SEC mutual-fund proposals address ethics, oversight

By John Waggoner
USA Today

The Securities and Exchange Commission is mulling more than a half-dozen new rules to stop the rapidly widening mutual fund trading scandal, increase disclosure and improve fund oversight.

The government watchdog proposed two rules yesterday requiring mutual funds to:

• Receive orders by 4 p.m., ET, to eliminate the potential for late trading through intermediaries.
• Disclose market-timing policies and practices for determining the fair value of securities — especially stocks on international markets — in their portfolios.

But it isn't stopping there. The SEC will propose the other rules in three waves, starting this month. Each will be put out for public comment before the SEC votes.

Sparking the proposals: late trading and market timing.

In late trading, an investor gets a fund's 4 p.m. ET closing price after 4 p.m. If favorable market news is released after 4 p.m., a late trader is virtually assured a profit by selling the next day.

Late trading is illegal.

Market timing is rapid-fire trading in and out of funds to take advantage of funds whose share prices are out of sync with the market. A Japan fund, for example, may have its stocks priced as of the Japanese closing — 2 a.m. ET.

If the U.S. market rallies sharply, a timer could buy the Japan fund, assuming Japanese markets would rally, too, and then sell it the next day for a fast profit.

Timing isn't illegal, but many funds kicked out small timers and let in big ones.

The SEC's forthcoming proposals also would affect:

Breakpoints. On large investments, funds offer discounts, called breakpoints, on up-front commissions. An investigation by the SEC and the National Association of Securities Dealers showed investors were overcharged an average $243 in 2001 and 2002.

The rule would make it easier for them to get their breakpoints.

Directors. Funds have boards of directors who are supposed to look after investors' best interests. Critics say the directors are too close to the companies that manage the funds, so they overlook high fees and poor performance. The SEC wants three-quarters of a fund's directors to have no affiliation with the company managing the fund. The rule would require a fund's board chairman to be independent, too.

Codes of ethics. Fund advisers — the companies that manage a fund's portfolio — will be required to have rules governing how insiders can invest in fund shares. They will have to report their trades to fund directors. The rule would make it easier to pinpoint market timing by portfolio managers and other insiders.

But it wouldn't necessarily make shady companies more ethical, says Richard Swanson, securities lawyer at Thelen Reid & Priest.

"You have to have a strong compliance culture," he says.

Conflicts of interest. Some brokerages have lists of "preferred" mutual funds that they offer investors. But many funds have to pay to be on those lists.

Fund companies and brokerages would have to disclose any inducements paid to brokers to push particular funds.

Mandatory redemption fees. Funds would have to charge a 2 percent redemption fee when investors redeem within five days of purchase. The fee would make market timing much less profitable.

In other mutual fund news:

• Piper Jaffray Cos., which is expected to be spun off from U.S. Bancorp in December, said the SEC and National Association of Securities Dealers have requested information from it over late trading and market timing of mutual fund shares.
• Strong Financial Corp. confirmed it is for sale one day after founder and chief executive Richard Strong resigned amid federal and state investigations into his trading activities.