==========================================START OF PAGE 1====== TESTIMONY OF ARTHUR LEVITT, CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING FINANCIAL MODERNIZATION BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES May 22, 1997 Chairman Leach and Members of the Committee: I appreciate the opportunity to testify on behalf of the Securities and Exchange Commission ("Commission") regarding modernization of the laws governing financial services. This is a significant issue that has defied consensus for more than a decade. I commend you, Chairman Leach, for your continuing efforts to bring financial regulation up to date with the financial markets. I. Overview Over the past decade, the financial services industry has evolved to permit diversity in services and providers of services. Today, a bank is as likely as a broker-dealer to sell securities to a first-time investor. A bank may also advise mutual funds. While these developments provide banks with greater flexibility and new areas for innovation, they also leave ==========================================START OF PAGE 2====== investors at risk. When a bank sells a security or advises a mutual fund, the bank is not subject to most federal securities laws and regulations because it is exempt from the definitions of "broker," "dealer," and "investment adviser." As a result of these 60-year old exemptions, securities activities engaged in by banks are governed by the federal banking statutes, and not the federal securities laws. The Commission believes that banking regulation is not an adequate substitute for securities regulation, especially when a bank fully engages in a public securities business. Banking regulation focuses on the safety and soundness of banking institutions and preventing the failure of banks. In contrast, securities regulation focuses on disclosure, investor protection, and the maintenance of fair and orderly markets. Moreover, securities regulation encourages innovation on the part of securities firms. Significantly, securities regulation does not protect broker-dealers from failure. It relies on market discipline rather than a federal safety net. These significant differences in philosophy and approach between banking and securities regulation reflect the real differences between the banking and securities worlds. As the debate on financial services reform moves forward, it is important to recognize that businesses in the United States depend on our capital markets and the securities industry to ==========================================START OF PAGE 3====== support their exceptional growth. The American public has the confidence to invest in securities because of the strong investor-oriented regulation of those markets. In 1996 alone, it is notable that businesses raised approximately $1.2 trillion from investors, without the benefit of federal deposit insurance, through the entrepreneurial efforts and risk-taking of securities firms.-[1]- The Commission believes that any legislation modernizing financial services must take into account the critically important factors that serve as the underpinnings for the success of our nation's securities industry. Specifically: ù Investor protection must be maintained. Investor protection must continue to be a cornerstone of the securities markets if they are to build on their present strength. Meaningful functional regulation is essential to ensure that investors receive the same protection whether they deal with banks or securities firms. ù The vitality of the markets must be preserved. While traditional banking services need to be regulated to ---------FOOTNOTES---------- -[1]- This figure includes firm commitment public offerings and private placements, and does not include best efforts underwritings. (Securities Data Company) ==========================================START OF PAGE 4====== ensure bank safety and soundness, this approach is inconsistent with the risk-taking that is essential in the securities industry. Securities firms affiliated with banks need to engage in risk-taking and entrepreneurial activities without an overlay of restrictive banking-style regulation that focus on safety and soundness. ù Competitive opportunities should be available to all firms providing financial services. Banks and securities firms should be given the opportunity to compete on an equal basis -- to the extent that banks may conduct securities activities, securities firms should be allowed to conduct banking activities. As Congress considers how to permit affiliations between the banking and the securities industries, it is important to remember that Congress' actions likely will have a profound effect on investors, the securities industry, and the securities markets generally, as well as on banks. Both H.R. 10 and H.R. 268 approach financial services reform largely from the banking perspective. As securities regulators, the Commission urges Congress also to consider the implications of reform on the securities industry and the securities markets. ==========================================START OF PAGE 5====== The way each of these key factors is addressed in H.R. 10 and H.R. 268 is discussed below. II. Functional Regulation to Assure Investor Protection The statutes that form the foundation for both banking and securities regulation remain based on the 60-year old assumption that the Glass-Steagall Act prohibits banks from engaging in most securities activities. Although that assumption is outmoded, the laws continue to exempt banks from the requirements applicable to brokers, dealers and investment advisers even though banks conduct these activities.-[2]- This means that a bank's securities activities are subject to the bank regulatory scheme with its primary focus on the safety and soundness of the bank, rather than the securities regulatory scheme, focused on disclosure, investor protection, and the maintenance of fair and orderly markets. As the Commission has urged for more than a decade, a system of functional regulation would eliminate the inconsistencies between regulation of securities activities of banks and ---------FOOTNOTES---------- -[2]- See, e.g., 15 U.S.C.  78c(a)(4), 78c(a)(5), and 80b-2(a)(11). ==========================================START OF PAGE 6====== securities activities of Commission-regulated entities, providing enhanced investor protection.-[3]- The present regulatory scheme is increasingly likely to create problems. Today, individual investors have more savings invested in mutual funds than in insured bank accounts.-[4]- ---------FOOTNOTES---------- -[3]- See, e.g., Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 268, The "Depository Institution Affiliation and Thrift Charter Conversion Act," Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 13, 1997); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Regarding H.R. 1062, The Financial Services Competitiveness Act of 1995, Before the Subcomm. on Telecommunications and Finance and the Subcomm. on Commerce, Trade and Hazardous Materials of the House Comm. 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 House Comm. on Banking and Financial Services (Mar. 15, 1995); Testimony of Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, Concerning Financial Services Modernization, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (July 11, 1990); Memorandum of the Securities and Exchange Commission (under Chairman David Ruder) to the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce Concerning Financial Services Deregulation and Repeal of the Glass-Steagall Act (Apr. 11, 1988). -[4]- Specifically, at the end of 1996, $3.6 trillion was invested in mutual funds. Data compiled by Office of Economic Analysis, U.S. Securities and Exchange Commission, based on January 1997 Federal Reserve Bulletin and 1997 Mutual Fund Fact Book; see Remarks by Eugene A. Ludwig, Comptroller of the Currency, before the Exchequer Club, Nov. 20, 1996 (OCC News Release 96-127). ==========================================START OF PAGE 7====== As we move toward the next century, this trend is likely to continue, particularly if recent proposals to privatize, or semi- privatize, the social security system are adopted.-[5]- If investors purchase their mutual fund shares through a bank, rather than a registered broker-dealer, they receive a different, lower, standard of investor protection. If the mutual fund they purchase is advised by a bank, rather than a registered investment adviser, again, investors receive a different, lower, standard of investor protection. To assure adequate investor protection, the Commission believes that bank securities activities must be brought within the securities regulatory framework. Such an 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. Broker-Dealer Activities. As noted earlier, banks that engage directly in broker and dealer activities are exempt from the definitions of broker and dealer in the federal securities ---------FOOTNOTES---------- -[5]- See "Report of the 1994-1996 Advisory Council on Social Security" (Jan. 1997); see also "Oversight on Social Security Investments in the Securities Markets," Hearings Before the Senate Comm. on Banking, Housing, and Urban Affairs (Apr. 30, 1997); "The Future of Social Security for this Generation and the Next," Hearings Before the Subcomm. on Social Security of the House Comm. on Ways and Means (Mar. 6 and Apr. 10, 1997). =========================================START OF PAGE 8====== laws, and therefore their purchases and sales of securities to customers are exempt from federal securities regulation.-[6]- Because the federal banking regulatory framework focuses primarily on the safety and soundness of banking institutions, it does not specifically address important aspects of direct bank brokerage activities.-[7]- For example: ù Banking statutes and rules neither comprehensively address sales practice issues nor impose express duties to supervise bank securities sales personnel; ù Banks are not subject to self-regulatory organization account transfer rules that require a broker-dealer to transfer a customer's account upon demand; ---------FOOTNOTES---------- -[6]- Bank securities activities are, however, subject to the antifraud provisions of the federal securities laws. Moreover, bank affiliates and subsidiaries, as opposed to banks themselves, are not exempt from the federal securities laws, and must register with the Commission when they engage in securities activities. As discussed later in this testimony, the securities activities of these affiliates and subsidiaries also are subject, inappropriately in our view, to bank safety and soundness supervision. -[7]- The federal banking regulations do contain limited recordkeeping and confirmation requirements relating to bank securities transactions. See, e.g., 12 C.F.R.  12.1-12.9 and 12.101-102, 12 C.F.R.  344.1-344.10, and 12 C.F.R.  208.24. ==========================================START OF PAGE 9====== ù Bank employees who sell securities currently are not subject to specific qualification and continuing education requirements; ù Banking statutes do not provide private rights of action;-[8]- ù Bank securities customers have no forum to address grievances such as the Commission's supervised arbitration forum available to customers of securities firms;-[9]- and ---------FOOTNOTES---------- -[8]- See, e.g., In re Fidelity Bank Trust Fee Litigation, 839 F. Supp. 318 (E.D. Pa. 1993), aff'd, 43 F.3d 1461 (3d Cir. 1994); In re Corestates Trust Fee Litigation, 837 F. Supp. 104 (E.D. Pa. 1993), aff'd, 39 F.3d 61 (3d Cir. 1994). Banks are subject, however, to the anti-fraud provisions in section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder. Therefore, bank customers presumably can bring private actions alleging fraud against banks under these provisions. But see Simpson v. Mellon Bank, N.A., [1993-94 Transfer Binder] Fed. Sec. L. Rep (CCH) 98,027 (Dec. 17, 1993). -[9]- See also, Testimony of Mary Griffin, Insurance Counsel, Consumers Union, Concerning the "Depository Institution Affiliation and Thrift Charter Conversion Act" (H.R. 268), Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 25, 1997) (explaining one problem with H.R. 268 is that the bill does not provide a recourse mechanism for consumers to recover losses directly from the wrong-doer, "unlike the investor protection rules under securities laws that provide a grievance forum for consumers"). ==========================================START OF PAGE 10====== ù Banking regulators' disciplinary actions are not fully disclosed, depriving investors of basic information with which to protect themselves.-[10]- Recent efforts by bank regulators to incorporate aspects of the federal securities laws into the bank regulatory scheme represent a step forward, but have not resolved the most pressing regulatory gaps.-[11]- While the Commission fully supports ---------FOOTNOTES---------- -[10]- The banking agencies are required to "publish and make available to the public" final orders issued in connection with enforcement proceedings. (12 U.S.C.  1818(u). The releases usually do not describe the nature of the violation and the enforcement action taken, however. Rather, they list enforcement actions, and typically include the docket number, names of the parties involved, type of action taken, date of the action and whether the action was by consent. In contrast, Commission and self-regulatory organization disciplinary proceedings are aggressively publicized. Commission press releases describe the nature of proceedings and the identities of the parties disciplined. In addition, as mandated by the Securities Exchange Act, the NASD operates an "800" telephone number hotline, which allows investors to obtain information about the disciplinary and civil liability records of broker-dealers' registered representatives. -[11]- For example, the federal banking regulators have issued guidelines that address some sales practice issues. See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency and Office of Thrift Supervision, "Interagency Statement on Retail Sales of Nondeposit Investment Products" (Feb. 15, 1994). As the Commission has testified before, while these guidelines represent an important step forward, they are advisory and therefore, not legally binding, and may not be legally enforceable by bank regulators or customers. See Testimony of Arthur Levitt, Chairman, U.S. (continued...) ==========================================START OF PAGE 11====== addressing gaps in investor protection, it has serious concerns regarding the creation of a "separate, but unequal" regulatory scheme for banks that may serve to compete with, and undermine, the securities regulatory scheme. For example, one recent proposal sponsored by the banking regulators would impose qualification requirements on bank employees who sell mutual funds and other securities to bank customers.-[12]- While the goal of this initiative is laudable, it notably would not impose on banks standards for qualifying supervisors or a duty to supervise bank securities sales forces. It also would not provide for self-regulatory organization inspections and oversight. Moreover, it may encourage banks that currently are selling securities through registered broker-dealer subsidiaries and affiliates to move these activities into the bank itself, where they are subject to fewer restrictions. The Commission believes that a parallel, but unequal, system of securities regulation administered by banking regulations -- within the general framework of federal banking regulation, which focuses primarily on the safety and soundness of banking ---------FOOTNOTES---------- -[11]-(...continued) Securities and Exchange Commission, Concerning The "Financial Services Competitiveness Act of 1995" and Related Issues, Before the House Comm. on Banking and Financial Services (Mar. 15, 1995). -[12]- Office of the Comptroller of the Currency, Treasury; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation, Qualification Requirements for Transactions in Certain Securities (Jan. 9, 1997). ==========================================START OF PAGE 12====== institutions -- would deprive investors purchasing and selling securities directly through banks of important regulatory protections. In the Commission's view, functional regulation is necessary to eliminate gaps in investor protection, as well as to provide a level playing field between banks and brokers engaged in the same securities activities.-[13]- Unfortunately, however, the Commission believes that neither H.R. 10 nor H.R. 268 would implement an adequate level of functional regulation. H.R. 10 would eliminate the bank exemption from the definitions of broker and dealer, but would introduce 16 significant new exemptions for banks that engage in specific types of securities activities. Among others, H.R. 10 would exempt bank sales of asset-backed securities and privately placed securities, two areas of significant market growth. As a result, it appears that banks could continue to operate a public securities business largely outside the framework of the federal securities laws. ---------FOOTNOTES---------- -[13]- In this regard, Commissioner Wallman has noted that, as distinctions between securities and nonsecurities financial products diminish, other forms of financial service regulatory reform may be worthy of long-term consideration. Remarks of Commissioner Steven M.H. Wallman before the SIA Conference on the National Securities Markets Improvement Act of 1996 (Jan. 9, 1997). ==========================================START OF PAGE 13====== Most significantly, H.R. 10 would provide for an open-ended exemption for transactions in securities that the Federal Reserve Board characterizes as "qualified financial contracts," which potentially could include any securities contract. Similarly, H.R. 10 would provide for an exception for bank transactions in securities that are deemed by the Federal Reserve Board to be "banking products." The Commission strongly opposes these open- ended exemptions which would perpetuate a lesser scheme of banking regulation for significant bank securities activities. H.R. 268 would retain the statutory exemption for banks from the definitions of "broker" and "dealer" for those banks not operating under the bill's new financial services holding company framework.-[14]- As a result, it would not resolve any of the issues that have arisen over the last decade with respect to bank securities sales. As the regulator charged with oversight of the securities industry and maintenance of fair and orderly markets, the Commission must have a comprehensive view of that industry and all its participants. Allowing banks to continue conducting significant securities activities outside of the federal ---------FOOTNOTES---------- -[14]- Basically, H.R. 268 would allow a bank to choose between continuing its current operations under the current rules or affiliating with a securities firm or other financial firm under a financial services holding company pursuant to a new regulatory framework. ==========================================START OF PAGE 14====== securities regulatory scheme would disable the Commission from effectively supervising and overseeing a growing segment of the securities industry. The Commission believes that financial services legislation could provide limited, defined exemptions or exceptions from securities regulation for a narrow class of traditional banking- related securities activities or for a low volume of activities engaged in by a small local bank. However, any additional exemptions would essentially codify the existing regulatory inconsistencies and frustrate functional regulation, which the Commission views as a vitally important component in financial services modernization. Investment Advisory Activities. As of December 31, 1996, 119 banks advised 2,857 mutual funds (including individual classes), representing approximately 28% of all funds registered with the Commission. Also, as of that date, assets of bank- advised funds totaled $493.2 billion, or 15% of total mutual fund assets.-[15]- By contrast, in 1990, banks advised 517 funds with total assets of $85.9 billion. Despite this dramatic growth, banks remain exempt, as discussed above, from the definition of "investment adviser" in the Investment Advisers Act. Consequently, banks that advise registered investment ---------FOOTNOTES---------- -[15]- Lipper Analytical Services, Inc., Lipper Bank- Related Fund Analysis (1996). ==========================================START OF PAGE 15====== companies are not subject to the substantive requirements applicable to other investment advisers. This hampers effective Commission oversight of bank-advised mutual funds by depriving Commission examiners access to all the books and records normally available when a fund adviser is registered with the Commission. The Commission supports the proposal in H.R. 10 that would require banks, or their separately identifiable departments or divisions, that advise registered investment companies to register as investment advisers.-[16]- This would ensure that federal securities laws and regulations would apply to these activities, permitting the Commission to see the complete picture of investment adviser activities in its examinations of mutual funds. In contrast, the Commission is concerned that H.R. 268 would eliminate the bank exemption from "investment adviser" only if the bank affiliates with a securities or other financial firm under a financial services holding company. Thus, a bank could continue to advise a mutual fund outside of Commission oversight. The Commission objects to maintaining this regulatory structure because, as described above, it prevents the Commission from effectively examining activities that may harm mutual fund ---------FOOTNOTES---------- -[16]- A more detailed analysis of the technical issues arising under the Investment Company Act and the Investment Advisers Act is included in an appendix to this testimony ("Appendix A"). ==========================================START OF PAGE 16====== shareholders, particularly at a time when individual investors are investing more of their savings in mutual funds than in interest-bearing bank deposit accounts. Investment Company Conflicts of Interest. In a related area, the Commission is concerned about increasing conflicts of interest resulting from bank involvement in mutual funds. Currently, the Investment Company Act places some restrictions on transactions between banks and affiliated investment companies. These restrictions were crafted, however, at a time when Congress could not have contemplated the dramatic change in the scope of these activities that has occurred in the past decade. The Commission supports the provisions in H.R. 10 that would improve the oversight of conflicts that exist when banks transact business with affiliated investment companies.-[17]- For example, a bank affiliated with a registered investment company, and any affiliated person of such bank, would be prohibited by H.R. 10 from lending money to such investment company in contravention of any rules or regulations that the Commission may prescribe. Also, the banking regulators would be required to provide the Commission with the results of any examination, reports, records or other information related to the investment advisory activities of any bank registered with the Commission. ---------FOOTNOTES---------- -[17]- See Appendix A. ==========================================START OF PAGE 17====== In contrast, the Commission is concerned about provisions in H.R. 268 that would reduce the Commission's ability to police conflicts of interest, as we have testified before.-[18]- This would happen because H.R. 268 would remove certain limitations under the Investment Company Act that now apply to all fund affiliates, and replace them with new limitations that apply solely to the activities of banks that operate under the new financial services holding company framework of H.R. 268. As discussed earlier in this testimony, maintaining the bank exemption under the Investment Advisers Act, as provided in H.R. 268, also would continue to hinder Commission oversight of bank- advised mutual funds.-[19]- Committee of Regulators. The Commission has significant concerns about the usefulness of a new regulator, such as the National Financial Services Committee proposed in H.R. 268 or the Banking and Financial Services Advisory Committee proposed in ---------FOOTNOTES---------- -[18]- See Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 268, "The Depository Institutions Affiliation and Thrift Charter Conversion Act," Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 13, 1997). -[19]- At present, Commission examiners do not have access to all the books and records of a fund adviser that is a bank, because the bank currently is not required to register as an adviser. The Commission and the banking regulators have agreed, however, to conduct joint inspections of banks and their affiliated mutual funds. Joint inspections will not, however, correct the underlying laws in the existing regulatory structure. ==========================================START OF PAGE 18====== H.R. 10. The Commission supports the existence of working groups, such as the existing Working Group on Financial Markets, to ensure effective sharing of information and, when appropriate, collaboration on issues of interest to more than one regulator. Empowering a group to set standards and define activities across the horizon of financial services, however, would not likely add substantial value to the day-to-day responsibilities of financial services regulators. Indeed, it is contrary to functional regulation because it removes decision-making from the hands of the expert regulator, and slows down the decision-making process. A substantive regulator does its job best with clear responsibilities and clear lines of authority. III. Maintaining the Vitality of the Securities Markets Legislation modernizing financial regulation must accurately reflect the financial markets as they exist today. Legislation also must anticipate the needs of the financial services industry into the twenty-first century. With advances in telecommunications and technology, the need for such meaningful reform becomes even more critical. ==========================================START OF PAGE 19====== The Commission questions, however, whether either H.R. 10 or H.R. 268 provides sufficient flexibility to anticipate the likely evolution in financial services. Holding Company Regulation. The regulatory models offered by both bills are based predominantly on the existing "top-down" regulatory model of the Bank Holding Company Act. This model provides for comprehensive regulation of all activities in holding company affiliates, with the ultimate goal to ensure that the affiliates' activities do not threaten the safety and soundness of affiliated banks. The traditional holding company model of regulation has never applied to securities holding companies and appears to be less and less appropriate for many of the nonbank activities now conducted by banks and their affiliates.-[20]- ---------FOOTNOTES---------- -[20]- H.R. 10 also offers a "special operating subsidiary" regulatory model that would permit special operating subsidiaries of banks, subject to oversight by the Comptroller of the Currency, to engage in activities that are "part of or incidental to the business of banking," including underwriting, dealing in, and distributing securities of any type. Special operating subsidiaries would also have authority to organize, control, manage and act as investment advisers to mutual funds. The Commission believes that the same concerns regarding consolidated supervision arise regardless of whether a bank affiliates with a broker-dealer under a holding company or through an operating subsidiary structure. Notably, the special operating subsidiary option in H.R. 10 would not provide the proposed reduced holding company oversight contained in H.R. 10 or the new holding company approach based on risk assessment contained in (continued...) ==========================================START OF PAGE 20====== Imposing a bank regulatory structure that is less flexible than the securities regulatory structure on the U.S. securities markets may not be a good idea. As noted earlier, U.S. businesses raise huge amounts of capital in our securities markets. This capital is raised through the entrepreneurial and risk-taking efforts of securities firms. Financial services modernization must preserve the ability of securities firms to assume risks, without layers of safety and soundness regulation, to ensure the continued vitality of the U.S. securities markets and the resulting flow of capital to the U.S. business community at large. It is critically important for the domestic economy that U.S. securities firms remain innovative and competitive. H.R. 10 does provide for reduced approval, capital, reporting and examination requirements for certain financial services holding companies engaged primarily in nonbanking activities and for certain investment bank holding companies. This lighter supervision would be available only within the Bank Holding Company Act structure, however, and only with approval of the Federal Reserve Board. The Commission appreciates this effort to minimize the extent to which bank holding company regulation would apply to holding companies with minimal levels ---------FOOTNOTES---------- -[20]-(...continued) H.R. 268. Commissioner Wallman notes further that provided appropriate protections are in place, the particular form of entity -- subsidiary or affiliate --should be irrelevant to the Commission. ==========================================START OF PAGE 21====== of banking activities. The Commission supports a new holding company approach based on the risk assessment model, however, for effective regulation of a multi-service holding company, as described below. Lead Regulator. If a lead regulator is necessary, as provided in both H.R. 10 and H.R. 268, the oversight of any holding company in which a securities firm is the largest affiliate in a holding company structure should be allocated to the Commission, not to a bank regulator. The Commission has the experience and expertise to oversee companies conducting primarily a securities business, and would defer to the appropriate banking regulator with regard to regulation of any affiliated bank.-[21]- Risk Assessment Oversight. In lieu of traditional consolidated holding company regulation, the Commission supports an approach based on strong functional regulation, effective ---------FOOTNOTES---------- -[21]- Chairman Greenspan has testified on behalf of the Federal Reserve Board before Chairman Roukema's Subcommittee that "[t]he case is weak . . . for umbrella supervision of a holding company in which the bank is not the dominant unit and is not large enough to induce systemic problems should [the bank] fail." Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Regarding H.R. 268, The Depositary Institution Affiliation and Thrift Conversion Act, Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services (Feb. 13, 1997) ("Federal Reserve Testimony"). ==========================================START OF PAGE 22====== firewalls and risk assessment of affiliates' activities. The Commission believes that a risk assessment model of oversight would permit effective monitoring of non-banking activities, while preserving bank safety and soundness regulation for bank affiliates. In addition, oversight based on a risk assessment model looks towards a financial services industry of the future, when related entities may have an even broader range of activities than we presently anticipate. The main benefit to a risk assessment model of supervision in a restructured financial system is that it would not constrain broker-dealers' ability to innovate at the fast pace demanded by the capital markets, while it would leave regulators free to concentrate on focused supervision of the regulated entity. Chairman Greenspan has cautioned that regulators must be careful "that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual."-[22]- While we commend the Federal Reserve Board's efforts to reduce the routine supervisory umbrella presence in holding companies, we believe that any requirement to obtain prior approval before engaging in new activities -- a bank-style regulatory approach and an element of consolidated supervision -- would unnecessarily hamper the operation of securities firms. ---------FOOTNOTES---------- -[22]- See Federal Reserve Testimony. ==========================================START OF PAGE 23====== The Commission's current use of a risk assessment model, coupled with the Commission's net capital rules, provides the Commission with the ability to identify and respond in a timely manner to risks that could potentially harm the broker-dealer and ultimately the U.S. investor. The risk assessment model the Commission uses is set forth in Section 17(h) of the Securities Exchange Act of 1934. The model requires broker-dealers to provide information routinely to the Commission regarding potential risks to the broker-dealer that could be posed by the activities of their affiliates. The Commission also can obtain additional information if necessary, such as in periods of market stress.-[23]- The risk assessment model of regulation is designed to alert regulators of impending problems, while minimizing the regulatory burdens imposed on regulated broker-dealers and their affiliates. If a broker-dealer has financial difficulty, the net capital rule and the customer protection rule allow the Commission to liquidate a broker-dealer, no matter how large, in an orderly manner without significant loss to the Securities Investor ---------FOOTNOTES---------- -[23]- In addition to the risk assessment rules, the Commission requires broker-dealers to promptly report net capital and other operational problems and prohibits the withdrawal of excessive amounts of capital from a broker-dealer. If a broker- dealer falls below its required minimum net capital, the Commission's answer is to require the broker-dealer to immediately cease conducting a securities business. ==========================================START OF PAGE 24====== Protection Corporation ("SIPC") or the United States government.-[24]- H.R. 268 includes elements of a risk assessment model but introduces an element of uncertainty into broker-dealers' activities. The bill threatens the flexibility necessary for broker-dealers to compete by authorizing bank regulators to impose additional "safety and soundness" limitations on the activities of banks' securities affiliates. Instead, we believe that any controls necessary for bank safety and soundness should be established in the bank by the bank regulator and necessary controls for investor protection should be established in the broker-dealer by the securities regulator or through firewalls established by Congress. Congress has the opportunity to include in financial service legislative reforms a risk assessment oversight system that focuses on the risks of the activities of particular affiliates, rather than the potential effect of those risks on the safety and soundness of bank affiliates. If Congress believes additional oversight of a holding company is needed to monitor adequately financial conglomerates, the Commission suggests that Congress consider an expanded risk assessment model that offers more ---------FOOTNOTES---------- -[24]- SIPC protects the funds and securities of securities firms' customers if the firms fail financially. ==========================================START OF PAGE 25====== flexibility than an approach based on top-down holding company regulation. Firewalls. Regardless of which framework Congress ultimately adopts for the oversight of financial markets, carefully tailored firewalls addressing not only bank safety and soundness concerns, but also conflicts of interest and adequate customer disclosures, are particularly important. For example, Congress deemed it prudent in the Exchange Act to prohibit a broker-dealer from overreaching to investors by lending them funds to purchase securities being underwritten by the broker- dealer.-[25]- Firewalls should be established to similarly prohibit banks from overreaching by lending funds to investors to purchase securities being underwritten by their brokerage affiliates. Similarly, banks should be required to obtain transaction-by-transaction consent from their customers to prevent their affiliated broker-dealers from dumping their poorly performing securities into the bank's trust department. Firewalls should not prevent development of competitive opportunities for financial services holding companies. On the other hand, they should be strong enough to protect the federal deposit insurance fund, to prevent banks from passing on any possible funding advantages to their affiliates, and to restrict any possible self-dealing and improper conflicts. ---------FOOTNOTES---------- -[25]- 15 U.S.C.  78k(d)(1). ==========================================START OF PAGE 26====== To the extent that firewalls are predicated on bank safety and soundness, the Commission generally defers to Congress and the banking regulators. The Commission generally supports the firewalls in H.R. 10 and H.R. 268 that would require a securities affiliate of a bank to make certain disclosures to its customers. For example, the bills would require disclosure that the securities being sold are not FDIC-insured, not bank deposits, and not bank-guaranteed. The Commission has reservations, however, about the way that firewalls would be administered under H.R. 10 and H.R. 268. The bills would place sole authority in the Federal Reserve Board (under H.R. 10) or the "appropriate Federal banking agency" (under H.R. 268) to modify existing firewalls, to impose additional firewalls, and to establish (by regulation or order) the firewalls covering director and executive officer interlocks. In order for firewalls to work effectively, securities and banking regulators both must examine for compliance and must communicate with each other about the effectiveness of the firewalls from each side. ==========================================START OF PAGE 27====== IV. Competitive Opportunities to Provide Financial Services Banks now may affiliate with securities firms and engage in securities activities to an extent unimaginable fifteen years ago. Fifteen years ago, we all thought that the Glass-Steagall Act barred banks from affiliating with securities firms. Now the Glass-Steagall Act seems no more than a vestigial formality -- a technical hurdle for a bank to jump before entering the securities business. Banking regulators routinely interpret the Glass-Steagall Act and related banking laws to give banks and bank holding companies the ability to own securities firms as special operating subsidiaries and as so-called "Section 20" subsidiaries. This year, for instance, it is likely that Bankers Trust New York Corporation will acquire Alex. Brown & Sons Inc., a full-service securities firm; SBC Warburg, a foreign investment bank, probably will acquire Dillon, Read & Co., a blue-chip broker-dealer; and it is possible that Zions First National Bank ---------FOOTNOTES---------- -[26]- The Office of the Comptroller of the Currency currently is reviewing an application by Zions First National Bank for authority for an operating subsidiary to underwrite, deal in, and invest in municipal revenue bonds (activities that a bank itself may not conduct). The Federal Reserve Board recently amended its rules to raise from 10 percent to 25 percent the amount of revenue that a Section 20 subsidiary may generate from bank- ineligible (i.e., securities) activities. This amendment will allow Bankers Trust New York Corporation to proceed with its proposed (continued...) ==========================================START OF PAGE 28====== will be allowed to underwrite and deal in municipal revenue bonds through a subsidiary.-[26]- The Glass-Steagall Act does not provide similar flexibility for securities firms. At present, the law, as a practical matter, prohibits a securities firm from acquiring a bank. This has the effect of prohibiting securities firms from entering the banking business -- either by establishing banking affiliates or by establishing special bank subsidiaries. The provisions permitting bank ownership of securities firms presently create competitive inequalities among securities firms. For example, securities firms affiliated with banks continue to have advantages due to access to the Federal Reserve System payments system. The Commission supports legislative efforts to permit affiliation among banks and securities firms. In particular, as we have said many times, to the extent banks are allowed to own securities firms, securities firms should be allowed to own banks. H.R. 10 would make progress toward a two-way street by allowing for "investment bank holding companies." These entities would be subject to limited bank regulation and would be allowed to conduct a broader array of activities than financial services ---------FOOTNOTES---------- -[26]-(...continued) acquisition of Alex. Brown & Sons Inc., which will operate as a Section 20 subsidiary. ==========================================START OF PAGE 29====== holding companies.-[27]- In addition, financial services holding companies meeting certain criteria would have the opportunity to qualify for lighter, albeit still banking, Federal Reserve Board oversight and expanded activities. This oversight would still be banking oriented, however. Beyond this, H.R. 10 still would require, pursuant to bank holding company-like regulation, a securities firm to divest most of its commercial business in order to acquire a bank. As described earlier, the Commission believes that traditional bank holding company-like regulation by the Federal Reserve Board may not always be appropriate, especially if a holding company's banking affiliates comprise only a small amount of the holding company's overall activities. An effective financial regulatory system must allow securities firms to continue to engage in entrepreneurial, risk- taking activities crucial to the capital formation process without the constraints of bank-like regulation. The risk-based oversight model described above would be especially important when financial services regulation permits securities firms to own banks. Safety and soundness principles that serve as the traditional basis for banking regulation would likely frustrate, ---------FOOTNOTES---------- -[27]- "Financial services holding companies," which would replace bank holding companies under H.R. 10, would be one of the possible structures under which banks and securities firms could affiliate pursuant to H.R. 10. ==========================================START OF PAGE 30====== rather than support, many of the activities of non-bank affiliated entities providing a variety of financial services. V. Commerce and Banking A regulatory structure that reflects today's financial marketplace and anticipates the future of financial services should permit, at a minimum, some indirect mixing of commerce and banking. This is true especially when a securities firm or an insurance company is part of a financial services holding company. Commercial companies and securities firms have always been allowed to affiliate.-[28]- Broker-dealers often hold equity investments in commercial firms as a result of merchant banking activities. In addition, we understand that most insurance companies have commercial affiliations. The Commission appreciates, however, that mixing commerce and banking presents difficult and unique issues from the banking perspective. VI. Concluding Remarks The Commission generally supports efforts to update federal financial services laws to recognize the changes in the financial services industry and to plan for the future, subject to the ---------FOOTNOTES---------- -[28]- Currently, for example, The Travelers Group Inc. owns Smith Barney Inc., Equitable Companies, Inc. owns Donaldson, Lufkin & Jenrette, Inc., and The Prudential Insurance Company of America owns Prudential Securities Incorporated. ==========================================START OF PAGE 31====== concerns described above. The Commission encourages the Committee to make investor protection a top priority as you consider modernizing the laws governing financial services. To do so, the laws must delineate clearly a rational system of functional regulation. A financial services industry in which a substantial level of securities activities occur outside of the system of securities laws and regulations is a financial services industry that provides less than full investor protection. Again, we sincerely thank you for offering us the opportunity to appear before the Committee today and to provide our thoughts for your consideration. The Commission and its staff stand ready to provide you with assistance as the debate on financial modernization continues. ==========================================START OF PAGE 32====== APPENDIX A Bank Investment Company Activities The Commission commends Congress' efforts in H.R. 10 and H.R. 268 to update the provisions of the Investment Company Act and the Investment Advisers Act to address issues that have arisen out of increased bank involvement in the mutual fund business. As a general matter, the Commission favors modernizing the regulatory scheme governing mutual funds to recognize and address the greater involvement of banks in the mutual fund industry. However, the provisions of H.R. 268 that would amend the Investment Company Act and Investment Advisers Act would apply only to banks that are affiliated with a financial services holding company ("FSHC"). Banks that are not affiliated with a FSHC would continue to operate under the present regulatory scheme. As a result, two banks engaged in the same mutual fund activities could be subject to entirely different regulatory schemes. The Commission believes that entities engaged in the same activities should play by the same rules and compete on a level playing field. For this reason, and as discussed in more detail below, the Commission strongly recommends that the provisions of H.R. 268 relating to investment companies and investment advisers-[29]- be made applicable to all banks ---------FOOTNOTES---------- -[29]- Subpart B of Title III of H.R. 268 (sections 311- 324). ==========================================START OF PAGE 33====== that participate in the mutual fund business, as in H.R. 10.-[30]- Regulation under the Investment Advisers Act Both H.R. 10 and H.R. 268 would amend the definition of "investment adviser" in the Investment Advisers Act to include banks that advise investment companies.-[31]- H.R. 268, however, would amend the definition to include as investment advisers only those banks that are affiliated with a FSHC. The Commission strongly supports amending the definition of "investment adviser" in the Advisers Act to include all banks that advise investment companies, as in H.R. 10.-[32]- This change would level the playing field for all entities that provide investment advice to mutual funds. It also would help the Commission to more effectively police the mutual fund industry.-[33]- ---------FOOTNOTES---------- -[30]- Subpart B of Title II of H.R. 10 (sections 211-224). -[31]- Section 217(a) of H.R. 10; section 317(a) of H.R. 268. -[32]- Both H.R. 10 and H.R. 268 would allow banks to segregate their fund investment advisory activities in a separately identifiable department or division ("SID"), and to register the SID (rather than the bank as a whole) as an investment adviser. We support this provision, provided it applies to all banks, not just those that are part of a FSHC, as would be the case under H.R. 268. -[33]- When examining mutual funds that are advised by a bank that is not a registered investment adviser, Commission staff is precluded from reviewing trading records related to bank (continued...) ==========================================START OF PAGE 34====== Conflicts of Interest Banks are now significant participants in the mutual fund industry. Because this was not the case when the Investment Company Act and the Investment Advisers Act were enacted, these statutes currently do not specifically address all the conflicts of interest that may arise when banks provide investment management and related services to funds. H.R. 10 and H.R. 268 recognize these conflicts and seek to address them.-[34]- The following paragraphs discuss the specific provisions of the bills that address these conflicts of interest. ---------FOOTNOTES---------- -[33]-(...continued) customers other than registered funds. This limitation makes it difficult to uncover certain practices that may violate the Investment Company Act. For example, a bank that advises a mutual fund could allocate more profitable trades to bank trust accounts and less profitable trades to the mutual fund. Bank advisory personnel also could engage in frontrunning the securities transactions of the fund by trading the same securities for their personal accounts. If all banks that advise mutual funds were subject to the Advisers Act, the staff would have access to books and records that might reveal these practices. -[34]- Many provisions of the Investment Company Act arguably provide the Commission with sufficient general authority to prevent abusive practices by banks affiliated with mutual funds. The provisions in the bills are intended to supplement this general authority with specific authority to regulate bank mutual fund activities. Of course, any rulemaking undertaken by the Commission pursuant to this authority would have to satisfy the standards set forth in section 2(c) of the Investment Company Act, which requires the Commission to consider, in addition to the protection of investors, whether the rulemaking will promote efficiency, competition, and capital formation. ==========================================START OF PAGE 35====== Bank serving as fund custodian. Under the Investment Company Act, a bank may serve as custodian of assets of an affiliated mutual fund. Both bills would permit mutual funds to use affiliated banks as custodians in accordance with Commission rules.-[35]- H.R. 268, however, would limit this ability to banks affiliated with a FSHC. Both bills similarly would authorize the Commission to adopt rules prescribing the conditions under which a bank affiliated with the underwriter or depositor of a unit investment trust may serve as trustee or custodian of the trust, although H.R. 268 would restrict this authority to a bank that is affiliated with a FSHC.-[36]- While the Investment Company Act already gives the Commission general rulemaking authority regarding mutual fund custodial arrangements, H.R. 10 and H.R. 268 would confirm that this rulemaking authority extends to custodial arrangements involving affiliated banks. By specifically restricting the rulemaking authority to banks that are part of a FSHC, however, H.R. 268 calls into question the Commission's authority with respect to banks that act as custodian to affiliated investment companies but that are not part of a FSHC. The Commission therefore recommends that the grant of rulemaking authority in sections 311(a) and (b) of H.R. 268 be extended to all banks that serve as custodian for affiliated investment companies, as in H.R. 10. We ---------FOOTNOTES---------- -[35]- Section 211(a) of H.R. 10; section 311(a) of H.R. 268. -[36]- Section 211(b) of H.R. 10; section 311(b) of H.R. 268. ==========================================START OF PAGE 36====== also suggest technical amendments to these provisions in both bills to clarify that investment companies may use affiliated banks as custodians in the absence of Commission rules. Both H.R. 10 and H.R. 268 would amend section 36(a) of the Investment Company Act, which authorizes the Commission to bring an action in federal court against certain persons who engage in personal misconduct that constitutes a breach of fiduciary duty owed to an investment company.-[37]- The amendments would extend section 36(a) to cover misconduct by an investment company custodian, although in the case of H.R. 268, this amendment would be limited to a custodian affiliated with a FSHC. The Commission supports an amendment applicable to all persons who act as a custodian to an investment company, as in H.R. 10. Lending to an affiliated investment company. Section 212 of H.R. 10 would prohibit any affiliated person of an investment company, or any affiliated person of such a person, from lending money to the investment company in contravention of such rules or orders as the Commission may prescribe. Section 312 of H.R. 268 contains a similar prohibition, although it is limited to an affiliated person of an investment company that is affiliated with a FSHC. Loans to an investment company from an affiliate carry the potential for overreaching. For example, the affiliate ---------FOOTNOTES---------- -[37]- Section 211(c) of H.R. 10; section 311(c) of H.R. 268. ==========================================START OF PAGE 37====== could charge the company an above-market interest rate. The Commission therefore supports a grant of authority to deal with any problems that may arise in connection with affiliates lending money to investment companies. The authority contained in section 312 of H.R. 268, however, covers only loans from investment company affiliates that also are affiliated with a FSHC. Under H.R. 268, the Commission would continue to be unable to regulate loans to investment companies from banks, broker- dealers, and other entities that are not FSHC affiliates. Because the potential for overreaching exists regardless of whether a lender is affiliated with a FSHC, we favor the approach adopted in H.R. 10.-[38]- Definition of "interested person." The Investment Company Act deems certain persons with a material relationship to an investment company or to a company's investment adviser or principal underwriter to be "interested persons" of those entities. The Act limits the number of interested persons who may serve on the board of an investment company and uses the ---------FOOTNOTES---------- -[38]- As currently drafted, the provisions of H.R. 10 and H.R. 268 that govern loans from banks to affiliated funds would be incorporated into section 18 of the Investment Company Act, which addresses a fund's capital structure. We recommend instead that these provisions be incorporated into section 17 of the Act, which addresses transactions between a fund and its affiliated persons. In making this revision, we also would suggest certain technical amendments to make the language in both bills conform to Investment Company Act section 17(a)(3), which prohibits an affiliated person of an investment company, or an affiliated person of that person, from borrowing money or other property from the investment company or any company controlled by the investment company. ==========================================START OF PAGE 38====== interested person concept to minimize conflicts of interests. For example, the Act requires a fund's investment advisory contract to be approved annually by a majority of directors who are not interested persons of the fund or the fund's adviser. The Investment Company Act defines an "interested person" to include any affiliated person of a registered broker-dealer. Section 213 of H.R. 10 would modify this definition by replacing the broad reference to registered broker-dealers with a more tailored reference to persons who engage in secondary transactions with a fund or with certain related persons.-[39]- That bill also would expand the definition to encompass persons who lend money to a fund or certain related persons. Section 313(a) of H.R. 268 would amend the definition of "interested person" of an investment company in the same manner as H.R. 10, but would limit its application to a person affiliated with a FSHC. As with the other provisions of the bill, section 313(a) would draw unnecessary distinctions between entities engaged in the same activities. Under section 313(a), broker-dealers and lenders not affiliated with a FSHC would not ---------FOOTNOTES---------- -[39]- This section would largely codify a distinction drawn in rule 2a19-1 under the Investment Company Act. In addition, we recommend technical amendments to both H.R. 10 and H.R. 268 to clarify that, in determining whether a person is an "interested person" of an investment company, it is necessary to consider the person's activities during the 6-month period preceding the date on which the determination is made. ==========================================START OF PAGE 39====== be interested persons of the fund, and thus would not be subject to various Investment Company Act provisions designed to minimize conflicts of interest. The Commission supports expanding the definition of interested person, as in H.R. 10, to cover all persons that engage in the transactions described above, whether or not such persons are affiliated with a FSHC. H.R. 10 includes a conforming amendment to the definition of "interested person" of an investment adviser of, or principal underwriter for, an investment company, that is not contained in H.R. 268.-[40]- The Commission believes that this provision is necessary to prevent the conflicts of interest sought to be addressed by the interested person definition and therefore recommends that H.R. 268 be revised to include a conforming amendment to section 2(a)(19)(B) of the Investment Company Act. Composition of board of directors. Both bills contain provisions that are intended to strengthen the independence of a fund's board of directors. Section 213(c) of H.R. 10 and section 313(b) of H.R. 268 would amend section 10(c) of the Investment Company Act, which currently prohibits an investment company from having a majority of its board of directors consist of persons who are officers, directors, or employees of any one bank. H.R. 10 would extend this prohibition to cover officers, directors, or ---------FOOTNOTES---------- -[40]- Section 213(b) of H.R. 10. ==========================================START OF PAGE 40====== employees of any single financial services holding company (including its subsidiaries and affiliates) or of any single bank (including its subsidiaries). The Commission supports this provision. H.R. 268 contains similar language, but would limit the prohibition so that it would apply only to officers, directors, or employees of a bank affiliated with a FSHC. The Commission opposes the limitation included in H.R. 268. Section 10(c) is intended to prevent interlocking relationships between investment companies and banks. The rationale underlying section 10(c) applies whether or not a bank is affiliated with a FSHC.-[41]- Voting requirements when a bank holds controlling interest in a fund as a fiduciary. Section 222 of H.R. 10 and section 322 of H.R. 268 would address certain conflicts that may arise when an investment company's adviser (or an affiliate of the adviser) holds a controlling interest in the investment company in a fiduciary capacity.-[42]- To ensure that the adviser does not use its fiduciary authority to further its own interests (such as by voting to perpetuate itself as adviser to the investment company), both bills would require the fiduciary to ---------FOOTNOTES---------- -[41]- In fact, section 313(b) of H.R. 268 would actually lessen the protections found in section 10(c) by permitting a majority of a fund's directors to be associated with a single bank, provided that the bank is not affiliated with a FSHC. -[42]- Section 2(a)(9) of the Investment Company Act creates a presumption of "control" when a person owns more than 25% of a company's voting securities. ==========================================START OF PAGE 41====== follow certain procedures when voting investment company shares.-[43]- Under H.R. 268, however, these voting procedures would not apply if the investment adviser is not affiliated with a FSHC. The Commission supports the voting procedures contained in section 222 of H.R. 10 and recommends that section 322 of H.R. 268 be amended to eliminate the exception for investment advisers not affiliated with a FSHC. As with other provisions of H.R. 268, we believe that there is no principled reason to differentiate between persons affiliated with a FSHC and those that are not. ---------FOOTNOTES---------- -[43]- Specifically, the bills would require the fiduciary to pass through voting rights to beneficiaries or certain other designated persons, vote the shares it holds in proportion to all other shareholders, or vote in accordance with Commission rules. The voting procedures required by the bills would not apply to any investment adviser that provides investment advice to church plans. This exemption is unnecessary in light of recent legislation that excluded church plans, and persons advising church plans, from the scope of the Investment Company Act and from registration under the Investment Advisers Act. See  508 of the National Securities Markets Improvement Act of 1996, amending Investment Company Act  3(c)(14) and Investment Advisers Act  203(b)(5). ==========================================START OF PAGE 42====== Customer Confusion Section 214 of H.R. 10 and section 314 of H.R. 268 are intended to address potential customer confusion caused when investors purchase securities on bank premises or purchase shares of an investment company that has a name similar to that of a bank. We commend Congress for seeking to deal with this issue, which has long concerned the Commission.-[44]- Both H.R. 10 and H.R. 268 would amend section 35(a) of the Investment Company Act to prohibit investment companies or sellers of investment company securities from representing or implying that the investment company, or any security issued by the company, is guaranteed by the U.S. government, insured by the FDIC, or guaranteed by a bank.-[45]- Section 214(a) of H.R. 10 also would require any person who issues or sells investment company securities to disclose prominently, in accordance with such rules as the Commission may prescribe, that ---------FOOTNOTES---------- -[44]- Because common names can be a source of customer confusion, the Commission staff has advised bank-sold and bank- advised funds that the use of common names may be misleading. The staff requires such funds to disclose prominently in their prospectuses that fund shares are not deposits or obligations of, or guaranteed or endorsed by, the bank and that the shares are not federally insured by the FDIC, the Federal Reserve Board, or any other agency. The Commission has proposed to simplify this disclosure requirement. See infra note 18. -[45]- Section 35(a) of the Investment Company Act prohibits only representations that an investment company or its securities are guaranteed, sponsored, recommended, or approved by the United States. ==========================================START OF PAGE 43====== neither the company nor any security issued by the company is insured by the FDIC, guaranteed by an affiliated bank, or an obligation of a bank. Section 314(a) of H.R. 268 contains a similar provision, but it would apply only to investment companies or sellers of investment company securities that are affiliated with a bank. The Commission supports the concept of a specific disclosure requirement, but recommends that the bills be simplified in two respects. First, we believe that the disclosure requirement should apply only to investment companies that are advised by, or sold through, a bank. We believe that customer confusion resulting from common names between banks and bank-advised or bank-sold mutual funds is not an issue with respect to funds that are not advised by, or sold through, a bank. Second, we recommend that the disclosure statement required under both bills be simplified to state in plain English that "an investment in the fund is not insured or guaranteed by the FDIC or any other government agency."-[46]- ---------FOOTNOTES---------- -[46]- In its recent proposal to amend the registration form used by open-end investment companies, the Commission proposed that the prospectus disclosure requirement for bank-sold or bank-advised funds be revised to include this simplified statement, instead of the longer statement that currently is required. See Investment Company Act Release No. 22528 (Feb. 27, 1997) (release proposing amendments to Form N-1A); supra note 16 (discussing the disclosure statement that currently is required). ==========================================START OF PAGE 44====== Both bills also would make it unlawful for any registered investment company to adopt as part of its name, or the name of any security it issues, any word or words that the Commission finds are materially deceptive or misleading.-[47]- These provisions would authorize the Commission to adopt rules or issue orders to prevent the use of deceptive or misleading names by investment companies. This amendment appears to be unnecessary, as virtually identical language recently was added to the Investment Company Act.-[48]- Section 314(b) of H.R. 268 also would provide that it is deceptive and misleading for an investment company that is affiliated with a bank that is affiliated with a FSHC to use as part of its name, or the name of any security it issues, any word that is similar to the name of the bank, in contravention of Commission rules or orders. Although the Commission supports the regulation of deceptive and misleading names, we do not support differentiating between investment companies whose names are similar to a bank that is part of a FSHC and investment companies whose names are similar to a bank that is not part of a FSHC. Moreover, because it would apply only to banks that are part of a FSHC, section 314(b) implies that the use of common names by ---------FOOTNOTES---------- -[47]- Section 214(b) of H.R. 10; section 314(b) of H.R. 268. -[48]- See section 208 of the National Securities Markets Improvement Act of 1996, codified at Investment Company Act  35(d). ==========================================START OF PAGE 45====== funds whose affiliated banks are not part of a FSHC would not be deceptive or misleading, and that the Commission does not have rulemaking authority to regulate the names of such funds. These implications are contrary to the Commission's position on common names. Finally, the authority conferred in section 314(b) appears to be unnecessary because the Commission already has sufficient authority under the Investment Company Act to make rules and issue orders concerning misleading or deceptive fund names.-[49]- Common Trust Funds H.R. 10 and H.R. 268 would codify, with some changes, a long-standing Commission position that the exception from the securities laws available to bank common trust funds-[50]- applies only if the fund is used solely to accommodate bona fide, pre-existing trust clients of a bank, and is not advertised or ---------FOOTNOTES---------- -[49]- Investment Company Act  35(d). -[50]- The federal securities laws exempt interests in common trust funds from the registration requirements of the Securities Act of 1933 and exclude common trust funds from the definition of investment company under the Investment Company Act. In addition, because interests in common trust funds are exempted securities under the Securities Exchange Act of 1934, persons effecting transactions in these interests need not register as broker-dealers. All three statutes limit the exception to a common trust fund or similar fund maintained by a bank exclusively for the collective investment or reinvestment of moneys contributed thereto by the bank in its capacity as a trustee, executor, administrator, or guardian. ==========================================START OF PAGE 46====== offered to the general public.-[51]- Section 221 of H.R. 10 would modify the language of the common trust fund exception in the Investment Company Act, and the companion provisions in the Securities Act and the Exchange Act, to restrict the exception's applicability to a bank-maintained common trust fund that meets three conditions. First, the common trust fund must be employed solely as an administrative convenience for the management of accounts created and maintained for fiduciary purposes. Second, interests in the fund may not be advertised or offered for sale to the public, except in connection with generic advertising of the bank's overall fiduciary services. Third, the common trust fund may not charge fees and expenses in contravention of fiduciary principles established under applicable federal or state law. Section 321 of H.R. 268 contains a similar provision, but its restrictions would apply only to a common trust fund maintained by a bank that is affiliated with a FSHC. The Commission generally supports codifying its position with respect to common trust funds, as in section 221 of H.R. 10, but does not support section 321 of H.R. 268. Because H.R. 268 would apply only to common trust funds of banks affiliated with a FSHC, it would result in the unequal regulation of common trust funds. It also would, by implication, overrule the Commission's common trust fund position with respect to banks that are not affiliated with FSHCs, effectively permitting these banks to ---------FOOTNOTES---------- -[51]- Section 221 of H.R. 10; section 321 of H.R. 268. ==========================================START OF PAGE 47====== offer such funds to public investors without registration under the Investment Company Act.