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Former ICI President Calls for Fresh Thinking on Reform

Regulators are searching for a rescue plan for the fund industry scandals, but the effort is doomed if the rulemakers continue in-the-box thinking, said David Silver, former president of the Investment Company Institute.

Silver red flagged a misguided focus on fair-value pricing and the Securities and Exchange Commission's obsolete structural organization as two major hurdles that could become barriers to long-term reform.

"With ever-increasing globalization, I do not think fair-value pricing is a viable long-term solution to the geographical aspects of market timing," Silver said. Instead, he proposes a rolling redemption. "It's a little complicated, but certainly within the technical feasibilities in this computer age."

Silver explained that by installing a rolling redemption model, an investor selling a hypothetical fund invested in 50% American securities and 50% Japanese securities, would be priced out of his U.S. securities at the closing bell on Wall Street and then have to wait until the exchange in Tokyo opens the next morning to get priced out of the remaining stocks. "It's a much more real approach than the guesstimates that are involved in fair-value pricing," Silver said.

Another major obstruction to reform is the inherent flaws in our nation's securities regulators, Silver said. "The real problems have to do with the fact that under modern conditions, the SEC's internal processes are increasingly dysfunctional," Silver said. While he is "absolutely flabbergasted" that legal and accounting professionals working for the deviate firms were totally ineffective, Silver says the SEC dropped the ball big time on obvious violations.

"Everyone in the 1990s was aware of the geographical market-timing problems, and the SEC essentially put its head in the sand, while wringing its hands," Silver said. Worse, the neglect not only failed to prevent timing, it also created a regulatory vacuum that improperly implied to some in the industry that timing was not a problem of regulatory significance.

Silver pointed to a half dozen lawsuits in the last decade brought by market timers against fund organizations that were trying to keep them out as proof that timing was a known problem. "Yet, over this 10-year period, while the SEC was aware of this problem, very, very little was done by the Commission to create an appropriate regulatory framework," he said.

Problems at the SEC stem from a silo-like infrastructure, which was created when there were a million Model T Fords on the road, where the different divisions relay information up the ladder to a Commission that is not structured to pull together the pieces of connected information and data, he said. "I think the internal problems of the SEC are not terribly unlike the spectacle we've been seeing recently with the lack of coordination between the FBI and the CIA in the U.S. intelligence community."

Recent talk of a new office of risk assessment and the creation of inter-divisional task forces to handle problems across jurisdictional boundaries are a step in the right direction. However, the Commission is not structured in a way to look at a modern financial services firm as one entity but as separate components, Silver said. In England, there is ongoing investment management regulation reform in which the Financial Services Authority now looks at firms as a whole, a mindset the U.S. could learn from, he said.

Despite shortcomings, there are several positive measures that are being adopted. Top of that list is the rule requiring compliance officers to report to the fund board of directors, especially to the independent directors. "This will change the focus enormously and give the directors much greater tools than they have available to them now in the area of compliance," Silver said.

It is key that there is a linkage between compliance and internal audit at the fund organization so that directors have additional influence to discharge their oversight or responsibilities.

While being "agnostic" as to whether the board chairman should be independent, Silver said that it is paramount independent directors be allowed, through the lead director, to add items to the board agenda and assure that appropriate staff members appear before the board to report on them.

Whether or not entry standards into the industry need to be developed is another topic the SEC needs to examine carefully. "At this point, portfolio managers at mutual funds are not required to be knowledgeable about the securities laws, less so than salespersons in a retail brokerage firm," Silver said. "I think that there ought to be a long, hard look at entry standards and qualifications."

However, once corrective measures to curb abuses are in place, the fund industry and regulators should take a step back before further tinkering with the Investment Company Act of 1940. The legislation has worked extremely well over the years, Silver said.

"While we have a scandal of very broad proportions, it should be kept in context. The scandal may be a mile wide, but it's no more than two inches deep."

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