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House Approves Mutual Fund Legislation
Washington, DC, November 21, 2003 - The U.S. House of Representatives recently approved a version of H.R. 2420, the “Mutual Funds Integrity and Fee Transparency Act of 2003,” that was amended to add several provisions intended to address abusive mutual fund trading practices.
H.R. 2420, introduced in June 2003 by Congressman Richard Baker (R-LA), contains several significant provisions concerning disclosure and the structure and duties of mutual fund directors. The version recently approved by the House aims to improve mutual funds integrity and fee transparency and prevent abusive trading practices.
Title I of H.R. 2420 includes provisions that would require the SEC to adopt new rules requiring funds to disclose to shareholders:
- estimated operating expenses,
- methods of determining employee compensation,
- portfolio turnover rate,
- information concerning soft dollar and directed brokerage policies and practices,
- information concerning revenue sharing payments, and
- information concerning breakpoint discounts on front-end sales loads.
These disclosures would be required in the quarterly statement or other periodic report to shareholders or other appropriate disclosure document, but could not be made exclusively in a prospectus or statement of additional information.
The bill would also require the SEC to:
- issue a concept release to examine the issue of portfolio transaction costs and how such costs may be disclosed to investors in a manner that will enable them to compare such costs among funds;
- adopt a rule requiring that periodic account statements contain a statement informing shareholders that they have paid fees on their investments, that such fees have been deducted from the amounts shown on the statements, and where shareholders may find additional information regarding the amount of these fees; and
- give consideration to methods for reducing the burdens to small investment companies of making this disclosure, consistent with the public interest and the protection of investors.
Fund Compliance, Governance, and Trading Practices
H.R. 2420 would also:
- require two-thirds of a fund’s board to be independent and would amend the definition of “interested person;”
- apply to open-end investment companies audit committee standards similar to those imposed on listed companies by Section 301 of the Sarbanes-Oxley Act of 2002;
- impose amended trading restrictions on registered investment companies;
- require the adoption of SEC or self-regulatory organization rules to clarify the definition of “no-load” as used by funds that have 12b-1 fees and require disclosure to prevent investors from being misled by the use of this term by the fund or its adviser or principal underwriter;
- require that if a report of an SEC inspection of a fund identifies significant deficiencies, the fund must provide that report to its directors;
- authorize the SEC to exempt a fund from the in-person meeting requirement, “when such a requirement is impracticable, subject to such conditions as the [SEC] may require;”
- make the disclosure by mutual funds of their proxy votes a statutory requirement;
- require the SEC to adopt rules requiring disclosure concerning incentive and other compensation paid to broker-dealers for selling mutual funds;
- call for an SEC study of the use of soft dollar arrangements by investment advisers to be submitted to Congress no later than one year after enactment of the Act; and
- require the SEC to conduct a study of the increased rate of arbitration claims and decisions involving mutual funds since 1995, for the purpose of identifying trends in claim rates and, if applicable, the causes of such increased rates and the means to avert such causes to be submitted to Congress no later than one year after enactment of the Act.
Title II of H.R. 2420, relating to the prevention of abusive trading practices, would expand sections of the Investment Company Act to cover fraudulent, deceptive or manipulative acts, practices, or courses of business in connection with purchases or sales by certain persons, not only of any security held or to be acquired by a registered investment company (as is currently the case), but also of any security issued by the investment company or an affiliate.
The SEC would have to adopt rules requiring registered investment companies and their investment advisers and principal underwriters to adopt codes of ethics, and requiring registered investment companies to disclose their codes of ethics, and any changes therein, in the periodic report to shareholders and to disclose such codes in a readily accessible electronic public information facility of the fund.
In addition, registered investment companies and registered investment advisers would be required to adopt and implement policies and procedures reasonably designed to prevent violation of the federal securities laws and certain other designated laws, and to review the policies and procedures annually for their adequacy and the effectiveness of their implementation. Investment companies would be required to appoint a chief compliance officer to oversee the policies and procedures. The chief compliance officer, whose compensation would have to be approved by a fund’s independent directors, would be required to report directly to the independent directors at least annually, in private if the directors so request.
Funds also would be required to adopt policies and procedures reasonably designed to protect their officers, directors, employees, contractors, subcontractors, or agents from retaliation for providing information to assist in an investigation relating to conduct that the person reasonably believes constitutes a violation of either the securities laws or a fund’s code of ethics.
Finally, the independent directors of registered open-end investment companies would be required to certify that:
- procedures are in place for verifying that the determination of the fund’s current NAV complies with the Investment Company Act, and that the fund is in compliance with such procedures;
- procedures are in place for the oversight of the flow of funds into and out of the fund and the fund is in compliance with those procedures;
- procedures are in place to ensure that investors are receiving any applicable sales charge breakpoint discounts;
- procedures are in place to ensure that, if the fund has multiple classes, they are designed in the interests of investors and could reasonably be an appropriate investment option for an investor;
- procedures are in place to ensure that information about the fund’s portfolio securities is not disclosed in violation of the securities laws or the fund’s code of ethics;
- the independent directors have reviewed and approved the compensation of the fund’s portfolio manager;
- the fund has established and enforces a code of ethics in accordance with the requirements noted above; and
- the fund is in compliance with the bill’s provisions relating to adoption and implementation of compliance policies and procedures.
The bill also would amend Section 15 of the Investment Company Act to prohibit an individual from serving as the portfolio manager or investment adviser of both a registered mutual fund and an unregistered investment company or other category of company prescribed by SEC rule in order to prevent conflicts of interest.
The bill would prohibit certain persons from engaging in “short-term transactions” in securities issued by a registered investment company or its affiliate, other than money market funds, other funds whose investment policy expressly permits short-term transactions, or other categories of registered investment companies specified by SEC rule.
The SEC also would be required to revise its rules as necessary to permit an investment company to charge redemption fees in excess of 2 percent upon the redemption of the company’s securities within such period after their purchase as the SEC specifies to prevent short term trading that is unfair to the investment company’s shareholders.
Within 90 days after the date of enactment of the Act, the SEC would be required to prescribe standards concerning the obligations of registered open-end investment companies to apply and use fair value methods of net asset value (NAV) determination in order to prevent dilution of the interests of long-term investors or as necessary in the other interests of investors. The SEC would have to identify, in addition to significant events, the conditions or circumstances from which the obligation to use fair value will arise and the methods by which fair value methods shall be applied.
Within 90 days after the date of enactment of the Act, the SEC would be required to issue rules to prevent transactions in the securities of any registered open-end investment company in violation of Section 22 of the Investment Company Act, including after-hours trades that are executed at a price based on an NAV that was determined as of a time prior to the actual execution of the transaction. The rules would have to permit execution of such “after-hours trades” that are provided to a mutual fund by an intermediary after the time as of which such NAV was determined if the intermediary has procedures that are (1) designed to prevent the acceptance of trades by the intermediary after the time as of which NAV was determined and (2) subject to an independent annual audit to verify that the procedures do not permit the acceptance of trades after the time as of which such NAV was determined. In addition, the rules would have to permit firms that collect transactions via computer systems and procedures provided by unaffiliated entities to satisfy the foregoing independent audit requirement by means of an independent audit obtained by the unaffiliated entity.
Within 180 days of the date of enactment of the Act, the SEC would be required to submit a report to Congress on market timing and late trading of mutual funds, which would have to include: (1) the economic harm of market timing and late trading of mutual funds on long-term shareholders; (2) the findings of the SEC’s Office of Compliance Inspections and Examinations and the actions taken by the Division of Enforcement regarding illegal late trading practices, illegal market timing practices, and market timing practices that are not in violation of prospectus disclosures; (3) when the SEC became aware that the use of market timing practices was harming long-term shareholders and the circumstances surrounding the SEC’s discovery of that activity; (4) the steps the SEC has taken to protect long-term fund investors since that time; and (5) any additional legislative or regulatory action that is necessary to protect long-term mutual fund shareholders against the detrimental effects of late trading.
Mutual fund legislation also has been introduced in the Senate, but no final Senate action is expected this year. Senate consideration of mutual fund legislation likely will resume when the Senate reconvenes in late January.
The Institute provided November 2003 testimony pledging that the industry will provide any assistance to Congress and the SEC in the effort to ensure that mutual funds retain the public’s trust and confidence. Earlier in November, the Institute testified before the House and Senate concerning the need for fundamental reforms to combat trading abuses that have been revealed at some fund companies.
The Institute supports practical measures to help investors understand all elements of investing, and believes investors continue to benefit from vibrant competition that has produced substantially lower costs along with an array of innovative investment products and services.
This website has a section devoted to the investigations of mutual fund practices.
- ICI President Testimony Before Senate Concerning "Shocking Betrayal of Trust," November 18, 2003
- ICI Chairman Testimony on Combating Trading Abuses, November 4, 2003
- ICI President Testimony Urging Specific Changes to Combat Trading Abuses, November 3, 2003
- ICI Executive Committee Statement Calling for Reforms to Address Trading Abuses, October 30, 2003
- SEC Responds to Congressional Request for Information on Fund Industry Legislation, July 2003
- Institute Chairman Testifies on Bill Concerning Fund Industry Practices, June 2003
- ICI Pledges Prompt, Decisive Action to Advance Investor Protection and Awareness, June 2003