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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Integrity and Accountability: The New Imperatives for the Mutual Fund Industry


Paul F. Roye

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

Remarks Before the 2004 Mutual Funds and Investment Management Conference
Palm Desert, California
March 22, 2004

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.

I. Introduction

Good morning and thank you for welcoming me here today. Before I begin, I need 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.

Frequently, when I am scheduled to speak at conferences such as this one, the audience, I believe, is most interested in knowing what can be expected out of the SEC in the future and the direction of mutual fund regulation. I will not disappoint you in that regard; however, I want to begin by looking back rather than ahead.

Looking back to one year ago, we had weathered a series of scandals in corporate America; the mutual fund industry had managed to avoid being embroiled in these events; the joint NASD/Industry Taskforce on Breakpoints had been formed; and the Commission had recently adopted the mutual fund proxy voting rule, which--as you will recall--generated substantial controversy and a record number of comment letters. In addition, the Commission had just welcomed its new Chairman, William Donaldson.

In that climate, I delivered a speech at this conference that identified the need for increased accountability in the fund industry and discussed various steps the Commission was taking to promote a culture of what Chairman Donaldson called "new respect" for honesty, integrity, transparency and, most of all, accountability. These steps included subjecting, at the direction of Congress, a reluctant mutual fund industry to a series of tailored mutual fund rules implementing the landmark Sarbanes-Oxley Act; what was then a proposal to require fund and adviser compliance procedures and chief compliance officers; as well as the concept release on possible private sector initiatives to promote fund and adviser compliance with the federal securities laws. Ironically, I stated that the Commission advanced the compliance procedures and chief compliance officer proposal "because we want[ed] to take steps to prevent the types of scandals that have plagued other segments of the securities industry from tainting the investment management industry."

Now, one year later, we unfortunately face a new environment in which the mutual fund industry is at the center of our nation's financial scandals, and the Commission is pursuing initiatives to promote accountability among fund and advisory personnel with renewed urgency. Unlike the earlier corporate scandals, when the fund industry sought to distance itself from the unfolding dishonesty and corruption, the fund industry in the wake of its own scandal has nowhere to hide and must shoulder much of the blame.

Yes, it is alleged that broker-dealers and other financial intermediaries facilitated late trading and abusive market timing activity. And it has also been alleged that in a number of cases the driving force behind the abusive activity was largely unregulated hedge funds seeking to profit at the expense of mutual fund shareholders. But in too many instances, the activities of these parties was facilitated by mutual fund personnel, in some cases with the alleged approval of management at the highest levels of the firms. And, in some instances, it was fund management personnel who were allegedly profiting personally by taking advantage of their own funds.

Given the extent of the fraud and wrongdoing that we have seen-and given the internal e-mails and other documents that have come to light-there were industry insiders who knew that harmful activity was occurring. Noted in some of the enforcement actions are references to the fact that the portfolio managers and compliance personnel complained about various abusive market timing arrangements. Their protests were dismissed. Unfortunately, rather than bringing the harmful activity to the attention of regulators, industry insiders allegedly either turned a blind eye, or followed their marching orders when higher-ups chose to permit the activity. Ultimately, as a result, fund shareholders have suffered and long-term damage has been done to the industry.

Following my remarks this morning is a panel entitled "Scandals of 2003: What Went Wrong and How We Fix It". It is perhaps easier to identify what went wrong, than to identify solutions to the problems. But what did go wrong? In my view, some of what went wrong can be traced back to lack of diligence, weak controls and compliance systems, the failure of funds to fair value price their portfolio securities, the abuse of certain operational constructs such as an order acceptance system that relied on intermediaries with weak or non-existent controls and the use of omnibus accounts, which inhibited the ability of funds to identify market timers. However, most of the problems ultimately are a result of the fact that too many members of the industry, and those that serve the industry, lost sight of their fiduciary obligations and the principle that the interests of investors come first, above all else.

As noted British economist and author Sir Josiah Stamp once said, "It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities." It seems that some in the fund industry are now coming face to face with the consequences of dodging responsibilities.

The recent spate of abusive activity has seriously compromised investor trust. Integrity and accountability must be the new imperatives for the mutual fund industry. First and foremost, you are accountable to your funds' shareholders. And we have seen that those who lose sight of this basic tenet will lose the trust-and the investment dollars-of their shareholders, as they are being seriously disciplined by the market. And they are also being held accountable by our Enforcement staff. The magnitude of monetary penalties and remedial actions being imposed through Commission enforcement actions is sending a strong message that these abuses will not be tolerated.

From a regulator's perspective, however, I must add that it seems to me that, in spite of all that has transpired, some in the industry have not yet fully embraced the need to encourage accountability. In fact, many of the criticisms of our new rules and rule proposals, I believe, can be chalked up to efforts to avoid accountability. Examples include CEO and CFO opposition to certification under Sarbanes-Oxley; opposition to proxy voting disclosure; attorney opposition to reporting wrongdoing; opposition to enhanced portfolio manager disclosure; opposition to the chief compliance officer requirement; and the opposition by some fund directors to certain of our proposals because they seek to avoid their responsibility for oversight of the funds on whose boards they serve.

While we are always open to constructive criticism and comment regarding our rule proposals, and in many instances we revise our rules to reflect insightful, practical and helpful comments, we cannot water down our rules to the point that they enable industry participants to avoid accountability. In fact, the Commission is in the midst of an aggressive rulemaking agenda that is designed in large measure to shore up the fund regulatory framework and to promote a culture of integrity, responsibility and accountability in the fund industry.

II. The Commission's Rulemaking Agenda

So, let me turn to what the Commission is doing, specifically, to address the problems. The Commission's mutual fund regulatory agenda is focused on four main goals: (1) addressing late trading, market timing and related abuses; (2) improving the oversight of funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) addressing or eliminating certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) in a further effort to promote accountability, improving disclosure to fund investors, especially fee-related disclosure.

A. Initiatives to Address Late Trading, Abusive Market Timing and Related Abuses

Late Trading: I'll begin with the Commission's efforts to address late trading. While last year we were grappling with issues such as breakpoints, proxy voting and, on a more fundamental level, shareholder confidence, late trading-we thought-was not an issue.

Sadly, we now know that the forward pricing rule was being evaded. The Commission's recent review of the largest brokers that sell fund shares identified numerous instances of late trading of fund shares, and we have seen what seems to be significant noncompliance with the forward pricing rule by those the Commission does not regulate. In order to shut the door on late trading, the Commission proposed the "hard 4:00" rule. This proposal would require that a fund or a certified clearing agency, such as NSCC - rather than an intermediary such as a broker-dealer or other unregulated party - receive a purchase or redemption order prior to the time the fund prices its shares (typically 4:00 p.m.) for an investor to receive that day's price.

We believe that this rule amendment would provide for a secure pricing system that would be highly immune to manipulation by late traders. It would substantially narrow the universe of those who are accountable for the processing of fund orders and better enable examiners to monitor compliance with the 4:00 cut-off restrictions. As we know, profits from late trading can be large; and large, easy profits frequently tempt those who would violate the law.

We received nearly 1,000 comment letters on the rule, and it is clear that some believe the hard 4:00 rule should not be the preferred approach. They argue that it will require some intermediaries to have cut-offs for orders well before 4:00 p.m. and limit investor opportunities to place orders for fund transactions, particularly in the 401(k) context. We have been presented with various alternatives to a hard 4:00 rule and are actively studying these approaches. We do not want to adversely impact fund investors if there are alternatives that effectively - truly effectively - address late trading abuses. Our efforts to address this problem, however, are complicated by the fact that fund orders, in many cases, are accepted by entities that are not regulated by the Commission.

Market Timing: With respect to market timing, especially so-called "arbitrage market timing," which seeks to exploit discrepancies between a fund's NAV and the value of its underlying portfolio securities, the Commission has stressed that, "fair value pricing" is critical in effectively reducing or eliminating the profit that many market timers seek and the dilution of shareholders' interests. In addition to reiterating the obligation of funds to fair value their securities to reduce market timing arbitrage opportunities, the Commission has proposed improved disclosure of a fund's policies and procedures regarding fair value pricing. If adopted, this disclosure will force funds and their boards to be accountable to their shareholders regarding when, how and under what circumstances they are fair valuing their portfolio.

We are currently gathering information regarding funds' fair value pricing practices and evaluating whether to recommend additional measures to improve funds' fair value pricing. The Commission has also sought public comment on the need for additional guidance or rulemaking in this area.

In a further effort to reduce the profitability of abusive market timing, the Commission late last month put forth a proposal that would require funds to impose a mandatory two percent redemption fee when investors redeem their shares within five business days. This fee would be payable to the fund, for the direct benefit of fund shareholders, rather than to the management company or any other service provider. The two percent redemption fee would hold accountable those who frequently trade mutual fund shares by charging them for the approximate cost of their frequent trading activity, rather than imposing these costs on long-term shareholders. With respect to arbitrage market timing, the two percent fee, combined with fair value pricing, would make market timing less profitable, and therefore reduce the incentive to engage in market timing.

A significant feature of the proposed rule, which has largely been overlooked in the commentary on the proposal, is the information pass-through that the rule would facilitate. The proposed rule would require that, on at least a weekly basis, a financial intermediary provide to a fund the Taxpayer Identification Number and the amount and dates of all purchases, redemptions or exchanges made during the previous week for each shareholder trading through an omnibus account. This information would not only enable the fund to confirm that fund intermediaries are properly assessing redemption fees, but allow funds to identify market timers to bar them from the fund and apply their market timing restrictions to them.

Enhanced Disclosure Related to Abusive Activities: In addition to the enhanced fair valuation disclosure and two percent redemption fee proposals, the Commission has proposed enhanced disclosure requirements of anti-market timing policies and practices as well as disclosure of the circumstances under which a fund will disclose its portfolio holdings. Again, if these requirements are adopted, funds will be forced to clearly and unambiguously disclose their policies to investors so that investors can determine whether they believe the fund's policies are in line with their interests.

B. Initiatives to Enhance Fund Oversight

As part of our effort to promote accountability in the mutual fund industry, the Commission is pursuing several initiatives to improve fund oversight and compliance, to minimize the possibility that the kinds of anti-investor activities we have recently seen find a home in the mutual fund industry. These initiatives are designed to strengthen the hand of fund boards and to provide the directors, particularly the independent directors, additional tools with which to protect fund investors, as well as reinforce ethical standards.

Fund Governance: In January, the Commission proposed a comprehensive rulemaking package to bolster the effectiveness of independent directors and enhance the role of the fund board as the primary advocate for fund shareholders. The proposals included a requirement for (i) a board comprised of 75% independent directors; (ii) an independent chairman of the board; (iii) independent director authority to hire, evaluate and fire staff; (iv) quarterly executive sessions of independent directors outside the presence of management; and (v) an annual board self-evaluation.

The proposed significant overhaul of the composition and workings of fund boards is intended to reinforce the dominant role of independent directors on a fund's board. With an independent board chairman and with independent directors representing at least 75 percent of a fund's board, independent directors would set the board agenda, have the power to control the outcome of board votes and could serve as an effective check on management, particularly when much of the board's responsibility includes policing the management company's conflicts of interest.

Some have suggested in comments on our proposed rules that we are interjecting directors into day-to-day management of fund operations. That is not our intent. We recognize that the role of fund directors is one of oversight. However, in order to fulfill their oversight function, directors must have sufficient information to carry out this vital responsibility. Consequently, the Commission has required a fund's chief compliance officer to report to the board and has promoted the authority of independent fund directors to retain staff and experts in facilitating their oversight responsibility.

Adviser Codes of Ethics and Fund Transactions Reporting: In another effort to promote accountability and reinforce the fundamental importance of integrity in the investment management industry, the Commission recently proposed that all registered investment advisers adopt codes of ethics. Investment advisers are fiduciaries and as such must place their clients' interests before their own. This bedrock principle, which historically has been a core value of the money management business, again appears to have been lost on a number of advisers and advisory personnel.

The Commission believes that prevention of unethical conduct by advisory personnel is part of the answer to avoiding the problems we have encountered recently-and is essential to ensuring that similar misconduct does not occur in the future. Consequently, the code of ethics would set forth standards of conduct for advisory personnel that reflect the adviser's fiduciary duties, as well as codify requirements to ensure that an adviser's supervised persons comply with the federal securities laws, report their securities transactions (including transactions in affiliated mutual funds) and require that supervised persons receive and acknowledge receipt of a copy of the code of ethics.

Compliance Policies and Compliance Officer: In addition to these initiatives, I expect that the Commission's new compliance policies and chief compliance officer rules will have a far-reaching positive impact on mutual fund operations and compliance programs. As we know, however, compliance procedures are meaningless if they are not enforced. We envisioned the compliance officer not only as the primary architect and enforcer of compliance policies and procedures for the fund, but also as the eyes and ears of the board on compliance matters. All too often in the Commission's recent enforcement cases, we have seen fund directors denied information about compliance matters. The rule will change this as a fund's compliance officer reports to, and is accountable to, the fund's directors. I hope that all of the firms represented here designate as a chief compliance officer someone who is forceful, scrupulous, qualified and, above all, undaunted in his or her commitment to establishing and enforcing a meaningful compliance program.

C. Initiatives Aimed at Conflicts of Interest

In addition to enhancing mutual fund oversight and compliance, the Commission is undertaking a series of initiatives aimed at certain conflicts of interest involving mutual funds and those who distribute fund shares.

Directed Brokerage: Last month, for example, the Commission voted to propose an amendment to rule 12b-1 to prohibit the use of brokerage commissions to compensate broker-dealers for distribution of a fund's shares. Effectively, the proposal would ban these types of directed brokerage practices by mutual funds. Such a ban would force advisers to be more accountable to fund investors about the fees they are paying for distribution. Advisers would no longer be able to mask their distribution payments by using a fund's commission dollars and eliminate a practice that potentially could compromise best execution of portfolio trades, increase portfolio turnover, and corrupt broker-dealers' recommendations to their customers.

Rule 12b-1: In addition, the Commission has requested comment on the need for additional changes to rule 12b-1. Over time, rule 12b-1 has come to be used in ways that exceed its original purpose. Consequently, the Commission is seeking comment on whether rule 12b-1 should be further revised or even repealed.

Soft Dollars: Another conflict that merits review in the current environment is soft dollar arrangements. Indeed, the ICI has requested that the Commission narrow its interpretation of research under the Section 28(e) safe harbor and proposed other limits on soft dollars. Chairman Donaldson has made the issue of soft dollars a priority and has directed the staff to explore the problems and conflicts inherent in soft dollar arrangements and the scope of the safe harbor contained in Section 28(e). The Divisions of Market Regulation and Investment Management are working together on this review, and we look forward to conducting a through analysis in order to make meaningful and informed recommendations to the Commission on this important issue.

D. Initiatives to Improve Fund Disclosure, Including Fee-Related Information

In the midst of the scandals and the Commission's efforts to improve fund compliance and oversight and address conflicts of interest, we cannot lose sight of the fundamental importance of disclosure and the need to provide investors with information that is useful. Long before mutual fund scandals hit the headlines, Chairman Donaldson identified improved disclosure, particularly disclosure about fund fees, conflicts and sales incentives, as a priority for the Commission's mutual funds program. The Commission has undertaken several initiatives in this area.

Shareholder Reports Disclosure: The Commission has wrestled for years with the problem of how to convey expense information to investors in a cost-effective way that permits investors to compare funds and to understand and appreciate the effect that expenses have on their investment.

Last month, the Commission took a leap forward in addressing these issues by requiring that shareholder reports include dollar-based expense information for a hypothetical $1,000 investment. Using that information, investors can then estimate the dollar amount of expenses paid on their own investment in a fund. For comparative purposes, shareholder reports also will contain the dollar amount of expenses an investor would have paid on a $1,000 investment in the fund, using an assumed rate of return of five percent. Using this second dollar-based number, investors can compare the level of expenses across various potential fund investments.

The new shareholder reports revisions also include significantly improved disclosure about a fund's investments. The recent amendments will replace a one-size-fits-all approach to portfolio holdings disclosure, where all funds deliver their full portfolio schedules to all their shareholders twice a year, with a layered approach that will make more information available, while permitting investors to tailor the amount of information they receive to meet their particular needs.

The additional quarterly disclosure of fund portfolio holdings will enable interested investors, through more frequent access to portfolio information, to better monitor whether, and how, a fund is complying with its stated investment objective. I believe the Commission's approach to portfolio holdings disclosure can become a model for us as we reassess the entire mutual fund disclosure framework to determine how best to get concise and meaningful information into the hands of investors while at the same time making more comprehensive information available to those who want it.

When the Commission adopted the shareholder report revisions, it also proposed to require disclosure in shareholder reports about how fund boards evaluate investment advisory contracts. A fund's board of directors plays a key role in negotiating and approving the terms of a fund's advisory contract. The Commission is proposing to make this process more transparent to fund shareholders. The proposed disclosure would include discussion of the material factors considered by the board and the conclusions with respect to those factors that formed the basis for the board's approval or renewal of the advisory contract. In making this proposal, the Commission is seeking to promote insightful disclosure of the board review process, rather than meaningless boilerplate that is not helpful to investors. I should also note that, as part of the fund governance rule proposal, the Commission proposed to require the preservation of documents used by boards in the advisory contract review process. These proposals should encourage fund boards to consider investment advisory contracts more carefully and promote the accountability of directors for the performance of their contract review function.

Let me respond to comments by some on our proposals that fund directors are not required to "negotiate" advisory contracts. Again, I disagree. Section 15 of the Investment Company Act charges the directors with the responsibility for annually evaluating the adviser's contract with a fund and the compensation paid under the contract. This is one of their most important responsibilities under the statute. If, after reviewing all of the relevant factors-including the advisor's cost and profitability as well as economies of scale, their judgment is that the fee is not reasonable, directors indeed should be negotiating a lower fee. To suggest otherwise lends credence to the perspectives of those who would advocate direct fee regulation or other drastic measures.

Mutual Fund Confirmation Form and Point of Sale Document: In a major proposal issued in January, the Commission proposed significant revisions to mutual fund confirmation forms and also proposed the first-ever point of sale disclosure document for brokers selling mutual fund shares. Together, these two proposals would greatly enhance the information that broker-dealers provide to their customers in connection with mutual fund transactions. They would also highlight for customers many of the conflicts that broker-dealers face when recommending certain mutual funds. The enhanced disclosure, therefore, should have the further effect of enhancing the accountability of broker-dealers to their customers when making fund recommendations.

Portfolio Managers: In the Commission's most recent disclosure initiative, which was issued earlier this month, the Commission proposed improved disclosure about a portfolio manager's relationship with the fund. The proposals include disclosure regarding the structure of portfolio manager compensation, ownership of shares of the funds that a manager advises, and comprehensive disclosure of specific investment vehicles, including hedge funds and pension funds, that are also managed by the fund's portfolio manager. This proposal would also require clear disclosure of who is managing a fund by requiring funds managed under a "team approach" to provide information about the individual members of the team who are primarily responsible for managing the fund's portfolio. If this requirement is adopted, portfolio managers could no longer avoid accountability for their fund's performance by hiding behind a nameless, faceless team.

Breakpoints Disclosure: In addition to these disclosure initiatives, the Commission in December proposed improved prospectus disclosure about fund breakpoints to address, in part, the wide-scale failure to provide appropriate breakpoint discounts on front-end load mutual fund purchases. This disclosure is designed to highlight for investors the availability of breakpoint discounts and implements recommendations made by the Joint NASD/Industry Taskforce.

Transaction Costs Concept Release: Also in December, the Commission issued a concept release requesting comment on methods to calculate and improve the disclosure of funds' portfolio transaction costs, which can be significant. We are now in the process of reviewing the comments we received as we further pursue the need to better convey information regarding portfolio transaction costs to investors.

III. Reassessment of Commission Effectiveness

One of Chairman Donaldson's goals has been to restore the Commission's credibility as the investors' watchdog. He has undertaken a comprehensive review of every division of the Commission-assessing current needs, resources, reviewing methodology and installing performance measures. I should note that, as a result of a budget increase and this review, the Commission has been able to increase its examination staff by a third to approximately 500 examiners. With increased staff, and new examination protocols, we have enhanced our ability to detect violations of the law.

Additionally, the Chairman has created a new Office of Risk Assessment, which is focused on early identification of new or resurgent forms of fraudulent, illegal or questionable behavior. The Division of Investment Management is in the process of establishing its own risk management group that will report into and work closely with the Office of Risk Management. He has also formed a new task force whose mission is to prepare the outlines of a new mutual fund surveillance program. This task force is rethinking the mutual fund reporting regime-considering both the frequency of reporting to the Commission and the types of information that should be reported to the Commission to facilitate oversight of the industry. The group is also considering how technology can be used to enhance the ability of the Commission in carrying out its oversight responsibilities. Under Chairman Donaldson's leadership, the Commission is taking significant steps to improve and enhance its watchdog function.

IV. Conclusion

In conclusion, coupled with aggressive enforcement actions to hold the wrongdoers accountable, the Commission's goal has been to create a fund governance, oversight and regulatory framework that will deter and minimize the recurrence of the types of abhorrent practices that we have recently witnessed. In most cases, this goal necessitates rules that reflect the fact that we cannot always predict the pattern of wrongdoing that fraudsters will next take. Rather than fighting yesterday's battles, we must shore up and reinvigorate our systems and framework in an offensive effort to forestall future attacks on fund investors.

However, any flexibility permitted by our rules requires that those who are charged with carrying out fiduciary and oversight responsibilities, including compliance officers, portfolio managers, brokers, fund executives and fund directors, act in the best interest of fund shareholders. The SEC cannot legislate honesty or mandate integrity. But that is your legal obligation, your unquestioned duty and your implicit promise to fund shareholders when they invest their hard earned dollars in your funds.

At the beginning of my speech, I said that we had to look back. This is painful both for the fund industry, but-more importantly-painful for fund investors. We solicit your comments and views on the proposed reforms, but I also challenge you to embrace the spirit of the Commission's reforms, so that we can move beyond this unfortunate period in the history of the mutual fund industry.

Thank you for your attention, and I hope you have an insightful and productive conference.



Modified: 03/24/2004