United States: Fund Investors Face Prospect of Mandatory Redemption Fees

On February 25,2004,the Securities and Exchange Commission ("SEC ")voted to issue a rule proposal that would require most mutual funds to adopt redemption fees on short-term trades.¹Proposed Rule 22c-2 is intended to serve as one of various measures designed to address abusive market timing activities in fund shares, which have roiled the fund industry in the last several months.

The redemption fee proposal would require mutual funds to impose a 2 percent fee on the redemption proceeds of shares redeemed within 5 days of their purchase. The fee would be mandatory; It would apply to redemptions in all fund shares, including shares held by a financial intermediary in omnibus accounts, unless one of four exceptions applies. In addition, the fee would be uniform –i.e., a fund could not impose a higher or lower fee than the 2%figure,so that implementation of the proposed rule would be simple and financial intermediaries holding shares in omnibus accounts would be better able to establish and maintain systems to collect redemption fees. As proposed, however, a fund would not be precluded from instituting a holding period longer than 5 days. The SEC explained that funds that are particularly susceptible to abusive market timing activities may want to have the flexibility to impose longer holding periods.

Under proposed Rule 22c-2,a fund would retain the proceeds generated from the mandatory redemption fees. This provision would be consistent with a general purpose of the rule to require short-term shareholders to reimburse the fund for the direct and indirect costs that the fund pays to redeem these investors ’shares. In order to minimize the effect of the redemption fee on smaller investors, funds would have to calculate the holding period for the redemption fee on a "first in, first out "basis. In other words, the first shares sold would be those held for the longest time period.

As proposed, Rule 22c-2 would contain four exceptions to the mandatory redemption fee requirement. First, the rule would not apply to money market funds since, according to the SEC, these funds are designed to accommodate frequent purchases and redemptions and do not appear to be susceptible to the harms caused by excessive trading. Second, Rule 22c-2 would not apply to exchange-traded funds since these funds redeem shares in large blocks known as creation units, and the redemptions of these units serve to correct the price of individual shares of the ETFs on the secondary market generally without posing risks of harm to the funds. Third, Rule 22c-2 would not apply to mutual funds that have adopted a fundamental policy to affirmatively permit short- term trading in their shares, and have disclosed this policy in their prospectuses, including that such trading will likely impose costs on the funds.

Finally, Rule 22c-2 would include a de minimis exception, which would permit a fund to effect redemptions of $2,500 or less without imposing the redemption fee, and would provide for fee waivers in the case of financial emergencies. As proposed, therefore, an investor could redeem shares without paying a redemption fee if the fee would be $50 or less. For unanticipated financial emergencies, an investor could make a written request for a fee waiver, which the fund would be required to grant for redemptions of $10,000 or less, but permitted to grant in its discretion for redemptions greater than $10,000.

Many funds that impose redemption fees have determined that they are not able to impose the fees on certain shareholders who hold their shares in omnibus accounts. An omnibus account is a bundle of individual accounts held in the name of a financial intermediary (such as a broker-dealer, bank, insurance company, or retirement plan administrator).Typically, it has been difficult for funds to obtain information regarding transactions in the accounts underlying an omnibus account. The proposed rule would require that, on a weekly basis, a financial intermediary provide information to the funds regarding the taxpayer identification number for the underlying account holders, and the amount and dates of all purchases, redemptions, or exchanges for each underlying account holder during the previous week.

Rule 22c-2 would allow a fund and financial intermediaries that maintain omnibus accounts with the fund to choose one of three methods of assuring that the appropriate redemption fees are assessed.

Under the first method, the fund intermediary would be required to transmit to the fund (or the fund ’s transfer agent)at the time of the transaction the account number the intermediary uses to identify the transaction. The fund would then assess the redemption fee, as applicable. 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 the pertinent information so that the fund could assess the redemption fee, as applicable. Under the third method, the fund and the intermediary would enter into an agreement that would require the intermediary to impose the redemption fee, as applicable, and remit the proceeds to the fund.

Redemption fees on short-term transactions may significantly reduce or eliminate the gains obtained by market timers. Some industry observers and others, however, have sharply criticized the fees as overbroad. In particular, it has been noted that the fee may penalize individual investors for responding to significant market events or reallocating their investments. The mere presence of redemption fees may result in a decrease in short-term shareholder redemptions, even in circumstances where such fees do not apply. The rule would also affect the way intermediaries and funds share information about the identities and transactions in the underlying accounts of an omnibus account.

The SEC has given interested persons until May 10,2004 to comment on the rule proposal. It is uncertain whether the rule will be adopted in its current form. Commissioner statements at the SEC open meeting indicate that the SEC may be particularly receptive to industry and shareholder comments² ,and the SEC has raised several questions soliciting comments on various aspects of the rule proposal.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.