Speech by SEC Commissioner:
Remarks Before the Mutual Fund Directors Forum Ninth Annual Policy Conference
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
May 4, 2009
Thank you, Al [Fichera], for that warm welcome. It is a pleasure to be speaking here today at the Ninth Annual Policy Conference of the Mutual Fund Directors Forum. The Forum has been at the forefront of fund governance since its creation and continues as an important voice for independent directors.
Before I begin my remarks, I must remind you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
There has been a lot of change in recent years — indeed, in recent months — impacting the mutual fund industry in one way or another. I cannot possibly recount all the industry has experienced, so I will be selective this afternoon in highlighting just a few things. My choice of discussion points allows me to share with you some of my observations on a range of topics I find important. One consistent theme flows throughout: Notwithstanding the strains that presently burden our economy, it is essential for government to retain a healthy respect for the role of markets and we must appreciate that there are limits to what we can and should expect from regulation.
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It is hard to argue that the mutual fund industry, on the whole, has been anything but a success for investors and our capital markets more generally. Two pieces of data capture it best. At the end of 2007, before the recent sharp declines in the market, mutual fund assets totaled approximately $12 trillion, according to industry estimates.1 Industry data also indicate that the number of funds stood at roughly 8,000.2 Mutual funds have become the investment vehicle of choice for households across the country.
Included among the thousands of offerings from which investors can choose are numerous variations of equity funds, bond funds, international funds, money market funds, and government funds. ETFs are a somewhat new option for investors, separate from the myriad mutual funds that are available. From 1993, when the product launched, to 2007, ETFs grew to number over 6003 with total assets exceeding $600 billion,4 according to industry estimates. The market has benefited as new ETF iterations have been offered. Other new products have been developed over the years, although not always enjoying the same success as ETFs.
The kind of investor choice the fund industry offers is significant. One size of investment does not fit every investor. Choice allows investors to tailor their investments as they see fit to meet their individual investment goals, time horizons, risk tolerances, economic forecasts, and strategies. Choice also allows investors to diversify.
The benefits of investor choice, including tailored portfolios, the chance to earn higher returns, and diversification, are important aspects of investor protection. Investor protection is about serving the broad interests of investors; it is not limited to shielding investors from fraud and manipulation.
I expect that product innovation will continue to contribute to the industry's growth and change. Ultimately, the marketplace is the best test of a new product. For a new product to succeed, investors must view the product as a good one and be willing to invest in it. The goal of providing products that investors will continue to want, therefore, drives product development. In addition, one must recognize that regulators themselves are not well-equipped to "sign off" on the substance of new products through some sort of merit review. This recognition is part and parcel of the disclosure philosophy of the federal securities laws.
This is not to say that investors do not sometimes make errors or regret their investment decisions in hindsight. But over the long run, the collective judgment of the marketplace is preferable to the judgment of an individual regulator or a small coterie of government officials. With adequate disclosure, investors remain best-equipped to decide how to allocate their capital.
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All of this and more has occurred against the backdrop of periodic regulatory developments impacting the fund industry, be it directly or indirectly. For example, since I joined in August of 2008, the Commission has adopted new requirements providing for the risk/return summary section of a mutual fund prospectus to be in XBRL.5 We also adopted rule amendments providing for a summary prospectus and improving the prospectus delivery process for mutual funds.6
Perhaps even fresher in one's mind are the regulatory steps taken in response to the pressures money market funds faced last year. These events have spurred active discussion regarding possible reforms to Rule 2a-7.
Although Rule 2a-7 has served investors well, I think we all recognize that the rule could be improved to address some of the lessons recent events have taught us. However, we need to be cautious. Lawmakers, including the SEC, should not overreact to "tail events" or "black swans." Instead, we must consider enhancements to Rule 2a-7 that work well in a prosperous economy, as well as during challenging times. The operative word is "balance."
While more could be said about various other aspects of the regulatory landscape governing mutual funds, I want to spend a moment considering credit ratings. The steps the SEC has taken in recent months concerning credit rating agencies are of significance to funds, particularly money market funds, as users of the ratings.
At the end of 2008, the SEC, building on earlier rulemakings, adopted requirements to enhance nationally recognized statistical rating organization (NRSRO) transparency and further address potential NRSRO conflicts of interest.7 We also proposed additional rules.8 I look forward to continuing to consider the comments on the proposal.
When credit ratings are discussed, scrutiny tends to focus on credit rating agencies and issuers and the potential for a conflict of interest to taint the issuer-pay NRSRO model. Less attention seems to be directed toward users of credit ratings. To be clear, users need to use credit ratings responsibly. Overreliance on ratings is part of the problem. I appreciate that credit ratings presently serve certain regulatory purposes, such as under Rule 2a-7. But whatever the regulatory import of a rating may be, users still need to make sound business judgments. That a fund can hold a particular asset with an investment grade rating, for example, does not mean that the fund should hold the asset as a business matter, particularly if the rating quality is in doubt.
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As you may know, I come from academia where my focus was securities regulation and corporate governance. So you can imagine the interest I take in the current debate over the appropriate level of scrutiny courts should bring to bear in reviewing investment advisory fees. I am referring, of course, to section 36(b) of the Investment Company Act, Gartenberg, and the Seventh Circuit's 2008 Jones v. Harris Associates L.P. decision.9 The Supreme Court will hear the Jones case next term. In deciding Jones, the Court undoubtedly will speak to the Gartenberg factors we have grown accustomed to applying.
I want to elaborate on the pending case, not only because it is important in its own right, but because it illustrates important regulatory principles.
Section 36(b) of the Investment Company Act, adopted in 1970, provides that the "investment adviser of a [mutual fund] shall be deemed to have a fiduciary duty with respect to the receipt of compensation . . . ." Section 36(b)'s adoption was driven by the view that the investment adviser's fee negotiation with the fund is not at arm's length, but tilts in the adviser's favor, because the fund, in practice, is captured by the adviser.10
In Gartenberg v. Merrill Lynch Asset Management, Inc.,11 decided in 1982, the Second Circuit set the standard that courts around the country have come to apply for evaluating whether there is a section 36(b) violation. The Gartenberg court stated that to violate section 36(b), the adviser's fee must be "so disproportionately large that it bears no reasonable relationship to the services rendered and could not be the product of arm's-length bargaining."12 As part of its reasoning, the court indicated that competition, which it found to be scarce at the time,13 could not be relied upon to keep advisory fees in check.14
Notwithstanding the seemingly open-ended nature of the opinion's "so disproportionately large" standard, Gartenberg provided important industry guidance by highlighting a number of specific factors for mutual fund advisers and boards to mind in negotiating the advisory fee.15
In Jones, written by Judge Easterbrook, the Seventh Circuit reached a different conclusion concerning the extent to which competition keeps advisory fees in check. Stated simply, Judge Easterbrook reasoned that, because investors care about after-fee returns, competition among mutual funds limits the fees that investment advisers charge. The Jones court built on its characterization of how the mutual fund industry has become increasingly competitive and streamlined the test for a section 36(b) violation as follows: So long as an adviser "make[s] full disclosure and plays no tricks," according to the Seventh Circuit, the adviser meets its fiduciary responsibilities.16 The Seventh Circuit recognized, though, that compensation could be "so unusual that a court will infer that deceit must have occurred, or that the persons responsible for decisions have abdicated . . . ."17
Instead of focusing on the finer doctrinal points of section 36(b) jurisprudence, I want to draw out three broader considerations. These considerations not only inform a framework for assessing an investment adviser's compensation-related fiduciary duty, but, insofar as they are more generally applicable, these considerations can influence regulatory and judicial decision making beyond the Investment Company Act.
First, adequate market discipline can obviate the need for more exacting and burdensome regulation. As I suggested earlier, one can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. But the industry has changed since 1970 (when the provision was adopted) and 1982 (when Gartenberg was decided). To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly adviser/board fee negotiations is mitigated. Put doctrinally, the difference may be between the Jones test of "full disclosure" and "no tricks" and the Gartenberg factors.
I will not opine on whether the mutual fund industry is sufficiently competitive to warrant updating section 36(b) jurisprudence, although it may be. The important point for now is to recognize that there is a continuing role for market pressure as a means of accountability that disciplines conduct.
Second, courts are not well-positioned to second-guess the business decisions that boards or others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board's decision-making process, but should steer clear of the temptation to override substantive outcomes. These basic observations animate the longstanding business judgment rule, which, although a state corporate law doctrine, is instructive in fashioning the appropriate judicial approach to enforcing section 36(b). These sensibilities cut against reading section 36(b) as implementing a sort of substantive limit on fees and instead recommend that courts focus on the process by which the fees were determined.
The size of the advisory fee is relevant in that it can shed light on the fee negotiation process. An especially large fee — whether characterized as "disproportionate" or "unusual" — evidences that the decision-making process that produced the fee may be inexcusably tainted, such as by disloyalty or a lack of adequate care. However, there are limits to this analysis. If the decision-making process, when evaluated specifically, holds up to judicial scrutiny, there is reason to conclude that the fee, although perhaps high by some measure, should not be subject to a judicial override. Phrased in Gartenberg-like terms, if careful, conscientious, and disinterested directors agree to the fee, little, if any, room is left for a court to declare that the fee is nonetheless so large that is could not be the result of an arm's-length bargain.18 The prospect that perhaps a better bargain could have been driven is a slim justification for allowing courts to substitute their business judgment for the collective judgment of independent directors acting in good faith.
Stating all of this much more generally, the law should not readily disregard private ordering.
Third, although it is possible to adhere too tightly to the status quo, the legitimate interest of predictability should receive considerable weight when evaluating the merits of a legal change. Gartenberg has long served as a constructive focal point for the mutual fund industry, as norms and practices have developed around the Gartenberg factors. Courts also have experience with Gartenberg, having applied the case for nearly 30 years. Even the SEC has incorporated Gartenberg into its rulemaking.19
Such predictability pays benefits. For example, an understood set of stable legal requirements allows a mutual fund adviser or board to organize its affairs efficiently and effectively in ensuring that it fulfills its responsibilities. Well-tested legal standards also enable courts to ascertain more readily when there has been a fiduciary shortcoming or other legal violation, as there are clear doctrinal markers by which to make the determination. With clear standards, lawsuits are decided at an earlier stage. The value of predictability would especially be compromised if a new approach to section 36(b) allowed courts meaningful discretion to second-guess good faith business decisions.
Broadening this out, private sector transacting and enterprise are frustrated when judicial doctrines or regulatory frameworks become unpredictable. This is so whether the uncertainty is because a doctrine or rule is applied inconsistently or because a doctrine or rule is expected to change but in an unknown way. Parties need to know what the rules of the road are and have well-founded confidence that the rules are not shifting beneath their feet.
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Let me turn my attention from your industry to the SEC. There inevitably is room for improvement; no organization is perfect. Everyday, leading businesses ask, "How can we do what we do better?" Everyday, we at the SEC need to ask ourselves the same question. Just because we are a government agency, we do not and should not get a pass from the obligation to reevaluate whether we have the right structures, processes, controls, and skills to ensure that we are exceeding every expectation of us.
One concrete suggestion that I urge is this: The SEC needs to be staffed with more economists and other non-lawyers with a deep understanding of financial markets. Our increasingly complex securities markets will be better served if the Commission has more economists, quantitative analysts, and others with strong backgrounds in trading and finance actively engaged in every feature of what the SEC does. For an agency that regulates the world's largest securities markets to be so dominated by lawyers is ill-advised.
Needless to say, I was pleased that the Commission very recently announced a new Industry and Markets Fellows Program to bring finance professionals to the agency. This program is focused on bringing in fellows who can help the SEC spot and evaluate risks in financial markets given their industry experience. We should consider opportunities for similar programs throughout the agency as a ready means of attracting individuals with extensive first-hand industry knowledge.
While some important changes are needed, one should not overlook the bottom line — namely, that the SEC is an agency of overall success. The Commission has a 75-year track record of commitment, excellence, and expertise. The agency's success is grounded, in part, in the integrated approach we take to overseeing our securities markets. Our broad responsibilities — from investment company and investment adviser oversight; to reviewing registration statements and annual reports; to regulating broker-dealers; to overseeing the exchanges; to bringing enforcement cases — are complementary and synergistic. We are better at each aspect of what we do because of the totality of our mission to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. These objectives are best served when advanced as a whole and not as distinct parts. This has been the Commission's longstanding tradition, and I expect it to be the agency's future.
Regarding the future, let me conclude with one final thought. Many have called for a systemic risk regulator. I understand the argument that some governmental body should have this explicit role. However, we need to guard against allowing a systemic risk regulator to be empowered with expansive authority that would permit it to override, as it sees fit, the federal securities laws.
I worry that if the government is not steadfastly committed to respecting and upholding the federal securities laws, including during times of severe financial stress, we will not have as much to protect from systemic risk in the first place. We enjoy the world's most robust securities markets, in notable part because of effective securities regulation, recent events notwithstanding. The prospect that a systemic risk regulator could in effect abrogate the federal securities laws would, in my view, do more harm than good, as the threat of such legal interference would persistently weigh on the markets. My concern is most acute when it comes to ensuring transparency, even when a required disclosure could adversely impact a systemically important institution.
I also have a more general concern about a systemic risk regulator. I still have not heard a satisfying definition of what constitutes a systemic risk. What does it mean for a firm to be "too big" or "too interconnected" to fail? A sort of "I know it when I see it" approach to systemic risk is untenable. It would be further discomforting if there were no clear guidelines and parameters to constrain a systemic risk regulator, as it would then be difficult to foresee how the regulator may act or to hold the regulator accountable in any meaningful way when it does act. I would not welcome such unbounded power, even if exercised with the best of intentions. It would inject too much uncertainty into the system — itself a risk — and concentrate governmental authority to a worrisome degree.
Having said this, I want to stress that the SEC should actively cooperate with a systemic risk regulator, consistent with the agency's mission and obligation to administer the federal securities laws in an even-handed way. If the Commission staffs up, as I hope we will, with more economists, traders, and other similar non-lawyers, we will have even more to contribute to systemic risk regulation given our comprehensive insight into securities markets.
Thank you and enjoy the rest of the program.