The frauds plaguing the mutual fund industry were not foreseeable.
The frauds were not only foreseeable, but they were, in significant respects, widely known. Articles about arbitrageurs exploiting stale fund prices had been published for years, including two that I wrote that were cited by New York State Attorney General Eliot Spitzer in his complaint against Canary Capital [a New Jersey-based hedge fund], yet the SEC never took any steps to address this widespread and well-known problem. The SEC chairman has admitted that the SEC was not even inspecting for late trading or market timing. It is eminently foreseeable that when regulators ignore potential abuses, those abuses will occur.

Now that the trading abuses have been identified, regulators can eliminate them.
As noted above, many of the trading abuses were common knowledge before Eliot Spitzer filed his first complaint, yet the SEC had not taken adequate steps to address them. Thus, there unfortunately is no historical basis for assuming that the SEC will ensure that these and other abuses are eliminated, although the SEC has vigorously prosecuted a number of wrongdoers in connection with the current scandal. For example, the SEC continues to ignore sales abuses that exist, in part, because of the lax SEC standards under which brokers operate. Legislation and constant vigilance by investors, state regulators and Congress are necessary to ensure that the SEC fulfills its responsibilities to the investing public.

The SEC comes down hard on violators.
Sometimes the SEC comes down hard on violators, but sometimes it is inexplicably soft on them. For example, when the SEC settled with the independent directors of the Heartland Funds [the Milwaukee-based mutual fund company], the SEC let them off with only a cease and desist order, the lowest possible form of penalty, and even permitted them to retain directors’ fees earned while the case was pending. These directors oversaw the worse case of mispricing in the history of the industry, in which some investors lost 70 percent of their retirement funds in one day. This pattern has continued through the current fund scandal, where not one independent fund director has been charged with any wrongdoing by any regulator—state or federal.

Congress should create a new oversight body to regulate the fund industry.
The pervasive, systemic nature of the mutual fund scandal has demonstrated that we need structural changes in the way funds are regulated, and the SEC has not proposed any such changes. One proposal I have put forward is the creation of a Mutual Fund Oversight Board that would have inspection and enforcement authority over fund boards.

The Oversight Board would be charged with identifying potential problems in the fund industry and ensuring that fund boards are actively addressing these problems before they spread. For example, the board would promulgate informal, minimum standards for fund boards regarding a range of issues, including fee negotiations, fair value pricing, market timing policies, redemption policies and distribution practices. It would establish clear standards for fund directors to give them the guidance they need to effectively protect shareholders’ interests, and enforce those standards when fund directors ignore their duties. The model for the board, the Public Company Accounting Oversight Board, is considered one of the most effective creations of the Sarbanes-Oxley Act.

Congress must create this Mutual Fund Oversight Board because the SEC does not have the authority to create it.

Many of the industry’s problems stem from a lack of fund board independence.
The current mutual fund scandal could not have been so widespread without a major failure by fund directors to take fundamental steps to protect shareholders. Strengthening the independence of fund boards, along with the creation of the Oversight Board, would increase effectiveness. It is self-evident that the current legal requirement that a fund board be at least 40 percent independent is inadequate to ensure that the independent directors, and not the fund manager, control the fund. It defies logic to believe that a fund chairman who is also CEO of the fund manager can effectively police the fund manager on behalf of the fund. It is outrageous that a former director or executive of the fund manager can be considered legally independent under the law. 

Congress should require that a fund’s chairman be independent, and it should require that a fund’s board be 75 percent independent. The SEC does not have the authority to impose either of these requirements on all mutual funds.

The independent directors need to be people who are flexible, and who have the sense to provide meaningful guidance—people who have been on a board and have expertise in securities law or investing. Many former regulators, academics and board members fit the bill.

Soft dollars are part of the problem.
Congress should ban soft dollars. The term generally refers to brokerage commissions that pay for both execution and research services, and they are widespread among investment advisors. Soft-dollar arrangements raise multiple policy concerns. The payment of soft dollars by mutual funds creates a significant conflict of interest for fund advisors. Soft dollars pay for research that fund advisors would otherwise have to pay for themselves. Advisors therefore have an incentive to cause their fund to engage in trades solely to increase soft- dollar benefits. The SEC has frequently acknowledged, but declined to address, the problem of soft dollars. When the SEC staff last evaluated soft-dollar arrangements in 1998, it concluded that additional guidance was needed in a number of areas. For example, the staff found that many advisors were treating basic computer hardware—and even the electrical power needed to run it—as research services. The staff recommended that the SEC issue interpretive guidance on these and other questionable uses of soft dollars, but it has failed to do so.

Some fund industry members—MFS Investment, Putnam Funds, Vanguard, American Century and Fidelity among them—have shunned or restricted the use of soft dollars for research. The difficulty, however, is that without a statutory ban on soft dollars, they may suffer a competitive disadvantage. It is unrealistic to expect these fund managers to maintain the high road at the expense of reduced advisory fees, while other fund managers continue to pay their own research expenses through soft dollars rather than out of their own pockets.

Mutual fund investors are at the mercy of their fund managers’ view of their fiduciary duty.
A fund director’s fiduciary duty has no teeth, and boards accordingly provide little or no protection for investors against fraud. We need legislation imposing a general fiduciary duty on fund directors to ensure that the funds they oversee could be a reasonable investment alternative, that the fees charged are reasonable, and that the funds’ affiliates are not abusing their relationship with the fund.

The light at the end of the tunnel appears to be an oncoming train. Reform is politically driven.

For 34 years, the SEC has abdicated its statutory duty to prosecute funds and directors for excessive fees. Section 36(b) of the Investment Company Act, which was passed in 1970, provides that a fund director and fund manager shall have a fiduciary duty with respect to the fees charged by the fund manager, and tasks the commission with bringing actions against directors and fund managers who violate this duty. But the commission has never brought a case for excessive fees. The Mutual Fund Oversight Board would remedy this failure by promulgating and enforcing minimum standards of conduct.

Information about fees and conflicts of interest is available to investors, but they do not adequately understand it.
In what sense is information “available” if it is not understood? The concept of full disclosure must consider whether the disclosure is actually effective, and there is substantial evidence that, for large numbers of investors, disclosure rules are worse than ineffective—they are misleading. Consider, for example, the disclosure of outsized fund returns in fund ads in the late 1990s, which encouraged investors to chase short-term returns and led to substantial losses from 2000 to 2002. The SEC has done little to crack down on this abuse. Improved investor education and a stronger sense of individual responsibility are primary components for America’s financial security, but the SEC also has a responsibility to ensure that investors have the information they need to invest wisely.

Additional disclosure of transaction costs, commissions and fees will reduce opportunities for fraud.
Congress should require that funds include portfolio transaction costs in a total expense ratio. It also should require that the dollar amount of expenses paid by a shareholder be disclosed in the shareholder’s periodic statement, and that fees of similarly managed funds and appropriate index funds be disclosed in the prospectus for cost comparison. Although the expense ratio is appropriate for providing comparability across different funds, it does not pack the same import as a dollar amount. Providing investors with the amount in dollars that they actually spent will give concrete form to an indefinite concept. However, the SEC has accepted industry arguments not to require dollar costs because individual figures are too expensive. Instead, it has decided to require disclosure of the hypothetical fees paid on a $1,000 account in the shareholder report. It is still not being an advocate for investors.

The SEC has itself stated that fund fees “can have a dramatic effect on an investor’s return. A 1 percent annual fee, for example, will reduce an ending account balance by 18 percent on an investment held for 20 years.”

Further, mutual fund shareholders should be entitled to receive the same information as other investors in securities in the form of full disclosure of their brokers’ compensation or fund transaction confirmations. Such disclosure also should show how breakpoints are applied, as well as any special compensation received by brokers for selling particular funds. When buying a house, purchasers are provided with an estimate of their total closing costs before making a final decision. However, fund shareholders do not even receive a final statement of their actual costs, much less an up-front estimate of such costs. The SEC has proposed to require brokers to provide, both at the point of sale and in the transaction confirmation, disclosure of the costs and conflicts of interest that arise from the distribution of mutual fund shares. Fund Democracy, along with other consumer groups, has filed comments with the commission generally supporting its proposal.

In addition, Congress should prohibit funds from using their assets to compensate brokers for sales of fund shares and should prohibit fund managers from compensating brokers in connection with sales of fund shares.

Advertising of funds is good for competition and therefore good for the investor.
In September 2003, the SEC adopted advertising rules that require that a statement along the lines that current performance may be higher or lower than the performance data quoted. But recent fund advertisements have demonstrated the inadequacy of the new rules. After three years of negative returns, stock funds had a banner year in 2003. Many of those funds are now advertising their stellar one-year performance without any disclosure of their poor returns in 2000, 2001 and 2002. Because they are required only to show their 1-year, 5-year and 10-year returns, the negative returns of 2000 to 2002 are hidden from view. Investors have consistently chased the best-performing funds just before they crashed, and dumped the worst-performing funds just before they recovered. This mentality is only encouraged by the SEC’s current approach to fund performance advertising, which permits funds to present outsized returns with no meaningful caveats regarding their volatility and the likelihood that performance will soon revert to its mean.

There is a light at the end of the proverbial tunnel.
The light at the end of the tunnel appears to be an oncoming train. Reform is politically driven. Commissioner Paul Atkins always says he is open-minded, but he has at least twice voted against even releasing proposals for comment. SEC Chairman William Donaldson at least shows some individuality in thinking what is best for the investor and economy. Republicans pushed for more meaningful reform in the House, but opposed it in the Senate. These issues are going to keep coming up, and will not go away. Ultimately, congressional action will be necessary.

Fund Democracy was never intended to be a full-time job, but the scandal and flurry of rules have almost turned it into that. My purpose in founding it was to provide more technical aspects of mutual fund regulation. Consumer groups lack that technical expertise, and I thought I could fill that gap. The result is that there are now letters going to Congress and the SEC about mutual fund reform that might not have been sent before.