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

Speech by SEC Staff:
ICI Workshop for New Fund Directors

Keynote Address of

Paul Roye

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

at the ICI Workshop for New Fund Directors
Washington, D.C.

April 3, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

I. Introduction

I would like to thank the Investment Company Institute for the opportunity to speak with you this afternoon. I want to commend all of you for taking on the very weighty responsibility of serving as mutual fund independent directors and taking the time to participate in this extremely important educational effort. While I hope that my remarks will be helpful, I have to first give you the standard disclaimer that the views that I express today are my views and do not necessarily represent the views of the Commission or my colleagues on the staff of the Commission.

I want to applaud this effort by the Investment Company Institute to introduce you to your important responsibilities as fund directors. I also want to commend the efforts of the experienced directors who are here today for taking the time to share their knowledge and experience, as fund directors, with you.

II.Importance of the Fund Industry

You are now part of an industry that is vital to our securities markets and to the financial futures of millions of investors. The fund industry has become the principal trustee of the nation's savings, with half of all U.S. households now owning mutual funds. Open and closed-end funds today own nearly 17% of the value of all equity securities trading in the United States - more than any other type of institutional investor. Mutual funds have over $7 trillion in assets, exceeding by approximately $4 trillion the amount on deposit at commercial banks. While the longest bull market in history undoubtedly contributed to the success of the industry, I believe strongly that the primary reasons for that success are first, the fact that mutual funds allow the average investor relatively inexpensive access to professional money management and second, the confidence that investors have in the mutual fund industry.

I suspect that the recent market reversals will only strengthen the desire of many investors for some form of professional money management. During the market boom, the media and the cocktail party circuit were rife with tales of people who made a killing in the market. T.V. ads made heroes out of fictitious truck drivers who become millionaires day trading online. Investment advice was not needed; mutual funds were thought by some to be passé. Some groups even created mutual funds on the basis that you didn't need a professional money manager running the fund, but that a mutual fund could be run based on stock picks of the fund's shareholders, so called "community" funds. But the dismal performance of the stock market in recent months has changed all that. Now the news media carry stories of woe, and day traders who quit their jobs, have returned to jobs in the old economy. Just yesterday, the Wall Street Journal ran an article indicating that online "community" funds are folding because they are not finding much support among investors. Long-term success in the stock market requires a lot of work. Although more information is available to investors than ever before, analyzing it and drawing the correct conclusions is not easy. Thus, the need for mutual funds. But if mutual funds are going to remain the favored choice of most investors for professional management, then the industry must vigorously maintain its reputation for integrity and deliver value to investors.

III. A Challenge to Fund Directors

Quite simply, you are the defenders of that reputation. It is impossible to overstate the importance of effective independent directors to the future health of the fund industry. You are the principal guardians of investors' trust in the industry. You are there to see to it that mutual funds earn acceptable returns, that their fees are reasonable, that fund assets are safe and that investors receive the reliable services promised. Mutual fund investors deserve more than spectators; they deserve - and the industry has thrived under - active, engaged and strong-willed directors who stand up for investor interests before all else.

My challenge to you is to deliver to your shareholders the vigilance they expect and deserve from you. I do not want to see independent fund directors go the way of the Knights Templars. The Knights Templars were a military religious order formed during the Crusades to protect travelers and pilgrims on the way to the holy land. These knights rose to the heights of glory, as they were respected by both Christians and Infidels as honest and courageous warriors. Over the next 200 years, the Templars came to be fabulously wealthy and famed for their military skill, but they lost sight of their original mission. The financial success of the Templars provoked the envy of the French King, Philip the IV, who took their property and persuaded the Pope to outlaw the order. Many of their leaders were burned as heretics in 1314, and the order came to an end.

Some critics of the fund industry and some in the press have questioned the effectiveness of independent directors. In some instances independent directors have come under fire by fund management and been replaced with directors who were nominated by management. Private litigants have challenged independent directors' independence and the SEC has at times had to institute enforcement actions against independent directors for failing to fulfill their legal obligations. In the course of rulemaking to improve the fund governance framework, we received a minority of comments from some that fund shareholders derive no benefit from independent directors and that independent directors are not really independent; that they are "house" directors, rubberstamping management decisions. I am sure that none of you, as you embark on your new roles, want to lend credence, or provide fuel, for these viewpoints.

The very fact that you are here today tells me that you take your responsibilities seriously. I want to briefly explain why those responsibilities are unique in corporate America. I know that many of you have also served on the boards of public companies. While your experience on these boards will no doubt assist you in the discharge of your fiduciary duties on mutual fund boards, there are several important distinctions that make your new roles uniquely challenging. As I am sure you have heard today, the Investment Company Act and our regulations impose specific responsibilities on fund directors. Congress formulated the role of the mutual fund board of directors in light of the external management structure typical of investment companies. Although a fund's investment adviser and shareholders have common interests in many areas, there are conflicts of interest and potential for abuse inherent in this organizational structure. Under the regulatory framework, you are responsible for monitoring conflicts and representing the interest of shareholders. The 1940 Act embodies a pervasive regulatory scheme that contemplates an important and vigorous role for fund independent directors, in addition to the traditional responsibilities imposed on directors by state law. Therefore, you need an understanding of the relevant provisions of the Investment Company Act and you must be appropriately informed of the scope and nature of your duties and responsibilities. Undoubtedly this workshop will contribute to an understanding of these responsibilities.

This afternoon, I want to briefly describe some of the Commission actions that directly bear on your jobs as independent directors. I also want to give you some practical advice about how to discharge your duties that is based both on my experience at the Commission and my earlier experience in a law firm as counsel to many independent directors.

IV. The Commission's Corporate Governance Rules

Earlier this year, the Commission adopted a comprehensive set of rules and rule amendments designed to enhance the ability of mutual fund independent directors to fulfill their most important role - the protection of investors. These rules represent the culmination of the Commission's examination of the role of mutual fund independent directors that began in May 1998 with the announcement that the Commission would host a roundtable on fund governance to work toward a consensus on whether changes were needed. At the roundtable in February 1999, the Commission brought together investor advocates, independent fund directors, fund managers, academics and legal counsel. After evaluating the suggestions offered by roundtable participants, the Commission proposed a set of initiatives in October 1999 to enhance the independence and effectiveness of mutual fund directors. At the same time, the Commission published an interpretative release expressing the views of the Commission and Division staff concerning a number of issues that related to independent fund directors. The focus on independent directors also spurred several significant efforts in the fund governance area. The Investment Company Institute organized an Advisory Group, which developed a set of best practices for fund directors. Former SEC Chairman David Ruder founded the Mutual Fund Directors Education Council, administered by Northwestern University, in response to former Chairman Levitt's call for improved fund governance. The Council's mission is to foster the development of programs to promote a culture of independence and accountability in fund boardrooms. The American Bar Association formed a Task Force which prepared a very useful report offering guidance to counsel and fund directors regarding standards of independence for counsel and guidelines for handling potential conflicts of interests.

I believe the rules and rule amendments ultimately adopted by the Commission reaffirm the important role that you as independent directors play in protecting the interests of mutual fund shareholders, strengthen your hand in dealing with fund management, reinforce your independence and provide investors with more information with which they can assess your independence.

Our fund governance initiative was a recognition that the SEC continually faces the formidable challenge of applying the existing regulatory framework that helped ensure the integrity of the industry, while providing a regulatory scheme that can keep pace with the increased competition and the vast technological changes that have been ongoing in the securities markets. As we work to keep pace and modernize the regulatory structure to accommodate the increased competitiveness and globalization of the fund industry, we will need to increasingly rely on fund directors to vigorously perform their "watchdog" duties on behalf of fund shareholders. Without the necessary tools to perform these duties, or if you fail to use them effectively, the inevitable result will be less flexibility and more government intervention in the regulatory regime.

Although no set of regulatory initiatives can ensure director independence and effectiveness, the initiatives adopted by the Commission in my view provide you with the tools, the access, and the power to fulfill your legal duty and moral mandate as shareholder representatives. The rules establish a sound foundation for the Commission to respond to calls for increased flexibility under the statute.

Now that our rules are out, it is incumbent upon you to understand what they require and to review your fund governance framework. In my judgment, this review should also embrace the ICI's best practice recommendations for fund governance. It is my understanding that a number of fund groups have not considered the ICI's best practices, awaiting action by the SEC on the fund governance rules. Well, now they have no excuse. The SEC has acted and it is time to review your fund governance framework. In some instances, our rules did not go as far as the ICI recommendations. But that does not necessarily mean that fund boards should in all cases be content to just satisfy the minimum standards established by the Commission's rules. For example, we did not require that independent directors have legal counsel - the rules only require that if you have counsel, you make a reasonable determination that your counsel is independent. However, the ICI recommends that independent directors have independent legal counsel. That is a recommendation that I strongly urge you to consider favorably, given the complexity of your responsibilities.

In adopting these rules, the Commission recognized that there are limits to what SEC rules can and/or should do. Nevertheless, fund groups should strive to employ the "best practices" in their operations, particularly in the area of fund governance. I suggest to you that best practices in the fund governance area will lead to best practices in other areas of your firm's operations.

V. Important Areas for Director Focus

We do not expect you to micro-manage the funds you oversee, and we have taken several actions designed to reduce burdens on you. In many instances, various functions and responsibilities can be delegated to fund advisers. We have taken recent actions related to fair value pricing, the monitoring of repurchase agreement transactions and foreign custody arrangements providing for delegation to reduce burdens on fund directors. We will continue to look for ways to reduce director involvement in routine, ministerial matters.

Last year, at this conference, I highlighted ten practical suggestions on how to be an effective independent mutual fund director and I would direct you to the SEC's Web Site if you are interested in these suggestions. However, this afternoon I thought I would expand on two of those suggestions: (1) focusing on the important issues, such as the impact of fees and expenses on your shareholders, and (2) paying appropriate attention to compliance and internal controls.

A. Fees and Expenses

While fund directors cannot ignore any of their statutory and regulatory responsibilities, some responsibilities are clearly more important than others. There are areas of your responsibilities that have significant impact on your shareholders, such as fee levels. The focus on fund fees is important because they can have a dramatic impact on an investor's return. For example, a 1% increase in a fund's annual expenses can reduce an investor's ending account balance in that fund by 18% after twenty years. Therefore consideration of fund fee issues in the advisory contract renewal process and in the consideration of distribution plans is extremely important. An investment adviser has an incentive to charge the highest possible fee for its services, while the fund and its shareholders wish to pay the lowest amount of fees possible because the fees directly reduce a fund's return on its investments.

Congress did not address this conflict by imposing fee caps or other direct regulation of fund fees and expenses. Rather, Congress adopted certain provisions in the Investment Company Act to place fund directors that are not affiliated with a fund's management in the role of "independent watchdogs" who would "furnish an independent check upon the management" of mutual funds.

The Investment Company Act further requires that a majority of a fund's independent directors approve the contract between the investment adviser and the fund, and any renewals of the contract. In evaluating whether to approve or renew the contract, the directors have a statutory duty to evaluate, and the adviser has a statutory duty to furnish, all of the relevant information that is needed to review the terms of the contract. This evaluation typically consists of a review of the amount of the advisory fee paid by the fund, the services provided by the adviser, and the profitability of the fund to the adviser.

The Commission has followed the approach of relying on a fund's independent directors to police conflicts of interest between a fund and its affiliates regarding the use of fund assets to finance activities that are primarily designed to result in the sale of the fund's shares, i.e., the expenses of distributing the fund's shares. Pursuant to Rule 12b-1 under the Investment Company Act, a fund may adopt a 12b-1 plan to provide for the payment of distribution expenses. Because of the possible conflicts of interest involved in a fund's payment of distribution expenses, the Commission requires funds to follow procedures similar to those required by the Investment Company Act for the approval of an investment advisory contract.

When reviewing and approving Rule 12b-1 plans, independent directors must decide, in the exercise of their reasonable business judgment and in light of their fiduciary duties under state law and under the Investment Company Act, that there is a reasonable likelihood that a plan will benefit the fund and its shareholders.

Most fund director's request data and other information that enable them to appropriately evaluate investment advisory contracts, distribution plans, and other material contracts. In addition to obtaining data and information from the investment adviser, fund directors may seek data and other information from outside sources. For example, the directors may obtain material prepared by outside experts that may be used to compare the fund's performance, fee structures, and expenses to funds of comparable size and investment objective. Independent directors also may rely on independent counsel for advice and information in connection with the evaluation of the investment advisory and other service contracts.

B. Fee Study

Mutual Fund fees have been an area of recent focus by the Commission. At the end of last year, the Division released a report on mutual fund fees and expenses. The report describes the legal framework with respect to mutual fund fees, analyzes how fees have changed over time, identifies factors that may influence the current level of fees, and recommends initiatives that are designed to improve the oversight of fund fees and the disclosure that investors receive regarding fees. Our goal in conducting the study was to provide objective data describing trends in mutual fund fees that would be useful to the Commission and the Congress in overseeing the mutual fund industry and to others focusing on the effect of mutual fund fees on investor returns. Our hope is that the report will contribute to the public dialog about mutual fund fees and thereby help to educate investors on the impact that fees have on their investment returns.

We concluded that the current statutory framework's primary reliance on disclosure and procedural safeguards to determine mutual fund fees and expenses, rather than on fee caps or other regulatory intervention, is sound and operates in the manner contemplated by Congress. But we concluded that this framework could be improved in certain areas.

We recommended in the study that the Commission continue to emphasize that mutual fund directors exercise vigilance in monitoring the fees and expenses of the funds that they oversee. You can strengthen your hand by educating yourselves about issues concerning mutual fund fees and expenses. In particular, we recommended that fund directors focus on the costs of providing investment management services and, in particular, on whether the funds that they oversee experience any economies of scale. In our study, we found that, for large funds, management expense ratios declined as fund family assets grew. We also found that the management expense ratios of large funds declined as individual fund assets grew, but the decline was not statistically significant. These results suggest that, in certain instances, economies of scale may be experienced primarily at the fund family level and only to a lesser extent or not at all at the fund level. However, we could not form conclusions as to why economies of scale would be experienced in this way, without knowing what the costs of supplying particular services were to the investment advisory firms.

However, fund directors can obtain information about the cost of providing investment management services to the funds that they oversee. You can use this information to evaluate whether the funds that you oversee are experiencing any economies of scale and to assist you in ensuring that fund shareholders share in the benefits of any reduced costs. Whether increases in assets of a fund or fund family produce economies of scale is a factor that may influence your views on, among other things, the amount of fees that the fund should pay for advisory and other services and whether a Rule 12b-1 plan for the fund is appropriate. Fund directors should, for example, attempt to ensure that an appropriate portion of the cost savings from any available economies of scale is passed along to fund shareholders. Our study noted that in a sample of the 100 largest mutual funds, most of the funds had some type of fee breakpoint arrangement that automatically reduces the management fee rate as the asset size of the individual fund or the fund family increases. However, most of the funds in the sample with management fee breakpoints had assets above the last breakpoint. If the fund or fund family is experiencing economies of scale, fund directors have an obligation to ensure that fund shareholders share in the benefits of the reduced costs by, for example, requiring that the adviser's fees be lowered, breakpoints be included in the adviser's fees, or that the adviser provide additional services under the advisory contract. Directors that ask pertinent questions about investment management costs can more effectively represent the interests of the shareholders they represent.

Not all costs associated with investment in a mutual fund are paid for via the fund's expense ratio. The cost of effecting the fund's portfolio transactions, for example, is reflected in the amount paid when the fund buys or sells portfolio securities. For many funds, the amount of portfolio transaction costs incurred during a typical year is substantial. Clearly, fund directors should focus on portfolio transaction costs. As you review fund transaction costs, you should pay particular attention to soft dollar practices -- arrangements under which the fund's investment manager obtains, from or through a broker dealer, products or services other than execution of securities transactions. The manager obtains these services in exchange for allocating client brokerage transactions to the broker-dealer.

In addition to reviewing soft dollar practices, fund directors should carefully consider directed brokerage arrangements. Under a directed brokerage arrangement, the fund asks the investment adviser to direct securities transactions to a particular broker that has agreed to provide services, pay for services provided by others, or make cash rebates to the fund. Funds typically enter into directed brokerage arrangements to offset fund expenses, such as audit, legal, and custodial fees. Although directed brokerage does not involve the conflicts posed by soft dollars, it does raise issues related to how a fund's assets are being expended and other issues, including disclosure.

VI. Compliance and Internal Control Systems

Another critically important area is paying appropriate attention to compliance and internal controls.

Directors should have an understanding of the manner in which the fund's compliance program is structured and the nature of the internal controls system. This understanding is gained through regular reports and meetings with compliance personnel to discuss procedures and deficiencies. Directors should also discuss and review the adequacy of internal controls and procedures with the fund's independent accountants. You also need to understand the operational risks that arise in mutual fund operations, such as those arising from portfolio management, custody, pricing and technology. Breakdowns in compliance and internal controls can lead to major problems for the fund, which can undoubtedly complicate your life as an independent director.

I can tell you that we spend most of our time in examinations on areas that are the greatest risks to investors. Our examiners will seek to determine if we should have confidence in your internal control and compliance systems. Lori Richards, the head of our Office of Compliance Inspections and Examinations has stated that in our "risk based" inspections process, we seek to answer several interrelated questions, which you as a fund director should also pursue:

  • Is a system of internal controls in place and operating? A compliance or procedures manual gathering dust on a bookshelf will not serve anyone's interests.

  • Is the system working as designed? No matter how good your formal system may be, you should expect informal systems to spring up around it. Many of these ad hoc methods are harmless. In fact, when you find them, some may be improvements over the formal system. In other instances, however, employees may circumvent important procedures in the interest of getting their work done more quickly or more easily.

  • Are exceptions and problems identified and resolved promptly? Of course, this is of critical importance. Once a potential problem is identified, prompt and effective resolution is the essence of compliance.

  • Is the system of controls reviewed periodically? Mergers, acquisitions, reorganizations, new staff and other changes necessitate that controls be frequently reviewed for continued effectiveness.

In addition to these global issues, we also ask some more detailed questions that may give us additional assurance that your firm's internal control systems are effective. Among other things, we ask:

  • Are your procedures in writing and made available to all appropriate personnel?

  • Are all appropriate staff trained in implementing the procedures?

  • Are remedial actions fully documented? If our examiners cannot determine how a problem was corrected, they will question the effectiveness of your controls.

As "management" of the funds, you must insist on an effective system of internal controls. You should insist that the management company acquire and retain the talent, as well as the technological tools, that are more and more critical to a good internal controls infrastructure. Are you going to be associated with a fund group that cuts it close to the line or a firm that strives for the best compliance practices and controls? I submit that the later approach is going to keep you out of trouble.

VII. Valuation and Pricing

An area where it is exceedingly important that you have good internal controls is in the area of valuation and pricing.

As you know, valuation is extremely important for mutual funds because they must redeem and sell their shares to the public at net asset value. If fund assets are incorrectly valued, fund investors will pay too much or too little for their shares, and redeeming shareholders will receive too much or too little for their shares. In addition, the over-valuation of a fund's assets will overstate the performance of the fund, and will result in overpayment of fund expenses that are calculated on the basis of the fund's net assets, e.g. the fund's investment advisory fee.

The Investment Company Act requires funds to value their portfolio securities by using the market value of the securities when market quotations for the securities are "readily available". When market quotations are not readily available, the 1940 Act requires fund boards to determine, in good faith, the fair value of the securities. The Commission has stated that, as a general principle, the fair value of a portfolio security is the price that the fund might reasonably expect to receive upon its current sale. Thus, ascertaining fair value requires a determination of the amount that an arms-length buyer, under the circumstances, would currently pay for the security. Accordingly, fair value cannot be based on what a buyer might pay at some later time, or prices which are not achievable on a current basis on the belief that the fund would not currently need to sell those securities. Likewise, bonds may not be priced at par based on the expectation that the securities will be held to maturity. Failure to adhere to the requirement to fair value portfolio securities when required has resulted in enforcement actions against some funds and even fund directors.

It is important, therefore, that fund directors receive periodic reports from fund management that discuss the functioning of the valuation process and that focuses on issues and valuation problems that have arisen. Fund directors should ensure that appropriate operational procedures and supervisory structures are in place with respect to both "market value" and "fair value" determinations. Funds typically obtain most of their pricing data from third party sources, such as pricing services and dealers, some of which involves "fair valuation" methodologies, such as matrix pricing. But even prices provided by third parties should be subject to appropriate controls. Controls should be incorporated at each level of the valuation process. Periodic cross-checks of prices received from pricing services should be conducted, such as checking quotes received against quotes from other pricing services, from dealers making a market in the relevant securities, or actual sales in particular securities against prices for comparable securities. These crosschecks should generate red flags when there are questions regarding the reliability of prices.

Unfortunately, the Commission has recently had to seek a receiver for three funds as a result of valuation issues. In SEC vs. Heartland Group, Inc., the SEC filed a complaint in federal court and obtained an order of permanent injunction against the Heartland group enjoining them from violation of the Investment Company Act. The order also freezes the assets of these mutual funds and provides for the appointment of a receiver to take control of the assets of the funds, manage the funds, suspend redemptions in the funds and, if appropriate, liquidate the funds.

Specifically, the Commission's complaint alleged that Heartland Group failed to send an annual report for three funds' to shareholders, and failed to file the report with the Commission in the time allotted under the federal securities laws. The Commission's complaint further alleges that the failure was due to Heartland Group's inability to obtain audited financial results for the three funds for fiscal year 2000, due to Heartland Group's independent public accountant's concerns regarding the underlying valuations of the securities held in the funds. The complaint further alleges that while the auditors had commenced an audit of the funds, they stated that they would disclaim any opinion as to the value of the securities held by the funds during Heartland Group's fiscal year 2000. As a result, shareholders of the funds were being deprived of statutorily required fundamental financial information upon which they could base a decision to remain invested, or to redeem shares in the funds.

This is not the kind of situation you want to be in as a director and emphasizes the importance of internal controls in the valuation area.

VII. Conclusion

I hope these suggestions on how to pursue your responsibilities as directors stimulate thought on your part. In the case of Litwin v. Allen, 25 N.Y.S. 2d 667 (1940), the Supreme Court of New York succinctly summarized the duties of a director:

They should know of and give direction to the general affairs of the institution and its business policy, and have a general knowledge of the manner in which the business is conducted, the character of the investments, and the employment of the resources. No custom or practice can make a directorship a mere position of honor void of responsibility, or cause a name to become a substitute for care and attention. The personnel of a directorate may give confidence and attract custom; it must also afford protection.

You are the Commission's partners in the protection of investor interests and it is to you that mutual fund investors owe a debt of gratitude for the daily commitment that you make to your independent watchdog role. You deserve the SEC's support and assistance.

But for all our efforts at the SEC, we cannot legislate independence. Independence is a state of mind. I close with simply the following, as you carry out your day-to-day responsibilities as independent directors be guided by the fundamental principal that you are a fiduciary. With respect to every issue before you, apply the care and skill which the situation demands, and be guided by what is in the best interest of investors.

Thank you.