarding late trading, market timing and related abuses. We believe that this package — a recommendation that mutual funds and advisers be required to adopt and implement compliance procedures and controls and a recommendation to propose the late trading and enhanced disclosure rules — is a crucial and significant package that will significantly limit the potential for late trading, market timing and selective disclosure abuses, as well as provide funds, their directors and advisers the tools they need to root out these evils.

Late Trading Rule

First, I'd like to discuss the late trading rule.

Every day hundreds of thousands of investors purchase or redeem shares of mutual funds. The price they pay (or receive) turns on when the order is submitted and to whom. Typically, funds price their shares at 4:00 p.m. Investors submitting orders before 4:00 p.m. receive that day's price; investors submitting orders later get the next day's price. This is a simple, but very important rule known as "forward pricing." If you can buy shares after the 4:00 p.m. price is determined, based on the old price, you can profit from new information in the market place at the expense of other fund shareholders. It's just plain cheating, and something that clearly violates existing Commission rules.

Therefore, we are not here today to recommend that you propose a rule to make late trading unlawful. We are here today to propose that you amend the rules to shut the door on late trading in a way that makes all but certain it never happens again.

The problem is that the current rules permit a large number of intermediaries that accept or transmit trades in fund shares to determine whether the order will receive the 4:00 p.m. price. Typically, investor trades are accepted throughout the business day by fund transfer agents, as well as brokers, banks, and retirement plan administrators. They pass on orders to fund companies in batches at the end of the day after 4:00 p.m. They are only supposed to pass on orders they receive before 4:00 p.m. This system, which was first created 35 years ago, relies heavily on the honesty of fund intermediaries to segregate orders based on the time they are received and then playing by the rules.

We know today that this trust has been misplaced. In order to help favored customers, certain intermediaries have "blended" legitimate (pre-4:00 p.m. orders) with late trades (post-4:00 p.m. orders). In some cases, fund managers participated in the scheme; but in many cases they were the victims along with fund investors. The problem is that fund companies have no way of identifying a late trade when it is bundled with legitimate trades and submitted to the fund company in the evening hours. In some cases, late trading has been so well concealed that our examiners (and third party compliance auditors) have been unable to find it even when looking specifically for it. Many of our cases have been developed only as a result of a tip from an informant.

There are potentially enormous profits to be gained by late trading, and all of those profits come out of the pockets of mutual fund investors. Stopping it, in our view, will require strong medicine.

Therefore, we recommend that you propose amendments to rule 22c-1 that will require each purchase or redemption order to be received by (i) the fund, (ii) its transfer agent, or (iii) Fund/SERV, which is the clearing agency that processes many of the fund trades each day. Transfer agencies and Fund/SERV are regulated by the Commission, and operate large automated systems that would be difficult to corrupt. We believe that this amendment will provide for a secure pricing system that will be highly immune to manipulation by late traders.

We recognize that this change will impose costs. Brokers and other intermediaries will likely impose earlier deadlines on customers (e.g., 2:00 p.m.) to permit them to process trades. And some pension plan administrators may have to move to a T+1 system that will not permit beneficiaries to make trades until the following day. But we believe that competition among intermediaries will, over time, move the deadline closer to 4:00 p.m. as trading systems are improved. Moreover, investors for whom it is important to submit trades close to 4:00 p.m. will seek out those many fund groups that permit shareholders to submit orders directly to fund transfer agents.

A substantial number of mutual fund investors, however, will not notice these rule changes. Many make their investments through automatic purchase payment programs. Which day payment arrives is to them a random event. All mutual fund investors, however, will benefit from the elimination of late trading, and the confidence of knowing that a favored few cannot take advantage of them.

Before we take your questions on this recommendation, I would like to thank, in particular, the staff who worked on the late trading rule: Bob Plaze, Hunter Jones, Penelope Saltzman and Adam Glazer.

Compliance Rule

The second matter before you today is an adoption of a rule under the Advisers Act and one under the Investment Company Act that would require registered advisers and investment companies to:

  • Adopt compliance policies and procedures,
  • Review them annually for their continued effectiveness, and
  • Appoint a chief compliance officer responsible for administering them.

You proposed these rules not in response to the current scandals that are now unfolding, but in an effort to forestall problems in the money management industry by requiring advisers and funds to develop strong compliance programs. The discussion of the need for the rule-set forth in the proposing release-presaged many of the issues the Commission is confronted with today in its busy enforcement calendar. Many of these cases illustrate the damage that can result when compliance breaks down.

Let me focus for a moment on the proposed mutual fund rule. Today, we expect funds to have compliance policies and procedures, and several of our rules require them in specific instances. But there is no requirement that they have a comprehensive set of policies and procedures that address the myriad of compliance issues that arise. This rule, which was supported by most commenters, remedies this situation.

We don't recommend that you specify the types of procedures that every fund group adopt. Fund groups are too varied for a one-size-fits-all approach. Instead, the release explains that the policies and procedures should be designed to prevent violation of the securities laws, detect violations when they occur, and correct promptly violations that have occurred.

We do, however, recommend that you take the opportunity in the adopting release to review the application of the policies and procedures to several important areas of current concern to the Commission and mutual fund investors:

  • Fair Value Pricing. Funds must adopt fair value pricing procedures designed to eliminate the time zone arbitrage opportunities that have led to so much of the current problem with market timers. In 1984, the Commission first identified the issue, which the Division again brought to the attention of mutual funds in 2001, that when prices of securities become stale or unreliable, funds have an obligation to re-price.

  • Insider Trading. The Draft Release makes clear that selectively divulging information about the fund portfolio-except under circumstances where that information is protected against misuse-can facilitate insider trading, and that funds must have policies and procedures to guard against it.

  • Market Timing. The Draft Release makes clear that funds must have policies and procedures reasonably designed to ensure compliance with the fund's disclosed policies regarding market timers. These procedures should include monitoring shareholder trades (or cash flows) to detect timing activity, and prevent any waivers from being granted for the benefit of fund insiders.

As you know, the boards of directors of mutual funds play a central role under the federal securities laws in protecting fund investors' interests. They play a similar role in the rule we recommend you adopt. First, the board-including a majority of independent directors-must approve the policies and procedures of the fund.

Second-and this is perhaps the most important aspect of the rule we are presenting you with-the rule requires that the fund have a chief compliance officer who reports directly to the board, who serves at the pleasure of the board, and whose compensation is controlled by the board.

We've crafted the rule to promote the independence of these compliance officers, and create a direct line of communication between the directors and the chief compliance officer. In too many of the cases we are now seeing, the board was shut out of critical information about compliance breakdowns. In several cases, fund compliance officers had raised red flags that were ignored by management. Why didn't they go to the fund boards?

I don't have the answer to that question. But the rule opens up a direct line of communication and responsibility to the board designed to promote "up the ladder" resolution of compliance issues that management fails to address. In addition it would protect compliance officers by making it unlawful to unduly influence or coerce the chief compliance officer.

We've tried to think of the ways we could ensure the independence of compliance officers while maintaining their effectiveness. You may benefit from additional ideas. So we recommend that you extend the comment period for an additional 30 days to give others an opportunity to give us their additional thoughts. We'll try to come back to you as soon as possible so that we might have any changes in place by the date the rules would go into effect.

In this regard, the release would require funds to have their compliance programs and chief compliance officers in place within 9 months of publication in the federal register.

Before turning to you for any questions you might have, I would like to thank Bob Plaze, Jamey Basham and Hester Peirce, all of whom worked diligently on this rulemaking.

Disclosure regarding Market Timing, Selective Disclosure and Fair Value Pricing

The Division is recommending that the Commission propose amendments to its registration forms to require better and more explicit disclosure with respect to the tools that mutual funds use to combat market timing activity. Again, the Commission's investigation thus far has revealed market timing abuses including the overriding of stated market timing policies by fund executives to benefit large investors at the expense of small investors or to benefit the fund's investment adviser or its employees. These recommended proposals are intended to enable investors to assess a mutual fund's practices regarding frequent purchases and redemptions of fund shares to determine if they are in line with their expectations.

First, the recommended proposals would require a mutual fund to describe in its prospectus the risks, if any, that frequent purchases and redemptions of fund shares may present for other fund shareholders.

Second, the recommended proposals would require a mutual fund to state in its prospectus whether or not the fund's board of directors has adopted policies and procedures with respect to frequent purchases and redemptions of fund shares. If the board has not adopted any such policies and procedures, the proposals would require the fund to state the specific basis for the view of the board that it is appropriate for the fund not to have such policies and procedures.

Third, the proposals would require a mutual fund to describe with specificity any policies and procedures for deterring frequent purchases and redemptions of fund shares, and any arrangements to permit frequent purchases and redemptions of fund shares. This description of a fund's policies and procedures would be required to include any restrictions imposed by the fund to prevent or minimize frequent purchases and redemptions, including, for example, any restrictions on the volume or number of purchases, redemptions, or exchanges that a shareholder may make, any exchange fee or redemption fee, and any minimum holding period that is imposed before an investor may make exchanges into another fund. A fund would be required to indicate whether each restriction applies uniformly in all cases, or whether the restriction will not be imposed under certain circumstances, and to describe any such circumstances with specificity. Finally, the recommended proposals would require similar disclosure in prospectuses for insurance company separate accounts offering variable insurance contracts, with respect to frequent transfers among sub-accounts.

The recommended proposals also would amend instructions to the Commission's registration forms to clarify that all mutual funds and insurance company managed separate accounts that offer variable annuities (other than money market funds) are required to explain in their prospectuses both the circumstances under which they will use fair value pricing and the effects of using fair value pricing. As I noted earlier, fair valuation of a fund's portfolio securities, which is required under certain circumstances, can be effective in foreclosing the arbitrage opportunities available to market timers.

The Commission's investigations have indicated that some fund managers have made selective disclosure of their funds' portfolio holdings in order to curry favor with large investors. Consequently, the Division is also recommending that the Commission propose amendments intended to provide greater transparency of fund practices with respect to the disclosure of a fund's portfolio holdings, and reinforce funds' and advisers' obligations to prevent the misuse of material, non-public information. Specifically, the proposal that the Division is recommending would require a mutual fund, or an insurance company managed separate account that offers variable annuities, to describe in its Statement of Additional Information, or SAI, its policies and procedures with respect to the disclosure of its portfolio securities.

This description would also be required to include any ongoing arrangements to make available information about the fund's portfolio securities, including the identity of persons who receive information pursuant to any such arrangements and any compensation or other consideration received by a fund or its investment adviser in connection with such arrangements. The proposing release explains that a mutual fund or investment adviser that discloses portfolio holdings information may only do so consistent with the antifraud provisions of the federal securities laws and the fund's or adviser's fiduciary duty to fund shareholders. The fund's prospectus would be required to state that a description of its policies and procedures is available in its SAI, and, if applicable, on its website.

We believe that these new disclosure requirements will have the effect of requiring fund management to carefully assess the propriety and circumstances under which portfolio holding information is divulged, as well as inform fund investors of the fund's policies in this area.

I would like to take a moment to thank all of our hardworking staff who have worked so tirelessly on these form amendments. In particular, Susan Nash, Paul Cellupica, Kieran Brown, Sanjay Lamba, David Schwartz and Debbie Skeens. We would be pleased to answer any questions.



Modified: 12/04/2003