"Trust but verify" - the phrase used by American negotiators in dealing with the Soviet Union over nuclear weapons - could symbolize the federal government's approach to mutual funds.
In a major shakeup of the scandal-tainted industry, the boards of mutual funds will be required to have more trustees independent of management and an independent chairman. The ruling by the Securities and Exchange Commission last week means that an estimated four of every five funds will have to replace their current chairmen. The SEC hopes the move will restore the confidence of some 95 million Americans who have invested $7.5 trillion in mutual funds.
But the challenge for the SEC and other regulators looms large: How to find a balance between giving business people the freedom to innovate, invest, or manage in ways that advance the economy while imposing rules that prevent or at least discourage fraud. It's a tricky task.
"We can't legislate ethics," noted SEC Commissioner Cynthia Glassman, in a talk this spring. "But we can motivate people to do the right thing.... There is no question that fear ... of an investigation or enforcement action motivates board directors and executives to make sure that their companies are complying with the spirit and letter of the securities law. That's OK with me."
So how did Ms. Glassman and fellow Republican Paul Atkins vote on the proposal? Nay. It squeaked by because chairman William Donaldson, a Bush appointee, sided with two Democratic commissioners in approving it.
Glassman has support among fund executives. The greatest degree of protection for shareholders is not new laws or the independence of the chairman or the trustees, but rather the "moral fiber" of the fund's leaders, Edward Johnson III, head of the nation's largest mutual-fund complex, Fidelity, has said. His fund group has been unscathed in the recent rash of scandals.
In addition to an independent chairman, the ruling requires mutual funds to have 75 percent of their trustees independent of the separate company managing the fund's assets, compared with half now. The change, which takes effect in about 18 months, gives trustees more clout. It aims at remedying what is widely seen as a bad conflict of interest arising from the unusual governance structure of mutual funds.
Some money managers support that approach.
"Obviously, integrity is the rock bed of trust," says Herb Allison, chairman of TIAACREF, an investment firm with $310 billion of assets under management, much of it belonging to teachers and researchers. Nonetheless, he emphasizes the "verify" part of "trust and verify." The new rules will impose a system of checks and balances that should provide extra assurance that fund executives and trustees are acting in the interest of shareholders, and not in ways that merely line their own pockets.
Trustees are supposed to assure that the investment-management firm they hire makes good choices of stocks, bonds, and other financial instruments. When they negotiate a contract for management, they're charged with ensuring that fees and expenses are kept reasonably low. And the Investment Company Act of 1940 enables trustees to change the investment-management firm if its performance is unsatisfactory.
But that has happened just three times since 1940, and then only in response to blatant violations of the law, says Tamar Frankel, a law professor at Boston University. "The law can't substitute for [management integrity]," but it can "plug identifiable issues, something that is a problem."
The conflicts of interest latent in this governance system are obvious, holds SEC chairman Donaldson. For a mutual-fund management firm, fees and other fund expenses provide the income that covers its salaries and rent. For shareholders, such expenses shrink the fund's investment performance.
Since September, the SEC and state regulators have imposed some $2 billion in fines on 19 mutual-fund firms involved in trading abuses. One common abuse was that fund officials let hedge funds or other specially authorized big investors trade after the 4 p.m. closing time for US stock markets. That's the time when share prices of funds for the next day are determined. These late traders took advantage of news breaking after 4 p.m. that would probably affect share prices the next day to skim off assets of other shareholders.
Of course, cheaters can often find ways around the law. "Unless people are self-limiting, unless there is a culture of honesty, a law change won't work," Professor Frankel says. "What has happened in America is that there is much more acceptance of fraud and deception than in the past."
"We have to look at our own culture," echoes Charles Elson, a corporate- governance expert at the University of Delaware. He approves of the new requirement for 75 percent of trustees to be independent. But he believes those independent trustees should be free to choose a chairman with an affiliation to the management company if they wish.
"It's not an earth-shattering move," he says. Those in the market for mutual-fund shares buy them on the reputation of the fund management, not on their confidence in the trustees.
More and more, though, it is not so easy for mutual-fund shareholders to dump their shares quickly if they get a whiff of scandal or become dissatisfied with the investment performance. That's because a record 36 percent of mutual-fund industry assets were held in retirement accounts in 2003, according to the Investment Company Institute, the industry's leading trade association.
Many of these assets, such as those invested through corporate-sponsored 401(k)s, can be shifted from one investment to another. Sometimes, though, the choice of investments is limited and it may require a tax payment. It is often not so easy as simply calling up a fund company to redeem your shares.