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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Opening Statement at the SEC Open Meeting


Chairman William H. Donaldson

U.S. Securities & Exchange Commission

Washington, D.C.

January 14, 2004

Item 1 - Investment Adviser Ethics Rule

This is an open meeting of the Securities and Exchange Commission. This is the third in a series of meetings that will be devoted to critical initiatives aimed at protecting mutual fund investors. At the first of these meetings, held on December 3, we approved a package of rules and rule proposals to combat late trading, market timing, and selective disclosure abuses, as well as requirements that all funds and advisers have comprehensive compliance policies and procedures and chief compliance officers.

At the second meeting, held on December 17, we approved rule proposals and a concept release that were directed toward providing mutual fund investors with more information about mutual fund sales load breakpoints and fund transaction costs.

Today, we are considering -

  • a proposal under the Investment Advisers Act that would require investment advisers to adopt codes of ethics that address, among other things, personal trading by employees who have access to nonpublic information;
  • a package of proposals to enhance fund governance, and
  • a proposal for point-of-sale disclosure and a new confirmation statement, that brokers will use when selling fund shares, that would spell out expressly the sales loads and other charges that investors incur when they purchase mutual funds, as well as the compensation of the selling brokers.

At an open meeting on February 11, we will consider a final rule to require funds to disclose semi-annually the dollar amount of fees and expenses that their shareholders pay, proposed amendments to rule 12b-1 that would prohibit funds from using brokerage commissions to pay broker-dealers for selling fund shares, and a proposal to include disclosure in fund annual reports to shareholders about the reasons supporting their directors' decision to approve the fund's investment advisory contract.

On February 25, we will consider additional proposals to combat market timing abuses, including a proposal that would require mutual funds to impose a mandatory redemption fee on market timers, and any pertinent recommendations from the NASD's Omnibus Account Task Force.

Finally, on March 10, we will consider proposals that would improve disclosure to fund shareholders about their portfolio manager's relationship with the fund.

As I have said before, every mutual fund investor should expect, and is entitled to, honest and industrious fiduciaries who sensibly put their money to work for them in our capital markets. Investors also deserve a brokerage and mutual fund industry built on fundamentally fair and ethical legal principles. The protections embodied in this comprehensive package of reforms are designed to address these concerns and restore investor confidence in these investment vehicles.

Like the proposals that are already out for comment, those that are before the Commission today are not without controversy. In the coming weeks, feedback from commenters will be critical to our evaluation of the proposals and any needed refinements. I look forward to hearing commenters views, and strongly encourage fund shareholders, as well as industry participants, to involve themselves in our rulemaking process.

Now - turning to the items on today's agenda - the first is a recommendation from the Division of Investment Management to require registered investment advisers to adopt codes of ethics that set forth standards of conduct expected of advisory personnel, safeguard material nonpublic information about client transactions, and address conflicts that arise from employees' personal trading. Among other things, the rule would require advisory personnel to report their personal securities transactions, including transactions in any mutual fund managed by the adviser.

It is extremely troubling that so many of the recent scandals in the mutual fund industry have involved a breach of the fiduciary relationship between investment advisers and their advised funds. As fiduciaries, advisers owe their clients more than mere honesty and good faith. What we are seeing leads me to believe that all too many advisers have been delivering much less. Today's proposals will reinforce for investment advisers and their employees the importance of fiduciary principles as the cornerstone of their relationships with advisory clients.

I congratulate the Division of Investment Management on this recommendation. In particular, I would like to thank Bob Plaze, Jennifer Sawin, Jamey Basham, and Robert Tuleya in the Division, as well as Paul Roye for his outstanding leadership on these issues.

Now, Paul, could you please give us the details of your recommendation.

Item 2 - Fund Governance

The next item on our agenda is a package of rule proposals from the Division of Investment Management that is designed to enhance fund governance and empower mutual fund independent directors to better serve as an effective check on fund management

Mutual fund directors must play a critical role in solving the ills that have befallen the fund industry. By law, directors generally are responsible for the oversight of all of the operations of a mutual fund. In addition, under the Investment Company Act, directors are assigned key responsibilities, such as negotiating and evaluating the reasonableness of advisory and other fees, selecting the fund's independent accountants, valuing certain securities held by the fund, and managing certain operational conflicts. Independent directors, in particular, serve as "independent watchdogs" guarding investors' interests - and helping to protect fund assets from uses that will be of primary benefit to management companies. These directors are investors' first line of defense in ensuring that their interests are being served, that conflicts of interest are appropriately managed and disclosed, and that their money is being managed responsibly. While the SEC shares the investor protection mission, we cannot be in the boardroom when investors' interest may be compromised. Investors must be able to depend on their directors to stand up for them.

Corporate governance in the mutual fund industry presents unique problems that are not present in the context of an operating company. The inherent conflict between the interests of the fund's shareholders, and those of the shareholders of the fund's manager demands that we pay particular attention to the independence of the fund's board of directors - in both composition, and leadership.

The components of today's package of proposals include:

  • Requiring an independent chairman of fund boards of directors;
  • Increasing the percentage of independent directors under SEC rules from a majority to three-fourths;
  • Providing independent directors with authority to retain staff as they deem necessary, so they are not obligated to rely on the fund's adviser for assistance; and
  • Requiring boards of directors to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure.

I understand that there are concerns about whether these changes will ameliorate the problems that have beset the fund industry. I anticipate that commenters will express a variety of views, and I will pay serious attention to the comments we receive. Nonetheless, I do believe that these proposals are taking us in the right direction, and if adopted, will strengthen the hand of independent directors when dealing with fund management and result in better service to fund shareholders.

In a moment, I will turn once again to Paul Roye for a discussion of the details of the proposal before the Commission. Before I do, I would like to acknowledge the members of the Division staff who have been instrumental in the development of this recommendation: Bob Plaze ,Hunter Jones, and Catherine Marshall.

Now, Paul, I turn the floor over to you.

Item 3 - Fund Confirmations

The final item on our agenda is a series of proposals from the Division of Market Regulation that are designed to provide useful information to investors about the costs and conflicts of interest that arise when broker-dealers sell mutual fund shares, unit investment trust interests - including variable annuities, and municipal fund securities for education savings - commonly known as 529 plans. As I outlined in my testimony regarding "Mutual Fund Investors' Rights," investors have the right to clear disclosure of fees, expenses, conflicts, and other important information. In this regard, investors not only deserve to know the fees and expenses their funds pay, they also deserve to know how much their broker stands to benefit from their purchase of a particular fund.

But the Commission's confirmation requirements have not kept pace with the various ways that broker-dealers are paid for distributing mutual funds. When the current confirmation rule (rule 10b-10) was adopted in 1977, broker-dealers were paid for selling fund shares principally by a dealer concession based on the front-end load.

Since then, the ways in which broker-dealers are paid for distributing mutual funds have dramatically expanded. Recently, the Commission's examiners conducted a series of examinations of broker-dealers, mutual funds and investment advisers to identify how the funds and their advisers are paying for distribution. These examinations revealed that broker-dealers receive several different kinds of payments for distribution - both from funds and from their advisers -- and that disclosure of these practices varies. The facts uncovered by the Division of Enforcement in connection with recent cases have underscored the importance of acting quickly to find a way to get investors the information they need and want - and to make sure that information is easily accessible, understandable, and clear.

For example, when a broker-dealer sells shares with a front-end load (Class A shares), it is compensated by the dealer concession based on the front-end load but also possibly by rule 12b-1 fees and revenue sharing. In addition, when a broker-dealer sells certain classes of shares without a front-end load (Class B or C shares), it is compensated by rule 12b-1 fees but also possibly by revenue sharing. Yet under the current confirmation requirements, investors are not provided transaction-specific information regarding these fees. This same disclosure problem also exists for unit investment trust interests, including variable annuities, and 529 plans.

These proposals seek to address this disclosure problem by:

  • requiring a new confirmation statement for transactions in mutual fund shares, unit investment trust interests, and 529 plan securities that would require the quantification of loads, rule 12b-1 fees, revenue sharing, and portfolio brokerage commissions received from the fund complex;
  • requiring new point-of-sale disclosure for transactions in these securities, usually provided to an investor before the acceptance of an order, that would also require disclosure regarding these fees.

Mutual fund investors must have the tools and the information to make intelligent investment decisions. Enhanced disclosure is the best approach to this problem. To that end, I believe that these proposals will enhance disclosure to fund investors not only of fees and expenses, but also the conflicts that arise as a result of the various arrangements between funds and brokers regarding the sale of fund shares.

I expect the notice and comment process to be particularly useful in developing recommendations for final rules, and the Division of Market Regulation plans to work with the Office of Investor Education and Assistance to reach out to investor groups to develop information about how best to require useful and cost-effective disclosure.

We are also considering today conforming amendments to the Commission's current confirmation rule (Rule 10b-10) and conforming amendments to the registration form for mutual funds (Form N-1A). In addition, we are considering enhanced disclosure regarding call rights for preferred stock and call dates for debt securities.

I will shortly turn to Annette Nazareth for a discussion of the details of the proposals before the Commission. But before I do, I would like to acknowledge the members of the Division staff who have been instrumental in the development of this recommendation: Catherine McGuire, Paula Jenson, Joshua Kans, and David Blass. I would also like to thank staff members of the Division of Investment Management for their assistance in putting these proposals together.

Now, Annette, I turn the floor over to you.



Modified: 01/14/2004