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Roye Offers Advice on Compliance Policies and Procedures

Division of Investment Management Director Paul Roye offered advice to mutual funds in implementing the new compliance policies and procedures rule which took effect October 5. Pay attention to the details of the policies and procedures so that you do not make a promise to investors that you fail to keep, he advised. Test the policies and procedures to ensure that they are working, he said, and do not allow exceptions that compromise their effectiveness. Roye said the inspections staff will ask about any exceptions that are allowed under a fund's policies and procedures. The text of Roye's remarks at the October 28 ALI-ABA course of study were made available on the SEC's Web site.

Roye also addressed the new ban on directed brokerage for the distribution of a fund's shares. The compliance date is December 13. Roye made clear that the new ban is not intended to compromise best execution, but funds that execute trades through selling brokers must have policies and procedures in place to ensure that the selections are based on the quality of the execution rather than the selling of fund shares. The reliance on a claim of best execution is not enough, Roye advised. He urged firms to monitor for brokerage patterns that may suggest that brokerage is being sent for reasons other than best execution.

New disclosure about a fund's policies and procedures for frequent purchases and redemptions of a fund's shares must be included in any registration statements or amendments filed on or after December 5. Roye urged funds to make sure that the disclosure provides an appropriate level of specificity so that it is meaningful to investors. If a fund does not restrict market timing uniformly, he added, it must disclose those circumstances in its prospectus, including whether restrictions will be imposed on trades placed through omnibus accounts.

Funds may reject a purchase or exchange request for any reason, Roye said, but the possibility must be disclosed in the fund's prospectus. He also emphasized that funds do not have to disclose their policies and procedures for detecting persons who may be violating the frequent purchase and redemption procedures. The SEC does not wish to provide a roadmap for market timers, he explained. This position represents a change from the proposal which the SEC made in response to commenters' concerns. Roye noted that the examination staff will ask about such practices, however, as well as how they are employed and who is responsible for them.

The SEC is examining the various approaches submitted as alternatives to its proposed "hard 4:00 close" for all fund orders. While the proposal would have provided a secure pricing system largely immune to manipulation by late traders, Roye said commenters raised concerns about the proposal's impact on west coast investors, intermediaries and 401(k) plans. The SEC may adopt a combination of the alternative approaches, Roye said, including procedural controls, independent audits and tamper-proof time-stamping systems.

Roye also discussed the status of the SEC's proposed 2% redemption fee rule which would allow funds to recover the administrative costs of rapid trading and help to deter abusive market timing. Many commenters oppose the proposal, he said. They believe that boards are in the best position to determine whether a redemption fee is appropriate for their funds and investors. Staff reviews have found that a redemption fee can deter market timing, Roye said, but the proposal was not meant to be a complete solution. Fair value pricing would also reduce the profit that market timers seek, Roye said, and the SEC likely will issue interpretive guidance to assist funds with their fair valuation obligations in connection with any final action on the rule.

The SEC in August reproposed a broker-dealer rule that addresses whether the Investment Advisers Act applies to full-service brokers that charge an asset-based fee rather than traditional commissions, mark-ups or mark-downs. Roye said the SEC intends to make a final decision on the proposal by year-end. The staff is continuing to evaluate the comments on the SEC's portfolio costs concept release to determine whether to recommend further action. Roye said a top priority for the SEC and the staff is to work with the industry to ensure that the new rules are implemented effectively.