American Council of Life InsurersFebruary 8, 2004 Jonathan G. Katz, Secretary
Submission by E-mail RE: Amendments to Rules Governing Mutual Fund Pricing; Release No.IC-26288; File No. S7-27-03. Dear Mr. Katz: The American Council of Life Insurers is a national trade association with 368 members representing 71 percent of all United States life insurance company assets. Many of our members manufacture variable contracts that are distributed directly or through broker-dealers and other intermediaries. Life insurers also manage one-fifth of America's privately administered pension and retirement plan assets, many of which are funded by variable annuity contracts totaling $918 billion. Our members and their affiliates provide both plan and participant recordkeeping services, as well as a broad range of funding options to retirement plans and their participants.1 As significant participants in the securities marketplace, life insurers have a direct interest in effective solutions to late trading in the mutual fund industry. Life insurers also have concerns about the impact of the proposed amendments upon insurance products used to fund retirement programs specifically and upon retirement programs generally. Our members have carefully evaluated the SEC's late trading initiative, and have developed suggestions to make the proposal more fully and equitably useful. We greatly appreciate the opportunity to add our views to the important dialog on these matters before the SEC. Overview of the Proposal The proposed amendments to Rule 22c-1 under the Investment Company Act of 1940 would require that orders to purchase or redeem investment company shares obtain the current day's price only if the investment company, its designated transfer agent, or a registered securities clearing agency receives the order by the deadline for calculating the investment company's net asset value. For most investment companies, the cutoff is 4:00 p.m. Eastern Time, and has been referenced as the "hard 4:00 close." Orders arriving after the cutoff time will receive the next day's price. The SEC designed the amendments to ensure that outstanding investment company shares are not diluted through the sale of shares below the net asset value, or the redemption of shares above the net asset value. Importantly, the proposed amendments would leave unchanged current operations of registered variable contract separate accounts concerning transactions in underlying mutual fund shares. As such, purchase, redemption, and reallocation instructions received by 4:00 p.m. at the life insurance company will obtain that day's net asset value. Under the proposed amendments, orders processed by "other" intermediaries up until the 4:00 "hard" close would obtain the next day's net asset value, because the orders will not arrive at the investment company or its transfer agent by the "hard close." The amendments seek to prevent unlawful late trading in investment company shares. Summary of Position
Further, we believe it appropriate to add a fourth condition to the three suggested in the SEC's release. Other intermediaries should also submit to SEC oversight of their order handling procedures, in order to accept purchase, redemption and reallocation instructions until the "hard" 4:00 close.
Evaluation of the Proposed Amendments We support the general thrust of the proposed amendments. The enhancements will strengthen protections against illegal late trading. We strongly support the SEC's determination to include registered variable contract separate accounts within the scope of the proposed amendments, allowing life insurers to accept purchase, redemption and reallocation instructions until the "hard" 4:00 p.m. close. This sensible approach will permit variable contract purchasers to formulate decisions on a basis equal to mutual fund shareholders, in light of the full day's market news. We are greatly concerned, however, that the proposed amendments may facilitate competitive imbalances between mutual funds and life insurers offering variable annuities in the pension market. Imposing different transactional deadlines on competing financial products will inevitably lead to unfair disparities in the market. Likewise, we have great concern that pension plan participants may be injured under the proposed amendments because they would be unable to formulate purchase, redemption and reallocation decisions based on the full day's market developments. These two concerns can be addressed through a variety of approaches. For example, the conditions discussed in the release for "other" intermediaries coupled with voluntary submission to SEC authority provides a constructive solution treating pension plan participants equitably with mutual fund shareholders, and preserves balanced competition among manufacturers of mutual funds and variable annuities. Mutual funds conducting business through these intermediaries can incorporate terms and conditions into their business agreements to ensure compliance with such conditions and incorporate a right of inspection and review. Failure to meet these requirements could be grounds for termination of the distribution agreement. In another example, some observers have discussed a clearinghouse, such as the National Securities Clearing Corporation (NSCC), as a viable alternative to process orders nearer to the "hard" 4:00 close. This provides a solution for some marketplace participants, particularly those currently using the clearinghouse. For other participants, however, the clearinghouse approach may be infeasible due to systems configuration and transactional flows. Accordingly, the SEC's amendments should allow several solutions to the problems of late trading issues, rather than a single solution. All solutions, however, such as conditions on "other" intermediaries or clearinghouse approaches, should successfully thwart late trading abuses. In this way, competition will be preserved and fraud will be terminated. This approach comports with the intent of H.R. 2420 and S. 1970. The Operation of Two-tier Financial Products Life insurers manufacture variable annuities and variable life insurance for distribution to individuals, and groups such as pension plans. These variable contracts are hybrid products with important insurance and securities characteristics. The SEC regulates the issuance and sale of individual variable contracts under the federal securities laws. The Department of Labor and the Department of Treasury, through the Internal Revenue Service, promulgate rules and regulations governing employee retirement programs and, consequently, to the products used to fund such programs. State insurance departments also regulate the insurance features of variable contracts. Like mutual funds, life insurers' variable contracts and separate accounts are registered, respectively, under the Securities Act of 1933 and the Investment Company Act of 1940 because the account values fluctuate according to the investment experience of an underlying securities portfolio. The structure, operation, and distribution of variable life insurance and variable annuities are, however, different from publicly available mutual funds. For example, variable contracts funded by life insurers generally operate under a two-tier structure. At the top tier, the separate account funds the variable contract based on an underlying menu of mutual funds at the bottom tier. Purchases, sales, and changes are transmitted from customers to the life insurance company, which in turn communicates the appropriate instructions to the underlying mutual funds. The life company processes customer orders directly and through intermediaries. Variable contract customers, therefore, do not have direct contact with the underlying mutual funds. In pension plans, participants transmit allocation and other transaction instructions to a record-keeper, often a life insurance company, which reconciles and aggregates transactions, ensuring that all plan rules and applicable regulations are satisfied, before conveying the trading information to the mutual funds. When a variable annuity contract is held by a plan, transaction information is also conveyed to the mutual fund underlying the variable annuity investment options. It is important that any late trading solutions give pension plan participants the same amount of time to make informed decisions as mutual fund investors, in spite of structural differences between the two financial products. Holding variable contract owners or 401(k) plan participants to different decisional trigger points from mutual fund investors would be an unfair response to systemic abuses that originated in the mutual fund industry. It is critical that pension plan record-keepers be able to ensure that transactional activity also satisfies applicable plan rules and regulations. Under current law, record-keepers achieve this by first subjecting the day's transactional activity to a litany of filters and edits. Closing NAVs are calculated and then entered into the recordkeeping system. Account balances are then adjusted for the day's transactions producing `net' trades that are placed with the applicable mutual funds. Any modifications to the intricacies of these processes would seriously impair the record-keeper's ability to satisfy various regulatory requirements. For example, a participant may take a retirement account loan up to a maximum amount set by law. Unless the record-keeper can establish the value of the participant's account on the same day the loan proceeds are taken, however, a dilemma is created. Either the participant cannot obtain a loan in the maximum amount allowed or the plan loan may exceed the maximum loan limit. Similarly, with regard to meeting minimum distribution requirements, a participant may be faced with not receiving the correct amount and being subject to excise taxes. In responding to the abuses associated with late trading, we urge the SEC to carefully consider the impact upon retirement plans. Technological solutions requiring significant programming modifications and alternation of recordkeeping processes will result in substantial costs and will create administrative burdens. Additional costs may be passed along to plan sponsors and, ultimately, to plan participants. The amendments should be designed to minimize these consequences. Likewise, different customer trading cutoffs would give mutual funds an unequal marketplace advantage over competing financial products. Different trading cutoffs for different investment options in the same retirement plan would also create significant confusion. The mechanics of the proposed amendments could cause potential delays in processing various transactions, such as rebalancing of a participant's retirement plan account or exchanges involving more than two investment options. These burdens should be carefully evaluated in the rulemaking. Bundled providers of proprietary mutual funds would gain an advantage over open-architecture arrangements in retirement plans, because participants could directly trade proprietary funds up to 4:00, but could face an earlier cutoff in nonproprietary funds. Unlike open-architecture arrangements, proprietary fund arrangements would not incur costs associated with refining and developing systems fulfilling the proposed amendments. Ultimately, these competitive differences could unnecessarily impair participants. Unlike mutual funds, variable annuities are strictly enforceable contracts between insurers and contract owners that are subject to state insurance regulation. Variable annuities, therefore, have similarities with, and differences from, publicly available mutual funds. Actions addressing mutual fund abuses should be carefully designed with those differences in mind. The mutual fund industry should not be able to obtain leverage over competitors through after-hours trading remedies. Strict Conditions on Processing Orders are Appropriate The release invites comment on a series of three conditions allowing entities outside the SEC's jurisdiction to process orders up until the "hard" 4:00 close. We strongly support this alternative approach because it would successfully thwart late trading abuses, while also protecting a viable, competitive marketplace. The three conditions presented in the release will successfully thwart late trading in mutual fund shares. Electronic or physical time stamping of orders in a manner that cannot be altered or discarded once the order is entered in the trading system is a meaningful enhancement that responds directly to abuse evidenced in the mutual fund industry. Annual certification that the intermediary has policies and procedures in place to prevent late trades, and that no late trades were submitted to the investment company or its designated transfer agent during the period, will provide an ongoing means to reinforce and verify effective compliance. Annual independent public accountant audits of the intermediary's controls, with a report to the investment company's chief compliance officer, will provide a coordinated enhancement against late trading. These three conditions are sufficient and will substantially, if not completely, eliminate late trading. Mutual fund companies doing business with insurance company separate accounts and with other intermediaries should be encouraged to incorporate these standards into business contracts. Should the SEC believe it to be appropriate, the three conditions could be buttressed with consent to SEC jurisdiction for those intermediaries not already subject to SEC jurisdiction over timely order processing and controls. Precedent exists for this approach to jurisdiction, as discussed below. SEC oversight will bolster compliance and protect the public. This conditional approach will allow non-registered separate accounts to receive orders from plan participants until the 4 p.m. close, and to place the resulting net transactions with the underlying mutual funds later, following processes and procedures similar to those currently in place. The alternative approach will also require, however, additional controls and certifications. Significantly, the alternative conditional approach would prevent next-day pricing of purchase, redemption, and reallocation on orders received from pension plan participants. Our recommendation to further require submission to SEC jurisdiction over order processing provides an important added protection against illegal late trading. Recommended revisions to the proposed amendments to Rule 22c-1 appear in an appendix following this letter that incorporate the strict conditions for "other" intermediaries to process orders up until the "hard" 4:00 close. As mentioned above, another alternatives could simply include non-registered separate accounts in the definition of "insurance company separate account." In this case we recommend that the non-registered separate accounts certify that the policies and procedures for processing orders are the same as those used with the insurer's registered separate accounts. Precedent for SEC Jurisdiction
In an analogous context, selected aspects of the Investment Company Act apply to private investment companies outside the scope of the Act. This provides parallel precedent for allowing entities to submit to SEC jurisdiction over procedures in handling purchase, redemption, and reallocation instructions up until the "hard" 4:00 p.m. close. Sections 3(c)(1) and 3(c)(7) of the Investment Company Act exclude two types of entities from the definition of investment company and, therefore, the Investment Company Act. Section 3(c)(1) excludes any investment company that has 100 or fewer shareholders of its outstanding voting securities, and that makes no public offering of its securities. Section 3(c)(7) excludes any investment company offering its securities on a non-public basis to an unlimited number of "qualified purchasers." Sections 3(c)(1) and 3(c)(7) of the Investment Company Act further provide, however, that these private investment companies excluded from the 1940 Act "shall be deemed to be an investment company for purposes of ownership limitations" in Section 12(d)(1) governing "fund of funds" structures. Congress added this selective application of 1940 Act provisions to entities outside the scope of the statute in 1970, and reconfirmed it in 1996. In context and substance, therefore, a directly parallel practice has existed since 1970 allowing selected application of 1940 Act provisions to entities outside the statute's scope. The same approach could readily be applied to "other intermediaries," such as variable contract separate accounts funding pension plans, that wish to process purchase, redemption, and reallocation instructions up until the "hard close" at 4:00 p.m. Voluntary submission to SEC oversight, together with the three conditions discussed in the release, constructively bars late trading abuses, while also giving pension plan participants the ability to make informed decisions on a basis equal to mutual fund shareholders. This approach also eliminates significant unwarranted regulatory disparities among financial product manufacturers competing with mutual funds. As such, consumers will not face artificial differentiations leading to a less competitive and less healthy marketplace. Balanced Marketplace Competition is Critical In 1974, Congress amended the Securities Exchange Act by adding Section 23(a), which requires the SEC to consider the anti-competitive effects of rule changes, and to balance any impact against the regulatory benefit to be obtained.2 In a different context, former SEC Chairman Levitt emphasized the importance of reviewing the impact of rulemaking on competition when he stated:
Solutions to mutual fund late trading abuses should fulfill these important SEC and statutory goals to protect both competition and investors. The SEC should develop corrective rule modifications carefully to prevent any anticompetitive impact. This can be readily accomplished with the conditions posed for "other intermediaries" in the release, and would provide a constructive solution that operates fairly across all product platforms. Impairment of Pension Plan Participants Unwarranted and Avoidable The release suggests that purchase and redemption orders processed through other intermediaries would not suffer significant disadvantages. We strongly disagree with this proposition. The cumulative impact of delayed, next-day pricing on plan participants' values can be profound and corrosive. We disagree with several premises expressed in the proposal. The release indicates that the burden of the proposed hard close will be small because most investors are not sensitive to the time at which their purchase or redemption orders are priced. Further, the release indicated that pension participants make long-term investments and treat the time and date of the purchase order as a random event controlled by their employer's payroll processing protocols, or the delivery of the mail. Pricing for pension participants is not a random, one dimensional issue as portrayed in the release. In making decisions, particularly for reallocation of account balances, participants should have the same ability to make informed decisions in reliance on the full day's market news, as do mutual fund shareholders. This element exists irrespective of the long-term nature of pension plans. Pension plan participants should not be punished by solutions to late trading abuses concentrated in the mutual fund industry. Consistently waiting an extra day to place participants' contributions into retirement allocations keeps participants out of the market on a recurrent basis. Procrastinated placement of contributions into the market is significant and unwarranted. For example, a regular one day pricing delay could keep participants' contributions out of the market for 240 days, assuming a ten year period of participation with bimonthly transmission to account values, such as in payroll-related timing. Keeping participants regularly out of the market is contrary to sound public policy, and contradicts the objectives of retirement planning. These negative factors can be effectively obviated if the proposal is modified to allow non-registered separate accounts to follow the same trading controls as the registered separate accounts to process orders up until 4 p.m. Alternatively, these negative factors can be avoided if entities otherwise outside the SEC's jurisdiction are permitted to process orders up until 4 p.m. provided that they satisfy the conditions presented in the release. As indicated above, ACLI members believe it reasonable that such entities also consent to SEC jurisdiction with regard to controls put in place to thwart late trades. In the absence of one of these alternative approaches, the proposed rule will also impose a competitive bias against variable contract as funding vehicles for retirement assets. In that event, participants and administrators will be left with fewer competitive choices, and may face higher program costs and expenses. The initiative provides a balanced solution to mutual fund late trading abuses. Significantly, the amendment would not impose unfair burdens on individuals in pension plans or variable annuities. All investors in mutual funds would be treated equally and fairly irrespective of the financial product involved. Likewise, the amendment would not create an unwarranted competitive advantage for mutual funds over other financial products such as variable annuities or retirement plans. This solution avoids punishing other financial service institutions for problems that principally originated in the mutual fund industry. Conclusion As a significant participant in the securities marketplace, the life insurance industry supports responsible remedies to mutual fund late trading abuses. We strongly endorse the SEC's determination to include registered insurance company separate accounts within the scope of the amended rule for processing orders up until the hard close. Other revisions are necessary and appropriate, however, to provide a balanced solution across all product platforms and to treat pension plans fairly. The proposal will prevent abuse, protect investors, and preserve fair competition if it is further modified to allow entities outside the SEC's jurisdiction to process orders up until the hard close under the strict conditions outlined in the release, together with SEC oversight. It may be constructive for the SEC to coordinate with the Department of Labor and Treasury and develop model language prohibiting late trading for incorporation into plan agreements with recordkeeping service vendors. Thank you for your courteous attention to our views. Please contact us if you have any questions or need additional information. Sincerely, Carl B. Wilkerson Appendix A: recommended revisions to proposed amendments § 270.22c-1 Pricing of redeemable securities for distribution, redemption and repurchase. (a) Forward pricing required. It is unlawful for any registered investment company issuing redeemable securities ("fund"), its principal underwriter, and any dealer to sell, redeem, or repurchase a redeemable security issued by the fund at a price other than the price based on the current net asset value established as of the next pricing time after the fund, its designated transfer agent, or a registered clearing agency receives an order to purchase or redeem the security. (1) Time. The fund's board of directors must initially set the time or times during the day as of which the current net asset value of the fund's redeemable securities must be calculated, and may make and approve any changes the board deems necessary. (2) Frequency. The fund must calculate the current net asset value of any redeemable security at least once daily, Monday through Friday, at the specific time or times during the day that the fund's board of directors sets, except on: (i) Days on which changes in the value of the fund's portfolio securities will not materially affect the current net asset value of the fund's redeemable securities; (ii) Days during which the fund, its designated transfer agent, and registered clearing agency receives no order to purchase or redeem the fund's redeemable securities; or (iii) Customary national business holidays described or listed in the prospectus and local and regional business holidays listed in the prospectus. (3) Notwithstanding the foregoing, if an order to sell, redeem, or repurchase a redeemable security issued by a fund is transmitted to and received by any person of a type designated in the fund's prospectus as authorized to consummate transactions in any such security, including the fund's designated transfer agent or a registered clearing agency (each an "authorized person"), prior to the pricing time, then such security may be sold, redeemed, or repurchased at a price based on the net asset value of such security computed as of the pricing time after receipt by the authorized person; provided, that both (X) the authorized person and (Y) the entity transmitting the order to the fund or authorized person ("transmitting entity") have established and maintained (or have entered into arrangement with third parties that establish and maintain on their behalf) policies and procedures sufficient to establish that the order was originally placed with the transmitting entity prior to the pricing time ("order transmittal policies"). Order transmittal policies must include:
(i). the establishment of an electronic audit trail system for fund orders documenting all material steps in the handling of the order, which shall include electronic [or physical] time-stamping of orders in a manner that cannot be altered or discarded once the order is entered into the trading system;4
(ii) daily control and testing standards reasonably designed and maintained to prevent or detect orders submitted in violation of the order transmittal policies;
(iii) quarterly certification to the fund or its agents of the establishment and implementation of order transmittal policies and that no late trades were submitted to the fund or its designated transfer agent during the period;
(iv) annual audit review of procedures reasonably designed and maintained to prevent or detect violations of the order transmittal policies by an independent public accountant, who would submit his report to the fund's chief compliance officer;
(v) contractual arrangements that require the authorized person or transmitting entity to provide agents of the fund reasonable access to and copies of any books, records, or access to employees necessary to determine compliance with the order transmittal policies; and
(vi) if the transmitting entity is not registered with the Commission as a broker-dealer, investment adviser, or transfer agent, or is not subject to the jurisdiction of another "appropriate federal regulator" (as such term is defined in section 3(a)(33) of the Securities and Exchange Act of 1934) that has adopted rules or regulations requiring the timely transmittal of orders to sell, redeem, or repurchase redeemable securities issued by a fund in accordance with this Section, consent to Commission jurisdiction, in a form acceptable to the Commission, for inspection and examination of the books and records related to the order transmittal policies adopted in accordance with this Section and their implementation by the Commission or any member or representative thereof. (b) Exceptions permitted. Notwithstanding paragraph (a) of this section: (1) Emergencies. (i) The fund may deem an order to have been received by the fund, its designated transfer agent, a registered clearing agency, or an authorized person or transmitting entity that meets the condition of paragraph (a)(3) immediately before the applicable pricing time if: (A) An emergency prevents a transmitting entity from timely transmitting the orders to the fund or , its designated transfer agent, a registered clearing agency, or the authorized person; and the chief executive officer of the transmitting entity provides a written certification to the fund as to the nature, existence, and duration of the emergency, and that the orders were received by the transmitting entity before the applicable pricing time; or (B) An emergency prevents an authorized person from timely receiving orders, and the chief executive officer of the authorized person notifies the fund as to the nature, existence, and duration of the emergency. (ii) The fund, or its designated agent, must maintain a written record of each certification it receives under paragraph (b)(1)(i)(A) for at least six years after the end of the fiscal year in which it receives the report, the first two years in an easily accessible place. (2) Transactions through conduit funds. A fund may deem receipt of an order to have occurred immediately before the applicable pricing time if the fund, its designated transfer agent, registered clearing agency, or a transmitting entity that meets the conditions of paragraph (a)(3) receives the order from a fund that invests in the fund in reliance on section 12(d)(1)(E) of the Act (15 U.S.C. 80a-12(d)(1)(E)). (3) Secondary market transactions. A sponsor of a unit investment trust ("trust") engaged exclusively in the business of investing in eligible trust securities (as defined in § 270.14a-3(b)) may sell or repurchase trust units in a secondary market at a price based on the offering side evaluation of the eligible trust securities in the trust's portfolio, determined at any time on the last business day of each week, effective for all sales made during the following week, if on the days that such sales or repurchases are made the sponsor receives a letter from a qualified evaluator stating, in its opinion, that: (i) In the case of repurchases, the current bid price is not higher than the offering side evaluation, computed on the last business day of the previous week; and (ii) In the case of resales, the offering side evaluation, computed as of the last business day of the previous week, is not more than one-half of one percent ($5.00 on a unit representing $1,000 principal amount of eligible trust securities) greater than the current offering price. (4) Insurance company separate accounts. A registered separate account offering variable annuity contracts may apply the initial purchase payment for any such contract at a price based on the current net asset value of the contract established as of the next pricing time: (i) Not later than two business days after receipt of the order to purchase by the insurance company sponsoring the separate account ("insurer"), if the contract application and other information necessary for processing the order to purchase (collectively, "application") are complete upon receipt; or (ii) Not later than two business days after an application which is incomplete upon receipt by the insurer is made complete, provided that, if an incomplete application is not made complete within five business days after receipt: (A) The prospective purchaser is informed of the reasons for the delay; and (B) The initial purchase payment is returned immediately and in full, unless the prospective purchaser specifically consents to the insurer retaining the purchase payment until the application is made complete. (5) Mergers. Any fund may adjust the price of its redeemable securities sold pursuant to a merger, consolidation or purchase of substantially all of the assets of a company that meets the conditions specified in § 270.17a-8. (c) Definitions. For purposes of this section, (1) Designated transfer agent means the single registered transfer agent (as defined in section 3(a)(25) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(25))) that is designated, in the fund's registration statement filed with the Commission, and is required by written contract to receive order information and maintain a record of the date and time it receives the order information. (2) Initial purchase payment means the first purchase payment submitted to the insurer by, or on behalf of, a prospective purchaser. (3) Order means a direction to purchase or redeem a specific number of fund shares or an indeterminate number of fund shares of a specific value. Each order is deemed to be irrevocable as of the next pricing time after the fund, its designated transfer agent, registered clearing agency, or a transacting entity receives it. If a fund, its designated transfer agent, or registered clearing agency receives a direction to purchase redeemable securities of the fund using the proceeds of a contemporaneous order to redeem a specific number of shares of another fund (an exchange), the first fund may deem the direction to purchase its redeemable securities to be an order. (4) Pricing time means the time of day as of which the fund calculates the current net asset value pursuant to paragraph (a)(1) of this section. (5) Prospective purchaser means either an individual contract owner or an individual participant in a group contract. (6) Qualified evaluator means any evaluator that represents it is in a position to determine, on the basis of an informal evaluation of the eligible trust securities held in a unit investment trust's portfolio, whether: (i) The current bid price is higher than the offering side evaluation, computed on the last business day of the previous week; and (ii) The offering side evaluation, computed as of the last business day of the previous week, is more than one-half of one percent ($5.00 on a unit representing $1,000 principal amount of eligible trust securities) greater than the current offering price. ____________________________
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