The main headlines from Mary Jo White’s Congressional testimony yesterday centered around her saying the markets were not “rigged,” yet several little known sentences could potentially lead to a significant policy shift at the agency regarding “rigging” investment disclosure, according to regulatory sources and recent on the record statements.  A new, aggressive SEC policy could impact alternative investment mutual funds, but it is unclear if this will impact “Dark Pools” used in high frequency trading, including the payments from exchanges to brokerage firms and the general lack of transparency.

SEC

SEC may target fund with cryptic fee disclosure and conflicts of interest

White’s statement essentially said the SEC’s policy of allowing what critics say is confusing fee disclosure, the subject of a battle between the SEC and CFTC, could be addressed.  Also on the table appears to be a more aggressive look at conflicts of interest, particularly between brokerage firms and the funds for whom they execute trades.

“The Commission has continued to bring many significant enforcement cases across our entire regulatory spectrum,” White said in Congressional testimony. This could include “actions against exchanges… and actions against investment advisers and broker-dealers for a variety of offenses, including taking undisclosed fees and conflicts of interest, and for disrupting the markets through automated trading, actions against auditors and others who serve as gatekeepers in our financial system, landmark insider trading cases, and additional cases against individuals and entities whose actions contributed to the financial crisis.”

Unlike what was generally reported, this is tough talk if it is backed with action.

In the fund arena, the “undisclosed fees and conflicts of interest” to which White refers to recently came to light in reporting by Bloomberg’s David Evans in an article on fee disclosure in managed futures mutual funds.  In the article Evans, a former CFTC enforcement lawyer turned Bloomberg columnist, reported that these algorithmic trading funds would charge fees as high as 9% without clear disclosure to the investor.

CFTC and SEC were said to have fought over managed futures mutual fund fee disclosure

The issue wasn’t so much with managed futures but more the general SEC fee disclosure policy, which was at odds with the CFTC.  CFTC Commissioner Bart Chilton, who was aware of the fight between the CFTC and SEC on the issue, advocated for transparent and simple fee disclosure. The fight centered around CFTC regulated direct managed futures accounts, which required clear and simple fee disclosure and accounting standards, vs the SEC’s more opaque mutual fund reporting standards and disclosure of fees.  When managed futures funds started offering the uncorrelated investment through securities brokerage firms for the first time, the fee and performance disclosure standards conflicted and the SEC prevailed over the CFTC on the issue.  The managed futures direct account mandated that performance was disclosed after all fees and expenses, net net, and that all account activity was transparent to the client.  Fee disclosure and the impact on performance followed a strict formula.  The SEC fee disclosure was extensive but legally dense for the average investor.  Critics have charged the complex disclosure was intentionally opaque so as to mask hidden fees, an issue first exposed on 60 Minutes but never addressed until now by White.

Get tough policy from white?

“For the 1,800 or so newly registered advisers to hedge funds and private equity funds, Chair White’s testimony yesterday highlights again some of the common deficiencies the SEC staff has encountered during its presence examinations,” said Paul Miller, a partner in the investment management practice at Seward & Kissel.  Miller, who specializes in mutual funds, noted the shot across the bow to which fund managers should adhere.  “The deficiencies, which fall into two broad categories those relating to inadequate disclosures and those relating to improper fee or compensation arrangements, have been addressed by various SEC staffers over the past year.”  From one perspective, the SEC has potentially found deficiencies in funds and will be addressing a tougher policy going forward.

“Newly registered advisers should take note of the common deficiencies and their import to the SEC, as reflected in this recent testimony,” Miller said pointing to the problem that should be addressed.  Among them mutual fund companies who benefit from transnational commissions from their broker and – hold your breadth – the hidden fees charged by brokerage firms to funds to gain access to an investment platform.  It was unclear just how far White and the SEC might extend this new policy, the point being that a new Sheriff was about to ride roughshod with funds that were held to a lighter regulatory touch in the past.

CFTC report on fee disclosure hasn’t surfaced yet

The CFTC was scheduled to release a report following the managed futures fee disclosure issue revealed in the Bloomberg article.  Speculation is the report touched on the topic of the nearly one year fight between the SEC and CFTC over proper fee disclosure and is being considered very carefully so as not to embarrass the SEC.  The SEC and CFTC have had numerous disagreements in the past, including what was said to be a “discussion” over the SEC’s version of the flash crash report, which didn’t mention high frequency trading as a cascading cause of the flash crash.