Lessons for Fund Directors from the "Bisys Crisis" Print E-mail
Written by C. Meyrick Payne, Partner, Management Practice Inc.   

The SEC has recently investigated the activities of Bisys Fund Services, a well known provider of administrative, transfer agency and fund accounting services, and 27 of their mutual fund clients.

This investigation alleges improper payments from Bisys to their clients for distribution and other services, which the Wall Street Journal describes as kickbacks of $230 million. More recently the SEC disclosed a similar investigation into SEI, another provider of back-office services. In essence this conduct constitutes taking money from fund shareholders described as being for one purpose and using it for another. The larger problem is that this conduct seems to have been conducted under agreements which were kept secret from the mutual fund boards.

The purpose of this MPI Bulletin is not to lay blame but rather to distill for fund directors five actions they could take to avoid this happening again. These are related to the contract renewal process, and are as follows:

(1) Change the responsibility for disclosure,

(2) Don’t assume that third party contracts are always independently negotiated

(3) Test the reasonableness of third party fees,

(4)Periodically issue a request for proposal (RFP) for all shareholder services, and

(5) Pay attention to the required profitability analysis. Each is discussed briefly below.

Change Responsibility for Disclosure

The most egregious aspect of this Bisys Crisis is that these agreements appear to have beenkept secret. Fund directors should change the onus of disclosure from the advisor responding toquestions from the directors to one in which the advisor is obliged to disclose whenever there areconflicts of interest and how the advisor has resolved them. The RiverSource Funds (nee AmericanExpress) have implemented an addendum to their management contracts which requires exactly this. This model has been adopted by several other complexes and seems to be working well.

Assume Nothing about Third Party Contracts

Mutual Fund Boards often focus much of their attention on the advisory contract and otheraffiliated agreements, while spending less time scrutinizing third party contracts. The commonassumption is that these contracts are de facto in the best interest of both management and the fundshareholders because the manager and the shareholder both benefit from lower expenses. A lessonfrom the Bisys Crisis is that third party contracts merit much closer attention because the potential forrebates, shared benefits and "favors" complicates the picture.

Test Reasonableness of Third Party Fees

Fund directors should satisfy themselves that the fees charged for all services are reasonable. One approach might be to retain an outside expert to contrast and compare these fees with those paid by other funds. To do this accurately two types of tests are needed, (a) buy side and (b) sell side.

Under the buy side approach, expenses for services such as administration, transferagency, fund accounting and custody are collected from other complexes and compared overtime in basis points. These analyses can conveniently be accomplished using data from Lipper,Morningstar and/or SimFund as well as using data feeds directly from the SEC’s Edgar database.

Under the sell side approach, an outside consultant needs to receive indicative pricesfrom alternate vendors. Not surprisingly these are difficult to compare because definitions arenotoriously variable and vendors are reluctant to provide indicative prices when they do not know the identity or purpose of the enquiry.

Periodically Issue an RFP

The only truly fair way to ensure that fund shareholders are receiving competitive pricing is to periodically request live bids from qualified vendors. Of course such a process is time consuming, expensive and potentially disruptive. This is why Boards should only do this, say, once every five years. The hardest part of an RFP process is to define accurately the tasks that constitute each service. For example there are many tasks which could fall under administration, rather than fund accounting or transfer agency. And, of course, the bidding process must enforce "apples to apples" consistency across each potential vendor. The act of defining the tasks under each service helps the Board to know that someone inmanagement actually understands what is going on and that prices are fair. This is important because under the typical mutual fund pass-through system of service provider costs, it is possible that no one is actually paying attention.

Pay Attention to Profitability Analysis

Profitability analysis, as required under the Gartenberg decision, is a very important but easily ignored step in the contract renewal process. Profitability is often thought to be meaningless because so many allocations are necessarily made. However the alleged rebates made by Bisys to the 27 fund companies should have been reported either as revenue or as an offset to administration, fund accounting or transfer agency costs.

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In conclusion, the lessons to be learned from the Bisys Crisis are just as important as those from the Canary Capital scandal. Both will lead to better fund governance and improved safeguards for the fund shareholder.
 
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