SEC Goes "Public" with Redemption Proposal

February 25, 2004 ( - As anticipated, the SEC has decided, by a 4-to-1 vote, to see what the public thinks about a mandatory redemption fee on quick, market-timing trades in mutual funds.

>If enacted, the SEC proposal would require that funds charge a 2% fee on shares sold within five days of purchase (see  SEC Ponders Five-Day Redemption Fee ).   Not that there isn’t concern about the proposal, even among the SEC commissioners who agreed to put the idea out for public comment yesterday.   In fact, SEC commissioner Paul Atkins was so convinced the plan will hurt shareholders that he voted not to issue it for public comment, calling the 2% a “simplistic solution.”   “The only winner here I see is the fund industry,” Atkins complained.

Retirement Plan Impact

>What isn’t totally clear at present is how such a redemption fee might be levied on retirement plan investors.   Frequently those trades are processed via an omnibus arrangement, obscuring the individual trading details from the fund company that would ostensibly be tracking and assessing the charges.   The SEC dealt with this possibility in the new proposal, noting that “Many funds today that impose redemption fees do not impose them on shareholders who hold their shares through financial intermediaries such as broker-dealers and retirement plans”, the SEC said the proposed rule would “require that funds obtain the information they need to assess the redemption fee, and to oversee the efforts of intermediaries to assess those fees and remit them to the fund.”  

>Perhaps more ominously for plan sponsors, the proposal might also mean that a plan participant’s regular payroll contribution, if followed by a routine rebalancing transfer within five days, might trigger the redemption fee on the perceived “quick” liquidation of monies.

>According to Dow Jones, Atkins said it’s no surprise that fund companies support redemption fees and predicted they will “laugh all the way to the bank” as mandatory fees boost fund assets and act as a disincentive for investors to leave a fund.   Indeed, the Investment Company Institute, a mutual fund trade industry group, was quick to lend its support to the proposal – which largely mirrored one the ICI put forth last Halloween (see  Mutual Fund Proposal No “Treat” for Retirement Plans ).    

>SEC commissioner Cynthia Glassman also raised reservations about the proposal, describing it as a “band-aid” that won’t deter market timing trades that generate big profits, making the 2% penalty the cost of doing business.   Even SEC chief William Donaldson said he may have reservations as well, but wants the SEC to get comment on the plan before making any final decision.

>Money market mutual funds and exchange-traded funds wouldn't be subject to early redemption fees under the SEC proposal.    Additionally, the SEC has proposed several provisions designed to prevent the redemption fee from affecting "most ordinary redemption transactions by smaller investors," including:  

  • The rule requires that a fund calculate the redemption fee on shares held the longest period of time first.    According to the SEC, this method will minimize the likelihood that redemptions of part of a shareholder's account will be assessed a redemption fee.
  • The rule would include a de minimis exception - the fund would not be required to impose a redemption fee of $50 or less.    According to the SEC, this means that a fund could waive redemption fees on the redemption of $2,500 or less in fund shares.
  • The rule would include an emergency exception that would allow a shareholder not to pay a redemption fee in the event of an unanticipated financial emergency, which according to the SEC, means that at least $10,000 would be available to a shareholder in a financial emergency and no redemption fee would be charged.

>Another big exception would be given to funds geared toward market timers, who clearly tell investors that they permit market timing, which can impose costs on fund investors. Paul Roye, director of the SEC's investment management division, said the plan isn't meant to be a cure-all but rather a supplement to fair-value pricing.

Fair Fare?

>The SEC also said that "The principal solution to abusive market timing transactions is the accurate calculation of net asset value each day, using current and not stale prices."   The SEC reiterated a statement it made last December that "the Investment Company Act of 1940 requires funds to calculate their net asset value based on the "fair value" of a portfolio security if the market quotes are unavailable or unreliable."

>The SEC went on to note that, "though fair value pricing can reduce the profits that market timers seek to extract from mutual funds, it is subjective in nature."   Consequently, the agency believe that a redemption fee, together with fair value pricing, can serve to "…reduce, if not eliminate, the profits that market timers seek to extract from the fund."   The SEC said the release for comments would solicit information on how funds can more effectively implement fair value pricing methods, and whether the SEC should provide further guidance in this area.

Comments on the proposed rule should be submitted to the Commission within 60 days of its publication in the Federal Register.   However, changes won't become final without a second vote by the SEC.