Beginning in the summer of 2003, the SEC and several State Attorney Generals initiated investigations into improper market timing and late trading by a number of mutual fund complexes. These investigations led to more than 30 Federal and state enforcement actions against certain mutual funds and their advisers for permitting improper arbitrage activities and accepting trading orders after the 4 PM close of the New York stock and bond exchanges.
The SEC and State regulators collected as much as $3.5 billion in penalties and fines from these mutual fund companies and the SEC is in the process of distributing these restitution monies to the investors aggrieved by improper market timing activities.
Excessive short-term trading activities in a mutual fund can cause a dilution in the value of the shares for long-term investors in the same fund. The excess profits taken by market timers in a fund reduce the capital appreciation for investors who are transacting in fund shares over a longer time horizon.
The lack of transparency within broker-dealer omnibus accounts was identified as a significant issue in the inability of mutual funds to identify and deter inappropriate short-term trading of fund shares. As stated by the Chairman of the Investment Company Institute in testimony on March 31, 2004: "A particular challenge that funds face in effectively implementing restrictions on short-term trading is that many fund investments are held in omnibus accounts maintained by an intermediary (e.g., a broker-dealer or a retirement plan record keeper). Often in those cases, the fund cannot monitor trading activity by individual investors in these accounts. Steps clearly need to be taken to enable mutual funds to enforce more effectively restrictions they establish on short-term trading when such trading takes place through omnibus accounts."
In response to this problem, the SEC adopted Rule 22c-2, requiring mutual funds to have written agreements with all of their financial intermediaries, in order to facilitate information-sharing at the individual investor level. Rule 22c-2 requires an intermediary to provide shareholder identification and transaction information for any or all of its customers at the request of a mutual fund.
Unfortunately, mutual funds are not using this information-sharing tool and instead are relying on their financial intermediaries to detect market timing activities and enforce other policies in each fund's prospectus. To provide a solution to this problem, CMFI has advocated that the SEC amend Rule 22c-2, in order to provide for full transparency of investor-level information within omnibus accounts, on a real-time basis. Under this approach, mutual funds would be able to enforce market timing and short-term trading policies in a uniform and cost-effective manner for all investors.
The SEC has not yet changed Rule 22c-2, even though there is evidence that market timing and other arbitrage activities still occur in certain international, small cap, and bond funds.
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