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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the ALI-ABA Compliance Conference


Andrew J. Donohue1

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

Washington, D.C.
June 3, 2010

I. Introduction

Thank you very much for the kind introduction. I appreciate the opportunity to speak with you this morning. The comprehensive program Tom, Karen and ALI-ABA have planned for you over the next two days examines a large number of the practical issues facing the investment management industry. These issues, including distribution, marketing and trading issues encompass some the fastest moving areas in the investment management industry and reflect the industry's rapid modernization. Being aware of the developments and nuances surrounding these, and the other areas you will be discussing, is critical to ensuring regulatory compliance in the current environment. Rest assured, over the next two days, you will be hearing from many experts on developments in investment management regulation and I am certain you will truly benefit from the discussions.

While delving into the details of the compliance and regulatory issues facing the modern fund industry, you will also be looking at each area within the statutory context in which it is governed. In doing so, you will be discussing the core principles embodied in the Investment Company Act of 1940 — one of the two primary governing statutes of the investment management industry. Your program brochure very appropriately refers to these principles as "timeless" — and they are. As the investment management industry continues to evolve and change at a rapid pace, these important principles continue to underlie the regulations in this area. During this program you will examine how many of the current investment management issues fit into different aspects of this governance framework.

What I would like to do this morning, before you begin looking at the different pieces of the Investment Company Act, is to step back even further and set the stage for these discussions by looking at the Act as a whole — briefly examining how it came to be and why it is unique among the federal securities laws. In this way, my intent is to give you a sense of how the principles embodied in the Act have truly aided investors and the investment management industry by reinforcing its understanding of the need to protect investors and instill investors' confidence in its products. The 87 million Americans currently invested in investment companies, coinciding with the incredible development of this industry since the Act's enactment in 1940, attest to the Act's success.

In addition, speaking of the rapid development of the investment management industry, particularly in recent years, I also would like to mention this morning some of the ways that the Act, while in fact being 70 years old, is being challenged and stretched in ways that were inconceivable when it was enacted, but which we in the Division of Investment Management are dealing with today.

Before I begin, 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. The Investment Company Act

As I had mentioned, the Investment Company Act remains a resilient and extremely successful piece of legislation. In fact, as we celebrate its 70th anniversary this year, it has been significantly amended only once, in 1970, in spite of the enormity of the industry that has developed since its enactment. Indeed, the investment management industry has grown from having approximately $1 billion under management in 1940, to over $12 trillion today. I believe the Act largely facilitated this tremendous growth.

The Investment Company Act, along with the Investment Advisers Act of 1940, were the final Depression-era federal securities laws to be enacted. The Investment Company Act is unique in many ways. The Act followed a 4-year study by the SEC of investment trusts, as funds were called at the time, and thus reflects a thoughtful approach to addressing the corrupt industry practices of the 1920s. These abuses were related primarily to the unique nature and affiliations of investment companies themselves as funds were operated and portfolios selected in the interests of insiders instead of fund investors.

Unlike typical operating companies, investment company employees do not operate investment companies. Instead, funds generally rely on external service providers, such as the fund's investment adviser, to manage the fund's portfolio and provide administrative services. As the officers of funds are usually affiliated with the fund's adviser, or the other outside service providers, the interests of fund management and shareholders of a fund often conflict in important ways. In the 1920s, investment companies were primarily closed-end funds, many of which were sponsored by or affiliated with investment or brokerage houses.

Other aspects of investment companies also led to the problems in the 1920s. The liquidity of fund assets also facilitated embezzlement and with the purchase price of securities based on the preceding day's closing price, investors were encouraged to purchase on rising markets to the detriment of current shareholders. As is also the case today, investment companies then served primarily smaller, less-experienced investors.

While investment companies, as market participants, are subject to the requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as state securities laws, the Investment Company Act serves as an overlay to these laws to address the unique aspects of the fund industry. Although the regulation of investment companies is based on the same principles of full and fair disclosure that are the foundation of the federal securities laws, in contrast to the 1933 and 1934 Acts, the 1940 Act imposes an extensive and comprehensive system of regulation for funds to address the abuses uncovered by the SEC study. In fact, the 1940 Act has been called "the most complex of the entire SEC series" as reflective of the fact that it specifically addresses virtually every aspect of investment companies' operations. Among its key protections are restrictions against certain transactions with affiliates, requirements that funds act in accordance with stated fundamental investment policies, rules to ensure the safe custody of fund assets, and the bonding of fund employees; restrictions on the use of leverage and fund investments in other funds. The Act also ensures open-ended fund investors a right of redemption.

To oversee the management of the conflicts of interest inherent in the mutual fund structure, the Act mandated that investment companies be governed by a board of directors. As with operating companies, investment company directors are fiduciaries subject to state corporate law requirements. However, unique to the 1940 Act is that fund boards must also include independent directors — directors unaffiliated with the fund's adviser or certain other third parties. As fiduciaries to the fund, the independent directors play a critical role in overseeing fund operations and protecting the interests of its investors. For example, among a number of obligations, the Board must approve the advisory contract and its fees, the contract with the fund's principal underwriter, a fund's use of 12b-1 fees as well as oversee the valuation and trading of fund portfolio securities.

Another characteristic of the Act, and one I consider even more important to the success of the investment management industry than the Act's comprehensive regulations, is the Act's flexibility in accommodating industry developments. This flexibility is due in part to a provision contained in the Act — until recently unique to it and the Investment Advisers Act — that allows the Commission to exempt certain transactions, structures and products that would otherwise be prohibited under the Act, if and to the extent that it is necessary or appropriate in the public interest and consistent with the protection of investors and the Act itself. The Commission has used this authority to accommodate investment company innovation in certain appropriate circumstances, through individual orders and, in some circumstances, later through rules of general applicability. Money market funds, exchange-traded funds and variable annuity products — some of the most innovative financial products of the past 30 years — were made available to the investing public in this manner.

III. New Forms of Investment Companies

Although the Investment Company Act has been remarkably effective and resilient, it is useful to keep in mind that the Act reflects merely a snapshot in time. Of course now the industry landscape looks quite different then it did 70 years ago. Rather than most investment companies being closed-ended, open-end investment companies, or mutual funds, are predominant. Now we also see a diversity of investments among investment companies, rather than simply investments in stocks, bonds and similar securities. Although the variety of investment companies we see today did not exist in 1940, in defining what was an investment company for purposes of the Act, the Act's authors cast a wide net and then used exceptions and exemptions to remove certain types of entities that may look like investment companies but were either adequately regulated by other statutes or did not warrant inclusion for other reasons. The Act remained relatively static, but the financial entities and products available to the public did not. New products evolved, some of which would have posed interesting questions for the Act's framers had they been around in 1940. But no matter, the sponsors of the products still needed to figure out where they fit within the statutory terms chosen decades before.

A good example is asset-backed securities, which didn't exist in 1940. They looked like investment companies — being pooled investment vehicles that issued shares to investors representing a pro rata share of a portfolio of securities — but had certain attributes that were unlike traditional investment companies. Some of the vehicles were able to shoe horn themselves into a statutory exemption, based not on how they operated but by virtue of limiting themselves to investing in interests such as mortgages. Vehicles that were backed by, say, auto loans, which were indistinguishable in terms of their structure, were not so lucky and had to apply to the Commission for individual exemptive relief. The Commission eventually adopted an exemptive rule in this area which clarified the status of most of these vehicles as not being investment companies.

We also see pooled investment vehicles that have traditionally fallen outside the Act based on their primary investments in non-traditional areas. However, in certain areas it might be appropriate to consider more carefully whether investors in these vehicles should receive the Act's protections. For example, mortgage real estate investment trusts, or REITS, rely on an exception from the Act based on their investment primarily in mortgage-related instruments.

Collective investment trusts is another area that has traditionally fallen outside the Act. These pooled trust accounts are operated by a trust company or bank, although each fund in the collective trust may be managed by an outside adviser that will also be responsible for marketing and distribution. Although these trusts have been around for decades, albeit previously with more limited availability, they are now being used to a much greater extent, particularly for retirement funds. Collective investment trusts may rely on an exclusion from registration under the Investment Company Act based on the premise that banks exercise full investment authority over the pooled assets, among other things. As collective investment trusts become more popular and their structures more varied, the Division of Investment Management is looking at whether, under certain conditions, this exemption is properly relied upon and consistent with the Act and the interests of investors. Similarly, separately managed account portfolios are marketed on a retail basis, but may also raise issues under the Investment Company Act.

A. Derivatives

Another area that has developed, which was not contemplated by Congress in 1940, but which the Commission staff is examining today, is funds' increasing investments in derivatives and other sophisticated financial instruments. 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 more conventional securities. Investment companies that seek to mimic hedge fund strategies, typically involving derivative products, have become more 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.

The 1940 Act truly contemplated a different world. These developments present challenges in giving effect both to the literal terms of the Investment Company Act as well as two of its underlying purposes 1) to address the speculative character of shareholders' interests arising from excessive borrowing or the issuance of excessive amounts of senior securities and 2) to assure full disclosure to investors of investment strategies and risks. The Act also approaches many areas such as concentration and diversification, to name but two, based on the amount of money invested, rather than the degree of economic exposure the fund has undertaken to a particular security, company or sector. That, of course, is not always the case now. With so many derivative instruments available to enhance an investment strategy, a fund's manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds. It is to assess and respond to this challenge that the Division has undertaken to review derivatives activities of investment companies and the implications of those activities for the regulatory framework.

B. Private Funds

We also are seeing new participants in the investment management area that did not exist in 1940 playing increasingly major roles in the markets. Most notably in this category are hedge funds, and private equity and venture capital funds. These funds traditionally have been organized in ways that avoid regulation as investment companies under the Investment Company Act, as well as avoid registration requirements of the Securities Act and the Securities Exchange Act. In addition, many hedge fund, private equity and venture capital fund managers, although they are investment advisers, avoid registration under the Investment Advisers Act of 1940 by taking advantage of an exemption from registration for small investment advisers — those with fewer than 15 clients. Private fund advisers qualify for this exemption by pooling client assets and creating limited partnerships, business trusts or corporations. Because advisers are permitted under a Commission rule to count each partnership, trust or corporation as a single client, they avoid registration while, in many cases, managing substantial amounts of assets on behalf of large numbers of investors.

With the growth of private fund assets, the question of whether the investment adviser registration requirement should be extended to hedge fund advisers has been considered by the Commission and staff for a number of years. Now, more than ever, I feel it is important to address regulation in this area, especially as the market influence of private funds has grown tremendously. Based on data collected from company filings on Form D — the Form routinely filed by firms relying on an exemption under Regulation D of the Securities Act — during the last 12 months there were over 2,100 hedge funds, 730 private equity funds and 165 venture capital funds raising money from investors. Even with these significant numbers, when compared to other sources, the number of hedge funds appears lower than I might have expected. This may be due to funds that do not file Form D when conducting their offerings and funds that are not currently raising capital from investors. In addition, about 1040 funds checked the box on Form D for "other investment funds" and some of these may be funds that observers would consider to be hedge funds. However, with the undeniable significance of private funds in the markets, I believe that in many ways, the registration of private fund advisers remains a regulatory gap that I believe should be filled. This issue also is now being considered as part of the comprehensive reform package in Congress.

In addition, ensuring that only appropriate, sophisticated persons invest in private funds is an important component to their unregistered status under the Investment Company Act and the other federal securities laws. Beyond the formal investor qualification tests embedded in the funds' exemptions, broker-dealer regulation of intermediaries provides important protections for investors. Under the Securities Exchange Act, any person engaged in the business of effecting transactions in securities for the account of others must generally register as a broker-dealer. As with advisers, registration of broker-dealers provides important investor protections. Among other things, registered broker-dealers are subject to SRO suitability requirements and other sales practice regulation. Although there are exceptions to the registration requirement, they are narrowly drawn and, as a practical matter, the lawful receipt of compensation in connection with the purchase and sale of securities typically requires registration as, or association with, a registered broker-dealer.

I am concerned that some participants in the private fund industry may be inappropriately claiming to rely on exemptions or interpretive guidance to avoid broker-dealer registration. In so doing, these participants may be creating a de facto gap in broker-dealer regulation in addition to the legislative gap in Commission authority with respect to adviser regulation. I urge that persons who are not currently registered as, or associated with, a broker-dealer should carefully consider whether they should be.

IV. Conclusion

I want to thank you for listening this morning. Even in this period of tremendous change in our financial markets, and particularly in the area of investment management, I think it is always important to step back and remember the basic principles that have led to success in this industry. This success is generally reliant on investors' confidence in entrusting their hard-earned savings to others to manage, a concept that Congress understood and got right when it enacted the Investment Company Act. I enjoyed discussing the Act with you this morning and some of the developments surrounding it that we are working on in the Division of Investment Management. Thank you again and I hope you enjoy the rest of the program.



Modified: 06/07/2010