Bullard Takes His Case to the Hill
November 3, 2003
The fund industry's most prominent shareholder advocate is urging Congress to create an oversight board to protect mutual fund shareholders from fraud.
Mercer Bullard, founder of shareholder advocacy group Fund Democracy and assistant law professor at the University of Mississippi, is scheduled to testify before the Senate Subcommittee on Financial Management today that a special task force dedicated to overseeing mutual funds is necessary in stamping out corruption and restoring investor confidence. His testimony will focus on the widespread trading abuses uncovered by state regulators including late trading, market timing, the use of stale pricing and the overcharging of commissions.
With the list of funds being investigated growing each day, Bullard believes the time has come for a significant sea change. The move comes just days after Putnam Investments was charged with securities fraud by Massachusetts regulators and the Securities and Exchange Commission. Two of the Boston-based firm's international portfolio managers admitted to timing their own funds, an express violation of securities law.
"These systemic frauds have exposed a compliance system that is not working and is in dire need of structural reform," Bullard said, in written testimony he posted on his Web site, funddemocracy.com. The allegations can no longer be brushed aside as a case of a few bad apples because they encompass the majority of mutual fund complexes, Bullard said.
Furthermore, the alleged frauds were not obscure schemes that exploited a previously unidentified legal loophole. Management knew about these violations and failed to take any action. "Each of these frauds was predictable and could and should have been prevented simply by enforcing minimal compliance standards."
Bullard outlines a number of reforms that would serve to strengthen the independence and authority of fund directors, thereby improving fraud detection. While each category of fraud has its own nuances based on different legal requirements, the underlying theme is the same: mutual fund boards' failure to meet fundamental standards for compliance oversight.
Empowering the Independents
The first step in correcting this problem, he suggests, is appointing independent directors as well as an independent chairman. That eliminates conflict of interest and gives independent directors complete control over the board. The best example of why this is necessary is illustrated in the case against Strong Financial of Menomonee Falls, Wis., in which the chairman allegedly engaged in market timing the funds whose boards he oversaw. It's common sense that a person with no vested interest is more likely to be truly independent.
Secondly, Bullard wants the minimum number of independent directors to be increased from 40% to 75% and Congress to prohibit a fund from requiring that board action necessitate approval from a non-independent director. If one person has the right to overrule the majority, then a vote on a highly sensitive issue becomes futile. Historically, shareholders have not voted to approve fund directors, which is ironic considering that they're the ones whose interests the directors are supposed to be protecting. To remedy that, Bullard proposes that an individual can only serve as an independent director if he or she has been approved at least once every five years.
Another sticking point is determining who qualifies as an independent director. Under the current system, individuals with significant conflicts of interest can serve on a board. Bullard's proposal, however, disqualifies anyone who has been involved with the fund or its service providers in the last 10 years.
The fourth reform speaks to the shortcomings of the SEC by expressly calling for a Mutual Fund Oversight Board to police fund boards and prevent problems before they spread. "Recent frauds demonstrate that the commission staff has too many responsibilities and not enough resources to provide adequate oversight of fund boards," Bullard said.
Also included in his reform plan is the elimination of excessive portfolio transaction costs and broker compensation, which represent two significant gaps in mutual fund fee disclosure. Those reforms are not new grievances, as they have been part of the Baker bill, approved by the House only to stall in the Senate.
Slam the Window Shut'
All told, Bullard's message is the culture that exists in the fund industry leaves it susceptible to obvious cases of fraud. Congress, he declares, must take "prompt and forceful action."
The Investment Company Institute, the industry's largest trade association, has told Money Management Executive it views the idea of an oversight board as unnecessary tinkering.
Still, in a conference call last Thursday on reforms to correct trading abuses, the ICI said it vigorously supports a firm 4 p.m. deadline for all mutual fund trades to be reported to fund companies, a move it believes will "slam the late trading window shut."
Another initiative it supports is imposing an industry-wide 2% redemption fee on the sale of funds for a minimum of five days after purchase - and these proceeds would go directly to the fund, thus benefiting the long-term shareholders as opposed to fund managers and intermediaries.
Yet a third reform ICI leaders would endorse is amending the code of ethics for senior fund personnel to include oversight of all trading activity in a complex's funds, proprietary or otherwise.
Copyright 2003 Thomson Media Inc. All Rights Reserved.