Few people in the mutual fund industry, outside of those who have been charged in the scandal, have been under as incredible pressure or faced as tough questions in the past few months as Paul Roye, the nation's top cop for the mutual fund industry.
When New York Attorney General Eliot Spitzer exposed the market timing and late trading abuses with the Canary Capital case on Sept. 3, the biggest question for Roye, of course, was why had the SEC failed to detect these endemic abuses?
When Congress got in the act, grilling the industry through its endless hearings and then with Mutual Funds Integrity and Fee Transparency Act in the House and six other mutual fund reform bills in the Senate, the question became, is the SEC even equipped to supervise the industry?
After the director of the SEC's regional office in Boston resigned over the embarrassment of having turned away a whistleblower and Spitzer called for Roye's own resignation, the question then became, should Roye step down?
In the nine months since the scandal first broke, the SEC has reemerged as capable of governing the industry, in large part due to sweeping reforms that Roye and his staff have recommended. In this time, the SEC has come out with 14 separate rulemaking adoptions, proposals or concept releases and brought 15 enforcement actions against fund companies and executives. The chairmen of the Senate Banking Committee and the House Financial Services Committee have both recently tipped their hats to the SEC and indicated that the reforms it is undertaking may preclude the need for additional legislation. And even the General Accounting Office recently concluded the SEC is doing a good job.
Money Management Executive Editor Lee Barney recently posed some of these tough questions to Roye, including why the SEC and fund directors were blind to the trading abuses, whether the scandal is over and if the historic reforms the industry is now going through will actually lead to meaningful change.
MME: Is the fund scandal over?
Roye: We've continued to gather information, and you are going to see a steady flow of cases.
The cases aren't going to be based on radically different theories than those that have already been brought, but as in the recent MFS case on directed brokerage, they will be variations of what we have already seen. Some of these cases won't only involve funds, but, for instance, variable annuities, particularly since you can move into and out of funds within annuities without tax consequences.
MME: Will more executives be sentenced to jail?
Roye: I think there's an interest in our enforcement division in pursuing certain cases criminally, and they are making referrals to U.S. attorney offices.
MME: Will there be enforcement actions against independent directors?
Roye: In every one of these situations, the question is being asked, "Where were the directors, what did they know and what did they do?" We are finding, though, that in a number of cases, the directors were duped along with the investors.
MME: Could the scandal move into separately managed accounts?
Roye: Here, you don't have to worry about pricing situations, but there is the potential conflict of interest at investment firms that run both an SMA or a hedge fund alongside a mutual fund, to favor them over the mutual fund because of their higher performance fees.
So, you may see cases against advisers running private accounts. We are looking at fair trade allocations and whether they are disclosing their conflicts, or managing their conflicts in a way that does not disadvantage investors.
MME: Eliot Spitzer has certainly thrown around a number of shocking and theatrical barbs, even saying the industry is filled with "vermin." What was your reaction when he said you should step down from your position?
Roye: Let me put it this way. I don't work for Eliot Spitzer. I work for Chairman Donaldson and the other commissioners. I've been here more than five years, and I'll stack my record up against anybody who's ever been in the position.
Sure, I wish we could catch everything. I wish we could be everywhere. But to assert that we were asleep at the switch, you'd be wrong, because we were very busy applying the Sarbanes-Oxley rules to the industry, against its resistance, requiring CEOs and CFOs to certify financial statements. We proposed the chief compliance officer and compliance policies and controls requirement long before the scandal broke. We had already brought the case on B share sales practices. We were beginning to look into directed brokerage and breakpoint abuses and whether there was a better way we could use auditors, such as having a third party come in and do a compliance audit of funds. Plus, we had looked into forming a private sector, self-regulatory oversight board for the fund industry.
We asked all these questions before the scandal broke, so to say we were sitting on our hands when we were asking all of these questions and looking into strengthening the compliance framework would be overlooking a lot of the proactive work we were doing.
MME: Do you think it's fair for critics to say the SEC was asleep at the switch?
Roye: When you talk about collusive fraud, it's very hard to see it or to find it unless a whistleblower comes to you and tells you where you ought to look.
The reality is we have a risk-based approach to examinations. We can't have our examiners coming in and looking at everything from A to Z at a fund group. Otherwise, we'd be examining funds once every 25 years.
Late trading was illegal, and virtually every fund had disclosure indicating they hated market timing. Since market timing is disruptive to portfolio management, drives up cost, and hurts performance, which ultimately hurts sales, it didn't make any sense for us to put this high on our priority list.
I've been here long enough to know we are going to get criticized no matter what we do. The problem is that there is an expectation that we are going to catch everything, that somehow we have the resources and the insight to be able to identify every problem. And we don't.
That's why we are trying to hold the industry accountable, hold individual firms accountable, and trying to get independent directors to do their job. We can't be in the boardroom when these deals are cut or find out about abuses spelled out in an e-mail. When our examiners go in the door, it is difficult to identify certain violative conduct.
MME: Will the new risk assessment office change the way of thinking at the SEC so that you will more actively look for profiteering?
Roye: When a scandal of this magnitude happens, you have to step back and reassess what you could have done differently. The chairman wants us to be out in front, not just reactive but proactive in heading off problems and abuses.
The new risk assessment office will look for fraud that cuts across different areas of investment management and issues of intersection with selling partners, like broker/dealers, for instance.
Another task force will look at ways we may want to change fund surveillance, what types of information we should have funds report, either publicly or non-publicly.
And finally, the SEC is getting the money for additional examiners and for the technology to help us be more efficient and improve our surveillance of the industry, looking, for example, through e-mails, by key words.
Investors have the right to expect an aggressive, knowledgeable, smart SEC looking out for their interests. We are trying to improve our ability to do that. But no matter how much we improve, it's unrealistic to expect us to head off every fraud before it occurs. All we can do is apply our resources the best and smartest way that we can to try and minimize problems.
Again, it's not just us but the industry itself has to do a better job of policing itself.
MME: Do you think Congress has gotten more involved than it should and that the pending bills are unnecessary?
Roye: Since the Canary case broke on Sept. 3, we have come out with 14 separate rulemaking adoptions, proposals or concept releases to strengthen the oversight framework of the mutual fund industry.
Chairman Donaldson has also set up task forces to look for areas of risk abuse and to improve fund surveillance, so I believe the SEC has the authority to do what needs to be done and is using its authority appropriately.
However, a few of the measures Congress is proposing are in areas where we don't have the authority, one being the definition of what constitutes an independent director. While we have voiced concern about the ability of family members and former executives to act as "independent" members of the board, some of the bills would tighten the definition, which we technically don't have the ability to do.
MME: The SEC has proposed a number of measures to curb improper trading. However, little, if any, attention has been given to the SEC's idea of disclosing the account names within an omnibus account on a weekly basis. Can you tell us anything more about this measure?
Roye: The mandatory 2% redemption fee will be paid back to the fund to offset the cost of investors rapidly getting in and out of a fund within five days. In order to apply the 2% redemption fee, the rule forces a pass-through of information through the omnibus accounts of who is actually doing the market-timing activity.
This is important, because one of the problems we identified was that many funds did not have the ability to identify who the timers were, because they were hidden in omnibus accounts.
MME: Of all of the new policies you have proposed, which do you think are the most important?
Roye: The chief compliance officer and compliance policies and procedures requirements. This chief compliance officer reports up to the board. Looking at what led up to the scandal, the directors in many cases were in the dark about what the problems were, so this is a mechanism to get the compliance person reporting up to the board.
I'd also point to the code of ethics requirement, to remind everyone at a firm of their ethical and fiduciary obligations. Banning directed brokerage altogether. Looking at what we ought to do with 12b-1 fees. The chairman has also formed a task force on soft dollars, and we will be looking at the conflicts there, as well as trying to enhance disclosure to investors of what these conflicts are.
We have the new requirement taking effect Dec. 5 ordering funds to better disclose their market-timing rules, so that investors can know with specificity what a fund's market-timing policies are. Better information about fees and expenses, including the new point-of-sale disclosure that brokers will have to share with investors, including their sales loads and whether they are receiving any incentives to recommend one fund over another. Fund shareholder reports will also include fees on a $1,000 investment.
All of this is designed to enhance investor understanding and improve fund oversight. And I haven't even mentioned the independent director piece of this. To have independent directors act more vigorously and scrutinize management more skeptically, and to have the board led by an independent chairman, is a tremendous advancement.
MME: Would you say this is probably one of the biggest periods of change in the fund industry?
Roye: Yes. I have been working in this area since late 1979, and have studied the industry since 1940. Going back 18 months , when we were busy putting in place all of the Sarbanes-Oxley rules, this is probably the biggest period of rulemaking in the industry's history.
MME: Why didn't funds already have chief compliance officers or have their general counsel reporting to the board?
Roye: That's a good question. At a fund, the lawyers, as well as the other officers, don't work for the fund but for the management company. One of the things we did in the Sarbanes-Oxley rules was require lawyers and general counsels to treat funds as their clients. With the chief compliance officer requirement, we have tried to make the lines of command even clearer.
MME: It's surprising that fund directors weren't looking into excessive fund flows, which would have tipped them off to some of the market timing. What are you now telling directors to look for?
Roye: There is no justification for complacency on the part of fund directors. Fund directors are paid to oversee management, ask tough questions, probe difficult issues and ultimately represent fund investors in the boardroom.
They must bring a healthy dose of skepticism to their oversight functions and demand accountability from fund management -- insisting on a "doctrine of no surprises" by asking questions and requesting additional reports and explanations.
MME: A lot of firms are resisting your measures, including the independent fund chairman and fee disclosure. Do you find this surprising, especially at a time when the industry is under such a cloud?
Roye: There are some folks in the industry who still don't quite get it, and others who are still trying to avoid accountability. They are pointing their finger at somebody else, saying it is not a mutual fund problem, but a broker problem. And the fund directors are pointing the finger at the management company, saying it's their problem. Some fund directors don't want the chief compliance officer reporting to the board. And still others are blaming the SEC.
This is one of those times in history when everybody's got to check themselves. We're certainly doing it at the Commission, engaging in a reexamination of how we can do a better job. I think all of the participants in the mutual fund industry have to ask themselves how they can do a better job of avoiding another scandal like this.
Yes, there are folks who don't want to be on the hook or on the line. Well, if you are at the top, the buck stops with you. All of the heads of fund companies have to be asking whether they have the right controls and compliance in place.
MME: You've never sounded so strident as recently, when you said the industry has turned a blind eye to market timing, late trading and self-dealing. Would it be fair to say you are angry?
Roye: Top executives at a number of firms dismissed internal complaints about market timing and late trading. It's bad enough that some people looked the other way. Worse yet is the notion that there were folks going around trying to set up these arrangements.
Folks in the industry have an obligation to look out for these kinds of things and call them to the attention of the regulators. If I sound a little harsh, it seems to be the appropriate message to send to the industry because everyone is paying a price.
But between the market's response, the enforcement actions and stronger rules, including strengthening the independence of the board and improved controls and oversight of the industry, I am optimistic that once we get through this, we are going to have a stronger, more ethical industry. And we will at least have minimized the possibility of these kinds of breaches happening again.
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