Speech by SEC Commissioner:
Remarks Before the Mutual Fund Directors Forum First Annual Directors Institute
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
Coral Gables, Florida
February 28, 2007
Good evening. I'd like to thank the Mutual Fund Directors Forum and Alan Mostoff for inviting me to join you today in beautiful Coral Gables, Florida. During my short flight to Florida, I was reading numerous predictions from various "financial experts" about where they think the market is heading in 2007. As always, the crystal-ball gazing ranged from the very bullish to doomsday catastrophic. Given the huge drop in the markets yesterday, these predictions, which are about as reliable as the Washington D.C. winter storm forecasts, nevertheless made for some highly entertaining reading and brought to mind a particularly wise observation once made by Mark Twain: "October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February." I can't imagine a better time to be attending this conference given that we are smack-dab in the middle of one of the most "dangerous" months of the year!
I'm particularly pleased to be joining you at the inaugural Directors Institute conference — this is an event whose time has most definitely come. As the gatekeepers protecting over 91 million individual mutual fund investors of all ages, incomes, and educational backgrounds, directors are essential in setting the appropriate tone at the top for their entire organization. As we saw in the mutual fund scandals of 2003 and 2004, mutual fund directors are critical to ensuring that a vigorous culture of ethics and compliance operate throughout their relative fund complexes for the benefit and protection of their funds' investors. Organizations like the Mutual Fund Directors Forum, and events like the Directors Institute, are essential components in ensuring that mutual fund directors not only maintain best practices, but that these practices are consistently evaluated, analyzed, improved upon, and shared within the director community and the mutual fund industry. I really commend the case study approach that the attendees will be doing over the next two days.
Which is why I'd like to focus today's remarks on two areas that are of particular interest to all of you here today: current hot topics affecting the mutual fund industry, and issues surrounding your roles and responsibilities as directors of some our nation's mutual funds. Before I begin, however, I must remind all of you that the comments I make today are my own and do not reflect the opinions of the Commission, its staff, or the other Commissioners.
I. Mutual Fund Developments
A. Independent Chair/75% Independence Requirement
MFDF has been extraordinarily helpful to the Commission in providing its views during all stages of the Commission's proposed fund governance rules. As an independent organization comprised of the independent directors of many of this country's mutual funds, the experience and expertise of the organization and its members has provided the Commission with extremely valuable and relevant insight into this particularly difficult rulemaking.
Throughout the entire rulemaking process, MFDF has unambiguously and unwaveringly supported the independent chair and 75% independent board provisions of the proposed fund governance rules as "best practices" for all mutual funds. As you know, I also have shared your view on these two particular provisions, and have consistently supported the Commission's preservation of both the independent chair and 75% independent board requirements, in spite of the vacation of the SEC's rule by the D.C. Circuit Court of Appeals.
Thus, I am sure that all of you were eagerly anticipating the Commission's actions in the fund governance area on December 13, 2006. Chairman Cox announced at that meeting that the Commissioners had agreed outside the meeting earlier in the day to seek public comment on two papers prepared by its Office of Economic Analysis relating to the costs of controversial proposals that would require the chairman and 75% of the directors of mutual fund boards to be independent from management.
I want to be clear that I was fully prepared to act on the proposed fund governance rules. After multiple comment periods on the proposed rules, I felt that we had received an extensive and comprehensive amount of data and public commentary on the entire rulemaking record — most of which supported my view that the independent chair and 75% board independence provisions had not imposed great expense and that the rule has been implemented widely across the industry, with generally very positive results.
However, I understand the Commission's caution and desire to gather as comprehensive a rulemaking record as possible, and that is why I ultimately supported the decision to seek further public commentary. I do want to reassure you though that there is a light at the end of this tunnel — the comment period for these two additional studies just ended on March 2, 2007, and I fully intend to push our Chairman and encourage, in my most persuasive manner, my fellow Commissioners to provide the industry and our investors with some finality on the fund governance rules. Specifically, I intend to make it clear that the Commission should be prepared to act on this rulemaking even if it results in a split Commission vote.
While I am keeping an open mind as I review the final stream of comments, I do want to be clear that my current review of the record and my lengthy involvement with the fund governance rules all indicate that the economic studies and current rulemaking record would fully support a 75% independent board and independent chair requirement, or a possible exemption from the independent chair requirement that would permit a non-independent chair subject to some stringent governance conditions. I am looking forward to reviewing our staff's recommendations in this area, and, as I am sure all of my colleagues will do the same, I plan to analyze those recommendations against what I believe the current rulemaking record and economic data supports.
I am troubled, however, by what appears to be renewed attacks on the basic principle of SEC rules pertaining to the governance of mutual fund boards. These attacks seem to be part of a broad ideological strategy to keep the SEC from adopting any regulation, whatsoever, even if such regulation is beneficial to both investors and the industry. The strategy seems to be to keep attacking the agency through adverse litigation based on any possible legal theory.
So what have been the arguments against these particular rules? First, at its broadest, is the argument that government should not be in the business of board governance. Well, I don't know where these folks have been, but Sarbanes-Oxley 301 requires audit committees for registered companies to be comprised of independent directors and nearly all of our exchanges require listed companies to have boards that are at least 50% independent. Nearly every jurisdiction in the world has copied these requirements because they make sense and because investors have clamored for them. Thus, government regulation in the U.S. and around the world employs as a critical part of their programs governance rules to protect investors and eliminate conflicts. Even the D.C. Circuit Court of Appeals stated clearly and unambiguously that the SEC had, under the Investment Company Act, the power to issue prophylactic governance rules, such as the independent chair and 75% independent director provisions.
The second argument goes like this: having independent directors does not guarantee that wrongdoing will not occur. The market timing cases, this argument goes, occurred as often with boards that had a supermajority of independent directors as those without. This argument simply misses the point. In almost all of these cases, the directors were kept uninformed of the abuses and did not know to ask questions about timing. More fundamentally, however, I will concede that being independent does not guarantee that a director will do his/her job or act independently. Being independent, however, does remove an obvious financial interest or conflict-of-interest that might color decisions in favor of the adviser over the fund investors. Certainly, the odds of acting in the best interests of investors as fiduciaries increase as independence increases.
It is also true that fund governance provisions do not, by themselves, increase fund performance. It is incredible to me that I still hear this argument. Let me clarify — the SEC is not is not in the business of improving performance. We are not an agency of investment analysts or professionals. Moreover, no other rule or regulation that I know of has ever been characterized as deficient from an investor protection standpoint because it does not improve performance or returns on investment. Again, the purpose is not to improve performance, but to eliminate a glaring conflict of interest.
Finally, my current review of the rulemaking record indicates that implementing an independent chair or 75% independent board would not come at a significant cost. This is obvious, of course, because you can increase the percentage of independent directors simply by removing an interested and non-independent director, and you can select an independent chairman from one of the current independent directors. However, even if you were to double or triple the cost estimates contained in the current studies, the total cost would still not be significant.
In the end, what effective fund governance does is to provide a prophylactic insulation to the board and the fund against accusations that the board was conflicted and favored the adviser — should there ever be a fraud or other problem. It helps protect the board and the fund, as well as their most valuable asset — the fund's reputation and integrity and, ultimately, the fund's investors. In short, these rules are a form of insurance policy for both investors and the mutual fund industry.
B. Mutual Fund Activism
As many of you may know, I have been very interested in the area of shareholder rights and activism and, in particular, the thorny issue of shareholder access. These have been big issues over the past few months, in particular because they have highlighted the fact that in the U.S., shareholders have very few formal routes to influence the election of directors. Fortunately, we have seen an increase in shareholder influence over corporate management and governance. The primary players in the area of shareholder activism have been hedge funds and pension funds — mutual funds have historically avoided this type of corporate activism.
However, I have noticed a recent increase in mutual fund activism. For example, the Franklin Templeton Mutual Series Funds has a long history of shareholder activism including its role in pushing Chase Manhattan to merge with Chemical Bank in the 1990s and its current efforts to push for action at Time Warner. Similarly, the Tweedy Browne funds, helped lead the effort to unseat newspaper baron Conrad Black from Hollinger, the Canadian publishing company.
Now I recognize that funds face serious challenges when they take a more activist course. Proxy battles are very expensive, and some managers may fear that companies will retaliate by restricting access to executives. This is why we often see fund companies that are unhappy with their investments frequently acting like "renters" — voting with their feet by redeeming and moving on — rather than "owners" who utilize their significant stake in the company to become constructive participants in how companies evolve. I also understand that many fund companies have arguable conflicts. The funds want the retirement and other lucrative business lines from the very same companies in which they are invested. It is difficult to go against management in such situations.
Moreover, I have heard some refer to shareholder activists as a new breed of "corporate raiders" with all of the negative connotations associated with the 80's era of ruthless corporate takeovers and company gutting. However, I want to be clear that my notion of shareholder activism is that of constructive, value-increasing activities designed to identify and remove corporate inefficiencies, ineffective corporate governance, and entrenched management that does not act in the best interests of shareholders. Simply put, my vision of effective shareholder activism is one in which company share-owners act exactly like they are supposed to
as true owners of the companies that they invest in.
People in the industry have been saying that fund shareholder activism is on the rise. Just look at Europe, which is now emerging as a new frontier in this area. With shareholder access currently on the table both in the courts and the SEC, and more and more institutional shareholders taking an active stake in the management of the companies that they invest in, I believe it may be time for the mutual fund industry to re-assess its historical recalcitrance in the area of shareholder activism. Many mutual fund shareholders — particularly those in value-oriented funds — could derive real benefits and value from fund managers who take a thoughtful activist approach. Now I'm not saying that a fund should automatically dig in for a massive and expensive proxy battle every time it becomes unhappy with management. Sometimes the best and most cost-effective course is, in fact, to walk away. However, funds may do well to seriously consider the power of effective shareholder activism. Rather than automatically voting with its feet any time a fund becomes unhappy with the current corporate structure or business strategy, it may be worthwhile for a fund to seriously assess the costs and benefits of using its significant leverage to generate value through management or other business changes. Such strategies are not easy to devise or implement, but it may be time to consider whether such activism is owed to shareholder in certain situations.
C. Mutual Funds vs. Hedge Funds
This increase in mutual fund activism is reflective of a broader paradigm shift in the world of asset management. Specifically, the lines between hedge funds and traditional asset management are converging today. We are seeing more and more conventional mutual funds and large money managers adopting hedge fund-like products and activist strategies, as well as alternative investment fee structures. At the same time, we are seeing more hedge funds entering the public markets and becoming real institutions with diversified business lines and global offices. This convergence has become particularly noticeable in recent months.
For example, traditional money managers like UBS and JP Morgan have launched long/short mutual funds for retail investors, or what some have referred to as a "poor man's hedge fund," resulting in the "retailization" of hedge fund strategies. These funds — dubbed "equity market neutral" or "long/short equity" funds — use puts, calls, and short-selling strategies, require minimum investments as low as $500, and have more than doubled in number (to 49 from 21) since the start of 2003. 12 of these funds were introduced in 2006 alone — a 32% jump since 2005. Major fund companies like Janus, American Century, Rydex, Dreyfus and Charles Schwab now offer these types of funds. In fact, the rising popularity of these vehicles led Morningstar to create its first "long-short" category in March 2006.
Similarly, several investment firms are now offering index investment products intended to passively mimic the performance of hedge funds. For example, Merrill Lynch currently offers the Factor Index and Goldman Sachs has a product in Europe called Absolute Return Tracker index. Both products seek to provide something like generic hedge fund performance at low cost and with high liquidity. Investors who don't want to pay hedge fund fees, who can't meet the minimum investment amounts, or who may want greater liquidity, may be interested in vehicles that aim to replicate 60-70% of hedge fund returns.
The rise of these new index and mutual fund products could eventually take a portion of the hedge fund business, and exert downward pressure on hedge fund fees.
In contrast, the well-known hedge fund group, DE Shaw, has made a push into traditional asset management with the launch of a long/short fund for institutional investors. Moreover, hedge fund managers are starting to resemble corporate institutions. Starting last year, hedge fund managers began taking their businesses public — more than 5 in Europe — and just a few weeks ago Fortress Investment Group became the first U.S. hedge fund to publicly sell its shares in our domestic markets (notably, with a gain of 68% over its IPO price on the first day alone). Some see this as the next evolution in hedge funds. Not only does this provide "permanent capital" (i.e., money that can't be withdrawn on a quarterly or annual basis), it also allows managers to have better liquidity management and to be less reliant on their creditors. However, the jury is still out with respect to the long-term benefits of listing asset management groups — what will happen when these businesses mature, growth slows, or clients start to pressure on fees? The advantage to being private is that the firms can focus on stability and allow decisions to be made over the long haul.
D. Fund of Hedge Funds
One particular "blended" product that I am specifically interested in seeing make its way into the markets is the listed "fund of hedge funds" — a registered closed-ended mutual fund that would be listed and made available to investors on a public exchange. I have often asked the question, "If hedge funds are so good for sophisticated and wealthy investors, why shouldn't these benefits be available for all investors?" To me, funds of hedge funds would be one way to provide all investors with access to the benefits of hedge fund strategies and diversification, while simultaneously providing investors with an important layer of investment protection and oversight.
Now, I want to first clarify exactly why I believe that funds of hedge funds should be made available to all investors, whereas, I have supported limiting investments in hedge funds to investors that meet certain sophistication and financial criterion. In short, funds of hedge funds are not hedge funds. Hedge funds are highly complex products and involve risks not generally associated with many other issuers of securities. Not only do hedge funds use complicated investment strategies, but there is minimal information available about them in the public domain. Accordingly, investors may not have access to or be in a position to negotiate for the kind of information necessary to understand the full nature of their investment, and may find it difficult to appreciate the unique risks of these pools, including conflicts of interest and complex fee structures.
Funds of hedge funds, in contrast, give investors access to a diversified group of hedge funds that are selected for them by a professional money manager who is in a position to obtain and evaluate information from the hedge funds. Indeed, managers of funds of funds owe the funds a legal duty to act in their best interest and, in that regard, to ensure that the fund's investment decisions are prudent and sound. The professional intermediaries that manage fund of hedge funds provide a crucial and meaningful layer of investor protection.
It is precisely for this reason why registered funds of hedge funds were not included in our recent December accredited investor proposal. The Commission expressly stated its belief that the safeguards provided by the proposed accredited investor threshold would not be necessary for pools that are managed by experienced investment professionals with explicit fiduciary obligations to the investor.
Moreover, investors in funds of hedge funds also would receive the benefits and transparency that would come with investing in products that are registered with the SEC. In contrast to the opacity that is generally associated with unregistered hedge funds, registered funds of hedge funds would be subject to all of the registration and regulatory obligations under the Investment Company Act. Investors in these products would have transparency, as required under the Act, regarding the nature of their investments and the principals managing those investments, disclosure regarding the fees involved, as well as specific protections against certain conflicts-of-interest and self dealing activities.
Lastly, I would like to address the comment that fund of hedge funds may be too risky or unsuitable for the average investor by noting that this comment simply misses the mark. The SEC has never been, and is not in the business of eliminating investment risk. Rather, we protect investors and their investments by regulating fund disclosures, conflicts-of-interest, and governance. We have always held that the determination of appropriate investment risk and investment suitability with respect to a particular product is to be made by the market and professionals and investors that operate in that space, not by the SEC. This is why we currently can purchase products in the marketplace today that are, by all metrics, extremely volatile and "risky" — for example, commodity funds or volatile sector funds that available for purchase by any investor. More specifically, look at all of these new mutual fund products — the long/short equity products — that are essentially adopting hedge fund strategies under the wrapper of a registered, open-ended mutual fund.
Now, I recognize that listed funds of hedge funds are not currently available to the public, and are currently under review by the SEC's Division of Investment Management. Thus, while I can't speak to the particulars of any specific pending application, all of the evidence I have seen to date points towards making these products available to the investing public.
What do all of these recent asset management developments foretell for the mutual fund industry in the foreseeable future? It is hard to say — the industry is rapidly changing, and — as always — constantly adapting to new business and competitive pressures. However, one thing is clear — the fund industry must be willing to think more and more outside of the box. With ETFs, hedge funds, and alternative investments all making inroads into traditional asset management territory, it is incumbent on you to think flexibly and creatively about how best to serve your investors — whether that means adopting new strategies, rolling out innovative new products, or challenging management when appropriate.
II. Director Issues
My own experiences at the Commission have led me to the irrefutable conclusion that directors serve as critical watchdogs, in both public companies and mutual funds. The market timing, revenue sharing, and soft dollar scandals of the past 4 years serve as sobering reminders that, left unchecked, greed and corruption can harm even the largest and most reputable of mutual fund complexes.
While directors can not and should not be expected to identify and catch every instance of fraud or misconduct that occurs in the funds that they oversee, they are critical in setting the appropriate tone at the top, reinforcing a strong culture of compliance, monitoring and reacting immediately to instances of misconduct, and remediating problems. In addition, boards are crucial liaisons in managing some of the most important aspects of mutual fund business — they help keep fees in line, negotiate important contracts, and effectuate changes that are suggested by the chief compliance officer.
Of course, strong boards of directors also give credibility and trust to mutual fund complexes. This credibility, in turn, adds value to the fund by attracting more assets.
I know that the vast majority of directors, including the ones in the audience today, handle their responsibilities with the utmost integrity and care. In fact, there are only a tiny number of cases where the SEC has named directors in an enforcement action. Those that found themselves in trouble were often an active participant in fraudulent conduct. The very fact of your participation in this conference today indicates that you are all among the most conscientious and diligent of fiduciaries. However, you must always remain vigilant against becoming complacent or less pro-active in following up on red flags and other warning signs. Your role as fiduciaries makes it incumbent upon all of you to not only refrain from inappropriately gaining from your position, but to also affirmatively and pro-actively protect and guard the trust, information, and confidences with which you are entrusted.
I know you will.
Thank you very much for you kind attention tonight.