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Bar Journal - Spring 2005

Regulation of Mutual Funds: What You Donít Know Can Hurt You



Many of the issues that a securities regulator may encounter on a day-to-day basis have little relevance to the majority of practicing lawyers in New Hampshire. However, as individuals with personal assets to invest or as professionals who advise on the management of assets, the subject of mutual fund securities and mutual fund investing is an important one that touches many individuals. According to the Investment Company Institute, "an estimated 91 million individuals in 53.3 million U.S. households owned mutual funds in 2003. These individuals held 77 percent of all mutual fund assets."1 Mutual fund assets totaled $7.4 trillion dollars by the end of 2003.

Recent enforcement actions by the Securities and Exchange Commission (SEC) against well-known mutual fund companies highlight the abuses that can occur when regulation does not fully protect shareholders. During the past year the SEC has amended rules regarding boards of directors, trading practices, and codes of ethics in an effort to better protect shareholders. Although a quick fix to the mutual fund industry is perhaps more optimistic than realistic, the rule changes provide a comprehensive road map to greater investor protection and confidence.

State and Federal Regulation of Securities

For those unfamiliar with securities regulation, the New Hampshire Bureau of Securities Regulation (the Bureau) administers the New Hampshire Uniform Securities Act (Uniform Act)2 under the authority of the Secretary of State.3 Mutual fund companies are subject to the jurisdiction of the Bureau for offers and sales of share interests of the fund in this state. These share interests are defined as "securities," under the Uniform Act.4 The chief regulator of mutual funds is the U.S. Securities and Exchange Commission (SEC) as provided by the Investment Company Act of 1940 (Investment Company Act).5

Mutual fund companies are required to register their shares under the Securities Act of 1933 (Securities Act),6 and pursuant to Section 18 of the Securities Act,7 they must "notice file" in each state they intend to offer shares for sale. Notice filing is an abbreviated filing meant only to inform the state that shares are offered and sold. Fund shares are sold by broker-dealers, who must be registered with the SEC, pursuant to the Securities Exchange Act of 1934 (Securities Exchange Act),8 and the state of New Hampshire, pursuant to Section 6 of the Uniform Act.9

The sales practices of broker-dealers selling mutual fund shares in New Hampshire are also regulated by the SEC and the Bureau, and also are policed by self-regulatory organizations such as the National Association of Securities Dealers (NASD). Mutual funds are managed by investment adviser firms, which must be registered with the SEC under the Investment Advisors Act of 1940 (Investment Advisers Act).10

Despite the multiple levels of regulation over mutual fund companies, their investment advisers, and the broker-dealers, a recent series of regulatory enforcement actions by state and federal regulators, as well as the NASD, against mutual fund companies has caused the SEC to take another look at the body of laws that regulate these companies and their broker-dealers.

Congress passed the Investment Company Act in 1940 to require registration of certain investment companies and the registration of the shares that they issue and to protect investors against the conflict of interest between the investment companies, also known as mutual fund companies, and their investment adviser, who manages the investment company. Despite this very significant body of law intended to protect investors, mutual fund companies and broker-dealers have found ways to enrich their coffers, sometimes at the expense of shareholders. While some of the methods of skirting the law are blatantly illegal, others fall within a gray area where arguably the best interests of the shareholders become secondary to those of the money managers and selling agents.

A Closer Look At Mutual Fund Companies

Section 4 of the Investment Company Act11 divides investment companies into three categories: Face amount certificate companies; unit investment trusts; and management companies. Section 5 of the Investment Company Act12 divides management companies into two categories: open-end investment companies and closed-end investment companies, also known as mutual fund companies. Most investment companies are open-end, meaning they issue and reissue redeemable shares priced at net asset value of the company. (Net asset value , NAV, equals the current market value of fund assets minus liabilities, divided by the total number of outstanding shares.) Closed-end companies have a fixed number of shares available for purchase and are traded on the securities exchanges or over-the-counter at a price established by the market.

Mutual fund companies uniquely allow investors to pool cash with others who want liquid and readily negotiable instruments, such as stocks and bonds, selected by investment professionals called investment advisers. Sections 10, 15, and 16 of the Investment Company Act13 establish the structure of mutual fund companies with investor protection in mind.

Section 10(a)14 requires that the board of directors of the investment company is comprised of both interested and disinterested persons. (To be disinterested means that the director has no affiliation with the investment adviser. The disinterested or independent director structure of the board establishes the means by which the interests of the shareholders can be protected against abuses by the investment adviser.)

Section 15 of the Investment Company Act requires that shareholders approve the contract between the investment company and the investment adviser; the investment company also must disclose all compensation to be paid to the investment adviser under the contract. Section 15 also requires that renewal of the contract take place at a special meeting, approved by a majority of the disinterested directors.

Section 16(a) of the Investment Company Act allows shareholders to elect at least two-thirds of the directors sitting on the board.

Unfortunately, despite these controls, mutual fund companies and their investment advisers do not always have the interest of the shareholders in mind. In the words of University of South Carolina Law Professor John P. Freeman, in a recent statement to a Senate subcommittee, the moral compass of the fund industry is broken, and conflicts of interest are rampant.15 Professor Freeman describes the governance structure of mutual fund companies this way:

"The fund industryís hallmark is its external management set-up by which an outside company manages the fund while populating a number of seats on the fundís board, including the Chairmanís seat. The external manager typically controls all facets of fund life, from the fundís incorporation through selection of the initial board. Historically, this control has tended not to be relinquished over time. This curious and dysfunctional external management governance system prevails throughout most of the fund industryÖ"16

Professor Freeman concludes that the fund industryís structure has built-in conflicts of interest, which heightens the risk that shareholders wonít be fairly treated. He calculates that shareholders pay as much as two times the amount for investment advice as other clients of the investment adviser, such as pension funds and institutional investors, due to the inherent conflict of interest of an investment adviser who not only sets the fees, but also receives them.

Mutual Fund Company Abuses

Abuses have taken place when the policies and procedures of the investment adviser are structured to benefit the adviser instead of the shareholder. Market timing, late trading, fee overcharging, and the misuse of fund expenditures have contributed to mammoth enforcement actions by both federal and state securities regulators.

Market timing includes frequent or rapid buying or selling of mutual fund shares of the same fund or buying or selling shares in order to exploit inefficiencies in mutual fund pricing, such as when a fund's Net Asset Value may not reflect a recent upturn in value of shares in its portfolio. Market timers harm the fund by diluting the value of the shares, disrupting the management of the fundís investment portfolio, disrupting the cash flow of the fund through frequent share redemptions, and causing the fund to incur artificially high trading costs, which are ultimately borne by the shareholders.

Late trading is an example of how inefficiencies in share pricing are exploited. Mutual fund shares are priced after the market closes, and before the market opens for trading the following day. A late trader places an order to buy or sell shares after the market closes, but receives the price in place before the market closed. In a global market place, a late trader could use a share value increase in a foreign market as a signal to late trade in the United States based on a lower price.

Another area of abuse is in the manipulation of expenses to benefit the mutual fund company at the expense of the investors.

Typical mutual fund operating expenses are paid out of fund assets. Fund expenses directly impact the net asset value of the fund shares. As might be expected, as expenses increase, net asset value decreases. These expenses include management fees (for the investment adviserís services and portfolio management), distribution fees made under SEC Rule 12b-1,17 and operating expenses. Distribution fees are deducted from fund assets to compensate securities sales professionals for marketing and advertising the fund.

Operating expenses can include fees paid to the fundís transfer agent for shareholder services such as account services, record keeping, printing, and mailing. Fund expenses also directly impact the fundís expense ratio, which measures expenses against assets. A fundís expense ratio is a common indicator of its profitability. The higher the expenses, the higher the fund expense ratio. Commissions paid to broker-dealers for selling shares are not included in the fundís expense ratio. In selling arrangements with broker-dealers, mutual fund companies will pay excessive commission expenses to broker-dealers and increase the profitability to the investment adviser through increased assets under management. The increase in commission payments will not appear in the funds expense ratio.

Finally, the misuse of fund expenditures can come in the form of soft dollar, directed brokerage, and revenue sharing arrangements between a mutual fund company and the broker-dealers.

In a soft dollar arrangement, a mutual fund can increase the commissions it pays to the broker-dealer which are paid for in part through services provided by the broker-dealer to the investment adviser. These services can come in the form of research to the adviser, access to information sources, and computer equipment. Soft dollar arrangements are a way for the investment adviser to avoid paying for these services out of the contracted advisory fee obtained from the fund, which directly increases the profit to the investment adviser. The less the investment adviser has to pay for these services, the greater the portion of the advisory fee that it keeps.

In a directed brokerage arrangement, the mutual fund directs extra brokerage commissions to the broker-dealer in exchange for increased attention and marketing of that fund.

In either a soft dollar or directed brokerage arrangement, the mutual fund shareholders may not get the benefit of the best possible commission pricing and pay higher commissions, resulting in an unnecessary decrease in net asset value of each mutual fund share.

In a revenue sharing arrangement, the investment adviser uses a portion of the investment advisory fee to pay for additional incentives to broker-dealers. The goal of the investment adviser is to boost the size of the fund, and consequently, increase its fee, which is based on the amount of assets under management. But an increase in the number of share purchases does not automatically translate into higher net asset value (NAV) for the fund. Net asset value is more a function of the success of the fundís portfolio than it is of the fundís size.

Curbing Abusive Practices

Recently, the SEC has taken major enforcement actions aimed at curbing abuses in the mutual fund industry. The bureau has also contributed to this effort. On February 5, 2004, the SEC announced a settlement with Massachusetts Financial Service, Co. ("MFS") and two of its employees for allowing widespread market timing in certain internally designated funds.18 The SEC brought its action in conjunction with the bureau,19 and the New York Attorney Generalís Office. The SEC alleged that MFS, a registered investment adviser, violated the antifraud provisions of the Investment Advisers Act,20 and the Investment Company Act.21 The bureau alleged that MFS violated the fraud provisions of the Uniform Act.22

The basis of the allegations was that the prospectuses for the funds designated by MFS for market timers actually prohibited market timing and other excessive trading practices. It was alleged that statements in the fund prospectuses prohibiting market timing were misleading and fraudulent, since the funds allowed market timing that harmed long-term investors.

In a settlement, MFS was required to change the composition of its funds' boards of directors to allow for no more than one-quarter of the board members to have an affiliation with MFS.23

Other major enforcement actions brought by the SEC include actions against Strong Capital Management, Inc., on May 20, 2004,24 PIMCO Advisors Fund Management, LLC, on September 13, 2004,25 and Franklin Advisers, Inc., on December 13, 2004.26

The actions taken and the outcomes of the cases against Strong and Franklin are discussed below as examples of the kinds of abuses that have occurred.

In the Strong matter, the SEC alleged that Strong Capital Management, a registered investment adviser, and its employee, failed to disclose to shareholders of Strong mutual funds that they market timed and allowed certain hedge funds27 to market time their funds in exchange for non-mutual fund business28 in other accounts managed by Strong Capital Management. The SEC also alleged that the hedge funds were granted access to the month-end portfolio holdings of the Strong funds. That same trading advantage was not granted to the other investors of the funds. Again, the SEC alleged that the Strong funds consistently and openly discouraged market timing through its fund prospectuses.

What made this case particularly egregious was the allegation that Strong Capital Management, through its wholly-owned transfer agent, Strong Investment Services, Inc., implemented a procedure to monitor certain Strong funds for market timing. If the market timing was detected, the customer was warned, and if the practices continued, the customer would be banned from trading in the fund. Strong Capital Management employees were also warned against market timing. Despite these warnings, the SEC alleged that an employee continued to market time and other employees allowed the market timing to occur in the very funds that they managed.

In addition to the remedial measures directed toward boards of directors, the SEC ordered Strong Capital Management to obtain the services of an independent compliance consultant29 to conduct a comprehensive review of supervisory and compliance procedures designed to prevent and detect breaches of fiduciary duty, breaches of code of ethics, and violations of securities law. The disgorgement and penalties assessed to Strong in that case totaled $140 million.

In the action against Franklin Advisers, a registered investment adviser, the SEC uncovered $52 million dollars in commission payments made to broker-dealers by Franklin Templeton Investments, a global mutual fund complex. The SEC alleged that these commission payments were made pursuant to undisclosed agreements with broker-dealers to provide shelf space for the Franklin Templeton mutual funds. The SEC determined that these shelf-space agreements created an undisclosed conflict of interest between Franklin Advisors and the fund shareholders.

While the increase in fund sales produced an increase in fees paid by the funds to Franklin Advisers, this was done at the expense of the fund shareholders. The SEC determined that the prearranged, shelf-space agreements meant that the funds were predisposed not to seek out the best broker-dealer to execute trades. Further, the SEC alleged that in the shelf-space agreements, funds paid the extra commissions which benefited the marketing of other funds. This arrangement was not in keeping with SEC requirements that fund boards approve all marketing plans.30

This enforcement action resulted in civil penalties of $20 million dollars, as well as a general compliance agreement that Franklin Advisers would not select broker-dealers based on their promotion of the fund and that a broker-dealer would not be given commission payments in exchange for fund promotion.

SEC Rule Changes

In an effort to promote transparency in the mutual fund industry, in 2004 the SEC announced a series of rule amendments affecting investment company governance, disclosure to shareholders, and reporting to shareholders. Many of these new rule changes are specifically aimed at righting the wrongs identified in the recent enforcement actions. These new rule changes encompass disclosure requirements to combat market timing, stricter prohibitions on the payment of brokerage commissions, tighter governance provisions designed to reconfigure mutual fund boards of directors, investment adviser ethics, and greater disclosure regarding approval of investment advisory contracts.

The SEC also announced31 that registration forms for open-end management investment companies must more fully discuss in their reports to shareholders the key factors that the board considered in its approval of the investment adviser and its contract. Similar, more detailed disclosures are required in fund prospectuses and proxy statements. The discussion of the investment advisory contract must include a complete description of amounts to be paid by the fund company under the contract, and disclosure of whether the board compared other fee structures and services provided under other investment advisory contracts for clients such as pension funds and institutional investors.

Rule changes effective September 7, 2004,32 enhance requirements for the independence of the boards of directors of mutual fund companies. In establishing these rule changes the SEC cited their recent enforcement actions and stated that the alleged abuses it had found reflected a breakdown in management controls. The SEC noted that fund boards were frequently dominated by the fund advisers, who controlled information about the fund and the agenda of the board, and that fund insiders were using the funds for their own benefit.

"[T]o be truly effective, a fund board must be an independent force in fund affairs rather than a passive affiliate of management."33, the SEC noted. The SEC has called on independent directors to ensure negotiation over fees and a reduction of fees where appropriate, and encouraged that in choosing independent directors, fund companies must have the goal of "identifying individuals who have the background, experience, and independent judgment to represent the interests of fund investors."34

Further rule changes have been put in place to protect investors from the ills uncovered by the SEC mutual fund investigations. Effective October 14, 2004,35 the

SEC prohibited mutual fund companies from paying for distribution costs through brokerage commissions, and prohibited broker-dealers from conditioning the promotion of mutual fund sales on the receipt of brokerage commissions. In reciting the justification for these prohibitions, the SEC indicated that distribution expenses covered by Rule 12b-1, were not intended to authorize commission compensation to broker-dealers for promoting fund shares. Therefore, Rule 12b-1 was amended to ban directed brokerage, and to ensure that broker-dealers are not selected for brokerage based on their promotion of fund sales.

Effective May 28, 2004,36 rule changes require mutual fund companies to disclose in their prospectuses the risks to shareholders of frequent purchases and redemptions and to specify policies and procedures with respect to such transactions. Prospectuses must say whether or not the fund discourages frequent purchases and redemptions, the restrictions imposed by the fund to prevent or minimize such trading, and the fees associated with redemption of shares. If a fund allows frequent trading, the fund must disclose any frequent trading arrangements and traders. If a fund makes its portfolio holdings available, it now must disclose the ongoing arrangement, the identity of the persons receiving the information, and any compensation received in exchange.

Finally, the SEC has adopted new rules effective August 1, 2004,37 which require registered investment advisers to adopt codes of ethics. The codes must address the personal trading of adviser employees and must require adviser personnel to report their personal securities holdings and transactions. The ethics codes must prevent access to material non-public information, such as the adviserís securities recommendations and client holdings. The codes shall require pre-approval of certain investments traded by company personnel.


Securities regulators have been active in taking enforcement action to protect investors and to ensure sound financial markets, and the SEC has been active in changing mutual fund law to meet and address abuses in the marketplace. When one reads the SEC releases which address the recent rule changes, it becomes evident that the SEC received many comments criticizing the ever more burdensome array of compliance requirements for the securities industry. Nevertheless, it is clear that counter measures were needed to secure sound markets for the investing public. As we have seen in this recent bear market, unsound practices and the lack of investor confidence substantially reduces share value and market participation.38


1. Investment Company Institute, Mutual Fund Fact Book, at 79 (44th ed. 2004).

2. N.H. Rev. Stat. Ann. 421-B et. Seq.

3. N.H. Rev. Stat. Ann. 421-B:21.

4. N.H. Rev. Stat. Ann. 421-B:2,XX(a).

5. 15 U.S.C.A. Sec. 80a et. Seq.

6. 15 U.S.C.A. Sec. 77a et. Seq.

7. 15 U.S.C.A. Sec. 77r.

8. 15 U.S.C.A. Sec. 78a et. Seq.

9. N.H. Rev. Stat. Ann. 421-B:6.

10. 15 U.S.C.A. Sec. 80b et. Seq.

11. 15 U.S.C.A. Sec 80a-4.

12. 15 U.S.C.A. Sec. 80a-5.

13. 15 U.S.C.A. Sec. 80a-10, 15, and 16.

14. 15 U.S.C.A 80a-10.

15. Professor John P. Freeman, Before the Senate Governmental Affairs Subcommittee on Financial Management, the Budget, and International Security, (2004).

16. Id at 1-2.

17. 17 CFR 270.12b-1.

18. SEC Investment Advisers Act Release No. 2213 (Feb. 5, 2004).

19. In the Matter of: Massachusetts Financial Services, INV03-037 (2004).

20. 15 U.S.C.A. Sec. 80b-6(1) and (2).

21. 15 U.S.C.A. Sec. 80a-33(b).

22. N.H. Rev. Stat. Ann. 421-B:3.

23. "Interested person", is defined by Section 2 of the Investment Company Act at 15 U.S.C.A. Sec. 80a-2(a)(19). In its simplest terms, an interested director is affiliated with the investment adviser company.

24. SEC Securities Exchange Act Release No. 49741 (May 20, 2004).

25. SEC Securities Exchange Act Release No. 50354 (Sept. 13, 2004).

26. SEC Securities Exchange Act Release No. 50841 (Dec. 13, 2004).

27. Hedge funds are usually exempt from the Investment Company Act having less than 100 investors and not making public offerings. Hedge funds are for high net worth investors.

28. Market timing arrangements in exchange for the investment of other assets earned the name, "sticky assets", because the market timing arrangements attract and keep the assets positioned with the companies that allow market timing.

29. "Compliance", is a term associated with one aspect of the function of a securities firm which is tasked by regulators with ensuring compliance with securities laws and regulations by the firm. Compliance departments can consist of multiple layers of supervision, record keeping, and controls, designed to detect illegal securities activity.

30. See 17 CFR 270.12b-1

31. SEC Investment Company Act Release No. 26486 (Aug. 5, 2004).

32. SEC Investment Company Act Release No. 26520 (Sept. 7, 2004).

33. Id at 4.

34. Id at 5.

35. SEC Investment Company Act Release No. 26591 (Oct. 14, 2004).

36. SEC Investment Company Act Release No. 26418 (May 28, 2004).

37. SEC Investment Company Act Release No. 26492 (Aug. 31, 2004).

38. According to the Investment Company Institute, Mutual Fund Fact Book, at 80 (44th ed. 2004), mutual fund sales in 2000 to 2002 stagnated, and in 2003 declined on the heels of a bear market.


Attorney Jeffrey D. Spill is the Deputy Director in charge of
Enforcement for the New Hampshire Bureau of Securities Regulation. The views expressed in this article are his, and not those of the Bureau.


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