Frequent Trading / Insider Trading

[RCK]

In response to the all the current Mutual Fund commotion, as well as insider trading issues, we are considering:

1. Imposing fees on quick round trip trades in any fund. This could be along the lines of last week's SEC proposal (2% fee on shares redeemed within 5 days of their purchase).

2. Imposing a limit on number of trades a participant could make during a specified time period, or a complete ban on round trip trades over time periods shorter than XX days.

3. For the Company Stock Fund Only, greatly expanding our definition of what constitutes a 16(b) insider, and prohibiting all trades by that group in the period 10 days preceeding and 3 days following a earnings release date.

Background: plan has approximately 20,000 participants and $500 million of assets, a third party recordkeeper, and no two funds from the same investment manager.

So the question is: We are aware that many companies are thinking about these issues, but has anyone done anything yet?

RCK

[MGB]

On (1):

Imagine a participant has a payroll deduction on 3/1 and is invested in a mutual fund. On 3/2, they take a distribution (loan, hardship, or termination). Are you going to charge them a 2% fee for this quick round trip trade? The proposals from the SEC would.

[Demosthenes]

Couple of things to consider. Market timing is not useful in all funds. It is primarily of benefit in international funds and small cap funds where stale prices occur. An across the board round trip trade fee is overkill. However, it does generate revenue for the fund.

Next, a number of plans limit the number of trades in a year. If they do, it should already be part of the compliance monitoring for a plan. Timers may trade a couple of times per week. If the plan has a 12 transfer per year limit, it severely limits the timer's strategy.

Finally, fund rules are going to rule. The biggest issue is whether or not your recordkeeping system has the ability to apply the fund's rules at the participant level and how cash/trade operations will collect and remit the fees. For a number of DC systems this is going to be a headache but it's going to be a requirement.

I would not be surprised to see this as well as items related to a hard 4:00 PM close begin to show up in SAS 70 requirements and in RFPs.

Best advice I can offer is to

1. Be certain your rk system can handle fees on round trip trades within x days

2. If it can't, start the development effort or start getting your system's vendor moving.

3. Prepare your cash/trade operations for the fee collection and remittance

4. Be able to demonstrate one of more of the following capabilities;

a) Secure time-stamping of orders;

b) An annual audit of the your controls on late trading

c) An annual certification that policies and procedures are maintained to prevent late trades and that no late trades were effected during the period under audit.

[mbozek]

Two Q:

1. who will keep the penalty - the fund or the plan? Is this penalty in addition to a charge by the fund?

2. Is the fee necessary for plan administration and is it reasonable as required by ERISA. I dont think a plan can impose a charge on participant actions as a deterrent.

Most of the frequent trading occurs in funds where stale pricing creates the opportunity for arbitrage by buying or selling a fund after foreign markets close, e.g, international funds receive prices on foreign securities at times that are 6 or more hrs old before US markets close. This allows US investors to make bets without risk because they know which direction the fund will open at the next day. Fund managers are moving to change this practice and replace it with fair value pricing which will take changes after the close of the foreign market into account.

[Demosthenes]

IMHO, the penalty/fee is revenue to the mutual fund and will be driven by the prospectus

As you said, for the plan to impose and retain a fee, its necessity and reasonability under ERISA would have to be demonstrated. That may be doable by arguing harm to other participants in the plan.

However, the cost/effort of getting the DOL to issue that guideline is going to be a deterrent for any plan that wants to add the fee. I have seen places where it's been done, plansponsor.com had a recent article on strategies to reduce timing, but I'm not certain that it's been challenged by a participant or that the DOL has issued a ruling.

On the flip side, the DOL is getting interested; EBSA is starting a probe of service providers to look for late trading and timing in retirement accounts. The outcome could very well be a hard ruling.

If both things happen, a fund fee and a plan fee, it looks like 2 different revenue streams and destinations. Just to muddy the waters, on the plan fee, I could easily argue that any collected fee be allocated to the remaining participants in the fund. After all, if the fee is there to prevent/compensate for harm, shouldn't the fee go to those damaged to make them "whole"?

[jquazza]

I think it's really up to the fund company to monitor this and assess any penalty if they wish (providing they can under the fund prospectus.)

I work for a bank that does a lot of trading with various of fund families, and we started to get trade rejections due to timing concerns.

Keep in mind that timing a fund in itself is not illegal. Fund companies have gotten themselves into trouble because they prohibited timing in their prospecti and did nothing to monitor such activities (and in some instances knowingly facilitated such activites in contravention of their self-imposed rules.)

Unless you have arrangements with fund companies that put the burden of monitoring timing on your shoulders, it's not your problem.

[Demosthenes]

Fund companies can't. By some estimates 50% of assets in a mutual fund are invisible to the fund company. They're shielded from view by some sort of sub-TA arrangement and all the fund sees is some sort of omnibus account.

Furthermore, if you have a sub-TA agreement from a fund and are collecting sub-TA revenues and you are not monitoring individual accounts for violations of the prospectus ...

Well, as the saying goes "Stuff rolls downhill and you are living in the valley"

But seriously, if a timing issue exists, rather than take the hit for violations, the fund company is going to be taking a serious look at the sub-TA. If your bank is only trading individual accounts, one person, one account at the fund, you should be fine. If you are trading into an omnibus account and the bank is responsible for maintaining the individual account balances under a sub-TA the bank is at risk.

[Jon Chambers]

Your proposed approach is similar to an approach taken by at least one other large plan sponsor that I've talked about these issues with. I think your proposed approach is reasonable. There are a couple of key points to consider:

1) Think about how your proposed structure may impact your 404© status. If you limit the number of trades annually, and a participant uses all available trades early in the year, you may not satisfy the 404© requirement that participants be permitted to trade at least quarterly.

2) Consider your disclosure requirements. If you have a redemption fee in addition to any fee imposed by the fund (and I assume this fee will be paid to the plan and reallocated to other participants), you'll need to make this part of your disclosures, since it won't be part of the standard prospectus disclosure.

In general, I think the proposed approach may be a good idea. My contacts at the DOL indicate that they will provide reasonable latitude to sponsors that make fiduciary decisions in the best interest of participants. So, presuming the fee is allocated to remaining participants, and the fee is imposed to prevent or address a perceived problem (such as excessive trading), it's unlikely the DOL will challenge your approach. Mbozek, you may want to review the recent Prudential decision, which is similar in many aspects to this thread (it deals with trading limits, not redemption fees).

[RCK]

To MGB: Yes, I believe that we would take the charge where a final contriubtion was allocated to a fund and then a distribution was taken. I think that is what SEC 2004-23 contemplates, subject to the $50 de minimis fee rule.

To Demosthenes: I don't see that the SEC cares with the trading strategy is effective or not. Your warnings are well taken. I see the flow here as SEC says it can be done, fund says the they are going to do it, we tell the recordkeeper that they have to facilitate it.

To mbozek: I understand the international arbitrage possibilities, but I don't see that the SEC is going to confine it's rulings to international funds. I agree with demosthenes--the fee goes to the fund, not the plan.

To Jon Chambers: good point on the 401© issue--I guess that if we go with the limited trade route, I'd prefer a quarterly limit on trades, so the participant has at least X chances to trade every quarter.

RCK

[mbozek]

RCK: Will the plan establish its own penalty for round trip trade in addition to any fees imposed by the SEC to deter such trading?

I dont see how the plan can turn over plan assets to the fund which are not required under the fund's prospectus or agreement between the plan and the fund. It doesn't seem to be reasonable comp by the plan under ERISA. Maybe Kirk can lend his expertise as to whether this can be done.

I have no problem with the imposition of any penalty or charge by the Fund on transactions by plan participants.

[Jon Chambers]

mbozek--In the cases I've seen where sponsors have assessed a charge in addition to any charge imposed by the fund, the charge is retained by the plan and reallocated to the other plan participants in the same fund. The purpose of the charge is to compensate remaining shareholders for the transactional costs and disruption caused by the individual making the market timing trades. There is no issue with reasonable compensation, b/c there is no compensation paid to the fund--it's simply a redistribution of assets from the market timer to the buy and hold participants. Fiduciaries justify this redistribution b/c it serves to equalize the implicit redistribution that occurs in the opposite direction when the market timers trade. Remember, just b/c a fund doesn't charge a fee for trading, that doesn't mean that there is no cost for trading. There is always a cost. If there is no fee, the cost is being absorbed by all the other owners of the fund.

[GBurns]

After reading the many well reasoned posts, I wonder if this action is really necessary, if as has been pointed out, it is even allowed. Would it also not be a deterrent to participation?

To me this seems like an unnecessary overkill. This fund has an average participant balance of only $25,000. I do not think that this is the sort of plan participant or transaction type that the SEC is worried about nor does it have the potential to be, unless the true picture is really a few very large accounts and a large number of very small accounts, making the average misleading.

The burden by the SEC is enough anything else stinks.

[Demosthenes]

I have to agree that this is going to be a burden. I also have to agree that in most cases the absolute number of people involved in timing trades is small as a total of plan participants, but I also expect that the people involved have much larger than average balances. I have no facts to back that up, just a gut feeling.

Stipulating that there is a real possibility of abuse, the SEC and DOL are going to take steps to address the potential damage. It maybe overkill and may not. As an example, in at least one case I am aware of, (don't ask who), a large group of participants, about 1,500 out of a population of 10,000 actually subscribed to a service that advised them on when to make timing trades. The movement was in the seven figures range every time the service sent out an alert.

The Fund didn't prohibit rapid trading, the Plan and Trust didn't limit the number or frequency of trades, no laws were broken, but the buy and hold crowd were definitely getting hurt. This is an extreme case but it does illustrate the potential for harm.

As to the mechanisms used to prevent the abuse, unless there is a unified approach to penalties, either by the SEC or the fund industry, Plan Sponsors are going to get left to fill in the gaps. Say that 50% of the funds impose a fee/penalty and you have a Plan with a fund in the other half.

The Sponsor knows there's a potential for abuse and is worried about a fiduciary liability because of the possible harm to the majority of participants. In self defense, isn't the Sponsor forced to add a penalty clause to the Plan?

[mbozek]

I dont see any compelling need for a plan to impose a penalty on transactions by participants simply because it offers a fund that does not impose a penalty. Many funds are not susceptable to trading abuses because the price does not vary much on a day to day basis e.g., bond funds and index funds. Some funds limit volitile price swings by using fair value pricing of securities traded in foreign markets. I dont think that there is any basis under the fiduciary provisions of ERISA to impose penalty on trading by a participant in a fund that does not impose such a penalty to protect the other participants who make up an insignificant proportion of all investors in the fund. I dont think there is any support in applicable law for a plan to impose such a penalty or to transfer penalities collected to a fund company. The plan could limt any potential for abuse by limiting the trading frequency of a participant to the extent permitted under the 404© regs. I dont know what the fiduciary liability would be if the plan did not impose a penalty. The real risk in penalizing frequent trading in a fund that does not provide for a penalty is that the fund co will object because it will deter investments by participants and result in a withdrawal of the fund as a plan investment for all participants.

[Guest halka]

Would like to see some comments about trading restrictions on employer stock in participant-directed plans. RCK mentioned expanding list of insiders and trading restrictions related to earnings announcements. Do RCK’s steps, at some point, become a blackout period requiring recurring notice, etc?? Is it sufficient for the Plan fiduciary to simply adopt/change such rules or must they be an actual provision of the Plan document?? How about applying a quick turnaround penalty for all employer stock roundtrips with xx days (using LIFO method)??