Mutual Fund Transparency Bill Clears House Committee

By Sarah Borchersen-Keto and Peter Feltman, CCH Washington Staff Writers

Nearly one year after enactment of the Sarbanes-Oxley Act of 2002, which reformed corporate responsibility laws in the wake of the Enron collapse, Congress has turned its attention to oversight of mutual funds, an important vehicle in investing and retirement planning.

Legislation that would improve the transparency of fees and costs for the country's 95 million mutual fund investors, and strengthen funds' corporate governance standards, cleared the House Financial Services Committee by voice vote on July 23, 2003.

The Mutual Funds Integrity and Fee Transparency Act directs the Securities and Exchange Commission (SEC) to issue rules requiring funds to provide investors with improved disclosure. Under the legislation, mutual funds would be forced to disclose fees, in dollar amounts, on a hypothetical $1,000 investment. The bill also provides investors with access to enhanced information with which to compare the costs of different funds, and establishes several new requirements to strengthen mutual fund corporate governance and management accountability.

During testimony to the committee last month, Paul Haaga, chairman of the Investment Company Institute, said the mutual fund industry wants to work with Congress, the SEC, and the General Accounting Office (GAO) to find the best ways to help restore investor confidence. "We clearly recognize the need, especially in the current environment, to re-examine our regulatory system in order to determine if it is working as intended, and, even if it is, to determine whether there are ways to make it even stronger and more responsive to investor needs," Haaga said.

Specifically, the bill would require two-thirds of a fund's boards of directors to be independent, and then would give directors the option to elect an independent member as chairman. The bill also would apply auditor independence standards, similar to those of Sarbanes-Oxley corporate reform, to mutual funds, and each audit committee member must be independent as well. Moreover, each fund would need a code of ethics and a chief compliance officer, under the measure, and fund managers would need to disclose holdings they have in their funds, as well as financial incentives they have to sell a particular class of fund shares. However, an additional amendment was passed that would encourage the SEC to reduce disclosure burdens for small funds.

The bill aims to give investors a better sense of what incentives the fund manger has, in order to help the investor decide if the manager's goals are the same as the investor's goals. To that end, the bill would increase disclosure on the payments made by the investment adviser to the fund's portfolio manager. Generally, fund assets are used to pay fees to the investment adviser, who in turn hires portfolio managers to run the fund. Current disclosure requires the amount of the advisory fee in a fee table in the fund's prospectus. Additional disclosure would help fund owners understand the incentives of the fund's manager. For example, the SEC believes that useful information includes whether the manager is compensated for long-term or short-term performance, to give the investor a better idea of the long- or short-term goals of the fund. Furthermore, information on whether the compensation is based on pre-tax or post-tax fund performance can help an investor to determine whether the fund is more suitable in a taxable or tax-deferred investment account.

Approximately 80 percent of all mutual funds are sold through brokers, according to the GAO, and these intermediaries would have to help get the proper disclosures to their customers. GAO has also said in the past that mutual fund disclosures are less burdensome than bank and brokerage product disclosure.

Generally, most mutual fund disclosure is twice a year. Recently, an SEC proposal was put forward that would provide for quarterly disclosure, and the bill would leave determination of the disclosure period to the SEC. Most mutual funds do, however, provide quarterly statements that include the number of shares owned at the beginning and end of the quarter, and the total value. Currently, some costs are more transparent than others. Front- and back-end sales loads are fairly transparent, but portfolio transaction costs, which include management fees and distribution fees, are less transparent and deducted directly from the fund's assets. The bill would specify disclosure in account statements of any fee deductions.

In addition, the bill would require new recordkeeping of soft dollar transactions, where investment companies pay higher brokerage fees in return for research services. Under current law, investment advisers have a safe harbor that allows them to charge clients more than the lowest available commissions, if the adviser believes that the excess commission is a reasonable price for the additional research services provided by the broker. While the research can be valuable, soft dollars can lead to conflicts of interest between a fund and the fund's investment adviser. Such conflicts include when the adviser directs fund trading on the basis of research, instead of on the quality of the trades made; when the adviser foregoes opportunities to recapture brokerage costs, costs that can be recaptured by having the broker pay accounting, transfer agency, custodial service and other fees; and when overtrading occurs because the adviser has a soft dollar commitment.

The bill's soft dollar provisions would require each investment adviser to file an annual report with the investment company's board detailing payments by the adviser that were directly or indirectly made for the purpose of promoting the sales of the fund's shares, as well as services to the investment company provided or paid by the broker in exchange for brokerage business. The report would also detail research services. The SEC has traditionally not required fund prospectuses to list soft dollars, but has required disclosure in a form available to investors on request.

Other provisions of The Mutual Funds Integrity and Fee Transparency Act would:

• Require the disclosure of portfolio turnover rates in a way that facilitates comparison among funds; portfolio turnover is easy to calculate, but is currently only disclosed if it is a principal investment strategy
• Impose fiduciary duties on board directors to review revenue sharing arrangements--where the investment adviser, but not the fund itself, makes a payment to a broker-dealer to get the fund sold; while the mutual fund itself does not make the payment, the investment adviser can factor in the payments when assessing fees charged to mutual funds, and mutual fund customers do not currently receive disclosure of these payments (customers of the broker, however, do receive the disclosure)
• Direct the SEC to clarify the definition of "no-load" funds to ensure that investors are not being misled
• Call on the SEC to study the recent increase in arbitration cases involving mutual funds
• Require that directors be informed of any significant deficiencies in the operation of a mutual fund discovered in a SEC inspection
• Require that summaries of reports regarding fund distribution arrangements are made public

The bill now goes to the full House of Representatives, where passage seems certain, and then to the Senate for their approval.

Related items:

401(k) Reforms Take Effect; Feds Increase Access to Rulemaking

Posted July 30, 2003.