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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at 2007 Mutual Funds and Investment Management Conference


Andrew J. Donohue1

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

Palm Desert, CA
March 26, 2007

I. Introduction

Thank you very much. Before I begin, I would like to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the SEC staff.

It is a privilege and an honor to be here before you today as the Director of the Division of Investment Management. Throughout my 30-plus-year career in the fund industry, I have developed a genuine and healthy respect for the Securities and Exchange Commission, the Division of Investment Management and the regulatory regime that fostered a vibrant and varied fund industry that, most importantly, was beneficial to America’s investors. Since the passage of the Investment Company Act in 1940, the fund industry has grown and prospered in part because of the ingenuity, entrepreneurial spirit and commitment to excellence exhibited by most fund industry personnel. I believe, however, that one of the fund industry’s greatest strengths is its effective regulatory regime and the protections it has afforded American investors.

The mutual fund regulatory regime has a fundamental focus of managing the conflicts of interest inherent in the fund structure and of ensuring that the interests of investors are paramount to those of fund management. It is those ideals that I am proud to represent and hope to continue to foster as the Director of the Division of Investment Management.

Being successful in this mission, however, is not an easy task. Thankfully, I have some tremendous role models. As Division Directors, Paul Roye, Barry Barbash, Marianne Smythe, Kathryn McGrath, Joel Goldberg, Sydney Mendelsohn, Anne Jones and Allan Mostoff displayed astute wisdom, strong leadership, practical problem-solving skills and an unwavering commitment to investor ideals. As a result, funds stand in the position of prominence they hold today: at over $10 trillion in assets and the unrivaled investment vehicle of choice for the average American. Funds have achieved this milestone despite the very well-publicized anti-investor behavior revealed during the so-called mutual fund scandals of the very recent past.

They have also reached this milestone despite an admittedly comprehensive regulatory regime that some have labeled rigid, out-of-date, and even anti-competitive. I, however, strongly disagree. I believe our fund regulatory regime with effective SEC oversight to be true strengths of the industry, and I seek to follow the example of my well-respected predecessors to promote investor-oriented policies and a healthy fund industry benefiting investors.

While passing the $10 trillion threshold was a significant event for the fund industry, it would be foolish to gloat about past accomplishments and today’s achievements. If we are to be successful in serving America’s investors, the fund industry and fund regulators need to focus on where we are going tomorrow.

Looking toward the future, there are several areas that I believe we need to work on. The first is modernizing regulations so that they are effective in the 21st century. The second is continuing to recognize the increasing globalization of the securities markets and the importance of international coordination and cooperation. The third, and possibly most important, is remembering the basics, those fundamental regulatory requirements that helped to build a strong fund industry by protecting fund investors. The fourth is promptly identifying and confronting our fears, not ignoring possibly risky practices or emerging negative trends or issues.

II. Modernizing Rules for the 21st Century

If the Division of Investment Management wants to retain its role as a relevant and respected regulator in the 21st century, then we must seriously consider which of the regulations we administer has outlived its utility or is in need of a 21st century makeover. In the latter category, the investment adviser and investment company books and records rules immediately jump to mind. I think the current requirements in some cases may, at a minimum, be confusing to funds and advisers. In other cases, I think the requirements may be inadequate for the needs of our examiners. And in all cases, I think today’s issues with the books and records requirements stem in part from the fact that the requirements were primarily developed in the early 1960s when the world, especially from a technology perspective, was a very different place. By the way, in the beginning of the 1960s, there were less than 200 mutual funds having assets of less than $20 billion. Thus, the books and records requirements were written for a far different environment than exists today.

Back when the SEC adopted its current books and records requirements, what we today call “snail mail” was actually the gold standard in communication. Neither overnight delivery, two-day priority packaging nor e-mail--let alone instant messaging--yet existed. If an investment adviser had a particularly urgent message, I suppose the adviser headed down to the local telegraph office and had the telegraph officer bang out a message. In fact, when I started working in the industry in 1975, the firm I worked for was “advanced” and had a telegraph type system in our offices (as well as an IBM selectric typewriter). Needless to say, the world has certainly changed—as has the fund industry. Unfortunately, the books and records requirements generally have NOT changed along with it.

If the recordkeeping rules are not working well for the fund industry and are not working well for our examiners, then the ultimate losers in that equation are fund investors. Therefore, I believe it is time to engage in a significant overhaul of our recordkeeping requirements after a thoughtful and comprehensive review.

The staff of the Division of Investment Management has begun this effort—with a view toward moving away from the paper and file-drawer focus of our current recordkeeping rules and focusing instead on technology-based alternatives. Essential to this process is an understanding of how funds and their investment advisers implement technology currently to maintain and retrieve books and records and meet their other regulatory requirements. In order to improve our understanding of these practices, Investment Management staff have been participating in some on-site examinations, though not in an examiner’s role. Instead, they are meeting with CCOs, compliance staff and back-office personnel in order to listen and learn from those in the trenches regarding practical and effective recordkeeping techniques. In addition, Division staff are working with examination staff to understand the practical limitations that the current rules may bring to bear on the recordkeeping process and the SEC’s effective oversight of the fund industry.

While this recordkeeping modernization initiative is critically important, it is not an initiative that should be rushed. If the SEC is going to modernize the books and records rules, it should be done right. That is why the staff is engaging in a thorough study and review of current requirements, and current deficiencies with the requirements, as well as present practices and use of technology. I expect the staff will engage in this process for close to the remainder of the year as it listens and learns. From the experience they gain and the perspective they develop by reaching out to those personnel responsible for records management, the Division can then develop rule proposals for Commission consideration that will work in a 21st century global, technological, competitive and investor-oriented environment. I look forward to working with you to make this a reality.

III. Coordinating Internationally

Speaking of a global environment, it is abundantly clear that in the 21st century, U.S. markets are no longer financially isolated, if indeed they ever were. Therefore, if we are to have an effective fund regulatory regime, that regime cannot be isolationist or U.S.-centric. During my ten months on the job as Division Director, I have met with foreign regulators and benefited greatly from the experiences they shared and the insights they provided. We have much to learn from our overseas counterparts, as they do from us.

In many cases, the financial regulatory regimes in effect overseas were developed decades after those in the United States—often with the benefit of evaluating our system. Therefore, many overseas regulatory regimes have a more modern approach and perhaps a less disjointed foundation. As we know all too well, the foundation for the U.S. securities regulatory regime is the four principal securities statutes enacted between 1933 and 1940. While those statutes have worked well and withstood the test of time, I doubt that any of us starting from scratch today would advocate a four-statute approach for the laws applicable to the current securities industry. And, of course, there are separate laws for banks, insurance companies and the rest of the financial sector.

As a U.S. regulator, I want to learn from my foreign counterparts, find out what works well for them and what we can perhaps implement in our regulatory regime and oversight environment. I encourage the fund industry to similarly look overseas for investor-oriented practices that can be imported to the U.S. fund industry.

The mutual fund industry in the United States, with approximately 9000 funds and over $10 trillion in assets, is the envy of the world. The U.S. mutual fund regulatory regime has served investors well. We should all strive to maintain that standard by assessing internationalization from the perspective of fund investor interests.

IV. Remembering the Basics

As I have stated, seeking to modernize and focusing internationally are important if we are to have a regulatory regime in place that is to remain effective. But we also need to remember the basics – and that applies both to fund regulators and to the fund industry. Perhaps the most fundamental principle in the fund business is that fund advisers are fiduciaries, which means the investor comes first. If this fundamental principle is embedded in your culture and drives your actions, then you will be highly respected, both by fund investors and fund regulators.

Beyond this fundamental principle, however, there are some basic regulatory requirements that should be hard-baked into the DNA of any fund management firm. And I am always surprised when I see these types of requirements being ignored. I cannot find any justification for such actions or lapses.

For example, the Investment Company Act, as you are aware, prohibits the payment of a dividend or distribution from any source other than net income unless the payment is accompanied by a written statement identifying the source of the payment. This is a basic and fundamental statutory requirement. However, last year, the Commission settled a case in which three closed-end funds, over a four-year period, made 98 distributions that included a return of capital. None of those distributions was accompanied by the required written statement. I was shocked that a requirement so fundamental was so thoroughly ignored.

I raise this issue because if the fund industry wants to be strong in the future, you cannot forget what made you strong in the past. The fund industry continuously evolves, with new entrants joining, new funds being developed, new employees being hired and new services being provided to fund investors. As this evolution occurs, however, the fund industry cannot stray from the fundamental fiduciary, compliance-oriented culture on which it was built. Running a sloppy business or ignoring regulatory requirements will eventually catch up with you. It is intolerable that fund investors could be potentially harmed by breaches of basic regulatory requirements.

Another area in which “getting back to basics” is important is in the role of fund directors. The fund industry has prospered, and fund investors have benefited, under a mutual fund governance regime that relies on fund directors to exercise judgment and oversee conflicts of interest. Oversight of conflicts is a basic and fundamental function for fund directors, and I want to make sure that we have not so overloaded fund boards that it is difficult for them to effectively perform their oversight role.

Therefore, I am committed, in 2007, to undertaking the beginning of a review of fund director responsibilities under the Investment Company Act, Commission rules and Commission exemptive orders. I have begun to engage in a dialogue with fund directors to see whether the Division should consider recommending that the Commission amend its rules to revise requirements that may not make the best use of director time. Throughout the year, I expect to focus on reaching out to fund directors to hear from them what the Commission can do to enable directors to be more effective.

Along these lines, I am interested in potential rule revisions that are easy to do—i.e., quick fixes—and important to do—i.e., not necessarily easy, but could have a significant impact. I am also interested in whether there are areas in which fund directors could benefit from additional guidance, in addition to fair valuation and soft dollars.

In engaging in this exercise, I think it is worthwhile to hear directly from fund directors, rather than having the Division staff guess at what would be helpful to fund boards. I approach this exercise with the idea that blindly following tradition does not always lead to the most effective regulatory landscape or director oversight structure. Just because fund directors have been performing a certain task, or undertaking a certain review, in the past, does not mean that it is the most effective way for fund directors to serve investors going forward. I truly believe it is time for a forward-looking review of fund director responsibilities, from the viewpoint of maximizing fund directors’ ability to serve and protect investors. And I look forward to listening to what fund directors have to say on this important issue.

Before I move beyond the theme of getting back to basics, I must discuss one basic issue, with a very modern twist. And that is the fund disclosure that investors receive. Adequate, meaningful disclosure has been one of the most basic and fundamental hallmarks of the U.S. mutual fund regulatory regime. But the fund disclosure of the past, very likely will not work for the fund investor of tomorrow. There is no denying that many investors have entered the technological age. The U.S. regulatory regime therefore should further investors’ use of technology to obtain mutual fund information, not hinder it.

A strong step in this direction is the Commission’s initiative to institute a program for mutual funds to voluntarily file their prospectus risk/return summaries using interactive data. The risk/return summary provides information about fund objectives, strategies, risks, costs and performance that many investors need when making a fund investment decision. “Tagging” that information using interactive data opens a world of possibilities in terms of searching, comparing and analyzing that information in ways that currently are far too time consuming for the average investor. I wholeheartedly encourage fund participation in the voluntary filing program, if adopted by the Commission, so that the Commission can assess the benefits of an interactive data program, as well as any pitfalls that may exist.

Closely tied to the Commission’s voluntary interactive data program for mutual funds is the project the staff is undertaking to recommend to the Commission a streamlined, short-form disclosure document for mutual fund investors. Again this project represents an effort to make use of technologies available today to enhance the mutual fund regulatory regime. As envisioned, investors would receive a short-form, streamlined disclosure document, with additional information available on the Internet or in paper upon request. While this disclosure model would be a significant departure from past practices, it would represent an acknowledgment that many fund investors currently are overwhelmed with paper—they need and deserve a streamlined disclosure system that better meets their needs and is consistent with the manner in which most Americans retrieve and process information in the 21st century.

V. Confronting Our Fears

As we are all aware, in the dynamic fund industry of the 21st century, there are constantly evolving investment techniques and industry issues that must be addressed. When I was in the fund industry, one of the most frightening phrases I heard come out of a portfolio manager’s mouth, or the mouths of my colleagues, was “there is nothing to worry about.” When I heard those six words, I would begin to work on overdrive to better understand a new investment technique, business prospect or legal issue.

I have found that those who are most successful in life are also, very often, the biggest worriers. They are not placated by a calming voice saying everything is under control; instead they use their own initiative and energy to fully assess a potentially problematic situation.

Surprisingly, now that I have held the job of Division Director for a while, the number one question I get is no longer, “how do you like it?” I suppose no one cares if I am happy or not – or they take me at my word when I say that I am thrilled with my current position. Instead, the number one question I now receive as Director of the Division of Investment Management is “what do you worry about?” And that question comes not from psychiatrists, as one might expect, but from reporters, fund directors, fellow regulators—both domestic and international, and even some of your colleagues. It is an excellent question, and one we should all be asking ourselves if we want to stay ahead of issues.

When I am asked “what do I worry about,” several items come to mind. It does not mean that I am crafting a regulatory proposal to address each one. But it does mean that I view them as emerging areas of concern that both regulators and the industry should monitor and explore.

One issue I worry about is rule 12b-1 fees. I have said that rule 12b-1 is an issue I would like to see the Division address during my tenure as Director. Looking backward to the time when rule 12b-1 was adopted in 1980, the fund industry was in a very different state. There had been a period of net redemptions, and there was a concern among some industry observers that if funds were not permitted to use a small portion of their assets to facilitate distribution, funds might not survive.

Fast forward to today, and at over $10 trillion, the fund industry does not seem to be in imminent threat of extinction. Furthermore, the industry has not been through a recent period of sustained net redemptions, and with the growing popularity and acceptance of mutual funds by average American investors, the fund industry’s demise seems unlikely. Not surprisingly, the primary use of 12b-1 fees has shifted from the limited marketing and advertising purposes that were originally envisioned. Instead, it appears that, in many cases, rule 12b-1 fees are used primarily as a substitute for a sales load or for servicing. Against that backdrop, and with a forward-looking perspective, it would seem wise to reconsider rule 12b-1, both the rule itself and the factors that fund boards must consider when considering approval or renewal of a rule 12b-1 plan. While I have previously stated that this is something I would like to address during my tenure with the Division of Investment Management, I am announcing today that this is something that we will address. This is now a high priority for the Division this year.

Another issue I worry about is the proliferation of certain yield-based investment products, especially as many baby boomers approach the distribution phase--as opposed to the wealth accumulation phase--of their personal investment cycles. The fund industry has been very successful at creating funds that have enabled investors to accumulate wealth through investment in domestic and global securities markets. I now hope the industry will be responsible as it develops products to meet the needs of those investors in the distribution phase. It has been reported that many investors at the retirement stage of their lives are investing in funds based principally on the yield those funds may provide. It is imperative that funds, and those who sell fund shares, are clear about how that yield is generated, whether that yield is from income, and the risks that may be associated with a fund and its yield-generation techniques. This phase of an investor’s cycle is extraordinarily important and ill-designed funds can have a devastating effect on America’s senior citizen investors.

Another area of concern for me is the increasing use by funds of derivatives and sophisticated financial instruments. I have concerns on multiple levels. First, as we saw with the tender option bonds/inverse floaters issue, it is imperative that all relevant parts of a fund’s operations team understand a portfolio instrument and appreciate its use and implications. Of course, the portfolio manager and investment officers will be involved in the decision to use a new type of financial instrument. In addition, however, it is imperative that the legal, compliance and accounting groups understand the instrument as well—and have implemented the proper legal, accounting and compliance techniques and controls. I also worry because many fund firms’ systems, particularly compliance systems, may not be sophisticated enough to effectively handle synthetic instruments. Furthermore, these instruments generally emanate from the sell side. The sell side has the systems to manage them and the experience to better deal with their risks, pricing and volatility. Funds, on the other hand, very often are newcomers. I am not trying to say that funds should not invest in these instruments, but I am saying that you should do a lot of work up front before you wade into uncharted territory. That way you—and your fund investors—will not be disappointed later.

These are but a few of the issues I worry about. Ask me in one month’s time and the list may be entirely different. But my point to you is that we should not ignore those issues that worry us. I am hopeful that we can trust our instincts, investigate further and seek to manage the issues that are the most worrisome or perplexing. By doing so, I believe that funds can be an investment vehicle that is deserving of the trust and confidence of today’s and tomorrow’s investors.

VI. Conclusion

In conclusion, we all have been handed a legacy. Me by the previous leaders of my Division and you by your predecessors who have nurtured an industry from under 500 funds and $50 billion in assets when I began my career in 1975 to its current status. I believe the fund industry of tomorrow, if it is to be successful – or even to continue to exist – must have one key attribute that the industry has exhibited during most of its post-1940 existence: a commitment to an investor-oriented fiduciary culture. As I have said before, if the fund industry or its personnel engages in anti-investor behavior, I will be your harshest critic. I have too much respect for funds and their investors to permit actions that are not conducive to a fiduciary culture.

I look forward to the fund industry of tomorrow. And I hope that I can follow the example of the men and women who came before me to help shape the mutual fund regulatory regime to provide the flexibility, oversight and investor protections needed in the 21st century marketplace.

Thank you very much.

1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.



Modified: 03/26/2007