Operation Mutual Fund

As the mutual-fund scandal widens, the Securities and Exchange Commission recently held an open meeting to offer up a line of defense to combat trading abuses. Although practices such as late trading and market timing may have existed in the mutual-fund industry for many years, Laura Unger, a former SEC commissioner, explains that the combination of corporate scandal and lower-than-usual market returns have increased public examination of the investment vehicles.

"This has highlighted the cracks in the foundation more than ever before. It's trickled down to being an item of interest for the average investor," she says. "It will change the way people invest forever, in terms of really scrutinizing who their broker is, where they have their funds and what they invest in."

The SEC meeting resulted in recommendations such as a "hard cutoff" of 4 p.m. EST for buy or sell orders to be received by a mutual fund's transfer agent or a registered securities-clearing agency.

The earlier deadline will have a multitude of technological ramifications for the industry.

Kevin McGovern, vice president of transfer-agency operations for Rockville, Md.-based Rydex Funds, says that he expects increased scrutiny on time stamps to ensure that trades do not arrive late. However, he adds that most transfer agencies already focus much attention on guaranteeing the accuracy of their time stamps.

While the deadline might not impact processing of mutual funds at the transfer agent because its batch processing typically occurs overnight, other legs of the workflow may be more affected. For example, third-party intermediaries might see increased back-office processing pressures to ensure that their orders arrive at the appropriate destination on time.

Rick Nummi, chief compliance officer at the Tampa, Fla.-based broker/dealer GunnAllen Financial, says that he has already established a 3:30 p.m. deadline for the firm to receive mutual-fund orders. "I've built myself a 30-minute leeway," he explains, during which time the firm can process an order entry and transmit it to its clearing firm, for example.

Nummi also stresses that broker/dealers must begin to alert their customers, no matter how large they may be, that an order submitted past that deadline will not be executed that day.

While the 4 p.m. deadline has many in the industry up in arms, Nummi points out that this has always been the deadline. "[The SEC] relies upon broker/dealers to be self-policing, but when the self-policers stop policing, you have a really big problem," he says.

He continues, noting that the proposed 4 p.m. cutoff would be a positive change for those intermediaries that weren't engaging in late trading. "The folks that were adhering to the letter of the law were placed at a disadvantage. A client would approach us and say, 'Why aren't your returns as good as Putnam's?' and might go to a different broker/dealer that was participating in late trading or market timing," Nummi says.

SEC commissioner Paul Atkins echoes the sentiments of others by suggesting the use of atomic time stamps, such as those used when the SEC issued a requirement for an Order Audit Trail System (OATS) to track Nasdaq trades in the 90s. An atomic time stamp is a technology that could retain a master time, such as synchronization with the National Institute of Standards and Technology, which provides measurements and standards for the official U.S. time.

Time-stamping may fall on the shoulders of the National Securities Clearing Corporation, the SEC-registered clearing agency that processes a major volume of mutual-fund orders between intermediaries and funds.

The NSCC is working with many of its intermediary and mutual-fund clients, including Edward Jones and Fidelity Investments, to provide a technological solution for the industry. According to an NSCC spokesman, the clearing corporation is exploring ways to enhance its transaction data with a time-stamp solution that would verify when and from whom orders were received. However, the spokesman says the NSCC will not issue details on how the solution would work or when it would be introduced until mutual-fund regulations are finalized.

At the meeting the SEC also proposed enhanced disclosure on market-timing policies and fair-valuation procedures. Market timing, a strategy by which investors profit on short-term investing while the market moves up and pull out as it moves down, has also been widespread. While not illegal, most mutual funds frown upon the tactic, as it adds operational costs and skews cash positions, creating decreased returns for long-term investors.

Mutual funds could leverage technology such as fair-valuation models to assign prices for post-market-close movements, as well as surveillance systems to monitor how often shareholders move in and out of mutual funds.

However, Atkins warns that those fair-valuation procedures and policies must be foolproof. He recalls the recent case of Bedford, Mass.-based FT Interactive Data, which allegedly allowed a mutual-fund firm, Heartland Advisors, to influence its decisions in valuing bonds. While FT Interactive didn't admit or deny the allegations, Atkins notes that "things are open to manipulation if you don't watch out on the fair-value side."

Finally, the SEC will require every mutual fund to implement compliance policies and procedures that will be reviewed annually. These procedures will be overseen by a designated chief compliance officer, who will report to the fund's board of directors. Mutual funds have nine months to appoint the compliance officer. Joanna Haigney, vice president of compliance for Rydex Funds, explains that recent industry regulatory requirements have increased the interaction between the compliance officer and the technology department.

"In the past, my need [for technology] was pretty diminished, but there is definitely increased involvement," she says. "Now firms are identifying where they have gaps and holes and how they want to fill them through technology."

Yet, even Atkins worries about overregulation of the mutual-fund industry. He says, "My fear is that in order to answer today's crisis, we come up with the seeds of tomorrow's scandals."