Speech by SEC Chairman:
Address to the Mutual Fund Directors Forum
Seventh Annual Policy Conference
Chairman Christopher Cox
U.S. Securities and Exchange Commission
April 13, 2007
Thank you, Susan [Wyderko, Executive Director of the Mutual Fund Directors Forum] for that kind introduction. If my kids could hear you talk about their Dad, they'd wonder if it's the same person. The incongruity would probably be too much for them. Sort of like the way we feel when we watch someone order a double cheeseburger, large fries, and a Diet Coke.
So let me take a minute to sing Susan's praises. The Forum is truly fortunate to have such an outstanding Executive Director. It was my privilege to work with Susan at the Commission, where she was a dedicated advocate for the protection of investors, as she is today. Whether it was through investor education or leadership of the Commission's regulatory program, Susan was tenacious in advancing the Commission's mission. And the mantel over her fireplace bears the honors she won in the process: the Distinguished Service Award, the Stanley Sporkin Award, the Federal Bar Association's Manuel F. Cohen Younger Lawyer Award, and - on three separate occasions - the Commission's Law and Policy Award.
I also know that David Ruder very much wanted to be here today, and so I'd like to say how honored I am to be here at his invitation, nearly 20 years after President Reagan named him to be Chairman of the Securities and Exchange Commission. As a counsel to President Reagan at the time, I had the privilege of knowing first hand how the President came to make such an outstanding choice. It's really astonishing to consider how much David Ruder must know now, given that when he was nominated, he'd already written more than 40 articles and led more than 150 educational programs for corporate and securities practitioners - not to mention having served as dean of Northwestern University's School of Law for eight years. By the time of his appointment, he'd spent more than eight years working on the ALI project to codify the six statutes then administered by the SEC. And if that weren't enough, during his tenure as Chairman, he dealt with Black Monday on October 19, 1987; led the Commission through the Milken/Drexel Burnham era; and showed great foresight in expanding the international reach of the Commission. And as Susan well knows, David's campaign against penny stock fraud is alive and well at the SEC in the Internet era.
So the Forum - and more importantly, the investors you serve - are very fortunate to have both Susan Wyderko and David Ruder applying their extraordinary talents and energies to your critical agenda.
Eight years into your mission, good governance of the mutual fund industry has never been more important. With more than $10 trillion in assets, mutual funds have replaced the savings accounts of old as the primary long-term savings vehicle for almost half of all American households. As a result, insuring that investors can have confidence in the way their mutual funds are managed is key to maintaining confidence in our financial system.
As independent directors, you play a critical part in the stewardship of this industry. I greatly appreciate and thank you for your commitment to the important work of protecting mutual fund investors. You have helped us in so many different areas that are critical to investor protection - not least of all with respect to 12b-1 fees, which, as you know, the Commission is closely examining this year.
When the Commission adopted Rule 12b-1 more than a quarter century ago, our premise was that 12b-1 plans would be relatively short lived. The idea was that 12b-1 fees would be used to solve specific distribution problems, as they arose. And indeed, in the early going, that was our experience. No-load funds used 12b-1 fees of 25 basis points or less to offset the costs of advertising, of printing and mailing prospectuses, and of printing and mailing sales literature.
All of this was consistent with the Commission's purposes in adopting the rule, at a time when nurturing mutual fund growth was an SEC priority. Specifically, the Commission's action came at a time of net redemptions. There was a very real concern that if funds were not permitted to use at least a small portion of their assets to facilitate distribution, many of them might not survive.
Very quickly, however, 12b-1 plans came to be used for other reasons. Most notably, instead of paying for distribution, they became a substitute for front-end loads. In this way, more substantial sales loads could be collected while the fund could still advertise itself to investors as "no load." The transformation of the 12b-1 fee from a distribution subsidy to a sales load in drag is now so nearly complete that the primary purpose to which the $11 billion in 12b-1 fees last year were put was to compensate brokers.
Another way that 12b-1 fees have veered away from their conceptual basis as distribution subsidies has been using them to pay for administrative expenses in connection with existing fund shareholders. Even some funds which are closed to new investors continue to collect 12b-1 fees.
So it is that today, by far the lion's share of mutual funds' 12b-1 fees are used for these two purposes. Back in 1980, the Commission noted in our adopting release that we and our staff would monitor the rule's operation closely. And if experience suggested that the rule's restrictions on the use of fund assets were insufficiently strict, we made it clear we would be prepared to act to remedy the situation.
Now, with nearly three decades of experience under our belts - and with today's uses of 12b-1 fees barely recognizable in the light of the rule's original purpose - it is high time for a thorough re-evaluation. The considerable distance that 12b-1 fees have strayed from the rule's paradigm isn't just occasion for the Commission to take a hard look at current practices. It's also a reason for independent directors to take a fresh look at the way this use of investors' funds has evolved.
That's because Rule 12b-1 places considerable burdens on independent directors, without whose approval no payment may be made by a fund in connection with the distribution of its shares. Specifically, not just the fund's board, but a majority of the independent directors have to agree to the 12b-1 plan. And the rule imposes additional oversight duties on fund directors, including that each year, without fail, you're required to approve your fund's 12b-1 plan. One element of the plan you cannot leave out, or change, is that it may be terminated at any time by vote of a majority of the independent directors.
Rather obviously, the Commission had you in mind when the rule was devised. And if that weren't enough to make you feel intimately involved with the decision to collect 12b-1 fees, you are also required to periodically review all of the amounts that are spent in the name of the plan for which you are so personally responsible - and to satisfy yourself as to the reasons for those expenses.
In doing all of this, fund directors are held to the fiduciary standards set out in both Section 36 of the Investment Company Act, and in applicable state law.
Given that the Commission has so thoroughly bound the decision to charge 12b-1 fees to the independent judgment of the fund's disinterested directors, both we and you together have to tackle head-on the problem of brokers' sales commissions masquerading as fund marketing costs. It is worth revisiting, therefore, the original intent of Rule 12b-1, and considering its meaning in light of today's market realities and current practice.
What the SEC had in mind in 1980 is that requiring current investors to subsidize the sale of fund shares to new investors could be a good thing - even from the standpoint of the current investors - because increasing overall fund size could help better diversify their holdings, and also proportionally reduce the burden of administrative costs that might now be spread over a wider pool of investors. After all, higher expense ratios reduce investors' returns percentage point for percentage point.
But whether, in fact, a fund's current investors are getting a break depends upon how the investment advisory contract is written. If increasing the size of the fund simply enlarges the fees earned by the investment adviser, the supposed benefits from economies of scale are undone. So one of the things that independent directors must concern themselves with in reviewing the propriety of any 12b-1 fees used for distribution is whether the fees paid to the management company and other vendors, as a percentage of total fund assets, has risen or fallen as the fund has grown. If the size of the fund is increasing, but the expense ratio isn't falling, then using a 12b-1 fee for marketing and distribution expenses is very likely harming, not helping, the current investors.
There are other reasons to question the continued vitality of Rule 12b-1. Today the mutual fund industry is no longer at risk of suffering crib death, as was the case years ago when rule 12b-1 was adopted. At more than $10 trillion and counting, the survival of the mutual fund industry is plainly no longer at issue. Indeed, we have learned by this point in the 21st century that it can be just as big a problem for investors when a fund grows too large as when it is too small. The assumption can't always be made that growth in total assets inevitably assists existing investors. When funds grow too big, they can lose flexibility, with the result that investors get lower returns.
For all of these reasons, the original premises of Rule 12b-1 seem highly suspect in today's world. If ever it was justified to indulge an irrebuttable presumption in favor of using fund assets to compensate brokers for sales of fund shares, that time surely has passed. Collecting an annual fee from mutual fund investors that is supposed to be used for marketing is no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers.
In meeting the fiduciary standards of the Investment Company Act and state law, of course, independent directors have to focus on the investors whose interests they represent. And so the independent directors' decision whether to approve a 12b-1 plan, and payments out of fund assets made pursuant to the plan, has to be no unless existing shareholders will benefit. Ironically, the strongest case for saying yes might well be when the 12b-1 fee is used to pay not for distribution, but for administrative services that are far afield from the kinds of costs that the original rule had in mind. After all, there is no question that processing shareholder transactions, maintaining shareholder records, and mailing account statements, fund communications, and reports to shareholders are services delivered to current investors - not potential new ones. That is at least a tangible something, as opposed to paying a commission to a broker. And it has a basis in some of the exemptive orders that have been issued over the years. But to the main point, it is a very different something than the rule itself contemplated when it was first adopted.
That is why Rule 12b-1 is an issue the Commission will address this year. And as we do so, we will have the interests and concerns of independent directors, whose responsibilities and sensitivities to the fund's investors are thought to be particularly acute, uppermost in our minds.
Nor is that all that the Commission will be doing this year that will be of direct interest to you. We intend to re-propose and then finalize our mutual fund governance rule. As you know, the comment period recently ended on the economic studies that were done in connection with the rule as it was first proposed - before its invalidation in the court of appeals. We are reviewing these comments carefully, analyzing them in the context of a comment file that now spans almost four years and includes more than 14,000 letters -including the thoughtful comments submitted by the Forum. We will punctiliously observe the procedural requirements to which the court directed us, and we will complete that important business with due regard for the comments already submitted, and those yet to be received.
We are also in the midst of a broad initiative to examine the adequacy of investor disclosures by mutual funds and other investment vehicles in a typical 401(k) plan. With an emphasis on both the disclosures by the constituent investments in the 401(k), and the aggregate disclosures by the plan, we aim to make it far easier for busy Americans to understand the expenses they're being charged in connection with their investments, and the after-tax, after-inflation returns they're actually getting compared to an appropriate index. Even though this will require collaboration with the Department of Labor and other investment regulators, we're confident we can achieve a great deal in the coming months - and that the effort is supremely worthwhile, given what's at stake.
The historic shift from company-guaranteed pension plans to investor-directed vehicles such as 401(k) plans and other defined contribution retirement plans has put this issue at the center of our radar. Americans no longer can count on conventional pensions for support during their increasingly long retirement years. Defined benefit plans are going the way of the 8-track tape. So applying yourself diligently all of your working life won't mean retirement. It will mean a new career as a do-it-yourself money manager.
Every American worker and every American family potentially are affected. And, as a nation, we've got to get this right, because an America burdened by large numbers of elderly living in straitened circumstances will not be a happy place, and the resulting problems will manifest themselves in countless dysfunctional ways.
Our current arrangements, however, fall tragically short.
To far too great a degree, and in substantial part because of a regulatory cumbersomeness that obscures the real numbers, our financial services industries are able to skim off much more of the assets they handle than would be the case in a well-functioning market. The difference materially burdens an investor's annual expected returns. And compounded over the retirement time horizon of even someone in his or her 50s, this can result in truly astronomical shortfalls.
This is happening even now on a nationwide basis. That's why you can be sure that the "investors advocate" will be tackling this issue for the benefit of not only our senior citizens, but today's young savers as well.
Americans already invest well over $3 trillion through these defined contribution retirement plans. And as I'm sure you know, nearly half of that is in mutual funds. And with the number of elderly Americans expected to grow 80% within the next 25 years, these already eye-popping numbers will grow further still. We want to be sure that today's retirees, and tomorrow's, have the information they'll need to successfully manage their savings through a retirement that, actuarially speaking, is guaranteed to be far longer than their parents'. So to insure we get the job done sooner rather than later, in the coming months we'll hold roundtable discussions with the nation's leading experts, and publish a concept paper outlining the issues we're addressing and the solutions that have been suggested. That, in turn, will pave the way for a formal rule proposal later this year.
In this process, we'll be building on a substantial record that has already been compiled, including at our SEC Roundtable last June. From the input of investor advocates, third-party users of fund disclosure, fund directors such as yourselves, and others, a strong consensus emerged for the creation of more succinct, easy-to-understand disclosure documents for investors that highlight the key information about mutual funds that is most important to investors. The Commission's staff is already working on proposals to create this streamlined disclosure document for investors. Along with the improved presentation, those proposals may also call for better and more detailed information about investment objectives, strategies, risks, and costs, which could be made available online or in writing, as the investor prefers.
And while we're doing this we'll continue to work to purge all of the legalese from these disclosures, and convert them into plain English. Getting rid of gobbledygook is no easy task, of course. After all, it isn't just legalese that has problems - even ordinary English often needs improvement. Just ask yourself: why is "abbreviated" such a long word?
So we'll stay at it. And at the same time, we'll be examining the different types of disclosure that 401(k) participants receive, which today vary from full prospectuses and shareholder reports to one-page charts that contain extremely limited information. Our goal, working with our fellow regulators, is to develop an approach to 401(k) disclosures that permits each investor to obtain the information necessary to inform a sound investment decision.
Nor will we stop there.
Your organization has consistently focused on the significant conflicts of interest that fund directors face in connection with soft dollars, and the Commission plans more work here, as well.
Soft dollars can serve as an incentive for fund managers to disregard their best execution obligations, and also to trade portfolio securities inappropriately in order to earn credits for research and brokerage. Soft dollars also represent a lot of investors' hard cash, even though it isn't reported that way. The total of soft dollars runs into the billions each year for all investment funds in the United States.
An agency focused on ensuring full disclosure to investors has to be very concerned about this, because soft dollars make it more difficult for investors to understand what's going on with their money. Hard dollars eventually end up being reported as part of the management fee the fund charges its investors. But soft dollars provide a way for funds to lower their apparent fees - even though, in the end, investors pay for the expense anyway.
The very concept of soft dollars may be at odds with clarity in describing fees and costs to investors. The 30-year old statutory safe harbor, in Section 28(e) of the Exchange Act, was probably thought to be a useful legislative compromise when it was packaged with the abolition of fixed commissions. But surely in enacting Section 28(e) Congress meant to promote competition in research, not to create conflicts of interest by permitting commission dollars to be spent in ways that benefit investment managers instead of their investor clients.
That is why the Commission is continuing to examine the potentially distortive effects that soft dollars can have on what should be the normal market incentive to seek best execution. And we're looking to ensure that when soft dollars are used to pay for research, it doesn't interfere with the full disclosure of actual management costs. In particular, the Commission will consider whether fund boards could better assess soft dollar arrangements if the Commission were to mandate better disclosure of the research and brokerage services that the adviser gets in return for a bundled commission. If directors are able to compare the broker's execution-only commission rate with its bundled rate, they could make more meaningful inquiries into the value of the additional services that the fund shareholders are getting.
Our recent interpretive guidance was a step forward in this area, but it may not be enough to wipe out the abuses that the Commission has discovered, such as soft dollars used to pay for membership dues; carpeting; entertainment and travel expenses; and lavish expenditures for interior decorators and beachfront villas. So while the Commission's soft dollar release was important, you can rest assured it won't be our last word on this subject.
Again, I want to commend each of you, and this organization, for your leadership in this area. I look forward to our continued work together.
As you almost certainly know by now, no speech of mine, whether short or long, would be complete without a mention of interactive data. And because of the leadership that the mutual fund industry has shown, my mentioning it in this context is a very pleasant opportunity. Earlier this year, the Commission issued a proposing release requesting comment on whether mutual funds should now begin to use interactive data to report the information in the risk/return summaries. Since these summaries include a fund's investment objectives as well as its strategies, costs, risks, and historical performance, letting investors and analysts easily use and compare this data has the potential to vastly improve the quality of information that's provided to mutual fund investors.
Your industry's participation in the Commission's interactive data initiatives has been truly exemplary.
The truth is, as independent directors, you share more than just our goals at the Commission. An article in today's paper reminded me that not only are we partners in our mission of investor protection, but also the way the law expects us to execute our roles gives us similarly weighty responsibilities.
Like you, each of the five Commissioners of the SEC shares the duty of overseeing and monitoring the operations and activities of our organization. Under procedures established long before I became Chairman, no formal investigation is initiated, no case is filed, no settlement is agreed to without Commission approval. Each of us has been appointed by the President and confirmed by the Senate with the express understanding that, like you, we will be independent in our actions and our judgments, with only the welfare of the nation's investors and markets as our special interest.
Nowhere is this more important than in the area of enforcement, where - as we saw in the mutual fund scandals of 2003 and 2004 - vigorous Commission action is necessary to ensure that a culture of ethics and compliance operates throughout a fund complex for the benefit and protection of the funds' investors. At the same time, Commission review of enforcement actions shouldn't slow down the process. As both the Commission's caseload and its staff have grown in recent years, that has posed a genuine tradeoff for Commissioners seeking to fulfill their fiduciary duty.
What full Commission review should provide is a guarantee of fairness and of horizontal equity in a nationwide program. And it should be the wind at the backs of our staff across the country as they seek to obtain the best possible results for America's investors. When enforcement lawyers in settlement discussions sit eye-to-eye across the table from counsel for the defense, we want them to know they have the full backing of the Commission. Our staff will have the strongest negotiating position, of course, if the Commission has reviewed the proposed range of outcomes before the offers in settlement are made. So in a handful of cases where the need for national consistency is greatest, we're reviving what had been a long standing policy of the SEC for all cases for many years - that Commission approval be obtained before settlement discussions are commenced. But we'll do so with a difference: When cases are settled within the range of guidance provided by the Commission, they will be eligible for summary approval through the Commission's seriatim procedure. And I and each of the Commissioners are committed to seeing to it that this procedure works to speed up, not slow down, our cases.
The category of cases we've selected consists of those in which a monetary penalty against a company might be involved. As you know, very recently the Commission adopted new guidelines for cases of this kind, and we are anxious to ensure that in the early days of its implementation, the precedents we establish are clear, consistent, and in accordance with the instructions of Congress in the Remedies Act. Already, there's been speculation whether this procedural change portends a shift to higher or lower penalties. It is, of course, designed to do neither, but rather to ensure that the laws are vigorously enforced with the benefit of full Commission review.
But if I had to hazard a guess, it would be that if anything, the penalties you will see imposed in future cases will be stiffer - because the staff lawyers negotiating them won't have to hedge their bets, wondering whether the Commission will later on back them up, or rather cut them off at the knees. We should never put our staff in such a position. They are America's finest, and every Commissioner is extremely proud of the work they do. We're confident that this new approach will give them more flexibility and better tools to do their jobs more effectively and more quickly. It will also give each of the Commissioners a better opportunity to do our jobs, which require of us the same oversight responsibilities that each of you must constantly exercise as independent directors.
We have much to learn from working with you. And because the key to any good partnership is communication, I and each of the Commissioners have been actively reaching out to fund directors to engage in a dialogue. I plan to continue to meet personally with members of mutual fund boards, because you know from first-hand experience what SEC regulators can do that would make a positive impact in your work. You best understand the funds you oversee and your shareholders' expectations; you are the ones who are called upon to make determinations about fund fees and operations; you routinely interact with fund management and have intimate knowledge of not only the funds, but also their service providers and personnel.
That is why we need you to partner with us to make sure the mutual fund industry meets the highest possible standards for investors. We need you to help us in constantly enhancing oversight. Ultimately, investors are depending on you to get the answers, to require accountability, and to ensure fairness and integrity in the conduct of the funds' business. Their investments are in your hands. You have a truly important responsibility, to our nation and its citizens, and we at the SEC have every confidence that you are up to the challenge.
Thank you for inviting me, and more importantly, thank you for what you do every day. We at the SEC are proud to be your partners.