Speech by SEC Staff:
Remarks Before the NAVA Compliance and Regulatory Affairs Conference
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
June 25, 2007
Thank you for that kind introduction, Mike DeGeorge. It is good to be here this afternoon, and I thank NAVA for the invitation to speak to you today. Before I begin, however, I need 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 Commission staff.
There is something I find particularly attractive about the tag line for this conference: “Technology and Compliance — Essential Elements for Meeting the Needs of Clients and Regulators.” This suggests to me that you and I share certain common goals. We both want to meet investors’ needs in the best possible way. We want to use current technology to make that effort more efficient and to make important information more accessible to investors. So my starting point is a sense of alignment of my objectives with those of my audience.
Today, I would like to discuss with you some of the regulatory challenges that are currently the focus of our attention in the Division of Investment Management at the SEC, and to give you a sense of what you might expect in the upcoming months. I thought it might be helpful to look together at what makes certain regulatory issues become “hot button” topics.
Sometimes the reason is obvious — when the Commission responds to specific problems within the industry by strengthening regulations. This happened in response to the problems of late trading and market timing. Other times — and this is what I like to see — regulatory initiatives are proactive. As part of the Division’s ongoing responsibilities, we review the regulations governing investment companies and investment advisers and consider whether any of them need to be revised, updated, or eliminated. With the passage of time and developments in the investment management industry, some regulations may need to be refined to serve their purposes in light of product developments and changes in industry practices. The practice of reviewing our rules is broad in scope, and relates to the investment management industry as a whole; the variable insurance products industry and your investors are a part of it. I invite you to share your views regarding regulations affecting variable insurance that could be more effective. The staff is interested in hearing from you.
Now I’d like to share with you a few specific initiatives that are a focus of attention in the Division of Investment Management.
II. Rule 12b-1
One such focus is Rule 12b-1. In April this year, Chairman Cox announced that rule 12b-1, which was adopted over 25 years ago when the fund industry was in a very different state from what it is today, was ripe for re-evaluation. In this regard, the Commission has been taking steps towards examining how the rule is currently used and determining whether it continues to fulfill its original purpose of allowing funds to use a small portion of their assets to facilitate distribution. The Commission’s examination of rule 12b-1 is likely to be of interest to this audience, as a number of funds underlying variable insurance products, since 1996, have adopted 12b-1 plans in connection with the distribution of fund shares through the sale of variable contracts. Your industry has thus become very much a part of the 12b-1 picture.
As you may know, as one step in re-evaluating 12b-1, the Commission held a roundtable discussion last Tuesday, June 19th. The roundtable participants, which included industry experts, academics and investor advocates, discussed the many issues that have developed surrounding the use of rule 12b-1, including the historical circumstances that led to the fees, their intended purposes, the changes in their uses, the rule's current role in fund distribution practices, the costs and benefits of the current system, and the options for reform or repeal.
In conjunction with the Roundtable, the Commission has also requested public comment on rule 12b-1. As I mentioned, your industry has become part of the 12b-1 picture and I strongly encourage you to submit your comments. Your insights will greatly assist us in identifying and evaluating the appropriate course for any reforms. We especially need your assistance to ensure that, regardless of what direction reform may take, the specific issues and nuances relevant to the variable products industry are fully considered. All comments we receive become part of the public record of the roundtable and will be posted on the Commission’s website. Please note that the comment period will close on July 19th.
III. Revenue Sharing
I would like to talk a little bit about the practice of revenue sharing. In the Division, we continue to consider the disclosure and regulatory issues raised by the practice of revenue sharing. Advisers of funds often pay, out of their profits, amounts intended to compensate those who sell fund shares, service shareholder accounts, or provide other services to the fund.
The Division is considering the regulatory issues that may be raised by some of these arrangements. Certainly, it is settled that a fund may pay for legitimate distribution services under a bona fide 12b-1 plan, and that an adviser may pay out of its profits for legitimate distribution or other services rendered. However, recently the Division has received inquiries about some arrangements that have raised questions about the nature of the services being provided in return for revenue sharing payments. One place these questions have arisen is in the context of funds of funds, in which a variable annuity may offer as an investment option a fund of funds managed by an affiliate of the insurer. In these structures, a contract owner would choose to invest in the fund of funds, and the fund of funds would have complete control over its underlying investments — indeed, the fund of funds' investment adviser would have fiduciary duties with respect to the selection of those investments. In such a structure, I am curious about the extent to which revenue sharing payments from an adviser of a bottom-tier fund to the insurance company or other affiliates of the adviser of the fund of funds could represent payments for services rendered rather than kickbacks for purchases of shares of the bottom-tier funds, which could raise issues under Section 17 of the Investment Company Act. The Division is considering these issues, and my staff and I welcome your thoughts as to the appropriate regulatory treatment of these arrangements.
IV. Disclosure Reform and Interactive Data
This leads me to another initiative - the Division's disclosure reform project. This is a top priority and plays a key role in what Chairman Cox has called the Commission's "war on complexity" in the information that investors receive. I am hopeful that it will result in the presentation of information that is clear, meaningful, and helpful to investors in making their investment decisions. To that end, the staff is examining various ways to streamline disclosure to produce more understandable, useful information that investors can and will actually use.
A. Prospectus Improvement and Interactive Data
The initiative has two interconnected components — prospectus improvement and interactive data. For the prospectus improvement component, the Division is formulating a recommendation to the Commission that would permit funds to offer securities using streamlined disclosures that would be provided directly to investors, with more detailed information provided on the Internet or in paper upon request.
In lieu of the current prospectus/SAI regime in which a full prospectus is provided with the trade confirmation, I envision a disclosure regime involving layers of disclosure. The initial layer would be streamlined information available to assist in the investment decision. This would include key information investors need to make informed decisions, such as investment objectives and strategies, costs, risks, and historical returns. I envision providing investors, their intermediaries, analysts, and others with access to supplemental layers of information with additional detail so that investors and other users can choose how deep to go. The staff is considering the form the additional layers should take and how to make that information most accessible to investors. Ideally, the information would be available in an electronic form that is interactive and searchable.
This concept represents an effort to make use of technologies available today to enhance the mutual fund disclosure regime. However, it also represents an acknowledgment that many fund investors currently are overwhelmed with paper — they need and deserve a disclosure system that better meets their needs and is consistent with the manner in which Americans increasingly retrieve and process information in the 21st century.
For the past two years, the SEC has been working on the technological infrastructure that would make this kind of a layered and interactive disclosure regime possible — data tagging. Data tagging uses standard definitions (or data tags) to translate text-based information into data that is interactive, that is, data that can be retrieved, searched, and analyzed through automated means. Tags are standardized through the development of taxonomies, which are essentially data dictionaries that describe individual items of information and mathematical and definitional relationships among the items. Tagged information can help investors, analysts, and other users to mine the wealth of information contained in detailed disclosure documents, providing users with the ability to access precisely the information in which they are interested and to analyze and compare that data.
As you are aware, the Commission currently permits companies, including mutual funds, to voluntarily submit financial statement information in a tagged — or XBRL — format. Early this year, 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 of the mutual fund prospectus. This information, including investment objectives and strategies, costs, risks, and historical performance, is critical to an investor's informed investment decision. I am pleased to tell you that this month the ICI’s risk/return summary taxonomy was recognized as an acknowledged XBRL taxonomy by XBRL International.
June has been a banner month for moving XBRL forward. Just last week, the Commission adopted rule amendments expanding the current interactive data voluntary reporting program to enable mutual funds to submit exhibits to their registration statements containing tagged risk/return summary information. I expect that by later this summer EDGAR will be updated, which will allow volunteers to begin submitting tagged risk/return summary information under the expanded program. Hopefully, the spirit of voluntary participation will be strong and provide the Commission with sufficient data to test the interactive tagging system’s usefulness to investors, third-party analysts, mutual funds, and the marketplace.
To the extent that those disclosure initiatives yield benefits for fund investors, the benefits should be magnified for those who invest in funds through variable products. Given the sheer number of underlying fund options some products offer, it is difficult at best for an investor to navigate the “phone book” of fund offering documents currently delivered in connection with variable product sales. I see streamlined and interactive disclosure as particularly helpful in this context. In addition, these initiatives undertaken at the fund level will help to pave the way for parallel initiatives at the variable contract level. Enhancing the ability of investors to compare the features and costs of competing variable annuities would be a welcome development. I encourage you to think about how the industry can further the cause of electronic data tagging for variable products and what leadership role your company might play in that effort.
B. Plain English
Ultimately, the goal of our disclosure initiative is to help investors make informed investment decisions by encouraging accessible, user-friendly disclosure. But good communication is more than just making information accessible in better formats. It has another side. While the staff works on expanding methods for delivery of key information, it is up to you to improve the quality of information that gets delivered. No matter how easily investors are able to access information, if they find poor disclosure that they cannot understand, these initiatives will have achieved nothing. In the variable insurance industry, this issue is more important than ever. Variable products are becoming ever more complex with the proliferation of innovative living benefits over the last several years. On a practical level, this means that your job is both harder and more important than it has ever been.
No doubt, at some point many of you have spoken with a member of the SEC staff and been asked to explain how some variable annuity or variable life insurance benefit works. Given the myriad of new and different benefits offered through variable products, these kinds of questions are inevitable. I understand from the staff that, with some frequency, an attorney representing a variable product issuer is unable to clarify the prospectus disclosure because the attorney doesn’t fully understand the benefit in question. I would ask you to bear in mind that if disclosure requires an actuary or someone else to explain the basics, it simply is not clear enough to be used in sales to the public. Complex variable products may be the right choice for certain investors, but only if both the selling broker and the purchasing investors can understand the product without consulting actuaries, lawyers, or other variable product translators. The bottom line is this: the staff is serious about plain English and effective disclosure. Insurers owe it to their investors to be serious about it as well.
V. Insurance Product Specific Issues
A. Mixed & Shared Funding
I’d like to talk now about a regulatory issue that is specific to variable insurance products. In recent weeks, I have been discussing with the staff ways to update and improve our approach to mixed and shared funding. As you know, Commission rules provide exemptions from various provisions of the Investment Company Act for variable life separate accounts, but make the exemptions subject to the condition that a fund selling its shares to the separate account not also sell to unaffiliated separate accounts, variable annuity separate accounts, or other types of investors. Over the years, many have applied for individual orders from the Commission that allow the applicants to have it both ways: to get the same exemptions for VLI separate accounts as provided under the rules, while permitting the underlying funds to sell their shares to variable annuity separate accounts and other types of investors, or to separate accounts of unaffiliated insurance companies. The Commission has routinely granted these orders, subject to the condition that the fund’s board monitor for conflicts and address any conflicts among the various investors in the fund.
In recent months, the Office of Insurance Products has been taking a fresh look at these exemptions and the conditions that have been imposed under the exemptive orders the Commission has granted. I am particularly concerned that the mixed and shared exemptive orders may be imposing burdens on fund boards that are not necessarily well correlated to the exemptions provided in those orders and that may not be effective in advancing shareholder protection. More generally, I am also wondering how necessary these exemptions really are to the operation of companies issuing variable life insurance. Is anyone really relying on the exemptions provided in the rules as well as in these exemptive orders? When the rules were formulated in the early days of variable life insurance, these exemptions were believed to be necessary for a VLI separate account to operate under applicable state insurance regulation and insurance company business practices. However, that was thirty years ago. Today, some in the industry have suggested that a number of the exemptions are rarely, if ever, used. I believe that it is time to reassess the regulatory regime in this area, with a view to removing unnecessary and burdensome underbrush.
The staff is reevaluating the mixed and shared funding regime in the context of a broader inquiry regarding the Commission’s variable products rules. The staff is taking a look at all the variable life and variable annuity rules to determine where updates and streamlining may be appropriate. One focus is the elimination of various obsolete cost provisions of the variable life rules. With the elimination of these provisions, it may be possible to combine the scheduled and flexible premium variable life rules and possibly the variable annuity rules as well.
B. New Products
The Office of Insurance Products is seeing an interesting development that I think may portend a wave of new product development in the coming months and years. There has been commentary in the financial press about the shifting focus of baby boomers from accumulation of wealth to the problem of income management — of not outliving one’s savings. In this regard, the staff is seeing interest in the idea of combining insurance guarantees with investment vehicles other than variable insurance products in order to protect investors from outliving their assets. Products of this type can raise interesting issues under both the Securities Act and the Exchange Act. If a contract is a security, it must be registered under the Securities Act and the insurer becomes subject to Exchange Act reporting and Sarbanes-Oxley requirements — not a minor consequence to potential insurance company issuers of these products who do not otherwise come under the Exchange Act. I anticipate an interesting dialogue about these issues as insurers position themselves to meet this new market.
I have discussed a variety of regulatory initiatives that we are undertaking at present. Some affect the investment management industry generally; however, the Division remains mindful that variable products are unique and present unique regulatory challenges. As the Division conducts its review of the continuing appropriateness of the Commission’s rules and regulations, I encourage you to weigh in with your perspectives and insights. I value your input. And again let me point out that we share the common goal of meeting investors’ needs in the best possible way. If we maintain our commitment to that goal and an open dialogue about the best way to reach it, I believe that investors will benefit and your industry will flourish. It is a win-win proposition.
I appreciate the opportunity to speak to you, and thank you for your attention to these important and challenging issues. I hope you enjoy the rest of the conference.
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.