Remarks Before the Investment Company Institute's Annual Capital Markets Conference
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
New York, New York
September 24, 2009
Thank you for the warm welcome. Before I begin my remarks, I must say 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.
I am delighted to be in New York this morning at the Investment Company Institute's Annual Capital Markets Conference. Since its inception in 19401 — a historic year for the SEC — ICI has been an important voice, actively contributing to improving the oversight of our securities markets. In fact, many of the rules and regulations that the SEC has enacted in the subsequent decades were refined thanks to the thoughtful comments and research ICI and its members have provided. I am sure that this conference, like others before it, will spawn interesting insights that can help us achieve a well-calibrated regulatory regime that strikes appropriate balances.
I considered a range of topics to address today before deciding on three: custody, money market funds, and the Jones case.
Safeguarding client assets is a critical function of investment advisers. Investors must feel safe knowing that the funds and securities they own on paper exist in reality. Investors need to be confident that their returns are not fictitious and that their assets have not been misappropriated.
To this end, this past May, the Commission proposed rules under the Investment Advisers Act to enhance the safeguarding of investment adviser client assets.2 Among other things, the Commission proposed amending the custody rule to require an annual surprise examination of client assets by an independent public accountant for registered investment advisers with custody.
Although I voted in favor of the Commission's custody proposal, I raised certain reservations at the open meeting, particularly about extending the surprise exam to the extent proposed.3 First, I questioned whether the surprise exam should cover investment advisers with an independent qualified custodian or be targeted to instances where the investment adviser or a related person is the qualified custodian. Given that non-affiliated custodians already serve as an important safeguard of client assets, it is not self-evident that the cost of a surprise exam is warranted. Second, I sought comment on whether the custody rules should cover investment advisers who have custody only because they withdraw fees from client accounts. Is the ability to withdraw fees a sufficient basis upon which to subject an adviser to the cost of yearly surprise exams? I expressed a related reservation that surprise exams may undercut competition if they were disproportionately costly and burdensome for smaller advisers.
Having had occasion to consider comments the Commission has received, I still question whether the proposed surprise examination requirement may reach too far. Without doubt, investors need to be secure that their investments are protected. That said, it is possible to regulate past the point of prudence. It is always possible to take another regulatory step to protect against fraud and other abuses, but is the cost of the additional regulation warranted? Given the rest of the relevant regulatory regime and the steps advisers already take to secure investor assets, the marginal benefit of a surprise examination may not outweigh the attendant cost. Not every incremental benefit of additional regulation is justified; there are diminishing returns.
Out-of-pocket compliance costs — which commenters have suggested could be considerable — are the most obvious cost of a surprise examination. But they are not the only cost to consider. Exams distract time and effort away from other productive matters that could better benefit investors. One also should consider the extent to which requiring surprise exams could foster moral hazard by promoting an undue sense of security that dissuades investors from taking steps to protect their own interests. If the benefit that flows from the threat of a surprise exam is not substantial, requiring a surprise exam may do more harm than good if it undercuts constructive forms of investor self-protection. Active investor skepticism and diligence — which regulators can promote by explaining the limits of what regulation can do to protect investors — may do more to deter and detect misconduct than particular regulatory demands.
While these considerations are worth underscoring as I have, it is premature to determine what they ultimately mean for the Commission's custody rule. I look forward to continuing to review and consider the comments and giving the custody proposal careful attention.
Money Market Funds
Careful attention also is directed at money market funds. It goes without saying to this audience, that money market funds serve an essential function for investors, issuers, and our economy overall. Money market funds are a popular investment and cash management option for both retail and institutional investors. Furthermore, money market funds are important to businesses of all shapes and sizes as a source of financing. Evidencing their significance to the economy, over 750 money market funds are registered with the SEC, holding in the aggregate around $3.8 trillion in assets.4
The distinctive feature of money market funds is their $1 per share stable net asset value. Money market funds provide an element of stability while allowing investors the opportunity to earn higher returns on their money than, say, bank products typically yield. Investing in money market funds is not riskless; but it is this marginal risk that generates the reward of higher returns.
Money market funds came under severe stress during the financial crisis of 2008, and one money market fund — The Reserve Primary Fund — "broke the buck." These events spawned a reconsideration of money market funds and whether Rule 2a-7 under the Investment Company Act needed reforming.
In June of 2009, the SEC proposed sweeping amendments to Rule 2a-7.5 The SEC's proposal goes to great lengths to reduce the risk that money market funds could again come under undue stress by, for example, shortening portfolio maturities and imposing new liquidity requirements. I voted in favor of the proposal, but I expressed significant reservations about two features of the rulemaking.6 I'd like to revisit my questions, which persist.
I continue to question the proposal to eliminate Second Tier securities from money market fund holdings. Today, Rule 2a-7 caps at five percent the portion of a money market fund's assets that may be invested in Second Tier securities. The SEC's proposal would reduce this to zero percent.
Is such an unequivocal step as banning money market funds from investing in Second Tier securities warranted? In short, the Commission's proposal release reasons that it is possible that Second Tier securities could contribute to the instability of money market funds because Second Tier securities are of lower credit quality than First Tier securities. For support, the release points to data showing that credit spreads widened more for Second Tier securities than First Tier securities during the 2008 market turmoil. It's worth considering the extent to which the widening of credit spreads for Securities Tier securities when compared to First Tier securities may be attributable to support that the government implemented for First Tier securities. I will refrain from suggesting further possible interpretations of these data in favor of offering a straightforward counterpoint to provide balance: I have not seen any evidence showing a causal link between Second Tier securities and the stresses that strained money market funds last year. Indeed, the Commission's release does not suggest any such link.
Against this backdrop, a number of questions can be posed in evaluating competing approaches to Second Tier securities. For example, is it possible that eliminating Second Tier securities could lead to less well-diversified money market funds that actually put investors at greater risk? To what extent might banning Second Tier securities from money market fund portfolios reduce yields investors earn? Might the proposal impede competition by undercutting the ability of certain funds to offer investors better returns? Will certain money market funds opt not to hold more marginal First Tier securities if Rule 2a-7 is amended to eliminate Second Tier securities? To what extent do certain non-money-market-fund investors key their investment decisions off Rule 2a-7 so that the proposed amendments would chill these investors from investing in Second Tier securities? Can an appropriate balance be struck by, say, reducing the maximum percentage of Second Tier securities a fund can hold but without a ban or shortening the maximum permitted maturity of Second Tier securities? The Commission has received comment on these and a host of other aspects of the proposal. I look forward to continuing to review and consider the comments.
In striking the appropriate balance — and thus in assessing these and other questions — the Investment Company Act obligates the SEC to consider, "in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation."7 As I noted at the open meeting when the Commission considered the proposed Rule 2a-7 reforms, in keeping with this statutory mandate, we should consider the impact the proposed amendments could have on issuers of commercial paper. Not only are we required to consider such impacts, but it is prudent for us to do so to ensure that we have a thorough understanding of the potential consequences of our rulemaking. A basic question captures the core of the needed inquiry: What would prohibiting money market funds from holding Second Tier securities mean for businesses that rely on money market funds to help finance their operations?
My second concern centers on the prospect of replacing the longstanding stable $1.00 net asset value of money market funds with a floating market-based NAV. The proposal release sought comment on the possibility of requiring a fund's NAV to float. Such a departure from a stable $1.00 NAV would fundamentally change money market funds. The question is whether the change would be for the better or for the worse.
The Commission's request for comment has generated just that — a considerable amount of comment. Again, I look forward to continuing to review and consider the comments. For now, I'll offer just a few brief thoughts on one aspect of a floating NAV.
A leading argument advanced in favor of requiring that a money market fund's NAV float is that a floating NAV will stem the risk of another run on funds like The Reserve Primary Fund experienced. In this view, with a stable $1.00 NAV, investors are more likely to rush to redeem during a period of financial stress to get out at $1.00 before the buck is broken and they are forced to redeem for less. Under such circumstances, the breaking of the buck can be self-fulfilling. The rush of investors to exit can cause a fund that is otherwise stable to break the buck. When a fund breaks the buck, the consequences are not isolated to the fund and its investors, but can have a widespread market impact. Indeed, precautionary steps that a fund might take to avoid breaking the buck may themselves impact a wide swath of market participants, even if the buck is never broken.
These are legitimate concerns, but I wonder whether a floating NAV is the answer. First, if Rule 2a-7 is amended to, among other things, shorten portfolio maturities and mandate liquidity requirements, the contribution of a floating NAV to reducing the risk of a run may be marginal and not worth the disruption that a floating NAV would cause the money market fund industry. Second, if investors see a fund's floating NAV begin to fall, it seems that investors using money market funds as a cash management device might want to redeem before the price falls more. Accordingly, it's not clear that a floating NAV would prevent a run during a serious financial disruption. On the other hand, one could imagine that a stable $1.00 NAV makes the threat of a loss in value more salient and thus more psychologically impactful to investors in a way that could precipitate a rush to exit; whereas over time, investors may become less sensitive to the ups and downs of a floating NAV, so that a decline is less likely to trigger a run. Third, we need to consider that if NAVs float, investors likely will turn to alternative investment options, such as various bank products. A considerable outflow from money market funds could adversely impact our markets generally, including companies for which a key source of financing dries up. I look forward to continuing to review and evaluate the helpful comments we have received addressing these and related considerations.
One takeaway is this: In evaluating the potential reform of Rule 2a-7, the Commission needs to account for the full history of money market funds to avoid having its analysis unduly skewed by the events of 2008. The Reserve Primary Fund's breaking of the buck spawned hardship, but the breaking of the buck is an outlier event, at least as measured against the decades-long history of money market funds. While changes may be called for, we need to be cautious, particularly if certain reforms would fundamentally alter a multi-trillion dollar industry that, on the whole, has served our economy extremely well.
Jones v. Harris Associates L.P.
Another important development is taking place in the courts. The Supreme Court soon will hear oral argument in the case of Jones v. Harris Associates L.P.8 The Supreme Court is set to decide the appropriate level of scrutiny courts should bring to bear in reviewing investment advisory fees under section 36(b) of the Investment Company Act. Given the significance of this case to many in the audience, I would be remiss if I did not share some observations on it.9
As you know, in the 1982 Gartenberg case,10 the Second Circuit found that for an adviser of a mutual fund to violate the section 36(b) fiduciary duty, 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."11
In Jones, the Seventh Circuit took a different approach, placing greater emphasis on the extent to which competition keeps advisory fees in check. In the Jones opinion, Judge Easterbrook 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.12
Much could be said about the case. Indeed, the briefs are extensive. I will limit myself to highlighting two core points, leaving the details to others.
First, adequate market discipline can obviate the need for more exacting and burdensome regulation, including demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. Put differently, the legal accountability of section 36(b) can be thought of as substituting for a lack of market-based accountability. The industry, however, has changed since section 36(b) was adopted in 1970 and Gartenberg was decided in 1982. 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 the adviser/board fee negotiations is mitigated.
Second, courts are not well-positioned to second-guess the business decisions that boards and 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 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.
An especially large advisory fee that appears to be "disproportionate" would seem to evidence that the decision-making process that produced the fee was inexcusably tainted, giving rise to a section 36(b) fiduciary duty breach. However, if on further scrutiny a court determines that careful, conscientious, and disinterested mutual fund directors agreed to the fee, little, if any, room is left for the court to declare that the fee is nonetheless so large that it could not be the result of an arm's-length bargain. To the contrary, if a faithful, diligent board decided that the fee was appropriate, it would seem to rebut any preliminary determination that the fee ran afoul of section 36(b). The prospect that perhaps a better bargain could have been driven is a slim justification for allowing judges — who have no comparative expertise negotiating or setting advisory fees — to substitute their judgment for the collective judgment of independent directors acting in good faith.
Like you, I look forward to hearing the argument in Jones and reading the Court's opinion. Whatever the outcome, I hope that the Court speaks with sufficient clarity so that mutual fund boards and advisers understand what is required of them and can organize their affairs accordingly. Such predictability is unlikely to result if a new approach to section 36(b) is adopted that allows courts meaningful discretion to second-guess good faith business decisions.
I've only been able to touch on a handful of topics. There is much more to say. For now, though, let me simply again say thank you to ICI for inviting me to speak to you. Enjoy the rest of the conference.