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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the ICI General Membership Meeting


Paul F. Roye1

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

Washington, DC
May 20, 2004

Mutual Fund Industry at a Crossroads: The Losers, the Winners and the Spirit of Reform

I. Introduction

Good morning and thank you for welcoming me here today. Before I begin my remarks, let me remind you that the views I express are 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 first commend Matt Fink, the outgoing President of the ICI, for his distinguished service since he first joined the Institute in 1971 and became its president in 1991. While there have been times when we have agreed to disagree, I have enjoyed the debate with Matt, and I have appreciated his insights and his commitment to promoting what is best for America's 95 million mutual fund investors. Matt can be proud of his accomplishments at the Institute and of the astounding growth of the mutual fund industry during his tenure. I know that I join all of you in wishing Matt a fulfilling and relaxing retirement.

I bring you greetings from the Securities and Exchange Commission. But then many of you, I am sure, are of the opinion that you have received too many "greetings" from the Commission in the form of document or information requests from our Office of Compliance Inspections and Examinations and, for a smaller subset of you, subpoenas and interrogatories from our Division of Enforcement.

The mutual fund industry has been through a year unlike any other since prior to the adoption of the Investment Company Act of 1940. The curtain was raised on some sordid practices in the industry, and none of us liked what we saw. What was exposed was some fund executives and those who sell fund shares striking secret deals for favored customers-at the expense of average shareholders-in order to increase the profits of fund management companies and their own personal fortunes. This was reprehensible conduct by any standard. The Commission is committed to doing more about these abuses than simply aggressively sanctioning the wrongdoers, sending a strong message through its enforcement actions and closing the curtain on this episode. The scandals reveal a need to reform the fund industry and hopefully re-orient its focus on integrity and investment stewardship.

The events of the last year hearken back to the mid- to late 1930s. After the genesis of the modern investment company industry in the 1920s, the industry experienced rapid growth, but the rapid growth was in large measure at the expense of the investing public. Dishonest sponsors used investment companies to further their own business interests. Failure to observe principles of fiduciary duty were widespread, and unsophisticated small investors paid the price. After the issuance of a landmark SEC study, exposing many unsavory practices in the investment company industry, Congress passed much-needed sweeping reform legislation: the Investment Company Act of 1940, which established a comprehensive federal regulatory framework for investment companies.

Unfortunately, what we have seen recently in large measure is history repeating itself: management company insiders and those selling mutual fund shares engaging in practices for their benefit, to the detriment of the funds' investors. The difference this time, some 64 years after passage of the Investment Company Act, is that the fraud is in a different form and the dramatic overhaul of the mutual fund regulatory framework is being driven by rulemaking and other Commission actions, using the broad authority vested in the agency by the Congress.

Under Chairman Donaldson's leadership, the Commission has been swiftly and aggressively following through on an action plan to address identified abuses and to lay a foundation to minimize the possibility of insider and self-dealing abuses occurring in the future. Since September of 2003, when the New York Attorney General announced his action against the Canary hedge fund, the Commission has taken action on 16 rulemaking proposals and adoptions and concept releases in the mutual fund area designed to strengthen the regulatory framework. The Commission is in the process of soliciting the views of all interested persons on many of these proposals in moving thoughtfully and carefully in its efforts to reform the mutual fund industry.

II. The Spirit of Reform

The responsibility for reforming the mutual fund industry, however, does not rest with the Commission alone. While the Commission can write rules, set standards and hold lawbreakers legally accountable, true reform must also rest on the establishment and nurturing of a culture of fiduciary responsibility that comes from within the industry, not just one that is imposed from the outside through regulation or legislation.

Thus, each fund management firm must examine what Chairman Donaldson calls your "moral DNA." Chairman Donaldson has explained what it means to elevate a firm's moral DNA:

It means that senior executives must recognize that while maintaining their focus on the bottom line, they must also remain focused on the ethical lines. It means that management needs to incorporate sound ethics and compliance measures into company business practices, and it means remaking business systems to reduce the incentives, or pressures, for cutting corners. It means that leaders not only live up to the letter of the law, but also internalize and advocate the spirit of these reforms to everyone in their organization. It means that senior managers need to communicate at every level of the business - with consistent actions and words - that ethical conduct is absolutely critical to the success of the business. Finally, leaders must remember that establishing integrity as an organizational culture is a lengthy process - one that requires prioritization, communication, training, and reinforcement.

I believe that the industry must embrace the spirit of reform if meaningful change is to take place. Reform must be embraced from the top. It is the leaders of the mutual fund industry--management executives, fund directors and trade association heads--who must embrace change and steer the industry toward reform. When these leaders serve as an example, and set the tone from the top, their pro-investor attitudes can permeate all fund operations.

I therefore applaud the efforts of the Mutual Fund Directors Forum, which at Chairman Donaldson's request is developing a set of recommended best practices for independent directors of mutual funds in certain areas in which director oversight and decision making is critical for the protection of fund shareholders, and the efforts of the Investment Counsel Association of America to develop a model code of ethics for investment advisers, including advisers to mutual funds.

We have witnessed a period of great turmoil, outrage and shame in the fund industry. We are currently engaging in a process of cleansing, reassessment and restoration of confidence. Indeed, this annual conference is a time for taking stock of where the industry has been and where it is going. Now, I challenge you to determine what the results will be. Will this unfortunate chapter in the industry's history be the beginning of a new era of fiduciary responsibility? Will the industry learn from past mistakes and take serious steps to regain its reputation as an industry of integrity? Or, will this tumultuous period in the fund industry's history be marked by lots of hot air that resulted in little real change and a back to business as usual attitude, and the triumph of self interest rather than the greater good of investors' best interests?

The answers to these questions are in your hands. The final chapter of the mutual fund scandals has yet to be written. By your actions and your attitudes, you will determine the future and fate of the mutual fund industry. And as you do so, I urge you to keep in mind the millions of Americans who have placed their financial security-and their investment hopes and dreams-in your hands. Sadly, many of these investors rightfully feel that they have been betrayed by the fund industry.

In the past year, the Commission and state regulators have taken actions against nearly half of the 25 largest mutual fund companies. Despite this startling statistic, investors continue to invest in funds, with approximately $76 billion in net inflows invested in funds in the first calendar quarter of 2004. But do not mistake these fund inflows for unwavering investor confidence in the mutual fund industry. In the wake of the recent scandals, investors are much more skeptical and cynical. Investors may forgive short-term poor performance, but they ultimately will not forget double standards, dishonesty or unethical behavior.

III. The Losers and the Winners

We have seen this firsthand as investors have pulled significant assets from funds managed by scandal-tainted firms. Many people believe that these sizable redemptions and the recent large inflows to funds managed by firms that have not been embroiled in the scandals will result in two classes of fund firms: the losers and the winners. The losers are those firms that lost sight of their fiduciary standards and are now paying the price in terms of damaged reputations, angry investors and diminishing assets under management. And some individuals within these firms have lost their positions, and careers have been destroyed. Indeed, there are some who are not at the meeting this year, including those who were at the highest levels of their firms.

The winners, on the other hand, are those firms that have maintained their ethical standards. They have not been exposed as currying favor with big investors or deviating from investor-oriented policies. These firms seem to have strong compliance systems and controls and exhibit an understanding of the fundamental importance of treating investors fairly. These winning firms have been rewarded recently in the form of increasing assets and investor interest in their funds.

However, as we meet here today, no one is truly a "winner" in the fund industry as a result of recent events. The reputation of the entire fund industry has been tarnished, and no one can take delight in the betrayal of trust that has been perpetrated on fund shareholders by some firms. I believe that fund investors have long memories, and the fund industry-the entire fund industry-will have to work long and hard to regain investor confidence.

IV. The Need to Rekindle Reputation and Restore Credibility

With respect to loss of reputation, the ancient Greek philosopher Socrates said:

Regard your good name as the richest jewel you can possibly be possessed of - for credit is like fire; when once you have kindled it you may easily preserve it, but if you once extinguish it, you will find it an arduous task to rekindle it again. The way to gain a good reputation is to endeavor to be what you desire to appear.

Although Socrates shared these words of wisdom over 2,400 years ago, I hope the fund industry is striving today to follow his advice: to rekindle its reputation for integrity and seeking to act ethically rather than simply talking about, and appearing to be, ethical.

We have seen some in the fund industry who have compromised fiduciary responsibility for the sake of profitability. Through the actions of some, the fund industry now has a credibility gap with regulators, with lawmakers, with the press and, most significantly, with investors. Here is a sampling of what is being said; some of it hyperbolic but nonetheless important in gauging the task before you.

  • The fund industry "has lost its moral compass."2
  • "The ethical loss is cataclysmic."3
  • The fund industry is a "witches' brew of unsavory business practices."4
  • The fund industry is "now the world's largest skimming operation."5
  • "The fund industry … just doesn't get it."6
  • "They aren't as innocent as they look. … The folks running the mutual fund business aren't exactly choirboys and girls."7

Millions of fund investors were outraged to learn that funds were cutting secret deals with favored market timers, while rank-and-file investors were promised imposed limits on roundtrip trades. We were similarly dismayed when we discovered that many of the same fund groups clamoring for additional tools to thwart market timers allegedly were allowing the largest of those timers to trade in their funds-often for the promise of sticky assets and, therefore, increased profits for the management companies. In addition, as the fund industry was resisting efforts to require more frequent disclosure of mutual fund portfolio holdings, some management firm personnel allegedly were selectively disclosing portfolio information that was later used to trade against their funds and harm their investors.

In light of these comments, how can you quiet your critics? It will not be easy. But you can start by promoting responsibility rather than excuses-and by actions to match the rhetoric. Unfortunately, however, it seems that there are still some within the industry who are seeking to avoid reform. They seek to avoid accountability in favor of plausible deniability. Let me give you some examples:

The Investment Company Act creates the obligation of funds to fair value their securities. In 1999 and 2001, we issued letters reiterating that obligation. While some fund groups embraced their responsibilities and took steps to protect their shareholders, others resisted, whined and complained. These fund groups failed to protect their investors from market timers and, in some cases, aided others in profiting from their failures to fulfill their obligations under the Investment Company Act.

Responding to complaints about the lack of guidance, the Commission recently asked for comment on what guidance we might provide. We have received little help, leading some of us to wonder whether the complaints were really just an excuse for avoiding responsibility for employing effective fair valuation policies.

While I am on the subject of assuming responsibility to protect investors, let me talk a moment about omnibus accounting. Fund managers complained to us about their lack of ability to "look through" omnibus accounts to identify harmful market timers, and to apply redemption fees to their transactions. Earlier this year the Commission proposed a rule that would fix this problem. The rule was proposed at the request of the fund industry and after extensive consultation with the industry through the good offices of the NASD. And last week we received some truly astounding comment letters opposing the requirement that intermediaries provide fund managers with omnibus trade information. A lot of arguments were made that do not seem to hold much water, and some of us are left wondering whether fund managers are unwilling to accept the responsibility of using this data to protect fund investors from market timers.

These are the kinds of positions that baffle us and cause us to question whether there is only lip service being paid to the primacy of the interests of fund investors.

V. Reform is the Responsibility of the Entire Industry

But in many respects, the mutual fund industry can be proud of the investment vehicle it has provided to America's investors. The mutual fund continues to be the primary investment vehicle of the average American. Mutual funds have provided investors access to our securities markets with the added benefits of instant diversification, professional money management and daily redeemability-which many fund investors could not afford or obtain by investing directly in individual stocks. Mutual funds are a primary investment in retirement accounts and education savings plans and serve as the investment of choice when seeking to attain many of our financial goals. In this season of graduations, we are reminded that, for the current generation of college graduates, mutual funds will serve as their principal entrée into securities investing. In short, mutual funds have become a staple of the American financial landscape. Of this, the mutual fund industry can be proud.

Some of you may feel that criticism of the industry is unfair, especially if your firm was not implicated in the recent scandals. But it underscores the point that you sink or swim together. Any taint is harmful to the industry. As I previously stated, there may be losers and illusional winners coming out of the fund scandals. But when investors lose confidence, the effects are hard to contain.

That is why your responsibility in the effort to accomplish reform involves more than instituting reforms in your own firms, as important as that may be. Inculcating a moral DNA and establishing an investor-oriented tone at the top is essential, but it is only part of the equation. In addition, you must consider your role for instituting reforms for the industry as a whole. Investor protection is not a competitive issue. It should not be approached from the perspective of competition among firms, but from the perspective of creating an industry-wide culture that is fair to fund investors.

VI. Need for Independent Fund Chairmen

I want to comment on one of the more controversial items on the Commission's reform agenda: the independent fund chairman proposal. I fully recognize that there are interested fund chairmen who admirably represent the interests of fund investors in the boardroom while also serving as executives of the fund's adviser. Some interested chairmen run fund organizations are touted for their strong performance, low expenses, ethical cultures and investor-oriented policies.

However, what must be our focus when addressing the independent chairman issue is what is best for fund investors overall. The proposal invokes the fundamental question of just whose fund is it, the management company's or the fund's investors. If the answer is fund investors, then why shouldn't the board be led by an independent chairman? Is a board with an independent chairman more likely to be an effective check on management, particularly when so much of the board's responsibility under the Act involves policing the management company's conflicts of interest? Is an independent culture more likely to prevail at board meetings when those meetings are led by an independent chairman? Will the power of independent directors to advance the interests of investors be enhanced with an independent chairman? Or is that the ultimate fear with this proposal, and the proposal to increase the percentage of independent directors to 75%, that the independent directors will have too much power from the management company's perspective?

The Mutual Fund Directors Forum, in comments to the Commission on this proposal, stated that the independent chairman requirement would empower independent directors, not weaken their authority as contended by some. The Forum views the independent chairman requirement as a best practice, and I also ask you what industry other than the mutual fund industry chairs its boards with vendor or service provider representatives?

In addition, I question whether fund boards would suffer if an interested chairman is asked to relinquish his or her title to an independent director. The former chairman would continue to be a member of the board and would continue to share critical insight and expertise in the boardroom. In addition, the board would continue to function with direct contact with the manager's executives. I fully expect that well run fund organizations will continue to be well run with an independent chairman for their fund boards.

I also want to comment on the role of interested fund directors generally. The Commission, the press, the courts, the lawmakers and industry observers routinely focus on independent fund directors because of the watchdog function they play in protecting fund investors. However, I believe additional focus should be placed on the role of those directors who are affiliated with a fund's management company. Whether interested or independent, all directors owe fund shareholders fiduciary duties of care and loyalty. Interested fund directors, therefore, are legally bound to vigilantly protect and promote the interests of fund shareholders. And the Commission and the courts will hold interested directors to this standard.

Problems arise, however, because in many cases inside directors also owe fiduciary duties to a competing interest: the fund's management company. We have seen situations recently in which interested directors allegedly have compromised their fiduciary duties to fund investors, perhaps because of their conflicting loyalties. These dual obligations can motivate interested directors to take actions that favor a fund's management company over a fund's investors. Divided loyalties, however, are no excuse for unethical behavior or neglect of one's fiduciary obligations to fund investors.

VII. Role of the Investment Company Institute

As we examine the fund industry at this turning point in its history and review the importance of embracing reform initiatives, we naturally consider the role of the ICI, which in many ways is at its own crossroads. As the ICI welcomes new leadership, the question arises of what role the ICI will play in the future. When we look back on this period, on what side of history will we find the ICI?

Today the mutual fund industry must stake out positions on the reform of the industry. Will the ICI be limited to the narrow self-interest of your management companies? Or will you rise to the occasion and champion the long-term interests of fund investors? We want to be able to work with the ICI to proactively identify problem areas within the fund industry and address them before they cause investor harm. We want to be able to work with the ICI to prevent further scandals.

VIII. Conclusion

I conclude by stating what I believe obvious: America's mutual fund investors are asking whether they can trust the mutual fund industry. Winning back the trust of these investors will require effort and commitment: commitment to compliance, commitment to ethics and-most of all-a commitment to reform. As I have said before, the status quo is no longer acceptable to America's investors. Nor will they accept empty promises of reform. They are looking for action; they are looking for meaning behind the words; they expect a reinvigorated, investor-oriented fund industry. They, and we at the Commission, expect money, resources, time and executive attention to be devoted to compliance and controls.

The recent scandals should be a wake-up call for the fund industry. The Commission has responded by pursuing an aggressive reform agenda and instituting significant revisions to our examination practices and protocols and emphasizing new methodologies to identify areas of risk in the investment management industry. Yes, we too at the SEC have to redouble our efforts to protect America's investors. Lawmakers have responded by introducing a variety of mutual fund bills and engaging in frequent and wide-ranging debate on problems they perceive in the mutual fund industry. Investors have responded by withdrawing their money in some cases, while others are watching over their fund investments with a healthy dose of skepticism. But the jury is still out on how the industry is responding. This is a time in which you are being tested, and watched, like never before. As an industry, this is one of your defining moments. You will be judged by your actions. I encourage you to seek the greater good, to rekindle investor trust and take action to restore the fund industry's credibility.

Thank you very much and enjoy the rest of your conference.



Modified: 05/20/2004