TESTIMONY OF BARRY P. BARBASH, DIRECTOR DIVISION OF INVESTMENT MANAGEMENT U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING MUTUAL FUNDS AND MUTUAL FUND INVESTORS BEFORE THE SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES, AND GOVERNMENT SPONSORED ENTERPRISES OF THE COMMITTEE ON BANKING AND FINANCIAL SERVICES UNITED STATES HOUSE OF REPRESENTATIVES JUNE 26, 1996 Chairman Baker and Members of the Subcommittee: I am pleased to appear today before the Subcommittee on behalf of the Securities and Exchange Commission ("Commission"). My testimony will discuss the tremendous recent growth of the mutual fund industry in the United States, a joint survey of mutual fund investors released today by the Commission and the Office of the Comptroller of the Currency ("OCC"), and related issues pertaining to the sale of mutual fund shares, including sales of fund shares by banks. A. Introduction: Growth of the Mutual Fund Industry The growth and success of the mutual fund industry over the past decade has been dramatic. It was not until 1986 that total industry assets reached $500 billion. It took another five years for mutual funds to amass another $500 billion. In 1995 alone, by contrast, mutual fund assets increased more ==========================================START OF PAGE 2====== than $600 billion, an increase of over 30%.-[1]- There are now more than 5,800 mutual funds in the United States, more than ten times the number in 1980. Approximately one- third of U.S. households own one or more mutual funds. During the last ten years, financial institutions, including banks,-[2]- have greatly increased their presence in the mutual fund industry. During the late 1980s and early 1990s, the number of banks advising mutual funds, the number of funds advised by banks, and the amount of assets managed by bank advisers increased at a rate much greater than for nonbank funds and nonbank advisers. Much of this increase occurred initially as a result of trust asset conversions. Retail sales of fund shares through banks and fund assets managed by banks continue to grow, although the growth rate recently has leveled off and now is more in line with the growth rate for mutual funds generally.-[3]- As of year- end 1995, the value of assets in proprietary bank mutual funds-[4]- was approximately $400 billion, more than -[1]- All asset figures included in this discussion are taken from the Investment Company Institute's 1996 Mutual Fund Fact Book. -[2]- Unless the context requires otherwise, references in this testimony to banks include bank subsidiaries and affiliates. -[3]- See Yvette E. Kantrow, "Banks Heartened by Gains in Their Fund Assets," American Banker, at 1 (May 13, 1996). -[4]- Proprietary funds are funds managed by a bank or a bank affiliate. Nonproprietary funds are sold by a bank or a bank affiliate but managed by an entity unrelated to the bank. ==========================================START OF PAGE 3====== three times what it was at the end of 1992.-[5]- Also as of year-end 1995, 120 banks advised 2,481 mutual funds, which is roughly 28% of all funds registered with the Commission.-[6]- Banks continue to be active in selling both proprietary and non-proprietary mutual fund shares to the public.-[7]- The rapid growth of bank mutual fund sales over the last several years has raised concerns that bank customers may not fully understand the risks of investing in mutual funds generally, and in particular that shares of bank-advised and bank-sponsored mutual funds are not insured or guaranteed by the federal government. Lending support to these concerns are a number of recent surveys suggesting that the typical U.S. investor is not knowledgeable about financial matters and that -[5]- Lipper Analytical Services, Inc., Lipper Bank- Related Fund Analysis (1996). -[6]- Id. This statistic counts different classes of a multiple class fund as separate funds. A multiple class fund is a mutual fund that issues more than one class of shares, with each class typically subject to a different sales charge structure. An investor in a multiple class fund might have the option, for example, to purchase shares subject to a sales charge at the time of purchase or, alternatively, at the time of redemption. -[7]- Fund assets attributable to bank sales doubled between 1991 and 1994, from $158 billion to $317 billion. Total mutual fund industry assets during the same period increased only 60%. Investment Company Institute Research Dept., FUNDamentals (Sept./Oct. 1995), at 4. ==========================================START OF PAGE 4====== many bank mutual fund customers are unaware that funds sold through banks are not insured against investment losses.-[8]- In light of these concerns, and to provide perspective on regulatory issues arising from the growth of mutual funds, the Commission and the OCC decided early last year to conduct a detailed survey of mutual fund investors. The survey, which was not restricted to mutual fund investors who are bank customers, was designed to obtain demographic information about mutual fund investors and to assess their financial literacy and knowledge of certain risks associated with mutual funds. I will first discuss some of the more significant findings of the joint survey, which will lead me into a discussion of current Commission initiatives that relate to improved mutual fund disclosure and investor education. -[8]- A January 1996 survey commissioned by the Investor Protection Trust and conducted by Princeton Research Associates found that fewer than one-fifth of all individual investors (in stocks, bonds, funds, and other securities) could be considered "financially literate" based on responses to a quiz. A survey released in early 1994 by the American Association of Retired Persons, Consumer Federation of America, and North American Securities Administrators Association, Inc., stated that "the vast majority of American bank consumers are unaware of the risks and fees involved in the sale of uninsured investment products, such as mutual fund and annuities, that are increasingly available at U.S. banks and other financial institutions." Several surveys have found that many banks do not adequately inform their customers about the investment risk of noninsured investment products sold through the bank. See Market Trends, Inc., Survey of Nondeposit Investment Sales at FDIC-Insured Institutions, at 15-16 (May 1996); General Accounting Office, Bank Mutual Funds: Sales Practices and Regulatory Issues, at 5, 29-30 (Sept. 1995). ==========================================START OF PAGE 5====== Finally, I will discuss the regulatory scheme governing the activities of banks in connection with the management of mutual funds and the selling of their shares. B. The Joint Survey of Mutual Fund Investors In August of last year, the Commission and the OCC contracted with Market Facts, Inc., a market research firm, to conduct a survey of mutual fund investors. The nationwide telephone survey of 2,000 randomly selected mutual fund investors collected data on the demographic, financial, and fund ownership characteristics of these investors. The survey examined whether these characteristics varied by the financial intermediary from or through which investors purchased their fund shares. The survey examined six such intermediaries, referred to in the survey report as "distribution channels" -- brokers, banks, mutual fund companies, insurance companies, employer-sponsored benefit plans, and other (including, for example, financial planners). The survey also gathered data on fund investors' familiarity with the costs and certain investment risks associated with mutual funds, the information sources used to learn about mutual funds, and the overall level of fund investor financial literacy. The survey's findings on demographic and financial characteristics of mutual fund investors are generally similar to those described in other recent studies of fund ==========================================START OF PAGE 6====== shareholders.-[9]- The survey found that mutual fund investors, on average, are older, wealthier, and better educated than other Americans. The typical mutual fund shareholder has invested in funds for several years; two- thirds of survey respondents had owned funds for at least five years. Many of the investors surveyed had purchased fund shares through more than one distribution channel. Survey respondents were most likely to have purchased a fund through an employer-sponsored employee benefit plan. The survey results raise significant questions about the financial knowledge of some mutual fund investors. The survey indicated, for example, that: ù fewer than one in six survey respondents understood that higher mutual fund expenses can lead to lower returns;-[10]- ù one-third of the respondents believed that money market funds are insured; ù one-quarter of the respondents did not know that, over time, stock market returns have exceeded the return on U.S. Treasury bills; and -[9]- See, e.g., Investment Company Institute, The Profile Prospectus: An Assessment by Mutual Fund Shareholders, at 24 (May 1996). -[10]- Consistent with this statistic, the level of fund expenses does not seem to be an important factor in the purchasing decision of many mutual fund investors. Fewer than one in five survey respondents was able to provide any estimate at all of the expenses of their largest fund holding. Of those who provided an estimate, many gave estimates that were not in line with typical expenses paid by mutual funds. ==========================================START OF PAGE 7====== ù although the vast majority of those surveyed knew that they could lose money in a stock fund, a substantial minority answered "No" or "Don't Know" when asked whether they could lose money in a bond or money market fund. The survey revealed differences in the level of financial knowledge of mutual fund investors purchasing shares through different distribution channels. In a general quiz of financial literacy included as part of the survey, investors purchasing directly from mutual fund companies scored much higher than those purchasing elsewhere. Investors who purchased funds through brokers also scored well, whereas bank purchasers scored poorly.-[11]- As noted in the survey report, these results do not necessarily indicate that fund companies or brokers do a better job than other intermediaries in educating investors. Rather, the results may simply indicate that more knowledgeable investors make greater use of certain distribution channels than others. More knowledgeable investors, for example, may be comfortable purchasing funds -[11]- That survey respondents who purchased mutual funds through banks had lower quiz scores than respondents who purchased funds through other distribution channels may be a function of the type of mutual fund purchased. According to the survey, bank customers are significantly more likely to own money market funds, and significantly less likely to own stock funds, than investors who purchase funds through nonbank channels. An investor can make an informed decision to purchase a money market fund without knowing the answer to several of the questions posed in the quiz, including questions about the risks of investing in stock and bond funds. ==========================================START OF PAGE 8====== directly from a fund company, whereas less knowledgeable investors (including those who purchase from banks) may seek guidance from an investment professional, such as a banker. The survey's data on sources of information used by mutual fund investors when purchasing fund shares show that investors have mixed views of mutual fund prospectuses. The investors surveyed consulted the mutual fund prospectus more than any other source of information about the funds they purchased. Over 40% of those surveyed, however, indicated that they did not use the prospectus. Moreover, the survey respondents considered the prospectus only the fifth best source of information about mutual funds, behind employer- provided materials, financial periodicals, friends or family, and brokers. The joint survey does not indicate whether any particular financial intermediary does a better job than any other of educating fund investors. The survey does, however, reveal that many fund investors are not familiar with certain basic investment concepts, thus lending strong support to two of the Commission's most important recent initiatives -- improving fund disclosure materials, particularly mutual fund prospectuses, and educating investors, including mutual fund investors. These initiatives are discussed in detail below. C. Improving Mutual Fund Disclosure Materials ==========================================START OF PAGE 9====== The Commission believes that the joint survey results send a strong message that mutual fund prospectuses are an important source of information for many investors, but that more can and should be done to make fund prospectuses more useful to investors. The Commission has heard this message previously and has already undertaken a series of initiatives designed to improve the quality of information provided to mutual fund investors through the prospectus and other materials. The Commission currently is engaged in a high-priority project to reassess core disclosure requirements for mutual funds. The Commission expects to receive a staff proposal within the next several months that will significantly update and improve existing disclosure requirements for funds. The effort will be based in part on the Commission's recent experience with fund profiles and the results of an inquiry into different ways of disclosing risk to fund investors. The Commission's initiatives concerning improved mutual fund disclosure are discussed below. 1. Fund Profiles The Division has worked with the investment company industry and state securities regulators over the course of the last year to develop a "fund profile." The profile, which initially was intended to be used together with a fund's prospectus, contains a brief summary of the fund's key ==========================================START OF PAGE 10====== features in a standardized format designed to facilitate comparison among funds. Over the past ten months, eight fund groups have used prototype profiles and have found investor reaction to the document to be quite positive.-[12]- Earlier this month, the Commission, together with certain insurance companies and insurance company trade groups, began a similar profile project for variable annuities.-[13]- In the coming months, the Commission's staff will consider a series of issues relating to the profile, including whether, in its current form, the profile contains enough information to permit fund investors to make informed investment decisions and whether investors should be permitted to purchase mutual fund shares after reviewing only the profile. The Commission anticipates that the staff's analysis will be completed some time this fall and that thereafter the Commission will issue a rule proposal for public comment relating to the use of profiles by fund investors.-[14]- -[12]- Investment Company Institute, The Profile Prospectus: An Assessment by Mutual Fund Shareholders (May 1996). The eight fund groups are: American Express Financial Corp.; Bank of America N.T. & S.A. (Pacific Horizon Funds); Capital Research and Management Co. (American Funds); The Dreyfus Corp.; FMR Corp. (Fidelity Funds); Scudder, Stevens & Clark, Inc.; T. Rowe Price, Associates, Inc.; and The Vanguard Group, Inc.. -[13]- See Letter from Heidi Stam, Associate Director, Division of Investment Management, to Mark J. Mackey, President and Chief Executive Officer of the National Association for Variable Annuities (June 4, 1996). -[14]- For a recent general discussion of the profile initiative, see Jerry Morgan, "What Profile Best Becomes a Mutual Fund," Washington Post, at H-3 (June 23, 1996). ==========================================START OF PAGE 11====== 2. Improved Risk Disclosure The Commission currently is considering ways to improve investor understanding of mutual fund risk. In March of last year, the Commission issued a release asking for comment on the relative merits of various presentations of risk. The response to the request was most impressive; the Commission received over 3,700 comments, mostly from individual investors. The Commission's staff currently is considering the issue of risk disclosure in the larger context of improving fund disclosure documents. Although no definitive decisions have yet been made, the staff has advised the Commission that it is unlikely to recommend the use of a single quantitative risk measure. At this time, the staff believes that no single quantitative risk measure would serve all fund investors well, and that its goal should not be to find such a measure. Rather, the staff believes its goal should be to foster disclosure formats designed to help investors understand the potential risks and rewards of the funds in which they invest. Among the options the staff is considering to enhance risk disclosure to mutual fund investors is a requirement that every fund include a risk summary in its prospectus focusing on the overall level of risk in the fund's portfolio.-[15]- The staff also is considering amending -[15]- Under existing Commission rules, funds are required to disclose the principal types of investments they (continued...) ==========================================START OF PAGE 12====== existing rules to require a closer correlation between a fund's name and its investment objectives and strategies so that a fund's name presents a clearer picture of its potential risks and rewards. 3. Brochures for Benefit Plan Investors The Commission also is working to improve disclosure to persons who invest in mutual funds through defined contribution employee benefit plans. The Commission has long recognized, and the joint survey confirms, that employee benefit plan participants increasingly are investing their plan assets in mutual funds. The Commission's staff, acknowledging the need of these investors for additional information about their mutual fund investment options, last year approved the use of summary brochures for participants in defined contribution employee benefit plans that invest in funds.-[16]- The brochures briefly describe the key features of the funds that serve as investment options for plan participants. According to research conducted by one -[15]-(...continued) propose to make and the essential risks involved in those investments. See, e.g., Guide 3 to Form N-1A. (Form N-1A is the form on which mutual funds register their shares with the Commission.) This disclosure approach may not provide investors in all cases with sufficient information to understand the overall risks of the fund's portfolio. -[16]- See Letter from Robert E. Plaze, Assistant Director, Division of Investment Management, to Richard M. Phillips, Esq., Kirkpatrick & Lockhart, on behalf of Fidelity Institutional Retirement Services Co. (Apr. 5, 1995). ==========================================START OF PAGE 13====== large fund group, the brochure has been well received by plan administrators and plan participants alike.-[17]- -[17]- See Fidelity Institutional Retirement Services Co., A Quantitative Assessment of 401(k) Plan Administrators' Reaction to a Prototype Summary Mutual Fund Prospectus (Aug. 1995). ==========================================START OF PAGE 14====== 4. Plain English Initiatives The Commission's efforts to improve mutual fund disclosure extend beyond reassessing its existing disclosure forms and considering new approaches. While we are in the process of updating fund disclosure requirements, we are encouraging funds now to produce easier-to-use documents that effectively communicate information to investors. The Commission has worked with and supported the efforts of a number of fund groups to write prospectuses that, both in format and content, are easier for investors to use and understand. A key initiative of the Commission today is to encourage greater use of easier-to-understand language in all disclosure materials. The Commission expects to publish, within a few months, a handbook for companies (including mutual funds) and their lawyers on how to write prospectuses and other disclosure documents in plain English. The Commission will hold workshops for those who design and write these documents, in an effort to make plain English the norm rather than the exception in securities-related disclosure materials. C. Investor Education Initiatives Educating investors has been a central goal of the Commission during the past two years. Chairman Levitt personally has participated in a series of town meetings across the country, offering information on how to invest ==========================================START OF PAGE 15====== wisely and raising investors' awareness of important questions to ask their brokers, bankers, and financial planners before investing. The Commission is in the process of preparing a video on investor rights and remedies, and worksheets designed to help investors determine whether they are saving enough for retirement. We also will be developing a curriculum on personal finance for high school and adult education classes. Among the other recent investor education initiatives undertaken by the Commission are the following: ù The Commission has prepared a set of brochures that explain, in clear and simple language, the basics of investing in stocks and mutual funds. Over 200,000 copies have been distributed so far. ù The Commission has established a toll-free information line to provide free investor information. ù The Commission has established a home page on the World Wide Web that is available 24 hours a day and that offers access to the Commission's database of corporate information on thousands of registered companies. The web site also offers access to the Commission's investor brochures, speeches, testimony before Congress, and press releases. ù The Commission has begun to publish plain English summaries of its significant rule proposals affecting investors. ==========================================START OF PAGE 16====== ù The Commission, with the assistance of the securities industry, has offered 16 seminars on a wide variety of topics of interest to investors, and more seminars are planned. The Commission also is working to help others, such as employer sponsors of employee benefit plans, to educate investors. Late last year, the Commission's staff issued an interpretive letter that enables an employer, without registering with the Commission as an investment adviser, to provide investment-related information to employees who participate in the employer's defined contribution employee benefit plan.-[18]- We anticipate continuing to work in the future with the U.S. Department of Labor and with employee benefit plan sponsors to educate employees about retirement savings. -[18]- See Letter dated December 5, 1995 (and follow-up Letter dated February 22, 1996) from Jack W. Murphy, Associate Director (Chief Counsel), Division of Investment Management, to Olena Berg, Assistant Secretary, U.S. Department of Labor. These letters were issued by the Commission staff in conjunction with an interpretive bulletin published by the Department of Labor. The bulletin provides guidance to plan sponsors and service providers regarding their activities under the Employee Retirement Income Security Act of 1974 ("ERISA"). Under ERISA, any person who provides "investment advice" regarding plan assets for a fee is deemed to be a plan "fiduciary." ERISA imposes duties on fiduciaries in connection with their activities relating to the plan and plan assets, and prohibits fiduciaries from engaging in certain transactions with respect to plan assets. The bulletin clarifies the circumstances in which a plan sponsor or service provider may assist plan participants in making informed investment decisions without being deemed to be providing investment advice regarding plan assets. See Department of Labor Interpretive Bulletin 96-1 (June 11, 1996). ==========================================START OF PAGE 17====== The Commission believes that the education initiatives described above not only will help investors, but also are cost-effective. Underlying the initiatives is the view that it costs taxpayers far less to prevent fraud (by giving investors the information they need to protect themselves) than to investigate and prosecute wrongdoers after they have done their damage. The initiatives also are beneficial because they encourage investors to become more responsible for their investment decisions. E. The Regulatory Scheme Governing Bank Mutual Fund Activities 1. Overview The joint survey, among other things, focuses on the different financial intermediaries that are involved in the sale of mutual funds. As noted above, banks and their affiliates are now major participants in the mutual fund industry, advising and selling a large number of funds. Like all publicly available funds, mutual funds advised and marketed by banks are regulated under the Investment Company Act of 1940 ("Investment Company Act")-[19]-. Banks themselves, however, currently engage in mutual fund activities largely outside of the traditional securities regulatory scheme due to provisions in the federal securities -[19]- 15 U.S.C.  80a-1 et seq. ==========================================START OF PAGE 18====== laws that except banks from regulation thereunder.-[20]- The Commission has testified before Congress on numerous occasions in the past decade regarding the difference between bank and securities regulation and the regulatory gaps engendered by the current regulatory scheme.-[21]- The Commission continues to support the concept of functional regulation, which would bring bank securities activities within the securities regulatory scheme.-[22]- Such an -[20]- Securities Exchange Act of 1934, sections 3(a)(4) and (5), 15 U.S.C.  78c(a)(4) and (5) (excepting banks from the definitions of "broker" and "dealer," respectively); Investment Advisers Act of 1940, section 202(a)(11), 15 U.S.C.  80b-2(a)(11) (excepting banks from the definition of "investment adviser"). -[21]- See, e.g., Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 1062, the "Financial Services Competitiveness Act of 1995," before the Subcommittees on Telecommunications and Finance and Commerce, Trade, and Hazardous Materials of the House Committee on Commerce (June 6, 1995); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning the "Financial Services Competitiveness Act of 1995" and Related Issues, before the Senate Committee on Banking and Financial Services (Mar. 15, 1995); Testimony of Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 797, the "Securities Regulatory Equality Act of 1991," before the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce (Apr. 30, 1991); Statement of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Structure and Regulation of the Financial Services Industry, before the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce (Oct. 5, 1987). -[22]- See, e.g., Chairman Levitt's Testimony on March 15 and June 6, 1995, supra note 21; Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 3447 and Related Functional Regulation Issues, (continued...) ==========================================START OF PAGE 19====== approach would ensure that the securities activities of all market participants, regardless of the structure in which they are conducted, would be subject to a single set of standards, consistently applied by one expert regulator. We believe that proposals to institute functional regulation, such as repealing the exception for banks from broker-dealer and investment adviser regulation,-[23]- would help reduce, if not eliminate, duplicative and conflicting regulation-[24]- and would better protect investors. Absent legislation designed to implement functional regulation, the Commission has been working to address the regulatory gaps, overlaps, and conflicts inherent in the current regulatory system. I will now briefly describe the principal provisions of the federal securities laws that govern the marketing and sale of mutual fund shares, and explain how the Commission and the National Association of -[22]-(...continued) before the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce (Apr. 14, 1994). -[23]- The Commission does not advocate the wholesale repeal of the exception for banks from investment adviser regulation. Rather, the Commission supports eliminating the exception only to the extent a bank advises a registered investment company. In the Commission's view, a bank that serves as an investment adviser to a registered investment company should be regulated as any other investment company adviser. -[24]- For an example of duplicative and conflicting regulation, see infra footnote 42. ==========================================START OF PAGE 20====== Securities Dealers ("NASD")-[25]- use those provisions to oversee mutual fund activities. 2. Regulation of Disclosure and Advertising Through a disclosure and advertising review process, the Commission and the NASD implement a comprehensive regulatory structure governing mutual fund sales practices. Even in the case of bank-sold funds, fund sales literature and advertising must comply with Commission rules and must be filed with the Commission or the NASD. The rules of the Commission and the NASD provide important protections against fraud in the marketing and sale of mutual fund shares. Disclosure: Section 8 of the Investment Company Act-[26]- requires investment companies, subject to certain exceptions,-[27]- to register with the Commission under the Act. If the company is conducting a -[25]- The NASD, which operates under the Commission's oversight, is a self-regulatory organization for broker- dealers. Among other things, the NASD promulgates rules of conduct for its members, reviews their advertisements and sales materials, conducts disciplinary hearings, and, when appropriate, imposes sanctions on members who violate its rules. -[26]- 15 U.S.C.  80a-8. -[27]- For example, a company that otherwise meets the Act's definition of "investment company" but that has 100 or fewer investors and is not conducting a public offering of its shares is deemed not to be an investment company and is not subject to the Act. See Investment Company Act section 3(c)(1), 15 U.S.C.  80a-3(c)(1). ==========================================START OF PAGE 21====== public offering of its shares, it also must file a registration statement to register those shares under the Securities Act of 1933 ("Securities Act").-[28]- The registration statement includes the fund's prospectus, the principal selling document that is required to be delivered to prospective investors. The prospectus describes, among other things, the fund, its investment policies, and the risks involved in investing in the fund. A fund's prospectus may not contain information that is materially misleading or omit information that is necessary to make the information included not misleading.-[29]- As part of its review of registration statements, the Commission's staff typically looks at whether a fund's name may be misleading to investors.-[30]- In this regard, the Commission's staff has taken steps to address the potential investor confusion that may result when a fund has a name that is the same or similar to the bank that serves as the fund's adviser or through which the fund's shares are sold. In 1993, the staff sent a letter to all funds registered under the Investment Company Act expressing concern that investors in bank-advised and bank-sold mutual funds may -[28]- 15 U.S.C.  77a et seq. -[29]- See Securities Act sections 11(a) and 12(2), 15 U.S.C.  77k(a) and 77l(2). -[30]- See, e.g., Guide 1 to Form N-1A. Form N-1A is the form on which mutual funds register their shares with the Commission. ==========================================START OF PAGE 22====== be misled into believing that their investments are guaranteed or insured bank deposits. The staff advised funds having names similar to federally insured institutions, and all funds advised, sold, or marketed by or through these institutions, that they must prominently disclose, on the cover of their prospectuses, that shares of the fund are not deposits or obligations of the bank and are not insured by any federal agency.-[31]- Advertising: The Commission regulates fund advertising and sales literature pursuant to several rules under the securities laws.-[32]- These rules, along with applicable NASD rules, are described below: ù Omitting Prospectus: Rule 482 under the Securities Act-[33]- permits funds to publish advertisements containing a broad range of information, including performance data, so long as the substance of that -[31]- Letter to Registrants from Barbara J. Green, Deputy Director, Division of Investment Management (May 13, 1993). -[32]- Under the Securities Act, a fund may not offer its shares for sale unless prospective investors receive a current prospectus meeting the requirements of the Act in advance of or at the time of sale. Securities Act section 5(b)(2), 15 U.S.C.  77e(b)(2). The term "prospectus" is broadly defined to include any notice, circular, advertisement, or letter of communication (including any radio or television broadcast) that offers any security for sale. Id. section 2(10), 15 U.S.C.  77b(10). The effect of this broad definition is to subject fund advertising and sales material to Commission regulation under the Securities Act. -[33]- 17 C.F.R.  230.482. ==========================================START OF PAGE 23====== information is included in the fund's prospectus.-[34]- If an ad contains any performance information for the fund, the ad also must present the fund's total return, calculated under a formula specified by the Commission, for the last one, five, and ten years. In addition, the ad must state that the performance figures represent past performance and that the investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original investment. ù Tombstone Advertisements: Rule 134 under the Securities Act-[35]- permits advertisements that contain certain limited information about a mutual fund. These types of advertisements may not contain performance information, and must direct the reader to obtain the fund's prospectus for further information. ù Generic Advertisements: Rule 135a under the Securities Act-[36]- permits generic advertisements that do not refer to the securities of any particular fund. ù Anti-Fraud Provisions: All fund advertisements and sales literature are subject to the anti-fraud provisions of the federal securities laws. Rule 156 under the Securities Act-[37]- identifies particular fund advertising practices that may be misleading, such as the use of implied promises of future performance. ù Sales Literature: Rule 34b-1 under the Investment Company Act-[38]- imposes certain requirements on fund sales material that is preceded or accompanied by a fund prospectus. -[34]- H.R. 3005, passed last week by the House of Representatives, would remove this "substance of" requirement. See H.R. 3005,  204, 104th Cong., 2d Sess. (1996). A similar provision is contained in S. 1815, currently under consideration by the Senate. See S. 1815,  204, 104th Cong., 2d Sess. (1996). -[35]- 17 C.F.R.  230.134. -[36]- 17 C.F.R.  230.135a. -[37]- 17 C.F.R.  230.156. -[38]- 17 C.F.R.  270.34b-1. ==========================================START OF PAGE 24====== ù NASD Requirements: NASD rule 2210 governs broker-dealer communications with the public. The rule contains specific guidance with respect to the use of rankings in investment company advertisements and sales literature and with respect to communi-cations about variable life insurance and variable annuities.-[39]- Mutual fund advertisements and sales literature are required to be filed with the NASD (if the fund's shares are sold by an NASD member) or with the Commission. Because most fund shares are sold by an NASD member, most fund ads and sales literature are filed with the NASD rather than with the Commission. The NASD's advertising department reviews advertisements and sales literature for compliance with both the Commission's rules and the NASD's rules, and generally provides written comments on the material filed. 3. Oversight of Mutual Fund Sales Activities According to a recent report issued by the General Accounting Office, most sales of bank mutual funds are conducted through broker-dealer firms registered with the Commission-[40]- under the Securities Exchange Act of -[39]- The NASD recently reorganized its manual. NASD rule 2210 was formerly Article III, section 35 of the NASD's Rules of Fair Practice. The rule's provisions regarding variable contracts and the use of investment company rankings formerly were guidelines under Article III, section 35. -[40]- General Accounting Office, Bank Mutual Funds: Sales Practices and Regulatory Issues, at 6-7, 52 (Sept. 1995). The report estimated that only about 8% of the 2,300 banks that sold mutual funds did so directly by using their own employees. The other banks (and all thrift institutions) conducted their sales through broker-dealers registered with the Commission. Id. ==========================================START OF PAGE 25====== 1934 ("Exchange Act").-[41]- The Commission and the NASD actively and comprehensively regulate and oversee the mutual fund sales practices of these firms, including those affiliated with banks or operating on bank premises.-[42]- A brief description follows of how the Commission and the NASD enforce the rules applicable to broker-dealers through their inspection programs, and how they are tailoring their rules and their inspection programs in response to the growth of the mutual fund industry, particularly the increasing sales of mutual fund shares on bank premises. Broker-Dealer Inspection Program: As stated above, the NASD, subject to Commission oversight, is responsible for regulating the activities of its broker-dealer members.-[43]- The Commission oversees broker-dealers and the NASD's regulation of broker-dealers through its -[41]- 15 U.S.C.  78a et seq. -[42]- In 1994, the federal banking regulators issued guidelines in the form of an interagency statement regarding depository institutions that sell securities products to their customers either directly or through registered broker- dealers. As the Commission has noted previously in testimony before various Congressional committees, to the extent the interagency statement applies to NASD-member broker-dealers (rather than only to banks that engage directly in the sales of fund shares), the statement contributes to duplicative and possibly conflicting regulation. See Chairman's testimony on June 6, 1995, supra note 21, at 12 n. 18; Chairman's testimony on March 15, 1995, supra note 21, at 10-11. -[43]- See supra footnote 25. ==========================================START OF PAGE 26====== broker-dealer examination program.-[44]- Although the primary purpose of Commission examinations is to oversee the examination operations and capabilities of the NASD, the Commission also conducts "cause" examinations of broker-dealer financial records and sales practices. In fiscal year 1995, for example, the Commission completed 662 broker-dealer exams of which 393 were oversight exams and 269 were cause exams. Of the 662 total exams, 37 involved bank-affiliated broker- dealers or broker-dealers participating in arrangements with banks relating to the sale of noninsured investment products. In addition, the NASD conducted over 1500 routine broker- dealer examinations in calendar year 1995. In recognition of the tremendous recent growth of mutual fund sales, the Commission has devoted considerable time and attention to reviewing the mutual fund sales practices of broker-dealers. In assessing these practices during the course of its examinations, the Commission's staff focuses on evidence of potentially abusive transactions, such as unsuitable transactions,-[45]- the failure to alert -[44]- The Commission is authorized to inspect broker- dealers and to review the regulatory and enforcement actions of the NASD pursuant to sections 17 and 19 of the Exchange Act, 15 U.S.C. 78q, 78s. -[45]- A broker-dealer and its registered representatives have a general obligation to determine that securities recommended to a customer, including shares of most types of mutual funds, are suitable for the customer. Various courts have imposed this obligation on broker-dealers through the application of rule 10b-5 under the Exchange Act and other anti-fraud provisions of the federal securities laws. (continued...) ==========================================START OF PAGE 27====== customers to breakpoints,-[46]- switching or churning,-[47]- failure to disclose material information, and misrepresentations made in the selling process. Recognizing the continuing growth of mutual fund -[45]-(...continued) Moreover, the suitability requirements have been incorporated into the rules of self-regulatory organizations ("SROs"), including the NASD. See NASD rule 2310 (formerly Article III, section 2 of the NASD Rules of Fair Practice). To ensure that their suitability requirements are followed by their members, the SROs are authorized to bring actions against noncomplying members. The threat of such action is not idle; in the past, SROs, including the NASD and the New York Stock Exchange, have brought actions against broker-dealers for making unsuitable recommendations of mutual fund shares. See, e.g., In the Matter of Timolean Nicholaou, Admin. Proc. File No. 3-8160, Securities Exchange Act Release No. 34454 (July 28, 1994) (Commission review of New York Stock Exchange disciplinary proceeding). -[46]- Frequently, the amount of a mutual fund's sales charge (assuming there is one) decreases as the number of shares purchased by an investor increases. The points at which the sales charge decrease are referred to as breakpoints. Under NASD rules, a broker-dealer may not sell mutual fund shares just below a breakpoint in order to share in the higher sales charge applicable to sales below the breakpoint. See NASD rule IM-2830-1 (formerly a Board of Governors' Interpretation of Article III, section 1 of the NASD's Rules of Fair Practice). For an example of a Commission enforcement proceeding against a broker-dealer that failed to alert customers to breakpoints, see In the Matter of Advest, Inc., Admin. Proc. File No. 3-6783, Securities Exchange Act Release No. 24072 (Feb. 1987). -[47]- Switching in the mutual fund context occurs when a salesperson inappropriately causes a fund investor to sell shares of a fund on which the investor paid a sales charge, and reinvest the proceeds in shares of another fund subject to a sales charge. Churning occurs when a salesperson causes a fund investor inappropriately to engage in a substantial number of purchases and sales of fund shares. In both switching and churning, the essence of the wrongful conduct is the salesperson's desire to generate commissions for himself or herself, rather than making the interests of the customer paramount. ==========================================START OF PAGE 28====== sales, the Commission's staff is revising its existing broker- dealer examination procedure to include a greater and more in- depth focus on fund sales by broker-dealers. The Commission expects that this increased focus will enhance the quality of mutual fund selling practices. Agreement with OCC to Conduct Joint Examinations: The Commission and the OCC last year agreed on a framework for conducting joint examinations of mutual funds and advisory entities in which both agencies have regulatory interests. To date, the staffs of the two agencies have conducted three joint inspections of bank-advised mutual fund groups; a fourth is currently underway. Generally, the joint inspections have afforded the staff of each agency with a better understanding of the inspection objectives and procedures of the other agency. The joint inspection program provides the Commission's staff with access to information that it otherwise would not have when conducting an inspection of an unregistered bank adviser. Without this information, the staff would not be able to determine whether bank advisers to mutual funds are engaging in certain practices prohibited under the securities laws, such as: ù allocation of investment opportunities to benefit certain clients and not others; ==========================================START OF PAGE 29====== ù front-running-[48]- or the impermissible taking of investment opportunities by fund portfolio managers; ù cross-trading among clients to correct trading errors or to move poorly performing securities from one client's account to another client's account; and ù inappropriate soft-dollar practices that benefit an adviser at the expense of certain clients.-[49]- NASD Proposal: Over the last decade or so, an increasing number of banks and other deposit-taking financial institutions have sought to enter into arrangements, typically called "networking arrangements," with registered broker- dealers. A networking arrangement generally contemplates a broker-dealer's selling noninsured financial products, such as mutual fund shares, on the premises of a financial institution. In a series of letters beginning in 1982 and culminating in a letter to Chubb Securities Corporation in 1993, the Commission's staff addressed networking arrangements -[48]- "Front-running" occurs when a fund insider engages in a securities transaction ahead of the fund with the expectation that the fund's transaction will have a favorable effect on the price of the securities. See Division of Investment Management, U.S. Securities and Exchange Commission, Personal Investment Activities of Investment Company Personnel, at 4 (Sept. 1994). -[49]- Even if a mutual fund is advised by a subsidiary of a bank that is registered with the Commission as an investment adviser, the staff would not have access (but for the joint inspection program) to the records necessary to detect these practices unless all of the bank's trust and advisory activities are conducted through the registered adviser. ==========================================START OF PAGE 30====== between savings and loan associations and broker- dealers.-[50]- The staff in those letters indicated certain actions that needed to be taken with respect to the broker-dealer's promotional literature, customer disclosure, and physical location on the financial institution's premises to distinguish clearly the broker-dealer's services from the deposit-taking function of the institution. Under the staff's letters, a broker-dealer must stipulate that it will be solely responsible for all securities business conducted on the financial institution's premises. In March of this year, the Commission published for comment an NASD proposal, based in large part on the staff's earlier letters described above, that would regulate specifically the conduct of NASD member firms operating on the premises of financial institutions where retail deposits are taken. The proposal, among other things, would require: ù that the broker-dealer's services, whenever possible, be offered in a physically distinct location from the deposit-taking activities of the financial institution; ù that the broker-dealer's services be clearly distinguished from the financial institution's deposit- taking activities; ù that the broker-dealer disclose, at the time a new customer account is opened, that the securities purchased are not insured by the Federal Deposit Insurance -[50]- Chubb Securities Corp., SEC No-Action Letter (Nov. 24, 1993). See also Anchor National Financial Services, Inc., SEC No-Action Letter (Jan. 22, 1992); Savings Association Investment Securities, Inc., SEC No-Action Letter (July 8, 1992). Savings and loan associations are not "banks" for purposes of the bank exclusions contained in the definitions of "broker" and "dealer" in the Exchange Act. ==========================================START OF PAGE 31====== Corporation, are not deposits or other obligations of the financial institution, are not guaranteed by the financial institution, and are subject to investment risk, including loss of principal; and ù that the broker-dealer seek to obtain the customer's written acknowledgment that he or she received the required disclosure.-[51]- The comment period for the NASD's proposed rule amendment ended on May 21, 1996. To date, the Commission has received approximately 100 comment letters on the proposal, which the Commission is currently reviewing in considering the NASD proposal. 4. The Commission's Enforcement Program A crucial component of the Commission's efforts to ensure compliance with the provisions of the federal securities laws is a strong enforcement program. In recognition of the growth of the mutual fund business in the United States and the importance of funds to the operation of our markets, the Commission has made abusive fund sales practices a priority of its enforcement program. The Commission has commenced a number of proceedings in the mutual fund area in response to -[51]- Securities Exchange Act Release No. 36980 (Mar. 15, 1996). The proposal also would: prohibit NASD members from compensating unregistered financial institution employees for any activity related to referral of customers to the NASD member; preclude the NASD member from using customer financial information (except information that can be obtained from an unaffiliated credit bureau) provided by the financial institution, unless the customer consents in writing; require a written agreement between the member and the financial institution; and impose certain requirements on member's communications, including advertisements and sales literature, with the public. ==========================================START OF PAGE 32====== wrongful conduct that included misleading fund sales practices,-[52]- abuses by a fund's adviser in allocating securities transactions among the fund and other clients of the adviser,-[53]- and abuses by portfolio managers regarding their personal investments.-[54]- Dealing with abusive fund sales practices remains a priority of the Commission. Conclusion The growth of mutual funds in the United States over the past decade has been nothing short of spectacular. The joint survey undertaken by the Commission and the OCC provides important insights about the fund industry and fund shareholders. Those insights in turn will provide guidance to the Commission as it implements its program regulating fund operations and the sale of fund shares.