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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the National Investment Company Service Association 22nd Annual Conference & Expo


Paul F. Roye

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

Miami, FL
February 23, 2004

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.

I. Introduction

Good morning and thank you for welcoming me here today. I am very pleased to join you for my inaugural appearance at a NICSA Conference. By providing educational and related services for the operations and shareholder servicing sector of the fund industry, NICSA performs a valuable function, and I appreciate the opportunity NICSA has provided me to speak here today. Before I begin, I would like to remind you 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. Role of Fund Service Providers

As operations and shareholder servicing professionals, you are very much the backbone of the investment company industry. While you may not receive the media attention of the portfolio managers who manage fund investments, or engage in the same level of regulator interaction as the attorneys who represent funds, we know that you perform critical functions on behalf of fund investors. These functions sometimes go unheralded but are nonetheless essential to the smooth and, just as important, the "ethical" operation of mutual funds.

You control the processes and administer the procedures, and therefore in your hands rests the power to operate funds in shareholders' best interests-or, alternatively, the power to pursue your own, or your firm's, pecuniary gain at the expense of shareholders' best interests. Every day you have the opportunity to promote the interests of the over 90 million Americans who have a portion of their hard-earned money invested in mutual funds. It is important that you take seriously this obligation to further shareholders' interests--and at all times resist the temptation to overlook a transaction, authorize an exception or fail to follow up on a complaint, with a wink and a nod and tacit understanding that you "will look the other way." There is no place for such weakness or compromise in the investment company industry. With the unfolding mutual fund scandal, we are seeing first hand how investors have been betrayed and the cost the industry is paying for these gross breaches of fiduciary obligations. Careers are being destroyed; jobs are being lost; and reputations of firms that have been built since the founding of the fund industry have been sullied.

Unfortunately, many of the problems related to mutual funds that have recently surfaced directly involved fund service providers. For example, we have seen, on a wide-scale basis, that fund investors were not receiving the front-end load breakpoint discounts to which they were entitled from broker-dealers selling fund shares. While the failure to credit breakpoint discounts appears, for the most part, to have resulted from carelessness rather than intentional fraud on the part of service providers and others, it represents a lack of diligence that is harmful to investors, which cannot be tolerated.

Even more alarming and distressing is that certain service providers were also involved in facilitating late trading of fund shares-a practice that is clearly fraudulent. In addition, some fund service providers even developed elaborate schemes to hide late trading or abusive market timing activity from regulators and others who were trying to do the right thing by investors by policing these activities.

I have no sympathy for those who were engaging in these collusive practices to loot money from America's mutual fund investors, and I am confident these wrongdoers will be held accountable to the full extent of the law. In fact the Commission and state regulators have brought actions against several service providers and their employees related to the late trading and market timing scandals. For example, we recently brought an action against a bank employee who it is alleged was knowingly arranging for the financing of hedge funds to engage in these abusive practices.

In addition, fund service providers are being held accountable for their lack of diligence and follow up with respect to compliance policies and procedures. Late last week, the NASD fined a major fund service provider $1 million and ordered the firm to pay over $500,000 in restitution because the NASD found that the service provider's procedures and systems were not adequate to prevent and detect market timers. In addition, the NASD found the procedures failed to provide for adequate follow-up. Significantly, this action was premised on lack of diligence rather than deceit, theft or manipulation on the part of a service provider. But the lax oversight and inadequate procedures had a significant harmful impact on fund investors.

III. Lessons for Service Providers

The recent fund scandals underscore the importance of rules and processes. They are not meaningless red tape. They serve a legitimate purpose-and that purpose is to ensure that insiders and overly-aggressive market participants do not take advantage of ordinary fund shareholders. Fund shareholders must trust that the system works for them. That trust has been shattered, and it is up to all of us to rebuild it again.

You are the ones with the ability to ensure that fund rules and processes are meaningful tools to thwart wrongdoers. Those who are charged with overseeing and implementing fund policies cannot be lackadaisical paper pushers. You control the vigilance with which fund rules and processes are followed and, as we have seen, if you do not stand up and question an inappropriate practice or maintain your ground when asked to make an exception to a rule, disastrous consequences can result.

I know that many of you provide services to hedge funds as well as mutual funds. Another theme emerging from the market timing and late trading scandals is that service providers to hedge funds were willing to make special allowances for the hedge funds, or engage in or facilitate illegal activity on behalf of the hedge funds, sometimes to the detriment of the investors in their mutual fund clients. Hopefully, those in the service provider community have learned that there can no longer be a "beneath-the-radar," anything-goes attitude when it comes to servicing hedge funds.

And, finally, an overarching theme evident in the recent scandals is the willingness of some to compromise their integrity in order to attract new business or retain current clients. There is always pressure to develop business, and I certainly believe that fund shareholders benefit when there is healthy competition in the fund services industry. However, as professionals, you must be guided by more than the bottom line. You cannot sacrifice business ethics in the name of competition. A business built by compromising ethical standards is simply a house of cards waiting to crumble. As some would say in Kentucky where I grew up, "sooner or later the chickens will come home to roost."

As an example, one of the Commission's complaints against a broker-dealer and several of its executives accused of facilitating late trading and abusive market timing activities on behalf of 18 institutional clients, including several hedge funds, contains a quote from an internal e-mail. The quote reads:

[Two of their executives] know the position that they have put us in relative to these fund groups - and they will openly state that their customers will continue to seek places where this type of activity is allowed until the breaking point is hit…. It's not unlike a rock band which knows that they continue to trash hotel rooms on their tours-and as soon as Hyatt throws them out, they'll move on to Hilton, then Marriot, then somebody else. They know it's coming each time, and they'll just keep moving to the next outlet as long as they can continue to play the game …. At the same time [the firm] is in no hurry to turn off the customers-there's revenue in the tickets and value in having the assets on the books for as long as the gig is on.

Well, the gig is now off. The two executives named in the e-mail, and their firm, are facing SEC fraud charges based on their alleged efforts to facilitate late trading and market timing.

Fund service providers must also keep in mind that you generally are agents of mutual funds and their investors-not agents of the management companies that set up and run the funds. Throughout the course of your work on behalf of mutual funds, you likely develop relationships and establish a rapport with individuals at the fund's management company. You may even seek additional business from these management company representatives. But these are not the firms and individuals to whom you owe a duty of loyalty. As a fund agent, your loyalty lies with the fund and its shareholders, and you cannot subvert this loyalty, or engage in illegal or unscrupulous acts, simply to curry favor with those other than your ultimate client.

IV. Commission's Regulatory Agenda

As I mentioned, the Commission has committed its unceasing effort to holding accountable those who violate the federal securities laws. The Commission is equally devoted to enhancing the investment company regulatory framework so that it best serves fund investors. As Chairman Donaldson has stated, "The Commission is deeply committed, and is working on all fronts to restore investor confidence in fund investments."

As you have no doubt seen, the Commission is pursuing an aggressive rulemaking agenda that is focused on four main goals (1) to address late trading, market timing and related abuses; (2) to improve oversight of funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) to address or eliminate certain conflicts of interest; and (4) to improve disclosure to fund investors, especially fee-related disclosure.

A. Initiatives to Address Late Trading, Abusive Market Timing and Related Abuses

Hard 4:00 Rule: With respect to late trading abuses, the Commission has proposed the so-called "hard 4:00" rule. This proposal would require that a fund or a certified clearing agency, such as FundSERV-rather than an intermediary such as a broker-dealer or other unregulated party-receive a purchase or redemption order prior to the time the fund prices its shares (which, as you know, is typically 4:00 p.m.) for an investor to receive that day's price.

We are currently analyzing the comment letters we received during the comment period on this proposal, which closed on February 6th. While the proposed rule amendment would virtually eliminate the potential for late trading through intermediaries that sell fund shares, it is clear from the comments that some believe that the hard 4:00 rule is not the preferred approach. They argue that it will require the intermediaries to have cut-offs for orders well before 4:00 p.m. and limit investor opportunities to place orders for fund transactions. We will be considering other approaches to addressing this issue, but will recommend an alternative solution only if we can be assured that the alternative effectively addresses the problem.

Mandatory Redemption Fee: In an effort to reduce the profitability of abusive market timing, the Commission on Wednesday, will consider the proposal of a mandatory two percent redemption fee when investors redeem their shares within five business days. This fee would be payable to the fund, for the direct benefit of fund shareholders, rather than to the management company or any other service provider. I should also note that in preparing the mandatory fee recommendation, we relied significantly on the report of the Omnibus Account Taskforce, which was organized by the NASD. This Taskforce was comprised of various mutual fund service providers who lent their expertise to helping us address how best to implement a possible redemption fee in an omnibus account environment.

The two percent fee is designed to strike a balance between two competing policy goals of the Commission - preserving the redeemability of mutual fund shares and reducing or eliminating the ability of shareholders who frequently trade their shares to profit at the expense of the fellow shareholders. Although such a rule would make market timing less profitable, and therefore reduce the incentive to engage in market timing, we recognize that redemption fees alone would not be effective in preventing market timing. In my opinion, redemption fees in conjunction with fair value pricing can effectively reduce or eliminate the profit that many market timers seek.

Fair Value Pricing: The Investment Company Act requires funds to calculate their net asset values using the market value of portfolio securities when market quotations are readily available. If a market quotation for a portfolio security is not readily available (or is unreliable), the fund must establish a "fair value" for that security, as determined in good faith by the fund's board. Fair value pricing can minimize market timing and eliminate dilution of shareholders interests. In a recent release adopting the new compliance procedures rule, the Commission reiterated the obligation of funds to fair value their securities under certain circumstances to reduce market timing arbitrage opportunities. I hope that those of you involved in fund pricing are aggressive in urging funds to embrace their fair value pricing obligation. I should also point out that the Commission has proposed improved disclosure of a fund's policies and procedures regarding fair value pricing.

Enhanced Disclosure Related to Abusive Activities: The Commission has proposed that funds make clear and specific disclosures regarding their procedures to address market timing-as well as disclosure of their actual practices with respect to marketing timing. For funds that cater to market timers, they are welcome to disclose this and are in no way required to employ policies to deter market timers. However, for funds that state they have a policy to deter market timers, they must explain that policy and how they implement it on a practical basis. This type of explicit disclosure would shed light on market timing so that investors can better understand a fund's market timing policies and how the fund manages abusive market timers.

The Commission has also proposed disclosure of a fund's policies and procedures with respect to the disclosure of its portfolio holdings. Long term investors can be significantly harmed if a fund's portfolio schedule is released privately, or selectively, and then used to try and market time or trade ahead of the fund. Thus, the Commission has proposed that funds disclose how, when and to whom they are revealing their portfolio holdings, as well as any safeguards they have in place to prevent misuse of that information. Unfortunately, we discovered instances of this type of abuse in our investigations.

B. Initiatives to Enhance Fund Oversight

The recent mutual fund scandals have highlighted the need to improve oversight of the industry, and the Commission has undertaken several initiatives on this front.

Fund Governance: In January, the Commission proposed a comprehensive rulemaking package to bolster the effectiveness of independent directors and enhance the role of the fund board as the primary advocate for fund shareholders. The proposals included a requirement for (i) an independent board chairman; (ii) 75 percent independent directors; (iii) independent director authority to retain staff; (iv) quarterly executive sessions of independent directors outside the presence of management; (v) an annual board self-evaluation; and (vi) preservation of documents used by boards in the contract review process.

This significant overhaul of the composition and workings of fund boards is intended to establish, without ambiguity, the dominant role of independent directors on a fund's board. With an independent board chairman and with independent directors representing at least 75% of a fund's board, independent directors will set the board agenda as well as have the power to control the outcome of board votes. The very nature of external management that characterizes the U.S. fund industry creates conflicts of interests, particularly when personnel of fund advisers are faced with choices that may benefit the adviser over fund shareholders. While not a guarantee that all conflicts of interest will be resolved in the best interests of shareholders, a board composed of an independent chairman and a super-majority of independent directors is more likely to be an effective check on management, particularly when so much of the board's responsibility involves policing the management company's conflicts of interest. As Chairman Donaldson recently commented, " a fund board can be more effective when negotiating with the fund adviser over matters such as the management fee, if it were not at the same time led by an executive of the adviser with whom the board is negotiating."

By empowering independent fund directors to retain staff, in conjunction with the role envisioned for the newly-required chief compliance officer, the Commission's proposals emphasize the importance of boards relying on experts other than advisory personnel to provide information in appropriate circumstances. In addition, reinforcing the ability of the board to hire staff recognizes that directors often must make decisions on issues about which they may need to seek out expertise, such as the fair value pricing of portfolio securities.

Boards would also be required to perform a thorough self-evaluation in order to identify structural changes and processes that might enable the board to be a more potent advocate for shareholder interests. Boards would be required to assess periodically whether they are organized to maximize their effectiveness. As part of this evaluation, boards would consider the number of fund boards on which individual board members sit, as well as consider the nature and effectiveness of their board committee structures.

As part of its effort to enhance fund governance, the Commission has proposed to amend the fund recordkeeping rule, to mandate that funds keep copies of the materials on which directors rely when approving the fund's advisory contract each year. This amendment is designed to give the Commission's examinations staff access to the information on which directors rely when making this crucial decision. This requirement also could have the effect of focusing directors on this key information, since they would be aware that it will be subject to Commission scrutiny.

Adviser Codes of Ethics and Fund Transactions Reporting: Also in January, the Commission proposed that all registered investment advisers adopt codes of ethics. Investment advisers are fiduciaries, and owe their clients a series of duties enforceable under the Advisers Act antifraud provisions. This bedrock principle, which historically has been a core value of the money management business, appears to have been lost on a number of advisers and advisory personnel.

We believe that prevention of unethical conduct by advisory personnel is part of the answer to avoiding the problems we have encountered recently. Consequently, the code of ethics would set forth standards of conduct for advisory personnel that reflect the adviser's fiduciary duties, as well as codify requirements to ensure that an adviser's supervised persons comply with the federal securities laws, and require that supervised persons receive and acknowledge receipt of a copy of the code of ethics. In addition, the code of ethics must include provisions that address the safeguarding of material nonpublic information about client transactions, reporting promptly any violations of the code of ethics, and mandating pre-clearance of personal investments in initial public offerings and private offerings.

Finally, the ethics code is designed to address conflicts that arise from the personal trading of employees of advisers. A principal feature of the code of ethics rule is a requirement that certain advisory personnel, referred to as access persons, must report their personal securities holdings and transactions, including transactions in any mutual fund managed by the adviser or an affiliate. The rule would close a loophole under which investment company personnel have not been required to report trading in shares of funds they manage. This loophole became apparent when, unfortunately, fund personnel were discovered market timing their own funds.

Compliance Policies and Compliance Officer: In an action that we expect to have a far-reaching positive impact on mutual fund operations and compliance programs, the Commission in December adopted rules that require funds and their investment advisers to have comprehensive compliance policies and procedures in place, and to designate a chief compliance officer. In the case of a fund, the chief compliance officer would be answerable to the fund's board and fired only with the board's consent.

The compliance officer has dual roles: first, as the primary architect and enforcer of compliance policies and procedures for the fund; and second, and perhaps more importantly, as the eyes and ears of the board on all compliance matters. While the role of developing and enforcing an aggressive compliance program is certainly important, let me focus my comments on the role of serving as the eyes and ears of the fund board.

The chief compliance officer, at the behest of the board, is expected to extend the board's hand of compliance oversight into the details of the operations of funds and advisers, where compliance lapses and abuses often germinate and remain hidden from even the most watchful board. In order to support the "watchdog" role of the compliance officer, the rules require the chief compliance officer to meet in executive session with the independent directors at least once each year, outside the presence of fund management and the interested directors. This executive session will create an opportunity for open dialogue between the chief compliance officer and the independent directors and encourage the compliance officer to speak freely about any sensitive compliance issues, such as any reservations about the cooperativeness or compliance practices of fund management. To insulate a chief compliance officer from the pressures, real or perceived, brought to bear by fund management, a fund's board, including a majority of the independent directors, must approve the chief compliance officer's compensation, as well as any changes in compensation.

To further encourage a culture of compliance among fund officers and personnel of fund advisers, the compliance rule calls for funds and advisers to adopt policies and procedures designed to lessen the likelihood of securities law violations. The adequacy of these policies and procedures must be reviewed at least annually in order to ensure that fund directors assess whether internal controls and procedures are working well and whether certain areas can be improved.

I believe that an active and independent board, supplied with reliable information as to the effectiveness of compliance programs and procedures, will serve as an important check against abuse and fraud on the part of fund management.

C. Initiatives Aimed at Conflicts of Interest

In addition to the matters I have outlined above, the Commission is undertaking a series of initiatives aimed at certain conflicts of interest involving mutual funds and those who distribute fund shares.

Directed Brokerage: Earlier this month the Commission voted to propose an amendment to rule 12b-1 to prohibit the use of brokerage commissions to compensate broker-dealers for distribution of a fund's shares. Effectively, this proposal would ban so-called directed brokerage practices by mutual funds. The conflicts of interest that surround the use of brokerage commissions (which, of course, are fund assets) to finance distribution may harm funds and their shareholders. For instance, directed brokerage practices potentially could compromise best execution of portfolio trades, increase portfolio turnover, conceal actual distribution costs and influence broker-dealers' recommendations to their customers. Therefore, the Commission has proposed to ban these types of arrangements.

Rule 12b-1: At the same time, the Commission voted to request comment on the need for additional changes to rule 12b-1. The Commission's request for comment will include comment on an alternative approach to rule 12b-1 that would require distribution-related costs to be deducted directly from shareholder accounts rather than from fund assets. We are interested in the practical impact of such an approach and look forward to your comments. In addition, the Commission is seeking comment on whether rule 12b-1 continues to serve the purpose for which it was intended and whether it should be repealed.

Soft Dollars: With respect to soft dollar arrangements, Chairman Donaldson has directed the staff to explore the problems and conflicts inherent in these arrangements and the scope of the safe harbor contained in Section 28(e) of the Exchange Act. The Division of Market Regulation and the Division of Investment Management are working together to conduct this review.

D. Initiatives to Improve Fund Disclosure, Including Fee-Related Information

The Commission is quickly progressing on its continued effort to improve fund disclosures and highlight for investors fee-related information. This effort began long before mutual fund scandals hit the headlines, and Chairman Donaldson has identified improved disclosure as a priority for the Commission's mutual fund program.

Shareholder Reports Disclosure: Earlier this month, the Commission voted to significantly revise mutual fund shareholder report disclosures. Shareholder reports will now be required to include dollar-based expense information for a hypothetical $1,000 investment. Using that information, investors can then estimate the dollar amount of expenses paid on their own investment in a fund. Shareholder reports also will contain the dollar amount of expenses an investor would have paid on a $1,000 investment in the fund, using an assumed rate of return of 5%. Using this second dollar-based number, investors can compare the level of expenses across various potential fund investments.

This initiative also includes quarterly disclosure of a fund's portfolio with a 60-day lag. This portfolio information will appear on the Commission's EDGAR website and also will be available to fund shareholders free of charge upon request to the fund. In addition, a fund's portfolio schedule will be presented to investors in shareholder reports in a streamlined format, listing only the top 50 holdings and any investment that exceeds one percent of a fund's net asset value.

At the same time as it adopted these revisions, the Commission also proposed to require disclosure in fund shareholder reports about how fund boards evaluate investment advisory contracts. The disclosure would include discussion of the material factors considered by the board and the conclusions with respect to those factors that formed the basis for the board's approval or renewal of the advisory contract. In making this proposal, the Commission is seeking to promote insightful disclosure of the board review process, rather than meaningless boilerplate that is not helpful to investors.

Mutual Fund Confirmation Form and Point of Sale Document: In a major proposal issued last month, the Commission proposed significant revisions to mutual fund confirmation forms and also proposed the first-ever point of sale disclosure document for brokers selling mutual fund shares. Together, these two proposals would greatly enhance the information that broker-dealers provide to their customers in connection with mutual fund transactions. The proposals call for disclosure of targeted information, at the point of sale and in transaction confirmations, regarding the costs and conflicts of interest that arise from the distribution of mutual fund shares.

Breakpoints Disclosure: In light of the wide-scale failure to provide appropriate breakpoint discounts on front-end load mutual fund purchases, the Commission in December proposed improved prospectus disclosure about fund breakpoints. This disclosure is designed to highlight for investors the availability of breakpoint discounts and follows on recommendations made by a Joint NASD/Industry Taskforce that convened to study and make recommendations to improve the identification and processing of breakpoint opportunities for fund investors.

Transaction Costs Concept Release: Also in December, the Commission issued a concept release requesting comment on methods to calculate and improve the disclosure of funds' portfolio transaction costs. Transaction costs can represent a significant portion of the overall expenses incurred by a mutual fund. Although transaction costs are taken into account in computing a fund's total return, there is a concern that investors do not fully understand the impact of transaction costs on their fund investments because those transaction costs are not separately disclosed in a fund's expense table. However, there is no agreed-upon, uniform method for the calculation of fund transaction costs. Thus, the Commission issued its concept release to elicit helpful commentary to guide us as we pursue this issue.

Fund Advertisements: In September of 2003, the Commission adopted revisions to the mutual fund advertising rules. In part, these revisions require that fund advertisements state that investors should consider fees before investing and that advertisements direct investors to a fund's prospectus to obtain additional information about fees. The rules also require more balanced information about mutual funds when they advertise performance and require funds to provide updated performance numbers in certain circumstances.

Portfolio Managers: Finally, in March, we expect to submit to the Commission new proposals to improve disclosure to fund shareholders about their portfolio manager's relationship with the fund. These proposals will include disclosure regarding the structure of portfolio manager compensation, ownership of shares of the funds that a manager advises, and comprehensive disclosure of specific investment vehicles including hedge funds and pension funds that are managed by a portfolio manager to a registered fund. This proposal will also require clear disclosure as to who is managing a fund, addressing the current state of disclosure requirements that allows advisers to use a portfolio management team to avoid identifying the principal managers of the fund.

V. Conclusion

In conclusion, as is hopefully evident, the Commission under the leadership of Chairman Donaldson has been pursuing an aggressive rulemaking agenda in the mutual fund area. You will be charged with implementing many of the new requirements that are forthcoming. Therefore, we welcome your comments on these initiatives. We hope that these proposals, if implemented, will meaningfully strengthen and improve the mutual fund regulatory framework. With your help, we can reinvigorate the compliance culture within the mutual fund industry.

Your attention to the needs of America's investors is appreciated, and I encourage you to make a renewed commitment to providing services to fund investors that are of the highest quality and with the utmost integrity. These are the standards that America's investors expect, and they, I am sure you agree, deserve nothing less. I note that the theme of the conference is "What's Next: A Futuristic Look at Financial Services." I urge you, in looking ahead, that you not to lose sight of your legal and ethical obligations to fund investors.

Thank you for your attention and I hope you have an informative and productive conference.


Modified: 02/23/2004