Targeting Mutual Funds

Fund Administration

Regulators will likely focus on the fiduciary duties of mutual fund directors and investment advisers to ensure that the fund favors the investor's interests over the those of the fund's managers. Investment advisers typically operate numerous funds and provide services to multiple clients. There will be greater scrutiny over the disclosures the fund makes to its shareholders and the fees it incurs.

Securities laws presently specify mandatory disclosures that mutual funds must make, including the fund's past performance (which shareholders consider one of the most important judges of the fund's likelihood of future success), fees charged, and the fund's financial condition. In general, an investment adviser must disclose all information that tends to indicate a conflict of interest. All disclosures must be accurate, timely and contain all material information. An investment adviser must disclose all personal fees, including how fees are calculated and whether the fees are negotiable. Any personal or professional affiliations with broker-dealers or other issuers of securities should also be disclosed.

With respect to fees, investigators are concerned with the brokerage fees a fund pays to execute trades. Does the investment adviser get the lowest possible price, in accordance with its fiduciary duties? For funds marketed through third parties such as brokerage houses, investment advisers may trade brokerage opportunities in exchange for customer referrals.

Many investment companies are engaged in what are called soft-dollar transactions. Soft-dollar transactions occur when advisers direct client brokerage to obtain analyst reports or other services from the executing broker. Regulators focus on soft-dollar transactions because they involve potential conflicts of interest. For example, investment advisers may direct the fund's money in favor of research that aids the adviser rather than the fund. Furthermore, investment advisers may violate their fiduciary duty by forgoing opportunities or over-trading the fund to fulfill excessive soft-dollar commitments.

Investment advisers must disclose all soft-dollar practices to clients. Violations of the 1940 Act may occur when advisers allocate client brokerage to a broker in exchange for client referrals, analytical research or other services without disclosure. Mutual-fund advisers should provide the fund's board of directors with information regarding their soft-dollar practices. Investment advisers cannot receive compensation through soft-dollar arrangements and must disclose the factors used to select brokers, types of research, and whether the investment adviser uses the research to benefit other clients.

In auditing a fund for compliance, it is important to focus on internal controls to ensure that all employees' activities comply with all provisions of securities law, especially disclosures. A common weakness that leads to SEC investigations despite comprehensive compliance policies is the inadequacy of the fund's monitoring procedures. For example, an investment adviser has an insider trading policy, but does not review personal securities transactions for violations of that policy. Other examples are where a fund's procedure allows a portfolio manager to value the fund's securities in client reports without independent review of the manager's accuracy or where the fund lacks procedures to ensure that each investment complies with the fund's specified objectives and risk tolerance.

Investment advisers should assess their individual risk areas and audit themselves. Investigators usually mine emails and other internal correspondence for statements they consider to be admissions of liability. Fund managers and marketing staff may not be sufficiently sensitive to regulatory issues. They are as likely as health care, defense and other executives to generate documents that, in the hands of an investigator, will rouse more suspicion than the underlying behavior warrants. Compliance staff should be auditing investment advisers before the subpoena arrives, to stop inappropriate practices, and to curb glib, sarcastic and needlessly inculpatory e-mails. In addition, there may be situations in which an investment adviser is publicly touting an investment in one area while its managers are taking a contrary investment strategy for their personal portfolios.

Conclusion

Next month's article discusses Trade Allocations and Advertising and Marketing.

Successful enforcement efforts against investment banks have emboldened state and federal authorities to target the next deep pocket in the securities industry: mutual funds, or more precisely, the funds' investment advisers. There are over 10,000 mutual funds in the United States today, with approximately $7 trillion in investments from approximately 83 million individual investors.

Over the next several years, one can expect to see a familiar pattern repeat itself. As happened with defense contractors, commercial bankers and then with health care providers, federal and state regulators will direct their sights at investment advisors and mutual funds. What was traditionally an administrative issue for the SEC or state could become major civil enforcement litigation. Fines could easily skyrocket into multimillion-dollar figures. Prosecutors – armed with statutes that prohibit false statements, fraud, theft of honest services, and others – will threaten criminal sanctions in what had previously been regulatory actions under the Investment Company Act of 1940, the main statute governing mutual funds, and related securities laws. The mutual fund industry will see prosecutors target common practices that the industry thought acceptable, or at least inevitable.

There is a large variety of mutual funds, ranging from modest investment pools to multibillion-dollar funds. Investment advisers range from well-known companies with sophisticated compliance programs to small operations that mirror the ethics of the few key individuals who run them. As New York Attorney General Elliot Spitzer, a leader in the enforcement efforts against investment banks, said at a law school forum in mid-2003: “If you think the amounts involved in the investment banks were big ($1.4 billion global settlement), wait until you see what happens with mutual funds.” Counsel representing investment advisers subject to the 1940 Act need to reexamine their compliance efforts and prepare themselves for outside review. Regulators' inquiries will most likely examine two general categories, fund administration and marketing.

Fund Administration

Regulators will likely focus on the fiduciary duties of mutual fund directors and investment advisers to ensure that the fund favors the investor's interests over the those of the fund's managers. Investment advisers typically operate numerous funds and provide services to multiple clients. There will be greater scrutiny over the disclosures the fund makes to its shareholders and the fees it incurs.

Securities laws presently specify mandatory disclosures that mutual funds must make, including the fund's past performance (which shareholders consider one of the most important judges of the fund's likelihood of future success), fees charged, and the fund's financial condition. In general, an investment adviser must disclose all information that tends to indicate a conflict of interest. All disclosures must be accurate, timely and contain all material information. An investment adviser must disclose all personal fees, including how fees are calculated and whether the fees are negotiable. Any personal or professional affiliations with broker-dealers or other issuers of securities should also be disclosed.

With respect to fees, investigators are concerned with the brokerage fees a fund pays to execute trades. Does the investment adviser get the lowest possible price, in accordance with its fiduciary duties? For funds marketed through third parties such as brokerage houses, investment advisers may trade brokerage opportunities in exchange for customer referrals.

Many investment companies are engaged in what are called soft-dollar transactions. Soft-dollar transactions occur when advisers direct client brokerage to obtain analyst reports or other services from the executing broker. Regulators focus on soft-dollar transactions because they involve potential conflicts of interest. For example, investment advisers may direct the fund's money in favor of research that aids the adviser rather than the fund. Furthermore, investment advisers may violate their fiduciary duty by forgoing opportunities or over-trading the fund to fulfill excessive soft-dollar commitments.

Investment advisers must disclose all soft-dollar practices to clients. Violations of the 1940 Act may occur when advisers allocate client brokerage to a broker in exchange for client referrals, analytical research or other services without disclosure. Mutual-fund advisers should provide the fund's board of directors with information regarding their soft-dollar practices. Investment advisers cannot receive compensation through soft-dollar arrangements and must disclose the factors used to select brokers, types of research, and whether the investment adviser uses the research to benefit other clients.

In auditing a fund for compliance, it is important to focus on internal controls to ensure that all employees' activities comply with all provisions of securities law, especially disclosures. A common weakness that leads to SEC investigations despite comprehensive compliance policies is the inadequacy of the fund's monitoring procedures. For example, an investment adviser has an insider trading policy, but does not review personal securities transactions for violations of that policy. Other examples are where a fund's procedure allows a portfolio manager to value the fund's securities in client reports without independent review of the manager's accuracy or where the fund lacks procedures to ensure that each investment complies with the fund's specified objectives and risk tolerance.

Investment advisers should assess their individual risk areas and audit themselves. Investigators usually mine emails and other internal correspondence for statements they consider to be admissions of liability. Fund managers and marketing staff may not be sufficiently sensitive to regulatory issues. They are as likely as health care, defense and other executives to generate documents that, in the hands of an investigator, will rouse more suspicion than the underlying behavior warrants. Compliance staff should be auditing investment advisers before the subpoena arrives, to stop inappropriate practices, and to curb glib, sarcastic and needlessly inculpatory e-mails. In addition, there may be situations in which an investment adviser is publicly touting an investment in one area while its managers are taking a contrary investment strategy for their personal portfolios.

Conclusion

Next month's article discusses Trade Allocations and Advertising and Marketing.