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SEC Rule 22c-2-Much More than Contractual Agreements


Now that the Securities and Exchange Commission's Rule 22c-2 has been finalized, mutual fund companies of all sizes are putting plans in place to potentially deal with the receipt and management of detailed shareholder transaction information from financial intermediaries selling their funds.

Three principal areas of capability are needed to comply with the rule: transparency, data management and policy management.

Funds must be able to acquire data from intermediaries, preferably in an automated fashion, from within omnibus accounts via the DTCC or directly from other third-party sources, translate and map disparate data formats to common definitions, and store, associate and track data at the tax ID level. They must then be able to monitor transactional data for violations of a fund's trading rules. And finally, they must be able to manage intermediary relationships including: documented agreements, risk rankings, communications, procedures and work flow processes.

Fund companies seem initially more heavily focused on data and policy management, paying less attention to transparency. This is likely due to the staging of the compliance dates of the rule, with April 16 as the first date by which data-sharing agreements must be in place and Oct. 16 as the date for data sharing.

And, perhaps transparency has been lowered in priority by some funds since the SEC opened the door somewhat by including within the rule, the possibility that "a fund in appropriate circumstances could reasonably conclude that an intermediary's frequent trading policies sufficiently protect fund shareholders and could therefore defer to the intermediaries policies." Funds may have deduced from this language that frequent trading policies applied by the intermediary can mitigate the need for data sharing. Although transaction monitoring by the distributor might be a fund's first line of defense, recent public comments by SEC staff suggest that fund companies should not rely solely on the intermediaries' frequent trading policies. And in other statements, the SEC has reinforced that shareholder level data within omnibus accounts is clearly the fund's responsibility.

Funds should be prepared that a logical sequence will be for the SEC to focus first on the fund's transparency capabilities before looking further at data and policy management tools, including the rationale and processes for risk ranking intermediaries since the fund's transparency capability is fundamental to the effectiveness of both data and policy management tools.

In March of 2004 when the SEC proposed the initial rule, it included language regarding the reason for sharing tax identification numbers (TINs) between intermediaries and mutual fund companies. From our discussions and product demonstrations with the SEC as recently as this past August and September, we expect that they view the ability to acquire and manage data at the TIN level across distribution platforms to be a critical element of the rule and a principle on which all other aspects of a 22c-2 compliance program will be based. To illustrate the SEC's original intent, the following text was included in its proposed rule dated March 5, 2004:

"This information [TIN] is designed to enable the fund to confirm that fund intermediaries are properly assessing the redemption fees. It would also permit funds to detect market timers who a fund has prohibited from purchasing shares and who attempt to enter the fund through a different account."

The reason to continue to include the TIN within the rule is because, as a universal identifier for a shareholder, it is also the only way to link "different accounts" across multiple intermediaries. In a review process, the SEC may require a fund to display technical and operational transparency to sub-account data, but we do not think this implies that they will expect fund companies to take a "data-driven" approach and acquire detailed data on a daily or regular basis from all intermediaries. The ability to acquire data and the need to acquire data are two separate but related issues.

There will be a benefit to having a comprehensive transparency policy and an automated transparency platform. We expect that on-demand access to intermediary data, automatically requested due to violations of pre-defined omnibus rules and analytics, will give your funds a stronger case for a "risk-based" versus a "data-driven" approach. This will lessen your need to take in more data than necessary and help you contain costs. Integrating your transparency platform with data and policy management tools will create a straight-through systematic and auditable process for the chief compliance officer.

Many funds plan on taking a risk-based approach to 22c-2 to minimize the acquisition of data. But, they need to be prepared for the possibility of dealing with more data than they planned from more intermediaries since, in the final analysis, the rule holds the fund company responsible for enforcement of its excessive trading policies no matter where the recordkeeping occurs.

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