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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the Hofstra Journal of International Business Law Conference on Investment Management Law


Andrew J. Donohue

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Hofstra Law School
Hempstead, New York
October 9, 2009

I. Introduction

Good morning and thank you. It is a pleasure to be here. I am very pleased to open this important and timely conference on the legal and regulatory structure governing the investment management industry. I first want to thank everyone involved in developing today's program. In particular, I want to recognize Hofstra Law School, its Journal of International Business Law for sponsoring this event, and Professor Ronald J. Colombo for his work in this area. The decision to focus your symposium on this area of law showed a great understanding of its importance — with over half of all Americans owning mutual funds — through retirement accounts, money market funds or other investment vehicles — the investment management industry plays a crucial role in our markets, our economy and in the lives of hundreds of millions of individual investors. The evolution of this industry from the establishment of the first mutual fund in 1924 — not that long ago — into the staggering $10 trillion in mutual funds and $33 trillion of assets under management by advisers is a fascinating story of ingenuity, ethics and governmental and industry cooperation. As investment management practices continue to evolve at a rapid pace, I appreciate the opportunity today to step back and examine different aspects of the industry and think about the role of regulation — how it has worked and should work to protect investors while allowing the industry to flourish. In addition, while in the midst of potentially some of the most far-reaching legislative and regulatory developments we have seen in decades, this opportunity takes on an even greater significance. I hope this symposium is the first of many to follow.

I also want to thank Jay Baris for his initiative in developing today's program. Jay and I have spent the majority of our careers in the investment management industry. I share his appreciation and enthusiasm for its intricacies and significance. The program that he helped devise today provides a unique opportunity to examine the laws that are the foundation of the investment management industry and to reflect on the role governance plays in its success and resilience. Today you will hear from several of the experts on various aspects of investment management law, including Commissioner Luis Aguilar, who had considerable experience in this industry before being appointed his seat with the Commission two years ago. I very much appreciate each of today's panelists taking the time to come and participate in what I anticipate will be a truly exceptional program. Finally, I want to acknowledge the presence of Dan Waters here today. Dan is Sector Leader for Asset Management at the U.K.'s Financial Services Authority. In that role, Dan is responsible for the FSA's overall strategy and liaison with the asset management sector in the U.K. As we explore the evolution and development of the investment management industry, and its regulation, it would be remiss not to consider the now very global nature of the industry. It is fitting that Dan is here, and I am grateful that he was able to join us.

To set the stage for today's discussions, I would like to take a step back and look at the evolution of the investment management industry — its stunning growth and development over the years and the regulatory initiatives paralleling its establishment. Before I begin, however, 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.

II. Establishment of the Modern Investment Management Industry

Although often considered an American invention, mutual funds, and the investment management industry, not only play a significant role in the US markets, but now also in major markets around the world. The success of this industry in the United States has been attributed to a number of factors. One of which is the system of governance put in place with the passage of the Investment Company Act and the Investment Advisers Act in 1940. Others attribute the industry's success to its creativity and sophistication. Furthermore, and maybe most importantly, since the inception of the modern investment management industry, there generally has been a common industry understanding that a commitment to ethics and the confidence of investors is a critical component to its overall success. However, as we examine how the industry got to this point, it is apparent that its impetus was not any one of these things, but rather a mix of each of these mutually reinforcing elements that created an industry that simply works.

A. Enactment of the Investment Company and the Investment Advisers Act

This mix was first evident when looking at how the Investment Company and the Investment Advisers Acts came about. Unlike any of the other federal securities laws, these statutes were the result of a unique industry /governmental cooperative effort. This effort was reflected in a massive two year study by the Commission. The study, submitted to Congress as the Investment Trust Study of 1939 and reflecting industry views, served as the basis upon which the two statutes were predicated. In addition, each of these statutes, like all the federal securities laws, were enacted against the backdrop of the 1929 stock market crash — a crash that led to the securities listed on the New York Stock Exchange losing 83 percent of their value over the course of three years. As you might expect, during the 1930s, few people considered securities as appropriate investment vehicles, preferring instead to put money into bank accounts or even their mattresses. Although by the late 1930s, investor confidence had substantially returned and the markets were once again vigorous, the importance of investor sentiment was now understood.

This understanding was relevant in both the investment company and advisory contexts. Prior to 1940, many funds, mainly closed-end funds, in disregard of their fiduciary status, were formed and operated for the benefit of their sponsors and affiliates, not their investors. The industry, aware that this common practice would ultimately lead to its demise, embraced the idea of imposing strong fiduciary standards within the industry and worked along with the Commission staff to hammer out the Investment Company Act over a period of six weeks. As a result, the Company Act imposes some of the most restrictive regulatory requirements under the federal securities laws.

However, offsetting the statute's highly regulatory nature, is a built-in flexibility that has truly allowed the Company Act to serve as a vehicle for the fund industry's evolution over the past 70 years. In providing the Commission the authority to exempt new products and structures from the Act's confines, if, as stated in the Act, "they are necessary or appropriate in the public interest, consistent with the protection of investors," Congress allowed the Commission to expand or contract the Act to accommodate new products and firm structures. This authority, until recently unique to the Company Act, has proven enormously important as without it we may not have seen some of the most significant industry developments occur when they did. Money market funds, variable annuities and life insurance products and exchange-traded funds — products that are truly benchmarks of this industry — were all developed through the exemptive process under the Investment Company Act.

The Investment Advisers Act of 1940, enacted shortly after the Company Act, also facilitated tremendous industry development, but with a different approach. As in the fund industry, the advisory industry was plagued with fraudulent practices of individuals serving as "investment counselors" as they were called. The practices included advisers trading from their personal accounts in securities in which their clients were invested, inappropriate use of performance fees, misappropriation of client assets and abusive practices with respect to advisory contracts.

Similar to the fund industry, investment advisers recognized the problem of unethical individuals representing themselves as true "investment counselors" and thus supported enactment of the Act and its basic purpose to protect investors against malpractice and fraud. However, rather than being proscriptive, the Advisers Act generally consisted of broad principles intended to protect investors from fraud and facilitate a profession providing clients unbiased investment advice. The Act's requirements focused on disclosure and generally served as a "compulsory census" by requiring advisers to file certain information with the Commission. There were no standards set for investment advisers to maintain, and certain advisers were exempted or excluded from the Act's provisions.

B. Growth of the Investment Management Industry

The success of the governance regime established by the two 40 Act statutes was evident as the decades following were characterized by tremendous industry growth and change. As of 1940, only 68 investment companies existed in the United States, with assets of about half a billion dollars. By 1966, with the incredible popularity of mutual funds, investment company assets had increased from about $2.1 billion to $46.4 billion. The number of mutual fund investors also substantially increased. In 1940, 300,000 Americans held mutual fund shares, by the end of 1965, there were over 3.5 million mutual fund investors. Since that time a number of significant developments have further changed the industry landscape. Probably most significantly, the establishment of the first money market fund in 1971, and the Commission's adoption of rule 2a-7 under the Company Act in 1983, creating the modern money market fund, were key events leading to the tremendous growth of the industry in the 1980s and 1990s.

Other legislative developments in the 1970s also had a significant impact on the growth of the industry, particularly with respect to retirement assets, which currently represent almost 32.7% percent of all mutual fund assets. For example, the enactment of ERISA in 1974, which authorized the establishment of individual retirement accounts, the introduction of the first tax-exempt municipal bond funds after the Tax Reform Act of 1976 and the enactment of the Revenue Act of 1978, which created 401(k) retirement plans and simplified employee pensions.

By 1980, 40 years later, the number of investment companies had grown to 564, with $135 billion in assets. Skip ahead another 20 years. By 2000 there were over 8000 funds with almost $7 tillion in assets. In 2009, the number of funds was just under 8000, but with assets under management at over $10 tillion.

For investment advisers, we have seen similar amazing growth. In 1960, there were 1,832 investment advisers and 350 investment counsel registered with the Commission. By 1980, the number of registered advisers had grown to 5,680 advisers managing 450 billion dollars in assets. By 2009, this number had more than doubled to over 11,000 registered advisers managing over $33 trillion dollars in assets, with another 14,000 advisers registered with the states.

C. Changes in the Original Legislative Scheme

Even with major changes in the investment management industry, the Investment Company and Investment Advisers Acts have shown incredible resilience. The Acts have weathered events such as the market crash of 1987, the demise of Long Term Capital Management, the late trading and market timing scandal in 2003, and the latest series of market events. Helping the statutes hold up through the years, as the investment management landscape changed, a few amendments were enacted since 1940. For example, in 1970 amendments to the Company Act concerned fund management fees, sales charges and withdrawal penalties and also set the maximum load fee that mutual funds can charge. The 1970 amendments also imposed a fiduciary duty on investment advisers with respect to their compensation,

Unlike the Company Act, as the advisory industry grew and developed, the original Advisers Act proved deficient in several areas. In 1960, the Act was substantially amended to convert it from being considered merely a census statute to a more regulatory one. The original Advisers Act gave the Commission no authority to inspect, advisers' books and records, or even require that they maintain them. The 1960 Amendments changed this. The Amendments also extended the Act's antifraud provisions to cover any adviser, not just those registered with the Commission, and gave the Commission authority to define through rulemaking actions that are fraudulent, deceptive or manipulative.

Following the 1960 amendments, the most significant change occurred with the passage of the National Securities Markets Improvements Act, or NSMIA. With the proliferation of the number of investment advisers over the years, in 1996, Congress passed NSMIA with the purpose of reducing the complexity and duplicative regulation among state and federal securities regulators. Towards this end, the legislation divided the regulation of investment advisers between state and federal regulators, limiting state regulation to those advisers with less than $25 million under management.

III. Challenges in the Investment Management Industry

A. Challenges in the Industry

Now that we have looked at where we have been — and the stability, success and resilience the industry has demonstrated over the years — we come to today. We are certainly in a period of considerable upheaval throughout our financial markets and in the regulation of them. In investment management, the industry is facing considerable challenges, the extent of which it hasn't seen since its inception. For example, we have seen recently declining asset values requiring funds and advisers to adjust their operations to the new market environment. Business models are also changing, with, for example, the rapid growth of separately managed and unified managed accounts in recent years. Furthermore, advisers are recommending investments in increasingly complex products such as derivatives and are using sophisticated computer models to manage client assets. Along with other technological developments driving rapid change in the investment management industry, firm are faced with significant challenges in keeping up with these advancements. The challenges firms face in adjusting and operating in a very dynamic period in the markets' history is a very important topic and I look forward to exploring it further this morning in the panel discussions.

B. Challenges to the Investment Management Governance Structure

These extraordinary times have also led to calls for changes in the investment management industry's governance structure. As these changes may impact fundamental elements of the Investment Company and Advisers Acts, we are in a period of such significant development, it, in many ways, parallels the period preceding the enactment of the statutes in 1940.

1. Broker-Dealer — Investment Adviser Regulation

For example, in 1940, one motivation of the investment advisory industry in supporting legislation to govern adviser's activities was to distinguish themselves from other professionals such as lawyers, banks, trust companies and brokers, who, at the time, typically provided investment advice to individuals as part of their general services. However, as investors began to seek continuous investment guidance, the advisory profession grew to meet the need for unbiased investment advice, compensated solely with definite, fully-disclosed professional fees. The idea that registered advisers should be distinguished from those providing advice as an ancillary service is embodied in the Advisers Act, which states that it is unlawful for someone registered under the Act to represent that he is an investment counsel or to use the name "investment counsel" as descriptive of his business unless (l) his or its principal business consists of acting as investment adviser, and (2) a substantial part of his or its business consists of rendering investment supervisory services.

Today, a similar tension with respect to the regulation of broker-dealers and investment advisers exists. The services provided by investment advisers and broker-dealers have evolved and converged since the regulatory schemes governing each of these industries were enacted almost 70 years ago. On the broker-dealer side, brokerage commissions were unfixed in 1975 and discount brokerage services developed. In the late 1990s, fee-based accounts and discount brokerage services were common in the marketplace. While broker-dealers viewed the fee-based compensation programs as providing the same services that broker-dealers have traditionally provided to their customers, just with a different compensation scheme, investment advisers saw brokers' implementing fee-based compensation as a transformational event — no longer were customers paying for brokerage transactions, but for a client relationship in which advisory services predominate. In addition, the brokerage industry commonly describes their services in terms very similar to those used by investment advisers, adding to confusion among investors as to what they are paying for.

These developments raised questions as to the applicability of the Advisers Act to brokers. To resolve this issue, in July, the Administration announced proposed legislation to harmonize the regulatory schemes governing broker-dealers and investment advisers. The Investor Protection Act of 2009 would give the Commission authority to, among other things, require a fiduciary duty for any broker, dealer, or investment adviser who gives investment advice about securities. In this way, the legislation would apply a functional approach, and align the standards based on activity, instead of on legal distinctions. In general, the question of how to apply the Advisers Act to the current activities of broker-dealers represents the need to adapt a regulatory scheme established under a 70-year old statute to a changing industry environment. We are watching the developments in this area closely.

2. Hedge Fund Registration

Along similar lines, another area where we see the question arising as to the applicability of the Company and Advisers Acts to industry participants whose activities have traditionally fallen outside statutory confines is in regard to hedge funds. The proliferation of hedge funds over the years has created questions as to whether they are being appropriately regulated. Hedge funds traditionally have been organized to avoid regulation under the Investment Company Act, as well as the registration requirements under the Securities and Securities Exchange Act. In addition, many hedge fund advisers avoid registration under the Advisers Act by taking advantage of an exemption from registration for small investment advisers — those with fewer than 15 clients. Hedge fund advisers qualify for this exemption by pooling client assets and creating limited partnerships, business trusts or corporations in which clients invest. With the tremendous growth of hedge funds and the influence they exhibit in the markets, is this a loophole that needs to be closed?

There are of course many other areas in the governance of the investment management area that are being examined in the current environment of regulatory reform. One more I will briefly mention is money market funds. Although the regulatory scheme governing money market funds has worked very well for over 30 years and facilitated the incredible growth and popularity of these funds, the challenges these funds have faced over the past two years has prompted the need for a regulatory review. Most significantly, in light of the occurrence of a money market fund "breaking the buck," and the ensuing redemption pressures on money market funds, the Commission has proposed amendments to the rules governing money market funds designed to make them more resilient to market risks and to better protect investors.

IV. Conclusion

In short, having looked back and now thinking forward — it is certainly a very interesting, and in many ways, exciting time to be working in the investment management industry, or simply watching its developments. Over the years, this industry has shown remarkable ingenuity in developing products and services to provide investors access to our securities markets — predominantly with the view that the fiduciary obligation to act in the best interests of their clients is the keystone to its success. With this understanding, the industry has weathered the storms over the years and often has come out even stronger. I don't expect this period to be any different.

I look forward to today's program during which we will have the opportunity to delve into matters of current significance to the industry. The developments in the hedge fund industry, issues concerning derivatives and leverage and the regulatory implications, as I mentioned are of great significance. In addition, during today's program we will also have the chance to focus on the other side of the regulatory equation — the enforcement of the rules. Along these same lines, the panel examining the challenges facing fund directors and trustees is of great significance, as the role of directors in overseeing the inherent conflicts of interest is a critical part of the functioning of investment companies.

Finally, although we will discuss briefly the impact of significant events in the investment management industry, in the final panel today, you will hear from those who really know what happened surrounding these events — the former directors of the Division under whose watch these events occurred. As they say, you only know where you are going, if you know where you have been. These panelists, who I am grateful were able to join us today, will certainly be able to give us some insight in this regard.

Thank you very much for listening this morning and enjoy the rest of the day.


Modified: 10/09/2009