(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

SEC Supports Mutual Fund Reform Bill

The SEC has expressed support for a House bill that would apply many of the reforms found in the Sarbanes-Oxley Act to mutual funds. Introduced by Rep. Richard H. Baker, chairman of the Capital Markets Subcommittee, the Mutual Funds Integrity and Fee Transparency Act, H.R.2420, would require all mutual funds to abide by the same audit committee standards required of exchange-listed companies under the Sarbanes-Oxley Act. The measure also builds on the Sarbanes-Oxley Act by furthering the independence and accountability of mutual fund directors. In general, H.R.2420 would also enhance the disclosure of mutual fund fees and costs to investors and heighten the awareness of boards about mutual fund activities.

Paul F. Roye, director of the Division of Investment Management, told the subcommittee that the bill would importantly provide fund investors with disclosures about estimated operating expenses incurred by shareholders, soft dollar arrangements, portfolio transaction costs, sales load breakpoints, directed brokerage and revenue sharing arrangements. The bill also would require disclosure of information on how fund portfolio managers are compensated.

The Commission fully supports the bill's efforts to increase the transparency of costs and other information to mutual fund investors. The improved disclosure wrought by the bill will, in Mr. Roye's view, support the current lynchpin of mutual fund cost disclosure, which is the standardized fee table the SEC has required in every fund prospectus since 1988.

The bill would require improved disclosure of the estimated amount, in dollars, of a fund's operating expenses that are paid by each shareholder. Requiring that disclosure be provided in dollars, rather than just as a percentage of net assets, explained the director, should help investors understand, in very practical terms, the impact of fund expenses to each shareholder.

SEC rules currently require a fund to provide disclosure only of the amount of the advisory fee paid to the investment adviser in the fee table in the fund's prospectus. The bill would go further and require disclosure of compensation paid to the portfolio manager hired by the adviser. According to Mr. Roye, this disclosure will allow fund shareholders to assess the incentives of the individuals who are managing the fund. For example, disclosure that a manager is compensated based on the fund's performance for a particular period, such as one year, may shed light on the manager's incentives to maximize short-term or long-term performance.

The bill would direct the SEC to require this improved disclosure in a fund's quarterly statement, periodic report to shareholders or other appropriate disclosure document. The bill would also specify that disclosures would not considered to be made in an appropriate disclosure document if made exclusively in a prospectus. Objecting to this exclusivity, Mr. Roye urged Congress not to preclude the use of any particular disclosure document, but rather preserve the Commission's flexibility to determine the appropriate disclosure document.

The bill would require investment advisers to report to fund directors on three types of common arrangements that raise significant issues in the management of an investment company. The report would cover revenue sharing arrangements, in which the adviser pays to promote the sale of fund shares. Also covered would be directed brokerage arrangements, in which the fund obtains payments or services as a result of the adviser's direction of its brokerage transactions. Finally, the report must discuss soft dollar arrangements under which the adviser obtains research services from brokers in return for the direction of fund brokerage transactions.

According to Mr. Roye, these changes acknowledge the important role that fund boards play in the supervision of fund brokerage arrangements by recognizing a federal duty to supervise the adviser's use of the fund's brokerage, and by requiring advisers to provide fund boards with information sufficient to fulfill that obligation and safeguard the interests of shareholders.

The SEC also favors provisions increasing the number of independent directors to two-thirds of the fund's board. In addition, the Act would require the board chairman to be independent. The Investment Company Act currently requires that at least 40 percent of a fund's board be independent. The bill would authorize SEC rulemaking to deem some directors as non-independent as a result of material business or close familial relationships. The senior official said that this provision will allow the SEC to close gaps in the Investment Company Act that have permitted persons to serve as independent directors who do not appear to be sufficiently independent of fund management.

As an example, he cited the fact that currently a fund manager's uncle is permitted to serve on the board as an independent director. In other cases, former executives of fund management companies have served as independent directors.

The bill would also impose on mutual funds the same audit committee requirements the Sarbanes-Oxley Act placed on listed companies. Thus, each member of the fund's audit committee would have to be independent. In addition, the audit committee would be directly responsible for the appointment, compensation, and oversight of the outside auditors. Fund audit committees would also have to establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls, or auditing matters, including procedures for the anonymous submission by employees of concerns regarding questionable accounting or auditing matters. The SEC believes that mutual funds would benefit from each of these corporate governance reforms.

Testifying on behalf of the Investment Company Institute, Paul G. Haaga, Jr. said that, while the ICI generally supports H.R.2420, it is neither necessary nor appropriate to require mutual funds to have an independent chairman of the board. In many cases, he noted, a person needs to be intimately familiar with the operations of a company in order to be an effective chairman, and a management representative is often in the best position to do this. In addition, the ICI believes that the combination of regulatory mandates and industry best practices make an independent chair unnecessary.

He also said that provisions relating to fund operating expenses seem to contemplate disclosure of expenses on an individualized basis. In this context, he noted that the SEC's report found serious problems with this approach, including significant costs and logistical complexity, lack of comparability and lack of an effective context for investors to evaluate the expenses shown.

In addition, while the Institute believes that it is appropriate for directors to review soft dollar and directed brokerage arrangements, it does not believe it appropriate for boards to review revenue sharing arrangements. These payments are not made by the fund, he emphasized, but rather by the underwriter or adviser out of its own resources to compensate financial intermediaries who sell fund shares.

While supporting the bill's enhancement of fund disclosure, the ICI expressed concern about the legislation's presupposition that prospectus disclosure is not sufficient. Noting that the prospectus is the legal document required to include all of the important information necessary to assist in the making of an investment decision, the ICI said Congress should not inadvertently discourage investors from viewing the prospectus as the most important disclosure document.

John Bogle, founder of the Vanguard Funds, praised the bill, particularly the sections calling for disclosure of the dollar amount of annual operating expenses paid by each shareholder, the increase in the number of independent directors to two-thirds of the board and the requirement that the fund chairman be independent. Mr. Bogle, however, wants the legislation to go further. For example, he urged Congress to create an express standard of fiduciary duty on the part of directors to place the interests of fund shareholders ahead of the interests of fund managers and underwriters.