1. Mandatory Redemption Fees:
An Objective, Logical Deterrent to Abusive Mutual Fund
Trading or a Swiftian “Modest Proposal” for Mutual Fund
Investors and the Defined Contribution Industry?
October 2004

2. UPDATE (April 20, 2005)
This paper analyzes Proposed Rule 22c-2 (Proposed Rule 22c-2) of the Investment Company Act, as proposed on February
25, 2004, by the Securities and Exchange Commission. The Rule was designed to deter abusive mutual fund trading by impos-
ing mandatory redemption fees on certain short-term mutual fund redemptions. The SEC received comments on the Rule and,
on March 3, 2005, adopted Rule 22c-2 (New Rule 22c-2), albeit in a substantially different form. This paper does not address
New Rule 22c-2, only Proposed Rule 22c-2 as promulgated on February 25, 2004. As such, this paper should not be relied
upon for guidance, advice or interpretation. It does, however, describe one point in Rule 22c-2’s evolution prior to its adop-
tion and may be helpful in understanding the context from which the New Rule arose.
Some highlights of New Rule 22c-2:
• New Rule 22c-2 requires fund boards of directors to determine whether or not their funds should levy redemption
fees. In other words, the New Rule does not require the imposition of redemption fees as they would have been
under Proposed Rule 22c-2.
• As under the Proposed Rule, the New Rule limits the size of the redemption fee to a maximum of 2% of the value
of the redemption.
• The minimum period in which a redemption would trigger redemption fees is seven calendar days under the New
Rule. Funds may choose a longer period.
• Under the New Rule, funds must now arrange with financial intermediaries to provide transaction information
(including the Taxpayer Identification Number of all shareholders who purchase, redeem, transfer or exchange
fund shares held through an intermediary account) to the fund at the fund’s request. Under the Proposed Rule, this
information would have had to been delivered to fund companies on a weekly basis.
• The New Rule also requires intermediaries to follow any instructions issues by the funds to impose restrictions
against individuals the fund believes are trading abusively.
• Money market funds, exchange-traded funds (ETF’s) and funds designed specifically for market timers are exempt
from the redemption fee requirements.
New Rule 22c-2 has an effective date of May 23, 2005 and a Compliance Date of October 16, 2006. The SEC will solicit com-
ments on the New Rule through May 9, 2005.

3. Callan Associates Inc. 1
On September 3, 2003, New York Attorney General Eliot
Spitzer launched what has become the largest investigation
into the mutual fund industry in its history. Since the filing of
his now-famous “Canary Complaint” on that date, at least
seven mutual fund companies have paid in excess of $3 bil-
lion in fines, restitution, fee reductions, and disgorgement of
profits to fund investors and state and federal regulators.
Several more large firms have not yet settled as of this writ-
ing.
At its core, the investigation focuses on the harm caused to
long-term individual mutual fund investors by other investors
engaged in frequent trading. In some instances, these abusive
traders sought to exploit inefficiencies in the pricing mecha-
nisms behind mutual funds. In other instances, the offending
traders were simply making directional bets that required sig-
nificant fund trades. Frequently, the offending trades arose
out of quid pro quo deals between the mutual fund organiza-
tions and large hedge funds or other individual investors. In
these arrangements, abusive traders were typically granted
permission to frequently trade mutual funds in contravention
to their prospectus language in exchange for some form of
consideration.
The investigations continue to expand into an increasing vari-
ety of issues affecting the asset management business and its
practices. Deeper inquiries have revealed offending trades
conducted by investment professionals, including portfolio
managers, who market timed their own funds. In other, infre-
quent, instances, the employees of the mutual fund manager
approved and/or facilitated the quid pro quo relationships
without the consent or knowledge of the funds’ boards.
Occasionally, these relationships were established and fos-
tered despite the protestations of portfolio managers, who
objected to them on the grounds that they were harming fund
performance.
Attention has now turned to what regulatory changes, if any,
should be enacted to prevent or deter these abuses in the
future. To this end, the Securities and Exchange Commission
(the SEC) has proposed a series of reforms to the Investment
Companies Act of 1940 (the ’40 Act). These rules are
designed to supplement one another and balance the compet-
ing interests protecting long term investors while preserving
the inherent liquidity of owning and trading mutual fund
shares.
Regulatory Solutions to Abusive Trading
The Canary Complaint focused on two particular types of
offensive trading: late trading and market timing. Late trad-
ing occurs when an investor is permitted to buy and/or sell
shares of a fund after the fund’s 4:00 PM Eastern Standard
Time close at that day’s closing price. Some commentators,
notably Eliot Spitzer, have analogized late trading as betting
on a horse race after it’s over. Late trading is prohibited under
existing law and is clearly illegal. It is worth noting that late
trading should not to be confused with orders received prior
to 4:00 PM by an intermediary and placed with a fund com-
pany after that time.
Market timing, on the other hand, is a blurrier issue. Market
timing is not clearly illegal. In fact, market timing can be used
as part of a legitimate, legal investment strategy, such as with
targeted maturity funds or asset allocation funds, where a
Mandatory Redemption Fees: An Objective, Logical Deterrent to
Abusive Mutual Fund Trading or a Swiftian “Modest Proposal” for Mutual
Fund Investors and the Defined Contribution Industry?
Abstract:
The ongoing investigation into mutual fund market timing and late trading has revealed a series of chronic problems affecting
the mutual fund industry. These problems, collectively described as abusive trading, have generated significant expenses for
long-term mutual fund investors. In response, the SEC has proposed a series of rules designed to eliminate, or at least deter, abu-
sive trading. One of these rules contemplates requiring fund managers to levy a mandatory 2% redemption fee on mutual fund
redemptions effected within at least five business days. In order to ensure the equitable and effective implementation of redemp-
tion fees, the proposed rule may require complicated and highly onerous reporting requirements on financial intermediaries. This
paper examines what impact the rule would have on mutual fund investors, the defined contribution industry and the extent to
which the proposed rule is likely to accomplish its goals. It concludes that the proposed rule will deter some abusive trading but
at significant cost to financial intermediaries. As written, the rule will likely be far less effective at halting abusive trading con-
ducted by more sophisticated investors and may inadvertently be applied to investors not engaged in abusive trading.
Redemption Fees

4. portfolio manager attempts to take a tactical bet on market
direction. However, market timing can take on a more malig-
nant mien, especially when the technique is used to exploit
the fact that a mutual fund’s price does not accurately reflect
its true value, such as with an international fund, where there
exists an opportunity to exploit time-zone arbitrage.
Regardless of the intent of the timer, the frequent trading that
accompanies most forms of market timing can have a sub-
stantial, negative impact on long-term investors. Estimates of
the cost of market timing on mutual fund investors have run
as high as $4 billion per year.1
This figure greatly exceeds the
estimated $400 million per year investors are believed to lose
to late traders. Frequent trading generates: increased transac-
tional expenses, short-term capital gains, significant levels of
frictional cash which can dampen returns or generate tracking
error, distract portfolio managers, require increased cash
positions, generate short term capital gains, and otherwise
dampen performance.
What is particularly noteworthy about the proposed rules is
that they seek not only to deter and/or prevent abusive trad-
ing by hedge funds and other large investors but to also dis-
courage frequent trading conducted by small investors who
trade simply because they changed their minds.2
In its com-
ments and discussions of the rationale behind its rulemaking,
the SEC has repeatedly stated that it wants to prevent the
harm caused by short-term trading, whatever the source.
Thus, the SEC has targeted investors who “frequently buy
shares and soon afterwards sell them, in reaction to market
news or because of a change of heart.3
” Moreover, the SEC
states that one of the prime motivators that drove it to draft
Proposed Rule 22c-2 is that, “The costs imposed on long-
term investors in funds by the cumulative effect of many
smaller short-term traders may be greater than those imposed
by a few large traders.4
”
Redemption Fees and Proposed Rule 22c-2
On February 25, 2004, the SEC proposed Rule 22c-2, a mod-
ification to Rule 22(c) of the ’40 Act, the rule that requires
that each redeeming shareholder receive his pro rata portion
of a fund’s net assets5
. Proposed Rule 22c-2 would require
mutual funds to levy redemption fees of 2% on exchanges
that take place within at least five business days, subject to
certain exceptions, discussed below.
The SEC closed the Comment Period—the period during
which the SEC solicited public comment on Proposed Rule
22c-2—on May 10, 2004. As of October 15, 2004, the SEC
has not yet commented on any of the proposed comments or
the rule’s status. A decision is expected by the end of 2004.6
The intent behind Proposed Rule 22c-2 is to:
“reduce or eliminate the opportunity of
short-term traders to exploit other investors
in the mutual fund by (i) requiring them to
reimburse the fund for the approximate
redemption-related costs incurred by the
fund as a result of their trades, and (ii) dis-
couraging short-term trading of mutual
fund shares by reducing the profitability of
the trades.7
”
As discussed above, Proposed Rule 22c-2 is designed to dis-
courage frequent and abusive trading; to deter large and small
investors from excessively trading a fund and driving up fund
expenses. Thus, redemption fees are designed to halt and/or
deter not only the type of illegal trading activity made famous
by Canary but also the abusive trades that are, in the aggre-
gate, believed to have an even more harmful impact on
longer-term mutual fund investors than illegal late trading.
Proposed Rule 22c-2 is designed as a supplement to Fair
Value Pricing (FVP) and other measures already required by
the ’40 Act.8
Under FVP, a security’s stale price is adjusted to
reflect a best estimate of what its current price would be if the
security were actively traded at that time, taking into consid-
eration after-market events.9
For example, the value of
Japanese stocks held in a U.S.-based Japanese stock fund
would be set as of the closing of the Tokyo Stock Exchange.
However, the net asset value of that Japanese fund would be
Callan Associates Inc. 2
1 Estimates of the harm caused to long term investors by market timers or, more broadly, abusive traders differs dramatically. For example, Eric
Zitzewitz, of the Stanford University School of Business, estimates that U.S. mutual funds lose $4 billion per year to timers (Who Cares About
Shareholders? Arbitrage-Proofing Mutual Funds, Eric Zitzewitz, October 2002). The same author reports that late trading (which is clearly illegal)
costs mutual fund shareholders $400 million per year since 2001, or 5 basis points for international funds and 0.6 basis points for U.S Equity funds.
Roger Edelen in Investor Flows and the Assessed Performance of Open-end Mutual Funds, 53 J. Fin. Econ, 439, 457 (1999) estimates that the “the
costs of liquidity in mutual funds as $0.017-$0.022 per dollar of liquidity-motivated trading.” (Cited in Mandatory Redemption Fees for Redeemable
Fund Securities, infra, p. 11762, FN 3.)
2 Mandatory Redemption Fees for Redeemable Fund Securities. Federal Register, Part IV: Securities and Exchange Commission 17 CFR 270. Release
No. IC-26375A, www.sec.gov/rules/proposed/ic-26375a.htm
3 ibid., p. 11762
4 ibid., p. 11763
5 ibid., p. 11763
6 “SEC May Reduce Reporting Requirements On Redemption Fees” Defined Contribution News, August 20, 2004. See also: “Mutual-Fund Reforms
by Year End” The Wall Street Journal, October 20, 2004. P. C19
7 Mandatory Redemption Fees for Redeemable Fund Securities. Federal Register, Part IV: Securities and Exchange Commission 17 CFR 270. P.
11763
8 ibid., p. 11763
9 ibid., p. 11768, FN 64

5. struck at 4:00 PM Eastern Standard Time. Some market
timers have tried to exploit the pricing inefficiencies gener-
ated by this time difference by buying or selling shares in a
company based on events that occur in the time between the
Japanese market closes and the fund’s net asset value is deter-
mined. FVP attempts to close this price arbitrage by revalu-
ing the security to reflect the same informational advantages
available to an erstwhile timer.
Ultimately, using FVP is a subjective process and may be
(indeed, has been) exploited. Proposed Rule 22c-2 is an
objective rule designed to offset some of the inherent subjec-
tivity of FVP.10
Fair Value Pricing’s goal is to curtail any abil-
ity to exploit price arbitrage. Proposed Rule 22c-2 attempts to
further discourage timers by increasing the expense of timing
and also limiting the techniques and avenues available to
timers to frequently trade in contravention of prospectus lan-
guage.
The SEC recognizes that automatically implementing manda-
tory redemption fees across all types of funds would decrease
the liquidity of mutual funds and thereby decrease their
attractiveness to investors.11
As a means to ameliorate the
impact of Proposed Rule 22c-2 on the redeemability of
mutual fund shares, the SEC has proposed excluding the fol-
lowing types of transactions from redemption fees:
1) redemptions of $2,500 or less;
2) redemptions made due to an “unanticipated finan-
cial emergency” if the shareholder issues a
request. In this case, the fund must waive the
redemption fee if the amount redeemed is $10,000
or less and may redeem the fee if the amount
redeemed is more than $10,000;
3) exempt funds such as a) a money market funds, b)
funds that issues securities that are listed on a
national securities exchange (e.g., Exchange
Traded Funds), and/or funds that state in their
prospectus that they explicitly allow short-term
trading and do not levy redemption fees;
4) pooled investment vehicles not covered under the
’40 Act. Note that 22c-2 would apply to short-
term transfers among subaccounts within variable
annuity contracts.12
Proposed Rule 22c-2 requires that all fund flows be
accounted for using First-In First-Out (FIFO) methodology.
Note that Last-In First Out (LIFO) accounting would apply
redemption fees to participant-initiated transfer activity as
well as normal contributions through payroll deductions, loan
repayments, and the like. Revenues generated by the fees will
be paid to the fund, not the fund’s advisors. Again, it is the
intent of the SEC that the fees compensate the fund for the
increased expense of abusive trading.
The Increased Burden on Intermediaries
and Record Keepers under Proposed Rule
22c-2
Over the past decade, there has been a significant change in
the sale and distribution of mutual funds. Increasingly, third
party distributors aggregate their client’s orders into an
omnibus account, a process typically followed in most retire-
ment plans. Today, the Investment Company Institute esti-
mates that 85-90% of mutual fund purchases are conducted
through intermediaries.13
Mutual fund managers receive
orders for the accounts and are responsible for executing
them. Thus, the mutual fund manager is usually unaware of
each individual account’s activities in an omnibus account. In
these instances, redemption fees were frequently not levied
on participants in omnibus accounts as doing so would be
problematic.
One key issue brought to light by the mutual fund investiga-
tions is the role of financial intermediaries, including retire-
ment plan administrators, played (usually inadvertently) in
facilitating market timing. On more than one occasion, fund
managers were unable to identify timers due to the anonymity
provided by omnibus accounts. Several of the complaints
filed against mutual fund companies included evidence that
fund companies were suspicious of omnibus account activi-
ties but were unable stop them. Some abusive traders went as
far as to disguise their voices, and established accounts under
multiple identities so that they could continue to trade in
funds from which the fund managers had attempted to block
them.
Proposed Rule 22c-2 attempts to close this loophole by
requiring financial intermediaries14
to ensure that redemption
fees are levied where appropriate. Under Proposed Rule 22c-
2(b), funds must:
1) require the intermediary give the fund the account
number used by the intermediary to identify the
transaction;
2) give the fund transaction and holdings informa-
tion sufficient to permit the fund to assess the
Callan Associates Inc. 3
10 ibid., p. 11768
11 ibid., p. 11764
12 ibid., p. 11764
13 Testimony of Matthew Fink, President of the Investment Company Institute, before the Senate Subcommittee of Financial Management, the Budget
and International Security, Committee on Government Affairs, 108th Congress. 1st Sess., 8 n. 6 (Nov. 3, 2003). As cited in Federal Register, Vol. 69,
No. 48, p. 11764, FN 17
14 Financial Intermediaries are defined as record holders as defined in Rule 14a-(i) of the Securities Exchange Act of 1934 and an insurance company
that sponsors a registered separate account organized as a unit investment trust. Proposed Rule 270.22c-2(f)(2).

6. Callan Associates Inc. 4
amount of the redemption fee in cases where the
redemption would trigger a fee; or
3) have established an agreement with the intermedi-
ary in which the intermediary is required to levy a
redemption fee per the requirements of Proposed
Rule 22c-2.
The SEC intends that the redemption fee be “both mandatory
and uniform” in that it “applies to all fund shares, including
shares held by financial intermediaries,” thereby prohibiting
exceptions tailored for certain intermediaries. The size of the
fee (2%) is inflexible, in order to “simplify the implementa-
tion of the rule” and ease the burdens on intermediaries in
collecting these fees.15
Intermediaries would also be required to provide Taxpayer
Identification Numbers (TINs) of all shareholders that had
purchased or redeemed shares held through an account with a
financial intermediary and the amount and dates of the trans-
actions. The intermediary would have to transmit this infor-
mation on a weekly basis per Proposed Rule §22c-2(c)(1).
It is clear that Proposed Rule 22c-2 dramatically increases the
administrative burdens on intermediaries and, to a lesser
degree, the fund’s shareholder services. The SEC estimates
that there are 6,800 financial intermediaries that would have
to transmit the aforementioned information to 3,100 fund
companies. According to SEC and fund company estimates,
the costs of implementing these provisions are substantial,
especially for intermediaries who appear to have little or no
clout in determining the policy. The SEC estimates that the
weighted average aggregate annual cost of 22c-2 for all 9,900
parties would be more than $1 billion. That number breaks
down as follows:16
Note that the fund company drives the choice of methodol-
ogy discussed above. Both funds and intermediaries would be
required to collect the TIN of fund shareholders.
Intermediaries, as discussed, would be required to transmit
this information to funds on a weekly basis. The SEC esti-
mates that this data collection process will cost the fund
industry $310,000,000 per year, or $100,000 per fund and an
ongoing cost of $20,584,000 for the fund industry. TIN col-
lection and transmission will cost the intermediary industry
an estimated $150,000 per intermediary in capital expenses
and $100,000 in annual expenses, which translates into an
aggregate of $1,020,000,000 in capital expenses for the inter-
mediary industry and an annual, industry-wide costs of
$680,000.
These numbers give us pause.
Within the context of the defined contribution industry, some
fund companies have taken this step upon themselves by
requiring record keepers to provide them with this informa-
tion or to be precluded from working with their products.
Requirement Expected participation Cost to Fund Cost to Intermediary
§22c-2(b)(1) Fund to devel-
op/upgrade systems for stor-
age and evaluation of infor-
mation from intermediary:
15% of all funds are
expected to elect this option
(i.e., 465 funds)
Industry:
Startup: $260,400,000
Ongoing: $3,087,600
Fund:
Startup: $560,000
Ongoing: $6,640
Industry:
Startup: $102,000,000
Ongoing: 102,000,000
Intermediary:
Startup: $100,000
Ongoing: $100,000
§22c-2(b)(2) Fund to enter
into agreement with record
keeper to provide fund with
transaction history and hold-
ings information to permit
fund to levy redemption fee:
35% of all funds expected
to choose this option
(i.e., 1,085 funds)
Industry:
Startup: $607,600,000
Ongoing: 7,204,000
Fund:
Startup: $560,000
Ongoing: $6,640
Industry:
Startup: $23,800,000
Ongoing: $23,800,000
Intermediary:
Startup: $10,000
Ongoing: $10,000
§22c-2(b)(3) Fund and inter-
mediary enter into agreement
requiring intermediary to
assess fee
50% of funds expected
to choose this option
(i.e., 1,550 funds)
To Fund:
Startup: None
Ongoing: None
Industry:
Startup: None
Ongoing: None
*The SEC reports that there
would be no data collection
expenses for intermediaries17
15 ibid., p. 11764
16 Source: Securities and Exchange Commission Release No. IC-26375A; File No. S7-11-04. www.sec.gov/rules/proposed/ic-26375a.htm; Federal
Register Vol. 69, No. 48, pp. 11770-11771.
17 Federal Register/ Vol. 67, No. 48, Part IV, p. 11771.

7. Callan Associates Inc. 5
Analysis
It is clear that Proposed Rule 22c-2 is the product of a com-
promise, borne of competing interests and designed to work
as part of a greater whole. Again, the purpose of the rule is to
act as part of an arsenal of tools designed to prevent market
timing and, more broadly, abusive trading by large and small
investors. The SEC itself asserts that “The principal solution
to abusive market timing transactions is the accurate calcula-
tion of net asset value each day, using current and not stale
prices.18
” While FVP requires a subjective judgment and has
been the source of abuse in the past,19
redemption fees are
largely objective in nature. Finally, the rule is designed to
shut down an avenue by which abusive traders have exploited
funds through the onerous reporting requirements placed
upon financial intermediaries.
In our opinion, Proposed Rule 22c-2 has a number of limita-
tions that may cause it to fall short of one aspect of its goal of
deterring large, sophisticated, abusive traders. However, it is
likely to be more effective at other aspects of its goal, that is,
deterring smaller abusive traders and timers. Moreover, there
exists a significant chance that the rule can lead to some unin-
tended consequences that could harm long-term mutual fund
investors, including increased costs and investor confusion.
Finally, the significant costs that the fund and financial inter-
mediary industry expect to incur as a result of Proposed Rule
22c-2 will likely result in increased costs to retirement plan
participants. However, there are ways in which these costs
can be curtailed, so they may not be as onerous as they first
appear.
Choice of Accounting Methodology
First, as written, Proposed Rule 22c-2 will not halt market
timing; in fact, it will leave open the possibility that even a
moderately sophisticated investor could continue to exploit
the rule while less sophisticated investors inadvertently trig-
ger redemption fees. Under the FIFO method, each sale of a
fund’s shares is matched with the first purchases made. The
redemption fee would be applied on any redemptions effected
within five days of the first offsetting purchases. Obviously,
one strategy by which an abusive trader could continue to
trade a fund unfettered by redemption fees would be to stag-
ger redemptions in such a way as to ensure that none (or, at
least, an acceptable proportion that would not preclude the
abusive trader from accomplishing his or her goals) fall
within five days of a matching purchase.
Moreover, the FIFO methodology ignores the most important
trades for a market timer and those trades most likely to harm
other investors. Quick in-and-out trades demand maintenance
of cash positions that can create a drag on fund performance
and can drive up transactional fees and short-term capital
gains—exactly the type of harm Proposed Rule 22c-2 is
designed to deter. One could argue that a more prudent solu-
tion would be to use LIFO accounting. Under LIFO, the most
recently purchased shares are deemed to be the first sold.
LIFO accounting would impose a redemption fee on trades
that are most proximate in time to the purchase in question
and, thus, the most problematic for long-term investors.
However, LIFO accounting is not without its faults. First, as
pointed out by the National Defined Contribution Counsel,20
the majority of record keepers track contributions and
redemptions on a FIFO basis. Brokerage fees and some loads
are already calculated using FIFO. Switching to LIFO would
require a significant change in the accounting procedures uti-
lized by the entire industry. Second, LIFO accounting could
incur punitive brokerage charges to investors in certain
classes of mutual funds or participants in smaller plans sub-
ject to Contingent Deferred Sales Charges (CDSCs).
The SEC recognizes that difficulty in balancing these com-
peting interests, and decided on FIFO accounting because it
would least affect most ordinary redemptions conducted by
longer-term investors, especially those who make automatic
contributions to a fund. This decision is therefore the lesser of
two evils. The FIFO method, while leaving much to be
desired, is the least likely to harm longer-term investors and,
especially, defined contribution plan participants who make
regular payroll contributions to their funds.
Money Market Funds versus Short-Term
Bond Funds
Proposed Rule §22c-2(e)(2)(i) specifically exempts money
market funds from its purview. Money market funds are nar-
rowly-defined types of funds operating under a series of
requirements set forth in Rule 2a-7 of the ’40 Act. Generally,
money market funds are funds that invest in highly liquid
securities with a minimum credit rating. Typically, these
funds maintain a net asset value of $1.00/share. Money mar-
ket funds are the only type of fund categorically excluded
from Proposed Rule 22c-2’s purview.
By design, money market funds are highly liquid and able to
handle substantial trading activity and cash flows as they are
often used by investors for their own cash management.
Thus, this exemption is necessary if money market funds are
to function properly for the purpose for which they are
designed. However, over the past few years, many individu-
als have begun using short-term bond funds for exactly the
same purpose. Short-duration bonds are usually highly liquid
18 SEC Proposes Mandatory Redemption Fees for Mutual Fund Securities, February 25, 2004. www.sec.gov/news/press/2004-23.htm
19 For example, in its Administrative Proceeding, In the Matter of FT Interactive Data, File No. 3-11352, the SEC found that a mutual fund manager,
Heartland Advisors, colluded with a firm that provided it fair value pricing for a high yield and short-duration bond fund in such a way as to gradual-
ly price in catastrophic losses.
20 Mandatory Redemption Fee for Redeemable Fund Securities. File No. S7-11-04. Al Brust and Randy Hardock, National Defined Contribution
Council.

8. Callan Associates Inc. 6
and able to handle frequent trading without generating many
of the adverse effects suffered by other types of funds.
Despite this fact, the exemption from mandatory redemption
fees is not extended to short duration bond funds.
Nevertheless, under Proposed Rule 22c-2, these types of
funds will be required to levy redemption fees on their
investors.
As discussed below, the proposed rule, as drafted, allows any
type of fund to exclude itself from redemption fees by affir-
matively, clearly, and prominently stating in its prospectus
that it allows short-term trading of its securities and that this
trading may result in higher costs. Thus, short-term bond
fund managers can avail themselves of this provision should
Proposed Rule 22c-2 pass. However, this will force investors,
intermediaries, plan sponsors, and consultants to search for
and continually monitor prospectus language to ensure that a
fund allows trading. For those not equipped to handle this
type of work, there is a significant risk for increased investor
confusion.
Financial Hardship Rule
The rule requiring fund companies to exempt from redemp-
tion fees investors who are experiencing a “unanticipated
financial emergency” may prove problematic to administer.
The rule provides a safe harbor in that an automatic financial
hardship will be granted on request for amounts less than
$10,000. However, the logistics behind approving requests
for amounts in excess of $10,000 would be difficult. There
are many unanswered questions behind this exception to the
rule. For example, who will have the authority to grant a
financial hardship exception? Would granting permission
over, for example, the telephone without conducting due dili-
gence expose the fund company to any sort of liability should
the requestor misrepresent the nature of their emergency?
What constitutes an “unanticipated financial emergency?”
The SEC is considering drafting a laundry list of specific
events that constitute financial hardships. Among these are
medical emergencies, death, personal economic hardship,
unemployment, major political or economic events, etc. If an
individual was laid off from a job, for example, it might make
sense for the individual to consider reallocating his or her
portfolio towards a more conservative, less volatile stance. If
so, would this be enough to count as an “unanticipated finan-
cial emergency?” Unfortunately, the law is not clear.
Note also that there are instances where liquidating an invest-
ment in a fund would be prudent but would not constitute a
personal financial emergency. For example, should a major
catastrophe affect the fund manager (e.g., a 9/11-style terror-
ist attack, fraudulent behavior by fund management, portfolio
manager lift-outs, etc.), then immediately selling a fund, even
if it was very recently purchased, may be prudent. In these
instances, it would seem inappropriate to fine investors.
Finally, the law does not set a cap on the number of sub-
$10,000 trades a trader can make. Thus, it appears that a
trader can make repeated sub-$10,000 trades unfettered by
redemption fees if a financial hardship exemption is claimed.
This clearly violates the intent behind the rule and further
weakens its ability to deter or prevent abusive trading by
sophisticated individuals.
Voluntary Non-Compliance
As discussed above, allowing funds to opt out of redemption
fees will create confusion among most investors. The same
can be said for the flexibility the rule grants mutual fund man-
agers in varying the holding period, so long as the period lasts
a minimum of five days. The ability to opt-out of Proposed
Rule 22c-2 and the discretion to extend the holding period
beyond five days leaves open the likelihood that investors
may inadvertently select funds inappropriate for their needs.
Of particular importance is the impact this flexibility will
have on defined contribution plan record keepers. Under
Proposed Rule 22c-2, they will be tasked with monitoring
fund prospectuses and, possibly, levying appropriate redemp-
tion fees. Given the proliferation of funds today, enforcing
this provision could be costly. Smaller record keepers may
find the costs prohibitive.
Finally, there are instances in which frequent trading may
actually be beneficial for long-term mutual fund investors.
For example, there are firms that will work with mutual fund
managers to decrease the volatility of fund cash flows by off-
setting redemptions or purchases of a fund with an offsetting
trade. These organizations give fund management time to
manage cash flows and can ameliorate the harmful effects of
frequent trading.
The Five Day Holding Requirement
Under the Proposed Rule, redemption fees are levied on
redemptions effected within five business days of the first
purchase of a mutual fund. Currently, mutual fund managers
that levy redemption fees require holding periods ranging
from five to 90 days. (ERISA law generally requires that
investors be able to rebalance their plans once a quarter, so
most funds do not require holding periods in excess of 90
days.)21
Some mutual fund managers, academic, and industry
groups in their comments on the proposed rule argue that five
days is not sufficient time to eliminate the advantage of fre-
quent trading in mutual funds. These individuals and organi-
zations point out that sophisticated investors, with access to
hedging techniques and other such strategies, can still effec-
tively exploit a market timing strategy in some types of funds
with holding periods greater than five days.
The SEC recognizes that abusive trading can impact different
funds in different ways, so Proposed Rule 22c-2 allows
mutual fund managers to require a longer holding period if
21 ERISA Section 404(c)

9. Callan Associates Inc. 7
101 CALIFORNIA ST., SUITE 3500, SAN FRANCISCO, CALIFORNIA 94111 TELEPHONE 415.974.5060 FACSIMILE 415.274.3049 www.callan.com
Mitch Fielding
October 2004
they so desire. As discussed above, this flexibility will
increase the administrative burdens on record keepers should
the law come into effect and likely increase investor confu-
sion.
The Reporting Requirements Placed on
Financial Intermediaries and Pooled
Investment Vehicles and Exchange Traded
Funds: An End-Run Around Redemption
Fees?
Needless to say, the reporting requirements placed on finan-
cial intermediaries will result in significant expenses.
However, given that intermediaries now effect some 85-90%
of mutual fund purchases, any redemption fees that do not
contemplate imposing some sort of either reporting, monitor-
ing, or collection requirements on intermediaries would be of
questionable value.
Proposed Rule 22c-2 only extends to mutual funds, defined in
§22c-2(f)(1) as “an open-end management investment com-
pany that is registered or required to register under section 8
of the [’40 Act], and includes a separate series of such an
investment company.” Proposed Rule 22c-2 also extends to
variable annuity sub-accounts. It does not appear to apply to
managers of commingled funds or of Exchange Traded Funds
(ETFs), which are specifically exempt from Proposed Rule
22c-2 under §22c-2(e)(2)(ii). Given the significant sums of
money intermediaries will have to expend on implementing
the changes required under Proposed Rule 22c-2, we would
not be surprised to see an industry-wide shift to ETFs and
pooled vehicles outside the scope of Proposed Rule 22c-2.
It seems clear that Proposed Rule 22c-2 will further the
“institutionalization” of the defined contribution industry by
accelerating the industry’s move to commingled trusts and
separate accounts in lieu of mutual funds for their partici-
pants.
Thus, the defined contribution industry may be able to avoid
some of the enormous expenses discussed above. At first
blush, this loophole seems to further erode the ability of
Proposed Rule 22c-2 to accomplish its goals. However, the
industry can react (indeed, has reacted) to the issue of abusive
timing by imposing direct constraints on the trading activity
of plan participants. For example, some plans now limit
transactions to a monthly or quarterly basis, others charge
redemption fees in excess of 2%, some plans require partici-
pants to “pend” trades for a defined period of time prior to
effecting a participant’s order as a means of eliminating the
pricing arbitrage aspect of market timing.
Conclusion
As drafted, Proposed Rule 22c-2 would provide some protec-
tion to mutual fund investors from abusive traders. However,
redemption fees in and of themselves are clearly not a
panacea against many of the abuses brought to light by the
recent mutual fund investigations. In fact, Proposed Rule
22c-2 will likely have little impact on the most sophisticated
abusive traders. However, the rule will likely have success in
slowing those smaller, less sophisticated investors who may
be responsible for the majority of the harm done to long-term
investors. Finally, it is not clear that the costs of the rule on
the defined contribution industry (and, by extension, defined
contribution plan participants) will be justified by decreasing
the losses investors suffer due to abusive trading.