Guest Article

(From the October 9, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

SEC Finalizes Amendments to Market Timing Rules

The Securities and Exchange Commission (SEC) has amended the final mutual fund market timing rules it released last year. The amendments clarify certain issues relating to shareholder information 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. The final changes are slightly modified versions of the amendments to the final rule the SEC proposed earlier this year, but also extend until April 16, 2007 the deadline for 401(k) plans and other financial intermediaries to enter into shareholder information agreements with mutual funds.

All 401(k) plan administrators and other fiduciaries need to be aware of, understand, and ensure compliance with the SEC's market timing rules. This is true regardless of whether the 401(k) plan submits purchase and redemption orders directly to mutual funds, or uses a broker or clearing house to facilitate such transactions. If a 401(k) plan fails to enter into a shareholder information agreement with a fund when required, or fails to provide shareholder information to a fund when requested, the plan's participants may lose the ability to invest in that fund. This type of sudden disruption in the availability of a plan investment option could be an administrative nightmare and perhaps trigger ERISA's advance notice requirements for "blackout" periods. See ERISA § 101(f).

Background

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 401(k) plan administrators, broker-dealers, banks, and insurance companies. 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 -- called "shareholder information agreements" -- whereby each intermediary agrees to:

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 plan administrator or recordkeeper generally will have enter into a shareholder information agreement with the fund, 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.

Amendments to Final Regulations

The amendments change the shareholder information agreement requirement by --

The preamble to the final amendments also addresses certain operational issues and reiterates the SEC's decision not to establish standardized terms and conditions for redemption fees. Additionally, the final amendments extend the compliance deadline for funds to enter into shareholder information agreements with their intermediaries by six months, until April 16, 2007, and extend the compliance deadline for funds to be able to request and promptly receive shareholder identity and transaction information pursuant to these agreements by one year, until October 16, 2007. However, the final amendments do not change the October 16, 2006 compliance deadline for a fund's board to consider adopting a redemption fee policy.

Financial Intermediary Definition

The market timing rules require funds to enter into shareholder information agreements with financial intermediaries that submit orders to purchase or redeem shares directly to the fund, its principal underwriter or transfer agent, or to a registered clearing agency. However, in many cases financial intermediaries use agents to submit purchase and redemption orders to funds on their behalf. The amendments clarify that the fact a financial intermediary uses an agent to submit orders to the fund on the intermediary's behalf does not change the fund's obligation to enter into a shareholder information agreement with the financial intermediary.

Some funds have expressed concerns that the market timing 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, the SEC has modified the market timing regulations to "exclude from [the definition of 'financial intermediary'] any entity 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, i.e., frequent trading and redemption fee policies." As a result, funds will not have to enter into information sharing agreements with small employer retirement plans if they apply the redemption fee or exchange limits to transactions by the plan, instead of to transactions by individual 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. As issued in 2005, the market timing regulations did not specify whether, in these cases, the fund must enter into shareholder information agreements with all intermediaries in the chain, or just with the first tier-intermediary (e.g., the brokerage firm) that actually submits orders to the fund. The amendments clarify that funds must enter into shareholder information agreements only with first-tier intermediaries.

These shareholder information agreements must obligate the first-tier intermediary to provide to funds, upon request, identification and transaction information for any shareholder accounts the first-tier intermediary holds directly. Once the fund receives this information, it can make a specific request for information on certain shareholders. The shareholder information agreement then must require the first-tier intermediary to "use its best efforts to identify whether or not certain specific accounts identified by the fund are indirect intermediaries." If the shareholder is an indirect intermediary and the indirect intermediary will not provide individual shareholder information to the first-tier intermediary, the fund -- pursuant to the shareholder information agreement -- can require the first-tier intermediary to prohibit the indirect intermediary from using it to purchase additional fund shares.

First-tier intermediaries do not have to enter into information sharing agreements with indirect intermediaries. However, the market timing regulations do not prohibit such agreements.

Effect of No Agreement

What happens if a fund fails -- or is not able -- to enter into shareholder information agreements with all of its financial intermediaries? The amendments clarify that, if a fund lacks an agreement with a particular financial intermediary, the fund must prohibit that intermediary from purchasing the fund's securities "in nominee name on behalf of other persons." This prohibition does not extend to the automatic reinvestment of dividends. Also, a financial intermediary that does not have a shareholder information agreement with a fund can still purchase the fund's securities on its own behalf.

What About Plan-Imposed Frequent Trading Restrictions?

Some 401(k) plans may have policies specifically designed to prevent market timing, or may have general restrictions on the frequency of participant investment directions that have the effect of preventing market timing. The preamble to the final amendments to the SEC's market timing rules clarify that a fund might defer to these policies instead of enforcing its redemption fee or other frequent trading rules against the 401(k) plan's participants.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any 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, 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.