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Redemption Fee Break May Be Allowed


PALM DESERT, Calif. - The SEC might permit an exception to its two percent cap on redemption fees, allowing closed-end funds that are converting to an open-end structure to assess a redemption charge in excess of two percent, according to Paul Roye, director of the SEC's division of investment management.

The SEC may permit the exception because newly-converted open-end funds impose the fees for a limited period of time and face potential redemption pressure that funds usually do not encounter, Roye said. Otherwise, the SEC intends to hold firm on the two percent standard, he said.

"We recognize that redemption fees can have legitimate purposes, such as requiring investors to bear the costs of exiting the fund and deterring short-term trading," Roye said. "However, redemption fees should not be imposed at a level that imposes a penalty on an investor's ability to redeem out of a fund."

Roye spoke at the 2000 Mutual Funds and Investment Management Conference held here last week. Approximately 1,600 fund lawyers, compliance executives, accountants and consultants attended the conference, sponsored by the Federal Bar Association of Washington and the Investment Company Institute.

Redemption fees are charges a fund assesses on investors who hold fund shares for only a short time before selling. Shareholders who redeem their holdings sooner than the fund's stated minimum holding period must pay a percentage of their redemption proceeds to the fund. That fee goes to defraying the costs in trading that the fund incurs because of the redemption request.

The fees usually run from one percent to two percent. The SEC has interpreted a provision of the federal securities laws to mean the two percent charge is the highest level a fund can levy.

Executives of a handful of funds have asked the SEC to allow higher redemption fees in some instances, according to fund lawyers. Roye declined to discuss specific funds that had made such requests.

The SEC generally does not expect to move away from the two percent cap, Roye said.

"We're going to hold the line on the two percent position," he said.

The ability to redeem funds has been a key to funds' popularity and growth, Roye said. The fund industry, which is facing increasing levels of redemptions and slowing net sales, should not be tempted to impose redemption fees as a means of preserving assets, he said. It is ironic that at the same time transaction costs are declining because of advances in electronic networks, some funds seek to have redemption fees in excess of two percent, Roye said. The electronic networks will execute fund transactions at a low charge.

"Redemption fees at penalty levels are not the answer," Roye said. "Funds should be trying to eat the competition, not the franchise."

Closed-end funds that convert to an open-end structure frequently impose a redemption fee after the conversion. The funds impose the fee to recoup costs associated with having to sell securities to meet redemptions. The fees also are intended to discourage arbitrageurs that invest in a closed-end fund shortly before it changes its structure, intending to sell their positions once the fund opens. The redemption fees for converted closed-end funds usually are in effect for only the first year after the fund changes from the closed-end to the open-end structure.

Because of these special circumstances, it is appropriate that funds that are converting from a closed- to open-end structure be allowed to exceed the two percent standard, Roye said.

It can be difficult to say exactly what the cost is of a quick redemption, according to fund lawyers. Transaction costs can be quantified but some expenses associated with short-term trading are difficult to assess, lawyers said.

For example, a fund and its shareholders can suffer lost opportunities and incur unnecessary tax liabilities because of short-term traders, said David Sturms, a lawyer with Vedder, Price, Kaufman & Kammholz of Chicago. Funds can be forced to sell securities they might otherwise hold and sell securities with unrealized capital gains to meet redemption requests, he said.

"You're balancing between costs that are reasonable for a shareholder to pay versus the right to get back (net asset value)," Sturms said.

In another conference address, Matthew Fink, president of the ICI, said the ICI planned to lobby foreign governments over shareholder rights. In some countries, minority shareholders in a company - the usual role for mutual funds investing abroad - can enjoy privileges not available to majority shareholders, Fink said. For example, shareholders that control a company may be able to sell their stake at a premium not available to minority shareholders, he said.

The ICI has begun surveying foreign laws on minority shareholder rights, Fink said. The institute will use the survey results to identify countries with laws that put minority shareholders at a disadvantage and try to have those laws changed, he said.

"When a foreign law or policy puts our shareholders at an unfair disadvantage, it is our obligation to work for change," Fink said.