Speech by SEC Staff:
Address at the Mutual Fund Directors Forum Third Annual Directors' Institute
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
January 13, 2009
Once again I am pleased to be the keynote speaker for the Mutual Fund Directors Forum's annual Directors' Institute. A lot has happened in the intervening twelve months since I last addressed this group. A credit crunch negatively impacted liquidity across a broad spectrum of the market. Among other things, this led to a freeze in the auction rate preferred market, difficulties at money market funds, and thorny issues associated with portfolio valuation. In spite of these challenges, I am pleased to say that we achieved some important accomplishments. In the time that I have with you this evening, I would like to discuss significant 2008 accomplishments and highlight some of the issues that I see as Division of Investment Management priorities for 2009. However, before I continue, let me 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.
II. Accomplishments of 2008
The Division achieved a number of important accomplishments this year. Some fall into the category of crisis management. The majority, however, relate to the critical day-to-day work that is necessary to oversee the fund and investment advisory industries.
I believe the single most important accomplishment for the mutual fund industry in 2008 has been the Commission's vote to adopt a Summary Prospectus. This represents a revolutionary change in mutual fund disclosure providing fund investors key information they need in a user-friendly format.
The adoption of a Summary Prospectus reflects productive collaboration among the Commission, the fund industry and fund investors — all of whom are to be congratulated. In addition to investor testing conducted by the Commission, the Investment Company Institute and earlier by the Consumer Federation of America, we received thoughtful comments from the Mutual Fund Directors Forum and many others representing all segments of the fund industry. The universal goal of improving disclosure from the investor's perspective guided us to a great outcome. Indeed, the Summary Prospectus provides key information in a simple, accessible, user-friendly form, with additional information on-line, or in paper upon request, for those who want it. I am sincerely thankful to all who participated — over a period of many years — to turn the vision of a Summary Prospectus into a reality.
Money Market Funds
The past year has been a challenge to money market fund managers, regulators and, most especially, money market fund investors. In 2008, we saw the first "breaking of the buck" by a widely-held money market fund. Needless to say, we continue to assess the impact and aftermath of that event. It is gratifying to note that in the wake of adverse market conditions, many intervened in the money market arena swiftly, dealing with such adversity for the greater good of investors and the market. Specifically, many money market fund sponsors or their parent firms were willing to voluntarily step in and assist money market funds facing credit or liquidity challenges by entering into asset purchase or credit support arrangements.
These arrangements constitute affiliated transactions generally prohibited by the Investment Company Act. Thus, these firms typically sought no-action relief from my staff. In response, the Division has actively worked with the managers of money market funds as they have been coping with events of the past year. I applaud the money market fund industry's willingness to voluntarily come to the support of their funds when that support is structured to benefit all fund shareholders. I also thank fund directors who have diligently represented the interests of money market fund investors when evaluating various arrangements between money market funds and affiliates. At the risk of blowing my own horn, I likewise applaud the Division staff for its timeliness, responsiveness and helpful assistance in working with money market firms often under stressful conditions.
In addition to the letters providing no-action relief for certain affiliated asset purchases and credit support agreements, the Division took a number of important actions to assist various liquidity facilities and other government programs to assist money market funds. The staff consulted closely with the Treasury Department on the development, documentation and implementation of the Treasury Temporary Guarantee Program. The staff also issued a no-action letter stating that it would not recommend enforcement under the "senior security" provisions of the Investment Company Act for money market funds participating in the Temporary Guarantee Program. In addition, the Commission issued a temporary rule enabling a money market fund participating in the program to immediately suspend redemptions, as contemplated by the program, if it breaks the buck. This rule thus allows for an orderly wind down of a fund under the program.
In September the staff issued a no-action letter permitting money market funds to access the Federal Reserve's Asset Backed Commercial Paper Facility through affiliated banks and in October issued a no-action letter clarifying diversification analysis and other operational impacts of the Federal Reserve's Money Market Investor Funding Facility. Also in October, the staff issued a no-action letter providing temporary no-action relief for money market funds to shadow price securities at amortized cost, if they have a final maturity of 60 days or less. This temporary relief was granted based, in part, on the assertion that the markets for short-term securities, including commercial paper, were not functioning as intended or were not resulting in the discovery of prices that properly reflected the fair value of securities that were fully expected to pay off upon maturity.
That relief expired, as scheduled, this past Monday. As required by Rule 2a-7, all money market funds should resume shadow pricing their portfolio securities based on their market price. In my view, funds and fund boards with concerns about occasionally receiving marks from pricing services that do not accurately reflect values may wish to consider developing appropriate price override policies as they have in the case of non-money market funds.
Last month the Commission voted to adopt rule amendments requiring mutual funds to file the risk/return summary section of their prospectuses in interactive data format, using eXtensible Business Reporting Language or "XBRL." The Commission adopted this requirement in conjunction with rules that require operating companies to file their financial statements with the Commission in interactive data format. In a nutshell, interactive data format refers to software that allows for data to be "tagged" so that users, including investors and analysts, can quickly and easily obtain information useful to them. Because the data is "interactive," users may readily compare information from any number of mutual funds.
For mutual funds, the interactive data filing will include information about a fund's investment objectives and strategies, costs, risks, and past performance. The decision to require mutual funds to file risk/return summary information in XBRL flows from the Commission's experience with its ongoing voluntary interactive data program enabling mutual funds voluntarily to submit this information.
The Commission has established a compliance date of January 1, 2011 for XBRL filings by mutual funds. This extended period of time allows for the finalization of the recent updating to the list of tags that mutual funds will use and also affords the Commission time to complete its current upgrade of the viewer on its Web site that allows users to view and compare mutual fund risk/return summary information. In the interim, mutual funds may continue to participate in the voluntary program, which the Commission expanded by allowing for mutual funds voluntarily to submit a schedule of portfolio holdings in interactive data format without having to submit other financial information.
Additional 2008 Accomplishments
Although responding to events related to money market funds and adoption of rules for the Summary Prospectus and interactive data required significant staff resources, nonetheless this past year the Division also was active in many other important areas. In particular, the Division actively supported Commission rulemakings and facilitated the timely review of exemptive applications.
For Commission rulemaking, the Division supported a number of proposed and adopted rules. The Commission proposed and adopted disclosure rules under the Sudan Accountability and Divestment Act under a tight statutory deadline. In addition, the Commission proposed rules related to Regulation S-P privacy issues, references to credit rating agencies in Commission rules and investment adviser disclosure in Form ADV. The Commission also proposed a rule that would permit Exchange Traded Funds to come to market without first obtaining a Commission order. In addition, last month the Commission voted to adopt new rules for indexed annuities that prospectively define certain indexed annuities as not falling within the section 3(a)(8) exemption under the Securities Act.
The Commission also proposed guidance to assist fund directors in fulfilling their fiduciary responsibility to oversee investment advisers' trading of fund portfolio securities, including an adviser's determination of best execution and use of soft dollars. The proposed guidance is not intended to impose any new requirements on fund directors or advisers, but instead proposes to provide a flexible framework to assist directors to fulfill existing oversight obligations. In this regard, the proposed guidance suggests information directors may request from advisers to monitor the conflicts of interest advisers face in their trading activities and reminds directors that they have the authority to direct how an adviser uses fund brokerage.
The comment period for the proposed guidance closed on October 29, 2008 and the Commission received 23 comments, including a submission from the Mutual Fund Directors Forum. While most commenters were generally positive about the intent and design of the proposed guidance, many had specific concerns. Interestingly, commenters' observations largely related to concerns of what the guidance was not intended to be, such as the fear that it may be viewed as a checklist or new set of standards directors must follow and that boards may be exposed to liability by not following it. Concerns were also raised that the guidance was too prescriptive and that boards would be expected to micro-manage their funds' adviser rather than use their business judgment in their oversight. Others commented that the guidance created a negative tone towards soft dollar usage. We are also considering the other comments, such as the comment that the guidance does not assist directors in applying the information they receive from advisers and how they may approach valuing research. These comments are important as the purpose of the guidance is to help fund directors in this challenging area. We very much appreciate your thoughtful feedback. Rest assured, the staff will keep your comments in mind as we prepare a recommendation for Commission adoption of the guidance.
With respect to exemptive applications, the staff continued its significant progress on meaningful reforms to the application review process. For fiscal year 2008, the staff set a goal of issuing 65 investment company exemptive notices. I am pleased to report that the staff exceeded this goal, issuing a total of 66 notices. To increase transparency and hopefully, help similarly situated parties, in 2008 we began posting exemptive application notices and orders on the Commission's website. Taking this progress one step farther, beginning this month, exemptive applications are now filed on EDGAR and readily accessible by the public.
As an aside, I also note that beginning this month all registered investment companies are required to make their proxy materials available on the Internet and have two options for providing proxy materials to shareholders -- the "notice only" option or the "full set delivery" option. Under the "notice only" option, an issuer must send a notice to its shareholders to inform them of the electronic availability of the proxy materials and, in addition, must provide copies of proxy materials upon request. The "full set delivery" option is similar to the traditional proxy delivery process in that an issuer can deliver a full set of proxy materials to shareholders along with the notice of electronic availability.
In addition to the first fully-transparent actively managed ETF orders issued, the Exemptive Applications Office, along with the Chief Counsel's Office, also played a leading role in the development of the Commission's and Division's regulatory actions relating to the freeze in the auction rate preferred securities market. Most notably, the Commission issued an order temporarily permitting five closed-end funds to apply the 200% asset coverage requirements applicable to preferred stock to debt incurred to redeem auction rate securities — rather than the normal 300% asset coverage requirements for debt.
While on the subject of auction rate preferred securities, I will also note that a number of institutional shareholders have requested funds privately to repurchase securities at a price below par. The Commission by rule requires shareholder-initiated repurchases to comply with certain conditions. Among other things, a fund must determine that such a repurchase does not unfairly discriminate against other shareholders. In the end, whether a particular privately negotiated repurchase unfairly discriminates against other preferred shareholders depends on all of the facts and circumstances. I would suggest that you carefully consider, however, how to structure a repurchase from one shareholder in an illiquid market so as to meet your obligation to act in the best interest of all shareholders and not to discriminate unfairly.
Those of you who serve as directors to closed-end funds that issued auction rate preferred securities faced difficult challenges in light of the freeze in this market. I appreciate the care and attention you devoted to addressing these challenges and your focus on protecting the interests of both preferred and common shareholders.
The Division's Chief Counsel's Office has rapidly responded to regulatory issues presented by the changing market dynamics. In addition, this office was instrumental, along with the Division of Corporation Finance and money market fund experts in my own Division, in issuing no-action letters regarding the development of liquidity protected preferred stock as a substitute for auction rate preferred securities. The Chief Counsel's Office also worked with the Division's Exemptive Applications Office to once again begin issuing orders under section 19(b) of the Investment Company Act to facilitate closed end funds' managed distribution plans by permitting the funds to include long-term capital gains in their periodic distributions.
The Division's disclosure review and insurance products staff has also kept up with demand. As anticipated by the Sarbanes-Oxley Act, the staff reviewed one-third of all registered funds' financial statements (and other disclosures) during fiscal year 2008. This figure represents a review of over 4,400 financial statements, plus related disclosures.
Obviously, 2008 was a busy year for the Division. I am grateful to the hard-working Division staff for its tireless efforts.
III. Priorities for 2009
The Division has several priorities for 2009. These include consideration of the money market fund model and its regulation, adoption of an ETF rule, reform of the existing books and records requirement for investment advisers and funds, adoption of soft dollar guidance for fund directors, consideration of shareholder report reform, and further consideration of Rule 12b-1. In the limited time that I have this evening, however, I would like to focus my discussion on one priority that I believe is particularly relevant for this audience.
Director Outreach Initiative
In 2007 I asked the staff to undertake an examination of independent directors' duties. As you know, the Investment Company Act imposes a variety of statutory responsibilities on the independent directors of registered investment companies. These duties involve situations where a conflict is likely to arise and include directives that expressly require approval by the independent directors in order for a particular action to be lawful, such as annual approval of a mutual fund's advisory contract and annual selection of the fund's independent accountant.
In addition to statutory responsibilities imposed by the Act itself, the Commission has ten exemptive rules that impose specific responsibilities on independent directors. These rules exempt registered investment companies from the prohibitions in the Act and allow them to engage in otherwise unlawful activity.
Our examination of independent director duties — informally designated as the "Director Outreach Initiative" — has twin goals. First, to gain from independent directors a better understanding of how they discharge their current responsibilities and suggestions for any improvements. Second, if the determination is made that independent director effectiveness could be enhanced, to make recommendations to the Commission for its consideration regarding rules that the Commission might propose to increase such effectiveness. This initiative has sought to focus the attention and resources of the independent directors on those matters most critical to their mission to oversee conflicts.
We employed a three-pronged approach to conduct the Director Outreach Initiative. First, staff reviewed relevant statutory and regulatory provisions that require the affirmative action of the independent directors. This review identified the use of different language (particularly in the rule text) and different requirements imposed on the independent directors based on the activity to be performed. Moreover, our review of the statutory, regulatory and state law duties imposed on mutual fund directors, and in particular independent directors, has yielded a greater understanding of how these duties have evolved since 1940 when the Act was enacted. Second, to date my staff and I have attended more than 25 board meetings of independent directors at mutual fund complexes of varying size (Chairman Cox and Commissioner Casey separately participated in two of these meetings). This has allowed the Division to obtain direct insight from independent directors. Third, industry participants, including the Mutual Fund Directors Forum, submitted written recommendations for possible ways to improve director effectiveness. The recommendations from these industry participants provided additional thoughtful insight.
The Director Outreach Initiative has afforded the staff significant insight regarding the role of independent directors. As a result, the Division is contemplating certain recommendations for the Commission's consideration. In particular, the Division is analyzing whether to recommend modifications to the current requirements imposed on independent directors in order to recognize situations where independent directors, while maintaining ultimate responsibility for fund oversight, may delegate certain responsibilities consistent with the valid exercise of their business judgment. The Division is also analyzing whether the general requirements imposed on independent directors in the ten exemptive rules can be unified. In particular, the staff believes that unifying the standards and requirements in each of these rules may promote consistency thereby avoiding overlapping and time-consuming requirements that currently must be fulfilled as a predicate to relying on a particular rule.
My staff continues to work diligently on this initiative. I am hopeful that we will see the fruits of this labor later this year.
Annual Review of the Investment Adviser Contract
The final topic that I would like to address before I conclude lies at the heart of the Directors' Institute. Specifically, you have gathered for this conference in order to focus on the vitally important annual review of the investment adviser contract, commonly known as the "15(c) process."
As many of you may recall, my theme last year was the annual review of the investment adviser contract, commonly known as the "15(c) process," including any suggestions for conducting it. I will not rehash my earlier remarks. However, I believe it is important to recognize that the challenges you face conducting your annual review in 2009 have increased from those you encountered in 2008. In particular, market events in 2008 likely have driven fund expense ratios up, fund performance down, and have impacted investment adviser profitability. Also, many funds likely face additional cost constraints. These changes since last year succinctly demonstrate that the 15(c) process is not static, but rather, is dynamic.
Each year, fund directors approach the 15(c) process as one of the most vital tasks they perform on behalf of fund investors. Indeed, the importance of this process has been repeatedly recognized by the Commission, most recently in 2004 when it adopted a final rule that requires a registered investment company to provide disclosure in its report to shareholders regarding the material factors and the conclusions with respect to those factors that formed the basis for the board's approval of advisory contracts during the most recent fiscal half-year.2 This rule requires a registered investment company to provide disclosure in its report to shareholders regarding the factors relating to both the board's selection of the investment adviser and its approval of the advisory fee and any other amounts to be paid under the advisory contract. In addition, the rule requires certain other enhanced disclosures, including: a) the nature, extent, and quality of the services to be provided by the adviser; b) the investment performance of the fund and the adviser; c) the costs of the services to be provided and profits to be realized by the adviser and its affiliates from the relationship with the fund; d) the extent to which economies of scale would be realized as the fund grows; and e) whether fee levels reflect these economies of scale for the benefit of fund investors. Moreover, if any of the enumerated factors is not relevant to the board's evaluation of the investment advisory contract, the discussion must note this and explain the reasons why that factor is not relevant.
Given the market events of 2008, this year the 15(c) process will be even more critically important. This is because in addition to the typical issues regularly reviewed as part of this process, fund directors will likely want to consider carefully additional information or issues that may not have been present in previous reviews. For example, for a fund with an expense cap that has experienced an increase in its expense ratio due to a decline in asset values or redemptions, is it appropriate to modify or eliminate the expense cap? What standard will the board employ to determine any such modification? Similarly, many funds use funds in a "peer group" as a benchmark to analyze fees charged and expense ratios incurred. Boards should be mindful in evaluating funds within a peer group that the funds that historically may have comprised this peer group may no longer be a member of that group or have comparable assets under management. The challenges you face in evaluating certain data regarding peer funds, especially historical expense ratio and other cost data, are not insignificant. As such, in the presence of extreme conditions, directors should be sensitive to the limitations of comparable data. While this sensitivity is always important, it will be particularly essential in the coming year. I have no doubt that you will focus on all relevant issues in your analysis as you conduct your robust and thoughtful review in 2009. I commend your continuing efforts acting on behalf of investors.
It has been a busy year for the Division, for the fund industry and for fund directors since I last met with you. Much has been accomplished, but there is plenty more work to do. As we transition into the new year and begin to focus on 2009 priorities, I look forward to the continued cooperation and support we have received from fund directors, including the helpful insight provided by the Mutual Fund Directors Forum and its many members.
I encourage each of you to share with me and my staff any thoughts you have generally about the fund industry and specifically about your duties as independent directors and suggestions for what, if anything, the Commission should consider or can do to make the performance of these duties more effective.
Thank you for once again inviting me to join you at this conference and I am happy to answer any questions.