Speech by SEC Staff:
Remarks Before the Society of American Business Editors & Writers Conference on Personal Finance

by Paul F. Roye

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

Las Vegas, Nevada

November 8, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

Thank you and good morning. It is a pleasure to be at your Conference on Personal Finance, although I’m not sure being in Las Vegas will be good for any of our own personal finances, if we yield to the temptations surrounding us.

As you all know, the investment management industry has experienced tremendous growth in recent years. From 1988 to 1998, total assets under management by federally registered investment advisers grew from $4.4 trillion to $15 trillion, an increase of over 240 percent. The mutual fund industry also has witnessed tremendous growth, with over $6 trillion invested in mutual funds, up over 580 percent between 1988 and 1998.

Our mandate at the Commission and the Division of Investment Management is, of course, the protection of investors. As the industry continues to grow, our job of protecting investors becomes more difficult; not only because of the sheer number of investors in investment management products, but also because investors are bombarded with information from new avenues of communication such as cable news programs and the Internet. In today’s investment world, investors not only can access information about their investments instantly, they also can trade instantly on-line, and purchase, redeem or exchange fund shares in a few keystrokes.

A key component of protecting investors is educating them. This becomes more of an imperative given the ease today with which investors can effect securities transactions. Chairman Levitt has made investor education a priority at the Commission. We endeavor to educate investors through a variety of means. Our Office of Investor Education issues investor education information through publications and by posting information such as Investor Alerts and Frequently Asked Questions about various topics on our Internet site. Tools like our Mutual Fund Cost Calculator allow investors to analyze the impact that costs can have on their investment returns and compare funds with different load and expense structures. However, we are not able to reach investors with the immediacy and in the shear numbers that you are. While we had approximately 6.5 million visits to our website last week, your combined weekly circulation is in excess of 200 million people. Consequently, I would like to indicate to you that we truly value your efforts to keep investors educated about advances (and perils) in the investment management industry.

We at the Commission envy and applaud your ability to address and educate investors on topics of interest regarding mutual funds and other investment management products. Our budget and resources are limited so we cannot be everywhere; we cannot see everything.

You, however, are at the forefront of identifying innovations, trends and problems in the investment management industry. Through your reporting, you probe issues that present themselves at the very earliest stages. Through your articles, analyses and critiques, you provide us with a gauge as to what issues investors are likely to find important. In some instances, you are able to highlight important events, innovations and trends that are not immediately identifiable by us. You also monitor the financial markets and focus on issues and concerns that are important to investors. In this way, we are able to use your work to take the temperature of the investing public. Your work also serves as an indicator of where we should focus our efforts.

You also serve a role in warning investors of some of the perils that can be associated with investing in certain products. Because we are regulators, and must conduct our activities within a statutory scheme, we cannot address every potential issue that is on the horizon. We must operate within the framework established by Congress set forth in the federal securities laws. When new products or ideas or even gimmicks come along, it generally is not our job to pass on the merit of those innovations. Rather, our role is to ascertain whether the idea is permitted within the regulatory framework and whether investors have the proper information to make a reasoned judgment about the investment. As you know, the federal securities laws largely are premised on the concept of full disclosure -- it is not a "merit" based approach to regulation. The old adage that "sunlight is the best disinfectant" certainly rings true about full disclosure. You have the unique ability to thoroughly examine the merits of the idea or product and report to your readers both the good and the bad aspects of the investment in question. You often have the ability to go farther than we can in shining "sunlight" on bad ideas.

And, yes, you also help us by being a critic of our policies and regulations. Your reporting on Commission initiatives, interpretations, orders and regulations serve as a system of checks and balances on us, thereby not only helping us, but also investors. We may not always like what you report about our initiatives, but we respect and appreciate that you serve an important role in reviewing and analyzing our activities. We also know that in the vast majority of circumstances your reports are professional, thorough and well researched. But, just as we sometimes don’t get it right, there are times when some reporters don’t get it right. (But of course, that doesn’t apply to anyone in this room!)

Before I turn to some of the specific initiatives we are working on in the Division that might be of interest to you and your readers, I would like to emphasize that our goals are somewhat aligned -- for us it is providing investors with clear, concise and thorough information about their investments and protecting their interests; your goals, it seems to me, are the same: providing your readers with complete and accurate information about their investments and the people who manage their money. Given these goals, we collectively have an awesome responsibility, as millions of American investors look to us to guide them and to assist them in safeguarding their interests.

Now I would like to discuss some of the initiatives that we are working on in the Division that you and your readers should find interesting.

Chairman Levitt has made improving the mutual fund governance structure a top priority of the Division. Independent directors play a unique and crucial role in the mutual fund governance structure. Independent directors serve as the "independent watchdogs;" they are charged with protecting fund shareholders, monitoring fund management and overseeing conflicts of interest. Because there are 77 million investors whose livelihoods are now tied to mutual funds, we at the Commission believe that they deserve a fund governance system that enables independent directors to represent investors from a position of strength and power. While the mutual fund industry largely has been free of the abuses and mismanagement that have beset other financial intermediaries, even in these times of tremendous growth, there is no reason to be complacent. Because it has been almost 30 years since significant improvements were made to the fund governance structure, we believe that this is the appropriate time to strengthen the governance structure.

Consequently, we have proposed a comprehensive package of fund governance reforms. Some of the major proposals in the package include the following:

Majority Independence. First we would require that independent directors constitute either a simple majority or two-thirds super-majority of fund boards. We believe that a fund board that has at least a majority of independent directors is better equipped to perform its duties and responsibilities. If a board is comprised of at least a majority of independent directors, it would be able to act without the approval of the adviser and the inside board members, and the dynamics of the decision-making process would be improved. Such an independent board would be better able to exert a strong and independent influence over fund management and oversee areas where the fund’s and its shareholders’ interests might diverge from the interests of the adviser.

Self-Selection and Self-Nomination. We believe that self-selection and self-nomination of independent directors by other independent directors works to create a greater sense of autonomy from management on the part of the independent directors. Directors who are selected and nominated by other directors are unlikely to feel beholden to fund management for their positions and therefore are free to speak their minds, question management and represent investors as their sole concern. This selection and nomination process should give the board an opportunity to consider selecting director candidates that have the right mix of backgrounds, skills and experience to compliment those of existing board members.

Independent Legal Counsel. Another proposal in the package is that any person who acts as counsel to a fund’s independent directors be an "independent legal counsel." Funds are subject to a complex regulatory scheme that includes federal statutory law, SEC rules and regulations and state corporate law. Also, because of their unique external management structure, funds continuously encounter conflicts of interest between the fund and its management. In this complex structure, an independent director is well served by the assistance of legal counsel who truly is independent of fund management.

Too often, however, independent directors rely on fund management to provide them with information, and then they rely on legal advice of counsel who also represents the fund’s adviser, leaving shareholders without an independent filter. Independent counsel is a tool that can facilitate a director performing his or her duties in an informed, competent and diligent manner.

We also provide for audit committees consisting of independent directors to oversee the fund’s internal controls and preparation of the fund’s financial statements. These and other measures in the governance initiatives are designed to provide the independent directors with the tools they need to challenge management if necessary to protect the interests of fund investors.

Disclosure. Another key component of the package relates to disclosure. We believe that shareholders are entitled to know who the independent directors are of their funds, whether those directors’ interests are aligned with shareholders’ interests, whether those directors have any conflicts of interest, and how the directors govern the fund. Today, basic information about fund directors can be found in the fund’s statement of additional information and proxy statements. However, we are concerned that investors do not in all cases have access to significant information about fund directors when they need it. We are concerned that there are gaps in the information that shareholders receive about the directors of their funds. Consequently, we have proposed amendments to our disclosure rules that would require enhanced disclosure about the fund’s board, including public disclosure to shareholders about certain conflict of interest information. We believe that disclosure of conflicts -- including disclosure of positions held with the investment adviser and any securities holdings or material interests in the investment adviser or its affiliates -- will provide the public, including the financial press, access to information about directors’ potential conflicts of interest. The resulting public dissemination may discourage the selection of independent directors who have relationships or engage in activities that raise questions about their independence.

As I just mentioned, one of the key components of the corporate governance package is clear and concise disclosure. As you know, the Commission undertook a major effort to simplify mutual fund prospectuses. We would like to extend that effort and simplify some of the communications received by shareholders from their fund and its management.

Shareholder reports are a potentially effective tool for communication with shareholders that too often is left unused or underutilized. Because shareholders ultimately pay for these reports, we want to ensure that they receive "the most bang for their buck." In a shareholder report, fund management can tell the story of what it has done for shareholders. Our goal will be to facilitate getting that information from management to the fund’s shareholders.

One part of the shareholder report that bears review is the schedule of portfolio investments. This schedule, along with management’s discussion of fund performance, should help an investor understand how his or her fund has been managed. We will review both the quality and quantity of information that goes into the schedule. Our goal is to make the prospectus and the shareholder reports work together to provide information that investors need, when they need it, and in a format that they can use.

In pursuing the goal of meaningful disclosure to mutual fund investors, we are working to develop effective disclosure about the impact of taxes on fund performance. Mutual funds are currently required to disclose in their prospectuses and annual reports information about tax consequences; portfolio turnover; and distributions. However, one component of disclosure that currently is not required to be addressed is the effect of taxes on mutual fund performance.

The Commission staff has been considering whether mutual fund disclosure requirements could be revised to provide investors with a better understanding of the tax consequences of holding and disposing of a fund, the relative tax efficiencies of different funds, and how much of a fund’s reported pre-tax return will be paid out by an investor in taxes. Legislation has been introduced to require the Commission to promote this type of disclosure and we hope to be out in front of any legislation ultimately enacted on this issue.

As many of you have been reporting, Congress has approved sweeping reforms to the financial services laws -- including the repeal of the Glass-Steagall Act. These reforms have the potential of resulting in major consolidation of industries that have been separate for well over 60 years. The consequences of these consolidations will be significant both from the investment management industry’s perspective and from that of the regulators. How will these consolidating industries meet the needs and expectations of investors? What about compliance strategies in a mega-firm that suddenly finds itself more diverse, with divergent practices, conflicting cultures and increasingly complex affiliations?

As banks, insurance companies and securities firms merge, the boards and shareholders of mutual funds will be called upon to take action. For example, in a typical merger, a fund’s board would be called upon to determine whether the transaction produces benefits for the fund and is in the best interest of fund shareholders. A fund board generally must approve the adoption of a new advisory contract since, by law, the existing advisory contracts terminate. It is the responsibility of the fund’s directors to reach a business judgment as to whether the new arrangement contemplated in the new advisory contract and/or distribution agreement is in the best interests of the fund and its shareholders, even in situations where the fund operations are a small part of a mega-merger.

We at the Commission also will be called upon to take action. The Commission strongly advocated provisions in H.R. 10 addressing conflicts of interest and other issues that arise when banks are investment advisers to mutual funds. Consequently, banks or divisions of banks will register with us as advisers, and our examination staff will for the first time be inspecting bank registered investment advisers to funds. These steps are necessary to ensure that the Commission has adequate information about bank investment advisers to inspect for trading violations such as front-running and illegal personal trading. We also will be considering the need for new rules and regulations governing circumstances under which banks serve as custodians or lend to affiliated funds.

Finally, these newly consolidated firms also will bear a great deal of responsibility in developing and implementing compliance programs that blend different cultures. The compliance structure of a bank traditionally has varied from that of an insurance company or a securities firm. An entity that combines two or more of these industries will have to find a way to craft a compliance program that addresses the unique conflicts of interest that can arise in each industry. Inconsistent personal trading policies, conflicting policies governing transactions between affiliates or how these policies are enforced are examples of the problems that may be created by these consolidations. One of our focuses will be to ensure that responsible oversight of compliance systems are a central component of these consolidations.

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These are just a few of the matters we are working on in the Division. In conclusion, I would like to note that in April of this year, Chairman Levitt spoke at the Media Studies Center in New York, where he outlined three steps the media can take to help educate investors. The first step is to work together to raise financial literacy levels through a long-term, national public awareness campaign. The second step is to put the financial literacy message on the "front page" of newspapers and magazines. And the third step is to educate investors and not just titillate them -- that is to report on how to invest wisely and avoid fraud. We believe that you all have done a good job in taking these steps. We call upon you today to continue in that effort. The next several months promise to be an exciting time for you, your readers and us. I’ll now open the floor for questions.

http://www.sec.gov/news/speech/speecharchive/1999/spch316.htm