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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the ICI 2009 Securities Law Developments Conference


Andrew J. Donohue1

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

Washington, D.C.
December 9, 2009

I. Introduction

Good morning and thank you, Karrie [McMillian] for that 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 today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I always enjoy speaking at this conference — normally one of the last opportunities I have to discuss our work in the Division of Investment Management before we close our calendars and move on to a new year. For this reason, I often view this event as a chance to review the work of the Division and provide you something of a report card and review both our accomplishments over the past year, as well as acknowledge those projects we were not able to complete. With respect to these projects, the unanticipated market events we all have experienced recently drove much of the Division’s work and compelled us to temporarily defer projects otherwise high on our agenda. For this reason, in addition to our accomplishments, this morning I would like to review the Division’s “to do” list with you and hopefully give you an idea of what you could potentially look out for in the coming year.

I also enjoy preparing to speak at this event because it gives me a chance to step back and reflect on the year that has largely passed and think about some of the general developments we are seeing in the fund industry. Last year, when I did this, I mentioned my concern with the increasingly complex nature of our markets, as well as the intricate products and the complex portfolio strategies fund managers are utilizing. I questioned whether products are not only too complex for investors to understand, but also fund managers. Today, before I turn to the Division report card, I would like to give you my thoughts on a corollary to these developments. It seems these days there is frequent reference to “risk management” within the financial services industry and questions as to how to deal with the complexity and interconnected nature of our markets. In fact, as of this past summer, we now have an entire Division within the SEC devoted to examining and determining market risks.

II. Risk Management

What exactly is risk management? There are of course many types of risk. But, in addition, I feel that there are also different ways of thinking about risk. In today's market environment, risk is typically thought of as something to be avoided or at least minimized. Whereas I tend to think of it as something that should be identified, properly understood and optimized, with the best interests of investors in mind. Risk, as you know, is fundamental to the theory underlying our markets dictating that risk and returns should bear some relation. All investors take on some degree of risk with the expectation that the returns they will potentially enjoy more than offset the risks. The higher the investment risk, the higher the expected return. Investors must be able to weigh the potential reward of an investment against the investment’s risk to determine if the risk is worth the potential gain.

As risk is fundamental to the financial markets, what should the goals be with respect to managing those risks? The complex products in the market today are designed to mitigate risk in some areas, but they also create it in others as greater returns are sought. Because certain risks must be embraced in order to minimize others, I believe the question to ask is not how to eliminate risk, which can never be achieved, but rather determine whether the risks a fund is taking are the right risks and whether those risks can be disclosed in a way that investors understand. For example, funds’ investment in derivatives is done to offset certain risks while taking on others. Although optimizing risk has many factors, I would like to suggest a few ways to determine whether certain risks are appropriate for a fund and its investors.

For investors, first, can the investor take on the risk being considered? For example, if I offered you the opportunity to triple your net worth if you win the flip of a coin, but lose everything is you lose the coin flip, you probably would not take me up on it (even though statistically, I am offering you a great deal). The risk is too great — you could not afford to go broke.

Second, what are the investor assets that are being invested needed for? If an investor has a house closing next week it is less important what those assets will earn over the next week, but it is critical that next week the funds are there. I heard someone describe this concept as not so much worrying about the return on your investment as the return of your investment.

With regard to risks to investors, let's look at target date funds for a moment. While many have focused solely on the investment risk when discussing these types of funds, target date funds actually try to address three types of risks that people preparing for retirement face: in addition to (1) investment risk — the risk I might loose some or all of my retirement savings; investors also face (2) longevity risk — the risk that I might outlive my retirement resources; and (3) inflation risk — the risk that inflation devalues the resources I have for my retirement. Now depending on how a particular investor values those risks, each investor may wind up with significantly different asset allocation strategies.

For funds, I think some things to think about regarding risk are: (1) whether you have correctly identified the risks to a fund and its shareholders; (2) whether you have eliminated or mitigated risks that are not appropriate for the fund; and (3) whether you have communicated the risks the fund has accepted to the fund’s investors in a manner they can understand and in a way that allows them to make an informed decision about investing in the fund. In regard to this last point, a never ending list of "risks" without any framework for an investor to understand and evaluate the risks, is not that helpful. To be truly meaningful to investors, a description of each risk should include some analysis as to the likelihood of the risk occurring and the consequences of the risk if it does occur.

Finally, while in general risks and returns are related, risk appears, at times, to be not properly identified and inadequately compensated for in potential return. So be vigilant.

III. Division of Investment Management — 2009 Review

On that note, I would like to descend a few thousand feet, and, as I mentioned earlier, discuss the Division of Investment Management’s report card for 2009 — what we did, what we did not do and what may be on our agenda for the coming year. Before I begin, I wish to express my gratitude to the Division staff for all their hard work and devotion in what was an extraordinarily busy and productive year. Without their tireless efforts, there would be little to say for the remainder of my time this morning.

A. Money Market Funds

In terms of the Division’s accomplishments, I first would like to discuss money market funds. As I had mentioned, much of the staff’s time has been devoted to issues arising in response to the unanticipated market events over the past two years. Money market funds, in particular, is an area the staff has paid considerable attention to in several aspects.

First, as an immediate response to the troubles in this area, the staff provided no-action letters permitting affiliates to support money market funds through capital support agreements and asset purchases, and to facilitate money market funds’ participation in the Treasury Money Market Fund Temporary Guaranty Program and the Federal Reserve liquidity facilities. The staff worked closely with the industry in the issuance of the no-action positions for the benefit of fund investors, and, I have said it before, but I would like to reiterate my commendation of the industry for its assistance and cooperation to abate further problems. The Division staff also worked with the Treasury Department on the development and implementation of the Money Market Fund Temporary Guarantee Program. In addition, Division staff helped develop the Commission’s court action that resulted in a judicial order to release, on a pro rata basis, nearly all remaining assets to investors in the Reserve Primary Fund, the money market fund that broke a buck last year. The Commission’s action is expected to expedite the equitable distribution of the fund’s assets.

In June, the Commission proposed amendments to rule 2a-7 to strengthen the resilience of money market funds during times of market turbulence and to increase protections for investors in a money market fund that is unable to maintain a stable net asset value. In doing so, the proposal would tighten rule 2a-7’s risk-limiting restrictions on money market funds relating to portfolio quality, maturity, and liquidity; require that money market funds disclose portfolio information on a more frequent basis (monthly); and permit a money market fund’s board of directors to suspend redemptions if the fund breaks a buck and decides to liquidate. In addition to these proposed rule changes, the Commission requested comment on certain more fundamental changes to the regulation of money market funds, including whether they should have “floating” rather than stabilized net asset values and whether redemption in kind should be mandated for certain redemptions.

The Commission received approximately 120 comment letters on the proposal. The staff is currently evaluating the comments and we expect to submit a recommendation to the Commission shortly.

The Commission also is working with the Federal Reserve and other regulators through the President’s Working Group to address potential systemic risk issues that may be presented by money market funds.

B. Advisers Act Rulemaking

The Division staff was also busy this year on rulemakings under the Investment Advisers Act and in the insurance area. Under the Advisers Act, in May of this year the Commission proposed amendments to the rule governing advisers’ custody of clients’ funds. The proposed rule would, if adopted, require an independent third party to annually examine the client assets for which an adviser has custody and impose additional requirements if client assets are held at an affiliated custodian. Over 1300 comment letters were filed with the Commission on the proposal. We expect the Commission to consider adoption of this rule shortly. Also under the Investment Advisers Act, the Commission proposed a rule prohibiting adviser “pay to play” practices with respect to political contributions.

C. Director Guidance

Other projects potentially coming down the pike include the Division staff’s Director Outreach Initiative as well as guidance to fund directors, proposed by the Commission in July of last year, designed to assist them in their oversight of advisers’ trading of fund portfolio securities, including the use of soft dollars. The Director Outreach Initiative was started to help the staff gain a better understanding directly from fund directors as to how they discharge their responsibilities and to learn of their suggestions for any improvements.

D. Other Rulemaking Initiatives

In addition, the Division is continuing to focus on improving mutual fund disclosure, one of our most important initiatives in recent years. Following the successful adoption of the Summary Prospectus last year, the Division staff is developing a recommendation to the Commission regarding proposing amendments to the shareholder report disclosure framework to make such disclosure more streamlined and user friendly for fund shareholders and to consider ways to better incorporate technology into the delivery of this information.

The Division is also looking at the issues surrounding Target Date Funds. Although the Commission does not regulate retirement plans, the staff has been cooperating closely with our counterparts at the Department of Labor to consider the appropriate regulatory response in this area. Following a joint hearing the Commission held with the Department of Labor this summer, the Commission is currently evaluating the different approaches to concerns that were voiced regarding investor education, fund names, sales materials and prospectus disclosure.

One other area the Division is looking at is concerns with investment companies’ use of derivatives and the requirements regarding senior securities under section 18 of the Investment Company Act. In April of this year, I challenged the American Bar Association to design an approach to address the concerns that have arisen in this area, namely that 1) funds should have a means to deal effectively with derivatives outside of disclosure; 2) a fund's approach to leverage should address both implicit and explicit leverage; and 3) a fund should address diversification from investment exposures taken on versus the amount of money invested. In response, the ABA created a Task Force on Investment Company Use of Derivatives and Leverage to evaluate and recommend how the Commission can improve regulations and regulatory guidance. I understand the Task Force expects to produce a report in this area. I appreciate the efforts of the Task Force in this regard and we look forward to learning its recommendations.

E. Chief Counsel’s Office

The Division’s Chief Counsel’s Office also had a very busy year. Last year, I had mentioned that I hoped that the Office’s work in preparing a first-of-its-kind bibliography of Commission documents related to funds’ use of senior securities under the Investment Company Act accessible from the Commission’s webpage would be a repeated effort. Well, the Office has done so and put together a similar bibliography of Commission releases, staff no-action letters and statutory provisions concerning valuation of fund securities. As with the senior securities bibliography, I have heard that it is quite helpful to have the Commission documents on valuation accessible in this way and that practitioners are finding it to be a very useful tool. In addition, the Chief Counsel’s Office led efforts on a staff no-action letter and Commission order that partially facilitated the redemption by closed end funds of approximately $29 billion or 45% of the $64 billion auction rate preferred securities outstanding at the beginning of 2008.

F. Disclosure Review and Exemptive Applications

The Division’s Office of Disclosure Review and the Exemptive Applications Office also accomplished a lot this year. In January of this year, the Commission adopted amendments to Form N-1A and adopted rule amendments that permit a person to satisfy its mutual fund prospectus delivery obligations by sending or giving key information directly to investors in the form of a “summary prospectus.” Funds began filing Form N-1A’s containing the new summary information after March 31, 2009. Since that date, the Division’s disclosure review staff has reviewed, or will be reviewing, more than 950 registration statements under the Form amendments. Further, 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 2009, as required by the Sarbanes-Oxley Act. This amounted to a review of over 4,500 financial statements, plus related disclosures.

In addition, the exemptive applications group had another productive fiscal year by issuing 67 notices of substantive applications, once again exceeding its goal of 65.

IV. Division of Investment Management — Upcoming Initiatives

Now that I have reviewed the Division’s accomplishments this year, and some of the work we have in progress, I have arrived at the time when I need to acknowledge that this year the Division did not accomplish everything that we had hoped to achieve. In particular there are two initiatives that I must own up to where we were not able to achieve our goals: rule 12b-1 reform and investment adviser recordkeeping modernization. As in previous years, I have a personal level of disappointment that I was unable to achieve my goals with respect to these initiatives this year as both of these initiatives represent regulations that have, in my view, been outdated by modern practices and of which reform is long, long overdue. With regard to 12b-1, the Chairman has announced that the Commission will consider a recommendation from the Division next year. The modernization of investment adviser record-keeping, while vitally important, I think may benefit from awaiting resolution of investment adviser / broker-dealer issues.

In addition, I hope to make progress on a number of other initiatives that we were unable to take to the Commission this year. These include the rule proposed by the Commission in March of last year to codify and expand relief currently provided in ETF exemptive orders and to permit funds to invest in ETFs. Also in March last year, the Commission re-proposed amendments to Form ADV Part 2 that would require advisers to deliver a narrative brochure to clients and prospective clients. I hope to have a recommendation for the Commission to consider in the coming year.

VII. Conclusion

I want to thank you for listening this morning. I appreciate the opportunity to review our work in the Division of Investment Management with you, which now has become somewhat of a tradition for me. I look forward to doing the same next year and am eagerly anticipating what I will be talking about. We are seeing significant legislation going through Congress and it is possible that there may be significant regulatory mandates that Congress may require of us; we may inherit significantly increased regulatory responsibilities. In any case, this is an exciting time and I look forward to speaking with you again next year concerning any new developments. Thank you again and 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.


Modified: 12/09/2009