Speech by SEC Staff:
Keynote Address at the Investment Company Directors Conference
Andrew J. Donohue
Director, Division of Investment Management
U.S. Securities and Exchange Commission
November 6, 2007
Good Morning. I greatly appreciate being invited to speak here today. In preparation for this event, I asked Amy Lancellotta what topics she thought you might be interested to have me address. I doubt if it will come as much of a surprise to hear that Amy was not shy in sharing her thoughts — the list was quite extensive. Fortunately, I have only been allotted thirty minutes to speak, so I have been able to whittle the list down to a few choice selections! Before I continue, however, I must give the standard disclaimer that my remarks represent my own views and not necessarily the views of the Commission, individuals Commissioners or my colleagues on the Commission staff.
Let me begin by commending you — fund directors — for the important role that you fulfill in the fund industry. The oversight provided by fund directors, and in particular independent fund directors, is essential to the integrity of the fund system. Indeed, while the Commission and other regulators provide oversight at a macro level, you as "independent watchdogs" have much greater knowledge of the funds you oversee and are in the best position to monitor the funds and to determine whether they are operating in the best interests of their shareholders.
As this audience well knows, the job of being a fund director has in the past few years become increasingly challenging and complex. There are a number of factors contributing to this. The Sarbanes-Oxley Act of 2002 heightened the duties of corporate directors, including those that serve as directors for listed closed-end funds. In addition, the stock exchanges and NASDAQ imposed additional director duties as part of their listing standards. Directors at open-ended funds also have been significantly affected by the new rules the Commission adopted in the wake of the market timing and late trading scandals. Many of these rules directly or indirectly task mutual fund directors with additional responsibilities. The effect of these external factors is compounded by the realization that there is no "right" or "single" approach for fund directors to fulfill their duties. On the contrary, what works for one fund board may or may not be desirable or even appropriate for another fund board.
II. Director Outreach Initiative
Recognizing that the duties of fund directors have increased in the past few years has led me to consider whether fund directors continue to be in a position to perform their important duties effectively. To find out, earlier this year I launched a Director Outreach Initiative. The goal of this initiative is to answer a simple but important question, namely: What can or should the Commission do in order to aid fund directors in the performance of their duties? Rather than guess how fund directors would respond to this question, I believe it is critical to obtain direct input from directors themselves so that the Division of Investment Management can make informed recommendations for the Commission's consideration. Accordingly, since January I have met with thirteen mutual fund boards on their turf, that is, at their regularly scheduled meetings in cities all over the country. I have at least seven more meetings scheduled through the end of this year. At the conclusion of these meetings my intention is to analyze the information that was gathered and to make recommendations to the Chairman and Commissioners regarding steps the Commission should consider to improve the effectiveness of fund directors.
Fundamentally, the question what can the Commission do to aid fund directors sounds simple. However, this seeming simplicity is deceptive. As proof, anecdotally I will share with you that in my meetings with fund directors I ask them this question: "Where do you add value for shareholders and the fund?" Often the response I receive is a perplexed look and a comment to the effect that "I'll get back to you." This bewilderment confirms for me that we need to evaluate carefully the duties imposed on fund directors and how we can best enable directors to effectively carry out these duties.
Before continuing, let me say that in my view a key area where fund directors add value for shareholders is the fair valuation of portfolio securities. We need look no further than the events of this past summer involving the sub-prime market to underscore the importance of the role of directors as outlined in the statutory requirement to fair value in Section 2(a) of the Investment Company Act. Moreover, when the Commission in 2003 adopted its rule requiring compliance programs for investment companies and advisers, the Commission elaborated on four important fair value requirements. First, funds must adopt policies and procedures that monitor for circumstances that may necessitate the use of fair value prices. Second, they must establish criteria for determining when market quotations are no longer reliable for a particular portfolio security. Third, funds must provide one or more methodologies for determining the current fair value of a security. Finally, funds must regularly review the appropriateness and accuracy of their valuation methodologies and make any necessary adjustments.
With these requirements in mind, I encourage you, the fund directors, to focus on portfolio valuation. You also should ask a fund manager about the liquidity, or more importantly, the illiquidity of securities in the fund. Key attributes of investment companies, especially open-ended companies, are accurate determinations of net asset value and maintenance of the liquidity that investors rely on. So, if you are having difficulty pricing a security or if securities pose liquidity challenges, query whether those securities belong in a mutual fund. Clearly fund directors that focus on these issues and remain vigilant add value for the shareholders and the fund. Fund investors and I are relying on you.
Forgive my slight detour and let me now turn back to the Director Outreach Initiative. Although a fund director's job today may be more complex — perhaps some may pine for the "good old days" — let me be clear that the goal of the Director Outreach Initiative is not necessarily to make the job of fund directors easier. Rather, the goal is to enable fund directors to be more effective. Embedded in this concept is the premise that directors may not currently be as effective as they could be. This of course is an unproven premise and the only way we can gauge its accuracy is to get feedback from you. However, I genuinely believe that there is always room for improvement — a belief obviously shared by the Commission as evidenced by its adoption in 2004 of an investment company governance requirement that fund boards conduct a self-assessment at least annually. I also note that this heightened level of scrutiny placed on the fund board, like many of the other situations where the role of the board and in particular its independent directors has been increased, is in the context of allowing a fund to rely on an exemptive rule to operate in a manner that is otherwise prohibited by law. Thus, the trade off for allowing a fund to operate under an exemptive rule is the corresponding requirement that its board be actively involved in overseeing the fund's operation.
With these thoughts in mind, let me share with you some of the fund director feedback that I have received. The two biggest topics by far that fund directors have discussed with me are Rule 12b-1 fees and soft dollars. In short, many of the independent fund directors that I have spoken with would like to get rid of these items or, at a minimum, better define how boards are to determine their appropriate usage. The fund directors' perspective on 12b-1 fees and soft dollars is not surprising — it is no secret that fund directors encounter challenges in fulfilling their oversight role for these items. To put it in context let me address each of these issues and the concerns associated with them.
1. Rule 12b-1
When the Commission adopted Rule 12b-1 in 1980, the fund industry was in a far different state than exists today. Starting a decade earlier, the U.S. had fallen into a recession. Productivity growth slowed and inflation reached into the double digits by the end of the 1970s. The effect on the stock market was dramatic. Between December 1968 and December 1974, the inflation adjusted S&P 500 lost 55% of its value. During the worst period — January 11, 1973 to December 6, 1974 — the (non-inflation adjusted) S&P 500 declined almost 46%.
At that time, funds had experienced a period of net redemptions and there was serious concern for the viability of the mutual funds market for a variety of reasons. The Commission adopted Rule 12b-1 which generally makes it unlawful for a fund to act as a distributor of its own securities — which the fund will be deemed to be if it engages directly or indirectly in financing any activity primarily intended to result in the sale of its fund shares — unless the fund adopts a plan of distribution. The adoption and continuation of a 12b-1 plan requires board approval and, in keeping with the release adopting the rules, boards typically consider nine factors when determining whether to approve or continue the plan. Many of those urging a repeal or refinement of Rule 12b-1 argue that the rule no longer serves the purpose for which it was intended and that the factors that a board considers are not relevant in today's market.
To address these and other concerns the Commission in June hosted a roundtable discussion on Rule 12b-1 and a series of panels addressed the historical circumstances that led to the promulgation of the rule, the original intended purpose of the rule, the evolution of the uses for Rule 12b-1, the rule's current role in fund distribution practices, the costs and benefits of the current use of the rule and the options for reform or rescission of the rule. Two independent directors participated in the panel discussions, including Bob Uek, the Chairman of the Independent Directors Council.
The Commission also solicited public comment on Rule 12b-1 and received more than 1450 comment letters (including a letter from the Independent Directors Council). Approximately 1000 of these letters are form letters that were sent by financial planners and registered representatives who oppose substantive reform of Rule 12b-1. An additional 400 or so individualized rather than form letters were sent in by financial planners, the majority of whom also oppose substantive rule reform. The Commission received approximately 25 letters from mutual funds, large broker-dealers, insurance companies, industry associations and counsels. The majority of these letters also oppose significant rule reform, but riddled throughout are various levels of support for changing the name of the fee, requiring additional disclosure and revising the role of the fund board in approving the distribution plan. Finally, the Commission received approximately 10 letters from investors most of whom support substantive reform or repeal of the rule. My staff is currently evaluating the many comments we received. Once that process is complete, we will formulate a recommendation to the Commission. Stay tuned for further developments.
2. Soft Dollars
Section 28(e) of the Securities Exchange Act of 1934 establishes a safe harbor that allows money managers, including advisers, to use client funds to purchase "brokerage and research services" for their managed accounts under certain circumstances without breaching their fiduciary duties to clients. Fiduciary principles require advisers to seek the best execution for client trades, and limit advisers from using client assets for their own benefit. Thus, using client commissions to pay for research and brokerage services presents advisers with significant potential conflicts of interest and may give incentives for advisers to compromise their best execution obligations when directing orders as well as to trade client securities inappropriately in order to earn soft dollar credits.
As fund directors, one of your duties is to appropriately monitor the conflicts of interest that are inherent in soft dollar arrangements. This is because brokerage commissions are paid with assets of the client fund, not the assets of the adviser. As such, fund directors must carefully monitor the way these assets are used and how the adviser's trading practices are described to investors in order to be satisfied that the use of soft dollars is appropriate and that the potential conflicts of interest have been adequately addressed. I am cognizant that such monitoring can be difficult, particularly when (as is often the case) transparency is lacking because brokerage and research services are "bundled" with execution costs.
Recent events and current market conditions may cumulatively alleviate some of the difficulties associated with monitoring soft dollar arrangement conflicts of interest. First, in 2006 the Commission issued an interpretive release that provided guidance with respect to what qualifies as execution and research services that may be purchased using soft dollars. This guidance should provide advisers and fund directors with greater clarity on the appropriate use of soft dollars.
Second, new technology may help facilitate director oversight. In particular, as firms employ new technologies in their brokerage practices, including broker-sponsored execution systems such as algorithms, new unbundling and commission sharing arrangements, dark pools and brokerage consolidation, these technologies make it easier for advisers to value with increasing specificity the cost of the research and brokerage services obtained with soft dollars. The greater specificity offered by these new technologies enhances transparency and allows greater opportunities for "virtual unbundling" of research and execution services. In turn, monitoring and oversight is enhanced when fund directors can determine more precisely the services and benefits that the fund's adviser and the fund obtain through the payment of soft dollars. Also, a by-product of these new technologies is an apparent current market trend evidencing an overall decline in commission rates as well as an apparent increase in internal reporting to fund boards of meaningful information on trading practices.
Third, requirements in other jurisdictions are helping to move U.S. firms toward greater transparency regarding the use of soft dollar arrangements. In particular, in 2005 the Financial Services Authority required the unbundling of research and execution services in the United Kingdom. Although such unbundling is not a requirement in the U.S., its presence in other markets has acted as a catalyst for change in our markets.
The next step, currently underway by my staff, is to provide the Commission with a recommendation for guidance to assist mutual fund boards in their oversight responsibilities in this area. Our recommendation may not be limited to transactions involving equity trades. Rather, consistent with an adviser's duty of best execution, I anticipate that the recommendation will more broadly address fund board oversight of trading practices generally, including principal trades of fixed income securities and other asset classes. Our goal is for the guidance to provide helpful assistance to you without adversely affecting the evolution of the trading markets in an unintended way. As such, to formulate our recommendation, the staff is speaking with advisers of all sizes, fund directors, and their counsel to make sure we get our recommendation right. As with the Commission's solicitation for comment on Rule 12b-1, I encourage you to please share with us any thoughts you have for crafting meaningful guidance to assist you in monitoring the adviser's best execution obligations and the use of soft dollars.
I would like to make one last point concerning soft dollars and that is that they cannot be considered by a fund board in isolation. Instead, in my view the dialogue between advisers and fund boards must focus on how soft dollar arrangements influence the adviser's overall trading practice and whether the adviser is properly meeting its best execution obligations.
A third topic that has garnered director feedback is the role of the chief compliance officer and, in particular, whether the board should be permitted to delegate to the CCO some of the more detailed oversight responsibilities that ultimately rest with the board. For example, some have suggested that the current requirements for the independent directors to determine at least quarterly that purchase and sale transactions among affiliates were effected in compliance with the fund's procedures could be properly monitored by the CCO who in turn could issue an exceptions report to the directors identifying any non-compliant transactions. As part of any recommendation to the Commission, we will examine what functions may be appropriately delegated to the CCO or other party. However, to this statement I would add two cautionary observations. First, the existence of a CCO in the fund hierarchy is relatively new, having only been required since 2004. Given this relatively short track record of experience, we all must be careful not to set up the CCO for failure by heaping too many responsibilities on his or her shoulders. Second, apart from the concern of overloading a CCO, we must be careful to make sure that the CCO is in fact the right person to shoulder a particular responsibility.
Let me conclude by acknowledging that the role of fund directors is to provide oversight and not management of a fund. As such, I want to make sure that fund directors focus their attention in the boardroom on areas where they can add the most value without directors spending the bulk of their time on rote reviews or bureaucratic exercises just to meet regulatory requirements. I am hopeful that the Director Outreach Initiative or DOI will give us valuable information and that it will result in recommendations that will allow you to focus on the areas where your oversight may be most critical — particularly areas involving potential conflicts of interest. In order to ensure that any DOI recommendations are not D.O.A., your support and participation in this process is paramount. Accordingly, I invite you, as some have already done, to please feel free at any time to contact me or my staff to share your thoughts as to how we may be able to help you to be more effective fund directors. My Director Outreach Initiative is not limited to those fund board meetings that I attend. Thank you.