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Speech by SEC Commissioner:
Mutual Fund Regulation: A Time for Healing and Reform


Commissioner Harvey J. Goldschmid

U.S. Securities and Exchange Commission

ICI 2003 Securities Law Developments Conference
Washington, DC
December 4, 2003


The corporate and financial scandals of the 1990s and early 2000s are the most serious that have occurred in this country since the scandals of the Great Depression. In the mutual fund area, I have been both saddened and angered by what has been disclosed since Eliot Spitzer first filed his Canary complaint, documenting late trading and market timing abuses, on September 3, 2003.

Saddened because of my high regard for what the mutual fund industry had accomplished in becoming the investment vehicle of choice for average investors, with well over 90 million Americans having invested over $7 trillion. At the close of 2002, mutual funds were entrusted with approximately 21 percent of the $10.2 trillion U.S. retirement market and 98 percent of the $18.5 billion placed in Section 529 college saving plans. Mutual funds were not only trusted with the future financial well being of American families, and other small investors, but were a vital engine of our capital formation process. The great growth of mutual funds during the past two decades was built on a foundation of trust.

Thus, the reason for my anger. What has occurred involves a grievous betrayal of trust. The investigations are ongoing, but at this point it is clear that venal self-interest has been widespread. Too often, fund officials — and other members of the financial community, including broker-dealers and bankers — have corruptly made themselves and their wealthy clients even richer at the expense of small fund shareholders.

Let me emphasize that I am not talking about a "few rotten apples." Much of the conduct has indeed been rotten, but we are now dealing with a significant number of senior fund employees and other members of the financial community. I expect the fund scandals to grow larger and more widespread as investigations continue.

As I make these blunt statements, I'm reminded to do something I should have done at the beginning of this talk: The comments I make today are my own and do not necessarily represent the views of the Commission, my fellow Commissioners, or the Commission staff.

With the Commission's standard disclaimer behind us, let me set forth an optimistic theme. Historically, the great strength of the U.S. system has been its ability to heal and reform itself. The result of our worst financial scandals, which of course occurred during the 1920s and 30s, was the 1933 Securities Act, the 1934 Securities Exchange Act, the two 1940 acts, and the formation of the SEC in 1934. These acts, and the Commission itself, remain the foundations of our securities regulation system today.

The Sarbanes-Oxley Act (of July 30, 2002) has provided the right framework for much of the nation's current healing process. But in the fund area, on the basis of what we now know, much remains to be done. This morning, you heard a great deal about what the Commission did yesterday, and will do, to address abuses like late trading, market timing, stale pricing, selective portfolio disclosure, and inadequate compliance systems. These are important topics, but in part to avoid duplication, I will focus my remarks on what I consider the centerpiece of reform efforts in the mutual fund area: improved corporate governance. Making the mutual fund board truly independent and effective is where a great deal of pay dirt lies.

I will also provide a very brief "feel" for other areas where I believe change is needed. When added to what you have already heard this morning, my overall aim is to suggest a blueprint for serious reform. It is meant to be a constructive blueprint, one which avoids overly intrusive and counterproductive measures. Nevertheless, let me be clear, the mutual fund industry cannot continue to function as it has in the past. Trust, honesty and fair dealing must be restored. Before average investors grow more disillusioned, and before we as a nation pay a heavy long-term price, we must act now to bring about a time of healing and reform.

Fund Governance Reforms.

A thumbnail sketch of lessons to be learned. I began teaching at Columbia Law School in the fall of 1970. The great scandal of that time involved the bankruptcy of Penn Central. Penn Central was the nation's largest railroad, our sixth largest industrial corporation, and its bankruptcy was the nation's largest since the Great Depression. SEC and congressional reports — and a book aptly entitled The Wreck of the Penn Central 1 — charged that Penn Central's directors had received almost no realistic financial information and had ignored indications of impending disaster.2

A director who joined the board in December 1969, when bankruptcy was near, is reported to have said the following about his fellow directors:

[T]hey sat up there on the eighteenth floor in those big chairs with the [brass name] plates on them and they were a bunch of, well, I'd better not say it. The board was definitely responsible for the trouble. They took their fees and they didn't do anything. Over a period of years, people just sat there.3

In the late 1960s and early 1970s, as documented by numerous scholars, this Penn Central picture was too close to the corporate norm.4 Senior managers dominated, and directors spent roughly 30 to 40 hours a year on the job.

From 1970 until today, the reform movement in corporate governance has focused on the development of a so-called "monitoring model," in which active, independent directors oversee and check full-time senior managers. This check and balance role is even more imperative in mutual funds because of the inherent conflicts and tensions between investment managers and the mutual funds themselves.

The governance failures at Enron, WorldCom, etc. do not, at least for me, call into question the good sense underpinning the monitoring model. In the public corporation context, we don't know how many additional Enrons and WorldComs were prevented by active, independent directors. Indeed, in the Sarbanes-Oxley Act, Congress indicated its faith in the monitoring model, by putting even more weight and responsibility on independent directors. In building upon Sarbanes-Oxley, the SEC has done the same.

In the mutual fund area, as you know, Congress understood from the beginning the potential for conflict and abuse. In addition to the Investment Company Act's many prohibitions on transactions between a fund and its affiliates, Congress conceived of independent directors as "independent watchdogs," in the words of the Supreme Court, who would "supply an independent check on management and . . .provide a means for the representation of shareholder interests in investment company affairs."5

This role for mutual fund independent directors represents common ground for virtually everyone who has thought about the area. As Dick Phillips, in a paper recently published by the ICI, put it, as "watchdogs for the shareholders," independent directors "have the responsibility to guard against abuses, particularly abuses that emanate from conflicts of interest and noncompliance with the shareholder protections of the 1940 Act."6

But too often, as demonstrated by cases that the Commission has brought since September, and other cases that are currently in the SEC's enforcement process, independent directors have been the "last to know" about fund conflicts and wrongdoing.

Descriptions of their involvement in these areas sound ominously like the Penn Central board of 1969.

Given the central role that independent directors must play in mutual fund governance and self-regulation, I believe the following five basic steps must be taken to strengthen fund boards. The first three steps are drawn from lessons learned in the context of public corporations.

First, even with an adequate definition of independence (which needs upgrading in this area), and directors trying to adequately do their jobs, it should be recognized that independent directors cannot be expected to carry their monitoring load alone. They are, by necessity, heavily dependent on information flows, proper disclosure, and the effectiveness of gatekeepers like auditors, lawyers, and compliance officers. Both information flows and the loyalty of gatekeepers to independent directors must be strengthened.

Second, in order to strengthen the loyalty of auditors to independent directors, and to enhance the effectiveness of mutual fund audit committees, public company audit committee listing rules, which already apply to closed-end funds, should be applied to mutual funds. Audit committees of public corporations now have "direct responsibility" for the appointment, evaluation, compensation, and firing (where appropriate) of a corporation's independent auditor. The public company audit committee has authority to engage independent counsel, accountants, and other advisers; it is required to establish a confidential process for the reporting of questionable accounting and auditing matters. Similarly, as I will soon discuss, the reporting responsibilities — and loyalties — of a fund's chief legal officer and its chief compliance officer must be to the mutual fund board and, particularly, to its independent directors.

Third, no one expects even the most active directors to catch every fraud or detect every violation of fiduciary duty, but it is fair — and perfectly consistent with modern corporate governance approaches — to require them to establish effective programs and procedures to assist them in their decision-making and monitoring roles. Yesterday, for example, the Commission adopted a rule requiring funds and their advisers to adopt policies and procedures reasonably designed to prevent securities law violations, including late trading, abusive market timing, and selective portfolio disclosure.

Fourth, in 1940, the Investment Company Act required that 40 percent of a fund's board consist of independent directors. As a result of a 1999-2000 SEC rulemaking, almost all mutual funds now have a majority of independent directors. But given the fundamental need for directors to scrutinize the fees of investment managers (which must be negotiated at arm's length), and to review with rigor the practices and performances of fund managers, a critical mix of at least 75 percent of independent directors now seems right.

Fifth, the board's chair should always be an independent director. The current scandals highlight the need for a chair who will independently ensure proper information flows, help establish sensible board priorities and agendas, and encourage candid and thorough discussions in the boardroom.

The roles of compliance officers, lawyers, and SEC enforcement.

A recent Fortune Magazine piece wisely noted that "in most organizations, bad news travels down but not up." 7 Yesterday, the Commission adopted procedures that will pull "bad" mutual fund news to the top. Under new Rule 38a-1, funds must have a chief compliance officer who reports directly to the board. The chief compliance officer will serve at the pleasure of the board, and his or her compensation will be controlled by the board. To facilitate frank discussions, the chief compliance officer is required to meet separately with the independent directors at least once a year, in addition to submitting a written report to the full board about material compliance matters.

Fund lawyers, under SEC rules that became effective August 5, 2003, have a similar "reporting up" duty. The SEC's attorney conduct rules apply to any attorney employed by an investment manager who prepares, or assists in preparing, materials for a fund that the attorney has reason to believe will be submitted to or filed with the Commission by or on behalf of a fund.

Under these rules, an attorney who is aware of credible evidence of a material violation of the securities laws, or a material breach of fiduciary duty, must report this evidence up the chain-of-command or ladder to the fund's chief legal officer, and ultimately, to the independent members of the mutual fund board.

This "reporting up" requirement should significantly enhance the flow of key legal information (involving "reasonably likely" material violations) to independent members of the fund board. "Reporting up" also empowers lawyers. The requirement will allow dispassionate, independent fund directors — not conflicted fund investment managers — to resolve key securities law and conflict-of-interest issues. Everyone should understand that the SEC's rules are now a matter of substantive federal law. As of August 5, available for violations are the Commission's traditional broad spectrum of remedies, penalties, and other sanctions.

These "reporting up" mechanisms should go far toward helping independent directors fulfill their role as "watchdogs."

The mention of sanctions brings me briefly to enforcement policy. Mutual fund investment managers and directors are fiduciaries with duties of care, loyalty, and utmost good faith to fund shareholders. The SEC, other federal authorities, and state securities regulators are now fully engaged in an aggressive program to ferret out fraud and other wrongdoing in the mutual fund area. Never in the SEC's history has an aggressive enforcement effort been more central to the Commission's mission. "Accountability" and "deterrence" are the key words at the SEC. Criminal penalties for willful and venal acts are obviously available and will be used.

I hasten to add that fairness, proportionality, and concern about culpability will also continue to count. It is critically important that good people continue to serve as directors and investment managers of mutual funds. The SEC's enforcement policy must, in short, remain tough, vigorous, just, and fair.

Other Areas In Which Change Is Needed.

In general, I agree with the comprehensive package of reforms outlined by Chairman Donaldson in his recent Congressional testimony. Enhanced fund disclosure, elimination of various sales practice abuses, and the registration of hedge fund advisers should all be part of the Commission's agenda.

In terms of disclosure, the first priority is addressing the need of mutual fund investors for accurate, understandable, and easy to apply and compare fee, sales load, and expense information. With such full and fair disclosure, competitive markets and independent directors (who truly represent fund investors) should drive excessive fees and expenses down. We must also finalize our proposal for more frequent portfolio disclosure. In addition to the disclosures proposed yesterday, we need new disclosures relating to broker-dealer "preferred lists," portfolio manager personal trading, breakpoint discounts, Rule 12b-1 fees, and revenue sharing arrangements. You should expect to see in the near future significant revisions of guidance on Rule 12b-1 Plans (any portion of brokerage commission used to pay for the distribution of fund shares must be included in a fund's 12b-1 Plan) and Rule 10b-10 (requiring additional, comprehensible disclosure). The entire "soft dollar" area needs a critical reexamination.

During the past two years, the Commission has brought a number of actions against brokers-dealers selling mutual fund shares for, among other things: (i) engaging in prohibited sales contests; (ii) failing to disclose special cash compensation that was paid to their sales force for selling mutual fund shares; (iii) recommending that their customers buy Class B shares when the firms should have been recommending Class A shares; and (iv) failing to deliver proper breakpoints discounts. These sales practice abuses — as well as advertising and other abuses — must continue to be vigorously prosecuted.

As to hedge funds, Canary's alleged corruption of mutual fund managers, broker-dealers, and bankers illustrates the need, at least to me, for the registration of hedge fund advisers. Too much money is now being managed in the shadows. As the SEC staff concluded in its September 2003 report:

Registration of hedge fund advisers would have several benefits. First, registered hedge fund advisers would become subject to the Commission's regular inspections and examinations program. Effective Commission oversight could lead to earlier detection of actual and potential misconduct, help to deter fraud and encourage a culture of compliance and controls. Second, the Commission would be authorized to collect basic and meaningful information about the activities of hedge fund advisers and hedge funds, which are becoming increasingly influential participants in the U. S. financial markets. Third, Advisers Act registration would enable the Commission to require hedge fund advisers to disclose information about issues important to investors, such as conflicts arising from side-by-side management of hedge funds and other client accounts and hedge fund advisers' relationships with prime brokers.

Let me close on my original theme. We have all been witness to a financial industry tragedy. The callousness and venality we have seen cannot be excused. But our nation's great strength has been its willingness to face up to scandal. I hope that the mutual fund industry will join the SEC, and other state and federal regulators, in bringing about a time of healing and reform.


1 Joseph R. Daughen & Peter Binzen, The Wreck of the Penn Central (1971).

2 SEC, The Financial Collapse of the Penn Central Company (1972).

3 Joseph R. Daughen & Peter Binzen, supra note 1, at 308.

4 See Harvey J. Goldschmid, The Governance of the Public Corporation: Internal Relationships, in Commentaries on Corporate Structure and Governance 167 (Donald E. Schwartz 1979).

5 Burke v. Lasker, 441 U.S. 471, 484 (1979).

6 Richard M. Phillips, Mutual Fund Independent Directors: A Model for Corporate America?, 9 Investment Company Institute Perspective 1, 12 (Aug. 2003)

7 Ram Charan & Julie Schlosser, Ten Questions Every Board Member Should Ask; And for that matter, every shareholder too. The responses should tell you everything, Fortune, Nov. 10, 2003, at 181, 186.



Modified: 12/09/2003