U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Chairman:
America's Need for Vigilant Mutual Fund Directors


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Mutual Fund Directors Forum
January 7, 2004


Good evening, and thanks for inviting me to join you. This is a critical time for the mutual fund industry and I cannot think of a better forum in which to put forth some thoughts on how the industry can earn back the trust and, I dare say, the respect of the investing public. I applaud all of you for being here tonight and for your willingness to devote your time to attending this important policy conference. As I will outline in a moment, mutual fund directors must play a key role in helping to restore trust in the mutual fund industry. The work of the Mutual Fund Directors Forum is an essential part of the solution to the crisis we are facing. In a very short time, the Forum has come to occupy an important place in the mutual fund world -- helping to focus independent directors on their role in protecting fund investors.

I applaud the efforts of David Ruder and Allan Mostoff, who have done excellent work in getting the Forum up and running, and in organizing this timely policy conference, which raises issues of critical importance to fund directors. I also want to thank the Forum for responding to my call to develop best practices in key areas of director responsibilities. You have the opportunity to establish guidelines and standards that go beyond the dictates of the law to establish the highest ethical principles, standards, and procedures for the benefit of fund investors. Your efforts can be a valuable source of guidance for fund directors and can provide an important complement to Commission rulemaking. To that end, we welcome your suggestions as to additional actions the Commission can take to further benefit investors.

Before I continue, let me remind you that the views I express here are my own, and do not necessarily reflect the views of my colleagues on the Commission or the Commission staff.

You are all keenly aware of the grossly harmful activity that has plagued the mutual fund industry and dominated the headlines in recent months -- namely late trading, abusive market timing, selective disclosure of portfolio holdings information, undisclosed payments for "shelf space" to gain placement on brokers' preferred lists, and, worst of all, fund insiders facilitating or participating in this abusive activity. While I will touch on our enforcement and regulatory responses to these problems, I want to emphasize the critical role that you, as mutual fund directors, play in the solution to the ills that currently befall the mutual fund industry. I will use most of the next few minutes to outline what I view as both your vital role, and your fiduciary responsibility, in protecting the interests of mutual fund investors.

Critical Role of Fund Directors

The board of directors of a mutual fund has significant responsibility to protect investors. By law, directors generally are responsible for the oversight of all of the operations of a mutual fund. In addition, under the Investment Company Act, directors are assigned key responsibilities, such as negotiating and evaluating the reasonableness of advisory and other fees, selecting the fund's independent accountants, valuing certain securities held by the fund, and managing certain operational conflicts.

The role of fund directors is particularly critical in the mutual fund context because almost all funds are organized and operated by external money-management firms, thereby creating inherent conflicts of interest and potential for abuse. Money-management firms operating mutual funds want to maximize their profits through fees provided by the funds, but the fees, of course, paid to these firms, reduce the returns to fund investors.

Independent directors, in particular, should serve as "independent watchdogs" guarding investors' interests — and helping to protect fund assets from uses that will be of primary benefit to management companies. These interests must be paramount, for it is the investors who own the funds and for whose sole benefit they must be operated.

The recent revelations about mutual funds have led to greater focus and scrutiny of the role played by independent fund directors. A November New York Times article on directors, headlined "Guard Dogs Without Teeth," captured the thinking of some of the critics. The article, and others like it, charged that directors should have been able to detect the abusive market timing and late trading at the funds on whose boards they sat. Some have questioned whether mutual fund directors are too passive, are captives of fund management companies, sit on too many boards, lack the knowledge to keep apprised of a fund's activities, and are paid too much for any value they bring in protecting fund investors. I believe these are appropriate questions to be asked in view of the widespread nature of the problems we are encountering.

You are the investors' first line of defense in ensuring that their interests are being served, that conflicts of interest are appropriately managed and disclosed, and that investors' money is being managed responsibly. While the SEC shares this mission to protect investors, we cannot be in the boardroom when investors' interests may be compromised. Investors are depending on you to stand up for them.

In our current investigations of firms involved in the mutual fund scandal, we are carefully looking at the role that independent directors played, if any, in the problems at these firms. We are asking whether the directors were aware of these abuses, and whether there were red flags that were ignored.

When we find those who harm investors, we will pursue them aggressively — even if they turn out to be fund directors. Indeed, when the Commission filed civil fraud charges last month against Heartland Advisors, for misrepresentations, mispricing, and insider trading, four of Heartland's independent directors consented to administrative sanctions for failing to adequately monitor the liquidity of Heartland funds and for failing to take adequate steps to address the funds' pricing deficiencies.

I certainly hope that the directors of funds implicated in these matters are asking questions such as: "What could we have asked of management to surface these issues?" and "What kind of reporting or information could we have requested that would have indicated that there was a problem?" We have certainly been asking such questions of ourselves at the Commission.

While the facts are still unfolding and the totality of the problem has yet to be identified, there are already some important lessons for fund directors in this unfortunate saga. For example, it is clear with hindsight that if there had been monitoring of fund flow data — that is, purchases and redemptions of fund shares — directors might have been able to detect significant short-term trading in their funds and pursue whether there were abuses in this area.

In addition to being individuals of integrity, intelligence and good judgment, effective fund directors must also possess a healthy dose of vigilance and skepticism in carrying out their responsibilities. Indeed, fund directors have a legal obligation to devote the appropriate effort and energy in carrying out their responsibilities. As such, there must be a recognition that management's interests are not always aligned with the shareholders of the fund. Constructive skepticism is necessary. The mutual fund regulatory framework and the nature of the mutual fund business should foster a healthy tension between a fund's management and the independent directors.

Recent events demonstrate that fund directors must be proactive and continually challenge and question fund management in other high-risk areas, such as portfolio management, pricing, sales of fund shares (including the use of fund assets to facilitate distribution), and the overall program of compliance and internal controls. In monitoring policies, procedures and internal controls of the fund and its service providers, you must regularly challenge whether they are effective.

While your role is one of oversight and not full-time, day-to-day management of the fund's operations, you must test those to whom you have entrusted that role. You must demand accountability from those to whom you have delegated, ensuring that they understand that you can relieve them of their duties if they are not performing to your satisfaction. You have the power as fund directors to insist on a culture of compliance, and we are endeavoring to provide you new tools in this area. You must wield your power appropriately to ensure that the interests of your fund investors are protected and that their interests come first.

Key Areas for Director Focus

Let me highlight several key areas where directors must be extremely vigilant — pricing of portfolio securities, fund fees and performance. Significant harm can be done to investors if fund shares are not accurately priced. When market quotations are readily available, these quotes must be used in valuing a fund's portfolio securities. Fund directors, however, must "fair value" a fund's portfolio securities when there are no readily available market quotations or when market prices are stale or unreliable, such as when there has been significant market events subsequent to the market close.

The market-timing abuses we are currently investigating highlight the importance of fair-value pricing. If a fund misprices its shares by failing to use fair-value pricing when market quotations for its portfolio securities are unreliable, market timers may take advantage of the disparity between the portfolio securities' last quoted sales prices and their fair value. As we have seen, when fund shares are mispriced, market timers have an arbitrage opportunity they can use to exploit a fund and disadvantage its long-term investors by extracting value from the fund without assuming any significant investment risk.

The Commission, in rulemaking last month, reemphasized the obligation of mutual funds to fair value their securities in such circumstances. This means that you must ensure that your funds have appropriate policies and procedures in place to accurately value your funds' portfolio securities. We expect you to take this obligation seriously, as funds that fair value price their portfolio securities consistent with their obligations can effectively eliminate the profit opportunities that market timers seek to exploit.

I am optimistic that the Forum can help you in this area, as this is one of the areas in which it is developing best practices, along with best practices for directors in monitoring fund fees.

As I am sure you are aware, there has been much focus on mutual fund fees in the past few weeks. In the Alliance enforcement matter, the Commission steadfastly refused to make fees a focus of the settlement, as my fellow Commissioners and I strongly believe that the Commission should not act as a "rate-setter" and determine how much mutual fund investors should pay for the services they receive from a particular fund. This decision is better left to the free market -- and informed investors who have the benefit of an independent and vigorous mutual fund board looking out for their interest in the area of fees.

The Commission will address this issue through what I believe is the appropriate forum for us to do so — as part of our rulemaking process. I firmly believe that rules uniformly applicable to the entire industry are more desirable than fees set through enforcement actions that can fragment the marketplace, particularly in enforcement matters that have nothing to do with fees. The rulemaking process — with its attendant protections of notice and public comment — is a better way to address fee issues.

We are moving forward on several fronts to enhance disclosure of mutual fund fees, including exploring ways to impose segmented disclosure of transactions costs, improved disclosure of breakpoint opportunities, dollars and cents disclosure to investors of mutual fund costs, as well as additional disclosure regarding the payments and incentives brokers receive in recommending particular funds to investors.

We also hope to bolster the effectiveness of independent directors in monitoring fees through our proposals to improve fund governance. A key component of this package will include a proposal requiring boards to focus on and preserve documents and information that directors use to determine the reasonableness of fees relative to performance, quality of service and stated objectives. We hope directors will focus on the need for breakpoints or reductions in advisory fees, and understand the differences in fees charged to other clients of the adviser. We also will be considering a proposal to require directors to explain in annual reports to shareholders the basis upon which they determined that fee levels were reasonable and appropriate. Hopefully, these requirements will help focus directors on the critical task of monitoring fund fees and negotiating appropriate fee rates on behalf of investors.

Related to the appropriateness of a fund's fees is the performance of the fund, whether the fund is fulfilling its stated investment objectives and delivering value to fund investors. As another of your key areas of responsibility, I hope that you give this issue sufficient attention and that you are asking tough questions of management in this area, such as: are our funds too large to achieve optimum performance? Should we close our funds to new investors? What steps do we need to take to improve performance? Does management have the right team and expertise in place to manage the fund? Investors are depending on you to obtain satisfactory answers to these questions.

Fund Governance and Oversight

It is clear to me that recent events in the mutual fund industry point to the need for the Commission to revisit the governance of mutual funds.

The circumstances that we are investigating reflect a serious breakdown in management controls in more than a few mutual fund complexes. The breakdown in compliance controls evidenced by our enforcement actions raises troubling questions about the ability of many fund boards, as presently constituted, to effectively oversee the management of funds. To empower independent directors to better serve as an effective check on fund management, next week the Commission will be considering proposals to require funds to adopt better governance practices.

The components of the fund governance package will include:

  • Requiring an independent chairman of the fund's board of directors;
  • Increasing the percentage of independent directors under SEC rules from a majority to three-fourths;
  • Providing independent directors with the authority to retain staff as they deem necessary, so they are not obligated to rely on the fund's adviser for assistance; 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.

I believe that increasing the percentage of independent directors on fund boards will strengthen the hand of independent directors when dealing with fund management and will better serve the needs of fund shareholders. I also believe that a boardroom culture conducive to decision-making, focusing on the long-term interests of fund shareholders, is more likely to prevail when the chairman of the fund's board is completely independent of the fund's adviser. A fund board can be more effective when negotiating with the fund adviser over matters such as the management fee, if it were not at the same time led by an executive of the adviser with whom the board is negotiating.

I also want to discuss the importance of self-evaluation of fund boards. There has been criticism of directors who sit on the boards of multiple funds, with some critics saying that there are not enough hours in the day, or the week, for these individuals to carry out all of their oversight responsibilities for every fund. All boards should regularly assess how well they are functioning, and all board members must also assess if they have the time and resources to fulfill their obligations as a director.

I believe that the decision about the number of boards upon which individuals can sit must be made by fund boards, and the directors themselves. Different boards have different needs, and different directors have different capabilities and time constraints — and they are in the best position to make these judgments. This, however, means that directors must regularly take a long hard look not only at the number of boards they are on, but also at whether they are performing well, if the board as a whole is effective, and if the fund's committee structure is effective. I believe that asking these questions, and answering them honestly, is fundamental to the mutual fund director's job.

When individuals choose to invest in a fund, one of their fundamental rights is for that fund to maintain a board of directors that is strong, effective, and independent. It is important that every time you sit down at a board meeting you remember that you have a constituency of investors that you are duty bound to protect. The initiatives the Commission is undertaking will provide you the tools, the access and the power to fulfill your legal duty and moral mandate as protectors of shareholder interests.

I also want to emphasize our commitment to helping you to be vigilant and effective board members. Our recently adopted compliance rule requires all funds and advisers to maintain comprehensive compliance policies and procedures and annually review them. The rule also mandates the designation of a chief compliance officer, who will answer to, and be accountable to, funds' boards of directors. This will give directors a powerful tool to exercise oversight responsibilities over fund compliance matters and provide strong incentives to ensure that their operations live up to both the letter and the spirit of the rules and regulations governing mutual funds.

You should also know that I have directed the Commission to explore several other complex issues, including a reexamination of Rule 12b-1 and the use of fund assets to facilitate distribution, the use of soft-dollar arrangements by investment managers and the scope of the safe harbor contained in Section 28(e) of the Exchange Act. I also directed the staff to explore steps to provide the Commission greater insight into the operation of hedge funds, which all too frequently have been focal points in our investigation of abuses in the mutual fund area. As we consider each of these issues, we welcome the input of fund directors.


As you can see, we have been busy at the Commission with rulemaking initiatives affecting fund directors.

Before I close, I'd like to underscore a couple of key points. It is not enough that you follow the letter of the law and the rules that the Commission has adopted. It's not even enough that you follow the best practices that the Forum will outline in the coming weeks. To be truly effective, you must be forceful in requiring your funds and their service providers to establish new standards of integrity. Investors must be able to see for themselves that fund companies, and fund directors, are living up to their fiduciary obligations and the spirit underpinning all of our securities laws. I hope we can count on your commitment and your support in enhancing the integrity of our securities market.

*  *  *  *  *

Once again, I want to thank the Mutual Fund Directors Forum for giving me this opportunity to speak. With your help, we can regain the confidence of our nation's mutual fund investors and restore the integrity of the mutual fund industry.

It has been an honor to be with you, and I thank you for listening.



Modified: 01/07/2004