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Guest Article


(From the March 13, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

SEC Proposes Changes to Market Timing Rules

The Securities and Exchange Commission (SEC) has issued proposed amendments to the final mutual fund market timing rules it released last year. The proposed amendments would clarify certain issues relating to information sharing agreements that mutual funds must enter into with financial intermediaries, including 401(k) and other retirement plans, and, to a limited extent, streamline the rule's application when "chains" of intermediaries are involved.


In general, market timing involves frequent buying and selling of mutual fund shares in order to take advantage of pricing discrepancies. The practice is not illegal, but most mutual funds have policies to discourage or prohibit market timing because of the harm it can cause other fund shareholders. For example, market timing can dilute the value of other shareholder's shares, disrupt management of the fund's investment portfolio, and cause the fund to incur higher transaction costs, which are borne by other shareholders.

Mutual funds currently use redemption fees and other techniques to limit or prevent market timing by shareholders. However, these policies are difficult to enforce against investors who purchase fund shares through intermediaries such as broker-dealers, banks, insurance companies, and 401(k) plan administrators. Because these intermediaries usually hold shares in omnibus accounts, funds do not have access to the names of individual shareholders. According to the SEC, some shareholders have been using omnibus accounts to conceal "abusive market timing trades."

As noted, the SEC issued final regulations last year to address the market timing problem. Basically, the final regulations provide that if a fund redeems its shares within seven days (as most do), the fund's board of directors must consider whether to impose a redemption fee of up to two percent of the value of shares redeemed shortly after their purchase. Additionally, funds and financial intermediaries must enter into written agreements whereby each intermediary agrees to:

  • provide the Taxpayer Identification Number (TIN) of all shareholders that purchase, redeem, transfer, or exchange shares held through an account with the intermediary, and the amount and dates of such shareholder purchases, redemptions, transfers, and exchanges, to the fund upon request; and
  • execute any instructions from the fund to restrict or prohibit further purchases or exchanges of fund shares by a shareholder who the fund identifies as having engaged in transactions (directly or indirectly through the intermediary's account) that violates the fund's market timing restrictions.

In the case of a 401(k) plan that owns a fund's shares, the final regulations define "financial intermediary" as the plan administrator or other entity that maintains the plan's participant records. Thus, the fund will have to enter into this agreement with the plan administrator or recordkeeper, and the plan administrator or recordkeeper will have to agree to execute the fund's instructions to restrict or prohibit future trades by market timers.

The compliance deadline for the final regulations is October 16, 2006.

Proposed Regulations

According to the preamble to the proposed regulations, fund managers and other market participants have complained to the SEC about the cost of implementing the final regulations. Thus, the proposed regulations "are designed to reduce the costs of complying with the rule and clarify its application in certain circumstances." Specifically, the proposed regulations would:

  • limit the types of intermediaries with which funds must negotiate information sharing agreements;
  • address the rule's application where there are chains of intermediaries; and
  • clarify the effect of a fund's failure to obtain an agreement with any of its intermediaries.

Small Intermediaries

One concern funds have expressed is that the final regulations will require them to review a large number of their shareholder accounts to determine which shareholders are "financial intermediaries." This term is defined broadly enough to include any entity that holds securities in nominee name for other investors, including a small business retirement plan that holds mutual fund shares on behalf of only a few employees. The funds argue that, "the task of identifying these intermediaries, as well as negotiating agreements with them, will be costly and burdensome."

In order to address this problem, which the preamble calls "an unintended consequence of the rule," the proposed regulations would "exclude from the definition of 'financial intermediary' any intermediary that the fund treats as an individual investor for purposes of the fund's policies intended to eliminate or reduce dilution of the value of fund shares." (The relevant "policies" include the fund's redemption fee program and other restrictions on frequent purchases and redemptions.) As a result, a fund could avoid entering into an information sharing agreement with a small employer retirement plan by applying the redemption fee or exchange limits to transactions by the plan, instead of to purchases and redemptions by plan participants.

Intermediary Chains

In some cases a 401(k) or other retirement plan will be a link in a "chain of intermediaries" with respect to a fund. For example, a brokerage firm might hold a fund's shares on behalf of a 401(k) plan. The final regulations do not specify whether, in these cases, the fund must enter into information sharing agreements with all intermediaries in the chain, or just with the first tier-intermediary (e.g., the brokerage firm).

The proposed regulations would clarify that funds must enter into so-called "shareholder information agreements" only with first-tier intermediaries -- i.e., those that submit orders to purchase or redeem shares directly to the fund, its principal underwriter or transfer agent, or a registered clearing agency. Additionally, according to the preamble, "The proposed rule would include transfer agents and registered clearing agencies among the entities that may enter into shareholder information agreements with financial intermediaries on behalf of funds."

Under these shareholder information agreements the first-tier intermediary would be obligated to provide to funds, upon request, identification and transaction information for any shareholder accounts the first-tier intermediary holds directly. Also, if the first-tier intermediary maintains a shareholder account for another financial intermediary -- such as a 401(k) plan -- the agreement must obligate the first-tier intermediary "to use its best efforts to identify, upon request by the fund, those accountholders who are themselves intermediaries, and obtain and forward (or have forwarded) the underlying shareholder identity and transaction information from those intermediaries farther down the chain (i.e., second- or third-tier intermediaries, or 'indirect intermediaries')."

Of course, the indirect intermediary will not be bound by the shareholder information agreement between the first-tier intermediary and the fund. Thus, the proposed regulations would require the agreement to obligate the first-tier intermediary to prohibit an indirect intermediary from purchasing additional fund shares through the first-tier intermediary, upon the fund's request.

The proposed regulations would not require first-tier intermediaries to enter into information sharing agreements with indirect intermediaries. However, the proposed regulations also would not prohibit such agreements.

Effect of No Agreement

The final regulations do not explain the consequences of a fund's failure (or inability) to obtain information sharing agreements with all of its intermediaries. The proposed regulations would clarify that, if a fund lacks an agreement with a particular intermediary, the fund must prohibit the intermediary from purchasing the fund's securities on behalf of itself or other persons.

Compliance Date

As noted, the compliance date for the final regulations is October 16, 2006. Even though some commenters have asked for more time, this deadline remains in effect. However, the preamble to the proposed regulations indicates the SEC may revise or extend the date in the future.

DeloitteThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.

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