NASD EVP Elisse B. Walter has a few words for mutual fund industry professionals who believe that the current regulatory atmosphere will soon pass and the good old days of lessened scrutiny will return.
"Such thinking, if it does exist, is a serious miscalculation," the NASD head of regulatory policy and programs told members of the Independent Directors Council at a recent workshop in Washington.
"In my view, the fund industry and the broker/dealer community will, for the foreseeable future, face heightened scrutiny. There is no reason to suppose that the regulatory spotlight will soon shift to other products and services, and there are serious risks if any in the industry fail to recognize this," said Walter. The NASD has brought more than 200 cases over the last 2-1/2 years and annually examines more than 80,000 pieces of advertising and sales materials for potentially misleading information.
Although the NASD doesn't police mutual funds, she admitted, as a regulator on the brokerage side of the business, Walter said the agency does have an obligation to protect shareholders and regain the confidence of the investing public in the wake of the scandal. That focus, she said, has prompted the NASD to devote greater attention to mutual fund reform, perhaps most visibly through an investigative and enforcement partnership with the Securities and Exchange Commission.
And while NASD task forces have recently uncovered several elements of mutual fund reform where it, the SEC and the IDC differ, Walter prefaced that portion of her remarks by outlining a number of collaborative initiatives that have recently borne fruit.
For starters, through its own examination process, the NASD discovered that investors were not routinely given the benefit of breakpoint discounts and has taken action against offending broker/dealers. The most recent action on that front was a combined $21.25 million penalty on March 23 against CitiBank Global Markets, American Express Financial Advisors and Chase Investment Services [see MME, 03/28/05].
In addition, at the request of the SEC, the NASD convened an industry task force consisting of fund leaders, large and small broker/dealers, transfer agents, Depository Trust & Clearing Corp. officials and others to devise technological and operational solutions to prevent further breakpoint oversight. The most recent action in that area was a recordkeeping network enhancement earlier this month at the DTCC that adds transparency to the information passed between funds and distribution firms. This should allow brokers to better apply for breakpoint discounts on behalf of investors [see MME, 04/18/05].
Another NASD initiative, conducted again at the request of SEC, Walter said, provided input on the impact of omnibus accounting for the Commission's proposal to implement mandatory redemption fees as a response to market timing. The SEC ultimately softened its stance and decided to make redemption fees voluntary [see MME, 03/07/05].
A third NASD task force was convened last year to provide the SEC guidance on the issues of soft dollars, portfolio transaction costs and mutual fund distribution.
Its conclusion on soft dollars, Walter said, is that the safe harbor set forth in Section 28(e) of the Exchange Act should be preserved. It's especially important to smaller investment advisers that cannot afford a large, internal research staff or hard dollar payments for research, she said. But while the NASD task force issued support for the safe harbor, it also suggested a number of new considerations.
Of particular note, Walter observed, is its recommendation that the SEC narrow its interpretation of the scope of research for purposes of the safe harbor, an issue on which the IDC has more recently voiced support. The NASD and IDC, however, differ on the council's position that the SEC require brokers executing transactions for funds to "unbundle" research and execution costs.
"The task force majority drew a distinction between third party and proprietary research, recommending dollar disclosure only for third-party soft-dollar benefits. This is an objective number that is easily determined," Walter said in a transcript of her closed-door speech obtained by MME. "In the case of proprietary research, however, the majority of the task force believes that there is no meaningful way for brokers or advisers to provide good faith estimates of the breakdown of total commissions into research and execution components."
Money managers here in the U.S. aren't the only ones facing such a dilemma, Walter observed. The Financial Services Authority in the United Kingdom has been studying the issue of soft dollars for years and just earlier this month proposed rules that would narrow the scope of permissible "research" and "execution" services that may be obtained with soft dollars. The NASD task force and the FSA agree on a surprising number of reform measures, Walter added, most notably the exclusion of soft dollars to obtain computer hardware, dedicated telephones and similar items. But like the IDC, the FSA disagrees with NASD task force on the unbundling of commission payments into their research and execution components and has decided to not even address the topic of consistent valuation techniques.
"Unless we can agree upon some definite standards for calculating unbundling, we run the risk that fairly arbitrary and meaningless estimates will be provided to clients," Walter remarked.
The NASD is also recommending enhanced disclosure on portfolio transaction costs. Walter said the regulator wants to see information from fund boards about the advisor's policies and procedures for monitoring transaction costs and brokerage allocation; as well as information on the reasonableness of all transaction costs, including commissions, commission equivalents, mark-ups and mark downs. The NASD is also interested in market impact costs, opportunity costs and other intangible trade costs.
For shareholders, the NASD would also like a brief narrative of those trading costs included in the fund prospectus and is urging the SEC to move commission disclosures from the statement of additional information to the prospectus. The NASD is further recommending that a five-year chart with data on average commissions, commissions as a percent of net asset value and portfolio turnover be included.
In terms of mutual fund distribution arrangements, including revenue sharing and its impact on sales practices, 12b-1 fees and the related issues that arise by retaining or eliminating them, Walter reported that the NASD's task force has concluded that all associated costs and potential conflicts of interest must be more visible to the retail investor. That position was submitted to the SEC on March 23.
"Basically, what the task force did was take the Commission's existing point of sale disclosure proposal and build on that initiative," Walter said, referring to the NASD's "Profile Plus" document, which describes key features of a fund [see MME 04/04/05]. But, she added, there are two major differences between the SEC point-of-sale disclosure recommendation and that submitted by the NASD task force.
While the SEC favors disclosure of fees, expenses and conflicts only, the task force recommends a snapshot of the fund, including investment risks and strategies. The task force further believes, Walter said, that the SEC should require a broker to post that information on its Web site for every fund that broker offers. In contrast, she noted, the SEC has expressed reluctance to use the Web as the primary mechanism for delivery of point-of-sale information.
"The task force believes that whenever the broker recommends a fund to an investor, the registered representative should refer the investor to the Web site for this information. Of course, investors should be able to opt out of electronic delivery. But I think that most investors will not. They will choose Web site delivery," she said, adding that its Profile Plus and full task force report is available at nasd.com.
Among some final recommendations from the NASD task force, is 12b-1 fees. The self-regulatory body recommends updating and modernizing the findings a fund board must make in approving a plan and changing the reference to those fees in a prospectus fee table to a less confusing title, perhaps "distribution and shareholder servicing fees." The task force also recommends better disclosure regarding the costs of B shares and consideration of regulatory caps on B share sales and limitations on conversion periods.
Reinforcing a current groundswell of opinion among many industry insiders, the task force also urged the SEC to reconsider unified fees.
Walters closed by reassuring the IDC that the NASD is not at war with profit seeking. Rather, she said, the regulator is concerned that profit-seeking not obstruct the industry from "honoring the responsibilities that arise from the trust placed in them by investors." It's a challenge, she hopes, both the mutual fund and brokerages industries are up to meeting.
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