Speech by SEC Staff:
Keynote Address, Investment Company Institute, 2009 Mutual Funds and Investment Management Conference
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Palm Desert, California
March 23, 2009
Good morning and thank you for the kind introduction. It is a pleasure to be here with you today. Before I begin, 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.
I very much appreciate the opportunity to speak with you this morning. The last time I spoke at this event was in 2007. In thinking about that fact, I could not help but shake my head in amazement at the turn of events that has occurred over the course of this two-year period. The state of our markets, the economy and the mutual fund industry are profoundly different. To get a sense of where we are in comparison, in preparing to speak with you today, I went back and reviewed my remarks at this conference two years ago. I was struck by the difference in outlook. In March, 2007, the fund industry were celebrating the industry’s achievements, and rightly so. Funds had just surpassed the $10 trillion mark in assets and were the clear investment of choice for the average American.
Of course, these achievements still stand and the industry continues to play a very important role within our markets. However, in the face of declining assets and investor uncertainty, perspectives have changed. In today’s market, you face incredible challenges, many unprecedented that may cause you to re-evaluate some of your basic assumptions and beliefs regarding the fund industry and its products. I would like to outline some of these challenges for you this morning. My talk will thus serve as a precursor to some of the conference panels that will focus on some of these concerns in more detail. I am sure you will find the discussions throughout the next two days very interesting, informative and reassuring as you explore various ways to approach and address issues in this new market environment.
I also would like to take the opportunity to frame these challenges in a somewhat positive light that hopefully will continue throughout the conference. Now, it is not just the Palm Desert sunshine that is influencing my outlook (although it certainly beats the traditional Washington transition to spring that has provided us weeks of gray, dreary days). However, from my years of experience in the fund industry, and knowing the ingenuity and innovative nature of its people, I am confident that funds will weather this storm and continue in their role as the premier investment vehicle for average American investors.
Furthermore, as I had mentioned in 2007, I believe that one of the fund industry’s greatest strengths is its regulatory regime and the protections that regime affords fund shareholders. As the nature of the fund industry evolves and adapts to changing market conditions and investor needs, this regulatory regime needs to be continuously evaluated to ensure a competitive fund industry benefiting investors. For this reason, we have not stopped working towards our goal of modernizing regulations governing funds that may have become outdated or less effective. I would like to review with you this morning some of the Division of Investment Management’s most important accomplishments over the past two years, as well as outline some of our key priorities for the near future, at least as I see them today.
Now, I would like to discuss some of the challenges funds are facing in today’s market.
II. Industry Challenges in the New Environment
When I reviewed my 2007 remarks, not only was I struck by the different state of the fund industry, I am haunted by my foreboding admission to worrying when there was nothing to worry about. As our markets became more and more complex and intertwined, I became increasingly concerned how they could withstand a market failure in one part without unraveling throughout. However, my worrying could not have predicted some of the developments that have come to bear. Even having spent more than 30 years in this industry, I am amazed by the various events that have created a mix of challenges for the fund industry from a number of different aspects.
Some of these events have shaken core understandings and left the financial world questioning basic tenets that we have always considered to be true. For example, in extreme market conditions, we are seeing strategies that were considered the basis for sound investing begin to fail. Take diversification. In times of crisis, rather than each market participant, including funds, following their own fundamentals and strategies, normally uncorrelated or negatively correlated investments appear to correlate with each other as we see “a flight to quality” and a movement to hold cash and treasury bills. If all markets move together, normally uncorrelated or negatively correlated assets become correlated, and investment strategies developed around more traditional correlations inevitably fail. In addition, we are also seeing reports showing that actively managed funds don't outperform major market indices over long periods of time. In fact, one report shows the indice benchmarks outperformed fund managers in at least 70 per cent of cases in almost all categories, and that is before considering the higher fees associated with active management.
As you know, funds and fund boards are also facing increased operational pressures arising from a variety of factors, including a lack of liquidity in the marketplace and the resulting difficulties in valuation of many portfolio securities. Furthermore, as a result of reduced asset bases from negative performance and fund outflows, expense ratios are increasing as transfer agent and other fixed dollar fees rise when expressed as a percentage of fund assets. Many funds’ expense ratios are up 15 basis points or more compared to 2007. Funds experiencing these increased ratios must adjust their disclosures in fund prospectuses and proxy statements. As you would expect, we are also seeing advisory fee breakpoints working “in reverse” to also increase fund expense ratios.
In addition, as a result of decreasing asset bases, funds may need to carefully review their 15(c) review process for investment advisory contracts. Funds are typically compared to peer funds that have similar investment objectives and asset sizes. Asset size is usually calculated as a fund’s average assets during its most recent fiscal year. However the current asset size of many funds may be only half the average asset size during the most recent fiscal year. This phenomenon may cause fund advisers and boards to reconsider the time period and other aspects of the methodology normally used to compare fund expense ratios for 15(c) reviews and determine comparable funds.
Money market fund managers are also facing continuing challenges in today’s markets. Last year, we saw the first "breaking of the buck" by a widely-held money market fund. The Division continues to assess the impact and aftermath of that event. It is gratifying to note that in the wake of adverse market conditions, many intervened in the money market arena swiftly, dealing with such adversity for the greater good of investors and the market. Specifically, 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 benefiting fund investors.
Money market funds have also had to address the challenges posed by low or non-existent yields in treasury securities — in fact, we have been seeing the lowest yields on Treasuries in 50 years. These low yields are driven by the flight to quality as institutions increasingly move into U.S. government money market funds. As some portfolio securities mature and these funds purchase new treasuries with new money the yield is diluted even further. As a result we have seen at least three treasury money market funds close to new investors and we understand funds have waived fees and expenses in order to avoid negative yields.
Another challenge the fund industry faces, and one that I had mentioned in 2007, but is highly relevant today, is the increasing use by funds of derivatives and sophisticated financial instruments. I have concerns on multiple levels in this area. First, it is imperative that all relevant parts of a fund’s operations team understand a portfolio instrument and appreciate its use, characteristics and implications. Of course, the portfolio manager and investment officers will generally be involved in the decision to use a new type of financial instrument. In addition, however, it is imperative that the legal, compliance and accounting groups understand the instrument as well—and have implemented the proper legal, accounting and compliance techniques and controls. I also worry because many fund firms’ systems, particularly compliance and accounting systems, may not be sophisticated enough to effectively handle synthetic instruments.
These, of course, are just some of the many challenges facing the fund industry today. In this environment, I am sure many of you are asking what do we do now? I think Keynes, the economist, provides an apt response. "When the data change, I change my mind. What do you do, Sir?"
This seems like sound advice. We can no longer assume an expected result. For this reason, I would like to reiterate a point I made to you in 2007, that still holds true: we should not ignore the issues that worry us, but, rather, confront our fears. Although the industry must certainly address the current challenges it faces, this is no time to sit back, instead it is important to be prepared for what may be coming. In this regard, I ask that you remain vigilant and aware, to the extent possible, of potential risks. For example, funds should be attentive to counterparty exposure and ask the “tougher questions” to evaluate potential credit and other risks, particularly with respect to derivative transactions.
Also, observe how well your risk systems worked during the past 18 months. Go back and review whether derivative instruments performed as expected, and review whether basic strategies have delivered expected results. These reviews, among many others, are undoubtedly going on now at many firms.
In addition, we are seeing that fund shareholders, both individuals and institutions, seem less willing to take management’s word on a fund’s risk exposure — they are demanding more information and greater disclosure than ever before. Even as marketing budgets decrease, firms should use all available means to keep investors informed in order that they continue to have confidence in their fund managers and their funds and have the information necessary for sound investment decisions.
Finally, I ask for your cooperation as the Division addresses problems as they arise. Please contact me or my staff promptly to let us know of issues you may be encountering. The industry has access to daily market occurrences and at times you know much more than I do in Washington. You may also know much earlier about events which are likely to impact your business. As events occur, look to the horizon when evaluating the risks that they present, not only at the potential impact on your individual firm, your funds and fund shareholders, but also on the industry as a whole. Unlike the so-called mutual fund scandals of 2003, where each firm was impacted differently based on its own behavior, we are all in these trying times together. With an expanded vision of the risks presented by complex and integrated markets, we all can be better positioned to mitigate the potential impact of a specific market event. When problems arise, come to my staff with recommended solutions that are real, not with suggestions to forestall real solutions that may only result in an even larger problem to be solved later. In this environment, we all serve to benefit from any early intervention, rather than a crisis-driven regulatory response. When possible, I would prefer to be proactive, rather than reactive.
III. Rulemaking Developments
I would now like to discuss some of the key initiatives in the Division of Investment Management. Before I do, I would like to take a moment to acknowledge the hard work and dedication demonstrated by the Division staff. Without them, I would not have anything to say in this part of my remarks. These important initiatives on behalf of America’s mutual fund investors over the past two years are a credit to their talent. I would now like to review some of their achievements over the past two years.
As I have previously stated, I believe the Commission’s vote to adopt a Summary Prospectus in 2008 was one of the most significant accomplishments for mutual funds and their investors. This development represents a revolutionary change in mutual fund disclosure providing fund investors key information they need in a user-friendly format.
The adoption of a Summary Prospectus reflects productive collaboration among the Commission, the fund industry and fund investors — all of whom are to be congratulated. In addition to investor testing conducted by the Commission, the Investment Company Institute and earlier by the Consumer Federation of America, the Commission received thoughtful comments representing all segments of the fund industry, as well as comment from the fund investor community. The universal goal of improving disclosure from the investor’s perspective guided us to a great outcome. Indeed, the Summary Prospectus provides key information in a simple, accessible, user-friendly form, with additional information on-line, or in paper upon request, for those who want it. I am sincerely thankful to all who participated — over a period of many years — to turn the vision of a Summary Prospectus into a reality.
I do understand that the use of a Summary Prospectus will require the industry to make significant system adjustments in order to implement the rule’s requirements, particularly those concerning tagging and risk return and signature requirements. I truly want this to be successfully implemented.
Money Market Funds
With changing market dynamics over the past eighteen months, the Division staff have been faced with numerous crises requiring rapid regulatory responses. I am very proud of the staff’s hard work and willingness to step up in times of crisis. This past eighteen months have truly been a testament to their dedication.
As I mentioned, the past eighteen months has been a challenging period for money market funds. In addition to experiencing the first "breaking of the buck" by a widely-held money market fund, over 120 money market funds faced their own credit or liquidity challenges. To allow the asset purchase or credit support arrangements for funds facing these challenges, over 30 firms sought and promptly received no-action relief from my staff. The Division actively worked with the managers of money market funds as they coped with events during this period. In addition, the Division took a number of important actions to assist various liquidity facilities and other government programs to assist money market funds, including consulting closely 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 immediately suspend redemptions, as contemplated by the program, if it breaks the buck. This rule thus allows for an orderly wind down of a fund under the program.
Furthermore, in September the staff issued a no-action letter permitting money market funds to 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 no-action letter providing temporary no-action relief for money market funds to shadow price securities at amortized cost, if they have a final maturity of 60 days or less. This temporary 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 properly reflected the fair value of securities that were fully expected to pay off upon maturity. That relief has now expired. As required by Rule 2a-7, all money market funds should have resumed shadow pricing their portfolio securities based on their market price.
Auction Rate Preferred Securities
The Division staff also was instrumental, along with the Division of Corporation Finance, in issuing no-action letters regarding the development of liquidity protected preferred stock as a substitute for auction rate preferred securities. In addition, the Division’s Chief Counsel’s Office and the Exemptive Applications Office worked 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.
In addition, the Division staff played a leading role in the development of the Commission's regulatory actions relating to the freeze in the auction rate preferred securities market. Most notably, the Commission issued an order [and related notice] temporarily permitting five closed-end funds 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.
Exemptive Applications and ETFs
I also want to acknowledge the Division’s work with respect to issuing exemptive relief. In addition to the issuance of orders permitting the first fully-transparent actively managed ETF, 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 exemptive applications are now filed on EDGAR and easily available to the public. In addition, the Commission also proposed a rule that would permit ETFs to come to market without first obtaining a Commission order.
I now briefly want to outline a few of the initiatives that we have coming down the pike in the Division of Investment Management.
Director Guidance on Soft Dollars
First, we hope to move forward on a proposal the Commission issued in July last year to provide guidance to fund directors with respect to their responsibility to oversee investment advisers' trading of fund portfolio securities. The proposal focuses on an adviser's determination of best execution and use of soft dollars. The guidance would not impose any new requirements on fund directors or advisers, but instead proposes to provide a flexible framework to assist directors in fulfilling existing oversight obligations. In this regard, the proposed guidance suggests information directors may request from advisers to monitor the conflicts of interest advisers face in their trading activities and reminds directors that they have the authority to direct how an adviser uses fund brokerage.
The comment period for the proposed guidance closed in October last year. The Commission received generally favorable feedback on the proposal, with some specific concerns that we intend to address as we prepare a recommendation for the Commission. We hope to submit our recommendation in the near future.
Another issue I want to talk about when discussing the Division’s current agenda is rule 12b-1. In 2007, I told you that reform of rule 12b-1 is a priority of the Division and an issue we would address. Interestingly, the basis for our determination that it was time to reconsider the rule was that when it was adopted in 1980, the fund industry was in a very different state than it was two years ago. There had been a period of net redemptions, and there was a concern that if funds were not permitted to use a small portion of their assets to facilitate distribution, they might not survive. In 2007, fund assets were over $10 trillion and the industry had not been through a period of sustained net redemptions. Extinction certainly did not seem to be a threat.
Again, it is amazing what can happen in a period of two years — the fund industry has evolved further and is in a different state now than it was in 2007. Just as you are adjusting to the new market realities, we also need to adjust and reconsider our regulatory priorities to ensure that limited resources are employed where they can provide the greatest impact and benefit to fund investors. While I know our Chairman is supportive of investor-oriented rule 12b-1 reform, I believe that it would be wise in the current market environment, for us to defer consideration of rule 12b-1 reform for this year. We should address a few fundamental matters that directly impact investor protection concerns. For example, we urgently need to reconcile the diverse regulatory regimes governing investment advisers and broker-dealers, and alleviate the uncertainty in the industry emanating from this unresolved matter.
Although we are deferring wholesale reconsideration of rule 12b-1, I am still committed to its reform and I am grateful to the Division staff who worked tirelessly on this initiative. However, it remains that the factors investment company boards must consider when approving or renewing a rule 12b-1 plan are outdated and may detract from effective board oversight. For this reason, it may be useful to consider exploring other potential means of addressing issues associated with the rule, separate from, and in advance of meaningful 12b-1 reform, such as the possibility of providing guidance to fund directors to better assist them in this area.
During this period of market pressures, fund directors’ role in overseeing conflicts faced by the fund and protecting the interests of fund shareholders is even more vital. In addition to considering 12b-1 reform in the context of the directors role in its execution, we are also focusing on other areas in which we can assist fund directors in being more effective and efficient in their important role. In this regard, we intend to move forward on providing guidance to fund directors in the valuation of portfolio securities. This is a difficult, and very important initiative. It has been over 35 years since the Commission last provided significant and comprehensive guidance to funds and their directors concerning their valuation responsibilities and since then, there have been many significant developments impacting valuation. For example, funds are now investing in many complex and difficult-to-value securities that did not exist a decade ago. Also, much more valuation-related information is now available to funds, and there are more companies that provide a wide array of pricing services to funds. As a result of these developments, there is a need for the Commission to provide guidance to assist funds and their directors to ensure that fund investors are treated fairly.
As a step in this process, the Division has posted on the SEC website a bibliography that lists select relevant provisions of the Investment Company Act and related rules and Commission guidance concerning valuation. The bibliography is similar to one we posted relating to funds' use of senior securities under the Investment Company Act, and is intended to assist funds and their counsel in understanding and applying the valuation requirements under the Act. The bibliography also includes proposing releases, select staff guidance (including no-action letters), and enforcement actions in this area. We are hopeful that fund directors and fund personnel will find the bibliography a useful tool when approaching valuation in this uncertain market. I am grateful to the Division staff who painstakingly prepared this bibliography and believe their efforts will truly benefit funds, directors and fund investors.
In addition to the specific areas of 12b-1 reform and valuation guidance, we are also continuing to focus on the general needs of fund directors and working to determine how we may assist them in their quest to do their jobs better. We have been doing this through a Director Outreach Initiative. Started in early 2007, this initiative was intended to help us gain a better understanding from directors as to how they discharge their responsibilities and to learn of their suggestions for any improvements.
Over the past two years I have attended more than 25 board meetings at fund complexes of various sizes throughout the U.S. Directors have voiced a variety of concerns and have suggested rule changes that would help them be more efficient in the execution of their responsibilities. In addition to obtaining input from directors, the Division has undertaken an analysis of the many Commission rules that impose specific obligations on directors, particularly independent directors. Based on director feedback and the Division’s own analysis, my staff is preparing recommendations for the Commission’s consideration that will suggest possible rule modifications and other guidance that may enable directors to focus their time more efficiently overseeing conflicts of interest rather than engaging in day-to-day management of the fund.
Annual and Semi-Annual Report Reform
The Division will also be considering reform of fund shareholder annual and semi-annual reports. Similar to the summary prospectus, the impetus behind this reform is a need for mutual fund disclosure that is easier to understand and accessible to investors, while maintaining the same amount of disclosure that is available today. In developing this proposal, the Division is building on its experience with the summary prospectus and will be reaching out to the industry and shareholder advocates to determine the information that should be in a summary shareholder report.
Review of Rule 2a-7
Finally, in light of recent events, I believe that it is time to review rule 2a-7 and the money market fund model. With almost $4 trillion in assets, money market funds are of fundamental importance to the financial system as they serve to meet the liquidity and capital preservation needs of all types of investors — both individual and institutional. I appreciate the work the ICI is doing in this area through its Money Market Working Group and believe the recommendations contained in the Group’s Report issued last week are a good first step in developing changes to rule 2a-7. I recognize that the stable net asset value of $1.00 has been an integral part of the money market fund model yet I am also aware of some of the challenges that it presents. I look forward to quickly developing recommendations for changes to rule 2a-7 to protect money market investors. This is a very high priority of my Division, however I will not preempt the next panel by discussing this important issue further now.
I want to thank you for listening this morning. It is a very interesting time to be working in financial services, and in particular the fund industry. As I mentioned, I have devoted my career to this industry and have a great respect for it. With the ingenuity, entrepreneurship and investor-focus that characterize this area of financial services, I look forward to watching how the industry responds and evolves to these unprecedented market events. Thank you again and I hope you enjoy the conference.
1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.