Speech by SEC Staff:
Remarks Before the Mutual Fund Directors Forum 7th Annual Policy Conference
Linda Chatman Thomsen1
Director, Division of Enforcement
U.S. Securities and Exchange Commission
April 12, 2007
It's April so it must be Christmas. I'm referring, of course, to the wonderful nationwide community service program, Christmas in Action, formerly known as Christmas in April. The program coordinates volunteers throughout the country to help renovate and repair homes for those in need. The program was conceived in Midland, Texas in 1972 and got its name when one excited recipient declared that the generosity of her neighbors made her feel "it was just like Christmas." Thinking of Christmas in April caused me to think of Christmas, and one beloved animated television special that, in turn, caused me to think of all of you. That special aired for the first time on December 6, 1964 on the General Electric Fantasy Hour. It has been rerun every year since. It is "Rudolph the Red-Nosed Reindeer," the story of Rudolph, his pal Hermie the elf and dentist wannabe, and various misfit toys including a Charlie-in-the-Box. Why, you ask, does this TV show cause me to think of you? A very good question. And the answer is: very early in the show Hermie, the elf wannabe dentist, leaves the toy workshop. He is, alas, not a very good toy maker. He strikes out on his own and meets Rudolph, who is also on the lam, having been rejected from Santa's A Team due to his unusual nose. Together they have a variety of misadventures. Eventually, they save the day, thanks of course to Hermie's skills as a dentist and Rudolph's shining nose. Anyway, when Hermie and Rudolph first meet, Rudolph asks Hermie what he's up to and Hermie declares: "I'm in-de-pendent." As he says it, he stands a little taller, his voice gets a little firmer and you sense a certain strength of character. After some further discussion with Rudolph, Hermie proposes that they be "independent together." The deal is struck after Hermie reassures Rudolph he doesn't mind his red nose, and Rudolph, in turn, reassures Hermie that he doesn't mind his unusual (for an elf) career aspirations.
And that's why I thought of all of you—independent is a very powerful word, an even more powerful concept. To be truly independent demands courage and character and should be a source of great personal pride. It also need not be a lonely, solitary undertaking; you can be independent together. And that, I think, is what this program and this organization are all about. Your website states that: "[t]he Mutual Fund Directors Forum is an independent, nonprofit membership organization for investment company independent directors dedicated to improving mutual fund governance by promoting the development of concerned and well-informed independent directors. The Forum focuses on the needs of independent directors by providing educational and outreach programs as well as the opportunity for directors to exchange views and meet with regulators."2 I applaud this mission and all of you for embracing it.
Now would be a very good time to remind you that my views are my own and do not necessarily reflect the views of the Commission or any other member of the staff. I should probably also add, if it weren't already obvious, I'm inclined toward digressions.
So let's get back on track and talk a little about the very important role of independent fund directors. As you are so often reminded, as independent directors, you are the watchdogs tasked with providing an independent check on fund management. You carry a heavy burden of responsibility, and we greatly respect the role you play in looking out for investor interests, and the commitment and sincere dedication you bring to the job. I am aware that, with the advent of the recent mutual fund scandals as well as the increasing responsibilities of fund directors over the years, some independent directors have become more concerned about potential personal liability for their actions. These are fair concerns and I won't downplay them. I will tell you, though, that you have nothing to fear from us if you comply with the law and perform your duties with care and diligence.
But let's go beyond the goal of merely avoiding the wrath of Enforcement, as appealing as that may be. While, understandably, most industry participants believe the best relationship to have with Enforcement is no relationship, I view the relationship between independent directors and Enforcement as an ongoing, symbiotic one. What do I mean by symbiotic? We need you and you need us in our shared goal of protecting mutual fund investors. As independent directors, you are on the front lines of investor protection — you have the ability to address concerns or potentially problematic practices before they become major compliance breaches or worse. Despite our best efforts, we often learn about violations only after significant investor harm has already occurred. While you also may encounter problems or violations at a point where there already has been some harm, you can play an important role in overseeing efficient and effective remediation at a pace and in a manner that we couldn't hope to replicate given our limited resources and your intimate knowledge of the funds you oversee. Your efforts do not go unnoticed by us.
As our Chairman said about our work at the SEC:
The danger is not that we will interfere too often but that we may act too late. That is why I appeal so frankly to you [in the business community] . . .You can help us. . . .[O]ur job will be better done and your interest will be better protected if, by alert and vigilant cooperation, you [in the business community] . . . share our task. The cooperation we ask of you we ask likewise of every other community in the country. But with respect to you in particular, we feel that our record of performance in this community (of encouraging and facilitating reputable transactions and of hindering, delaying, and stopping the disreputable) entitles us to your support. Have no fear that Government supervision will destroy honest enterprise. . . . This Commission will destroy nothing in our business life that is worth preserving. You are warranted in having confidence in our plans and purposes — confidence . . . "that if business does the right thing it will be protected and given a chance to live, make profits, and grow, helping itself, and helping the country." Honest business needs nothing more; the Commission promises nothing less.3
Now I said these were the remarks of our Chairman, but they are not the words of our current Chairman. Not that Chairman Cox disagrees with them; indeed, Chairman Cox quoted some passages from this same speech just a few weeks ago. These timely words, however, were uttered by our first Chairman, Joseph Kennedy, in one of his first speeches on November 15, 1934 at a meeting of the Boston Chamber of Commerce.
Let's talk in a more granular way about how you can, as Chairman Kennedy said, share our task. I, of course, look at good corporate citizenship from a cooperation perspective. A good starting point is the Commission's Report of Investigation issued in October 2001, commonly referred to as the "Seaboard Report," although the word Seaboard nowhere appears in that report.4 In it, the Commission outlined the factors it would consider in exercising its discretion on the issues of whether or not, and to what extent, to charge and sanction entities. The four fundamental factors are: self-policing, including the environment in which the misconduct occurred; self-reporting; remediation; and cooperation with law enforcement. A few minutes ago, I mentioned remediation, but I think independent directors have an important contribution to make to each of these factors. Most importantly, independent directors, who are chosen particularly for their independence, experience and judgment, have the ability to set the tone and ethical standards by which their funds operate. The Forum's development in 2004 of best practices for mutual fund directors is a terrific example of how this group is doing exactly that.5 Your single-minded focus on acting in the best interests of fund shareholders, and seeking to make sure fund management does the same, inevitably will serve your funds well in the event you are faced with a potential enforcement action.
One excellent example of how the Seaboard factors apply in practice in the broader context of regulated entities is a case from about a year ago involving a registered transfer agent. In this regard it is worth noting that when serious misconduct occurs at a registered entity, we are often inclined to charge and sanction that entity. In this case, the Commission decided not to. The underlying conduct was quite serious: it arose out of Putnam Fiduciary Trust Company's one-day delay in investing certain assets of a defined contribution client. We alleged that the markets rose steeply on the missed day, causing the client to miss out on nearly four million dollars in gains. We alleged that, rather than inform the client, PFTC employees shifted approximately three million dollars of the costs of the delay to shareholders of certain Putnam mutual funds through deception, illegal trade reversals, and accounting tricks. We alleged they allowed the client to bear approximately one million dollars of the loss without disclosing to the client that they had done so. As I said, the Commission did not sue the company; it sued the individuals who allegedly engaged in the misconduct. In doing so, the Commission explained that it did not sue PFTC "because of its swift, extensive and extraordinary cooperation in the Commission's investigation of the transactions that are the subject of the Commission's complaint. PFTC's cooperation consisted of prompt self-reporting, an independent internal investigation, sharing the results of that investigation with the government . . ., terminating and otherwise disciplining responsible wrongdoers, providing full restitution to its defrauded clients, paying for the attorneys' and consultants' fees of its defrauded clients, and implementing new controls designed to prevent the recurrence of fraudulent conduct."6
Sometimes we conclude that, despite significant cooperation, it is still necessary to bring an enforcement action, but we may decline to impose disgorgement and sanctions because of the remedial actions taken by the respondent. This occurred in our September 2005 case against OppenheimerFunds and its affiliated distributor, in which we found that the parties used fund brokerage commissions to reduce the distributor's revenue sharing obligations to certain broker-dealers. Our order noted the extensive remedial actions the parties took, including retaining an outside law firm to review the distributor's revenue sharing practices and report on those practices to the fund boards, and the adviser's determining, following discussions with the boards, that payment should be made to the funds. After further discussions with the fund boards, the adviser voluntarily reimbursed the funds an amount that exceeded the actual benefit the distributor had received from the directed brokerage practice.7
Sharing is not, however, a one-way street. As I say that, I am reminded of a now too close to two-decade-old encounter between my then three-year-old daughter and her best friend. It was parents' visiting day at preschool; I expect anxiety levels were running high for all involved. My darling daughter, pig-tailed, dressed in pink, cute as a button, walked up to her best friend, equally cute (well almost), smiled at her and then declared "you have to share," as she ripped the toy her friend was holding right out of her hands.
So how are we sharing? And how is it that you also need us in this symbiotic relationship I mentioned? You need us because our enforcement actions help create the environment that allows you to do your job effectively as independent directors. If you look at our cases that came out of the mutual fund scandals of the last few years, you will see a variety of conduct — secret market timing deals, use of directed brokerage to pay revenue sharing obligations, advisers' recommendations of service provider arrangements that may not have been in the best interests of the funds they advised.8 But most of these cases have in common a fundamental failure — they almost all involved the failure to disclose to fund boards the information they needed in order to be able to perform their function of assessing arrangements involving conflicts of interest and potential or actual harm to the funds involved. We take very seriously the obligations of fund advisers and others to disclose critical information to fund directors, and we are committed to continuing to bring these types of cases.
I know that part of your role is to oversee your funds' trading of portfolio securities, and I can assure you that we are doing our best to make sure the funds you represent are able to trade in the markets on a level and fair playing field. We bring many insider trading cases each year, including our case just last month against 14 defendants that alleged two overlapping schemes — one involving trading ahead of upcoming UBS analyst upgrades and downgrades, and the other involving trading ahead of corporate acquisition announcements using information stolen from Morgan Stanley.9 We are also well aware of the concerns funds and their advisers have expressed over the years about whether Wall Street insiders may be misusing funds' confidential trading information for the benefit of favored customers. As you may know, OCIE is currently conducting a risk-targeted examination focusing on this issue.10 We will work closely with OCIE regarding the results of their examination, and will continue to actively pursue cases that involve this type of conduct, such as our case last year against a former Merrill Lynch broker and ten former A.B. Watley day traders and their managers for allegedly participating in a scheme that involved trading ahead of large institutional orders broadcast over Merrill's in-house "squawk boxes."11
In addition to seeking to make sure insiders don't trade with an unfair advantage, we have brought numerous cases involving conflicted research recommendations by analysts, as well as cases intended to make sure investors are treated fairly by the brokers handling their orders. Most recently, we brought a settled enforcement action against Banc of America Securities for failing to safeguard its forthcoming research reports, including analyst upgrades and downgrades, and for issuing fraudulent research.12 Earlier this year, we brought a case against a brokerage firm for secretly double-charging certain customers markups and markdowns, in addition to commissions, a practice that was inconsistent with how those customers understood their orders would be handled.13
We are certainly not the only ones at the SEC that are trying to make sure mutual fund directors have the environment and tools they need to be able to do their jobs most effectively. As many of you know, the Director of the Division of Investment Management, Buddy Donohue, is committed to reaching out to fund directors. As he said to this Forum in early March:
. . . the respect the Division has for fund directors runs wide and deep. . . . I have committed to focus this year on reaching out to fund directors, with the ultimate goal of determining what the SEC and the staff of the Division of Investment Management can do to enable you to be more effective in your oversight role. My goal is not to make your jobs easier, but to allow you to be more effective. Your input will be critical regarding what you think would help you accomplish that goal. . . . [W]e as regulators have an obligation to listen carefully to you. We need to hear about appropriate steps that you, as fund directors, believe are necessary to enhance your effectiveness and to enable you to focus in the boardroom on areas where you can add the most value — rather than focusing your attention on simply meeting regulatory requirements.14
Another example of this kind of sharing is the CCOutreach Program that is sponsored jointly by the Office of Compliance Inspections and Examinations and the Division of Investment Management. As you know, mutual fund CCOs can be an important resource for you in helping to identify conflicts of interest and ensuring that controls are in place to manage those conflicts. As Lori Richards, OCIE's Director, has said, CCOs are the "eyes and ears" of the fund boards to which they report. Lori recently remarked that:
. . . it's important for us to communicate effectively with firms and to do what we can to assist CCOs in ensuring strong compliance. And, it's enormously healthy for us to hear directly from firms about the compliance issues they face, and the challenges they encounter. . . . CCOutreach is a way for us to communicate with CCOs in an environment that fosters communication. One strong message that we've heard from the compliance community is that, while understanding the overarching legal principles is interesting, what they want and need is practical information about specific compliance mechanisms that work. So, at CCOutreach events, examiners are sharing information with CCOs about the compliance deficiencies that we see, about compliance policies and procedures, about the exam process, and the results of our recent examination sweeps — valuable information about compliance problems that CCOs should be alert to in their own firms.15
On that front, OCIE has recently announced its schedule for CCO regional seminars for 2007. There will be 27 events throughout the country.16
That brings me back to Christmas, or at least to Rudolph and Hermie. Being independent and carrying out the many weighty responsibilities with which you are tasked as a director is not an easy undertaking. You are not alone, however, in your mission. Not only do you have the support of the Forum in helping you to be "independent together," but you also have our support. By each performing our important roles in protecting this nation's mutual fund investors, we can best leverage the particular tools and resources we each bring to the table. We are privileged to be your partners in this endeavor, and look forward to continuing our valuable relationship with you.