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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the ICI 2007 Securities Law Developments Conference


Andrew J. Donohue1

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

Washington, D.C.
December 6, 2007

I. Introduction

Good morning and thank you, Karrie, for that kind introduction. It is a pleasure to be here with you today. Before I begin my remarks, it is my obligation 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.

As we approach the end of the year, it is quite natural to look back and take stock of where we have been and then to consider where we are going. 2007 has been a year of unexpected surprises — most notably the market turmoil brought on by the subprime crisis. In other ways, however, 2007 lived up to expectations.

II. Division of Investment Management Priorities in 2007

Last year at this conference, I identified two key priorities for the Division of Investment Management in 2007. The first was mutual fund disclosure reform and enhanced use of interactive data. The second was a focus on the review of exemptive applications. I would like to take a few minutes today to report back to you on how the Division performed in achieving its goals.

A. Mutual Fund Disclosure Reform and Interactive Data

With respect to mutual fund disclosure reform, the Commission issued a proposal on November 21st that would essentially revolutionize the mutual fund disclosure regime. The core of the proposal is a concise, plain English summary of key information about a mutual fund's investment objectives and strategies, costs, and risks, with more detailed information available both in paper and in a user-friendly online format. The concept behind the proposal is disclosure that is layered in a manner that allows each mutual fund investor — and each intermediary, analyst, and other user — to quickly find and use the information that he or she needs and wants.

The proposal stems from a recognition that fund investors often find current fund prospectuses to be overly lengthy and legalistic — even confusing and overwhelming. As we are all aware, however, fund disclosure documents contain a lot of good information, if you know where to find it. The proposal, therefore, would rely on a summary to communicate key information to fund investors in a streamlined format, with the full prospectus and statement of additional information available on line or in paper upon request.

The proposal also would enhance the means of delivering more detailed information to fund investors because investors, and others who are interested, could make use of on-line, interactive hyperlinks. Those investors who want to continue to obtain their fund information in a paper format would continue to have that ability. In essence, the proposed mutual fund disclosure framework would provide information that is easier to use and more readily accessible, while retaining the comprehensive quality of the mutual fund information available today.

From my perspective, the Commission's proposal is a win-win for fund investors. It is intended to result in funds providing investors with easier to digest information in a more user-friendly format. It also should prove to be cost-effective. To the extent that funds would not be sending out very long, heavy and expensive prospectuses each year, those funds would cut costs and should provide a benefit to their investors where it certainly counts — on the bottom line, in the return column.

The comment period for the mutual fund disclosure reform proposal closes on February 28th, and I look forward to receiving and reviewing your comments. My staff worked hard on this initiative, and the Commission has put forth a finely-crafted proposal. While the staff spent a significant amount of time on the details, inevitably there are helpful ideas and recommendations that can be shared. As always, your input is encouraged.

The Commission also is explicitly reaching out to fund investors to obtain their input on mutual fund disclosure reform and particularly on the prototype summary prospectus posted on the SEC's website. The Commission is seeking investor input about what improvements would make the summary prospectus easier to read and understand, and what key information investors would like to see included. The Commission also is seeking comment on its proposal for mutual funds to provide investors the summary information while making the full prospectus available online or in paper copy upon request. In addition, my staff is working with the Office of Investor Education and Advocacy to develop plans for potential investor testing of the prototype summary prospectus.

With respect to mutual fund interactive data, the Commission also made progress in 2007, thanks in no small measure to the work of the fund industry through the Investment Company Institute. On August 20th, the Commission launched a voluntary filing program that enables mutual funds to file the risk/return summaries from their current prospectuses in an interactive data format — using a taxonomy developed by the ICI. I applaud those funds that have filed their risk return summaries using the new taxonomy, and I encourage other funds to follow their example. I believe that interactive data may in the future provide a critical tool for potentially easing the reporting burden on mutual funds while at the same time making the information that funds do report easier to use for fund investors and regulators alike.

B. Exemptive Applications Review

I also want to report back to you on the other major initiative identified last year — improving the Division of Investment Management's process for exemptive applications review. The Division staff, led by Assistant Directors Nadya Roytblat and Michael Mundt, set aggressive goals to increase the number of substantive orders issued under the Investment Company Act, including a goal to double the number of substantive notices for exemption issued in fiscal year 2007 over fiscal year 2006. By the end of our fiscal year on September 30, the Division had issued 81 substantive notices, an 84% increase over the prior fiscal year. While not quite double, I believe the staff made significant strides in its review of exemptive applications last year and should take great pride in the results that were achieved.

In addition to the increase in the number of substantive application notices issued, the median time that applications have been pending dropped from 16 months to 8 months over the course of the fiscal year. The staff has also reduced the number of pending applications by more than 25%.

The staff has prioritized matters to ensure that applicants receive initial comments within 120 days of our receipt of an application. In addition, the staff has formalized procedures intended to keep applicants better informed about the progress of their applications. Within days of filing an application, the staff attorney who will be reviewing it telephones the applicant to introduce himself or herself and to provide a telephone number the applicant can call to check on the status of the application. After that, unless there have been intervening communications about the application, the applicant should receive a "status call" every 60 days.

In a related development, the Commission began posting exemptive application notices and orders on its website this year. As a second step, the Commission has proposed amendments to the EDGAR rules to enable electronic filing of exemptive applications. Electronic filing will reduce delays and errors in the applications reaching the staff and facilitate the dissemination of information about those applications to the public. Comments on this proposal are due December 14th.

Perhaps one of the most significant developments related to the exemptive applications group is the recent naming of Elizabeth Osterman as a new Associate Director with responsibility for overseeing the group. Liz is an experienced attorney and highly regarded leader who is committed to maintaining the positive momentum the staff has developed. As I stated last year, however, enhancing the exemptive applications process is a two-way street. It requires attention, cooperation and hard work on both sides — from the staff and from the applicant and its representatives. I am pleased to state that my staff reports that applicants generally have done their part in responding to comments in a timely manner and following precedents suggested by the staff. These steps on the part of applicants assist our staff in their review and enable them to review more applications in a timely manner.

III. Other Events that Impacted 2007

Developing recommendations for mutual fund disclosure reform and interactive data and focusing on exemptive application review took up a significant portion of the Division's time and energy during 2007. However, there were other events that required substantial attention during the year.

A. Director Outreach

On a personal level, I dedicated 2007 to visiting one-on-one with fund boards as part of a Director Outreach initiative. By the end of the year, I will have met with 20 boards from fund families both large and small from all across the country. By attending their board meetings, I am able to get a sense, directly from fund boards, regarding where they add value and how they can be more effective. I also have asked directors for their insights on whether Commission rules assign fund directors the right duties and appropriate levels of review and oversight.

Meeting with fund directors during the past year has, for me, re-affirmed the importance of their role and let me witness, first-hand, the commitment that conscientious fund directors bring to the boardroom. Following on my Director Outreach initiative, I have asked Mark Berman, a Senior Special Counsel in the Division's new Special Projects Office, to develop recommendations for possible rule amendments or additional guidance. Our goal in developing these next steps is not to make fund directors' jobs easier, but to enable directors to be more effective and to more appropriately tailor their duties.

B. Market Events

Of course the most significant event that required SEC staff attention this year -- indeed it required the attention of all of us gathered here today -- was the turmoil in the markets. The markets of the past several months have experienced what "quants" like to call numerous "multi-sigma" events. Financial markets have shown increased volatility as problems associated with sub-prime lending spread to the broader commercial loan and credit markets.

Credit spreads have increased and market participants have become more risk averse. The spread between yields on U.S. government debt and the average investment-grade corporate bond at the end of November was over 190 basis points -- more than double the spread in June, according to Merrill Lynch indexes. Also, according to an index tracked by Citigroup Global Markets Inc., risk spreads on financial instruments rose to a high of 0.99 on November 22 from 0.77 on November 1, with 1.00 being the highest level of risk aversion.

Since its peak on August 8th, the market for asset-backed commercial paper shrank 30 percent to $824 billion and the market for all commercial paper has reportedly shrunk by almost 17%. At the same time, assets in money market funds have increased by more than $400 billion to almost $3.1 trillion.

There has been significant volatility in the equity markets as well. For instance, from July 19 to August 16, the Dow Jones Industrial Average fell by 8.3%; it then rose by over 10% from August 16 to October 9; only to fall by over 10% from October 9 to November 26. The volatility did not end there, however. On November 27 and 28, the Dow rose by more than 540 points, or more than 4%, the biggest two-day percentage gain since 2002. For the first 11 months of 2007, the Dow has experienced 68 triple digit moves — more than any year since 2002.

Recent market events have affected all who are involved in the fund industry. And it is not clear that the turmoil has abated. As a result, it is important that each of us has a heightened awareness of our responsibilities and obligations with respect to funds and their investors.

As a value proposition to investors, mutual funds provide liquidity — in the form of daily redemption — and reliable valuation and pricing — as reflected in a fund's daily NAV. The illiquidity and valuation uncertainty that has characterized the market of the past few months may have presented challenges to funds' ability to deliver their end of the bargain. Indeed, funds may be providing a degree of liquidity and pricing accuracy that may not be available elsewhere in the market.

Pricing accurately and maintaining sufficient liquidity may not have always been easy in the markets we have seen in the second half of 2007. However, these are funds' obligations — and these are commitments that funds have made to investors. While the current market is certainly creating challenges for the fund industry, it is paramount that each of us responds appropriately. Especially in this challenging environment, it is essential that each of us acts in the best interests of fund investors. And it is important that mutual funds respond to these challenges and uphold their commitments to fund investors of liquidity and accurate valuation. This period should be mutual funds' finest hour, where the fund industry demonstrates how well the mutual fund vehicle works — I don't want it to be the industry's worst moment. The nation's fund investors are relying on you.

IV. Priorities for 2008

Looking forward to 2008, I would like to highlight two priorities that I expect will receive significant focus and attention from the Division of Investment Management. These are rule 12b-1 and books and records reform.

A. Rule 12b-1

Since its adoption in 1980, rule 12b-1, which allows fund assets to be used to pay for distribution, has had a substantial impact on funds and their investors. The rule has had a significant role in the continued evolution of the mutual fund distribution system and has enabled additional choice for fund investors. While I would not attribute the bulk of such increase to rule 12b-1, mutual fund assets have grown by over $12 trillion (approximately 9,000%) since Rule 12b-1 was adopted.

Despite the benefits that many believe have come from rule 12b-1, many observers — including me — believe that the rule in its current form is broken, or at least is not functioning as it should. Rule 12b-1 and the concept of using fund assets to pay for distribution expenses are now ingrained in funds and the intermediaries who sell fund shares. I expect, however, that none of us would build the fund distribution system and the sometimes complicated share class structures that exist today (many of which require complicated "spaghetti charts" to depict) if we were starting from scratch.

There is no doubt that improvements can be made — especially if one evaluates the mutual fund distribution system from the eyes of an investor, rather than the eyes of a fund insider or intermediary. As my staff and I evaluate rule 12b-1 and prepare recommendations to the Commission, we are doing so with that perspective in mind — the perspective of a retail mutual fund investor who is not steeped in the logic, history, law and lore of fund distribution.

That is not to say that we are ignoring the insights of experts. In June the Commission held a full-day Roundtable on rule 12b-1. Panelists at the Roundtable included investor advocates, fund industry executives, independent directors, current and former regulators, fund industry observers and representatives from broker-dealers and others who sell fund shares. The discussions were insightful and informative, and I am quite certain that no one left the auditorium that day without learning something new. As part of the Roundtable, the Commission solicited comment on issues surrounding rule 12b-1. Interested persons responded by sending in over 1,450 comments, which the staff has reviewed closely.

The staff and I are relying on the discussions at the Roundtable and the insights in the comment letters to help inform our views — while approaching the 12b-1 issue from the perspective of a fund investor. With that in mind, we have identified some of our concerns with rule 12b 1 that we are seeking to address with a recommendation to the Commission.

First, about half of the dollar amount of 12b-1 fees collected — the amount attributable to the so-called 75 basis point distribution fee — represents the functional equivalent of an asset based sales charge. I believe that what has become the functional equivalent of a sales charge should be called a sales charge and treated as a sales charge. I want investors to better know and understand that they are paying a sales charge, whether that sales charge is paid over time and deducted from fund assets or paid in a lump sum at the time of purchase.

From an investor's perspective, "truth in labeling" is essential. In addition to disclosure from their financial advisor, I believe there are two prime locations where investors should be clearly informed that they are paying a sales charge (whether up front or over time from fund assets). They are in the fund's prospectus and in the confirm an investor receives when purchasing fund shares.

The second concern the staff and I have identified is that fund investors should not necessarily be economically disadvantaged depending on the retail share class they purchase. In other words, fund investors in each of the retail share classes should be treated fairly, and none should bear disproportionate distribution expenses.

By way of example, for many broker-dealer sold funds, the primary retail sales classes that currently exist are Class A, Class B and Class C. Class A typically has a front-end sales load, a 25 basis point 12b-1 service fee and no 75 basis point 12b-1 distribution fee. Class B typically has a contingent deferred sales load, a 25 basis point 12b-1 service fee, a 75 basis point 12b-1 distribution fee and an automatic conversion to class A after a prescribed number of years. Class C typically has no front end sales load, a contingent deferred sales charge in the first year, a 25 basis point 12b-1 service fee, a 75 basis point 12b-1 distribution fee, with no conversion rights.

Each of these retail classes has varying distribution related fees, sales charges and conversion rights. However, in regard to distribution fees, sales charges and conversion rights, there generally is no necessary relationship among the three classes, which can create confusion and misunderstanding for investors, at a minimum, and can even lead to potential unfairness for fund investors. The lack of relationship among the retail classes can also lead to conflicts of interest for those who sell fund shares. These conflicts have, in fact, occasionally led to enforcement actions.

The third concern is that the NASD rule that regulates the charging of sales loads and 12b-1 fees essentially focuses on whether a fund or a particular class of a fund's shares is overpaying the fund's distributor, which is understandable and addresses a legitimate concern. When examining the issue from an investor's perspective, however, it would seem more appropriate to focus on whether individual investors are paying more than the maximum sales loads and 12b-1 fees set by the NASD rule. This phenomenon is quite possible given that 75 basis point 12b-1 distribution fees on Class C shares continue forever and that there is no necessary relationship among the three primary retail share classes.

A fourth concern is the possibility of negative economic consequences to fund investors from the reform of rule 12b-1. The potential for negative consequences for investors includes tax considerations. The staff and I will seek to minimize the tax impact on individual investors of any recommendation we make to the Commission. We also will be mindful of potential operational issues and the costs of making significant systems changes since those costs are very often passed on to fund investors in the form of higher fees and expenses.

A fifth concern relates to the fund board's role with respect to rule 12b-1. The 12b-1 factors fund boards, as investors' representatives, consider are out of date in many ways. They do not conform to today's economic realities, including the notion that 12b-1 distribution fees are the functional equivalent of asset based sales charges.

A final concern is that fund investors are precluded from the benefits that could result from competition on sales loads. Section 22(d) of the Investment Company Act has historically been viewed as an impediment to such competition by requiring that a fund's public offering price be stated in its prospectus. The staff is examining section 22(d) and options to encourage and enable competition on sales loads for the benefit of fund investors.

Having laid out six significant concerns related to 12b-1 and the fund distribution system, I realize, yet again, that reform to address these concerns is not easy to craft — especially since we do not want to make a recommendation that could harm fund investors by "overcorrecting" for deficiencies we see in the system. Rule 12b-1 has funded important and meaningful services for fund investors, has helped to facilitate the reduction in front end sales loads over time and has enabled significant distribution-related innovations including fund supermarkets and 401(k) platforms. In preparing a recommendation for the Commission, the Division does not want to dismantle the good with the bad, but we are committed to addressing important investor protection issues.

B. Recordkeeping Reform

Rule 12b-1 has been a central focus of many fund-related public policy discussions in recent months. My guess is that fund books and records requirements have not. Books and records, by their very nature, are behind the scenes. Many are locked up in a warehouse or a decrepit file cabinet in the office file room. It is human nature to say "out of sight, out of mind" and focus on more exciting business or public policy goals. However, the investment adviser and investment company books and records regimes have been out of date for years, if not decades. There is a tremendous need to modernize fund and adviser recordkeeping requirements, many of which originated in the 1960s.

I have lived with the fund and adviser books and records requirements, on both the side of the regulator and the regulated. I therefore am acutely aware of the need to bring the books and records requirements into the 21st century. The paper and trade-blotter based books and records requirements of today are antiquated in a world that is accustomed to instant messaging, video conferencing and downloadable data. In my view, any reform of books and records requirements will need to harness the power of available technology and allow for developing technologies, all while not locking firms into a one-size-fits-all approach.

During 2007, my staff visited advisory firms, both large and small, to obtain a better sense of how they maintain their records and make use of the technologies available to them. During 2008, the staff will be putting what was learned to use as they develop a recommendation for books and records reform.

Our expectation is to focus first on reform of the adviser books and records requirements and then translate those reforms to funds' books and records. Of course, input from the fund industry will be essential once a proposal is put forward. I look forward to significant action on books and records reform in 2008.

IV. Conclusion

Accountability is important. Just as I reported this morning on our progress toward achieving the Division of Investment Management's goals related to disclosure reform and exemptive applications review, I hope to be in a position to report back next year on our progress on rule 12b-1, recordkeeping reform and other important projects. At the end of the day, as regulators and as fund industry professionals, we are all accountable to fund shareholders. If we keep fund shareholder at the forefront of our minds as we pursue our daily duties, we can be certain that our work will be worthwhile and our efforts appropriately placed.

As 2007 draws to a close, I thank you for your tireless efforts to serve funds and their shareholders during a very difficult period in the markets. As we have seen, we never know what the next day, next month or next year will bring. For those in the fund industry, however, the one constant — regardless of market conditions — is the primacy of the interests of fund investors and the obligation to maintain investors' trust.

Thank you for your attention, and enjoy the remainder of the conference.



Modified: 12/06/2007