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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Luncheon Address Before a Meeting of the Business Law Section of the American Bar Association Committee on Federal Regulation of Securities


Andrew J. Donohue1

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

Denver, Colorado
April 24, 2010

I. Introduction

Thank you very much for the kind introduction and for inviting me to join you this afternoon. I appreciate the opportunity to speak with you about our work in the SEC's Division of Investment Management. Not so long ago, I would have expected investment adviser and investment company regulation to be of interest to only a small subset of this section's members, but times have truly changed. Not only is Congress considering significant reforms to the investment management industry as part of its comprehensive legislation, but we also saw this past month the Supreme Court deliver a landmark decision concerning investment company regulation in the case of Jones v. Harris.

I am fortunate to have been working as a regulator during a period of such tremendous turmoil in the markets and now in what has followed to be a period of such tremendous reform. Under Chairman Schapiro's leadership, this reform has renewed the Commission's focus on its core mission as the investors' advocate. As she has noted, "there are other agencies of government that touch on what we do... [b]ut Congress created only one agency with the mandate to be the investors' advocate."

In line with this vision, in the Division of Investment Management, we are working to craft regulations from the investor's perspective — what information do investors need to make informed decisions and in what form would that information be most accessible and easy to use? What protections do investors need to instill confidence and allow them fair and easy access to the markets through pooled assets? I look forward to telling you about some of these initiatives this afternoon.

However, since many of you do not practice in this area, I thought I would also take a few moments to talk in broad terms about what we do in the Division of Investment Management and introduce the two statutes that we assist the Commission in administering.

I also want to take a moment at the outset to thank the ABA for providing thoughtful comments and other assistance in connection with the Commission's efforts to devise an efficient and effective regulatory scheme to govern our markets. In particular, I note the Task Force on Investment Company Use of Derivatives and Leverage, which was formed in response to my challenge to the American Bar Association to give some thought to new approaches that would address the concerns that have arisen regarding fund investments in derivatives. The Task Force is currently considering recommendations regarding how the Commission might improve regulations and regulatory guidance in this important area. I will talk about the Division's derivatives project a bit later, but wanted to put you at ease right up front that I will not be assigning you any more homework in my talk this afternoon.

Finally, one thing I must do before I go on is to make the standard SEC disclaimer 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.

II. The '40 Acts

One of the reasons I enjoy working in the investment management area so much is the genius underlying the statutes that govern this industry — the Investment Company Act of 1940 and the Investment Advisers Act of 1940. In fact I credit Congress's foresight in 1940 in creating a regulatory scheme of flexibility and adaptability that I believe has greatly assisted in making mutual funds and other investment companies an important element of our financial system and an investment vehicle of choice for over 87 million investors.

A. The Investment Company Act

The Investment Company Act of 1940 is the primary statute governing the activities of mutual funds, closed-end funds, ETFs, business development companies and other registered investment companies. It is an overlay to the Securities Act of 1933 and the Securities Exchange Act of 1934, which also apply to these companies. Although the regulation of investment companies is based on the same principles of full and fair disclosure that are the foundation of the federal securities laws, in contrast to the 1933 and 1934 Acts, the 1940 Act imposes an extensive and comprehensive system of regulation for funds. It also reflects a judgment in this area that disclosure alone is not enough to control potential abuses.

The Investment Company Act's highly regulatory nature reflects the unique structure of the typical investment company. Unlike a typical operating company, investment company employees do not operate investment companies. Instead, funds generally rely on external service providers, such as the fund's investment adviser, to manage the fund's portfolio and provide administrative services. As the officers of funds are usually affiliated with the fund's adviser, or the other outside service providers, the interests of fund management and shareholders of a fund often conflict in important ways.

To oversee the management of the conflicts of interest inherent in the mutual fund structure, the Act mandated that investment companies be governed by a board of directors. The boards consist in almost all cases of a majority of independent directors, unaffiliated with the fund's adviser or certain other third parties. A fund's independent directors continue to play a critical role in overseeing fund operations and protecting the interests of investors.

Louis Loss called the 1940 Act "the most complex of the entire SEC series" as reflective of the fact that it specifically addresses virtually every aspect of investment companies' operations. But complexity aside, the Act has also shown a resilience and flexibility over time, having only been significantly amended a handful of times since its adoption seventy years ago. The regulatory system established under the Act has worked well and, I believe, has enabled the growth of mutual funds and other investment companies. Why? Its authors effectively addressed the key abuses that gave rise to the Act — including when funds were operated and portfolios selected in the interests of insiders instead of fund investors. The fact that over 87 million investors have entrusted $12 trillion of their hard-earned savings with registered investment companies, in my view, speaks volumes about the effectiveness of regulation under the Act.

An important aspect of the Investment Company Act's flexibility — and one until recently unique to it and the Investment Advisers Act — is that it contains a provision that allows the Commission to permit certain transactions, structures and products that would otherwise be prohibited under the Act, but that benefit investors under carefully crafted conditions. This power has been used by the Commission repeatedly to accommodate investment company innovation, through individual orders and, in some circumstances, later through rules of general applicability. Money market funds, exchange-traded funds and variable annuity products — some of the most innovative financial products of the past 30 years, were made available to the investing public in this manner.

B. The Investment Advisers Act

The Advisers Act was the last of the federal securities laws to be enacted and is a short, principle-based statute imposing general fiduciary standards. In 1940, the investment advisory profession was fairly new and the original Advisers Act's basic purpose was to achieve a compulsory census of advisers by requiring them to register with the SEC by filing an application. The Act also contained broad anti-fraud provisions that prohibited certain transactions, such as those that might involve "self-dealing." With its principle-based nature, the Advisers Act stands in stark contrast to the complexity of the Investment Company Act. However, it has also worked remarkably well in that it has permitted a vibrant and diverse investment advisory industry to develop with a fiduciary culture at its core. Today, over 11,000 investment advisers are registered with the Commission with over $40 trillion in assets under management.

C. Division Operations

Our job in the Division of Investment Management is to help the Commission administer the Investment Company and Advisers Acts. We do this through various offices responsible for each aspect of the regulatory process — offices that process exemptive requests, those that develop rule recommendations to implement the statutes' provisions and offices that interpret the Acts. Our regulatory reforms are complemented by the Commission's vigorous inspection and enforcement programs.

I now would like to briefly discuss some of the major initiatives we are working on in the Division and some of the challenges we face.

III. Division of Investment Management Initiatives and Challenges

In spite of the flexibility built into the two 1940 Acts governing investment management, we face considerable challenges in applying the existing regulatory framework to an industry that continues to evolve and innovate at a rapid pace.

One way the investment advisory business has changed is through the entry of new market participants whose activities have traditionally fallen outside the statutory definition of an investment adviser or who are not subject to the Act's registration requirements. With unregistered market participants now providing advisory services to a larger number of investors, investor protection concerns have quite properly prompted the question of who should register under the Advisers Act?

Investment Adviser / Broker-Dealer Harmonization

An issue that exemplifies this problem is the differing regulatory regimes governing broker-dealers and investment advisers. As brokerage commissions have dramatically declined, and the retail broker-dealer model has evolved, broker-dealers are increasingly providing investment advice as a larger component of their services to customers. The question of whether, and under what circumstances, their customers should receive the protections of the Advisers Act is a matter the Commission has been considering since this issue came to the forefront in the late 1990s. As the determination of when the activities of broker-dealers are advisory activities subject to the Investment Advisers Act is often tied to compensation received, questions arose whether broker-dealers receiving new forms of compensation — such as asset-based fees rather than traditional brokerage commissions — would lose their statutory exception under the Advisers Act. The Commission first took action to address this situation in 1999, when it proposed a rule to exclude broker-dealers that offered fee-based programs under certain conditions from the Advisers Act. Although the rule eventually adopted by the Commission was determined to be beyond the Commission's authority and nullified by the DC Court of Appeals, the debate on this issue has continued. It is currently being considered as an aspect of the financial reform bills in Congress.

Private Fund Advisers

Other market participants whose activities have raised questions of whether they should be subject to increased regulation are advisers to hedge funds and other private funds. Hedge funds traditionally have been organized in ways that avoid regulation as investment companies under the Investment Company Act, as well as avoid registration requirements of the Securities Act and the Securities Exchange Act. In addition, many hedge fund managers, although they are investment advisers, avoid registration under the Advisers Act by taking advantage of an exemption from registration for small investment advisers — those with fewer than 15 clients. Hedge fund advisers qualify for this exemption by pooling client assets and creating limited partnerships, business trusts or corporations in which clients invest. Because advisers are permitted under a Commission rule to count each partnership, trust or corporation as a single client, they avoid registration while, in many cases, managing substantial amounts of assets on behalf of large numbers of investors.

With the growth of hedge fund assets and their market influence, the question of whether the registration requirement should be extended to hedge fund advisers has been considered by the Commission and staff for a number of years. In many ways, the registration of private fund advisers remains a regulatory gap that I believe should be filled. This issue also is now being considered as part of the comprehensive reform package in Congress.

Sophisticated Products

In the fund industry, there are also developments the Investment Company Act may not directly address. For example, I have a variety of concerns about the increasing use of derivatives and sophisticated financial instruments by mutual funds. Although derivative instruments may afford the opportunity for efficient portfolio management and risk mitigation, they also can present potentially significant additional risk as well as raise issues of investor protection. In the past two decades, the investment company marketplace has been significantly reshaped by the use of derivative instruments. During this period, investment companies have moved from relatively modest participation in derivatives transactions limited to hedging or other risk management purposes to a broad range of strategies that rely upon derivatives as a substitute for more conventional securities. Investment companies that seek to mimic hedge fund strategies, typically involving derivative products, have become more commonplace. New categories of investment companies have emerged: absolute return funds, commodity return funds, alternative investment funds, long-short funds and leveraged and inverse index funds, among others.

The 1940 Act truly contemplated a different world. These developments present challenges in giving effect both to the literal terms of the Investment Company Act as well as two of its underlying purposes 1) to address the speculative character of shareholders interests arising from excessive borrowing or the issuance of excessive amounts of senior securities and 2) to assure full disclosure to investors of investment strategies and risks. Engrained in the Act, and assumed until not that long ago, is that investment companies were investing in stocks, bonds and similar securities. The Act also approaches many areas such as concentration and diversification, to name but two, based on the amount of money invested, rather than the degree of economic exposure the fund has undertaken to a particular security, company or sector. That, of course, is not always the case now. With so many derivative instruments available to enhance an investment strategy, a fund's manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds. It is to assess and respond to this challenge that the Division has undertaken to review derivatives activities of investment companies and the implications of those activities for the regulatory framework. It is also in this area that I issued my challenge to the ABA last year as to how we might improve regulations and provide needed guidance in this area. Again, I thank the participants on the Task Force for their efforts in developing their recommendations in this area.

Rule 12b-1

In the Division, we are also developing a recommendation concerning so-called 12b-1 fees. These fees are automatically deducted out of fund assets to cover distribution expenses and other services to investors. Rule 12b-1, which authorizes these fees, was adopted in 1980 when the fund industry was in a very different state. There had been a period of net redemptions, and there was a concern that if funds were not permitted to use a small portion of their assets to facilitate distribution, they might not survive. Now fund assets are over $12 trillion and, while fund flows may vary, the industry has not been through a period of sustained net redemptions. As 12b-1 fees typically now constitute a meaningful cost of an investment in a fund and their use has changed significantly, I believe the role of fund boards and the factors they must consider when approving or renewing a rule 12b-1 plan need to be revisited. We hope to recommend to the Commission shortly an investor-oriented reform proposal that better reflects the current market environment and enhances investor awareness of the amounts and uses of these fees.

Target Date Funds

Along similar lines, Chairman Schapiro has requested recommendations from the Division regarding target date funds. Concerns over shareholders' awareness and understanding of investment risks have been raised in connection with these funds, especially with the allocation of the funds' investments. With a trend among 401(k) plans to offer target date funds to participants as a default investment option, there is concern that investors may hold these funds without in fact appreciating the associated risks.

Disclosure Initiatives

The Division is working on a number of other projects as well that further a continuing effort to improve the quality of mutual fund disclosure and assist investors in making better-informed decisions.

Summary Prospectus and Shareholder Report Reform

Disclosure is, of course, critical in assisting investors in making informed investment decisions. In my view, the potential for "disclosure creep" can create disclosure documents that are so dense that the information simply serves as methods for firms to avoid liability, rather than assisting investors in making investment decisions. For this reason, I have made improving the disclosure funds provide their investors and potential investors a Division priority.

In 2008, the Commission voted to adopt a Summary Prospectus for mutual fund investors. The concept behind the Summary Prospectus was to devise a brief, informative document for fund investors with key information presented in a concise, user-friendly manner, with additional information on-line or in paper upon request, for those who want it. The Summary Prospectus was a revolutionary change in mutual fund disclosure, and in the Division we are working on a recommendation for a similar type of disclosure document for variable annuities.

The Division is also looking at whether the current annual and semi-annual shareholder report disclosure can be made more streamlined and user-friendly for fund shareholders. As part of our work, we are considering how the Internet and other technology may be used to provide better delivery and accessibility of this information. For example, one idea being considered is to revise fund shareholder reports to include the information that is most important to the typical shareholders, while the more detailed information could be made available on the Internet.

Form ADV Part 2

We are also working to improve disclosure to investment advisory clients and prospective clients through the overhaul of Part 2 of Form ADV. Part 2 is the primary disclosure document provided by investment advisers. Its current check the box, fill-in-the-blank format may not be that helpful to clients. The goal in its revision is to provide a more useful format, most likely in a narrative.

Reform of Part 2 will have a universal impact on the advisory industry. As investment advisers are fiduciaries, it is important that they provide enough information to prospective clients to enable them to make an informed decision about whether to rely on the adviser for advice. In my view, few, if any, regulatory matters under the Advisers Act affect so many people so substantially. The Division staff is currently working to recommend a final version of Part 2 for adoption that remains true to the principle that advisory clients should receive clear and meaningful information about their investment advisers and the services provided to them. We expect to make a recommendation to the Commission to adopt a revised Part 2 soon.

Responses to Market Events

Finally, in addition to our initiatives that are needed to address market changes and the need to update regulations, and those aimed at improving fund disclosures, some of our initiatives are prompted by market events and the activities by market participants.

Money Market Funds

One the Division's major initiatives this past year was the reform of the regime governing money market funds. Since the beginning of the recent market turmoil in 2007, a priority for the Division has been the regulation of money market funds. This has been a challenging period for the $3 trillion money market fund industry, encompassing the first "breaking of the buck" by a widely held money market fund and the unprecedented enactment of various liquidity facilities and other government programs to assist the funds. Perhaps the most significant challenge in the current market environment is that persistent, low interest rates have caused many money market fund advisers to waive a large portion of their fees to avoid yields from going negative for investors. We understand that this has caused some sponsors to exit the business entirely as they see their profits evaporate. However, money market funds continue to play a crucial role for our economy by acting as buyers of short-term paper from businesses and government entities. They also remain an extremely popular product with all types of investors, both retail and institutional.

With respect to the money market fund regulatory model, the challenge is to strike the right balance between improving the safety of money market funds and preserving the ability of money market funds to generate yield for their investors. In this regard, the actions that the Commission has taken are aimed at improving the ability of money market funds to withstand the financial stresses that they will inevitably experience.

These actions include the Commission's adoption in January of new rules governing money market funds. The rules require, among other things, that money market funds comply with new maturity standards that make them less vulnerable to market risks; and that they meet new daily and weekly liquidity standards so that they have a greater portion of their assets in liquid investments and be in a better position to pay redeeming investors under any market conditions. Also under the new rules, money fund managers have to stress test their portfolios under different scenarios, such as a sudden increase in interest rates or the default of issuers of securities held by the fund. Furthermore, money funds must disclose portfolio information to the public each month on their web sites. This disclosure will equip investors with information they can use to evaluate the risks of investing in particular funds. Finally, money funds must file more detailed portfolio reports each month with the Commission to help us oversee the funds. The information also will be available to the public on a 60-day delay and will help investors to see more detail about the risks that a fund may be taking with their money. In my view, the availability of the information also may cause fund managers to think more carefully about the decisions they make about the fund's investments.

The new rules represented strong action by the Commission to make money market funds a more transparent and safe investment. However, I believe these were only a first step in a continuing effort to improve the regulation of money market funds. More is yet to come. The financial crisis exposed certain systemic risks connected to money market funds — namely the susceptibility of the funds to runs in times of extreme market stress. The Commission has asked more fundamental questions about money market funds and their ability to maintain a stable net asset value of one dollar per share, and I expect to see a robust policy discussion of these questions. I appreciate the proactive work of the industry in developing meaningful recommendations for the important changes the Commission has made. I encourage the industry to continue this work as we consider recommendations for further change.

Advisers Act Initiatives

The Commission has also taken important steps to provide greater protections to investors who entrust their assets to investment advisers. Following a series of enforcement cases the Commission brought against advisers and broker-dealers alleging fraudulent conduct, including misappropriation and other misuse of investor assets, the Commission adopted changes to the rule governing an investment adviser's custody of client assets. The Commission also recently proposed rules designed to prevent so-called "pay to play" by investment advisers that manage public pension fund assets.

IV. Conclusion

Thank you for listening this afternoon. I want to reiterate my gratitude for your comments and assistance with respect to our work in the Division. Comment letters are a vital part of the rulemaking process and I appreciate the non-billable time and effort you spend to prepare them and inform us on matters that are important to you. As we move ahead on the major initiatives I mentioned, I look forward to your thoughtful comments and suggestions on many of the issues we are addressing.

Thank you again.




Modified: 04/26/2010