A proposed remedy for stamping out illegal "late trading" in the mutual fund industry is drawing fire from critics who say it would unintentionally punish the nation's 48 million 401(k) retirement plan investors, especially those on the West Coast.
The proposal, which the Securities and Exchange Commission may unveil at a meeting today in Washington, is to put tighter controls on how late in the day mutual fund companies can take buy and sell orders and still execute the orders at that day's closing price.
Critics say mutual fund intermediaries, such as 401(k) plan administrators, brokerage firms and so-called fund supermarkets like Charles Schwab Corp., could be forced to stop accepting orders for a particular day as much as six hours before the stock market's closing bell -- in effect creating a blackout period.
"It's almost ironic," said Scott Peterson, head of defined contribution services at consulting firm Hewitt Associates Inc. "In a sense, it puts 401(k) investors at a disadvantage."
The SEC wants to curb one of the major mutual fund abuses that has surfaced in the last three months: after-the-bell trading.
Regulators have found several instances in which fund companies allegedly allowed favored investors to trade fund shares after the stock market's 4 p.m. Eastern time closing bell and still receive that day's closing price -- rather than the next day's price as required by law.
Some observers believe the SEC will propose a cutoff requiring any order received by a fund company before 4 p.m. to be priced at that day's closing price.
An SEC spokesman declined to comment Tuesday.
The plan is being debated as the mutual fund scandal intensifies. Invesco Funds Group on Tuesday became the latest firm accused of wrongdoing by New York Atty. Gen. Eliot Spitzer and the SEC. And Strong Capital Management's founder, Richard Strong, resigned under the threat of possible charges.
A strict cutoff could pose hardships for 401(k) plans and other intermediaries that process and bundle hundreds of trading orders before passing them on to fund companies, critics say.
The process can take hours, and even though trades are received on time by the intermediaries and priced legitimately at that day's closing value, the orders may not arrive at the funds until well after the market's close -- which, under a strict cutoff, would require the trades to be priced at the next day's closing price.
Last year, 87% of mutual fund trading orders went through an intermediary of some kind rather than directly from the investor to the fund company.
Experts say 401(k) investors would be affected the most by a strict cutoff because trades within the plans typically require extra time for processing, in part because of legal compliance procedures that require calculations.
Jan Jacobson, director of retirement policy for the American Benefits Council, which represents more than 200 large employers and several retirement plan administrators, said many of the group's members estimated that 401(k) trade orders would have to be cut off four to six hours before the market's close.
In a letter to the SEC on Tuesday, the council urged the SEC to back away from a strict cutoff.
The council and others are pushing for a looser rule that would let intermediaries accept orders until 4 p.m. and execute them at that day's closing price, with new electronic safeguards to prevent abuses.
But backers of the strict cutoff call it necessary, considering how badly accusations of after-the-bell trading have tarnished the $7-trillion fund industry's reputation.
"It has a trade-off, but the upside is slamming the door shut on late trading," said Paul G. Haaga Jr., chairman of the fund industry's lobbying group, the Investment Company Institute.
In recent congressional testimony, Haaga said a strict cutoff time was the most reliable way to combat late trading. Such a rule would ensure that only entities regulated by the SEC, which governs the fund industry, are responsible for applying the 4 p.m. cutoff, he said.
If the five commissioners recommend a proposal, it would be issued for a period of public comment and subject to revision before coming up for a final vote.
Julie Allecta, an attorney at San Francisco firm Paul, Hastings, Janofsky & Walker, which represents fund companies, noted that most 401(k) participants are long-term investors rather than rapid traders.
"For the vast majority of investors, the 'hard close' should not make a material difference," she said. "It's hard for me to believe that it's a huge disadvantage."
In its letter to the SEC, the benefits council laid out a scenario in which a West Coast investor's hypothetical 401(k) trade might take three days to finalize.
The council said it could happen like this: The investor, who lives in Los Angeles, places an order at 9:15 a.m. his time Friday with his 401(k) plan's record keeper to sell all of the shares of Fund A in his account and use the proceeds to buy shares of Fund B.
Under current rules, the Fund A shares are sold -- and the Fund B shares are bought -- at Friday's 4 p.m. Eastern time closing prices.
Under the proposal being debated, the plan might shut off trades at noon Eastern time to meet the 4 p.m. deadline. So the shares of Fund A wouldn't be sold until Monday -- at that day's closing price -- because the West Coast investor placed his order at 12:15 p.m. East Coast time Friday.
Because the closing price of Fund A shares wouldn't be known until after 4 p.m. Monday, the order to buy Fund B shares couldn't be processed until Tuesday. And the entire transaction probably wouldn't be reflected in records the investor could access until Wednesday.