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Outline of Comments
on Proposed Form Amendments
Requiring Disclosure Regarding
Market Timing and Selective Disclosure
of Portfolio Holdings

March 19, 2004
S7-26-03
Prepared by:
Kieran G. Brown &
David S. Schwartz
Division of Investment Management

DISCLOSURE REGARDING
MARKET TIMING AND SELECTIVE DISCLOSURE
OF PORTFOLIO HOLDINGS

LIST OF COMMENTERS

Funds/Fund Directors/Insurance Companies/Investment Advisers/Financial Advisers

1. Applegate Investment Management, LLC Applegate
2. William L. Armstrong Armstrong
3. Charles Schwab & Co., Inc., Schwab
4. DH2, Inc. DH2
5. Enforte Financial Services LLC Enforte
6. Fidelity Investments Fidelity
7. J Lyons Fund Management, Inc. JLFM
8. Keystone Capital Management, Inc. Keystone
9. Lebenthal Asset Management Lebenthal
10. Dana Lyons D. Lyons
11. Joseph M. Madden Madden
12. Nationwide Financial Services, Inc. Nationwide
13. Pax World Management Corp. Pax
14. The Prescott Center for Adaptive Market Strategies Prescott
15. Spectrum Financial, Inc. Spectrum
16. State Street Bank and Trust Company State Street
17. Tandem Financial Services, Inc. Tandem
18. T. Rowe Price family of mutual funds T. Rowe Price
19. The Vanguard Group Vanguard
20. Victory Capital Management Victory
Professional and Trade Associations
1. American Council of Life Insurers ACLI
2. Association for Investment Management and Research AIMR
3. Committee of Annuity Insurers CAI
4. The Financial Planning Association FPA
5. The Financial Services Roundtable FSR
6. Investment Company Institute ICI
7. National Association for Variable Annuities NAVA
8. Securities Industry Association SIA
Brokers/Service Providers
1. 1^st Global Capital Corp. 1st Global
2. Investortools, Inc. Investortools
3. Morningstar, Inc. Morningstar
4. Pension Specialists, Inc. Pension Specialists
5. SSM Health Care SSM
Investor Advocacy Groups
1. Coalition of Mutual Fund Investors CMFI
Individual Investors
1. Artemus Anderkay Anderkay
2. Francis J. Batchelder Batchelder
3. Carl Bryan Bryan
4. Adrian Burbage Burbage
5. Dave DasGupta DasGupta
6. Mark Drury Drury
7. GCaveness@aol.com Gcaveness
8. Jonathan E. Gobble R.L.S. Gobble
9. Jon Green Green
10. Hunter Greer Greer
11. Joseph M. Harvey Harvey
12. John Hauer Hauer
13. Donald M. James James
14. Glen Kindley Kindley
15. Michael J. Langdon Langdon
16. Elizabeth Lebrie Lebrie
17. Douglas and Diane Nieman Nieman
18. Joseph Orr Orr
19. Alex Reddick Reddick
20. Michele Riccio Riccio
21. John Robbins Robbins
22. Rodney@brazosnet.com Rodney
23. Mark Sayers Sayers
24. Byron G. Settles Settles
25. David Sitko Sitko
26. Gorham Smith Smith
27. David Strange Strange
28. P. A. Thews Thews
29. James Thomas Thomas
30. Jeffrey Weiss Weiss
31. Tony Wen Wen
32. Wrbhb@aol.com Wrbhb
Attorneys
1. Sheldon Stein Stein
Academics
1. Ben Buckner, PhD. (1) Buckner 1
2. Ben Bucker, PhD. (2) Buckner 2
3. Edward Miller Miller

Table of Contents

Introduction
Discussion

OUTLINE OF COMMENTS ON
PROPOSED FORM AMENDMENTS REQUIRING DISCLOSURE
REGARDING MARKET TIMING AND SELECTIVE DISCLOSURE
OF PORTFOLIO HOLDINGS

I. INTRODUCTION

On December 11, 2003, the Securities and Exchange Commission (the "SEC" or "Commission") issued a release proposing form amendments under the Securities Act of 1933 (the "Securities Act") and the Investment Company Act of 1940 (the "Investment Company Act").¹ The proposed amendments would require enhanced disclosure about funds' policies and procedures relating to market timing and the selective disclosure of portfolio securities. Specifically, the amendments would:

Require mutual funds to provide enhanced disclosure about their risks and policies and procedures with respect to frequent purchases and redemptions of fund shares and require similar disclosure by insurance company separate accounts offering variable insurance contracts, with respect to frequent transfers among sub-accounts;
Clarify that all mutual funds (other than money market funds) and insurance company managed separate accounts that offer variable annuities 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; and
Require mutual funds, and insurance company managed separate accounts that offer variable annuities, to disclose their policies with respect to the disclosure of portfolio holdings information.

The comment period closed on February 6, 2003. The Commission received 70 comment letters that used the file number of the proposal (S7-26-03), including 20 from participants in the fund industry; eight from professional and trade associations; five from brokers and service providers; one from an investor advocacy group; 32 from individual investors; one from an attorney; and three from academics. Only 47 of these comment letters addressed the proposed disclosure requirements in some way; the rest addressed other issues related to restrictions on purchases and redemptions or the mutual fund scandals in general. The 47 comment letters that addressed disclosure issues generally supported the Commission's proposals to improve the disclosure provided to investors, although some expressed concerns regarding portions of the disclosure or suggested changes.

II. DISCUSSION

A. Disclosure of Risks and Policies and Procedures With Respect to Frequent Purchases and Redemptions of Fund Shares

Summary: The Commission proposed form amendments that would require mutual funds to disclose in their prospectuses both the risks to fund shareholders of frequent purchases and redemptions of fund shares and the fund's policies and procedures with respect to such frequent purchases and redemptions. The required disclosure would include a description, with specificity, of any policies and procedures for detecting and deterring frequent purchases and redemptions of fund shares (including redemption fees, exchange fees, and other restrictions), the circumstances, if any, under which any restriction will not be imposed, and any arrangements to permit frequent purchases and redemptions of fund shares. The proposals would require similar disclosure by insurance company separate accounts issuing variable annuity and variable life insurance contracts, with respect to frequent transfers among sub-accounts.

Forty-three commenters addressed whether the Commission should require disclosure of a fund's risks and policies and procedures with respect to frequent purchases and redemptions of fund shares. Forty commenters generally supported the concept of requiring this disclosure, although some expressed concerns regarding portions of the disclosure or suggested changes.² Supporters of the proposal generally argued that the disclosure would help investors to make a more informed investment decision. In addition, commenters argued that enhanced disclosure in the area of frequent purchases and redemptions was an important part of the necessary regulatory response to problematic trading in the mutual fund industry.³

Two individual commenters and one attorney opposed required disclosure of a fund's risks and policies and procedures with respect to frequent purchases and redemptions of fund shares.⁴ The first individual commenter argued that aggressively pursuing and making public examples of wrongdoers would be of more help to investors than adding more disclosure forms and other redundant paperwork.⁵ The second individual commenter argued that the new proposals would be at the expense of small investors, and urged the Commission to make sure the people paying for preventing abuses are the perpetrators, not the victims.⁶ The attorney proposed that the Commission instead require mandatory next-day pricing of mutual fund shares, because there is no way to monitor timing in intermediaries and the disclosure requirements could result in high compliance costs and boilerplate disclosure.⁷

1. Disclosure of Risks of Frequent Purchases and Redemptions

Five commenters specifically expressed support for the proposal to disclose the risks of frequent purchases and redemptions.⁸

2. Disclosure of Policies and Procedures With Respect to Frequent Purchases and Redemptions

A number of commenters disagreed with aspects of the proposal that would require funds to describe with specificity, among other things:

any policies and procedures of the fund for deterring frequent purchases and redemptions of fund shares; and
any policies and procedures of the fund for detecting frequent purchases and redemptions of fund shares.

Sixteen commenters were in favor of specific disclosure with regard to funds' policies and procedures for deterring frequent purchases and redemptions of fund shares.⁹ These commenters consisted of intermediaries, individual investors, and others. These commenters argued generally that ambiguous prospectus language used by funds should be replaced with clear guidance of what transactions are permitted and what are prohibited. Many of these commenters also argued that the proposals would help to ensure that restrictions are uniformly applied to all investors, and would ensure fairness and prevent game-playing by investment companies and investment advisers. One commenter also noted that the disclosure would provide a basis for comparing how funds define and deal with frequent trading.¹⁰

Seven commenters believed that the disclosure of policies and procedures for deterring frequent purchases and redemptions should be more general in nature.¹¹ These seven commenters were generally concerned that specific disclosure would create a roadmap for potential market timers attempting to avoid the restrictions, limit funds' flexibility in responding to changing tactics by market timers, and result in substantially more voluminous prospectuses that would be confusing to investors. One commenter also pointed out that fair value pricing is the most effective means to prevent the unfair dilution caused by excessive market timing activity,¹² and a second commenter noted that the specific procedures adopted are matters of internal compliance subject to rule 38a-1 under the Investment Company Act, and, accordingly, subject to board approval and review by the Commission.¹³

In addition to arguing against requiring specificity in the proposed disclosure, one commenter also recommended that funds be permitted to reserve limited discretion to impose greater restrictions on market timers than those in the fund's stated policies.¹⁴ The commenter recognized that treating particular investors differently from other shareholders may raise questions of fairness, and therefore it recommended that funds be permitted to reserve this discretion only if the board receives quarterly reports regarding all instances in which a fund has imposed a restriction on market timing activity more restrictive than that specified in the fund's policies and procedures. Another commenter also urged the Commission to clarify that a fund's management may exercise reasonable judgment in applying its disclosed policies and procedures and reserve the general right to revise such policies and procedures as circumstances change.¹⁵ The commenter argued that a fund may wish to impose additional restrictions or special transaction rules (such as requiring exchange requests to be in writing or paying redemption proceeds in kind) under certain circumstances and believed that new Rule 38a-1 under the Investment Company Act would effectively prevent the enhanced discretion from leading to inappropriate exceptions. A third commenter recommended that the Commission clarify that a fund may reject any trade for any reason.¹⁶ This commenter argued that the unpredictability that would result from this discretion is an element in a fund's defense against market timers.

With respect to the proposal that funds be required to describe with specificity their policies and procedures for detecting frequent purchases and redemptions of fund shares, three commenters recommended that funds not be required to make the disclosure,¹⁷ and three commenters argued that the disclosure should be kept at a very general level.¹⁸ The commenters who argued against requiring the disclosure or in favor of more general disclosure stated that disclosure of policies and procedures to detect market timing would be of marginal use to most investors and could prove harmful, by giving clues to market timers about how to time the fund without being caught.¹⁹ One of these commenters suggested that in lieu of requiring the disclosure, the Commission could require a fund to disclose whether its board of directors has adopted policies and procedures to detect such activity and determined that such policies and procedures are reasonably designed to accomplish their objective.²⁰

One commenter argued that funds should not be required to disclose the reason for the absence of a policy regarding frequent purchases and redemptions of fund shares.²¹ According to this commenter, disclosure of this type unnecessarily invites litigation that second-guesses business judgment. However, a second commenter argued specifically in favor of requiring such disclosure.²²

3. Disclosure of Arrangements to Permit Frequent Purchases and Redemptions

Three commenters specifically addressed the issue of whether funds should be required to disclose arrangements to permit frequent purchases and redemptions of fund shares.²³ One of these commenters argued that the proposal appears to be sanctioning special treatment for some shareholders as long as the arrangements are properly disclosed, and that the Commission should require that the same rules be applied to all investors.²⁴ The other two commenters argued in favor of more generic disclosure in order to make the disclosure less onerous to registrants,²⁵ and to protect the privacy rights of shareholders.²⁶ One of the two commenters argued that in cases where a fund has made arrangements with a defined contribution plan, rather than disclosing a lengthy list of persons that may conduct frequent trades, the fund should plainly describe the nature of the circumstances, including the identity of the plan, the magnitude of frequent trading, and an estimate of the cost to long-term shareholders.²⁷ Similarly, the other commenter argued that all an investor needs to know is if there are any others who are permitted frequent trading privileges, and roughly how important they are.²⁸ The commenter also argued that if the rule requires a long list of investors, it should be put in the "supplemental information" to save paper.

Another commenter opposed requiring the identification of all "market timers," arguing that (1) disclosure may be counter to the privacy laws; (2) it is not clear who should be considered a "market timer" (i.e., whether this should be based on frequency of trades, size of trades, percentage of fund assets being traded, etc.); and (3) since market timers are short-term investors and most funds update their prospectus only annually, the information would be stale and not useful.²⁹

4. Disclosure By Insurance Company Separate Accounts With Respect to Frequent Transfers Among Sub-Accounts

Six commenters expressly addressed the issue of whether insurance company separate accounts should be required to disclose their risks and their policies and procedures with respect to frequent transfers among sub-accounts.³⁰ All six were generally in favor of some form of disclosure requirement, but five requested that the Commission make revisions to the proposed amendments. The one commenter that did not request any changes to the proposed amendments with respect to variable insurance products noted that insurance company separate accounts that issue variable annuity and variable life insurance contracts provide a similar opportunity for market timers at the expense of long-term investors as do mutual funds.³¹

Each of the other five commenters argued that the proposal failed to take into consideration the two-tier nature of variable insurance arrangements, whereby a separate account is divided into sub-accounts, each of which invests in an underlying fund, which may or may not be affiliated with the sponsor of the separate account.³² One commenter argued that this two-tier arrangement militates in favor of more general prospectus disclosure, since the policies and procedures will be continually evolving and will not be consistent from one organization to another.³³ Two other commenters argued that the Commission should clarify that underlying funds are allowed to rely on the market timing policies and procedures of the separate account, because (1) the separate account has direct contact with the investor and is in a better position to monitor, address, and analyze market timing activity; (2) it would be difficult to administer the many different policies and procedures of the underlying funds; and (3) variable product issuers will be unable to support all of the different variations of underlying fund market timing policies and procedures and, accordingly, if the Commission does not permit underlying funds to rely on the policies of the separate account, underlying fund organizations will only be able to offer their funds through a limited number of variable product issuers.³⁴ One of these commenters also urged the Commission to amend General Instruction C.3(d) to Form N-1A to add new Item 7(e) to the list of items that may be omitted or modified by mutual funds that are used as bottom-tier investment options for variable contracts.³⁵

Of the five commenters that requested changes in the proposals, four also noted that variable insurance contracts are governed by state law and that changes in policies must by approved by state regulators.³⁶ Three of these commenters also noted that the arrangements are governed by contracts, which may have been drafted before market timing became an issue and may prevent insurers from making unilateral changes.³⁷ One of these commenters that is an association of variable insurers noted that several of its members have been told that any endorsement modifying existing contract rights will not be approved by state insurance departments.³⁸ In fact, this commenter argued, specific disclosure could actually serve to educate certain contract holders of their right to engage in market timing activity.

One of the five commenters that requested changes in the proposal also asked the Commission to clarify that the proposed amendments are not asking or encouraging funds to adopt and disclose policies and procedures that simply place arbitrary limits on frequent trades.³⁹ This particular commenter noted that in the variable annuity context frequent purchases and redemptions are normal and are rarely synonymous with abusive market timing. For example, contractholders may trade to dollar cost average investments, pay for systematic withdrawals of cash value or annuity payments, automatically rebalance fund allocations on a regular basis, or tailor the choice of investments to match an individual's changing financial circumstances. The commenter expressed concern that underlying funds would adopt specific limits on the frequency of trades irrespective of the omnibus nature of the trade orders submitted by the separate account and whether such trades are causing actual damage to the underlying fund.

One commenter addressed two other aspects of the proposals as they relate to insurance company separate accounts.⁴⁰ First, the commenter opposed requiring a discussion of the risks of frequent transfers for persons other than contractowners, noting that it did not see how the risks would be different for such persons than for contractowners and that a detailed discussion of the risks to such persons would detract attention from more relevant disclosures. Second, the commenter noted that insurance companies often enter into agreements with investment professionals that are frequently trading on behalf of multiple contractowners, and argued that the proposals should not require disclosure of these agreements, because they are intended to allow the insurance company to identify and monitor the activities of these professionals and to limit their activities, not to promote market timing. The commenter believed that privacy and confidentiality issues would be raised by such disclosure. In addition, the commenter pointed out that some insurers have entered into settlement agreements that permit contractholders to make frequent transfers, and the terms of these settlement agreements commonly specify that they be kept confidential.

5. Location of Disclosure About Frequent Purchases and Redemptions

Fourteen commenters specifically addressed the issue of where the disclosure should be made.⁴¹ Nine of these commenters expressed support for prospectus disclosure of all of the required information.⁴² Two of the commenters specifically explained their reason for supporting prospectus disclosure over disclosure in other documents, noting the ready availability of the prospectus and the comparative lack of availability of the SAI.⁴³ Two such commenters also suggested that if the Commission does not agree with their argument and deems the SAI to be the proper location for the disclosure, funds and separate accounts that choose to make the disclosure in their SAI should be required to post the SAI on a publicly accessible website.⁴⁴

Two commenters favored prospectus disclosure for most of the required information, but argued that disclosure of a fund's policies and procedures for detecting frequent trading activity is better suited for the SAI.⁴⁵ One of these commenters argued that disclosure of these particular policies and procedures is not as critical to investors as the other required disclosures.⁴⁶

One commenter supported a reasonable division between the prospectus and the SAI, arguing that the prospectus should convey essential points, including the definition and risks of frequent purchases and redemptions, the board's policies and procedures with respect to frequent purchases and redemptions of fund shares, and, if the fund accommodates frequent trading, a description of the persons/circumstances and the nature of the arrangement.⁴⁷

Another commenter argued that the prospectus should summarize the information called for in both the frequent trading and fair valuation proposals, but noted that in many cases, the operational details could be provided in the SAI.⁴⁸ The commenter urged the Commission not to abandon the use of simplified prospectuses and plain English and noted that SAI disclosure would both compel transparency and bring Securities Act liability that would have the effect of curbing abuses.

Finally, one commenter noted that if specific disclosure were required in the prospectus, funds would have to issue supplemental prospectuses whenever they want to modify or impose new market timing restrictions.⁴⁹ The commenter believed that this would inhibit funds from quickly responding to changing tactics of market timers.

6. Application of Disclosure to ETFs

Two commenters specifically addressed the application of the disclosure requirements to ETFs.⁵⁰ These commenters supported the idea of not requiring ETFs to make the required disclosures for the reasons set forth in the Proposing Release.

7. Miscellaneous Comments Relating to Disclosure of Frequent Purchases and Redemptions

Several commenters suggested that the Commission require additional disclosure with regard to frequent purchases and redemptions beyond that proposed. For example, one commenter argued that funds should be required to disclose the potential costs and burdens the restrictions impose on shareholders, why the restrictions were adopted, and the actual cost savings (if any) that shareholders will receive from such restrictions.⁵¹ Another commenter recommended that the Commission require a fund to disclose how it defines frequent purchases and redemptions, regardless of whether or not it has policies and procedures for combating such activity, and to require each fund to include in its annual shareholder report a letter from the compliance officer detailing the compliance officer's findings from the year just concluded - including market-timing violations - along with an overall assessment of the strength of the compliance function.⁵²

Another commenter argued that the activity dealt with in the proposal should not be described as market timing, but rather should be described as arbitrage.⁵³

Another commenter suggested that mutual funds that permit market timing should be required to provide a context for the proposed disclosure, such as an explanation of how and why some investors engage in market timing strategies and under what circumstances such strategies are allowed.⁵⁴ The commenter also encouraged the Commission to provide examples and general guidance in the final rule of the types of disclosure that would be acceptable and unacceptable.

B. Disclosure of Circumstances Under Which Funds Will Use Fair Value Pricing

Summary: The Commission proposed amendments to instructions to 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.

Seven commenters expressly addressed whether the proposed clarification regarding use of fair value pricing should be made.⁵⁵ All seven expressed support for the proposal, although each expressed concerns regarding portions of the disclosure or suggested changes. Three additional commenters only addressed the benefits of fair value pricing generally, with two commenters expressing support for fair valuation as an effective means of deterring market timing activity and one commenter expressing support for the Commission's efforts to reemphasize funds' obligation to fair value their securities under appropriate circumstances.⁵⁶ One additional commenter opposed significant changes affecting how mutual funds calculate prices, because such changes would result in only large investors being able to take advantage of arbitrage opportunities.⁵⁷

1. Specificity of the Disclosure

Six of the seven commenters that expressly addressed the issue of whether the proposed clarification should be made noted that the disclosure regarding fair valuation should not be too specific or detailed.⁵⁸ The seventh commenter that addressed the issue of whether the clarification should be made argued in favor of more specific disclosure, including why fair valuation is used; who actually conducts the fair valuation; what exact methods and calculation methodologies are used (and why the board selected the particular methods and vendors); the impact of fair valuation on investors, performance information, and portfolio values; the risks of fair value pricing; fair value errors that have been made by the fund; and the controls that are in place to control the fair value pricing process.⁵⁹

The six commenters that were concerned about too much specificity in the disclosure generally believed that disclosure with too much specificity might help arbitrageurs to identify circumstances in which they could take unfair advantage of a fund's pricing policies.⁶⁰ One also argued that limiting funds to specific formulas that can be changed only by registration statement amendments or supplements will almost certainly prove unworkable in volatile markets or business emergencies that require real-time judgment calls.⁶¹ Two of these six commenters argued that the Commission's proposals require disclosure of the appropriate amount of information, because funds are not required to disclose the methodology the fund uses to fair value its securities.⁶² Three of the other four commenters argued that the required explanation should discuss generally (1) the types of situations in which the fund may be likely to use fair value pricing;⁶³ or (2) the factors considered and the delegation of specific authority to the Fair Value Committee to make decisions.⁶⁴ The fourth commenter argued in favor of requiring additional disclosure regarding fair value pricing in a fund's SAI, including a description of the qualitative and quantitative factors that trigger a fair value pricing adjustment, a description of the manner in which an adjustment is made, an accounting of the number of days during the most recent fiscal year that the fair value-pricing policy triggered an adjustment, and an accounting of the number of days during the most recent fiscal year that the fair-value pricing adjustment changed the fund's net asset value by 5% or more.⁶⁵

One commenter also argued that funds should be permitted to disclose that they reserve the right to use measures and procedures to determine fair value in addition to those referred to in the registration statement.⁶⁶

2. Disclosure of "Effects" of Fair Value Pricing

One commenter noted that the Proposing Release included minimizing the possibilities for time-zone arbitrage as an example of appropriate disclosure in the case of a fund investing in overseas markets.⁶⁷ Therefore, the commenter believed that the proposal was intended to provide investors with information about the objectives of fair value pricing, not to require that funds guarantee the results of fair value pricing. The commenter recommended that the proposal be modified to require that funds briefly explain the objectives (rather than effects) of using fair value pricing.

3. Applicability to Money Market Funds and Other Types of Funds

Two commenters expressly addressed whether money market funds should be required to provide the fair value pricing disclosure.⁶⁸ These commenters supported the proposal to not require money market funds to make the required disclosure because money market funds are subject to their own detailed pricing requirements under Rule 2a-7 under the Investment Company Act.

One commenter addressed the application of the fair valuation disclosure proposal with respect to funds of funds.⁶⁹ The commenter requested clarification that a registered fund of funds may state in its prospectus that (1) it is entitled to rely on the NAV calculated by its underlying registered mutual funds; and (2) information about the use of fair value pricing by each such underlying fund is available in that fund's prospectus.

4. Location of the Disclosure

Four commenters addressed the location of the fair valuation disclosure.⁷⁰ Two of these commenters argued that the information is generally better suited for the SAI (where, according to one such commenter, the fund can be more specific, without burdening the prospectus with disclosure that may not be important for that type of fund), but that in cases where market timing is a more important issue, such as foreign stock funds that are subject to time-zone arbitrage, the information should be included in the prospectus itself.⁷¹ The third commenter argued that the circumstances under which the fund will fair-value price securities should be disclosed in general terms in the prospectus, but also suggested that a fund should fully disclose the circumstances under which the fund will fair-value price securities as well as the factors, policies, and procedures that govern the process in the "Significant Accounting Policies" section of the fund's annual shareholder report.⁷² The fourth commenter argued that the prospectus should summarize the required information, and operational details of specific procedures should be set forth in the SAI.⁷³

5. Miscellaneous Comments on Fair-Value Pricing

One commenter suggested that the Commission clarify both the pricing model that a fund should use when multiple estimates of fair value are available and the circumstances under which fair-value pricing would be required.⁷⁴

Another commenter argued that the aspects of the proposal and the compliance rule release adopted at the same meeting⁷⁵ that address when fair valuation of portfolio securities is required conflict with the plain language of Section 2(a)(41) of the Investment Company Act and should be withdrawn.⁷⁶

C. Disclosure of Mutual Fund Portfolio Holdings

Summary: The Commission proposed to require mutual funds and insurance company managed separate accounts that offer variable annuities to disclose in their SAIs their policies and procedures with respect to disclosure of portfolio holdings information. The amendments also would require disclosure of certain information about any ongoing arrangements to make portfolio holdings information available to any person, and would require a fund to state in its prospectus that a description of the policies and procedures is available in the fund's SAI, and on the fund's website, if applicable.

Fourteen commenters commented specifically on the proposed amendments relating to selective disclosure of portfolio holdings information.⁷⁷ All of these commenters supported the proposal to improve disclosures regarding selective disclosure of portfolio holdings; however, some commenters suggested clarifications of, or refinements to, the scope of the proposed disclosure requirements. Three commenters suggested that certain categories of persons, including subadvisers, service providers, and ranking and rating agencies, should be excluded from the disclosure requirements.⁷⁸ One commenter requested guidance concerning the disclosure of portfolio holdings selectively to the media. In particular, the commenter objected to the requirement that each media outlet receiving such information be disclosed in the prospectus. In addition, the commenter requested guidance on whether such information provided to media outlets should be subject to confidentiality agreements.⁷⁹ The commenter also suggested that the Commission clarify that providing performance-related information that is derived from a fund's portfolio holdings to data service providers would not be considered an arrangement subject to disclosure under the proposed disclosure requirements.

Two commenters objected to the proposed requirement to identify by name each recipient of information about a fund's portfolio securities.⁸⁰ These commenters stated that investors do not need to know the name of each and every recipient of such information, and that identifying each recipient by name could prove to be more burdensome than anticipated. The commenters suggested that the Commission clarify that a fund may identify by category (rather than by name) the persons who receive information about its portfolio holdings pursuant to ongoing arrangements.

In addition, four commenters argued that selective disclosure of the holdings of municipal securities funds to bond dealers increased market efficiencies and should be exempt from certain aspects of the proposed disclosure requirements.⁸¹ They argued that a fund should be able to provide a general statement that it has arrangements to provide portfolio holdings information to bond dealers, rather than being required to provide specific disclosure about the arrangements and the identity of the persons receiving the portfolio holdings information and that this type of disclosure should not be subject to a requirement for a confidentiality agreement.

One commenter argued that with respect to the requirement to identify persons who may authorize disclosure of a fund's portfolio securities, the Commission should clarify that a fund may identify these persons by category (e.g., executive officers of the fund, the fund's adviser, or other service provider) rather than by name.⁸²

Several commenters, while supporting the proposed amendments, suggested that the disclosure and regulation circumscribing disclosure of portfolio securities should be even more restrictive than that proposed. Two commenters suggested that the Commission mandate that any legitimate disclosure that departs from the fund's standard disclosure policy be subject to a confidentiality agreement and prohibit any arrangements that would allow a party, other than those managing the portfolio (as is common in subadvisory agreements), to trade on such information.⁸³ One commenter stated, however, that it opposed exclusion from the proposed disclosure requirements of any arrangements subject to a confidentiality agreement.⁸⁴ This commenter also urged the Commission to ban outright the practice of receiving compensation or other consideration in connection with the disclosure of information about a fund's portfolio securities.

One commenter stated that disclosure of policies relating to the disclosure of portfolio holdings was insufficient to address abuses. The commenter suggested that the Commission provide guidance concerning the duties of the fund's adviser and its board regarding (1) the decision to make selective disclosure to any recipient, and (2) the appropriate lag time before holdings are made publicly available.⁸⁵ The commenter suggested that the Commission, in its final rule, require advisers to obtain the approval of fund boards as to their policies with respect to the time lag of disclosure of portfolio holdings and disclose those policies to fund shareholders.

Two commenters supported extending Regulation FD to mutual funds, just as it currently applies to closed-end funds.⁸⁶ These commenters argued that to maintain investor trust, mutual funds should not be permitted to enter into discriminatory disclosure arrangements with favored investors, and that applying Reg. FD to mutual funds is necessary to provide a level playing field for release of portfolio information. However, three commenters specifically opposed expanding Regulation FD to cover mutual funds.⁸⁷ These commenters argued that the mutual fund selective disclosure problem is different from the problem addressed by Regulation FD, of unequal access to information for retail stock market investors, because there is no mutual fund secondary market. They also argued that including mutual funds in Regulation FD is unnecessary, because the proposed disclosure requirements, coupled with aggressive enforcement, and the Commission's new compliance rule 38a-1, should be an effective deterrent to unlawful selective disclosure.

With respect to the location of the proposed disclosure, four commenters supported the Commission's proposal to require disclosure of a fund's policies and procedures with respect to disclosure of its portfolio holdings in the SAI.⁸⁸ One of these commenters also recommended that if a fund chose to provide full or partial holdings disclosure to all shareholders via a website, a fund should be able to provide a link to the SAI (provided the SAI is itself posted on the website and the SAI discusses website disclosure policies) without requiring additional disclosure.⁸⁹ Another commenter argued that, to the extent a fund's portfolio disclosure policies and procedures are placed in a fund's SAI, the Commission should require that every mutual fund with a website provide investor access to the SAI on its website.⁹⁰

Finally, one commenter requested that the Commission confirm that posting of information to a website in any readable data format (for example, .pdf, .html, or .xml) would be considered public disclosure.⁹¹

D. Compliance Date

Summary: The Commission proposed to require that all new registration statements and all post-effective amendments to effective registration statements filed on or after the effective date of the amendments comply with the proposed amendments.

Five commenters specifically addressed the compliance date for the proposals.⁹² All five commenters recommended extending the compliance date to provide sufficient time to implement any new requirements, draft appropriate disclosure, and renegotiate participation agreements and make appropriate state filings (in the case of insurance company separate accounts). Three of these commenters suggested specific compliance dates. One commenter recommended changing the proposed compliance date to December 5, 2004, which is two months after the date that fund boards are required to have approved compliance policies and procedures satisfying the requirements of new rule 38a-1 under the Investment Company Act.⁹³ The commenter noted that the policies and procedures required under rule 38a-1 would include policies and procedures in the three areas covered by the proposed disclosure, and believed that a compliance date of December 5, 2004, would give funds sufficient time between obtaining board approval and filing registration statements that contain disclosures based on those policies and procedures. Of the other two commenters, one argued that the compliance date should be one year after the effective date,⁹⁴ and the other argued that the compliance date should be 90 days after the effective date.⁹⁵

Two commenters requested confirmation that revised disclosure to fulfill the proposed amendments could be filed as a post-effective amendment pursuant to Rule 485(b) under the Securities Act.⁹⁶

E. Cost/Benefit Analysis

There were no comments specifically related to the Cost/Benefit Analysis.

F. Paperwork Reduction Act Summary

There were no comments specifically related to the Paperwork Reduction Act summary.

G. Regulatory Flexibility Act Analysis

There were no comments specifically related to the Regulatory Flexibility Act Analysis. However, one commenter, in requesting an extension of the proposed compliance date, stated that the Commission should be mindful of the costs to small mutual funds of requiring successive disclosure changes, particularly in light of the increasing compliance costs that these funds now face.⁹⁷

H. Consideration of Effects on Efficiency, Competition, and Capital Formation

There were no comments specifically related to this section. However, one commenter argued generally that the Commission should modify the proposals to prevent any anti-competitive impact on insurance company separate accounts that issue variable insurance contracts.⁹⁸

I. Comments Unrelated to the Disclosure Proposals

Twenty-three comments did not address the disclosure proposals at all.⁹⁹ These included 17 commenters that expressed opposition to the imposition of minimum holding periods, redemption fees, or other restrictions on purchases and redemptions, on the grounds that such measures will hurt small investors or are too onerous.¹⁰⁰ Two of the commenters argued that the solution to the mutual fund scandals is to put the wrongdoers in jail;¹⁰¹ one commenter argued that the Commission and the industry will most likely enact reforms that will end up hurting small investors, and that investors should vote against every virtually every measure that comes before them, until management fees are reduced and managers enforce existing rules for all customers;¹⁰² one commenter stated that the T+3 clearing time for stock transactions is arbitrary and out of date and should be updated to T+1;¹⁰³ one commenter argued that the Commission should not allow mutual fund managers and brokers to trade in stocks in which they hold positions;¹⁰⁴ and one commenter recommended that the Commission define activity that is presumed to be market timing.¹⁰⁵

Seventeen commenters that addressed the disclosure proposals also offered other suggestions to deal with market timing issues, including ten that made arguments against the imposition of minimum holding periods, redemption fees, or other restrictions on purchases and redemptions similar to those made by commenters that did not address the disclosure proposals,¹⁰⁶ and one commenter that recommended that the Commission define activity that is presumed to be market timing.¹⁰⁷ These commenters also made the following arguments:

Three commenters were not in favor of imposing a uniform definition of frequent trading.¹⁰⁸ One such commenter believed that in general providing investors with more information is better than enforcing "one size fits all" rules.¹⁰⁹
One commenter urged the SEC to consider adding substantive authority in the area of Rule 11a-3 to provide additional flexibility to funds to impose additional restrictions on exchanges.¹¹⁰
Two commenters supported allowing, but not requiring, redemption fees greater than 2%.¹¹¹ One of these two commenters also argued that a fund's director of compliance should be required to design the fund's policies and procedures for deterring frequent trading and that the parties responsible for monitoring adherence to these policies and procedures should be required to report violations to the director of compliance.¹¹²
Three commenters noted that intermediaries must provide transparency to funds so that funds can take appropriate steps to prevent harmful market-timing activity.¹¹³ According to one of the commenters, relying on contractual arrangements is insufficient, because it is not in the economic interests of the intermediary to enforce mutual fund rules on its customers.¹¹⁴ Another of these commenters argued that intermediaries should be required by rule to enforce mutual fund restrictions.¹¹⁵
One commenter argued in favor of allowing retirement plans to establish one redemption restriction applicable to all available investment options, and urged the Commission to work with the Department of Labor and the Department of Treasury to develop "safe harbor" redemption restrictions for retirement programs.¹¹⁶
One commenter urged the Commission to consider whether mutual fund analysts have a conflict of interest with mutual fund companies similar to the conflict of interest between stock analysts and investment bankers, and to regulate such analysts.¹¹⁷
One commenter argued that the Commission should "add to the rule a requirement for all funds to advertise their net performance, after subtracting costs of doing business / hidden costs, not their gross performance."¹¹⁸

__________________________

¹ Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings, Release Nos. 33-8343, IC-26287 (Dec. 11, 2003) [68 FR 70401 (Dec. 17, 2003)] ("Proposing Release").
² ACLI; AIMR; Anderkay; Applegate; Armstrong; Batchelder; Buckner 1; CAI; CMFI; DH2; Enforte; Fidelity; 1^st Global; FPA; FSR; Gcaveness; ICI; Investortools; JLFM; Keystone; Kindley; Langdon; D. Lyons; Madden; Morningstar; NAVA; Nationwide; Pax; Prescott; Riccio; Rodney; Sayers; Schwab; SIA; Spectrum; Tandem; Thomas; T. Rowe Price; Vanguard; Victory.
³ See, e.g., ICI, SIA. Fidelity, T. Rowe Price, and Vanguard stated that, in general, they agree with the recommendations made by the ICI.
⁴ Robbins; Stein; Weiss.
⁵ Robbins.
⁶ Weiss.
⁷ Stein.
⁸ ACLI; AIMR; FPA; Morningstar; Schwab.
⁹ Applegate; Batchelder; DH2; 1^st Global; FPA; Gcaveness; JLFM; Keystone; Langdon; D. Lyons; Madden; Morningstar; Sayers; Schwab; Spectrum; Tandem.
¹⁰ Morningstar.
¹¹ ACLI; CAI; Fidelity; ICI; NAVA; T. Rowe Price; Vanguard.
¹² ACLI.
¹³ T. Rowe Price.
¹⁴ ICI.
¹⁵ Vanguard.
¹⁶ Fidelity.
¹⁷ Fidelity; ICI; Vanguard.
¹⁸ ACLI; CAI; T. Rowe Price.
¹⁹ ICI; Fidelity; Vanguard.
²⁰ Vanguard.
²¹ ACLI.
²² Schwab.
²³ CMFI; Miller; Morningstar.
²⁴ CMFI.
²⁵ Miller; Morningstar.
²⁶ Miller.
²⁷ Morningstar.
²⁸ Miller.
²⁹ Pax.
³⁰ ACLI; CAI; FSR; Nationwide; NAVA; Schwab.
³¹ Schwab.
³² ACLI; CAI; FSR; Nationwide; NAVA.
³³ NAVA.
³⁴ CAI; Nationwide.
³⁵ CAI.
³⁶ ACLI; CAI; FSR; NAVA.
³⁷ ACLI; CAI; NAVA.
³⁸ NAVA.
³⁹ CAI.
⁴⁰ NAVA.
⁴¹ Applegate; Batchelder; CMFI; Fidelity; 1^st Global; FPA; FSR; Morningstar; NAVA; Pax; Schwab; Spectrum; Tandem; T. Rowe Price.
⁴² Applegate; Batchelder; CMFI; 1^st Global; FPA; Pax; Spectrum; Tandem; T. Rowe Price.
⁴³ Batchelder; 1^st Global.
⁴⁴ CMFI; 1^st Global.
⁴⁵ FSR; Schwab.
⁴⁶ Schwab.
⁴⁷ Morningstar.
⁴⁸ Fidelity.
⁴⁹ NAVA.
⁵⁰ ICI; State Street.
⁵¹ DH2.
⁵² Morningstar.
⁵³ JLFM.
⁵⁴ AIMR.
⁵⁵ DH2; Fidelity; FSR; ICI; Morningstar; Schwab; Vanguard.
⁵⁶ ACLI; CMFI; Pax.
⁵⁷ James.
⁵⁸ ICI; Fidelity; FSR; Morningstar; Schwab; Vanguard.
⁵⁹ DH2.
⁶⁰ Fidelity; FSR; ICI; Morningstar; Schwab; Vanguard.
⁶¹ Fidelity.
⁶² FSR; Schwab.
⁶³ ICI; Vanguard. The ICI also argued that requiring disclosure of every instance that potentially could require the use of fair value pricing is unreasonable.
⁶⁴ Fidelity.
⁶⁵ Morningstar.
⁶⁶ Fidelity.
⁶⁷ ICI.
⁶⁸ ICI; Schwab.
⁶⁹ ICI.
⁷⁰ Fidelity; FSR; ICI; Schwab.
⁷¹ FSR; Schwab.
⁷² Morningstar.
⁷³ Fidelity.
⁷⁴ Morningstar.
⁷⁵ Compliance Programs of Investment Companies and Investment Advisers, Release No. IC-26299 (Dec. 17, 2003) [68 FR 74713 (Dec. 24, 2003)].
⁷⁶ DH2.
⁷⁷ CMFI; Fidelity; FPA; FSR; ICI; Investortools; Lebenthal; Morningstar; Pax; Schwab; Smith; Strange; T. Rowe Price; Victory.
⁷⁸ ICI; Morningstar; Schwab.
⁷⁹ Fidelity.
⁸⁰ ICI; Morningstar.
⁸¹ Investortools; Lebenthal; T. Rowe Price; Victory.
⁸² ICI.
⁸³ Morningstar; Pax.
⁸⁴ Morningstar.
⁸⁵ Fidelity.
⁸⁶ CMFI; FPA.
⁸⁷ Fidelity; ICI; Schwab.
⁸⁸ Fidelity; ICI; Morningstar; Schwab.
⁸⁹ Fidelity.
⁹⁰ CMFI.
⁹¹ Fidelity.
⁹² ACLI; CAI; ICI; NAVA; Schwab.
⁹³ ICI.
⁹⁴ CAI.
⁹⁵ Schwab.
⁹⁶ ACLI; CAI.
⁹⁷ ICI.
⁹⁸ ACLI.
⁹⁹ Bryan; Buckner 2; Burbage; DasGupta; Drury; Gobble; Green; Greer; Harvey; Hauer; James; Lebrie; Nieman; Orr; Pension Specialists; Reddick; Settles; Sitko; SSM; Strange; Thews; Wen; Wrbhb.
¹⁰⁰ Bryan; Buckner 1; Burbage; DasGupta; Gobble; Green; Harvey; James; Lebrie; Nieman; Pension Specialists; Reddick; Settles; Sitko; Thews; Wen; Wrbhb.
¹⁰¹ Hauer; Orr.
¹⁰² Greer.
¹⁰³ Drury.
¹⁰⁴ Strange.
¹⁰⁵ SSM.
¹⁰⁶ ACLI; Armstrong; Batchelder; Buckner 2; FSR; Gcaveness; JLFM; Pax; Prescott; Rodney.
¹⁰⁷ 1^st Global.
¹⁰⁸ FSR; Morningstar; Schwab.
¹⁰⁹ FSR.
¹¹⁰ Fidelity.
¹¹¹ FSR; Morningstar.
¹¹² Morningstar.
¹¹³ CMFI; Fidelity; Schwab.
¹¹⁴ CMFI.
¹¹⁵ Fidelity.
¹¹⁶ ACLI.
¹¹⁷ Enforte.
¹¹⁸ Kindley.

http://www.sec.gov/rules/extra/s72603summary.htm

Outline of Comments on Proposed Form Amendments Requiring Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings

March 19, 2004 S7-26-03 Prepared by: Kieran G. Brown & David S. Schwartz Division of Investment Management

DISCLOSURE REGARDING MARKET TIMING AND SELECTIVE DISCLOSURE OF PORTFOLIO HOLDINGS

OUTLINE OF COMMENTS ON PROPOSED FORM AMENDMENTS REQUIRING DISCLOSURE REGARDING MARKET TIMING AND SELECTIVE DISCLOSURE OF PORTFOLIO HOLDINGS