[Federal Register Volume 69, Number 48 (Thursday, March 11, 2004)]
[Proposed Rules]
[Pages 11762-11774]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-5374]



[[Page 11761]]

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Part IV





Securities and Exchange Commission





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17 CFR Part 270



Mandatory Redemption Fees for Redeemable Fund Securities; Proposed Rule

  Federal Register / Vol. 69 , No. 48 / Thursday, March 11, 2004 / 
Proposed Rules  

[[Page 11762]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-26375A; File No. S7-11-04]
RIN 3235-AJ17


Mandatory Redemption Fees for Redeemable Fund Securities

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is proposing a new rule under the Investment Company Act that 
would require mutual funds (with certain limited exceptions) to impose 
a two percent redemption fee on the redemption of shares purchased 
within the previous five days. The redemption fee would be retained by 
the fund. The rule is designed to require short-term shareholders to 
reimburse the mutual fund for costs incurred when they use the fund to 
implement short-term trading strategies, such as market timing.

DATES: Comments must be received on or before May 10, 2004.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by one method only. Comments in 
paper format should be submitted in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609. Comments in electronic format should be 
submitted to the following E-mail address: [email protected]. All 
comment letters should refer to File No. S7-11-04; if E-mail is used, 
this file number should be included on the subject line. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, NW., Washington, 
DC 20549, and also will be available on the Commission's Internet Web 
site (http://www.sec.gov).\1\
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    \1\ We do not edit personal, identifying information, such as 
names or E-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Shaswat K. Das, Senior Counsel, or C. 
Hunter Jones, Assistant Director, Office of Regulatory Policy, (202) 
942-0690, Division of Investment Management, Securities and Exchange 
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Commission, 450 Fifth Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission today is requesting public 
comment on proposed rule 22c-2 [17 CFR 270.22c-2] and proposed 
amendments to rule 11a-3 [17 CFR 270.11a-3] under the Investment 
Company Act of 1940 [15 U.S.C. 80a] (the ``Investment Company Act'' or 
the ``Act'').

Table of Contents

I. Background
II. Discussion
    A. Two Percent Redemption Fee
    B. Five-Day Holding Period
    C. Smaller Investors
    D. Shareholder Accounts and Intermediaries
    E. Exceptions
    F. Request for Further Comment on Rule 22c-2
III. General Request for Comment
IV. Cost-Benefit Analysis
V. Paperwork Reduction Act
VI. Initial Regulatory Flexibility Analysis
VII. Statutory Authority
    Text of Proposed Rule

I. Background

    Mutual funds are attractive to even the smallest investors because 
they offer easy access to national and international securities 
markets.\2\ Mutual funds allow investors to pool their savings with 
those of other investors so that they may benefit from professional 
investment management, diversification, and liquidity. Fund 
shareholders share the losses and the gains of the fund, and also share 
its costs.
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    \2\ In this release, we use the term ``mutual fund'' or ``fund'' 
to mean an open-end investment company that is registered or 
required to register under section 8 of the Investment Company Act 
[15 U.S.C. 80a-8], and includes a series of a registered investment 
company that is a series company. See proposed rule 22c-2(f)(2).
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    Some fund investors take advantage of this collective relationship 
by frequently buying and redeeming fund shares. These investors may 
frequently buy shares and soon afterwards sell them, in reaction to 
market news or because of a change of heart. Such excessive trading 
occurs at the expense of long-term investors, diluting the value of 
their shares.\3\ It also may disrupt the management of the fund's 
portfolio and raise a fund's transaction costs because the fund manager 
must either hold extra cash or sell investments at inopportune times to 
meet redemptions.\4\
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    \3\ See Jason Greene & Charles Hodges, The Dilution Impact of 
Daily Fund Flows on Open-end Mutual Funds: Evidence and Policy 
Solutions, 65 J. Fin. Econ., 131-158 (2002) (estimating annualized 
dilution from frequent trading, based on market timing, of 0.48% in 
international funds: ``the dilution impact has brought about a net 
wealth transfer from passive shareholders to active traders in 
international funds in excess of $420 million over a 26-month 
period.''). See also Roger M. Edelen, Investor Flows and the 
Assessed Performance of Open-end Mutual Funds,'' 53 J. Fin. Econ. 
439, 457 (1999) (quantifying the costs of liquidity in mutual funds 
as $0.017 to $0.022 per dollar of liquidity-motivated trading). See 
also Ken Hoover, Why mutual funds discourage timers; Two forms of 
practice; They increase expenses, can disrupt portfolios and rob 
other investors, Investor's Business Daily, Sept. 17, 2003, at AO9.
    \4\ Frequent trading also may result in unwanted taxable capital 
gains for the remaining fund shareholders.
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    Some frequent fund traders seek short-term profits by buying and 
selling shares in anticipation of changes in market prices, e.g., 
market timing.\5\ Some have exploited pricing inefficiencies in which 
the price of mutual fund shares does not accurately reflect the current 
market value of the securities held by the fund, i.e., time-zone 
arbitrage.\6\ Mutual funds are a

[[Page 11763]]

prime vehicle for abusive market timing activity because they provide 
for daily redemptions and the long-term investors bear the 
transactional costs of those redemptions.
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    \5\ The Commission has settled a number of enforcement actions 
alleging federal securities law violations by investment advisers 
who permitted market timing transactions in a manner inconsistent 
with the funds' stated policies. See, e.g., In re Massachusetts 
Financial Services Co., Investment Company Act Release No. 26347 
(Feb. 5, 2004) (finding that investment adviser and two of its 
executives violated federal securities laws by allowing widespread 
market timing trading in certain funds in contravention of those 
funds' prospectus disclosures); In re Alliance Capital Management, 
L.P., Investment Company Act Release No. 26312 (Dec. 18, 2003) 
(finding that investment adviser violated federal securities laws by 
allowing market timing in certain of its mutual funds in exchange 
for fee-generating investments, or ``sticky assets,'' in its hedge 
funds and other mutual funds); In re Putnam Investment Management, 
LLC, Investment Company Act Release No. 26255 (Nov. 13, 2003) 
(finding that investment adviser violated Investment Advisers Act 
and antifraud provisions of the federal securities laws by failing 
to disclose potentially self-dealing short-term trading of mutual 
fund shares by several of its employees, failing to take adequate 
steps to detect and deter such trading activity, and failing to 
supervise employees who committed violations); In re Connelly, Jr., 
Investment Company Act Release No. 26209 (Oct. 16, 2003) (finding 
that an executive of an investment adviser to a fund complex, in 
derogation of fund disclosures, violated federal securities laws by 
approving agreements that allowed select investors to market time 
certain funds in the complex).
    We also have recently instituted numerous enforcement actions 
involving market timing. See, e.g., SEC v. Mutuals.com, Inc., Civil 
Action No. 303 CV 2912D (N.D. Tex. Dec. 4, 2003) (alleging that 
dually registered broker-dealer and investment adviser, three of its 
executives, and two affiliated broker-dealers assisted institutional 
brokerage customers and advisory clients in carrying out and 
concealing thousands of market timing trades and illegal late trades 
in shares of hundreds of mutual funds); SEC v. Invesco Funds Group, 
Civil Action No. 03-N-2421 (PAC) (D. Colo. Dec. 2, 2003) (alleging 
that investment adviser, with approval of its president and chief 
executive officer, entered into market timing arrangements with more 
than sixty broker-dealers, hedge funds, and advisers without 
disclosing these arrangements to the affected mutual funds' 
independent directors or shareholders); SEC v. Pilgrim, Baxter & 
Associates, Ltd., Civil Action No. 03-CV-6341 (E.D. Penn. Nov. 20, 
2003) (alleging that investment adviser and two senior executives 
had permitted a hedge fund, in which one of the executives had a 
substantial financial interest, to engage in repeated short-term 
trading of several mutual funds). A number of state actions are also 
pending.
    \6\ See Bridget Hughes, Deterring Market-Timers in International 
Funds, Morningstar.com (Sept. 24, 2003) (available at http://news.morningstar.com/doc/news/0,2,96909,00.html); Elliot Blair 
Smith, Investor Took Advantage of Time-Zone Lag, USA Today, Sept. 
15, 2003, at 3B; Kathleen Gallagher, In Funds, It Can Be a Matter of 
Timing; Arbitrageurs Take Advantage of Price Inefficiencies, 
Milwaukee Journal Sentinel, Nov. 30, 2003, at O1D. See also 
Compliance Programs of Investment Companies and Investment Advisers, 
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 
74714 (Dec. 24, 2003)] (adopting rule 38a-1 under the Investment 
Company Act) at nn. 40-42 and accompanying text (``When fund shares 
are mispriced, short-term traders have an arbitrage opportunity they 
can use to exploit a fund and disadvantage the fund's long-term 
investors by extracting value from the fund without assuming any 
significant investment risk.'').
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    Many funds have taken steps to deter excessive trading or have 
sought reimbursement from traders for the costs of their excessive 
transactions.\7\ These steps frequently include imposing redemption 
fees.\8\ Today, funds that impose a redemption fee often charge a two 
percent fee for redeeming fund securities that are held for less than a 
certain amount of time, as described in the fund's prospectus.\9\ These 
funds therefore have generally estimated their redemption-related costs 
to be at least two percent of amounts redeemed.\10\
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    \7\ Some of the approaches that funds have adopted include: (i) 
restricting exchange privileges, including delaying both the 
redemption and purchase sides of an exchange; (ii) limiting the 
number of trades within a specified period; (iii) delaying the 
payment of proceeds from redemptions for up to seven days (the 
maximum delay permitted under section 22(e) of the Act); and (iv) 
identifying market timers and restricting their trading or barring 
them from the fund. See also Disclosure Regarding Market Timing and 
Selective Disclosure of Portfolio Holdings, Investment Company Act 
Release No. 26287 (Dec. 11, 2003) [68 FR 70402 (Dec. 17, 2003)] 
(Commission proposed to require that funds provide specific 
disclosure regarding their market timing policies and practices 
concerning ``fair valuation'' of their portfolio securities).
    \8\ See Whitney Dow, Redemption Fees Surge 82% Since 1999: 
Assessment Periods Lengthen, While Fees Remain Constant, Financial 
Research Corporation (June 2001) (available at http://www.frcnet.com/research/articles/art_prc_fee.asp) (stating that 
the number of funds that charge redemption fees nearly doubled from 
2000 to March 2001). The Commission noted the use of redemption fees 
by funds in a 1966 report to Congress. Report of the Securities and 
Exchange Commission on the Public Policy Implications of Investment 
Company Growth, H.R. Rep. No. 89-2337, at 58, n.156 (1966) 
(``Redemption fees serve two purposes: (1) They tend to deter 
speculation in the fund's shares; and (2) they cover the fund's 
administrative costs in connection with the redemption.'').
    \9\ Funds often provide disclosures describing the redemption 
fee in footnotes to the fee table of the prospectus. See Item 3 of 
Form N-1A. We anticipate that funds will continue to do so under the 
proposed rule.
    \10\ Because funds are limited to the lesser of the actual costs 
of redemptions or two percent, and most funds that impose redemption 
fees charge a two percent fee, such funds must have redemption costs 
of at least two percent. See infra note 15.
    The staff has stated that a redemption fee may recoup or offset 
the following expenses that are directly related to processing 
shareholder redemption requests: (i) Brokerage expenses incurred in 
connection with the liquidation of portfolio securities necessitated 
by the redemption; (ii) processing or other transaction costs 
incident to the redemption and not covered by any administrative 
fee; (iii) odd-lot premiums; (iv) transfer taxes; (v) administration 
fees; (vi) custodian fees; and (vii) registrar and transfer-agent 
fees. See Separate Accounts Funding Flexible Premium Variable Life 
Insurance Contracts, Investment Company Act Release No. 15651 (Mar. 
30, 1987) [52 FR 11187 (April 8, 1987)] at text following n.74 
(noting positions in SEC staff no-action letters).
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    The Investment Company Act was enacted to protect the interests of 
mutual fund investors. Many provisions of the Act guard against 
overreaching by the fund's adviser. Other provisions, however, protect 
fund shareholders from each other.\11\ One of the most important of 
these is section 22(c), which, together with our rule 22c-1, requires 
that each redeeming shareholder receive his pro rata portion of the 
fund's net assets. These provisions are designed to prevent dilution of 
the interests of fund shareholders.\12\
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    \11\ Many of the Act's prohibitions, such as the affiliated 
transaction provisions, apply to an ``affiliated person'' of a fund, 
which includes any person owning five percent or more of the 
outstanding voting securities of the fund. See section 2(a)(3) of 
the Act [15 U.S.C. 80a-2(a)(3)] (definition of ``affiliated 
person''); section 17 of the Act [15 U.S.C. 80a-17] (prohibiting an 
affiliated person of a fund, and an affiliated person of such a 
person, from engaging in the purchase or sale of assets with the 
fund). Therefore, the Act prevents large shareholders from taking 
advantage of the fund and its other shareholders.
    \12\ See sections 22(a) and (c) of the Act [15 U.S.C. 80a-22(a) 
and (c)] (authorizing Commission rules ``for the purpose of 
eliminating or reducing so far as reasonably practicable any 
dilution of the value of other outstanding securities of [a fund] or 
any other result of [a] purchase, redemption, or sale which is 
unfair to holders of such other outstanding securities * * *'').
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    Today, we are using our authority under section 22(c) of the Act to 
propose a new rule requiring funds (with certain exceptions) to impose 
a two percent redemption fee on shares held for five business days or 
less.\13\ Proposed rule 22c-2, which we describe in more detail below, 
is designed to reduce or eliminate the opportunity of short-term 
traders to exploit other investors in the mutual fund by (i) requiring 
them to reimburse the fund for the approximate redemption-related costs 
incurred by the fund as a result of their trades, and (ii) discouraging 
short-term trading of mutual fund shares by reducing the profitability 
of the trades.
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    \13\ The proposed rule also applies to exchanges of securities 
issued by one fund for securities issued by another, because these 
transactions involve a redemption and purchase. See rule 11a-3 under 
the Act [17 CFR 270.11a-3] (regulating exchanges of fund securities, 
including the imposition of redemption fees). We also are proposing 
a conforming amendment to rule 11a-3.
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    Our proposal supplements the other measures the Commission has 
recently taken to address short-term trading, including abusive market 
timing activity.\14\ As discussed in Section II.F., of this Release, 
our proposals are not designed to be an exclusive cure for the problem 
of abusive market timing, which often (but need not) involves rapid 
trading strategies. Conversely, our proposal is not designed to solely 
address large traders. The costs imposed on long-term investors in 
funds by the cumulative effect of many smaller short-term traders may 
be greater than those imposed by a few large traders. If adopted, the 
proposal would allow funds to recoup some, if not all, of these costs.
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    \14\ See, e.g., Compliance Programs of Investment Companies and 
Investment Advisers, supra note, (adopting new rules requiring funds 
and advisers to adopt and implement policies and procedures designed 
to prevent violations of the federal securities laws, including 
policies to assure that the fund complies with existing obligations 
to establish fair value for securities in appropriate 
circumstances); see also Disclosure Regarding Market Timing and 
Selective Disclosure of Portfolio Holdings, supra note (proposing 
disclosure amendments concerning fund policies to detect and deter 
market timing activities).
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II. Discussion

A. Two Percent Redemption Fee

    Proposed rule 22c-2 would require mutual funds to impose a fee of 
two percent of the proceeds from fund shares redeemed within five 
business days of their purchase. The rule would not permit funds to 
impose a higher or lower fee than two percent.\15\ Each fund, unless 
excepted, would have to impose the fee.\16\
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    \15\ Although the two percent fee is designed to reimburse funds 
for the approximate costs associated with frequent trading, the fee 
itself would not be limited to particular costs associated with 
particular redemptions. Cf. John P. Reilly & Associates, SEC Staff 
No-Action Letter (July 12, 1979) (the staff would not recommend 
enforcement action if the redemption fee, subject to the at-cost 
standard, does not exceed two percent of the NAV of the redeemed 
shares); Separate Accounts Funding Flexible Premium Variable Life 
Insurance Contracts, supra note, at n. 74 (recognizing that staff 
informally has taken a position that a fund may impose a limited 
redemption fee to cover ``legitimate expenses that may be incurred 
to make the payment in cash to a redeeming shareholder''); see also 
section 10(d)(4) of the Act [15 U.S.C. 80a-10(d)(4)] (providing that 
a fund may have a board consisting of all interested persons of the 
fund, except one independent director, if, among other things, ``any 
premium over net asset value charged [by the fund] upon the issuance 
of any security, plus any discount from net asset value charged on 
redemption thereof, shall not in the aggregate exceed 2 per 
centum.'').
    \16\ See infra Section II.E. for a discussion of the exceptions 
in proposed rule 22c-2.

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    The two percent redemption fee would therefore be both mandatory 
and uniform. It is mandatory because it would apply to all fund shares, 
including shares held by financial intermediaries, which will prevent 
funds from creating exceptions for certain intermediaries, such as 
broker-dealers, banks, and retirement plans.\17\ The uniformity of the 
two percent fee is designed to simplify the implementation of the rule 
and better enable intermediaries that hold shares in omnibus accounts 
to establish and maintain systems to collect these fees. Moreover, 
absent a mandatory and uniform redemption fee, small funds may feel 
competitive pressures not to impose redemption fees, which could impose 
costs on their long-term investors and attract market timers to their 
funds. This proposed rule would place all funds (unless excepted) on an 
equal footing with respect to charging redemption fees. The rule also 
would apply to short-term transfers among subaccounts within variable 
annuity contracts.\18\
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    \17\ According to the Investment Company Institute (``ICI''), 85 
to 90 percent of mutual fund purchases are made through 
intermediaries. See Mutual Funds: Trading Practices and Abuses That 
Harm Investors, Testimony of Matthew Fink, President, ICI, before 
the Senate Subcommittee of Financial Management, the Budget and 
International Security, Committee on Government Affairs, 108th 
Cong., 1st Sess., 8 n.6 (Nov. 3, 2003) (available at http://www.ici.org/statements/tmny.html). A large portion of these fund 
investors invest through tax-advantaged retirement plans, such as 
401(k) accounts. About one-third of all mutual fund shares are held 
through retirement accounts. See Investment Company Institute, 
Mutual Funds and the U.S. Retirement Market in 2002, Fundamentals, 
June 2003, at 1, 2.
    \18\ The ability to transfer assets among subaccounts on a tax-
deferred basis makes variable annuities attractive to market timers. 
See Ian McDonald, Mutual Fund Scrutiny Spreads to Annuities, The 
Wall Street Journal, Nov. 7, 2003, at C1 (``[I]t is becoming clear 
that fund accounts that are part of the investment options for 
variable annuities also have been used by market timers to make 
profitable trades at the expense of long-term investors.''); Stephen 
Schurr, Annuities: The Other Variable in Abusive Fund Trading, 
TheStreet.com (Nov. 14, 2003) (available at http://www.thestreet.com/_tscs/funds/stephenschurr/10125895.html) 
(``[I]ndustry participants and watchers say a growing number of 
institutional clients have jumped in variable annuity contracts in 
recent years for market-timing purposes, because such contracts 
allow investors to move freely among funds on a tax-deferred 
basis.''). See also Karen L. Skidmore, Handling Market Timer Issues 
in Variable Insurance Products Through Cooperative Arrangements 
Between Insurance Company and Mutual Fund Sponsors, Practising Law 
Institute at 380 (2001) (``Market timing has also become a prevalent 
issue in the variable annuity industry where investors are permitted 
to make a certain number of transfers per year among different sub-
accounts within the insurance company separate account, without 
generating a commission fee.'').
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    The two percent fee is designed to strike a balance between two 
competing policy goals of the Commission--preserving the redeemability 
of mutual fund shares,\19\ and reducing or eliminating the ability of 
shareholders who frequently trade their shares to profit at the expense 
of their fellow shareholders. It reflects the level of redemption fees 
that many funds today impose, and the maximum level our staff has long 
viewed as consistent with provisions of the Act that require mutual 
fund shares to be redeemable.\20\ A higher fee could be more effective 
at stopping rapid trading,\21\ but at a cost to ordinary investors who 
may be called upon to redeem to meet financial exigencies.
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    \19\ During the legislative hearings on the Act, the Commission 
noted that ``the most important single attribute which induces 
purchases of the securities of open-end companies by the public is 
the so-called `redemption feature' of such securities--that is, the 
assurance that the shareholder may tender his shares to the company 
and receive at once, or in a very short time, the approximate cash 
asset value of such shares as of the time of tender.'' Investment 
Trusts and Investment Companies: Hearings on S. 3580 Before a 
Subcomm. of the Senate Comm. On Banking and Currency, 76th Cong., 3d 
Sess. at 985 (1940) (memorandum introduced by David Schenker, Chief 
Counsel, SEC Investment Trust Study).
    \20\ Section 2(a)(32) of the Act [15 U.S.C. 80a-2(a)(32)] 
defines the term ``redeemable security'' as a security that entitles 
the holder to receive approximately his proportionate share of the 
fund's net asset value. The Division of Investment Management 
informally took the position that a fund may impose a redemption fee 
of up to two percent to cover the administrative costs associated 
with redemption, ``but if that charge should exceed 2 percent, its 
shares may not be considered redeemable and it may not be able to 
hold itself out as a mutual fund.'' See John P. Reilly & Associates, 
SEC Staff No-Action Letter (July 12, 1979). This position is 
currently reflected in our rule 23c-3(b)(1) under the Act [17 CFR 
270.23c-3(b)(1)], which permits a maximum two percent repurchase fee 
for interval funds and requires that the fee be reasonably intended 
to compensate the fund for expenses directly related to the 
repurchase of fund shares.
    \21\ See, e.g., Letter from Steve Bartlett, The Financial 
Services Roundtable, to Paul F. Roye, Director, Division of 
Investment Management, SEC (Nov. 10, 2003); Letter from Geof 
Gradler, Senior Vice President and Head, Office of Government 
Affairs, Charles Schwab & Co., Inc., to Paul F. Roye, Director, 
Division of Investment Management, SEC (Oct. 27, 2003); Letter from 
David B. Yeske, President, The Financial Planning Association to 
William H. Donaldson, Chairman, SEC (Nov. 7, 2003). These letters 
are available in File No. S7-11-04.
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    We request comment on the proposed mandatory redemption fee.
     Should the rule permit, rather than require, 
funds to charge a two percent redemption fee on the redemption of all 
securities held five days or less? If so, would funds have enough 
information to assess those fees on accounts held through financial 
intermediaries such as broker-dealers and banks? \22\
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    \22\ See infra Section II.D.
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     Is two percent the appropriate level for the 
mandatory redemption fee? Should it be higher or lower?
     Available data indicate that active trading in 
fund shares imposes significant costs on mutual funds.\23\ We request 
further data on the magnitude and types of costs that funds bear as a 
result of the active trading by a small percentage of shareholders.\24\
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    \23\ See Roger M. Edelen, Investor Flows and the Assessed 
Performance of Open-End Mutual Funds, supra note 3 (estimating costs 
of the liquidity provided to investors by mutual funds).
    \24\ See Investment Company Institute, Redemption Activity of 
Mutual Fund Owners, Fundamentals, March 2001, at 1-3 (stating that 
the vast majority of fund shareholders do not frequently redeem 
their shares, and that a small percentage of shareholders account 
for the most active trading).
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     Does the two percent level approximate the 
transactional costs that funds incur as a result of frequent trading?
     Should the rule permit funds to impose a higher 
or lower fee? Would greater flexibility make it more costly for 
financial intermediaries to determine the applicability and amount of 
the fee? How would a higher fee affect the ``redeemability'' of the 
shares?
     Should redemption fees in excess of two percent 
be allowed only for certain types of funds?
     Should funds be permitted to voluntarily impose 
a fee higher than two percent outside the mandatory redemption fee 
period discussed below?
     We recently proposed a new point-of-sale 
disclosure rule, and changes to the rule governing the mutual fund 
confirmation document provided to fund investors.\25\ Should the 
mandatory redemption fee be disclosed as part of either or both of 
these proposals?
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    \25\ See Confirmation Requirements and Point of Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form of Mutual Funds, Investment 
Company Act Release No. 26341 (Jan. 29, 2004) [69 FR 6438 (Feb. 10, 
2004)].
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B. Five-Day Holding Period

    The proposed rule would include a minimum five-day holding period 
before an investor could redeem its shares without triggering the two 
percent redemption fee. The rule would not preclude a fund from 
instituting a holding period longer than five days.\26\ For example, 
funds that are particularly susceptible to abusive market timing 
activities may want to impose a longer

[[Page 11765]]

holding period.\27\ A five-day holding period may be sufficient to 
deter much of the rapid trading activities we have seen, including 
those involving time-zone arbitrage, without imposing too heavy a 
burden on regular fund transactions.\28\
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    \26\ Many funds that impose redemption fees require holding 
periods significantly longer than five days, typically ranging from 
30 days to a year. For periods longer than five days, funds would 
continue to be limited to the lesser of the actual costs of 
redemptions or two percent. See supra note 15.
    \27\ See Whitney Dow, Redemption Fees Surge 82% Since 1999: 
Assessment Periods Lengthen, While Fees Remain Constant, supra note 
8 (study finding that, as of March 2001, the number of funds 
charging redemption fees increased 82% in the previous fifteen 
months, the size of the fee remained constant, and the length of the 
holding period increased from 7.5 months to 9.4 months).
    \28\ The vast majority of investors hold shares of their funds 
for more than five days. See Investment Company Institute, 
Redemption Activity of Mutual Fund Owners, supra note 24 at 2 
(``vast majority of equity fund investors did not make a single 
redemption during the 12-month period ending January 1999'').
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     Would a five-day holding period be sufficient to 
deter frequent trading, especially frequent trading due to abusive 
market timing?
     Should we prescribe a longer minimum holding 
period? Would there be less incentive to engage in abusive market 
timing if a longer holding period were imposed?\29\ Would a shorter 
holding period be sufficient?
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    \29\ See William Samuel Rocco, Fighting Redemptions, 
MORNINGSTAR.com (July 30, 2001) (available at http://news.morningstar.com/doc/article/0,1,5086,00.html) (Morningstar 
study found that a longer redemption fee holding period would make 
redemption fees more effective in deterring market timers during a 
market downturn: ``[I]nvestors are only subject to [redemption fees] 
if they redeem within a specified period, which is often fairly 
short * * * [which] suggests fund companies that are concerned about 
withdrawals during tough markets should consider redemption fees 
with longer holding periods.'').
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     Instead of only setting a minimum holding 
period, should the rule also set a maximum holding period for imposing 
any redemption fee?
     Would the flexibility the proposed rule gives to 
funds to determine the length of the holding period make it more 
difficult for financial intermediaries to determine the applicability 
of the fee?
     Should the rule contain a special provision 
addressing account transfers within the previous five days, e.g., 
rollovers from a 401(k) plan to an Individual Retirement Account, to 
prevent the imposition of the redemption fee in those circumstances?
     Should the rule also apply to short-term 
transactions involving a redemption followed by a purchase within five 
days?

C. Smaller Investors

    We are sensitive to the potential effect of the proposed rule on 
smaller investors who may redeem their shares shortly after they 
purchase them because of unanticipated personal financial 
circumstances. Therefore, we have included three provisions in the 
proposed rule that would diminish the effect of the redemption fee on 
the accounts of smaller investors.
    First, funds would determine the amount of any fee by treating the 
shares held the longest time as being redeemed first, and shares held 
the shortest time as being redeemed last.\30\ Also known as the ``first 
in, first out'' (``FIFO'') method, this is the method commonly employed 
by funds that charge redemption fees.\31\ Use of the FIFO method would 
trigger redemption fees when large portions of an account are rapidly 
purchased and redeemed (a characteristic of abusive market timing 
transactions), but not when small portions of an account held over a 
longer period are redeemed.\32\ Thus, most transactions normally made 
by most investors would not be subject to the fee.
---------------------------------------------------------------------------

    \30\ See proposed rule 22c-2(d).
    \31\ See NASD, Report of the Omnibus Account Task Force Members, 
Jan. 30, 2004, at 8 (``Omnibus Report'') (available in File No. S7-
11-04).
    \32\ The application of the FIFO method also has the advantage 
of eliminating the need to include in the rule exceptions for 
numerous types of transactions in shareholder accounts that might 
regularly result if we used the last in, first out (``LIFO'') 
method, but which do not bear the characteristics of market timing 
transactions. These transactions include redemptions subsequent to 
purchases pursuant to dividend reinvestment plans, automatic 
purchase plans, and automatic account rebalancing arrangements. The 
$2,500 de minimis provision discussed below would prevent the 
application of the redemption fee when a redemption of all shares 
(including the most recently purchased shares) occurs shortly after 
a purchase of such shares as a result of one of these arrangements.
---------------------------------------------------------------------------

     Would use of a LIFO method of determining the 
redemption fee be more effective in combating market timing 
transactions? \33\ Would the answer turn on the amount of the de 
minimis exception, which we discuss below? Are there other methods of 
accounting for shares that are preferable?
---------------------------------------------------------------------------

    \33\ Investors could use multiple accounts to circumvent a 
redemption fee based on a LIFO method of accounting for the holding 
of shares. Therefore, use of such an approach might require 
intermediaries to transmit the account holder's taxpayer 
identification number (``TIN'') and require the fund to match 
transactions with the same TIN to determine the applicability of the 
redemption fee.
---------------------------------------------------------------------------

    Second, funds would be required to impose the redemption fee only 
on redemptions if the amount of the shares redeemed is greater than 
$2,500.\34\ As a result, an investor could redeem shares without paying 
a fee if the fee would be $50 or less. We are proposing this threshold 
amount to allow the fund not to charge the fee for smaller redemptions 
that may not be disruptive to the fund, including redemptions of shares 
purchased during the previous five days through a dividend investment 
plan or some other automatic investment plan.\35\ This approach permits 
a fund to perform its own cost-benefit analysis and determine whether 
the costs of collecting redemption fees in small amounts are worth the 
benefits.
---------------------------------------------------------------------------

    \34\ See proposed rule 22c-2(e)(1)(i).
    \35\ The exception also is designed to allow funds to avoid the 
administrative cost of imposing a redemption fee when the costs of 
collecting the fee may outweigh the amount of the fee itself.
---------------------------------------------------------------------------

    This de minimis provision therefore would permit, but not require, 
funds to forego the assessment of a redemption fee if the amount of the 
shares redeemed is $2,500 or less. We also propose--as an alternative 
to this approach--that the rule require funds to forego the assessment 
of redemption fees if the amount of the shares redeemed is $2,500 or 
less.\36\ This mandatory approach thus would prohibit funds from 
collecting these smaller redemption fees of $50 or less, under any 
circumstance. The uniformity of this approach across all funds may be 
advantageous for intermediaries who collect redemption fees on behalf 
of funds.
---------------------------------------------------------------------------

    \36\ If we were to adopt this alternative approach, paragraph 
(e)(1) of the proposed rule would be revised accordingly.
---------------------------------------------------------------------------

     Do these provisions sufficiently address the 
concerns of small investors?
     Do they sufficiently distinguish harmful rapid 
trading from occasional financial transactions that may involve a 
purchase of fund shares followed by a redemption?
     Conversely, would the thresholds permit a 
substantial amount of harmful rapid trading to occur?
     Many funds that currently impose redemption fees 
do not allow for any de minimis waivers of the fees to reimburse the 
fund for the costs of a relatively small number of shareholders that 
actively trade their shares.
     Would a mandatory de minimis exception serve to 
remove the reimbursement arrangements and protections against short-
term trading that these funds have already established?
     Would a de minimis threshold of $2,500 limit the 
effectiveness of the rule in reimbursing the fund for the costs of 
rapid trading by smaller investors?
     Would the failure of the Commission to adopt a 
mandatory de minimis threshold allow funds to unfairly deny smaller 
shareholders the ability to actively trade their funds?
     Should the de minimis threshold be higher (e.g., 
$5,000 or $10,000) or lower (e.g., $2,000 or $1,000)?
     Should the de minimis threshold be mandatory at 
one level (e.g., $2,500) and

[[Page 11766]]

voluntary up to another level (e.g., $10,000)?
    Third, the rule would provide for the waiver of redemption fees in 
the case of an unanticipated financial emergency, upon written request 
of the shareholder.\37\ The fund would be required to waive the fee on 
redemptions of $10,000 or less. The fund also would be permitted to 
waive the fee on redemptions greater than $10,000 in these emergency 
circumstances. This exception is designed to permit shareholders access 
to their investment when they need to meet unforeseen financial 
demands, such as payment for emergency surgery, soon after they 
purchased their shares. We request comment on this exception.
---------------------------------------------------------------------------

    \37\ See proposed rule 22c-2(e)(1)(ii).
---------------------------------------------------------------------------

     Should this exception be mandatory rather than 
discretionary, on the part of the fund, regardless of the amount of the 
shares redeemed?
     Should the rule define the circumstances that 
would constitute an unanticipated financial emergency?\38\
---------------------------------------------------------------------------

    \38\ See, e.g., 26 CFR 1.457-6(c)(2)(i) (2003) (``An 
unforeseeable emergency must be defined in the plan as a severe 
financial hardship of the participant or beneficiary resulting from 
an illness or accident of the participant or beneficiary, the 
participant's or beneficiary's spouse, or the participant's or 
beneficiary's property due to casualty * * * or other similar 
extraordinary and unforeseeable circumstances arising as a result of 
events beyond the control of the participant or the beneficiary * * 
*'').
---------------------------------------------------------------------------

     If so, what should those circumstances include? 
Should they include, for example, (i) death, disability, or other 
specific personal emergencies, (ii) personal economic hardship or 
unanticipated changes in personal circumstances, or (iii) emergencies 
such as market breaks or major political or economic events?
     What are the likely costs to funds of 
administering the financial emergency exception?
     Should the rule limit the number of emergency 
waivers that a shareholder may request, or that a fund may grant?
     Should funds be permitted to waive the 
redemption fee in other circumstances, such as purchases made in error, 
or purchases within the five-day period due to automatic investment or 
reinvestment programs?

D. Shareholder Accounts and Intermediaries

    Many investors' holdings in mutual funds are through accounts held 
by broker-dealers, banks, insurance companies, and retirement plan 
administrators. Many of these holdings are on the books of the fund (or 
its transfer agent) in the name of the intermediary, rather than in the 
name of the fund shareholder. Intermediaries controlling these so-
called ``omnibus accounts'' often provide the fund with insufficient 
information for the fund to apply redemption fees. Indeed, today many 
funds choose not to apply redemption fees, or their policies against 
market timing, to shares held through these omnibus accounts. A number 
of the market timing abuses identified through our examinations and 
investigations reveal that certain shareholders were concealing abusive 
market timing trades through omnibus accounts.\39\ As a result, those 
shareholders have often been beyond the reach of fund directors' 
efforts to protect the fund and its shareholders from the harmful 
effects of short-term trading.\40\
---------------------------------------------------------------------------

    \39\ See, e.g., SEC v. Security Trust Company, et al., Civil 
Action No. 03-2323 (D. Ariz. Nov. 24, 2003) (alleging that Security 
Trust Company (``STC''), an unregistered financial intermediary, in 
an attempt to conceal a hedge fund's market timing activities from 
mutual funds, opened five omnibus accounts for the hedge fund 
through which the hedge fund's trades were rotated to evade 
detection by the mutual funds. STC also allegedly opened mirror 
accounts for the five omnibus accounts using STC's taxpayer 
identification number, which approach was intended to impede efforts 
by mutual fund companies to detect market timers by their tax 
identification numbers).
    \40\ The state civil complaint in New York v. Canary Capital 
Partners, LLC, Canary Investment Management, et al., (N.Y.S. Ct. 
filed Sept. 3, 2003) at para. 46, illustrates this practice: 
``Timers * * * trade through brokers or other intermediaries * * * 
who process large numbers of mutual fund trades every day through 
omnibus accounts where trades are submitted to mutual fund companies 
en masse. The timer hopes that his activity will not be noticed 
among the `noise' of the omnibus account.''
---------------------------------------------------------------------------

    Last year, to address this serious and growing problem, Chairman 
Donaldson requested that the NASD convene a panel of experts from the 
brokerage, money management and retirement plan communities to create 
greater transparency of shareholder account activities.\41\ Its 
findings have been very useful to us in fashioning provisions of 
today's proposal on redemption fees.
---------------------------------------------------------------------------

    \41\ See Letter from William H. Donaldson, Chairman, SEC, to 
Mary L. Schapiro, Vice Chairman and President, NASD (Nov. 17, 2003). 
This letter is available in File No. S7-11-04.
---------------------------------------------------------------------------

    Proposed rule 22c-2 would give the fund and financial 
intermediaries through which investors purchase and redeem shares three 
methods of assuring that the appropriate redemption fees are 
imposed.\42\ Each fund would be able to select the method(s) to use. 
Under the first method, the fund intermediary must transmit to the fund 
(or its transfer agent) at the time of the transaction the account 
number used by the intermediary to identify the transaction.\43\ This 
information will permit the fund to match the current transaction with 
previous transactions by the same account and assess the redemption fee 
when it is applicable.
---------------------------------------------------------------------------

    \42\ See proposed rule 22c-2(b).
    \43\ See proposed rule 22c-2(b)(1).
---------------------------------------------------------------------------

    Under the second method, the intermediary would enter into an 
agreement with the fund requiring the intermediary to identify 
redemptions of account holders that would trigger the application of 
the redemption fee, and transmit holdings and transaction information 
to the fund (or its transfer agent) sufficient to allow the fund to 
assess the amount of the redemption fee.\44\ Under this approach, the 
intermediary would be required to submit substantially less data along 
with each transaction than under the first method.
---------------------------------------------------------------------------

    \44\ See proposed rule 22c-2(b)(2).
---------------------------------------------------------------------------

    Under the third method, the fund would enter into an agreement with 
a financial intermediary requiring the intermediary to impose the 
redemption fees and remit the proceeds to the fund.\45\ This approach 
would require the intermediary to determine which transactions are 
subject to the fee, and assess the fee. This method would alleviate the 
burden on intermediaries to transmit shareholder account and 
transactional information to the funds on a transaction-by-transaction 
basis.\46\
---------------------------------------------------------------------------

    \45\ See proposed rule 22c-2(b)(3). The Omnibus Account Task 
Force found this method to be the most viable approach. See Omnibus 
Report, supra note 31, at 2.
    \46\ Under the second and third methods, funds would be 
responsible for ensuring that intermediaries are properly 
determining the fee, or assessing it.
---------------------------------------------------------------------------

    Regardless of which of the three methods described above are used 
to collect the redemption fee, the proposed rule also would require 
that, on at least a weekly basis, the financial intermediary provide to 
the fund the Taxpayer Identification Number (``TIN''), and the amount 
and dates of all purchases, redemptions, or exchanges for each 
shareholder within an omnibus account during the previous week.\47\ 
This information is designed to enable the fund to confirm that fund 
intermediaries are properly assessing the redemption fees.\48\ It also 
would

[[Page 11767]]

permit funds to detect market timers who a fund has prohibited from 
purchasing fund shares and who attempt to enter the fund through a 
different account. In addition, this may in some cases be helpful to 
funds that would be able to use the information to determine whether 
shareholders received appropriate breakpoint discounts on purchases of 
fund shares sold with a front-end sales load.\49\
---------------------------------------------------------------------------

    \47\ See proposed rule 22c-2(c). This proposed approach was 
recommended by the Omnibus Account Task Force. See Omnibus Report, 
supra note , at 7. See also, e.g., Letter from Niels Holch, 
Executive Director, Coalition of Mutual Fund Investors, to William 
H. Donaldson, Chairman, SEC (Dec. 12, 2003) (available in File No. 
S7-11-04). A fund that receives this information pursuant to the 
proposed rule would not be able to use the information for its own 
marketing purposes, unless permitted under the intermediary's 
privacy policies. See sections 248.11(a) and 248.15(a)(7)(i) of 
Regulation S-P [17 CFR 248.11(a) and 248.15(a)(7)(i)].
    \48\ See, e.g., Jonas Max Ferris, Next Scandal: Brokers?, The 
Street.com, Nov. 26, 2003, (available at http://www.thestreet.com/_tscs/jonasmaxferris/10128667.html) (``Could a discount broker 
``forget'' to collect a fund's short-term redemption fee as stated 
in the fund's prospectus? `` Omnibus accounting offers interesting 
ways to cloak illicit trades from a fund, including matching retail 
buys and sells against big-money accounts taking the opposite trade 
at opportune times.''). In addition, more than one individual may 
trade through a particular account, in which case more than one TIN 
may be associated with the account. Providing this TIN information 
to the fund may enable the fund to determine whether a redemption 
fee should be charged on a redemption in that account.
    \49\ See Disclosure of Breakpoint Discounts by Mutual Funds, 
Investment Company Act Release No. 26298 (Dec. 17, 2003) [68 FR 
74732 (Dec. 24, 2003)] (proposed amendments to Form N-1A to require 
that funds disclose sales load breakpoint discount arrangements and 
methods for calculating discounts, based on recommendations of Joint 
NASD/Industry Task Force on Breakpoints and results of a joint 
examination sweep by the Commission, NASD, and NYSE of broker-
dealers revealing that most firms in some instances did not provide 
investors with breakpoint discounts for which they appeared to have 
been eligible).
---------------------------------------------------------------------------

     Would the account information provided by the 
intermediaries to the funds be sufficient for the funds to properly 
assess the fees?
     Should financial intermediaries provide 
shareholder identity and transaction information to the fund or its 
transfer agent more (or less) frequently than weekly?
     Should the rule limit the number of ways that 
redemption fees may be assessed, in order to promote greater uniformity 
in the enforcement of redemption fees across funds and their 
intermediaries?
     Should the rule require funds to match 
shareholder purchases and redemptions that occur through multiple 
accounts or intermediaries?
     With respect to foreign shareholders, who do not 
have a TIN, what alternative shareholder identity information should 
financial intermediaries send to funds?
     Should we require that funds retain their 
agreements with the financial intermediaries as part of their 
recordkeeping obligations?
     Are there additional ways to identify market 
timing trades that are executed through the use of multiple accounts, 
multiple customer account numbers, intermediaries, or any other means 
designed to evade detection?
     We also request comment on the administrative 
and legal issues that insurance companies and their underlying funds 
would face as a result of this rule.\50\
---------------------------------------------------------------------------

    \50\ See Letter from Stephen E. Roth and W. Thomas Conner, 
Sutherland, Asbill & Brennan LLP, to Paul F. Roye, Director, 
Division of Investment Management, SEC (Feb. 10, 2004). This letter 
is available in File No. S7-11-04.
---------------------------------------------------------------------------

E. Exceptions

    Proposed rule 22c-2 would include four exceptions to the mandatory 
redemption fee.\51\ First, as discussed above,\52\ the rule would not 
require funds to collect redemption fees on redemptions of $2,500 or 
less, and would provide for fee waivers in the case of financial 
emergencies.\53\ Second, the rule would except money market funds from 
its scope.\54\ Money market funds seek to obtain a stable net asset 
value of one dollar per share, and often are used for short-term 
investments. They are therefore designed to accommodate frequent 
purchases and redemptions, and do not appear to be susceptible to the 
harms caused by excessive trading; in fact, they are designed to 
facilitate frequent trading.
---------------------------------------------------------------------------

    \51\ See proposed rule 22c-2(e). The rule would not permit funds 
to exclude other types of funds or redemptions during the five-day 
holding period. (Funds that establish longer holding periods, 
however, would be free to provide exceptions from redemption fees 
imposed on shares held longer than five days.) Thus, a fund could 
not waive redemption fees for some investors (e.g., favored 
institutional clients, fund employees, or fund directors) but apply 
them to others. See Testimony of Don Phillips, Managing Director, 
Morningstar Inc., on ``Mutual Funds: Who's Looking Out for 
Investors,'' Before the House Subcommittee on Capital Markets, 
Insurance and Government Sponsored Enterprises of the Committee on 
Financial Services, 108th Cong., 1st Sess. (Nov. 4, 2003) (available 
at http://news.morningstar.com/doc/article/0,1,99258,00.html) 
(``From our conversations with fund managers, it is clear that they 
believe that redemption fees are the best deterrent to market 
timers. Of course, a fee is only effective if it is enforced. We 
think that funds must be much less lax in waiving fees for bigger 
accounts or for 401(k) plans, and that directors should be informed 
when and under what conditions these fees may be waived.'').
    \52\ See supra Section II.C.
    \53\ See proposed rule 22c-2(e)(1).
    \54\ See proposed rule 22c-2(e)(2)(i).
---------------------------------------------------------------------------

    Third, the rule would not apply to exchange-traded funds 
(``ETFs'').\55\ Shares issued by ETFs are listed on stock exchanges 
and, like the shares of other listed operating companies, trade at 
negotiated prices on securities exchanges. An ETF redeems shares or 
units in large blocks, or ``creation units,'' and redemptions of these 
units serve to correct the price of individual shares on the secondary 
market.\56\ These redemptions therefore are unlikely to pose risks of 
harm to the fund.\57\
---------------------------------------------------------------------------

    \55\ See proposed rule 22c-2(e)(2)(ii).
    \56\ See Actively Managed Exchange-Traded Funds, Investment 
Company Act Release No. 25258, at nn. 6-8 and accompanying text 
(Nov. 8, 2001) [66 FR 57614 (Nov. 15, 2001)].
    \57\ In addition, redeeming shareholders generally pay 
transaction fees to the ETF to cover the costs associated with 
redemptions. See Gary L. Gastineau, The Exchange-Traded Funds Manual 
(2002).
---------------------------------------------------------------------------

    Finally, proposed rule 22c-2 would not apply to any fund that (i) 
adopts a fundamental policy to affirmatively permit short-term trading 
in all of its redeemable securities,\58\ and (ii) discloses in its 
prospectus that it permits short-term trading of its shares and that 
such trading may result in additional costs for the fund.\59\ This 
exception is designed to permit funds and investors the freedom to 
invest in funds that affirmatively disclose their intent to allow 
short-term trading. Some short-term traders find these types of funds 
to be attractive vehicles. We are reluctant to propose a rule that 
would prohibit such funds and investors from achieving their objectives 
by requiring the funds to impose a redemption fee.
---------------------------------------------------------------------------

    \58\ A fundamental policy can be changed only by a majority vote 
of the outstanding voting securities of the fund. See section 8(b) 
of the Act [15 U.S.C. 80a-8(b)].
    \59\ See proposed rule 22c-2(e)(2)(iii).
---------------------------------------------------------------------------

     Should other types of funds also be excepted 
from the rule?

F. Request for Further Comment on Rule 22c-2

    The proposed mandatory redemption fee is designed to work together 
with our other regulatory initiatives and with tools fund managers 
already have at their disposal to curb harmful market timing 
transactions.\60\ Fund managers can use information they receive about 
transactions in omnibus accounts to take steps to better enforce market 
timing policies, including barring market timers from the fund. Tighter 
controls on information about portfolio holdings will make successful 
market timing transactions more difficult.\61\ While a mandatory 
redemption fee would reduce the profitability of abusive market timing 
trades, standing

[[Page 11768]]

alone it would be unlikely to deter abusive market timing transactions 
in which the profits are expected to exceed the fee, or that do not 
involve short-term transactions.\62\
---------------------------------------------------------------------------

    \60\ See supra note 7 and accompanying text.
    \61\ See Compliance Programs of Investment Companies and 
Investment Advisers, supra note 6, at nn. 54-56 and accompanying 
text (a fund's compliance policies and procedures should address 
potential misuses of nonpublic information, including the disclosure 
to third parties of material information about the fund's 
portfolio); see also Disclosure Regarding Market Timing and 
Selective Disclosure of Portfolio Holdings, supra note 7, at nn. 52-
67 and accompanying text (proposal to require open-end management 
investment companies and insurance company managed separate accounts 
that offer variable annuities to disclose their policies and 
procedures with respect to the disclosure of their portfolio 
securities, and any ongoing arrangements to make available 
information about their portfolio securities).
    \62\ See Conrad S. Ciccotello, Roger M. Edelen, Jason T. Greene 
and Charles W. Hodges, Trading at Stale Prices and Modern 
Technology: Policy Options for Mutual Funds in the Internet Age, 7 
VA J.L. & Tech. 6, at nn. 141-144 and accompanying text 
(``Redemption fees can be quite effective in reducing stale price 
trading.'' However, ``redemption fees cannot address the problems 
caused by large market moves. For example, in the 1997 Asian Crisis, 
a fourteen-percent overnight return was available based on the Hong 
Kong market. At that point, even a two-percent redemption fee would 
not deter stale price traders.'').
---------------------------------------------------------------------------

    A significant proportion of abusive market timing has been designed 
to exploit systematic pricing discrepancies between the value assigned 
to a fund's portfolio securities for purposes of calculating the fund's 
net asset value and the ``fair value'' of those portfolio securities. 
We believe that the use of fair value pricing, as required by the 
Act,\63\ can reduce or eliminate the arbitrage opportunities that these 
market timers seek, and that the primary response of funds and fund 
managers must, therefore, be to more accurately calculate the daily net 
asset value of the fund by using fair value pricing methods when 
closing prices are unreliable.\64\
---------------------------------------------------------------------------

    \63\ The Investment Company Act requires funds to calculate 
their net asset values using the market value of portfolio 
securities when market quotations are readily available. Section 
2(a)(41) [15 U.S.C. 80a-2(a)(41)] of the Investment Company Act and 
rule 2a-4 [17 CFR 270.2a-4]. If a market quotation for a portfolio 
security is not readily available (or is unreliable), the fund must 
establish a ``fair value'' for that security, as determined in good 
faith by the fund's board. See Pricing of Redeemable Securities for 
Distribution, Redemption, and Repurchase, Investment Company Act 
Release No. 14244 (Nov. 21, 1984) [49 FR 46558 (Nov. 27, 1984)] at 
n. 7 (proposing amendments to rule 22c-1).
    \64\ Fair value pricing takes after-market-close events into 
account in determining the fund's daily net asset value. In a 
release recently adopting rule 38a-1, we reiterated the obligation 
of funds to fair value their securities under certain circumstances 
to reduce market timing arbitrage opportunities and to have 
procedures to meet these obligations. See Compliance Programs of 
Investment Companies and Investment Advisers, supra note 6.
---------------------------------------------------------------------------

    Recent experience has shown, however, that the requirement to 
implement fair value pricing has not always been sufficient to 
eliminate these arbitrage opportunities. One possible reason is that 
fair value pricing involves subjective judgments that leave open the 
possibility of market timing, albeit at reduced profits.\65\ Another 
possibility is that some funds have applied fair value pricing 
inconsistently, or only to the most egregious pricing discrepancies. 
While a mandatory redemption fee may reduce, or eliminate, arbitrage 
profit opportunities, we are also actively considering ways in which 
the implementation of fair value pricing could be improved.
---------------------------------------------------------------------------

    \65\ See Frederick C. Dunbar and Chudozie Okongwu, (Market) 
Timing is (Not) Everything, Wallstreetlawyer.com, Oct. 2003, 
(``There are many possible ways to adjust pricing. The goal is to 
adjust the stale prices of the securities held by a fund by the 
predicted effect of the information that becomes known between each 
security's last trade and the pricing of the fund. However, such 
adjustments are costly to produce and inexact at best.'').
---------------------------------------------------------------------------

    Our examination staff is in the process of gathering information 
about funds' current fair value pricing practices, and we have directed 
the staff of the Division of Investment Management to examine the fair 
value pricing methodologies used by the funds and the quality of 
pricing those methodologies yield, for purposes of evaluating whether 
there are additional measures that we could take to improve funds' fair 
value pricing. In connection with our consideration of these issues, we 
will be seeking additional comment on specific issues related to fair 
value pricing.\66\ However, at this time we ask commenters to address 
generally fair value pricing as it relates to abusive market timing. 
What areas of uncertainty do funds face when trying to fair value their 
portfolio securities? Are there areas of uncertainty that could be 
resolved with further guidance from us? If funds implement fair value 
pricing effectively, is a mandatory redemption fee unnecessary to 
address abusive market timing? \67\
---------------------------------------------------------------------------

    \66\ Such a request for comment could include, for example, 
whether we should adopt a rule requiring funds to regularly review 
the appropriateness and accuracy of methods used in valuing 
securities. Currently such a practice must be a part of a fund's 
compliance policies and procedures. See Compliance Policies and 
Programs of Investment Companies and Investment Advisers, supra note 
14 at Section II.A. In addition, we could request comment on whether 
we should adopt a rule clarifying when a fund must re-calculate its 
net asset value when it has re-priced portfolio securities.
    \67\ We recognize, however, that a redemption fee may 
nonetheless be necessary to address the costs of short-term trading 
discussed previously.
---------------------------------------------------------------------------

    After reviewing all information, we will consider whether to issue 
additional interpretive guidance or undertake further rulemaking with 
respect to fair value pricing. Those additional comments and 
information will be relevant to our decision whether a mandatory 
redemption fee is necessary or appropriate to deter abusive market 
timing.
    We request comment on whether there are additional tools that the 
Commission should consider to combat harmful market timing 
transactions.
     Should the Commission require that funds 
determine the value of purchase and redemption orders at the net asset 
value calculated the next day after it receives those orders, rather 
than at the time that the fund next calculates its NAV? Under such an 
approach, market timers would not be able to predict whether the next 
day's NAV would be higher or lower and, therefore, would not be able to 
trade profitably. On the other hand, such an approach would diminish 
ordinary investors' ability to promptly effect their mutual fund 
investment decisions.
     Are there other means to discourage abusive 
market timing that we should consider?

III. General Request for Comment

    The Commission requests comment on proposed rule 22c-2, suggestions 
for additions to the proposed rule, and comment on other matters that 
might have an effect on the proposal contained in this Release. We note 
that comments are more helpful if they include supporting data and 
analysis.

IV. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits imposed by 
its rules. As discussed above, proposed rule 22c-2 would require that 
funds impose a two percent redemption fee on the redemption of fund 
shares within five days of purchase.

A. Benefits

    We anticipate that funds and shareholders would benefit from the 
proposed rule. The rule is designed to reimburse a fund for the costs 
of short-term trading in fund shares. Short-term trading can raise 
transaction costs for the fund, disrupt the fund's stated portfolio 
management strategy, require maintenance of an elevated cash position, 
and result in lost investment opportunities and forced liquidations. 
Short-term trading also can result in unwanted taxable capital gains 
for fund shareholders and reduce the fund's long-term performance. 
Excessive trading also can dilute the value of fund shares held by 
long-term shareholders if a short-term trader, or ``market timer,'' 
buys and sells shares rapidly to take advantage of market 
inefficiencies when the price of a mutual fund does not reflect the 
current market value of the stocks held by that mutual fund. Dilution 
could occur if fund shares are overpriced and short-term traders 
receive proceeds based on the overvalued shares. Although short-term 
traders can profit from engaging in frequent trading of fund shares, 
the costs associated with such trading are borne by all fund 
shareholders.
    To the extent that the rule discourages short-term trading, long-
term investors

[[Page 11769]]

may have more confidence in the financial markets as a whole, and funds 
in particular. Funds would benefit by the increase in investor 
confidence because long-term investors would be less likely to seek 
alternative financial products in which to invest. Because the fund 
retains the redemption fee, long-term shareholders are essentially 
reimbursed for some, if not all, of the redemption costs caused by the 
short-term traders.

B. Costs

    Currently, some funds already impose redemption fees on redemptions 
made within a specified period of time, often thirty days to a year. 
The proposed rule would likely result in minimal costs for those funds. 
With respect to funds that do not currently impose redemption fees, the 
proposed requirement of a mandatory two percent redemption fee also 
would likely result in a minimal burden.
    With respect to omnibus accounts, we recognize that the proposed 
rule, if adopted, may result in costs for funds and their 
intermediaries. The costs to a fund's transfer agent to store the 
shareholder information and track the trading activity may be 
significant, and those costs may ultimately be passed on to 
investors.\68\ In some cases, the transfer agent will have to upgrade 
its recordkeeping systems; however, some transfer agents may have 
software that can be used, or modestly modified, to accommodate the 
matching of purchases and redemptions. In addition, with respect to 
funds and their transfer agents, the costs of storing the data will be 
mitigated because the proceeds of the two percent redemption fee will 
be retained by the funds for the benefit of their long-term 
shareholders. We seek comments on these costs, and whether they are 
justified by the benefits of the proposed rule.
---------------------------------------------------------------------------

    \68\ Many funds already pay the intermediaries who sell their 
funds for the recordkeeping they perform for omnibus accounts.
---------------------------------------------------------------------------

    We also recognize that the proposed rule, if adopted, may impose 
some costs on financial intermediaries that will have to upgrade their 
software or other technology because their systems currently may not be 
able to either transmit the shareholder data or track trading patterns 
of individual accountholders.\69\ If financial intermediaries, such as 
retirement plan administrators, find it too expensive to upgrade their 
systems, potential investors may end up investing in alternative 
financial products. In some cases, however, the costs may be 
substantially less for broker-dealers and other intermediaries that 
already have transfer agent systems in place that can be modified to 
identify short-term trading.\70\ We seek comments on these costs, and 
whether they are justified by the benefits of the proposed rule.
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    \69\ See, e.g., Letter from Edward L. Yingling, American Bankers 
Association, to Paul F. Roye, Director, Division of Investment 
Management, SEC (November 12, 2003) (available File S7-11-04). The 
American Bankers Association noted that redemption fees would 
increase 401(k) plan costs: the ``need to set accounting processes 
for those accounts and to administer the movement of [redemption] 
fees will raise additional costs to plan participants.''
    \70\ Broker-dealers using National Securities Clearing 
Corporation already transmit TINs to fund transfer agents for 
certain types of ``networking'' arrangements. See Omnibus Report, 
supra note 31, at 4, n. 6.
---------------------------------------------------------------------------

    With respect to the method of determining which shares are subject 
to the redemption fees, we considered the benefits and costs associated 
with adopting a LIFO method compared to a FIFO approach, the current 
method used by most funds to impose redemption fees. We understand that 
the LIFO method may entail substantially greater costs than FIFO. 
Moreover, unlike FIFO, the use of LIFO may warrant the exclusion of 
certain transactions, such as investments made through a periodic 
purchase plan. Thus, the use of LIFO may add a level of complexity to 
the administration of the redemption fee, particularly in omnibus 
accounts, which could result in additional costs.

C. Request for Comment

    The Commission requests comment on the potential costs and benefits 
of the proposed rule. We also request comment on the potential costs 
and benefits of any alternatives suggested by commenters. We encourage 
commenters to identify, discuss, analyze, and supply relevant data 
regarding any additional costs and benefits. For purposes of the Small 
Business Regulatory Enforcement Act of 1996,\71\ the Commission also 
requests information regarding the potential annual effect of the 
proposals on the U.S. economy. Commenters are requested to provide 
empirical data to support their views.
---------------------------------------------------------------------------

    \71\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

V. Paperwork Reduction Act

    Certain provisions of proposed rule 22c-2 would result in new 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995.\72\ The Commission is submitting this 
proposal to the Office of Management and Budget (``OMB'') for review in 
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The title for the 
collection of information requirements is ``Rule 22c-2 under the 
Investment Company Act of 1940, `Redemption fees for redeemable 
securities.' '' An agency may not conduct or sponsor, and a person is 
not required to respond to, a collection of information unless it 
displays a currently valid control number.
---------------------------------------------------------------------------

    \72\ 44 U.S.C. 3501-3520.
---------------------------------------------------------------------------

A. Omnibus Accounts

    As discussed above, we are proposing rule 22c-2 to require a 
mandatory two percent redemption fee to be applied on all redemptions 
of fund shares held five business days or less, subject to certain 
narrow exceptions. To ensure that the redemption fees are applied 
uniformly, fund shares held by financial intermediaries in omnibus 
accounts must be subject to the fee.
    The rule would provide three methods by which a fund could assess 
and collect the redemption fees on shares held through omnibus 
accounts. The fund could direct the financial intermediary to: (i) 
Provide the fund, upon submission of each purchase and redemption 
order, the account number used by the financial intermediary to 
identify the shareholder (paragraph (b)(1)); (ii) provide the fund, as 
to redemption orders upon which the fund must charge a redemption fee, 
transaction and holdings information sufficient to permit the fund to 
assess the amount of the redemption fee (paragraph (b)(2)); or (iii) 
assess the redemption fee and remit the fee to the fund (paragraph 
(b)(3)). In addition, regardless of the approach selected above, at 
least once weekly, the fund must receive from the financial 
intermediary the TIN of all shareholders that purchased or redeemed 
shares held in omnibus accounts, and the amount and dates of such 
shareholder purchases and redemptions (paragraph (c)).
    The Commission staff estimates that there are currently 3,100 
active registered open-end investment companies and that each fund (or 
its transfer agent) would be required to collect redemption fees on 
transactions in omnibus accounts. We also estimate that about (i) 15 
percent of all funds would receive information from intermediaries 
according to the approach set forth in paragraph (b)(1), (ii) 35 
percent of all funds would receive information from intermediaries 
according to the approach set forth in paragraph (b)(2), and (iii) 50 
percent of all funds would arrange for intermediaries to assess the 
redemption fees, pursuant to paragraph (b)(3). These collection of 
information requirements

[[Page 11770]]

would be mandatory because a fund must receive the above information 
from the financial intermediary to ensure that redemption fees are 
properly assessed in omnibus accounts.
    Regardless of the approach selected, we anticipate that all funds 
would have to modify their agreements or contracts with their 
intermediaries. This modification would create a one-time burden of 4.5 
hours per fund (4 hours by in-house counsel, .5 hours by support staff) 
\73\ for a total burden of 13,950 hours.\74\
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    \73\ These estimates are based on discussions with fund 
representatives.
    \74\ (3,100 funds x 4.5 hours = 13,950 hours).
---------------------------------------------------------------------------

1. Funds: Paragraph (b)(1)
    As noted above, 15 percent of all funds (i.e., 465 funds) are 
expected to select the option set forth in paragraph (b)(1). The 
Commission staff estimates, based on information provided by funds, 
that the one-time burden on a fund to develop or upgrade its systems 
for the storage of information received from intermediaries, evaluate 
transactional data to match purchases and redemptions within a 
shareholder's account, and assess redemption fees would be 300 burden 
hours, for an aggregate burden of 139,500 hours for all funds.\75\ We 
estimate the start-up costs required to store and process information 
necessary to assess redemption fees to be $560,000 per fund, for an 
aggregate cost of $260,400,000 for all funds.\76\
---------------------------------------------------------------------------

    \75\ (300 hours x 465 funds = 139,500 hours).
    \76\ ($560,000 per fund cost x 465 funds = $260,400,000).
---------------------------------------------------------------------------

    In addition, funds also would have an ongoing burden to operate and 
maintain systems to store and process information necessary to impose 
redemption fees in omnibus accounts. Based on information provided by 
funds, we estimate this burden to be 300 hours annually per fund, for 
an aggregate burden of 139,500 hours.\77\ The operation and maintenance 
costs would be $6,640 per fund, for an aggregate cost of $3,087,600 for 
all funds.\78\
---------------------------------------------------------------------------

    \77\ (300 hours x 465 funds = 139,500 hours).
    \78\ ($6,640 per fund x 465 funds = $3,087,600).
---------------------------------------------------------------------------

2. Funds: Paragraph (b)(2)
    As noted above, 35 percent of all funds (i.e., 1,085 funds) are 
expected to select the option set forth in paragraph (b)(2). Under 
paragraph (b)(2) of the rule, the Commission staff estimates, based on 
information provided by funds, that the one-time burden on funds to 
develop or upgrade their systems for the storage of information 
received from intermediaries, evaluate transactional data to match 
purchases and redemptions within a shareholder's account, and assess 
redemption fees would be 300 burden hours per fund, for an aggregate 
burden of 325,500 hours for all funds.\79\
---------------------------------------------------------------------------

    \79\ (300 hours x 1,085 funds = 325,500 hours).
---------------------------------------------------------------------------

    We estimate the start-up costs required to store and process 
information necessary to assess redemption fees to be $560,000 per 
fund, for an aggregate cost of $607,600,000 for all funds.\80\ We 
estimate the annual ongoing operation and maintenance costs would be 
$6,640 for an aggregate cost of $7,204,400 for all funds.\81\ We 
estimate the ongoing collection of information burden on funds to be 
300 hours per fund, for an aggregate burden of 325,500 hours.\82\ The 
operation and maintenance costs would be $6,640 per fund for an 
aggregate cost of $7,204,400 for all funds.\83\
---------------------------------------------------------------------------

    \80\ ($560,000 per fund x 1,085 funds = $607,600,000).
    \81\ ($6,640 per fund x 1,085 funds = $7,204,400).
    \82\ (300 hours x 1,085 funds = 325,500 hours).
    \83\ ($6,640 per fund x 1,085 funds = $7,204,400).
---------------------------------------------------------------------------

3. Funds: Paragraph (b)(3)
    As noted above, 50 percent of all funds (i.e., 1,550 funds) are 
expected to select the option set forth in paragraph (b)(3). Under 
paragraph (b)(3), the fund and intermediary would enter into an 
agreement whereby the intermediary itself would assess the fee. Under 
this approach, funds would not receive any shareholder data from 
intermediaries. Therefore, there would be no collection of information 
requirements for funds.
4. Intermediaries: Paragraphs (b)(1)-(3)
    The Commission staff estimates that there are currently 
approximately 6,800 financial intermediaries (2,203 broker-dealers 
classified as specialists in fund shares, 2,400 banks,\84\ 196 
insurance companies sponsoring registered separate accounts organized 
as unit investment trusts, and approximately 2,000 retirement plan 
administrators) that would be required to transmit certain 
transactional and periodic information to the fund as outlined in 
Section II.D. For the purpose of these estimates, with respect to the 
transaction information under paragraph (b), we have assumed that about 
15 percent of intermediaries would supply the transactional information 
to the fund pursuant to paragraphs (b)(1), 35 percent of intermediaries 
would supply the transactional information pursuant to paragraph (b)(2) 
of the proposed rule, and about half of the intermediaries themselves 
would assess the redemption fee pursuant to paragraph (b)(3) of the 
rule.
---------------------------------------------------------------------------

    \84\ The Commission staff estimates that for the quarter ending 
September 30, 2003, about 2,400 banks reported to the Federal 
Financial Institutions Examination Council (on their Reports of 
Condition and Income) that they sell private label or third party 
mutual fund shares or variable annuity contracts (``annuities''). 
Unregistered annuities would not be subject to proposed rule 22c-2. 
This number may be an over-estimate of the number of banks that 
would be affected by the proposed rule because some of these banks 
may only sell annuities not required to register under the 
Investment Company Act of 1940. The number of banks selling funds or 
annuities may also count some banks selling on the banks' premises 
through registered broker-dealers. These banks have already been 
counted in the estimate of the number of broker-dealer respondents.
---------------------------------------------------------------------------

    Under paragraph (b)(1), the Commission staff estimates that the 
one-time capital cost to financial intermediaries to develop or upgrade 
their software or other technological systems to collect, and store the 
required transactional information to be $100,000 per intermediary for 
an aggregate cost of $102,000,000 for all intermediaries.\85\ The 
Commission staff also anticipates an ongoing burden for financial 
intermediaries to comply with the transactional information 
requirements set forth in the rule. We estimate the annual burden to be 
240 hours for an aggregate burden of 244,800 hours.\86\ The operation 
and maintenance costs would be $100,000 per intermediary for a total 
cost of $102,000,000 for all intermediaries.\87\
---------------------------------------------------------------------------

    \85\ ($100,000 per intermediary x 1,020 intermediaries = 
$102,000,000).
    \86\ (240 hours per intermediary x 1,020 intermediaries = 
244,800 hours).
    \87\ ($100,000 per intermediary x 1,020 intermediaries = 
$102,000,000).
---------------------------------------------------------------------------

    Under paragraph (b)(2), the Commission staff estimates that the 
one-time capital cost to financial intermediaries to develop or upgrade 
their software or other technological systems to collect, and store the 
required transactional information to be $10,000 per intermediary for 
an aggregate cost of $23,800,000 for all intermediaries.\88\ The 
Commission staff also anticipates an ongoing burden for financial 
intermediaries to comply with the transactional information 
requirements set forth in the rule. We estimate the annual burden to be 
24 hours per intermediary for an aggregate burden of 57,120 hours.\89\ 
The operation and maintenance costs would be $10,000 per intermediary 
for a total cost of $23,800,000 for all intermediaries.\90\
---------------------------------------------------------------------------

    \88\ ($10,000 per intermediary x 2,380 intermediaries = 
$23,800,000).
    \89\ (24 hours per intermediary x 2,380 intermediaries = 57,120 
hours).
    \90\ ($10,000 per intermediary x 2,380 intermediaries = 
$23,800,000).

---------------------------------------------------------------------------

[[Page 11771]]

    Under the approach set forth in paragraph (b)(3) of the proposed 
rule, there would be no collection of information requirements on 
intermediaries.
5. Funds and Intermediaries: Paragraph (c)
    With respect to the periodic information, including the TIN of the 
shareholder, to be provided on at least a weekly basis as set forth in 
paragraph (c) of the proposed rule, we estimate that there would be a 
burden on funds to collect and evaluate the data, and intermediaries to 
transmit it. However, that burden is reduced because we are requiring 
the data to be provided on at least a weekly basis, rather than on a 
transaction-by-transaction basis. We estimate the annual burden on a 
fund to be 2,080 hours \91\ for a total burden of 6,448,000 hours for 
all funds.\92\ We estimate the capital costs to be $100,000 per fund 
for an aggregate cost of $310,000,000 for all funds,\93\ and the 
ongoing yearly cost to be $20,584,000.\94\ We estimate the annual 
burden to be 240 hours per intermediary for a total burden of 1,632,000 
hours for all financial intermediaries.\95\ We estimate the capital 
costs to be $150,000 per intermediary for an aggregate cost of 
$1,020,000,000,\96\ and an ongoing cost to be $100,000 per intermediary 
for an aggregate yearly cost of $680,000,000 for all 
intermediaries.\97\
---------------------------------------------------------------------------

    \91\ (40 hours per week x 52 weeks = 2,080 hours per year).
    \92\ (2,080 hours per fund x 3,100 funds = 6,448,000 hours per 
year).
    \93\ ($100,000 per fund x 3,100 funds = $310,000,000).
    \94\ ($6,640 per fund x 3,100 funds = $20,584,000).
    \95\ (240 hours per intermediary x 6,800 intermediaries = 
1,632,000 hours).
    \96\ ($150,000 per intermediary x 6,800 intermediaries = 
$1,020,000,000).
    \97\ ($100,000 per intermediary x 6,800 intermediaries = 
$680,000,000).
---------------------------------------------------------------------------

B. Emergency Exception

    The proposed rule also would contain an exception that would permit 
a shareholder, in case of an unanticipated financial emergency, to make 
a written request to the fund to waive the redemption fee if the amount 
of the shares redeemed is $10,000 or less. We estimate that each fund 
would receive approximately ten waiver requests on an annual basis. 
Therefore, the aggregate number of requests would be 31,000.\98\ We 
estimate that it will take each shareholder 10 minutes to prepare a 
waiver, with an aggregate burden on shareholders of 5,167 hours.\99\
---------------------------------------------------------------------------

    \98\ (10 requests per year x 3,100 funds = 31,000 requests per 
year).
    \99\ (31,000 requests per year x 10 minutes = 310,000 minutes or 
5,167 hours).
---------------------------------------------------------------------------

C. Aggregate Hours and Cost Burdens

    To arrive at the total information collection burden for all 9,900 
respondents (i.e., 3,100 funds + 6,800 intermediaries) under the 
proposed amendments to rule 22c-2, an average of the first year burden 
and the subsequent annual burdens must be calculated. Over the three-
year period for which we are seeking approval, the weighted average 
aggregate annual information collection burden would be 8,856,737 
hours.\100\ The Commission estimates that there will be a total of 
155,592,600 responses annually, which includes responses by funds, 
intermediaries, and fund shareholders.\101\
---------------------------------------------------------------------------

    \100\ In the first year after adoption: (i) The aggregate burden 
for funds is expected to be 6,926,950 hours (13,950 hours for 
contract modifications + 139,500 hours for funds relying on 
paragraph (b)(1) + 325,500 hours for funds relying on paragraph 
(b)(2) + 6,448,000 hours for the information collection requirements 
in paragraph (c) = 6,926,950 hours); (ii) the aggregate burden for 
intermediaries is expected to be 1,933,920 hours (244,800 hours for 
intermediaries relying on paragraph (b)(1) + 57,120 for 
intermediaries relying on paragraph (b)(2) + 1,632,000 hours for the 
information collection requirements in paragraph (c) = 1,933,920 
hours); and (iii) the aggregate burden for redeeming shareholders is 
expected to be 5,167 hours. Thus, in the first year after adoption, 
the aggregate burden for all respondents is expected to be 8,866,037 
hours (6,926,950 hours for funds + 1,933,920 hours for 
intermediaries + 5,167 hours for redeeming shareholders = 8,866,037 
hours). In the second and third years after adoption, the annual 
burden for respondents is expected to fall to 8,852,087 hours, 
because the burden attributable to one-time contract modifications 
will no longer be incurred by funds. Thus, the average annual burden 
over the three-year period for which we are seeking approval is 
expected to be 8,856,737 hours (8,866,037 first year's burden + 
8,852,087 second year's burden + 8,852,087 third year's burden/3 = 
8,856,737 hours).
    \101\ Specifically, the staff estimates that annually there will 
be: (i) 150,000,000 responses under paragraph (b)(1) (1 response for 
each of the 15% of the estimated 1 billion purchase and sale 
transactions in fund shares that we assume will be subject to 
paragraph (b)(1) = 150,000,000 responses); (ii) 5,208,000 responses 
under paragraph (b)(2) (1 response for each of the estimated 35% of 
the approximately 14,880,000 affected redemption transactions per 
year (3,100 funds x 4,800 affected redemptions per fund per year = 
14,880,000 affected redemptions) that are subject to paragraph 
(b)(2) = 5,208,000 responses); (iii) 353,600 responses under 
paragraph (c) (6,800 intermediaries x 52 responses per year = 
353,600 responses); and (iv) 31,000 responses by shareholders 
seeking a financial emergency exception under the rule. Thus, we 
anticipate that there will be a total of 155,592,600 annual 
responses (150,000,000 responses under (b)(1) + 5,208,000 responses 
under (b)(2) + 353,600 responses under (c) + 31,000 responses for 
the emergency exception = 155,592,600 responses).
---------------------------------------------------------------------------

    To arrive at the total annual cost of the new information 
collection requirements for all 9,900 respondents (i.e., 3,100 funds + 
6,800 intermediaries), an average of the first year cost and the 
subsequent annual costs must be calculated. Over the three-year period 
for which we are seeking approval, the weighted average aggregate 
annual cost would be $1,053,492,000.\102\
---------------------------------------------------------------------------

    \102\ In the first year after adoption: (i) the aggregate cost 
burden for funds is expected to be $1,178,000,000 ($260,400,000 for 
funds relying on paragraph (b)(1) + $607,600,000 for funds relying 
on paragraph (b)(2) + 310,000,000 for the information collection 
requirements in paragraph (c) = $1,178,000,000); and (ii) the 
aggregate cost burden for intermediaries is expected to be 
$1,145,800,000 ($102,000,000 for intermediaries relying on paragraph 
(b)(1) + $23,800,000 for intermediaries relying on paragraph (b)(2) 
+ $1,020,000,000 for the information collection requirements in 
paragraph (c) = $1,145,800,000). Thus, in the first year after 
adoption, the aggregate cost burden for all respondents is expected 
to be $2,323,800,000. In the second and third years after adoption, 
the annual cost burden for respondents is expected to fall to 
$836,676,000, because funds and intermediaries will incur only the 
ongoing operation and maintenance costs of systems that have been 
put in place during the first year. Specifically, in each of the 
second and third years after adoption: (i) The aggregate cost burden 
for funds is expected to be $30,876,000 ($3,087,600 for funds 
relying on paragraph (b)(1) + $7,204,400 for funds relying on 
paragraph (b)(2) + $20,584,000 for the information collection 
requirements in paragraph (c) = $30,876,000); and (ii) the aggregate 
cost burden for intermediaries is expected to be $805,800,000 
($102,000,000 for intermediaries relying on paragraph (b)(1) + 
$23,800,000 for intermediaries relying on paragraph (b)(2) + 
$680,000,000 for the information collection requirements in 
paragraph (c) = $805,800,000). Thus, the average annual cost burden 
over the three year period for which we are seeking approval is 
expected to be $1,053,492,000 ($1,178,000,000 first year's burden + 
$805,800,000 second year's burden + $805,800,000 third year's 
burden/3 = $1,053,492,000).
---------------------------------------------------------------------------

D. Request for Comments

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
in order to: (i) Evaluate whether the proposed collections of 
information are necessary for the proper performance of the functions 
of the Commission, including whether the information will have 
practical utility; (ii) evaluate the accuracy of the Commission's 
estimate of the burden of the proposed collections of information; 
(iii) determine whether there are ways to enhance the quality, utility, 
and clarity of the information to be collected; and (iv) minimize the 
burden of the collections of information on those who are to respond, 
including through the use of automated collection techniques or other 
forms of information technology.
    Persons wishing to submit comments on the collection of information 
requirements of the proposed

[[Page 11772]]

amendments should direct them to the Office of Management and Budget, 
Attention Desk Officer of the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Room 10102, New Executive 
Office Building, Washington, DC 20503, and should send a copy to 
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 
Fifth Street, NW., Washington, DC 20549-0609, with reference to File 
No. S7-11-04. OMB is required to make a decision concerning the 
collections of information between 30 and 60 days after publication of 
this Release; therefore a comment to OMB is best assured of having its 
full effect if OMB receives it within 30 days after publication of this 
Release. Requests for materials submitted to OMB by the Commission with 
regard to these collections of information should be in writing, refer 
to File No. S7-11-04, and be submitted to the Securities and Exchange 
Commission, Records Management, Office of Filings and Information 
Services.

VI. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis (``IRFA'') has been 
prepared in accordance with 5 U.S.C. 603. It relates to rule 22c-2 and 
amendments to rule 11a-3 under the Investment Company Act, which we are 
proposing in this Release.

A. Reasons for the Proposed Action

    As discussed more fully in Section I of this Release, the reason 
for the proposed action is that short-term trading of fund shares, 
including market timing activity, imposes costs on funds that are borne 
by long-term shareholders.

B. Objectives of the Proposed Action

    As discussed more fully in Section II of this Release, the 
objective of the proposed rule is to require shareholders to reimburse 
the fund for costs incurred by the fund when they engage in short-term 
trading in fund shares, and to deter short-term trading.

C. Legal Basis

    As indicated in Section VII of this Release, new rule 22c-2 and 
amendments to rule 11a-3 are proposed pursuant to the authority set 
forth in sections 11(a), 22(c) and 38(a) of the Investment Company 
Act.\103\

D. Small Entities Subject to the Proposed Rule and Amendments

    A small business or small organization (collectively, ``small 
entity'') for purposes of the Regulatory Flexibility Act is a fund 
that, together with other funds in the same group of related investment 
companies, has net assets of $50 million or less as of the end of its 
most recent fiscal year.\104\ Of approximately 3,925 funds (3,100 
registered open-end investment companies and 825 registered unit 
investment trusts), approximately 163 are small entities.\105\ A 
broker-dealer is considered a small entity if its total capital is less 
than $500,000, and it is not affiliated with a broker-dealer that has 
$500,000 or more in total capital.\106\ Of approximately 6,800 
registered broker-dealers, approximately 880 are small entities, with 
approximately 400 of these classified as specialists in funds. A 
transfer agent is considered a small entity if it has: (i) Received 
less than 500 items for transfer and less than 500 items for processing 
during the preceding six months (or in the time that it has been in 
business, if shorter); (ii) transferred items only of issuers that 
would be deemed ``small businesses'' or ``small organizations'' as 
defined in rule 0-10 under the Securities Exchange Act of 1934; (iii) 
maintained master shareholder files that in the aggregate contained 
less than 1,000 shareholder accounts or was the named transfer agent 
for less than 1,000 shareholder accounts at all times during the 
preceding fiscal year (or in the time that it has been in business, if 
shorter); and (iv) is not affiliated with any person (other than a 
natural person) that is not a small business or small organization 
under rule 0-10.\107\ We estimate that 40 out of approximately 208 
registered fund transfer agents qualify as small entities.
---------------------------------------------------------------------------

    \103\ 15 U.S.C. 80a-11(a), 80a-22(c), and 80a-37(a).
    \104\ 17 CFR 270.0-10.
    \105\ Some or all of these entities may contain multiple series 
or portfolios. If a registered investment company is a small entity, 
the portfolios or series it contains are also small entities.
    \106\ 17 CFR 240.0-10.
    \107\ 17 CFR 240.0-10(h).
---------------------------------------------------------------------------

    As we discussed above, under the proposed rule, any redemption of 
fund shares (with certain limited exceptions) held for five business 
days or less would be subject to a two percent redemption fee. This 
rule would apply to all transactions, including those in omnibus 
accounts. The Commission staff expects that this rule would require 
that funds and intermediaries develop or upgrade software or other 
technological systems to impose redemption fees in omnibus accounts. 
Because the Commission and its staff are not familiar with the full 
range of available technologies associated with these upgrades, we 
request that commenters address the cost of such upgrades, including 
specific data when available.

E. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposal would not contain new mandatory reporting or 
recordkeeping requirements.

F. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission has not identified any federal rules that duplicate, 
overlap, or conflict with the proposed rule.

G. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. 
Alternatives in this category would include: (i) Establishing different 
compliance or reporting standards that take into account the resources 
available to small entities; (ii) clarifying, consolidating, or 
simplifying the compliance requirements under the rule for small 
entities; (iii) using performance rather than design standards; and 
(iv) exempting small entities from coverage of the rule, or any part of 
the rule.
    The Commission does not presently believe that the establishment of 
special compliance requirements or timetables under the proposal for 
small entities is feasible or necessary. The proposed rule arises from 
enforcement actions and settlements that underscore the need to 
reimburse funds so that long-term shareholders will not be 
disadvantaged by shareholders that engage in frequent trading and fund 
managers that selectively permit such short-term trading. Excepting 
small entities from the proposed rule could disadvantage fund 
shareholders of small entities and compromise the effectiveness of the 
proposed rule. Nevertheless, we request comment on whether it is 
feasible or necessary for small entities to have special requirements 
or timetables for compliance with the proposed rule. Should the 
proposed rule be altered in order to ease the regulatory burden on 
small entities, without sacrificing its effectiveness?
    With respect to further clarifying, consolidating or simplifying 
the compliance requirements of the proposed rule, using performance 
rather than design standards, and exempting small entities from 
coverage of the rule

[[Page 11773]]

or any part of the rule, we believe such changes are impracticable. 
Small entities are as vulnerable to the problems uncovered in recent 
enforcement actions and settlements as large entities; shareholders of 
small entities are equally in need of protection from short-term 
traders. We believe that a mandatory redemption fee will serve as a 
useful tool to discourage short-term trading. Exempting small entities 
from coverage of the rule or any part of the rule could compromise the 
effectiveness of the proposed rule.

H. Solicitation of Comments

    The Commission encourages the submission of comments with respect 
to any aspect of this IRFA. Comment is specifically requested on the 
number of small entities that would be affected by the proposed rule, 
and the likely impact of the proposals on small entities. Commenters 
are asked to describe the nature of any impact and provide empirical 
data supporting its extent. These comments will be considered in 
connection with any adoption of the proposed rule and amendments, and 
reflected in the Final Regulatory Flexibility Analysis.
    Comments should be submitted in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609. Comments also may be submitted 
electronically to the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-11-04, and this file 
number should be included on the subject line if E-mail is used.\108\ 
Comment letters will be available for public inspection and copying in 
the Commission's Public Reference Room, 450 Fifth Street, NW., 
Washington, DC 20549-0102. Electronically submitted comment letters 
also will be posted on the Commission's Internet Web site (http://www.sec.gov).
---------------------------------------------------------------------------

    \108\ Comments on the IRFA will be placed in the same public 
file that contains comments on the proposed rule.
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VII. Statutory Authority

    The Commission is proposing rule 22c-2 and amendments to rule 11a-3 
pursuant to the authority set forth in sections 11(a), 22(c) and 38(a) 
of the Investment Company Act [15 U.S.C. 80a-11(a), 80a-22(c) and 80a-
37(a)].

List of Subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Proposed Rule

    For reasons set out in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is proposed to be amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

    1. The authority citation for Part 270 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.

* * * * *


Sec.  270.11a-3  [Amended]

    2. Section 270.11a-3 is amended by revising the undesignated 
paragraph following (b)(2) to read as follows:
* * * * *
    (b) * * *
    (2) * * *
    Any scheduled variation of a redemption fee, other than pursuant to 
Sec.  270.22c-2, must be reasonably related to the costs to the fund of 
processing the type of redemptions for which the fee is charged;
* * * * *
    3. Section 270.22c-2 is added to read as follows:


Sec.  270.22c-2  Redemption fees for redeemable securities.

    (a) Redemption fee. It is unlawful for any fund issuing redeemable 
securities, its principal underwriter, or any dealer in such securities 
to redeem a redeemable security issued by the fund, within five 
business days after the security was purchased, unless the fund imposes 
a redemption fee of two percent of the amount redeemed, which fee shall 
be retained by the fund.
    (b) Transaction information required for assessment of fee. For the 
purpose of imposing the fee required pursuant to paragraph (a) of this 
section, a fund must, with respect to each shareholder account held by 
a financial intermediary:
    (1) Require the financial intermediary to provide the fund, upon 
submission of each purchase and redemption order, the account number 
used by the financial intermediary to identify the shareholder;
    (2) Have entered into an agreement with the financial intermediary 
under which the intermediary must provide the fund, as to redemption 
orders upon which the fund must charge a redemption fee under paragraph 
(a) of this section, transaction and holdings information sufficient to 
permit the fund to assess the amount of the redemption fee; or
    (3) Have entered into an agreement with the financial intermediary 
under which the intermediary must assess the redemption fee required in 
paragraph (a) of this section.
    (c) Periodic information required. In order to determine whether 
the redemption fee is properly assessed under paragraph (a) of this 
section, a fund must require each financial intermediary, as described 
in paragraph (b) of this section, to provide it no less frequently than 
once each week,
    (1) The Taxpayer Identification Number of all shareholders that 
purchased or redeemed shares held through an account with the financial 
intermediary for the time period submitted; and
    (2) The amount and dates of such shareholder purchases and 
redemptions for the time period submitted.
    (d) Calculation of the redemption fee. In determining the amount of 
the redemption fee under paragraph (a) of this section, the fund must 
treat the shares held in the account (or an account to which the 
account is the successor) the longest period of time as the first 
shares redeemed (first in, first out or FIFO). The fund must determine 
the amount of the redemption fee on the basis of proceeds payable to 
the shareholder before the imposition of any deferred sales load or 
administrative fee. The fee may either reduce the amount of the 
proceeds to the shareholder or increase the number of shares redeemed.
    (e) Exceptions.--(1) Waiver of fees. Notwithstanding paragraph (a),
    (i) A fund may waive the redemption fee if the amount of the shares 
redeemed is 2,500 dollars or less; \109\ and
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    \109\ As discussed in the preamble to this Release, the 
Commission also is proposing, as an alternative to this paragraph 
(e)(1)(i), that the waiver of fees on redemptions of $2,500 or less 
be mandatory rather than discretionary on the part of the fund. See 
supra note 36 and accompanying text. If we were to adopt this 
alternative approach, paragraph (e)(1)(i) of the proposed rule would 
be revised accordingly.
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    (ii) In the case of an unanticipated financial emergency, upon 
written request of the shareholder,
    (A) A fund must waive the redemption fee if the amount of the 
shares redeemed is 10,000 dollars or less; and
    (B) A fund may waive the redemption fee if the amount of the shares 
redeemed is more than 10,000 dollars.
    (2) Excepted funds. The requirements of paragraphs (a) through (c) 
of this section do not apply to:
    (i) Money market funds;
    (ii) Any fund that issues securities that are listed on a national 
securities exchange; and
    (iii) Any fund that has adopted a fundamental policy to 
affirmatively

[[Page 11774]]

permit short-term trading of its securities, if its prospectus clearly 
and prominently discloses that the fund permits short-term trading of 
its securities and that such trading may result in additional costs for 
the fund.
    (f) Definitions. For the purposes of this section,
    (1) Financial intermediary means a record holder as defined in rule 
14a-1(i) under the Securities Exchange Act of 1934 (17 CFR 240.14a-
1(i)) and an insurance company that sponsors a registered separate 
account organized as a unit investment trust.
    (2) Fund means an open-end management investment company that is 
registered or required to register under section 8 of the Investment 
Company Act (15 U.S.C. 80a-8), and includes a separate series of such 
an investment company.
    (3) Money market fund means an open-end management investment 
company that is registered under the Act and is regulated as a money 
market fund under Sec.  270.2a-7.

    By the Commission.

    Dated: March 5, 2004.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-5374 Filed 3-10-04; 8:45 am]
BILLING CODE 8010-01-P