www.pwc.com/us/assetmanagement Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 Highlights October 2012 Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Contents Introduction 1 Risk management 2 Regulatory change 6 Valuation 11 Contract review process 13 Board effectiveness 15 Concluding thoughts 18 Contact information 19 Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 1 Introduction PwC invited independent directors from the boards of some of the nation’s leading mutual fund complexes to participate in an informal discussion of current issues facing the industry. The exchanges, facilitated by members of PwC’s asset management practice, generated important insights into what directors are thinking about in today’s evolving marketplace. Directors shared their views on matters including compliance with new regulatory initiatives, risk management and valuation, questions surrounding the review of management contracts and the effectiveness of boards themselves. The perspectives provide a summary of leading practices in mutual fund oversight, explain how directors are meeting the challenges they face and provide insights into the evolving role of directors and boards in the funds industry. Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 2 Risk management Background The recent financial crisis has raised questions about the effectiveness of current risk management practices. Today, nearly four years after the beginning of the financial crisis, the mutual fund industry continues to explore how to identify, manage and mitigate risks and develop a more consistent, proactive and adaptive approach to risk management. Because of their fiduciary responsibilities, mutual fund directors have a keen interest in facilitating effective management of the risks undertaken by the adviser in the funds they oversee. Within the scope of their responsibilities, there is significant room for directors to exercise their oversight function. How they are doing so in a period of market volatility and uncertainty, and the concerns they and their peers are seeing, was the opening subject of this year’s PwC Mutual Fund Directors Roundtable. Directors’ comments How directors oversee the management of risk in their funds is among the most topical items on the agendas of many boards. Directors expressed their belief that they need to understand the key risks that affect their funds and strategies as well as the steps that management is taking to control and mitigate the risks; understand how the risk framework processes work, especially with regard to escalation of issues to the board; and set and reinforce the tone and culture around sound risk management. The role of the adviser in risk management, in contrast, is much more tangible: To implement the board’s risk management policies and support the board in its oversight role. Advisers should have processes in place, manage them and keep the board apprised as to their effectiveness. All of this should be done in ways that are digestible by the directors and useful in their oversight capacity. While some directors question whether they are doing enough to fulfill their risk management oversight and influence responsibilities, others are concerned over whether they may cross a line and become too involved in fund management decisions. Often, this tension is exacerbated by lack of clarity around roles and responsibilities between the board and the adviser. Other times, the board may feel that advisers also may not be proactive around what the board needs in its oversight role. If the board does not receive the information it believes it needs, it often feels compelled to become more directly engaged. In order to avoid this situation, the board and the adviser need a robust dialogue about expectations in which the board communicates what it wants to know, and the adviser provides the information to address any information gaps. The right amount of information is also important. In some cases, boards receive so much information that they cannot effectively put it into context. Similarly, some directors are concerned that advisers are taking a legalistic approach to risk management, with their efforts focused more on regulatory compliance and less on whether the adviser has the right people and processes in place for oversight. Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 3 Further driving the need for board oversight is that investor due diligence increasingly focuses on the risk management aspect of a fund’s operations. Beyond the implications for a fund’s ability to gather assets, the efficacy of risk controls has an enormous impact on reputational risk. This risk directly affects the brand, with implications across the platform for companies with multiple lines of business. The directors think that boards generally need simple, clear views into risk processes and better guidance about tested risk management processes that actually work, especially in times of stress. Part of the problem is that many senior people in advisory firms lack the requisite background in risk and often have not thought through the implications of risk management decisions. Ultimately, directors need relevant information that is provided in ways that are comprehensible and actionable. Having people in management trained and motivated goes a long way towards reducing the risks to which the fund is exposed. Tone at the top is crucial. Other risk management-related observations by directors: Risk management should not be a siloed function but instead operate across the organization. However, enterprise risk management processes and frameworks may appear to provide greater oversight than really exists. Enterprise risk management is only as effective insofar as it is able to produce a “risk radar” that is meaningful and forward-looking. Risk dashboards, a popular way of presenting risk information, can demand considerable resources and may not highlight underlying issues. Many current models of dashboards either have too many metrics to be comprehensible or, at the other extreme, do not have much data backing them. The well-designed risk dashboards synthesize key qualitative and quantitative data and generate meaningful and actionable information for the board. Because of regulations, banks have traditionally been forced to have more structure and scrutiny around risk management than investment advisers. However, regulatory changes such as those included in Dodd-Frank (including the Volcker Rule) will result in at least some areas of asset management, such as money-market funds, facing heightened risk oversight and some risk requirements similar to those which govern banks. A key distinction between banks and asset managers, however, is that traditional measures of banking risk including capital and balance sheets are not applicable to asset management firms which are typically funded by client assets. While the focus of risk management oversight is primarily on the adviser and the investment management process, directors recognize they also need to devote time to other potential sources of risk. For instance, information and data security, operational processes and client service are key risk areas to monitor. In addition, the role of third-party providers such as transfer agents, custodians and pricing services sometimes receives too little attention. Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 4 Risk management roles for directors and fund advisers Director responsibilities should include maintaining awareness of the most significant risks to the fund (including risks of the adviser or its affiliates that may affect the fund) and the steps being taken to manage those risks. Directors should understand the current risk management processes, ask questions where appropriate and obtain assurances that the processes are reasonably designed to manage and control the fund’s material risks. Perhaps most importantly, boards should encourage and reinforce a strong “tone at the top” at the adviser by, among other things, sustaining an appropriate focus on risk management. In addition, directors should be reassessing their tax functions, which are being asked to address new compliance requirements, more complex processes, smaller tolerances for error and expectations that they be a part of risk management. Advisers should support the board in its oversight role, providing educational sessions on risk management generally or on specific topics, providing regular, periodic reports on the fund’s investment risks. They also should identify and report on the most significant business operational risks and escalate material risk-related issues and events to the board when appropriate. The adviser also should demonstrate to the board the effectiveness of its risk management processes to identify, measure, control and monitor the most significant risks to the fund. PwC’s view The conditions that have led to a greater focus on risk management, such as economic uncertainty, volatile markets and new regulatory regimes, are likely to continue. In response, mutual fund advisers are seeking to enhance their risk management programs, especially to focus on newer, emerging risks or those that might be considered less probable – so-called “black swan” events. In order to do this, they are trying to identify emerging trends, understand interconnections between risks and develop relevant risk mitigation strategies. Advisers and boards will probably continue trying to take an enterprise-wide approach to risk management that would bolster the linkages between risk, regulation, investment performance and business strategy. As part of this, advisers should acquire a more nuanced approach to risk, distinguishing among operational risk, compliance risk, tax risk, et cetera, and developing more targeted mitigation initiatives. Although there are still significant differences in how advisers implement risk management, leading practices are gradually becoming accepted across the industry. Given the history of the past several years, when risks and correlations arose unexpectedly, more attention will be devoted to managing currently unknown risks. While the likelihood of many risks may have been deemed low, their impact can be significant, and potentially franchise-destroying. For example, many risk managers Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 5 focus on vulnerabilities such as the European debt crisis and its implications, but only on the primary exposure, and not the downstream implications and exposures. In addition to economic risks, managers are recognizing that tax risks need to be a part of the overall risk management function. No longer is tax simply an adjunct to a firm’s day-to-day operations; instead, it is becoming a fully integrated part of the firm’s risk management function. This requires some asset managers and their tax departments to approach the tax function differently. More focus also will be placed on continuously monitoring the environment to spot developing trends, understand interconnectedness with other risks and plan responses. The focus will be on identifying the vulnerabilities rather than on trying to predict risk events. Once vulnerabilities are identified, worst outcomes can be developed, risk assumptions detailed and scenarios for external events projected. A particularly effective way to understand such “unknown” risks is through reverse stress-testing. Unlike scenario analysis, which starts with a risk event, reverse stress- testing begins with the outcome and identifies circumstances that may cause it. Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 6 Regulatory change Background One of the most important debates arising from the financial crisis was over how to enhance the safety of the financial system. One answer was the new regulatory initiatives that were adopted in the US, Europe and elsewhere around the world. The Dodd-Frank Wall Street Reform and Consumer Protection Act, the Basel Accords and the Solvency II Directive, among others, are having enormous impacts on the financial services industry. The impacts of these initiatives have been more significant in some sectors, such as banking, than on others. Yet most areas, including mutual funds, are seeing the effects of the most ambitious regulatory initiatives in decades. While Dodd-Frank and other major legislative packages have received the greatest attention, less visible measures, such as the Foreign Account Tax Compliance Act of 2009 (FATCA) and the US Securities and Exchange Commission’s proposed changes to 12b-1 fees, are likely to have a greater direct impact on mutual fund governance and operations. The following table identifies key issues. The new regulatory and compliance reality for mutual funds New regulatory obligations and accelerated rulemaking The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 New rules for money-market funds, pay-to-play, short-selling, proxy disclosure, asset-backed securities, REITs, Form ADV, large trader reporting and CDS clearing Concept release on use of leverage and derivatives by mutual funds; potential new rules Incentive-based compensation rules for certain large advisers More to come: Proposed rules on target date funds, distribution expenses (i.e. 12b-1 plans) and dark pools Systemic risk reporting Monthly reporting requirements to Treasury on Form SLT Foreign jurisdiction laws and rules Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 7 The new regulatory and compliance reality for mutual funds Increased client/prospective client demands Prospective institutional shareholders due diligence and requests for proposals include questions concerning compliance programs and breaches Clients/shareholders request information about contacts from enforcement investigators and examination results, including copies of deficiency letters Sub-advisers are seeing more vigorous due diligence and ongoing monitoring and reporting requests from primary advisers; diligence is moving beyond certification process Increased regulatory expectations Regulators may expect a comprehensive compliance program: no gaps Examiners may look for senior management support for and knowledge of the compliance program – and may interview management about it during an exam Examiners may expect robust testing that identifies potential problems, annual reporting and use of available technological tools Examiners may expect a governance process that assures reporting up and timely action to resolve problems and address their root cause; information flow to and from the fund board is key More examinations Increase in staffing and budget Risk-driven examinations, cause exams, sweeps Consequences of non- compliance Enforcement investigations are more likely now – the SEC is targeting firms with a special unit of investigators focused solely on the asset management industry in coming years. Joint investigations by the SEC and the Department of Justice Cooperation among regulators: SEC, CFTC, FinCEN, IRS, FBI, Department of Labor, state AGs/securities divisions More cooperation agreements between SEC and foreign counterparts (FSA, SFC, CSRC) Cooperation and non-prosecution agreements between SEC and witnesses Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 8 The new regulatory and compliance reality for mutual funds Investigative techniques have changed New whistleblower program with bounties will encourage tipsters Revitalized bounty program for those who provide tips concerning insider trading Wiretaps Use of data analysis Ability to analyze hundreds of millions of electronic trading records to identify groups of traders who repeatedly made similar well-timed bets Trained, experienced investigators and examiners (industry experience, Chartered Alternative Investment Analysts, Certified Fraud Examiners) Directors’ comments The participants in the Mutual Fund Directors’ Roundtable believe that FATCA is currently one of the top regulatory issues from a compliance standpoint. While the banking sector has been focused on FATCA for a long time, asset managers had been less certain about both its final adoption and its applicability to them; now that the regulations were issued in February 2012, boards and advisers are focusing on building a path to compliance. One of the first and most relevant questions directors are considering is: Who owns FATCA? While it is a tax matter, other staff beyond the tax function – operations, data, compliance and information technology – should be closely involved in implementation of FATCA programs. Banks and insurers have come to this conclusion and focus on implementing FATCA across their business lines. The directors in attendance at the roundtable understand that both boards and management need to be engaged on FATCA compliance and know what the framework will be. There is a window in which they can focus on this, but it closes with the 2013 deadline for companies to enter into foreign financial institution agreements. With proposed SEC regulations on money-market funds expected shortly, the management and future of these funds is also an issue of growing importance. Federal officials think there is risk in the money-market arena that has not been mitigated by previous reforms. In turn, the directors see less certainty about the direction of the proposed reforms and significant potential impacts on the economic viability of these investments. Among the proposals under consideration are floating net asset values, increased capital requirements or buffers or shareholder redemption holdbacks. Each of these proposals brings with it sizeable implementation, programming and accounting issues that could affect the viability of these funds. Funds are looking closely at whether and how they could manage each of these sets of requirements. [...]... http://www.nacdonline.org/Store/ProductDetail.cfm?ItemNumber=3854 PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 17 Thoughts from the Boardroom Concluding thoughts The discussions at this year s Mutual Fund Directors Roundtable covered a wide range of issues of interest to board members From the discussions, it is clear that directors remain concerned about the rapid pace of change in the industry and the ability of fund companies to... business PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 16 Thoughts from the Boardroom environment and governance requirements The board s point person, whether the CFO, counsel, compliance officer or another designees, should take responsibility for regular educational modules, both during meetings and designed for the directors to learn at their own pace These could focus on everything from. .. management directors do not necessarily need funds expertise across the entire board PwC' s "Annual Corporate Director Survey" (2011) http://www .pwc. com/us/en/corporategovernance/publications/annual-corporate -directors- survey.jhtml 2 PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 15 Thoughts from the Boardroom There is considerable debate on boards over the various options for finding suitable... needed to accurately value the securities in their portfolios PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 12 Thoughts from the Boardroom Contract review process Background Section 15(c) of the Investment Company Act requires that a fund s independent directors approve the investment advisory contract by an in-person vote at a meeting called for that purpose The 15(c) contract review... strategies are implemented During the dot-com boom, for example, one fund company had its managers enter into technology investments, and so had similar kinds of exposure across the entire organization, rather than just individual sector funds PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 13 Thoughts from the Boardroom Sub-advised funds pose a different challenge Many fund boards have a hiring... primarily with the management contract, other contracts, including the fund s underwriter, are also subject to annual review However, there may be other service providers the board should examine, including custodians, fund administrators and transfer agents, to encourage them to be efficient, effective and acting in accordance with the board s directives PwC Mutual Fund Directors Roundtable 2012 | Highlights. .. reported to the board? PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 10 Thoughts from the Boardroom Valuation Background The Investment Company Act of 1940 requires that securities for which market quotations are readily available be valued at current market value, and that other securities be valued at fair value as determined in good faith by the board While boards can delegate the day-to-day... Email: david.l.trerice@us .pwc. com PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 19 www .pwc. com/us/assetmanagement © 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership All rights reserved PwC refers to the US member firm, and may sometimes refer to the PwC network Each member firm is a separate legal entity Please see www .pwc. com/structure for further details This content... challenges for mutual fund managers and directors who should understand the impacts of these new rules and regulations on the adviser and its affiliates and then develop and implement compliance initiatives Simultaneously with these accelerated rulemakings come higher expectations by investors and stakeholders and enhanced regulatory oversight and enforcement PwC Mutual Fund Directors Roundtable 2012 | Highlights. .. current and emerging regulatory focus areas? Fund governance/ information flow Has the fund board created an effective relationship with the fund CCO? Do the fund CCO and other service providers report sufficiently detailed information to enable the board to properly oversee the fund? Valuation Is your fund able to price and value securities appropriately? Is the fund s NAV susceptible to market timing? . www .pwc. com/us/assetmanagement Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 Highlights October 2012 Thoughts from. rules Thoughts from the Boardroom PwC Mutual Fund Directors Roundtable 2012 | Highlights Page 7 The new regulatory and compliance reality for mutual funds