Speech by SEC Staff:
Massachusetts Society of CPAs
Investment Company InfoShare Program
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
May 11, 2010
Thank you very much for the kind introduction and for inviting me to join you today. I appreciate the opportunity to speak with you about some of our initiatives in the SEC's Division of Investment Management, particularly some of the matters we are working on that may have accounting implications. Although I am a lawyer by training, and while lawyers and accountants have a common goal of assuring delivery of accurate information about investment companies for their investors, we do sometimes speak a different language. For this reason, it may give you comfort to know that in addition to speaking with you today, my speech will be posted to the Commission's website where you will be able to see plenty of tickmarks and footnotes accompanying the text. Hopefully, you will feel right at home.
In all seriousness, I have a great respect for the work you do and the importance of your judgment and clarity in fulfilling fund disclosure requirements — one of the most important aspects of investment company regulation and critical to the functioning of our markets. With your help, we are able to ensure investors have the necessary information available to them to make informed decisions concerning the investment of their hard-earned savings.
This idea — that investors need appropriate and correct information to make informed decisions and that they need information in a form that is accessible and easy to use, as well as investor protections to instill their confidence and access to the markets through pooled assets — has been the driving force behind the Division's most recent initiatives in this area. I now would like to tell you about some of the matters we have been working on.
Before I do, I need to make the standard SEC disclaimer 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. Division of Investment Management Initiatives and Challenges
Responses to Market Events
Our initiatives in the Division of Investment Management are prompted by various circumstances, such as the need to address market changes and update the regulations. Others are prompted by market events and the activities by market participants. In the aftermath of the recent market turmoil, a few of the Division's major initiatives fall into this category.
Money Market Funds
In particular, since the beginning of the turmoil in 2007, a priority for the Division has been the regulation of money market funds. This has been a challenging period for the $3 trillion money market fund industry, encompassing the first "breaking of the buck" by a widely held money market fund and the unprecedented enactment of various liquidity facilities and other government programs to assist the funds. Perhaps the most significant challenge in the current market environment is that persistent, low interest rates have caused many money market fund advisers to waive a large portion of their fees to avoid yields from going negative for investors. I understand that this has caused some sponsors to exit the business entirely as they see their profits evaporate. However, money market funds continue to play a crucial role for our economy by acting as buyers of short-term paper from businesses and government entities. They also remain an extremely popular product with all types of investors, both retail and institutional.
With respect to the money market fund regulatory model, the challenge is to strike the right balance between improving the safety of money market funds and preserving the ability of money market funds to generate yield for their investors. In this regard, the actions that the Commission has taken are aimed at improving the ability of money market funds to withstand the financial stresses that they will inevitably experience.
These actions include the Commission's adoption in January of new rules governing money market funds.2 The rules require, among other things, that money market funds comply with new maturity standards that make them less vulnerable to market risks; and that they meet new daily and weekly liquidity standards so that they have a greater portion of their assets in liquid investments and be in a better position to pay redeeming investors under any market conditions. Also under the new rules, money fund managers have to stress test their portfolios under different scenarios, such as a sudden increase in interest rates or the default of issuers of securities held by the fund. Furthermore, money funds must disclose portfolio information to the public each month on their web sites. This disclosure will equip investors with information they can use to evaluate the risks of investing in particular funds. Finally, money funds must file more detailed portfolio reports each month with the Commission to help us oversee the funds. The information also will be available to the public on a 60-day delay and will help investors to see more detail about the risks that a fund may be taking with their money. In my view, the availability of the information also may cause fund managers to think more carefully about the decisions they make about the fund's investments.
The new rules represented strong action by the Commission to make money market funds a more transparent and safe investment. However, I believe these were only a first step in a continuing effort to improve the regulation of money market funds. More is yet to come. The financial crisis exposed certain systemic risks connected to money market funds - namely the susceptibility of the funds to runs in times of extreme market stress. The Commission has asked more fundamental questions about money market funds and their ability to maintain a stable net asset value of one dollar per share, and I expect to see a continuing policy discussion of these questions.
Advisers Act Custody Rule
Another initiative that followed market events was the Commission's adoption of changes to the rule governing an investment adviser's custody of client assets, which you heard a discussion about earlier.3 In adopting that rule, the Commission took important steps to provide greater protections to investors who entrust their assets to investment advisers. The rule followed a series of enforcement cases the Commission brought against advisers and broker-dealers alleging fraudulent conduct, including misappropriation and other misuse of investor assets. I wanted to briefly add to the discussion of this rule, that I encourage registered investment advisers to incorporate changes to your compliance programs to ensure that client assets are properly safeguarded. I also wanted to acknowledge to advisers and their auditors that identifying misappropriation of assets can be a difficult task. However, as recent enforcement cases highlight, misappropriation of assets unfortunately does occur and therefore, advisers and auditors must be vigilant in their search for such activity.
One area that exemplifies the need to address a rapidly changing market is in regard to investment companies' use of derivatives. I have, for some time, made no secret of my concerns regarding funds' use of derivatives and my belief that these instruments, while affording the opportunity for efficient portfolio management and risk mitigation, also can present potentially significant additional risk as well as raise issues of investor protection. In the past two decades, the investment company marketplace has been significantly reshaped by the use of derivative instruments. During this period, investment companies have moved from relatively modest participation in derivatives transactions limited to hedging or other risk management purposes to a broad range of strategies that rely upon derivatives as a substitute for conventional securities. Mutual funds that mimic hedge fund strategies, typically involving derivative products, have become commonplace. New categories of investment companies have emerged: absolute return funds, commodity return funds, alternative investment funds, long-short funds and leveraged and inverse index funds, among others. It is also not uncommon for investment companies with traditional investment objectives to obtain synthetic market exposure through derivative products, such as credit default swaps, rather than invest directly in stocks, bonds and similar securities.
Funds' use of derivatives presents concerns and risks on many levels — such as market, liquidity, leverage, counterparty, legal and structure risks. One of the challenges posed by derivatives is how to appropriately inform fund shareholders of these and other relevant risks as part of the SEC's disclosure and financial reporting regime. Losses to the fund and its shareholders can result from a complicated mix of events, making it more difficult to predict or model expected outcomes. Further, it can be difficult to describe these risks in language that is easily understood by shareholders.
The use of derivatives poses challenges for financial reporting as well. Recent changes implemented by the FASB have increased the transparency related to the use of derivatives within the financial statements.4 Those changes require, among other things, disclosure of how and why funds used derivatives during the financial reporting period within the notes to the financial statements. Unlike prospectus disclosure, which generally describes the types of derivatives into which a fund can enter, the financial statement disclosure relates to the derivatives into which the fund actually entered. I encourage funds to approach this disclosure thoughtfully with a mind towards informing shareholders as to how derivatives were actually used during the period to meet the objectives of the fund.
In addition to these matters, the Division is also working to improve the quality of mutual fund disclosure. In this regard, I want to briefly mention some developments related to the use of XBRL, or eXtensible Business Reporting Language, for funds. On February 11th last year, the Commission adopted rules requiring funds to file their risk/return summary information in XBRL format and also to permit mutual funds to voluntarily submit portfolio holdings information in XBRL format without submitting the remainder of their financial statements in XBRL format.5 We recently issued a press release giving notice that the staff will conduct a public education seminar on June 4th regarding fund use of XBRL.6 The seminar will contain information that will help mutual funds and their financial statement preparers to comply with the requirements of the Commission's Risk/Return XBRL Rule and how to effectively utilize the new 2010 Risk/Return XBRL taxonomy. This is a great opportunity for preparers to better understand XBRL and how it will affect filings required under the Risk/Return Summary XBRL Rule and its implementation date of January 1, 2011.
I now would like to turn to some issues that we are looking at in the Division that pose certain challenges, particularly with respect to the transparency of fund investments and their financial disclosures.
First, certain transparency issues arise with respect to fund investments in non-registered investment vehicles. For example, some funds have made significant investments in vehicles that are not offered to the public as a way to obtain exposure to alternative asset classes such as commodities, private equities, and, in some cases, investment vehicles that specialize in purchasing troubled-bank assets. Private investment vehicles, such as private equity funds, often do not provide shareholders with the level of transparency that would be typically expected for a mutual fund. However, if a fund chooses to invest a significant portion of its portfolio in private investment vehicles, the fund should determine if any additional material information may be necessary so that its prospectus and shareholder reports are not misleading.
In a related matter, I have asked the Division staff to compare the current accounting and reporting requirements contained within Commission rules to those generally required under US GAAP. As some of you may be aware, the last time the Commission made any significant changes to its financial reporting rules for investment companies was in 1982. Since that time, investment companies have evolved and are engaging in more complex investments and investment strategies that provide more risk to investors. If the staff perceives a need, we may recommend amendments, enhancements, or other clarifications of the Commission's financial reporting rules to address any differences with US GAAP.
IFRS and Investment Companies
Finally, I would like to discuss a particularly challenging issue that I am sure you are all familiar with, and one that is continuously ongoing — and that is the harmonization of accounting standards within the international financial community. Towards this end, the Commission recently issued a statement reaffirming its belief that moving to a single set of high-quality globally accepted accounting standards will benefit US Investors and supported the continued convergence effort currently under way between the FASB and the International Accounting Standards Board, the IASB.7 The Commission confirmed that this goal is consistent with its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation.
The Commission has long promoted the use of a single set of high-quality globally accepted accounting standards.8 In 2008, the Commission issued a proposed roadmap towards harmonization where it recognized that the International Financial Reporting Standards, IFRS, issued by the IASB is best positioned to serve as the accounting standard in the US capital markets.9 Commenters generally supported the goal of having a single set of high-quality globally accepted accounting standards, but differed in their views about the approach in the Commission's proposed roadmap. Some of benefits of incorporating IFRS into the financial reporting system that have been mentioned include 1) improved financial comparability among companies worldwide; 2) streamlined accounting processes for multinational companies; and 3) easier access to foreign capital and improved liquidity, leading to a reduced cost of capital.
However, while operating companies would likely take advantage of these benefits, investment companies would not. Critics of adopting IFRS for US investment companies have argued that IFRS does not provide accounting standards or guidance specific to the investment company industry and therefore would not reflect the nature of a fund's investment activity. Critics have also said that provisions of the Investment Company Act limit foreign investment companies from registering and selling their shares in the U.S., and that U.S. tax laws make U.S. funds less attractive to foreign investors because of the requirements under which funds distribute virtually all of their income and gains in order to avoid taxes at the fund level. In contrast, many foreign jurisdictions do not require their funds to distribute their income and gains and impose little, if any, capital gains taxes. Their shareholders would recognize taxes when they redeem their fund shares.
In spite of the fact that the perceived benefits of IFRS may not apply to investment companies, I challenge the industry to take a closer look at whether it really makes sense for US funds to take a different direction when it comes to incorporating the use of IFRS. First, the convergence efforts between the FASB and IASB have been underway since 2002 and there have been new FASB pronouncements affecting investment companies that are consistent with IFRS. So, in these respects, investment companies will be following IFRS. Second, there are instances in which many in the investment management industry would say that FASB's efforts with the IASB had a positive impact on the standard setting process. For example, FASB's amendments to consolidation would have resulted in many investment advisers having to consolidate the funds they manage, including money market funds. However, the FASB deferred these amendments, because IFRS could have potentially resulted in a different conclusion and because concerns were also expressed with the FASB's consolidation model for investment managers and the investment funds they manage. The FASB and the IASB agreed to address the issue in their joint consolidation project. So as you think about the use of IFRS for investment companies, I urge you to do so with an open mind.
In this regard, at the SEC, the Commission has directed the staff to develop and execute a work plan to assist it with its evaluation of IFRS for US issuers.10 The work plan is publicly available and it contains a dedicated section for investment companies. In the Division of Investment Management, we will be evaluating whether investment companies should be included in the scope of any potential Commission decision in this area. Our evaluation will include making a determination as to whether IFRS contains sufficient standards for investment companies, and to the extent that changes need to be made, what the timing of those changes would be. We also will evaluate the effect on investors if investment companies were excluded from the scope. As the staff continues with our analysis, I encourage you to share any feedback you may have on this issue. In particular, I would like to offer some specific questions for your consideration:
- Are the reporting differences between US GAAP and IFRS so materially different that transitioning to IFRS could lead to investor confusion?
- Would financial statements prepared in accordance with IFRS result in a financial reporting NAV that is different than the NAV used to process shareholder transactions?
- How does IFRS work with other provisions of the Investment Company Act that rely on the accounting results?
- Are there contractual provisions that would be implicated and what are the implications?
In relaying any feedback to the Commission, please note that the Division of Investment Management has its own Office of the Chief Accountant — currently led by Rick Sennett — that deals with accounting and auditing issues associated with investment companies.
This office can be a great resource for resolving existing accounting, financial reporting and auditing matters in this area. I encourage you to take advantage of the consultation process. I also think it is particularly important for investment companies to participate in the accounting standard setting process. I think there is a tendency for investment companies to overlook the fact that accounting standards apply as much to them as they do to any other company and that their participation in the process is very important. Commenting on proposed accounting standards issued by the FASB will ensure that accounting standards are set in a way that appropriately considers the impact on mutual funds. Your voices should be heard as the Commission and others consider issues such as accounting convergence, the role of IFRS in our reporting regime, and other future accounting and financial reporting matters.
We value your input and encourage consultation, so please feel free to contact Rick or others on his team if you have a matter that you would like to discuss. Their contact information can be found on the Commission's website, or if you have questions today, Bryan Morris from my Division, who is participating on both panels, would be happy to answer them.
I appreciate you listening this morning. Thank you and enjoy the rest of the program.