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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Introductory Statement at February 11, 2004, Open Meeting


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Washington, D.C.
February 11, 2004

This is an open meeting of the Securities and Exchange Commission. It is the fourth in a series of meetings in which the Commission is considering critical initiatives aimed at protecting mutual fund investors.

At the first of these meetings, held on December 3, we approved a package of rules and rule proposals to combat late trading, market timing, and selective disclosure abuses, as well as requirements that all funds and advisers have comprehensive compliance policies and procedures and chief compliance officers.

On December 17, we approved rule proposals and a concept release that were directed toward providing mutual fund investors with more information about mutual fund sales load breakpoints and fund transaction costs.

On January 14, we approved a proposal under the Investment Advisers Act to require investment advisers to adopt codes of ethics, proposals under the Investment Company Act to enhance fund governance, and a proposal for point-of-sale disclosure and a new confirmation statement for brokers to use when selling fund shares.

Today, we are considering:

  • Final rule and form amendments to require fund shareholder reports to disclose, in dollar terms, the amount of fees and expenses their shareholders pay, and to provide more frequent disclosure about the fund’s portfolio investments;
  • A proposal to require fund annual reports to discuss the reasons supporting the directors’ decision to approve the fund’s advisory contract and fees; and
  • A proposal to prohibit funds from using brokerage commissions to pay broker-dealers for selling fund shares.

On February 25, we will consider additional proposals to combat market timing abuses, including a proposal to require mutual funds to impose a mandatory redemption fee on market timers, which will incorporate relevant recommendations from the NASD’s Omnibus Account Task Force.

Finally, on March 10, we will consider a proposal that would improve disclosure to fund shareholders about their portfolio manager’s relationship with the fund.

The Commission is deeply committed, and is working on all fronts, to try to restore investor confidence in fund investments. The comment periods on several of our earliest proposals will end this month and I have directed the Division staff to move quickly to bring recommendations for final rules to the Commission. I anticipate that the staff will have started to recommend final rules to us by the end of April.

All of the recommendations before the Commission today come from the Division of Investment Management. Before we dive into a detailed discussion of the recommendations, I would like to take a moment to acknowledge and thank Paul Roye, Director of the Division of Investment Management, and the members of his staff who were instrumental in drafting these recommendations – Susan Nash, Bob Plaze, Doug Sheidt, Paul Cellupica , Hunter Jones, Chris Kayser , Penelope Saltzman, Hester Peirce , Deborah Skeens, and John Faust.

Although the pace at which you have been working on these and other rulemakings has been relentless, the quality of your work has not suffered. As always, you have presented us with thoughtful, and thought-provoking recommendations – congratulations to you all.

Item 1 — Fund expense and portfolio holding disclosure

The first item on our agenda is a recommendation that we adopt amendments proposed by the Commission in December 2002, to require mutual funds –

  • To include dollar and cents disclosure of the fund’s expenses in their shareholder reports,
  • To disclose their portfolio holdings more frequently, and
  • To make the disclosure about portfolio holdings that is included in their shareholder reports more streamlined and understandable.

Portfolio holding disclosure

With respect to fund portfolio holdings, the amendments would require funds to disclose their complete portfolio holdings four times per year in filings with the Commission – instead of twice a year as currently required. In addition, the amendments would allow the disclosure that is provided directly to shareholders to be streamlined; permitting funds to list only the fund’s most significant holdings, and requiring that these holdings be illustrated with graphs or tables. These revisions will encourage funds to make the information that all shareholders receive more user-friendly, while accommodating the needs of investors who are interested in more detailed and more frequent disclosure.

I believe that fund investors will be well-served by these changes. The current disclosure, while comprehensive, is difficult and dense. The average mutual fund investor is unlikely to read, much less analyze, a multiple-page list of securities holdings. At the same time we don’t want to impede the investor who wants, and can use, more information. I believe that this recommendation strikes an appropriate balance among these various concerns.

Expense Disclosure

As to fund expenses — the level of a fund’s expenses, over time, has a significant impact on the fund’s shareholders investment experience. The Commission and its staff have wrestled for years with the problem of how to convey expense information to investors in a cost-effective way that permits them to compare between funds, and to understand and appreciate the effect that expenses are having on their investment. Today’s recommendation represents another step in this ongoing process. I support these amendments because they will help investors by requiring that fund expenses be expressed in a concrete way that may be more understandable to them.

This rulemaking will, however, not be the Commission’s final word on the subject. Our securities markets work best when populated with investors who make informed choices, and it is incumbent upon us to ensure that investors have the benefit of the clearest and most effective disclosure we can devise. In this spirit, I have asked our staff to consider whether there are ways in which our rules and forms should be revised to ensure that investors are receiving expense and other information in the most effective way, in the most sensible location, and in the most useful format.

Item 2 — Investment Adviser Contract Disclosure

A fund’s board of directors plays a key role in negotiating and approving the terms of the advisory contract between the fund and the investment adviser who is charged with its management. The second recommendation from the Division is a proposal to make this process more transparent to fund shareholders.

Almost all mutual funds are organized and operated by external money-management firms, creating an inherent conflict of interest, and potential for abuse and overreaching. This problem is nowhere more in evidence than in the negotiations over the advisory contract between the manager and the fund. The money manager wants to maximize its profits through the fees the fund pays. The fund’s shareholders want to maximize their profits by paying as little as they can for the highest level of service. The fund’s board of directors serves as the shareholders’ representative in this negotiation.

There are currently two places in which funds disclose to their investors the basis for the board’s approval, and the basis for the board’s recommendation that shareholders approve the investment adviser’s contract: the proxy statements soliciting shareholder approval of the contract, and the Statement of Additional Information, that is part of the fund’s registration statement. The Division is recommending that this disclosure be added to the fund’s annual report to shareholders, and that it be made better and more prominent.

In recent weeks, there has been much public debate about whether mutual fund fees are too high, and if they are, what the appropriate regulatory response should be. I have said before that I believe that the Commission should not act as a “rate-setter” for mutual funds, and that this decision is better left to the free market – and informed investors who have the benefit of an independent and vigorous mutual fund board looking out for their interests. As I see it, our role in this process should be to give the market every opportunity to work, by making sure that investors have the tools they need to be informed, and bolstering, wherever possible, the independence of the board.

Last month, we dealt with the second half of this equation, issuing proposals to increase the proportion of the fund’s board that must be comprised of disinterested directors, and to require that the board have a disinterested chairman. This month, we address the first half, as we consider proposals that would give fund shareholders access to better, more prominent, and more timely information that they need to assess the performance of their directors.

As always, I look forward to hearing from commenters on these proposals. Our rulemaking process works best when those who have to live by our rules involve themselves in the dynamic debate that always surrounds the rulemaking process.

Item 3 — Rule 12b-1 Amendments

The final item on our agenda relates to the Commission’s rule 12b-1. Several months ago, I directed the staff to reexamine rule 12b-1 and the use of fund assets for distribution. Today, the staff is recommending that we propose to amend rule 12b-1 to prohibit mutual fund brokerage from being used to compensate brokers and dealers for selling fund shares, and that we put out for comment the question of whether rule 12b-1 should be amended comprehensively.

The decision to use fund assets for purposes of distribution clearly presents a conflict of interest to the fund’s investment adviser, and rule 12b-1 was adopted only after a great deal of reflection and debate. Over time, the rule has come to be used in ways that far exceed its original purpose. And although, at the time when rule 12b-1 was adopted, the Commission thought that it would be relatively benign to permit funds to consider distribution when making brokerage allocation decisions, in recent years it has become painfully clear that the practice of directing a fund’s brokerage to a broker or dealer as compensation for distribution of the fund’s shares presents opportunities for abuse that are identical to those that arise when the fund pays the broker or dealer directly. In fact, the practice is even more troubling, because its impact is hidden from investors.

I anticipate that commenters will have much to say about both the proposal and the request for comment. Rule 12b-1 fees and directed brokerage quietly generate a lot of money for people in the fund and broker-dealer industries, and unlike some of our other proposals, this will have a major financial impact on people in those industries. While I look forward to hearing from industry participants, I also look forward to hearing from the fund shareholders who have been the source of the money flow.



Modified: 02/12/2004