The rocky road to mutual-fund morality
"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.
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