MIAMI -- In every business, you'll find a group of people whose hard work often goes unrewarded or overlooked. Within the mutual fund industry, operations personnel are the unsung heroes whose behind-the-scenes toil enables advisors to deliver quality investment products and services to 90 million investors.
Given the current regulatory environment, it is now more important than ever that companies have the right systems in place to adapt to a rapidly evolving business. Furthermore, the role of compliance departments and back-office staffers has increased exponentially, as they are forced to cope with the burdens of more stringent fund regulation.
Speaking at the 22nd Annual National Investment Company Service Association (NICSA) Conference and Expo, several industry leaders gave the operations gang their due and stressed that as a group, they will play a major role in restoring the industry's tarnished reputation. Individuals tasked with running the back office at fund houses and providing the technical capability for shareholder services are "the backbone of the investment company industry," according to keynote speaker Paul Roye, director of the Securities and Exchange Commission's division of investment management.
But as Charles Johnson, chairman and chief executive of Franklin Resources, once observed famously, "The spouting whale gets harpooned." Johnson was this year's recipient of the Robert L. Gould award for outstanding achievement in the mutual fund industry, and his message to conference attendees was the importance of humility in the fund business.
Terrance O'Malley, a partner at New York law firm LeBoeuf, Lamb, Greene & MacRae, stressed the importance of getting the proper controls in place that would effectively thwart market timers. He also told his peers that although they may have had good intentions when it came to servicing the client, it is still not acceptable to have market timing in their funds.
The key to attacking the problem, O'Malley noted, is for fund shops to pursue an aggressive employee training and education program. Oftentimes, firms that sell a wide array of investment products find themselves confused as to what rules pertain to each particular offering. O'Malley admitted that in many instances, if companies had spent as little as $1 million on enhancing internal compliance systems, they could have spared themselves the risk of huge settlements with regulators.
"We're living in a technical environment, and you need to be technically sound," he said.
"The only thing worse than not having policies and procedures, is having policies and procedures and not following them," said Cynthia Fornelli, deputy director of the SEC's division of investment management. In that, she was referring to cases in which fund boards and executives turned a blind eye to clear red flags in an attempt to get more "sticky assets" in the door.
One of the more colorful comments overheard at the conference was that fund companies are more fearful of losing their chief compliance officer than their CEO. Indeed, heads of compliance are gaining prominence within fund shops as securities regulators and lawmakers continue to put the squeeze on their trading operations (see related article, page one).
One of the most critical operations issues discussed at the affair was the use of fair-value pricing, which basically enables funds to synchronize their pricing with U.S. stocks whenever a significant event occurs after foreign markets close. The problem is that different funds value securities using different methods, and the SEC has yet to spell out what constitutes a significant event.
Thomas Smith, managing director and chief regulatory compliance officer at JP Morgan Fleming Asset Management, admitted that many firms don't have a fair-value system in place and that they need to get up to speed and find a "comfort level to embrace it." He went on to say that it is simply not enough to farm out a fair-value pricing model but that firms must monitor the individuals doing the pricing.
An internal review of the pricing system should be well documented and end up in a board of director's minutes, he said. JP Morgan set up a committee to oversee its operation and report its findings directly to the board. Smith pointed out that a big problem that contributed to a wave of trading abuses was that the boards didn't know what was happening. This "disconnect in dialogue" between compliance personnel and the board needs to be addressed, O'Malley agreed.
Smith suggested that funds should perhaps consider hiring a third-party compliance officer to assure independence and that the person does not also serve as the advisor's compliance officer.
IT to the Test
"You've got to have oversight for your service providers," said panel moderator Elizabeth Krentzman, partner, regulatory services, at Deloitte & Touche. The SEC is taking a close look at trading issues including best execution, trade allocation, policies and violations. Fornelli stressed the importance of "kicking the tires" at funds' service providers so that firms can avoid exposure to questionable or unethical behavior.
Keeping up with recently enacted rules such as Sarbanes-Oxley, the Patriot Act and the new shareholder report rule have put compliance departments to the test. But it is not getting any easier as the SEC currently has another 10 proposals up for adoption that will put further strain on fund compliance teams.
Fornelli noted that the Commission has a very active enforcement calendar in the coming months, including seeing to breakpoint discount violations. Failure to deliver breakpoints, Fornelli maintained, is not a case of outright fraud but sloppy oversight.
But as for market timing and late trading abuse, Fornelli attributed them to a combination of complacency and greed. In both cases, IT execs will be relied on heavily to put a stop to such egregious behavior. Creating a direct reporting line from the back office to the board is extremely important, she said.
In the end, it all comes down to education, O'Malley added.
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