An Informed Approach to Issues Facing the Mutual Fund Industry

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at the Mutual Fund Directors Forum’s 2014 Policy Conference; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

As a practicing securities lawyer for more than thirty years, I have in the past advised boards of directors, including mutual fund boards, and I am well acquainted with the important work that you do. I also understand the essential role that independent directors play in ensuring good corporate governance. As fiduciaries, you play a critical role in setting the appropriate tone at the top and overseeing the funds’ business. Thus, I commend the Mutual Fund Directors Forum’s efforts in providing a platform for independent mutual fund directors to share ideas and best practices. Improving fund governance is vital to investor protection and maintaining the integrity of our financial markets.

There are a number of issues that are important to the asset management industry, including the Commission’s recently proposed reforms to money market funds and the need to move quickly to adopt rules improving disclosure in the marketing of target date retirement funds. However, today I would like to focus my remarks on the following topics:

  • First, the need to utilize the Commission’s expertise in overseeing the asset management industry, including evaluating the risks that the industry may pose to our financial markets;
  • Second, the need to review our current market structure to ensure that the trading markets operate in a manner that is both transparent and fair; and
  • Finally, the need to address the growing cyber-threat to the capital markets.

Oversight of the Mutual Fund Industry

History of the SEC’s Regulation of the Mutual Fund Industry

The investment company concept dates back to the late 1700s in Europe. Later, the emergence of the “investment pooling” concept in the 1800s in England resulted in the fund concept being brought to the United States, which helped develop our nation’s post-Civil War economy. In 1924, the first open-end mutual fund was introduced in the United States, along with the innovative ideas of the simplified capital structure, the continuous offering of shares, and the ability to redeem shares.

A few years later, the stock market crash of 1929 and the Great Depression exposed the significant risks that arose from the widespread abuse in the securities industry, in which half of the $50 billion in new securities offered during that period became worthless. As a result, investor confidence plummeted and Congress held hearings over years to determine the causes of the crash. Based on the evidence and findings gathered in those hearings, Congress created the Securities and Exchange Commission and passed a number of landmark securities laws to create market and financial product transparency and to prevent investor harm and exploitation. These laws included the Securities Act of 1933, the Securities Exchange Act of 1934, and a few years later, the Investment Advisers Act of 1940 and the Investment Company Act of 1940.

Approximately 75 years have passed since that time and the mutual fund industry—and its regulation by the SEC—has had a long and synergistic history. In particular, the Commission has served as the watchdog for the capital markets, and has worked to implement the strong regulatory framework set out by Congress for the mutual fund industry. Today, the mutual fund industry in the United States is a vibrant and well-developed component of the world’s financial sector, offering investors a wide array of investment alternatives to meet their financial planning needs, such as saving for college and retirement. In fact, the U.S. mutual fund market, by itself, is the largest in the world and accounts for 49% of the $26.8 trillion in mutual fund assets held worldwide.

The SEC’s oversight of this industry continues through, among other things, rulemaking, examinations, and enforcement.

To name just a few examples in the rulemaking space, in the last few years the Commission has adopted rules to enhance the custody practices of investment advisers, rules to prohibit pay-to-play activities in the investment advisory industry, amendments enhancing Commission oversight of certain private fund advisers, and, in 2010, the Commission significantly reformed money market funds. Moreover, as is well known, we are currently considering additional reforms to money market funds.

In addition to its rulemaking responsibilities and activities, the SEC is responsible for the examination of over 10,000 investment advisers with more than $48 trillion of assets under management, as well as more than 800 registered investment company complexes. The SEC has approximately 450 examiners, accountants, and lawyers located throughout all 12 SEC offices dedicated to examining investment advisers and investment companies.

The Commission is also devoting significant resources to financial data and research. To that end, the Commission’s Division of Economic and Risk Analysis (“DERA”) provides support on data analytics to various operating segments of the SEC, including rulemaking, enforcement, and examinations. In particular, DERA has an Office of Asset Management that is dedicated to providing analytical support on issues relating to the regulation of investment advisers, investment companies, hedge funds, and other institutional investors.

The Commission has also been active in bringing various enforcement actions. For example, over the past three years, the SEC has brought more than 430 cases relating to investment advisers and investment companies, some of which involved mutual funds and their advisers. For example:

  • In November 2013, the SEC brought fraud charges against Ambassador Capital Management, an investment advisory firm, and a portfolio manager for misleading the trustees of a money market fund, and for failing to comply with rules that limit risk in a money market fund’s portfolio.
  • In May 2013, the SEC charged several gatekeepers—the fund trustees, chief compliance officer, and fund administrator—of certain Northern Lights trusts for causing false or misleading disclosures about the factors they considered when approving or renewing investment advisory contracts.

I mention all of these aspects of the Commission’s activities in the asset management industry—rulemaking, examinations, and enforcement—to highlight the proactive role of the Commission. And, going forward, I expect the Commission to continue to focus a significant portion of its resources to overseeing investment companies and investment advisers.

FSOC and OFR’s Recent Foray into the Money Market Fund and Mutual Fund Industry

Recently, however, the Commission’s authority in the mutual fund industry—an industry in which the SEC has capably served as the primary regulator for almost 75 years—has been undercut by the activities of the Financial Stability Oversight Council (“FSOC”) and its research arm, the Treasury Department’s Office of Financial Research (“OFR”). In particular, FSOC has focused its sights on various aspects of the asset management industry. Obviously, this is an area where the SEC has a great deal of expertise.

Initially, FSOC focused on money market funds. FSOC’s attention to this issue began in 2010, shortly after FSOC was created by the Dodd-Frank Act. Specifically, FSOC called for reforms to address what it viewed as structural vulnerabilities in money market funds that left them susceptible to shareholder runs.

As this group knows, the financial crisis of 2008 put pressure on various money market funds, with the most public example being The Reserve Fund “breaking the buck” in September 2008. In response, in 2010, the Commission acted to adopt amendments to make money market funds more resilient to short-term market risks and provide greater protections for investors. In late 2011 and early 2012, the SEC began to consider further money market reforms. However, at that time, a majority of the Commission felt it was appropriate, and responsible, to study the effects of the Commission’s 2010 amendments regarding money market funds before taking additional action. Also at that time, the SEC staff informed the Commission that it could complete such a study in only five to six weeks. For reasons I have never understood, the SEC staff was not authorized to do the study until late in 2012, and the study was not made available to the Commissioners until November 30, 2012, after the announcement of the then-Chairman’s departure. However, after receiving this study, and the data it contained, the Commissioners began productive discussions that led to a set of proposals to further reform the money market fund industry. The full Commission unanimously approved these proposals on June 5, 2013. The SEC staff continues to work on this matter and, just last week, published additional data analyses relating to money market fund reform. I am hopeful that the final rules will soon come to a vote. It is important for the Commission to bring closure to this issue and I am pleased that real data is being utilized in the process.

More recently, FSOC and OFR have focused on a wider swath of the asset management industry. In particular, FSOC charged OFR with studying the activities of asset management firms in order to aid FSOC in deciding whether to subject certain aspects of the industry to enhanced prudential standards and supervision. In September 2013, OFR published what it considered a study of the asset management industry. I recommend that you read the report in its entirety; however, in sum and substance, the report concluded that asset management firms and their activities “introduce vulnerabilities that could pose, amplify, or transmit threats to financial stability.”

The report should not take you very long to read. The OFR report, which purported to analyze the risks posed by the entire multi-faceted asset management industry, is only 34 pages long, and the report virtually ignored the hedge fund industry and the private equity industry. By contrast, the SEC staff’s November 30, 2013 study, which focused only on certain aspects of money market funds, was 98 pages long.

Although neither FSOC nor the OFR chose to solicit public comment on the report, the report was posted on the SEC’s website and public comments were solicited. Subsequently, OFR’s report received near universal criticism from academics, investor advocates, lawmakers, asset management firms, industry groups, and others. The criticisms generally referred to the report’s quality, research, and analysis. For example, according to commenters:

  • First, the report has significant factual and analytical defects that rendered it unreliable as a basis for making policy determinations.
  • Second, the report failed to draw a clear line between asset managers and the funds they manage. As one commenter noted, this line is important because mutual funds are organized separate and apart from their investment advisers and other funds in the same complex. As another commenter pointed out, asset managers act as agents for their clients, whose assets are held by custodians and not by the asset manager and asset management firms do not present systemic risk at the company level.
  • Finally, according to a bipartisan group of Senators in their joint letter to the U.S. Department of the Treasury, “[t]he OFR Study mischaracterizes the asset management industry and the risks asset managers pose, makes speculative assertions with little or no empirical evidence, and in some places, predicates claims on misused or faulty information.”

The concerns voiced by commenters and lawmakers raise serious questions as to whether OFR’s report provides an adequate basis for FSOC to designate asset managers as systemically important under the Dodd-Frank Act, and whether OFR is up to the tasks called for by its statutory mandate. As one commenter observed, OFR has been “expected to set the gold standard for independent, rigorous, unimpeachable, and sophisticated analysis of the financial system.” The criticism of the report has caused some observers to question OFR’s rigor for analysis, as well as its objectivity. As one commenter observed, “the numerous flaws in the [OFR] Report indicate that the writers of the Report may not have fully taken advantage of the SEC’s comprehensive understanding and knowledge of the asset management industry.” This view is consistent with what I have heard at the SEC.

Unfortunately, the Commission, as a body, does not have input or influence into what FSOC or OFR says or does. Only the SEC’s Chair or her designee participates in FSOC meetings. None of the Commissioners attends FSOC meetings, nor are we invited. Additionally, SEC staff may be working quite closely with staff of other FSOC member agencies and OFR staff on the SIFI designations, but the Commissioners are not involved in this process. Rather, we generally receive a quick 5-10 minute oral description of the FSOC agenda the day before a meeting, as well as a high-level, after-the-fact description of what occurred at the FSOC meetings, and only once every few months. Thus, my fellow Commissioners and I have very little control or input over the content and output of projects undertaken by FSOC, as well as the behavior, inputs, and conclusions supplied by others from the SEC working with FSOC and OFR.

The Need to Use the Commission’s Expertise in Regulating the Mutual Fund Industry

However, rather than continuing to discuss the merits of the research and analysis—or lack thereof—in OFR’s report, I would simply note that there needs to be a mechanism by which the full Commission, not just the Chair and SEC staff, provide meaningful input and coordinate with the leadership of FSOC and OFR. The Dodd-Frank Act envisions such coordination; for instance, the Dodd-Frank Act contemplates that federal agencies, including the Commission, would assist OFR on its work upon request. I do not think that assistance should be limited to one representative of the Commission, or limited to the SEC’s staff. Clearly, the expertise and judgment that the securities laws imbues in the presidentially appointed, Senate-confirmed Commissioners is undercut when there is an end-run around the Commissioners tasked with running the SEC.

Let me be clear, the work of FSOC and OFR to identify and mitigate systemic risk is important. However, there is real danger in that work being compromised if the full five-member Commission is cut out of the process. The SEC and our fellow regulators should assist FSOC’s efforts in a thorough and objective manner. My interest is in making sure that the full expertise and judgment of the Commission—and all the Commissioners—is being utilized, and that our authority and expertise are not being undercut. For the protection of our economy, financial regulators across the U.S. federal government have to work together to address risks and threats to the stability of our financial markets.

Before leaving the subject of the OFR report, I note that just last Friday, the Department of the Treasury announced that FSOC will hold a conference in May on the asset management industry and its activities. While I welcome the effort to better understand the asset management industry, this does not address the issues arising from the criticisms of the OFR report’s quality, research, and analysis, or the issues that arise when the SEC’s decision makers are excluded from the process. FSOC and OFR should acknowledge the Commission’s—and, in particular, the Commissioners’—role as the primary regulator of the asset management industry.

Reviewing Market Structure to Maintain Transparency and Fairness

I would like to spend a few minutes discussing mutual funds and the ongoing debate about equity market structure. Unfortunately, as many of you know, there is a growing perception that the trading markets do not appropriately serve the interests of all investors. As a result, many investors and investor advocates have expressed serious concerns about the way that the trading markets are operating. For example, some have raised concerns that the trading markets may not treat all investors fairly, and that they have become too fragmented, too fast, and too complex.

One aspect of the current market structure debate that has garnered significant interest from the mutual fund industry and others is the trading fee structure known colloquially as “maker-taker,” which has become the standard pricing model for stock exchanges and other trading venues. The maker-taker model was first used by electronic communication networks in the 1990s as a way to attract more liquidity to their systems, and the large, well-established exchanges began using this model during the mid- to late-2000s. Under the maker-taker model, buyers and sellers who submit standing limit orders or quotes are paid rebates, and those who “take” that liquidity by submitting immediately executable marketable orders are charged a fee by the trading venues to which those orders are routed. In just a few years, the maker-taker model has become an entrenched part of our market structure.

Proponents of the maker-taker model argue that the system increases competition and attracts liquidity providers. In addition, they say that the maker-taker model lowers costs for investors, eases the trading of shares, provides better execution, and improves quoted prices.

However, as broader concerns about our market structure have recently come to the fore, questions about the maker-taker model have emerged from various sectors of the capital markets. Many have observed that the maker-taker model may present a conflict of interest between brokers and their customers because broker-dealers are incentivized to send customer orders to the venue that pays the best maker-taker rebate, and not necessarily the venue that provides best execution. Some have argued that in order to mitigate this conflict, broker-dealers should be required to pass the maker-taker rebates they receive to their customers. Another criticism of maker-taker is that it produces quoted spreads that do not represent actual trading costs, thereby decreasing transparency, and could potentially confuse investors about the true costs of trading. Others claim that maker-taker has contributed to a market structure in which order execution is too fragmented among exchanges, dark pools, and broker-dealers that execute orders internally, and that it has incentivized some market participants, including high-frequency traders, to trade primarily, if not solely, to profit from collecting maker-taker rebates. These concerns should also be taken seriously by the mutual fund industry, since these entities are some of the largest buyers and sellers of equities.

As I said recently, the Commission needs to consider seriously whether the current equity market structure is working for all investors. Of course, any comprehensive market structure review would require a close examination of the maker-taker model and any resulting conflicts between broker-dealers and their customers. To that end, one idea that the commenters have recommended is a pilot program in which maker-taker rebates would be temporarily prohibited for certain securities. The idea is that such a pilot program would allow the Commission and others to study the effects of the maker-taker model on order routing practices, transparency, and other metrics, and would help inform the discussion on whether the maker-taker model needs to be changed or eliminated.

I am hopeful that the Commission will take a serious look at this proposal and have requested the staff of our Division of Trading and Markets to devote time in the near term to this issue. As we continue to consider this and other questions regarding our equity trading markets, it is important that the Commission considers the views of the mutual fund industry and, in particular, their investors. After all, it is their investments that fuel our economy. Accordingly, I encourage each of you to work within your organizations to facilitate the expression of those views.

Addressing the Growing Cyber-Threat

The last topic I want to touch on today involves the increasing concerns regarding cyber-threats. There is no shortage of evidence that the constant threat of cyber-attack is real. It is here to stay and cannot be ignored. One of the most prominent examples of the wide-ranging and potentially devastating effects that can result from cyber-attacks is the December 2013 data breach of Target Corporation. In addition, cyber-attacks on financial institutions appear to have become both more frequent and more sophisticated.

Mutual funds and their advisers are not immune to the ever-present threat of cyber-attacks. One significant cyber-risk that has been mentioned is the risk of hackers gaining unauthorized access to funds’ systems and communications to steal information about funds’ investment strategies and pending transactions. This information can be used by hackers to front-run large, market-moving trades, among other things. Another risk is that third-party service providers—such as transfer agents, custodians, and administrators—will be the subject of cyber-attacks, which, though several steps removed from the fund company itself, could nevertheless cause harm to the fund and its investors.

For these and other reasons, I know cyber-security is an important area of concern to fund boards and advisers. It is a serious concern to the SEC too. Just last week, the Commission held a Roundtable to develop a better understanding of these growing risks and to facilitate discussion about the ways in which regulators and industry can work together to address them. I will also note that the SEC’s Office of Compliance and Examinations announced that cybersecurity would be an exam priority. You should expect that SEC examiners will be reviewing whether asset managers have policies and procedures in place to prevent and detect cyber-attacks and whether they are properly safeguarding their systems against security risks.

Cybersecurity is an area that will only grow in importance, and fund boards need to get out in front of the problem to help prevent and mitigate investor harm.


I will conclude my remarks where I started. I have a great deal of respect for the contributions of independent directors to good governance. Your efforts are crucial to restoring investor confidence, which is even more important as we continue to emerge from the financial crisis and face the new challenges, risks, and threats that lie ahead. After all, public trust is the foundation on which our financial markets are built.

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