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SEC Commissioner Saw the Future of Mutual Funds

When SEC Commissioner Paul Carey passed away on Thursday at age 38 after a long bout with cancer, mutual fund shareholders lost a true unsung hero. Without much fanfare, Carey, a former legislative liaison for President Clinton and the son of former New York Gov. Hugh Carey, frequently tackled tough issues with insight and a knack for seeing what the future holds for mutual funds.

Commissioner Carey's vision and resolve made important contributions to issues ranging from Social Security private accounts to fund proxy voting.

Social Security Private Accounts

When former Chairman Levitt discussed the prospect of Social Security private accounts, he could only see the sky falling. While claiming neutrality, Levitt warned that private accounts would "provide the unscrupulous with new opportunities to deceive and distort," require "an unprecedented level of broad-scale policing of the equity markets" and permit fraud to "be perpetrated against an army of novice investors."

Commissioner Carey, although no less cognizant of the risks of private Social Security accounts, went much further by boldly confronting the possibility that private accounts would become a reality. With remarkable prescience, he analyzed the implications for mutual funds as the most likely recipients of private account investments.

Rather than hopelessly despairing over the plight of 140 million private account holders, half of whom would be new to investing, Carey recognized that the government would have to educate these investors about the relationship between risk and returns. Carey stressed, for example, the importance of improving disclosure of mutual fund fees to ensure that these investors understood the true cost of investing.

Carey observed that investment options for private accounts may need to be restricted -- by limiting switches between funds, for example -- to minimize administrative costs and the potential for sales abuses. Carey saw that the small size of initial private accounts, many under $400 in value, might necessitate creating a way station similar to the federal government's low-cost Thrift Savings Plan, in which small accounts could be invested until they were large enough to be economically feasible for existing funds.

When President Bush created the Commission to Strengthen Social Security in May, he mandated that its recommendations "include individually controlled, voluntary personal retirement accounts, which will augment the Social Security safety net."

Whether you like them or not, private Social Security accounts may lie in your future, and Commissioner Carey was way ahead of the curve in identifying the problems such accounts would present.

Independent Counsel for Fund Directors

When the SEC proposed to require that legal counsel to independent fund directors be independent of the fund's investment adviser, mutual fund lawyers led the attack on the rule.

So Commissioner Carey went to the enemy's own back yard, and, in a speech before the American Bar Association's securities law committee, squashed its self-interested objections.

It took Carey, a nonlawyer, to remind fund lawyers of the many conflicts between funds and their affiliates that fund counsel is responsible for monitoring. As discussed in my Jan. 18 article, Carey pointed out that funds and their affiliates have conflicting interests regarding, among other things, the amount of advisory fees and 12b-1 fees, the allocation of fund brokerage commissions to affiliates, the pricing of fund shares, and changes in investment policies and personnel.

While a few dozen securities lawyers squirmed in their seats, Carey rhetorically asked why investors should "wait for documented abuse before concluding that significant real or potential conflicts, with such clear impact on fund shareholders' interests, should not be left to industry 'best practices' or the vagaries of state or local bar enforcement."

Its resolve stiffened by Carey's forceful defense of fund shareholders' interests, the SEC adopted the rule in January.

Fund Performance Advertising

Nor was Carey willing to let the fund industry off the hook for performance ads that, while consistent with the letter of the law, violated basic principles of fair dealing.

At an industry conference in March, Carey took the industry to task for advertising stale performance results, cherry-picking end dates for performance periods used in ads and using broad boilerplate disclaimers to dilute important qualifying information -- such as the fact that a fund's past performance was largely attributable to an unsustainable string of hot IPO investments.

Carey threatened to raise the bar for fund ads above the technical requirements of SEC rules by applying a broad materiality standard. If ads omit information necessary to make them not misleading, Carey promised, the SEC "enforcement staff will take appropriate action."

Carey also promised that the SEC would soon release a legal bulletin clarifying the kinds of ads that may violate antifraud rules even if they comply literally with the four corners of SEC advertising rules.

When the SEC finally releases the bulletin, let's hope it reinforces Carey's requirement that technically legal fund ads, "when taken as a whole, are still not materially misleading."

Mutual Fund Proxy Voting

In what is probably his most forward-thinking contribution on mutual fund issues, Commissioner Carey argued that mutual funds must be more forthcoming about the way they vote proxies of their portfolios' securities.

A full year before the AFL-CIO formally petitioned the SEC last December to require funds to disclose their proxy voting records (as discussed in my Jan. 4 article), Carey encouraged funds to let their shareholders know how their money was being put to use through proxy votes.

Carey noted that this was not just a matter of providing useful information to investors. Disclosure also was advisable in order to highlight potential conflicts of interests, Carey asserted, as fund advisers often have "an economic interest to vote the fund's shares to please company management, even if such a vote might not be in the best interests of the fund."

Carey cited the example of fund advisers who seek to manage the pension assets of the very companies whose proxies they vote for their funds. "If the fund adviser wants the pension business of XYZ Co., or it wants to continue to manage XYZ's pension business, it might think twice before voting against the recommendation of XYZ's management -- even if voting against the recommendation could increase the value of the funds' holdings," Carey warned.

An Example for President Bush

Like his thoughts on private Social Security accounts, misleading fund ads, the proper role for fund counsel and mutual fund proxy voting, Carey was ahead of his time, identifying problems before they became daily headlines, and anticipating solutions with discerning clarity.

Carey was the only SEC commissioner whose term had not expired. Acting Chairman Laura Unger, whose term expired earlier this month, and Commissioner Isaac Hunt, whose term expired last year, are working on borrowed time.

This means Bush will have the opportunity not only to install a new SEC chairman (he plans to nominate Harvey Pitt), but also to fill the other four slots with two Republicans and two non-Republicans of his choice.

Bush hasn't made any noise about candidates for these slots, but if his nominees are half as forward-thinking about mutual funds as Commissioner Carey was, investors will be well-served.

Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group and publisher of Fund Democracy Insights, a newsletter for industry professionals.

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