(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.)

SEC Officials Outline Two-Pronged Mutual Fund Reform Initiative

SEC senior officials announced a coordinated regulatory and enforcement initiative to reform mutual fund practices against the backdrop of a broader legislative effort that appears to be reinvigorated by recent events. Testifying before the Senate subcommittee on financial management, Enforcement Director Stephen M. Cutler promised many more enforcement actions to police what he called the " unholy trinity" of illegal late trading, abusive market timing, and related self-dealing practices. Paul F. Roye, director of Investment Management, said that at the request of Chairman William Donaldson the staff would submit rule proposals this month designed to combat market timing and late trading abuses. At the same hearings, New York Attorney General Eliot L. Spitzer presented a blueprint for reform with the independence of fund boards as its centerpiece.

Mr. Roye said that the staff is examining the feasibility of requiring that a fund or one of its agents, rather than an intermediary such as a broker-dealer, receive a purchase or redemption order prior to the time the fund prices its shares, typically 4:00 p.m., for an investor to receive that day's price. In his view, this hard 4:00 p.m. cut-off would effectively eliminate the potential for late trading through intermediaries that sell fund shares.

With respect to market timing, the proposals would require explicit disclosure in fund offering documents of market timing policies and procedures. It is believed that this disclosure would enable investors to assess a fund's market timing practices and determine if they are in line with their expectations. The rule proposals would have a further component of requiring funds to have procedures to comply with their representations regarding market timing policies.

Thus, if a fund's disclosure documents stated that it discouraged market timing, the fund would be required to have procedures outlining the practices it follows to keep market timers out of the fund. The establishment of formal procedures, emphasized the director, would also enable SEC staff to examine whether those procedures are being followed and whether the fund is living up to its representations regarding curbing market timing activity. The SEC will also stress the obligation of funds to fair value their securities so as to avoid stale pricing to minimize market timing arbitrage opportunities as an important measure to combat market timing activity.

Mr. Cutler declared that enforcement staff, in addition to market timing and late trading, are also focusing on fund sales practices, fee disclosures, and breakpoints. In particular, the staff will examine what prospective investors are told about revenue sharing arrangements and other incentives doled out by fund management companies and the funds themselves to brokerage firms who agree to feature their funds.

The inquiry will focus on whether there is adequate disclosure of the source and nature of such payments and the fact that they may increase costs to investors as well as create conflicts of interest. Breakpoints are essentially volume discounts available to investors who make large purchases of mutual fund shares. The SEC has found numerous instances in which it appears that brokerage firms did investors the discounts to which they were entitled. The Commission, together with the NASD, is issuing notices to a significant number of brokerage firms for their failure in this regard.

In his testimony, Attorney General Spitzer urged that funds be required to have an independent board chairman with no relationship to the advisory and management company. As a corollary, the board chairman should be authorized to receive any and all information from the fund advisory and management company.

Rep. Richard H. Baker, chairman of the House capital markets subcommittee, told the Senate that he would insert a provision in his mutual fund reform bill mandating the independence of all mutual fund board chairmen. The bill, H.R.2420, has been favorably reported by the full Financial Services Committee and is awaiting floor action.

Mr. Spitzer also wants funds to provide their directors with the staff and data necessary to ensure that shareholder interests are being protected, which may require moving the compliance function from the management companies to the funds themselves. Importantly, the attorney general would require funds to provide a complete and categorized disclosure of the fees that they pay for advisory services, management and marketing services, and trading costs. Similarly, funds would also have to show that they have negotiated advisory and management fees that are in the best interest of their shareholders. In his opinion, this can be done by obtaining multiple bids, by an independent evaluation , by appraisal, or by some other means ensuring that shareholders are getting the best deal possible.