Many mutual fund portfolio managers and fund executives are sleeping more soundly now -- especially those who have engaged in illegal personal trading in the past.
Thanks to the Securities and Exchange Commission's long-anticipated new amendments to the rules governing personal trading by fund managers, they will be allowed to continue concealing their wrongdoing from the investing public. In weighing the interests of mutual fund investors against those of fund managers, the SEC once again sided with the fund industry.
All mutual fund companies are required to keep records of any personal trading violations for review by the SEC in connection with its ongoing inspection program. Who would argue that investors have no right to know whether the fund managers with whom they entrust their hard-earned savings have engaged in unethical and even criminal personal trading? Through the National Association of Securities Dealers, investors can research whether their brokers have had disciplinary problems in the past. Why shouldn't investors have access to similar information about fund managers? Fund managers are entrusted with substantially greater assets than brokers, and surely illegal activity on the part of managers poses a far greater risk to investors.
To simply have made these personal trading records available to the investing public would have resulted in no additional burden to the mutual fund industry. Unlike the approach adopted by the SEC, no additional reviews or reports would have been required. Managers who did not follow the highest ethical standards would have been forced to defend their actions.
However, the mutual fund industry would have howled at the prospect of such a public airing of its dirty linen. Some fund managers and executives would have been forced to resign their positions because no firm would want to defend individuals with histories of personal trading violations. Unfortunately, in the end, the right of fund managers to profit personally in private was upheld and the public's right to full disclosure of all information material to an investment decision -- the very premise of the federal securities laws -- was denied.
Is personal trading by fund managers a serious problem? The Investment Company Institute consistently has lobbied the SEC against any additional regulation in this area, arguing instead that fund companies should be free to establish their own standards on personal investing. Furthermore, the Association for Investment Management and Research has stated publicly that abusive personal trading practices are rare.
Both of these organizations seem to be curiously out of touch with their memberships, and their reassurances seem hollow. A recent PricewaterhouseCoopers survey of senior officials at 65 U.S. fund managers with combined assets under management in excess of $1 trillion, most of which are ICI members, revealed 74% of respondents listed personal trading and insider trading by fund managers as areas of "high concern." Another 66% said they were worried about conflicts of interests. The survey also noted a comprehensive and structured process for assessing employee compliance with the personal trading rules was not the norm in at least half of the organizations. Many respondents indicated that violations had been uncovered by regulatory examiners and customer complaints, rather than by the company itself.
But we can only guess whether personal trading is rampant throughout the mutual fund industry because the SEC has once again determined the best way to protect investors from the serious harm posed by managers' profiting personally is to keep such readily available information from them.
In a July 20, 1998, letter to SEC Chairman Arthur Levitt Jr., I set out a five-point proposal for eliminating the dangers personal trading by money managers poses to investors. I recommended:
* mutual funds be required, upon investor request, to provide investors with a copy of their codes of ethics, which would allow investors to compare manager ethics;
* investors be permitted to view copies of managers' personal trading records held at the managers' offices;
* investors be permitted to view records of any managers' code of ethics violations and any action taken to address these violations, which would permit investors to evaluate the personal ethics of their portfolio managers, as well as whether the management company is seriously punishing violators;
* an unambiguous statement that anyone responsible for monitoring and enforcing the code of ethics has a paramount duty to the shareholders of the fund, not the manager, and money managers should be specifically precluded from asserting the attorney-client privilege to prevent disclosure of personal trading violations; and
* limited prospectus disclosure be required regarding the risks personal trading poses to investors and the sources of information available to investors to evaluate these risks.
As I expected, the SEC adopted only the first and the last of these five points, failing to address the fundamental flaws in the regulatory scheme that enable mutual fund companies to hide illegal personal trading from the investing public, as well as regulators. The remaining three points were intended to address the bizarre, conflict-of-interests-ridden nature of mutual fund regulation.
The other amendments adopted by the SEC reflect its same tired approach to mutual fund regulation. The amendments require a fund's board of directors -- those sleepy watchdogs selected by the manager to protect investors from overreaching by the manager -- to approve the fund's code of ethics and annually review reports from the manager regarding any violations that have arisen in the past year. I cannot imagine why any board of directors that knows about the conflicts of interests and potential for fraud related to personal investing would not already have demanded such a report.
Other amendments intended to fill gaps in the current reporting system, as it applies to fund managers -- amendments intended to make it easier for funds and the SEC inspections staff to spot violations -- are elementary, uncontroversial and hardly restrictive. They require fund personnel to provide an initial report of their securities holdings and portfolio managers to obtain advance approval for purchasing initial public offerings.
The SEC has boldly said that fund boards selected by managers and fund managers themselves -- the parties who already were responsible for preventing abuses in this area -- should do a better job of protecting investors from personal profiting by employees of the manager.
Requiring public disclosure of unethical and illegal personal trading by fund managers and executives literally would have rocked the mutual fund world and given mutual fund investors their first real look at the ethical conduct of fund managers.
It would have changed the composition of many a mutual fund company's management. But the SEC deliberately avoided such a confrontation with the mutual fund industry, and it is the investor who has lost out once again.
Edward A.H. Siedle is chief executive officer of Benchmark Financial Services Inc., Lighthouse Point, Fla. He has served as an attorney with the SEC's Division of Investment Management, Washington, and as legal counsel and director of compliance of Putnam Investments, Boston.