In his seminal book "The Right Stuff," Tom Wolfe wrote of those engineers and test pilots who believed in the 1940s that the sound barrier was a "brick wall" that would cause anyone who attempted to break it to "augur in" and "buy the farm." Chuck Yeager, of course, proved them to be wrong.
Today, in the brouhaha embracing the mutual fund industry, there is a similar notion: that post-4 p.m. trading is (and was, prior to Labor Day 2003) illegal and constitutes a crime. This view, which represents the underpinning of the New York Attorney General's ongoing prosecutions, has been accepted as gospel by the media. The actual legal landscape, however, is different, less clear, and more nuanced than the direct simplicity of any brick wall imagery.
This all starts with a previously obscure forward pricing provision of the Investment Company Act, Rule 22c-1, adopted in 1968. Nowhere in Rule 22c-1 or the 40 Act do the terms "4 p.m." or "late trading" appear. The first appearance of the term "late trading" in connection with Rule 22c-1 was via the so-called "Canary" Complaint, on Sept. 3, 2003. Prior to that time, there had never been an SEC enforcement action for placing mutual fund orders after computation of the net asset value ("NAV"), or after 4 p.m.; nor had there ever been a criminal prosecution based upon similar conduct.
Rule 22c-1, as currently constituted, says: "No registered investment company issuing any redeemable security . . . shall sell, redeem, or repurchase any such security except at a price based on the current net asset value of such security which is next computed after receipt... The board of directors shall initially set the time or times during the day that the current net asset value shall be computed."
Rule 22c-1 thus does not mandate that orders for mutual fund purchases or sales received after 4 p.m. get priced at the next day's NAV. But what Rule 22c-1 does prohibit is the pricing of orders for mutual fund purchases or sales "except at a price based on the current net asset value of such security which is next computed after receipt."
Of further interest is the wisdom of Eric Zitzewitz, an assistant professor at Stanford Business School, whose theories have figured prominently in the New York Attorney General office's damages prosecutions. In October 2002, Zitzewitz wrote that "current-day NAVs are not published until approximately 5:30 p.m. EST, so, strictly speaking, the average current-day NAV for a category will not be known at 4 p.m."
But the world started to change last Labor Day, when the Canary complaint labeled "late trading" as criminal activity. Shortly thereafter, the SEC, which does not have criminal jurisdiction, weighed in with its first public pronouncement (ever) that "late trading" constitutes an illegal practice under the federal securities laws, setting off a rush of events.
First off, the SEC announced in November that in a poll of broker/dealers, "more than 25% reported that customers have placed or confirmed mutual fund orders after 4 p.m., and received the 4 p.m. NAV." Commission staff members have since reported that "late trading" appears to have been even more prevalent, and that a number of smaller firms actually advertised and promoted their ability to place orders after four o'clock.
Less than a month later, it was reported that a number of prominent law firms (pre Labor Day) provided advice to clients that Rule 22c-1 does not have a "hard 4" cutoff, due to language of the rule itself as well as the fact that most funds do not calculate their NAV before 5:30 or 5:45 p.m., thereby allowing trades as long as the orders came in before the computation.
Finally, in December, the SEC proposed replacing Rule 22c-1 with a rule that would establish a "hard 4" cutoff. Besides the rather clear message this proposal gives that Rule 22c-1 is not a "hard 4" rule, the Commission has since reported a record number of comment letters in protest of the "hard 4" close. (See MME 2/9/04, "SEC's Proposed Hard Close' Draws Critics."). The SEC is now considering "viable" alternatives to its December proposal.
Prosecutions underway and forthcoming are premised on the notion that the existing law and rules are "reasonably clear and precise" and that criminal action is "appropriate." In light of the indisputable facts and circumstances set forth above, both pre- and post-Labor Day 2003, query whether either notion is well premised. Justice Holmes observed that "hard cases make bad law." That dictum seems to be at play once again.
C. Evan Stewart is a partner with Brown Raysman Millstein Felder & Steiner, and an adjunct professor at Brooklyn Law School and Fordham Law School. He is currently legal counsel for Theodore C. Sihpol III. Stewart acknowledges the able assistance of his colleague Hillel I. Parness in the preparation of this article.
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