Speech by SEC Commissioner:
Remarks before the Independent Directors Council
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
San Francisco, California
November 28, 2007
Thank you, Bob [Uek], for that kind introduction. Thank you to the Independent Directors Council (IDC) for organizing this conference, which is sure to be of valuable assistance to you as you serve your funds in the upcoming months and years. I am sorry that I cannot be with you in person as I was with your colleagues three weeks ago in Washington, D.C., but this morning's public commission meeting on shareholder proposals regarding election of directors kept me from making the trip to San Francisco. I did participate in the SEC's last public meeting three weeks ago by videoconference from the U.S. Embassy in London. Because the videoconferencing technology passed that transatlantic test with flying colors, I am confident that it will handle the transcontinental test equally well. Before I begin, I must note that the views that I express here are my own and not necessarily those of the Commission or my fellow Commissioners.
One of the most notable events of this year in the mutual fund world was the capture of the suspected "Bishop" bomber. Beginning in 2005, threatening letters started arriving at, among other places, fund complexes. The intent of the letter writer, who called himself "The Bishop" appeared to be to scare readers into taking steps to raise the prices of certain stocks above $6.66 per share. In January of this year, two packages went out to two fund companies with pipe bombs and a note that included a demand for a stock price increase backed by a threat: "[t]he only reason you are still alive is because I did not attach one wire." 1 It is a great relief that a suspect is behind bars and that the disturbing mailings have ceased. And it is with great pride that I tell you that the staff from the SEC's Division of Enforcement was instrumental in tracking down the suspect. Chris Ehrman and Brian Shute as part of a collaborative effort with other federal and state agencies worked tirelessly to sort through the data and put the pieces together to determine "The Bishop's" likely identity. That laid important groundwork for the arrest of the suspect last April by the U.S. Postal Inspectors. The efforts by the SEC staff in this case illustrate how the hard work of a small number of individuals who are wholeheartedly committed to doing their jobs well can make a tremendous contribution to public welfare.
As independent directors, your individual and collaborative efforts also can and do make a tremendous difference. So, on behalf of investors and those of us at the SEC, the investors' advocate, I thank you for your service. You take on a lot of responsibility and risk as a director — including putting your personal reputation on the line. Investors are better off for your efforts — your diligence; your attention to the business; your advice to management; and, yes, as the party at the scene, your help in providing a sense of accountability.
I hope that investors will also be better off as a result of a rule proposal that the SEC approved at a public meeting earlier this month. The proposal would require the inclusion of single-fund summaries at the beginning of fund prospectuses and permits the distribution of a Summary Prospectus in lieu of the statutory prospectus. The statutory prospectus, SAI and shareholder reports would be online so that investors could access more information about matters in which they are interested. They would also be available in paper to anyone who asked. For those who look at the Summary Prospectus online, hyperlinking between documents would make accessing more information easy. The Summary Prospectus is intended to be trim and slim and much more attractive than its statutory counterpart. As proposed, it is limited to certain items that are presented in prescribed order: investment objectives; costs; principal investment strategies, risks, and performance; a snapshot of the top ten portfolio holdings; investment advisers and portfolio managers; information on purchases and sale of fund shares; tax information; and financial intermediary compensation. You can take a look at an example on our website to judge for yourselves how it looks.2
The SEC's tendency over the years with the prospectus has been to pile additional disclosures into it, to require that funds disclose more and more. The result has been a hulking prospectus that is daunting to the average lawyer, let alone to the average investor. According to a recent Investment Company Institute (ICI) survey, less than forty percent of investors look to a prospectus as a source of information prior to purchasing a mutual fund.3 Good disclosure that finds its way speedily into a trash can does not do much good.
We have tried to launch a slimmed-down version of the prospectus in the past. That is why it is reasonable to ask whether we, like a serial dieter, after earnestly trying to shed unwanted disclosure may soon abandon the Summary Prospectus and revert to using our hefty pre-summary prospectus. In October 1994, just before my first stint at the SEC ended, Chairman Arthur Levitt initiated a voluntary trial of a Profile Prospectus with the active participation of the ICI. In 1997, the SEC proposed allowing funds to offer investors a "fund profile," with more concise information than the fund prospectus. A year later, the Commission, with the enthusiastic support of individual investors, adopted a rule that enabled funds to use the profile. Very few funds ultimately used it.
I, for one, am optimistic that we can beat the odds this time and develop a summary prospectus that works. First, the technology is widely available to allow for a web-based summary that is backed up by readily accessible detailed information. If funds tag the data using the XBRL taxonomy that the ICI recently developed, the usefulness of the Summary Prospectus will only increase. Second, more investors are comfortable with that technology than ever before. Third, the proposal attempts to address liability concerns that dissuaded funds from using the Profile Prospectus. Our proposed approach may still need some modifications. There are a number of questions that I hope commenters will address: Should we require quarterly updates? Will the required information regarding portfolio turnover be clear to investors? Is disclosure of the top ten portfolio holdings key information for investors? Is there additional information that should be included in the Summary Prospectus? Is it clear what we mean when we say that the Summary Prospectus must be given greater prominence than any sales materials that are sent with it? I look forward to hearing what commenters have to say about these and other issues. I expect that our Office of Investor Education and Advocacy will play a role in assessing investor reaction to the proposed Summary Prospectus.
We are not proposing to include any disclosure about independent directors in the Summary Prospectus. This omission should not be taken to be an indicator of the level of our gratitude for the work that you do. As independent directors of investment companies, you serve a critically important role in the American economy. The fact that approximately 51 million households own mutual funds makes your job daunting,4 and your list of responsibilities seems to grow with every new rule that the SEC promulgates.
Independent directors now make up three quarters of nearly 90 percent of fund boards according to your newly released survey,5 and 100% of the membership of certain board committees such as valuation, audit, nomination, and so forth. So you literally carry the weight of almost every decision that the fund board makes. In making these decisions, you are all too aware that investors' money and your personal reputation are on the line. The IDC serves a valuable function in bringing you together to discuss how best to fulfill all of your obligations. The IDC also assists the SEC by providing us with your perspectives about regulatory actions that we are contemplating or problems that independent directors are facing. I am grateful for that and encourage you to continue to raise concerns with us, both collectively and individually.
If the concerns that you raise go unaddressed, it could become more difficult for funds to attract independent directors. After all, independent directors' list of duties is longer than ever as the SEC relies more heavily on them than ever before. Rhetoric about the responsibilities of the independent directors has perhaps unduly inflated expectations of the role that independent directors should play. You seem to be looked upon as part of the solution to every problem in the fund industry. The net result is significant responsibility for independent directors. As a consequence, independent directors are devoting more time to their board obligations. According to the results of an ICI/IDC survey, one third of fund complexes surveyed annually held five or more regularly scheduled meetings during 2006.6 Only eighteen percent held that many meetings ten years earlier. As you know, regular meetings are often supplemented by other meetings to address matters that may come up in between the regular meetings.
The SEC can contribute to the goal of attracting good independent directors by encouraging independent directors to focus their efforts on the areas in which they can contribute the most. The SEC should eliminate unnecessary obligations, think carefully before imposing new ones, and assist independent directors in complying with the remaining obligations. One important form of assistance is the provision of Commission guidance where it is needed.
Valuation is one area in which Commission guidance is needed. For you, as members of boards, who, after all, are responsible for valuation of funds' assets, valuation is undoubtedly on your minds. Recent events in the markets have heightened attention on valuation. It is time that the Commission undertake a more formal process of addressing this issue. Informal staff guidance without the full Administrative Procedure Act notice and comment process is not sufficient, particularly in view of how the industry has grown and the diversity of its investments. The input of directors like you who have concrete experience with valuation will be useful in helping us to get the guidance right. In the meantime, boards should use the events in the subprime market as a reminder of the importance of having robust valuation procedures and monitoring them to make sure that they are working.
Another matter for which updated guidance might be necessary is Rule 12b-1 fees. Your chairman, Bob Uek, who participated in the SEC's Rule 12b-1 roundtable last summer, noted the "badly outdated" nature of the factors that the board is supposed to consider in determining whether to continue a Rule 12b-1 plan.7 That was a frequently expressed view at last June's roundtable. When the SEC adopted Rule 12b-1 in 1980, it did not include in the rule a list of factors for the board's consideration as it had proposed to do. Rather, as commenters at the time suggested, it simply included the factors in the release. The release also included a cautionary note that suggested that those factors "would normally be relevant to a determination of whether to use fund assets for distribution."8 It is no longer necessarily the case that these factors are "normally relevant," so revisiting them seems to make sense.
Rule 12b-1 otherwise fared quite well in the roundtable discussions. Incidentally, there is some irony in the fact that some of the same people who so passionately support increasing the percentage of independent directors on the board are the same ones who say that 12b-1 plans -- which must be approved by a majority of the independent directors -- are not benefiting shareholders. There was considerable sentiment at the Roundtable that the rule had been a great success overall for investors and that, aside from some refinements around the edges, works well as is. Suggested refinements included better disclosure to investors, preferably without using terms like 12b-1, which mean nothing to most investors. This would certainly be a step in the right direction.
Three years ago, in connection with our rulemaking to prohibit the use of brokerage commissions to finance distribution, we asked whether we should propose additional changes to Rule 12b-1 or propose to rescind the rule altogether. The vigorous response to that request for comment prepared us for the avalanche of comments in connection with the roundtable.
Commenters continue to disfavor a possible approach that the SEC floated in 2004: amend the rule so that distribution-related costs would be deducted from individual shareholder accounts rather than from fund assets. Such a change would prevent shareholders from subsidizing one another's distribution and shareholder servicing costs. As the IDC and others pointed out, however, this approach would cause operational headaches for funds and unwelcome tax consequences for fund shareholders. Perhaps the operational issues could be overcome, but the tax issues would not be in our power or the industry's to overcome.
The IDC suggested that boards should be relieved of their annual approval obligations with respect to 12b-1 fees for advice and shareholder servicing, and should no longer receive quarterly reports. The IDC correctly observed that, to the extent 12b-1 fees compensate financial intermediaries for providing ongoing services to fund shareholders, fund directors are not in a position to assess the quality of the services that shareholders are receiving. Only the shareholder can do this.
In amending Rule 12b-1, the SEC should be mindful of the effects on small funds. Small funds rely on 12b-1 fees to edge their way into distribution channels that might otherwise be closed to them. If, as we were told at the Roundtable, "12b-1 fees really give smaller mutual fund companies a fighting chance against the big guys,"9 then we should consider how small funds will be affected if we change the rule.
The competitiveness of the fund industry is, of course, an issue that extends well beyond the Rule 12b-1 discussion. Small funds can fill very important niches and keep larger funds on their competitive toes. New entrants bring fresh ideas. The mutual fund industry, however, is a difficult one to enter. As you all know, the number and complexity of the regulatory obligations can be quite intimidating. That means money to hire lawyers, accountants, consultants, and advisors. The SEC ought to think about how it can address regulatory obstacles to entry.
The SEC is thinking more broadly about competitive issues. Over the past year, calls for reflection on the state of our capital markets and changes to improve the future prospects of those markets have come from many quarters, including through four high-profile reports, the most recent of which was published earlier this month. That most recent report explained the nature of the problem as follows: "While our system of financial regulation has served as a source of strength in the past, it is not flexible or adaptive enough to accommodate growing global competition, respond rapidly to innovative market developments, or fully meet the dynamic financial needs of all consumers."10
Among the specific problems that the reports identified was Sarbanes-Oxley Act Section 404 implementation. The SEC worked with the Public Company Accounting Oversight Board (PCAOB) over the past year to fix the implementation of Section 404 of the Act, which requires companies to evaluate the effectiveness of their internal controls and auditors to attest to, and report on, management's assessment of the effectiveness of internal control over financial reporting. The SEC issued interpretive guidance for management, and the PCAOB replaced the auditing standard that had made the Section 404 process an unfocused, document-intensive, and expensive exercise.
The old standard lacked grounding in materiality and drove the auditors to engage in redundant work from a shareholder's perspective — the auditor basically could not rely on anyone else's work, so the shareholders had to pay multiple times for similar work product. As companies and auditors put the new guidance and auditing standard to use, we will see whether our efforts will have helped to rationalize the process so that investors get their money's worth and real internal control problems are identified without a lot of unnecessary work.
When we were trying to understand the scope of the problems with the old standard, I took a field trip to visit a small biotechnology company that had the unfortunate distinction of paying more to its outside auditors and consultants to audit its financial statements and internal controls and help it implement 404 than it paid its CFO and all the people reporting to the CFO. That is, it was paying more to audit its financials than was paying to put them together! This for a company. It had no operating revenues and was trying to do more research and development while it waited for FDA approval for its drugs in the pipeline. Every dollar spent on excessive regulatory costs was a dollar less that the company could spend on building future value for the stockholders. The dollars were literally coming out of the investors' pockets.
The capital markets reports also suggested the need for changes with respect to accounting. The SEC has started down the road to making changes in this area. At our public meeting earlier this month, the SEC eliminated the requirement that foreign companies reconcile to U.S. GAAP the financial statements that they file with the Commission if their financial statements are prepared using International Financial Reporting Standards (IFRS). We are contemplating the further step of allowing U.S. filers to use IFRS instead of U.S. GAAP. In response to our concept release on the subject, the ICI wrote to express some concern about the propriety of allowing investment companies to file their financial statements in IFRS. The SEC will hold roundtables later this year to consider the issues that the concept release raised. The SEC also has established an Advisory Committee on Improvements to Financial Reporting, which is chaired by Bob Pozen. Its mission is to identify ways to reduce the complexity and increase the usability of financial reporting. The Committee held its second public meeting earlier this month. Bob Pozen is an ideal person to lead this effort, and I look forward to seeing the results of his committee's work.
Another area of concern identified by those who have been studying our capital markets is the costs of class action litigation. Private securities litigation can help to deter financial fraud, but a system that fosters meritless litigation can impose tremendous costs on investors and deter innovation and productive economic activity. It is very important to maintain the appropriate balance, a balance that I do not think we have yet achieved. Although there are ongoing efforts to try to bring balance to the system, countervailing forces on the other side seek to tip the system further out of balance. The Supreme Court recently heard arguments in a case, Stoneridge v. Scientific-Atlanta, that implicates the issue of so-called "scheme liability." This issue is in reality a backdoor attempt to expand the realm of private suits by recasting secondary liability as primary liability. Through scheme liability, plaintiffs would be able to reach third-party participants of whom the defrauded investors were unaware at the time of the fraud.
My hope is that the justices recognize the threat to our capital markets posed by this argument. Even non-publicly traded companies would have to take measures to protect themselves from potential misdeeds of customers, suppliers and clients for fear of federal securities fraud liability, not just for any transaction that they might have had with what turns out later to have been a securities fraudster, but for potentially the entire fraud of (in some recent cases) billions of dollars! Talk about a chilling effect on business! Think of the due diligence and representations and warranties that you would have to get on the simplest of deals. Imagine the business ramifications of paying lawyers, turning down business, or passing up other opportunities that would be replicated throughout the economy. Litigation risk would take on a whole new meaning. All this for liability that Congress never wrote into law, but that the courts have implied over the past 40 years or so.
Unfortunately, the Chairman and two of my colleagues endorsed the scheme liability approach. On a more positive note, however, Chairman Cox recently announced that the SEC will be organizing a formal roundtable to explore the topic of private securities litigation.
The SEC's own enforcement program, if not carried out with proper discipline, can have some of the same deleterious effects as meritless private securities actions. For example, hefty corporate penalties for financial frauds in which the shareholders were themselves the victims of deceit by their employees in management may appear to be of no consequence to the large companies on which we impose them. The cost of such penalties, however, like any other corporate expense, is borne by the company's shareholders. A large percentage of these shareholders are likely to have been victims of the financial fraud for which the company paid the penalty. The SEC should exercise more discipline in imposing corporate penalties to avoid further victimizing shareholders.
Recent lawsuits and commentary from observers of the SEC, including the ICI, have reminded the SEC of the importance of looking at the economic ramifications of its rules. Because the fund industry is so large and serves so many investors, the consequences of our rules can be tremendous. We need to do a better job of thinking about these consequences before adopting rules and after our rules are in place. Buddy Donohue has spoken about the importance of looking at whether our rules are working efficiently, and I expect that he will work closely with our new Chief Economist, Jim Overdahl, in putting this into practice. The ICI has offered its help in the area of assessing the costs of our rules. Among other things, the ICI is conducting a retrospective analysis of the costs of implementing the redemption fee rule. This analysis of a very costly rule should be instructive to us, and will, I hope, serve a cautionary role the next time we undertake a similarly far-reaching regulatory change. We welcome help from anyone else who can contribute to our understanding of how our rules will work in practice.
That rule has had a particularly checkered history. I voted against the first iteration of it in 2004, because it included a mandatory 2% redemption fee that served basically as a tax on mutual fund shareholders, especially those who inadvertently might fall within the proposed rule's broad sweep. I am happy that the Commission decided against adopting the mandatory redemption fee after vigorous, negative comment from many individual shareholders. Instead, we came out with a voluntary rule. After adoption, however, it became clear that the rule would pose significant implementation problems. We proposed and adopted amendments to the rule that were designed to make it workable. The final rule was much better, but its consequences have been costly and call into question our analysis in the first place.
Thank you for your attention across the many miles. Thank you also for the work that you do for fund investors. Your dedication to their interests serves them well and, incidentally, makes my job as a regulator easier. I look forward to hearing your thoughts now via satellite, or, when if you find yourself in Washington, and have a few minutes to stop by my office.