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  • 1. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 Investment Management Perspectives
  • 2. 1 Contents How the Sarbanes-Oxley Act is accelerating corporate governance 3 Foreword by Simon Jeffreys 7 A platform for change in US corporate governance by John Stadtler and David Trerice 17 Compliance in a multi-regulatory environment by Larry Friend 29 How leading investment management companies are meeting certification requirements by Bill Donahue 37 How to live with a new world order by John Tattersall and Andrew Plumridge 43 Rebuilding public trust by Chip Voneiff 51 Who to contact List of worldwide PricewaterhouseCoopers contacts
  • 3. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 Perspectives Contacts Editor: Andrea Lowe Contributors: Simon Jeffreys, John Stadtler, Chip Voneiff, Tracy Atkinson, Andrew Plumridge, Daniel Jessup, David Trerice, John Tattersall, Bill Donahue, Larry Friend, Chris Sullivan, Allen Goldstein, Ann Kennedy, Santa Sasena, Tony Evangelista, Jennifer Murray and Justine Gonshaw. Investment Management Perspectives is a publication of the PricewaterhouseCoopers Global Investment Management Group. Each issue focuses on a distinct theme or topic. To be added to the distribution list please send an email to russell.bishop@uk.pwc.com This information represents our understanding at time of going to press.
  • 4. 3 Welcome to the new-look investment management Perspectives. This edition focuses on the Sarbanes-Oxley Act and its impact on fund management organizations on a global basis. Foreword by Simon Jeffreys How the Sarbanes-Oxley Act is accelerating corporate governance The Sarbanes-Oxley Act is intended to build and restore public confidence in the financial reports of companies with a listing in the USA. In just over a year, it has already brought about significant change in corporate governance, accounting and the financial markets themselves. For investment managers, it has meant both ensuring their own houses are in order, and using their influence as shareholders and upholders of the capital markets to pursue a higher level of corporate governance and new standards of best practice. In requiring senior managers to provide and certify that, as far as they are aware, their periodic reports include all of the information considered “important to a reasonable investor”, Sarbanes-Oxley is increasing transparency. However, a short-term stumbling block to achieving greater openness is the paradox that some managers are unwilling to provide and certify more than the minimum requirements, as regulatory and shareholder liability concerns leave no margin for error. To draw back from being fully open and accountable with investors would be a pity, as Chip Voneiff notes in his article on page 43. It is through accountability, transparency and integrity that public trust will be rebuilt in investment management companies and their products. Sarbanes-Oxley places a premium on internal controls and the new concept “disclosure controls”, making management re-evaluate what it does. Investment managers can achieve the repeatable excellence needed in their internal control environment by building on-going processes for controls and disclosure into their system(s), rather than relying on periodic financial reporting reviews to discover any anomalies. On page 29, Bill Donahue discusses the nuances of meeting Sarbanes-Oxley’s Section 302 dealing with internal controls and disclosure and how some leading investment managers are approaching this challenge. The framework provided by Sarbanes-Oxley enables regulators to hold managers accountable. This has already begun to happen in the market timing and fair valuation
  • 5. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 4 areas for investment managers. These issues are particularly challenging for all international mutual funds (and not just those domiciled in the US) which invest and operate across a number of time zones. In bringing a high profile case, the regulator signals its intent and the necessity for all US investment managers to act with speed and thoroughness to ensure that they, and their intermediaries, are following all relevant rules and regulations, as well as internal policies and procedures. The fact that this negative publicity unsettles the investing public, can frustrate the building of public trust. Investment managers therefore need to work that much harder to reassure their investors of the best practices in operation at their firms, often supported by third-party assurances. As Larry Friend describes on page 17, this must be done against a background of numerous other regulatory requirements. These corporate governance concerns are not restricted to US publicly-held companies. For foreign investment managers doing business in the US, the Sarbanes-Oxley requirements (some of which they are exempt from) may be a substantial departure from their domestic regulations. For example, Sarbanes-Oxley requires all directors of an audit committee to be independent. For European-domiciled funds, independent directors have been the exception rather than the rule. Europe and Asia have also had their share of disappointed and disgruntled investors. Investment managers everywhere are adjusting to a new world order, as discussed by John Tattersall and Andrew Plumridge in their article on page 37. The climate for change in seeking higher levels of transparency and accountability is gathering pace worldwide. Thirty years ago the ERISA legislation with its concept of what a “prudent man” would do, enshrined the principle of portfolio diversification that spurred on international investment and alternative investments, among a host of other ramifications. It is likely that the needs of Sarbanes-Oxley’s “reasonable investor” will create changes of an equal magnitude in our industry. I hope you enjoy this issue of Perspectives. If you would like more information on any of the topics addressed in this issue, please contact the authors (contact information is provided at the end of each article) or indicate your area of interest on the tear-out reply card. You can also use the reply card to let us know what you think about this issue and what you would like to see in future issues. The climate for change in seeking higher levels of transparency and accountability is gathering pace worldwide Simon Jeffreys: Global leader, Investment Management Industry Group Telephone: +44 20 7212 4786 Email: simon.j.jeffreys@uk.pwc.com
  • 6. 5
  • 7. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003
  • 8. 7 The Sarbanes-Oxley Act was passed with remarkable speed and support in July 2002. It put in motion the most significant reform in US securities laws since their enactment in the 1930s, with the purpose of building and restoring public confidence in the financial reports of American corporations. In just over a year, it has already brought about significant change in corporate governance, accounting and the financial markets themselves. Sarbanes-Oxley Act of 2002 A platform for change in US corporate governance by John Stadtler While the Sarbanes-Oxley Act has been the topic of much debate, various publications and David Trerice and a little confusion, it clearly ushers in a new era of greatly increased regulation and government oversight for all US publicly-held companies, foreign registrants doing business in the US, and many US privately-owned companies as well. The regulators continue to focus on the investment management industry, for example with investigations in early September into market timing (late trading and disclosures of portfolio details to selected customers) policies and procedures, fair valuation procedures, as well as the correct disclosures of those procedures. Sarbanes-Oxley makes clear the requirements for internal controls, disclosure of controls, and certification of those disclosures, and regulators will be holding investment management companies, and the mutual funds they manage, accountable.
  • 9. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 8 An overview of the Sarbanes-Oxley Act The Sarbanes-Oxley Act is comprised of 11 titles. Within these titles are certain sections that have already entered the investment managers’ lexicon as frequent abbreviations. It is important to note that mutual funds are exempt from some aspects of the Act. • I: Public Company Accounting Oversight Board • II: Auditor Independence Section 201: Services outside the scope of practice of auditors Section 202: Pre-approval requirements Section 203: Audit partner rotation Section 204: Audit reports to audit committees of public companies – including those mutual funds registered under the United States Securities and Exchange Act 1940 Section 206: Conflicts of interest • III: Corporate Responsibility Section 302: Corporate responsibility for financial reports • IV: Enhanced Financial Disclosures Section 404: Management assessment of internal controls Section 406: Code of ethics for senior financial officers Section 407: Disclosure of audit committee financial expert • V: Analyst Conflicts of Interest • VI: Commission Resources and Authority • VII: Studies and Reports • VIII: Corporate and Criminal Fraud Accountability • IX: White Collar Crime Penalty Enhancements Section 906: Corporate Responsibility for financial reports • X: Corporate Tax Returns • XI: Corporate Fraud and Accountability The Act is quite specific in some areas, but in other areas it only provides a framework for rule-making by the US Public Company Accounting Oversight Board (PCAOB), created in
  • 10. 9 the first title of the Act. The PCAOB is charged with establishing, adopting or modifying: auditing, quality control, ethics and independence standards for public companies. It consists of five members, with William Donahue serving as the first chairman. The PCAOB can also conduct disciplinary proceedings and impose sanctions. The Sarbanes-Oxley legislation makes fundamental changes in the way three groups carry out their responsibilities: audit committees, senior managers and auditors. Audit committees All members of the audit committee must now be independent directors. They are required to disclose, in periodic reports, whether at least one “financial expert” sits on the committee, and if so, to identify him/her. If no expert is identified, the committee must explain why not. The committee is directly responsible for the appointment, compensation and oversight of the work of a company’s auditor. Audit committee members must be “independent.” They may not accept any consulting, advisory or other compensatory fee from the company (other than director’s fees) nor be an affiliate of the company or any of its subsidiaries.
  • 11. 10 The legislation renews the focus on auditor and audit committee interactions, particularly now that the auditor must report directly to the audit committee. Furthermore, the audit committee must establish procedures for: • receipt, retention and treatment of complaints received by the company regarding accounting matters, and • confidential, anonymous submission of concerns by employees regarding questionable accounting matters (known as whistleblower regulations). The audit committee has the authority, and must be given the funding, to engage independent counsel and other advisors. The audit committee must consider reports from the independent auditor on: • the company’s critical accounting policies and practices; • all alternative treatments of financial information permitted within generally accepted accounting principles that have been discussed with management; and • all other material written communications between the independent auditor and management. The audit committee must pre-approve all audit services and permitted non-audit services, including tax services. However, the audit committee can delegate pre-approval authority to one or more independent members of the audit committee, subject to later review by full audit committee. Pre-approval may be given in advance of the activity and must be disclosed in a company’s SEC filing. Senior managers Senior managers have multiple new responsibilities under the Act, with the major initial change requiring chief executive officers and chief financial officers to certify periodic reports containing financial statements on the financial condition and results of operations of the company. The SEC requires that the certification includes statements that: • The officer has reviewed the report;
  • 12. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 11 • Based on his/her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to ensure the statements are not misleading; • Based on his/her knowledge, the financial statements and other financial information in the report present fairly, in all material respects, the financial condition and results of operations of the issuer as of, and for, the periods presented in the report. Violation of this rule carries criminal penalties under Section 906. Additionally, section 302 requires senior executives to certify the effectiveness of the “disclosure controls and procedures” (a newly defined term) that produced the periodic reports. The substance of these disclosures state that certifying officers: • Are responsible for establishing and maintaining “disclosure controls and procedures”; • Have designed disclosure controls to ensure that material information is made known to them, particularly for the period covered by the report; • Evaluated the effectiveness of the disclosure controls and procedures within 90 days of the report date; and • Presented in the report their conclusions about the effectiveness of the disclosure controls and procedures. Section 302 certification also includes a representation that the certifying officers have disclosed to the auditors and the audit committee (or persons fulfilling the equivalent function): • All significant deficiencies in the design or operation of internal controls and have identified to the auditors any material control weaknesses, • Any fraud (whether or not material) that involves management or other employees who have a significant role in the internal controls, • Whether or not there were significant changes in internal controls subsequent to the date of their evaluation, including corrective actions with regard to significant deficiencies and material weaknesses. Violation of this rule carries criminal penalties under Section 906.
  • 13. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 12 For US Registered Investment Companies (“RICs”), this is required for fiscal years ending after June 15, 2004 and (at the end of a transition period) this certification must be done on form N-CSR (Certified Shareholders Report), a more comprehensive form than form N-SAR. Companies who are listed in the US market also have requirements under Section 404. Management must sign and file an internal control report which includes: • A statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the company; • A statement identifying the framework used by management to evaluate the effectiveness of the company’s internal control over financial reporting; • Management’s assessment of the effectiveness of the company’s internal control over financial reporting; and • A statement that the external auditor of the company has issued an attestation report on management’s assessment of the company’s internal control over financial reporting. It is noteworthy that mutual funds are exempt from having to provide this Section 404 certification, primarily because their auditors already provide attestation as to those internal controls. However, there are signs that this exemption is already under review. While these certification requirements have provoked the Act’s greatest impact on the role of senior managers, there are many rules that increase regulatory oversight and affect business operations. The law requires that managers interact more deeply or in different ways with their boards of directors and their auditors. Managers must also address other regulatory changes, including accelerated SEC filing deadlines, new stock exchange rules, and increased scrutiny from shareholder groups. Auditors Another area of fundamental change involves the oversight of the external audit function. Auditing is now a truly regulated profession, coming under the jurisdiction of the Public It is noteworthy that Company Accounting Oversight Board, and the implications of this new structure can only mutual funds are be surmised. What is certain is that audit committee members are now directly responsible exempt from having to provide this Section 404 certification.
  • 14. 13 for the performance of auditors, and there will be a much closer working relationship between these members and the auditors. In particular, discussions now need to cover judgmental accounting issues, such as where different accounting options exist, or why significant accounting policies and items were adjusted (or not) in the audit. The most widely publicized change is the intense focus on auditor independence. The list of services that auditors may not provide their client remains largely consistent with earlier SEC releases, but there are new disclosure requirements for proxy disclosures, audit partner rotation and hiring of audit firm personnel. While the rules will drive significant change in the activities of these three groups, the biggest change may be in the platform it provides for the SEC and other regulators to enforce their expectations. The US legislature has given the SEC a mandate to renew and expand its regulatory oversight. Companies over which the SEC has jurisdiction will see greater scrutiny over their published documents whether filed with the commission or not. A major example of heightened regulatory scrutiny occurred in early September 2003 when the New York Attorney General filed a complaint against the activities of a hedge fund arbitraging certain mutual funds (market timing). These mutual funds, in their prospectuses, vowed to actively prevent market timing, an activity which enables arbitrageurs to profit at the expense of long-term shareholders. However, it is alleged that, although aware of the market timing, these companies chose not to enforce the procedures (for reasons benefiting the mutual fund management company but not the mutual fund shareholders). The alleged late trading and market timing circumvented existing internal controls and therefore, if known to the certifying officers, should have been included in their Section 302 reports under Sarbanes-Oxley. Regulators are now on a fact-finding mission to determine whether the same matter exists at other companies. The SEC has written to the Investment Company Institute (ICI) encouraging it to urge its members to promptly seek assurances from their selling broker-dealers and other intermediaries that they are following all relevant rules and regulations, as well as internal policies and procedures, regarding the handling of mutual fund orders on a timely basis.
  • 15. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 14 Looking ahead Leading companies in this new era will be those who embrace this new scrutiny in order to rebuild public trust. As regulators raise both industry and public awareness by prosecuting those whose disclosure and controls are inadequate, the bar to win public trust keeps being raised. That trust will only be regained through greater transparency of the roles taken by senior management, audit committees and auditors. Although the new rules are focused on companies over which the SEC has jurisdiction, best practice would have private and public companies alike adopting the principles of the new legislation. We believe there is a competitive advantage – for US domiciled investment vehicles and those around the globe – for those asset managers who embrace and promote their focus on controls and the new corporate governance model. The investment management industry is an industry built on the trust and confidence of investors. The investment manager, and those who service the industry, who can distinguish themselves in this area, are sure to have an advantage over similarly performing peers. The Sarbanes-Oxley legislation creates both challenges and opportunities for public companies, including asset managers and their sponsored products. Further clarification continues to be given by regulators and by how public companies carry out their enactment of the regulations, yet in some areas, more is needed. However, the Act clearly heightens the importance of the assurance function and increases risk and liability risks faced by the managers of US-registered investment products. There can be no doubt that the Act strengthens the audit committee role in financial reporting, reinforces management responsibility for financial statements and highlights the need for external assurance. It also directs companies to expand disclosures of their business and its control processes to increase the public’s trust in the reporting process for information used in investor decision-making processes. Nevertheless, for investment managers and their sponsored products, there are many challenges in applying the Act in an already highly-regulated and control-conscious environment. Leading companies in this new era will be those who embrace this new scrutiny in order to rebuild public trust. John Stadtler: Partner Telephone: +1 617 530 7600 Email: john.w.stadtler@us.pwc.com
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  • 17. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003
  • 18. 17 Over the past two years, the US Congress and the SEC have launched what is seen by many as the most aggressive and far-reaching reform agenda for the investment management industry in its history: The USA PATRIOT Act of 2001, The Sarbanes-Oxley Act of 2002, proxy voting disclosure, fair valuation, hedge fund regulation, mutual fund fraud – the list goes on and on. New regulations are already being proposed while investment managers, fund boards and compliance officers struggle to implement and oversee existing rules. Compliance in a multi-regulatory environment by Larry Friend Sarbanes-Oxley, in particular, was the US Congress’s reaction to an investing public that was justifiably outraged at the corporate scandals that jeopardized its financial wellbeing, threatening the integrity of the US capital market system and investors’ confidence in it. Nearly $8 trillion has evaporated from the capital markets, and investors need assurances that corporate officers, auditors of public companies and boards are honest, above conflict and acting in the best interests of shareholders.
  • 19. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 18 Much of the subsequent focus of SEC rule-making on the investment management industry has emanated from Sarbanes-Oxley. While the text of the Act, makes clear that the authors of the legislation had conventional, operating companies in mind, many provisions of Sarbanes-Oxley apply to investment companies. One of the hallmarks of our industry over the years has been its diligence in protecting investors’ interests. This record is in part based upon fundamental characteristics of US fund management: daily market valuations, limitations on affiliated transactions, oversight by independent boards, and fiduciary responsibility and accountability associated with a lack of the guarantees that are in the banking industry. US investment management firms are subject to the reporting requirements of both the Investment Company Act of 1940 and the Securities Exchange Act of 1934. On the whole, investment companies are ahead of the curve in terms of having both a code of ethics and disclosure controls and procedures in place. Since the Investment Company Act was passed more than 60 years ago, the investment management industry has, until recently, been free from the scandals that have plagued other industries. The industry has been shaken recently by a host of investigations into practices such as market timing which seem likely to continue. Still, the inescapable fact is that investors are now paying a great deal more attention to their investments as a result of precipitous market decline over the past two years. In turn, and not surprisingly, this has had and will continue to have an effect in Washington. While the impetus for many of the regulatory reforms was gross irregularities in reporting and disclosure among operating companies outside the financial services industry, the SEC’s actions can and will only strengthen our industry. Furthermore, the investment management industry has such a large stake in restoring trust in the capital market system that it should always support regulatory change that would make a good system even better. One of the hallmarks of our industry over the years has been its diligence in protecting investors’ interests.
  • 20. 19 The impact of a changing regulatory environment on the investment management industry Clearly, Sarbanes-Oxley and the USA PATRIOT Act are the most far-reaching and comprehensive reforms in US financial history. The fair value of portfolio securities, however, is also a particularly thorny issue, and recent action by the New York Attorney General, and the SEC indicates that this, along with market timing, will be under the spotlight. The SEC’s most recent focus on hedge funds will surely result in new rules that will substantially alter the competitiveness of that industry and its global growth outlook. In today’s dynamic, multi-regulatory environment with its heightened level of accountability, the stakes of non-compliance are higher than ever. It is essential that all companies assure their compliance and inspection procedures are thorough and well documented in order to withstand the intense scrutiny, not only of the Commission but also of the investing public, who are increasingly litigious. There is no doubt that Sarbanes-Oxley, proposed new regulations, and subsequent rules create a daunting task for compliance departments to protect their firms and ensure that the controls will withstand the rigorous scrutiny now applied to their operations. In the end, will the reforms restore investor confidence? And what will be the trickle-down effect on the industry and cost incurred? It is too early yet to assess exactly how the new SEC rules will ultimately affect investment companies and, perhaps more importantly, the investing public’s response to it. Certainly, there are increased costs and liabilities associated with ongoing compliance, and the role of the compliance department itself is changing from one that was reactive and enforcement-driven to one that proactively adds value to management decisions and corporate governance. Investment management in the United States is, and has been, a highly regulated industry that already complied with a more complex and rigorous regulatory framework compared to operating companies. The greatest challenge for investment management firms will be in determining exactly how the Sarbanes-Oxley Act changes the existing reporting requirements and the related SEC review process. The provisions of the Sarbanes-Oxley Act
  • 21. 20 do not substantially change the code of ethics nor the overall responsibility of investment companies to collect and disclose information. The new certification requirements (under Section 302 of the Sarbanes-Oxley Act) and the decision to disclose the presence of a financial expert on audit committees, however, represent two of the biggest hurdles for investment companies. The following explores some of the major new reforms and the challenges they present to investment companies operating in the United States. New certification requirements The Commission adopted rules under the Sarbanes-Oxley Act that require certification of shareholder reports by funds' principal executive and financial officers and require the regular evaluation of the effectiveness of disclosure controls and procedures to ensure that the information contained in shareholder reports is complete and reported in a timely manner. Even before the Sarbanes-Oxley Act was passed, the SEC had adopted rules requiring CEOs and CFOs of publicly held companies to sign reports containing their company’s financial information. Form N-SAR has been the form designated for registered investment companies to comply with their reporting requirements under Sections 13(a) and 15(d) of the 1934 Act. This form, however, was primarily a regulatory reporting form for use by the SEC in its inspection and compliance programs. Now, under Section 302 of the Sarbanes-Oxley Act, investment companies will file with the SEC semi-annual shareholder reports on the new Form N-CSR, and the CEO and CFO must certify the reports. This added certification requirement is intended to improve the quality of the disclosure that a company provides about its financial condition and results of operations in its periodic reports to investors. The reality is that this duplicates current rules that already This added certification mandate the signature of corporate officers to accompany such filings. The one exception requirement is intended to improve the quality of the is that the executive must now voice that as far as he or she is aware, the report includes disclosure that a company all the information considered “important to a reasonable investor”. provides about its financial The extension of certification to filings under the 1934 and 1940 Act necessitates significant condition and results of staff resources that will place a great burden on investment companies, particularly smaller operations in its periodic reports to investors. fund complexes, although arguably many of the procedures are already in place.
  • 22. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 21 The new certification requirement generated significant industry opposition because of the added reporting burden. The SEC estimates that having CFOs and CEOs sign off on their company's filings will require five additional hours of work, but some corporate executives at large firms predict an additional 500 hours of time by the slew of lawyers, accountants, auditors and consultants required to provide assurance of adequate controls and procedures. The key to success in meeting this requirement and keeping costs to a minimum will be clearly defined, well-monitored internal and external audit functions. The audit committee financial expert requirement The new audit committee financial expert requirement to disclose whether you have a financial expert poses a marketing challenge. Will investors be more attracted to an institution that has a more qualified financial expert? Under Sarbanes-Oxley, mutual funds and other registered investment companies are now required to disclose whether there is at least one financial expert on the audit committee as determined by the fund’s board of directors. The initial difficulty was the strict definition of a “financial expert” and whether there would be enough qualified financial experts in the industry to go around, not to mention the increased liability and insurance required for these individuals. While there is no doubt that having a member of the audit committee who has experience in preparing and/or auditing mutual fund financial statements is useful for effective oversight of a fund’s financial reporting, the SEC’s original definition of a “financial expert” meant that only certain CPAs were qualified for the job, a relatively small universe of people. Fortunately, the SEC expanded its definition to meet its original intent to include knowledgeable non-CPAs. Still, it is important to note that investment companies are not required to have a financial expert on the audit committee, only to disclose whether they do, and give reasons if they ...some corporate executives at large firms do not. Some boards may elect not to have a financial expert. It will be interesting to note predict an additional how this develops and whether investors shun companies who choose not to have a 500 hours of time by the financial expert on the audit committee. This may depend on the reasons given on the slew of lawyers, form. The disclosure rule only applies to annual reports filed with respect to fiscal years accountants, auditors ending on or after September 15, 2003. Since the majority of the industry reports on a and consultants required calendar year basis, the impact of this disclosure will not be felt until 2004. to provide assurance of adequate controls and procedures.
  • 23. 22 The USA PATRIOT Act* Concern about money laundering is not a new issue for investment companies. However, given the new era of terrorism, it is now the subject of intense legislative activity. The most notable implications for the industry are the exposure to regulatory risk associated with non-compliance with applicable rules and the substantial reputational risk of being associated with money laundering activities. One of the greatest vulnerabilities for investment firms may be a fund’s participation in offshore limited partnerships and its lack of access to complete information about the beneficiaries of these investments. Investment companies must now be extra vigilant, not only to “know the customer” but also to “know the partner,” and they must be prepared to demonstrate how they are doing so. The USA PATRIOT Act amends existing anti-money laundering provisions in the United States Code, primarily Title 31 of the Bank Secrecy Act and Title 18 of the Criminal Code. * The USA PATRIOT Act (Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act)
  • 24. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 23 At a minimum, investment companies are now required to have an anti-money laundering program in place, and this program must include the designation of a dedicated compliance officer, an internal auditing process and development of written and verifiable internal policies, procedures and controls, as well as comprehensive employee training. Additionally, by rules adopted in April 2003, investment companies must, at a minimum, implement procedures to verify the identity of any person seeking to open an account, to the extent reasonable and practicable; to maintain records of the information used to verify the person’s identity; and to determine whether the person appears on any lists of known or suspected terrorists or terrorist organizations. While funds may rely on anti-money laundering procedures of other institutions, including banks, brokers and dealers, each fund is ultimately responsible for compliance with respect to customers. This may entail written agreements and on-site visits from compliance representatives of the fund. The future of hedge funds For years, hedge funds have largely operated beyond the scope of the SEC’s regulatory oversight. But that is likely to change. A great deal of the SEC’s attention is now being directed at the hedge fund industry. In May, the Commission held two days of hearings to explore the nature of hedge funds, how the industry operates and whether more oversight is in order. Many believe this is the precursor to new and stronger regulation. Given the complexity and risk associated with hedge fund investing, the historical opaqueness of its reporting and disclosure procedures and the recent increase in SEC actions, it is not surprising that the SEC and Congress are looking into greater oversight. This is because hedge funds, which are very different from retail open-end investment companies and are largely not registered, have grown increasingly popular among retail investors. Once an exclusive investment vehicle for a finite group of well-qualified, While funds may rely on high-net-worth investors, hedge funds are now attracting smaller investors who may anti-money laundering procedures of other not understand the risks and may be going in with their eyes closed. institutions, including Rightly or wrongly, the perception is that the hedge fund industry is doing something banks, brokers and dealers, each fund is secretive and that secrecy is an incubator for mischief. Of course, the SEC has always had ultimately responsible for compliance with respect to customers.
  • 25. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 24 the authority to chase fraud through the anti-fraud provisions in the various securities acts, regardless of whether the person or entity is registered or not. Still, the impetus for reform, including possible compulsory registration of hedge funds, has increased attention regarding potential hedge fund abuses including fraudulent representation of performance numbers and associated fees. Funds-of-hedge-funds, in particular, are the object of considerable attention. These registered funds invest shareholder assets in private hedge funds and are now being made available to a broader investor base because the original investment is placed in a registered investment company. These funds could thus pool smaller investors together to meet the high minimum investments hedge funds require. The SEC is scrutinizing these funds-of-hedge-funds for appropriate disclosure and is particularly interested in the procedures funds use to value their investments in the underlying hedge funds to determining their own net asset values. To deal with what they perceive as a possible problem, the SEC could reinterpret the definition of “client”. For example, the SEC could impose basic restrictions on hedge funds advisers that rely upon the regulatory exemptions from investment adviser registration which treat a private investment fund with many shareholders as a single “client” of the manager for the purpose of determining whether the manager has 15 or more clients. Such a change would cause the adviser to become subject to registration under the Investment Advisers Act. Investment managers that operate private investment funds that do not meet these standards would be required to look through the investment fund and treat each of its investors as a "client", thus subjecting the investment manager to registration, SEC examination and regulation under the Investment Advisers Act. It is difficult and sometimes dangerous to predict the future in the securities industry, but it is safe to say that regulation and reform could be swift in coming. The range of possible outcomes to the Commission’s current exploratory process might include a decision to maintain status quo, however this is an unlikely scenario. Options for change include: • Requiring hedge-fund managers to register as investment advisers with the SEC To deal with what they perceive as a possible under the Investment Advisers Act. This could be accomplished by amending problem, the SEC could reinterpret the definition of “client”.
  • 26. 25 Rule 203(b)(3)-1, which currently has the effect of exempting advisers to hedge funds. Under the Act, the SEC could adopt rules that restrict the fees advisers charge, as well as limit or ban some of their investment techniques. • Recommending to Congress a revised definition of the Investment Company Act to include hedge funds. • Increasing the dollar amount of assets, net worth and income of an investor to limit the number of more sophisticated investors with a high tolerance for loss. Coupled with anti-money-laundering requirements, new registration requirements could lead to a substantial financial burden for advisers, particularly advisers to small funds. Increased regulation changes the competitive outlook for this industry, and could result in further consolidation and even the closure of some funds. In addition, it is certainly going to make starting up new hedge funds more difficult. The SEC permitted public comment on hedge fund oversight through July 7, 2003, and released a report titled “Implications of the Growth of Hedge Funds” in September. One question within the industry, and even for some people on the SEC staff, is whether the recent reported increase in its fraud cases is a result of inherent problems in the hedge fund industry or simply a reflection of the increase in the number of funds (or perhaps greater willingness on the part of investors to report concerns). The Commission seems unsure whether major modifications in the hedge fund business are necessary. In addition, it is questionable whether the SEC has the resources to handle the added workload that would occur with more oversight of the growing hedge fund world. Mutual fund fraud After receiving more than 27,000 complaints of professional misconduct in 2002 in the financial services industry, the SEC has taken a more aggressive stance against fraud and other forms of misconduct. As already discussed, fair valuation procedures and market timing are under particular scrutiny. Well before Sarbanes-Oxley, the Auditing Standards Board of the American Institute of Certified Public Accountants approved the Statement on Auditing Standards (SAS) 99:
  • 27. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 26 Consideration of Fraud in a Financial Statement Audit, which gave US auditors expanded guidance and significant new requirements in the completion of their audit. This includes what they test and who they discuss the potential of fraud with during the audit as part of the process of detecting potential fraud. The standard reminds auditors that they must approach every audit with professional skepticism and put aside any prior beliefs about management's honesty. Furthermore, the standard requires members of the audit team to include audit steps that identify fraud risks and to become reasonably certain that controls are in place to reduce the likelihood of fraud that has a significant effect on the financial statements from occurring. Still, because of the potential for fraud and ongoing questions about the ability for both advisers’ and funds’ compliance systems to uncover it, the SEC recently released proposed rules to further combat fraud in the investment industry, under the Investment Company Act, proposed rule 38a-1 and a companion rule 206 (d)-7 under the Investment Advisers Act. The Commission also hopes to decrease misconduct by requiring firms to disclose more information, such as advisors' compensation and investment philosophies and the complete disclosure of legal sanctions against firms and companies. More recently, the industry has been rocked by assertions of violations of securities laws by the SEC and certain state attorneys-general. These asserted violations have taken the form of permitting selective investors both to purchase fund shares after 4 pm to gain a price advantage and to redeem shares that have quickly increased in value within a short time after purchase in order to capture the gain (“market timing”). Both late trading and market timing are harmful to long-term shareholders. While the effects of these asserted violations have not been ascertained, the industry can expect closer scrutiny by regulators and more interest by Congress that may lead to legislation. The key to ensuring compliance The SEC's recent activity has been extraordinary across the spectrum of its divisions and offices, and the pace and boldness of its actions in such a concentrated period of time is unprecedented. As already discussed fair valuation Keeping up with all these new regulations, and implementing them will be a major challenge. procedures and market Indeed, investment companies are under a great deal of pressure to comply with all the timing are under particular scrutiny.
  • 28. 27 new SEC rules, many of which still have wrinkles that need ironing out. Furthermore, the timeline is short for implementation of some of these rules and it comes against the background of the prolonged economic downturn and intensifying cost pressures throughout the industry. Investment companies need to resist the temptation to cut back on compliance assurance, believing that it is an area of focus that does not enhance the bottom line. It is crucial to attracting and keeping investors. The key to success will be in committing appropriate resources to oversight, compliance and quality controls. Larry Friend: Partner Telephone: +1 202 404 4548 (Washington D.C.) +1 617 530 7720 (Boston) Email: lawrence.friend@us.pwc.com
  • 29. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003
  • 30. 29 Investment management firms are responding to the certification requirements under Section 302 of the Sarbanes-Oxley Act of 2002 in a variety of ways. Briefly, this rule requires that senior managers attest to the effectiveness of the “disclosure controls and procedures” that produce the company’s financial statements. The rule also imposes additional requirements for audit committees and auditors, in conjunction with senior company management, to provide reliable, timely and useful information to stakeholders to assist them in their decision-making process. How leading investment management companies are meeting certification requirements by Bill Donahue For many firms, the first step to address the certification requirements is initiating a series of cascading certification letters. Here, business unit managers responsible for various elements of the Form N-CSR and financial statements certify in writing to the senior signing officers as to their knowledge of any material errors or significant deficiencies in internal controls. For those firms that have outsourced some of their fund accounting, fund administration, custody and transfer agency operations, the service providers may also have to provide periodic certifications, including descriptions of the controls surrounding the preparation of the periodic shareholder reports and Form N-CSR, which are not typically covered by SAS 70 reports.
  • 31. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 30 Most firms have established disclosure review committees which include legal, compliance, fund administration and marketing personnel. The activities of the disclosure controls committee is actively documented. The process by which they carry out their duties is discussed with the audit committee, including summaries of results. This disclosure controls committee also analyzes the risks inherent in the company’s activities, and talks with senior officers to identify and address weaknesses in controls and procedures. Additionally, many organizations have mapped information that will be needed in the Form N-CSR or financial statements, tracing the source of the reported information back to the specific reports and departments that are responsible for these data elements. Each company must determine for itself what disclosure controls and procedures are necessary. In addition to those covering financial accounting and reporting, there may be additional controls needed to support non-financial disclosures. Many companies have taken a broad view of their operations, compliance, and other areas to determine which activities or events will trigger the need for upstream communications, possibly impacting the chief executive of the funds and the chief financial officer of the funds’ certifications. Determining who is the chief executive of the funds and the chief financial officer has been an arduous process. These chief executives are required to devote significant time to the review of financial controls, disclosures and regulatory reports. In multi-product and service organizations, the identification of these individuals has been an evolving assessment. Many are struggling to apply the term “disclosure controls and procedures,” which was created by the SEC. The SEC defines the term as follows: “Controls that are designed to ensure that information required to be disclosed by the investment company on Form N-CSR is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an investment company in the reports that it files or submits on Form N-CSR is accumulated and communicated to the investment company’s management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to Each company must allow timely decisions regarding required disclosure.” determine for itself what disclosure controls and procedures are necessary.
  • 32. 31 In June 2003, the SEC amended the S404 certifications to require firms to maintain internal control over financial reporting with respect to fiscal years ending on or after June 15, 2004. The amendments define “internal control over financial reporting” as: “A process designed by, or under the supervision of, the registrant’s principal executive and principal financial officers, or persons performing similar functions, and effected by the registrant’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: • Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the registrant; • Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the registrant are being made only in accordance with authorizations of management and directors of the registrant; and • Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the registrant’s assets that could have a material effect on the financial statements.” Thus, safeguarding of assets is one of the key elements of internal controls over financial reporting. The SEC has also stated that registrants must maintain sufficient documentation of the design of internal controls and the testing processes to support the assessment by senior management of a company’s internal controls over financial reporting. The challenges investment management firms are attempting to resolve include:. • What are the firm’s disclosure controls and procedures and internal controls over financial reporting? How are these controls incorporated into the firm’s internal control environment to facilitate periodic reporting? • Does the firm have a process to evaluate and document the effectiveness of disclosure controls and internal controls and procedures every six months?
  • 33. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 32 • How does the firm effectively evaluate the internal control environment and the changes that have occurred to this environment since the last evaluation? • How does the firm demonstrate that it did what is necessary to be able to issue the certifications? Firms will be required to include their annual or semi-annual shareholder reports when they file Form N-CSR. Some firms are reassessing the information that they currently include in these periodic shareholder reports, with the aim of providing only the minimum requirements, thereby reducing the amount of information subject to certification. What are leading firms doing? As they have gained experience, some leading firms have begun to focus on the processes that support their certification procedures. They are providing sub-certifiers with the guidance they need to completely understand what they are certifying and confirm that the certification procedures are consistently applied throughout the organization. Additionally, managers of these firms are formally documenting their evaluation of controls. Thus, these firms are implementing three-phase documentation projects. Phase 1 covers the sub-certification process Phase 2 documents key controls; and Phase 3 documents management’s evaluation of controls. Each firm must decide the degree of structure and level of formal documentation required to provide the chief executive and the chief financial officer of the funds with the confidence to sign the periodic 302 certifications. Many firms have decided that the rules compel them to formalize their control structures, enhance existing controls and establish monitoring programs to enable their senior executives to form their evaluations and report their conclusions. Each firm must decide the degree of structure and level of formal documentation required to provide the CEO and CFO with the confidence to sign the periodic 302 certifications
  • 34. 33
  • 35. 34 These leading firms have recognized that they need processes designed to provide reasonable assurance that: • The company’s transactions are properly authorized; • The company’s assets are safeguarded against unauthorized or improper use; and • The company’s transactions are properly recorded and reported to permit the preparation of the registrant’s financial statements to conform with generally accepted accounting principles. Many leading firms recognize that they need to focus on more than internal controls surrounding their financial statements. Therefore, they have begun to enhance the certification procedures to include: • A documented internal control structure that includes all relevant policies, procedures and operating principles; • A structure that is able to deal with the changes of a dynamic organization; • An infrastructure that facilitates risk assessment, communications, reporting, training, incident identification and issues management; • An infrastructure that facilitates rollup certifications, acknowledgements and monitoring; • An infrastructure that facilitates management’s ability to have confidence that the control structure is effective and one that can be tested; and • An infrastructure that can support monitoring the completion of applicable control procedures on a real-time basis. Practical considerations Firms are addressing a number of practical considerations that arise out of the certification process, including: • An enterprise-wide gap analysis needs to be undertaken to determine the current control environment, what needs to be certified under Sarbanes-Oxley, and any gaps that need to be rectified. To remediate these gaps may involve putting in controls or expanding existing controls and/or their level of coverage. All this is necessary to
  • 36. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 35 ascertain the operating effectiveness and support the certification statements that the chief executive and chief financial officers must sign. • Controls should be mapped to demonstrate how they impact on significant accounts, classes of transactions, disclosures and other items. This can be done most effectively by working back from disclosure documents and trigger points, through the control environment, to the input of source data. Where does the information come from and how was it obtained; what kind of controls are in place and are they the right controls? • Internal audit should periodically review and evaluate the operating effectiveness of disclosure controls and procedures. • A materiality level must be determined and applied. What counts as material for the purposes of determining required disclosures in certification statements? The disclosure review committee and senior signing officers must make this determination for significant accounts, classes of transactions and disclosures. • There needs to be a consistent and articulate process of communicating the results of these assessments to the audit committee and of determining whether any of the deficiencies require reporting or notification. The impact or possible mis-statement in a company’s financial statements must be considered in determining whether a deficiency represents a material weakness. A company must review other facts and circumstances to decide whether there are any compensating controls that may reduce the risk of mis-statement. The spectrum of current company approaches varies significantly. Several firms have nearly adopted a full assessment, documentation and testing process of the control environment (including outside assurance). Others are focused on the initial mapping of the financial ...the certification disclosure controls process and its documentation. In each case, along these various states requirements represent of readiness, the certification requirements represent a significant organizational and a significant information-gathering challenge for investment managers. It is one they have only begun to organizational and address and will surely be struggling with for years to come. information-gathering challenge for investment managers. It is one they have only begun to address and will surely be struggling with for years to come. Bill Donahue: Director Telephone: +1 617 530 7037 Email: bill.j.donahue@us.pwc.com
  • 37. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003
  • 38. 37 For investment managers, the difficult stock markets have led to margin pressures, disappointed clients and risk management concerns. Add to this a media frenzy from corporate scandals, and, in a host of countries, active regulators trying to prescribe “good behavior” under numerous scenarios. This article discusses some of the requirements for firms doing business in the US and U.K., and also seeks to highlight issues that firms may want to consider globally. How to live with a new world order by John Tattersall and As investment managers restructure their businesses to cope with today’s conditions and Andrew Plumridge position themselves for tomorrow’s, an exhaustive look at internal controls must be high on the agenda. Financial services firms (as well as corporates) are being pushed inexorably toward devoting significantly more time and resources to documenting and managing their risks, and making sure that there is a proper audit trail to show how they are achieving this. Following the passing of Sarbanes-Oxley, the US is perhaps the most extreme market in its requirements. Senior managers and directors, who can now be held personally liable, are therefore very motivated to comply. But investment management firms worldwide are seeing the desirability of running a tight ship, and using this as a platform to improve the dialogue with their investors by being more open and transparent. Dipping into the US pond Foreign investment managers conducting business in the United States need to be aware of the impact of Sarbanes-Oxley, and the increased environment of regulatory and media
  • 39. 38 scrutiny, on each of their entities registered in the US. While some American companies would consider Sarbanes-Oxley just “good housekeeping”, the problem for most foreigners is that the new US regime is unique. Certainly to those familiar with EU and European domestic regulation, it is very different from any in Europe. And, while it is a wake up call to address these issues, it is also a management and compliance challenge to ensure controls are in place, demonstrate satisfaction with those controls, certify those controls and provide an audit trail that meets US approval. While there are some exceptions and transition provisions for foreign registrants, these are onerous requirements. First, if the investment management firm or its parent company is listed on a US exchange, then the firm needs to be considering how it is complying or will comply with the requirements of Sections 302, 404 and 906, in the same way as any other US-listed company. Second, if the investment manager has any US Registered Investment Companies (“RICs”), attention needs to be given to the impact of Sarbanes-Oxley on their operations, as they will need to follow the same rules as any other RICs. (These are discussed in more detail in the previous article “How leading investment management companies are meeting certification requirements”.) If a manager’s business includes the management of RICs, the audit committee has additional responsibilities to oversee auditor independence, which includes establishing pre-approval processes for non-audit services provided by the auditor to related entities, including the investment adviser. (For details of this guidance, please refer to the publication PricewaterhouseCoopers co-authored with Dechert LLP “Auditor Independence After Sarbanes-Oxley: A Guide to Auditor Services for Fund Audit Committees”.) For investment managers outside the United States, these responsibilities can lead to a need to separate the management of US and non-US funds to avoid exposing non-US domiciled funds to US procedures, which could cause costs and discomfort to non-US investors. Finally, any firm registered as an investment advisor with the SEC will continue to be required to meet all of the same advisor requirements that a local advisor would have to meet. Trends in the UK market In the UK, the Financial Services Authority has been focusing since 2001 on the arrangements by which senior management, including the directors, manage business.
  • 40. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 39 They have set clear standards and guidelines requiring companies to document their systems and establish a clear audit trail to show how senior management is determining risks, how risks are managed, what ought to be disclosed to regulators and what ought to be assessed against the firm’s risk appetites. In other words, the firm has to be able to demonstrate the process of how the board makes decisions, periodically on how much risk they are willing to run, realizing that taking zero risk may limit business growth. In some cases, firms will be prepared to understand what the regulator’s objectives and principles are and to manage the business on that basis, which could possibly breach some of the more detailed rules. However, this should be done knowingly, not discovered after the fact, and needs to be addressed now. In contrast, the US approach is more prescriptive, and less focussed on risk assessment. Following corporate scandals such as Enron, the difference for investment management firms everywhere is the irreversible change in attitude and the degree of focus that the media, regulators and the public have on the way companies and their directors manage their business. This is a particular challenge for firms which are thinking “out of the box” and their goal must be to out-perform the market, but in a controlled way. They still need properly documented controls; processes showing how they govern their business; proper transparency in the way they run the business; and full understanding of how they set a risk appetite (identifying the risks and defining which risks they are actually taking). Risk management has to be transparent enough for investors to assess, because it is their money that is at risk. If it is in a pension fund, it is the investor’s life in retirement that is under threat. And it is not simply a question of retail savings, but the vast amounts of assets invested by institutional investors. Management’s responsibility The standards now being demanded of the financial services industry have been raised considerably. A trigger for regulatory action in the UK was high profile failures caused by very high gearing in the split capital investment trust market, which was not very closely regulated. The problem for the regulator and investors, though, is that the trusts probably did not break any rules in that that the prospectuses did actually say that if the market fell by 30 per cent these shares could lose their complete face value. But this was in the small print, and not publicized.
  • 41. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 40 The major problem came in the distribution of split-capital investment trusts, where financial advisers were encouraging investors, often people of modest means, to put their savings into these “safe” schemes. There are also examples in personal pensions and endowment policies where products where unsuitably sold. While there is much finger-pointing, it should be remembered that even if it is a third-party which mis-sells the product, investor trust and the investment manager’s reputation will still suffer. Interestingly, one of the first moves by John Tiner, the new Chief Executive of the FSA, has been for the FSA to call for a database of products and establish the risk on those products to enable consumers to make better choices. This still doesn’t free the investment manager from undertaking thorough diligence on establishing and monitoring product risk, but the manager should now be able to articulate the risk appetite of the firm and the product, so customers can ensure that they are aligned before they buy the product. Seeing the future The reputation of an investment manager is a precious thing; once tainted, whether by wrongdoing or association, it is hard to restore. In addition to avoiding association with mis-selling, investment managers are fortifying their protection of shareholders in their funds. Investment managers of international funds in particular can no longer afford to be complacent should market timers or arbitrageurs be using their funds for gain to the detriment of long-term shareholders. Firms need to be dealing successfully with all the elements of risk, be it regulatory risk, risk to reputation, operational risk or market credit risk. They also need to be realistic about their internal weaknesses and human frailty. A problem with meeting the requirements for Sarbanes-Oxley and similar initiatives is that it is often the employees most directly involved who are essentially being asked to critique how they are doing their jobs. For example, it may be difficult for finance staff to step back and look objectively at where the key numbers come from, what risks those numbers represent and what systems they rely on to produce those numbers. Another problem can be that data Firms need to be designed for one purpose, say internal benchmarking, progress to being relied on dealing successfully inappropriately, e.g. for significant price sensitive disclosures put in financial statements. with all the elements of risk, be it regulatory risk, All information needs to be challenged robustly, which may be done more effectively by risk to reputation, an independent team with a broad mix of skills and experience. Also, in seeking to provide operational risk or market credit risk.
  • 42. 41 an effective gap analysis, it is helpful to compare with industry benchmarks and best practice, particularly what is relevant for their size and type of organization. It is not enough for a firm to devote adequate resources to making sure that it complies with current regulatory requirements. It also needs to be in a position to act on prospective regulatory requirements. For example, companies throughout the EU will have to comply with International Financial Reporting Standards from 2005. They will need to be much more robust, not just in getting the right numbers for now, but as they move into a new era with new requirements and new accounting practices. The successful investment management firm keeps abreast not just of change, but also of what is likely to change across each of the markets in which they operate. This is why the Sarbanes-Oxley developments have relevance for all investment managers, as regulators and best practice set new standards for how a well-managed firm should be run. John Tattersall: Partner Andrew Plumridge: Manager Telephone: +44 20 7212 4689 Telephone: +44 20 7212 4293 Email: john.h.tattersall@uk.pwc.com Email: andrew.r.plumridge@uk.pwc.com
  • 43. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003
  • 44. 43 Back in 1987, Jack Bogle, founder of Vanguard Group and subsequently its chairman, reminded a mutual fund industry trade group that trust is a cornerstone of money management. Noting that a banner hung behind the podium at a meeting the previous year had read, “Mutual Funds: a $600 Billion Industry,” he suggested it be changed to “Mutual Funds: a $700 Billion Trust.” Rebuilding public trust: meeting the challenge by Chip Voneiff There can be little doubt that the trust placed by investors in mutual fund companies has contributed to the industry’s exponential growth. Today, US mutual funds are a $7 trillion industry. American families saving for college have contributed $25 billion to 529 plans, a vehicle which didn’t exist five years ago. Hedge funds – once the province of a select few – are a $600 billion industry globally and increasingly attract the attention of retail investors, not to mention the Securities and Exchange Commission (SEC). In spite of how far the investment management industry has come, the past few years have been the most difficult it has faced in decades. Fund companies have been battered by a market decline, a major economic downturn and a genuine loss of faith by investors. Trust has faltered, and the investing public is not always interested in the confluence of factors behind the market’s collapse. For many people, the key issue is their perception that a corrupt corporate culture misled, mis-advised and misinformed investors.
  • 45. 44 This erosion of trust affects every major industry, and many governments around the globe • 60 percent of survey respondents have responded to some of these concerns. Without question, the past 18 months have believe that trust in financial institutions has eroded – so much been the busiest in the history of the SEC. Far-reaching reforms have been introduced in so that major structural reforms the US, most notably the Sarbanes-Oxley Act. Ultimately, however, government cannot are necessary. legislate integrity and the trust it generates. • More than 80 percent believe that As the custodian of investor assets and as both consumer and purveyor of financial failure to improve their own information, the investment management industry is in a unique position to rebuild trust standards of governance could make capital more expensive for in the markets. But first the industry needs to address concerns about its own financial them and their stock less stable or reporting, and prove to regulators and the investing public that it is capable of less attractive to investors. self-governance. Without that first step, the industry risks continued market uncertainty, further loss of investors and more regulation. • 63 percent say that demands for ever-higher quarterly earnings is Even though it is not their only responsibility – or even their primary responsibility – the biggest barrier to improving governance. This suggests greater the investment managers have a major stake in rebuilding trust. Furthermore, as conduits attention is focused on generating for investment, investment managers are in a position not only to leverage influence, short-term performance than on but also to act on behalf of average investors and to encourage better communication achieving long-term growth. with investors. • 56 percent say that the real pressure to improve transparency and The financial services industry’s role: A survey governance has come from outside – from investors and regulators – PricewaterhouseCoopers recently surveyed senior executives at top financial institutions rather than from management. around the world to check the industry’s progress in leading the rebuilding of public This increases the challenge, confidence. The survey’s bottom line is that the bankers, investment managers, because to be genuinely effective, fund executives and other executives we interviewed, despite their key role in the change has to be embraced internally, not externally imposed. financial services industry, acknowledged that they are not taking the lead they could do in improving governance standards and restoring trust in the public markets. These leaders understand the stakes. They recognize the need for stronger governance procedures as a way to restore trust among their investors and the investing public at large. But institutions do not always act on that understanding. Financial services companies have a broad range of disclosure practices. Most report only what the law or regulations require, rather than an inclusive array of predictive business performance indicators. Few consistently report relevant non-financial information.
  • 46. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 45 Principles for restoring trust PricewaterhouseCoopers believes the financial services industry’s leadership role must go beyond providing more information toward a focus on three core principles: accountability, transparency and integrity. • Accountability: The provision of information must be supported by a commitment to be responsible and accountable; that is, we must deliver accurate and useful information – as management, as auditors, as regulators – and be held accountable for our actions. • Transparency: Investors and other stakeholders deserve information that is complete, easy to understand, and timely. In the months ahead, the fund industry is likely to be challenged to further improve its transparency. Recent SEC hearings on hedge funds included calls for greater disclosure paired with sympathy for making hedge funds more accessible to small investors. Congress also has asked the SEC to report on the transparency of mutual fund investment performance and expenses. • Integrity: While compliance with laws and regulatory requirements can be enforced, integrity comes from within. People at all levels of every firm must do the right thing, delivering both positive and negative information, and not just what is easy or profitable. How can fund companies and service providers make this happen? The industry’s road map starts with some specific suggestions enabling it to play a leadership role in restoring public trust. Global GAAP The industry should lend its support to moves by regulators to formulate consistent international accounting principles. We call this IFRS (International Financial Reporting Standards). Such a system, based on principles rather than rules, does not exist today but is a logical step for an increasingly global world. Markets, companies, investors and capital flows all transcend borders. So should accounting standards.
  • 47. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 46 Consistent standards enable investors and underwriters to gain a clearer picture of an institution’s performance. They ought to be principles-based, giving flexibility without compromising transparency. Such standards for measuring and reporting financial information would be consistently applied, permitting accurate analysis on any basis, at any time, anywhere. The European Union has taken an important step by requiring its member states, as well as companies registered within their boundaries, to comply with international accounting standards within two years. Some tailoring of global standards may be appropriate for investment companies to recognize their unique attributes. The importance of flexibility in principles-based standards is to allow information to be reported in a way that is most understandable to the ordinary investor. As with all other financial statements, investment company financial statements must be sufficiently transparent to allow both current and prospective investors to make fully informed financial decisions. Relevant disclosure Financial institutions should rethink their own standards of disclosure, especially non-financial disclosure. Our survey found that financial institutions remain wary of disclosing more than the requirements. As a result, most internally available information used to manage the business is not revealed to investors. However, investors need to know all factors that create value. Equity analysts evaluate both tangible and intangible factors to measure the risks and prospects that determine a company’s valuation. Standards for non-financial and intangible asset disclosures must be established within the financial services industry, possibly through trade associations drawing up guidelines that identify the sector’s value drivers. Essentially, we need a set of agreed metrics that are used consistently among companies within the industry. Promoting XBRL Financial companies and regulators must work together to develop Web-based reporting through the use of Extensible Business Reporting Language, or XBRL. Employing the Web’s
  • 48. 47 ability to enhance the timeliness and relevance of data will make analysis of companies easier. XBRL is a series of “tags” that are added to data to make them more readily accessible via the Web. In addition to helping disclosure, XBRL can improve internal productivity as information is prepared once and shared more easily across an institution. A number of issues are driving the need for the industry’s adoption of XBRL, including: • Companies face demands for increased timeliness, greater transparency and more frequent reporting, as well as enhanced internal decision-making capabilities. • Inefficient systems and poor interfaces hamper the consolidation of processes, resulting in manual processing of information or dual data entry (with increased errors). • Selection and implementation of new applications, often to meet the demands of mergers and acquisitions activity, creates the need for open architecture. • The conversion to different GAAPs drives the adoption of new reporting models. • Multiple forms of reporting, including regulatory filings, puts pressure on the industry to standardize and accelerate data exchange. The investment management industry has much to gain from the adoption of XBRL. Producers of financial information would be able to tell their story more clearly with Web reporting enhanced by XBRL. For the industry’s customers, XBRL enables more timely, accurate information for making decisions, enhanced functionality on Web sites, and improved language translation capabilities, which is increasingly important in a global market place. Strengthening governance Whenever financial institutions provide capital, they should seek to strengthen standards at those companies. Investment managers should establish corporate governance guidelines, and work together to compel the companies they invest in to meet these criteria. Increasingly, institutional investors in the US and Europe are discussing this option. They need to assert their rights as owners, and intervene in poorly governed companies.
  • 49. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 48 Similarly, financial institutions ought to uphold the highest underwriting standards when they bring companies to the capital markets. This requires their best efforts to avoid conflicts of interest. Checks and balances Financial institutions should do more to put in place appropriate checks and balances on their own top managers. If they are to hold other companies to the highest standards of governance, their own house needs to be in good order. Yet, we see only tepid support for beefing up the role and responsibility of independent directors, and find that the pressure to alter governance practices is most intensively exerted from outside the organization, rather than coming from within. Conclusion Many people have lost confidence in the competence of business leaders. They question the integrity and independence of outside directors and auditors. They wonder about the completeness and accuracy of corporate reporting. All of this shakes their faith in the business world and in the securities markets in which funds invest. This industry can and should use its market power and influence to strengthen governance standards. Beyond our industry’s own initiatives, investors will have to regain their understanding of risk which many forgot in the bull market. Equity investment means investing in companies, which can fail for all sorts of reasons. Nevertheless, if investors have accurate and complete information, they will feel that they have a fair chance of correctly evaluating their risk. Ultimately, a long-term commitment to reform is necessary to restore the public’s faith in the capital markets – faith that is essential to their willingness to invest in mutual funds and other investments. The industry must work together to rebuild the trust that we have lost, and that is so essential to our long-term success. This industry can and should use its market power and influence to strengthen governance standards. Chip Voneiff: Partner Telephone: +1 312 298 4815 Email: chip.voneiff@us.pwc.com
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  • 51. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003
  • 52. 51 PricewaterhouseCoopers (www. pwc.com) the world's largest professional services organization, helps its clients build value, manage risk and improve their performance. As a leading provider of professional services to investment managers, PricewaterhouseCoopers has a multi-disciplinary team of professionals comprised of business advisors dedicated to the industry. Who to contact This team includes over 500 partners, supported by a network of professionals, whose specialist knowledge and experience enable us to provide our clients with insights into marketplace developments and global opportunities. PricewaterhouseCoopers offer industry-focused solutions and strong implementation capability, providing a globally coordinated approach to the investment management industry's business needs. To find out more about our services, contact your usual PricewaterhouseCoopers representative or one of the following Investment Management Leaders:
  • 53. 52 Global and UK Simon Jeffreys +44 20 7212 4786 Asia Pacific and Hong Kong Robert Grome +852 2289 1133 Europe, Middle East and Africa Marc Saluzzi +352 49 48 48 2009 US and North America Chip Voneiff +1 312 298 4815 Global Corporate Finance & Recovery Nigel Vooght +44 20 7213 3960 Global Systems and Process Assurance and XBRL Thom Barrett +1 617 530 7363 Global Tax Services David Newton +44 20 7804 2039 Argentina China Santiago Mignone +54 11 48 91 24 12 Alex Wong +86 21 63 86 59 99 Australia Cyprus David Prothero +61 2 8266 2916 Costas Mavrocordatos +357 2 55 52 02 Austria Czech Republic Christian Kraetschmer +43 1 501 881 901 Petr Kriz +420 2 5115 2045 Bahamas Denmark Clifford Johnson +1 242 302 53 07 Mikael Sørensen +45 39 45 91 02 Barbados Estonia Michael Bynoe +1 246 467 6801 Urmas Kaarlep +372 614 1 801 Belgium Finland Emmanuèle Attout +32 2 710 40 21 Juha Wahlroos +358 9 22 80 14 37 Bermuda France George Holmes +1 441 299 7109 Jacques Lévi +33 1 56 57 80 46 Brazil Germany João Manoel dos Santos Markus Burghardt +49 69 9585 22 40 +55 11 367 437 87 Gilbraltar Canada Colin Vaughan +350 73520 Barry Myers +1 416 869 2441 Greece Cayman Islands Lorraine Scaramanga +30 1 68 74 710 Noel Reilly +1 345 914 8600 Guernsey Central & Eastern Europe Coordinator Mike Bane +44 1481 719 314 Dariusz Nowak +385 1 6328 840
  • 54. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 53 Hungary Norway Mike Birch +36 1 461 91 83 Geir Julsvoll +47 23 16 05 40 Iceland Philippines Hjalti Schiöth +354 550 53 37 Blesilda Pestaño +63 2 459 3035 India Poland Kersi Vachha +91 22 22 83 27 75 Reg Webb +48 22 5234 437 Ireland, Republic of Portugal Marie O'Connor +353 1 66 26 308 António Assis +351 213 197 013 Isle of Man Romania Mike Simpson +44 1624 689 689 Vassile Iuga +40 21 202 8800 Israel Russia Joseph Fellus +972 3 795 4683 Richard Munn +7 095 967 6374 Italy Singapore Fabrizio Piva +390 2 77 85 241 Bin Hwee Quek +65 62 36 30 28 Japan Slovak Republic Toshiyuki Tanaka +81 3 5532 2508 Eva Hupkova +421 2 5441 4101 Jersey South Africa Brendan McMahon +44 1534 83 82 34 Pierre de Villiers +27 11 797 5368 Korea South & Central America Coordinator Jae-Hyeong Joo +82 2 709 06 22 Santiago Mignone +54 11 48 91 45 12 Latvia Spain Juris Lapshe +371 709 45 05 Antonio Greño +34 91 568 46 36 Lithuania Sweden Chris Butler +372 5 239 2303 Sussanne Sundvall +46 8 555 332 73 Luxembourg Switzerland Thierry Blondeau +352 49 48 48 2511 Thomas Huber +41 1 630 24 36 Malaysia Taiwan Mohammad Faiz Azmi +60 3 26 91 9773 James Huang +886 2 27 29 52 08 Malta Thailand Joseph Camilleri +356 25 647 603 Unakorn Phruithithada +66 2 344 11 34 Mauritius Turkey Jean-Paul de Chazal +230 207 5100 Faruk Sabuncu +90 212 259 4980 Netherlands Ukraine Sonja Barendregt-Roojers Jorge Intriago +380 44 490 67 77 +31 10 4008 639 United States New Zealand John Stadtler +1 617 530 7600 Paul Mersi +64 4 462 7272
  • 55. INVESTMENT MANAGEMENT PERSPECTIVES NOVEMBER 2003 54 In addition to Perspectives, PricewaterhouseCoopers regularly produces surveys, newsletters, white papers and brochures on industry issues. These include: • Global Investment Management Survey • Global Private Banking/Wealth Management Survey • Eurofunds Survey • Global Investment Performance Measurement Survey • EIU E-briefings: Compliance: A gap at the heart of risk management, Wealth management at the crossroads: Serving today’s consumer, Economic Capital: At the heart of managing risk and value • Global Statement of Qualifications • Savings Directive Seminar Highlights • The regulation and distribution of hedge funds in Europe: Changes and challenges • European Investment Management Newsletter • Trusted and Efficient Financial Reporting: A working paper discussing a new solution to facilitate straight-through reporting of business information • Working guide for an investment company’s audit committee • Auditor independence after Sarbanes-Oxley: Guide to auditor services for fund audit committees • Discriminatory tax barriers facing the EU funds industry • Financial services outsourcing insights For more information and copies any of these publications, please contact Justine Gonshaw, Global Marketing Manager on +44 20 7213 3453 or justine.gonshaw@uk.pwc.com. To be added to our mailing list, please contact Russell Bishop: russell.bishop@uk.pwc.com
  • 56. Disclaimer: Investment Management Perspectives is produced by experts in their particular field at PricewaterhouseCoopers, to address important issues affecting the investment management industry. It is not intended to provide specific advice on any matter, nor is it intended to be comprehensive. If specific advice is required please speak to your usual PricewaterhouseCoopers contact or the contacts detailed on page 51 of this publication. PricewaterhouseCoopers (www.pwc.com) is the world's largest professional services organisation. Drawing on the knowledge and skills of more than 125,000 people in 142 countries, we build relationships by providing services based on quality and integrity. © 2003 PricewaterhouseCoopers. All rights reserved. “PricewaterhouseCoopers” refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. Designed by Court Three Graphic Design Consultants
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