Hearing of the Subcommittee on Financial Management, the Budget, and International Security of the Senate Governmental Affairs Committee

Federal News Service

HEADLINE: HEARING OF THE SUBCOMMITTEE ON FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY OF THE SENATE GOVERNMENTAL AFFAIRS COMMITTEE

SUBJECT: MUTUAL FUNDS: TRADING PRACTICES AND ABUSES THAT HARM INVESTORS

CHAIRED BY: SENATOR PETER FITZGERALD (R-IL)

WITNESSES PANEL I:

REPRESENTATIVE RICHARD H. BAKER (R-LA)

PANEL II:

STEPHEN M. CUTLER, DIRECTOR, DIVISION OF ENFORCEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION;

PAUL F. ROYE, DIRECTOR, DIVISION OF INVESTMENT MANAGEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION;

WILLIAM F. GALVIN, SECRETARY OF THE COMMONWEALTH OF MASSACHUSETTS;

ELIOT L. SPITZER, ATTORNEY GENERAL FOR THE STATE OF NEW YORK;

MARY L. SCHAPIRO, VICE CHAIRMAN AND PRESIDENT OF REGULATORY POLICY AND OVERSIGHT, NATIONAL ASSOCIATION OF SECURITIES DEALERS;

PANEL III:

JOHN C. BOGLE, FOUNDER AND FORMER CEO, THE VANGUARD GROUP;

MERCER E. BULLARD, FOUNDER AND PRESIDENT, FUND DEMOCRACY;

MATTHEW P. FINK, PRESIDENT, INVESTMENT COMPANY INSTITUTE

LOCATION: 342 DIRKSEN SENATE OFFICE BUILDING, WASHINGTON, D.C.A. M. EST

BODY:
SEN. COLLINS: Okay, thank you, we're both being so polite here.

SEN. FITZGERALD: That's right, thank you. Senator Collins.

SEN. COLLINS: Thank you, Mr. Chairman. Let me begin by saluting you for your leadership and your hard work in investigating this issue and convening this very important hearing this morning. This hearing is about abusive and in some cases possibly illegal practices allowed by some mutual fund companies. But the hearing is about more than that. It's really about people, good, hardworking, middle income families who are doing their best to plan for their retirement or to save for their children's education by investing their savings in mutual funds that have long been promoted as a haven for small investors.

Of all the components in the financial industry, the mutual funds sector has perhaps the greatest responsibility to safeguard the interests of small investors. Yet within the last two months, more than a dozen companies have been named in allegations of misusing millions of dollars of their investors money. These practices benefit a select few at the expense of the vast majority of mutual fund investors.

As one of our witnesses has indicated, there is evidence, troubling evidence, that officials at fund companies profited personally at the expense of their customers by market timing their own funds. It's equally troubling to me that this is not a new problem. According to the securities administrator in the state of Maine, similar allegations involving these practices arose in the late 1990s. And yet, little has been done since then to protect the nation's 95 million mutual fund investors, 445,000 of whom live in Maine. Surely they deserve better.

I question why the Securities and Exchange Commission which has regulatory responsibility for the mutual funds and their broker dealers, has failed to detect these practices, to impose appropriate restrictions or to penalize those who appear to be misusing their investors money. I question why mutual funds companies and their boards of directors would sacrifice the trust of their investors in the $7 trillion industry to benefit a select group of individuals who can afford to play the mutual fund market.

Clearly much more must be done to protect mutual fund investors, whether it is through legislation, tougher enforcement actions, new and stronger regulations, or all three. We have a regulatory system that is supposed to ensure that companies are acting in an ethical and legal manner. Mutual fund companies have boards of directors who are supposed to fulfill their fiduciary obligations toward their investors. And yet, these abuses occur over and over again. The system is obviously flawed.

As the chairman may well remember, I spent five years in the state of Maine as commissioner of the department with responsibility for securities regulation. This is an issue that is of great interest to me, we need to know what actions will be most effective in stopping these abusive practices once and for all, and this hearing is certainly a worthwhile step in that direction. Thank you, Mr. Chairman.

SEN. FITZGERALD: Thank you, Madam Chairman. May I just ask you, what office was that that had responsibility for securities in Maine?

SEN. COLLINS: It was-I was the commissioner of the Department of Professional and Financial Regulation, and that includes the Securities Division. Our administrator in Maine was the recent chair of the National Association of Securities Administrators and works very closely with some of our witnesses today.

SEN. FITZGERALD: Well, thank you.

BREAK IN TRANSCRIPT

SEN. COLLINS: Thank you, Mr. Chairman.

Mr. Roye, Mr. Bogle noted in a recent interview that there's an old saying in corporate America, and that is, quote, 'when you have strong managers, weak directors and passive owners, it's only a matter of time before the looting begins.' I want to talk to you about the role of the boards of directors and in particular about the possibility that the directors are not doing an effective job because they're so over-committed. They're serving on so many different boards within a family of funds. In looking at the SEC filings, I notice that there's tremendous overlap among the boards of director in fund families.

There are, in fact, plenty of fund family directors who serve on the boards for 80 or even 90 different funds, which seems too many to me. The chairman of Bank of America's Nations Fund sits on the boards of 85 funds. The chairman at Janus sits on 113 fund boards. Now, I realize that many of the funds have similar structures and approaches so there may be some economies of scale, if you will. But it's hard for me to see how anyone, any one director could effectively monitor the activities of so many different entities. Is the SEC taking a look at this area as far as issuing guidelines to limit the number of boards that a director can serve on within the same family of funds?

MR. ROYE: I think you point out real limitations in terms of director oversight. I think every director who serves on a mutual fund board, who's in a mutual fund complex, has to ask his or her self whether or not they're effective. You point out that there are directors that sit on multiple fund boards. As you indicate, there are common issues as between funds. When you get into issues like how they're sold and how their transfer agent is operating, a lot of those issues are the same for every fund. So once directors ask questions about those types of operations, the answers apply really across the board to all funds.

Of course, when you get to particular funds, you get into different investment objectives, policies, different portfolio managers, different performance and you get into individual issues with regard to each fund. But I think you're right in that there is a limit, and I think the problem that we have as the government is prescribing exactly what that limit is. To this point in time, I think what we've done is look to the directors to exercise that judgment. And there can be benefits of serving on multiple boards in the sense that issues come up, problems come up and issues and you can make sure that those issues don't creep into your other funds where you see a problem in one funds, and directors sitting on common boards can benefit from that information flow.

But I think you're right that there is a limit, and then I guess the question is from the standpoint of the government, what should our role be? What's the right number of funds to effectively oversee, and to this point we look to the directors to make that judgment. I know that the Investment Company Institute and its best practice for fund directors has recommended that directors do a self-evaluation periodically to assess whether or not they're effective. Are they organized the right way? And I think that we try to get a sense of that when go in and do an examination, looking at their committee structures and how they function. But to this point, we haven't gone down the path of coming up with what's the right number.

SEN. COLLINS: I would note that there's also monetary issues at work here. It's very lucrative if you're serving on many of these individual boards, and given the pattern that we've seen of lax oversight, widespread abuses and the lucrative incentive to serve on as many boards as you possibly can, I think this is an area that the SEC really needs to take a hard look at. I cannot imagine how an individual director serving on 80, 90 even 100 boards, even if they have a lot in common, can be doing a truly effective job. And yet those directors are well compensated for serving on each of those boards. So I would encourage the SEC, as you take a look at the issue of whether or not there need to be more independent directors to also look at whether directors are over-committed and not able to exercise effective oversight.

MR. ROYE: Let me just add that in terms of director compensation, this is an area where we have forced disclosure of how much directors are paid so that investors can make judgments about that compensation. And I think this is also an area where at the SEC, when you talk about the regulatory framework and the statute, we have certain authorities where we can act, and indeed as I outlined how we had-the rulemaking tried to require a majority of independent directors, self-nominating directors, independent legal counsel, when we advanced issues like that the rulemaking, there were people who told us that we were exceeding our authority to do that. And so this might be an area where we may need some legislative help in terms of addressing an issue like you outlined.

SEN. COLLINS: Thank you.

Mr. Cutler, you explained to us that the SEC receives thousands of tips from the public and that it's difficult sometimes to sort through those and I may be difficult to identify one sitter worth following up on. But the SEC has another, I would argue far more effective, tool to use and that is the examination and audit process. I'd like to know, first of all, whether you believe that the current audit schedule is adequate to enforce the law. I know mutual funds have to register with and regularly report to the SEC, the must submit to regular audits and examinations by the commission's staff.

I'm wondering why these problems were not revealed through the examination and audit process?

MR. CUTLER: And I don't oversee that process, but let me do my best to address your question, Senator Collins, I think it's a very fair question. I know that in recent years the SEC could examine funds and fund advisors only once every five years. There are over 6,000 mutual funds in our country and over 7,000 advisors. And so there are some resource constraints here at issue. As recently as 1994 I'm told the average frequency for examining advisors was once every 22 years. So that number has come way, way down.

With the additional resources that I know that you were instrumental in helping us to get, Senator, in the last few months we have moved towards a cycle of every two, four or five years for advisors and funds, based on the level of risk posed by the individual firms. And as we absorb new staff I know that our office of compliance inspections and examinations will be continuing to evaluate whether the cycle should be further reduced.

But you're obviously right, examinations have to be a key component to how the agency gathers intelligence and understands what's happening out there in the industry.

SEN. COLLINS: Thank you, Mr. Chairman.