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Speech by SEC Staff:
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| 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 herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff. |
Good afternoon and thank you for inviting me to speak to you today. I am thrilled to have this opportunity to meet with you, the independent directors of mutual funds.
You play a unique and crucial role in the mutual fund governance structure. Independent directors serve as "independent watchdogs": protecting investors, monitoring funds operations and overseeing conflicts of interest.
This system of fund governance, and its reliance on independent directors, has served us well. The industry has grown tremendously, while, at the same time, funds largely have been free of the abuses and mismanagement that have beset other financial intermediaries. It is difficult to overstate the importance of the fund industry 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 over 83 million investors investing their hard-earned dollars in mutual funds, representing over half of all American households. The $7.6 trillion that funds manage is a staggering testament to the well-deserved trust that investors have placed in funds and their directors.
I do not need to tell you that the financial services industry is in the midst of a technological revolution and mutual funds are at the forefront. The SEC faces the formidable challenge of applying the existing regulatory framework that helped ensue the integrity of the industry, while at the same time providing a regulatory scheme to keep pace with the increased competition and technological revolutions underway 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 the help of fund directors.
We recently held a program at the Commission commemorating the 60th anniversary of enactment of the Investment Company Act. We discussed how the Act has proved to be remarkably resilient. Indeed, the true genius of the Act was its drafters’ understanding that markets and circumstances change, and that industries evolve. For example, the Act gives the Commission express authority to exempt any person, security, or transaction from any section of the Act – consistent with the protection of investors. This authority makes the Act flexible and allows it to accommodate change and innovation in ways that preserve its underlying principles. This flexibility has permitted the development of money market funds, variable insurance products, expanded international investing, securities lending programs, and unique exchange-traded products that serve particular investor needs. However, none of this change would have been possible without independent fund directors to administer and oversee these new innovations and products. In large measure, it has been because of the important role that independent directors play in the fund framework and the confidence that the Commission has had in the integrity and ability of independent directors, that the regulatory framework has been able to respond to changes over the last 60 years.
However, keeping pace with an evolving industry has not been without its burdens; increasing responsibility has been placed on the shoulders of independent directors, magnifying the vital role that independent directors play in protecting fund investors.
This afternoon, I would like to discuss the importance of "independence" in your functioning as directors; the status of our fund governance initiatives and how we believe these measures will enhance your effectiveness; lessons learned from SEC enforcement actions involving fund directors and finally some key areas that we think are important areas for increased independent director scrutiny.
I noted earlier that its not only millions of Americans that are dependent on the effectiveness of independent directors, but also us at the SEC. Chairman Levitt has characterized the relationship between the SEC and fund directors as a partnership in the public interest. Your supervision complements our oversight of funds – in fact, the SEC’s abilities as a watchdog pale in comparison with yours. You’re in an ideal position to monitor new developments and troubleshoot problems as they arise.
We are pleased to see educational efforts like this conference. We know that you will be called upon to take significant actions and make important judgments that will have broad ramifications for the investors you represent. You have a complex job that requires enormous vigilance, diligence, and skill. You must be prepared to step in at any time; you must know what to look for; you must know when to act; and, just as important, you must also know when not to act.
This conference focuses on a number of the critical issues facing fund directors today. But underneath all the statutes, rules, regulations and complex questions, there is a simple truth that will put you on the right side of any issue that you’ll confront. Be guided by what’s in the best interest of your fund’s shareholders. This should be your watchword and standard first, foremost and always. While the Investment Company Act defines independence principally in terms of whether you are affiliated with the investment adviser, independence ultimately is a state of mind and approach to issues. You must be able to act with an eye single to the best interests of the fund’s shareholders, setting aside the interests of fund management. Being independent means you must ask the hard questions and if satisfactory answers are not forthcoming, act accordingly. How else is a fund manager to know when a judgment is wrong, or a standard too low, unless someone with a clear sense of right and wrong and free of conflicting interests has the courage to question it? You are in a position to define and maintain standards for your funds. You have the ability to demand a culture within your fund complexes that considers SEC rules as merely a starting point – a culture in which we enforce the minimum standard of behavior, while you insist on the highest – a culture in which Best Practice becomes Common Practice. Every time you sit down at the Board meeting table with your fellow directors, remember that you have a constituency, usually numbering in the thousands, that you have a duty to protect.
While we recognize that we cannot legislate independence, we have undertaken efforts to enhance the effectiveness of independent directors by proposing a comprehensive package of fund governance reforms and a staff interpretive release providing guidance on specific issues relating to independent directors.
The Rule proposal was designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen your hand in dealing with fund management, reinforce your independence, and provide investors with better information to assess your independence. The proposal would amend certain exemptive rules under the Investment Company Act by adding a number of conditions to the exemptive rules that any fund must meet to rely on the rules. These conditions are: (1) independent directors must constitute at least a majority of their board of directors; (2) independent directors must select and nominate other independent directors; and (3) any legal counsel for the independent directors must be an independent legal counsel. We also proposed rules that would prevent qualified individuals from being unnecessarily disqualified from serving as independent directors, protect independent directors from the costs of legal disputes with fund management, and encourage audit committees composed entirely of independent directors.
We also have proposed a number of disclosure requirements that will enhance shareholders’ ability to evaluate whether the independent directors can act as an independent, vigorous, and effective force in overseeing fund operations. These proposals would require funds to provide basic information about directors to shareholders annually so that shareholders will know the identity and experience of all directors. They also would require disclosure of directors’ ownership of fund shares, information about director’s potential conflicts of interest, and would provide information to shareholders on the board’s role in governing the fund.
We are close to finalizing our recommendations to the Commission for adoption of the Fund Governance initiatives. Our recommendations will reflect many of the suggestions we received in the comment letters, particularly those of independent directors. Many commenters felt that the disclosure requirements, especially as they related to directors’ family members went to far. It is likely that our recommendation to the Commission will be to scale back the proposed disclosures in several areas, particularly with regard to family members. Many commenters also believe that that the proposal regarding independent counsel for directors was too paternalistic or that our definition of independent counsel was too rigid. In the wake of our proposal, an ABA Task Force issued a report that reminded lawyers of their obligations under existing ethics rules to disclose to independent fund directors their potential conflicts of interest. We agree with the ABA Task Force that independent fund directors benefit from the advice of counsel who can render objective and unbiased advice and that independent directors can only effectively assess the independence of their counsel when that counsel has thoroughly disclosed all of the relevant information regarding conflicts and potential conflicts of interest. Of course, directors who choose to rely on their own counsel have an interest in assuring that their counsel is independent of the Fund’s adviser and principal underwriter. I am confident that the rule, which will be considered by the Commission, soon, will strike an appropriate balance in encouraging independent counsel for fund directors.
While our fund governance reforms are designed to encourage effective oversight of fund operations, I wanted to discuss today some examples of how things can go terribly wrong with that oversight. In virtually every investigation and enforcement action involving a mutual fund, the SEC and its staff focus on the role of the board of directors of the fund. What did the directors know, when did they know it, what did they do, are questions that are commonly considered in assessing the adequacy of the director’s actions under the federal securities laws. Former SEC Chairman and Supreme Court Justice William O. Douglas described the SEC’s oversight role as akin to keeping a "shotgun, so to speak, behind the door, loaded, well-oiled, cleaned, ready for use, but with the hope that it would never have to be used." Unfortunately, Douglas’ proverbial shotgun in the closet sometimes has to be fired at fund directors.
In recent years, the SEC has instituted a few enforcement actions against fund directors. In these actions, the misconduct at issue generally has involved conflicts of interest, breaches of fiduciary duty or valuation-related actions.
As an aside, Enforcement is loath to sue the funds themselves, as that ultimately harms shareholders, the potential victims in any action. Specifically, Enforcement is most likely to sue a fund director when he or she has violated a clear duty owed to fund shareholders under federal law.
Directors have express duties to shareholders under the Investment Company Act. For example, Section 2(a)(41)(b) requires the board to value "in good faith" those securities in the fund’s portfolio for which market quotations are not readily available. Rule 12b-1 under the Act requires the board of directors annually to approve distribution fees for the fund’s shares. Directors also must annually approve the fund’s contract with its investment adviser. Finally, Section 36(a) of the Act authorizes the SEC to bring an action against any director who, through personal misconduct, breaches his or her fiduciary duty.
Additionally, a director can be held liable for misleading statements made by the fund. Directors have been held liable for misleading statements directly or as aiders and abettors of a violation committed by the investment adviser to the fund.
Probably the best-known case in this area has been the one that the Commission brought in 1997 against Parnassus Investments. There were several different violations in this matter, but I will just focus on those involving the fund’s directors. For over two years, the directors clearly overvalued a security in the fund’s portfolio. After the issuer of the security had been delisted from NASDAQ and had subsequently filed for bankruptcy protection, the board continued to value the security at approximately 35 cents per share. That price was the last available NASDAQ quote. They continued to use that price despite the fact that the security was being traded at prices as low as 1 cent per share during the period. Those directors were found to have aided and abetted and caused a violation of Rule 22c-1 under the Investment Company Act by causing the fund to value a portfolio security at a value higher than its fair value. The Administrative Law Judge ordered respondents to cease and desist from any similar violations.
Earlier this year, the Commission brought two related actions against the directors of a money market fund. These actions involved a money market fund that "broke the dollar" (i.e., failed to maintain a $1.00 per share net asset value) and liquidated in September 1994 at 96 cents per share. The Commission found that the fund’s two portfolio managers invested 27% of the fund's assets in adjustable-rate derivatives, known as structured notes, an amount that the Commission found unsuitable for a money market fund. The Commission also found that the two portfolio managers had made these investments for the fund without adequately assessing the risks of a money market fund holding such a large portion of its portfolio in such derivatives in an environment of increasing short-term interest rates. In addition, the Commission found that the fund’s directors knew at least by June 1994 that the fund had made a substantial investment in the derivatives and that the derivatives were plummeting in value in response to a sharp increase in short-term interest rates, which had a material, negative effect on the fund’s NAV. They nonetheless continued to permit fund shares to be sold and redeemed at $1.00 per share and continued to permit the fund’s portfolio securities to be valued using the amortized cost method without any reasonable expectation that the value of the derivatives would return to par or that they could be liquidated at their carrying value in the near future.
The Commission found that the directors violated Sections 17(a)(2) and 17(a)(3) of the Securities Act and aided and abetted the fund's violation of Rule 22c-1 under the Investment Company Act, and that they violated section 34(b) of the Investment Company Act in connection with the filing of a registration statement. Community Bankers’ directors were ordered to cease and desist from committing or causing such violations. In addition, the president and a director of the fund, was ordered to pay a $10,000 civil penalty; and two other fund directors were each ordered to pay a $5,000 civil penalty.
In addition to these cases involving directors of mutual funds, the Commission has also brought enforcement actions that focused on the valuation duties of directors of business development companies, or publicly traded venture capital funds. Among other things, the SEC alleged and found that the directors of the BDCs, including the independent directors, had approved valuations of the BDC’s portfolio securities under circumstances in which they knew were unsupportable, or acted with reckless disregard for whether the valuations were supportable. In some instances, the directors approved valuations of very recently acquired portfolio securities at multiples of their cost, without any support for the increased valuations.
The cases I have discussed up to this point highlight directors’ responsibility to actively assure that their funds’ securities are being valued fairly. But there are other ways that directors can run afoul of the federal securities laws, as is evident from the recent action the Commission brought against Monetta Financial Services. Monetta received profitable short term trading opportunities in hot IPOs from certain broker-dealers. The allocations were made based on business Monetta had directed to the broker-dealers, principally on behalf of the funds. Monetta allocated portions of the IPOs to certain fund directors even though the funds were legally and financially able to invest in the IPOs. The Commission charged the Monetta directors who received preferential IPO allocations without making disclosure and obtaining the consent of disinterested representatives of the funds under the antifraud provisions for having breached their fiduciary duty of loyalty.
In March of this year, the Administrative Law Judge found that the undisclosed allocations of IPOs constituted antifraud violations. The sanctions were stiff, including disgorgement, and civil penalties ranging from $10,000 to $100,000 for the directors and $200,000 for Monetta.
In 1988, the SEC instituted and settled an action against fund directors, including independent directors, who allegedly had approved payments by the fund for litigation expenses that were incurred in a lawsuit instituted by the fund’s investment adviser and distributor, when the directors allegedly knew that the fund had no stake in the outcome of the litigation. The SEC alleged that the directors had engaged in a "breach of fiduciary duty involving personal misconduct" within the meaning of Section 36(a) of the Investment Company Act.
In addition to these cases, there have been other enforcement actions involving funds when the directors were not charged primarily because the record indicated that the board had been diligent in focusing on the problem; had asked the right questions; but had simply been misled by the adviser and/or the portfolio manager.
Actually there are many factors that the Commission considers when contemplating whether to charge the directors in a matter involving violations by a fund, its adviser, and/or its portfolio manager. No one of these factors is dispositive, and their application to a given situation is highly dependent on the specific facts of that case. Nevertheless, I thought it might be helpful to discuss generally a few of these factors.
The duration of the violation, particularly after the point that the board knew or should have known of the violation is important. And with respect to the board’s knowledge, reckless disregard of problems is treated almost the same as actual knowledge. An obvious factor is whether or not any of the directors, or any persons associated with the directors, benefited from the misconduct. Another factor is whether the board had taken reasonable measures to assure that the fund had proper procedures and controls in place. There are many important functions, such as fair value pricing, which I will discuss further, that are the board’s ultimate responsibility for which the board may properly delegate responsibility. However, a board that does not establish reasonable procedures and controls and that does not periodically monitor their effectiveness cannot disclaim all responsibility if serious problems arise.
I want to emphasize that the Commission does not consider lightly a decision to charge a fund’s directors. The purpose of this discussion about enforcement actions was not to alarm any of you, or to send a message that we believe that there is a growing problem with directors failing to satisfy their important duties. And I certainly don’t want to deter you from continuing your service to fund shareholders. But I did want to remind you that we are watching; your shareholders are watching. The best way to fulfill your duties and avoid entanglements with the Division of Enforcement is to be proactive and energetic. Willfully ignoring problems or just closing your eyes is not acceptable.
This conference focuses on a number of current regulatory developments of interest to directors including renewal of advisory and underwriting contracts, issues relating to the distribution of fund shares, evaluation and oversight of compliance with Codes of Ethics, issues associated with mergers and acquisitions, best execution concerns and mechanisms to enhance board effectiveness.
We want directors focusing on the important issues like those being discussed at this conference. We do not expect directors to micro-manage funds, and we have taken several actions designed to reduce burdens on directors. 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.
I would like to highlight three areas that I believe merit increased focused by fund independent directors, the areas of valuation, best execution and the related subject of oversight of portfolio management.
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 (the value of their portfolio securities and other assets, less liabilities). 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 and bonds may not be priced at par based on the expectation that the securities will be held to maturity. As noted earlier, failure to adhere to the requirement to fair value portfolio securities when required, has resulted in enforcement actions against some funds and fund directors.
At the end of last year, we issued an interpretative letter to the ICI providing additional guidance that supplements the SEC Accounting Releases on the fair value pricing process. The letter emphasizes that while no single standard exists for determining fair value in good faith, fund boards should satisfy themselves that "all appropriate factors" have been considered, and should take into account" all indications of value available to them" when fair value pricing a portfolio security.
The letter further recognizes that fund boards typically are only indirectly involved in the day-to-day pricing of a fund’s portfolio securities, and notes that most boards fulfill their obligation by reviewing and approving pricing methodologies, which may be formulated by the board, but more typically are recommended and applied by management. The letter suggests that funds may use a number of techniques to minimize the burdens of fair value pricing on their directors, such as delegating certain responsibilities for fair value pricing decisions to a valuation committee. If a fund’s board has approved comprehensive procedures that provide methodologies for how fund management should fair value price portfolio securities, it would need to have comparably little involvement in the valuation process in order to satisfy its good faith obligation. On the other hand, the Board’s involvement must be "greater and more immediate" if it has vested a comparatively greater amount of discretion in fund management, or when pricing procedures are relatively vague. Nevertheless, the letter stressed that in any event, the fund’s board retains oversight responsibilities for the valuation of the fund’s assets.
It is important therefore that fund directors receive periodic reports from fund management that discuss the functioning of the valuation process and that focus 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.
This is an important area for board focus, since proper valuation of fund portfolio securities is critical to ensure that the fund share prices derived from those valuations will be fair to purchasing, redeeming and existing shareholders. Issues related to valuation will be a continuing focus of the Commission, and we urge fund directors to devote careful attention to this issue.
I know that there is a session tomorrow entitled, challenging the traditional notions of best execution. Earlier this month, Chairman Levitt gave a speech entitled "Costs Paid with Other People’s Money". In this speech, the Chairman focused on the cost of investing, noting that among the most significant costs of investing today are brokerage commissions. He noted the good news that retail commissions have dropped to only a fraction of what they were just a few years ago. He pointed out however that "full service commissions paid by mutual funds have remained steady at five to six cents a share for nearly a decade. He questioned whether fund portfolio managers are bringing to bear the pressure they should on brokerage rates today. While the Chairman acknowledged that there is more to execution quality than the Commission rate, he asked why the emergence of electronic markets has not driven commission rates lower for funds? The Chairman explained that fund directors have a duty to inquire about the process and put more pressure on fund managers to drive hard bargains with their brokers. He explained that there is no substitute for asking hard questions about order routing arrangements, to ensure investors reap the full benefits of the dynamic competition unfolding in our markets. Finally, he noted that this is your duty as fund directors to pursue this issue, because it’s other people’s money. Brokerage is an asset of the fund and its shareholders. In other words, those who spend other people’s money must exercise the same care as they would in spending their own.
Also related to directors’ oversight of portfolio management, are two practices that apparently go on to some extent in the management of funds, "portfolio pumping" and "window dressing".
Portfolio pumping is the practice of increasing a fund’s stake in portfolio securities at the end of the financial period solely for the purpose of fraudulently driving up the NAV of the fund. Academic studies have suggested that the practice goes on in the fund world.
We have not yet brought a case in this area, but it is something we are paying close attention to. Earlier this year, our office of Compliance Inspections and Examinations formed a task force to look into the practice. The task force is carefully evaluating trading data of fund securities that would indicate manipulation. And this concern extends beyond our borders – our colleagues in Canada, the Ontario Securities Commission, recently brought a case of this sort against Royal Bank of Canada’s investment management arm.
We are also concerned about the misleading practice known as "window dressing." Here, advisers buy or sell portfolio securities at the end of a reporting period for the purpose of misleading investors as to the securities held by the fund, the strategies engaged in by the advisers or the source of the fund’s performance. For example, an adviser may cause the fund to hold significant positions in securities that are not permitted under the fund’s disclosed investment objectives. As the reporting period draws near, the adviser liquidates these positions to come into compliance with its stated objectives. OCIE is examining trading patterns to detect violations in this area. We view this as an antifraud violation. Investors are misled if they are told that the fund is investing consistent with prospectus disclosure when it is not.
Window dressing may also occur when an adviser replaces investments in otherwise permissible securities with investments in high performers just before the end of the reporting period to make it appear as though the adviser has a winning hand.
We urge fund directors to encourage compliance personnel and the fund’s auditors to scrutinize trading near the end of reporting periods, to be on guard for portfolio pumping and window dressing.
I want to close by emphasizing that you are our 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. As you carry out your day-to-day responsibilities as independent directors, be guided by what is in the best interest of your shareholders. Remember that every time you stand up for what is right, the investors you represent stand with you and what’s more the SEC stands with you. The 83 million Americans who invest in mutual funds are counting on us to look after their interests. We can’t let them down.
Thank you.
http://www.sec.gov/news/speech/spch426.htm
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