This Bulletin was written, in part, from the proceedings of a panel discussion of mutual funddirectors/ trustees and formed the basis of a special supplement of the Fund Directions newsletter.

 The purpose of this MPI Bulletin is to provide mutual fund directors with some practical guidelines as to their responsibilities for the management aspects of the Internet on fund operations. The supplement is divided into three sections:

Statutory and practical authority, under which fund directors are permitted, even encouraged, to address these topics. This section also tries to define the scope of their authority.

Competitive and strategic impact of the Internet on mutual funds, including the variety of uses to which it may be put.

Responsibilities of directors for issues relating to privacy and security, both of which are exacerbated by the wide application of the Internet.

Prescribing the Directors' Authority and Responsibility for Fund Operations

The panel explored in considerable depth the limits and statutory authority which the directors have to deal with these issues. Their fear was that the term "Internet Operations" provides a temptation for the directors to get into micro-management as opposed to good governance. On the other hand, the Internet is so important and the supporting technology so fundamental to the future of collective investment vehicles that directors have no option but to be well informed and able to provide, at the every least, meaningful guidelines for the fund manager.

The provisions of the 1940 Investment Company Act, which relate to 12b-1 distribution fees anticipate that the fund directors will ensure that the money will be used for the benefit of shareholders. Historically, the implication is that expending 12b-1 fees on marketing will grow the assets and provide economies of scale, which can be shared with the shareholders. Use of the Internet both by the fund governed and by competitors is so critical to the marketing mix that directors have no option but to be involved.

In addition, the contract renewal process calls for the directors to make a judgment about the future ability of the manager to provide good investment, accounting, transfer agency and custodial services. All of these are so dramatically impacted by the Internet, that the directors must be involved. Furthermore, the contract renewal process calls for the directors to make a judgment about the adequacy of the level of shareholder services. The level of service, for example, response time and accuracy, are tied to the fund's Internet strategy.

However, the panel was concerned that directors confine the scope of their responsibilities to setting guidelines, adopting policies and reviewing strategy. They should not get into making decisions about technical, or even strategic issues. Furthermore, the directors should recognize that the shareholders have the right and ability to sell their shares if some aspect of the fund's operations displeases them.

Strategic Uses of the Internet

The panel's intent was not to be exhaustive about all the possible strategic uses of the Internet, but rather to provide a general primer for fund directors as they review alternative strategies.

Spectrum of Alternate Internet Strategies

The Internet can be used along a wide spectrum of strategies, ranging, at the least sophisticated end, from use solely as an communications vehicle for management company personnel (essentially an Intranet) to, at the most sophisticated end of the spectrum, an additional sales channel, where investors can actually buy and sell fund shares.

An Intranet can be used (a) solely internally, (b) to embrace the wholesale sales force, (c) to incorporate external brokers and financial advisers and finally (d) to electronically connect to the major fund supermarkets, such as Schwab, Fidelity and Merrill Lynch.

The Internet may be used as a communications device with investors and potential customers. In this regard, it may a supplement to well-established telephone and written communications. It may merely provide a general description of the funds available from the manager, leaving the most intricate description of risk and asset allocation to written materials. Alternatively, the Internet may provide an extensive education tool, with sophisticated allocation models, risk evaluators, rate of return estimators and cost projections.

The Internet may be used solely as a method of distributing outward-bound communications ­ as a way to distribute prospectuses, fund profiles, and annual reports. In every case, use of the Internet calls for just as much care, accuracy and review as written documents. The fact that the Internet is an interactive tool in no way reduces, indeed it may increase, the need for careful review and checks of accuracy.

Long term, the Internet will inevitably be used to increase assets. Only a few fund families do this today, most noticeably Invesco and Prudential. When this is adopted as a strategy, the directors have all the same responsibilities as they do when funds are sold off the (advertising) page, most importantly, required disclosure and test of appropriateness. The recent passage of E*Signature legislation combined with the SEC clarification of what constitutes adequate delivery of prospectus information on the Internet, will greatly increase the number of fund groups which utilize the Internet for fund sales. The Internet is already being used as an asset allocation tool and this will grow rapidly as it simplifies the job of a financial advisor or broker.

Lastly, the Internet may be used to reduce the operations or processing cost associated with managing mutual funds. Distributing monthly investor balance information; the actual purchase, sale and exchange of fund shares; as well as the periodic assessment of portfolio risk and asset allocation can be accomplished over the Internet.

The Internet will also play a large part in the differentiation of one fund family from another in the hugely important 401(k) market. Most corporate sponsors of 401(k) plans want their employees to have ready access to their balances and to be able to complete purchases and sales within their accounts. A fund group that does not provide this facility may soon find itself cut out of this rapidly growing source of fund assets.

Internet as a Competitive Threat

The panel felt that the directors of a fund would not be exercising their fiduciary duty and business judgment if they ignored the competitive threat posed by the Internet. Since the directors have to be concerned with passing economies of scale through to the investors, particularly when there is a 12b-1 distribution fee in place, they must also be concerned about diseconomies of scale. Should a fund, which they govern, lose assets to a competitor because the Internet strategy of the manager is poor, or non-existent, the directors must be concerned.

In addition, the existence of the Internet has opened up several business model alternatives to mutual funds, as we know them today. Twenty years ago, the concept of a pooled investment trusts was only possible using a physical collection and investment mechanism. With the Internet, it is possible to achieve the same result in a virtual way. The best known of these today are Exchange Traded Funds (or ETFs), although these do require a physical sponsor. A more recent, and still obscure, mechanism allows individual investors to diversify their holdings according to a formula or in accord with the recommendations of an experienced professional, without using the services of a corporate entity. The best known of these are Netfolio and Fund(fn) that, interestingly, is owned by a former SEC commissioner.

Recognizing that new alternatives to mutual funds as we know them today are emerging, the Panel felt that directors may have to be cautious not to inadvertently allow the existing shareholders to subsidize the development and distribution of these new vehicles. Such alternatives may gradually steal assets from today's mutual funds, triggering diseconomies of scale that will only hurt the existing shareholders.

Legal Review of Internet Related Subjects

The operation of the Internet is, by its nature, interactive and informal. Selling and servicing mutual funds, on the other hand, is full of legal complexity and precedent. The employees who manage and control the fund websites may not be familiar with the discipline, financial rigor and need for detailed review as those employees who managed the publication and distribution of fund literature. It would be a rare fund group which did not have their prospectuses and published reports reviewed by counsel, but that could easily happen with materials published on the web.

One of the unique features of the Internet is that it reaches potential investors beyond the geographic boundaries for which the fund is intended and registered. Perhaps the most typical example of this is when potential investors from overseas want to buy US registered funds. Similarly, US investors may want to purchase foreign funds not registered with the SEC. Clearly, the directors need to know that the manager has established a system of checks and balances to prevent sales of non-registered securities.

Privacy, Advertising and Security Issues

This section will address some of the unique responsibilities that mutual fund directors have for Internet operations in connection with privacy, advertising, chat rooms and security.

Privacy

The recent passage of the Graham, Leach, Bliley law set some stringent requirements about Internet privacy.

The most general principle is that each website which asks for identification of the visitor must state their privacy policy. For a fund group, this means that the list of visitors cannot be sold or used by a third party without the express consent of the site visitor. No panel member has knowledge of any fund web site that sells or rents their visitor list. The directors must satisfy themselves that there is an Internet privacy policy and that it is followed. Just like any other compliance issue, the directors have a right to be informed if any of the internal or external checks and balances find violations.

Advertising on the Internet

The SEC is taking a particularly aggressive stance against misleading or incorrect advertising on the Internet. Because the net is both interactive and needs to be updated daily, it is easy for routine checks and balances to be passed over in the interest of speed ­ particularly with regard to investment performance, risk-return ratings and fees and expenses.

Security and Chat Rooms

Fund operations are no different than other types of business in that the security of the website is crucial, particularly with regard to access control and password protection. In addition the directors want to assure themselves that individual investors cannot accomplish transactions over the web that would be curtailed, or at least monitored, if completed on paper or over the phone. These activities might include short-term trading and inordinately large transactions.

Included in this general category, the directors might wish to set, or at least review the manager's guidelines, for chat room conduct. At the most basic level, the employees of the manager should have some guidelines as to what they can or cannot say in Internet chat rooms. These guidelines may also extend beyond the manager's walls to brokers and financial intermediaries who sell or service the funds.

The directors should know if employees monitor chat rooms where the fund's shareholders are likely to congregate. In particular, they should know what the manager's policy is with regard to employees becoming involved in these interchanges, even if their role is solely to correct a major misstatement or misleading information. This is not unlike the responsibility to correct a major misconception with occurs in the financial media.

Finally, the directors want to ensure that there is a mechanism to find out if someone is deliberately manipulating a fund's reputation. One of the panel had experience with an arbitrageur who was trying to collect proxy votes in a chat room to overthrow the board and change a currently closed-end fund to open-end. When the directors found this was happening, they authorized a lawsuit against the arbitrageur, finally winning a landmark case.

Conclusion

In sum, the Internet has become too important, strategically and competitively, to be ignored. A significant percent of the 12(b)-1 distribution fee is absorbed in web related activities and the potential for future cost reductions is so substantial that directors have no choice but to be involved.