Speech by SEC Staff:
2008: Important Accomplishments, Meaningful Lessons and Getting Back to Basics
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
ICI 2008 Securities Law Developments Conference
December 15, 2008
Good morning and thank you, Karrie [McMillan, General Counsel of the Investment Company Institute] for that kind introduction. It is a pleasure to be here with you today. Before I begin my remarks, it is my obligation to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
By the middle of December, there is a natural inclination to look back over the year that is coming to a close and reflect on its highs and lows. This year certainly has had its share of challenges. It has been so challenging, in fact, that many are racing to shut the door on 2008. The natural inclination is to hope, wish and pray for better times ahead. By doing so, however, we may overlook some important accomplishments and meaningful lessons.
II. Summary Prospectus
In the category of accomplishments, I think we must look first and foremost at the Summary Prospectus. Ten years from now, 2008 may be remembered for the credit crisis and the bear market. Hopefully, however, it will also be remembered as a year of revolutionary change in mutual fund disclosure — the year when we were finally successful in providing fund investors the key information they need in a user-friendly format.
One reason why I am so certain about the success of the Summary Prospectus is that it is the result of a productive collaboration among the Commission, the fund industry and fund investors, particularly those who participated in the investor testing conducted by the SEC, the ICI and earlier testing conducted by the Consumer Federation of America. With a common goal of improving disclosure and a guiding principle of approaching the issue from the investors' perspective, we came to a great outcome — the Summary Prospectus. The Summary Prospectus provides key information that is critical to evaluating an investment decision in a simple, accessible, user-friendly form, with additional information on-line, or in paper upon request, for those who want it. Thanks to all who participated in the public and private sector collaboration to move the Summary Prospectus from vision to reality.
III. Money Market Funds
I hope to bring that same cooperative spirit to one of the more important initiatives that I expect will be undertaken in 2009 — review of the money market fund model and its regulatory regime. I expect that regulators and the fund industry will have a common goal of conducting a wholesale review of the money market fund model, its attributes and the regulatory requirements applicable to it and updating those regulatory requirements where and as necessary. I further expect that this endeavor will be guided by the fundamental principle that the money market fund model and its regulation should be tailored to best meet the liquidity and capital preservation needs of fund investors. It is with this principle in mind that I very much look forward to reviewing the recommendations of the ICI's Money Market Fund Working Group.
Events of the past year have been particularly challenging to money market fund managers, regulators and, most especially, money market fund investors. In 2008, we saw the first "breaking of the buck" by a widely-held money market fund, and the impact and aftermath of that event continue to be assessed. It is essential that we take the experience of money market funds from the last several months and draw from it to consider important lessons.
For instance, money market funds have twin goals of providing liquidity, typically on a same-day basis, and preserving capital to maintain a stable net asset value of $1.00. At times these goals can conflict. And in times of severe market turmoil, the twin goals may not be able to be achieved simultaneously. As an example, when liquidity is at a premium, spreads may widen considerably, thus making it more difficult to sell even the highest quality instruments at or near "amortized cost." On the other hand, a desire to maintain a $1.00 NAV can cause a fund to seek to delay redemptions or the payment of redemptions and thus fail to meet fund shareholders' expectations of liquidity.
This situation becomes more challenging when one considers that different shareholders may have quite different ultimate goals for their money market fund investments. Some primarily want liquidity and use their money market funds as a source of ready access to funds to pay expenses. Others are more interested in preservation of capital and certainly don't want to risk the loss of any of their principal just to help facilitate someone else's liquidity.
Interestingly, our current money market fund regulations contain strong provisions related to credit quality, maturity and diversification. These provisions are geared toward preserving capital and enabling a money market fund to maintain a $1.00 NAV. Liquidity, on the other hand, has not been a particular focus of our money market fund regulations. It is liquidity, however, that has been one of the greatest challenges for money market funds since the beginning of the credit crisis in August 2007.
Not all money market fund investors are the same. Some are institutional; some are retail. Some use money market funds as a checking account; others use money market funds as a relatively safe place to store a nest-egg built up over a lifetime. As I indicated earlier, some have a primary goal of liquidity and others have a primary goal of preserving capital. It is important, therefore, that the money market fund regulatory regime provide meaningful protections for all money market fund investors.
When analyzing money market reform, or when making an investment or operational decision for a money market fund, it is essential to remember that every money market fund has essentially three sets of shareholders: those who are redeeming; those who are purchasing; and those who are staying the course. What may be best for one of those groups — for example selling all of the fund's liquid holdings or borrowing money to meet the redemption needs of redeeming shareholders — may not be in the best interests of the other non-redeeming shareholders.
As I stated, the theme of my remarks today is important accomplishments and meaningful lessons. I have just outlined some of the meaningful money market fund lessons of the past year and hopefully these lessons and others will help inform the work of the ICI's Money Market Fund Working Group. I know these lessons will greatly assist my staff's own review of money market fund regulation.
But we also should remember that the money market arena saw some important accomplishments this past year. For one thing, many money market fund sponsors or their parent firms were willing to voluntarily step in and assist money market funds facing credit or liquidity challenges by entering into asset purchase or credit support arrangements. The Division staff has been active in working with the managers of money market funds as they have been coping with events of the past several months. I applaud the money market fund industry's willingness to voluntarily come to the support of funds when that support is structured to benefit all fund shareholders. And I applaud the Division staff for its timeliness, responsiveness and helpful assistance in working with money market firms.
The Division of Investment Management took a number of important regulatory actions to assist various liquidity facilities and other government programs to assist money market funds. The staff consulted with the Treasury Department on the development, documentation and implementation of the Treasury Temporary Guarantee Program. The staff also issued a no action letter stating that it would not recommend enforcement under the "senior security" provisions of the Investment Company Act for money market funds participating in the Temporary Guarantee Program. In addition, the Commission issued a temporary rule enabling a money market fund participating in the Program to suspend redemptions, as required by the Program, under certain circumstances. This rule thus allows for an orderly wind down of a fund under the Program.
The staff issued a no action letter in September stating that it would not recommend enforcement action against affiliates of money market funds that access the Federal Reserve's Asset Backed Commercial Paper Facility through affiliated banks and in October issued a no action letter clarifying diversification analysis and other operational impacts of the Federal Reserve's Money Market Investor Funding Facility. Also in October, the staff issued a letter providing temporary no-action relief for the shadow pricing of securities at amortized cost, if they have a final maturity of 60 days or less. This temporary no action relief was granted based, in part, on the assertion that the markets for short-term securities, including commercial paper, were not functioning as intended or were not resulting in the discovery of prices that reflected the fair value of securities that were expected to pay off upon maturity.
IV. Auction Rate Preferred Securities
Earlier this year, the Division's Exemptive Applications Office, along with the Chief Counsel's Office, played a leading role in the development of regulatory actions intended to better enable the closed end fund industry to address the freeze in the auction rate preferred securities market. First, these Offices, along with the Division of Corporation Finance and my own Division's money market fund experts, were instrumental in the issuance of a no action letter to enable the development of liquidity protected preferred stock as a substitute for auction rate preferred securities. The staff also worked closely with the Treasury Department, which on the same day Commission staff issued its no action letter, issued an IRS notice stating that, subject to certain conditions, the IRS would not challenge the equity characterization of liquidity protected preferred stock for Federal income tax purposes. In addition, my staff worked long and hard on a Commission order [and related notice] temporarily permitting five funds, subject to certain conditions, to apply the 200% asset coverage requirements applicable to preferred stock to debt incurred to redeem auction rate securities — rather than the normal 300% asset coverage requirements for debt. In part as a result of these regulatory actions, closed end funds have redeemed approximately $29 billion or 45% of the $64 billion auction rate preferred securities outstanding at the beginning of 2008.
V. Non-Crisis-Related Accomplishments
As you can see, events related to money market funds and auction rate preferred securities took up a significant portion of Division staff time, focus and attention during the past year. But I believe that one of the unheralded stories of 2008 is that the staff's work on crisis-related matters — while significant — did not disrupt the important day-to-day, non-crisis-related work of the Division.
I have already mentioned the adoption of the Summary Prospectus and the related investor testing that took place. Also on the rulemaking front, the Commission proposed and adopted disclosure rules under the Sudan Accountability and Divestment Act under a tight statutory deadline. The Commission also proposed, and on Wednesday will consider adoption of, rules related to interactive data and indexed annuities. In addition, the Commission proposed rules related to Regulation S-P privacy issues, references to credit rating agencies in Commission rules, investment adviser disclosure in Form ADV, and also proposed Commission guidance on board oversight of soft dollars and execution of fund portfolio transactions. In addition, the Commission also proposed a rule that would permit ETFs to come to market without first obtaining a Commission order.
B. Exemptive Application Review
With respect to exemptive applications, the staff continued its significant progress on meaningful reforms to the application review process. For fiscal year 2008, the staff set a goal of issuing 65 investment company exemptive notices. Our staff met that goal and even went one better, issuing 66. Also of significance, exemptive application notices and orders are now posted on the Commission's website and, beginning on January 1st, exemptive applications will be filed on EDGAR and easily available to the public.
C. Chief Counsel's Office
During the past year, the Chief Counsel's Office also worked with the Exemptive Applications Office to once again begin issuing orders under section 19(b) of the Investment Company Act to facilitate closed end funds' managed distribution plans by permitting the funds to include long-term capital gains in their periodic distributions. Also, in a first-of-its-kind effort — that I hope will be repeated in the future, the Chief Counsel's Office prepared a bibliography of Commission releases, no action letters and statutory provisions related to funds' use of senior securities under the Investment Company Act. The bibliography is available on the Division's webpage. Early reviews indicate that the on-line bibliography is a very useful tool and much appreciated by fund practitioners.
D. Disclosure and Enforcement Review
The Division's investment company and insurance products disclosure review staff has also kept up with its demands, having once again reviewed 1/3 of all registered funds' financial statements (and other disclosures) during fiscal year 2008, as anticipated by the Sarbanes-Oxley Act. Interestingly, this amounted to a review of over 4,400 financial statements, plus related disclosures. In addition, my staff consulted on over 400 enforcement-related matters in coordination with many divisions, including primarily the Division of Enforcement. Not all of these matters moved forward, but they all received a thorough and principled review from my staff.
It has been a busy and productive year, and my thanks go out to the hard-working Division staff.
VI. Rule 12b-1 and Recordkeeping Reform
As I just outlined, the Division achieved a number of important accomplishments this year. These accomplishments related both to crisis-oriented matters as well as the normal, yet critical day-to-day work necessary to oversee the fund and investment advisory industries and administer the Investment Company and Investment Advisers Acts. The Division, however, did not accomplish all that it set out to achieve in 2008. Most notably, when I spoke to you at this conference last year, I laid out two initiatives I expected to pursue: rule 12b-1 reform and investment adviser recordkeeping modernization. I have a personal level of disappointment that I was unable to achieve my goals with respect to these initiatives this year, despite the significant efforts that were made by the Division. While I might have used the market events of the past year as an excuse, I won't. Clearly the Division was able to accomplish much of what it set out to do, despite the challenges posed by the markets. I expect that substantial work will continue on these initiatives in 2009.
With respect to rule 12b-1, the staff made great progress in its thinking on possible approaches to resolving a fundamental concern about rule 12b-1 — namely that the rule provides for an alternative means of paying a sales load, but those 12b-1 fees are not treated, regulated or disclosed as a sales load. The concerns about rule 12b-1 remain, and I am hopeful that the Commission can be in a position to address them in the near term.
With respect to recordkeeping reform, I believe that the Division can look to one of its most important accomplishments of the past year — the Summary Prospectus — and apply many of the same principles employed there to hopefully achieve success in 2009. The Summary Prospectus is an example of a Commission initiative that used the power of technology, namely the Internet, in order to provide investors with information in a more usable format at a lower cost than in the traditional all-paper regime. We seek to achieve a similar goal with recordkeeping reform. The goal is a more useful recordkeeping system, at a lower cost, by relying on technology rather than paper. This goal could be achieved by making better use of technology available today that was not available when the recordkeeping rules were adopted in 1961. Needless to say, that gives us 47 years worth of technological developments to take advantage of.
To bring home this point, I think it can be instructive to look back at what else was going on in the world in 1961. Here are a few examples: I was eleven; then-president Kennedy, on his sixth day in office, conducted the first ever live presidential news conference; IBM introduced the Selectric typewriter; Fairchild Semiconductor marketed the first commercial integrated circuit; and the Beatles made their debut concert performance.
Forty-seven years later, I am now a grandfather three times over. We have had many live presidential (and even presidential-elect) news conferences. Examples of the Selectric typewriter and first commercial integrated circuit can be found, if at all, on display in a museum. And the Beatles will not be touring any time soon. The Commission's recordkeeping rules, however, have not undergone any major substantive changes. It is time we caught up.
I believe that the recordkeeping reform initiative, like the Summary Prospectus initiative, will be most successful if we pursue a cooperative approach among regulator and industry representatives. This cooperative approach worked well in developing a more useful and cost-effective mutual fund disclosure regime. On recordkeeping, we have already engaged in substantial industry outreach. Our rulemaking staff visited advisory firms of multiple varieties and sizes to better understand how technology is used to maintain business records. My staff will use the insights gleaned from these on-site visits as we consider recommendations to restructure the recordkeeping regime. I want to thank the firms that opened their doors — and computer systems — to us for this important purpose.
Our plan is first to recommend revisions to the investment adviser recordkeeping regime and then translate that approach to investment company books and records. This recordkeeping reform initiative will, by necessity and design, seek to make better use of technology to maintain, create and produce records. It could also provide a less disruptive and less expensive means for interface between the Commission staff and the fund industry.
In keeping with my theme of important accomplishments and meaningful lessons, I would like to conclude my remarks today with perhaps the most meaningful lesson of all: sometimes it is important to get back to basics. Having seen the market events of this past year — and the corresponding impact on funds, particularly money market funds, leveraged closed end funds, 130/30 funds, registered funds of hedge funds and others, I have to wonder whether some funds have become too fancy, too complicated. Are portfolio strategies too complex? And when I speak of complexity, I mean too complex for fund investors to understand as well as for fund managers to manage effectively. Until this year, certain assumptions were made about the liquidity of certain instruments, including auction rate preferred securities. These assumptions have not borne true in today's reality. Certain assumptions were made about the behavior of particular strategies in bull and bear markets. These also have not borne true in some cases. And certain assumptions were made about the strength of particular counterparties, and some of those counterparties no longer exist. I ask you, should we consider this past year an anomaly, or has the norm changed?
I believe the norm may have changed. My preliminary view is that, at a minimum, fund managers and fund regulators need to expect and be prepared for more frequent market disruptions than in the past. I also believe that, if the mutual fund industry is to remain strong in this new market reality, it is worth looking at how the industry grew by serving investors' needs. It is necessary to get back to basics. The industry prospered by embracing a core fiduciary culture and developing products based on the needs of investors, rather than allure of the latest fad. The industry grew by providing investors with prompt liquidity at an accurate price. To the extent that funds invest in instruments that may undermine their ability to provide liquidity and accurately value their assets, funds are moving away from the basics that made them strong and served investors so well.
Traditionally, the core feature of a mutual fund has been daily redeemability at an accurate, mark-to-market net asset value. Investor confidence was premised on these liquidity and valuation precepts. As I have said before, turbulent markets challenge a fund's ability to meet investors' liquidity and valuation expectations. Funds, however, must be in a position to meet the liquidity and valuation requirements of the Investment Company Act and the promises made to their investors, in any kind of market. Investment strategies and techniques that challenge a fund's ability to redeem and value as promised have the potential to irreparably harm investors' confidence in mutual funds.
The fund industry grew by implementing a compliance-oriented culture that respected the rules, and also respected the role of a strong regulator to ensure an even playing field with respect to those rules. These basic attributes made the fund industry strong, and the continued embrace of them, rather than a rejection of them, will keep the industry respected, even in the most challenging of markets. I have faith that the industry will maintain its commitment to fundamental pro-investor ideals.
Thank you very much, and I wish you a successful conference.