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News August 16, 2004 Issue

SEC To Adopt Portfolio Manager Disclosure Rules and Directed Brokerage Ban

On August 18, the SEC plans to adopt changes to the way funds disclose information about their portfolio managers and the way they use brokerage to compensate broker-dealers for selling their shares.

As proposed, the portfolio manager rulemaking would require that open- and closed-end funds provide new SAI disclosure about:

  • other accounts managed by the fundís portfolio managers (namely, the number of accounts and total aggregate assets in other registered investment companies, non-registered funds, pooled investment vehicles, and other types of accounts managed by the fundís portfolio managers, along with information about the conflicts those other accounts present and how many of them carry performance fees);
  • the structure of, and the method used to determine, the portfolio managersí compensation structure (the actual dollar amount of the compensation would not have to be disclosed); and
  • each portfolio managerís personal securities ownership in the fund, other accounts under his management, and other accounts managed by the advisory firm or a control affiliate of the fundís adviser or principal underwriter.

If that seems like a lot to disclose, consider this: As proposed, the disclosures would apply to all members of any committee, team, or group jointly and primarily responsible for the day-to-day management of the fundís portfolio. These team members also would have to be listed individually in the fundís prospectus, as well (currently, funds just have to disclose the fact that the fund is managed by a group, without listing the membersí names). Money market funds wouldnít have to list the individuals.

Not surprisingly, commenters pushed back on the quantity and detail of the proposed disclosure. For example, several argued that research-driven funds have a lot of "team members" that would have to be disclosed. T. Rowe Price noted that it had one such fund with approximately 35 analysts. Disclosing all of their biographical information, said the fund group, "would be overkill, to say the least." It is possible that the final version of the rule will be scaled back a bit from the proposal.

In contrast, the ban on fund brokerage for distribution is largely considered a done deal. Not only does the Investment Company Institute (ICI) support the measure, the group first suggested it back in December 2003. Moreover, several large fund complexes already have abandoned the practice. The 12b-1 amendments would ban directed brokerage for distribution arrangements as well as step-outs and other indirect methods of using commission flow to reward broker-dealers for selling fund shares.

In each proposal, there are open issues. Some things to watch for in the portfolio manager disclosure adoption:

Will the SEC narrow the scope of "compensation"? Several commenters asked that the term "compensation" be defined to exclude benefits such as health and insurance coverage and 401(k) matching.

Will the SEC require disclosure of subadvisersí portfolio managersí compensation? Vanguard commented that it and similar funds "do not control how unaffiliated subadvisers compensate their portfolio manager employees and do not ordinarily have access to such information." In fact, it added, Vanguard has "never asked for nor been interested in that data." The group argued that requiring subadviser information will make it "much more burdensome, and therefore less desirable, for independent advisory firms to provide portfolio management services to mutual funds as compared to other types of accounts."

Will the SEC really require portfolio managers to disclose the personal holdings of their immediate relatives in the same household? This stems from the broad definition of "beneficial ownership," which is referenced in the proposed rule. Several commenters argued that this could effectively result in a portfolio managerís net worth being disclosed on EDGAR and could dissuade portfolio managers from managing funds. "Prospectus disclosure of the value of assets held by the portfolio manager or a member of his or her immediate family in each individual account, or disclosure of any personís net worth, would be an undue intrusion on the individualís or familyís privacy," argued Goldman Sachs.

Other commenters took issue with the general premise behind holdings disclosure. The ICAA asked the SEC to require funds to accompany personal holdings disclosure with cautionary language "discouraging investors from interpreting a portfolio managerís disclosed holdings in a fund necessarily to be indicative of his or her alignment with fund shareholders or confidence level in the fund." Vanguard argued that a managerís personal holdings "should not be considered an important indicator of how closely his interests are aligned with those of fund shareholders." The fund group noted that portfolio managers "like anyone else" invest based on a variety of factors such as age, family and financial situation.

Some issues to watch in the directed brokerage rulemaking:

Will the SEC create a brokerage safe harbor? The ICI, Securities Industry Association, and others told the SEC that unless it provides some comfort in the final adoption, funds may be dissuaded from executing portfolio trades through brokers that happen to distribute their shares, for fear of regulators second-guessing the transaction and concluding that it was really brokerage for distribution. The ICI urged the SEC to include a safe harbor in the rule. "In todayís world of integrated financial services firms, most of the major broker-dealers that funds typically use for execution services are also major distributors of fund shares," said the group. Since funds often have selling arrangements with hundreds of brokers, "it might be almost impossible for funds to avoid directing portfolio transactions to broker-dealers that sell their shares," said the ICI. "In the absence of a safe harbor, a mutual fund could run the risk of being challenged by regulators or class-action attorneys each time it directed a portfolio transaction to a major broker-dealer firm." The SIA didnít explicitly request a safe harbor, but it did ask the SEC to clarify this point in the final rule or release.

What will the SEC do with 12b-1 fees? Perhaps the most striking aspect of the SECís February 2004 proposing release was the extensive request for comment section about Rule 12b-1 generally. Industry members submitted comments generally urging the SEC not to alter the structure 12b-1 fees. At the least, they said, the agency should carefully study the issue of fund distribution before making any changes. "This egg is not merely scrambled, it has been cooked, eaten and absorbed into the very morrow of the industry," said Federated Investors. The SIA asked the SEC to convene a roundtable, similar to last yearís hedge fund roundtable, "to explore the overall mutual fund compensation structure, the services that are funded through this structure and the adequacy of the present disclosure regime." The American Bar Associationís committee on federal securities regulation also urged the SEC to hold a roundtable and conduct a comprehensive study of Rule 12b-1 practices, taking into account factors such as the history and evolution of distribution practices and "the recognition that any proposed regulatory solution could result in unintended consequences that would cause more problems than the regulations would solve."

The ICIís comments were a bit more subdued. The group noted that 12b-1 fees can serve as an alternative to front-end loads as well as an incentive for financial professionals to continue to provide services to shareholders. The ICI also took issue with criticisms that 12b-1 fees serve no purpose for closed-end funds, noting that the fees can be used to compensate intermediaries for advice previously provided to fund investors and to compensate third parties for providing ongoing administrative and shareholder services. Those services, said the group, "are not affected by the fact that a fund has stopped accepting new investors."

The ICI recommended that the SEC update its guidance to fund directors with respect to the factors that they may wish to consider in approving a 12b-1 plan. The group also asked that the ruleís quarterly reporting requirement be eliminated.

In contrast, the CFA Institute (the group formerly known as AIMR) urged the SEC to abolish 12b-1 plans, saying they have "outlived their useful purpose and do not serve the interests of long-term shareholders." If the SEC decides to keep them, added the group, it should mandate better disclosure to shareholders and require 12b-1 fees to be deducted directly from shareholder accounts.

The ICI said that direct 12b-1 fee deductions would have negative tax consequences for fund shareholders, present operational difficulties, and impose additional costs. The SIA also opposed direct deduction.