[Federal Register: March 18, 2005 (Volume 70, Number 52)]
[Rules and Regulations]
[Page 13327-13342]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr18mr05-22]
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Part IV
Securities and Exchange Commission
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17 CFR Part 270
Mutual Fund Redemption Fees; Final Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-26782; File No. S7-11-04]
RIN 3235-AJ17
Mutual Fund Redemption Fees
AGENCY: Securities and Exchange Commission.
ACTION: Final rule; request for additional comment.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is adopting a new rule that allows registered open-end
investment companies (``funds'') to impose a redemption fee, not to
exceed two percent of the amount redeemed, to be retained by the fund.
The redemption fee is intended to allow funds to recoup some of the
direct and indirect costs incurred as a result of short-term trading
strategies, such as market timing. The new rule also requires most
funds to enter into written agreements with intermediaries (such as
broker-dealers and retirement plan administrators) that hold shares on
behalf of other investors, under which the intermediaries must agree to
provide funds with certain shareholder identity and transaction
information at the request of the fund and carry out certain
instructions from the fund. The Commission is also requesting
additional comment to obtain further views on whether it should
establish uniform standards for redemption fees charged under the rule.
DATES: Effective Date: May 23, 2005.
Compliance Date: October 16, 2006. Section III of this release
discusses the effective and compliance dates applicable to rule 22c-2.
Comment Date: Comments should be received on or before May 9, 2005.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml.
); or Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-11-04 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549-0609.
All submissions should refer to File Number S7-11-04. This file
number should be included on the subject line if e-mail is used. To
help us process and review your comments more efficiently, please use
only one method. The Commission will post all comments on the
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml
). Comments are also available for public inspection and
copying in the Commission's Public Reference Room, 450 Fifth Street,
NW., Washington, DC 20549. All comments received will be posted without
change; we do not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly.
FOR FURTHER INFORMATION CONTACT: William C. Middlebrooks, Jr., Senior
Counsel, or C. Hunter Jones, Assistant Director, Office of Regulatory
Policy, (202) 551-6792, Division of Investment Management, Securities
and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-
0506.
SUPPLEMENTARY INFORMATION: The Commission today is adopting rule 22c-2
[17 CFR 270.22c-2] under the Investment Company Act of 1940 [15 U.S.C.
80a] (the ``Investment Company Act'' or the ``Act'') and amendments to
rule 11a-3 [17 CFR 270.11a-3] under the Act.\1\ We invite additional
comment on the issues discussed in Section II.C of this release.
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\1\ Unless otherwise noted, all references to statutory sections
are to the Investment Company Act of 1940, and all references to
``rule 22c-2'' or any paragraph of the rule will be to 17 CFR
270.22c-2; all references to rule 11a-3 or any paragraph of that
rule will be to 17 CFR 270.11a-3 as amended. References to comment
letters are to letters available in File No. S7-11-04.
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Table of Contents
I. Background
II. Discussion
A. Redemption Fees
B. Shareholder Transaction Information
C. Request for Additional Comment
1. Elements of a Uniform Redemption Fee
2. Financial Intermediaries
3. Recordkeeping
III. Effective and Compliance Dates
IV. Cost-Benefit Analysis
V. Consideration of Promotion of Efficiency, Competition and Capital
Formation
VI. Paperwork Reduction Act
VII. Final Regulatory Flexibility Analysis
VIII. Statutory Authority
Text of Rule
I. Background
Investors in mutual funds can redeem their shares on each business
day and, by law, must receive their pro rata share of the fund's net
assets.\2\ This redemption right makes funds attractive to fund
investors, most of whom are long-term investors, because it provides
ready access to their money if they should need it. The redemption
right also makes funds attractive to a small group of investors who use
funds to implement short-term trading strategies,\3\ such as market
timing,\4\ by making frequent purchases and redemptions in order to
capture small gains.\5\ Most fund shareholders, however, are not active
traders of their shares.\6\
Excessive trading in mutual funds occurs at the expense of long-
term investors, diluting the value of their shares.\7\ It may disrupt
the management
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of a fund's portfolio and raise the fund's transaction costs because
the fund manager must either hold extra cash or sell investments at
inopportune times to meet redemptions.\8\ Frequent trading also may
result in unwanted taxable capital gains for the remaining fund
shareholders. Funds have taken steps to deter excessive trading or have
sought reimbursement from traders for the costs of their excessive
transactions.\9\
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\2\ An open-end investment company (i.e., a ``mutual fund'')
issues ``redeemable securities,'' which entitle the holder of the
securities to receive approximately his proportionate share of the
fund's net asset value. See section 2(a)(32) of the Act [15 U.S.C.
80a-2(a)(32)] (defining ``redeemable security''); section 5(a)(1) of
the Act [15 U.S.C. 80a-5(a)(1)] (defining ``open-end company'').
\3\ These market strategies include time zone arbitrage, but may
include others that are not dependent on the misvaluation of
portfolio securities. See, e.g., Borneman v. Principal Life Ins.
Co., 291 F. Supp. 2d 935 (S.D. Iowa 2003), which involved a dispute
resulting from an insurance company's market timing restrictions on
annuityholders who were exploiting a correlation between changes in
the value of shares of a separate account investing in international
equities and one investing in domestic equities.
\4\ Market timing includes (a) frequent buying and selling of
shares of the same fund or (b) buying or selling fund shares in
order to exploit inefficiencies in fund pricing. Market timing,
while not illegal per se, can harm other fund shareholders because
(a) it can dilute the value of their shares, if the market timer is
exploiting pricing inefficiencies, (b) it can disrupt the management
of the fund's investment portfolio, and (c) it can cause the
targeted fund to incur costs borne by other shareholders to
accommodate the market timer's frequent buying and selling of
shares.
\5\ See Edward S. O'Neal, Purchase and Redemption Patterns of
U.S. Equity Mutual Funds, 33 Fin. Mgt. Assoc. 63, at text following
n.1 (2004) (``[H]eightened redemption activity, even among a
minority of fund investors, has liquidity-cost implications for all
fund shareholders.'').
\6\ See Redemption Activity of Mutual Fund Owners, Fundamentals
(Investment Company Institute, Washington, D.C.), March 2001, at 1-3
(stating that the vast majority of fund shareholders do not
frequently redeem their shares, and that a small percentage of
shareholders account for the most active trading).
\7\ See Gary L. Gastineau, Protecting Fund Shareholders from
Costly Share Trading, 60 Fin. Analysts J. 22 (2004) (estimating that
frequent buying and selling reduces an average stock fund's annual
returns by at least 1%, which amounts to nearly $40 billion annually
for all stock mutual funds). See also Jason Greene & Charles Hodges,
The Dilution Impact of Daily Fund Flows on Open-end Mutual Funds:
Evidence and Policy Solutions, 65 J. Fin. Econ. 131 (2002)
(estimating annualized dilution from frequent trading, based on
market timing, of 0.48% in international funds: ``the dilution
impact has brought about a net wealth transfer from passive
shareholders to active traders in international funds in excess of
$420 million over a 26-month period.''). See also Roger M. Edelen,
Investor Flows and the Assessed Performance of Open-end Mutual
Funds, 53 J. Fin. Econ. 439, 457 (1999) (quantifying the costs of
liquidity in mutual funds as $0.017 to $0.022 per dollar of
liquidity-motivated trading). A more recent study conducted by
Edelen and others estimated that commissions and spreads alone cost
the average equity fund as much as 75 basis points. See John M.R.
Chalmers, et al., Fund Returns and Trading Expenses: Evidence on the
Value of Active Fund Management, (last modified Aug. 30, 2001), at
10 (available at http://finance.wharton.upenn.edu/edelen/PDFs/MF_tradexpenses.pdf
.
\8\ See William Samuel Rocco, Are You Safe from Market-Timers?,
Morningstar.com (June 22, 2004) available at http://news.morningstar.com/doc/article/0
,1,109373,00.html (``Both the
deliberate and the inadvertent short- to mid-term market-timers
raise trading costs and undermine long-term performance by forcing
managers to carry more cash than they otherwise would and make sales
they otherwise wouldn't during sell-offs.'') (last visited Sept. 24,
2004); Paula Dwyer, et al., Mutual Funds Feel The Heat, Bus. Wk.,
Oct. 20, 2003, at 50 (``[S]hareholders get short shrift when funds
sell off good investments or hold extra cash to pay back the timers.
Shareholder returns also decline because market timing raises mutual
funds' own trading costs.''). See also Ken Hoover, Why Mutual Funds
Discourage Timers; Two Forms of Practice; They Increase Expenses,
Can Disrupt Portfolios and Rob Other Investors, Investor's Bus.
Daily, Sept. 17, 2003, at AO9.
\9\ Some of the approaches that funds have adopted include: (i)
restricting exchange privileges, including delaying both the
redemption and purchase sides of an exchange; (ii) limiting the
number of trades within a specified period; (iii) delaying the
payment of proceeds from redemptions for up to seven days (the
maximum delay permitted under section 22(e) of the Act); (iv)
satisfying redemption requests in-kind; and (v) identifying market
timers and restricting their trading or barring them from the fund.
See Disclosure Regarding Market Timing and Selective Disclosure of
Portfolio Holdings, Investment Company Act Release No. 26287 (Dec.
11, 2003) [68 FR 70402 (Dec. 17, 2003)] at text preceding and
following n.14 (discussing the various steps that funds have taken
to discourage market timing).
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These steps frequently include establishing market timing policies
that prevent shareholders from making frequent exchanges among funds,
and imposing a redemption fee--a small fee at the time a shareholder
redeems shares, typically a short time after purchasing them.\10\
Many funds, however, have been unable to effectively enforce their
market timing policies or impose redemption fees on the accounts of
investors who purchase fund shares through broker-dealers, banks,
insurance companies, and retirement plan administrators
(``intermediaries''). These share holdings frequently are identified in
the books of the fund (or its transfer agent) in the name of the
intermediary, rather than in the name of the fund shareholder. Many
intermediaries controlling these so-called ``omnibus accounts'' have
provided the fund with insufficient information for the fund to apply
redemption fees. Because of this lack of information, today many funds
choose not to apply redemption fees, or are unable to enforce their
policies against market timing with respect to shares held through
these omnibus accounts. As a result, those shareholders have often been
beyond the reach of fund directors' efforts to protect the fund and its
shareholders from the harmful effects of short-term trading. A number
of the market timing abuses identified through our investigations
reveal that certain shareholders were concealing abusive market timing
trades through omnibus accounts.\11\
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\10\ See Arden Dale, Mutual-Fund ``Timers'' Get Clocked--
Scandals Lead to Grief; How the Dreaded T-Word Became ``Active
Investment,'' Wall St. J., Aug. 23, 2004, at C15 (``Tarred by the
fund-trading scandal, the practice of rapid trading--also known as
market timing--is under fire by fund companies. * * * To turn up the
heat on timers, fund companies are adding new [redemption] fees.'').
Lisa Singhania, Mutual Fund Redemption Fees are Rising, USA Today,
July 12, 2001 (``Financial Research Corp. found the number of funds
charging redemption fees rose 82 percent between Dec. 31, 1999 and
Mar. 30, 2001.''). Funds' use of redemption fees is not new. We
noted the use of redemption fees by funds in a 1966 report to
Congress. Report of the Securities and Exchange Commission on the
Public Policy Implications of Investment Company Growth, H.R. Rep.
No. 89-2337, at 58, n.156 (1966) (``Redemption fees serve two
purposes: (1) they tend to deter speculation in the fund's shares;
and (2) they cover the fund's administrative costs in connection
with the redemption.'').
\11\ See, e.g., SEC v. Security Trust Company, et al.,
Litigation Release No. 18653 (Apr. 1, 2004).
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Last year we proposed to address the widespread problem of short-
term trading in fund shares by requiring funds to impose a redemption
fee of two percent of the amount redeemed on shares held for five
business days or less.\12\ Under our proposal funds also would have had
to require that intermediaries provide them weekly information about
transactions of beneficial owners of shares held in omnibus accounts
controlled by intermediaries. Our rule proposal was intended to
reimburse the funds for the costs of short-term trading and to
discourage short-term trading of fund shares by reducing the
profitability of the trades.
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\12\ See Mandatory Redemption Fees for Redeemable Fund
Securities, Investment Company Act Release No. 26375A (Mar. 5, 2004)
[69 FR 11762 (Mar. 11, 2004)] (``Proposing Release'') (the proposed
rule provided exceptions from the redemption fee for de minimis
redemptions, financial emergencies, money market funds, exchange-
traded funds, and funds that permit short-term trading).
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II. Discussion
We received nearly 400 comments on the proposed rule. Although many
commenters, including fund management companies, supported the
proposal, most commenters objected to a rule that would mandate a
redemption fee.\13\ Many were concerned that the redemption fee would
inadvertently apply to harmless transactions such as account
rebalancings or redemptions after recent periodic contributions.\14\ In
contrast one commenter urged that, if we were to adopt a mandatory fee,
we require that the fee be imposed on all short-term redemptions so
that it would be easy to implement,\15\ while others argued for a
variety of exceptions under which a redemption fee would not apply.\16\
Still others urged that we permit redemption fees greater than two
percent.\17\
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\13\ A substantial number of commenters, including about 100
investors who submitted substantially the same comment letter,
objected to the imposition of redemption fees generally.
\14\ See, e.g., Comment Letter of Charles Terrell (Mar. 20,
2004); Comment Letter of Stephanie Kelly (May 10, 2004); Comment
Letter of Eugene Asken (Mar. 31, 2004).
\15\ See Comment Letter of Fidelity Investments (June 4, 2004)
(recommending that funds be required to implement redemption fees
consistently, including to short-term trades in retirement plans or
omnibus accounts).
\16\ See, e.g., Comment Letter of the Vanguard Group (May 10,
2004); Comment Letter of the Investment Company Institute (May 7,
2004).
\17\ See, e.g., Comment Letter of the Investment Company
Institute (May 7, 2004) (stating that some funds may need to impose
redemption fees greater than two percent to balance the interests of
redeeming shareholders and shareholders that remain in the fund);
Comment Letter of Consumer Federation of America and Fund Democracy,
Inc. (May 11, 2004) (recommending a two percent redemption fee for
sales within 30 days of purchase and permitting redemption fees of
up to five percent for sales within five days of purchase). In the
Proposing Release, we also requested that commenters address fair
value pricing as it relates to market timing, including areas of
uncertainty that require further guidance from the Commission. See
Proposing Release, supra note , at Section II.F. Almost all the
commenters that addressed fair value pricing supported it as an
effective means to combat market timing, but many stated that fair
value pricing alone is not sufficient to address short-term trading
because it does not address the ability of market timers to trade
for free while the costs of their trading are borne by long-term
shareholders.
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We continue to believe, and the weight of evidence submitted by
commenters suggests, that redemption fees, together with effective
valuation procedures,\18\ can be an effective means
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to protect funds and fund shareholders by requiring that short-term
traders compensate funds for the costs that may result from frequent
trading.\19\ Commenters persuaded us, however, that a mandatory fixed
redemption fee imposed by Commission rule is not the best way to
achieve our goals. Some funds may not have costs that warrant imposing
any redemption fee; others may have lower costs and could protect their
shareholders by imposing a redemption fee of less than two percent.\20\
Boards of directors, as several commenters suggested, are better
positioned to determine whether the fund needs a redemption fee and, if
so, the amount of the fee.\21\ We agree and have decided not to adopt a
mandatory redemption fee.
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\18\ The Investment Company Act requires funds to calculate
their net asset values using the market value of the portfolio
securities when market quotations for those securities are readily
available, and, when a market quotation for a portfolio security is
not readily available, by using the fair value of that security, as
determined in good faith by the fund's board. 15 U.S.C. 80a-
2(a)(41); 17 CFR 270.2a41-1. These valuation requirements are
critical to ensuring that fund shares are purchased and redeemed at
fair prices, shareholder interests are not diluted, and
opportunities for arbitrage through short-term trading are
diminished. We are working to address issues that arise under the
valuation requirements and anticipate issuing a release in the near
future.
\19\ See Comment Letter of the Vanguard Group (May 10, 2004)
(``In our experience, redemption fees, together with fair value
pricing and active transaction monitoring, are very effective in
curtailing short-term trading that may harm funds and their
shareholders.''); Comment Letter of Consumer Federation of America
and Fund Democracy, Inc. (May 11, 2004) (recommending that mandatory
redemption fees supplement fair value pricing); Comment Letter of
Fidelity Investments (June 4, 2004) (``Even for international funds
it should be recognized that fair-value pricing cannot eliminate
potential short-term trading. In our experience fair-value pricing
of foreign markets can curtail potential arbitrage profits on days
when markets move significantly, but is less reliable in preventing
short-term trading profits on less active days: a price move of 25
or 50 basis points, for example. Redemption fees assure that traders
are not tempted to try to capture these small potential profits at
the expense of other investors.''). See also, e.g., Gregory B.
Kadlec, On Solutions to the Mutual Fund Timing Problem (Aug. 30,
2004) http://www.ici.org/issues/timing/wht_04_mkt_time_solutions.pdf
, appended to Comment Letter of the Investment Company
Institute (Sept. 2, 2004) (study commissioned and submitted by the
Investment Company Institute, (``In principle, the timing problem
could be fully resolved by either removing predictability from NAVs
(i.e., fair value pricing) or imposing barriers to its exploitation
(i.e., redemption fees). Because of the practical limitations of
removing predictability and the cost of imposing barriers, the most
effective and efficient solution involves a balanced and modest
attack on each front.'').
\20\ See Comment Letter of Fidelity Investments (June 4, 2004)
(``We do not believe that lower-volatility funds that invest in more
liquid markets--government bond funds, for example or balanced
funds--should be required to adopt redemption fees in order to
protect shareholders in international funds and a few other fund
types from short-term trading.''); Comment Letter of Merrill Lynch,
Pierce, Fenner & Smith Inc. (May 10, 2004) (``The short-term trading
issue is actually a number of different, although related, issues,
which affect different types of investment companies and products in
different ways.''); Comment Letter of the Vanguard Group (May 10,
2004) (recommending that short-term bond funds be excepted from
mandatory redemption fee rule).
\21\ See Comment Letter of Charles Schwab & Co., Inc. (May 10,
2004) (arguing that fund boards should decide whether redemption
fees are appropriate in order to avoid a ``one-size fits all''
approach); Comment Letter of Fidelity Investments (June 4, 2004)
(recommending that the rule require a fund board to consider whether
redemption fees are appropriate, because a mandatory fee would, in
many cases, penalize shareholders who are not engaging in excessive
trading); Comment Letter of Merrill Lynch, Pierce, Fenner & Smith
Inc. (May 10, 2004) (recommending that fund boards address the
different issues resulting from short-term or frequent trading, as
applicable, to different types of funds because a mandatory
redemption fee would be unfair to many shareholders who are not
frequent traders); Comment Letter of Rydex Investments (Apr. 20,
2004) (opposing ``one-size fits all'' mandatory redemption fee
because fund boards should decide whether redemption fees are
appropriate).
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Instead of requiring that each fund impose a redemption fee, the
rule we are today adopting authorizes fund directors to impose a
redemption fee of up to two percent of the amount redeemed when they
determine that a fee is in their fund's best interest.\22\ It permits
each board to take steps it concludes are necessary to protect its
investors, and provides the board flexibility to tailor the redemption
fee to meet the needs of the fund. As a result of our adoption of this
rule, which is described in more detail below, the staff no-action
positions concerning redemption fees have terminated.\23\
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\22\ Rule 22c-2 prohibits a fund from redeeming shares within
seven days after the share purchase unless the fund meets three
conditions. See rule 22c-2(a). First, the board of directors must
either (i) approve a redemption fee, or (ii) determine that
imposition of a redemption fee is either not necessary or not
appropriate. Second, the fund (or its principal underwriter) must
enter into a written agreement with each financial intermediary
under which the intermediary agrees to (i) provide, at the fund's
request, identity and transaction information about shareholders who
hold their shares through an account with the intermediary, and (ii)
execute instructions from the fund to restrict or prohibit future
purchases or exchanges. Third, the fund must maintain a copy of each
written agreement with a financial intermediary for six years.
\23\ See, e.g., John P. Reilly & Associates, SEC Staff No-Action
Letter (July 12, 1979) (``Reilly No-Action Letter''); Neuberger &
Berman Genesis Fund, Inc., SEC Staff No-Action Letter (Sept. 27,
1988) (``Genesis Fund No-Action Letter'').
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We also are adopting a requirement that each fund enter into
written agreements with its financial intermediaries, including those
holding shares in omnibus accounts, providing the fund with access to
information about transactions by fund shareholders. This information
will permit funds to better enforce their market timing policies.\24\
The agreement also must contain a provision requiring the intermediary
to execute the fund's instructions to restrict or prohibit further
purchases or exchanges by any shareholder identified by the fund as
having engaged in trading that violates the fund's market timing
policies.\25\
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\24\ See Comment Letter of the American Council of Life Insurers
(May 10, 2004) (suggesting as an alternative to imposing a mandatory
redemption fee in the retirement plan context, that the Commission
together with the Departments of Labor and Treasury authorize
pension record keepers to take individual action against
participants engaging in market timing or other abusive transactions
in reliance on instructions from a plan's underlying funds.).
\25\ See infra Section II.B.
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Finally, we are requesting comment on whether we should adopt a
uniform redemption fee for those funds deciding to impose such a fee
and, if so, the terms of such a fee. A uniform fee may be less costly
for the thousands of fund intermediaries to collect, and may result in
greater willingness on the part of these intermediaries to collect the
fees. We discuss the new rule and our request for further comment in
more detail below.
A. Redemption Fees
Rule 22c-2 requires that each fund's board of directors (including
a majority of independent directors) either (i) approve a redemption
fee that in its judgment is necessary or appropriate to recoup costs
the fund may incur as a result of redemptions, or to otherwise
eliminate or reduce dilution of the fund's outstanding securities, or
(ii) determine that imposition of a redemption fee is not necessary or
appropriate.\26\ The rule thus requires each board before the
compliance date to at least consider implementing a redemption fee
program to counter short-term trading.\27\
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\26\ Rule 22c-2(a)(1). The requirement does not apply to money
market funds, exchange-traded funds, and funds that affirmatively
permit market timing of fund shares. See rule 22c-2(b). Any such
fund that elects to impose a redemption fee, however, would need to
comply with the other requirements of the rule. See id. Unlike the
proposal, the exception in the final rule for funds that actively
permit market timing does not require that the fund's treatment of
short-term trading be a fundamental policy (i.e., one that may be
changed only with shareholder approval). See rule 22c-2(b)(3). We
revised this condition so that a fund's board can quickly implement
policies it determines are necessary to protect shareholders from
the dilution and expense of short-term trading. See Comment Letter
of Rydex Investments (April 20, 2004).
\27\ For a discussion of the effective and compliance dates, see
infra Section III. A fund that currently has a redemption fee would
meet the rule's requirement, although the fund's directors may
choose to review the redemption fee to determine whether the amount
of the fee and the holding period continue to meet the fund's needs.
Because the rule defines the term ``fund'' to include a separate
series of any open-end investment company, the board of directors of
any newly established separate series would have to make the
determination required under rule 22c-2(a)(1) with respect to that
series.
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[[Page 13331]]
The proceeds of the redemption fee, in all cases, must be paid to
the fund itself. The redemption fee is designed to reconcile conflicts
between shareholders who would use the fund as a short-term trading
vehicle, and those making long-term investments who would otherwise
bear the costs imposed on the fund by short-term traders. Directors may
impose the fee to offset the costs of short-term trading in fund
shares, and/or to discourage market timing and other types of short-
term trading strategies.\28\
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\28\ Under rule 38a-1, a fund must have policies and procedures
reasonably designed to ensure compliance with the fund's disclosed
policies regarding market timing. We noted when we adopted rule 38a-
1 that these procedures should provide for monitoring of shareholder
trades or flows of money in and out of the fund in order to detect
market timing activity, and for consistent enforcement of the fund's
policies regarding market timing. See Compliance Programs of
Investment Companies and Investment Advisers, Investment Company Act
Release No. 26299 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)]
(``Compliance Programs'').
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The redemption fee may not exceed two percent of the amount
redeemed. Some commenters called for us to permit higher redemption
fees because such fees may be more effective at preventing abusive
market timing transactions.\29\ We believe that a higher redemption fee
could harm ordinary shareholders who make an unexpected redemption as a
result of a financial emergency. Moreover, it would in our judgment
impose an undue restriction on the redeemability of shares required by
the Act. The two percent limit is designed to strike a balance between
two competing goals of the Commission--preserving the redeemability of
mutual fund shares while reducing or eliminating the ability of
shareholders who rapidly trade their shares to profit at the expense of
their fellow shareholders.\30\ Funds have, and should utilize,
additional tools to prevent abusive market timing transactions.\31\
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\29\ See, e.g., Comment Letter of the Investment Company
Institute (May 7, 2004); Comment Letter of Morningstar, Inc. (May
10, 2004).
\30\ We also are using our exemptive authority under section
6(c) of the Act in adopting rule 22c-2. By adopting the rule, we are
providing an exemption from the Act's requirement that investors
redeeming shares of a mutual fund must receive their pro rata net
asset value of their shares (section 2(a)(32) of the Act [15 U.S.C.
80a-2(a)(32)) and from the Act's prohibition against the issuance of
a senior security. Shares not subject to the redemption fee could be
considered to be a senior security, in violation of section 18(f)(1)
of the Act [15 U.S.C. 80a-18(f)(1)] (prohibiting a fund from issuing
a security that has priority over other securities with regard to
distribution of assets).
\31\ See supra note 9. Our decision today to provide fund
managers with access to omnibus account transaction information
should substantially enhance these tools by permitting funds to
better identify frequent traders and detect violations of their
market timing policies. We discuss this provision below. See infra
Section II.C.
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Directors may set a redemption fee of less than two percent under
rule 22c-2.\32\ Unlike the approach taken by certain funds in the
past,\33\ the amount of the redemption fee approved by directors need
not be tied to the administrative and processing costs associated with
redeeming fund shares.\34\ By adopting rule 22c-2, we now are
permitting redemption fees to be based on the judgment of the fund and
its board rather than on a strict assessment of administrative and
processing costs, which can be difficult to estimate and may vary from
period to period.\35\ Under rule 22c-2, a fund board setting the amount
of the redemption fee could, for example, take into consideration
indirect costs to the fund that arise from short-term trading of fund
shares, such as liquidity costs, i.e., the cost of investing a greater
portion of the fund's portfolio in cash or cash items than would
otherwise be necessary.\36\
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\32\ The details of the redemption fee, the circumstances under
which it would (and would not) be imposed, and the specific
exceptions to imposition of the fee are currently disclosed to fund
investors when they decide to invest in a fund and may include
exceptions for particular transactions. See Forms N-1A, N-3, N-4,
and N-6.
\33\ See Reilly No-Action Letter, supra note 23. (``a mutual
fund may make a charge to cover administrative expenses associated
with redemption, but if that charge should exceed 2 percent, its
shares may not be considered redeemable [as defined in section
2(a)(32) of the Act]. * * *''); Genesis Fund No-Action Letter, supra
note 23 (stating that staff would not recommend enforcement action
under section 18(f)(1) of the Act regarding the issuance of a senior
security as a result of a fund's redemption fee policy).
\34\ See Reilly No-Action Letter, supra note 23.
\35\ We also are adopting conforming amendments to rule 11a-3
that reflect the approach taken in the rule. See rule 11a-3(a)(7)
(revising the definition of ``redemption fee'' to mean a fee imposed
pursuant to rule 22c-2); rule 11a-3(b)(2)(ii) (deleting the
paragraph providing that any scheduled variation of a redemption fee
must be reasonably related to the costs to the fund of processing
the type of redemptions for which the fee is charged).
\36\ We note that funds relying on staff no-action letters have
not used redemption fees to recoup or offset those types of costs.
The Commission took the approach embodied in the rule in the context
of redemption fees imposed on exchanges. The Commission stated that
the ``inclusion [in a redemption fee] of costs, other than those
directly related to processing exchanges,'' would be considered by
the Commission or staff on a case-by-case basis. See Offers of
Exchange Involving Registered Investment Companies, Investment
Company Act Release No. 17097 (Aug. 3, 1989) at n.37 (adopting rule
11a-3). The amendments to rule 11a-3 conform the redemption fee
provisions in rules 11a-3 and 22c-2. See supra note 35.
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Rule 22c-2 authorizes the board to approve a redemption fee on
shares redeemed within seven or more calendar days after the shares
were purchased.\37\ Thus, the rule permits a fund board that adopts a
redemption fee to determine, in its judgment, whether a period longer
than seven calendar days is necessary or appropriate for the fund to
protect its shareholders. This determination could, for example,
include considerations as to whether different combinations of holding
periods and redemption fee levels are appropriate for different funds
that do not have the same vulnerability to market timing.\38\
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\37\ The proposed rule provided for imposition of the fee for
redemptions within five business days. We have revised the holding
period slightly in response to commenters who noted that fund
complexes, broker-dealers, and other businesses observe different
business holidays, and who supported a simpler approach of using
seven calendar days. See, e.g., Comment Letter of Fidelity
Investments (June 4, 2004).
\38\ See id.
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B. Shareholder Transaction Information
Rule 22c-2 also requires funds to enter into written agreements
with their intermediaries under which the intermediaries must, upon
request, provide funds with certain shareholder identity and trading
information.\39\ This requirement will enable funds to obtain the
information that they need to monitor the frequency of short-term
trading in omnibus accounts and enforce their market timing
policies.\40\
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\39\ Rule 22c-2(a)(2)(i).
\40\ The rule requires that the fund's agreement with the
intermediary be in writing so that the fund can maintain a record of
the agreement that Commission examination staff can review. See
infra section II.C.3.
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Many commenters opposed our proposal, which would have required
financial intermediaries to deliver identification and transaction
information each week. Commenters argued that weekly delivery and
receipt of the information would be costly and burdensome for funds and
financial intermediaries.\41\ Most of these commenters preferred that
financial intermediaries be required to provide the information at the
fund's request.\42\ Because some funds may need the information only on
occasion, while others may need the information regularly, the final
rule allows each fund to determine when it should receive the
information.
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\41\ See, e.g., Comment Letter of Integrated Fund Services, Inc.
(May 7, 2004) (the exchange of investor data would be costly and
difficult to manage).
\42\ See, e.g., Comment Letter of American Century Investments
(May 10, 2004); Comment Letter of Charles Schwab & Co., Inc. (May
10, 2004); Comment Letter of the SPARK Institute, Inc. (May 10,
2004).
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Commenters also disagreed among themselves whether funds or
intermediaries should be responsible for
[[Page 13332]]
enforcing fund market timing policies. Intermediaries argued that funds
should bear the responsibility for enforcing fund policies,\43\ while
the funds argued that the intermediaries were in a better position, at
least with respect to shares held in omnibus accounts, because fund
managers had inadequate information about the transactions.\44\ In the
past, such disagreements have in some cases resulted in no one
enforcing fund market timing policies with respect to shares held in
omnibus accounts. The rule we are adopting makes funds responsible for
determining when they need a financial intermediary's assistance in
monitoring and enforcing fund market timing policies.
---------------------------------------------------------------------------
\43\ See, e.g., Comment Letter of Charles Schwab & Co., Inc.
(May 10, 2004) (arguing that ``[i]ntermediaries may not be able to
enforce market-timing policies on behalf of hundreds of different
fund families and thousands of different funds because the
complexity of doing so would make the task prohibitively
expensive.'').
\44\ See, e.g., Comment Letter of the Investment Company
Institute (May 7, 2004) (recommending that the rule require an
intermediary to take reasonable steps to implement restrictions
imposed by a fund on short-term trading, in addition to facilitating
the proper assessment of redemption fees). See also SEC v. Scott B.
Gann et al., Litigation Release No 19027 (Jan. 10, 2005) (available
at: http://www.sec.gov/litigation/litreleases/lr9027.htm) (managers
at a broker-dealer used multiple accounts and other techniques to
evade trading bans that funds tried to establish with respect to
their customers who were market timing); In the Matter of Lawrence
S. Powell et al., Investment Company Act Release No. 26722 (Jan. 11,
2005) (available at: http://www.sec.gov/litigation/admin/34-51017.htm
) (registered representatives at a broker-dealer used
multiple account and representative numbers to evade trading bans
that funds had established for the representatives' market timing
customers).
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These modifications to the final rule should reduce the costs of
compliance to funds and financial intermediaries. Nevertheless,
aggregate one-time costs for financial intermediaries to create systems
to collect and transfer information to the funds may be
significant.\45\ At the same time, the rule should result in cost
savings to funds and their long-term shareholders because funds will be
able to better enforce their market timing policies against traders who
engage in short-term trading through omnibus accounts. The rule also
should result in the more consistent application of market timing
policies between shareholders who purchase funds shares directly and
those who purchase through omnibus accounts.
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\45\ We discuss the costs in greater detail in sections IV and
VI below. Although financial intermediaries may have to create
systems to assemble this information in a particular format, certain
intermediaries currently are required to make and maintain records
of the identity and transaction information required under the rule.
See, e.g., 17 CFR 240.17a-3(a)(1), 17 CFR 240.17a-3(a)(6), 17 CFR
240.17a-3(a)(17)(A)(i), 17 CFR 240.17a-4(b)(1) (requiring broker-
dealers to make records of customer accounts and purchases and sales
of securities and to preserve those records); 31 CFR
103.122(b)(2)(i)(A) and 31 CFR 103.122(b)(3) (requiring broker-
dealers to adopt as part of their anti-money laundering program
policies to obtain and maintain records of certain customer
identification information and to retain customer identification
records for five years).
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(1) Fund Responsibilities. Rule 22c-2 requires that each fund (or
its principal underwriter), regardless of whether it imposes a
redemption fee, enter into a written agreement with each of its
financial intermediaries under which each intermediary must provide the
fund, upon request, information about the identity of shareholders and
about their transactions in fund shares.\46\ Funds can use this
information to monitor trading and identify shareholders in omnibus
accounts engaged in frequent trading that is inconsistent with fund
market timing policies.\47\ Funds have flexibility to request
information periodically, or when circumstances suggest that a
financial intermediary is not assessing redemption fees or that abusive
market timing activity is occurring.\48\ Access to this trading
information provides funds (and their chief compliance officers) an
important new tool to monitor trading activity in order to detect
market timing and to assure consistent enforcement of their market
timing policies.\49\ We expect funds that are susceptible to market
timing will use it regularly.\50\
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\46\ Rule 22c-2(a)(2)(i). Under the rule, financial
intermediaries include broker-dealers, banks, or other entities that
hold fund shares in nominee name. Rule 22c-2(c)(1)(i). Thus, the
agreement would not be required with an intermediary with respect to
shares that are held on a fully disclosed basis (i.e., accounts in
which the shareholder's name and other information are fully
disclosed to the fund, which maintains account records on behalf of
the shareholder). One commenter pointed out that in some cases, the
fund may not know that a particular recordholder is, in fact, an
intermediary. The Commission expects that funds and their transfer
agents will use their best efforts to ascertain which recordholders
are holding shares as intermediaries.
\47\ Our privacy rule prevents a fund that receives this
information from using the information for its own marketing
purposes, unless permitted under the intermediary's privacy
policies. See 17 CFR 248.11(a) and 248.15(a)(7)(i).
\48\ Under the rule, a fund that does not impose a redemption
fee may nonetheless request the transactional information from its
intermediaries. In some cases, such funds may wish to access this
information to determine whether a redemption fee is necessary. In
addition, intermediaries may have agreed to enforce a fund's market
timing policies, or have established procedures designed to preclude
violations of the fund's trading policies. In these circumstances, a
fund may not need to exercise its rights under the contract. Funds
could contract with financial intermediaries for the period of time
that intermediaries would have to retain the shareholder information
for transmission to the fund.
\49\ See Compliance Programs, supra note (stating that fund
compliance procedures ``should provide for monitoring of shareholder
trades or flows of money in and out of the funds in order to detect
market timing activity, and for consistent enforcement of the fund's
policies regarding market timing.'').
\50\ See, e.g., Comment Letter of the Coalition of Mutual Fund
Investors (May 10, 2004) (urging Commission to require financial
intermediaries to disclose shareholder identity and transactional
information to funds on a daily or transactional basis to enable
funds ``to ensure the uniform application of [fund redemption fee]
policies and procedures.'').
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(2) Financial Intermediaries. Rule 22c-2 also requires the
agreement with financial intermediaries to contain a provision under
which the intermediary agrees to execute the fund's instructions to
restrict or prohibit further purchases or exchanges by a specific
shareholder (as identified by the fund) who has engaged in trading that
violates the fund's market timing policies.\51\ We have included this
provision in response to comments regarding the difficulty of applying
fund market timing restrictions to shares redeemed through omnibus
accounts. Intermediaries currently may not enforce funds' market timing
restrictions on their customers because, as one commenter explained, it
is not in the intermediary's interest to do so.\52\ Accordingly, even
if funds receive shareholder trading information, as another commenter
pointed out, it will have little practical value if the fund is unable
to prevail upon the intermediary to enforce its market timing
policies.\53\ The requirement in the final rule that the written
agreement provide for the intermediary to execute the fund's
instructions should address these concerns.
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\51\ Rule 22c-2(a)(2)(ii).
\52\ See Comment Letter of the Coalition of Mutual Fund
Investors (May 10, 2004).
\53\ See Comment Letter of the Investment Company Institute (May
7, 2004). See also supra note.
---------------------------------------------------------------------------
We also have revised the definition of ``financial intermediary''
in the final rule, at the suggestion of several commenters. Under the
rule, a ``financial intermediary'' includes: (i) A broker, dealer,
bank, or any other entity that holds securities in nominee name; (ii)
an insurance company that sponsors a registered separate account
organized as a unit investment trust, master-feeder funds, and certain
fund of fund arrangements not specifically excepted from the rule; and
(iii) in the case of an employee benefit plan, the plan administrator
or plan recordkeeper.\54\ The definition clarifies that a ``financial
intermediary'' can be either the plan administrator, who is responsible
for the overall administration of the plan, or an entity that maintains
the plan's
[[Page 13333]]
participant records, i.e., the plan recordkeeper who typically is
engaged by the plan administrator.\55\
---------------------------------------------------------------------------
\54\ See rule 22c-2(c)(1).
\55\ We have also included a definition of ``shareholder'' in
the final rule. The term includes a beneficial owner of securities
held in nominee name, a participant in a participant directed
employee benefit plan, and a holder of interests in a master-feeder
fund or an insurance company separate account organized as a unit
investment trust. The term does not include a fund that relies on
section 12(d)(1)(G) of the Act to invest in other funds in the same
fund group. These funds often are used as conduits, allowing a
shareholder to invest in multiple funds in the complex through a
single fund. Although shareholders in the conduit fund may engage in
abusive trading strategies, a conduit fund itself would appear to
have little incentive to engage in such strategies because they may
adversely affect another fund in the same complex. The definition of
``shareholder'' also excludes a section 529 account or the holder of
an interest in such an account. The loss of tax benefits that a
holder would incur as a result of changing investments more than
once a year makes it unlikely that the holder would use a section
529 account for short-term trading.
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C. Request for Additional Comment
In addition to adopting rule 22c-2, we request additional comments
on whether we should establish a set of uniform standards that may
facilitate intermediary assessment of redemption fees on shares held
through omnibus accounts. We are requesting further comment on what any
such standards should be, including the method for determining the
duration of share ownership and exceptions from the application of the
redemption fee.\56\ Although we received comment on these issues during
the initial comment period, those comments were offered in the context
of a mandatory redemption fee. We also request comment on any other
aspects of the rule in light of the additional solicitations for
comment. For example, as funds begin to implement rule 22c-2, including
entering into written agreements with financial intermediaries, we
request comment on implementation of the rule's requirements.
---------------------------------------------------------------------------
\56\ See Proposing Release, supra note 12.
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We proposed a uniform mandatory redemption fee because the current
voluntary arrangements may, as a practical matter, deny many funds the
ability to impose redemption fees on shares held in omnibus accounts.
As discussed below, intermediaries face certain costs in assessing
redemption fees on a fund's behalf. Intermediaries therefore may prefer
to offer only those funds that do not charge a redemption fee, or that
do not apply the fee to redemptions made through omnibus accounts. Many
funds today do not impose redemption fees for this reason. If
intermediaries refuse to collect redemption fees, fund boards will be
unable to use these fees to their full potential as a tool to protect
fund investors.
One solution might be for the Commission to adopt a uniform
redemption fee that would be applicable only to those funds that chose
to impose a redemption fee. This approach may address the primary
reason many fund intermediaries have refused to participate in
redemption fee programs. Commenters representing both fund complexes
and intermediaries asserted that the wide variations in the rate,
duration, exceptions, and other features of redemption fees imposed by
funds have made it costly for intermediaries to assess the redemption
fees. These costs associated with a lack of uniformity may have
contributed to the unwillingness of many intermediaries to assess fees
on behalf of funds.\57\ Commenters representing intermediaries have
suggested to us that their willingness to undertake these efforts will
likely depend on the costs they would bear, which could be
substantially reduced if we were to establish the terms for a uniform
redemption fee.\58\ One commenter suggested that a uniform fee would be
easier for investors to understand and would enable them to make
comparisons among funds.\59\
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\57\ See Comment Letter of the Vanguard Group (May 10, 2004)
(``The Commission has recognized that many intermediaries are
currently unable to deduct redemption fees or have found it
impractical to develop the systems and procedures necessary to
monitor and enforce multiple trading restrictions * * * While
[Vanguard's] efforts to implement effective controls over frequent
trading have been somewhat successful on an ad hoc basis, we believe
that the industry will never achieve complete success without the
SEC's regulatory support * * * If the Commission mandates a
consistent approach [to redemption fee policies], intermediaries
will be encouraged to develop the systems and procedures required to
apply redemption fees to remain competitive.''); Comment Letter of
the American Society of Pension Actuaries (Apr. 21, 2004) (``[T]he
existence of non-uniform redemption fee structures will create a
competitive disadvantage for retirement plan administrators and
intermediaries who offer `open architecture' multiple fund family
platforms relative to mutual fund companies providing retirement
plan services that offer only a single family of funds.'').
\58\ See, e.g., Comment Letter of the American Society of
Pension Actuaries (Oct. 8, 2004); Comment Letter of Hewitt
Associates LLC (May 10, 2004); Comment Letter of the SPARK
Institute, Inc. (May 10, 2004).
\59\ Comment Letter of the American Society of Pension Actuaries
(Oct. 8, 2004). For example, it might be much easier for an investor
to compare a fund with a one percent redemption fee to one that had
a two percent redemption fee, if the prospective investor did not
have to take into account the method of measuring holding periods,
e.g., between LIFO and FIFO. See infra notes 64-66 and accompanying
text.
---------------------------------------------------------------------------
We request comment on whether we should require a uniform standard
for any redemption fees charged by a fund. Would a uniform standard
encourage intermediaries to cooperate with fund managers by decreasing
the costs and burdens on them? Would a uniform standard decrease
certain costs that investors (or plan participants) would otherwise
ultimately bear? On the other hand, given the extensive use of
electronic systems to determine the applicability and amount of fees
charged against brokerage, pension plan, and other accounts, would
uniform parameters established by the Commission not appreciably
decrease costs, but rather serve principally to reduce flexibility for
funds?
1. Elements of a Uniform Redemption Fee
The mandatory redemption fee rule that we proposed last year
established specific guidelines for redemption fees that funds would be
required to impose, and that intermediaries would therefore be required
to implement. Some of those features were fixed, such as the level of
the fee (two percent) and the method used to calculate the time period
between purchase and sale of shares in an account (first in, first out,
or ``FIFO''). Other features were variable, such as the duration of the
time period for the redemption fee (at least five business days) and
the provision of waivers for de minimis redemption fees (waiver of
redemption fees on redemptions of 2,500 dollars or less). We provided
these guidelines in order to establish a certain degree of uniformity
among redemption fees charged by funds, while permitting funds some
flexibility in designing the redemption fee that best suited their
circumstances.
During the comment period no consensus emerged regarding the
features of a redemption fee that are most effective in deterring
excessive trading and compensating a fund for the costs of such
trading. The wide array of comments relating to the elements of the
redemption fee may reflect, in part, the different views regarding the
purpose of redemption fees. Some commenters viewed the redemption fee
solely as a mechanism to recover costs associated with short-term
trading, and therefore argued that the proposed exceptions were largely
unnecessary.\60\ Other commenters viewed redemption fees as a tool to
penalize or deter market timers, and therefore gave importance to the
intentions of the trader as well as the
[[Page 13334]]
susceptibility of certain transactions to abusive short-term
trading.\61\
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\60\ See, e.g., Comment Letter of Fidelity Investments (June 4,
2004) (``When funds have redemption fees, they should be required to
be applied consistently, since the purpose of redemption fees is to
recover for a fund the costs imposed upon it through short-term
trading, regardless of who is engaged in such trading.'').
\61\ See, e.g., Comment Letter of the Vanguard Group (May 10,
2004) (``In our experience, redemption fees, together with fair
value pricing and active transaction monitoring, are very effective
in curtailing short-term trading that may harm funds and their
shareholders.'').
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The myriad of commenters' views expressed about the proposed
mandatory rule has led us to request additional comment on the
redemption fee parameters, if any, that should be specified for all
funds that voluntarily choose to charge redemption fees.\62\ We are
considering whether to revise the rule to require some or all of the
following uniform fee parameters, on which we request comment: \63\
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\62\ Some commenters raised concerns about redemption fees
charged to investors who invest in funds through insurance company
separate accounts. See, e.g., Comment Letter of Pacific Life
Insurance Company (May 10, 2004); Comment Letter of Transamerica
Occidental Life Insurance Company (May 10, 2004); Comment Letter of
NAVA (May 7, 2004). Although variable insurance contracts are
designed to provide individuals with retirement or death benefits,
they have been purchased as investment vehicles by hedge funds and
other aggressive traders in order to engage in market timing.
Indeed, because there are no immediate tax consequences, we
understand that market timing may be a greater problem for separate
accounts and the mutual funds in which they invest. Although we
appreciate the administrative burdens insurance companies will bear
in order to initially implement redemption fees, we do not believe
such one-time burdens are a basis for excluding funds underlying
separate accounts, as some commenters suggested. Nor do we believe,
as several commenters suggested, that the application of rule 22c-2
will present an insuperable conflict with state insurance laws when
a redemption fee is imposed on transactions by holders of existing
variable annuity or variable life insurance contracts. The
redemption fee would be imposed by the fund rather than pursuant to
a contract issued by the insurance company. See Miller v. Nationwide
Life Ins. Co., 391 F.3d 698 (5th Cir. 2004).
\63\ These elements were addressed in our Proposing Release,
supra note 12.
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a. Share Accounting. We are considering adopting, as proposed, a
provision that would require funds to determine the amount of any
redemption fee by using the FIFO method, i.e., by treating the shares
held the longest time as being redeemed first, and shares held the
shortest time as being redeemed last.\64\ This is the method commonly
employed by funds that currently charge redemption fees, and was
supported by most commenters.\65\ We proposed use of the FIFO method
because it was less likely than other methods, such as LIFO (treating
the shares most recently purchased as being redeemed first), to result
in a redemption fee being imposed on ordinary shareholder
redemptions.\66\ We request comment on whether rule 22c-2 should
require that, if a fund imposes a redemption fee, the fee be determined
by the use of FIFO, or alternatively by the use of some other method.
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\64\ See proposed rule 22c-2(d). See also Proposing Release,
supra note 12, at nn.30-33 and accompanying text (requesting comment
on whether and how rule 22c-2 should specify the method of
calculating how long fund shares are held).
\65\ Many commenters acknowledged that a ``last in, first out''
(``LIFO'') method might capture more abusive short-term trading, but
nonetheless supported FIFO because it would minimize the negative,
unintended consequences when small, long-term investors are charged
redemption fees on transactions unrelated to market-timing, and
because redemption fee systems that are currently in place at many
funds, broker-dealers and transfer agents assess fees on a FIFO
basis. See, e.g., Comment Letter of the Securities Industry
Association (May 10, 2004). Commenters also pointed out other
advantages to the use of FIFO. See, e.g., Comment Letter of Charles
Schwab & Co., Inc. (May 10, 2004) (arguing that FIFO is already used
by broker-dealers and transfer agents to calculate the tax effects
of redemptions). But see Comment Letter of the Vanguard Group (May
10, 2004) (stating that LIFO offers a ``simpler and more
comprehensive'' solution than FIFO does); Comment Letter of Capital
Research and Management (May 10, 2004) (arguing that using LIFO is
essential for a redemption fee program to be effective against
excessive trading).
\66\ See Proposing Release, supra note 12, at n.32.
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b. De Minimis Waivers. We are considering requiring that the
redemption fee not be charged if the amount of the fee would be fifty
dollars or less. Under such a provision, a shareholder in a fund with a
two percent redemption fee could redeem as much as 2,500 dollars of
shares within seven days of purchasing them without paying a redemption
fee. Use of FIFO accounting for share transactions, as discussed above,
will likely result in few redemptions normally made by most investors
incurring a redemption fee, except when the shareholder redeems all of
his or her fund shares. The primary effect of a de minimis provision,
therefore, would be to prevent recent purchases of fund shares from
being charged a redemption fee when a shareholder makes a complete
redemption of his or her shares in a particular fund.
Most commenters who addressed this exception supported a uniform de
minimis waiver provision.\67\ Many intermediaries strongly urged that
we make a de minimis exemption mandatory to avoid the costs they
asserted they would incur to accommodate various different de minimis
arrangements.\68\ Some commenters opposed allowing any de minimis
exceptions, arguing that such exceptions permit market timers to break
up transactions into smaller amounts in order to avoid the fee.\69\ We
request comment whether the rule should permit, or require, funds to
waive redemption fees under a certain dollar amount.
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\67\ See, e.g., Comment Letter of Morningstar, Inc. (May 10,
2004).
\68\ The proposed rule would have permitted, but not required,
funds to forego assessment of a redemption fee on redemptions of
$2,500 or less, i.e., redemption fees of $50 or less (``de minimis
exception''). Most commenters who addressed this exception supported
it. However, many of the financial intermediaries strongly
recommended that the de minimis exception be mandatory to avoid the
system and compliance costs necessary to accommodate funds that have
different de minimis rules. See, e.g., Comment Letter of Merrill
Lynch, Pierce, Fenner & Smith Inc. (May 10, 2004). Other commenters
recommended that the rule state a de minimis provision in terms of
the amount of the redemption fee rather than the amount of the
redemption in order to address a redemption in which only a portion
of the shares redeemed were purchased within the previous seven days
and thus subject to a redemption fee. See Comment Letter of the
Investment Company Institute (May 7, 2004).
\69\ See, e.g., Comment Letter of the Investment Company
Institute (May 7, 2004).
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c. Amount of Redemption Fee; Length of Holding Period. As discussed
above, we do not contemplate establishing a uniform amount for the
redemption fee, i.e., the percentage charged upon early redemption.\70\
Nor do we anticipate establishing a uniform minimum holding period
(beyond the seven day minimum specified in the rule). As a result, fund
boards will retain flexibility to address the needs of their funds. It
is our understanding that systems employed by fund intermediaries can
more easily handle variations in the amount of the fee and holding
periods than, for example, some of the other exceptions discussed in
this section.\71\ We seek comment on whether intermediaries would be
able to administer fees more easily if the fee and holding period vary
among funds but the parameters discussed below are uniform, than if all
of these elements were variable. We would expect that the rule would
not permit funds to vary the redemption fee based on the amount of time
that fund shares are held.\72\ We request comment on such a provision.
---------------------------------------------------------------------------
\70\ See Comment Letter of Charles Schwab & Co., Inc. (May 10,
2004) (``From a systems and implementation standpoint, it is
absolutely essential that the Proposed Rule not inadvertently create
multiple tiered redemption fees on a single fund * * * Imposing on a
single fund different levels of redemption fees that vary based on
the holding period would create significant confusion on the part of
investors. The costs and complexity of implementing such a system
would be substantial.'').
\71\ See Comment Letter of the American Benefits Council (Oct.
15, 2004) (``However, our most significant point regarding
uniformity concerns differences in the types of transactions to
which fees will be applied by the various funds.'').
\72\ In the Proposing Release, we suggested that funds might
charge a fee on redemptions that occur during the first five days,
which would be different from the fee that would be charged
afterwards. Proposing Release, supra note 12 at n.26. Commenters
objected to a provision that would require or permit different
levels of fees based on the time that shares are held. See, e.g.,
Comment Letter of Charles Schwab & Co., Inc. (May 10, 2004).
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[[Page 13335]]
d. Investor Initiated Transactions. We are considering whether the
rule should require that any redemption fee charged by a fund be
limited to transactions initiated by investors. Under such an approach,
redemption fees would not be assessed with respect to (i) shares
purchased with reinvested dividends or other distributions,\73\ and
(ii) shares purchased or redeemed pursuant to a prearranged contract,
instruction or plan, such as purchases, redemptions, transfers, or
exchanges \74\ that are not discretionary transactions for employee
benefit plans.\75\ As discussed above, many commenters (particularly
administrators of retirement plans) were concerned that the redemption
fee would inadvertently apply to harmless transactions such as account
rebalancings or redemptions after recent periodic contributions, and
strongly favored this approach, urging us to include such an exception
in any rule we adopt.\76\
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\73\ An investor who chooses to reinvest the dividends and
distributions on his shares typically makes the election in advance,
and cannot vary the timing or amount of the purchases. Commenters
emphasized that these systematic transactions generally are not
susceptible to short-term trading abuses. See, e.g., Comment Letter
of Charles Schwab & Co., Inc. (May 10, 2004); Comment Letter of the
American Society of Pension Actuaries (Apr. 21, 2004) (``[Pension
plan] participants do not have the capability to `time' mutual fund
share purchases in connection with payroll contributions or periodic
loan repayments because the timing of these purchases depends upon
when the employer deposits the funds into the plan, and the
contributions are invested according to standing participant
instructions.'').
\74\ Intermediaries, as well as many individual investors,
supported an exemption for redemption transactions executed pursuant
to prearranged instructions, such as periodic contributions,
periodic rebalancings, or other ``involuntary'' transactions. These
types of transactions appear to pose little or no short-term trading
risk.
\75\ See rule 16b-3(b)(1)(i), (ii), and (iii) under the
Securities Exchange Act of 1934 [17 CFR 240.16b-3(b)(1)(i), (ii),
and (iii)] (definition for purposes of the beneficial ownership
reporting requirements of ``discretionary transaction'' under an
employee benefit plan).
\76\ See supra note 14 and accompanying text.
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We request comment on the need for such an exception. Is it
necessary if we provide for FIFO accounting for share holding periods
and a de minimis exception that addresses complete redemptions? Can
funds identify which transactions (other than those made in connection
with retirement plans) would qualify for this exception? If not, should
the rule make such an exception mandatory only with respect to
shareholders who hold through retirement plans? Alternatively, should
we make such an exception voluntary? Such an approach would not require
all funds to provide the exception, but would leave it to funds and
their intermediaries to work out the terms of such an approach.
Those commenters who favor a mandatory exception should address how
the rule would identify such transactions in the context of different
types of intermediaries. Would the formulation that we set out above be
workable?
e. Financial Emergencies. We envision that the rule would permit
funds to grant a redemption fee waiver in the case of an unanticipated
financial emergency, upon the written request of the shareholder. Most
commenters who addressed the issue opposed the mandatory financial
emergency exception that we proposed last year.\77\ Some argued that
the exception would rarely be invoked for legitimate purposes, and thus
could be used to circumvent redemption fees.\78\ Others, including many
intermediaries, stated that an open-ended ``financial emergency''
exception could be difficult to administer and may cover too many
circumstances, such as market declines.\79\ We request additional
comment whether the rule should require funds to waive redemption fees
in the case of unanticipated financial emergencies. We request comment
whether such a provision would discourage funds from adopting
redemption fees--an issue that we did not address in our proposed rule
because it provided for mandatory redemption fees. We also seek comment
on what circumstances should constitute a financial emergency.
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\77\ The mandatory redemption fee rule that we proposed last
year provided, in the case of an unanticipated financial emergency,
that a fund must waive the redemption fee upon written request if
the amount of shares redeemed is $10,000 or less, and that a fund
could waive the redemption fee if the amount were greater. See
proposed rule 22c-2(e)(1)(ii).
\78\ See, e.g., Comment Letter of the Investment Company
Institute (May 7, 2004); Comment Letter of the Vanguard Group (May
10, 2004).
\79\ See, e.g., Comment Letter of Charles Schwab & Co., Inc.
(May 10, 2004); Comment Letter of the American Bankers Association
(May 20, 2004) (recommending that the definition of unforeseeable
emergency should conform to the standards for a hardship withdrawal
under section 401(k) of the Internal Revenue Code).
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f. Other Exceptions and Waivers. We also request comment on whether
the rule should include additional exceptions that would limit the
circumstances under which funds may charge redemption fees. For
example, should funds generally be required to apply any redemption fee
to all underlying shareholders, and not exclude fees on the redemption
of shares held through omnibus accounts? If so, would the fund need to
be able to obtain additional shareholder information regarding shares
that are transferred from one omnibus account to another? For example,
would the fund need information from an intermediary (such as a
retirement plan administrator) that submits a net fund order (on behalf
of the plan) to a financial intermediary that holds the plan's shares
in an omnibus account? Requiring that a redemption fee apply to all
fund shareholders would be designed to eliminate the special treatment
of omnibus accounts that has permitted abusive market timers to avoid
redemption fees, and in some cases to avoid detection.\80\ Conversely,
should the rule permit a fund to waive the fee (i.e., decide not to
impose the fee on a case-by-case basis) only in accordance with
policies and procedures approved by the board of directors, including a
majority of the independent directors? Should a fund be required to
maintain records of such waivers?
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\80\ One commenter pointed out that the redemption fee rule or
the release should clarify that intermediaries who hold fund shares
through omnibus accounts should not themselves be subject to
redemption fees. Comment Letter of the Investment Company Institute
(May 7, 2004).
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We also request comment on whether there are certain types of funds
that should receive special treatment under the redemption fee rule.
For example, should there be special provisions regarding funds that
invest small amounts in other funds in reliance on section 12(d)(1)(F)
of the Act? Should there be an exception for unit investment trusts?
Because a unit investment trust invests in specified securities, is it
unlikely to engage in market timing? Should redemptions by section 529
plans that invest in funds be excepted from redemption fees? Investors
that hold interests in section 529 plans seem unlikely to engage in
short-term trading because they lose tax benefits if they change
investments in the account more than once a year.\81\
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\81\ See Comment Letter of the Investment Company Institute (May
7, 2004).
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g. Variable Insurance Contracts. We also envision that the rule
would not permit the assessment of redemption fees on the redemption,
pursuant to partial or full contract withdrawals, of shares issued by
an insurance company separate account organized as a unit investment
trust that is registered under the Investment Company Act. These types
of redemptions are unlikely to occur as part of a market timing or
rapid trading strategy, and will permit contract holders to exercise a
``free look'' provision of their contracts
[[Page 13336]]
without paying a redemption fee.\82\ We received a significant number
of comment letters from insurance companies that were concerned about
the potential conflict that mandatory redemption fees could generate
with some state insurance laws. We request additional comment whether
other provisions are needed to address the special circumstances of
insurance company separate accounts.
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\82\ A ``free look'' provision permits a contract owner, within
a short period of time after purchasing the contract, to surrender
the contract without cost. Other exceptions that we have discussed
above (and on which we request comment) also may work well to
accommodate insurance company investments. See supra notes 73-75 and
accompanying text. Those revisions would include a requirement that
redemption fees apply only to investor initiated transactions, which
would mean that redemption fees would not be imposed on automatic
transactions as a result of, for example, periodic redemptions to
pay the cost of insurance charges, or systematic withdrawal plans.
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2. Financial Intermediaries
The mandatory redemption fee rule that we proposed last year would
have provided funds and the financial intermediaries through which
investors purchase and redeem shares three methods of assuring that the
appropriate redemption fees are imposed.\83\ First, fund intermediaries
could transmit to the fund (or its transfer agent) at the time of each
transaction the account number used by the intermediary to identify the
transaction.\84\ Second, intermediaries could enter into an agreement
with the fund requiring the intermediary to identify redemptions of
account holders that would trigger the application of the redemption
fee, and transmit holdings and transaction information to the fund (or
its transfer agent) sufficient to allow the fund to assess the amount
of the redemption fee.\85\ Third, the fund could enter into an
agreement with a financial intermediary requiring the intermediary to
impose the redemption fees and remit the proceeds to the fund.\86\
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\83\ See Proposing Release, supra note 12, at section II.D
(discussing proposed rule 22c-2(b)).
\84\ This information would permit the fund to match the current
transaction with previous transactions by the same account and
assess the redemption fee when it is applicable. This approach is
designed to accommodate broker-dealers that both hold fund shares in
omnibus account form as well as maintain accounts that are fully
disclosed to the funds directly. Some broker-dealers using the
National Securities Clearing Corporation already transmit taxpayer
identification numbers to fund transfer agents for certain types of
``networking'' arrangements. See NASD, Report of the Omnibus Account
Task Force Members, Jan. 30, 2004, at n.6 (``Omnibus Report'')
(available in File No. S7-11-04).
\85\ Under this approach, the intermediary would be required to
submit substantially less data along with each transaction than
under the first method.
\86\ The NASD Omnibus Account Task Force found this method to be
the most viable approach. See Omnibus Report, supra note 84.
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These methods were designed to work for different types of
intermediaries. Commenters were divided on whether the rule should
provide flexibility to funds and intermediaries to choose alternative
means to assess redemption fees in omnibus accounts. Some funds and
intermediaries supported the rule's flexibility.\87\ Other funds and
intermediaries, including many insurance companies, opposed the
proposed framework, arguing that it would require both funds and their
intermediaries to accommodate all three alternatives, which would be
very costly.\88\ Instead, these commenters suggested that most funds
and intermediaries are likely to use the third option because it may be
the most cost-effective.\89\ We request further comment on whether the
rule should limit the ways that redemption fees may be assessed to
promote greater uniformity in the enforcement of redemption fees across
funds and their intermediaries. Should we retain all three options to
accommodate, for example, the small intermediary that does not have the
capability to collect and transmit redemption fees? If we retained
these options, which entity should determine the option used to assess
redemption fees?
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\87\ See, e.g., Comment Letter of Charles Schwab & Co., Inc.
(May 10, 2004); Comment Letter of the Investment Company Institute
(May 7, 2004); Comment Letter of the Vanguard Group (May 10, 2004);
Comment Letter of Merrill Lynch, Pierce, Fenner & Smith Inc. (May
10, 2004).
\88\ See, e.g., Comment Letter of Fidelity Investments (June 4,
2004); Comment Letter of Transamerica Occidental Life Insurance (May
10, 2004); Comment Letter of Nationwide Financial Services, Inc.
(May 10, 2004).
\89\ See, e.g., Comment Letter of American Century Investments
(May 10, 2004).
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3. Recordkeeping
Under rule 22c-2, if the fund's board approves a redemption fee,
then the fund must retain a copy of the written agreement between the
fund and financial intermediary under which the intermediary agrees to
provide the required shareholder information in omnibus accounts.\90\
This recordkeeping requirement is designed to assist our examination
staff in assessing compliance with the new rule. We request comment
whether we should adopt an additional requirement that a fund retain
copies of the materials provided to the board in connection with the
board's approval of a redemption fee.
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\90\ Rule 22c-2(a)(3).
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III. Effective and Compliance Dates
The new rule will be effective on May 23, 2005. The compliance date
of the rule is October 16, 2006.\91\ The transition period for rule
22c-2 is intended to give funds and their financial intermediaries
ample time to make needed contractual amendments and system
enhancements.
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\91\ If the Commission changes the rule in response to its
request for comment, the compliance period may be extended.
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IV. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by
its rules. As discussed in Section II above, rule 22c-2 permits each
fund, with the approval of its board (including a majority of
independent directors), to impose and retain a redemption fee that does
not exceed two percent of the amount redeemed. The Commission is also
requiring funds (or their principal underwriters) to enter into written
agreements with intermediaries who hold shares on behalf of other
investors, under which the intermediaries must provide funds with
certain shareholder identity and transaction information at the request
of the fund and must execute certain of the funds' instructions.
A. Benefits
We anticipate that funds and shareholders will benefit from the
rule. Rule 22c-2 is designed to allow a fund to deter, and provide for
reimbursement for the costs of, short-term trading in fund shares.
Short-term trading can increase transaction costs for the fund, disrupt
the fund's stated portfolio management strategy, require maintenance of
an elevated cash position, and result in lost investment opportunities
and forced liquidations. Short-term trading also can result in unwanted
taxable capital gains for fund shareholders and reduce the fund's long-
term performance. This trading also can dilute the value of fund shares
held by long-term shareholders if a short-term trader, or market timer,
buys and sells shares rapidly to take advantage of market
inefficiencies when the price of a mutual fund does not reflect the
current market value of the stocks held by that mutual fund.\92\
Although short-term traders can profit from engaging in frequent
trading of fund shares, the costs associated with
[[Page 13337]]
such trading are borne by all fund shareholders.
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\92\ Dilution could occur if fund shares are overpriced and
short-term traders receive proceeds based on the overvalued shares.
---------------------------------------------------------------------------
Rule 22c-2 also is designed to enable funds to monitor the
frequency of short-term trading in omnibus accounts and to take steps,
where appropriate, to respond to this trading. We believe that this
requirement will facilitate greater cooperation between funds and their
intermediaries. The right to access this trading information provides
funds with an important new tool to monitor trading activity in order
to detect market timing and to assure consistent enforcement of their
market timing policies.
To the extent that rule 22c-2 discourages short-term trading, long-
term investors may have more confidence in the financial markets as a
whole, and funds in particular. Increased investor confidence may
result because the rule enables funds to obtain from financial
intermediaries information that will allow funds to identify investors
who are market timing through omnibus accounts. Funds would benefit by
an increase in investor confidence because long-term investors would be
less likely to seek alternative financial products in which to invest.
Because the fund that imposes the redemption fee retains the fee, long-
term shareholders of those funds essentially will be reimbursed for
some, if not all, of the redemption costs caused by the short-term
traders.
The recordkeeping requirements outlined above in Section II.C.3.
are designed to assure the documentation of the fund's agreement with
its intermediaries concerning the availability of shareholder identity
and transaction information in omnibus accounts. These records will
assist our examination staff in determining compliance with the rule.
B. Costs
The new rule will result in additional costs for funds and their
financial intermediaries, which we expect will be passed on to
investors or borne by fund advisers. The bulk of these costs, however,
are one-time costs, whereas the benefits of the board determination and
the adoption of a redemption fee for some funds and their shareholders
will be enduring.\93\ The rule we adopt today is intended to be
responsive to the cost concerns that have been articulated by a number
of commenters, including both funds and financial intermediaries.
---------------------------------------------------------------------------
\93\ See supra Section IV.A.
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We received a number of comments regarding the costs associated
with the proposed mandatory redemption fee rule. The comments primarily
addressed the costs of providing shareholder identity and transaction
information in omnibus accounts. Many funds and intermediaries
expressed concern that the proposed rule, in particular the proposed
weekly reporting requirement, would have resulted in significant costs
for both funds and financial intermediaries that may not be justified
by its benefits.
The intermediaries generally have stressed the importance of
uniformity as a means of reducing some of these costs; otherwise, they
argued, systems and compliance costs would be significant. In addition,
since intermediaries must comply with specific instructions by a fund
to restrict or prohibit further purchases or exchanges in transactions
of fund shares by a shareholder, intermediaries may incur costs
associated with making these terms explicit to their clients.
We modified the proposal in several ways in response to commenters'
concerns. These revisions to the proposed rule should result in
significant savings to retirement plans and other intermediaries, as
well as funds. First, unlike our proposal, the rule does not require
funds to impose a redemption fee. Thus, a fund and its board may decide
that a redemption fee is not necessary or appropriate to address short-
term trading. We also concluded that the proposed weekly reporting
requirement was unnecessarily burdensome and costly, and instead we are
requiring that funds enter into agreements with intermediaries under
which, as commenters recommended, shareholder identity and transaction
information will be available to funds upon request.\94\ Although this
modification should reduce costs under the final rule for financial
intermediaries and funds, financial intermediaries in the aggregate may
still face significant one-time costs to develop systems to assemble
the information for transfer to funds on request.\95\ For purposes of
the Paperwork Reduction Act analysis, we estimate that each fund will
incur capital costs of $100,000, for an aggregate cost of $162,000,000
for all funds.\96\ We also estimate that each intermediary will incur
capital costs of $150,000 for an aggregate cost of $949,500,000 for all
intermediaries.\97\
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\94\ See, e.g., Comment Letter of American Century Investments
(May 10, 2004); Comment Letter of Charles Schwab & Co., Inc. (May
10, 2004); Comment Letter of the SPARK Institute (May 10, 2004).
We are requiring funds to retain copies of their written
agreements with their intermediaries, which should result in limited
additional costs because most funds (or principal underwriters)
already have agreements with their distributors. The agreement
between the fund or its principal underwriter and the intermediary
is usually referred to as the ``selling agreement.''
\95\ See discussion in Section VI below. Commenters that
expressed concerns with costs did not provide detailed data or
supporting information regarding estimated one-time costs for
intermediaries to develop systems to collect the information,
ongoing costs of maintaining those systems, or the cost to funds of
collecting and receiving that information.
\96\ See discussion infra Section VI.
\97\ We further estimate that intermediaries will face ongoing
annual costs of $60,000 per intermediary for an aggregate yearly
cost of $379,800,000 for all intermediaries. See infra Section VI.
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The one-time costs may vary significantly among individual
financial intermediaries depending on circumstances, such as the number
of funds with which the intermediary must communicate, the frequency of
communication, and whether the intermediary develops systems itself or
purchases systems from a third party provider. At the same time, the
rule should result in cost savings to funds and their long-term
shareholders because funds will be able to better enforce their market
timing policies against traders who engage in short-term trading
through omnibus accounts. The final rule also should result in the more
consistent application of market timing policies between shareholders
who purchase funds shares directly and those who purchase shares
through omnibus accounts.
Today, we also are requesting additional comment on whether we
should adopt uniform standards for all redemption fee programs. We seek
comment on whether uniform parameters, if adopted, would reduce the
systems and compliance costs on both funds and intermediaries. For
example, we are requesting further comment on whether we should mandate
that all funds use the FIFO method, which is the method used by the
vast majority of funds that impose redemption fees. We believe, and the
commenters have generally argued, that the standardization of certain
redemption fee parameters could reduce the costs of implementing
redemption fee programs, as compared to allowing greater variety among
redemption fee programs. We seek comment on the effect, if any,
standardization could have on the cost of implementing a redemption fee
program.
V. Consideration of Promotion of Efficiency, Competition and Capital
Formation
Section 2(c) of the Investment Company Act requires the Commission,
when engaging in rulemaking that
[[Page 13338]]
requires it to consider or determine whether an action is necessary or
appropriate in the public interest, to consider whether the action will
promote efficiency, competition, and capital formation.
As discussed above, rule 22c-2 will enable funds to impose, where
appropriate, redemption fees designed to reimburse the fund for the
direct and indirect costs associated with short-term trading
strategies, including market timing. The rule also is designed to
supplement other means of combating market timing practices by imposing
a cost on those transactions. This new rule will promote efficiency by
deterring short-term trading, and by giving funds the information they
need to monitor short-term trading in omnibus accounts. Funds, armed
with the ability to obtain the identity and transactional information
of each fund shareholder, will be able to monitor shareholder trades or
flows of money in and out of funds held by intermediaries, and enforce
their market timing policies and procedures.
We do not anticipate that this rule will harm competition. The rule
will help ensure that a fund's market timing policies, which may or may
not include redemption fees, are applied consistently between direct
purchase investors and investors that invest through intermediaries. By
placing these shareholders on a more level basis than currently exists,
short-term traders in omnibus accounts will no longer be able to trade
for free at the expense of their fellow shareholders who purchase
shares directly.
We recognize the potential for anti-competitive behavior under a
rule that does not mandate redemption fees. The competitive pressure of
marketing funds, especially smaller funds, coupled with the costs of
imposing redemption fees in omnibus accounts, may deter some funds from
imposing redemption fees. Intermediaries may use their market power to
prevent funds from applying the fees, or to provide incentives for fund
groups to waive fees. Accordingly, we are requesting comment on whether
the uniform parameters discussed above will encourage intermediaries to
cooperate with funds.
Several commenters cautioned that the proposed mandatory redemption
fee rule could have anti-competitive effects on intermediaries because
it would disproportionately burden small intermediaries, who may incur
the largest relative costs as a result of the new rule. We believe the
modification to the proposed weekly reporting requirement, as discussed
above, will greatly benefit small intermediaries. We also are asking
comment on whether we should implement uniform redemption fee
requirements, which could reduce the costs incurred by small
intermediaries.
We anticipate that the new rule will indirectly foster capital
formation by bolstering investor confidence. The rule is likely to
reduce the risk of securities law violations, such as market timing
violations. In addition, the rule will encourage the use of redemption
fees as a tool to address short-term trading because funds will be able
to access shareholder information in omnibus accounts, thus preventing
short-term traders from diluting the interests of long-term investors,
who represent the vast majority of fund shareholders. The fund's
retention of redemption fees should result in lower expense ratios and
costs for these shareholders. If short-term trading declines, then
shareholders should receive better investment performance. To the
extent that the rule enhances investor confidence in funds, investors
are more likely to make assets available through intermediaries for
investment in the capital markets.
VI. Paperwork Reduction Act
As we discussed in the Proposing Release, the rule would result in
new ``collection of information'' requirements within the meaning of
the Paperwork Reduction Act of 1995.\98\ We published notice soliciting
comments on the collection of information requirements in the Proposing
Release and submitted these requirements to the Office of Management
and Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d)
and 5 CFR 1320.11. The Commission has resubmitted these proposed
collections of information to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. The title for the collection of information requirements
associated with the rule is ``Rule 22c-2 under the Investment Company
Act of 1940, ``Redemption fees for redeemable securities.'''' An agency
may not conduct or sponsor, and a person is not required to respond to,
a collection of information unless it displays a currently valid
control number.
---------------------------------------------------------------------------
\98\ 44 U.S.C. 3501-3520.
---------------------------------------------------------------------------
The collections of information created by rule 22c-2 are necessary
for funds to be able to assess redemption fees and monitor short-term
trading, including market timing, in omnibus accounts. One of the
collections of information is mandatory. As stated earlier, under rule
22c-2, funds and intermediaries must enter into written agreements
under which the intermediary agrees to provide certain shareholder
identity and transaction information upon request by the fund.\99\ We
are imposing a new requirement that funds retain a copy of the
agreement that is or was in effect within the past six years in an
easily accessible place.\100\ We do not expect that this requirement
will impose additional costs on funds because most funds in the
ordinary course of their business retain these agreements with their
intermediaries. This collection of information is necessary for our
staff to use in its examination and oversight program. Responses
provided in the context of the Commission's examination and oversight
program are generally kept confidential.
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\99\ In the proposal, we estimated this contract modification
would create a one-time burden of 4.5 hours per fund (4 hours by in-
house counsel, .5 hours by support staff) for a total burden of
12,150 hours (2,700 funds x 4.5 hours = 12,150 hours).
\100\ Rule 22c-2(a)(3). In the Proposing Release, we requested
comment on whether funds should retain their agreements with
intermediaries as part of their recordkeeping obligations. We did
not receive any comments.
---------------------------------------------------------------------------
We requested comment on whether the estimates contained in the
Proposing Release were reasonable. We received extensive comments on
the projected costs of the proposal. In many cases, funds and
intermediaries, including a number of small broker-dealer firms,
generally argued that the system functionality or start-up costs
necessary to assess and collect redemption fees on shares held through
omnibus accounts, coupled with the operational and maintenance costs,
would be significant and in some cases greater than what we
estimated.\101\ In particular, commenters found the weekly reporting
requirement to be burdensome;\102\ the estimated costs to comply with
this requirement were by far the largest component of the aggregate
cost burden that was estimated in the Proposing Release.\103\
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\101\ In the Proposing Release we estimated that, over a three
year period, the weighted average annual cost to all funds and
intermediaries would approximate $673,171,200. One commenter
estimated the costs to funds and intermediaries to be $2,278,363,734
per year. See Comment Letter of First Trust Corporation (May 10,
2004).
\102\ Some small intermediaries recommended that the shareholder
identity and transaction data be transmitted on a monthly or
quarterly basis. See e.g., Comment Letter of James Desmond (Apr. 13,
2004); Comment Letter of Lloyd Drucker (Mar. 22, 2004).
\103\ In the Proposing Release, in order for intermediaries to
comply with the weekly reporting requirement, we estimated the
aggregate start-up costs for all intermediaries to be
$1,020,000,000, and the ongoing costs to be $680,000,000 per year on
an aggregate basis.
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In response to commenters' concerns, we have decided not to require
that
[[Page 13339]]
funds impose redemption fees. Instead, we are allowing funds and their
boards to determine whether, and under what circumstances, a redemption
fee is necessary to protect the fund from excessive trading.\104\ We
are also reducing the burden on funds and intermediaries by requiring
that funds' agreements with financial intermediaries provide for
intermediaries to transmit shareholder identity and transaction data at
the fund's request, rather than on a weekly basis as originally
proposed. This modification should significantly reduce the costs
incurred by funds and their intermediaries.
---------------------------------------------------------------------------
\104\ For instance, funds may decline to impose redemption fees
on shares purchased as a result of transactions that pose little
risk of short-term trading, such as payroll contributions and
periodic rebalancings.
---------------------------------------------------------------------------
The Commission staff estimates that there are currently 2,700
active registered open-end investment companies. For purposes of this
section, we estimate that 60 percent of funds (1,620) will request the
shareholder information. In addition, for purposes of this estimate, we
assume that funds will request the shareholder identity and transaction
data quarterly, or four times a year. We anticipate that 6,330
financial intermediaries, a slightly lower number of intermediaries
than estimated in the Proposing Release, will be subject to the
collection of information requirements.\105\ We anticipate that all
funds would have to modify their agreements or contracts with their
intermediaries. This modification would create a one-time burden of 4.5
hours per fund (4 hours of in-house counsel time, .5 hours of support
staff time)\106\ for a total burden of 12,150 hours,\107\ at a cost of
$3,353,279.\108\ In light of our decision to allow funds to determine
whether, and under what circumstances, to obtain the shareholder
transactional data in omnibus accounts, we are revising some of the
estimates that we provided in the Proposing Release. Similar to the
proposed rule, we estimate that, under rule 22c-2, there would be a
burden on funds to collect and evaluate the data, and intermediaries to
transmit it. However, that burden is substantially reduced under rule
22c-2 because, as stated above, the intermediary will provide the data
to the fund upon the fund's request, rather than weekly.
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\105\ In the Proposing Release we estimated that 6,800
intermediaries would be subject to the information collection
requirements of rule 22c-2. Since we proposed the rule, we have
learned that approximately 470 of the 6,800 intermediaries are
broker-dealers that transmit the shareholder data to funds on a
fully-disclosed basis. Funds would not need to request the
shareholder data from these broker-dealers, and therefore would not
need to establish the systems to comply with this portion of the
rule.
\106\ These estimates are based on discussions with fund
representatives.
\107\ This estimate is based on the following calculation: 2,700
funds x 4.5 hours = 12,150 hours.
\108\ This estimate is based on the following calculations: (4
attorney hours x $66.31 = $265.24) + (.5 support staff hour x $21.50
= $10.75) = $275.99; (12,150 hours x $275.99 = $3,353,278.50). The
hourly rates in this release are derived from the average annual
salaries reported for employees outside of New York City in
Securities Industry Association, Management and Professional
Earnings in the Securities Industry (2003) and Securities Industry
Association, Office Salaries in the Securities Industry (2003).
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We estimate the annual burden on a fund to collect information it
requests from financial intermediaries will be 160 hours \109\ for a
total burden of 259,200 hours for all funds.\110\ We estimate the
capital costs for a fund will be $100,000 per fund for an aggregate
cost of $162,000,000 for all funds.\111\ We estimate the ongoing yearly
cost will be $6,640 per fund for an aggregate yearly cost for all funds
of $10,756,800.\112\ We estimate the annual burden for financial
intermediaries to establish systems for the collection and transfer of
data to funds will be 240 hours per intermediary for a total burden of
1,519,200 hours for all financial intermediaries.\113\ We estimate the
capital costs will be $150,000 per financial intermediary for an
aggregate cost of $949,500,000.\114\ We estimate ongoing costs of
$60,000 per financial intermediary for an aggregate yearly cost of
$379,800,000 for all intermediaries.\115\
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\109\ This estimate is based on the following calculation: 40
hours per quarter x 4 quarters = 160 hours per year.
\110\ This estimate is based on the following calculation: 160
hours per fund x 1,620 funds = 259,200 hours per year.
\111\ This estimate is based on the following calculation:
$100,000 per fund x 1,620 funds = $162,000,000.
\112\ This estimate is based on the following calculation:
$6,640 per fund x 1,620 funds = $10,756,800.
\113\ This estimate is based on the following calculation: 240
hours per intermediary x 6,330 intermediaries = 1,519,200 hours.
\114\ This estimate is based on the following calculation:
$150,000 per intermediary x 6,330 intermediaries = $949,500,000.
\115\ This estimate is based on the following calculation:
($60,000 per intermediary x 6,330 intermediaries = $379,800,000). We
have reduced the ongoing costs incurred by each intermediary to
$60,000 (we estimated that the ongoing costs would be $100,000 in
the Proposing Release) to reflect the elimination of the weekly
reporting requirement.
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The estimated collection burden for all 9,030 respondents (i.e.,
2,700 funds + 6,330 intermediaries) under rule 22c-2, is determined by
calculating an average of the first year burden and the subsequent
annual burdens. Over the three-year period, we estimate the weighted
average aggregate annual information collection burden will be
1,895,250 hours.\116\ The Commission estimates that there will be a
total of 25,320 responses annually, which includes responses by funds
and intermediaries.\117\
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\116\ In the first year after adoption we estimate the aggregate
collection of information burdens resulting from the written
agreement requirement will be: (i) 271,350 hours (12,150 hours for
contract modifications + 259,200 hours for the information
collection requirements) for funds; and (ii) 1,519,200 hours for
intermediaries. Thus, in the first year after adoption, we estimate
the aggregate burden for all respondents will be 1,790,550 hours
(271,350 hours for funds + 1,519,200 hours for intermediaries). In
the second and third years after adoption, we estimate the annual
burden for respondents will fall by 12,150 hours, because the burden
attributable to one-time contract modifications will no longer be
incurred by funds. Thus, we estimate the average annual burden over
the three-year period for which we are seeking approval will be
1,782,450 hours (1,790,550 first year's burden + 1,778,400 second
year's burden + 1,778,400 third year's burden/3).
\117\ Specifically, the staff estimates that annually there will
be 25,320 responses under rule 22c-2 (6,330 intermediaries x 4
responses per year).
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The total annual cost of the new information collection
requirements for all 7,950 respondents (i.e., 1,620 funds + 6,330
intermediaries), is determined by calculating an average of the first
year cost and the subsequent annual costs. Over the three-year period,
we estimate the weighted average aggregate annual cost will be
$630,871,200.\118\
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\118\ In the first year after adoption of rule 22c-2 we estimate
the aggregate cost burden of the information collection requirement
for funds will be $162,000,000; and for intermediaries will be
$949,500,000. Thus, in the first year after adoption, we estimate
the aggregate cost burden for all respondents will be
$1,111,500,000. In the second and third years after adoption, we
expect the annual cost burden for respondents to fall to
$390,556,800 because funds and intermediaries will incur only the
ongoing operation and maintenance costs of systems that have been
put in place during the first year. Specifically, in each of the
second and third years after adoption (i) we estimate the aggregate
cost burden for the information collection requirements for funds
will be $10,756,800; and (ii) for intermediaries will be
$379,800,000. Thus, we estimate that the average annual cost burden
over the three-year period for which we are seeking approval will be
$630,871,200 ($1,111,500,000 first year's burden + $390,556,800
second year's burden + $390,556,800 third year's burden/3).
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VII. Final Regulatory Flexibility Analysis
This Final Regulatory Flexibility Analysis (``FRFA'') has been
prepared in accordance with 5 U.S.C. 604. It relates to rule 22c-2 and
the amendments to rule 11a-3 under the Investment Company Act. The
Initial Regulatory Flexibility Analysis (``IRFA''), which was prepared
in accordance with 5 U.S.C. 603, was published in the Proposing
Release.\119\
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\119\ See Proposing Release, supra note 12, at Section VI.
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[[Page 13340]]
A. Need for, and Objectives of, the Rule
As described more fully in Section I of this Release, rule 22c-2 is
necessary to enable funds to recover some, if not all, of the direct
and indirect (e.g., market impact and opportunity) costs incurred by
the fund when shareholders engage in short-term trading of the fund's
shares, and to deter short-term trading, including market timing
activity. As stated in Section I, many funds have not imposed
redemption fees on shares held in omnibus accounts because they often
do not know the identities and transactions of the beneficial owners of
those shares, and may be unable to obtain the cooperation of the
intermediaries to impose the fee. Rule 22c-2 requires that funds enter
into written agreements with financial intermediaries that will allow
funds to obtain this information on request, and to direct
intermediaries to prohibit or restrict further purchases or exchanges
by shareholders who have engaged in trading that violates the funds'
market timing policies.
B. Significant Issues Raised by Public Comment
We requested comment on the IRFA. We also specifically requested
comment on the number of small entities that would be affected by the
proposed rule, the likely impact of the proposal on small entities, the
nature of any impact, and empirical data supporting the extent of the
impact. We received a number of comments on the impact on small
entities. These commenters, primarily small financial intermediaries,
generally expressed concern that the costs associated with the proposed
mandatory redemption fee would be significant and disproportionately
affect small entities because of the costs to record, store, track and
transmit data.\120\
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\120\ Although the estimates varied, most intermediaries
estimated that their first year start-up costs to comply with the
proposed rule would be between $200,000 and $300,000. In the
Proposing Release, we estimated the first year start-up costs for
intermediaries that used the option set forth in proposed rule 22c-
2(b)(1), in conjunction with the weekly reporting requirement, would
be $250,000.
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We are concerned about the impact of the rule on small entities,
and therefore have amended the rule to address many commenter concerns.
Rule 22c-2 no longer requires funds to impose a redemption fee if they
determine that a fee is not necessary or appropriate to prevent
dilution. Under rule 22c-2, rather than requiring funds to obtain
shareholder information from financial intermediaries on a weekly
basis, intermediaries must agree to provide the information upon a
fund's request, e.g., periodically or when circumstances suggest that
redemption fees are not being assessed or that abusive market timing
activity is occurring. In addition, the rule does not prevent funds
from excluding certain types of transactions that do not involve
shareholder discretion from the fee, e.g., redemptions that follow
purchases made pursuant to periodic portfolio rebalancings.\121\ We
believe that this flexibility will be very helpful to small
recordkeeping firms by enabling them to negotiate greater uniformity in
the administration of retirement plans. In addition, we request comment
on whether we should require a uniform standard for any redemption fees
charged by a fund and whether such uniformity could result in cost
reductions for funds and financial intermediaries.
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\121\ Intermediaries generally recommended that redemption fees
should apply only to transfers and exchanges in participant-directed
employee benefit plans, and stated that excluding ``involuntary''
transactions from redemption fee requirements would significantly
reduce the costs associated with the rule.
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C. Small Entities Subject to the Rule
A small business or small organization (collectively, ``small
entity'') for purposes of the Regulatory Flexibility Act is a fund
that, together with other funds in the same group of related investment
companies, has net assets of $50 million or less as of the end of its
most recent fiscal year.\122\ Of approximately 3,925 funds (2,700
registered open-end investment companies and 825 registered unit
investment trusts), approximately 163 are small entities.\123\ A
broker-dealer is considered a small entity if its total capital is less
than $500,000, and it is not affiliated with a broker-dealer that has
$500,000 or more in total capital.\124\ Of approximately 6,800
registered broker-dealers, approximately 880 are small entities, of
these, approximately 470 are broker-dealers that already transmit the
shareholder data to funds on a fully-disclosed basis. Funds would not
need to request the shareholder identity and transaction data from
these broker-dealers. These particular intermediaries therefore would
not need to establish or maintain systems to comply with this portion
of the rule, so we have not included them in our start-up or ongoing
maintenance calculations.
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\122\ 17 CFR 270.0-10.
\123\ Some or all of these entities may contain multiple series
or portfolios. If a registered investment company is a small entity,
the portfolios or series it contains are also small entities.
\124\ 17 CFR 240.0-10.
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As discussed above, rule 22c-2 provides funds and their boards with
the ability to impose a redemption fee designed to reimburse the fund
for the direct and indirect costs incurred as a result of short-term
trading strategies, such as market timing. To facilitate the uniform
application of redemption fees to all shareholders of the fund,
including shareholders who own their shares through financial
intermediaries, rule 22c-2 requires that funds and financial
intermediaries enter into written agreements that allow funds to obtain
shareholder identity and transaction information and to direct the
financial intermediary to execute the funds' instructions in certain
circumstances. While we expect that the rule will require that some
funds and intermediaries develop or upgrade software or other
technological systems to enforce certain market timing policies, or
make trading information available in omnibus accounts,\125\ we
anticipate that the modifications, as discussed above, will reduce the
costs incurred by small entities.
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\125\ In some cases, the fund (or its transfer agent) will have
to upgrade its recordkeeping systems; however, some may already have
software that can be used, or modestly modified, to accommodate the
matching of purchases and redemptions. In addition, the costs may be
substantially less for broker-dealers and other financial
intermediaries that already have transfer agent systems in place
that can be modified to identify short-term trading.
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D. Reporting, Recordkeeping, and Other Compliance Requirements
The rule does not introduce any new mandatory reporting
requirement. The rule does contain a new mandatory recordkeeping
requirement. The fund must retain a copy of the written agreement
between the fund and financial intermediary under which the
intermediary agrees to provide the required shareholder information in
omnibus accounts.\126\
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\126\ Rule 22c-2(a)(3).
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E. Commission Action To Minimize Effect on Small Entities
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objective,
while minimizing any significant adverse impact on small entities.
Alternatives in this category would include: (i) Establishing different
compliance or reporting standards that take into account the resources
available to small entities; (ii) clarifying, consolidating, or
simplifying the compliance requirements under the rule for small
entities; (iii) using performance rather than design standards; and
(iv) exempting small entities from coverage of the rule, or any part of
the rule.
[[Page 13341]]
The Commission does not believe that the establishment of special
compliance requirements or timetables for small entities is feasible or
necessary. The rule arises from enforcement actions and settlements
that underscore the need to reimburse funds so that long-term
shareholders will not be disadvantaged by shareholders that engage in
frequent trading and by fund managers that selectively permit such
short-term trading. Excepting small entities from the rule could
disadvantage fund shareholders of small entities and compromise the
effectiveness of the rule.
With respect to further clarifying, consolidating or simplifying
the compliance requirements of the rule, using performance rather than
design standards, and exempting small entities from coverage of the
rule or any part of the rule, we believe such changes are
impracticable. Small entities are as vulnerable to the problems
uncovered in recent enforcement actions and settlements as large
entities. Therefore, shareholders of small entities are equally in need
of protection from short-term traders. We believe that the rule will
enable funds to more effectively discourage short-term trading of all
fund shares, including those held in omnibus accounts. A recent staff
review of fair valuation practices of mutual funds found that one of
the biggest obstacles to preventing short-term trading is the existence
of omnibus account platforms. Exempting small entities from coverage of
the rule or any part of the rule could compromise the effectiveness of
the rule.
VIII. Statutory Authority
The Commission is adopting rule 22c-2, and amendments to rule 11a-3
pursuant to the authority set forth in sections 6(c), 11(a), 22(c) and
38(a) of the Investment Company Act [15 U.S.C. 80a-6(c), 80a-11(a),
80a-22(c) and 80a-37(a)].
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Rule
0
For reasons set out in the preamble, Title 17, Chapter II of the Code
of Federal Regulations is amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
1. The authority citation for part 270 continues to read in part as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
0
2. Section 270.11a-3 is amended by:
0
a. Revising paragraph (a)(7); and
0
b. Removing the undesignated paragraph following paragraph (b)(2)(ii).
The revision reads as follows.
Sec. 270.11a-3 Offers of exchange by open-end investment companies
other than separate accounts.
(a) * * *
(7) Redemption fee means a fee that is imposed by the fund pursuant
to section 270.22c-2; and
* * * * *
0
3. Section 270.22c-2 is added to read as follows:
Sec. 270.22c-2 Redemption fees for redeemable securities.
(a) Redemption fee. It is unlawful for any fund issuing redeemable
securities, its principal underwriter, or any dealer in such
securities, to redeem a redeemable security issued by the fund within
seven calendar days after the security was purchased, unless it
complies with the following requirements:
(1) Board determination. The fund's board of directors, including a
majority of directors who are not interested persons of the fund, must
either:
(i) Approve a redemption fee, in an amount (but no more than two
percent of the value of shares redeemed) and on shares redeemed within
a time period (but no less than seven calendar days), that in its
judgment is necessary or appropriate to recoup for the fund the costs
it may incur as a result of those redemptions or to otherwise eliminate
or reduce so far as practicable any dilution of the value of the
outstanding securities issued by the fund, the proceeds of which fee
will be retained by the fund; or
(ii) Determine that imposition of a redemption fee is either not
necessary or not appropriate.
(2) Shareholder information. The fund or its principal underwriter
must enter into a written agreement with each financial intermediary of
the fund, under which the intermediary agrees to:
(i) Provide, promptly upon request by the fund, the Taxpayer
Identification Number of all shareholders that purchased, redeemed,
transferred, or exchanged shares held through an account with the
financial intermediary, and the amount and dates of such shareholder
purchases, redemptions, transfers, and exchanges; and
(ii) Execute any instructions from the fund to restrict or prohibit
further purchases or exchanges of fund shares by a shareholder who has
been identified by the fund as having engaged in transactions of fund
shares (directly or indirectly through the intermediary's account) that
violate policies established by the fund for the purpose of eliminating
or reducing any dilution of the value of the outstanding securities
issued by the fund.
(3) Recordkeeping. The fund must maintain a copy of the written
agreement under paragraph (a)(2) that is in effect, or at any time
within the past six years was in effect, in an easily accessible place.
(b) Excepted funds. The requirements of paragraphs (a) of this
section do not apply to the following funds, unless they elect to
impose a redemption fee pursuant to paragraph (a)(1) of this section:
(1) Money market funds;
(2) Any fund that issues securities that are listed on a national
securities exchange; and
(3) Any fund that affirmatively permits short-term trading of its
securities, if its prospectus clearly and prominently discloses that
the fund permits short-term trading of its securities and that such
trading may result in additional costs for the fund.
(c) Definitions. For the purposes of this section:
(1) Financial intermediary means:
(i) Any broker, dealer, bank, or other entity that holds securities
of record issued by the fund, in nominee name;
(ii) A unit investment trust or fund that invests in the f