Securities and Exchange Commission Historical Society

Investment Company Regulation: The Intricacies of an "Enlightened Partnership"

A Rule In Time… 2003-2017

Late Trading And Market Timing

One morning in late August 2003, ICI President Matt Fink was playing tennis on a Bethesda, Maryland court when Eliot Spitzer showed up at the next net.  “How are mutual funds doing, Matt?” the New York attorney general asked as Fink left.  Assured “Just fine,” Spitzer replied, “Just you wait.”  A little over a week later, Spitzer announced proceedings against hedge fund Canary Capital Partners, which had been allowed by some of the largest mutual funds to engage in illegal late trading and market timing.46

As news of similar operations hit the headlines, investment companies, long considered  upright vessels in an ocean of financial buccaneers, now appeared to be among the pirates.  Five years later came more bad news when a major money market fund, supposedly the safest of these safe investments, traded below the standard dollar value.  Either of these incidents could have brought transformative legislation.  Instead, swift regulatory response helped preserve the flexibility of mutual funds under the 1940 Act.

A cornerstone of the successful and safe industry was forward pricing rule 22c-1, adopted in 1968.  It formally required mutual funds to trade at a NAV established daily at the 4 p.m. market close.  This attempt to ensure a level field also created opportunities—during the intervening 24 hours developments affecting the funds or the underlying securities could render shares overvalued or underpriced.  Market timers tried to anticipate those changes and trade accordingly.  There was no statutory prohibition of market timing.  The SEC was aware of the practice and allowed it so long as mutual funds adhered to their stated policies on the practice and advisers did not market time with the accounts of unsophisticated investors.  The SEC had also enabled funds to apply “fair value” pricing after extraordinary events greatly undermined a NAV overnight.

Then things changed.  With the bursting of the dotcom bubble, equity funds began to lose assets—trillions of dollars between 2000 and 2002.  Most established fund complexes appeared willing to ride it out.  But new players, the banks and brokerage firms that had acquired funds at the top of the market, appear to have been more determined to recapture the losses.47  In return for cash infusions, some advisers began to allow customers to market time infallibly by late trading—buying or selling shares retroactively at the earlier-established NAV.  The SEC had accepted assurances from brokers they would only process later in the day orders received before 4:00 PM.  But late traders had gone far beyond this.  Spitzer had found it: the SEC had not.  Embarrassed, the Commission began to investigate and implicated major firms including Strong Capital Management, Putnam Investments, Franklin Templeton, and Prudential Securities.

It was hard for the individual to determine how he or she had been hurt by late trading and market timing, but with Spitzer castigating the SEC for its “outrageous betrayal of the public trust,” it was easy for the public to be indignant.48  The House Financial Services Subcommittee threatened to add a late trading rider to an existing bill.  The Senate Banking Committee called hearings and contemplated new legislation.  Even the Senate Subcommittee on Consumer Affairs and Public Safety called hearings and introduced a hastily-prepared bill.  All of these measures would have undermined the creativity and flexibility allowed by the 1940 Act.

Rulemaking at Mid-Decade

Chairman William Donaldson wished to put the Commission out in front of this wave of reform.  By the end of 2003, the Office of Compliance Inspections and Examinations had reviewed 318 funds, looking for the first time at late trading and market timing.  The Commission also began releasing the new rules.  These included enforcement of a “hard” 4 p.m. NAV and a requirement that every adviser and every fund have a chief compliance officer reporting to its board.  Donaldson also asked the Mutual Fund Directors Forum to come up with a set of industry best practices.

Reasoning that only self-interested insiders would have allowed late trading and market timing to undermine the value of their funds, Donaldson and his staff were convinced that the mutual fund problem was essentially one of governance.  In July 2004 the SEC adopted a comprehensive package of rules intended, as the SEC Annual Report put it, to “solidify the role of the fund board as the primary advocate for fund shareholders.”49  Key provisions were that every fund should have 75 percent independent directors, including an independent chairman.  These rules were approved despite a 3-2 split in the Commission, with Donaldson joining the Democratic commissioners and the other Republicans opposed. 

The governance rules hit a more effective barrier in August 2005 when, in Chamber of Commerce v SEC, the United States Court of Appeals for the District of Columbia Circuit struck them down as not sufficiently supported by economic analysis.  Donaldson, who had already announced retirement, pushed for readoption after only a week of economic review and without further public comment.  The governance rules were struck down a second time in April 2006.  In the meantime the Commission had introduced another set of rules aimed at the mechanics of market timing, revisiting old assumptions that mutual funds must provide for ready redemption and allowing boards to impose a 2 percent redemption fee on investors who redeemed shares within 5 days of purchase—with the fee going to the fund rather than management.  This Mutual Fund Redemption Fee Rule was adopted in 2005.  Although the governance half of the SEC rulemaking package was ultimately struck down, during the critical period after the late trading and market timing scandal, the initiative itself had helped avert legislation that would have transformed the industry.

Rulemaking Under the 40 Act

Regulating the New Mainstream

In the second decade of the 21st century, regulators looked out on an investment company landscape that would have been unrecognizable to the authors of the Public Policy Study, let alone the 1940 Act.  There was, for example, extraordinary growth among privately managed funds, hedge funds, and registered investment advisers.  This was due in part to the National Securities Markets Improvement Act of 1996 which expanded exempt funds beyond those with less than 100 investors to include larger funds offered only to wealthy “qualified purchasers.”  Similar growth has taken place among registered investment advisors who manage accounts for retail customers without establishing funds.  Largely unregulated previously, the Dodd–Frank Wall Street Reform and Consumer Protection Act required that hedge funds and private equity funds (but not venture capital funds) managing more than $150 million in assets had to register with the SEC.  In 1991 the managed funds industry had been worth less than $60 billion; in 2015 hedge funds had $3 trillion under management.

Still, that $3 trillion was only one-tenth the value of mutual funds which continued to boom thanks to sustained innovation. Exchange traded funds (ETFs) were the most recent innovation, their market value jumping from $38 billion in 2000 to $143 billion in 2004.  But as ETFs gained in popularity, they also grew in complexity; in the early 2000s, for example, the SEC permitted the creation of actively managed and fixed income ETFs.  The 1940 Act still required issuers to obtain a specific exemption for every ETF to go to market, creating delays and incurring costs.  In early 2008 the SEC proposed allowing ETFs to go to market without an exemption.  But director of investment management Andrew Donohue soon realized that it was likely too early to impose even a “plain vanilla” rule of this type.  Rapid change, Donahue recalled, made it “extraordinarily difficult to adequately address the issues and come out with a rule adoption during that period.”50

The financial crisis threw harsh light upon increasingly innovative and ever more risky financial instruments.  While CDOs and structured notes devastated the banking sector, fund complexes were introducing innovations such as leveraged ETFs and even “inverse ETFs,” created not to track a particular benchmark, but to perform counter to it.  This kind of experimentation in the midst of a continued boom, with global ETF assets hitting $2 trillion, led the SEC to introduce reporting modernization rules applying to all investment company products in 2016.

Far more worrisome during these years was failure in the investment company sector widely considered to be the safest of all—money market funds.  For a quarter century, exemptions under the 1940 Act had allowed money market funds to keep their NAV pegged at one dollar.  The result was a new specter of redemption—what happens if a major fund “breaks a buck?”  In September 2008 everyone found out.  The Reserve Primary Fund, the money market pioneer, had 1.2 percent of its assets in Lehman Brothers commercial paper.  The bank collapsed on the 15th and the Reserve Fund priced its securities at .97 per share the next day.  During the next week investors rushed to redeem their shares and prime money market funds as a whole lost 14 percent of their assets.  At the same time the SEC issued more than a dozen no-action letters enabling other funds to support their $1 NAV.  The SEC charged the Reserve Fund with failing to disclose the Lehman investment and presided over a speedy settlement of 98 cents on the dollar.

In June 2009 the Commission proposed a new set of rules intended to make money market funds safer.  Approved in March 2010, the rules raised liquidity standards, prohibited money market funds from holding long-term debt, and restricted them to the highest quality securities.  The rules also provided for the “stress-testing” of funds.  Another rule required funds to calculate their “mark-to-market” value—the underlying value beneath the dollar per share.  In 2011 the SEC put this mark-to-market value, or “shadow NAV,” up on the web.

Still, said Donohue, the Commission’s biggest problem at that point was “we didn’t have a lot of insight into money market funds in terms of what was really happening.”51  As a result the commissioners were split on money market reform.  Therefore, the commission approved a staff study that tracked investor behavior during the 2008 financial crisis and evaluated the 2010 reforms.  The study, released in November 2012,  found that in times of stress money market fund investors were likely undertake a “flight to quality”—dumping prime funds for government money market funds.  The study also noted that large institutions were far quicker than individuals to unload risky funds, leaving retail investors exposed.  Most importantly, it broke the logjam in the way of money market reform.  As investment management director Norm Champ put it, “the study really laid the foundation for achieving a compromise on Money Market Fund reform  because we had much more data.”52

By 2014, the money market study, problems noted during financial stress in the Eurozone, and two government shutdown threats led the Commission to take a bigger regulatory step.53  For prime money market funds, exemptions for  amortized valuation and penny rounding were canceled.  Henceforth they would have a floating NAV.  And if liquid assets fell below 30 percent of the total, money market fund boards were empowered to put barriers in the way of redemption including liquidity fees of up to 2 percent of redemption value and a “redemption gate” that could last up to ten days.  The next year came another round of investment company rules.  These compelled money market funds and ETFs to establish liquidity risk management programs and allowed all other mutual funds to implement “swing pricing” after a certain threshold, taking costs of purchases and redemptions only out of the share value of traders, not long term investors.

In the wake of the financial crisis, legislation was likely for the second time in less than a decade, and the fact that a single party controlled the White House and Congress meant that it could be big.  But SEC rulemaking under the 1940 Act helped ensure that for all the 90 rules and 30-some studies called for by Dodd-Frank, very few applied to investment companies.  One notable move was, in fact, to bring hedge fund and private equity advisors within the purview of the Advisers Act.  Indeed, the 1940 Act has proven a remarkably durable and living document, now regulating financial instruments that its framers could never have imagined, more than 75 years after it made an earlier innovation, the open-end mutual fund, mainstream.

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(46) March 9, 2006 Interview with Matthew Fink, 22-23.

(47) Matthew P. Fink, The Rise of Mutual Funds, An Insider’s View (Oxford, 2008), 238-39.

(48) Matthew P. Fink, The Rise of Mutual Funds, An Insider’s View (Oxford, 2008), 232.

(49) 2004 SEC Annual Report, 19.

(50) Rulemaking Under the ’40 Act, June 1, 2017, 11.

(51) Ibid, 17

(52) Ibib, 22.

(53) SEC Release: Money Market Fund Reform; Amendments to Form PF.

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