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U.S. Securities and Exchange Commission

Speech by SEC Staff:
The Exciting World of Investment Company Regulation

Remarks by

Paul F. Roye

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

Before the American Law Institute/American Bar Association
Investment Company Regulation and Compliance Conference

June 14, 2001

The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the staff of the Commission.

I. Introduction

Thank you and good morning. It is a pleasure to be here with all of you today as you begin a review of the regulation of investment companies. Welcome to the world of the Investment Company Act of 1940 - or as practitioners often call it: the '40 Act. While preparing for this conference, I found an old Investment Company Act outline that stated nothing is more frightening to the corporate and securities practitioner than addressing issues in the specialized world of the '40 Act. For those of you who don't consider yourselves to be '40 Act practioners, let me assure you that after the next 3 days, you should be able to at least identify when you have a '40 Act issue and you should know how to proceed without the need to grab for a bottle of Tums!

If you took a securities regulation course in law school, more than likely the course covered the Securities Act of 1933 and the Securities Exchange Act of 1934. Somewhere in the textbook there may have been a fleeting reference to the Investment Company Act of 1940, with a statement that review of the statute was beyond the scope of the textbook. But we are here to tell you that indeed the '40 Act merits its own textbook and probably should be given more attention in law schools today because of the importance of the investment company industry to the American economy.

Today, investment companies, which are vehicles for the pooling of capital to invest in securities, are one of America's primary savings and investment vehicles. Over 50 million U.S. households -- that's over 51 percent of all households -- today own mutual funds. Mutual funds, which are the largest segment of the investment company industry, have over $7 trillion in assets under management, exceeding by approximately $4 trillion the amount on deposit at commercial banks and surpassing the total financial assets of commercial banks, currently $6 trillion. Since 1990, the percentage of U.S. retirement assets held in mutual funds has more than tripled. At the end of 2000, there were over 33,000 investment company portfolios, managed or sponsored by over 1000 investment company complexes. Closed-end funds, exchange traded funds, variable insurance products, unit investment trusts, venture capital funds, private equity funds and hedge funds also have become popular investment options among investors. All of these investment vehicles raise issues under the '40 Act.

The great securities law scholar, Louis Loss, described the '40 Act as the most complex of the federal securities laws. This is because the reach of the '40 Act extends beyond disclosure and reporting requirements, which are the foundations of the federal securities laws. The '40 Act is, in effect, a comprehensive corporate statute. It places substantive restrictions on virtually every aspect of the operation of investment companies: their governance and structure; their issuance of debt and senior securities; their investments, sales and redemptions of their shares; and, perhaps most significantly, their dealings with service providers and affiliates.

Through an outstanding faculty, you will be receiving an excellent introduction to the nuts and bolts of the '40 Act. So I thought I would first set the context for your review of this area by providing you with some historical background regarding the statute, the role of the SEC in administering the statutory provisions and then discuss some current regulatory issues and developments that you may find of interest.

II. Background on Investment Company Regulation

The origin of the U.S. investment company industry can be traced back perhaps most directly to the English common law, which developed the institution of the trust, which put the trustee in the position of the manager of other persons' property. Investment trusts have existed in England since the late 19th century.

It is important to note that the turbulent, early history of the investment company industry in the U.S. is a primary source of the principles reflected in the '40 Act. The story essentially begins in the Roaring `20s. State law restrictions on companies owning shares of other companies had fallen, thus opening the door to a boom in the investment company industry. World War I was over; business was booming; and Wall Street was thriving. There was an increasing interest in securities, generally ascribed by some to the Liberty Bond and Victory Loan drives during World War I. Investors of modest means were looking to cash in on a roaring stock market and investment companies were offering a means of pooling funds to provide for diversification, economies of scale and professional management. Most investment companies were closed-end funds. This means that shareholders did not have a right to redeem their shares based on the value of the fund's net assets. Shares of these funds traded in the secondary market at market prices. Many of these companies were sponsored by, and affiliated with, investment houses. These investment houses seemed to have the magic touch with regard to investments, creating a tremendous demand for securities of investment companies affiliated with them. These funds were the vehicle for the average investor to participate in the attractive returns generated by these investment houses. And before the market crash of 1929, shares of these closed-end funds frequently traded at a premium to the funds' net asset values. After the crash, not surprisingly, the supply of shares of closed-end funds exceeded the demand, and their shares began trading at a discount.

This liquidity crisis aided the emergence of two other kinds of investment companies: the unit investment trust, which held a fixed portfolio of securities, and the open-end managed fund, now known as the mutual fund. Shareholders were attracted to these types of funds because they offered the ability to redeem shares for cash at the funds' net asset values.

Edward G. Leffler, one of the founders of the first open-end fund, Massachusetts Investors Trust, was asked about the theory that motivated the formation of the fund and he answered as follows:

From my experience I came to the conclusion that an investor needed three things in his economic life. I felt in order of importance he probably needed insurance first; second, he needed a reasonable rainy day bank account; and I felt the savings banks we had in this country provided the first and our insurance company provided the second, or perhaps vice versa. Then a man had gotten to a point in life where he could become an investor there was really no sound investment medium available for him; the best he could do was to buy an individual stock or individual bond, and it did not work very well. In some of my studies the English investment trust had been called to my attention. I found the investor would invariably buy the wrong stock because he wanted a high yield. I came to the conclusion that that was unsound. So it was a question of providing a medium for the investor. I believed it could grow into a tremendously large business, because if you were going to ask the average individual the simple question: "What can I do for you?" that you would more than anything else be convinced that he would probably answer, "Help me to get somewhere financially." So it seemed to me I had at least a very large potential market. Out of that grew the idea of the Massachusetts Investors Trust.

Needless to say Mr. Leffler was prophetic in spite of the fact that some were skeptical and critical of investors in investment trusts. An article in the April 28, 1928 edition of the Saturday Evening Post stated:

"No human being is more lazy than the investor; he will go to almost any length to avoid making up his mind. His one desire is to shift responsibilities, to pass the buck. So when individuals with money to invest first begin to read about the marvels of the investment trust, they went to their brokers, bond houses, banks and trust companies and inquired about this or that offering which they had seen advertised."

The author of the article obviously was of the view that each investor should have the expertise, as well as the time, to manage their own securities portfolio. Today, he would be a big proponent of online trading.

With the exception of disclosure requirements and anti-fraud requirements, the fund industry managed to grow without effective regulation. By the mid-1930's, it had became apparent that there were problems prevalent in the investment company industry. The close relationships between investment companies and their sponsors proved disastrous as a group of unscrupulous sponsors treated fund assets as their own. Many funds failed, and many shareholders lost their investments. The SEC estimated that between 1929 and 1936, investment company shareholders lost 40 per cent of their investments.

In 1935, Congress asked the Commission to conduct a comprehensive study of the investment company industry, looking specifically at the functions and activities of investment companies, their corporate structures and their investment policies. Congress also wanted to know how investment company sponsors and affiliates exerted influence over the investment companies they controlled. The resulting report, called the Investment Trust Study, laid the foundation for the '40 Act.

The Investment Trust Study, and the subsequent Congressional hearings, found that, to an alarming extent, investment companies were being organized and operated to benefit the interests of their affiliates rather than the interests of their shareholders. The highly liquid nature of fund assets made them easy targets for embezzlement by affiliates, who often viewed them as a source of private capital. Transactions between investment companies and their affiliates, which were expressly permitted to allow investment companies to participate in the business dealings of affiliated financial firms, often resulted in improper transactions. Underwriters found it convenient to dump into the portfolios of affiliated funds securities that they found to be unmarketable.

Furthermore, investment companies were structured to ensure that they remained under the control of their sponsors. The directors of investment companies typically were affiliated with the sponsor. Sponsors were able to control a number of investment companies by organizing them into layers. One fund would invest in another, which would invest in another, enabling the sponsors to control the resulting pyramid with a minimum investment of capital.

Fund managers usually had few restrictions on the types of securities they could purchase, and often-invested fund assets in whatever securities would best benefit the fund's sponsor. The Study and subsequent hearings also revealed that the capital structures of many investment companies were highly complex, often consisting of many classes of securities with different dividend, liquidation and voting rights. Often the fund sponsor owned a class of shares with senior voting rights, enabling it to control the fund at the expense of common shareholders. This complex capital structure led to investor confusion and conflicts of interests among the various classes of securities. In addition, investment companies often issued debt securities without adequate assets and reserves. This excessive leverage often led investment companies to make risky investments to produce the income needed to cover their obligations. Finally, the fact that investment companies generally attracted small, unsophisticated investors allowed sponsors to mislead these investors as to the actual nature of their investment. These investors often did not understand their rights, the sales charges they were obligated to pay, or how the investment company's manager was managing the company's assets.

In short, a number of fund sponsors abandoned their fiduciary obligations and acted without regard to any stewardship on behalf of fund investors. Some suggested that the whole investment company industry was a parasite upon the stream of industrial earnings, levying a toll upon the yield of blue chip companies, resulting in unnecessary administrative costs and taxes that were not economically justified.

It is fortunate for our economy and millions of investors that Congress, the Commission, and the investment company industry worked to address these problems, rather than listen to those who advocated shutting down the industry. The resulting legislation - the Investment Company Act of 1940 - was truly a negotiated statute, with extensive hearings before Congress, punctuated by intensive discussions between the Commission and the industry. Concepts embodied in the Investment Company Act were borrowed in particular from the Public Utility Holding Company Act of 1935, the Securities Act of 1933, the Securities Exchange Act of 1934, the Chandler Act (which regulated the reorganization of companies in bankruptcy), the banking laws, including the Glass Steagall Act provisions and, strangely enough, the Civil Aeronautics Act. However, there were issues involving investment companies for which there was no precedent and the '40 Act reflects in various areas novel approaches to these problems.

The U.S. Congress enacted the Investment Company Act to address these abuses in the investment company industry, assure investor protection, and preserve the important role investment companies play in capital formation.

III. Provisions of the Investment Company Act

The Investment Company Act imposes significant requirements on the organization and operation of investment companies, reflecting Congress' view that disclosure alone would not cure the abuses it found in the industry in the 1930's. The heart of the Investment Company Act is Section 17, which prohibits a wide array of investment company insiders from using the investment company to benefit themselves to the detriment of the company and its shareholders. Section 10(f), which prohibits an investment company from purchasing securities that are underwritten by a syndicate containing an investment company affiliate, also is important.

The '40 Act also contains provisions relating to investment company governance. One of the more significant of these provisions requires that at least 40 percent of an investment company's board of directors not be, in the terminology of the Act, "interested persons." These directors must be independent of the investment company, its investment advisers, and its principal underwriter. Other significant provisions govern the procedures by which investment company shareholders or boards of directors (including a majority of independent directors) approve or renew investment advisory and underwriting contracts; generally prohibit investment companies from having complicated capital structures; limit their use of leverage; authorize the Commission to examine investment company books and records; require investment companies to provide full and accurate information through periodic reports to the Commission and to shareholders; and require consent of the shareholders for certain changes in an investment company's operations.

IV. Adapting to Change

Since 1940, the '40 Act has proved to be remarkably resilient. Its drafters understood that markets and circumstances change, and that industries evolve. Consequently, Congress gave the Commission express authority to exempt any person, security, or transaction from any section of the Act - consistent with the protection of investors. This authority makes the '40 Act flexible and allows it to accommodate change and innovation in ways that preserve its underlying principles. This flexibility has permitted the development of money market funds, variable insurance products, expanded international investing, and unique exchange-traded products that serve particular investor needs.

V. Role of SEC Offices and Divisions

My Division of the SEC, the Division of Investment Management, is responsible for administering and interpreting the provisions of the `40 Act.

In applying the statute and regulations of the '40 Act to the investment company industry, we work to improve disclosure and minimize risk for investors, without imposing undue costs on investment companies. As part of these functions, the Division staff interprets the '40 Act and underlying regulations for the public and our inspections and enforcement staffs; responds to interpretive and exemptive questions; reviews investment company disclosures and filings; and develops new rules to adapt the regulatory structure to new circumstances and products. We are greatly assisted in our efforts to protect investment company investors through the efforts of other Offices and Divisions of the SEC, particularly our Office of Compliance Inspections and Examinations and the Division of Enforcement. We work closely with these two groups in our endeavors to protect investment company shareholders.

A. Office of Compliance Inspections and Examinations

Our Office of Compliance Inspections and Examinations, or OCIE, conducts the SEC's examination program of investment companies and investment advisers. OCIE seeks to conduct at least one inspection during a five-year period of every fund complex. They conduct inspections to foster compliance with the securities laws, to detect violations of those laws, and to keep the SEC informed of developments in the investment management industry. One of the most important objectives of this program is the quick and informal correction of compliance problems. Approximately 90-95% of inspections result in the issuance of a deficiency letter. Violations that appear too serious for informal correction are referred to our Division of Enforcement.

B. Division of Enforcement

Our Division of Enforcement investigates possible violations of the securities laws and, when appropriate, recommends that the SEC file enforcement actions, either in a U.S. federal court or in an administrative proceeding. While the SEC has civil enforcement authority only, we work closely with various criminal law enforcement agencies throughout the country to develop and bring criminal cases when the violations warrant. SEC enforcement actions serve as a significant deterrent to those who would consider violating the securities laws, since the SEC can seek injunctions, cease and desist orders, suspension or revocation of licenses, bars from association with the industry, and monetary penalties.

VI. Current Developments

During the course of this conference, you will undoubtedly hear references to a number of rulemaking actions that the Commission recently has taken in the investment company area, including the Commission's fund governance rules, disclosure of mutual fund after tax returns, the investment company names rule, privacy regulations and the new electronic record keeping rules. However, I thought it would be helpful to you if I reviewed some of the major issues that are likely to be on the Commission's agenda in the coming weeks and months.

A. Valuation

One of our current concerns is valuation. Valuation is extremely important for mutual funds because they must redeem and sell their shares to the public at net asset value. If fund assets are incorrectly valued, fund investors will pay too much or too little for their shares. In addition, the over-valuation of a fund's assets will overstate the performance of the fund, and will result in overpayment of fund expenses that are calculated on the basis of the fund's net assets, such as the fund's investment advisory fee.

The Investment Company Act requires funds to value their portfolio securities by using the market value of the securities when market quotations for the securities are "readily available". When market quotations are not readily available, the `40 Act requires fund boards to determine, in good faith, the fair value of the securities.

Fund management should ensure that appropriate operational procedures and supervisory structures are in place with respect to both "market value" and "fair value" determinations. Funds typically obtain most of their pricing data from third party sources, such as pricing services and dealers. But even prices provided by third parties should be subject to appropriate controls. Controls should be incorporated at each level of the valuation process. Periodic crosschecks of prices received from pricing services should be conducted. These crosschecks should generate red flags when there are questions regarding the reliability of prices.

Unfortunately, the Commission has recently had to seek a receiver for three funds as a result of valuation issues. In SEC vs. Heartland Group, Inc., the SEC filed a complaint in federal court and obtained an order of permanent injunction against the Heartland group enjoining them from violation of the Investment Company Act. The order also freezes the assets of these mutual funds and provides for the appointment of a receiver to take control of the assets of the funds, manage the funds, suspend redemptions in the funds and, if appropriate, liquidate the funds.

Specifically, the Commission's complaint alleged that the Heartland Group failed to send an annual report for three funds' to shareholders, and failed to file the report with the Commission in the time allotted under the federal securities laws. The Commission's complaint further alleges that the failure was due to Heartland Group's inability to obtain audited financial results for the three funds for fiscal year 2000, due to Heartland Group's independent public accountant's concerns regarding the underlying valuations of the securities held in the funds. The complaint further alleges that while the auditors had commenced an audit of the funds, they stated that they would disclaim any opinion as to the value of the securities held by the funds during fiscal year 2000. As a result, shareholders of the funds were being deprived of statutorily required fundamental financial information upon which they could base a decision to remain invested, or to redeem shares in the funds.

The Commission has also recently sanctioned a closed-end fund and its directors in connection with the valuations of restricted securities held in the fund's portfolio. The Rockies Fund held both restricted and unrestricted shares of a particular issuer. While the fund's prospectus stated that restricted securities would be valued at a discount from the fair market value of similarly publicly traded securities, the restricted shares in fact were valued using the bid prices for the unrestricted securities. The administrative law judge found no evidence that the fund's directors engaged in a good faith effort to arrive at fair value of the securities as required by the '40 Act.

Recently, we issued a letter to the ICI that provides guidance on firms' obligations to fairly price foreign securities. This letter follows up on our December 1999 letter on valuation related issues. This new letter focuses on the need for funds to avoid dilution of its long-term shareholders by those seeking arbitrage opportunities that may arise when significant events occur in foreign markets. Funds generally calculate their net asset values by using closing prices of portfolio securities on the exchange or market on which the securities principally trade. Many foreign markets however operate at times that do not coincide with those of the major U.S. markets. As a result, the closing prices of securities that principally trade on foreign exchanges may be as much as 12-15 hours old by the time of a Fund's NAV calculations and may not reflect the current market value of those securities at that time. In particular, the closing prices of foreign securities may not reflect their market values at the time of a fund's NAV calculation if an event that will affect the value of those securities has occurred since the closing prices were established on the foreign exchange, but before the fund's NAV calculation. Dilution of the interests of a fund's long-term shareholders could occur if fund shares are overpriced and redeeming shareholders receive proceeds based on the overvalued shares. The risk of dilution increases when significant events occur because such events attract investors who are drawn to the possibility of arbitrage opportunities. Fair value pricing can protect long-term fund investors from those who seek to take advantage of funds as a result of a significant event occurring after a foreign market closes. The letter highlights a fund's obligation to monitor events that might necessitate the need to use fair value pricing to protect fund shareholders.

B. Portfolio Pumping and Window Dressing

We are also concerned about two practices that apparently go on to some extent in the investment management area - "portfolio pumping" and "window dressing". Portfolio pumping is the practice of increasing a fund's stake in portfolio securities at the end of a financial period solely for the purpose of fraudulently driving up the NAV of the fund. Academic studies have suggested that the practice goes on in the fund world.

Our Office of Compliance Inspections and Examinations formed a task force to look into the practice. The Task Force analyzed trading data of various registrants that might indicate manipulation. Earlier this month, the Commission filed fraud charges against a hedge fund manager alleging market manipulation and portfolio pumping. Among other things, the Commission charged that the investment manager manipulated the value of the common stocks of an OTC bulletin board company in which the hedge fund held an interest at the end of each month during the last five months of 2000. The Commission also alleged that the investment manager caused approximately $2.4 million in fund redemptions to be made at inflated values for its benefit and to the detriment of the fund's other investors.

We also are concerned about the misleading practice known as "window dressing". Here, advisers buy or sell portfolio securities at the end of a reporting period for the purpose of misleading investors as to the securities held by the fund, the strategies engaged in by the advisers or the source of the fund's performance. For example, an adviser may cause the fund to hold significant positions in securities that are not permitted under the fund's disclosed investment objectives. As the reporting period draws near, the adviser liquidates these positions to come into compliance with its stated objectives. OCIE is examining trading patterns to detect violations in this area. We view this as an antifraud violation. Investors are misled if they are told that the fund is investing consistent with prospectus disclosure when it is not.

Window dressing may also occur when an adviser replaces investments in otherwise permissible securities with investments in high performers just before the end of a reporting period to make it appear as thought the adviser had a winning hand.

We hope that funds have appropriate controls in place to prevent these abusive practices.

C. Conflicts Generated by New Business Opportunities

As many mutual fund managers look to generate revenues by expanding into other areas of the investment management business such as offering private accounts or sponsoring and advising hedge funds and other alternative investment vehicles, they should be mindful that certain of these new opportunities raise conflict of interest issues and the potential for abuse.

Management arrangements for hedge funds can be structured to enable portfolio managers to participate directly in the profits generated by the funds that they manage. The conflicts in these arrangements result from the differing fee structures of hedge funds and mutual funds, and the fact that greater profits can be earned by the adviser from the performance based compensation of a hedge fund. The differing fee structures create a risk of favoring a hedge fund over a mutual fund when allocating trades. Conflicts can also arise when a hedge fund effects short sales of securities, if such securities are held long by mutual funds managed by the same advisory firm. Such trades could adversely affect long positions held by mutual funds. Or mutual fund trades could be used to benefit a hedge fund, when mutual fund long positions are sold after the hedge fund sells the same security short. We expect firms to have compliance procedures in place to address these concerns.

We also are monitoring carefully those mutual funds that are using hedge fund type strategies, such as short selling, the aggressive use of leverage and derivatives or investing in hedge funds. The Investment Company Act imposes limits on the use of these strategies.

D. Improving Shareholder Communications

We continue studying how to simplify and improve shareholder report and financial statement presentations. I believe that management's discussion of fund performance can be improved and should be mandated in the shareholder report. We are also taking a hard look at disclosure of fund portfolio holdings, with the goal of improving the quality of portfolio schedule information. Would a summary portfolio schedule, in lieu of a full schedule, which highlighted a fund's major holdings be more useful to the average mutual fund investor? If an investor wanted the entire schedule, they could request it and it could be forwarded promptly. We are also considering whether tables, charts or graphs depicting a fund's holdings by identifiable categories, such as industry sector, geographic region, credit quality or maturity would convey important information to investors disinclined to read through a standard portfolio schedule. Should we exempt certain funds such as index funds and money market funds from portfolio schedule requirements altogether?

We have received several rulemaking petitions asking us to review the frequency with which portfolio holdings are disclosed. Our consideration of this issue requires us to balance the needs and desires of various types of investors, against imposing undue burdens or causing adverse impacts on funds, such as facilitating "front-running" of the fund or compromising their investment strategies.

We are also exploring in the context of shareholders report improvements, the issue of making mutual fund fees more transparent to investors. Both our SEC Staff Report on mutual fund fees in December 2000 and the General Accounting Office ("GAO") Report on fees in June of 2000 concluded that mutual fund investors could benefit from additional information regarding mutual fund fees so as to heighten their awareness and understanding of these fees and their effects. The GAO recommended that the SEC require mutual funds' quarterly account statements to include the dollar amount of each investor's share of operating expenses. The GAO Report acknowledged, however, that there are advantages and disadvantages to this recommendation and suggested other alternatives for enhancing investor awareness and understanding of mutual fund fees, in view of the additional costs and administrative burdens of such an approach. Recognizing that the compliance cost associated with a new personalized expense disclosure requirement would ultimately be borne by fund shareholders, and may be considerable, we embraced one of the GAO's alternative suggestions, namely, disclosure of the dollar amount of fees paid for standardized investment amounts. As discussed more fully in our Report, we believe that this alternative is likely to achieve the most favorable trade-off between costs and benefits.

While we recognize that fund quarterly account statements are an important source of information, and are provided more frequently than shareholder reports, we nonetheless believe that placement of additional fee information would be more appropriate in shareholder reports, alongside other key information about the fund's operating results, including management's discussion of fund performance. This would allow shareholders to evaluate the costs they pay against the services they receive and encourage investors to consider information about the dollar amount of fund fees in their decision-making process.


Fund advertising is another important area that demands focus. In the year 2000, it was reported that mutual fund companies spent $515 million on advertising - 22 per cent more than they spent in 1999. That surprised industry observers because fund advertising usually declines in market downturns. Another trend that these observers noted is that more ads relied on performance claims. We are pleased to see fund ads these days that while including performance numbers, also alert readers to market volatility and refer readers to web sites and other sources for more current performance numbers. We believe these types of disclosure are constructive for both investors and fund companies and put performance numbers in an appropriate context, serving to temper unrealistic expectations about fund performance.

We are actively considering revisions to our advertising rules and exploring how to promote the use of more current performance information. Rule 482 requires that total return information be calculated as of the most recently completed calendar quarter. Should this calculation be as of the most recently completed month end, or the most current date practicable, to promote currency of the information? Much more information is available to investors today about current fund year-to-date performance, through newspapers and fund websites. Should fund advertisements be required to refer investors to this more current information? In any event, our goal will be to seek to promote in these rule amendments, balance and responsibility in fund advertising.

F.New Products and Technologies

The Internet has spurred a flurry of new products and ways of offering and delivering investment products and investment advisory services. It is incumbent upon regulators to understand these products and monitor their compliance with the federal securities laws.

1. Web-Based Products

The development of so-called web-based baskets of securities has caused some concern in the mutual fund industry. Many of these programs allow investors to purchase and sell baskets of securities over the Internet. The ICI has submitted a rulemaking petition asserting that certain of these products are unregistered investment companies. We are analyzing how these products fit within the federal securities laws. That analysis is principally focused on two issues. First, are these products investment companies as the ICI argues? For us, the answer to that question hinges on whether these products constitute the creation of new securities and result in the creation of an investment company within the statutory definitions. We are not persuaded by arguments that because a product competes directly with mutual funds it should be regulated as a mutual fund. Our determination must be based on our analysis of the statutory provisions defining investment companies.

An issue with some products is whether the promoters of the products should be registered as investment advisers. While some are registered as broker-dealers, there is some amount of advice inherent in creating the baskets of securities that they offer. If that advice is more than incidental to their brokerage business, then they will have to be regulated as investment advisers. We are reviewing how these various products operate and want to make sure they are operating in the appropriate regulatory box.

2. Exchange Traded Funds

We are also focusing on the latest developments in exchange-traded funds, or ETFs, which surged in growth last year. An ETF is a hybrid investment company - it has characteristics of an open-end fund that redeems its shares daily at net asset value and of a closed-end fund whose shares trade on an exchange. An ETF issues and redeems it shares at NAV daily in large aggregations only (e.g. 50,000 share, called "Creation Units"). Creation Units are usually bought and redeemed in kind (i.e. in exchange for a basket of securities specified by the ETF sponsor that generally reflects the ETF's portfolio). Individual shares of the ETF trade on an exchange at market prices. This hybrid structure was designed, among other things, to create arbitrage opportunities that would keep the market price close to NAV.

The hybrid structure of an ETF requires exemptive relief from various provisions of the '40 Act (e.g. to permit issuance of shares that are not individually redeemable and to permit secondary market trading in the shares). ETFs generally are perceived as offering the benefits of index investing at a low cost, with trading flexibility and tax efficiency.

Some 80+ ETFs currently trade on the AMEX, totaling over $65 billion in assets. And during the 4th quarter of 2000, the $26.8 billion that flowed into ETFs nearly equaled the $29.6 billion that went into mutual funds. Each of the products approved thus far has been based on an equity securities index. We currently have pending an application for a bond index ETF and there are those trying to figure out how to structure an actively managed ETF. The prospect of actively managed ETFs raises many issues including how to achieve enough transparency of the Fund's portfolio to permit the arbitrage discipline to function so as to keep the market price of shares close to the fund's net asset value. I anticipate that the Commission will soon publish a concept release regarding actively managed ETFs. Our goal will be to generate comments so we can gain a better understanding of the various perspectives on the issues surrounding actively managed ETFs. We then will be able to better evaluate any proposals for these types of products as they are presented to us through the exemptive process on a case-by-case basis.

G. Affiliated Transactions

As the financial services industry undergoes consolidation on a global scale, we are increasingly being called on to keep up and provide flexibility in the area of affiliated transactions. As we have in the past, we remain open to dealing with a variety of issues relating to transactions between funds and their affiliates on a case-by-case basis through exemptive orders. We recognize that there are areas where the restrictions on affiliated transactions no longer make sense, or that with the appropriate conditions and safeguards should be allowed to proceed. To the extent possible, we have also tried to provide flexibility with regard to affiliated transactions through the no-action and interpretive letter process. We have been asked by some to look at the possibility of expanding the scope of existing rules and the adoption of new rules to provide additional relief in this area. But any rule amendments in this area must first recognize that Section 17 is the heart of the '40 Act and any changes must be tested against the possibility of abuse and cannot compromise investor protection.

VII. Conclusion

Hopefully, this overview of investment company regulation and some current Commission concerns and initiatives will pique your interest in the many significant topics that will be discussed at this conference. As you will hear, the regulation of investment companies involves more than just the '40 Act. Investment companies are subject to the disclosure and reporting requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934. In addition, advisers to investment companies are regulated under the Investment Adviser Act of 1940. You also have to worry about provisions of the Internal Revenue Code, ERISA and the Commodity Exchange Act. All of this makes the regulation of investment companies one of the most exciting and intellectually challenging legal practice areas today. I hope you enjoy the conference.

Thank you.



Modified: 06/22/2001