SEC Adopts Amendments to Mutual Fund Fee Rule, Extends Compliance Dates
Date: November 01, 2006
With regard to the Rule’s requirement that fund directors consider whether to adopt a redemption fee, commenters raised concerns about the lack of standards surrounding the terms and conditions under which funds may charge such a fee. Despite such feedback, the Commission neither standardized the terms and conditions for the redemption fees nor adopted a uniform redemption fee because the Commission wanted to guarantee each fund the flexibility to create policies that are best suited to the fund and its investors. Thus, the terms and conditions governing a fund’s redemption fee are matters for the fund’s board to determine.
On September 27, 2006, the Securities and Exchange Commission (the “Commission”) adopted amendments to Rule 22c-2 (the “Rule”) under the Investment Company Act of 1940, as amended. With regard to shareholder information agreements (“Agreements”), the amendments:
- limit the types of intermediaries with which funds must enter into such Agreements;
- address the Rule’s application when there are chains of intermediaries; and
- clarify the effect of a fund’s failure to obtain an Agreement with any its intermediaries.
In addition to the amendments to the Rule’s Agreement provisions, the release:
- offers operational guidance by (i) providing five factors that a fund may consider before requesting the transaction information that must be provided by intermediaries pursuant to an Agreement, and (ii) clarifying that a fund is permitted to defer to an intermediary’s frequent trading policy if such deference would reasonably protect shareholders;
- reiterates that the terms and conditions of any redemption fee adopted under the Rule are to be determined by the fund’s board; and
- extends the date by which funds must enter into Agreements with intermediaries, as well as the date by which a fund must be able to receive the inform-ation that must be provided under the Agreement.
Rule 22c-2 Background
The Rule was adopted on March 11, 2005, as a means of deterring and addressing the direct and indirect costs associated with short-term trading of mutual fund shares. The Rule has two fundamental components: Under Rule 22c-2(a)(1), a fund’s board of directors must either approve a redemption fee of up to 2% of the amount redeemed, or affirmatively decide that such a fee is either not necessary or not appropriate. Under Rule 22c-1(a)(2), a fund is required to enter into written Agreements with intermediaries that obligate the inter-mediaries to respond to the fund’s requests for certain shareholder and transaction information. Further, Rule 22c-2(a)(2) requires that these Agreements contain a provision obligating the intermediaries to carry out the fund’s instructions to restrict or prohibit additional purchases or exchanges by any shareholder identified by the fund as having engaged in trading practices that violate the fund’s market timing policies. The Commission initially set October 16, 2006 as the compliance date for the Rule
Operation of the Rule
Frequency of Requesting Transaction Information
The Commission received a number of comments expressing concern about the frequency with which fund managers, under the terms of an Agreement, could request transaction information. Commenters were concerned that frequent use of this tool could be costly for funds and intermediaries. The Commission refused to impose limits on the frequency of information requests made by funds because it wishes to give managers flexibility in requesting such information to prevent abusive trading activity and because it expects funds that are susceptible to market timing to use the tool regularly.
However, the Commission did provide the following factors that a fund may consider in determining the frequency with which it should seek transaction information: (i) unusual trading patterns that may indicate the existence of frequent trading abuses; (ii) the risks that frequent trading poses to the fund and its shareholders in light of the nature of the fund and its portfolio; (iii) the risks to the fund and its shareholders of frequent trading in light of the amount of assets held by, or the value of sales and redemptions through, the financial intermediary; and (iv) the confidence that the fund and its chief compliance officer have in the implementation by an intermediary of trading restrictions designed to enforce fund frequent trading policies or similar restrictions designed to protect the fund from abusive trading practices.
Use of an Intermediary’s Frequent Trading Policies
In situations in which an intermediary has its own frequent trading policy dealing with market timing concerns, and that policy differs from the fund’s frequent trading policy, the Commission stated that a fund could defer to the intermediary’s policies if a fund in appropriate circumstances could reasonably conclude that an intermediary’s frequent trading policies sufficiently protect fund shareholders. However, the fund should disclose in its prospectus that certain intermediaries through which a shareholder may own funds may impose frequent trading restrictions that differ from those of the fund, generally describe the types of intermediaries, and direct a shareholder to any disclosures provided by an intermediary with which the shareholder has an account to determine what restrictions apply to the shareholder. Moreover, a fund is required to disclose whether each frequent trading restriction applies to trades that occur through omnibus accounts at intermediaries, and to describe with specificity the circumstances, if any, under which each such restriction will not be imposed.
In amending the Rule, the Commission extended the compliance dates for some provisions of the Rule from the original compliance date of October 16, 2006. The new compliance dates are as follows:
October 16, 2006: By October 16, 2006, a fund’s board must consider the adoption of a redemption plan. Please note that the Commission has not extended this compliance date.
April 16, 2007: By April 16, 2007, a fund must enter into Agreements with its intermediaries.
October 16, 2007: By October 16, 2007, a fund must be able to request and promptly receive shareholder identity and transaction information under its Agreements.
Shareholder Information Agreements
Rule 22c-2 requires a fund to enter into written Agreements with its financial inter-mediaries that hold shares on behalf of other investors. Under these Agreements, the intermediaries must agree to provide, at the fund’s request, shareholder identity and transaction information and to carry out instructions from the fund to restrict or prohibit further purchases or exchanges by any shareholder, as identified by the fund, who has engaged in trading that violates the fund’s frequent trading policies.
Prior to the amendments, the term “financial intermediary” was broad enough to include any entity that holds securities in nominee name for other investors, such as a small business retirement plan that holds mutual fundshares on behalf of only a few employees and that may not identify itself as a financial intermediary to the fund. Commenters noted that identifying and negotiating Agreements with such intermediaries would have been costly and burdensome. In response, the Commission amended the definition of “financial intermediary” in Rule 22c-2(c)(1)(iv) to exclude any entity that a fund treats as an “individual investor” for the purposes of the fund’s frequent trading and redemption fee policies. As a result, under the amended Rule, if a fund applies a redemption fee or exchange limits to transactions by a retirement plan (an intermediary) rather than to the purchases and redemptions of employees in the plan, then the plan would not be considered a “financial intermediary” under the rule, and the fund would not be required to enter into an Agreement with that plan.
In addition, in response to the observation that some purchase and redemption orders are aggregated and submitted by agents of intermediaries on behalf of intermediaries, the Commission revised Rule 22c-2(a)(2) to provide that funds must enter into Agreements with “each financial intermediary that submits orders, itself or through its agents, to purchase or redeem shares directly to the fund” (changes italicized). Thus, a fund must enter into Agreements with financial intermediaries or their agents even if the intermediaries submit orders through entities that do not qualify as financial intermediaries.
The Commission received comments from fund managers expressing uncertainty as to how the Rule applied to intermediaries that hold shares of a mutual fund not only on behalf of individual investors, but also on behalf of “indirect intermediaries” through multiple layers of intermediaries or “chains.” In response, the Commission amended the Rule to clarify its applica-bility to “chains of intermediaries.”
Amended Rule 22c-2(c)(5) requires a fund or, on the fund’s behalf, its principal underwriter or transfer agent, o enter into an Agreement only with those financial intermediaries that submit purchase or redemption orders directly to the fund, its principal underwriter or transfer agent, or a registered clearing agency—that is, with “first-tier intermediaries.” However, first-tier intermediaries need not enter into Agreements with any indirect intermediaries.
The amendments as proposed called for Agreements to require a first-tier intermediary to use its best efforts to identify any accountholders that are themselves intermediaries and to obtain and forward, or arrange to have forwarded, the underlying shareholder identity and transaction information from those indirect intermediaries farther down the chain. Commenters found such a requirement to be both burdensome and costly, as first-tier (and indirect) intermediaries would have had to canvass all of their shareholder accounts to determine which accountholders are themselves intermediaries if a fund were to make a blanket request to identify all indirect intermediaries.
The amendments as adopted clarify that a fund, after receiving the initial shareholder identity and transaction information from a first-tier intermediary, must make a specific further request to the first-tier intermediary for information on certain shareholders. Under the amended definition of “shareholder information agreement” in Rule 22c-2(5)(iii), an Agreement requires an intermediary to “[u]se [its] best efforts to determine, promptly upon request of the fund, whether any specific person about whom it has received the identification and transaction information . . . [required by the Rule], is itself a financial intermediary” (changes italicized). Thus, an Agreement need not obligate a first-tier intermediary to perform a complete review of its books and records to identify all indirect intermediaries.
Rather, a first-tier intermediary must use its best efforts to identify whether or not certain specific accounts identified by the fund are indirect intermediaries.
Finally, if an indirect intermediary does not provide the underlying shareholder information to the first-tier intermediary with which it has an account, the Agreement must obligate the first-tier intermediary to prohibit, upon the fund’s request, that indirect intermediary from purchasing additional shares of the fund through the first-tier intermediary.
Lack of an Agreement
Amended Rule 22c-2(c)(5)(iii)(B) provides that if a fund does not have an Agreement with | a particular intermediary, the fund must prohibit only that intermediary from purchasing the fund’s securities, leaving unaffected purchases by other intermediaries.
An exception to the above prohibition applies to purchases that are fully disclosed to the fund and made by intermediaries without an Agreement. The underlying rationale is that the fund does not need the information provided by an Agreement to scrutinize such fully disclosed purchases. The amended language provides that, if there is no Agreement with a particular intermediary, the fund must prohibit that intermediary from purchasing the fund’s securities only “in nominee name on behalf of other persons.” Thus, this provision places no restrictions on the intermediary’s purchasing of fund securities on behalf of the intermediary itself or on behalf of others (but not in nominee name).
Additionally, because of the dual nature of an exchange request as a simultaneous redemption order and purchase order, a fund may restrict or prohibit an intermediary from making both “purchases” and “exchanges.” Thus, if a fund instructs an intermediary to restrict an “exchange,” the intermediary may inform the investor that it will not carry out the redemption portion of the request to exchange into the fund, as well as the purchase portion of the request.