Speech by SEC Staff:
Mutual Funds in 2006: Getting Back to Basics and Embracing Core Values:
Remarks before the ICI 2006 Securities Law Developments Conference
Andrew J. Donohue
Director, Division of Investment Management
U.S. Securities and Exchange Commission
December 4, 2006
Good morning and thank you, Elizabeth, for that kind introduction. It is a pleasure to be with you today. I am pleased to be at the Securities and Exchange Commission in my new role as Director of the Division of Investment Management. In this capacity, I now have the privilege and obligation of reminding you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
II. Fiduciary Culture of the Fund Industry
As we know, the past three years have been a period of upheaval for the fund industry, marked by the late trading and market timing scandals and related enforcement actions, investigations and press scrutiny. In addition, the past three years have featured an unprecedented period of new mutual fund regulation and its resulting implementation challenges. The SEC has also been experiencing its own period of transition with a new chairman, Chairman Cox, taking the reigns of the agency last year and my arrival in May to lead the Division of Investment Management. In fact, the heads of each of the major SEC Divisions as well as the General Counsel have changed in the past two years.
The recent tumultuous period experienced by the fund industry has resulted in unprecedented fund personnel changes, significant improvements to business practices, enhanced focus on compliance policies and procedures, and some healthy introspection and self-evaluation. It also, hopefully, has resulted in a rededication, on an industry-wide basis, to serving fund investors, which, of course, should be a primary focus of anyone involved in the fund business.
As the new Director of the Division of Investment Management, my message to fund managers is to get back to basics and embrace core fiduciary values. By getting back to basics and focusing on fiduciary values, I mean fund managers should focus on the investor-which is where the industry's focus is properly placed. After all, over 96 million investors have entrusted you with properly managing $10 trillion of their assets. This is an incredible responsibility and one that the fund industry must discharge consistent with the highest fiduciary standards.
Having spent some thirty years at fund management firms, I have a genuine respect for the fund industry and the people who work in it. I know, from first hand experience, that the fund industry by and large is composed of honest, hard-working professionals who are committed to serving investors and enhancing the financial well-being of their clients. The fiduciary culture is integral to the fund industry, and is one of the true strengths of mutual funds. This fiduciary culture--and the focus on investor interests that derives from fiduciary values--should be apparent at any well-run mutual fund firm.
Because my belief in the fund industry's core fiduciary values is so strong, I believe you will find me to be one of the harshest critics of those who are not seeking to serve the interests of their investors. If fund managers are not striving to further their investors' interests, then they should no longer have the privilege of serving investors. If someone cannot abide by a fiduciary's code of conduct, then there should be no place for that person in an industry that is dedicated to fiduciary values. If a fund industry professional is improperly pursuing his or her own interests over the interests of fund investors, then it is my hope and full expectation that the Commission would aggressively pursue an enforcement action.
A fund manager's fiduciary obligations to fund investors are continuous - on that, I believe, we all agree. A fiduciary duty therefore requires a full-time commitment to maximizing investor interests, rather than part-time attention, when convenient. The ongoing nature of a fund manager's fiduciary obligation also requires that fund managers re-assess whether they are continuing to maximize investor interests as their businesses change.
The mutual fund industry is continuously evolving and seeking out new ways to serve investors. I welcome that innovation and encourage your creativity. In particular, as America's population ages and significantly larger numbers of us join the ranks of so-called "senior" citizens, I believe it can be helpful for the fund industry to continue to develop funds and related services that benefit this growing segment of America's population. I caution you, however, to never decouple innovation from your continuing fiduciary obligation. With each new innovation comes new compliance challenges and responsibilities. As the investment management industry develops new products and services, meeting your fiduciary obligation to investors should be your driving force and ultimate goal - not an afterthought.
In my opinion, no new product should be brought to market, no new service agreement should be entered into and no new fee arrangement should be brokered without senior management, representing the business, legal and compliance areas, giving careful and thorough consideration to whether the new product, service or arrangement will benefit investors and whether the material management conflicts have been identified and appropriately resolved. America's investors deserve nothing less.
III. Investment Management Priorities
Given that I am speaking to you for the first time as the Director of the Division of Investment Management, I imagine that you are anxious to hear more than my philosophy about fiduciary values. You also may be curious about particular regulatory priorities that the Division of Investment Management may pursue under my direction, or that we might recommend that the Commission pursue. Today, I would like to focus on two of those priorities: the mutual fund disclosure reform and interactive data initiative and the Division's focus on the processing of exemptive applications. I have chosen to focus on these initiatives because of their importance, their relevance to this audience and because, from the moment I first walked through the front door of the SEC's headquarters back in May, they have received a significant amount of my time, focus and attention as Division Director.
A. Mutual Fund Disclosure Reform and Interactive Data
I'll start with the mutual fund disclosure reform and interactive data initiative. To summarize the goal of this initiative, I borrow from the title of a recent speech by Chairman Cox: the goal is "Giving Investors the Information They Need, in a Form They Can Use." If that goal sounds simple-the process of achieving that goal certainly is not. There are several challenges that lie ahead-principally challenges regarding mindsets and challenges related to technology. I believe both sets of challenges can be overcome, but it will require leadership from the industry as well as a commitment to serving the needs of investors.
The first challenge involves changing the mindset of many in the industry-but most particularly the attorneys-when it comes to the primary purpose of disclosure. The mutual fund prospectus is viewed by many in the industry primarily as a litigation protection document, rather than a tool to effectively communicate with shareholders and prospective investors. We all need to work to change this viewpoint. The fund prospectus can serve both purposes. Both as mutual fund regulators and as mutual fund industry professionals, we should have a fundamental focus on ensuring that fund investors facing the daunting challenge of deciding where to invest should have access to meaningful, helpful, clear information about a fund. On many levels the current fund prospectus may not be achieving this important goal.
Within a month of my arrival at the SEC, we held a Roundtable on Interactive Data and Mutual Fund Disclosure Reform. The Roundtable featured speakers representing a variety of perspectives. Fund industry representatives, investor advocates, third-party users of fund disclosure and even a plain English expert were present. Out of these different perspectives came a strong concensus for a short-form disclosure document for investors containing key information about a mutual fund investment, with more detailed information available on-line, or if requested, in paper. This disclosure model may represent a significant departure from past practices. However, I believe that the current disclosure regime has not been fully successful in communicating effectively with fund investors. Therefore, it seems appropriate to make significant-even radical-changes to our disclosure requirements, rather than making small changes around the edges.
With respect to technological challenges, there are many. To the extent that the Commission, as a regulator, permits increased use of technologies such as interactive data and the Internet to enable investors to access information, we-the Commission staff-need to better understand those technologies and how they can be best utilized for and by fund investors. Interactive data holds great promise as a tool that can be used by investors in a targeted, meaningful way to obtain the fund-related information they most care about - while at the same time avoiding the "clutter" that accompanies flipping through a hefty printed document.
With the advent of interactive data as a tool for fund investors, we are at the forefront of a meaningful, perhaps even revolutionary, change in the way that investors access information about their funds. I like to think of interactive data capabilities as providing investors with "Disclosure on Demand." Developing a meaningful and useful interactive data system for mutual funds may be a challenge, but it is a challenge I look forward to working with you to meet. Together, I believe we can lay the groundwork for an interactive data system that will serve the needs of many generations of mutual fund investors.
I should emphasize that the disclosure reform initiative and the increased use of technological capabilities, particularly interactive data, are closely tied. If the staff's work on disclosure reform does lead us to recommend a short-form disclosure document, it will be extremely important to also provide for a mechanism, such as an interactive data system, that will enable fund investors, the intermediaries who help them evaluate funds and others to have access to more detailed fund information-in a more accessible, user-friendly and automated fashion than is available today.
I would like to thank the Investment Company Institute for the leadership it has shown with respect to mutual fund disclosure reform and interactive data. First, as many of you are aware, the ICI has announced a project to extend current interactive data capabilities by creating additional tags, or identifiers, that will cover all of the information in the risk/return summary of a mutual fund prospectus. This is an important project that will greatly enhance the potential utility of interactive data for mutual fund investors. In addition to that effort, the ICI participated in the SEC's June Roundtable on interactive data and mutual fund disclosure reform and even at today's conference reserved the first panel for a discussion of disclosure reform and interactive data. Among its speakers, that panel features Susan Nash, Associate Director in the Division of Investment Management, who is providing the key leadership to the Division's efforts on mutual fund disclosure reform and interactive data.
Like you, I look forward to the panel's discussion of these timely and important matters, so I will leave a discussion of the details to them. Before leaving this topic, however, I do encourage the mutual fund industry to follow the lead of the ICI in embracing efforts to assist the Commission and its staff to reform fund disclosure and make greater use of interactive data for the benefit of fund investors. I would also like to thank Old Mutual Advisor Funds and Allegiant Advantage Fund, which are the two funds that have filed financial documents using tagged data under the Commission's pilot program.
If the Commission is to be successful in its simple and laudable goal of Giving Investors the Information They Need, in a Form They Can Use, then the Commission and its staff will need your willingness to work with us to make this goal a reality. Without a doubt, the industry's commitment to providing meaningful information to investors in a simple and useful format exemplifies the kind of investor-oriented focus that I encourage the fund industry to embrace.
B. Exemptive Applications Processing
Another area where I encourage the fund industry to work with the Division's staff involves exemptive applications processing -- the other Division priority I plan to discuss today. As you know, the Investment Company Act imposes significant, substantive restrictions on the operation of investment companies. In drafting the Act, however, Congress recognized the need for flexibility in the administration of the Act. The Act therefore contains provisions that empower the Commission to issue orders granting exemptions from restrictions of the Act, authorizing transactions, or providing other relief, provided that the exemption is necessary or appropriate in the public interest and consistent with the protection of investors. Each year the Commission receives hundreds of applications seeking orders under the Act. As a general matter, the staff of the Division reviews and comments on these applications. If we determine to support the requested relief, a notice is published in the Federal Register that gives interested persons an opportunity to request a hearing on the application. If no hearing request is received, and the Commission does not order a hearing, an order is issued granting the relief.
The applications process under the Act has been a significant and valuable tool in the evolution of the fund industry. For example, the Commission oversaw the creation of money market funds in the 1970s and a variety of exchange-traded funds ("ETFs") during the past 13 years through the applications process. More generally, granting appropriate relief under the Act often provides important economic benefits to funds and their shareholders. The staff therefore recognizes the importance of considering and, where appropriate, granting relief as quickly and efficiently as possible. However, we also recognize the critical importance of analyzing applications carefully to determine whether the relief requested, together with any conditions to the relief, meets the relevant statutory standards and truly benefits investors.
The efficiency of the processing of exemptive applications in the Division of Investment Management has been frequently criticized by the fund industry and industry observers. I would note here that this is not a new issue, and probably every Investment Management Director has had this important area as a focus at some point in his or her term. Without debating the merits of those criticisms or the various reasons for delay in the processing of certain exemptive applications, I am here to tell you that we, as a Division, are committed to processing exemptive applications in an appropriate and efficient manner, consistent with our duties to protect investors.
It is my firm belief that you will soon see noticeable improvements in exemptive applications processing-if you have not already. These improvements are due almost entirely to changes developed and implemented by the hard-working staff in the Investment Management Division. But, as you know, we on the staff control only one side of the process-the regulator's side. You, as applicants, also have responsibilities and a key role to play when it comes to improving the process for reviewing and issuing exemptive relief.
First, I would like to discuss some of the steps that our staff is taking to improve the efficiency of the processing of exemptive applications. The first step involves enhanced communications with applicants. Within days of filing a new application for exemption, you should receive a call from one of our staff members confirming that the application has been received by our Division, identifying the staff attorney assigned to the application and providing you with a telephone number you can call at any time to check on the status of your application.
As a result of this new procedure, it is my expectation that there will be no more stories of applicants submitting applications and then hearing nothing for months. Despite some such portrayals, our Applications Office is not a black hole. Our staff is committed to informing applicants about the status of their applications.
As part of this commitment, another new procedure our staff has implemented is that they will provide applicants with a "status update" call within 60 days after receiving an application. In addition, if there has been no communication between an applicant and our staff for any 60-day period, the applicant should receive an additional call from our staff providing an update. During intervening periods, if you have questions about the status of your application, you should call the staff member designated and request the information you need. Our staff is committed to returning all calls from applicants in a prompt manner, which generally means by the end of the next business day.
Our staff is not trying to play hide the ball with your applications or trying to wish away an application's existence by ignoring it. Very often, there is extensive work being performed on an application that is not always visible to the applicant, so please feel free to ask, keeping in mind that the staff will share what they can with you but cannot disclose non-public information, including Commission consideration.
In addition to these enhanced communications, our staff has set an aggressive goal for itself of essentially doubling the number of exemptive orders that are issued this fiscal year. This is no small feat, and I am extremely pleased that our staff has set such a high standard for itself, which they are committed to meeting without sacrificing the quality of our review process. I also expect that many applicants will be receiving initial comments on their applications more quickly as a result of these new procedures instituted by our staff.
Another exemptive applications initiative our staff is pursuing is the filing of exemptive applications on EDGAR, similar to the way registration statements and amendments are filed on EDGAR. It is my expectation that EDGAR filing will enhance the efficiency and especially the transparency of the exemptive applications process.
A key element of these steps to improve the efficiency of applications processing is that each of the ideas was initiated and implemented by the staff. They were not imposed from the top down, which suggests to me that they are likely to be meaningful steps that will take hold and improve the process for some time to come.
As I indicated, however, our staff represents only one side of the equation. We need to work in tandem with you, the applicants, if we are to be successful in our goal to significantly improve the processing of exemptive applications. Therefore, I asked the staff to provide a list of DOs and DON'Ts for your consideration when it comes to exemptive applications. I thought they came up with some helpful ideas, so I would like to share them.
First, before you file an application --
DO call the Applications Office for guidance on the most recent developments, the best precedent to use, or any other helpful hints. Our staff is pleased to answer questions before an application comes in -- it saves everyone time and ultimately makes for happier applicants and reviewers.
DO anticipate the staff's questions and concerns when drafting the application -- if your application deviates from the relevant precedent, explain the differences, and the reasons for the differences, in detail in a cover letter with the application. Try to project yourself into the staff's position as reviewers. The better job you do in identifying and addressing the legal and policy issues, the easier -- and quicker -- their review will be. If you are not sure what their concerns might be, call the Applications Office.
DO NOT submit an application you know is quickly drafted just to "get in line." A quickly drafted application will take us longer to review than a well-drafted one that might be farther back in the line. In addition, I have encouraged the Applications Office to reject poorly drafted applications.
DO NOT let a first-year associate run with the application -- close supervision of the application and familiarity with the facts and issues by an experienced '40 Act attorney will speed the application's progress and avoid misunderstandings.
Next, when you file an application --
DO make sure it is properly filed. Sending a copy only to the Division's Applications Office does NOT satisfy the filing requirement. If in doubt about how to file, call the Applications Office, they will be glad to explain. Misfiled applications could result in weeks of delays.
DO include a redlined copy if you're closely tracking a previously ordered application. It will speed the review process. Make sure that you are redlining against the final version of the previously approved application.
DO work with the staff in responding to comments. If you do not understand a comment, or think it is unnecessary, tell us and we will talk it over. Don't sit in your office and stew about it.
And, finally --
DO tell the staff about deadlines ahead of time - the staff does its best to accommodate applicants' deadlines, but they need reasonable notice.
As with many issues, communication is key, and we look forward to working with you to enhance communications and thereby enhance the applications review process, for the benefit of applicants and fund investors. Again, this type of commitment to engaging in innovations in a responsible manner for the benefit of investors, is the type of fiduciary focus that I, our staff, and your shareholders expect from the fund industry.
In addition to our direct efforts to improve the processing of exemptive applications and work more effectively with applicants, there are several indirect measures we can take to relieve the burden on our Applications Office. Of course, the most obvious way is to recommend that the Commission codify certain types of frequently-granted exemptive relief through the rulemaking process. Earlier this year, for example, the Commission adopted new fund of funds rules, which codified previously granted exemptive orders and eliminated the need to file an exemptive application when structuring many fund of fund arrangements. In addition, the staff is preparing a recommendation for adoption of a manager of managers rule and a recommendation for proposal of an index-based exchange-traded fund rule. We are also in the process of addressing the backlog of managed distribution plan exemptive applications that have been pending by imposing a new and unified set of conditions for applicants requesting this type of relief. In addition, the staff has a longer-term plan to consider recommending a new rule to address this area.
One type of exemptive application that our staff has particularly targeted in 2006 is exchange-traded funds. Seven ETF applications have been noticed this year, including ones providing for novel relief in the ETF space. By focusing on ETF applications now, it will free up our staff to work on other types of investment company applications in 2007. In addition, the ETF rule proposal that our staff plans to recommend to the Commission would eliminate the need to obtain an exemptive order to introduce certain index-based exchange-traded funds, if the rule is ultimately adopted.
In conclusion, while many in the fund industry may be breathing a sigh of relief that the period of mutual fund scandals may be behind us, I believe that the period we are entering into may be similarly challenging. The fund industry has an opportunity to prove to America's investors that it is deserving of their trust and confidence. You have an opportunity to assert your primacy as an industry dedicated to fiduciary values.
However, proving your worth to America's investors will require more than talk - it will require demonstrable actions that benefit your investors. It will require a return to the fiduciary values on which the fund industry is based. And it will require a commitment to the basic principles that helped funds become a $10 trillion industry - values like the primacy of investor interests, the importance of resolving conflicts in the interest of investors rather than management, and the old-fashioned idea that investors in mutual funds deserve a fair deal and straight talk from the fund managers. By embracing these basic and timeless fiduciary values, I believe that the fund industry can once again emerge as an industry where America's investors can place their trust.