From the November 2005 issue of Investment Advisor • Subscribe!

November 1, 2005

Round Two of Market Timing

The SEC designed Rule 22c-2 to help mutual fund companies deal with market timing, but is it working?

By October 12, 2006, mutual fund companies have to comply with the Securities and Exchange Commission's mutual fund redemption fee rule, Rule 22c-2. The rule, which is voluntary, has received much criticism from the Investment Company Institute (ICI), the mutual fund trade group, because it requires all funds, regardless of whether they impose a redemption fee, to draw up written contracts with every intermediary with which they do business.

The SEC hopes the rule will help funds recoup the costs that short-term trading can impose on funds and their long-term shareholders. Peter Delano, a senior analyst at TowerGroup, says the SEC also issued the rule so that funds could better keep track of what's happening at intermediaries. But the ICI is up in arms because it says that some funds have relationships with tons of intermediaries, and it will require huge amounts of time--and money--for them to comply. Plus, the SEC has yet to clarify the definition of intermediary. Elizabeth Krentzman, the ICI's general counsel, told the SEC in a comment letter that the rule also unfairly requires funds "to bear all of the responsibilities and liabilities associated with imposing redemption fees." Krentzman wrote that the rule "is silent with respect to the obligations of intermediaries (including those maintaining omnibus accounts with a fund and being compensated by the fund for their recordkeeping activities) to impose, or facilitate the imposition of, redemption fees."

In early October, the NASD fined three firms--ING Funds Distributor (IFD), First Allied Securities, Inc., and Janney Montgomery Scott--for market timing violations. ING Funds Distributors was fined $1.5 million, so far the largest fine NASD has imposed in a market timing case, for allowing market timing in its Pilgrim Funds. First Allied Securities of San Diego was fined $408,000 for facilitating the deceptive efforts of three hedge fund customers to engage in improper market timing, according to NASD. Janney Montgomery Scott, based in Philadelphia, was fined $1.2 million for improper market timing and related violations, which included "allowing two hedge fund customers to evade attempts by mutual fund companies to block or restrict their market timing transactions," according to NASD. In settling each matter, none of the firms admitted nor denied the NASD allegations, but consented to the NASD findings.

Delano addressed Rule 22c-2 in an August report called The SEC's Response to Market Timing: Implications for the Mutual Fund Industry. I chatted with him recently about what the rule means for mutual funds and investment advisors.

Does the rule have a direct effect on investment advisors? While advisors are not directly affected, based on the structure of the mutual fund, it could be the case that within a complex [the fund company is] doing investment advisory services, distribution services, and transfer agency services, but there isn't a direct link to the money management arm.

One thing that will affect advisors is the analysis of whether to use redemption fees. Fund boards would want their advisors to give them a sense of what market timing would mean to their portfolio strategies. How much cash do they have to have on hand? What types of securities are they trading? For instance, international funds tend to be more subject to market timing because of time-zone differences. So in the analysis of portfolios, in the sense that if a board decides to charge a 1% or 2% redemption fee for a certain holding period, what does that mean to the investment advisor?

At what stage are funds now in trying to comply? They are in that first phase of trying to figure out who their intermediaries are based on this ruling and how to enter into agreements with them. They are still waiting for SEC guidance--right now the intermediary definition is still broad. Intermediaries could mean retirement plans, bank trust departments, any situation where there is one account that may be held for multiple individuals within that account.

Any indication of when the SEC plans to come out with clarifications? I haven't seen even when they might make an announcement. That's been a big question. Firms can't wait; they're going to have to start at least with the known relationships that they have and start putting those contracts in place and doing the data analysis for their boards.

What's the SEC's ultimate goal in implementing Rule 22c-2? They're hoping that this 22c-2 ruling will give them not only the push to look at redemption fees and see if they'll help [deter market timing], but also give the fund more oversight responsibility of what's happening at their intermediaries. [With the ruling, the fund companies] can see if someone maybe has their account through a fund supermarket, where their transaction is bundled with everybody else's, if they can get more details and see if certain individuals are timing through those large omnibus positions.

Who's ultimately responsible for compliance with this rule? The fund's compliance department only? It's a combination. On the compliance side of the funds, they're going to be working on the contractual language. The legal compliance group will put together the agreement that they will enter into with the intermediaries. The distributor has the relationships, so the distributors have to figure out who they speak with and who has the signing authority on the contract for the intermediary. Then you have the transfer agency that's working with the compliance department to think about what the oversight is going to look like once the data gets submitted. What are they looking for? How often do they want to receive the data? If they identify a market-timing pattern, what are their next steps?

When you say the cost will be borne by the fund shareholders, where will the fees be coming from? It will come in transfer agency costs; those will increase because generally that's where the analysis of the activity is going to happen. The data transmission will also be an expense--moving the transactional data from the intermediary to the mutual fund. It could be any technology the transfer agency has to purchase to do the analysis--that gets passed on in higher transfer agency expenses. I didn't really get a [clear] sense of the distribution expenses--as to how those might be transferred. I was even hearing that intermediaries may charge the funds to receive their transactional data.

Do you think your report encompasses everything that is involved in the ruling? Did you want to go more in-depth into a certain area of the ruling? I tried to match up the report to the SEC analysis. I've identified some areas where I think the costs will be higher than what the SEC estimated--four hours of legal time and a half-hour of support for each fund. But we think if you're a fund family that has a large number of intermediaries, it's going to take in some cases 100 times more [because] there's going to be back and forth [between the fund company and intermediaries in drawing up agreements]. You've got committees that are put in place where people are strategizing and figuring out who their intermediaries are. There are people writing and reviewing the agreements and mailing them; you're not going to get instant signing of these agreements.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

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