The Securities and Exchange Commission Thursday approved a new rule to combat market timing that would leave the decision to impose redemption fees on mutual funds up to the board of directors and allow funds to hold intermediaries more accountable for abusive trading.
In a unanimous decision, all five SEC commissioners voted to approve a more flexible version of a proposal floated last year that sought to stamp out rapid short-term trading. The original proposal called for funds to impose a mandatory 2% redemption fee on shares sold within five days of purchase. According to the Commission, 85% of the 400 comment letters it received opposed mandatory redemption fees.
Under the revised rule, funds may impose a redemption fee of up to 2% on shares redeemed within seven days of purchase but are not required to do so. The rule excludes money market funds and exchange-traded funds from the equation as well as funds that encourage active trading and disclose to investors in the prospectus its financial impact on the fund. At present, roughly 10% of all mutual funds carry redemption fees.
The move comes as part of the SEC's robust regulatory agenda in the wake of a pervasive trading scandal that roiled the $8 trillion industry.
"Redemption fees are not really susceptible to a one-size-fits-all approach," said SEC Chairman William Donaldson, at an open meeting. "They are not costless to implement, and it is not easy to structure them in a way that captures all of the activity we are trying to deter and none of the activity we aren't. Moreover, funds are not equally vulnerable."
"The less restrictive, more flexible alternative that we have today is worth trying, although I think we'll have to keep our eye on it to see if it's working," said Democratic Commissioner Harvey Goldschmid. Commissioner Cynthia Glassman, a Republican who opposed the first draft of the rule, characterized the revision as "a measured response." She also urged the division of investment management to finish its fair-value pricing guidance, identifying it as the primary method of stamping out market timing.
Paul Atkins, a Republican, cautioned that although fund boards have the discretion to choose an appropriate redemption fee amount, there is a danger that the 2% cap will become the default level in the industry. He said that if this leads to fund shareholders being charged excessive fees, he would make referrals to the enforcement division himself.
As stipulated by the rule, fund boards will be asked to determine on a fund-by-fund basis whether there is a market-timing issue by looking at flow data and relevant trading information. If market timing exists, the fund can delay or restrict trading activity, redeem shares in kind or send in their internal market-timing police squad to investigate. However, these efforts can be costly, so it is up to the board and the chief compliance officer to decide whether or not a fund warrants a redemption fee based on the level of activity.
Another tenet laid out in the anti-market timing provision is a requirement that funds negotiate written contracts with their intermediaries obligating them to hand over shareholder trading information. The data provided by brokers and retirement plan administrators will help funds identify customers who trade through omnibus accounts and oversee intermediaries' assessment of redemption fees when shareholders violate market-timing policies.
The SEC estimated the cost of setting up systems for intermediaries to do their due diligence at $630 million over three years, after which only an ongoing maintenance fee would apply. The original rule proposal would have cost funds and intermediaries $1 billion, but the revision lowered costs due to the shift to a fee system based on fund demand.
The intermediaries handling portfolio transactions for multiple funds in multiple fund complexes have complained that they struggle to levy redemption fees when up against a potentially unlimited combination of variables.
While confident that the benefits of the voluntary redemption fee approach outweigh the mandatory approach, the SEC expressed concern that the fund intermediaries may not cooperate adequately by refusing to impose redemption fees on shareholders that own shares through omnibus accounts. Historically, intermediaries have been "unwilling to affect this issue," Goldschmid noted.
To address that concern, the commissioners decided to reopen the comment period to hear recommendations on how to streamline the "design elements" of redemption fees in an effort to pare implementation costs.
Paul Roye, outgoing director of the SEC's division of investment management, suggested as a possible solution that those funds that opted to impose a redemption fee adhere to certain parameters. "We believe that a uniform standard would decrease intermediaries' costs of imposing redemption fees, and therefore encourage more intermediaries to assess them," Roye said.
"A uniform standard would have the added benefit of allowing investors greater ability to compare the cost of investing in different funds, and promote greater certainty as to when to expect that a fund will impose a redemption fee." Currently, redemption fee holding periods vary widely across the industry ranging from five to 90 days.
Donaldson stressed the importance of exploring further steps to lessen the burden on intermediaries, while still affording fund boards the flexibility to address specific issues unique to their funds and shareholders. "We may not all need or want the same color, size or style of kitchen sink, but at the end of the day, it makes sense to standardize the connection between the sink and the plumbing."
During a question-and-answer period with the commissioners, Roye noted that direct-sold funds have a distinct advantage over broker-sold funds in this area because they know their customers and are not burdened with peeling back the different layers of distribution.
When asked about the 2% cap designation, Roye said his staff deemed it a "small enough amount that we weren't doing damage to the principle in the statute on redeemability of fund shares, but allowing redemption fees to deal with this market-timing activity. We're striking a balance."
The SEC plans to reach out to broker-sold funds to assist them in overseeing intermediaries.
The Investment Company Institute, which originally pushed for mandatory redemption fees, supports the SEC initiative but does not believe it goes far enough in protecting investors from abusive trading. "We are concerned that without further action by the Commission, market timers will still be able to play catch us if you can' with mutual funds," said ICI President Paul Schott Stevens, in a statement.
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