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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Mutual Fund Issues of Interest to Defined Contribution Plan Sponsors and Participants


Paul F. Roye

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

Remarks before the Institutional Investor Defined Contribution Forum
Hallandale, FL
May 7, 2003

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.

I. Introduction

Good afternoon and thank you for welcoming me here today. I am privileged to be with you today as you conclude this Forum, which highlights important issues faced by defined contribution plan sponsors and plan participants. I understand that throughout the forum, you have focused on such timely and wide-ranging issues as managing risk, controlling plan expenses, measuring the performance of investment managers and reviewing the role of plan sponsors as fiduciaries.

Since mutual funds are one of the primary funding vehicles for defined contribution plans, I would like to discuss the issue of accountability in mutual fund regulation and the adequacy of disclosure to plan participants. Before I do that, however, I must remind you 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.

As you are aware, we recently have witnessed a growing sense of skepticism among America's investors, including defined contribution plan participants. The events of the past 18 months have tested their confidence in the markets and market intermediaries.

Just last week, our Chairman William Donaldson announced the settlement of enforcement actions imposing record-setting penalties against ten securities firms regarding the activities and conduct of certain of their research analysts. According to Chairman Donaldson, these cases "are an important milestone in our ongoing effort both to address serious abuses that have taken place in our markets and to restore investor confidence and public trust by making sure these abuses don't happen again. ... the hallmark of our business and financial system is the rule of law and the rule of law must prevail. And when wrongdoing occurs, it must be confronted and punished .... "He further emphasized that these cases reflect a very sad chapter in the history of American business, a chapter in which those who reaped enormous benefits based on the trust of investors profoundly betrayed that trust." Along these lines, I believe there needs to be an appropriate focus on accountability on the part of mutual funds and their managers so that we don't see the kind of problems we have seen in other segments of the securities industry creep into the mutual fund industry.

The Investment Company Institute, the mutual fund industry trade association, estimates that as of the end of 2001, there were approximately $1.1 trillion invested in mutual funds through employer-sponsored defined contribution plans. The ICI further estimated that, as of the same date, approximately 44% of all 401(k) assets were invested in mutual funds. Therefore, mutual fund oversight is of great importance to defined contribution plan sponsors and participants.

Consequently, I would like to review for you various initiatives to promote accountability and responsibility within the mutual fund industry.

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, as well as 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. These 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 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 mutual funds, and recognized that these lawyers may very well work for a service provider to the funds.

I should also note for this group that the Commission, after consulting with the Secretary of Labor, adopted regulations clarifying the scope and operation of Section 306(c) of Sarbanes-Oxley which makes it unlawful for any director or executive officer of a company to purchase, sell or transfer securities of the company during any pension plan blackout period, if the securities were acquired in connection with service or employment as a director or executive officer. Several highly publicized cases have demonstrated the catastrophic consequences that can befall employees who have invested substantially all of their retirement savings in their employer's equity securities when the value of an issuer's securities fall sharply during a blackout period. There also have been allegations that, at the time rank-and-file employees were precluded from selling their employer's securities in their pension plan accounts, corporate executives were exercising and cashing out their employee stock options and selling other securities acquired through the company's equity compensation plans. Section 306(a) equalizes the treatment of corporate executives and rank-and-file employees with respect to their ability to engage in transactions involving company securities during a pension plan blackout period. The statute's trading prohibition should mitigate the risk that corporate executives put their personal interests ahead of their responsibilities to their companies, their employees and their company's shareholders.

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.

Under this new rule, funds will be required to disclose their proxy voting records to the Commission on an annual basis. This information will then be available to the public through the Commission's Edgar database. 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.

Mutual funds and investment advisers have discretionary investment authority with respect to approximately $21 trillion of assets, including large holdings in equity securities. The enormity of this voting power gives mutual funds and advisers significant ability collectively, and in many cases individually, to affect the outcome of shareholder votes and to substantially influence the governance of corporations. Accordingly, mutual funds and their advisers are in a position to have a significant effect on the future of corporations and the value of securities held by mutual fund shareholders. The importance of proxy voting by mutual funds and advisers — both to their shareholders and clients and to the system of corporate governance, particularly in light of the spate of recent corporate scandals, as well as the conflicts faced by some advisers, suggested a need for the Commission to address proxy voting by advisers.

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 mutual fund advertising proposal was prompted by the Commission's concerns that performance advertising could create unrealistic expectations by investors. Accordingly, the amendments are intended to convey more balanced information to prospective investors, particularly with regard to past performance, to ensure that investors are informed and not misled.

The proposed amendments would require funds that advertise to make available to investors a toll-free or collect telephone number where they may obtain the most recent month-end performance information for the fund's 1-, 5- and 10- year periods, thereby giving investors access to the most current performance information available. The proposed amendments also reemphasize that fund advertisements are subject to the antifraud provisions of the federal securities laws, and would increase funds' flexibility in advertising, by eliminating the requirement that advertisements contain only information the substance of which is included in the prospectus. However, with this increased flexibility would come responsibility bolstered by 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 for mutual funds. As I mentioned earlier, 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.

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, such as a self regulatory organization for funds and advisers. 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.

IV. Prospectus Delivery

Finally, I would like to discuss an issue that continues to be raised in connection with defined contribution plans. As you likely are aware, investors that invest in a mutual fund through defined contribution plans, such as 401(k) plans, are not required by law to receive a copy of the fund's prospectus. The federal securities laws generally are premised on the concept of full and fair disclosure, and I can tell you that issuers and the Commission staff spend a significant amount of time focusing on the nature of fund disclosures, so that fund investors receive appropriate information prior to making investment decisions. However, in many cases, this effort is for naught because investors who invest in funds through 401(k) may not receive a fund's prospectus.

A proposal advocating prospectus delivery was included in the Division of Investment Management's study over 10 years ago entitled, "Protecting Investors: A Half Century of Investment Company Regulation." The Division recommended legislative amendments that would apply the securities laws' prospectus delivery requirements to investors that invest in funds through employer-sponsored, participant-directed defined contribution plans, such as 401(k) plans.

Without a prospectus, investors may be denied valuable information regarding a fund, including information regarding fees and expenses. The prospectus also discusses a fund's investment objective, the techniques the fund uses to meet its investment objective and, importantly, the risks associated with those investment techniques. In addition, the prospectus details information about a fund's adviser, portfolio managers and other service providers.

Since the creation of the 401(k) plan in 1978, we have seen massive growth in defined contribution plans. Press reports indicate that more new money is now invested in the markets through defined contribution plans, than defined benefit plans. And indications are that the trend toward defined contribution plans, and away from defined benefit plans will continue. Thus, more and more U.S. workers are now making their own investment decisions when it comes to funding their retirement. These workers deserve the opportunity to make investment decisions based on the same set of information to which other fund investors are entitled, namely a fund's prospectus.

Congress' rationale for not requiring prospectus delivery for mutual fund purchases made through pension plans was that the person making investment decisions for a plan, historically the plan's sponsoring employer or a professional investment manager, was a sophisticated investor able to fend for itself and obtain the information it needed to make investment decisions. In this context, however, defined contribution plans must be distinguished from defined benefit plans. With defined benefit plans, the plan bears the investment risk. On the other hand, with defined contribution plans, the plan participant, and not the plan, bears the investment risk. Consequently, the plan participant should receive the prospectus information necessary to evaluate his or her investment decision. Additionally, plan participants should review annual and semi-annual shareholder reports from funds so they can appropriately evaluate their investments and decide whether to maintain their current investments or make reallocation decisions.

As a partial solution to the lack of investment information for some plan participants, the DOL adopted regulations under Section 404(c) of ERISA. The 404(c) regulations reduce the exposure of a plan's sponsor and trustees to liability for losses in participant accounts and, at the same time provide employees more information about, and more control over, their investment choices. While the new rules are voluntary, a plan that does not conform to the rules cannot claim immunity from lawsuits by employees who are disappointed with their investment return. Among other things, the 404(c) regulations require that a plan offer a range of diversified investment vehicles. The regulations also require the sponsor to assure that plan participants are given, or can obtain, the information necessary to make an informed investment decision. At a minimum, sponsors must give employees information about each investment option, as well as information about transfer procedures, the expenses and performance of each investment option, and last, but not least, a prospectus for any vehicle, including a mutual fund, which is registered under the Securities Act. While the 404(c) regulations help, it is unfortunate that the federal securities laws have not been updated along these lines to reflect the emergence and increasing popularity of worker-directed investing through defined contribution plans.

V. Conclusion

Many of you have responsibilities for making decisions designed to meet the retirement needs of your plan's participants. You are responsible for evaluating and selecting investment managers and investment options and monitoring services, expenses and performance. There may be instances when you have to terminate an investment manager and substitute another when the manager is not meeting the needs of the participants. This is a responsibility that I know you take seriously.

At the Commission, we are committed to making your job easier in fulfilling your responsibilities, as we seek to improve fund disclosures and assure accountability in the mutual fund industry. If you have ideas on how we can better meet this objective, I hope you will contact us.

Thank you for listening.



Modified: 05/12/2003