SEC’s Plan for Fund Trades a Hard Sell
More than a year after revelations of widespread cheating rocked the mutual fund industry, federal regulators are still searching for a workable formula to prevent the trading abuses at the center of the scandal.
Two proposed reforms -- a “hard close” to stamp out illicit fund trading after 4 p.m. Eastern time and a required 2% sales fee to discourage the churning of shares known as market timing -- are in limbo as the Securities and Exchange Commission contends with a barrage of criticism aimed at each.
The new rules, once expected this year, will probably continue to be debated in 2005.
“Late trading and market timing were the core issues of the scandal, and the industry and regulators still don’t have a definitive solution,” said Don Phillips, managing director of Morningstar Inc., an independent mutual fund research firm. “It’s not for want of trying,” he added. “I think the reality is there are no easy answers.”
Last year, New York Atty. Gen. Eliot Spitzer revealed that many fund companies broke the rules for insiders and favored clients at the expense of typical shareholders. His revelations caught the SEC flat-footed, and the embarrassed feds pledged to clamp down.
As recently as May, SEC Chairman William H. Donaldson declared that his agency’s efforts to reform the $7.6-trillion mutual fund industry were proceeding “at warp speed.” Indeed, in the course of this year, the SEC has put teeth in certain fund disclosures, required greater independence on fund boards and ruled that fund portfolio managers must abide by codes of ethics, to cite a partial list.
But the warp-speed attempt to impose new rules on late trading and market timing has smacked into a wall of opposition. At this point, no one will hazard a guess as to when such proposals might reemerge on the SEC calendar.
An SEC official, speaking on condition of anonymity, offered only this: “I’d anticipate that any rules proposals will look substantially different from the originals.”
The problem doesn’t seem to be political rifts on the five-member commission, which is sometimes split between its two free-market Republicans and the two activist Democrats, with Republican Donaldson often providing the swing vote.
Rather, the efforts to attack trading abuses have been confounded by other hurdles, including time-zone disparities, gripes from retirees, questions of fairness and added costs.
“The reason for the delay is they have run into a tremendous amount of opposition to those proposals,” said Mercer Bullard, founder of Fund Democracy, which advocates the rights of mutual fund shareholders.
An initial attempt came in December 2003, when the SEC proposed a “hard close” to prevent late trading. Investors weren’t supposed to get the day’s closing price for fund transactions ordered after the deadline of 4 p.m. Eastern time (which is tied to the closing time for the major stock exchanges). But in practice, many shareholders traded through intermediaries, such as retirement plans and brokers, who did not conclude their dealings with the fund itself until long after 4 p.m.
A small percentage of investors exploited the situation, executing large trades with the benefit of information that only became available after the markets closed.
Under the proposal, a fund would have to finalize a trade by 4 p.m. for it to be valued at that day’s price, meaning that the trade would have to reach an intermediary significantly earlier in the day.
That prompted howls of protest. Critics said that as a practical matter, many trades would have to be ordered several hours ahead of closing time, because of added processing times.
For investors operating on Pacific time the effect could be severe, potentially making it impossible to get a same-day price for a transaction.
“It’s certainly more of a concern for people on the West Coast,” said Jan Jacobson, director of retirement policy for the American Benefits Council, which represents corporate health and retirement plans.
In light of such complaints, the SEC has been considering a more flexible approach, which may allow for trades to be placed by intermediaries after 4 p.m. Eastern time if they can certify that the investor met the 4 p.m. deadline. Administrators would have to establish a credible time stamp and an audit trail that protects investors’ privacy.
Nonetheless, “what we’ve heard is that a technological solution has been elusive,” said Elizabeth R. Krentzman, general counsel of the Investment Company Institute, which represents the mutual fund industry.
In early 2004, regulators took aim at market timing, the rapid-fire trading of fund shares typically by favored investors such as hedge funds. Although not necessarily illegal, such strategies often violated fund policies and reduced returns for small, buy-and-hold investors.
To discourage excessive, short-term trades, regulators proposed a 2% redemption fee on sales of shares held five days or less. But critics said such a fee would be a costly burden on investors conducting legitimate trades. They also warned that redemption fees would create new costs for plan administrators and record keepers.
In a recent letter to the SEC, James A. Klein, president of the American Benefits Council, urged that such a fee be uniform and that it not apply to trades in which market timing was not even possible, such as sales required for divorce settlements or plan distributions upon death.
“We understand the original proposal was designed to address the problems caused by market timing, but in this case, the solution may be worse than the problem, at least so far as retirement plan participants are concerned,” he said
Although only a minority of funds impose such fees to deter short-term trading, there are signs that the industry may be starting to move ahead of its regulators.
Fidelity Investments, for example, is demanding that third parties that market some of its funds charge fees of about 0.25% to 2% for short-term sales. The fund company has charged such fees for years, but that has not been the case with all intermediaries who also market its funds.
Such fees are paid back to the fund itself, noted David Jones, senior vice president, Fidelity Management & Research Co., the investment advisor to Fidelity mutual funds. “This is the fee that really works. It takes care of the problem and it’s fair to everyone. It makes the short-term trader pay their own way.”
Krentzman of the Investment Company Institute said the SEC had been going through an extraordinarily busy period of rulemaking, which might help explain why the key rules for fund trading were taking so long.
But she added: “It is ironic that the commission could have such an active schedule and do so many things, yet the proposals that go directly to market timing and late trading are still on the table. These need to be adopted.”
