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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Mutual Fund Management: Taking Responsibility, Maintaining Trust and Influencing Positive Change


Paul F. Roye

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

Remarks Before the 2002 Mutual Funds and Investment Management Conference

Orlando, Florida
March 25, 2002

The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission or the staff of the Commission.

I. Introduction

Good morning. I am pleased to be here once again with you at the annual Mutual Funds and Investment Management Conference. Throughout my 23 years working with mutual funds, both as a private sector attorney and as an SEC official, this conference has been an annual highlight. The gathering has over the years enabled industry and Commission participants to review recent developments, share new ideas and engage in high-level discourse on the role of mutual funds in meeting the needs of American investors. I have always found the interaction among regulators, colleagues and competitors to be eye opening and thought provoking. Hopefully, my remarks this morning will meet this standard. However, it is always a challenge to follow Matt Fink, whose remarks are always insightful. For many years now Matt has ably lead the Investment Company Institute, and we appreciate the cooperation and support we receive from the ICI and their thoughtful input on the challenges and issues facing the Commission. As always, my remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff and, by the way, not necessarily the views of the ICI.

But seriously, we arrive in Orlando at an important time for the fund industry. The recent bear market and economic recession caused total assets in equity funds to decline in each of the past two years, the first back-to-back decline since 1977-78. However, last year also marked the first time that more than half of all U.S. households invested in mutual funds. As recently as 1980, only one in 16 households invested in funds. Mutual funds have become a mainstay of the American investment landscape. And even during the market of the last two years, fund investors generally have stayed the course, not abandoning their fund investments. Indeed, a Wall Street Journal article this past fall stated that the mutual fund companies were the "Teflon" industry of the financial world, able to withstand recession and a market downturn with far less pain than other sectors.

We can theorize about the various reasons for the popularity of mutual funds as an investment vehicle. We also can speculate about whether mutual funds will be able to maintain their prominence in the decades to come. I believe, however, that one of the primary answers to both questions lies with mutual fund management. Since the adoption of the 1940 Act over 60 years ago, mutual funds have flourished, and their popularity has grown. Remarkably, the industry has not been tarnished by any major scandal or debacle. The integrity of the fund industry has been a major key to its success. The fund industry has earned investor trust and confidence. You, as fund industry professionals and advisers to fund management, must stay true to certain core principles by taking responsibility, maintaining trust and influencing positive change.

I believe that the fund industry was built on these core principles, and that they must permeate your advice and management decisions if the fund industry is to continue to prosper and maintain its reputation for trustworthiness and integrity. You can do this by making the interests of investors paramount.

II. Taking Responsibility

First, let's talk about taking responsibility. At its core, fund management's job can be summarized as "taking responsibility" for the fund. The fund, as a separate entity with no employees of its own, operates solely through its outside management and its board of directors. More than merely picking stocks for a fund, management, working with the fund's board of directors, provides the fund with direction, nurtures relationships with investors, establishes a fund's cost structure and assures the delivery of promised services.

The best fund management also takes responsibility at a higher level, stepping in to fix problems that confront the fund and the industry as a whole. There has been a steady stream of examples of fund management and the industry taking responsibility and establishing standards in order to address problems for the benefit of fund investors.

For example, in 1994, the industry formed a special Advisory Group on Personal Investing in the wake of allegations that a small number of portfolio managers had traded securities for their personal accounts to the detriment of the funds they managed. The industry's Advisory Group prepared a report addressing the conflicts of interest associated with personal trading by portfolio managers and recommended a number of "best practices" to be followed. Today, the fund industry widely adheres to the recommendations in the Advisory Group's report.

Similarly, in 1999, the industry created another special Advisory Group to recommend best practices for fund directors. In view of the rapid growth of the industry in the late 1990's, the Commission and the fund industry turned their attention to the fund governance system and the role of independent directors in an effort to make certain that independent directors had the necessary tools in place to enable them to be effective watchdogs. Along these lines, the Advisory Group issued a report outlining a series of fund governance "best practices." Again, many funds have widely embraced the recommended best practices of the Advisory Group.

More recently, AIMR proposed Trade Management Guidelines for investment management firms to consider when executing trades on behalf of clients. This is an important effort in assisting advisers in developing a constructive framework for their best execution policies and procedures. As you know, best execution is a duty of every money manager to its clients and also is an issue of substantial current interest to the Commission and the staff.

Perhaps the greatest example of the fund industry acting responsibly on behalf of its investors occurred in the aftermath of September 11th. Following the devastation of September 11th, the fund industry cooperated with regulators and, more importantly, cooperated with each other to restore funds to operation with as little disruption as possible to investors. The ICI disseminated information to its members and relayed to us information and concerns that helped shape the Commission's response to the events. Fund management teams manned phone banks with extra staff to ease the concerns of nervous shareholders, and former competitors opened their doors and, in some cases, their trading systems to provide space and technical capabilities to firms that had suffered significant losses in the World Trade Center. Thanks to the decisiveness, the dedication and the generosity of many in the fund industry, fund investors were secure in knowing that their savings were being handled responsibly in the wake of so much destruction and uncertainty.

As a result of September 11th, fund management now needs to take responsibility in some other areas. A key area is contingency planning. The industry should be proud of how well and how quickly it responded to previously unimagined disruption and destruction. However, I don't think there is a firm out there that didn't recognize certain improvements that could be made in its contingency plans as a result of the real life events of September 11th. Contingency planning is not only important for your firm, it is important for the security and confidence of your funds' investors. Consequently, all fund firms should have contingency plans in place that seek to maintain a firm's functioning in the wake of a natural or other disaster. When conducting fund exams, our inspection staff will be focusing on funds' contingency planning procedures. There are also service providers such as pricing services, transfer agents, custodians and fund administrators that funds depend on to function on a daily basis. Collectively, we must work to make sure that these firms also have adequate contingency plans in place. We need to know where the vulnerabilities are and address them. We will be asking questions and so should you of your service providers.

Another outgrowth of September 11th is the focus on anti-money laundering efforts. In the wake of the September 11th tragedy and the passage of the USA Patriot Act, funds and their service providers are going to have to take a much more activist role with respect to the government's anti-money laundering effort. Along these lines, we are working with the Treasury Department to develop a rule regarding the establishment of anti-money laundering policies and procedures, which all funds must have in place by April 24th. At a minimum, the rule will require that an anti-money laundering compliance person be designated, that an anti-money laundering training program be established, and that the procedures be tested. I understand that there will be additional focus on anti-money laundering compliance later in this conference.

Finally, September 11th once again shined the spotlight on valuation practices. A fund's valuation obligations include monitoring for the effect on valuation of significant events. September 11th opened our eyes to the unpredictable nature of significant events occurring in our own market, as well as in foreign markets. I've talked about the importance of trust to the fund industry. Valuation, it seems, is one of the crucial areas in which investors must feel comfortable that they can trust a fund's managers and board of directors. If an investor is not confident that his or her fund is valued properly, an investor likely will not feel confident turning over his or her retirement or other savings to the fund. Investors must know that the price at which they purchase or redeem shares represents the fair and accurate value of the fund's shares. The fund industry understands the critical nature of proper valuation. In 1997, the industry, through the ICI, issued a paper on valuation and liquidity issues for mutual funds. The ICI has recently followed up with a supplement to this paper, again providing useful and practical guidance to the industry.

While the fund industry has generally acted responsibly in valuing fund portfolios, several recent enforcement actions indicate that there still are improvements that must be made by some. I encourage all fund managers to review their firms' valuation procedures with a view toward ensuring that those procedures have the effect of building investor trust and confidence in the fairness of fund valuations.

By acting quickly and decisively and, most importantly, acting for the benefit of investors in each of these situations, the fund industry has reinforced its reputation as an industry of integrity.

III. Maintaining Trust

Taking responsibility and acting with shareholders' interests in mind inevitably builds trust among the investing public. The fund industry has worked hard to earn this trust. Now the challenge for the fund industry, and for fund management, is to maintain that trust, and not take it for granted.

The Enron debacle likely will be good material for business and law school classes in the future and a catalyst for change in a number of areas. There are many lessons to be learned from the Enron situation. One of the most significant for the fund industry is that investor trust and confidence can be lost almost overnight. Enron's energy trading business, which was the source of a significant percentage of Enron's profits, was heavily dependent on investor trust. As we saw from Enron, once trust is lost, it can be exceedingly difficult, and even impossible, to regain. Once Enron's credit was downgraded and especially after its off-the-books partnerships and accounting practices came to light, investors shunned Enron as a trading partner and avoided Enron's trading platforms.

Recently, I had the pleasure of attending the Securities Industry Association's Compliance & Legal Division Seminar. At the seminar, the SIA presented a well-deserved lifetime achievement award to Stephen Hammerman, former Vice Chairman of the Board of Merrill Lynch & Co., Inc. and current Deputy Commissioner for Legal Matters at the New York City Police Department. In his remarks, Mr. Hammerman noted that, in business, many focus on ROE or "return on equity" in determining the financial success of a corporation. But Mr. Hammerman emphasized that companies should also focus on ROI or "return on integrity." While a "return on integrity" can't be precisely quantified, if a company permits integrity to erode, the cost could be greater than any dollar amount. The cost could be the company's business.

As Stephen Hammerman makes clear, trust and integrity are important in any business. But when you are making trades or managing other people's money, trust and integrity are paramount. Yes, the mutual fund industry offers investors professional money management, diversification of investments and convenient services. However, if investors do not have confidence that the money they invest in funds will be handled responsibly and with integrity, all the conveniences and services in the world will not lure them into funds.

To a certain extent, questions about trust and confidence are evident in the hedge fund arena. In recent years, as hedge fund assets have grown, we also have seen an unfortunate growth in hedge fund-related fraud. The Commission has had to bring far too many hedge fund fraud cases in circumstances where the losses to investors have been substantial. The Commission and its staff are actively monitoring hedge fund developments and will continue to be vigilant in identifying cases of hedge fund fraud.

The importance of trust and integrity is not limited to fund management; it extends to the independent watchdogs that are charged with overseeing fund operations on behalf of shareholders. I'm speaking of course about fund independent directors, fund auditors and fund counsel. As Chairman Pitt recently stated, "The public cannot be served if professionals who serve as gatekeepers merely follow the letter of the law, but not necessarily its spirit. We need to move away from wooden, rigid literalism, and encourage all upon whom the present system depends to adopt a bias in favor of the needs of the investing public." Certainly Chairman Pitt's remarks remind us of the crucial role of independent gatekeepers as well as the duty they owe to the investors and clients they serve.

There has been much talk recently about corporate governance. For those of us involved with funds, governance has been a high priority for many years. We always have relied on strong and effective independent directors to oversee fund management and handle conflicts of interest. Just last year, the Commission acted to shore up the independence and effectiveness of fund independent directors by adopting a series of rule amendments related to independent directors. At the same time, the Commission required that funds better inform investors about who their independent directors are, whether their interests are aligned with shareholders through fund ownership and what factors they considered when approving fund management contracts. Funds are working on improving their independent director disclosure as we speak.

The Commission's rule amendments followed a sustained period of focus on fund independent directors, during which the industry debated the role of independent directors and what practices could best enhance director authority and autonomy. As a result of this debate, the fund industry introduced its own "best practices" for fund governance, which I mentioned earlier. Many of these best practices were similar to rules the Commission later adopted.

Following adoption of the Commission's rule amendments, some funds raised questions about the independent legal counsel provision. In particular, funds were concerned that they could retroactively lose the ability to rely on a Commission exemptive rule if their directors' determination that a counsel is independent was questioned. In a letter to the ICI dated February 12th of this year, I stated that the new rule amendments rely on independent directors to determine whether a person is an independent counsel and that independent directors' selection of their counsel is a matter of their business judgment. As such, their selection of counsel is subject to considerable deference. In the absence of facts showing that the independent directors did not act in good faith or exercise care and diligence in scrutinizing conflicting representations that counsel may have, the Commission staff will not seek to question retroactively their judgments regarding the selection of counsel.

Again, fund shareholders have benefited from the strength of independent directors over the past decades, and I hope and expect that the fund industry will continue to be a leader in corporate governance matters.

In addition to independent directors, fund shareholders rely on independent fund auditors-another area that has received additional consideration as a result of the Enron situation. The role of a fund auditor is not limited to signing off on financial statements. The auditor examines and reports on a fund's internal controls, providing assurance to the board and fund shareholders that a fund's internal controls are working. Fund auditors also perform a valuable function as a "second pair of eyes" on fund financial and operational issues. Fund shareholders rely on fund auditors to serve as an independent check on fund management. Auditors must remember that their ultimate duty is to fund shareholders. And fund management should keep in mind that their reputation is strengthened to the extent that they have strong, vigilant and truly independent auditors reviewing a fund's financial information and controls on behalf of shareholders. A well-functioning internal audit program and active oversight by a fund board's audit committee is also crucial to the maintenance of financial integrity and investor confidence.

With respect to auditor issues, last week the Commission issued orders and rules to address issues that might arise for funds, advisers and other registrants in light of the circumstances surrounding Arthur Andersen LLP. The rules and orders seek to ensure that investors continue to obtain timely financial information as provided under the federal securities laws. Consequently, eligible funds that have engaged Andersen as the funds' independent public accountant but are not able to obtain from Andersen, or elect not to have Andersen issue, a manually signed audit report with respect to their financial statements may send shareholders annual reports containing unaudited financial statements as long as appropriate disclosures outlined by the Commission are made. These funds would later file an amended annual report containing audited financials within 60 days of the original due date. The Commission made similar accommodations for the updating of registration statements, filing of Form N-SAR, selection of a fund's independent public accountant, verification of assets in custody, review of balance sheets of investment advisers and auditor-related conditions and representations in exemptive orders. The Commission's efforts to address the impact of the Arthur Andersen situation represents an example of the Commission acting to maintain market stability and investor confidence.

IV. Influencing Positive Change

As I've discussed, the fund industry has been proactive about taking responsibility to improve its governance, police conflicts of interest and build investor trust and confidence. The fund industry now has an opportunity to weigh in on measures to improve our system of disclosure and accounting.

With combined assets of approximately $7 trillion, and as a representative of America's investors, the fund industry can speak with a strong voice, potentially the most powerful investor voice on Wall Street. Indeed, it has been estimated that the fund industry controls more than half of all the equity securities in the United States. As a result of recent high-profile bankruptcies, public scrutiny has focused on corporate governance, management conflicts, public disclosure, accounting practices and related issues. In the interest of fund shareholders, the industry must weigh in on these critical issues.

Chairman Pitt has called for your input on these issues, acknowledging that the Commission does not have a monopoly on wisdom. He has emphasized that the Commission is seeking to learn more on these issues and will not foreclose any valuable alternatives and suggestions. I believe that the fund industry is uniquely qualified to bring its expertise to bear on the types of improvements that can be made. In the wake of recent corporate failures, many have asked, "Why don't professional money managers identify these issues before a company's downfall?" To the extent that governance, accounting and corporate disclosure issues are addressed and improved, you will be able to better monitor the companies your funds invest in, and have a better sense of a company's financial and business condition. We are at an important crossroads in the direction of corporate disclosure and accounting in America. And, as the managers of vast amounts of individual Americans' investment dollars, I believe fund management has a responsibility to provide input on these significant issues.

V. The Commission's Actions

I've talked about areas in which fund management has taken responsibility and other areas where the industry can pursue positive change in the interests of fund investors. Now that I've discussed your part, what can the Commission do?

First, the Commission should always be questioning the wisdom of its regulations, taking steps to modernize its rules and keep up with industry innovation. Chairman Pitt has called for a review and modernization, as necessary, of all federal securities regulations. Several recent actions exemplify this effort. In an effort to modernize the rules related to funds' use of securities depositories, the Commission recently proposed amendments to rule 17f-4. The Commission also issued a concept release requesting input on actively managed exchange-traded funds so that the Commission can respond efficiently and knowledgeably to exemptive applications for these innovative products. Finally, the Commission has modernized its investment adviser registration process, moving to the IARD, an Internet-based system that processes electronic filings and makes them available to the public through the Web at no charge.

The Commission also can assist you by loosening certain restrictions in areas where the industry has shown that it acts responsibly and with investors' best interests in mind. For instance, funds have requested greater flexibility to engage in certain types of affiliated transactions. Along these lines, the Commission has proposed substantial revisions to rule 17a-8, the affiliated fund merger rule. These revisions would expand the rule to enable funds to rely on it when they are affiliated for any reason and would also allow for the merger of bank common and collective trust funds into affiliated registered funds. The Commission's recent fund governance amendments, and the industry's recent efforts to strengthen the independence and effectiveness of independent directors, have laid the groundwork for this type of proposal-and very likely for similar future proposals. Greater comfort can be taken in expanding exemptive rules knowing that actions taken under those rules are monitored by a strong legion of independent-minded directors.

While the Commission's efforts to update and modernize its rules should undoubtedly be helpful to you as fund managers, I know that there are other areas in which you would like to see improvement. One of these areas is the amount of time it takes to process no-action letter and exemptive application requests. A GAO Report issued earlier this month stated that resource constraints have contributed to delays in the turnaround time for many Commission regulatory activities. The GAO Report also noted that, over the last decade, increases in Commission workload have far outpaced increases in Commission staffing, causing an imbalance in workload and staffing.

Last week Chairman Pitt announced a Special Study to examine the Commission's operations, efficiency, productivity and resources. I expect that the Special Study group, which will be comprised of mid- and senior-level staff from the various divisions and offices in the Commission assisted by an outside consultant, will be focusing on improving procedures, proposing more effective use of technology and examining workload and staffing issues and the role they may play in delaying the issuance of no-action letters, exemptive orders and rulemaking actions. Your comments and suggestions on these and related issues would be extremely valuable to the Special Study group.

As we explore ways to speed up the exemptive applications process, we recognize that one method we can use to eliminate some of the backlog is to codify certain frequently-requested forms of relief. The rule 17a-8 proposal is an example of this type of rulemaking. The staff is actively working on other recommendations to the Commission to propose exemptive rules in other areas where we receive frequent requests for relief.

VI. Conclusion

Now, as we gather here in 2002, we stand at a crossroads. The fund industry experienced extraordinary growth in the 1990's and at the same time funds became the primary investment vehicle of the average American investor. We should now reassess what has made funds popular with investors and reaffirm our commitment to those investors. In short, investors have trust in mutual funds. Investors believe that assets invested in funds will be handled responsibly, with their own best interest in mind. Of course, that's also what fund investors deserve. Those of us involved with the fund industry should be proud that an estimated 88 million individual investors have entrusted a portion of their savings to funds. However, we should also be challenged by this trust-challenged to work to maintain their trust. In addition, you should be challenged to accept your place as the voice of American investors, speaking up to make your views known on some of the most significant financial issues of our day.

Once again, I thank you for inviting me to be with you here today. It is always a privilege and an honor to be here, and I look forward to an insightful and productive conference.

Thank you for listening.



Modified: 03/25/2002