Charles Schwab & Co., Inc.
February 6, 2004
Via Electronic Filing
Mr. Jonathan G. Katz
Re: File No. S7-26-03-- Proposed Rule: Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings
Dear Mr. Katz:
Charles Schwab & Co., Inc. ("CS&Co"), along with its affiliate Charles Schwab Investment Management, Inc. ("CSIM" and together with CS&Co, "Schwab")1 appreciates the opportunity to comment on the Securities and Exchange Commission's (the "Commission" or "SEC") recent proposed disclosure rule regarding market timing and selective disclosure of portfolio holdings (the "Proposed Rules").2 The Proposed Rule would amend certain forms under the Securities Act of 1933 and the Investment Company Act of 1940 to require open-end management investment companies and insurance company separate accounts issuing variable annuity and variable life insurance contracts (collectively, "mutual funds") to disclose in their prospectuses both the risks to shareholders of the frequent purchase and redemption of investment company shares, and the investment company's policies and procedures with respect to such frequent purchases and redemptions. Second, the Commission will also clarify that such funds, other than money market funds, are required to explain both the circumstances under which they will use fair value pricing and the effects of using fair value pricing. Third, the Proposed Rule will also require funds to disclose their policies and procedures with respect to the disclosure of their portfolio securities, and any ongoing arrangements to make available information about their portfolio securities.
Schwab Supports the Commission's Proposals to Enhance Disclosure Regarding Market Timing, Fair Value Pricing, and Selective Disclosure of Portfolio Holdings
Schwab agrees with the Commission that reform is required in the area of market timing and selective disclosure of portfolio holdings. Recent, highly publicized reports about the mutual fund industry have underscored the need for the regulators and the industry to take strong and effective steps to restore the confidence of individual investors in mutual funds. Meaningful reform is needed to enable mutual funds to enforce consistently their policies concerning short-term trading or "market timing" of mutual funds, fair value pricing, and selective disclosure of portfolio holdings.
We believe that the Commission's Proposed Rules are an important first step in that process and that further steps can and should be taken to address these issues. In this regard, we understand from public comments made by SEC staff that the Commission is considering further rule-making in this area, including examining how funds can better use redemption fees to discourage short-term trading of mutual funds.3 We applaud both the Commission's Proposed Rules and its further efforts in this area. Schwab also supports the Commission's goal of preventing unlawful late trading, and we are submitting a comment letter under separate cover on the Commission's proposed rules relating to the pricing of mutual fund shares.4
Funds Should Adopt Reasonable Policies With Respect to Harmful Market Timing, Disclose Them Clearly To Investors, and Consistently Enforce Them
The Commission has rightly focused attention on the potential negative effects that market-timing has on long-term investors. In particular, the alleged practice of overriding stated market timing policies by mutual fund executives to benefit large investors or the fund management company at the expense of small retail investors undermines investor confidence in the mutual fund industry. Schwab supports the market timing disclosure proposals in the Proposing Release.
Funds should disclose to shareholders the specific risks that market timing may pose to a particular type of mutual fund. As noted in the Proposing Release, market timing can potentially dilute the value of fund shares for long-term shareholders, adversely impact portfolio management, and increase trading costs. Each shareholder should be informed of these risks and the impact the risks may have on the shareholder's investment in a particular fund. Schwab agrees that the fund should be required to disclose whether the fund's board of directors (the "Board") has adopted policies and procedures to prevent market timing, and if the Board has not done so, the basis for the Board's view that it is appropriate not to have such policies.5
Schwab supports the Commission's view that funds should disclose in the prospectus all policies adopted by the Board intended to accommodate or discourage frequent purchases and redemptions by fund shareholders. Schwab believes the most effective tool to deter market timing is the contingent or short term redemption fee on shares that are sold within a specified period of time after purchase ("Redemption Fees"). However, as the Proposing Release recognizes, funds have at their disposal a wide variety of tools to combat abusive market timing. All of those tools, alone or in combination, can provide an effective deterrent to market timing activity. But while funds are already required to disclose Redemption Fees in the prospectus, funds are not required to disclose other market timing policies and procedures. Disclosing these policies and procedures serves the important purpose of putting shareholders on notice of what types of activities a particular fund considers harmful and the consequences shareholders will face if they engage in those activities. Shareholders can also learn from such disclosure how serious a particular fund is about deterring market timing activity.
In addition to the above, Schwab believes it is equally important to disclose any exceptions to a fund's market timing policies and the circumstances under which those policies may not apply. The presumption should be that all shareholders should be treated on an equal basis, unless there is a compelling justification and it is in the best interest of the fund and its shareholders to treat a particular class of investors differently. Funds should disclose such exceptions to all investors.
The Proposed Rules importantly avoid imposing a "one size fits all" approach to how funds deal with market timers. Recent experience shows that certain types of funds are particularly susceptible to detrimental and abusive market timing activity. These include certain international funds subject to time-zone arbitrage, and funds holding concentrations of more volatile securities, including small capitalization stocks, technology stocks, and high yield fixed-income securities. But other funds, for example diversified large capitalization domestic equity funds, may not be subject to market timing activity because they do not present the same opportunity for short term profit. Still other funds may be specifically designed or able to accommodate frequent short-term trading activity. Schwab believes that the Proposed Rules correctly recognize the differences between the various types of mutual funds made available to investors, and rightly place the responsibility on a fund's Board to determine what market-timing policies, if any, are most appropriate for a particular fund.
Schwab also supports the Proposing Release provisions that make the above-mentioned disclosure requirements applicable to insurance company separate accounts that issue variable annuity and variable life insurance contracts, with respect to frequent transfers of contract value among sub-accounts of the registrant. These vehicles provide similar opportunity for market timers at the expense of long-term investors, with the added incentive that the gains are subject to tax-deferred treatment.
The Proposing Release requests comment on whether the appropriate location for each of the disclosures is the prospectus or the Statement of Additional Information (the "SAI"). We agree that the prospectus is the appropriate location for each of the disclosures required by the Proposed Rule, with the exception that the disclosure of policies and procedures of the fund to detect frequent trading activity, including any arrangements for detecting such arrangements through intermediaries, is better suited for the SAI. We believe that disclosure of policies for detecting (as opposed to methods for preventing) frequent trading entail detailed discussions and are not as critical information to investors as the other required disclosures.
Funds Should be Required to Provide Brief Disclosure of the Circumstances under Which They Will Use Fair Value Pricing
Schwab agrees with the Commission that fair value pricing is another effective tool to deter market timing. While funds are already required to use fair value pricing when market quotations for their portfolio securities are not readily available, including when they are unreliable, the circumstances giving rise to an obligation to fair value securities may differ significantly depending upon the type of fund.
We agree with the SEC's approach that would require brief disclosure of the circumstances that would give rise to fair value pricing and the effect of using fair value pricing, but does not require disclosure of the methodology the fund uses to fair value its securities. Disclosure of the methodology of fair value pricing would be counterproductive because it might provide market timers with information that actually could help them engage in profitable arbitrage activity. For that reason, we do not believe that the brief disclosure called for by the Proposed Rule should include, for example, the precise numerical triggers based on domestic market movements that a fund investing in international markets employs in its fair valuation process. Nor should such disclosure include any formula or algorithm the fund uses to fair value portfolio securities.
The Proposing Release seeks comment on the best location for disclosure about fair value pricing. We believe that while such disclosure is important to many investors, its importance will vary from one fund to the next. In addition, given that funds are legally required to fair value portfolio securities when market quotations are not readily available, the substance of that disclosure likely will focus on when quotations for a particular fund's securities holdings are not readily available. In most circumstances this type of disclosure is better suited to the SAI, where the fund can be brief but specific, without burdening the prospectus with disclosure that may not be important for that particular type of fund (for example, a diversified large capitalization domestic stock fund). On the other hand, where market timing is a more important issue, such as foreign stock funds that are subject to time-zone arbitrage, the fund could include appropriate market timing disclosure in the prospectus itself.
We also agree with the Proposing Release's exemption of money market funds from these disclosure requirements because they are subject to their own pricing requirements under Rule 2a-7 under the Investment Company Act. In addition, money market funds are not subject to the abusive market timing practices that afflict variable net asset value funds because they seek to maintain a stable net asset value.
Funds Should Disclose their Policies with Respect to Selective Disclosure of Portfolio Holdings
Schwab agrees with the Commission that mutual fund managers should not be permitted to selectively disclose their funds' portfolio holdings in order to favor larger investors. There is no reason why institutional or affluent investors-such as hedge funds-should have access to more frequent reports on fund portfolio holdings than ordinary retail investors, and doing so provides those investors with an unfair advantage that could encourage harmful market timing and other trading activity.
We agree with the SEC's position in the Proposing Release to require funds to disclose any policies and procedures with respect to the disclosure of the fund's portfolio securities to any person and any ongoing arrangements to make available information about the fund's portfolio securities to any person. We believe that disclosing portfolio holdings to selected third parties may be permissible when there is a legitimate business purpose for doing so and the recipient is subject to a duty of confidentiality and to restrictions on trading. The examples set forth in the Proposing Release of legitimate instances of disclosure of portfolio holdings are reasonable (including due diligence disclosures in the context of merger negotiations, to newly hired investment advisers or sub-advisers prior to commencement of their duties, or to rating agencies for use in developing a rating), and we do not believe that they should be the target of regulatory efforts to curb abusive activity. Legitimate arrangements with third party service providers, ratings and ranking organizations, and other non-market participants should be excluded from the disclosure requirements. We do not believe that it is necessary that funds disclose all instances of selective disclosure to the public, although we do believe that they should be disclosed to the fund's board of directors.
We agree with the Proposing Release requirement that policies regarding selective disclosure of portfolio holdings should be included in the fund's SAI, with a brief statement in the Prospectus that disclosure is available in the SAI and, if applicable, on the fund's website. Because the core of the problems alleged in recent investigations appears to be that selective disclosure to large investors involved conflicts of interest between the investment adviser and the funds' shareholders, we further agree that disclosure must include policies on how the fund addresses conflicts between the interests of fund shareholders, on the one hand, and those of the investment adviser, principal underwriter and their affiliates, on the other.
The Proposing Release seeks comment on whether Regulation FD should apply to mutual funds and managed separate accounts with respect to their disclosure of portfolio holdings or other information. The Proposed Rule's disclosure requirements combined with aggressive enforcement action against fraudulent behavior should by itself be an effective deterrent to unlawful selective disclosure. We do not believe that it is necessary to amend Regulation FD to apply to mutual funds to address the harm of selective disclosure of portfolio holdings.
Regulation FD was adopted in response to problems arising from the constant flow of communication between operating companies and the investment analysts who follow those companies. This relationship led to an alleged abusive pattern of behavior centered on quarterly earnings announcements and analyst expectations that gave analysts and, ultimately, many of the brokerage firms for which they worked, access to material non-public information before ordinary retail investors had access to it. The release adopting Regulation FD discussed the uncertainty over whether such selective disclosure by corporate insiders to securities analysts was illegal, noting that "many have viewed issuer selective disclosures to analysts as protected from insider trading liability."6 In the case of investment companies, the Proposing Release discusses the viewpoint that disclosure of portfolio holdings to selected third parties is only permissible when the fund has legitimate business purposes for doing so, and legitimate business purposes generally would not include the receipt of consideration by the investment adviser or its affiliates. The broad fiduciary duty owed by investment advisers to mutual funds distinguishes the legal status of selective disclosure in the investment company context from that of the operating company context.
The Proposing Release requires that all new registration statements and post-effective amendments to effective registration statements filed on or after the effective date of the amendments comply with the proposed amendments. Requiring compliance immediately upon the effective date of the amendments could leave some funds with only a matter of days to draft and implement the new disclosure requirements, depending on their annual update cycle, which could be both disruptive and expensive, particularly since many of the amendments will impact the prospectus and therefore could disrupt printing schedules. Instead, Schwab believes that all new registration statements and post-effective amendments to effective registration statements filed 90 days or more after the effective date of the amendments should be required to comply with the proposed amendments. The additional 90 days will provide necessary time to draft appropriate disclosure.
Schwab wholeheartedly supports the Commission's goal to enhance disclosure of mutual funds' policies regarding market timing and selective disclosure of portfolio holdings. With the comments above, we support the adoption of the Proposed Rule. If you have questions about this letter, please contact the undersigned at (415) 667-3461 or at firstname.lastname@example.org.
cc: Paul F. Roye