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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Statement at Open Meeting on Guidance to Fund Boards Regarding Investment Adviser Trading of Fund Portfolio Securities and Use of Soft Dollars


Chairman Christopher Cox

U.S. Securities and Exchange Commission

Washington, D.C.
July 30, 2008

Our next item of business is a Commission release that would propose guidance to mutual fund boards on managing their investment advisers' conflicts of interests in trading activities, particularly the use of soft dollars. The proposed guidance is intended to help directors analyze when it's necessary or advisable to rein in the adviser's use of soft dollars. This is an important subject for the millions of retail investors in mutual funds in particular, because soft dollars are their dollars.

Today, over 40 percent of American households entrust their savings and retirement assets to mutual funds and other investment companies. The protection of these investments, therefore, is of vital importance for all of them. Mutual funds and other investment companies typically are operated by investment advisers and other organizations that are separate from the funds themselves. This external management can lead to conflicts of interest between the fund and its investment adviser. Conflicts of interest, of course, are a fact of life in our complex economy, but they can also present opportunities for abuse.

Congress recognized the potential for abuse stemming from fund advisers' conflicts of interest, and it assigned the policing of these conflicts to the funds' boards of directors. The Investment Company Act, and the fiduciary responsibilities of directors under state law, place important duties on the shoulders of fund directors to oversee the safety of fund assets and the protection of investors.

One of the most significant conflicts of interest arises when a fund's investment adviser directs the trading of a fund's portfolio, and especially when the adviser uses soft dollars as part of its business practices. Soft dollars are essentially credits earned from brokerage commissions that a broker-dealer's customer can use to pay the broker dealer for research reports or other things of value. These soft dollars total almost one billion dollars a year. They represent the assets of investors, although investors themselves neither monitor nor approve the accumulation and spending of these assets. Therefore, it is critical that fund directors understand how a fund adviser uses soft dollars, and whether soft dollars are being spent in the best interest of fund investors who ultimately pay for them.

Over the years, the Commission has taken action to address the conflicts in connection with an adviser's trading activities on behalf of funds. We have clarified the adviser's obligation to act in the fund's best interest by seeking best execution on fund portfolio trades. We have also acted numerous times to address the conflicts raised by soft dollars. Most recently, in 2006 we issued interpretive guidance to clarify for advisers and other money managers what they can and cannot purchase with soft dollars under the safe harbor provided to them in Section 28(e) of the Exchange Act.

The guidance that we are proposing today for fund directors follows naturally from the guidance we provided for fund advisers in 2006. Directors fulfill their obligation to protect fund investors through the oversight of the adviser's trading practices to ensure the adviser is acting in the fund's best interest. But in today's rapidly changing markets, boards are presented with new and difficult challenges in fulfilling that oversight role. With the increasing use of alternative trading venues, such as dark pools, and the use of algorithmic trading and client commission arrangements, evaluating an adviser's trading practices can sometimes seem an overwhelming task.

From a fund director's perspective, the technological developments in the brokerage industry have created something of a double-edged sword. On the one hand, electronic trading allows greater transparency because funds are able to determine more easily the precise costs of execution and research. On the other hand, with this information readily available, our staff has been told that directors are routinely given reams of trade data that they simply do not have the time or the expertise to digest.

The guidance we are considering today is intended to assist fund directors in fulfilling their responsibilities by providing them a flexible framework when evaluating an adviser's trading practices. Our goal is to help directors focus their review efforts and evaluate an adviser's trading activities in the most efficient and effective way possible.

In fulfilling their oversight role, fund directors also must be informed of the scope and nature of their duties and responsibilities. In particular, they must understand that they have the authority to demand information from their fund's investment adviser and that the adviser has to provide that information. When directors evaluate an adviser's trading practices, they may decide not to approve the adviser's use of fund assets, in which case the board can direct the adviser to conduct its trading practices as the directors believe is appropriate. For example, a fund board may limit an adviser's use of soft dollars, or possibly prohibit an adviser from using soft dollars altogether, even for items that may otherwise fall within the safe harbor provided by Section 28(e) of the Exchange Act.

The conflicts and the costs to investors associated with advisers' trading practices are very serious. Fund boards are in the best position to monitor and evaluate the management of any potential conflicts of interest that may harm the interests of the fund and its shareholders. So I look forward to the comments the Commission may receive on our proposed guidance to assist fund boards in fulfilling these very important responsibilities.


Modified: 08/04/2008