Speech by SEC Staff:
Remarks Before the 2004 New Directors Workshop
Paul F. Roye1
Division of Investment Management
U.S. Securities and Exchange Commission
April 2, 2004
Mutual Fund Scandals: Lessons for Fund Directors
Good morning. I am pleased to be with you here today and appreciate your commitment to serving America's investors through your role as independent fund directors. It is no understatement to say that, in your role as fund directors, you are performing a vital service as part of the first line of defense in protecting the interests of mutual fund investors. I applaud you for taking the time and making the effort to be here to enhance your understanding of your role as an independent fund director.
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.
I would like to focus this morning on the recent mutual fund scandals and the lessons arising out of these scandals for fund directors. The recent scandals, I believe, should serve as a significant wake-up call for fund directors. In light of these events, no fund director can lightly approach the role and responsibility of serving investors as a member of a fund's board. And, going forward, hopefully all fund directors will keep the events of recent months in the forefront of their consciousness because they drive home the fundamental importance of meaningful oversight by an informed and appropriately skeptical fund board and the importance of instilling a culture of compliance in your fund organizations.
II. The Scandals
The mutual fund scandals that have recently been brought to light involved the late trading of mutual fund shares and abusive market timing arrangements in which fund management companies in some cases agreed to permit select market timers to engage in abusive short-term trading of certain funds in violation of stated policies or in exchange for placing so-called "sticky assets" in other financial vehicles managed by the company. Both of these practices involved a blatant violation of fiduciary principles, and both have harmed long-term fund shareholders.
Late Trading: "Late trading" refers to the practice of placing orders to buy or sell mutual fund shares after 4:00 p.m. east coast time, when most mutual funds calculate their net asset value, but receiving the price based on the prior NAV already determined at 4:00 p.m. Late trading also refers to the practice of placing conditional trades prior to 4:00 p.m. with the option of withdrawing or confirming the trades after 4:00 p.m.
Late trading enables the trader to profit from market events that occur after 4:00 p.m. but that are not reflected in that day's price. In particular, the late trader obtains an opportunity for a virtually risk-free profit when he learns of market moving information and is able to purchase mutual fund shares at prices set before the market moving information was released. Much of the late trading activity that has been alleged occurred through broker dealers and other fund intermediaries who were willing to facilitate or even set up late trading platforms in order to attract select, large clients. These practices have been illegal since 1969.
Market Timing: Like late trading, abusive market timing also negatively impacts long-term shareholders. Mutual funds that invest in overseas securities markets are particularly vulnerable to market timers who take advantage of time zone differences between the foreign markets on which international funds' portfolio securities trade and the U.S. markets which generally determine the time that NAV is calculated. Thus, market timers frequently purchase or redeem shares of mutual funds that invest internationally based on events occurring after foreign market closing prices are established, but before the funds' NAV calculation at 4:00 p.m. Market timers generally then purchase or redeem the fund's shares the next day, for a quick profit at the expense of long-term fund shareholders. Funds that invest in small cap securities and other types of specialty investments, including high yield funds, also can be the targets of market timers.
Although market timing is not per se illegal, mutual fund advisers and fund directors have an obligation to ensure that mutual fund shareholders are treated fairly and that one group of shareholders (i.e., market timers) is not favored over another group of shareholders (i.e., long-term investors). In addition, when a fund states in its prospectus that it will act to curb market timing, it cannot knowingly permit such activities. One of the most alarming parts of the recent fund scandals is that some portfolio managers and fund executives were allegedly market timing the very mutual funds they managed.
Selective Disclosure: Recent allegations also indicate that some fund managers may have been selectively disclosing their portfolios in order to curry favor with large investors. Selective disclosure of a fund's portfolio can facilitate fraud and have severely adverse ramifications for a fund's investors if someone uses that portfolio information to trade against the fund.
III. Specific Lessons Learned as a Result of the Scandals
In view of these and other allegations of wrongdoing, you as fund directors are no doubt concerned about how you can prevent this type of harmful activity from occurring in your fund group-especially in light of the fact that, in many cases, fund directors were kept in the dark, even as some compliance personnel and portfolio managers were complaining about some of these activities to their superiors within fund management firms. Drawing from these experiences, what should fund directors, particularly new fund directors, learn that will enable them to more effectively perform their oversight functions?
I think there are some specific as well as some general lessons to be learned.
Our rules require the forward pricing of fund shares, which means that an investor submitting a purchase order or redemption request must receive the price next calculated after receipt of the purchase order or redemption request. Therefore, pursuant to the recently adopted compliance procedures rule, a fund should have in place procedures that assure the appropriate pricing of fund orders. Funds typically have contractual provisions with transfer agents and other intermediaries that obligate those parties to segregate orders received by the time of receipt in order to prevent late trading. It is clear now that reliance on these contractual provisions alone was not sufficient to prevent late trading. Fund directors should be approving and periodically reviewing the policies and procedures of transfer agents, and taking affirmative steps to protect the funds against late trading by obtaining assurances that those policies and procedures are effectively administered.
While in some cases late trading was facilitated with the cooperation of fund management, it appears that much of the abuse was being facilitated by third-party intermediaries who were processing fund orders, without the knowledge of fund management. Consequently, in order to protect fund investors from the harms of late trading, fund directors should not only obtain assurances from fund management that late trading is not being facilitated, but also make inquiries and obtain assurances, beyond the confines of the fund and its transfer agent.
Fund directors should ask a fund's principal underwriter about the nature and type of intermediaries who sell the fund's shares. Directors should feel comfortable that dealer agreements and other contracts reflect intermediaries' obligations to comply with the law and to appropriately segregate and process fund orders. You should also assure yourselves that the fund's underwriter is appropriately monitoring the intermediaries to ensure that they are processing fund transactions according to the agreed-upon guidelines. Fund directors can no longer take these issues for granted. You should be asking the questions and obtaining the assurances necessary to make sure that late traders have no opportunity to take advantage of your funds' investors.
With respect to market timing, fund directors must be at the heart of establishing a fund's market timing policies and reviewing the methods the fund employs to deter market timing activity. More importantly, however, fund directors need to follow up to make sure that anti-market timing policies and procedures are being enforced and applied to all investors across the board on a consistent basis. Furthermore, fund directors should closely scrutinize-and be particularly skeptical of-any exceptions that are made to a fund's market timing policies-or, for that matter, exceptions to any of a fund's compliance policies and procedures. If exceptions are made, they should be documented and you should be sure that there is adequate justification for any deviations from policy.
Directors should also inquire as to whether funds that could be susceptible to abusive market timing, such as international funds, small cap funds and other funds that invest in thinly-traded securities, have systems in place to monitor information about a fund's daily transaction flows, i.e., the fund's daily purchases and redemptions. Examination of a fund's daily flow information can reveal significant spikes in purchase or redemption activity on particular days, which can provide a strong indication of market timing, late trading or other manipulative activity. In adopting the compliance procedures rule, the Commission emphasized that the monitoring of the flow of money in and out of a fund could not only facilitate the detection of market timing activity but also could allow for the monitoring of the enforcement of the fund's market timing policies.
Fund directors, furthermore, must pay close attention to their statutory obligations to fair value price portfolio securities for which market quotations are unavailable or unreliable. 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 to effectively reducing or eliminating the profit that many market timers seek and the dilution of shareholders' interests. Fund directors, at a minimum, must ensure that their funds have meaningful fair valuation procedures-if the funds invest in securities for which quotations are unavailable or unreliable.
But fund directors cannot stop there. Fund directors must monitor how fair valuation procedures are applied in practice. You should know how often, and under what circumstances, a fund's securities are fair valued. You should also ask about follow up to the fair valuations assigned. In hindsight, were they accurate? Did the fair valuations appropriately approximate actual market value? Fair valuation procedures must continuously be back tested, critiqued and refined in order to maximize their effectiveness for the benefit of shareholders. Fair valuation, therefore, must be a dynamic process.
Beyond focusing on late trading and market timing, the recent scandals have taught us that fund directors must question the extent and under what circumstances a fund's portfolio holdings will be disclosed. Directors must ask when, to whom, and under what circumstances a fund's portfolio holdings will be revealed. In addition, fund directors must feel comfortable that there are appropriate controls on the release of portfolio information, including confidentiality agreements, so that fund investors will not be harmed by anyone who wants to use the portfolio information in ways that could adversely impact the fund. Divulging portfolio holdings to selected third parties is permissible only when the fund has a legitimate business purpose for doing so and the receipt of the information is subject to a duty of confidentiality.
The Commission has proposed enhanced disclosure of a fund's policies and practices in the three areas of market timing, fair valuation and portfolio holdings disclosure. Under the proposals, funds would be required to provide specific and meaningful disclosures on these topics so that investors could assess whether a fund's policies, and the way it administers those policies, comport with the investors' interests and expectations. In addition to your role in the oversight and administration of these policies, you as fund directors would have to ensure that the policies are disclosed to investors in a meaningful and helpful way. Furthermore, if the Commission adopts its disclosure proposals, the disclosures would appear in each fund's registration statement, for which you are accountable.
If you are a director to one of the funds that was harmed in the scandals, I hope you are examining possible ways to obtain restitution on behalf of the fund's investors. In the wake of the recent scandals, directors should seriously and carefully consider whether their funds have legitimate causes of action against fund management companies, hedge funds or other traders who were breaking the law, or against intermediaries who facilitated the frauds. In too many cases, fund shareholders have been cheated-cheated by some of the very people with whom they placed their trust and investment dollars. The Commission is doing all that it can, through our enforcement actions, to make these investors whole. But, as fund directors, you have an obligation to consider means to obtain restitution for the benefit of your funds and their investors.
IV. General Lessons Regarding Director Oversight
In addition to these specific issues that were highlighted for directors by the recent fund scandals, we can also glean some general tenets that should guide fund directors as they perform their responsibilities in the future.
First, there is no justification for complacency on the part of fund directors. Fund directors are paid to oversee management, ask tough questions, probe difficult issues and ultimately represent fund investors in the boardroom. Directors cannot be complacent when performing these functions. Mutual fund investors deserve fund directors that are more than spectators. They deserve active, energized and strong-willed directors who will advocate the interests of fund investors.
Second, fund directors must bring a healthy dose of skepticism to their oversight functions. Although a fund's investment adviser and fund shareholders have common interests in many areas, there are conflicts of interest and potential for abuse inherent in the external management structure typical of mutual funds. Under the regulatory framework, you are responsible for monitoring these conflicts. You cannot blindly accept that management's judgment will not be skewed by self-interest. Remember that fund service providers are motivated, in part, to maximize their profits. Therefore, you must be motivated solely by your duty to ensure that fund shareholders are treated fairly.
Third, fund directors must insist on a culture of compliance at the firms that manage their funds. No amount of portfolio management wizardry can make up for a betrayal of fund shareholders. You are witnessing this currently as the market is severely disciplining those fund groups caught up in the scandals. Therefore, the firms managing mutual funds must focus on more than stock and bond picks and bringing in more assets to manage; they must focus on creating a culture in which funds are managed in a decent, honest and fair manner that maximizes the interests of fund investors. Thus, compliance must be as central to the firm as is portfolio management and distribution. The recent scandals reinforce that fund investors may be taken advantage of if there is not a strong system of compliance controls in place that is being enforced. As independent directors, you have the responsibility to demand a robust compliance and control environment.
On this topic, I would note that one of the Commission's recent proposals would require that investment advisers adopt codes of ethics. 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 employees comply with the federal securities laws, report their securities transactions (including transactions in affiliated mutual funds) and require that advisory employees receive and acknowledge receipt of a copy of the code of ethics. Because this rule is in the proposal stage, it is not a current requirement. As fund directors, however, you can demand that your funds' advisers live up to these standards and adopt for themselves-regardless of the status of our rule proposal-a comprehensive code of ethics that seeks to promote ethical and responsible conduct by advisory personnel.
Another lesson we can learn from the recent fund scandals is that directors must demand accountability from fund management. It is wholly inappropriate for fund directors to be left in the dark about major compliance lapses involving a fund they oversee. Directors, however, must set the tone at the top. You must make sure that management understands that you expect them to report to you regarding material conflicts of interest and compliance-related issues. You should insist on a "doctrine of no surprises."
In this vein, one of the Commission's new requirements should be of great assistance to fund directors. The Commission recently mandated that all funds, by October 5, 2004, designate a chief compliance officer who has been approved by the board, reports directly to the fund's board, can be removed only with the board's consent and is empowered with full responsibility to develop and enforce appropriate policies and procedures for the fund. In addition, the chief compliance officer will be required to meet in executive session with the independent directors at least once each year, outside the presence of fund management and the interested directors. This executive session will create an opportunity for the chief compliance officer and the independent directors to speak freely about any sensitive compliance issues of concern, including any reservations about the cooperativeness or compliance practices of fund management.
Of course, as independent directors, you should meet with the chief compliance officer as often as you deem necessary. I believe that these sorts of independent meetings can lead to more fulsome discussions and encourage constructive dialogue between a fund's independent directors and the person you have assigned with the all-important task of overseeing a fund's compliance functions. In addition, the chief compliance officer can become an important source of information for you, especially information that has not been "sanitized" by fund management and management's lawyers.
In addition to the new chief compliance officer, other tools that can be particularly helpful to fund directors as they perform their oversight functions include a fund's independent auditor and the independent directors own independent counsel. In addition, the Commission's recent fund governance proposal reiterates the ability of independent directors to hire staff and experts to assist them. As you perform your independent director functions, you should be aware of the personnel who are available to assist you and do not be afraid to request their assistance and counsel.
Finally, and most importantly, in the wake of the recent scandals, you must remember that the fund's management company works for you-not the other way around. The fund's managers are not the people you need to please; it is the fund's investors to whom you owe your duty. As fund directors you cannot allow yourselves to be charmed, overwhelmed or duped by a fund's managers. You must remember that you have the right, and the obligation, to stand up to management and assert your views, ask questions and request additional reports and explanations. Investors are not in the boardroom to do this for themselves; you must do it for them. You are the principal guardians of their interests.
In conclusion, 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. But you also must remember that your oversight responsibilities are significant and substantial.
You must be vigilant in carrying out your responsibilities. In some instances you may be the only barrier that separates investors from harm. The buck, so to speak, stops with you. And you must use your judgment, your integrity, your determination and your expertise to ensure that the right questions get asked, uncover the conflicts of interest and identify the risk areas so that fund investors never again are subject to the types of unscrupulous frauds we have seen recently. As a new director, it will be difficult to go wrong, if you are guided in your decision-making by what is in the best interests of investors.
Thank you again for your attention, and especially for your willingness to take on the vitally important role of an independent mutual fund director. Enjoy the rest of the conference and thank you for listening.