Speech by SEC Chairman:
Keynote Address to the Investment Company Institute 4th Annual Mutual Fund Leadership Dinner
Chairman Christopher Cox
U.S. Securities and Exchange Commission
Folger Shakespeare Library
April 30, 2008
Thank you, Paul [Stevens, President and CEO, Investment Company Institute], for that kind introduction. And I am happy to return the compliment. Paul is an outstanding leader, and he has done an exceptional job in promoting high ethical standards for mutual funds. He's been a great asset for mutual fund shareholders, and a resource for policymakers and regulators on compliance issues that affect fund directors and investment advisers. So thank you, Paul, for all that you do.
I would also like to recognize the Majority Leader, Steny Hoyer, Senator Bob Bennett from Utah, and Congressman Richard Neal from Massachusetts, who are with us at the head table, as well as so many other leaders and former colleagues from the House and the Senate who are with us here this evening. It is a testament to the commitment of our elected leaders to the health of our financial markets and our economy that so many of you have made such a generous commitment of your time to be here.
This is a splendid venue, and a fitting one, to discuss the subject of our markets and our economy from the mutual fund investor's point of view. In the midst of a credit crisis, and concerns that investment banks and hedge funds have been overleveraged — while at the same time Americans are borrowing too much and saving too little — there's no better muse than Shakespeare.
I'm sure you all remember the object lesson he provided in the Merchant of Venice. When the hapless merchant, Antonio, went deep into debt with the notorious lender Shylock, it was to pay for a luxury. He wanted to subsidize his friend Bassanio's travels to woo a wealthy heiress. But when Antonio couldn't pay the money back, he nearly lost that famous pound of flesh. The clear moral of the story is: be fiscally responsible. Otherwise, you may need more than a clever plot device to extricate yourself from the penalties of risky borrowing.
That wasn't the only advice Shakespeare had on clean balance sheets. In Hamlet, Polonius wisely counsels his son Laertes to "neither a borrower nor a lender be." Not only that, but he gives reasons: as a creditor, you can lose both your money and the friend you loaned it to. And as for borrowing, it destroys the habits of thrift. Clearly, Shakespeare would approve of the current round of deleveraging.
This beautiful setting is also a reminder of those days, three-quarters of a century ago, when both this Library and the SEC itself were founded. Both the SEC and the Folger, in different ways, grew out of the stock market crash of 1929 and its aftermath. As you know, we are currently celebrating the 75th anniversary of the Securities Act of 1933,
and beginning in just a few months we'll be celebrating the 75th anniversary of the creation of the Commission. As for this Library, it was the retirement project of Henry Folger, whose timing was impeccable — he left as Chairman of Standard Oil in 1928, one year before the market crashed. Still, the market debacle took its toll on him and his estate. He died the year after the crash, and his wife, Emily, had to donate substantially more of the now-depreciated Standard Oil securities to assure the Library's future. But as the Bard would say, "all's well that ends well." And the result of the Folger family's generous contribution, as well as Congress setting aside the land, is that we have a marvelous and inspirational setting for tonight's event.
This evening is styled as a Leadership Dinner, and indeed it is. Among us tonight are the leaders with whom nearly 90 million American mutual fund investors have entrusted their savings. You hold in your hands their hopes and dreams, and above all, their trust. That's why it's so important that ICI has devoted itself, first and foremost, to high ethical standards. It is just as true today as it was when Shakespeare said it, that "No legacy is so rich as honesty."
In that respect, your mandate and ours at the SEC are complementary. What your leadership and exhortation cannot inspire, our regulations enforce. That's because beginning with our creation 75 years ago and ever since, Congress and the American people have taken the view that when it comes to investor protection, Shakespeare was right: it is important to "Let every eye negotiate for itself and trust no agent."
That's particularly true when it comes to mutual funds, which have become the investment vehicle of choice for the average American. Our investor protection mandate is nowhere stronger than in the areas that concern individual investors.
In the current environment of the subprime mortgage crisis, a weakened dollar, and rising oil and commodity prices, the confidence of ordinary investors has been mightily tested. We have had turbulent markets so far this year. Americans are worried about their personal finances. And yet in the midst of these rough seas, many mutual funds have been a relative safe harbor of calm. The funds that are professionally managed, diversified, liquid, free of leverage, and highly transparent have served investors well in these trying times.
As you know, within this industry the subprime contagion has had its most significant effects on bond and money market funds that owned mortgage-backed and asset-backed securities — and particularly those bond funds with higher-risk strategies. But even bond fund investors with a low tolerance for risk, who may have intended to stick with funds
that bought only very safe, AAA-rated investments, too often discovered that in practice it was not that simple. When bond-rating agencies such as Standard & Poor's and Moody's downgraded many formerly high-rated securities, it affected even some bond funds that might otherwise have been considered safe.
One issue of great concern to me and to all of us at the SEC beginning earlier this year was the failure of auctions in the auction rate securities market. Those failed auctions had a significant impact on investors' liquidity. As you know, we took aggressive and quick action to help free up the market for auction rate municipal securities, including providing guidance that has permitted issuers to participate as bidders when markets are illiquid.
And for investors whose funds are tied up in auction rate securities, we've worked with the Financial Industry Regulatory Authority to make it possible for their brokers to loan them money, so long as this does not impair the financial condition of the broker-dealer or jeopardize the funds and securities of its customers.
In the same vein, we are currently considering ways to provide relief to investors in closed-end fund auction rate preferred securities — while at the same time not harming the closed end funds' common shareholders. I very much appreciate the closed-end fund industry's willingness to work with us on these and other issues.
In the past few months, I have seen many examples of the fund industry acting responsibly to address the impact of the subprime crisis on money market funds. I want to take this opportunity to thank you for developing pro-investor solutions to these problems. And I want to encourage you to maintain that same investor-oriented focus as you address other issues, such as valuation and liquidity, that are posed by the current markets.
As you work your way through these challenges, do not hesitate to contact us. The staff in the Division of Investment Management are always open to investor-oriented solutions. They and all of us at the SEC welcome your input and your insight as fund industry leaders with the interests of your fund investors at heart. That dialogue with the regulator is essential. The truth is, we can't know what you think fund investors require, unless we hear it from you.
We're also tackling the issue of credit ratings head on. As of the end of September 2007, seven credit rating agencies — including those that were most active in rating subprime RMBS and CDOs — became subject to the Commission's new oversight authority. And as of tonight, there are nine credit rating agencies registered with the SEC. In the coming weeks, we will consider proposed new rules to strengthen the rating agencies' accountability, increase their transparency, and make their industry more competitive.
Among the new rules that the Commission may consider are requirements for enhanced disclosures about ratings performance; specific prohibitions on practices that lead to conflicts of interest; requirements to disclose information about the assets underlying the mortgage-backed securities, CDOs, and other structured finance products they rate; more robust disclosure about how they determine their ratings for structured products; new disclosures regarding how the firms monitor current credit ratings on an ongoing basis; and clear disclosure to investors through a ratings symbology that would make it possible for them to readily distinguish among ratings for different types of securities, such as structured products, corporate securities, and municipal securities.
The Commission is also reconsidering its extensive reliance on credit ratings in its own rules. Our intent in doing this is to promote greater competition among rating agencies so as to produce the highest quality, most reliable ratings. We may also seek to enhance competition through rules designed to ensure that every credit rating agency has access to the information underlying ratings for structured products issued by its competitors. That way, regardless of whether a credit rating agency follows the "issuer pays" or the subscriber-based approach, there would be no competitive disadvantage based on lack of access to the information on the assets underlying the structured credit product.
Of course, because this planned proposed rulemaking is ongoing, there could and undoubtedly will be other subjects covered in the draft rules that the staff will present to the Commission for its consideration.
Yet another way that the subprime turmoil has affected the outlook for mutual fund investors is through the crisis of confidence that led to a run on the bank at Bear Stearns last month. Since 2004, the SEC had required that Bear Stearns and the other major U.S. investment banks maintain an overall Basel capital ratio at the consolidated holding company level of not less than the Federal Reserve's 10% "well-capitalized" standard for bank holding companies. The Bear Stearns experience has shown, however, that the prevailing measurements of liquidity that were then being used by the SEC and by every bank and securities regulator, not only here in the United States but around the world, were inadequate to prevent or predict the "run on the bank" that Bear endured.
In just two days between Thursday, March 13, and the close of business on Friday, March 14, Bear's liquidity pool fell by over 83% — from $12 billion to $2 billion. In a development that neither the Consolidated Supervised Entities program nor any bank regulatory model had anticipated, short-term secured financing was unavailable even when Bear offered high-quality collateral such as agency securities. For that reason, in the very same week that JPMorgan agreed to acquire Bear Stearns, I urged the Basel Committee to deal explicitly with liquidity risk in new, updated capital standards. And since then, the SEC has arranged to participate with the Basel Committee in this important work.
At the same time, without waiting for new Basel standards, we have also made immediate changes to the way we are assessing the adequacy of capital and liquidity at the major investment banks, to reflect the experience of recent weeks. The models did not anticipate this, but we now know it can happen. Both we and the Federal Reserve are strengthening our capital and our liquidity assessments accordingly.
There is yet another issue arising out of the subprime crisis that all of us at the Commission are intently focused upon, and that is the impact of fair value accounting on so-called Level-3 assets under Financial Accounting Standard 157.
This is a topic that Shakespeare has commented on.
"It so falls out," he wrote in Much Ado About Nothing, "that what we have we prize not … but being lack'd and lost, why, then we rack the value." That is, of course, precisely the sentiment of anyone who has lately tried to "rack the value" of a Level 3 asset under FAS 157 — only to find that the asset has, for accounting purposes, been "lack'd and lost."
Mark-to-market, as this accounting is popularly known, is not an ancient tradition. To the contrary, it is a relatively new exception to the age-old accounting principle of historical cost. The fair value measurement statement from the Financial Accounting Standards Board took effect only this year — it is effective for fiscal years beginning after November 15, 2007. It provides for expanded disclosures and provides for additional consistency in measurement, reflecting a consensus among accounting standard setters that users of financial statements would be better served if they knew the current value of a firm's assets, rather than what they once cost.
Without question, fair value has been just what the doctor ordered to solve problems such as those that arose in the 1990s with the failure of Barings Bank and the collapse of Long Term Capital Management. But having now neatly addressed the problems of the 90s, we're confronted head-on with the problems of the 21st century, which fair value accounting seems only imperfectly to have anticipated.
In the context of the current subprime troubles, the apparent pro-cyclicality of fair value accounting has gotten the attention of economists as well as accountants. At the same time, the fact that model-based valuations in the absence of an active market can be highly variable across companies in similar circumstances means that almost every estimate of fair value requires significant judgment.
These issues are sufficiently important that the SEC's Office of the Chief Accountant is preparing for a Roundtable to address them this summer, that would include the FASB, the PCAOB, banking regulators, investors, and other experts. Through the planned Roundtable, we hope to shed light on these questions, and possibly to generate recommendations for action that build upon the lessons learned in the current market turmoil. We hope to be able to announce plans for the Roundtable soon.
In the few moments I have remaining, let me address three issues that are of immediate and direct relevance to all of you in the mutual fund industry.
Our proposed rulemaking to authorize a summary prospectus for mutual funds; the interactive data initiative on which ICI has shown such leadership; and our pending repeal or reform of rule 12b-1 — all are on the Commission's front burner. Here's what you can expect in the weeks ahead.
First, with respect to the summary prospectus, we very much appreciate the comments we received from investors, the industry, and many others. The comment period closed February 28, and we are now working on the text of a final rule that reflects those comments. In addition, we've conducted focus groups with mutual fund investors to get first-person, live reactions to the proposed summary prospectus. All of this, as well as the ICI's own investor testing, will be a great help to the Commission when we consider a final rule. Among the issues this rulemaking will resolve are the content of the summary prospectus and the frequency of its updating.
This would be a momentous step forward, because today, even though your industry is very much focused on the retail investor, mutual fund prospectuses are widely considered to be too long, too wordy, and too legalistic.
I hope you're as excited as I am about what the summary prospectus will mean for investors. Along with mutual fund data tagging, it's going to make life better in a big way for anyone shopping for a mutual fund, or wondering whether to hang on to the one they've got. Instead of legalese, it will provide some "straight talk."
This will be a particularly welcome development for anyone investing for retirement through a 401(k) plan. Already, about $4 trillion of today's $12 trillion in mutual fund assets are held in self-directed retirement accounts, principally 401(k) plans and IRAs. And that number is expected to grow significantly in the coming years, as the conversion from defined benefit to defined contribution plans continues to dominate the retirement market.
Self-directed investors truly need an easy to understand description of their mutual fund investments. And for that reason, the SEC has been working closely with the Department of Labor to make this vision a reality, and to incorporate the new summary prospectus in the 401(k) plan materials as well.
What's really exciting about the summary prospectus is what investors will be able to do with it online. This is the first SEC disclosure document that has really been engineered for the Internet, with individual investors in mind. To adapt to the online world, the summary prospectus layers the disclosure from summary to granular detail, in a way that lets each investor quickly find the information they're looking for. This "vertical" disclosure would enable investors to reach the level of detail that meets their individual needs.
Combined with interactive data, the new summary information and vertical search capability will allow investors to instantly get that same information for dozens, hundreds, or even thousands of funds in order to do quick and easy comparisons. They will no longer need to wade through lengthy documents to find the relevant information for each fund in order to comparison shop. Interactive data will let them analyze and understand financial information with an economy of effort that's never been possible before.
Even though some of this is still just a gleam in our eye, you can already give mutual fund interactive data a test drive using our new Mutual Fund Reader on the SEC website. I hope that in the days ahead millions of fund investors, and all of the leaders of the mutual fund industry in this room, if you haven't already, will give it a try.
In the coming weeks, the Commission will consider a rule that sets out a schedule for data tagging by all public companies. At the same time, I expect the Commission will consider a rule for data tagging by mutual funds. We really are on the threshold of some exciting new technology for investors. Or, as Shakespeare put it in King Henry V — we're about to "ascend the brightest heaven of invention."
When I said, a moment ago, "repeal or reform" of rule 12b-1, I meant it with the same precision of language that Shakespeare would demand. Not just reform but repeal is very much on the table.
Rule 12b-1 was controversial when it was adopted in 1980, and it remains controversial today. But the rule has experienced dramatic changes over the years.
When it was first adopted, the fees it authorizes funds to collect from investors were used almost exclusively to pay for fund advertising and promotion. Today, on the other hand, over 90% of the fees are used to pay compensation for sales and shareholder servicing. And the amount of 12b-1 fees has grown beyond anything that was envisioned when the rule was adopted. In 2006, rule 12b-1 was used to collect over $14 billion in investors' funds out of fund assets, based on ICI data.
Whatever you may think about rule 12b-1, it is difficult to argue with the proposition that the rule is outdated and in need of reform. Speaking for myself, I support scrapping the rule — and its "12b-1" nomenclature, which only confuses investors — and starting over. If fund assets are to be used to compensate salespeople for distributing fund shares, then that is how those payments should be treated. And that is how they should be disclosed. I would venture to say that to most investors, a sales load is a sales load — whether it is paid in a lump sum up front, or over time through a deduction from fund assets. Either way, it is compensation paid for out of the investor's pocket.
So in coming days, you can look for the SEC to open up the hood of this old jalopy and start cleaning out the gunk. When the overhaul is done, I predict there won't be a 12b-1 in there anymore. And along with it, we can throw out the investor confusion and the misunderstanding that surrounds rule 12b-1, in favor of modern regulation that is more consistent with economic realities.
As a first step in this direction, the Commission last year hosted a roundtable that brought together representatives from mutual funds, financial services companies, and investor advocacy groups to discuss issues relating to rule 12b-1. Following the Roundtable, we sought public comment on these topics. Thus far, the Commission has received almost 1,500 comment letters. Based on all of this very valuable input, the staff are currently preparing a recommendation for the Commission that, I expect, they will present to us this summer.
I have very much enjoyed this opportunity to talk briefly with you tonight. It has been especially inspiring to be here in the midst of so many vivid reminders of Shakespeare's plays — although we shouldn't forget that in addition to his plays, he wrote 154 sonnets, too. One of those sonnets memorably tells us that "If there be nothing new, but that which is hath been before, how are our brains beguil'd …."
I know that many of you have traveled a considerable distance to be here in Washington for tonight's dinner. And several of you have asked me earlier this evening to address the subject of the Treasury Department's Blueprint for a Modernized Financial Regulatory Structure. So let me say simply in reply, that "if there be nothing new" for the structure of financial services regulation than that which "hath been before," then investors will surely be beguiled.
That's because today's Balkanized patchwork of agencies — chartered decades ago before today's world of separate derivatives trading on options and futures exchanges, functionally merged securities and banking organizations, cross-border investing, and global systemic risk — need badly to be updated with a more modern system of regulation.
The ideas in the Treasury Blueprint were intended to start a discussion, and they've done that. Of course all of the ideas would require legislation, and so they should not be considered imminent by any means. For our part at the SEC, it's important that the agency's primary missions of investor protection, maintaining orderly markets, and promoting capital formation be kept intact, and that they not be subsumed in a Cuisinart of other priorities including the safety and soundness of financial institutions or the health of the overall U.S. economy. At times, these interests can clash. And it is important that when they do, a strong regulator is charged with approaching them from the investors' point of view.
Let me leave you with just one last bit of trivia inspired by our surroundings here at the Folger. In Shakespeare's time, mattresses were secured on bed frames by ropes. When you pulled on the ropes, the mattress tightened — making the bed firmer to sleep on. That's where the phrase "goodnight, sleep tight" came from. So goodnight — and after you have driven home, not before — sleep tight.
All of you who are leaders in the mutual fund industry have faced a challenging market environment in recent months. In your hands, no less than in ours at the SEC, rest the trust, confidence, hope and faith of millions of American investors. I therefore thank you for your leadership and for your willingness to bear this tremendous responsibility each day for the benefit of our nation's investors. All of us at the Securities and Exchange Commission are proud to be your partners.