(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Roye Details Planned Rules on Late Trading, Market Timing

Quoting Napoleon, Paul F. Roye, director of the SEC's Division of Investment Management, stated that the "art of policing is, in order to punish less often, to punish more severely." Mr. Roye vowed severe punishment if the alleged violative mutual fund conduct the Commission is examining is proved true.

On the regulatory front, Chairman William Donaldson has given the SEC staff a late November deadline to complete rule proposals to curb late trading and market timing abuses. In remarks at a seminar on mutual fund regulation, Mr. Roye outlined in significant detail the shape that those proposals are likely to take and pledged to eliminate the potential for late trading through intermediaries that sell fund shares.

On a broad policy level, noted the director, the agenda outlined by Chairman Donaldson to confront late trading and market timing abuses will have the effect of strengthening the regulatory regime to help restore investor confidence in the fairness of mutual fund operations and practices, as well as the practices of intermediaries selling fund shares. Most important, he noted, is that the issues being examined primarily flow from intermediaries who are in the chain of distribution for selling fund shares.

Late trading enables traders to profit from market events that occur after 4:00 p.m. but that are not reflected in that day's price. Late traders obtain an opportunity for a virtually risk-free profit when they learn of market moving information and purchase fund shares at prices set before the market moving information was released. In a process known as forward pricing, SEC rules prohibit late trading by requiring funds and their principal underwriters and dealers to assign the next computed net asset value to any order to purchase or redeem the fund's shares.

Based on recent allegations of late trading and circumvention of the forward pricing rule by some intermediaries, Chairman Donaldson requested rulemaking recommendations to prevent late trading abuses. The staff is considering comprehensive proposals to eliminate or significantly minimize the potential for late trading abuses and assure fund investors that the value of their investments will not be diluted.

More specifically, the staff is examining the feasibility of requiring that the fund, rather than intermediaries such as brokers, must receive a purchase or redemption order prior to the time the fund prices its shares in order for an investor to receive that day's price. For most funds, this would mean that the order would have to be received by approximately 4:00 p.m. eastern time, for the investor to receive that day's price. The director believes that this amendment would effectively eliminate the potential for late trading through intermediaries that sell fund shares and place control of the process squarely on the fund.

Recent events have also exposed abuses related to market timing, including the alleged overriding of stated market timing policies by fund executives to benefit large investors at the expense of small investors, or to benefit the fund's adviser. Although market timing itself is not illegal, the director cautioned mutual fund advisers to treat fund shareholders fairly by not favoring market timers over long term investors. Moreover, when a fund states in its prospectus that it will curb market timing, he emphasized, it cannot knowingly permit such activities.

Chairman Donaldson has requested a proposal mandating explicit disclosure of a fund's market timing policies and procedures in its offering documents. This would enable investors to assess a fund's market timing practices and determine if they are in line with their expectations, as well as allow flexibility to adopt policies and procedures best suited to the fund's investments and the needs of its investors. For example, observed the director, some funds welcome market timers, while others, such as money market funds, cannot be timed. These funds would not be required to adopt policies to prevent market timing, assured the director, but instead would be required to disclose their open policy with respect to these practices, if relevant.

The rule proposals will also require funds to have procedures to comply with their representations regarding market timing policies and procedures. Thus, explained the director, funds disclosing that they discourage market timing would be required to have procedures outlining the practices they follow to keep market timers out of the fund. In addition to the fact that investors deserve this level of follow-up, observed Mr. Roye, the establishment of formal procedures would assist SEC staff in reviewing if the procedures are being followed and whether the fund is living up to its representations.