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U.S. Securities and Exchange Commission

Speech by SEC Staff:
A Turning Point for America's Mutual Fund Industry


Paul F. Roye1

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

ICI 2003 Securities Law Developments Conference
Washington, DC
December 4, 2003

I. Introduction

Good morning 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.

Unfortunately, we gather today under a cloud. And this cloud did not develop out of a market downturn or a sinking economy or competition from outside the mutual fund industry. The industry's problems are not the result of external forces beyond its control, but directly flow from the unscrupulous actions of some mutual fund personnel and those who sell mutual fund shares and their colleagues who looked the other way when unlawful activity was occurring.

For quite a while, I, my predecessors, my colleagues on the Commission staff and the Commissioners themselves have been preaching the importance of vigilant compliance and attention to the paramount interests of fund investors, even when these messages were not popular. At times, representatives from the Commission may even have sounded out of synch with reality-when we focused on enhanced compliance, improved fund governance and investor-friendly disclosure initiatives-while the industry was experiencing vast fund inflows and an apparent abundance of investor trust and confidence.

Our concern about maintaining investor confidence, and ensuring that investor interests were appropriately protected, led the Commission to take a series of actions that were criticized by some as unnecessary at the time, but were intended to be proactive measures to protect investors. These include applying the Sarbanes-Oxley provisions to mutual funds, issuing a concept release on further private sector involvement in fostering compliance by funds and advisers, adopting rule amendments to improve the fund governance framework, and, of course, proposing the compliance policies and procedures rules, which the Commission adopted yesterday.

All of these initiatives represented forward-thinking structural changes to improve fund oversight for the benefit of investors. While they may have been criticized by some, I am proud of the Commission's commitment to investor-oriented fund regulation-both now and in the last few years, when few were looking, but the issues were no less pressing.

Nearly every time we open a newspaper or business magazine, we see negative headlines regarding mutual funds and news stories outlining conduct that represents the antithesis of a mutual fund manager's fiduciary duty to put investors first. Along these lines, I would like to share with you a quote about the U.S. investment company industry. The quote reads as follows:

"'[W]e in the United States shall inevitably go through a ... period of disaster and disgrace'" because investment companies are "being operated primarily to serve the self-interest of the sponsors rather than the best interests of the shareholders." ... "General abuses [by] ... [investment company] managers can be traced to `dishonesty, inattention, inability and greed.'"2

Ironically, while these words ring true today, they were spoken in April 1940 when SEC Commissioner Robert Healy testified before a subcommittee of the Senate Banking Committee in support of the passage of the Investment Company and Investment Advisers Acts. Commissioner Healy was quoting Paul Cabot of the State Street Investment Corporation who in 1929 [in an article appearing in "The Atlantic Monthly"] predicted a period of "disaster and disgrace" for the U.S. investment company industry because of the unprincipled activities of some of its managers. While Mr. Cabot may have had a pulse on the environment and activities that led to the passage of the 1940 Acts, he equally foreshadowed the current state of affairs in the mutual fund industry.

As I have said before, when you lose trust, you predictably lose investor confidence. Unfortunately, when it comes to mutual funds, this is no longer a theoretical proposition. It is the reality that you now face. The conduct that has been unearthed by the recent scandals is reprehensible conduct. It has no place in an industry that is based on fiduciary principles.

This conduct, which put the management company or fund personnel's interests above fund investors, will have significant and wide-ranging costs and impact on the industry. First, there is the cost to the individuals who were foolish enough to compromise their integrity in order to line their pockets with, what in many cases, was a relatively small amount of profit. These individuals may be facing jail time or, at the very least, loss of career and loss of reputation.

Second, there is the cost to fund management companies. Management companies with lax compliance procedures or that looked the other way when their executives, portfolio managers or marketing personnel were engaging in activities that were harmful to shareholders will now pay the price. Some have already seen significant assets withdrawn from their management. And the market will continue to punish those management companies that failed to ask the right questions and stop anti-investor conduct.

Third, there is the cost to innocent individuals at fund management companies who were not in a position to stop, or even aware of, these abuses but may lose their jobs in the layoffs that inevitably will result from the loss of assets under management, as disillusioned investors pull their investments from suspect fund management companies.

Next, there is the loss of credibility to the industry as a whole. Many investors are asking whether mutual funds are safe places for their investments or whether they are being ripped off through hidden and unscrupulous practices. As a regulator, you question credibility when you have fund groups knocking on your door for additional tools to curb market timing activity, when they are facilitating market timing in their funds in return for "sticky assets" or investments in other funds to increase management fee revenue. You question the credibility of those who on one hand protest more frequent portfolio disclosure for investors so that they can make better asset allocation decisions, but then selectively disclose their fund's portfolio holdings to curry favor with large investors who then trade against the fund.

Finally, and most importantly, there is the cost to investors of feeling betrayed by the fund management companies in whom they placed their investment dollars, and their trust. Fund investors are the ultimate losers in this scandal. However, they also continue to be the center of the Commission's focus as we work to clean up this mess.

As you no doubt have realized by now, our Enforcement Division and Examination staff are in high gear, working closely with the states to investigate the full extent of the abuses, identify and root out the wrongdoers and restore to investors the amounts to which they are due. But the Commission's actions are not limited to enforcement activity. Where the regulatory regime is broken, we will fix it.

We witnessed an example of this yesterday as the Commission took action on three fronts to benefit fund investors and reinforce protections provided through fund regulation.

II. Compliance Policies and Procedures Rule

First, the Commission adopted the compliance policies and procedures rules. As indicated in the discussion at yesterday's Open Meeting, the compliance rules represent one of the core enhancements the Commission is making to the mutual fund regulatory regime in light of the recent abuses we have seen. Indeed, many of the cases that the Commission has considered recently illustrate the damage that can result when compliance breaks down.

As will be laid out in the adopting release that the Commission will issue shortly and make available on its website, the Commission believes that the types of policies and procedures that are required under the fund compliance rule include policies and procedures to guard against late trading, abusive market timing and selective disclosure of nonpublic information about fund portfolio holdings.

I should also state that the adopting release contains a clear and unambiguous statement of the Commission that funds have an obligation under certain circumstances to fair value price their securities. Much of the current market timing activity involves "time zone arbitrage," whereby opportunities are created to profit when, for example, a fund holds portfolio securities traded on a foreign market that closes hours before the fund prices its securities. If an event affecting the value of the foreign securities occurs after the foreign market closes, but before the fund prices its shares, the fund's share price will be inaccurate if it is calculated on the basis of stale foreign market closing prices. The release states that funds in these circumstances must determine the fair value of these securities at the time the fund prices its shares.

The release further indicates that a fund's compliance policies and procedures must include procedures that require funds to (i) monitor for circumstances that necessitate the use of fair value prices, (ii) establish criteria for determining when market quotes are no longer reliable for a particular portfolio security, (iii) provide a methodology, or methodologies, by which the fund determines the current fair value of its securities, (iv) and regularly review the appropriateness and accuracy of the methodology used in valuing securities and making any necessary adjustments.

The release also notes that, in some cases, funds have adopted policies and procedures requiring the use of fair value pricing, but have established criteria that result in infrequent use of fair value pricing, which provides an opportunity for price arbitrage. The release addresses this issue by indicating that the failure of a fund to establish sufficiently sensitive criteria for using fair value pricing should be recognizable in subsequent measures of the accuracy of the prices used to compute net asset value of the fund. This is clearly an area that requires, indeed the statute mandates, close scrutiny by fund directors.

In addition to mandating compliance policies and procedures, and the annual review of those policies and procedures, the compliance rules also require each fund and adviser to designate a chief compliance officer responsible for administering the compliance policies and procedures. The designated chief compliance officer should be competent and knowledgeable regarding the applicable federal securities laws and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures.

I cannot overstate the importance of the chief compliance officer's role in ensuring fund compliance and, ultimately, protecting fund investors. Compliance must be a critical function in any money management organization. Therefore, I encourage you to carefully consider candidates for this position at each advisory firm and further encourage fund directors to choose a candidate who is principled, responsible, firm and determined when designating a chief compliance officer for each fund.

III. Amendments to Rule 22c-1

The second action the Commission took yesterday was the proposal of amendments to rule 22c-1 under the Investment Company Act, which mandates forward pricing of mutual fund shares.

We are very concerned that rule 22c-1, in its current form, which permits intermediaries to process trades after 4:00 p.m. if those trades were received by the intermediary prior to 4:00 p.m., has failed to prevent the late trading of mutual fund shares, as evidenced by the recently exposed numerous incidences of late trading. Consequently, to minimize late trading opportunities, the Commission proposed what we call the "hard 4:00 p.m. close." We understand that such a change does not come without a cost-most notably a decline in the ability of some fund investors, particularly 401(k) plan investors, to obtain a same day price for their fund purchase and redemption orders. Therefore, we and the Commission will closely examine the comments we receive on this proposal.

But it must be noted that, for a substantial number of mutual fund investors, such a change would not be noticed because they are long-term investors and, therefore, the price they receive is a non-event. All mutual fund investors, however, will benefit from the elimination of late trading and the confidence of knowing that a favored few cannot take advantage of them.

IV. Disclosure Amendments

The third action the Commission took yesterday was to propose a series of revisions to its disclosure requirements. These revisions, if adopted, will highlight for investors fund policies related to market timing, fair value pricing and disclosure of portfolio holdings information. These enhanced disclosures will allow investors to scrutinize fund policies in these areas and hopefully cause the appropriate focus to be placed on the importance of these issues by fund management.

V. Additional Regulatory Reforms

While the Commission and the states are continuing their efforts to uncover the extent of the wrongdoing, yesterday's regulatory actions by the Commission represent a first step toward an improved regulatory framework that will severely curtail, and hopefully deny, fraudsters' ability to engage in the kinds of late trading, market timing and selective disclosure abuses that have dominated headlines since September.

The Commission will not stop there. Chairman Donaldson has called for a package of further reforms that are designed to provide reassurances and additional protection for mutual fund investors. He has directed the staff to study additional measures to combat problematic market timing activity, including requiring a mandatory redemption fee imposed on short-term traders, and developing a solution to the problem of market timers trading through omnibus accounts.

We are re-doubling our examination efforts, coordinating with the Mutual Fund Directors Forum and the NASD on their respective projects to prepare best practices for independent directors and to examine and make recommendations regarding omnibus accounts, and targeting other fund-related areas for regulatory reform--including fund governance.

The problems that recently have come to light underscore the need for enhanced effectiveness of independent directors in carrying out their responsibilities. Therefore, Chairman Donaldson, has asked the staff to consider a number of areas for reform including requiring an independent chairman of each fund's board of directors and increasing the percentage of independent directors from a majority to three-fourths and requiring boards of directors to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure.

Finally, Chairman Donaldson has identified improving fee disclosures for mutual fund investors as a top priority. I anticipate that, in January, the Commission will consider adopting rules that would require "dollars and cents" disclosure to shareholders, coupled with more frequent disclosure of portfolio holdings information. The Commission also will be considering a proposal to require disclosure to mutual fund investors regarding the availability of sales load breakpoints and considering the issuance of a concept release on ways to provide fund investors better information on portfolio transaction costs.

The Chairman has also directed the staff to prepare a new mutual fund confirmation statement that will provide fund investors with information about sales loads and other charges they incur as well as highlight the incentives that brokers have in recommending particular funds, including specific information regarding revenue sharing arrangements, differential compensation for the sale of proprietary funds and other incentives--such as commission business-that brokers receive to sell fund shares that may not be readily apparent to fund investors.

All of the regulatory initiatives that I have outlined are designed to address immediate areas of abuse, improve disclosure to investors and foster enhanced oversight and governance of the mutual fund industry.

VI. Conclusion

In conclusion, I can promise you this. With the combined efforts of the SEC, the states and other regulators, as well as the efforts of responsible industry participants, the fraudsters will not win. We do not want them in our midst, and in light of SEC and state enforcement actions, as well as fund management companies' and brokerage firms' own "cleaning house," they will be gone.

But that is only half the battle. We must also view the recent scandals as an industry wake-up call. We should be outraged, disturbed and disgusted by what has transpired. Every firm must now realign itself to ensure that it is focused on investors' best interests, first and above all else. Similarly, the Commission and the staff are examining our fund regulations to ensure that they are fashioned to best promote investor interests and curb temptations to enhance insiders' returns at the expense of fund investors.

And as you review the proposals coming out of the Commission, I urge you to consider them first with a view of how they can be improved to enhance investor protection, and not from the perspective that we see reflected all to often in industry comments, comments which are designed in many cases to maintain the status quo. It is clear that the status quo is unacceptable to America's investors.

The year 2003 will no doubt be remembered as a turning point in the history of America's mutual fund industry. It is up to us, however, to determine if that turn is for the better or for the worse. At no time since the 1920s and 1930s has the industry been shown to have behaved in such an irresponsible manner. It is my hope that in the decades to come, at conferences such as this one, our progeny will look back at 2003 and applaud the regulatory reforms and industry initiatives we put in place to address anti-investor behavior. They will hopefully look back and say that the industry learned from its mistakes and recast itself as an industry deserving of its role as the investment of choice for the average American to invest for retirement, save for educational expenses and meet his or her financial goals.

Ladies and gentleman, you carry a heavy burden to restore investor trust in funds. As I have said before, trust is not given freely, it must be earned. Each of you has a responsibility to step in and stop particular actions the moment you suspect they might have an anti-investor component. Finally, you must build fund cultures where pro-investor sentiments are welcomed and those with a view toward maximizing management return at the expense of fund investors are shunned. Only then will the industry deserve the trust, respect and confidence of America's investors.

Thank you for listening, and I hope you have a constructive and productive conference.


1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

2 "Investment Trusts and Investment Companies," Hearings before a Subcommittee of the Committee on Banking and Currency, United States Senate, 66th Congress, 3rd Session on S. 3580 (Apr. 2, 1940) (statement of Robert E. Healy) (quoting Paul Cabot).



Modified: 12/04/2003