New Rules For Mutual Funds

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New Rules For Mutual Funds

Michael Schroeder, The Wall Street Journal

December 3, 2003

The Securities and Exchange Commission is taking its first stab at reform in the wake of the trading scandal sweeping through the mutual-fund industry.

At a public meeting Wednesday, the SEC will be considering changes designed to curb trading abuses in the $7 trillion industry.

The agency is expected to immediately require that funds appoint chief compliance officers and boost their internal monitoring to catch traders skirting rules. And it is expected to approve two other key proposals that should result in new rules early next year. One proposed rule would ban the after-hours trading that improved returns for large customers at the expense of long-term investors. The other would require companies to more fully disclose their fund's policies on preventing market-timing speculators.

The SEC rules could have a direct impact on the way the average mutual fund investor buys and sells funds. For example, the expected rule against after-hours trading could mean that many 401(k) investors will be forced to make all their trades hours before the market closes at 4 p.m. But investor groups say the changes will be just the beginning of a broad, much-needed overhaul of the mutual-fund industry.

The Investment Company Institute, a trade group representing 9,400 mutual funds, has told Congress it supports the proposals being considered by the SEC.

The action Wednesday is part of a much broader regulatory push expected from the agency over the next couple of months. At a recent Senate hearing, SEC Chairman William Donaldson outlined a slew of areas targeted for new oversight. He wants to look at whether investors are hurt by the common industry practice known as soft-dollar deals in which fund managers direct trades to brokers in exchange for research and other services.

The SEC also will consider ways to give investors more information about fund expenses and sales commissions, including revised confirmation statements for investors that show brokers' commissions.

If the agency doesn't respond with sufficient toughness, Congress appears ready to step in with tough mutual-fund reforms on a par with the recent Sarbanes-Oxley Act, which dealt with corporate accounting scandals such as Enron Corp. Indeed, the House recently passed a fund-reform bill directing the SEC to halt trading abuses. The bill also addresses numerous other concerns, including banning insider-trading in mutual funds and prohibiting the same manager from running a hedge fund and mutual fund. The Senate plans legislation early next year that is expected to go beyond the House bill.

Mutual-fund boards, accused of serving the interests of fund management rather than those of ordinary investors, are also coming under assault. The SEC will soon consider requiring that board chairmen are independent of fund management and that 75% of all directors be independent.
The Most Controversial Measure

The most controversial immediate SEC proposal involves requiring mutual funds or their agents to receive trading orders by 4 p.m. EST, when the fund's daily price is calculated. This so-called hard closing for trades is intended to halt late-trading abuses -- the practice of obtaining closing prices for trades after the market's close to the benefit of selected customers.

Such a move may stop abusive late trading, but it also could be problematic for average investors. The American Benefits Council, a group representing employers and benefit plan providers, said "significant problems" could result for investors who buy funds through brokers, retirement plans or other intermediaries because they would have to place orders earlier in the day.

For participants of 401(k) and other retirement plans, the rule would have the effect of a blackout, forcing them to place orders as early as 10 a.m. so their requests are processed on the same day, Council President James Klein said in a letter to the SEC. The group instead recommends that the SEC consider a simple mechanical solution -- requiring an automatic time stamp on each trade to create an audit trail in lieu of imposing a hard 4 p.m. deadline.

Late trading came to light this fall when New York Attorney General Eliot Spitzer settled with a hedge fund alleged to have traded mutual funds after 4 p.m., touching off numerous other state and federal probes into the practice at other funds. He compared the practice to betting on a race after the horses have crossed the finish line.

Stopping Market-Timing

There's less opposition to the SEC's proposal to combat market-timing abuses. The practice of rapid-fire buying and selling of fund shares isn't illegal, but can raise fund costs and cut performance.

To curb rapid trading, the SEC is expected to recommend a mandatory minimum 2% penalty on early redemptions. Funds now have the option of imposing a maximum penalty of 2% of assets or actual costs, and while many funds do have such penalties, few are that high.

But the penalties may not address what many experts consider the real problem: stale fund pricing. Prices of mutual funds are adjusted just once a day, and thus often may not reflect the true value of their underlying assets. Market-timers have earned quick profits by taking advantage of these price discrepancies.

Mercer Bullard, head of investor-advocacy group Fund Democracy and law professor at the University of Mississippi, said that using updated "fair value" pricing and barring market timers from mutual funds would be a better fix for market-timing abuses.

"The biggest lapse at the SEC -- three months after the scandal broke -- is that they haven't come out and said that the enforcement division will sue companies for using stale prices," he added.

An SEC spokesman said, "We don't talk in advance about who we will sue for what."