Speech by SEC Staff:
Keynote Address at the Practicing Law Institute Investment Management Institute 2007
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, N.Y.
April 12, 2007
Good morning. It is a pleasure to be here. I want to thank Joel Goldberg and Paul Roye and the Practicing Law Institute for inviting me to speak with you. I am particularly grateful for the opportunity to participate in this conference. Not surprisingly, I have found that in our work in the Division of Investment Management we can get easily caught up in the details of current rulemakings and important issues that arise throughout the day. I know many of you share a similar experience in your practices in this area as you focus on discrete transactions and respond to particular situations. This conference, however, with the high quality of the presenters and the diversity of topics covered, provides a great opportunity to reflect over the next two days on the investment management regulatory regime as a whole: to review where we have been, where we currently are, and where we might be going. It is in this context that I will focus my remarks this morning. Before I begin, however, I need to state clearly that my remarks here today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
I. Where Have We Been?
As I was preparing my remarks for this morning, I picked up a copy of the conference brochure and the first paragraph struck me. It notes that "over the past year the investment management industry has spent a lot time, effort and money coming into compliance with a host of new regulations… and that the industry has now returned to a state of normalcy, but it is also moving ahead with the creation of new products, new distribution models and other developments." Reading this made me realize that you as industry practitioners and we in the Division of Investment Management are operating on parallel tracks. While the industry experienced an upheaval in 2003 as the late trading and market timing scandals came to light, the Commission also experienced the urgency of the situation as it adjusted its regulatory agenda to respond to this event. In the years since, while the industry has been determining how to best implement the variety of new regulations that were adopted, we have been responding to your questions, assisting with implementation of new regulations and assessing the effectiveness of the new regulatory landscape. Now, I would contend that, like you, we have also returned to a certain extent to a state of normalcy.
II. Where Are We Now?
Review of Regulatory Inventory
For the Division, this period of normalcy is characterized as one of review and refinement of our regulatory inventory. In this regard, one of the most important projects we are currently undertaking is an exercise that I anticipate continuing on a regular basis. Over the years, the regulations governing investment companies and investment advisers have accumulated as the Division and the Commission have responded to important issues of the day. As time has passed and circumstances have changed, certain regulations may no longer be relevant or necessary or could be improved to adapt to modern practices. This year, and going forward, my staff and I will be reviewing the regulations governing investment companies and investment advisers and considering whether any may need to be revised, updated or eliminated. Part of the Division's objective in embarking on this review is to enable us to focus on achieving our regulatory goal of investor protection without overburdening firms and investors with regulations that may no longer be necessary or effective. This cataloguing of all our regulations will help us to determine how we should focus our limited resources as we go forward.
Another way that we are identifying the areas that might require revision is through an active outreach effort to fund directors to learn their perspective on our current regulatory regime. As you know, the laws and regulations governing investment companies, and many exemptive orders, rely heavily on the oversight activities of fund directors, especially independent directors, a reliance that has steadily increased over the years. With the increase of regulations requiring action by fund boards, we risk overburdening directors and detracting them from their fundamental activities, which I believe should be largely devoted to monitoring conflicts of interest and looking out for shareholder interests. For this reason, I am reaching out to fund directors by attending industry meetings they attend and by attending fund board meetings. Through this effort I hope to learn the regulations and guidance that directors believe should be amended or revised that would make a big impact on their work, as well as any quick regulatory fixes we could make that would assist them. Ultimately, through this effort, we hope to learn what we can do that may enable fund directors to be more effective in their essential role.
Back to Basics
In addition, I would like to mention that even though we are currently examining the regulations governing investment companies and investment advisers to determine those that may require revision, firms still need to comply with all the regulations governing them — even the seemingly most mundane requirements.
Perhaps the most fundamental principle in the fund business is that fund advisers are fiduciaries, which means the client 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 believe that focusing on basic and fundamental compliance obligations is the best way to achieve a culture of compliance within firms and also will hopefully prolong this period of relative normalcy that we are all enjoying.
III. Where Might We Be Going?
Ah, now we have arrived at the fun part — where are we going? I am very fortunate to be in my current position in the Division of Investment Management during this period of time. While responding to issues resulting from some recent court cases does require the commitment of Division resources, I believe we can now also devote some of our limited resources to rules that were either adopted many years ago when the state of the industry was vastly different and are now outdated or to rules that could be revised or improved to better address the needs of the industry and investors.
Disclosure Reform and Interactive Data
In this regard, the first initiative I would like to discuss is the Division's disclosure reform initiative. This initiative is a top priority for Chairman Cox and plays a key role in what he has called the Commission's "war on complexity" in the information that investors receive. I am hopeful that it will greatly assist investors and funds by providing a format for disclosure information that is clear, meaningful and helpful to investors in making their investment decisions.
The initiative has two interconnected components — the first is mutual fund disclosure reform and the second is interactive data tagging. For the mutual fund disclosure reform component, my Division is preparing a recommendation to the Commission that would permit funds to offer securities pursuant to a streamlined disclosure document to be delivered to investors electronically or on paper, while requiring more detailed information to be available on the Internet or delivered in paper upon request. The streamlined disclosure document that the Division is considering could include key information investors need to make informed decisions, such as fees and expenses, risks, investment objectives and strategies, and historical returns.
Although the Division's recommendation is still being prepared, the current profile prospectus is one model we are looking closely at. We are considering how that model has worked with respect to liability, updating, delivery and other issues. In terms of format, I have a personal preference for a two-page document with only a single fund discussed in the short-form document. I believe this type of format will remove much of the confusion and "clutter" about which many fund investors complain.
The staff is also examining whether to update and streamline shareholder report requirements, including whether to recommend rules that permit mutual funds to provide a streamlined report with more detailed information available via Internet posting or in paper form upon request.
In addition to providing investors with significantly streamlined disclosure, the second component of disclosure reform would provide investors with a complementary ability to access more detailed information about a fund through the use of interactive data.
Recently, there have been some significant developments in this project. In January, the Investment Company Institute released for public review a draft taxonomy that it developed for tagging the key disclosure data contained in the risk/return summary that is at the front of every mutual fund prospectus. This information, including investment objectives and strategies, costs, risks, and historical performance is critical to an investor's informed investment decision. With this development the ICI has made great strides towards the creation of a technological tool that has the potential to enhance the way in which information is provided to mutual fund investors. In February, the Commission issued a proposing release requesting comment on permitting funds to use the new taxonomy developed by the ICI to tag their risk return summaries in the Commission's voluntary interactive data filing program. The comment period closed on March 14th, and we are in the process of reviewing the comment letters. The voluntary risk return summary tagging program would allow us to test the usefulness of the interactive tagging system, as well as identify any deficiencies of the system. I am very hopeful that this initiative is successful.
Additionally, a very exciting development with the disclosure initiative is that the Division is now working with the Department of Labor to extend the application of these reforms to the disclosures made to participants in 401(k) plans. The amount of fund investments that come through 401(k) plans continues to grow and the staff is considering closely the type of disclosure that 401(k) participants receive about the funds they invest in or are considering investing in. Different 401(k) participants receive varying levels of information, from full prospectuses and shareholder reports to one-page charts containing limited data and information. I believe 401(k) participants investing in funds would benefit greatly from standardized information about fund investments — if that standardized information is clear and meaningful. I am hopeful that, working with the Department of Labor, the streamlined mutual fund disclosure document that the Division expects to recommend to the Commission will become the type of standardized mutual fund disclosure document that 401(k) investors receive as they consider mutual fund investment options.
Another 401(k) related issue that the staff is examining is the expenses relating to the administration of 401(k) plans, about which plan participants may not be aware. The staff is also examining revenue sharing issues and the information plan sponsors may be receiving. While these issues are not principally the Division of Investment Management's responsibility, we are reviewing our role with respect to these fees and disclosures and considering whether we should recommend any regulatory revisions — again in coordination with the Department of Labor.
Another initiative that fits squarely into this period of considering rules that may not be fully effective in the current mutual fund environment is the review of rule 12b-1. Rule 12b-1 was adopted over 26 years ago, in 1980, when the fund industry was in a substantially different state. There had been a period of net redemptions and there was concern that the fund industry may not survive without the ability to use a small portion of fund assets to facilitate distribution. The factors that fund boards are to consider in adopting and renewing 12b-1 plans were developed then and are still in effect.
Today, with over $10 trillion in assets, the fund industry seems to be thriving and it has not experienced a recent period of sustained net redemptions. 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, the $11 billion funds pay annually through rule 12b-1 fees are used primarily as a substitute for a sales load or to compensate brokers for servicing their clients — uses that are much different than the Commission originally intended when adopting the rule. I submit that few would contend that the rule doesn't need at least a tune-up after all these years. Accordingly, I recently announced that it was time for the Division 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. This initiative is a top priority of the Division this year.
Books and Records
When considering regulations that have not been updated in some time and that are in need of reform, the investment company and investment adviser books and records requirements come immediately to mind. These requirements were adopted in the early 1960s. With the technological advances of the current electronic age and the changes in the investment management industry, these rules are in great need of reform. The Division is currently undertaking a comprehensive review and wholesale re-thinking of the recordkeeping requirements for investment companies and advisers. As we go through our analysis, we will look at the purpose behind each requirement and determine whether we can obtain the same information in a more meaningful and less obtrusive manner. We are looking at how firms currently maintain and update their records. We are also considering the technologies available today that may assist firms in maintaining and producing records in a cost-effective manner. We want to get these revisions right and I have asked the Division staff to use the time necessary to understand current practices and technologies that investment advisers and funds are using to maintain and produce their records.
When looking into the future in terms of regulation, a good place to start is to follow developments in the industry. In my opinion, the investment management industry has always been one of the most creative, dynamic and innovative areas in financial services. During this period, the industry continues to be very active in moving forward with new products. For example, we have seen the introduction of a number of new exchange-traded funds, including so-called leveraged ETFs, or ETFs that seek a multiple or inverse multiple of the return of various indices, an ETF based on affiliated indices, and the introduction of high yield bond ETFs. The Division is also continuing to consider the issues involved with proposals for actively-managed ETFs. Separately-managed accounts is another area of investment management that is growing in popularity.
Other developments that are on the Division's radar screen include 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.
An additional area of concern for me is the increasing use by funds of derivatives and sophisticated financial instruments. I have concerns on multiple levels and believe it is imperative that all relevant parts of a fund's operations team understand a portfolio instrument and appreciate its use and implications. This should include, not only the portfolio manager and investment officers involved in the decision to use a new type of financial instrument, but the legal, compliance and accounting groups must understand the instrument as well — and have implemented the proper legal, accounting and compliance techniques and controls. I have further concerns that many fund firms' systems, particularly compliance systems, may not be sophisticated enough to effectively handle synthetic instruments. Fund managers should also be certain they understand the risks, pricing and volatility of these instruments.
I want to thank PLI again for inviting me to speak with you today. I hope that they will not have much work to do on the text of the brochure for this program next year and that it rightly notes again that the mutual fund industry is in a period of normalcy, and that it has allowed both you and us to keep moving ahead. Thank you for listening and I hope you enjoy the conference.