Christopher Cox, the new U.S. Securities and Exchange Commission chairman, comes into office with a long list of to-do (and perhaps to-not-do) items. Although not expected to be an activist regulator like his predecessor, William H. Donaldson, Cox must contend soon with one item on his agenda: deciding what rules should govern rapid trading in mutual funds -- the suspect practice that sparked the market-timing scandals of 2003 and led to $2.2 billion in fines against 14 mutual fund companies.
Though technically legal, granting some investors, such as hedge funds, preferential permission to move in and out of mutual funds to reap fleeting price differentials not only put other fund investors at a disadvantage but in several cases explicitly violated fund policies as defined in the funds’ prospectuses.
As Cox takes office, the agency appears to be backing off its March edict on rapid trading. At that time the SEC attempted to tackle the problem by issuing what it termed a final rule on rapid trading (Rule 22-c-2) while simultaneously calling for industry comment between mid-March and mid-May 2005 -- suggesting it wasn’t comfortable with its own rule.
Typically, the commission invites comment on proposed, not final, rules. “This is unusual, though not entirely unprecedented,” notes Robert Plaze, who, as associate director of the SEC’s division of investment management, oversees policies and rules governing mutual funds.
The commission says the rule won’t take effect until October 16, 2006, tacitly acknowledging that the mutual fund industry will need months to prepare to implement the required changes. The rule requires fund firms to arrange written contracts with all of their “omnibus” account holders -- the bankers, brokers and 401(k) administrators that aggregate orders of individual investors. These account holders are to forward individual investors’ trading information to the fund companies so the funds can monitor trading patterns and levy redemption fees, when necessary.
The rule also addresses -- but does not resolve -- the closely related issues of how redemption fees should be structured and when they should be imposed.
The holding periods and levels of redemption fees vary with the types of securities underlying the fund (for example, emerging-markets versus fixed-income) and the fund’s structure (passive versus active). Generally, the higher penalties correlate to short holding periods.
The SEC asks if the fees should be standardized. Currently, each mutual fund family sets its own redemption fee policy. In 2004 the agency proposed a mandatory 2 percent redemption fee on all mutual fund trades within five days of purchasing shares, but it has retreated from that proposal in the face of industry opposition.
All in all, the flip-flops suggest that the SEC is ambivalent about how it wants to deal with rapid trading.
The agency’s March salvo prompted widespread protest from mutual fund executives, who see the rule on rapid trading as unduly burdensome. The Investment Co. Institute, the leading industry trade group, noted that at least two of its members -- Vanguard Group and T. Rowe Price -- have more than 1.3 million relationships apiece with omnibus account managers. Would they really have to conclude contracts with every one of these entities by mid-October next year?
Reading the responses was a sobering experience, acknowledges the SEC’s Plaze: “When the letters came in, I did the proverbial slap on the forehead.”
Plaze addressed the industry’s complaints at a Washington conference on June 23. He announced that the staff of the SEC would recommend changes in Rule 22-c-2 to the commission this month.
Fund families are concerned about having to sign contracts with 401(k) plans as small as, say, a dentist’s office with six employees. The mutual fund family would assume that the plan should be treated as a single investor, Plaze notes. This means that if the fund limits all its investors to one trade every three months (the 90-day holding period that is most common), those six employees will be allowed only one unpenalized trade among them every three months. The dentist’s office will be penalized if collectively there is more than one round-trip, a purchase and redemption, in a mutual fund within the specified period. The penalty would not apply if the office manager could prove that the buy and sell orders came from two different employees.
If the dentist’s office or another plan sponsor wants to allow its employees to trade more frequently, it will have to sign a contract with the mutual fund firm agreeing to forward individual investors’ trading information. Under the terms of the contracts, the omnibus account holders, also known as intermediaries, would be obliged to remit information about individual trades, indicating to mutual fund firms which investors were liable for redemption fees.
“But the rule doesn’t spell out what recourse fund firms would have if the intermediaries don’t cooperate,” says ICI general counsel Elizabeth Krentzman.
Plaze insists that intermediaries have a contractual obligation to cooperate and that if they don’t, fund firms can sue them.
Omnibus accounts first came into the news in 2003. One of the dens of market-timing activity was the Boilermakers Union Local 5 in Floral Park, New York. Members were hyperactively trading their 401(k) accounts, which were managed in an omnibus account by Putnam Investments. New York State Attorney General Eliot Spitzer and the SEC charged Putnam with permitting the Boilermakers to engage in activity that was specifically prohibited in the Putnam funds’ prospectuses. The Boston-based fund firm terminated its relationship with Local 5 in late November 2003 and settled the SEC’s charges for $55 million.
Automated transactions pose additional complications for the SEC. The commission has been flirting with requiring redemption fees on every automated transaction. Thus, if an employee were to make a regular contribution to his 401(k) twice a month and at the same time withdraw money from the account to repay a loan from the plan, that round-trip exchange would trigger a redemption fee. What about an automatic rebalancing plan? If the redemption rules were to cover such scenarios, their scope would be vast.
Several fund companies already levy redemption fees on participants in defined contribution plans. In July, Vanguard Group announced that, beginning January 1, its retirement plan participants will have to pay redemption fees of from 0.5 percent to 2 percent on holding periods ranging from two months to five years, with a one-year holding period the most typical. The fees already applied to fundholders outside of retirement plans.
However, Vanguard only imposes redemption fees on transactions that plan participants initiate themselves. The Valley Forge, Pennsylvaniabased fund family’s policy is not to levy redemption fees on transactions in retirement accounts that occur automatically, whether for rebalancing or loan payments.
Similarly, T. Rowe Price has been charging defined contribution retirement plan participants redemption fees since January, but the fees do not apply to automated transactions or loans.
Other fund companies have quite different redemption-fee arrangements. Fidelity, for one, chooses to include all transactions in retirement accounts, regardless of volition on the investor’s part.
The plethora of approaches puts retirement plan administrators in a bit of a predicament. Most operate in an open-architecture system, offering plan participants a wide range of investment options. They have no choice, therefore, but to accommodate an array of redemption policies. And to comb through each fund’s policies -- 34 Vanguard funds alone charge redemption fees, for example, each with an idiosnycratic combination of fee amount and holding period -- within the 600 fund families in the U.S. marketplace would be unwieldy.
The SEC’s attempt to impose one standard on the industry seemed ham-fisted to many, given the differences between, say, Vanguard’s emerging-markets fund (two-month holding period, 2 percent redemption fee) and its tax-managed balanced fund (five-year holding period, 1 percent redemption fee).
Yet the retirement plan industry may have to learn to live with these disparities, unless the SEC weighs in. And that isn’t likely to happen soon. Noting that imposing redemption fees on automated transactions is much more than a technical issue, Plaze says, “We will reserve this for another day,” after Commissioner Cox has settled into his new role.
