Mutual - Funds Under Fire

Mutual funds under fire: reform initiatives
Thomas R. Smith Jr
Thomas R. Smith Jr Abstract

(tsmith@sidley.com) is a Purpose – To describe the broad range of reform initiatives that has been undertaken in response to a
Partner at Sidley Austin series of mutual fund scandals that have become apparent starting in 2003. This is the second of a
Brown & Wood LLP New two-part article. The first part, in Volume 7, Number 1, is a chronology of developments related to the
York, NY, USA. fund scandals since 1 January 2003.
Design/methodology/approach – Describes SEC reforms, including governance reforms; compliance
reforms; SEC-directed expanded disclosure regarding fund expenses and costs; reforms with respect
to share distribution practices; reforms addressing market timing, selective disclosure, and fair value
pricing; other reform initiatives including codes of ethics for investment advisers and a requirement that
hedge fund advisers register with the SEC; an enhanced surveillance and inspection program for mutual
funds; and enforcement activities. Describes private civil suits brought against fund companies,
legislative proposals, the roles of NASD and New York State Attorney General Eliot Spitzer, the
development of ‘‘best practices’’ guides by industry groups, and measures being promoted by
institutional investors.
Findings – A broad range of reform initiatives has been undertaken by the SEC; NASD; and the New
York, Massachusetts, and California Attorneys General. Both the US House of Representatives and the
Senate have held hearings and proposed legislation, which at the moment appears dormant.
Independent directors of only one mutual fund have been implicated in the trading abuse scandals.
Hundreds of private civil lawsuits have been brought by fund shareholders against fund groups but
virtually none has resulted in substantial restitution to plaintiffs.
Originality/value – A detailed and comprehensive analysis of reform initiatives in response to mutual
fund scandals since 2003.
Keywords United States of America, Unit trusts, Fund management
Paper type General review
A. Overview
In response to the mutual fund scandals first uncovered in 2003, a broad range of reform
initiatives has been undertaken resulting in significant changes in the manner in which funds,
fund directors and their service providers conduct business. The SEC has enacted a
number of rules, conducted studies and engaged in extensive inspection and enforcement
activities. The NASD has taken action in the sales practice and revenue sharing areas. New
York Attorney General Eliot Spitzer, Massachusetts Secretary William F. Galvin, California
Attorney General Bill Lockyer, and other state authorities have been active in bringing civil
and criminal charges. Spitzer has been promoting reform in the context of negotiated
settlements and in testifying before Congress. The US Government Accountability Office
(GAO) has conducted a number of studies on matters related to the scandals. Both the
House of Representatives and the Senate have held hearings and have proposed legislation
which at the moment appears dormant.
There has been much discussion as to the failure of fund independent directors to detect
and prevent the fund trading violations. The SEC and others are seeking to determine why
PAGE 4 j JOURNAL OF INVESTMENT COMPLIANCE j VOL. 7 NO. 2 2006, pp. 4-27, Q Emerald Group Publishing Limited, ISSN 1528-5812 DOI 10.1108/15285810610711545
the directors were unaware of the problems and whether there were red flags that were
ignored. To date, the only independent directors allegedly implicated in the trading abuse
scandals are those of Bank of America’s Nations Funds. Civil actions brought against
independent directors for failing to detect or put an end to abusive market timing have been
unsuccessful to date as the courts have reaffirmed the independent directors’ role as one of
oversight not micromanagement (see Section B.8(c)). To strengthen the hands of the
independent directors and widen the purview of their general oversight responsibilities, the
SEC has adopted a number of governance reforms as well as adopted new rules designed
to strengthen the compliance programs of funds and their advisers and to provide for
greater oversight of compliance activities of other service providers to funds. Certain of the
governance rules and hedge fund reforms have been successfully challenged in the courts.
B. SEC reforms
The SEC has enacted a comprehensive reform package. See Table I for a listing of the rule
proposing and adopting releases and the effective dates of the rules. The SEC program
includes:
B governance provisions designed to enhance the independence and effectiveness of fund
boards;
B a new compliance rule mandating a comprehensive new compliance regime for funds,
advisers, and other service providers;
B expanded disclosure requirements as to the factors that must be considered by
independent directors in the approval of advisory contracts;
B expanded disclosure in prospectuses and shareholder reports concerning fund fees and
costs;
B provisions as to sales practice issues including a prohibition on directed brokerage and
proposed disclosure at the point of sale and in confirmations as to revenue sharing and
other costs and conflicts that arise in the distribution of fund shares; and
B provisions addressing market timing, late trading, and selective disclosure abuses and
the use of fair value pricing.
Much of the reform package has been adopted (see Table I). The governance conditions
that fund boards must be comprised of at least 75 percent independent directors and
chaired by an independent director have been vacated by the DC Circuit Court in an action
brought by the US Chamber of Commerce and in response thereto the SEC is seeking
further comment thereon (see Section B.1). The other reform proposals which have not been
adopted at the date hereof are the ‘‘hard 4:00 p.m.’’ close pricing proposal and the
point-of-sale and confirmation disclosure requirements as to revenue sharing. The SEC is
still considering reform in other areas such as soft dollars, the disclosure of portfolio
transaction costs and the financing of distribution expenses. There has been regulatory
scrutiny and enforcement activity by the SEC, the NASD and certain states as to fund sales
practices involving revenue sharing and the manner in which distributors obtain ‘‘shelf
space’’ at selling broker dealers (see Section B.4(a) hereof).
When the mutual funds scandals broke in late 2003, the fund industry was largely supportive
of the SEC’s reform efforts perhaps in part to head off the more draconian legislative reforms
that were being proposed. Now with the SEC reform program largely in place, the fund
industry has become more aggressive in asserting its views on fund reforms. At the May 10,
2005 House Subcommittee hearings, ICI President Paul Schott Stevens stated that the SEC
reforms impose substantial new costs on funds and fund advisers at a time when there are
constant calls for funds to lower their fees. He stated that he believed that funds now need
some ‘‘breathing room’’ to enable them to absorb and implement the new regulations.
Echoing the Chamber of Commerce decision, Mr Stevens emphasized the need for the SEC
to conduct more informed and rigorous analysis of the costs as well as the expected benefits
of new regulations and stated that the ICI intends to become a more active commentator on
the cost benefit aspects of SEC rulemaking. Mr Stevens stated that the regulators should
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Table I
Principal rule or rules Proposed (P) Effective date (E)
adopted or amended Adopted (A) Compliance Date (C)
1 Fund Governance Standards Rule 0.1(a)(7) P IC-26323 (1/15/04) E 9/7/04

A IC-26985 (6/30/05) C 1/16/06
A IC-26520 (7/23/04)
2 Compliance Rules Rule 38a-1 P IC-25925 (2/5/03) E 2/3/04
A IC-26299 (12/3/03) C 10/5/04
3 Disclosure as to approval of P IC-26350 (2/4/04) E 10/5/04
advisory contracts A IC-26486 (6/23/04) C 3/15/05a
4 Enhanced point of sale P IC-26341 (1/29/04)
disclosure on revenue sharing, P IC-26782 (3/3/05)
directed brokerage and
differential compensation
5 Enhanced shareholder reports: P IC-25870 (12/18/02) E 5/10/04
disclosure as to costs, portfolio A IC-26372 (2/11/04) C 7/9/04a
investments and performance
6 Enhanced prospectus P IC-26298 (12/17/03) E 7/23/04
disclosure regarding A IC-26464 (5/26/04) C 9/1/04a
breakpoints
7 Enhanced prospectus P IC-26383 (3/11/04) E 10/1/04
disclosure regarding portfolio A IC-26533 (8/18/04) C 2/28/05a
managers
8 Rule 12b-1 amendment to ban Rule 12b-1(h) P IC-26356 (2/11/04) E 10/14/04
directed brokerage A IC-26591 (8/18/04) C 12/13/04
9 Disclosure provisions P IC-26287 (12/3/03) E 5/28/04
addressing market timing, late A IC-26418 (4/13/04) C 12/5/04a
trading, and selective
disclosure
10 Hard 4 p.m. pricing Rule 22(c)1 P IC-26288 (12/3/03) E
A N/A C
11 Voluntary 2 percent redemption Rule 22c-2 P IC-26375A (3/11/04) E 5/23/05
fee A IC-26782 (3/3/05) C 10/16/06
12 Investment Adviser Code of IA Rule 204A-1 P IA-2209 (1/7/04) E 8/31/04
Ethics A IA-2256 (5/26/04) C 1/7/05
13 Concept release on measures to IC-26313 (12/18/03)
improve disclosure of
transaction costs
Note: aGenerally for filings made after this date
consider the implications of the burgeoning number of regulations that uniquely impact
mutual funds that could have the effect of making mutual funds less competitive, less
innovative, and less attractive to talented investment firms and professionals. In this regard,
Stevens singled out the disclosure requirements for portfolio managers and the proposed
point-of-sale disclosure requirements, both of which he asserted may have unintended
consequences. Going forward, Mr Stevens urged the SEC to focus on the following three
issues in particular:
1. the need for better coordination among the different SEC divisions and offices that deal
with mutual fund issues;
2. better coordination of, and other improvements to, the inspection process, including a
reconsideration of the SEC Office of Compliance, Inspection and Examinations’ (OCIE’s)
extensive use of ‘‘sweep’’ exams and steps to ensure that de facto rulemaking is not
occurring through the inspection process; and
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3. improvements in the handling of exemptive applications to eliminate the lengthy and
unnecessary delays that characterize the current process.
Industry observers are also questioning whether the new rules mire independent directors in
a sea of details pertaining to mundane and routine approvals best handled by management
resulting in a shift of focus away from the directors’ core duties such as monitoring conflicts
of interest (see Testimony of Barry P. Barbash at the May 10, 2005 House Subcommittee
Hearing).
1. Governance reforms
On July 23, 2004, the SEC adopted the following governance measures proposed on
January 14, 2004. See IC-26323 (proposing release) and IC-26520 (adopting release).
B the chairman of a fund’s board of directors must be an independent director;
B the minimum percentage of independent directors must be increased from a majority to
75 percent;
B the board must conduct a self-assessment at least annually;
B the independent directors have the authority to retain staff and experts as they deem
necessary to help them carry out their duties; and
B independent directors must hold separate meetings without the presence of fund
management at least once quarterly.
These governance standards amend the set of governance standards adopted in 2001
which apply to funds that have adopted certain widely used SEC exemptive rules (see
IC-24816). As a practical matter, the SEC governance standards apply to most funds
because few funds could operate without having the ability to rely upon one or more of the
exemptive rules.
The US Chamber of Commerce has challenged the independent chairman and the 75
percent independent director conditions. On April 7, 2006, the Court issued an opinion
holding that the SEC violated the Administrative Procedure Act[1] by failing to seek comment
on the data used to estimate the costs of the two conditions. The Court vacated the two
conditions but withheld its mandate for 90 days to afford the SEC an opportunity to reopen
the record for comment. On June 13, 2006, in IC-27395, the SEC requested further comment
on the two conditions. The comment period ends on August 21, 2006.
2. Compliance reforms
Rule 38a-1. On December 3, 2003, the SEC adopted a compliance rule for funds and
advisers first proposed on February 5, 2003 (Rule 38a-1 under the 1940 Act; and Rule
206(4)-7 under the Advisers Act). See IC-25925 (proposing release) and IC-26299
(adopting release). The rules became effective on October 5, 2004. The rules require funds
and advisers to:
B have written compliance policies and procedures reasonably designed to prevent
violation of the federal securities laws;
B review those policies and procedures annually for their adequacy and the effectiveness of
their implementation; and
B designate a chief compliance officer (‘‘CCO’’) who must report to the fund board of
directors and be responsible for keeping the board apprised of significant compliance
events at the fund and its service providers (investment adviser, sub-advisers, distributor,
administrator, and transfer agent of the fund) and for advising the board of needed
changes in the fund’s compliance program.
Fund complexes have flexibility as to whether the compliance policies and procedures of the
service providers are those adopted by the fund or, in the alternative, are the service
providers’ own policies and procedures. In the latter case, the separate policies and
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procedures must be approved by the fund’s board, acting through the CCO, and the board
must have oversight responsibilities with respect thereto.
The rule does not enumerate specific elements that must be included in the compliance
policies and procedures. In the adopting release, the SEC states that the fund and the
adviser should identify conflicts and other compliance factors that create risk exposure in
light of their particular operations and design policies and procedures that address these
risks. The SEC does recommend certain focus areas at the adviser level including portfolio
management processes; trading practices; personal trading; accuracy of disclosures;
safeguarding of assets; recordkeeping; and advertising. At the fund level, in addition to the
foregoing focus areas, the SEC recommends the following focus areas: fund and portfolio
pricing; purchase and redemption processing; identification of affiliated persons; fund
governance; market timing disclosure compliance; and oversight of service providers’
compliance. The compliance program will also encompass the numerous areas in which the
SEC has mandated that policies and procedures be adopted to prevent violations. The
compliance program must also contain policies and procedures related to the fund’s
obligation under certain circumstances to fair value pricing of securities (see Section B.5(a)).
Crucial role of the chief compliance officer. The CCO may be employed either by the fund or
by fund management. In an effort to deal with conflicts of interest and assure independence
of a CCO employed by fund management, the directors would have to approve the hiring,
compensation and firing of the CCO. The CCO reports directly to the fund’s board and must
annually furnish a written report to the board on the operation of the fund’s policies and
procedures and those of its service providers. The report must address, at a minimum:
B the operation of the policies and procedures of the fund and each service provider since
the last report;
B any material changes to the policies and procedures since the last report;
B any recommendations for material changes to the policies and procedures as a result of
an annual review; and
B any material compliance matters since the date of the last report.
The term ‘‘material compliance matter’’ refers to those compliance matters about which the
fund’s board reasonably needs to know in order to oversee fund compliance.
OCIE is making a major effort to monitor the compliance policies and procedures adopted
pursuant to Rule 38a-1. The compliance inspections seek to evaluate the adequacy of the
policies and procedures and the effectiveness of the compliance program. OCIE has
indicated that it seeks to assess the compliance culture in an organization by determining
how seriously the organization takes compliance. In this regard, OCIE looks at such factors
as involvement of senior management (the ‘‘tone at the top’’), cooperative attitudes and
compliance department funding. The staff has stated that they expect that the fund’s
compliance staff will utilize forensic testing to determine if the compliance programs are
working (such as analyzing share turnover to detect market timing). OCIE has been seeking
to provide guidance to CCOs in the development of their compliance programs and is
considering fostering best practices through periodic meetings with CCOs, newsletters for
CCOs and identifying red flags for CCOs.
Oversight of service providers. The CCO oversees the fund’s service providers with separate
compliance programs, which will have their own compliance officers. The SEC adopting
release provides guidance as to how the CCO should relate to the service providers stating
that the CCO should be familiar with each service provider’s operations and understand
those aspects of their operations that expose the fund to compliance risks. The SEC states
that in reviewing the policies and procedures of an unaffiliated service provider that provides
similar services to a large number of funds, the CCO may rely on a third-party report that
meets certain requirements. The CCO should maintain an active working relationship with
each service provider’s compliance personnel. Arrangements with the service provider
should provide the CCO with direct access to such personnel and should provide the CCO
with periodic reports and special reports in the event of compliance problems. In addition,
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the fund’s contracts with its service providers might also require service providers to certify
periodically that they are in compliance with applicable federal securities laws, or could
provide for third-party audits to evaluate the effectiveness of the service provider’s
compliance controls.
3. SEC expanded disclosure regarding fund expenses and costs

(a) Approval of Advisory Contracts. On June 23, 2004, the SEC adopted a rule designed to
improve disclosures that funds make in their shareholder reports about how their boards
evaluate and approve investment advisory arrangements and the fees to be paid
thereunder. See IC-26350 (proposing release) and IC- 26486 (adopting release). The rule
requires a fund to provide disclosure, in reasonable detail, to its shareholders regarding the
material factors and the board’s conclusions with respect to those factors that formed the
basis for the board’s approval of advisory contracts.
The rule cited the concerns raised by industry critics about the adequacy of review of
advisory arrangements by fund boards including the allegations in the 2001 Freeman Brown
Study[2] (often cited by Spitzer) that ‘‘advisory fees charged by investment advisers for
equity pension funds are substantially lower than advisory fees charged by investment
advisers for equity mutual funds because advisory fees for pension funds are negotiated
through arm’s-length bargaining.’’[3] The SEC stated that the new rule will encourage ‘‘fair
and reasonable’’ fund fees through increased transparency, which will encourage fund
boards ‘‘to engage in vigorous and independent oversight of advisory contracts.’’
The rule provides that the fund’s discussion should include factors relating to both the
board’s selection of the investment adviser, and its approval of the advisory fee and any
other amounts to be paid under the advisory contract. The fund is required to include a
discussion as to specific factors, and how the board evaluated each factor including, but not
limited to, the following:
B the nature, extent, and quality of the services to be provided by the investment adviser;
B the investment performance of the fund and the investment adviser;
B the costs of the services to be provided and the profits to be realized by the investment
adviser and its affiliates from the relationship with the fund;
B the extent to which economies of scale would be realized as the fund grows; and
B whether fee levels reflect these economies of scale for the benefit of fund investors.
The fund’s discussion must indicate whether the board relied upon comparisons of the
services to be rendered and the amounts to be paid under the advisory contract with those
under other investment advisory contracts, such as contracts of the same and other
investment advisers with other registered investment companies or of other types of clients
(e.g. pension funds and other institutional investors). If the board relied on such
comparisons, the discussion would be required to describe the comparisons that were
relied on and how they assisted the board in concluding that the contract should be
approved. The rule became effective in the spring of 2005.
Over the long term, these disclosures could prove to be one of the most significant reforms
implemented by the SEC in response to the mutual fund scandals. These provisions will
likely provide downward pressures on advisory fees over time. Furthermore, the substantive
disclosures to be required with respect to the conclusions reached in the decision making
process may be highly susceptible of being second guessed by the SEC and state
regulatory agencies in enforcement proceedings and by fund shareholders in private
Section 36(b) excessive fee class actions.
One of the concerns expressed in early 2003 by industry critics was that the advisory fees
paid by funds were too high. Since such time there have been a number of fee reductions,
but the reductions have not been industry wide. Most of the fee reductions have involved
those funds which settled with Spitzer for market timing violations (see Section 8(a)). There
have been some fee reductions by index funds. Other fund groups which have experienced
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large cash inflows such as the American Funds have reduced fees. There have been other
groups such as Morgan Stanley, Van Kampen, American Express and ING that have made
fee reductions for various reasons. The fee reductions come in several forms. Often the
reduction consists of the addition of a new breakpoint (which will result in a lower effective
fee if the breakpoint is ‘‘in the money’’) or a fee waiver rather than a reduction in the actual
rate. Under the new disclosure rule, there will be greater fund-by-fund scrutiny and there
may be fee reductions for funds that have the combination of higher-than-average fees and
poor performance. Finally, it is difficult to predict what will result from the new wave of Section
36(b) excessive fee suits involving equity funds. The only excessive fee case to be resolved
to date (the American Century case) was dismissed.
(b) Enhanced fund disclosure as to costs, portfolio investments, and performance. On
February 11, 2004, the SEC adopted rules, proposed on December 18, 2002, intended to
improve the periodic disclosure that funds provide to shareholders regarding costs, portfolio
investments, and performance (see IC-25870 (proposing release) and IC-26372 (adopting
release)). The new disclosure requirements include:
B Enhanced expense disclosure. Open-end funds must disclose in their shareholder
reports fund expenses borne by shareholders during the reporting period. The disclosure
must include the cost in dollars associated with a $1,000 investment based on the fund’s
actual expenses for the period (a measure intended to permit investors to estimate the
actual costs they bore) and the fund’s actual expense ratio for the period and an assumed
annual return of 5 percent (a measure intended to provide investors with a basis for
comparing the level of current period expenses of different funds). The expense
disclosure will also be required to include the fund’s expense ratio and the account values
as of the end of the period for an initial investment of $1,000.
B Quarterly disclosure of fund portfolio holdings. Open-end and closed-end funds must file
their complete portfolio holdings schedule with the SEC.
B Summary portfolio schedule. An open-end fund may include a summary portfolio
schedule (including the fund’s largest holdings) in its semi-annual reports to shareholders
in lieu of the complete schedule, provided that the complete schedule is filed with the SEC
and is provided to shareholders on request.
B Presentation of portfolio holdings. Shareholders reports must include a tabular or graphic
presentation of an open-end fund’s portfolio holdings by identifiable categories (e.g.
industry sector, geographic region, credit quality, or maturity) to concisely illustrate the
allocation of investments across asset classes.
B Management’s discussion of fund performance. Mutual funds must include the MDFP in
their annual reports to shareholders.
The new requirements apply to shareholder reports and quarterly portfolio disclosure for
reporting periods ending on or after July 9, 2004.
Other SEC proposals designed to improve transparency concerning fees and charges are
as follows:
B fund advertisements to highlight the availability and importance of fee and expense
information found in the prospectus; and
B enhanced disclosure on breakpoint discounts on front-end sales loads.
The SEC has also published a concept release seeking comment regarding improving
disclosure of transaction costs (see IC-26313). This matter is still under review.
(c) Soft dollars. Consideration of soft dollars is a high priority for the SEC and the NASD.
Questions regarding the use of soft dollars have led legislators, regulators, and fund industry
participants to consider whether changes should be made to current soft dollar practices
and the Section 28(e) safe harbor. In this context, on July 18, 2006, in 34-54165 the SEC
adopted interpretative guidance as to the scope of the soft dollar safe harbor. At the same
time, the SEC solicited further comments on client commission arrangements under Section
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28(e). The soft dollar interpretive guidance was proposed on October 19, 2005 in 34-52635.
This guidance narrows the SEC’s previous interpretation of the scope of eligible brokerage
and research services, proposing that permissible research be restricted to advice,
analyses and reports that have intellectual and informational content and not include items
with tangible characteristics and operational overhead expenses, such as computer
hardware or the salaries of research staff. Eligible products or services must provide the
adviser with lawful and appropriate assistance in making investment decisions. The SEC is
considering proposing requirements for disclosure and recordkeeping of soft dollar
commission arrangements.
On November 11, 2004, the NASD’s Mutual Fund Task Force issued a Report on Soft Dollars
and Portfolio Transaction costs. In the Report, the Task Force unanimously agreed that the
safe harbor set forth in Section 28(e) should be preserved, concluding that investors are
best served if research of all types, including both proprietary and third-party research,
continues to be widely available to all investment managers. It further concluded that soft
dollar practices may be especially beneficial to the clients of smaller investment advisers,
which can afford neither a large internal research staff nor extensive hard dollar payments for
research. The Task Force recognized that the advantages of soft dollar practices must be
balanced against the need to address the potential conflicts of interest and disclosure
issues involved. Based on consideration of these issues, the Task Force recommended that
the SEC should:
B narrow its interpretation of the scope of research services for purposes of the safe harbor
set forth in Section 28(e) to better tailor the safe harbor to the types of services that
principally benefit clients rather than the adviser;
B ensure that a fund board obtains appropriate information regarding a fund adviser’s
brokerage allocation practices, including soft dollar products and services received;
B mandate enhanced disclosure in fund prospectuses to foster better investor awareness
of soft dollar practices;
B consider soft dollar issues raised by other managed advisory accounts;
B apply disclosure requirements to all types of commissions;
B explicitly require that advisers provide certain information concerning portfolio
transaction costs to fund boards; and
B require enhanced disclosure to fund shareholders about portfolio transaction costs.
(d) Disclosure regarding portfolio managers. On August 18, 2004, the SEC adopted a series
of disclosure rules (proposed on March 11, 2004), designed to address areas of concern
identified with respect to the information funds provide about their portfolio managers (see
IC-26383 (proposing release) and IC-26533 (adopting release)). The rules are designed to
achieve increased information about fund portfolio managers, including their identity,
incentives, potential conflicts of interest, other accounts they manage, compensation
structure, and ownership of securities in accounts they manage. Particular concerns have
been expressed as to the potential conflicts of interest to which a portfolio manager may be
subject as a result of managing a fund and other portfolios – particularly a hedge fund.
In his Congressional testimony on May 10, 2005, ICI President Stevens pointed out that the
additional portfolio manager disclosure applies uniquely to portfolio managers of mutual
funds and that the ICI hears from its members that some of their most skilled portfolio
managers have expressed a preference not to manage mutual funds because of the new
disclosure requirements.
4. Reforms with respect to share distribution practices

(a) Revenue sharing. Over the past decade, broker-dealers and other financial
intermediaries have increasingly sought compensation from fund advisers and
distributors for selling fund shares in addition to the compensation received from the
funds in sales loads and Rule 12b-1 fees. Such payments are generally referred to as
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‘‘revenue sharing’’ payments. Revenue sharing payments can cover a wide range of
distribution or administrative services and are generally made by the adviser or distributor
out of their own resources. Revenue sharing had also been made through fund directed
brokerage arrangements, but this has been banned under Rule 12b-1(h)(l) as of December
14, 2004. One form of revenue sharing is so-called ‘‘shelf space’’ payments to
broker-dealers to create incentives for the broker-dealer and its sales representatives to
sell the fund’s shares. Revenue sharing payments generally are not a fund expense from an
accounting standpoint.
Revenue sharing arrangements (including shelf space payments) have been a
well-established practice for a number of years and the revenue sharing practices have
been well-known to the SEC, NASD and other regulators. In an amicus brief filed in the
Second Circuit in a case in 2000 as to how the 1934 Act Rule 10b-10 disclosure obligations
apply to mutual funds, the SEC recognized that no precise standard existed as to how much
disclosure was required as to revenue sharing and undertook to determine if new Rule
10b-10 disclosure standards should be adopted (see Press v. Quick & Reilly, Inc., 218 F 3rd
121 (2d Cir 2000). The SEC brief stated: ‘‘We are not saying that this is necessarily all the
disclosure about these types of fees that should be required as a matter of policy.’’ The brief
noted that, ‘‘We have directed the staff to make recommendations to us about whether to
require new disclosure or to refine the existing disclosures (see IC-26341 (January 29, 2004)
p. 10). It was not until January, 2004 that the SEC made recommendations for new
disclosures in point-of-sale and confirmation documents (see IC-26341, January 29, 2004).
In the meantime, the SEC, the NASD, and state regulatory agencies had all engaged in
enforcement activity in this area.
While not illegal per se, revenue sharing raises a number of legal issues. The SEC has
recently amended Rule 12b-1 to prohibit the use of fund directed brokerage to finance
distribution (see Section B.4(b)). The primary legal issues raised by revenue sharing
payments are whether the payments should be made pursuant to Rule 12b-1 plans and
whether the revenue sharing practices create a potential conflict of interest that requires
disclosure by the fund and/or the broker-dealer. One concern about payments for shelf
space is that a broker-dealer may tend to recommend one fund over another solely because
the broker-dealer and its brokers have a greater incentive to sell that fund not necessarily
with the interests of the investor in mind. The same incentive exists when there is differential
compensation to brokers creating an incentive to sell one fund (or one class) over another.
The Rule 12b-1 issue is whether the revenue sharing payments are paid out of legitimate
profits from the adviser’s contract with the fund or whether they constitute an indirect use of
the fund’s assets to finance the distribution of its shares and therefore must be made
pursuant to the requirements of Rule 12b-1. The SEC states that the directors, particularly
the independent directors, are primarily responsible for determining whether
revenue-sharing payments constitute an indirect use of the fund’s assets for distribution.
In the past three years, the SEC, NASD, and certain states have brought a number of
enforcement actions against fund groups and broker-dealers for failure to make appropriate
disclosure to investors of conflicts of interest arising from shelf-space payments. In certain of
the actions, the SEC found that the adviser had failed to adequately disclose the revenue
sharing arrangements and the conflicts created thereby to the fund’s board (see Section
B.8(a)). Industry observers have been critical of these enforcement actions as constituting
‘‘regulation by enforcement’’ because the SEC had recognized in its amicus brief in the
Press case that there were no precise disclosure standards in this regard and had
announced that it had this matter under review. These observers note that the promulgation
of disclosure standards would have been better accomplished through the regulatory
process of the SEC and NASD than through the enforcement process. For a number of
years, many funds have made disclosures in their prospectuses or SAI’s about their adviser
or distributor’s revenue-sharing payments to broker-dealers. The nature of the disclosures
has varied considerably with much of the disclosure being quite general. In response to the
enforcement actions, fund groups have begun to expand their disclosures of revenue
sharing arrangements. The expanded disclosures include such information as description of
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the shelf space services being purchased, the amounts paid for such services, the
broker-dealers quid pro quo obligations under the arrangements, and disclosures as to the
conflicts of interest resulting from the revenue sharing arrangements. Disclosures are also
being considered about any differential compensation made to brokers. There has also
been a focus on the adequacy of broker-dealer disclosure of revenue sharing practices[4].
Fund advisers are also increasingly discussing and seeking approval of revenue sharing
arrangements with their fund boards. The SEC has proposed new disclosure requirements
to require broker-dealers to provide their customers targeted information regarding
distribution costs and conflicts of interest at both the point of sale and in confirmations (see
Section B.4(c)).
In its second phase report issued on April 4, 2005, the NASD’s Mutual Fund Task Force
concluded that many of the developments in distribution payments since the adoption of
Rule 12b-1 in 1980 have benefited investors by allowing them to choose to pay distribution
costs up-front, over time, or when fund shares are redeemed. On the other hand, it
concluded that the extent of the costs and the incentives that they may create may be
obscure to retail investors. The Task Force recommended that the SEC should require that a
broker-dealer make available to investors, at the point of sale, a short, easy-to-understand
document that describes the salient features of a fund, including revenue sharing and
differential compensation arrangements (the ‘‘Profile Plus’’). The broker-dealer would be
required to provide the Profile Plus on its web site with ready access to additional, more
detailed disclosure through hyperlinks to the fund prospectus and a dealer disclosure
statement concerning revenue sharing and differential compensation arrangements.
(b) Rule 12b-1 Amendment to prohibit directed brokerage. On August 18, 2004, the SEC
adopted an amendment to Rule 12b-1, proposed on February 11, 2004, which prohibits the
use of directed brokerage to finance distribution (see IC-26356 (proposing release) and
IC-26591 (adopting release)). The SEC stated that the intense competition among advisers
to secure ‘‘shelf space’’ creates powerful incentives for fund advisers to direct brokerage
based on distribution considerations rather than best execution considerations creating
conflicts of interest that are unmanageable. Accordingly, rather than attempting to manage
the conflict through disclosure as is the case with revenue sharing cash payments made by
the adviser, Rule 12b-1(h)(1)
B prohibits funds from compensating a broker-dealer for promoting or selling fund shares
by directing brokerage transactions to that broker;
B prohibits ‘‘step-out’’ arrangements (where a broker executing a trade may ‘‘step out’’ a
portion of the commission to pay the broker who distributes the fund’s shares) and similar
arrangements designed to compensate selling brokers for selling fund shares; and
B requires any fund (or its adviser) that directs any portfolio securities transactions to a
selling broker-dealer to implement policies and procedures (approved by the fund’s
board) designed to ensure that its selection of brokers to effect transactions is not
influenced by considerations regarding the sale of fund shares.
The fund’s board of directors, including a majority of its independent directors, must approve
the policies and procedures.
From the broker-dealers’ perspective, directed brokerage activities are subject to NASD
Rule 2830(k), the so-called anti-reciprocal rule. Effective February 14, 2005, Rule 2830(k)
was amended to prohibit directed brokerage for fund distribution purposes. See NASD
Notice to Members 05-04 (January 2005).
The SEC, the NASD, and certain states have been bringing enforcement proceedings
involving directed brokerage activities (see Section B.8(a)). Actions brought against certain
fund groups and broker-dealers by California Attorney General Lockyer have been
challenged on the grounds that the state is infringing on SEC powers to regulate funds’
disclosure of shelf-space arrangements.
In the proposing release, the SEC also sought comment on other aspects of Rule 12b-1. One
of these issues is the current practice of using Rule 12b-1 fees as a substitute for a sales
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load. The SEC requested comment on an alternative approach to Rule 12b-1 that would
require distribution-related costs to be deducted directly from shareholder accounts rather
than from fund assets. This proposal met with strong industry opposition and seems to have
been discarded. Finally, the SEC sought comment on whether Rule 12b-1 continues to serve
the purpose for which it was originally intended and whether it should be repealed. It is not
expected that any fundamental changes in Rule 12b-1 will be proposed until 2006 at the
earliest (see ABA Section of Business Law Comment Letter dated May 14, 2004 on
IC-26356).
(c) Proposed new disclosure requirements and increased focus on revenue sharing,
directed brokerage, and differential compensation. On January 29, 2004, the SEC proposed
new disclosure requirements under the 1934 Act to require broker-dealers to provide their
customers with targeted information at both the point of sale and in transaction confirmations
regarding distribution costs and conflicts of interest (see IC-26341). Also proposed are
amendments to Form N-1A requiring mutual funds to make additional disclosure as to sales
loads and revenue sharing. These rules would require brokers to make specific disclosure in
the written confirmation about:
B front-end and deferred sales fees and other distribution-related costs that directly impact
the returns earned on mutual fund shares;
B revenue-sharing arrangements and directed brokerage arrangements; and
B whether their salespersons receive extra compensation for selling certain fund shares or
fund share classes (i.e. differential compensation).
Because the confirmation disclosures are not made until after the transaction has been
effected, the point-of-sale disclosure would enable investors to receive transaction-specific
distribution information prior to entering into transactions. The point of sale disclosure would
consist of quantified information regarding distribution-related costs, along with qualitative
information about revenue sharing, directed brokerage and differential compensation.
Under certain circumstances, the point of sale disclosure may be made orally.
On March 1, 2005, the SEC announced it had reopened the comment period for, and
requested supplemental comments on, the proposal (see 1C-26778).
(d) Enhanced breakpoint disclosure. On May 26, 2004, the SEC adopted disclosure rules
(proposed on December 17, 2003) that require mutual funds to make enhanced disclosure
regarding breakpoint discounts on front-end sales loads. The rules resulted from
widespread failure of many broker-dealers to properly apply breakpoint discounts (see
IC-26298 (proposing release) and IC-26464 (adopting release)). The amendments require a
mutual fund to describe briefly in its prospectus:
B any arrangements that result in breakpoints in sales loads, including a summary of
shareholder eligibility requirements;
B the methods used to value accounts in order to determine whether a shareholder has met
sales load breakpoints;
B that in order to obtain a breakpoint discount, it may be necessary for a shareholder to
provide information and records, such as account statements, to a mutual fund or
financial intermediary; and
B that the fund makes available on its website information regarding its sales loads and
breakpoints.
5. Reforms addressing market timing, selective disclosure abuses and fair value pricing
(a) Enhanced disclosure provisions. On April 13, 2004, the SEC adopted disclosure
provisions (proposed on December 3, 2003) with respect to market timing, selective
disclosure and fair value pricing (see IC-26287 (proposing release) and IC-26418 (adopting
release)). The disclosure provisions are described below.
(i) Market timing. The fund’s prospectus must describe the risks, if any, that frequent
purchases and redemptions of fund shares may present for other shareholders of the fund.
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The SEC states that ‘‘these risks may include, among other things, dilution in the value of
fund shares held by long-term shareholders, interference with the efficient management of
the fund’s portfolio, and increased brokerage and administrative costs.’’ The prospectus
must also state whether the fund’s board has adopted policies and procedures with respect
to market timing. If the board has not adopted any such policies and procedures, the
prospectus would be required to include a statement of the specific basis for the view of the
board that it is appropriate for the fund not to have such policies and procedures. On the
other hand, if the board has adopted such policies and procedures, the fund’s prospectus
must include a detailed description of those policies and procedures addressing an
extensive number of factors. Among the factors, there must be a description of procedures
designed to restrict market timing and the extent to which these restrictions have not been
imposed. There also must be a description of any arrangements with any person to permit
market timing.
(ii) Selective disclosure. The disclosure amendments require mutual funds to disclose in the
prospectus their policies and procedures with respect to the disclosure of their portfolio
securities and any ongoing arrangements to make available information about their portfolio
securities. The SEC staff has stated that the selective disclosure of portfolio holdings
provisions have proved difficult to interpret particularly as they relate to disclosure of
derivative information about the portfolio. The SEC is considering providing interpretive
guidance as to the rule.
(iii) Fair value pricing. The SEC states in IC-26418 that funds have an obligation under certain
circumstances to fair value price their securities. The disclosure provisions require mutual
funds to explain in their prospectuses both the circumstances under which they will use fair
value pricing and the effects of using fair value pricing. The SEC staff has indicated that it is
considering issuing an interpretive release addressing fair value pricing issues such as
pricing methodologies and when fair pricing should be used. The SEC’s adopting release for
the compliance program requirement (IC-26299) states that a fund’s compliance policies
and procedures must include procedures that require funds to:
B monitor for circumstances that necessitate the use of fair value prices;
B establish criteria for determining when market quotes are no longer reliable for a
particular portfolio security; and
B provide methodologies by which the fund determines the current fair value of its
securities.
The release states that whether the criteria for when fair value pricing must be used is an
area that deserves close scrutiny by fund directors.
(b) Proposed ‘‘Hard 4 p.m.’’ close. To combat late trading, on December 11, 2003, the SEC
proposed to amend Rule 22c-1 to provide that all share orders be received by:
B the fund itself;
B the fund’s designated transfer agent; or
B a clearing agency registered with the SEC (e.g. NSCC’s Fund/SERV system) by 4 p.m. to
be effective that day (see IC-26288).
This requirement is referred to as a ‘‘hard 4 p.m.’’ close. Many intermediaries have
complained that the hard 4 p.m. close proposal discriminates against them and are
suggesting alternatives. The GAO has issued a report suggesting modifications. See
GAO-04-799. One alternative is a ‘‘smart 4 p.m.’’ close that would provide exceptions to the
‘‘hard 4 p.m.’’ close for orders arriving through intermediaries that contain specified
verifications that the order was received before 4 p.m. The staff is also considering making
an exception for orders that can be tracked through the system and monitored and audited.
The proposal is still under consideration.
(c) Proposed 2 percent redemption fee. On February 25, 2004, to further combat market
timing, the SEC proposed a new Rule 22c-2, which would impose a 2 percent redemption
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fee on fund shares redeemed within five days of their purchase (see IC-26375A). The
proceeds would go to the fund. The SEC characterized the fee as a ‘‘user fee’’ to reimburse
the fund for the cost of market timing. The fee would be imposed on a FIFO basis, have a de
minimus exception for redemptions of $2,500 or less and have an exception for
emergencies. The rule would require that funds obtain the information from intermediaries
necessary to assess the fee and oversee the efforts of intermediaries to assess the fees and
remit the proceeds to the fund. The proposed rule would give the fund and financial
intermediaries three methods of assuring that the appropriate redemption fees are imposed.
The rule does not apply to money market funds, exchange traded funds, and funds that
expressly permit market timing.
On March 11, 2005, in IC-26782, the SEC adopted a revised Rule 22c-2, which requires fund
boards to consider whether to impose a redemption fee (considering certain specific factors)
and to either impose a redemption fee not to exceed 2 percent on shares redeemed within a
period no less than seven days or determine that a redemption fee is not necessary or
appropriate. The revised rule was not submitted for further comment. The rule requires the fund
(or its distributor), regardless of whether redemption fees are imposed to enter into written
agreements with financial intermediaries maintaining omnibus accounts to provide the funds
with access to information about shareholder transactions to allow them ‘‘to better enforce their
market timing policies.’’ On February 28, 2006, in IC-27255, the SEC proposed amendments to
Rule 22c-2 intended to address cost and operational concerns raised in comment letters when
the rule was adopted. The compliance date for the rule is October 16, 2006.
6. Other reform initiatives

(a) Investment Adviser Code of Ethics. On May 26, 2004, the SEC adopted a rule, proposed
on January 20, 2004, that requires registered investment advisers to have a code of ethics
(see IA-2209 (proposing release) and IA-2256 (adopting release)). The code must:
B set forth standards of business conduct expected of the adviser’s supervised persons;
B require supervised persons to comply with applicable federal securities laws;
B restrict access to material, non-public information about the adviser’s securities
recommendations and client securities holdings and transactions; and
B require limited reporting of personal securities transactions and holdings (including
holdings of mutual fund shares) by access persons, and mandatory pre-clearance of
investments in IPOs or limited offerings.
(b) Required Advisers Act Registration for Hedge Fund Advisers. On October 26, 2004, by a
3-2 vote, the SEC adopted new Rule 203(b)(3)-2 under the Advisers Act that would require
most hedge fund advisers to register with the SEC under the Advisers Act (see 1A-2266
(proposing release) and IA-2333 (adopting release)). The rule requires an adviser to ‘‘private
funds,’’ as defined, to look through the fund and count the number of investors (rather than
the fund) when determining whether the adviser is eligible for the fewer-than-15 client
exemption from registration. The definition of private funds is not intended to apply to private
equity and venture capital funds.
The SEC states that registration under the Advisers Act permits the Commission to collect
basic information about hedge funds and their advisers, conduct examinations of hedge
fund advisers to identify compliance problems and deter questionable practices, require
hedge funds to implement compliance controls and codes of ethics, maintain books and
records in accordance with the Advisers Act rules, and improve disclosures to hedge fund
investors. The SEC noted that up to 50 percent of all hedge fund advisers are currently
registered under the Advisers Act.
The new rule became effective on February 10, 2005 and, as to compliance dates, advisers
were required to register under the new rule by February 1, 2006. On June 23, 2006, the United
States Court of Appeals for the District of Columbia Circuit in Goldstein v. Securities and
Exchange Commission, No. 04-1434, 2006 (D.C. Cir. June 23, 2006) vacated Rule 203(b)(3)-2
on the grounds that the SEC did not have the authority to make a rule requiring hedge funds to
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registered with the Commission. In testimony before the Senate Banking Committee on July 25,
2006, Chairman Cox stated that the SEC will not appeal the Goldstein decision but he indicated
that legislation may be needed to address the risks inherent in hedge funds. On August 10,
2006, the Division of Investment Management issued an interpretive letter expressing its views
on a number of questions arising as a result of the Goldstein decision.
7. Mutual fund enhanced surveillance and inspection program

(a) Development of inspection program. The SEC has revised the manner in which it conducts
surveillance of the mutual fund industry, seeking to put greater emphasis on identifying
problems before they occur. The SEC has formed an Office of Risk Assessment designed to
enable the agency to anticipate, identify, and manage emerging risks across divisional
boundaries even if no clear wrongdoing is yet evident. The SEC has created a number of
multi-divisional task forces including a permanent task force on mutual fund surveillance (the
‘‘Task Force’’). The Task Force is headed by the director of the Office of Risk Assessment and
includes representatives from OCIE, the Division of Investment Management, the Office of the
General Counsel, the Office of Economic Analysis, and the Office of Information Technology. In
this regard, the SEC is conferring with other regulators including bank regulators and their
counterparts in other countries. The Task Force is studying the fund reporting regime and
rethinking the adequacy of the frequency and information contained in current fund filings.
Other changes intended to strengthen overall examination oversight include increased use of
computer technology to facilitate review of large volumes of data, especially in such critical
areas as portfolio trading and best execution. The SEC budget increases have allowed the
SEC to increase its staff for fund examinations significantly.
(b) Types of OCIE examinations. OCIE Associate Director Gohlke has described OCIE’s new
inspection approach stating that OCIE currently employs the following different types of
examinations:
(i) Risk-targeted mini sweep examinations. These are targeted sweep or ‘‘mini sweep’’
examinations of a group of fund complexes looking at specific issues seeking information
about problems or seeking information as to industry practices. The sweeps may involve
only a few or a large number of firms. The sweeps may be conducted by SEC regional
offices. Mini sweeps have been conducted in a broad range of areas including:
B market timing and late trading;
B soft dollars;
B valuation and pricing (including fair value pricing);
B revenue sharing and directed brokerage;
B portfolio trading and best execution;
B ETFs (including fund investments in ETFs);
B personal trading (including front running);
B Rule 12b-1 fees;
B administrative fees (concerning whether they are being used properly for the services for
which they are supposed to cover and not marketing and distribution costs which should
be made under Rule 12b-1 plans or out of the advisory fees);
B anti-money laundering and suspicious activity reports;
B retention of affiliated service providers (especially transfer agents and administrators);
B index fund expenses;
B 401(k) plans;
B variable annuities;
B calculation of performance fees;
B securities lending;
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B Section 529 plans;
B conflicts involved in advising both hedge funds and mutual funds;
B money fund pricing and expense levels;
B proxy voting; and
B the pursuit of class action rights.
Often the mini sweep results from matters raised in the press.
(ii) Cause inspections. These are inspections of a fund or fund group based on a specific
problem that has come to light.
(iii) Routine full examinations of higher risk profiles. These examinations involve advisers
perceived to have weak control systems, advisers with a high disciplinary pattern or
significant conflicts of interest and newly registered advisers. Advisers in this category can
expect a full examination every two or three years.
(iv) Routine full examinations of ‘‘everyone else’’. These examinations are made of an ever
increasing number of advisers. OCIE no longer tries to conduct a full scope examination of
every firm within a specified period. Increasingly, OCIE hopes to utilize forensic testing to
assist in these examinations.
OCIE is considering assigning designated examiners to the larger fund groups. This would
provide greater continuity of oversight and better quality of two-way communications. The
designated examiner would develop a relationship with the CCO with the objective of having
‘‘no surprises’’. In the most recent GAO audit of the SEC, the GAO cautions that having OCIE
teams permanently assigned to mutual fund groups risks conflicts of interest unless
post-employment restrictions have been established because OCIE examiners typically
seek employment with mutual fund compliance offices upon leaving the SEC staff.
OCIE is increasingly focusing on the preservation of e-mails. Inspectors are routinely
seeking e-mails in their examinations, often demanding their production in a short period of
time that poses problems for the fund groups. Failure to keep or promptly produce internal
e-mails can result in an inspection deficiency or even an enforcement proceeding. On June
15, 2005, Banc of America Investment Services and an affiliate settled an administrative
proceeding with the SEC for a $1 million fine for books and records violations related to the
failure to retain e-mails (see IA-2396 (June 15, 2005)). This settlement was the first which
relates only to e-mail violations and which is not ancillary to other violations.
OCIE is increasing its focus on the role of independent directors looking for deficiencies on
the part of directors in exercising their duties. For instance, the independent directors
receive reports under such rules as Rule 10f-3 and Rule 12b-1 and receive reports under
many of the compliance policies and procedures. OCIE states that it is looking to see what
the directors do with such reports. OCIE is also looking at the Section 15(c) process and how
boards approve the advisory arrangements. The staff has indicated that it expects the
minutes of board meetings to provide information as to what the boards considered. If the
information is too skimpy the examiners may want to discuss this matter with the
independent directors. OCIE may send deficiency letters to the board asking for a response
and may seek to meet with the boards. OCIE will also focus on the relationship of the CCO
with the board.
8. Enforcement activities
(a) Enforcement actions. Through 2005, fund group settlements with respect to market
timing and late trading charges have resulted in fines, restitution payments and fee
reductions exceeding $3 billion. Among those settling are Alliance, Amvescap
(AIM/Invesco), Bank of America, CIBC, Fleet Boston, Janus, MFS, Strong, Bank One,
Pilgrim Baxter, PIMCO, Putnam RS Investments and Fremont.
Table II shows information on certain of the more prominent market timing actions through
2005.
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Table II Information on certain of the more prominent market timing actions through 2005
Defendant Date of settlement Regulator Damagesa
Alliance 12/18/03 SEC/NY $250 million

$350 million (fees)
AIM/Invesco 9/7/04 SEC/NY $375 million
$75 million (fees)
Bank of America/Fleet Boston 3/15/05 SEC/NY $515 million
$160 million (fees)
Bank One 6/29/04 SEC/NY $50 million
$40 million (fees)
CIBC 7/20/05 SEC/NY $125 million
Franklin 8/2/04 SEC/CA/MA $73 million
Janus 4/27/04 SEC/NY/CO $106 million
$125 million (fees)
MFS 2/5/04 SEC/NY/NH $225 million
$125 million (fees)
Pilgrim Baxter 6/21/04 SEC/NY $90 million
$10 million (fees)
PIMCO 9/13/04 SEC $50 million
Putnam 4/8/04 SEC/NY/MA $110 million
$5 million (fees)
RS Investments 10/6/04 SEC/NY $25 million
Strong 5/20/04 SEC/NY $140 million
$35 million (fees)
Individuals
Richard S. Strong 5/20/04 SEC/NY/WI $60 million
Harold Baxter/Gary Phillips 11/17/04 SEC/NY $160 million
Note: a The references to fees denotes Spitzer-induced agreed upon advisory fee reductions to take
place over a five year period
Regulators continue to investigate and bring actions as to whether potential conflicts of

interest stemming from revenue sharing, directed brokerage and differential compensation
were properly disclosed by the fund groups and broker-dealer participants (see Section
B.4(a)). The actions have been brought principally by the SEC, NASD, and the California
Attorney General Lockyer. Table III shows certain of the actions brought through 2005.
Other enforcement actions by the SEC or NASD have involved the following:
B actions against broker-dealers for unsuitable sales of fund shares largely involving the
recommendation of Class B-shares under circumstances where the purchase of Class
A-shares would have resulted in lower sales charges; and
B actions against broker-dealers for failure to provide the sales load breakpoints for larger
purchases.
Table III Actions brought through 2005

Defendant Date of settlement Regulator Damages
Morgan Stanley 11/17/03 SEC $50 million

MFS 3/31/04 SEC $50 million
PIMCO 9/16/04 SEC/Lockyer $11.6 million – SEC
$9 million – Lockyer
Franklin 11/17/04 Lockyer $18 million
Franklin 12/13/04 SEC $20 million
Edward R. Jones 12/22/04 SEC, NASD, NYSE $75 million
Quick & Reilly 2/22/05 NASD $570,000
Piper Jaffray 2/22/05 NASD $275,000
Putnam 4/23/05 SEC $40 million
Citigroup 4/23/05 SEC $20 million
Capital Analysts 4/23/95 SEC $450,000
Notes: The actions have been settled except as noted
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(b) Remedial sanctions in settlement orders. The remedial sanctions in the SEC settlements
in the market timing and in the directed brokerage cases are set forth in the public
administrative orders setting forth the terms and conditions of the settlements. For example,
see the Order with respect to the settlement involving Janus Capital Management LLC
(IC-26532 – August 18, 2004). The undertakings by the defendants (typically the fund
managers) contained in these orders are quite detailed and set forth substantive highly
prescriptive policies and practices which go well beyond the measures in the reform
package rules adopted by the SEC. The orders issued by the state authorities also contain
remedial sanctions but they are not made as publicly available as the SEC orders. Some
speculate that certain of the undertakings could become industry standards. It is also
speculated that some of the outstanding private civil suits may be settled by having the fund
group manager agree to adopt a package of remedial undertakings.
The undertakings in the SEC settlements contain provisions such as the following:
1. Governance provisions:
B the independent directors (including the independent chairman) may not include
persons who were directors, officers, or employees of the manager at any point within
the preceding ten years;
B the independent directors must be represented by ‘‘independent legal counsel’’ as
defined in Rule 0.1(a)(6);
B no action will be taken by the board or by any committee thereof unless such action is
approved by a majority of the independent members of the board or of such
committee, as the case may be. In the event that any action proposed to be taken by
and approved by a vote of a majority of the independent directors of a fund is not
approved by the board, the fund will disclose such proposal and the related board
vote in its shareholder report for such period;
B if any one or more fund directors vote against a proposal, disclosure of the
circumstances must be disclosed in the fund shareholder report for the period in which
the dissent occurred; and
B the funds are required to have shareholder meetings to elect directors at least every
five years.
2. Compliance provisions:
B The manager must maintain a ‘‘Compliance and ethics oversight structure’’, as
specified in the order, including a requirement for a full-time senior level officer
responsible for compliance matters relating to conflicts of interest and a corporate
ombudsman.
B The manager must retain an ‘‘Independent Compliance Consultant’’ not unacceptable
to the staff of the SEC and a majority of the independent directors to review the
compliance regime including a review of its market timing controls. The Consultant
must perform a number of highly prescriptive duties. For the period of the engagement
and for two years thereafter, the Consultant cannot enter into a business or
professional relationship with the manager.
B A compliance review must be conducted by an independent third party at least once
every year.
B The manager must maintain a ‘‘Code of Ethics Oversight Committee’’ having
responsibility for all matters relating to issues arising under the adviser code of ethics
(the ‘‘Code’’). The committee must be comprised of senior executives and must hold at
least quarterly meetings to review violations of the Code, to consider policy matters
relating to the Code of Ethics and shall report on issues arising under the Code,
including all violations thereof, to the audit committee of the funds.
B In the order settling SEC charges with respect to directed brokerage arrangements of
MFS, MFS agreed that at least once every year for at least five years, it will provide the
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fund boards with a best execution analysis performed by a recognized independent
portfolio trading analytical firm (see IC-26409).
3. Distribution of settlement monies – the manager must retain the services of an
‘‘Independent Distribution Consultant’’ not unacceptable to the staff of the SEC and a
majority of the independent directors who shall be charged with developing a distribution
plan for the distribution of the monies ordered to be paid in the settlement. The
undertakings contain a number of specific provisions as to what must be contained in the
distribution plans and have independence standards for the Consultant similar to those
contained in the Compliance Consultant undertakings.
4. Cooperation with the SEC – the manager shall cooperate fully with the SEC in any and all
investigations, litigations, or other proceedings relating to or arising from the matters
described in the order. In this connection, the manager specifically undertakes to
produce documents without a notice or subpoena and use its best efforts to obtain the
cooperation of employees. In certain of the orders, the manager agrees not to assert the
attorney-client privilege in the proceedings.
5. Certification – the chief executive officer of the manager must certify to the SEC no later
than 24 months after the date of entry of the settlement order that there has been
compliance with the undertakings set forth in the order.
(c) The Bank of America Market Timing Settlement. On September 3, 2003, the Nations
Funds group sponsored by BOA was one of the four fund groups named in New York
Attorney General Spitzer’s Canary Capital settlement. On March 15, 2004, the SEC and
Spitzer announced a $375 million settlement against Bank of America Capital Management
(‘‘BACAP’’), BACAP Distributors and Bank of America Securities (‘‘BAS’’) for entering into
improper and undisclosed market timing arrangements with a number of Nations Funds
mutual funds and for fraudulently facilitating market timing and late trading in Nations Funds
and other unaffiliated mutual funds. The agreement provided for payments of $250 million in
restitution and $125 million in penalties. At the same time, Fleet’s Columbia mutual fund
adviser and distributor agreed with the SEC and Spitzer to pay $140 million to settle market
timing charges. In a separate agreement with Spitzer’s office, BACAP and the Columbia
adviser collectively agreed to reduce the advisory fees they charge the funds they manage
by $160 million over a five-year period. BOA and Fleet subsequently merged on April 1,
2004.
Of particular significance, the Spitzer press release announcing the BACAP settlement on
March 15, 2004 stated that eight members of the board of trustees of Nations Funds would
resign or otherwise leave the board within one year for their role in approving a measure that
enabled Canary Capital to conduct company-sanctioned market timing of the Nations
Funds. The SEC press release stated that BACAP had agreed to implement certain election
and retirement procedures that will result in the replacement of the trustees within one year
but did not specify any reason therefore. According to the Spitzer release, in May 2002, the
Nations Funds boards approved a 2 percent redemption fee on sales of certain international
funds held for less than 90 days to discourage market timing. At the same time the release
stated that the trustees agreed to exempt Canary Capital from the redemption fee. Canary
Capital subsequently conducted extensive timing of two of the funds in question.
It was reported in the press at the time that the Nations Funds trustees had not been
consulted with respect to the settlements with Spitzer or to their being replaced. One of the
independent trustees was quoted in the Boston Globe as saying that the trustees did not
authorize or sanction market timing arrangements with Canary Capital. Rather the board had
been told by BACAP that the trading exemption related to an existing contract with an
unnamed shareholder intended to limit market timing not allow it. In response, the SEC staff
indicated that the Nations Funds settlement was only proposed and had not been finalized.
The BACAP agreement to replace independent trustees has been heavily criticized by the
fund industry, particularly independent directors, as weakening the authority of independent
directors. On April 22, 2004, the Mutual Fund Directors Forum (‘‘MFDF’’) sent a letter to
Chairman Donaldson criticizing the proposed BACAP settlement for ‘‘having the potential to
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undermine director independence by reversing the relationship between fund and
independent directors and the adviser, thereby turning the Investment Company Act on
its head.’’ The letter expressed the concern that the SEC press release seems to indicate a
view that BOA, as the adviser to the Nations Funds, has the capacity to effect changes in the
composition of the Funds’ boards of directors. The letter was signed by former SEC
Chairman David Ruder.
The MFDF also sent a letter dated May 6, 2004 to Attorney General Spitzer. Referring to its
letter to the SEC, the MFDF stated that, ‘‘We have a similar concern, with all due respect, that
your Office’s press release of March 15 seems to take the same view (as the SEC press
release). We understand, appreciate and share your commitment to strengthening the role
of independent directors in fund governance, and we hope that your Office’s future actions
with respect to any instances of misfeasance in the fund industry will reinforce rather than
tend to undermine this principle.’’
On February 9, 2005, the settled enforcement action against BACAP and related parties was
announced by the SEC and set forth in an administrative order (the ‘‘Order’’) (see IC-26756,
February 9, 2005). In the Order, seven of the nine Nations Funds independent trustees were
replaced and three new trustees nominated for election bringing the size of the board to five
independent trustees. The implementation thereof has been recharacterized to be voluntary
on the part of the funds and the trustees, and not the work of the adviser. The two trustees not
being replaced were reportedly not at the meeting in which the redemption fee was
imposed. Retaining these two trustees also enabled them to nominate the three new
trustees. The financial terms of the settlement have not been changed.
C. Private civil suits brought against fund companies

The mutual fund scandals have resulted in hundreds of private civil lawsuits brought by fund
shareholders against fund groups involved in the fund scandals generally alleging either
breach of fiduciary duty or disclosure deficiencies in connection with their market timing
and/or late trading activities. The suits have been filed in federal and states courts and styled
either as derivative actions or class action suits. The suits seek damages and/or rescission of
the advisory contracts, including the return of advisory fees. There have also been a number
of private class action civil actions against fund groups and broker-dealers alleging
disclosure deficiencies related to revenue sharing. Lastly, there have been a number of
Section 36(b) excessive fee suits filed against equity funds by a new group of plaintiffs
lawyers, many based upon the Freeman-Brown rationale. See Section B.3 for information as
to the American Century excessive fee suit in which the judge did not allow the plaintiffs to
introduce evidence as to non-fund accounts.
On February 20, 2004, the Judicial Panel on Multidistrict Litigation grouped a large number
of the mutual fund cases into a single MDL (MDL-1586) and transferred the cases to the
United States District Court for the District of Maryland. The Court has consolidated and
coordinated class action and derivative action suits relating to 18 fund families (AMCAP,
Excelsior, Federated, Scudder, Alliance, Franklin-Templeton, Bank of America/Nations
Funds, PIMCO, Pilgrim Baxter, Alger, Columbia, Janus, MFS, Bank One Group, Putnam,
AIM/INVESCO, Strong, and T. Rowe Price) into sub-MDL’s for each family for pre-trial
purposes. In the Order, the Court assigned the sub-MDL’s to four different judges and
appointed a lead plaintiff and lead class counsel for the class actions in each sub-MDL and
appointed a lead fund derivative counsel for the derivative actions in each sub-MDL. The
MDL web site for In re Mutual Fund Investment Litigation is part of the MDL-MD web site.
In responding to motions brought in the Janus funds subtract, on September 6, 2005, Judge
Motz dismissed claims against the independent directors of the funds. On the grounds that
there were no allegations by plaintiffs that the directors knew that widespread late trading
and market timing activities were occurring within the Janus funds, Judge Motz stated that
there is no evidence of the existence of ‘‘red flags’’ evidencing wrongdoing in the funds for
which they were responsible. Generalized wrongdoing in the industry of which those
corporations were a part was not enough. Judge Motz further stated, ‘‘Perhaps with the
benefit of hindsight it may be said that the fund trustees were asleep at the switch and should
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have been more vigilant in detecting late trading and market timing activities occurring
within the Janus funds. However, at most their failure to do so constituted negligence, not the
intentional conduct, recklessness, or, at the least, gross negligence, required to hold them
liable for their inactions.’’
In what could be quite a significant development in these cases, Judge Motz observed that
plaintiffs deserve no restitution in these civil actions if the defendants can demonstrate that
the amounts paid in the state and federal settlements cover the damages incurred. Janus
had reached a $226 million settlement with the regulators in 2004. The independent
distribution consultant overseeing the settlement determined that Janus investors lost about
$22 million as a result of the abusive trading. This matter was not definitively determined
because the issue was not before the court.
D. Legislative proposals
In early 2003, the House Subcommittee on Capital Markets, Insurance and
Government-Sponsored Enterprises held hearings on mutual fund practices largely
related to the topics of performance, mutual fund fees and cost disclosure issues, sales
practices, and governance. On June 11, 2003, H.R. 2420 (the ‘‘Mutual Fund Integrity and
Fee Transparency Act of 2003’’) was introduced in the House. Among other things, H.R.
2420 would require the SEC to require disclosure of a number of items and require the
adviser to submit an annual report to the directors on revenue sharing, directed brokerage
and soft dollars (a fiduciary duty would be imposed on fund directors to supervise these
arrangements). H.R. 2420 would also require brokers to disclose information about
differential compensation and conflicts of interest associated with the broker’s sale of a
particular fund, along with information about commissions that may be charged based on
the class of shares the investor has purchased.
By mid-summer, efforts to pass H.R. 2420 had stalled and the House Subcommittee was
directing its efforts to having the SEC deal with the matters addressed by H.R. 2420 through
rulemaking. After the market timing and late trading scandal broke in early September,
Congress renewed its efforts at mutual fund reform.
The House passed a beefed up version of H.R. 2420 on November 19, 2003 by a vote of
418-2. The following five bills were introduced in the Senate in the 108th Congress:
B S.1822, the ‘‘Mutual Fund Transparency Act of 2003,’’ introduced on November 5, 2003
by Senator Daniel K. Akaka (D-HI);
B S.1971, the ‘‘Mutual Fund Investor Confidence Restoration Act,’’ introduced on November
25, 2003 by Senators Jon Corzine (D-NJ) and Christopher Dodd (D-CT);
B S.1958, the ‘‘Mutual Fund Investor Protection Act,’’ introduced on November 29, 2003 by
Senators John Kerry (D-MA) and Edward Kennedy (D-MA);
B S.2059, the ‘‘Mutual Fund Reform Act of 2004,’’ introduced on February 10, 2004 by
Senators Peter Fitzgerald (R-IL), Carl Levin (D-MI), and Susan Collins (R-ME);
B S.2497, the ‘‘Small Investor Protection Act of 2004,’’ introduced on June 3, 2004 by
Senator Joe Lieberman (D-CT).
The following bill has been introduced in the 109th Congress:
B S.1037, the ‘‘Mutual Fund Transparency Act of 2005,’’ introduced on May 16, 2005 by
Senator Daniel Akaka (D-HA).
With the SEC having enacted a comprehensive reform package, Congress appears to be
taking a wait-and-see approach on legislation. It may take a new fund scandal for legislation
to be seriously considered again.
Set forth below is a description of certain of the legislative proposals in the bills that have
been introduced which go beyond the provisions contained in the SEC reform package.
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H.R. 2420 Proposed Director Certifications
To mandate director involvement in operational areas, H.R. 2420 would require that the
independent directors of open-end funds certify in the company’s disclosure documents
that the fund has, and is in compliance with, the following compliance procedures:
B verify that the determination of the fund’s current NAV complies with the 1940 Act;
B oversee the flow of funds into and out of the funds;
B ensure that investors are receiving any applicable sales charge breakpoint discounts;
B ensure that if the fund has multiple classes, they are designed in the interests of investors
and could reasonably be an appropriate investment option for an investor;
B ensure that information about the fund’s portfolio securities is not disclosed in violation of
the securities laws or the fund’s code of ethics;
B ensure the independent directors have reviewed and approved the compensation of the
fund’s portfolio manager;
B ensure the fund has established and enforces a code of ethics in accordance with the
requirements in H.R. 2420; and
B ensure the fund is in compliance with provisions relating to adoption and implementation
of compliance policies and procedures.
The Corzine-Dodd bill (S.1971) introduced in the Senate includes similar provisions but
imposes the certification requirements only on the independent chairman of the board.
The certification requirements in the Sarbanes-Oxley Act are imposed on senior officers of
the company within their supervisory responsibilities. The certification requirements for
directors have been widely criticized as being beyond the actual knowledge of the
independent directors and confusing the oversight responsibilities of directors with the
operating responsibilities of management.
Provisions related to approval of advisory arrangements

The pending legislation in the House and Senate addresses the approval of advisory
arrangements in varying ways. In particular, note S. 1958 (the Kerry-Kennedy bill) which
would require the SEC to adopt regulations to require that the Board have a fiduciary duty
. . . to demonstrate that the negotiated advisory, management, marketing, and investment service
fees are reasonable and are in the best interests of their shareholders. This may be accomplished
by obtaining multiple bids, an independent evaluation or appraisal, including a provision in all fee
contracts preventing contractors from charging rates in excess of those paid by other clients, and
any other means practicable to ensure that shareholders are not overcharged for any services
provided to the registered investment company.
H.R. 2420 would amend Section 15 of the 1940 Act to require fund management to annually
provide the fund’s board of directors with a report on:
B revenue sharing arrangements;
B directed brokerage arrangements; and
B soft dollar arrangements.
It would impose a fiduciary responsibility on fund directors to review these arrangements
and to determine that the direction of fund brokerage is in the best interests of fund
shareholders and that revenue sharing arrangements are consistent with the 1940 Act and in
the best interests of fund shareholders. The SEC would be given rulemaking authority to
implement these requirements. The implementing regulations would have to require that
annual reports to shareholders contain a summary of the management reports submitted to
fund directors under this provision.
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Mutual Fund Oversight Board
Some industry observers and S. 1958 (the Kerry/Kennedy bill) propose the creation of a
Mutual Fund Oversight Board, a self-regulatory organization, with:
B inspection, examination, and enforcement authority over mutual fund boards;
B funding from assessments against fund assets;
B members selected by the SEC; and
B rulemaking authority.
The rationale for the Board is that the SEC’s staff has too many responsibilities and not
enough resources to provide adequate oversight of funds.
E. Other
1. Role of the NASD

The NASD has been very active in the sales practice area. On August 7, 2003, the NASD
proposed for comment a rule (proposed Rule 2830) that would expand broker disclosure to
customers on revenue sharing and broker compensation arrangements. See Notice to
Members 03-54. If sales representatives receive different rates of compensation for selling
different investment company products, disclosure must be made at the point of sale of the
nature of these arrangements, as well as the names of the investment companies favored by
these arrangements. The NASD is conducting widespread investigations of member firms
as to ‘‘breakpoint’’ overcharges, Class B suitability issues and improper fund trades, and
bringing enforcement proceedings with respect thereto. The NASD has also proposed that
fund distributors be required to disclose certain expense information in fund advertisements
and sales materials.
The SEC asked the NASD to head an Omnibus Account Task Force to study issues raised by
the widespread use of omnibus accounts by intermediaries. The ICI estimates that 85
percent to 90 percent of fund purchases are made through intermediaries. Typically
intermediaries use omnibus accounts to maintain the investors’ holdings and do not provide
the fund’s transfer agent with information as to the individual shareholders and their
transactions. This lack of transparency greatly facilitated the fund trading and sales practice
violations. On January 30, 2004, the Task Force issued a Report dated January 30, 2004
setting forth conditions as to which there was general consensus among Task Force
members. These conditions included that:
B the fee should be assessed at the recordkeeper level (usually the intermediary); and
B mutual funds or their designated transfer agent should have access to information on
investor trading activities to, at a minimum, audit whether intermediaries are applying the
rules properly.
The NASD has created a Mutual Fund Task Force to consider how to bring greater
transparency to fund costs and expenses and consider reform in the area of mutual fund
distribution arrangements. On November 11, 2004, the Task Force issued a ‘‘phase one’’
report on soft dollars and portfolio transaction costs (see Section B.3(c)). On April 4, 2005,
the Task Force issued a ‘‘phase two’’ report with respect to distribution arrangements,
including Rule 12b-1 fees and revenue sharing (see Section B.4(a)).
2. Role of the New York Attorney, General Spitzer

New York Attorney General Eliot Spitzer has listed the following six steps (that he stated were
by no means exhaustive) that would be necessary to achieve necessary reforms for the fund
industry:
1. require funds to demonstrate that they have negotiated advisory fees in the best interest
of the shareholders (which can be done by obtaining multiple bids, an independent
evaluation, or by some other means);
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2. require funds to obtain a ‘‘most-favored nation’s’’ clause in their advisory contracts that
will prevent advisers from charging funds fees in excess of those paid by pension funds;
3. require funds to have an independent board chairman who would have the authority to
receive any and all information from the advisory company;
4. require directors to be truly independent of the adviser;
5. require funds to provide their directors with staff and data necessary to ensure that
shareholder interests are being protected (this may require moving the compliance
function from the adviser to the funds themselves); and
6. require funds to provide a uniform, complete and categorized disclosure of advisory fees,
marketing services, and trading costs.
Spitzer says the reforms can be achieved in a variety of ways: through legislation in
Congress, regulation by the SEC or other regulatory bodies, or by the terms of a settlement
of current and future investigations.
3. Development of best practices

Industry-related groups increasingly have been developing ‘‘best practices’’ guides for fund
directors. The first well-known guide is the ICI-sponsored corporate governance ‘‘best
practices’’ report. Developed by an advisory group of fund directors, the report identifies a
variety of practices beyond those required by law that investment company boards and
independent directors may consider adopting. The ICI report was first issued in 1999 and
has been updated periodically. In July 2004, the Mutual Fund Directors Forum published a
‘‘best practices’’ report providing practical guidance regarding board review of
management arrangements and other fund-related matters. The IDC has published
several reports on such topics as soft dollars, the independent chair requirement, and board
self-assessments. The Section of Business Law of the American Bar Association has
published a Fund Director’s Guidebook, the Third Edition of which was published on April 1,
2006. Other groups, such as Investment Adviser Association (‘‘IAA’’) (formerly the
Investment Counsel Association of America (‘‘ICAA’’)) and the CFA Institute (formerly the
Association of Investment Management and Rsearch (‘‘AIMR’’)), also have issued policy
statements that serve as guidance for directors.
4. Measures being promoted by institutional investors

On November 17, 2003, the North Carolina State Treasurer told nine fund companies that
they must adopt a package of reforms to continue to manage the $58.5 billion in retirement
assets of the State. On January 15, 2004, the State Treasurers of North Carolina, New York,
and California announced proposed Mutual Fund Protection Principles which they said will
be a significant factor in determining whether a mutual fund will have the right to do business
with their respective states.
One of the Principles states that in arriving at the management fee schedule, ‘‘the board will
conduct a comparative analysis using other funds, including fees charged to institutional
accounts by the adviser. The mutual fund will furnish the board with an itemization of the
expenditures associated with investment advisory services, marketing and advertising,
operations and administration and general overhead, as well as the pre-tax profit. The
rationale and analysis supporting the fee schedule including the various items of expense
coverage by the fee must be set in the fund’s annual report.’’
TIAA-CREF has issued a set of principles for fund governance and practices which it states
are ‘‘a set of measures reflecting ways in which funds can put shareholders’ interests first.’’
Among the principles is a governance requirement that funds hold regular shareholder
elections of directors.
Editor’s note: Anyone desiring a copy of this document in electronic form in order to access
the links, please e-mail tsmith@sidley.com
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Notes
1. Chamber of Commerce v. Securities and Exchange Commission, 443 F.3d 890 (D.C. Cir. 2006).
2. See John P. Freeman and Stewart L. Brown, Mutual Fund Advisory Fees: ‘‘The cost of conflicts of
interest,’’ 26 Iowa Journal of Corporation Law 609 (Spring 2001).
3. In a Section 36(b) excessive fee lawsuit involving three equity funds managed by American Century,
Judge Ortrie Smith of the Western District of Missouri ruled that the plaintiffs were not allowed to
present evidence about American Century’s management of non-mutual fund accounts because
such evidence is ‘‘irrelevant’’ to the plaintiffs’ allegations.
4. In an April 2005 settlement with Capital Analysts Incorporated, a broker-dealer, CAI undertakes to
make disclosures on its web site as to the following: (i) the existence of its revenue sharing program;
(ii) the fund complexes participating in the program; (iii) the estimated amount of payment that CAI is
to receive from a fund complex in connection with the program; and (iv) the source of such
payments.
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Mutual funds under fire: reform initiatives

Thomas R. Smith Jr Abstract

1 Fund Governance Standards Rule 0.1(a)(7) P IC-26323 (1/15/04) E 9/7/04

Note: aGenerally for filings made after this date

3. SEC expanded disclosure regarding fund expenses and costs

4. Reforms with respect to share distribution practices

6. Other reform initiatives

7. Mutual fund enhanced surveillance and inspection program

Alliance 12/18/03 SEC/NY $250 million

Regulators continue to investigate and bring actions as to whether potential conflicts of

Table III Actions brought through 2005

Morgan Stanley 11/17/03 SEC $50 million

Notes: The actions have been settled except as noted

C. Private civil suits brought against fund companies

Provisions related to approval of advisory arrangements

1. Role of the NASD

2. Role of the New York Attorney, General Spitzer

3. Development of best practices

4. Measures being promoted by institutional investors

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