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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Understanding Securities Products of Insurance Companies – 2004 Conference


Paul F. Roye

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

Practicing Law Institute
New York, New York
January 27, 2004

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any 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.

I. Introduction

Good afternoon. I am pleased to be here today to discuss with you some of the significant recent regulatory developments in the investment management industry and some of the initiatives that the Commission is undertaking to combat the abuses that have garnered so much attention recently.

Let me begin with the usual disclaimer: 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.

As a result of the various abuses that have come to light in recent months, the Commission has embarked on a dramatic overhaul of the regulatory environment in which mutual funds, including funds underlying variable insurance products, operate. The Commission's actions, taken together with recent enforcement proceedings and actions by state securities regulators, are intended to prevent and deter the types of market timing, late trading and sales practice abuses that have come to dominate the public discussion of the fund industry in recent months. Perhaps more importantly, the Commission's rulemaking initiatives are aimed at restoring the trust and confidence of investors that are crucial to the continued success of this industry.

Approximately 95 million investors have entrusted over $7 trillion dollars to mutual funds. As mutual fund assets increasingly fund the most important personal goals in investors' lives, from retirement and education savings to charitable giving, these investors rightfully look to fund managers and fund boards to act in their interests. Unfortunately, as some managers have forgotten or willfully disregarded their responsibility to act for the benefit of their investors, the integrity of the entire fund industry has come into question.

Consequently, I would like to discuss our regulatory initiatives that are designed to enhance the culture of integrity and compliance that must be components of the business of investment management.

II. Structural Changes and Improving the Compliance Framework

Let me start with some of the initiatives to improve the compliance framework for funds, including the funds underlying insurance products. While we recognize that there is no single rule change that can preclude all fraud, in my view improved compliance practices, at funds, advisers and broker-dealers, may have the greatest impact on preventing fraud, detecting it if it occurs, and promptly rectifying the consequences of any malfeasance. With this in mind, I would like to briefly discuss two new compliance requirements the Commission adopted last month: the chief compliance officer requirement and a requirement that funds and advisers adopt compliance policies and procedures; and two other recent proposals: a rule that would mandate that all registered advisers adopt a code of ethics and a rule that would impose structural changes regarding the receipt of fund orders to curb late trading abuses.

A. Compliance Officer

Under the first of the rules adopted by the Commission in December, all funds must designate a chief compliance officer who reports directly to the fund's board. The compliance officer, who must be approved by the board and who can only be removed with the board's consent, has dual roles: first, as the primary architect and enforcer of compliance policies and procedures for the fund; and second, and more importantly, as the eyes and ears of the board on all compliance matters.

While the role of developing and enforcing an aggressive compliance program is certainly important, let me focus my comments on the role of serving as the eyes and ears of the fund board.

The chief compliance officer, at the behest of the board, is expected to extend the board's hand of compliance oversight into even the mundane operations of funds and advisers, where compliance lapses and abuses often germinate and remain hidden from even the most watchful board. In order to support the "watchdog" role of the compliance officer, the rules require the chief compliance officer to meet in executive session with the independent directors at least once each year, outside the presence of fund management and the interested directors. This executive session will create an opportunity for open dialogue between the chief compliance officer and the independent directors and to encourage the compliance officer to speak freely about any sensitive compliance issues, such as any reservations about the cooperativeness or compliance practices of fund management. To further insulate a chief compliance officer from the pressures, real or perceived, brought to bear by fund management, a fund's board, including a majority of the independent directors, must approve the chief compliance officer's compensation, as well as any changes in compensation.

B. Policies and Procedures

To further encourage a culture of compliance among fund officers and personnel of fund advisers, the compliance rule calls for funds and advisers to adopt policies and procedures designed to lessen the likelihood of securities law violations. The adequacy of these policies and procedures must be reviewed at least annually in order to ensure that fund directors assess whether internal controls and procedures are working well and whether certain areas can be improved.

I believe that an active and independent board, supplied with reliable information as to the effectiveness of compliance programs and procedures, will serve as an important check against abuse and fraud on the part of fund management. In addition, an informed board along with an empowered chief compliance officer will, in my view, go a long way toward restoring investor confidence in the integrity of the fund industry.

I would also point out that these requirements apply to investment companies structured as unit investment trusts, including insurance company separate accounts. In this case, as the release makes clear, the compliance officer would interface not with a fund board or adviser, but generally with the sponsoring insurance company. He or she will have to oversee the insurance company's compliance program with respect to the separate account, including the processing of new account applications, premium payments, and exchanges.

C. Adviser Code of Ethics

In a further move to enhance the compliance framework within the industry, the Commission two weeks ago proposed a new rule under the Advisers Act that would require all advisers registered with the Commission to adopt codes of ethics. Investment advisers are fiduciaries, and owe their clients a series of duties enforceable under the Advisers Act antifraud provisions. This bedrock principle, which historically has been a core value of the money management business, appears to have been lost on a number of advisers and advisory personnel.

We believe that prevention of unethical conduct by advisory personnel is part of the answer to avoiding the problems we have encountered recently. Consequently, the code of ethics would set forth standards of conduct for advisory personnel that reflect the adviser's fiduciary duties, as well as codify requirements to ensure that an adviser's supervised persons comply with the federal securities laws, and require that supervised persons receive and acknowledge receipt of a copy of the code of ethics. In addition, the code of ethics must include provisions that address the safeguarding of material nonpublic information about client transactions, reporting promptly any violations of the code of ethics, and mandating pre-clearance of personal investments in initial public offerings and private offerings.

Finally, the ethics code is designed to address conflicts that arise from the personal trading of employees of advisers. A principal feature of the code of ethics rule is a requirement that certain advisory personnel, referred to as access persons, must report their personal securities holdings and transactions, including transactions in any mutual fund managed by the adviser or an affiliate. The rule would close a loophole under which investment company personnel have not been required to report trading in shares of funds they manage. This loophole became apparent when unfortunately fund personnel were discovered market timing their own funds.

D. Structural Change to Address Late Trading Abuses

In response to late trading abuses in the investment management industry, the Commission proposed a rule requiring that fund orders be received by a 4:00 p.m. cutoff in order to receive that day's price. Specifically, this proposal requires that an order to purchase or redeem mutual fund shares be received by the mutual fund - or its primary transfer agent or a registered securities clearing agency - by the time that the fund establishes for calculating its net asset value. For most mutual funds, this time is typically 4:00 p.m. If not received by this cutoff, an order will receive the next day's price. We recognize that this proposal is tough medicine. However, the proposed rule should limit the potential for late trading through intermediaries that sell fund shares. It is important to note that this rule essentially leaves unchanged the current operations of variable product separate accounts with regard to transactions in underlying fund shares. As long as an insurance company receives an order by 4:00 p.m. the order will receive that day's price, even when the orders are not submitted to the underlying funds until later.

III. Fund Governance

Closely allied with these efforts to enhance the compliance framework are the Commission's efforts to improve fund governance. Two weeks ago the Commission proposed rules to provide additional tools to assist independent directors and strengthen fund governance. These proposals include new requirements for funds relying on various exemptive rules to:

  • increase the minimum percentage of independent directors from a majority to 75%,
  • require an independent chairman of a fund's board of directors,
  • require that independent directors have the authority to retain staff as they deem necessary,
  • require fund boards to perform an annual self-evaluation of their effectiveness, and
  • require that the independent directors meet together in separate sessions each quarter.

This significant overhaul of the composition and workings of fund boards is intended to establish, without ambiguity, the dominant role of independent directors on a fund's board. With an independent board chairman and with independent directors representing at least 75% of a fund's board, independent directors will set the board agenda as well as have the power to control the outcome of board votes. The very nature of external management that characterizes the U.S. fund industry creates conflicts of interests, particularly when personnel of fund advisers are faced with choices that may benefit the adviser over fund shareholders. While not a guarantee that all conflicts of interest will be resolved in the best interests of shareholders, a board composed of an independent chairman and a super-majority of independent directors is more likely to be an effective check on management, particularly when so much of the board's responsibility involves policing the management company's conflicts of interest. As Chairman Donaldson recently commented, "a fund board can be more effective when negotiating with the fund adviser over matters such as the management fee, if it were not at the same time led by an executive of the adviser with whom the board is negotiating."

By empowering independent fund directors to retain staff, in conjunction with the role envisioned for the chief compliance officer, the Commission's proposals emphasize the importance of boards relying on experts other than advisory personnel to provide information in appropriate circumstances. In addition, reinforcing the ability of the board to hire staff recognizes that directors often must make decisions on issues about which they may need to seek out expertise, such as the fair value pricing of portfolio securities.

Boards would also be required to perform a thorough self-evaluation in order to identify structural changes and processes that might enable a board to be a more potent advocate for shareholder interests. Boards would be required to assess periodically whether they are organized to maximize their effectiveness. As part of this evaluation, boards would consider the number of fund boards on which individual board members sit, as well as consider the nature and effectiveness of their board committee structures.

As part of this effort to enhance fund governance, the Commission has proposed to amend the fund recordkeeping rule, to mandate that funds keep copies of the materials on which directors rely when approving the fund's advisory contract each year. This amendment is designed to give the Commission's examinations staff access to the information on which directors rely when making this crucial decision. This requirement also could have the effect of focusing directors on this key information, since they would be aware that it will be subject to Commission scrutiny.

IV. Improved disclosure

The Commission has long sought clear, easy to understand disclosure of material information for mutual fund investors. As some of you know, attaining this goal of easily comprehensible, yet complete disclosure, can be extremely difficult, particularly in relation to increasingly complex products such as variable life and variable annuities. We also recognize that even "perfect" disclosure could not fully safeguard fund shareholders from the willful malfeasance of some industry participants. Even with these difficulties in mind, the Commission continues to pursue an aggressive agenda to improve fund disclosure, particularly with regard to fees and expenses.

Last fall, the Commission adopted amendments to mutual fund advertising rules. The amended rules require that fund advertisements state that investors should consider fees, as well as investment objective and risks, before investing and that advertisements direct investors to a fund's prospectus to obtain additional information about fees, investment objectives and risks. The rules were also designed to encourage advertisements that convey balanced information to prospective investors. The Commission also recently proposed rule amendments regarding fund of funds products, including amendments to Forms N-4 and N-6 used for the registration of variable insurance products, which would require these products to include additional disclosure in their prospectus fee table as to the costs of investing in underlying funds.

A. Transaction Costs

This past December, the Commission issued a concept release on mutual fund transaction costs. The release requests public comment on whether mutual funds should be required to quantify and disclose to investors the amount of transaction costs they incur in connection with buying and selling portfolio securities and how this might be accomplished.

Portfolio transaction costs are significant for two reasons. First of all, the amount of these costs tends to be substantial. A study cited in the release estimated that commissions and spreads alone can cost the average equity fund as much as 75 basis points. Second, fund managers are subject to a number of conflicts in connection with the allocation of portfolio transactions among brokers and dealers. Commissions, which are paid out of fund assets, may, for example, be used to pay for research or other services that would otherwise be paid for by the adviser. These are typically referred to as "soft dollar" benefits to the adviser.

Portfolio transaction costs are reflected in a fund's total return, but they are not reflected in the fund's expense ratio, nor do they show up in the fund's fee table. Now, we currently do require disclosure of two related items: portfolio turnover rate, in the prospectus, and the dollar amount of brokerage commissions, in the statement of additional information. However, the Commission is concerned that the current disclosure requirements do not directly address a fund's overall transaction costs or elicit sufficient information about these costs.

Public comment was requested as to what form this disclosure might take, such as whether mutual funds should include transaction costs in their expense ratios and fee tables or whether funds should provide other measures or disclosure that would indicate the level of a fund's transaction costs. In addition, the concept release seeks comment on whether mutual funds should be required to include transaction costs or the portion of those costs that represent soft dollar benefits as an expense in their financial statements. The comment period on this release remains open until February 23, and I encourage investors and industry participants to submit comments for consideration by the staff.

B. Market Timing, Fair Valuation, and Selective Disclosure of Portfolio Holdings

Also this past December, the Commission proposed enhanced disclosure requirements in order to combat abuses in the areas of market timing and the related issue of selective disclosure of portfolio holdings. These enhancements are intended to deter abusive practices and to enable investors to better understand a fund's policies in these areas.

1. Market Timing

The Commission proposed amendments to require more open and unambiguous disclosure with respect to the methods that mutual funds use to combat market timing activity. These market timing proposals include revisions to the registration forms for insurance company separate accounts that issue variable annuities and variable life insurance policies, Forms N-3, N-4, and N-6, regarding policies for frequent transfers among sub-accounts. Among other changes, the Commission's proposed reforms would:

  • first, require a mutual fund to describe in its prospectus the risks, if any, that frequent purchases and redemptions of fund shares may present for other fund shareholders;
  • next, require that a mutual fund state in its prospectus whether or not the fund's board of directors has adopted policies and procedures with respect to frequent purchases and redemptions of fund shares. If the board has not adopted any such policies and procedures, the fund's prospectus would be required to state the specific basis for the view of the board that it is appropriate for the fund not to have such policies and procedures; and
  • finally, mandate that a fund describe with specificity any policies and procedures for deterring frequent purchases and redemptions of fund shares, and any arrangements that exist to permit frequent purchases and redemptions of fund shares. This description must include any restrictions on the volume or number of purchases, redemptions, or exchanges that a shareholder may make, any exchange fee or redemption fee, and any minimum holding period that is imposed before an investor may make exchanges into another fund. Moreover, a fund would be required to indicate whether each restriction applies uniformly in all cases, or whether the restriction will not be imposed under certain circumstances, and to describe any such circumstances with specificity.
2. Fair Value Pricing

Another powerful tool to combat abusive market timing is to limit the available arbitrage opportunities through the proper use of fair value pricing of portfolio securities. The Commission has also proposed to amend the instructions to its registration forms to clarify that all mutual funds and insurance company managed separate accounts that offer variable annuities, other than money market funds, are required to explain in their prospectuses both the circumstances under which they will use fair value pricing and the effects of using fair value pricing. Funds are required to use fair value prices any time that market quotations for portfolio securities are not readily available or when such quotations are not reliable. I should also note that the Commission emphasized in the release adopting the compliance procedures rule, which I discussed earlier, the importance of having fair valuation procedures in place.

3. Selective Disclosure of Portfolio Holdings

The Commission also proposed amendments intended to provide greater transparency of fund practices with respect to the disclosure of a fund's portfolio holdings. Specifically, a mutual fund, or an insurance company managed separate account that offers variable annuities, will now be required to describe in its Statement of Additional Information its policies and procedures with respect to the disclosure of its portfolio securities, including any arrangements to make available information about the fund's portfolio securities, the identity of any persons who receive such information, and any compensation or other consideration received by a fund or its investment adviser in connection with such arrangements. These amendments do not alter the requirement that a mutual fund, or investment adviser, that discloses a fund's portfolio of investment securities may do so only if it is consistent with the antifraud provisions of the federal securities laws and the fiduciary duties owed to fund shareholders. Simply stated, disclosure, supplied in response to the Commission's proposed amendments, would not make lawful conduct that is otherwise unlawful.

I believe that this new disclosure requirement will have the effect of requiring fund management to carefully assess the propriety and circumstances under which portfolio holding information is divulged, as well as inform fund investors of the fund's policies in this area.

C. Mutual Fund Confirmation and Point of Sale Disclosure

As you know, broker-dealers are compensated for the sale of mutual fund shares in various ways, including not only concessions based on sales loads and rule 12b-1 fees, but also revenue sharing arrangements with fund advisers. We recently announced the findings of a probe into revenue sharing agreements in which we found 13 out of 15 broker dealers had accepted revenue sharing payments from advisers and in return favored those funds in some fashion, such as providing shelf space or placing the funds on a preferred provider list. At present, investors have very little access to useful information about revenue sharing and other potential conflicts of interest brokers may have in connection with selling fund shares. In order to improve investor access to information about costs and conflicts of interest associated with the distribution of mutual fund shares and variable insurance products, the Commission, two weeks ago, voted to propose a new point of sale disclosure rule and a new confirmation rule.

The new point of sale rule is designed to provide information to investors prior to transactions in mutual fund shares, UIT interests (including interests in separate accounts funding variable insurance products), and 529 plan shares. The rule would require the broker, dealer or municipal securities dealer to inform its customer about the distribution-related costs that the customer would be expected to incur in connection with the transaction. This would include separate disclosure about:

  • the amount of sales loads that would be incurred at the time of purchase, and the amount of that load that would be paid to the broker-dealer;
  • estimated asset-based sales charges and asset-based service fees paid out of fund assets in the year following the purchase if net asset value remained unchanged; and
  • the maximum amount of any deferred sales load that would be associated with the purchase if those shares are sold within one year, along with a statement about how many years a deferred sales load may be in effect.

These disclosures may be accomplished by either a reference to the value of the specific purchase, or if no amount was specified, by reference to a model investment of $10,000. In addition, the rule would require disclosure of whether the broker, dealer or municipal securities dealer receives revenue sharing or portfolio brokerage commissions from the fund complex, as well as whether it pays differential compensation in connection with different classes of shares or proprietary products. Finally, under this rule, an order made prior to the required point of sale disclosure would be treated as an indication of interest and may be terminated by the customer.

The new confirmation rule incorporates the point of sale disclosures I have just outlined as well as additional disclosure requirements. The new confirmation statement for funds, as well as for variable products, will provide customers with quantified information about the sales loads and other charges that customers incur when they purchase products that carry these charges. To address an investor's right to know about conflicts of interest that brokers may have when selling fund shares, the new mutual fund confirmation statement also will include specific disclosure regarding revenue sharing arrangements, portfolio brokerage, differential compensation for proprietary funds and other incentives for brokers to sell fund shares that may not be readily apparent to fund investors.

V. Future Initiatives

As you can see, we have been busy in the Division of Investment Management and more changes are on the horizon.

As announced by Chairman Donaldson, the Commission, at an open meeting in February, is expected to consider several important mutual fund initiatives. First, the Commission will consider a final rule to require funds to disclose semi-annually the amount of fees and expenses that their shareholders pay. The fees will be expressed in terms of dollars and cents, as opposed to the expense ratio disclosure currently provided in prospectuses. This is an important reform, as it will allow investors to determine not only the dollar amount of fees and expenses they are paying on their particular funds, but will also greatly facilitate comparison among different funds.

Second, the Commission will consider a proposed rule to include disclosure in a fund's annual reports to shareholders about the reasons supporting the directors' decision to approve the fund's investment advisory contract. This kind of disclosure is currently required in a fund's statement of additional information. Given the central importance of this board function, the staff believes that the disclosure warrants the greater prominence of disclosure in the annual report. We are also considering ways to elicit better disclosure regarding the substantive deliberations of the board, in lieu of the boilerplate list of factors frequently included in response to the current SAI requirement.

Also, the Commission will consider amendments to rule 12b-1 that would prohibit funds from using brokerage commissions to pay broker-dealers for selling fund shares.

In addition, the Commission will soon consider further proposals to combat market timing abuses, including a proposal to require mutual funds to impose a mandatory redemption fee on short-term redemptions of fund shares. Of course variable insurance products, by virtue of tax deferral, may be particularly attractive vehicles for market timers. However, because underlying fund shares in a variable product are held by the separate account, and not by individual contract owners, the fund generally is unaware of the individual transactions by contractowners, including short term trades, that make up a net transaction by the separate account. In this case, any required redemption fee could not be charged directly by the fund; instead, the insurance company would have to identify the timers, assess the fee and remit the fee to the fund. This scenario is comparable to other omnibus fund account arrangements, such as those with broker-dealers and fund supermarkets. The staff is considering the specific challenges of the proposed fee in the context of these arrangements, with a view towards submitting a comprehensive proposal to the Commission.

Finally, in March, we expect to submit to the Commission new proposals to improve disclosure to fund shareholders about their portfolio manager's relationship with the fund. These proposals will include disclosure regarding the structure of portfolio manager compensation, ownership of shares of the funds that a manager advises, and comprehensive disclosure of specific investment vehicles including hedge funds and pension funds that are managed by a portfolio manager to a registered fund. This proposal will also require clear disclosure as to who is managing a fund, addressing the current state of disclosure requirements that allows advisers to use a portfolio management team to avoid identifying the principal manager of the fund.

VI. Inspections and Enforcement

Meanwhile, in the course of all this rulemaking activity, the Commission's Office of Compliance Inspections and Examinations, and the Division of Enforcement, have been vigilant in identifying compliance lapses, as well as more systemic problems, at fund complexes, issuers of variable products, and the broker dealers that sell them, as well as transfer agents and others that process transactions.

Not surprisingly, a large part of the recent focus has been on late trading of investment company shares, and market timing of funds in contravention of stated policies, including whether these abuses have occurred in variable products. The staff is also looking at the related issue of funds' policies, procedures and practices for fair valuing their securities. The staff is actively examining and investigating firms industry-wide to determine the extent of the problem in these areas. Unfortunately more enforcement proceedings are forthcoming.

On the broker dealer side, much of the focus has been and continues to be on suitability and other sales practice issues. In the case of variable insurance products, this is a particular concern in the context of so-called "1035" exchanges of variable annuities. To cite just one example of the problem, the NASD a few weeks ago filed complaints against Waddell & Reed and its president and national sales manager for recommending 6,700 variable annuity exchanges to customers without assessing the suitability of these transactions. According to the complaint, the firm pressured clients to replace variable annuity contracts with similar annuities in order to advance the firm's commercial interests and in direct contravention of the best interests of its clients. These "switching" transactions are alleged to have generated $37 million in commissions and cost customers nearly $10 million in surrender fees.

This kind of abuse cannot be tolerated. The staff, in cooperation with the NASD and others, is aggressively examining the firms and registered reps that sell variable products for these and other types of improper sales practices, and enforcement proceedings should be expected where they are found.

VII. Conclusion

Warren Buffet is quoted as saying "It takes twenty years to build a reputation and five minutes to ruin it." This is a good reflection on what has happened to the fund industry. From 1940 until last year, the industry enjoyed a sterling reputation as a scandal-free industry. This was in part attributed to the efficacy of the regulatory scheme embodied in the Investment Company Act and the Commission's rules under it. That reputation has, unfortunately, been tarnished. But hopefully it can be rebuilt, and I believe that the new regulatory initiatives I've been discussing will lay the foundation for achieving that goal. But the Commission cannot do the job alone. The industry must be committed to quickly and aggressively addressing these problems as well. I hope the industry rises to the challenge.

Some of the Commission's initiatives I have mentioned are not without controversy. As always, feedback from commenters will be critical to our evaluation of the proposals and any needed refinements. We look forward to hearing commenters' views, and strongly encourage fund shareholders, variable product contactowners, as well as industry participants, to involve themselves in our rulemaking process.

Thank you for your time and attention.


Modified: 01/27/2004