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"Hard Close" Proposal Languishes at SEC

More than two years after proposing a new "hard close" rule to prevent late trading in mutual funds, the Securities and Exchange Commission (SEC) has yet to introduce it. Many retirement plan sponsors and fund industry executives are glad the Commission is moving slowly.

Late trading became an issue in 2003 after New York State Attorney General Eliot Spitzer filed charges that several mutual funds had allowed hedge fund manager Canary Partners LLC to buy shares in their funds after the stock market's 4 p.m. Eastern time close yet still receive that day's closing price. That was a violation of federal securities laws; it gave Canary the opportunity to trade on potentially market-moving news that came out after the market's close. If there were a very bullish development at 5 p.m., for example, Canary could buy fund shares and, with little risk, reap the benefits when the market moved higher the next day.

To guard against late trading, the SEC proposed in December 2003 that only trades received by a fund company or its transfer agent by 4 p.m. Eastern time could receive that day's price. It turned out, however, that such a rule would impact a whole host of investors who, unlike Canary Partners, weren't trying to trade on late-breaking news. Chief among them: investors in 401(k) plans, particularly on the West Coast. Even though they might place their orders with a plan administrator before the market's 4 p.m. close in New York, critics warned, their plan administrator might not be able to submit the order by that time, since it first had to comply with various recordkeeping and compliance requirements. That, the critics said, would mean retirement plan investors could lose access to the same-day trading privileges that other mutual fund investors enjoy.

Jaime Doyle, a spokesman for the Investment Company Institute (ICI), says that in response to this concern, the SEC has been exploring other possible approaches to preventing abusive late trading. "There may well be alternatives to the hard 4:00 p.m. close that provide effective safeguards while offering greater flexibility," Doyle says, adding that the ICI supports the SEC's deliberate approach to the issue.

In March 2005, in testimony before the Senate Committee on Banking, Housing and Urban Affairs, then-SEC Commissioner William Donaldson confirmed that the Commission was concerned a hard close might create difficulties for investors in some retirement plans and in different time zones. As a consequence, he said, the SEC staff was focusing on alternatives to its original proposal, including some that would rely on technology to ensure investors weren't taking advantage of late trading. "The technological alternatives could include a tamper-proof time-stamping system and an unalterable fund order sequencing system," Donaldson said then. "These technological systems could be coupled with enhanced internal controls, third party audit requirements and certifications." He also said that given the implications of the proposed rule, he had instructed the SEC staff to take "the necessary time" to fully understand the technological issues and "get it right." He said he did not expect a final rule until mid-2005.

Donaldson resigned in June of last year and was replaced by Rep. Christopher Cox, a California Republican. An SEC spokesman said in late February that the proposed ruling is still pending, but that no further information was available from the Commission.

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