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Stiffer SEC Rules Weigh on Fund Ops

ORLANDO -- A number of new regulatory developments have imposed a hefty burden on the back-office and operations personnel employed by most mutual funds, prompting an industry-wide discussion of how to address trouble spots and adapt to a rapidly changing compliance landscape.

Speaking at an Investment Company Institute operations conference here, a panel of regulators and fund executives reflected on the new rulemakings and their impact on transfer agents and third-party service providers. Perhaps the most complex issue on the table is the hard 4 p.m. close for fund transactions, which requires broker/dealers to segregate trade orders by those submitted before the closing bell and those submitted after.

"Whatever is done will directly affect fund shareholders," said Henry Hopkins, chief legal counsel for T. Rowe Price Associates, drawing a line of distinction from other rules that have little relevance for investors. He noted that a hard close would mean "foreclosed opportunities" for investors on the West Coast, who would have to submit trades by 1 p.m., essentially cutting their ability to make moves in half. In addition, Hopkins noted that intermediaries and 401(k) administrators would have to overhaul their systems to facilitate a new trading procedure.

The Securities and Exchange Commission has received more than 1,000 comment letters on this topic, a majority of them recommending that the Commission seek "alternatives that won't distort competition in the marketplace," according to Jennifer McHugh, senior advisor to the director of the division of investment management at the SEC (see related story, page 9). Given the fact that this proposed rule or any amended version of it will incur "significant systems and implementation costs, we have to get it right the first time," she said. When asked whether the SEC is, in fact, planning to amend the proposal, McHugh declined comment.

Another rule would require funds to administer a mandatory redemption fee for shareholders who exchange shares within five days of purchase. McHugh acknowledged that a 2% redemption fee may not be the appropriate amount to combat market timing and that it is certainly not a panacea. Redemption fees may not work in omnibus accounts without a weekly pass-through of information. Still, she said that redemption fees can have "a positive effect on deterring market timing" and that the Commission staff is weighing different ways to address the problem of hidden trades in omnibus accounts. Among the most effective anti-timing measures, she noted, is using fair value to mitigate arbitrage opportunities.

The problem with stamping out market timing, the panel agreed, is that there is no clear definition of it. "It's a tough nut," said Charlie Hawkins, vice president of PFPC. On one hand, standard redemption fees ensure that everyone is playing by the same rules, but on the other hand, not all mutual funds operate the same, so does a redemption fee really work?, he asked. He also raised the question of whether the SEC would hold the omnibus administrators accountable. Many recordkeepers are not registered transfer agents. Nor are many intermediaries registered, even though they remain a vital part the distribution engine.

With respect to rule 38a-1 requiring funds to have chief compliance officer, Hawkins stressed the importance of constant communication between funds, the board of trustees and the CCO. "We're in transition," he said. "Oct. 5th was setting the table. It's now dinner hour." The next step, he noted, is implementing a mechanism or means of alerting the CCO to a problem and having the appropriate protocols in place so that problems don't fester.

Transfer agents are also going under the knife, not only due to the new rulemakings but also the evolution of technology. "The business has outgrown regulation," said Susan Peterson, special counsel to the SEC's division of market regulation. Under new rules, transfer agents will undergo a "wholesale overhaul" that requires all transfer agents to register with the Commission, adhere to minimum performance standards and new recordkeeping and reporting rules.

The new rules will effectively eliminate exemptions for smaller transfer agents, those having 500 items or less in a specified time frame. It will also establish internal audit controls for transfer agents, as there are none currently. Rule 17ad-2, which governs the turnaround, processing and forwarding of items, will be completely rewritten, with certain functions being moved out of the jurisdiction of transfer agents and into the broker/dealer channel. Any sub-contractors that have been hired to conduct certain transfer-agent functions must now register with the Commission, as well. Petersen told attendees to "expect more broker/dealer-like regulation."