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U.S. Securities and Exchange Commission

Speech by SEC Staff:
A New Era of Accountability in Fund Regulation


Paul F. Roye

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

2003 Mutual Funds and Investment Management Conference
Palm Desert, CA
March 31, 2003

I. Introduction

Good morning and thank you for welcoming me here today. I am truly honored to be with you once again as we gather to discuss industry developments, review regulatory actions and pause for an annual assessment of where the mutual fund industry has been and where it is going.

I am pleased to see so many of you here. Your presence represents a continued commitment to excellence in the mutual fund industry and a desire to stay abreast of current developments, ensure a culture of compliance at your firms, maintain a vibrant industry and, above all, serve mutual fund shareholders well.

Before I begin, I need to remind you that, as always, my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff. I want to talk to you this morning about this current period in mutual fund history, which I characterize as a new era of accountability.

I do not need to tell you that we recently have experienced a very difficult period in the history of our nation's securities markets, also impacting the fund industry. Market scandals have roiled our economy, and trillions of dollars of wealth have evaporated. As a result of scandal, employees' retirement plans have dwindled, and far fewer investors feel secure in their ability to save for their children's educations and meet other financial goals. In short, many investors have lost confidence in the fairness of the markets.

In the wake of this lost confidence, many fund managers and other institutional investors are pointing the finger at operating company executives. Executives are then implicating auditors who failed to catch financial irregularities. The auditors respond that company executives misled them and that company lawyers should have given more sound legal advice. Lawyers and others retort that executives, auditors, boards of directors and regulators were asleep at the switch-and that mutual funds and other institutional investors should have been more active in their oversight of the companies in which they were invested.

All of this finger pointing reminds me of the adage that when a man points a finger at someone else, he should remember that four of his fingers are pointed at himself. So, while there are those who would debate whether mutual funds were part of the problem, there is no doubt that they must be part of the solution.

Investors, who have suffered significant losses, are demanding accountability. Therefore, Congress is demanding accountability. As our new chairman, William Donaldson, stated in his first major address as head of the SEC,

In order to restore their trust, American investors must see businesses shift from constantly searching for loopholes and skating up to the line of legally acceptable behavior. They must see a new respect for honesty, integrity, transparency, [and] accountability.

I believe that Chairman Donaldson's remarks outline a standard that should be adhered to by the fund industry. Accordingly, the fund industry should look inward and demand accountability among its participants.

I hope that this first part of the 21st century comes to be remembered, not for the scandals, but as a new era of accountability, the creation of a new "fairer" deal for America's investors. Already, there are many examples of initiatives to promote responsibility and focus attention on meeting the needs of America's investors.

II. Sarbanes-Oxley Act and Related Rulemaking

Of great significance, was Congress' passage of the Sarbanes-Oxley Act last summer. Sarbanes-Oxley is one of the most important pieces of securities legislation in decades. Much of the Act is premised on the need for a heightened level of accountability in the securities industry and in corporate America in general. While it was the failings on the part of some in corporate America that led to the passage of Sarbanes-Oxley, Congress viewed mutual funds as part of corporate America, and extended the provisions of the legislation, with a few exceptions, to mutual funds.

The focus on promoting accountability did not end with Congress. The Commission was given significant responsibility in carrying through on Sarbanes-Oxley's mandates. In a flurry of rulemakings that the Commission undertook in late 2002 and early 2003, our agency sought to define the requirements of Sarbanes-Oxley for the fund industry and ensure that fund investors benefit from the Act's tenets of fair-dealing, responsible management and meaningful oversight.

Consequently, the Commission adopted rules under the Sarbanes-Oxley Act requiring certification of shareholder reports by funds' principal executive and financial officers and requiring the maintenance and regular evaluation of the effectiveness of controls and procedures designed to ensure that the information contained in shareholder reports is summarized and reported in a timely manner. The Commission's new rules also require that funds disclose whether they have adopted a code of ethics that applies to the funds' senior officers covering a broad range of issues, including disclosures provided in filings with the Commission and ethical conduct generally.

Together, these rules reinforce that funds' key officers are accountable for their funds' financial statements-and for their own actions. The rules seek to ensure that these officers understand the full extent of their responsibilities.

The Commission also adopted rules encouraging the identification of audit committee financial experts. Later this week, the Commission will consider adoption of rule amendments that would mandate that the securities exchanges and NASDAQ establish listing standards that would enhance the independence of audit committees and ensure that they have the funding and independent advisory assistance necessary to appropriately perform their duties. If the rules are adopted, any new listing standards would apply to closed-end funds listed on an exchange and to exchange traded open-end funds. While these requirements would not extend to open-end funds more broadly, the proposals represent best practices worthy of consideration by all mutual fund boards of directors.

The rule amendments and proposed amendments under the Sarbanes-Oxley Act dovetail with the efforts undertaken by the industry and the Commission a few years ago to improve the effectiveness of mutual fund independent directors. You should take great pride in knowing that the fund industry was ahead of the curve in recognizing the crucial role that independent directors play in promoting compliance with the federal securities laws and ensuring that investor interests remain paramount in the boardroom.

The important role of gatekeepers does not end with independent directors. Fund auditors also perform a vital function when they review a fund's financial statements on behalf of shareholders. Because the financial oversight provided by auditors is so central to our securities markets, the Sarbanes-Oxley Act, in addition to creating the Public Company Oversight Accounting Board, directed the Commission to take steps to help ensure that those serving as auditors are truly independent. Accordingly, in January, the Commission adopted rules to strengthen the independence of public accountants. These rules have specific provisions designed to address issues that are unique to the fund industry and seek to ensure that fund accountants are accountable to fund investors.

The Sarbanes-Oxley Act also identified attorneys as important gatekeepers who owe a level of accountability to the companies they represent. The Commission adopted rule amendments that prescribe minimum standards of professional conduct for attorneys appearing and practicing before the Commission on behalf of issuers, including funds, and recognized that these lawyers may very well work for a service provider to the funds.

III. Commission Rulemaking Actions

The Commission's actions to promote accountability have not been limited to rulemaking under the Sarbanes-Oxley Act. One recent rulemaking that highlights accountability of fund managers to fund shareholders is the new proxy voting rule.

The fund industry largely opposed disclosing fund proxy voting records. This criticism largely overshadowed the fact that the Commission made significant adjustments to the fund proxy voting rules to accommodate industry concerns. At the risk of further offending those who oppose this disclosure, I submit that on this matter the fund industry has largely been asking the wrong questions. The question should not be whether mutual funds are the only institutional investors who will be required to make this disclosure, but at this difficult time, what role we can play in improving the governance of America's corporations. How can the mutual fund industry be a leader in this important area? How can we assure our investors that we take our fiduciary responsibilities seriously when voting proxies?

Transparency of the proxy voting process should foster investor confidence in the mutual fund industry. The Commission determined that transparency of this voting information would facilitate accountability on the part of fund managers in voting proxies in the best interest of fund shareholders. Since the fund industry contends that it has been fulfilling its fiduciary obligations when voting proxies, it should not fear a little sunlight in this area.

The Commission's pending rule proposals to improve shareholder report presentations and to modernize fund advertising rules also have components that are designed to foster a greater level of accountability. Under the Commission's shareholder report proposal, funds would reveal their portfolio holdings on a quarterly basis, rather than twice a year. Not only will this more frequent disclosure enable fund shareholders to better monitor their investments and make better asset allocation decisions, it will allow for greater scrutiny of the composition of fund portfolios and portfolio management techniques.

The advertising rule proposal would increase funds' flexibility in advertising by eliminating the requirement in Rule 482 that fund advertisements relying on the rule contain only information the substance of which is included in the prospectus. While the proposal increases flexibility in fund advertisements, with that flexibility comes an increased level of responsibility and accountability, especially for fund managers who advertise past performance with the principal constraint being the applicability of the antifraud provisions of the federal securities laws.

Another Commission rule proposal that undoubtedly underscores the Commission's focus on accountability is the proposal on compliance programs and compliance officers. Many have asked, why this proposal now? Quite simply because we want to take steps to prevent the types of scandals that have plagued other segments of the securities industry from tainting the investment management industry. Today, funds and advisers control over $21 trillion in assets. Industry growth has substantially exceeded the growth in Commission resources. Unlike the brokerage industry, the Commission has sole oversight responsibility for the 34,000 investment company portfolios and 7,800 investment advisers that are registered with us.

Our oversight is predicated on the assumption that those who manage investment companies and advisers have procedures to comply with the law. But in fact, with the exception of a few discrete areas, there is no requirement that funds or advisers have a comprehensive set of compliance controls, although most do. Many of our enforcement cases in the investment management area, however, are often the result of weak or nonexistent compliance controls. If adopted, these rules should help protect investors by improving day-to-day compliance with the federal securities laws, while at the same time, increasing the efficiency and effectiveness of our examination program. These rule proposals do not ask anything that any well-managed fund or adviser should not be doing today.

The rule proposal exemplifies the Commission's approach to proactive regulation of the securities industries. Chairman Donaldson, a former Marine rifle platoon commander, has indicated that the agency should take a lesson from the U.S. military which has had to evolve into a "much more efficient force--quicker, more agile and more proactive." He has stated that he hopes the agency can develop a similar approach to its mission — "that we can play offense more often, be more proactive, and anticipate the problems we may face."

Unfortunately, the compliance policies and procedures proposal has been largely overshadowed by the request for comment on the advisability of additional private sector involvement in promoting fund and adviser compliance with the federal securities laws. Surely, the events of recent months highlight the need for the Commission to regularly reassess whether it is achieving its mandate as best it can in light of the growth and change in the financial services industry.

Requesting comment on these questions, however, does not necessarily indicate that implementing additional forms of oversight is the approach the Commission ultimately will take. Rather, we feel it is important to advance a public dialogue on these issues, so that the Commission can consider whether the regulatory oversight scheme can be improved in the best interests of investors. We look forward to considering your reasoned views on the ideas set forth in the concept release and any other ideas you may have that will enhance the regulatory framework.

IV. Other Commission Initiatives to Promote Accountability

In addition to its rulemaking activity, the Commission has undertaken two other initiatives that are, in part, focused on promoting accountability in the investment management area. The first involves the problems outlined in the recently published joint report by the Commission, the NASD and the New York Stock Exchange, which found that there have been significant failures to deliver breakpoint sales load discounts to eligible mutual fund investors. Obviously, these problems must be addressed, and addressed quickly.

Brokers, of course, have a role in ensuring that their customers receive appropriate breakpoint discounts. Funds also have a role in ensuring that breakpoints are disclosed in a clear and understandable manner, and fund directors have a role in overseeing how their funds are sold. Regulators have a role in overseeing whether brokers, funds and directors are meeting their responsibilities in this area.

The solution to the breakpoints situation lies with no one party, and requires input from multiple market participants, another situation where finger pointing is not productive. Accordingly, a working group representing various constituencies, including the ICI, the NASD and the Securities Industry Association, has been formed to address deficiencies in the current structure under which breakpoints are calculated and applied. We look forward to the results of their efforts to ensure that the fund and brokerage industries eliminate errors and prevent abuses related to breakpoints.

Another Commission initiative designed to highlight accountability, or the possible lack of accountability, is our fact-finding inquiry regarding hedge funds. Hedge funds typically are not registered as investment companies, their securities offerings are not registered with the Commission and, in many cases, their managers are not registered as investment advisers. Thus, for many hedge funds, the only level of accountability to which they are subject under the federal securities laws are anti-fraud provisions enforced by the Commission and private litigants. The hedge fund inquiry was prompted by the perceived growth in these products and what Chairman Donaldson calls the increasing "retailization of hedge funds." Unfortunately, the growth in hedge funds has been accompanied by fraud on the part of some hedge fund sponsors.

One of the issues the Commission is reviewing is whether there should be greater oversight and accountability on the part of hedge funds and their managers in order to identify problems early before they become full-scale blow-ups. In an effort to engage in a public dialogue on various investor protection concerns regarding hedge funds, the Commission has announced that it will hold a public roundtable on hedge funds on May 14th and 15th , and we welcome the submission of written comments on this important issue.

V. Congressional Interest in the Mutual Fund Industry and Accountability

In the wake of the mutual fund fee hearings recently held by a subcommittee of the House Financial Services Committee, Chairman Donaldson last week received a letter from Subcommittee Chairman Richard Baker and a letter from Congressmen Paul Kanjorski and Robert Ney raising various accountability issues. The letters request that the Commission provide its views, including recommendations for legislative and/or regulatory actions, on a wide range of fee-related issues, including fee transparency, transaction costs, soft dollars, rule 12b-1 fees, fee levels, revenue-sharing payments, fund performance disclosure and the role of independent directors in overseeing fund fees.

Congress has raised some very fundamental questions, some of which have been debated for decades. In the wake of this significant Congressional interest in the mutual fund industry, all of us-industry and regulators alike-are essentially being asked, "Can we do better for fund investors?" Are there improvements we can make in the reporting of fees, the disclosure of soft dollar practices and the payments funds make for distribution? I can assure you that in the time frames given us we will conduct a focused and comprehensive review of these issues in preparing responses to these letters.

VI. Accountability Within the Division of Investment Management

While Congress and the Commission have both undertaken a series of actions to increase accountability in the fund industry, we in the Division of Investment Management also understand that we are accountable in the performance of our regulatory duties. First and foremost, we are accountable to fund investors who rely on us to provide diligent and vigorous oversight of the fund industry.

While our primary focus is, and always must be, investor protection, like all organizations, we understand that we must operate as efficiently as possible to best effect our mission. Consequently, the Division plans to seek permission from the Commission to implement a new exemptive application triage system that would eliminate full review for applications containing an attorney's certification that the relief requested is materially the same as relief previously provided to a similar applicant. Streamlining the processing of these routine applications would free much of the staff's time to focus on those applications requiring more detailed review and analysis and would, we hope, allow the exemptive applications process to run more efficiently. Not only would this plan facilitate the processing of applications more quickly, it also would rely heavily on those who file exemptive applications, particularly those attorneys who would make the required certification. The Division also plans to institute a new system of refusing to process applications that contain insufficient factual or legal analysis.

In addition, the Division is reviewing other measures to speed up the processing of no-action and interpretative letters and to become more efficient and consistent in the manner in which we review disclosure filings. At the same time, we are preparing for the additional financial statement reviews our staff must conduct as mandated by the Sarbanes-Oxley Act.

VII. Conclusion

Before I conclude, I note that my experience with the mutual fund industry-either as a regulator or a private practitioner-has spanned across almost 25 years from the late 1970's until now. Looking back over that period, I have seen many significant developments in the evolution of the industry.

The industry has an excellent record of being innovative and has created many commendable products and product features. But not all new fund ideas are good for investors, or good for the industry. It is not the role of the Commission to consider the merits of new fund products or new features for fund products unless they raise issues regarding compliance with the federal securities laws, particularly the Investment Company Act.

I am concerned, however, that there may be a herd mentality on the part of some in the industry, with some organizations seemingly taking a "fund of the month" approach to marketing and following the latest fad in the new type of fund or feature being offered. When the marketing executives within your organization say they can sell a new product, who within your company steps up and asks, "But is this product truly good for investors; will it meet a legitimate need"? When launching a new fund, the question should not simply be, "Can we package the fund around a clever marketing pitch"?

Every fund organization must have a conscience. Every fund organization must be accountable for its business decisions and the impact they have on fund investors. Who is the conscience in your organization? Who holds accountability? Whose role is it to ask tough questions before a new product is launched? Someone must determine whether the concept is valid, whether the new feature works, whether the product will produce solid investment returns over time, whether the product's investment profile is fairly represented, and whether the investment strategy and marketing pitch are just smoke and mirrors. We do see products and features where we wonder whether these types of questions were asked.

I challenge you to do your part to ask the tough questions, to put on the brakes when your organization seems swept away in a tide of enthusiasm over the latest investment fad. America's investors deserve better.

* * * *

I realize that these last 12 months have been extremely challenging for all of us. There seems to be no shortage of new regulatory measures to discuss and, unfortunately, there are a series of investor confidence issues that have yet to be entirely overcome. However, I believe that you as fund professionals and we as fund regulators can persevere through this difficult period in our nation's markets, and restore investor confidence--if we keep in mind that we are accountable to America's investors.

The fund industry can be proud of its history of promoting a culture of honesty, integrity, transparency and accountability and also should be proud of its commitment to strong fund governance and compliance practices. But we cannot rest on past accomplishments. You must continue to be leaders in the establishment of fair, ethical, and investor-oriented business practices.

I thank you very much for your attention, and I look forward to another interesting and informative ICI Mutual Funds and Investment Management 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: 04/03/2003