Federal regulators on Wednesday proposed to close a loophole that allows illegal after-hours trading in mutual funds, in a bid to help restore investor confidence in funds that has been shaken by aspreading scandal.
The Securities and Exchange Commission voted 5-0 to tentatively adopt and open to public comment a new trading rule, the first step in its planned overhaul of how the $7 trillion fund industry operates.
To stem illegal late trading that brings profits to a favored few shareholders, the rule would impose a “hard cutoff” of 4 p.m. Eastern time for pricing of fund shares.
The SEC is acting as problems spread through the mutual fund and brokerage industries, more big-name companies are cited for allowing special trading deals that disadvantage ordinary investors and a money stampede continues out of implicated funds. Some 95 million Americans – half of all households – invest in mutual funds.
The SEC move comes two weeks after the House overwhelmingly passed legislation requiring mutual fund companies to disclose more information to investors about fees and operations, and making directors on fund company boards more independent from fund managers.
Treasury Secretary John Snow said the independent agency’s reform plan marks “important progress in strengthening the governance and transparency of mutual funds, in preserving the critical role that these funds play in our financial system and in protecting investors.”
But senators of both parties, while endorsing the SEC’s move as a positive step, continued to criticize the agency for what they said was its delay in acting against fund abuses. “Far more aggressive action will have to be taken before the (fund) industry regains investor confidence,” said Sen. Joseph Lieberman, D-Conn., a candidate for the Democratic presidential nomination.
The Senate is expected to act on related legislation early next year.
In January the SEC will consider far-reaching proposals, including requirements for mutual funds to provide more information, and for board chairmen of fund companies to be wholly independent from the companies managing the funds.
By going through brokerage firms and other third parties, some big investors such as hedge funds are able to cash in on after-hours news ahead of most shareholders, who at that hour would be forced to chance buying at the next day’s closing price.
Under the new rule, mutual funds rather than third parties would have to receive trading orders by 4 p.m., before the funds price their shares for the day. So the order must be in by then for the investor to receive that day’s price.
An SEC official acknowledged that could mean that investors in and managers of 401(k) and other retirement plans, with slower order processing systems than other market participants, would be forced to make their fund trades several hours before the 4 p.m. stock market close.
“There definitely is a tradeoff” in the proposed rule, said Cindy Fornelli, deputy director of the SEC’s investment management division. “We did appreciate that there was this cost.”
However, the agency believes that the benefits of cutting off late trading far outweigh the potential disadvantage to some investors, Fornelli said in an interview. Moreover, having to get the next day’s price could be a disadvantage one day but beneficial another so that the effect could even out over time, SEC staff says.
Trade groups representing investment plans are urging the SEC to instead consider as a solution requiring an automatic time stamp on each trade to verify that the proper price was in effect.
“At a time when Americans are trying to save for their retirements, we are disturbed that the SEC has proposed a rule that disadvantages retirement-plan investors,” said James Klein, president of the American Benefits Council, which represents employers and plan providers.
At a public meeting, the five SEC commissioners also proposed new rules requiring mutual fund companies to clearly disclose their market-timing policies and procedures in sales material. Market timing, which capitalizes on short-term movements in stock prices with quick “in and out” trading of shares, is not illegal but violates the rules of most fund companies.
The practice is under scrutiny in many of the recent cases cited by regulators – including civil fraud charges by the SEC and New York Attorney General Eliot Spitzer on Tuesday against Invesco Funds Group Inc. and its chief executive. The regulators said the company devised a system to recruit big-money market timers despite complaints from its own employees that shareholders were being harmed.
SEC Chairman William Donaldson said the 4 p.m. cutoff and other proposed changes “will go a long way toward restoring investor confidence in these important investment vehicles.”
The proposals could be adopted formally by the SEC after the commission gathers public comment.
The SEC did adopt Wednesday a requirement that all mutual funds have a chief compliance officer reporting to the fund’s board of directors. Most funds already do, but they all will be compelled to do so by next summer.
The embattled mutual fund industry has embraced the proposals, first announced in October. But brokerage firms, which sell some 80 percent of all mutual fund shares and collect billions in fees annually for those sales, are opposed.
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On the Net:
Securities and Exchange Commission: http://www.sec.gov
The House-passed bill, H.R. 2420, is available at http://thomas.loc.gov
