Investment Management
JANUARY 2004
SEC Proposals Address Late Trading, Market Timing,
Fair Value Pricing, and Disclosure of Portfolio Holdings
In response to allegations of widespread abuses in
the fund industry, the Securities and Exchange
Commission (“SEC”) recently proposed regulatory
and disclosure reforms intended to prevent such
abuses from recurring in the future. The proposed
reforms are intended to address “late trading” of fund
shares, “market timing,” fair value pricing and
selective disclosure of fund portfolio holdings.
share price calculated as of 4:00 p.m. that day.” The
proposed change would require a “hard 4:00 p.m. cutoff,” such that an order to purchase or redeem fund
shares qualifies for the current day’s price only if
received by the fund, its designated transfer agent or
a registered clearing agency1 by the “pricing time”
established by the fund for calculating its net asset
value (“NAV”), typically 4:00 p.m. Eastern time.
As a practical matter, the proposed regulatory
reforms addressing late trading would effectively
require investors who buy or sell fund shares
through intermediaries to place their orders well
before 4:00 p.m. in order to receive the current day’s
price—a significant departure from current
requirements. The proposed disclosure reforms
would necessitate heightened fund compliance
practices, and fund board oversight responsibilities,
to support the detailed level of disclosure.
PROPOSED AMENDMENTS TO FORWARD
PRICING RULE TO ADDRESS LATE
TRADING ISSUES
The proposed rule amendment is a significant
departure from the current rule and SEC
interpretations, which allow an investor to receive
the current day’s price for orders submitted before
the pricing time to any of the fund, its principal
underwriter or a third party intermediary, such as a
retirement plan administrator or broker-dealer, even
though the intermediary submits the order to the
fund well after the pricing time. Under the proposals,
orders submitted to fund intermediaries would no
longer be considered orders received by the fund,
even if those intermediaries are agents of the fund.
Only those orders received directly by the fund or
through its designated transfer agent or a registered
clearing agency would be considered received by the
fund for purposes of determining receipt by the
pricing time.
The SEC proposed amendments to rule 22c-1 under
the Investment Company Act of 1940 (“1940 Act”) to
address “late trading” issues. In its proposing
release, the SEC defined “late trading” as the “illegal
practice of permitting a purchase or redemption order
received after the 4:00 p.m. pricing time to receive the
The proposed amendments to rule 22c-1 would
permit, but not require, a fund to designate a transfer
agent to receive orders to purchase or redeem shares.
Funds would be required to identify “designated
transfer agents” in their registration statements and
include a provision in contracts with transfer agents
Comments on the proposals must be received by the
SEC on or before February 6, 2004. Each of the
proposals is discussed in more detail below.
Currently, the only registered clearing agency is the National Securities Clearing Corporation (“NSCC”), which operates
the automated central processing system called “Fund/SERV.”
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Kirkpatrick & Lockhart LLP
requiring the transfer agents to receive order
information and to maintain a record of the date and
time they received the order information. To prevent
orders from being rescinded after calculation of the
daily NAV, each “order,” as defined by the proposal,2
would be deemed irrevocable as of the next pricing
time after receipt by the fund.
orders to a fund after the pricing time. According to
the proposing release, these protections could
include:
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Electronic or physical time-stamping of orders in a
manner that cannot be altered or discarded once
the order is entered into the trading system;
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Annual certification that the intermediary has
policies and procedures in place designed to
prevent late trades, and that no late trades were
submitted to the fund or its designated transfer
agent during the period; and
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Submission by the intermediary to an annual audit
of its controls conducted by an independent
public accountant who would submit a report to
the fund’s chief compliance officer.
Costs, Benefits and Alternative Approaches
In the proposing release, the SEC explained that
current rules, allowing fund intermediaries to process
trades after the pricing time, and recordkeeping rules
requiring broker-dealers to time-stamp fund orders,
have proven inadequate to prevent late trading. The
SEC indicated that some broker-dealers successfully
concealed late trading activities from examination
staff while other intermediaries are not subject to SEC
regulation and examination, thereby making it
impossible to detect late trading through those
intermediaries.
The SEC acknowledged that the proposed rule likely
would require investors to submit purchase and
redemption orders to fund intermediaries as much as
several hours prior to the pricing time in order to
receive the current day’s price, so as to provide the
fund intermediary with sufficient processing time.
This problem may be especially acute for fund
intermediaries on the West Coast who would have to
receive orders from investors much earlier in the day
in order to send the orders to the fund prior to the
pricing time. The SEC noted that 401(k) plan
administrators may be at the greatest disadvantage,
as many have indicated that they would be unable to
process on a same-day basis, and is seeking
comment on these issues.
An alternative approach to the “hard 4:00 p.m. cutoff” suggested by the SEC could be to require fund
intermediaries to adopt protections designed to
prevent late trading in order to be eligible to submit
The SEC has requested comment as to whether these
protections would be appropriate and whether there
are other protections that would be necessary to
prevent late trading of fund shares. The SEC is also
seeking comment on proposed exceptions to the
“hard 4:00 p.m. cut-off,” described below.
Emergency Exceptions
The proposed amendments contain a narrow
exception permitting current-day pricing in cases of
emergency, such as power failures or hurricanes, but
not internal operational difficulties. First, an
exception would apply where a dealer or the dealer’s
agent is unable to transmit the orders to the fund’s
designated transfer agent or clearing agency, but
only if the chief executive officer of the dealer
certifies to the fund (1) the nature, existence, and
duration of the emergency and (2) that the dealer
received the orders before the fund’s pricing time.
Second, an exception would apply where the fund’s
designated transfer agent or a registered clearing
agency is unable to receive the orders by the fund’s
pricing time, provided that the chief executive officer
of the designated transfer agent or clearing agency
provides written or telephonic notice of the
emergency to the fund.
Under the proposed amendments, “order” would mean a direction to purchase or redeem a specific number of fund
shares or an indeterminate number of fund shares of a specific value. The proposed definition of “order” would preserve
the ability of funds to offer “seamless” exchange transactions by further clarifying that an “order” includes a direction to
purchase redeemable securities of the fund using proceeds of a contemporaneous order to redeem a specific number of
shares of another fund.
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Kirkpatrick & Lockhart LLP
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Exception for “Conduit” Funds
The proposed amendments contain an additional
narrow exception for specified “conduit” funds, such
as master-feeder funds and insurance company
separate accounts, that invest all of their assets in an
underlying fund and are therefore required to
calculate their NAV on the basis of the underlying
fund’s NAV. The exception would permit a conduit
fund to submit its orders based on the NAV
established by the underlying fund on the same day,
thereby allowing investors who submit orders to the
conduit fund prior to the pricing time to receive the
current day’s price of the underlying fund.
PROPOSED AMENDMENTS TO REGISTRATION
STATEMENT DISCLOSURES REGARDING
MARKET TIMING, FAIR VALUE PRICING AND
DISCLOSURE OF PORTFOLIO HOLDINGS
The SEC proposed amendments to current disclosure
requirements that apply to registered investment
companies and insurance company separate
accounts issuing variable annuity and variable life
insurance contracts. The proposed amendments
would require enhanced disclosure of policies and
procedures regarding market timing,3 fair value
pricing and selective disclosure of fund portfolio
holdings. A summary of the proposed requirements
is set forth below.
Market Timing
The SEC proposed new and enhanced prospectus
disclosure requirements of risks, policies and
procedures related to frequent purchases and
redemptions of fund shares. The proposals would
require a fund to: (1) describe the risks, if any, that
frequent purchases and redemptions of fund shares
may present for other shareholders; (2) state whether
the fund’s board has adopted policies and
procedures with respect to frequent purchases and
redemptions of fund shares and, if not, the basis
upon which the board determined that such policies
and procedures are unnecessary; and (3) describe
any policies and procedures intended to deter, or any
arrangements to permit, frequent purchases and
redemptions of fund shares. The proposed
amendments would require similar prospectus
disclosure for insurance company separate accounts
offering variable insurance contracts, with respect to
frequent transfers among sub-accounts.4
The proposals would require all risk disclosure to be
specific to each fund, taking into account its
investment objectives, policies and strategies. The
proposing release suggests that this disclosure may
include such risks as dilution in the value of fund
shares held by long-term shareholders, interference
with efficient management of the fund’s portfolio, and
increased brokerage and administrative costs.
Descriptions of policies and procedures would be
required to include: (1) whether or not the fund
discourages or accommodates frequent purchases
and redemptions of fund shares; (2) any policies
intended to detect such activity, including through
fund intermediaries; and (3) policies or procedures
intended to deter frequent purchases and
redemptions of fund shares, such as a redemption fee
or minimum holding period.
Funds also would be required to describe in their
prospectuses any arrangements to permit frequent
trading, including the identity of the parties to the
arrangement and any compensation or other
consideration received by the fund, its investment
adviser or any other party pursuant to such
arrangement. The consideration required to be
disclosed would include any agreement to maintain
“sticky assets,” i.e., assets in the fund or in other
funds managed by the investment adviser or an
affiliated person of the adviser. The proposing
release makes clear that disclosure of these
arrangements would not render lawful an
arrangement that otherwise violates the antifraud
provisions of the federal securities laws or the
fiduciary duties of funds or their advisers.
The proposing release states that market timing may take many forms, but for purposes of the proposed amendments,
the term refers “to arbitrage activity involving the frequent buying and selling of mutual fund shares in order to take
advantage of the fact that there may be a lag between a change in the value of a mutual fund’s portfolio securities and the
reflection of that change in the fund’s share price.”
3
The requirements for insurance company separate accounts would differ in some respects due to the different structure
of these issuers. For example, the proposed amendments would require insurance company separate accounts to
disclose the risks of, and policies and procedures with respect to, frequent transfers of contract value among the
registrant’s sub-accounts, each of which invests in a particular underlying mutual fund. In addition, the proposed
amendments would require disclosure as to whether the separate account or its depositor (as opposed to its board of
directors) has policies and procedures with respect to frequent transfers of contract value among sub-accounts.
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Kirkpatrick & Lockhart LLP
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A major concern arising from the proposed disclosure
is whether it will provide a roadmap for market timers
to avoid detection under the fund’s policies to the
detriment of long-term shareholders.
Fair Value Pricing
The SEC proposed requiring all funds (other than
money market funds) to include prospectus
disclosure regarding (1) the circumstances under
which the fund will use fair value pricing and (2) the
effects of using fair value pricing. The proposals
require the disclosure to be fund specific. For
example, the SEC indicated that funds that invest in
securities traded on overseas markets would be
expected to have a fuller discussion of the events
that would cause the fund to fair value its securities
and the effect of using fair value pricing (such as
minimizing time zone arbitrage) than would a fund
that invests in large-cap domestic securities.
The proposals would establish a fund’s “obligation”
to fair value price when market quotations for
portfolio securities are not readily available,
including when they are not reliable. This proposal
would require funds to review their fair value pricing
procedures and actively monitor their portfolios to
ensure that fair value pricing is applied when
circumstances warrant, consistent with their
procedures and prospectus disclosure. The
proposing release states that funds that fair value
price their portfolio securities effectively can reduce
or eliminate the arbitrage opportunities available to
market timers. The SEC has requested comment on
whether there are cases where disclosure of the
circumstances under which a mutual fund will use fair
value pricing and the effect on the fund of using fair
value pricing may assist investors who intend to
engage in market timing strategies.
Disclosure of Portfolio Holdings
The SEC proposed disclosure amendments to require
a fund to: (1) describe in its statement of additional
information (“SAI”) any policies and procedures with
respect to the disclosure of fund portfolio securities
to any person; (2) describe in its SAI any ongoing
arrangements to disclose information about the
fund’s securities to any person and any
consideration received by the fund or its investment
adviser in exchange for such disclosure; and (3) state
in its prospectus that these descriptions are available
in the fund’s SAI, and, if applicable, on the fund’s
website. The SAI also must disclose the manner in
which the board exercises oversight of disclosure of
the fund’s portfolio securities.
In the proposing release, the SEC emphasized that
disclosure of a fund’s portfolio securities must be
consistent with the antifraud provisions of the
federal securities laws and with a fund’s or adviser’s
fiduciary duty to shareholders to prevent the misuse
of material non-public information; disclosure
provided pursuant to the proposed amendments
would not make lawful conduct that is otherwise
unlawful. The proposing release emphasizes that
divulging portfolio holdings to selected third parties
is permissible only when a fund has a legitimate
business purpose for doing so and the recipients are
subject to a duty of confidentiality. Legitimate
business purposes identified in the proposing release
include, for example, disclosure for due diligence
purposes when an adviser is being acquired or
disclosure to a rating agency for use in establishing a
fund’s rating.
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This article does not address all of the issues raised
by the proposed regulatory and disclosure reforms.
If you want more information on the proposals,
please contact your K&L relationship attorney or one
of the authors of this article, Diane E. Ambler,
Lori Schneider or Ndenisarya Meekins.
DIANE E. AMBLER
202.778.9886
dambler@kl.com
LORI L. SCHNEIDER
202.778.9305
lschneider@kl.com
NDENISARYA MEEKINS
202.778.9021
nmeekins@kl.com
Kirkpatrick & Lockhart LLP
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© 2004 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.