U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the Practicing Law Institute
Investment Management Institute 2008


Andrew J. Donohue1

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

New York, N.Y.
April 24, 2008

I. Introduction

Thank you very much for that kind introduction. I also want to thank former Division of Investment Management Directors Joel Goldberg, Barry Barbash and Paul Roye for inviting me to speak to you here today. The commitment of these gentlemen to continuing legal education, as displayed by this conference, is a tribute to their dedication to the investment management industry and fund investors and to their willingness to share what they have learned throughout their distinguished careers.

Before I commence my remarks today, I need to remind you that my comments represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I expect the remainder of 2008 to be an exciting time for those of us at the Commission and, similarly, those of you who practice in the investment management area. I am hopeful that the Commission and its staff will be addressing three fundamental issues of critical importance to America’s investors. They are the structure of the mutual fund disclosure regime, the payment of distribution-related fees from fund assets as permitted by rule 12b-1 under the Investment Company Act, and the appropriate regulatory framework that should govern relationships between financial professionals and retail investors as discussed in the recent report issued by the RAND Corporation.

Each of these issues is of fundamental importance to investors. Indeed they directly affect the majority of retail investors that access our nation’s securities markets on a daily basis.

For example, investors rely primarily on SEC-mandated prospectuses for information about their mutual fund investments. Virtually all Americans invested in the securities markets have had at least one (if not dozens) mutual fund prospectus clog up their mailboxes. Many of us, however, have questioned whether those mailbox-clogging documents are the best way to communicate to fund investors. The Commission’s summary prospectus proposal and the related data tagging project are designed, in part, to address this situation.

With respect to 12b-1 fees, these fees are nearly universal in the fund industry. They are charged in virtually all broker-dealer sold retail share classes, many no-load funds and in the growing retirement share space. Based on ICI data, approximately $12 billion in 12b-1 fees were paid by mutual funds in 2006. Those are real dollars paid by real people — namely retail fund investors. Thus, as the staff prepares a recommendation regarding rule 12b-1, we are very mindful of the impact that 12b-1 fees can and do have on mutual fund investors and their investment returns.

In addition, survey after survey reveals that the majority of mutual fund investors typically work with financial intermediaries when making fund investment decisions. Even outside of the fund context, many retail investors rely on an advisor of one sort or another to assist them with their securities investments. However, the regulation of brokers, dealers, financial advisors, financial planners, investment advisers and others who provide assistance to retail securities investors can be perplexing for even the most seasoned securities lawyer — let alone the average retail investor.

Thus, each of these three important issues directly affects retail investors. As a result, when considering the appropriate regulatory approach to address each of these issues, the staff has looked at potential solutions from the investors’ perspective, rather than from a mutual fund insiders’ perspective. Today, my remarks will highlight how the staff is seeking to implement this approach.

II. Mutual Fund Disclosure Regime (Summary Prospectus and Data Tagging)

Mutual funds serve as the entrée into the securities markets for many retail investors. Most retail investors with securities market exposure own at least one mutual fund. As regulators, we rely on SEC mutual fund disclosure requirements, in large measure, to enable those retail investors to appropriately evaluate their investment options.

When it comes to the mutual fund disclosure regime, I believe that we are on the brink of a revolutionary, rather than an evolutionary change.

In November, the Commission proposed a mutual fund disclosure reform initiative. The core of the proposal is the summary prospectus — 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 lengthy and legalistic — perhaps even confusing and overwhelming. Fund disclosure documents, however, do contain a wealth of valuable information. The proposal, therefore, would rely on a summary prospectus 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 accessing more detailed information by fund investors because investors, and others who are interested, could make use of on-line, interactive hyperlinks to navigate easily through layered information. 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. Those investors who want to continue to obtain their fund information in a paper format would continue to have that ability.

The comment period on the summary prospectus proposal closed on February 28th, and the Commission has received approximately 135 comments. Many comments from the fund and broker-dealer industries focused on a proposed requirement to update the summary prospectus on a quarterly basis. The staff is closely reviewing those comments.

Especially as this is an investor-oriented initiative, the staff will pay critical attention to the feedback received from investors themselves. Because this initiative is so important to investors, the Commission specifically reached out to them to get their comments by issuing a special press release and establishing a simple, straightforward webpage through which investors can comment. To date, we have received 53 comments from investors.

In addition, with the assistance of an outside contractor, the staff has conducted focus group interviews with mutual fund investors to obtain their input on the summary prospectus. The investors were asked to provide reactions to a statutory prospectus and a hypothetical summary prospectus. They were also asked to consider specific content within the summary prospectus, including portfolio holdings and financial intermediary compensation disclosures, as well as presentations of information for multiple funds. We also asked investors for their views on updated performance and portfolio holdings information and different methods for obtaining updated information.

I expect that this focus group testing will prove extremely valuable to my staff and me by further instructing us on what fund investors want and need as we prepare a recommendation for Commission adoption of the summary prospectus initiative.

As important as the summary prospectus initiative is, it is but the first prong in the Commission’s efforts to make the mutual fund disclosure regime more user-friendly. The second prong is the Commission’s mutual fund data tagging project. Last year, the Commission launched a voluntary filing program to enable funds to file the risk/return summaries from their prospectuses using a data tagging taxonomy developed by the Investment Company Institute. Approximately 20 funds have made filings using the new data tagging capability.

Earlier this month, the Commission launched a new interactive webpage called the Mutual Fund Reader. The Reader enables investors to read, analyze, and compare the information provided by mutual funds related to fund cost, risk, investment objective, strategy and past performance using the data tagged filings from the voluntary program. By accessing the new web page, investors can “test drive” the capabilities that data tagging offers and get a glimpse of the interactive nature of the future of mutual fund disclosure. The webpage also features a link that enables fund investors and others to directly share with the SEC their thoughts on the new web page, interactive data, and the promise it holds for improving fund investors’ ability to access and analyze important fund information. I encourage you to check out this impressive new tool, and I thank those funds that have voluntarily filed their information for use in this important investor-oriented project.

As Chairman Cox said in an April 18th speech to the U.S. Chamber of Commerce, data tagging technology can enable investors to analyze and understand financial information with an economy of effort that has never been possible before. He also stated that he expects the Commission will consider a rule for the use of interactive data by U.S. reporting companies in the coming weeks. Data tagging holds significant promise in the corporate setting. However, given the importance of mutual fund investments to retail investors, enhancing and formalizing data tagging for mutual funds also is critically important, and I believe it can make mutual fund disclosure requirements more meaningful for fund investors.

III. Rule 12b-1

Another area that my staff and I are committed to analyzing from the point of view of the investor is rule 12b-1, which permits the use of fund assets to pay for distribution-related expenses. Rule 12b-1 fees affect investors where it counts — in their pocket books. Unfortunately, however, many investors do not understand rule 12b-1, the services that 12b-1 fees pay for, or even the fact that 12b-1 fees are being deducted from their fund investments.

Some of this lack of understanding can be traced back to a regulatory approach that does not match the economic realities of today’s mutual fund marketplace. This sentiment was expressed at a 12b-1 Roundtable the Commission held in June 2007. Following the Roundtable, the Commission had a public comment period inviting public input on the issues discussed at the Roundtable.

Both the Roundtable and the more than 1400 comment letters received during the comment period were extremely valuable in helping the staff focus on the issues surrounding rule 12b-1 fees and how they impact investors.

In approaching 12b-1 repeal and reform, the staff is committed to doing so principally from the investor’s perspective. We are hopeful that, among other things, a staff recommendation regarding 12b-1 repeal and reform would streamline the regulatory approach, create disclosure that communicates more effectively, and develop a regulatory system that properly protects investors’ interests while continuing to ensure that they receive the benefits and services that 12b-1 fees currently pay for.

When viewing rule 12b-1 from the investor’s perspective, the staff recognizes that many investors are paying a sizable portion of 12b-1 fees (typically 75 basis points annually) as a substitute for a front-end sales load. Unfortunately, however, investors may not fully appreciate that this fee is being deducted from their fund assets to ultimately compensate the broker who sold them the fund. Part of the problem is that SEC rules have not treated 12b-1 fees as sales loads, which I believe in many instances is what they have become.

If 12b-1 fees (or at least the 75 basis point so-called “distribution fees”) are functioning similar to a sale load an investor pays over time or an “asset based sales charge” to borrow from NASD/FINRA rules, then I believe the staff should recommend that the Commission treat them as a sales load -- and require that they be disclosed as a sales charge to investors. As was explained in the 1991 Commission notice of proposed rule change to amend the NASD mutual fund sales charge rules to include consideration of rule 12b-1 asset based sales charges:

The NASD's main objective of applying the maximum sales charge rule to asset-based sales charges is to comply with the Congressional mandate that it prevent excessive sales charges on mutual fund shares.  The proposed rule change aims to achieve this by subjecting all charges for sales related expenses, no matter how they are charged, to the same limitations....Because sales charges may be assessed in different ways, it is important to assure a level playing field among those selling mutual fund shares in order to avoid circumvention of the maximum sales charge rule.2

I believe that it would be reasonable to consider this same philosophy for SEC rules as the staff prepares recommendations for 12b-1 repeal and reform that assess the impact of ongoing 12b-1 fees on retail mutual fund investors.

Viewing the 75 basis point distribution fee portion of 12b-1 fees as a sales load could further enable the Commission to revise its approach to the role of fund directors with respect to 12b-1 fees. Currently, directors of funds that use fund assets for distribution are required to adopt a 12b-1 plan and annually consider its renewal. As part of this process, directors analyze factors contained in the Commission release adopting rule 12b-1 in 1980. These factors presuppose that there is a distribution problem with a fund and that the fund has implemented a 12b-1 plan to address that problem. As a result, a fund board’s analysis based on the factors can be difficult and even strained in light of the current uses and economic realities surrounding 12b-1 fees.

If the staff recommends that the Commission treat the distribution fee portion of 12b-1 fees as the functional equivalent of a sales load, we could further recommend that the role of fund directors be significantly revised and made more appropriate to today’s marketplace. Fund directors could have the same role with respect to 12b-1 fees that substitute for a load as they currently have with sales loads themselves. If 12b-1 distribution fees are not treated as the functional equivalent of a sales load, however, it may be significantly more difficult to recommend that the Commission substantially revise directors’ role with respect to rule 12b-1.

The other piece of 12b-1 fees is the so-called service fee, which generally pays for shareholder servicing and distribution-related administrative costs. Again, in viewing these fees from the perspective of fund investors, my staff and I would like investors to better understand the nature of these fees. In addition, we would want investors to better understand exactly how much they are paying for these services, which typically amount to 25 basis points annually.

As we consider rule 12b-1 reform, the staff will be mindful of any tax or operational implications of our recommendations, especially in light of comments received in response to topics discussed at the 12b-1 Roundtable. In addressing the issues surrounding rule 12b-1, we do not want our recommendations to have an unintended negative impact on fund investors.

As I stated, in developing a recommendation for reform the staff is seeking to develop a regulatory system that matches economic realities by treating the two pieces of current 12b-1 fees differently. We would seek to regulate the portion that substitutes for a sales load as a sales load and more appropriately regulate the portion that pays for shareholder servicing and distribution-related administration.

The staff’s goal is not to eliminate any particular share class or favor a particular distribution channel or business model over another. However, since 12b-1 fees that function as asset based sales charges are just that -- sales charges, the staff wants to make sure that investors are not paying more in asset based sales charges paid over time, through the payment of 12b-1 fees, than they would have paid in a single, one-time sales load under applicable regulations. In the end, we want to streamline and modernize a dated regulatory system for the benefit of the nearly 90 million mutual fund investors.

IV. RAND Report

Speaking of the possibility of streamlining and modernizing a regulatory system, I turn now to the RAND report. At the end of December 2007, the RAND report on the current state of the retail investment adviser and broker-dealer industries was delivered to the Commission. This report provides an important resource to the Commission as it evaluates the current and future regulation of those industries. Chairman Cox has directed Erik Sirri, the Director of the Division of Trading and Markets, and me to review the empirical data and analysis contained in the RAND report and prepare a range of options for Chairman Cox's consideration by May 5. For those of you who are counting, that is just 11 days away.

When developing the range of options for the Chairman, we have tried to approach the issues from a perspective outside of the traditional influences of Washington. The guiding factor in developing the options has been, and will continue to be, the needs of retail investors.

The separate broker-dealer and investment adviser regulatory regimes have built up under statutes that are over 65 years old. These regulatory regimes may have worked effectively decades ago. However, based on my industry experience, they may likely not be the optimal approach in today’s environment when the services and products offered by the broker-dealer and investment adviser industries are merging. It is no secret that the securities markets are increasingly more complex and difficult to navigate for Wall Street professionals, let alone Main Street investors.

V. Conclusion

In conclusion, today I discussed three pressing issues with you: the mutual fund disclosure regime, rule 12b-1, and the appropriate regulatory regime applicable to broker-dealers and investment advisers’ interaction with retail investors. Each of these issues has presented long-standing challenges, many of which are not easily addressed because they are, frankly, difficult to fix. As in much of life, there are no easy solutions. But these challenges still should be addressed for the benefit of investors.

I believe that if we on the staff can maintain our efforts to seek solutions to these issues from the point of view of America’s investors, we will be guided by appropriate principles and can display an insight that will further our goal of a strong and healthy securities market that has the faith of well-informed, well-served investors.

Thank you very much.

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.

2 Exchange Act Release 29070 (April 12, 1991) (Commission notice of proposed rule change by NASD, File No. SR-NASD-90-69).



Modified: 04/24/2008