Speech by SEC Staff:
Mutual Fund Consolidation and Globalization:
Challenges for the Future
Barry P. Barbash
Director, Division of Investment Management
U.S. Securities & Exchange Commission
to the Mutual Funds and Investment Management Conference
Sponsored by the Federal Bar Association
and the ICI Education Foundation, Orlando, Florida
March 23, 1998
Thank you. After almost 24 hours in Orlando, I have found that Central Florida has lots to offer besides Disney. What is most striking about everything is its size. Here you can shop at the biggest FAO Schwarz in America and play at the biggest McDonald's indoor playground.
In the near future, if you tire of driving, you'll be able to park in the biggest garage in the universe, which will soon be opening at Universal Studios. For more shopping, you can visit the 49,000 square foot Virgin Records Megastore in Downtown Disney, or go to nearby Apopka, where Wal-Mart is building its own megastore on nearly 30 acres, which will include, among other things, a bank. By all accounts, Central Florida exemplifies the observation 50 years ago of British author E. M. Forster that "America is rather like life. You can usually find in it what you look for. . . . It will probably be interesting, and it is sure to be large."
Bigness seems to pervade not only Central Florida, but also American economic life today. Hardly a day passes without another story about the bulking up of U.S. industries. Within the last few months, merger announcements have swept businesses ranging from utilities to waste management to securities exchanges.
Newspaper editors are struggling to come up with creative headlines for the almost daily merger developments. Some of the most vivid include: "Two Top Garbage Companies Announce Singular Merger"; "Global Swarming; Corporations Are In A Merger-and-Acquisitions Bonanza"; and "Firms' Mergers Back in the Melting Pot." And then there's the ever-present matrimonial theme: "Exchanging Vows"; "Traders Weigh the Marriage of the Markets"; and "There's a Steady Rush to the Corporate Altar."
The fund industry has certainly seen its share of mergers and consolidations. Back in 1995, a Goldman Sachs study boldly predicted that within five years the investment management business would be characterized by 20 to 25 giant firms, each with at least $150 billion in assets. The industry does seem headed down this track; each of the top 14 firms today manages over $150 billion in assets. The corporate transactions about which we read almost daily are further evidence supporting the prediction -- consider Merrill Lynch's $5.3 billion purchase of the U.K. firm, Mercury Asset Management, Morgan Stanley's merger with Dean Witter Discover & Co., Travelers' merger with Salomon, and The Zurich Group's purchase of Kemper and then Scudder in the past two years. Here's an as yet unreported statistic consistent with the prediction -- over the past year, the Division of Investment Management has received merger-related applications from investment company and advisory firms at the rate of about one a week -- and these are only the mergers that need exemptive relief.
The ongoing technological revolution is giving this wave of consolidation an unprecedented global dimension. Round-the-clock trading, the Internet, and other advances that in large part are technology-driven make national borders and time zones appear irrelevant. It has become logistically much easier to acquire assets, distribution channels, and expertise on a global scale.
Today's global financial services firms seek to serve an investor's every possible need. A recent headline in the Wall Street Journal exclaimed "It's a Broker! It's a Banker! It's a Mutual Fund Group!" The ability to offer everything to everyone -- the perennial goal of being a financial services supermarket -- seems to translate into a quest for size. Technology facilitates this goal. When an investor visits a group of mutual funds on an Internet site, the firm's got him in its web -- a simple click will lead an investor to its other financial services. Technology and a new generation of investors -- with more investment dollars, demands, and questions -- have fueled the drive in the money management industry to be able to offer just about every financial service under one roof.
We all need to pause and consider the implications and the consequences of this growth and consolidation. The consequences will be significant both from the industry's perspective and from that of the regulators.
How will a consolidating fund industry meet the needs and expectations of investors? What about compliance systems in an organization that suddenly finds itself much more diverse, with varying priorities, conflicting cultures, and increasingly complex affiliations? What will the challenges be for regulators of a booming global industry? Transnational business means multinational regulation and an international investor base -- what tensions will this create? These are the issues on which I will focus this morning.
I. Serving the Needs of Investors
To understand the latest wave of consolidation in the fund industry, one needs to look at the forces behind it. Many point to the desire to gain access to the individual investor as the driving force.
Today's retail investor has been called the tycoon of modern finance. Ron Chernow, in an article entitled "Death of the Banker," put it this way -- "J.P. Morgan is dead. But the transcendent power of the banker in his prime hasn't passed to today's mutual fund managers. Instead, it is parceled out among millions of small investors who follow their stocks and mutual funds and move money from places of lower to places of higher returns with a phone call or the stroke of a computer key."
What does today's investor want? Above all, it seems, an investor wants to be sure that she is making the right investment decisions. Thus, she increasingly is seeking help in managing her money, and appears to be willing to pay for the convenience of one-stop shopping and a variety of investment advisory services. The industry is responding to this trend; many major newspapers today contain half-page ads, often from mutual funds, reassuring readers that the
smart choice is to hire a financial adviser.
How is this demand for investment advice reflected in the industry's merger trends? We have only to look at a recent phenomenon, referred to by some as "The Demise of the No-Load Fund." The Wall Street Journal recently noted that "One of the striking aspects of the current wave of fund-industry mergers has been how willing buyers have been to combine load and no-load companies, which once mixed like oil and water."
Some fund groups have taken things one step further, and converted their no-load funds to load, causing the load fund to be dubbed the "Come-Back Kid of Mutual Funds."
Investors pay for investment advice, whether it comes in the form of a mutual fund, a wrap fee program, or a broker. How much an individual investor pays for the services of a financial adviser or investment manager appears to be somewhat less of a concern for her today, when she may do more comparison shopping for her VCR than for her mutual funds. The observation that "Most investors are blissfully unaware of how much they are paying for the privilege of owning a mutual fund," may not be an overstatement.
5 A 1996 OCC/SEC survey concluded that fewer than one American in five knows how much her funds charge.
6 It seems that, when economic times are good, investors think that they can afford to be oblivious to these costs.
Investor attitudes toward fund fees are likely to change, however, should fund performance decline. At some point in the future, a consolidating fund industry may be faced with a penny-pinching financial services consumer, and will have to tailor fees and other aspects of its business to accommodate this change. I think that I can safely predict that a spotlight will be on expenses related to the distribution of fund shares. Distribution-related expenses always have been, and always will be, a sensitive issue.
One consequence of consolidation is that it may reduce the number of distribution channels available to funds, giving distributors greater market power, and potentially make fund access to investors, and investor access to funds, more expensive. The question then will be how much the industry needs to spend on distribution services and where it will find the necessary resources. Will investment advisers, for example, find more of their financial and managerial resources being devoted to distribution and less being focussed on basic portfolio management? How will investors react to these developments? Will their expectations concerning fund performance -- expectations that have been raised by the greatest bull market in history -- continue to be met?
We already have a preview in the 401(k) plan market of how the issue of fund fees may play out. A primary force behind recent mergers in the fund business has been the desire to gain access to this market, which includes 25 million participants investing about $1 trillion in the aggregate.
The issue of the day for almost every financial magazine lately is the topic of fees charged by 401(k) plans and whether they are excessive.
7 On the regulatory side, the Department of Labor held a hearing last Fall to consider whether 401(k) plan sponsors and participants understand the fees they are paying and whether additional disclosure is needed. Our Division is beginning an updated study of mutual fund fees, including those associated with 401(k) plans. We will look at trends in the overall level of fees, the way fees are assessed, and whether fees continue to reflect the existence of economies of scale that are passed along to fund shareholders. Raising investor awareness and understanding of fund expenses may, in turn, lead investors to demand greater clarity and accountability for fund fees, both in the context of 401(k) plans and otherwise. Preparing for these changes should be one of the top priorities for the industry.
Investor demands will take on an altogether different meaning as a result of the globalization of the financial services industry. Many recent international mergers likely will make it easier for the investment management business to enter foreign markets, efforts that at present appear to be in the pioneering stage. Having a universe of investors that includes those from other countries, however, has its own implications.
An issue that recently has come to the fore is the disparity in the type of fee disclosure that U.S. and foreign investors receive. Most funds based in Europe and Asia, for example, disclose only management fees, not other expenses, such as distribution costs, paid by fund shareholders.
8 The stark contrast between the opaqueness of the information provided by these funds and the transparency of fee information relating to U.S. registered funds has begun to be noticed. A recent study concluded that, for the year ended 1996, the fees paid by offshore funds based in Europe actually were $2 billion higher than the management fees disclosed to investors.
9 Criticizing this state of affairs, the study's author expressed support for the U.S. system of fee disclosure and urged European regulators to adopt a similar system.
10 I can report that at least some of those regulators believe that measures to improve fee disclosure by European funds should be undertaken and soon.
The U.S. appears to have a successful export to offer foreign investors when it comes to fees. Our pricing rules and our accounting policies already are being used by offshore funds. It would not be surprising to see our fee disclosure and other rules adopted by regulators in other countries.
The goal of finding an appropriate framework that meets the needs of investors in different countries is not new -- almost thirty years ago, SEC Chairman Hamer Budge spoke about an effort to create international regulatory standards for the operation of mutual funds, including uniform standards for disclosure and fees. Given the large-scale globalization of the industry, will anyone need to make the same point thirty years from now? The answer to that question will in large part depend upon whether the industry and regulators can meet the compliance and regulatory challenges presented by this wave of consolidation -- the issues to which I will now turn.
II. Compliance Systems
Transnational differences in fee disclosure requirements are but one example of the differences in approaches -- both regulatory and cultural -- that will accompany the consolidation in the financial services industry in the 1990s. The "urge to merge" has brought together firms from different hemispheres with readily apparent differences in business approaches, worldviews, and regulatory environments.
I submit that whether a firm achieves its hoped-for business synergies will depend in no small part on how effectively it can integrate the different regulatory compliance systems in its organization. In the most immediate future, operational systems must be able to function in the new millennium -- which will be here in 21 months and 9 days. The information processing challenges of the Year 2000 problem are likely not on the top of the to-do lists of companies involved in mergers or consolidations. But any merged or consolidated company that finds the different parts of its organization in various stages of Year 2000 readiness will need to take immediate steps to coordinate these efforts or suffer firm-wide consequences when the Year 2000 arrives.
An international financial services firm will face its own distinct systems issues. As my European colleagues remind me continually when I bring up the Year 2000, the Year 1999 comes first, bringing with it a unified currency system on the Continent. Dealing with this issue alone is likely to be daunting for the global money management firm. Add to this compliance mix the need to address the regulatory requirements and possible inconsistencies among a number of countries.
Consolidation among geographically and functionally diverse firms is bound to bring together different approaches to compliance. Inconsistent personal trading policies, conflicting policies governing transactions between affiliates, or uneven enforcement of these policies, may be common examples of the problems faced by these firms. Proper coordination, clear communication, and responsible oversight of compliance systems must be a central post-merger goal. An increasingly large organization -- larger, perhaps, because of a merger -- can make achieving the goal more difficult.
Anyone watching tonight's Academy Awards no doubt will hear the word "Titanic" mentioned numerous times. Think about the lessons of the Titanic -- the ship, not the movie. The ship was big and seemed to offer passengers everything, but "big" may have contributed to the tragedy. "Big" gave those running the ship a false sense of security so that iceberg warnings were repeatedly ignored. "Big" caused people to believe that a grossly inadequate number of lifeboats was sufficient. "Big" caused otherwise responsible, experienced professionals to ignore established procedures and take reckless chances. So while size may create business opportunities, it may also increase the compliance challenges, both in terms of the complexity of the organization and, perhaps, its culture and mindset.
Integrating compliance systems is a task that cannot be ignored, undertaken halfheartedly, or become a race to the bottom. The Commission's fund examination staff recently has been looking closely at compliance issues raised by consolidation in the money management industry. Their examination findings point to a range of problems that arise when companies attempt to integrate compliance systems. Some companies have encountered difficulties integrating their systems due to something as basic as incompatible computer systems. Other companies have had to deal with problems caused by time-zone differences and geographical distance between compliance officers and the investment staff.
Some other troublesome themes found by the examination staff include inconsistencies in compliance policies, uneven enforcement of compliance procedures among different parts of the firm, insufficient communication among the various compliance personnel, and varying levels of awareness about compliance policies and procedures among employees. Hasty elimination of compliance departments of acquired companies, perhaps in an effort to reduce costs, in some cases appears to have reduced the overall quality of the compliance program or left gaps in a firm's compliance system. Given the implications of this approach to realizing the goals of mergers, I don't understand how it can be tolerated by business executives or regulators.
The issues relating to integrating compliance systems become even more complicated when a fund group becomes part of a larger organization that includes other financial services firms. Increasingly, fund complexes are becoming affiliated with firms with which the funds regularly transact business. Any new relationship could give rise to a host of issues under the Investment Company Act, which, as we all know, restricts, and in certain cases prohibits, a fund's transactions with its affiliates.
From the standpoint of compliance systems, just keeping track of the relationships and their implications for the transactions in which a fund and its various affiliates may wish to engage is difficult but extremely important. It is important both for the fund and for the entities that may be used to doing business with the fund but suddenly find themselves subject to unanticipated regulatory limitations resulting from a merger or consolidation. A key goal of a compliance system in this situation should be to convey to all parts of the organization that these limitations are not a nuisance but must be taken seriously and properly addressed. Procedures need to be revisited to assure that they reflect the new business landscape -- to assure, for example, that existing business relationships have not evolved into conflicts of interest. Effective procedures will prevent a firm from finding itself unable to engage in a transaction that would benefit investors, but that is prohibited because a conflict of interest has not been addressed in time.
Admittedly, creating a unified system of compliance that meets the needs of different business entities under a single organizational umbrella may be complicated and costly. In some respects, the process presents issues that are unique to the 1990s. For reasons that should be clear to all of us, however, achieving synergized compliance systems should be foremost in everyone's post-merger game plans.
III. Regulatory Implications
The evaluation of the Commission's examination staff of the effects of mergers and consolidations on the compliance systems of investment management firms is part of a broader response that we as regulators will be formulating in the coming years to these developments in the industry. The effort cannot be confined to this country -- we are now in a global economy with a growing number of international firms.
Any inconsistencies among regulatory systems are likely to become magnified in the near term as U.S. firms do more business overseas. The Commission has recognized the goal of increased coordination by fund regulators throughout the world and has sought to achieve this goal through its participation in, among other groups, IOSCO, the International Organization of Securities Commissions. While drafting the Commission's interpretive Release on the transnational reach of the Internet issued this morning, the Commission's staff communicated and discussed in some detail with our regulatory counterparts in IOSCO the fundamental concepts underlying the Release. We hope this process of cooperation and communication can serve as a blueprint for future, more in-depth consultation with other regulators on international issues. In a global economy, international cooperation cannot be an afterthought. Rather, it has to be a prerequisite to effective regulation.
The Commission's mandate first and foremost is to assure the protection of investors. As regulators of the investment management industry, we also are well aware that it is a very fluid, innovative and forward-looking industry, and that the Investment Company Act gives the Commission the tools to adapt regulation to changes in the industry. Evaluating and responding to the consequences that this wave of consolidation will have for investors and the industry certainly is one of the greatest challenges we at the Commission face.
Let me return to the Titanic again. Regulators facing a changing industry can learn many lessons from the ship's fate. Probably everyone here -- including the 2 or 3 in the audience who haven't seen the movie -- knows that the ship didn't have enough lifeboats on board. What is less commonly known, though, is that the reason for the insufficient number of lifeboats was not that the Titanic was in violation of a safety code. In fact, she had four more lifeboats than were required. Unfortunately, the British Board of Trade, the regulatory body responsible for ship safety requirements, failed to keep pace with the increasing size of ocean liners and failed to update its regulations accordingly.
The regulatory implications of globalization of the fund industry and of recent technological advances are significant. Take fund boards, for instance. It may be appropriate for the Commission to reconsider the way in which fund boards conduct their affairs. In 1970, the Investment Company Act was amended to require that boards meet "in person" to approve advisory contracts. At that time, teleconferencing and other similar means of communicating were in their infancy. Today, technology that visually links multiple locations is commonplace, as are funds having directors scattered throughout the United States or the world. The inevitable question that is raised is whether our interpretation of "in person" to require that directors be physically present at a meeting should be revised. To my mind, we should seriously consider following the lead of states that now deem an in person requirement to be fulfilled by a meeting held through the means of videoconferencing.
The area of investment company regulation that is perhaps most affected by industry consolidation is the Act's restrictions on transactions with affiliates by investment companies, their advisers and principal underwriters. The determination of whether a transaction in which a fund and its affiliates participate is a "joint" transaction within the meaning of the Act has become more difficult as the number of permutations of these transactions increases with the consolidation in the financial services industry. It is time to revisit section 17(d) of the Act and rule 17d-1, which address joint transactions, to clarify their scope and application.
The concept of affiliation as a whole under the Investment Company Act is an issue that by necessity will have to be reevaluated in light of the changes in the financial services business. We should consider whether the rules under section 17 of the Act governing affiliated transactions should be retooled to reflect the Commission's experience in granting exemptive relief over time and to acknowledge the benefits that can accrue to a fund's shareholders if the fund is permitted to engage in transactions with certain of its affiliates. Any such change, though, will need to be made with restraint in light of the importance of section 17 to the regulatory scheme of the Investment Company Act.
One possible approach to revising our rules under section 17 may be to exempt transactions between funds and their affiliates on the basis of the degree of affiliation; the more remote the affiliation, the less conditional the exemption. We also should consider whether informational barriers can be relied upon as a basis for exemption from some of the Investment Company Act's prohibitions on funds' dealings with their affiliates. We need to recognize from the outset, however, that taking this approach creates certain tensions. Informational barriers can prevent conflict of interest situations from occurring. On the other hand, certain information sharing may be appropriate to detect a conflict of interest and may even be necessary to guard against abuses that could result from the conflict.
Consolidation in the financial services industry is likely to have a host of other regulatory implications. In many respects, we are navigating in uncharted waters. In other respects, we have seen all of this before. There is no need for wholesale legislative changes to the Investment Company Act to respond to an industry characterized by consolidation and globalization. All that is necessary to deal with the dynamic industry that we have come to take for granted is for the Commission to follow its long history of administering the Investment Company Act in a manner that is flexible but consistent with the Act's core principles.
Some believe that what we're seeing in the 1990s is just another in a long cycle of companies coming together and then breaking apart. Will the future prove these commentators to be right, and will the corporate wedding announcements of today be replaced with divorce notices tomorrow? The statistics for marriages in this country suggest that one out of every two will end in divorce. One can only guess whether the statistics will be similar for the fund industry. My guess is that this wave of global mergers is likely to persist well into the future because our economy is changing fundamentally and becoming increasingly global.
There do not appear to be any limits to the growth and globalization of the industry. Some of the headlines about mergers or rumored mergers over the past six months would have been unimaginable only a year ago. Try and come up with a fantasy headline for a merger that you know would never occur. I tried, but I couldn't. The quest for size and worldwide presence appears to have no limits.
Could mutual fund assets surpass the market value of all U.S. public companies? Probably yes, and in the not so distant future. Will we see a single fund supermarket offering more choices than there are companies listed on the New York Stock Exchange? I see it happening. Will some financial services firm take advantage of modern technology and put a virtual financial planner at the foot of Mount Everest? Yes, if it makes marketing sense.
Whatever the direction the fund industry takes in the next century, one can firmly predict that the industry's goals will remain inextricably tied to the needs and expectations of the individual investor. In the face of these changes, serving the needs of investors well must continue to be the goal for both the industry and the Commission.
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.
Dawson, "Mega-Trend Getting a Little Out of Hand," The Orlando Sentinel, Feb. 15, 1998, at B1.
Chernow, Death of the Banker (Apr. 1997).
McGough, "The Comeback Kid of Mutual Funds: The Load," Wall Street Journal, Jan. 28, 1998, at C1.
"Costly Nuisance," The Economist, Jan. 24, 1998, at 72.
Report on the Office of the Comptroller of the Currency/Securities and Exchange Commission Surrvey of Mutual Fund Investors (1996).
Laderman, "That 401(k) May Cost More Than You Think," Business Week, Nov. 10, 1997, at 130.
"Costly Nuisance," The Economist, Jan. 24, 1998, at 72.
Paul Moulton, "Fund Charges - Continuing to Paint a False Picture," Marketing Investment Funds in Europe, 1997, at 20.