SEC reforms following the Bernard Madoff investment fraud scandal

Mutual Fund Disclosure for the SEC

The Why of Regulation:

It is the general theory of economics that in the Capitalist society the government ought to follow the laissez faire policy and let market forces decide rather than compel the entities by regulations and controls. This was also applied to the stock exchanges and capital market. Thus in the earlier periods there were investors and 'mutual funds' had not been in vogue. In the U.S. during the early part of the 21st century, there was very little control of the securities and financial markets and until the stock market crash of 1929 occurred, the danger of unsupervised sales of securities, which also involved unscrupulous or incompetent issuers and other market participants, came to light. Thus the regulatory system was born. Thus the activities of institutions, brokers and dealers, and the very operation of stock exchanges and securities markets came under statutory provisions and regulations.

The 'Securities and Exchange Commission -- SEC' was created to supervise the implementation of the regulations and for mutual funds and other financial instruments and securities it is the authority, making rules and regulations. The acts that governed these activities were the 'Securities Act of 1933', and later the 'Securities Exchange Act of 1934', and from then on the stock markets have grown with the banks and institutional investors are the major participants. (Oditah, 157) It was this shift from individuals to institutions that created the growth of mutual funds, which other than in the U.S. domestic market, also resulted in cross-border transactions, and international investment. Today the securities markets all over the world are under significant regulation.

Why the SEC was peeved?

The Securities and Exchange Commission came up with reforms after the Madoff scandal. "Bernard L. Madoff was sentenced to 150 years in prison during June 29, 2009, after pleading guilty in federal district court in New York to perpetrating a massive Ponzi scheme since the early 1990s that victimized thousands of investors. Mr. Madoff pleaded guilty to 11 criminal counts including securities fraud, investment adviser fraud, and providing false documents and testimony to the Securities and Exchange Commission." (Security Exchange Commission (a)) Back in 2008 an investigation was launched which resulted in the SEC resolving that there will be rules to protect investors, One being a random examination of the working of investment advisers and subjecting them to an annual "surprise exam."

The second was in the case of "investment advisers who do not use independent firms to maintain their clients' assets. They would be subject to a third party written report assessing the safeguards that protect the clients' assets." (Security Exchange Commission (a)) Further proposals include the creation of Enforcement Directorate and better handling of customer complaints. There is also a Whistleblower Program that would reward whistleblowers on federal securities violations. Then agency-Wide Risk Assessments are in place and steps are being taken to improve fraud detection. But traveling a little back, we can realize that these occurrences are contrary to the U.S. policies which on basis of all regulatory systems in the U.S. is based on the cannon that 'the market must be kept fully informed about issuers whose securities are offered and traded.' The crash 1929 showed that investors were mostly in the dark about the financial condition and business affairs of the companies in the market. Thus the first regulations always centre on the proper disclosure system and the disclosure was made mandatory. (Oditah, 161)

However the controversies dog the investment world to this day. (Lowy, 263) says that at that time in the early 1990s there was a spate of laws that sought to regulate banks, money lending and financial institutions. These laws complicated the economy and the functioning of these entities so much that there came a time when authorities were sought to be bye passed. The American bank regulatory system, for instance became complicated in the 1980s, and there was bankers trying to overcome the Glass-Steagall Act which checked the relation between banking and the securities business.

Thus the investment bankers moved into a secondary market for financial instruments like mortgages, car loans, and credit card loans. The problems with this was that the banks, accountants, and the authorities and the S&L managements were caught in the web of complexities that had to be understood in new terms -- like the cash flow characteristics of the new instruments and types of these businesses. Banks were first unhappy with the coming of an alternate that could bring about more return than their interest for depositors and the mutual funds and government bonds offered the customer just this. Wall Street gave many companies the option of direct borrowing from the public, without banking intermediation. (Lowy, 263)

It was then that financial institutions began speculation in Wall Street, companies like Franklin, for example. The growth and operations were so mind boggling that even Congress could not understand what was going on. (Lowy, 264) "In 1995, Congress significantly curtailed the availability of private securities claims under federal law by enacting the PSLRA.6" (Ramirez, 1055) "This heightened pleading standard endangers important securities law principles, such as the 'group-published' information doctrine." (Ramirez, 1055) The PSLRA creates a safe harbor for certain fraudulent misstatements in 'forward looking statements.' The PSLRA has a very controversial history. (Ramirez, 1055) Thus the modern laws and regulations are a part of the ongoing process to bring transparency in the dealings with public funds and to remain out of controversy the Citibank must show respect and adhere to the directives of the SEC.

In this memo the new SEC's rule on disclosure for mutual funds and the methods of complying with that rule, and thus avoiding investigations directed against Citibank is being discussed. The need for the rule and why the SEC was compelled to enact it can be traced back to the scams and litigations that have been dogging the Mutual fund operations of a number of financial institutions and unfortunately some banks. Mutual Funds were the most favorite medium of investment for the investors especially in the U.S. Far back in 2003, it was acknowledged that there were abuses within 'the mutual fund industry' which had to be rectified. Thus on Dec. 3, 2003 the 'Securities and Exchange Commission' resolved action with regard to three perceived ills that plagued the industry at that time- "late trading, market timing and related abuses in the mutual fund industry." (Security Exchange Commission (c))

The time when orders were received by the mutual fund company was sought to be restricted to 4pm on working days to enable the proper calculation of net asset value to seek the day's price and avoid the intermediaries that sold fund shares in late trading. The second was the drafting of a mandatory provision that made it necessary for mutual funds and advisers to declare their policies and methods of operation and submit and annual review. This was to be submitted to 'the SEC's examination staff so as to review'. There was also to be more disclosure requirements that would touch upon 'fair valuation' of portfolio securities and disclosure of portfolio holdings. This would help in understanding the market timing and make investors 'understand the policies and the risks relating to the funds.' (Security Exchange Commission (c))

The Position Now:

Even as of today the cases are undecided on many issues. For example on the fees payable to consultants, there is controversy still. On November 3, 2009, Chicago Tribune Newspaper carried an article that in a case of one Chicago investment firm, the U.S. Supreme Court was hearing a landmark case of Jones v. Harris Associates, the result of which would affect finances of 91 million Americans. That would be half of U.S. households with their money invested in mutual funds. The ongoing litigation challenges the $100 billion in fees mutual fund investors pay annually to advisers. Management fees are determined by the mutual funds' boards of directors. The conflict has become sharp with the mutual funds becoming part of the 401(k) plan for tax benefits and pension investments. (Savage, 4)

The court stands divided since fees cannot be judicially enforced, and there is also the counter argument that it can be so in the interest of social justice. The outcome of the issue is awaited. Meanwhile it would be in the interest of the bank to comply with the existing regulations and also take note of the possible controversies that may arise in the future and provide for the safety in case of an investigation or class action. It is to be noted that actions of this kind takes years to end and by which time many changes in the institutions would have occurred. The executives of the institution thus are in a situation of elongated risk periods.

The Regulations and what needs be done:

The current regulations passed by the SEC in 2008 are based primarily on the mandatory disclosures required of the mutual funds. The salient features of the rules that need be followed by Citibank are as follows:

a) The mutual fund information must be devoid of technical jargon and must be in plain English that could be understood by anyone.

b) It is required that the "summary prospectus appear at the front of a fund's prospectus." (Security Exchange Commission (b))

c) Amendments have been made so that the Internet can be used to give important 'information' inclusive of "description of the fund's investment objectives and strategies, fees, risks, and performance." (Security Exchange Commission (b))

d) The Form N-1A, for mutual funds, should have the "key information at the front of its statutory prospectus" regarding "the fund's investment objectives and strategies, risks, and costs. The summary will also include brief information regarding investment advisers and portfolio managers, purchase and sale procedures, tax consequences, and financial intermediary compensation." (Security Exchange Commission (b))

d) It is enough to send the summary prospectus for the delivery requirements if all other information is made freely available online. The 'online materials' has to be accessible and 'in a format' which permits easy navigation and all information must be made downloadable and the investor be permitted to retain the same. However the print copy of the prospectus must be provided on demand on request by the investors. These rules came into effect Feb. 28, 2009, and must be complied by Jan. 1, 2010. (Security Exchange Commission (b))

Thus these regulations are not very difficult to comply and are cost effective when used with the facilities of the internet. Along with the complying of these regulations, the bank must also prepare for internal audits and surprise audits when applicable by the SEC.

The Citigroup Compliance requirements and how to comply

As far as the compliance of the orders above the problem is not complicated.

1. Citibank must create a separate website for the mutual funds it handles, direct and where it is the banker for other funds. Investment Products of the bank like 'Citibank Systematic Investment Plan' and the 'third party Mutual Funds' have to be explained in detail with removal of register words, that is jargon. It is suggested that the bank make use of competent writers and outsource the work of creating a simple and detailed display that explains the working of the mutual funds and how the Bank proposes to handle and govern the operations. Risks must be outlined to the maximum and where the funds are not in the direct control of the bank the agencies must be prevailed upon to create a site of their own and which must be lined to the Bank's site.

2) The bank must create a new summary prospectus and make it available online and in print with the compliance of all regulations. The internet and the e-format an be taken advantage of and the bank is advised to delegate the work of customer interaction to companies which are proficient and experienced in handling online information queries. Accordingly all printed matter must be vetted to see that the provisions of the new Form N-1A, is complied and that the agency with whom the bank contracts for the customer interaction be made responsible for making information available online. Thus the requirements for the print copy of the prospectus should be sent in the daily routine to the investors. All these can be complied with by outsourcing these activities to competent firms who are experts in handling online transactions and daily interactions. In other words the bank must create a separate wing to handle mutual fund operations which in the near future will be extensive. The costs of the change is going to be high and therefore costing for this alternate has to be worked out in terms of both outsourced activities and in-office work and the better option selected.

Changes Proposed in the Legal Disclaimers

The current disclaimer only states that the "Investment Products including those invested under the Citibank Systematic Investment Plan are third party Mutual Funds not bank deposits or obligations of or guaranteed by Citibank N.A., Citigroup Inc., or any of its affiliates or subsidiaries, are not insured by any governmental agency and are subject to investment risks, including the possible loss of the principal amount invested." (Citibank Online) This must be modified to include the right of the customer in reading the jargon less prospectus and a method of reply ought to be devised where either online or by written consent the customer signifies that the prospectus was simple, understandable and the customer has understood the exact meaning and the risks involved in the document. This is important and there is a need to make such a document so that when litigations arise the bank has defense in complying with the statute and the law of estoppels. Thus other than the standard "Mutual Funds are subject to market risk. Please read the offer document carefully before investing." (Citibank Online)

The concurrence of the customer must be obtained online as to the complete understanding of the documents. Finally with proper audit and transparence that bank will be in a safer position with litigation. However there is a need to be aware of issues like the consultants fees which are controversial. Therefore disclosures of such fees and other tariff collected must also be made available with the stipulation that the customer agrees to these fees. However if the court rules other wise, in controversial cases, the bank must have provisions for refunding the collected amounts. It is better to use arbitration rather than court disputes. Thus it will be better to have a named arbitrator and the prospectus subject's disputes to arbitration.

Suggestion for arbitration clause:

It is emphasized that "Arbitration is capable of achieving rapid adjudications that undermine the possibility of extortionate settlements. Arbitration can reduce defense costs. Securities and Exchange Commission -- SEC supervision provides investors with a fair process for the resolution of securities claims. The creation of a system of arbitration that becomes mired in litigation regarding its legitimacy would be counterproductive. Congress or the SEC should begin to implement an arbitration program that ultimately would require agreements to arbitrate all securities disputes involving publicly-traded companies before a SEC-sponsored forum. Under the authority and supervision of the SEC, arbitration of these disputes can be regulated and monitored to preserve substantive fairness while securing the benefits of arbitration, especially lower costs, and arbitration has been a favored method of dispute resolution." (Ramirez, 1055) Therefore the bank must have the arbitration clause in the prospectus and have a named arbitrator approved by the SEC if possible. These changes must be in place by 2010.