In reaction to allegations of widespread misconduct and abusive practices involving mutual funds, regulators have responded with various proposals. In early September 2003, the Attorney General of the State of New York filed charges against a hedge fund manager for arranging with several mutual fund companies to improperly trade in fund shares and profit at the expense of other fund shareholders. Since then, widening federal and state investigations of illegal late trading and improper timing of fund trades have involved a growing number of prominent mutual fund companies and brokerage firms. One of the abuses that has come to light recently is late trading. Under current rules, funds accept orders to sell and redeem fund shares at a price based on the current net asset value, which most funds calculate once a day at 4:00 p.m. Eastern Time. Many investors, however, purchase mutual fund shares through other intermediaries such as broker-dealers, banks, and retirement savings plans. Instead of submitting hundreds or even thousands of individual purchase and redemption orders each day, these intermediaries typically aggregate orders received from investors and submit a single purchase or redemption order that nets all the individual shares their customers are seeking to buy or sell. Because this processing takes time, SEC rules permit these intermediaries to forward the order information to funds after 4:00 p.m. However, late trading occurs when some investors are able to illegally purchase or sell mutual fund shares after the 4:00 p.m. Eastern Time close of U.S. securities markets, the time at which funds typically price their shares. An investor permitted to engage in late trading could be buying or selling shares at the current day’s 4:00 p.m. price with knowledge of developments in the financial markets that occurred after 4:00 p.m. Such investors thus have unfair access to opportunities for profit that are not provided to other fund shareholders. The extent to which some investors were allowed to submit late trading orders may have been significant. In September 2003, SEC sought information from fund advisers and broker-dealers about their pricing of mutual fund orders and late trading policies. SEC’s preliminary analysis of this information showed that more than 25 percent of the 34 major broker- dealers that responded had customers that still received that day’s price for orders they had placed or confirmed after 4:00 p.m. As of March 1, 2004, SEC had formally announced seven enforcement cases involving broker-dealers and other firms that were allegedly involved in late trading schemes; other cases may be forthcoming. We will be initiating a review of the adequacy of SEC’s enforcement efforts and the sanctions that it can and has applied in these cases and will be reporting separately on these issues later this year. In addition, legislation is under consideration in the House of Representatives that will expand SEC’s enforcement capabilities by raising the civil penalties for securities law violations, enhance the investigative procedures available to SEC, and streamline the process by which fines are disbursed among injured parties. Another abuse that has come to light is known as market timing. Market timing occurs when certain fund investors place orders to take advantage of temporary disparities between the share value of a fund and the values of the underlying assets in the fund’s portfolio. For example, U.S. mutual funds that use the last traded price for foreign securities (whose markets close hours before the U.S. markets) to value their portfolio when the U.S. markets close could create opportunities for market timing if events that subsequently occurred were likely to cause significant movements in the prices of those foreign securities when their home markets reopen. Market timing, although not currently illegal, can be unfair to long-term fund investors because it provides the opportunity for selected fund investors to profit from fund assets at the expense of long-term investors. The following example illustrates how market timing transactions can reduce the return to long-term shareholders of a fund. As shown in the figure, the loss to long-term holders of the fund in this case is only $.01 per share. Although the amount by which a single market timing transaction reduces a fund’s overall return can be small, repeated and large transactions over long periods of time can have a greater cumulative effect. For example, one fund company whose staff were accommodating market timing transactions by 10 different investors estimated that these investors earned $22.8 million through their trading and that these activities costs its funds $2.7 million over a period of several years. In addition, the redemption fees that these investors should have paid but did not, amounted to another $5 million. Market timing may also have been widespread. According to testimony by SEC’s Director of Enforcement, although most mutual funds have policies that discourage market timing, this strategy was popular among some individuals and institutional traders who attempted to conceal their identities from fund companies. He also stated that 30 percent of the broker-dealers responding to an SEC information request reported assisting customers in attempting to conduct market timing trades, by using methods, such as breaking their orders into smaller sizes to avoid detection by the fund companies. Of the twelve cases SEC formally opened that involved market timing activities, including five cases that also involved late trading, two have been settled. In the settlement for one case that involved both late trading and market timing, SEC ordered the firm to pay fines and disgorgements of $225 million. In the other case, SEC ordered the firm to pay $250 million in fines and disgorgements. NASD also has taken various enforcement cases against broker-dealers involving late trading and market timing, including one in which a broker-dealer was fined $1 million and ordered to provide restitution of more than $500,000 for failing to prevent market timing of an affiliated firm’s mutual funds. Additional abusive practices associated with mutual funds have also come to light. To facilitate late trading and market timing arrangements, some fund advisers selectively disclosed information about their funds’ portfolio holdings to outsiders. They also allowed these parties to late trade or conduct market timing in their funds. For example, in one SEC case a fund manager allowed a hedge fund to engage in market timing in a fund that he managed. The fund manager also disclosed portfolio information to a broker that enabled brokerage customers to conduct market timing transactions in the funds. In another state-administered case, a hedge fund executive obtained special trading privileges from several mutual fund companies that allowed him to engage in late trading and market timing in those funds. In addition to enforcement actions, SEC has also proposed amending regulatory rules to address late trading, market timing, and selective disclosure abuses. In December 2003, SEC proposed amending the rule that governs how mutual funds price their shares and receive orders for share purchases or sales. Since many of the cases of late trading involved orders submitted through intermediaries, including banks and pension plans not regulated by SEC, the proposed amendments to its rules would require that orders to purchase or redeem mutual fund shares be received by a fund, its transfer agent, or a registered clearing agency before the time of pricing (that is, 4:00 p.m. Eastern Time). Many organizations that purchase mutual fund shares, particularly those that administer retirement savings plans, have expressed concerns that such a “hard close” would unfairly prohibit some of their participants from receiving the same day’s price on share purchases. Because intermediaries generally combine individual investor orders and submit single orders to funds to buy or sell, many officials at such firms are concerned that the time required to complete this processing will not allow them to meet the 4:00 p.m. deadline. In such cases, investors purchasing shares from Western states or through intermediaries would either have to submit their trades earlier than other investors in order to receive the current day’s price or receive the next day’s price. A letter commenting on SEC’s proposal from two investor advocacy groups indicated that implementing the hard close would relegate some retail investors to the status of “second-class shareholders.” Some plan sponsor organizations and plan record keepers have also raised concerns about the potential significant administrative costs associated with adopting systems to accommodate the 4:00 p.m. hard close and other proposed rules. Because the hard close could affect some investors’ ability to trade at the current day’s price, some groups have called on SEC to allow industry participants to develop systems of internal controls that would serve to ensure that intermediaries receive individual orders before 4:00 p.m. With such controls in place, these orders could continue to be processed after this time. However, SEC officials told us that they were skeptical that any system that relies on internal controls could not provide certainty that late trading was not occurring because many of the late trading abuses happened at firms that purportedly had such controls in place. However, SEC remains open to the possibility of the development of systems that could reasonably detect and deter late trading. In its proposals, SEC requests comments on various approaches designed to prevent late trading. Such protections could include a system that provides an electronic or physical time-stamp on orders. Other possible controls could include certifications that the intermediary had policies and procedures in place designed to prevent late trades, or audits by independent public accountants. Because multiple regulators oversee the operations of these financial intermediaries, any assessment of the reasonableness of recommended systems or controls would likely require effective coordination. SEC is also proposing to take actions to address market timing. On December 11, 2003, SEC released a rule proposal to provide greater transparency to funds’ market timing policies. Specifically, SEC would require mutual funds to disclose in their prospectuses the risks to shareholders of the frequent purchase and redemption of investment company shares, and fund policies and procedures pertaining to frequent purchases and redemptions. The proposal also would require funds to explain both the circumstances under which they would use fair value pricing and the effects of using fair value pricing.