Ethics in Mutual Fund Management: Conflicts and Reform

Introduction: Ethics as the Foundation of Financial Law

Conflict of interest is at the core of nearly every ethical dilemma. A conflict of interest, simply put, is a situation in which the decision maker has two or more competing interests (Davis, 2003). Market timing, late trading, insider trading, illegal trading, fraud, partial disclosure, non-disclosure — the manifestation of conflicts of interest is seemingly endless. The business landscape today is a minefield of ethical disasters, some of which have already occurred, and some of which wait quietly in the shadows to erupt into scandal. Clearly, something more than the conventional approach to ethics is needed. Enron failed to benefit from its own 64-page ethics code or an audit committee that included both the retired dean of a business school and the former chair of the Commodity Futures Trading Commission (Davis, 2003). What was missing was a policy requiring board members to raise ethical issues whenever they had questions and to request the advice of independent third parties.

Ethics is much more than simply obeying the law (Davis, 2003). An action can be technically legal yet remain unethical. Lord Moulton, a nineteenth-century English jurist, when asked to sum up the relationship between law and ethics, said that ethics is "obedience to the unenforceable."

Laws grow out of the ethical convictions of the people who make and enact them. The very essence of human civilization has resulted from the combined experiences of mankind over the millennia, in which various laws have been recognized as being ethical and appropriate. According to Davis, the history of jurisprudence acknowledges a common law of this sort, established in social practices rooted in a dim and distant past but still significant enough to be a guide for positive law. However, because of the enormous cultural changes taking place in the world today, it becomes increasingly difficult to apply this ethical framework to new moral situations. Certainly ethical standards evolve over the ages, from one generation to the next and sometimes within the same generation. Therefore, as opposed to being an extension of the law, ethics is the law's very foundation (Davis, 2003). Ethical decisions have the power to change behavior even when they are not legally enforceable, and ethical behavior often exacts a high price.

The beginning of the twenty-first century is a skeptical time. The public's ability to trust is difficult to maintain amid a pervasive and uncomfortable feeling that government leaders have been deceptive. Newspapers have apologized for misleading readers. Major corporations have filed false financial statements. Members of the clergy have abused parishioners. To preserve trust, business leaders and politicians must take the initiative to demonstrate a genuine commitment to ethical behavior (Davis, 2003).

The Mutual Fund Scandal and the Call for Reform

Nowhere is the need for ethical leadership clearer today than in the field of financial management. In the summer of 2002, when Congress was attempting to decide how to clean up the shady financial practices of corporate America, mutual fund company lobbyists convinced lawmakers to exempt their area of the financial services industry. The funds' six decades of apparent scandal-free operation lulled Congress into obliging them, excusing funds from the more onerous provisions of the Sarbanes-Oxley corporate reform law. However, as of September 2003, when the Attorney General for New York State, Eliot Spitzer, revealed his "stunning" charges of illegal trading in mutual funds, this industry has occupied center stage in the spotlight being shone on ethical problems in financial management (Borrus & Dwyer, 2003).

Hard on the heels of this spreading scandal, the Congressional hammer began to come down. The legislative, regulatory, and market reforms that were in the works could add up to an overhaul as large as that of Sarbanes-Oxley, with an even more immediate impact on American investors.

For the time being, it is the state treasurers, pension fund trustees, and 401(k) plan managers — with billions invested with fund companies — who are doing the most to shake up the industry (Borrus & Dwyer, 2003). Congress is also pressing ahead, with the SEC racing to keep pace. Each of these groups is acting for the benefit of the people who have invested over $7 trillion in mutual fund assets.

The SEC is considering new rules to halt market timing and other trading abuses. Between them, the SEC and Congress are addressing measures to strengthen fund boards, to give fund investors better information about portfolio holdings, to require portfolio managers to reveal their own trades in fund shares (Borrus & Dwyer, 2003), to require disclosure on a semi-annual basis of dollar-and-cents amounts of fees and expenses that investors pay, to prohibit funds from using brokerage commissions to pay broker-dealers for selling fund shares, to prohibit individual fund managers from overseeing hedge funds, and to require investment advisers to adopt and vigorously enforce codes of ethics for their employees (Hume, 2004).

There are a number of important ethical issues that have been ignored by mutual fund managers and their firms — issues of great concern to investors, and now to legislators and regulators as well. All of them should and must be addressed. Some new behaviors will be mandated by new rules, some by the firms themselves, and some things will only change as a result of investors being better educated and demanding greater disclosure from mutual fund firms — and simply not investing in those that will not provide appropriate information.

The main areas of concern addressed in the following sections include conflicts of interest, director independence, and transparency of fee and expense reporting.

References

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