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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the Mutual Fund Directors Forum
Fifth Annual Policy Conference:
Critical Issues for Investment Company Directors


Paul F. Roye

Division of Investment Management
U.S. Securities and Exchange Commission

Washington, D.C.
February 17, 2005

I. Introduction

Good afternoon and thank you for welcoming me here today. Before I begin, I would like to remind you that, as always, my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I would like to thank David Ruder, Allan Mostoff and the Directors of the Mutual Fund Directors Forum for inviting me to speak to you today. I would also like to commend Northwestern University School of Law for its continuing support of the Forum and its support of these policy conferences. I am always pleased to have an opportunity to share views and receive feedback from mutual fund directors, and I would like to take this opportunity to join Chairman Donaldson in thanking you for the important service you perform on behalf of America's 92 million mutual fund investors.

There can be no doubt that this is a critical period for independent mutual fund directors. Through our new fund governance rules, the Commission has taken steps to expand your control and influence in the boardroom. But it is up to each of you to give meaning to these new requirements by fulfilling your boardroom duties to the best of your abilities--and always with a focus on the needs and interests of your funds' investors.

I do not need to tell you that, as independent fund directors, you are subject to an enhanced level of scrutiny--from regulators, from fund industry observers, from the press and-most significantly-from fund investors in the wake of last year's mutual fund scandals. I believe this spotlight on your activities can have a positive and healthy outcome. It highlights the essential role you play in the protection of mutual fund investors and the importance of your duties in managing and overseeing the funds. Mutual fund directors who exhibit care and diligence in performing their duties have nothing to fear from this increased scrutiny.

At the same time, I understand that many directors may be asking themselves what their role and their focus should be in the wake of last year's mutual fund scandals, and that is where I would like to direct my remarks today.

II. MFDF Best Practices

Mutual fund directors have an opportunity to provide leadership in restoring and solidifying investor confidence in the mutual fund industry. The Mutual Fund Directors Forum is taking the lead in that effort. An important example of this leadership is the development and publication of the MFDF's report titled, "Best Practices and Practical Guidance for Mutual Fund Directors." This very helpful report is the product of an extraordinary amount of time, dedication, hard work and energy of many independent directors seated here today.

I recently heard a clever witticism about the nature of hard word: "Hard work spotlights the character of people; some turn up their sleeves, some turn up their noses, and some don't turn up at all."

When Chairman Donaldson called on the Forum to develop best practices for fund directors, you certainly turned up-and rolled up your sleeves to produce a comprehensive set of guidelines and recommendations that will serve fund directors for a long time to come. Thank you for your efforts and for your willingness to take on this important task-and thank you also for your willingness to take on the tough issues.

I believe that your hard work will pay off as directors now have a set of guidelines and suggested best practices to guide them through the myriad of issues that you face in the boardroom. From structural changes to enhance independence, to recommendations for oversight of fund fees and expenses, brokerage arrangements, valuation and pricing, and management of conflicts of interest. The topics covered by your best practices underscore that, while the scandals revolved around market timing and late trading-two topics that no responsible fund board will likely ignore in the future, a number of the core oversight responsibilities of fund directors remain constant, even in the wake of the scandals. Your best practices will assist directors in tackling these issues.

III. The Scandals

The events of last year hearken back to the mid- to late 1930s. After the genesis of the modern investment company industry in the 1920s, the industry experienced rapid growth, but the rapid growth was in large measure at the expense of the investing public. Dishonest sponsors used investment companies to further their own business interests. Failure to observe principles of fiduciary duty were widespread, and unsophisticated small investors paid the price. After the issuance of a landmark SEC study, exposing many unsavory practices in the investment company industry, Congress passed much-needed sweeping reform legislation: the Investment Company Act of 1940, which established a comprehensive federal regulatory framework for investment companies.

Unfortunately, what we have seen recently in large measure is history repeating itself: management company insiders and those selling mutual fund shares engaging in practices for their benefit, to the detriment of the funds' investors. The difference this time, some 65 years after passage of the Investment Company Act, is that the fraud is in a different form and the dramatic overhaul of the mutual fund regulatory framework is being driven by rulemaking and other Commission actions, using the broad authority vested in the agency by the Congress. Under Chairman Donaldson's leadership, the Commission has moved swiftly and aggressively to address identified abuses and to lay a foundation to minimize the possibility of insider and self-dealing abuses occurring in the future.

While the Commission can write rules, set standards and hold lawbreakers legally accountable, true reform must also rest on the establishment and nurturing of a culture of fiduciary responsibility that comes from within the industry, not just one that is imposed from the outside through regulation or legislation. Thus, fund directors must demand that each fund management firm examine what Chairman Donaldson calls their "moral DNA." Chairman Donaldson has explained what it means to elevate a firm's moral DNA:

It means that senior executives must recognize that while maintaining their focus on the bottom line, they must also remain focused on the ethical lines. It means that management needs to incorporate sound ethics and compliance measures into company business practices, and it means remaking business systems to reduce the incentives, or pressures, for cutting corners. It means that leaders not only live up to the letter of the law, but also internalize and advocate the spirit of these reforms to everyone in their organization. It means that senior managers need to communicate at every level of the business - with consistent actions and words - that ethical conduct is absolutely critical to the success of the business. Finally, leaders must remember that establishing integrity as an organizational culture is a lengthy process - one that requires prioritization, communication, training, and reinforcement.

IV. Code of Ethics

Therefore, it is important that fund directors demand an ethical culture and environment of their advisory firms. In this regard, I would like to discuss certain issues that directors should consider in connection with the new investment adviser code of ethics requirement. Hopefully, all of the investment advisers of the funds you oversee met the February 1st compliance date and have adopted a code of ethics that lays out a standard of ethical conduct for advisory employees. One significant requirement in the new code of ethics rule is that fund managers and other insiders are required to report their transactions in the funds they manage. For the most part, however, the Commission's code of ethics rule allows advisers the flexibility necessary to develop codes of ethics that are tailored to the size and structure of their firms.

It is my hope that advisers use the development of their codes of ethics as an opportunity to review the ethical cultures within their firms and focus on areas where conflicts and temptations exist. You, as fund directors, should question whether advisers' codes of ethics adequately address circumstances where advisory employees' actions could permit them to gain some advantage at the expense of fund investors.

One example that has received attention recently is advisory employees' acceptance of gifts and entertainment. There is no doubt that the receipt of lavish gifts and entertainment can influence fund personnel's actions, and even tempt fund personnel to take actions that may not be in the best interest of fund investors. Consequently, it is essential for advisers-and fund directors-to consider whether there are appropriate controls in place addressing the receipt of gifts and entertainment. A code of ethics is an appropriate place to outline a firm's philosophy regarding the receipt of gifts and entertainment as well as establish the controls the firm puts in place to limit the corrupting influence of such gifts.

In addition to the receipt of gifts and entertainment, there are a number of other areas that may be appropriately addressed by a firm's code of ethics. Particularly instructive and helpful in this regard is a report prepared by the Investment Counsel Association of America entitled "Best Practices for Investment Adviser Codes of Ethics." This best practices report was also prepared at the request of Chairman Donaldson and provides guidance on a number of areas where code of ethics restrictions may be appropriate, but not necessarily required by the SEC's new rule. These include outside employment and other personal activities; outside board service; marketing and promotional activities; political and charitable contributions; and financial transactions and other interactions with clients, vendors and marketers. All of these are areas worthy of consideration by fund boards, as they have the ability to compromise the judgment of fund personnel-if not handled appropriately.

V. Important Lessons for Directors

In the wake of the scandals, what else have we learned that can be helpful to fund directors (as well as regulators) in carrying out their responsibilities for fund oversight?

A. Think Outside the Box

One thing that I believe is clear, is that in trying to anticipate problems and areas where there could be issues within the firms that manage your investors' money, you have to be prepared to "think outside the box." Why would the founder and chief executive officer of a substantial money management firm market time his firms' funds for relatively small profit? Why would executives at the highest levels of firms provide non-public information about a fund's portfolio holdings to preferred clients so they could trade against the fund and potentially depress the value of the fund's portfolio securities? Isn't fund performance a key component of attracting assets and growing funds?

Why would high level executives sanction and approve market timing arrangements that allow for the rapid switching in and out of a fund substantial assets that disrupt portfolio management, drive up transaction costs and adversely impact fund performance? These unlawful actions were potentially questionable when in many cases the additional fees generated by "sticky asset" arrangements were relatively small when juxtaposed against the adverse impact on the performance of their funds, which made the fund less attractive to prospective investors.

So while some types of malfeasance may seem counterintuitive, you nevertheless need to expect the unexpected and urge your compliance personnel to take nothing for granted.

B. Beware Fund Intermediaries

Many of the issues identified in the fund area give fund directors plenty of reason to "beware fund intermediaries". For example, we have seen, on a wide-scale basis, that fund investors were not receiving the front-end load breakpoint discounts to which they were entitled from broker-dealers selling fund shares. While the failure to credit breakpoint discounts appears, for the most part, to have resulted from carelessness rather than intentional fraud on the part of service providers and others, it represents a lack of diligence that is harmful to investors, which cannot be tolerated.

Even more alarming and distressing is that certain fund intermediaries (again broker-dealers and pension plan recordkeepers) were also involved in facilitating late trading of fund shares--a practice that is clearly unlawful. In addition, some of these intermediaries even developed elaborate schemes, even created business models designed to hide late trading or abusive market timing activity from regulators and the funds who were trying to do the right thing for investors by policing these activities.

As an example, one of the complaints in a Commission action against a broker-dealer and several of its executives accused of facilitating late trading and abusive market timing for key institutional clients, including several hedge funds, contains a quote from an internal e-mail. The quote reads:

[Two of their executives] know the position that they have put us in relative to these fund groups - and they will openly state that their customers will continue to seek places where this type of activity is allowed until the breaking point is hit…. It's not unlike a rock band which knows that they continue to trash hotel rooms on their tours-and as soon as Hyatt throws them out, they'll move on to Hilton, then Marriot, then somebody else. They know it's coming each time, and they'll just keep moving to the next outlet as long as they can continue to play the game …. At the same time [the firm] is in no hurry to turn off the customers-there's revenue in the tickets and value in having the assets on the books for as long as the gig is on.

Well, the gig is now off. The two executives referred to in the e-mail, and their firm, are facing SEC fraud charges based on their alleged efforts to facilitate late trading and market timing. As you consider the adequacy of compliance controls and procedures to protect your investors and the reputations of your funds, you should obtain assurances from fund managers that the intermediaries that sell your funds are complying with the law. For example, directors should feel comfortable that dealer agreements and other contracts reflect intermediaries' obligations to comply with the law and to appropriately segregate and process fund orders. You should also assure yourselves that the fund's underwriter is appropriately monitoring the intermediaries to ensure that they are processing fund transactions according to the agreed-upon guidelines. The following questions are appropriate: Are our investors receiving the breakpoint discounts to which they are entitled? Are brokers making the appropriate disclosures to investors about their conflicts and compensation in selling our fund shares? Fund directors can no longer take these issues for granted. You should be asking the questions and obtaining the assurances necessary to make sure that abusive practices are not permitted to take advantage of your funds' investors.

C. Gathering Assets at the Expense of Fiduciary Obligations

Another overarching theme evident in the recent scandals is the willingness of some to compromise their integrity and ethical standards in order to attract new assets to their funds. I believe this is the primary reason we are dealing with the aftermath of a scandal today. In the late 1990s and early 2000, it was blue skies and smooth sailing for the fund industry, as the markets were doing well and assets were flowing into funds. But with the downturn in the markets, performance of funds lagged and asset growth slowed. But the pressure on fund executives to grow or maintain the size of their funds continued. Unfortunately, many sacrificed their business ethics, cut corners and traded-off investor interests for their own. But as we have seen, business built on questionable ethical standards is simply a house of cards waiting to crumble. As some would say in Kentucky where I grew up, "sooner or later the chickens will come home to roost."

So fund directors should be on guard to see to it that the distribution side of the mutual fund business does not compromise the business; that "we must grow at any cost" is not the mantra, or, to paraphrase Jack Bogle, you do not trade off stewardship for unethical salesmanship. Therefore, there should be no place in your fund groups for "sticky asset" arrangements, undisclosed compensation, kick-back schemes, or other unscrupulous practices to promote distribution of fund shares.

In this regard, as a result of the conflicts of interest that surrounded the use of brokerage commissions (which, of course, are fund assets), to promote distribution of fund shares, the Commission banned so-called directed brokerage practices by mutual funds. The concern was that directed brokerage practices to promote distribution can compromise best execution of portfolio trades, increase portfolio turnover, conceal actual distribution costs and inappropriately influence broker-dealer recommendations to investors.

D. Focus on Conflicts of Interest

In most of the enforcement cases arising out of the scandal, we cannot blame fund boards for the compliance lapses within the funds. Fund managers actually concealed these compliance issues from the board. But troubling questions persist as to why management personnel were able to successfully conceal these problems. What questions could have been asked that would have unraveled the frauds at an early stage? What steps could boards have taken that would have prevented the types of abuses we are seeing?

One answer is that directors must focus on areas where conflicts of interest present themselves. This is perhaps the most significant and enduring problem in the fund industry - conflicts between fund managers and the funds they advise. The Commission's recent enforcement actions in many cases reflect instances in which funds were used for the benefit of fund insiders, often the management company or its employees.

I hope that the recent effort to review compliance policies and procedures has been therapeutic and an opportunity to rethink practices and ways of doing business, and that your fund groups and their service providers have addressed or eliminated conflicts of interest and practices that can compromise investor interests.

A fund's CCO 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 you know, part of the job of a CCO is to monitor the effectiveness of a firm's compliance policies and procedures, and we envision that this monitoring will include periodic testing of the procedures to ensure that they are working. You should be requesting information from your CCOs about the results of this kind of testing--with a particular emphasis on ensuring that the procedures in place are effective in controlling conflicts of interest.

Indeed the Forum's Best Practice Guidelines recommend that a fund board establish a process for identifying and reviewing conflicts of interest that can flow, for example, from the operation of other businesses by the adviser or an affiliate or the adviser making available new investment products or services.

VI. Consider Risk Assessment

So given the types of frauds we have seen--management company insiders and fund intermediaries yielding to conflicts of interest--just what should fund directors do to head off or minimize the impact of the next scheme to defraud or overreach fund investors? Beyond effective use of the new compliance officer function, I would suggest that fund directors encourage management companies to engage in the type of risk assessment exercise that Chairman Donaldson has instituted at the Commission.

As Chairman Donaldson has stated, his belief is that, if the Commission is to create an effective oversight regime, we must be better equipped to anticipate, find and mitigate areas of financial risk, potential fraud and malfeasance. We have engaged in a risk-mapping exercise from the bottom-up in our various offices and divisions to identify potential areas of concern. This risk-mapping exercise has provided the senior managers at the Commission the information necessary to make better, more informed decisions and to proactively adjust operations, resources and methods of oversight to address these risks and potential problem areas.

Given the 8 trillion dollars in mutual funds today, the time is ripe, post-scandal, for mutual fund management companies to embrace these types of risk assessment initiatives. Such an exercise should start with the various ways you attract investors to your funds, through your receipt of their investments, to the management of these investments and day-to-day operations, through returning money to investors who redeem out of your funds. Along this continuum, how can our investors and funds be harmed, where are our vulnerabilities, where do we have major expenses, where are we dependent on the integrity of service providers? Then, once these risks have been identified, how can we eliminate, mitigate or control for them? What structural or organizational changes or defensive approaches might be applied to address the issues? And as you prioritize your risk areas, be mindful of where the conflicts are the greatest, but do not look past the obvious or assume too much. This is a process that requires a healthy dose of skepticism, particularly in light of the events of the last 18 months.

VII. Conclusion

In conclusion, I ask that you continue to focus on your special role as fund directors. Sixty-five years ago, Congress identified the need for independent oversight in order to manage the conflicts inherent in the mutual fund management structure and therefore required that funds have independent members on their boards. In the ensuing decades, you as fund directors have become more empowered and your role further expanded to encompass the "independent watchdog" function you serve today.

In light of the recent scandals, you face new challenges in your continuing efforts to protect investors. We want to do everything we can to assist you in meeting these challenges. We encourage you to rise to meet these demands and challenges and serve fund investors with your talent, dedication and tenacity.

Thank you very much for listening.


Modified: 02/17/2005