U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the
National Association for Variable Annuities


Paul F. Roye

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

2003 Regulatory Affairs Conference
Washington, D.C.
June 17, 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 at this year's Regulatory Affairs Conference, which highlights important issues faced by the variable products industry. As always, I must remind you before I begin 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.

The variable products industry is coming through one of the more difficult environments it has faced. While assets on the variable annuity side of the business stand at approximately $800 billion and $75 billion on the variable life side of the business, sales over the last three years have been relatively stagnant. The investment company industry as a whole has had to operate in a more challenging regulatory environment following the passage of the Sarbanes-Oxley legislation, the PATRIOT Act and new regulations mandated by these statutes. The latest challenge for the variable products industry is the new tax cut legislation and its possible impact on the attractiveness of variable products.

You have already heard interesting discussions in the course of this conference on what the industry is doing by way of product development and adjustments in response to this challenging environment. What I would like to do this afternoon is discuss with you what I hope are current issues of interest and some of the regulatory initiatives recently undertaken by the Commission and those that we would like to pursue in the future.

II. Letters From Congress

First, I thought I would discuss recent Congressional actions regarding the mutual fund industry. You may already know that a few months ago the Commission received two separate letters of inquiry from members of the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the House Financial Services Committee, one from the Chairman of the Subcommittee, Richard Baker, and the other from Congressmen Robert Ney and the ranking minority member of the Subcommittee Paul Kanjorski. We submitted our responses last week.

The letters evidence a continuing concern on the part of some in Congress regarding the degree to which investors understand mutual fund fees and expenses, notwithstanding existing disclosure requirements and educational efforts, certain conflict of interest issues, and the adequacy of the mutual fund governance framework.

While transactional fees tend to be relatively transparent, ongoing fees and expenses are less so, in part because of the fact that they are deducted from fund assets and are expressed as a percentage of net assets and reflected in reduced account balances. Surveys have indicated that investors may not understand the nature and effect of these ongoing expenses. It appears that, for whatever reason, current disclosure documents are not conveying this information effectively. Clearly, more can and should be done.

Having said that, I am proud of our efforts to date in improving the quality of disclosure. Notable among the various initiatives we have taken was the introduction of the Mutual Fund Cost Calculator, an Internet-based tool available on the Commission's website that enables investors to compare the costs of owning different mutual funds. More recently, we have a pending rule proposal that would require mutual funds to disclose in their reports to shareholders the amount of fund expenses borne by shareholders during the reporting period. We indicated in our response to the Congressional inquiries that we continue to believe that use of shareholder reports to convey additional fee information to fund investors, from a cost/benefit standpoint, provides a better approach than use of account statements as recommended by the General Accounting Office in its review of this issue.

Questions were also raised in the Congressional inquiries about the adequacy of disclosure in other areas, such as portfolio trading costs, soft dollar arrangements, portfolio manager compensation, revenue sharing arrangements and fund performance. The questions were wide ranging, and we hope our responses will further the process of identifying areas where improved disclosure can advance investor protection interests.

With regard to portfolio transaction costs, some have called for reflection of those costs in a fund's expense ratio or a quantification of these costs. Our response noted that, although such proposals are attractive in theory, they may not be feasible in practice, given that transaction costs not only include commissions, but also spreads, market impact costs and opportunity costs. Nonetheless, we indicated that investors would benefit from better, more understandable disclosure of transaction costs and we suggested a variety of approaches which we will consider.

We also thought that investors could benefit from having information regarding the compensation structure for fund portfolio managers. This information could be helpful in assessing the incentives of individuals managing a fund, such as whether the manager is compensated for short-term or long-term performance or performance based on pre-tax or after-tax returns.

We expressed concern about the growth of soft dollar arrangements and the conflicts they may present to fund advisers. As you know, certain of these soft dollar arrangements are protected by Section 28(e) under the Securities Exchange Act. However, the general effect of Section 28(e) is to suspend the application of otherwise applicable law, including fiduciary principles, and to shift the responsibility to fund boards to supervise the adviser's use of soft dollars and the resulting conflicts of interest, subject to best execution and disclosure requirements.

We expect to continue our efforts to improve disclosure regarding soft dollar arrangements and expect to ask the Commission to propose changes to the record-keeping rule under the Investment Advisers Act to require advisers to keep better records of the products and services they receive for soft dollars. But we also noted that, after 28 years, it may be appropriate to reconsider Section 28(e) or, alternatively, amend the provision to narrow the scope of the safe harbor.

One other issue raised in the Congressional letters that I would like to highlight deals with the recovery of distribution expenses under Rule 12b-1. Although 12b-1 plans for variable product funds are relatively new, having been first introduced in 1996, they are now increasingly common. In fact, while an assumption underlying the original adoption of rule 12b-1 is that distribution fees authorized by the rule are temporary, many in the industry have argued that this assumption is now obsolete. In many cases, 12b-1 fees paid by underlying funds to insurance companies that sell variable contracts and indirectly sell fund shares have become an integral element of the pricing of the products overall. Further, when a fund pays asset based fees for a combination of distribution and non-distribution services (such as account maintenance), it can be difficult to determine precisely when and how rule 12b-1 applies to those fees. In light of these realities, we are currently considering whether the requirements of rule 12b-1 should be modified to reflect fund practices as they exist today.

We also have concerns as to the use of revenue sharing payments made by a fund's adviser to finance the distribution of the fund's shares. One issue raised by a fund investment adviser's revenue-sharing payments is whether the payments are an indirect use of the fund's assets to finance the distribution of its shares and therefore must be made in accordance with the requirements of rule 12b-1. In our view, a fund indirectly finances the distribution of its shares within the meaning of rule 12b-1 if any allowance is made in the fund's investment advisory fee to provide money to finance the distribution of the fund's shares. In that case, the investment advisory fee essentially serves as a conduit for the indirect use of the fund's assets for distribution, and the portion of the advisory fee that is used to finance the distribution of the fund's shares must be paid in compliance with the requirements of the rule.

In this regard, a fund's board of directors, particularly its disinterested directors, is primarily responsible for determining whether revenue-sharing payments are an indirect use of the fund's assets for distribution or whether they are paid out of the "legitimate profits" from the investment adviser's contract with the fund. If the fund's board of directors determines that the payments are an indirect use of the fund's assets for distribution, it must ensure that the payments are made in accordance with the requirements of rule 12b-1.

Shortly after we submitted our responses to the Congressional inquiries, Chairman Baker introduced legislation entitled the "Mutual Fund Integrity and Fee Transparency Act of 2003." The bill calls for improved disclosure to mutual fund investors regarding estimated operating expenses incurred by shareholders, soft dollar arrangements, portfolio transaction costs, sales load breakpoints, as well as directed brokerage and revenue sharing arrangements. The bill also would require disclosure of information on how fund portfolio managers are compensated and require fund advisers to submit annual reports to fund directors on directed brokerage and soft dollar arrangements, as well as revenue sharing. It also would impose fiduciary obligations on fund directors to supervise these activities and assure that they are in the best interest of the fund. In addition, the Bill would require the Commission to conduct a study of soft dollar arrangements to assess conflicts of interest raised by these arrangements and examine whether the statutory safe harbor in Section 28(e) of the Exchange Act should be reconsidered or modified.

Hearings will be held tomorrow on this legislation.

III. Regulatory Initiatives

A. Form N-6

I would like to turn now to some of the regulatory initiatives currently underway. First, however, I would like to commend the industry for what I consider to be the successful introduction of Form N-6 in the most recent post-effective amendment season for variable life registrants. I understand that over 400 filings, including post-effective amendments, converting registration statements for variable life insurance policies to Form N-6 came in during the season. Certainly, the conversion of so many variable life insurance prospectuses to the format prescribed by the new form required a great deal of work on the part of both you and our staff, but I trust you will agree that the enhanced disclosure of fees, expenses and product features will prove to be a great benefit to investors going forward.

It is important, however, that we not adopt a complacent attitude that the job is done now that the form is in place. Marginal or poorly written disclosure is not cured by simply importing it into the new form. The staff made suggestions for improvements in many cases, but in the end an effective, well written prospectus requires diligence on the part of the registrant. Therefore, let me urge you to continue your best efforts to craft the best disclosure possible in future filings, disclosure that as clearly as possible explains your product and the terms of your offering. We remain confident that the new form will prove to be a helpful vehicle for doing so.

B. Compliance Rule Proposal

Another important regulatory initiative I'd like to discuss briefly concerns the proposed compliance program rules, which the Commission published for comment in February. These rules would require investment companies and investment advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the federal securities laws. The proposal also would require investment companies and investment advisers to designate a chief compliance officer.

I would point out that the proposed rules do not enumerate specific elements that funds must include in their compliance policies and procedures, simply because funds are too varied in their operations for the Commission to impose a single list of required elements. What is important is that policies and procedures be in place and that they be reasonably designed to lessen the likelihood of violations, detect any violations that do occur, and provide guidance on appropriate responses to such violations for fund officers.

In many cases, the proposal would codify the prudent compliance practices followed by investment companies that already have a dedicated compliance officer and effective compliance procedures. In fact, some investor advocates have singled out the fund industry for a remarkably clean record when it comes to investor fraud generally.

Nonetheless, it is common knowledge that industry growth has substantially exceeded the growth in Commission resources. Our ability to exercise meaningful oversight plainly depends on the establishment and implementation of internal procedures and controls reasonably designed to ensure compliance with the law. Surprising as it may sound, some investment companies have virtually no compliance controls in place. In fact, many of our enforcement cases in the investment management area are the result of weak or nonexistent compliance controls. We want to raise the compliance standards of all funds to the standards already adopted by the more responsible and proactive fund complexes.

If adopted as proposed, 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. Again, these rule proposals do not ask anything that any well-managed adviser or fund complex is not already doing today.

C. Shareholder Reports Proposal

Another Commission initiative I'd like to highlight is the shareholder reports proposal. I believe this initiative is one that could go a long way in addressing some of the concerns expressed in the Congressional inquiries I referred to earlier regarding the opacity of fund fees.

This proposal would require mutual funds to disclose in their reports to shareholders the amount of fund expenses borne by shareholders during the reporting period. Fund shareholder reports would be required to include the dollar cost of fees and expenses on a $10,000 investment, based on the fund's actual expenses and investment performance. In an effort to promote comparability among funds with different investment returns, we have also proposed requiring disclosure of the dollar cost of that same investment, based on the fund's actual expenses and an assumed return of 5 percent per year.

This initiative is also notable for certain other proposals intended to improve disclosure to investors. For example, we have proposed increasing the frequency with which portfolio holdings are reported, from semi-annually to quarterly. In an effort to minimize the cost burden on the industry, our proposal calls for these reports to be filed on EDGAR, but does not require that they be printed and mailed to shareholders. Shareholders would be notified in the semiannual reports that this information is available on EDGAR.

We believe that this more frequent disclosure will enable investors to make better asset allocation decisions, and will allow for greater scrutiny of the composition of fund portfolios and portfolio management techniques. However, the release also asked for comments on issues such as the nature and magnitude of any potential costs of free-riding that may result from more frequent disclosure of portfolio holdings and the extent to which these proposals could impose costs resulting from predatory trading practices, such as front-running.

This proposed rulemaking has other initiatives designed to keep investors better informed. For example, funds would be required to include in shareholder reports a tabular or graphic presentation of a fund's portfolio holdings by identifiable categories and to include Management's Discussion of Fund Performance in its annual report shareholder reports. In addition, in an effort to simplify disclosure, a fund would be permitted to include a summary portfolio schedule in these reports to shareholders, provided the complete portfolio schedule is filed with the Commission and made available to shareholders on request without charge.

The release asked for comments on several questions, such as whether in fact the proposed disclosure would be an appropriate means to provide investors with comparative cost data and whether there are better vehicles than the annual and semiannual reports to communicate this information. Of course, the devil is always in the details. However, I believe that soon we will be in a position to recommend that the Commission adopt a shareholder reports rule and a compliance rule that provide greater protection to investors, while avoiding unnecessary compliance burdens for funds and their advisers.

D. Hedge Funds

I'd like to now touch on the Commission's review of hedge funds. Organizations that track hedge funds indicate that assets invested in these vehicles have increased from approximately $50 billion at the end of 1990 to approximately $650 billion today. Insurance companies recently have shown interest in including hedge funds as investment options for their variable insurance products. While the amount of variable product assets invested in hedge funds is a small percentage of total assets in variable products and is limited at this point to unregistered products, some observers suggest it could grow quickly.

It is easy to understand the attraction of these funds, which often employ market neutral investment strategies, given the recent past performance in the equity markets. It was recently reported, for example, that the average equity stock fund lost over 22 percent in 2002, while the average hedge fund was able to earn positive returns in the same period, of slightly over three percent.

Of course, 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, except to the extent of the anti-fraud provisions, most hedge funds are not subject to Commission oversight under the federal securities laws. In addition, the growth in hedge funds unfortunately has been accompanied by fraud on the part of some hedge fund managers.

The growth of this sector raises a question as to whether there should be greater oversight and accountability of hedge funds and their managers in order to identify problems early before they develop into disasters. As many of you may know, the Commission just last month brought these questions into focus by hosting a two-day public roundtable discussion of hedge funds and related regulatory issues. Discussions focused on key aspects of hedge fund operations, how they are structured and marketed, the investment strategies they use and how they impact our markets, how hedge funds are regulated, and whether the regulatory framework should be modified. The staff is analyzing the information it has gathered and is in the process of determining whether to recommend to the Commission changes in the regulatory landscape for hedge funds. It is my hope that we will be able to provide a report to the Commission of our findings sometime in the near future.

E. Upcoming Rulemakings

In addition to the initiatives I've mentioned affecting the fund industry generally, we are also considering other rulemaking initiatives that relate specifically to variable products.

One relates to substitutions of funds. As you know, section 26(c) of the 1940 Act provides that the depositor of a unit investment trust, such as an insurance company separate account, cannot substitute the underlying investment it holds, unless the Commission has approved the substitution. To do so, the Commission must find that the substitution is consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the 1940 Act.

We continue to get a number of substitution applications filed by insurance companies seeking to change underlying funds held in separate accounts. In reviewing the applications, we consider various factors, including the reason for the substitution, comparability of investment objectives and policies, as well as a comparison of fees and overall expense ratios, and others.

Except in cases where the applicant is unaffiliated with the substitute fund and net overall expenses of the substitute fund are no higher than those of the replaced fund, we generally will not approve an application unless the applicant undertakes to cap expenses of the substitute fund at a level that is no higher than the net expense ratio of the replaced fund for some period of time. In addition, if the insurance company has an interest in the transaction, by ownership of the adviser or by virtue of new or higher 12b-1 fees, revenue sharing, or other benefits of the transaction, we generally will not approve a substitution involving increases in advisory and/or 12b-1 fees, unless the increase has been approved by shareholders.

We are considering whether it would be appropriate to recommend to the Commission a new exemptive rule permitting certain types of substitutions. We recognize that this would be a welcome development from the industry's perspective, and would also free up valuable staff resources for other important work.

Another variable products initiative deals with the prohibition in Rules 6e-2 and 6e-3(T) on what has become known as mixed and shared funding - that is, funds underlying separate accounts for both variable annuity and variable life contracts, and separate accounts of two or more unaffiliated investment companies.

At the time these rules were promulgated there was some concern that conflicts of interests among different classes of shareholders might arise in the administration of the funds underlying separate accounts funding variable life contracts. Accordingly, in considering applications requesting relief from this prohibition, we have developed certain standard conditions designed to address potential conflicts of interest.

These conditions are geared toward monitoring for potential conflicts, providing notice to the board in case of a conflict, and assuring that steps are taken to remedy any conflict that arises. For example, one such remedy could be withdrawing the assets from the underlying fund and reinvesting those assets in another investment medium.

The Commission has now issued over a hundred of these orders and, as some of you know, the exemptive process has become quite routine. Meanwhile, many have questioned whether any conflicts have actually arisen in the circumstances contemplated by the rules.

Based on this history, we are currently considering recommending to the Commission a rule that would obviate the need for individual exemptive relief. As part of this deliberation, we are also considering what conditions would still be relevant to providing relief from the prohibition in the rules.

IV. Industry Actions

I'd like to come back at this point to something I mentioned earlier, namely that our oversight depends in large measure on the quality of your efforts in ensuring compliance with the law. You are in a better position than we are to question and stop irresponsible practices before they harm investors and cause a black eye for the industry. And, just as importantly, it is in your own best interests to police and root out practices that are not in the best interests of investors.

As I have mentioned before at this conference, issuers of variable products can and should be involved in the process of ensuring suitable sales of their products. This is particularly true where the insurer is affiliated with a selling broker-dealer.

A recent NASD proceeding is illustrative of this point. In this case, the NASD took action against a broker-dealer for failure to have adequate procedures in place to handle customer complaints relating to sales of variable annuities. In this matter, the affiliated insurance company received all customer complaints, not its affiliated broker-dealer, with the result that the broker-dealer was unable to report all complaints to the NASD as required by NASD rules. Here, the insurance company was in a position to establish, and should have established better procedures to assure that all complaints were being handled appropriately and in accordance with NASD guidelines.

Sales abuse is a high enforcement priority for both the Commission and the NASD. Just recently, the NASD issued an investor alert to prospective and existing variable annuity owners. This alert provides guidance as to when a purchase or an exchange is or is not suitable, and it warns investors to check the background of the broker offering the sale or exchange of the annuity. In addition, NASD arbitration panels have recently imposed large fines in several matters, one involving suitability issues in the sale of a variable annuity by a large wire house, and the other involving fraud and gross negligence in the exchange of a variable annuity.

I do not mention these examples to suggest that insurance companies should assume the broker-dealer's traditional role of establishing suitability at the point of sale. However, I do believe it is important that insurance companies should do all they can to instill a culture of compliance throughout the organization, and to monitor their sales networks with regard to these matters, particularly in the case of broker-dealer subsidiaries engaged in the sale of their products.

In addition to being vigilant in your compliance efforts, I want to encourage you to do all you can in the area of investor education. As the investment environment changes and, correspondingly, your products continue to evolve, I think that educating investors is a challenge that will require a continuous and concerted effort from all of us.

V. Conclusion

It has certainly been a very challenging period for you and for us since the regulatory affairs conference last year. The coming months are likely to be equally challenging in view of the current investment climate for variable products, changes in the tax law and regulatory challenges. I can assure you that the Commission will continue to stand by as a resource for you as you grapple with how best to respond to these changes.

We look forward to working with NAVA on these issues and to working with member companies directly. Once again, I thank you for your attention and thank you for your continued dedication to serving America's investors.



Modified: 06/24/03