By: Mary C. Moynihan, Diane E. Ambler
Although mutual funds have not been implicated as a cause of the financial crisis, many investors have experienced the crisis most directly through the plummeting value of their mutual fund investments. As Washington moves to address the myriad issues arising from the crisis, the mutual fund industry should expect to see changes that will directly affect how funds—and their advisers, distributors and custodians—do business. Changes of particular interest to the mutual fund industry are discussed below.
Change to Primary Regulator for Registration of Mutual Funds, Broker-Dealers and Advisers
Lawmakers are considering several configurations for a new regulatory regime. These include consolidation of the SEC with the CFTC—although Barney Frank, the powerful chair of the House Financial Services Committee, has expressed doubts as to whether such consolidation will happen. Another idea involves the creation of a financial products safety commission. Whether that proposal will take hold is unclear, although key Democrats in the Senate and House have submitted a bill to create the commission. Even if it were created, the White House is reported to support a plan under which the new financial products safety commission would focus on consumer products such as mortgages and credit cards, but would not have jurisdiction over securities (and therefore mutual funds), which would instead be regulated by the new agency resulting from a merger of the SEC and CFTC. Because the proposals are likely to trigger a turf war in Congress and among the affected agencies, it is still too early to predict the outcome. Lawmakers are also still waiting for final proposals from the Obama administration.
Money Market Funds
Money market funds have drawn closer regulatory scrutiny since the Reserve Primary Fund broke the buck in September, spurring large-scale redemptions from money market funds with large institutional investor bases and a guarantee program from the U.S. Treasury. While the Group of 30 proposed earlier this year that funds that maintain a stable $1 NAV be regulated as special purpose banks, this proposal does not seem to have gained traction. However, a consensus has developed on the need to tighten the rules governing money market funds’ portfolio assets’ credit quality, maturity and liquidity. The first detailed proposal came in March from a task force convened by the Investment Company Institute, which included proposals to (1) impose daily and weekly minimum liquidity requirements; (2) stress test the portfolio; (3) tighten portfolio maturity limits; (4) raise credit quality standards on portfolio investments; (5) address client concentration risks; (6) disclose portfolio investments monthly; (7) require additional risk disclosures; (8) authorize suspending redemptions for several days for failing funds; and (9) establish a nonpublic reporting scheme to regulators for all money market investors. The SEC has not yet produced a detailed proposal. However, SEC Chair Mary Schapiro has made clear that the SEC will propose tougher rules later this month that will “extend beyond” the ICI task force proposals. The staff is examining the credit quality, maturity and liquidity provisions currently applicable to money market funds and considering whether more fundamental changes are needed, including floating rate net asset values for money market funds.
“Proxy Access” and “Say on Pay”
In May, the SEC proposed a new “proxy access” rule that would set a tiered system under which shareholders may nominate candidates for election to boards of directors. For example, for companies with a market cap of $700 million or more, shareholders owning at least 1% of the voting securities would be eligible to nominate directors. By some estimates, this could increase by three or four times the number of contested director elections that funds must evaluate in exercising proxies. In addition, funds themselves would be subject to the proposed rule, which would allow shareholders to nominate fund directors. Finally, funds with ownership positions in excess of the thresholds would need to determine whether they should be proposing director candidates for portfolio companies. These proposals would transform a fund’s traditional analysis of “buy vs. sell” and force new decision-making concerning voting and management. Also in May, Senators Charles Schumer and Maria Cantwell introduced a “shareholder bill of rights” that would require non-binding shareholder votes on how executives are paid. The bill is not likely to pass in its current form but, particularly in view of the action taken earlier this year by the House to limit compensation of recipients of TARP money, any reform package is likely to include some corporate governance component.
Emerging Best Practices Relating to Risk Management
Many fund advisers and boards are examining whether the events of the past year suggest that they need additional risk monitoring programs to evaluate risk elements in the portfolio and the adviser’s organization. There is no “one size fits all” answer to the risk management puzzle, and the precise actions that a fund family and its board should take with respect to risk assessment are highly subjective and based on many different factors, including the nature of the fund family’s investments, experience with risk, organizational structure, and nature of investors. Nonetheless, the SEC has indicated that risk will be a central concern, suggesting that advisers may need to develop a more robust approach to risk management and that fund boards may wish to consider creating a risk management oversight committee or adding responsibility for risk oversight to an existing committee, such as compliance or investment performance.
Target Date Funds
In a May speech to the Mutual Fund Directors Forum, SEC Chair Schapiro stated that the SEC is closely examining target date funds due to concerns with performance of the funds during the market decline. As these funds approach their “target” date, their asset allocations should move toward a more conservative allocation, often referred to as a fund's “glide path.” Some funds may have established more aggressive glide paths based on the assumption that investors would continue to maintain their investments, and partially live off the proceeds following retirement. This could be particularly problematic for a target date fund underlying a college investment plan, since those investors would need to access their investment at or near the fund’s target date. Chairman Schapiro stated that the SEC staff would be closely reviewing target date funds’ disclosure about their glide paths and asset allocations, examining whether the same target date funds underlie both retirement and college savings plans and considering whether the target dates in some funds’ names are misleading. Chairman Schapiro also challenged fund directors to review their funds’ allocations between asset classes.
Custody of Client Assets by Investment Advisers
Following the Madoff scandal, the SEC has moved swiftly to propose new rules governing the custody of client funds held by all registered investment advisers. The proposed rules would require advisers to undergo an annual surprise examination by an independent public accountant to verify client assets. In the case of assets that are not maintained by an independent qualified custodian, the rules would require a “SAS-70” report from an independent public accountant registered with and inspected by PCAOB that includes an opinion covering controls over custody of client assets. The proposed rules would not apply to custody of assets held by mutual funds, but would affect advisers with respect to other classes of client funds.
When the dust settles, the investment management landscape will undoubtedly be much changed. Mutual funds will likely be subject to new rules, regulated by a reconstituted regulator, and, especially if hedge funds and other unregulated entities face more regulation, will encounter a new competitive environment. Industry participants should closely monitor these developments and may wish to provide input into policy choices that will have direct implications for them and their investors.
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The Fall 2010 Edition of K&L Gates' Investment Management newsletter is offered as a timely aid in addressing the myriad regulatory issues confronting the investment management industry. Watch for future issues discussing up-to-the-minute developments and trends in the industry.