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U.S. Securities and Exchange Commission

Oral Testimony Concerning Initiatives to Address Concerns in the Mutual Fund Industry

Paul F. Roye

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

Before the Senate Subcommittee on Financial Management, the Budget and International Security, Committee on Governmental Affairs

November 3, 2003

Chairman Fitzgerald, Ranking Member Akaka and Members of the Subcommittee:

On behalf of the Securities and Exchange Commission, I appreciate the opportunity to discuss possible regulatory responses to recent allegations of abusive practices in the mutual fund industry and initiatives to improve the regulatory framework governing mutual funds. With over 95 million Americans invested in mutual funds, representing approximately 54 million U.S. households, and a combined 7 trillion in assets, mutual funds are unquestionably one of the most important elements of our financial system.

The conduct alleged in the various cases brought by the Commission, as well as the New York Attorney General and the Secretary of the Commonwealth of Massachusetts, represents reprehensible conduct that are gross violations of the federal securities laws, as well as basic fiduciary principles. As my colleague, Stephen Cutler just outlined for you, the Commission has put in motion an action plan to vigorously investigate these matters, assess the scope of the problem and hold wrongdoers accountable.

While our enforcement efforts are a key tool in protecting the nation's investors, another critical component is a regulatory framework designed to prevent or minimize the possibility of these abuses from happening in the first place. Before I discuss regulatory initiatives in this area, I would like to take a moment to place these initiatives in context.

In recent years, the Commission has had a principal focus on strengthening the mutual fund governance framework. The Commission has adopted rules that (1) effectively require fund boards to have a majority of independent directors; (2) require that independent directors select and nominate other independent directors to fill vacancies on fund boards; (3) promote the concept of independent legal counsel for fund directors; (4) enhance disclosures regarding fund directors, including information concerning whether directors own shares of the funds they oversee and information about independent directors' conflicts of interest, as well as disclosures about the board's role in governing funds, including the basis upon which they renew a fund's investment advisory contract. More recently, the Commission has tailored the provisions of the Sarbanes-Oxley Act to apply to mutual funds, including the provisions to improve oversight and internal controls, such as key officer certifications and code of ethics requirements. The Commission has proposed that each fund have a chief compliance officer reporting to and accountable to fund independent directors whose responsibility would be to provide that the fund has procedures in place reasonably designed to ensure compliance with the federal securities laws. The Commission also has supported key provisions of legislation introduced by Congressman Richard Baker to further enhance mutual fund governance, including provisions that give the Commission the authority to close gaps in the definition of independent director in the Investment Company Act.

Indeed, so far this year, the Commission has proposed or adopted 16 rulemakings related to mutual funds. Again, through these rulemakings, the Commission has sought to enhance fund governance and internal controls, improve fund disclosures and minimize conflicts between funds and their managers. We have sought public input on additional measures the Commission should take to improve the mutual fund regulatory framework so that we can avoid the problems that we are currently investigating. In addition, the staff in September issued a comprehensive report on hedge funds, making a series of recommendations to improve the Commission's ability to monitor the activity of these vehicles — the most significant being a recommendation to require that hedge fund advisers register under the Investment Advisers Act and thereby become subject to Commission examination and routine oversight. This review of hedge funds, and the staff's recommendations, become all the more important when we consider that we have seen a number of hedge funds engaging in late trading and market timing of mutual fund shares, serving as the impetus for the current investigations and enforcement actions related to these activities.

The 16 rulemakings initiatives in 2003 (along with those to come), combined with the staff's work on hedge funds, will represent to my knowledge the Commission's most productive year in investment management regulation since the Commission was charged in 1940 with overseeing this segment of the financial services industry. Fund investors are benefiting from the Commission's proactive and responsible oversight in this area. But we are not done yet-you can expect significant mutual fund regulatory initiatives before the year is through.

On October 9, slightly more than a month after the New York Attorney General announced his action against Canary Partners, Chairman Donaldson outlined a regulatory agenda to confront late trading and market timing abuses to help restore investor confidence in the fairness of mutual fund operations and practices. He requested that the staff submit rulemaking recommendations to the Commission this month to address these issues. In preparing its recommendations to the Commission, the staff is examining the feasibility of requiring that a fund (or certain designated agents) — rather than an intermediary such as a broker-dealer or other unregulated third party — receive a purchase or redemption order prior to the time the fund prices its shares (typically, 4:00 p.m.) for an investor to receive that day's price. This "hard" 4 o'clock cut-off would effectively eliminate the potential for late trading through intermediaries that sell fund shares.

The staff is also considering recommending that the Commission address late trading in connection with a recommendation to adopt the mutual fund compliance policies rule, which the Commission proposed in February of this year. Again, this proposal calls for a chief compliance officer, accountable to fund directors, whose responsibility it would be to ensure that funds have effective policies and procedures in place to prevent activity such as late trading.

With respect to market timing, we are preparing recommendations to require explicit disclosure in fund offering documents of market timing policies and procedures. This disclosure would enable investors to assess a fund's market timing practices and determine if they are in line with their expectations.

The rule recommendations requested by Chairman Donaldson would have a further component of requiring funds to have procedures to comply with their representations regarding market timing policies. Thus, if a fund's disclosure documents stated that it discouraged market timing, the fund would be required to have procedures outlining the practices it follows to keep market timers out of the fund. The establishment of formal procedures would also enable the Commission's examination staff to review whether those procedures are being followed and whether the fund is living up to its representations regarding curbing market timing activity. The Commission also will emphasize the obligation of funds to fair value their securities so as to avoid "stale pricing" to minimize market timing arbitrage opportunities as an important measure to combat market timing activity.

Allegations of portfolio managers market timing the funds they manage or other funds in the fund complex, raise issues regarding insider trading, as well as the need for, and adherence by fund personnel to, policies and procedures to prevent the misuse of material, non-public information. We expect that the issue will also be addressed in the rulemaking recommendations to be submitted to the Commission later this month.

Recent allegations indicate that some fund managers may be selectively disclosing their portfolios in order to curry favor with large investors. Selective disclosure of a fund's portfolio can facilitate fraud and have severely adverse ramifications for a fund's investors if someone uses that portfolio information to trade against the fund. Consequently, Chairman Donaldson has asked the staff to consider whether additional requirements are necessary to reinforce funds' and advisers' obligations to prevent the selective disclosure of portfolio holdings information in a manner that can harm investors.

In addition to these initiatives, Chairman Donaldson has asked the staff to consider whether funds should have additional tools available to thwart market timing activity such as mandatory redemption fees or allowing funds to retain the profits of short term traders in their shares. If the profit potential can be taken away from market timers, we can eliminate abuses in this area. Chairman Donaldson has emphasized that he will not hesitate to call for other regulatory measures if we discover additional information in the course of our investigation that merits regulatory action. No reform — whether structural, fund governance or board composition — is off the table. The Commission is committed to moving swiftly and aggressively to take all necessary steps to protect mutual fund investors from abusive and harmful activity.

In addition to the initiatives to address late trading and market timing abuses, the staff and Commission have been working on other initiatives designed to assist mutual fund investors in making the best investment decisions for themselves, attack inappropriate mutual fund sales practices and bolster confidence in mutual funds. These initiatives seek to provide for complete transparency of fees and expenses, as well as improve fund governance and include initiatives related to fund advertising, fund of funds products, breakpoint disclosure regarding sales loads, shareholder report disclosure of operating expenses, more frequent disclosure of fund holdings information, enhanced disclosure of incentives and conflicts that brokers have in offering mutual fund shares to investors, and director nomination initiatives. We are committed to moving forward with our mutual fund agenda in these areas as well. I should also note that with additional funding from congress, we are beefing up our oversight of the fund industry with additional staffing that will allow for more frequent inspections of funds to monitor for compliance with the federal securities laws.

In conclusion, I would like to reiterate that the protection of our nation's mutual fund investors is of paramount importance to the Commission and the staff. I can assure you that the Commission will deal immediately with the reprehensible abuses that have taken place, and we are committed to rooting out the problems, punishing the perpetrators, and putting the proper rules in place so that these abuses do not happen in the future. Again, I appreciate the opportunity to be here today, and I would be happy to answer any questions that you may have.



Modified: 11/03/2003