WASHINGTON In the first of a series of actions to put broad-based reforms in place for the entire mutual fund industry, including municipal bond funds, the Securities and Exchange Commission yesterday adopted new rules requiring fund companies and investment advisers to set up comprehensive compliance programs that include written policies on fair-value pricing.
The SEC commissioners also unanimously voted to propose rules that would require funds to disclose to shareholders their policies and procedures for establishing fair-value prices of shares, their procedures and arrangements for disclosing information about portfolio holdings, and their policies on market timing, which involves the frequent purchase and redemption of fund shares. Fair-value pricing has been an issue in the municipal market since October 2000, when a fund manager dramatically repriced the shares of two municipal bond funds an action that led to the funds shutdown and an SEC investigation.
In an effort to prevent circumvention of a longstanding prohibition on late trading of fund shares, the commissioners also voted unanimously to propose rules that would set a hard 4:00 p.m. daily close for mutual fund trading. The proposal would require that all trades of fund shares be submitted through the funds, transfer agents, or a registered securities clearing agency. SEC officials said this could lead brokers to impose earlier deadlines on customers buying and redeeming fund shares.
In addition, SEC chairman William H. Donaldson detailed several SEC staff rulemaking proposals, to be considered by the commission during the next three months, that would strengthen fund governance; require better disclosure of portfolio transaction costs, fees, and breakpoint discounts; overhaul mutual fund confirmation statements; direct investment advisers to adopt codes of ethics; and require fund advisers to disclose any trading they do for themselves in the funds that they manage.
The recent spate of mutual fund scandals are deeply disturbing to me, Donaldson said at the SEC meeting. We have seen a betrayal of individual investors who entrusted their confidence, the fruits of their labor, their hopes and dreams for the future to this industry for safekeeping.
I firmly believe that the protections embodied in the comprehensive package of reforms that the commission is set to consider will begin to address these concerns and will go a long way toward restoring investor confidence in these important investment vehicles, he said.
The new compliance rules adopted under the Investment Company Act of 1940 and the Investment Advisers Act of 1940, would require funds, within nine months of when the rules are published in the Federal Register, to have comprehensive compliance policies and procedures and to appoint chief compliance officers who would administer these programs and report directly to the funds boards.
Paul Roye, the director of the SECs investment management division, said the new rules will not specify the compliance policies and procedures to be adopted by funds, because fund groups are too varied for a one-size-fits-all approach. However, he said, the policies and procedures should be designed to prevent violations of the securities laws as well as to detect violations when they occur and ensure that they are promptly dealt with and corrected.
In addition, the new rules will explicitly state that funds have an obligation to adopt written fair-market value pricing policies and procedures that will eliminate time zone arbitrage opportunities and ensure that fund share prices are not overstated, understated, or stale.
In October 2000, the Milwaukee-based Heartland Group Inc. dramatically repriced the shares of two municipal bond funds, causing the value of the funds share to plunge 44% to 70%. The SEC ultimately got a court to freeze the assets of three of Heartlands muni funds and to appoint a receiver to liquidate and distribute the funds shares. SEC lawyers launched an investigation and this summer notified Heartland that they were planning to recommend that the SEC take enforcement action over the incident.
The new compliance rules will also require funds to have written policies making clear that selective disclosure of information about portfolio holdings can facilitate insider trading and that insider trading should be prevented. Funds would also have to have policies to prevent abusive market timing practices.
The chief compliance officer would have to give a funds independent directors annual reports on the compliance program as well as any material compliance matters that occurred. These would be defined as matters the board would reasonably need to know to oversee the fund and would cover violations of securities laws and of fund policies and procedures.
The SEC commissioners lauded the new rules.
This is a reform with great potential, said Harvey Goldschmid, adding that it tracks with the governance standards that have been put in place for corporations. said.
This is a best practice requirement for mutual funds, and Paul Atkins.
Commission rules already prohibit late trading, but Roye said that such practices have occurred and have been hard to track because the current rules permit intermediaries such as brokers, bankers, and retirement fund administrators, some of which the SEC does not regulate, to accept or transmit trades. Late trading is trading after a fund has calculated its net asset value, typically at 4:00 p.m., and then profiting from that price, based on new information that has surfaced. Roye called it just plain cheating and said the proposed rule on late trading, in conjunction with other rules to be proposed, will shut the door on such practices.
The proposed rule requiring funds to tell investors how they disclose information on portfolio holdings, is aimed at putting a halt to funds selectively disclosing key information to favored investors, Roye said. The federal securities laws generally prohibit selective disclosure of information that would be material to investors and the market.
SEC commissioner Cynthia Glassman warned funds against taking the new disclosure requirement as a license to selectively disclose information. Disclosing that you selectively disclose when youre not allowed to doesnt make it okay, she said.
Meanwhile, Donaldson said at the meeting that on Dec. 17 the commission will consider a proposal to require funds to better disclose so-called breakpoint or volume discount opportunities, as well as a concept release on the disclosure of portfolio transaction costs. On Jan. 14, the commission will consider a proposal to require portfolio managers to report their personal trading in the funds they manage, a proposed new confirmation statement that would spell out funds sales loads and charges, as well as an interpretative release clarifying how the SECs Rule 12b-1 applies to funds use of brokerage commissions to distribute fund shares.
At that meeting, the SEC also will consider proposals to strengthen fund governance. Fund boards would be required to be led by independent chairmen and would have toincrease to three-fourths from one-half the number of their directors that are independent. Under the proposal, fund directors would have to tell fund shareholders how the board determined that management fees were appropriate. Fund boards also would have to perform annual self-evaluations of their effectiveness and would have to preserve documents.
On Feb. 11, the SEC will consider additional proposals to prohibit market timing abuses, Donaldson said.
