January 26, 2004
Mr. Jonathan G. Katz, Secretary
Dear Mr. Katz:
On behalf of Nationwide Financial Services, Inc. ("Nationwide"),1 we are grateful for the opportunity to provide comment with respect to the proposal by the Securities and Exchange Commission ("Commission") to amend Rule 22c-1 under the Investment Company Act of 1940.
The proposed amendments are intended to prevent unlawful late trading in mutual fund shares by providing for a so-called "hard close," meaning that purchase or redemption orders would be permitted to receive the current day's price only if such orders are received by the mutual fund, its designated transfer agent, or a registered securities clearing agency by the time the fund calculates its net asset value.2
We share the Commission's concern over recent revelations of unlawful late trading schemes and, as a leading provider of retirement and long-term savings products and services, Nationwide recognizes that the integrity of the forward pricing system for mutual funds is a foundational cornerstone of its business and the financial services industry. We are thoroughly committed to just and equitable mutual fund trading policies, and we commend the Commission for its response in the wake of these revelations and for its long history of being duly attentive to the costs as well as the benefits of proposed regulatory actions.
Moreover, we applaud the Commission for its recognition of conduit funds and registered insurance company separate accounts as having parallel legal standing with management investment companies for purposes of the proposed amendments. Despite this recognition - and the related exemptions from "hard-close" requirements spelled out in the proposed amendments - the main implications of the Commission's "hard close" proposal hold profoundly adverse implications for Nationwide and its diverse customer base, a substantial proportion of which does not make use of Nationwide products funded through registered separate accounts.
Through its three main business segments and subsidiary companies,3 Nationwide serves over 2.5 million investors or retirement plan participants and provides access to over 4,000 different mutual funds from over 200 different mutual fund complexes. Through the processing of payroll deferrals, benefit plan distributions, loans, and customer reallocations of retirement account balances, Nationwide processes several million mutual fund transactions on a monthly basis. Nationwide companies have operated in this capacity - as mutual fund intermediaries and omnibus mutual fund traders - for more than 25 years. Several of Nationwide's key operating subsidiaries, and at least 1.5 million of the retirement plan participants they serve, will be adversely affected by the proposed amendments to Rule 22c-1.4
COST/BENEFIT ANALYSIS OF THE COMMISSION'S PROPOSALS
The proposed amendments would have the effect of dramatically reducing the number of channels through which mutual fund redemption and purchase orders can be made before 4:00 p.m. (while receiving the price next computed). Effectively, the proposal eliminates
(1) the long-standing ability of many authorized "intermediaries" to accept trade orders on behalf of funds until 4:00 p.m.,
(2) the practice of allowing "intermediary" processing systems to run overnight in order to reflect investor account values based on the preceding 4:00 p.m. price, and
(3) the completion of this process through aggregated omnibus trades accomplished the subsequent morning.
The regulatory benefits of the "hard close" proposal, and the effective dismantling of these long-standing processes, are perceived to be twofold. First, with fewer channels through which actual trades can be placed, the probability or incidence of late trading, and the opportunity to engage in late trading, is believed to be reduced. Second, by limiting the population of entities authorized to accept orders to a small group of registered organizations - that is, the funds themselves, their transfer agents, or registered clearing corporations - the entire mutual fund pricing process can be policed more effectively.
If this is an accurate summary of the perceived benefits of the Commission's proposed amendments, then it is entirely valid to question - as others providing comment surely will - whether recent revelations of late trading would have been more likely to be deterred by the proposed "hard close" system. The answer to this question, we believe, is far from obvious; in fact, we believe that reasonable, objective observers can conclude that the proposed system, had it been in place, would have had negligible effect on late trading transgressors.
In other words, late trading practices by such entities are no more or less emphatically proscribed under the Commission's proposed regulatory structure than they are under the current structure; further, the same civil and criminal enforcement mechanisms applicable to such entities today will continue to be applicable whether the proposed amendments are promulgated or not. Does it follow that the examples of late trading revealed over the past several months would have been more likely to be deterred had the Commission's proposals been in effect? Given the enormous costs associated with these proposals (more fully discussed below), this question appears to be particularly relevant.
IMPACT ON RETIREMENT PLAN PARTICIPANTS
The Release accompanying the proposed amendments suggests that the adoption of Rule 38a-1, mandating new investment company policies and procedures under a chief compliance officer, will make such schemes "more difficult."5 We are concerned, however, that if the heightened compliance responsibilities of Rule 38a-1 alone are deemed sufficient to allay concerns over late trading among funds and their transfer agents (whose processes will be largely unaffected by the proposed amendments to Rule 22c-1), then, from a policy standpoint, the effective dismantling of long-standing business processes of certain classes of "intermediaries," seems disproportionately burdensome. We believe the asymmetrical impact of the Commission's proposals to be particularly pronounced, and particularly objectionable, with respect to defined contribution retirement plan intermediaries and their customers, who have not been widely implicated as "late traders."6
In the proposing release, it is stated that:
This general statement, we believe, obscures a much more complex reality and assumes a degree of indifference among retirement plan investors that does not comport with Nationwide's long experience with defined contribution retirement plan participants. For most such participants, retirement plan investment represents their main hope of achieving financial security. This class of investors is extremely attentive to market fluctuations and the process by which their transactions are valued. While the amounts they invest through payroll deduction may be controlled to a degree by their employer's processing protocols, reallocation and withdrawal decisions are not. The current system allows such investors to make these decisions - decisions viewed as critical to attaining a secure retirement - on the same footing, and with the same market intelligence, as any other mutual fund investor. Under the proposed "hard-close" system, retirement plan participants are asked to sacrifice this equal standing.
Consider, for example, a participant requested exchange among mutual fund options made on a Friday afternoon. The transaction requires both purchases and redemptions. Intermediaries, like Nationwide, will be required to halt order taking early in the day on Friday (e.g., 1:00 p.m. ET) in order to organize buy and sell instructions to the funds before 4:00 p.m. And, with respect to exchange transactions, the redemption must be accomplished prior to the purchase in order to ascertain the amount available for the purchase. Accordingly, the retirement plan participant's exchange request (made, for example, at 1:30 p.m. on Friday) will be completed on the following Tuesday. That is, the order was made too late on Friday to be reflected in any buy or sell order prior to 4:00 p.m., the redemptions are processed on Monday at the 4:00 p.m. price, and the redemption proceeds are used to complete purchases on Tuesday.
Nationwide believes that this multi-step process will create untold confusion and complexity for retirement plan investors. In the scenario described in the foregoing paragraph, how will plan intermediaries account for participant account values in the midst of the multi-day execution process? What would a participant statement reflect if the reporting period ended on Monday (in the situation described above)? These and many other problems would be created. Far from restoring investor confidence, we believe it quite possible that these changes could erode investor confidence even further, as the implications of mutual fund ownership within retirement plans grow more and more complicated.
In contrast to this confusing, multi-step process, investors dealing directly with a fund who make the same type of exchange at precisely the same time as described in the foregoing example will be able to complete the transaction on Friday at 4:00 p.m. Clearly, retirement plan investors will be disadvantaged in comparison. The proposed rule amendments effectively impose secondary status on them compared with shareholders who deal directly with the funds or their transfer agents. In many respects, this proposed process seems to legitimize a fundamental inequity associated with late trading itself - two pricing systems, one for preferred investors which ensures attainment of a price reflecting market intelligence obtained at a point in time closest to the trade decision, the other for second-class investors (most defined contribution retirement plan investors) whose transactions may be priced over several days, significantly removed in time from the market information that may have prompted the trade in the first instance. In our view this is inconsistent with one of the main policy underpinnings of federal securities law and the long-standing bias of the Commission for equal treatment of all investors. Moreover, we believe this divergent treatment will translate into unhealthy shifts in the competitive landscape that should not be supported or encouraged by regulatory action.
IMPACT ON COMPETITIVE FORCES WITHIN THE RETIREMENT SAVINGS INDUSTRY
The Commission's proposal would give "bundled" providers (mutual fund entities that offer full investment and retirement plan services) an unnatural competitive advantage over "unbundled" providers. Retirement plan sponsors will be drawn to providers that can, under the "hard-close" system, maintain current processing protocols as opposed to the new and complex multi-step processes other financial intermediaries will be required to implement. As plan sponsors migrate to unfairly advantaged "bundled" providers, the net result for plan participants will be the elimination of choice among multiple investment management organizations and philosophies in favor of a single investment management (a single fund complex) orientation. Nationwide questions whether this is desirable from a policy standpoint, especially as pressing demographic realities converge with increasing uncertainty over many traditional sources of retirement income. A system fostering more flexibility, and more choice among investment management options, seems vastly preferable to one in which such choice is effectively limited.
In the proposing release, it is suggested that the competitive response by intermediaries to this uneven playing field will be to develop "more efficient order processing systems" or to "eschew customers [for whom it is important to place orders up until 4:00 p.m.] because they tend to be short term traders or market timers." We question whether intermediaries will continually strive to develop more and greater systems enhancements when it is clear that such enhancements will never be able to completely erase the advantage of fund complexes not required to modify their systems. Nor do we believe that eschewing customers who simply wish to enjoy the same trading status as other fund shareholders is a reasonable business response.
Instead, we believe it just as likely that many retirement plan intermediaries will seek to erase the advantage of "bundled" providers by becoming bundled themselves. We believe it highly likely that many (unbundled) retirement plan intermediaries will independently seek to develop investment management capabilities that match or equate to those of "bundled" providers unaffected by the proposed amendments. The result of this will be a proliferation of new fund registrations, many with sub-advisory structures that essentially replicate existing funds. This will widen the Commission's policing obligations and continue to stretch its resources even more thinly. While this evolution unfolds, many smaller intermediaries will simply be forced out of the industry altogether, weakening competitive forces to the further detriment of retirement plan investors.
COST OF COMPLIANCE
By any measure, the expense to be incurred within the retirement savings industry by entities such as Nationwide in order to implement newly required, multi-step trading processes will be enormous. In addition to obviously needed systems modifications, the cost of training administrative personnel, plan sponsors and customer service representatives will be significant and ongoing. Moreover, entities such as Nationwide will not only be required to incur the expense of overhauling certain existing systems, but will also be required to maintain certain other systems for businesses unaffected by the proposed amendments. This means that, in certain instances, maintenance efforts will be doubled to account for the necessity of having two different pricing/processing systems. All of this excess expense will eventually be reflected in the price of Nationwide's products and services, and those of other industry participants - all to the ultimate detriment of average retirement plan investors.
These costs, as well as the other considerations outlined in the preceding sections, cast significant doubt on the question of whether the proposed amendments will yield regulatory benefits commensurate with the direct and indirect costs created. These doubts, we know, are shared by many other entities; we anticipate that they will provide similar comment. We also expect, and hope, that these entities will voice support for the alternative approach outlined in the proposing release.
The proposing release specifically seeks comment on an alternative regulatory approach.7 Under the alternative approach, in order to maintain eligibility to submit orders to designated transfer agents or Fund/SERV after 4:00 p.m., intermediaries would be required to:
Defined contribution retirement plan providers and intermediaries act as de facto transfer agents for multiple funds and are relied on by such funds to administratively distill multiple orders from multiple plan participants into single, omnibus orders. The Commission states in the adopting release of Rule 38a-1 that "reliance on contractual provisions [with intermediaries such as retirement plan providers] alone would be insufficient to meet the requirements of the new rule [i.e., Rule 38a-1]."8 It seems evident that the additional standards and safeguards set forth in the "alternative approach" would sufficiently augment contractual obligations to ensure protection against late trading. Effectively, this inter-weaving of the "alternative approach," outlined above, with the enhanced compliance requirements of Rule 38a-1 amount to multiple layers of regulatory protection.
First, a fund would need, through the exercise of due diligence, to satisfy itself that a proposed intermediary was qualified and had adequate processes in place, to prevent late trading. Second, a contract memorializing these intermediary obligations, and in all cases, indemnifying the fund in case of negligent or intentional failures, would need to be approved by fund management, its compliance officer and board. Third, the intermediary would be required to annually certify that its procedures were adequate for these purposes and that no late trades were submitted during reporting period. Fourth, the intermediary would be required to submit to an annual certification review of its procedures by a certified public accountant, with the report to be forwarded to the funds' compliance officers.
To this structure Nationwide proposes the addition of another layer of protection: voluntary submission by intermediaries to Commission examination, upon demand, as a condition of being authorized to accept trades on behalf of funds. For intermediaries confident in their procedures, this will not be an onerous requirement; for those that lack such confidence, the result will be their departure from the market or significant effort to upgrade such procedures.
In addition to, or in lieu of, subjecting intermediaries to examination by the Commission, funds relying on intermediary order acceptance could simply be required to certify that intermediary compliance structures and processes are not substantially dissimilar to the requirements and processes employed by the fund itself for these purposes. In other words, for purposes of mutual fund trading practices, intermediaries would be required to adopt processes and organizational structures that substantially mirror the compliance processes and structures deemed sufficient for funds - specifically, Rule 38a-1.
Nationwide supports the "alternative approach" and believes it will be effective in deterring future incidents of late trading. We also believe that the reforms embodied in the "alternative approach" will be met with renewed confidence in the forward pricing system without the host of negative consequences we strongly believe will be created by the "hard close" proposal.
We thank the Commission for its consideration of our views.
Joseph J. Gasper