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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the Investment Counsel Association of America


Commissioner Paul S. Atkins

U.S. Securities and Exchange Commission

San Francisco, California
April 11, 2003

Good Morning. I'd like to thank David Tittsworth, as well as you, the members, for inviting me to speak to you this morning. Before I begin, I have to take a moment to comply with the demands of my lawyers and compliance officers back at the SEC by noting that the views I express today are my own and do not necessarily reflect those of the SEC as an institution or of the other Commissioners.

As you just heard, I guess that I can confess to being a recidivist SEC employee — in 1990, I came to work at the SEC under then-Chairman Richard Breeden, stayed on with Arthur Levitt, then came back to work with Harvey Pitt and now Chairman Bill Donaldson. Some thirteen years ago, the major issues that we faced at the SEC included corporate governance, , accounting for stock options, harmonization between US GAAP and international accounting standards, revenue recognition, and ... this is the real kicker ... the effect of the war in the Persian Gulf on the markets. Any of that sound familiar? Each one of those is still with us today.

As you all are only too well aware, the markets have certainly changed in the past thirteen years. For example, the other day I spoke to the Council of Institutional Investors in Washington, and in preparing my remarks I ran across an old speech that we had prepared for Richard Breeden in 1990. Thirteen years later, the statistics that then-Chairman Breeden cited in his speech seem almost quaint.

U.S. equity markets had grown during the 1980s by about 400% to $3 trillion. Even after the bursting of the 1990s bubble, the market stands today at a capitalization of about $17½ trillion. That means, assuming that the market has stabilized, one could estimate the size of the 1990s bubble itself at about $7 trillion, which is more than twice the entire market cap of 1990. So, at least on paper, we are richer. But try telling that to the millions of Americans who lost billions of dollars of their savings and their retirement prospects, and in many cases even their jobs.

I don't need to tell you about the political impact those losses had in the election year of 2002. We live now in a country in which the 401(k) plan is more or less the norm and in which, for the first time ever, more than 50% of all households are stockholders, directly or indirectly. Congress, through the Sarbanes-Oxley Act of 2002, reacted to a public that was rightfully outraged at the corporate scandals that threatened their financial ability to fund their retirement and their children's college education. During the past six months, the SEC has engaged in its largest rulemaking period since its inception, primarily as a result of those Sarbanes-Oxley mandates.

People often ask me what it is like to be at the SEC during this period. I can honestly tell you that the eight months since my confirmation seem like a couple of years. For many of you, I am sure that you can say the same thing even more emphatically from your vantage point, where your businesses and careers may have been on the line.

Emphasis on Mutual Fund Regulation

Sarbanes-Oxley has likely had the largest impact upon those of you in this room that work in the registered fund area. I'm sure many of you have noticed the focus that funds have received of late as part of recent SEC rule-making. And, consistent with articles that you've seen in the papers, you may also have wondered where this emphasis has been coming from. Well, much of the regulatory emphasis on funds has emanated from Sarbanes-Oxley, which includes the fund industry in a number of its provisions.

The overall corporate governance issues raised by Sarbanes-Oxley are as crucial to investment companies as investors. Investors need to believe that auditors of public companies are without conflict, ethical, and acting in the best interests of shareholders, that corporate officers are honest and have the best interests of their companies and stockholders in mind, that boards are actively guarding their interests and that financial reports issued by public companies present a clear and accurate picture of the financial health of those companies.

But, Sarbanes-Oxley did paint with a broad brush. Some have argued that Congress gave little thought to how the provisions of Sarbanes-Oxley would affect the fund industry. As a result, we at the SEC were left to figure out how to implement numerous portions of the Act within the realities of the marketplace and the regulatory structure of the Investment Company Act of 1940.

It is apparent from the nature of these requirements, and the text of Sarbanes-Oxley itself, that the drafters of the legislation clearly had conventional, operating companies in mind. However, many provisions of Sarbanes-Oxley capture investment companies through the definition of the term "issuer," since public investment companies register their shares. So, much of the recent focus on funds has been mandated by Sarbanes-Oxley.

I can imagine that most, if not all, of you in the registered fund arena might be thinking to yourselves: Why are we being subjected to these regulations at all? We are not Enron, WorldCom or any other operating company whose failure led to the passage of Sarbanes-Oxley. With all of the new regulations, you may perceive yourselves as being hit twice as hard as operating companies. In fact, investment companies are, in a sense, the victims -- the loss of confidence in the markets from the corporate scandals has caused investors to take their money out of funds. Why are funds being forced to pay the price for a problem they didn't cause?

From a macro perspective, the simple fact is that the public is now paying more attention to its investments as a result of the market decline. And, the inescapable fact is that funds play a larger role in the US markets — largely through investors' retirement plans. Today, more than half of all U.S. households — or approximately 95 million persons — own mutual funds. The Federal Reserve estimates that institutional investors hold 49% of market capitalization. As a result, when investors raise concerns regarding corporate scandals, the market decline, or fees and expenses associated with investments, they are generally referring to their mutual fund accounts.

Not surprisingly, this impact on investors has had an effect in Washington. Congress, just one month ago, held hearings on fund industry practices and their effect on individual investors. Two weeks ago, the House Capital Markets Subcommittee Chairman followed up the hearings with a request for the SEC to answer eighteen questions, relating to concerns such as transparency in mutual fund fees and expenses. In addition, the General Accounting Office, again just a month ago, issued its second report on trends in mutual fund fees. In short, it appears that the recent attention is not likely to subside.

I recognize that the mutual fund industry has largely avoided the scandals plaguing other industries. I believe this record stems from the simple, fundamental properties of fund management: (1) limitations on affiliated transactions, (2) daily market valuations, (3) oversight of funds by independent boards to eliminate conflicts of interest and prevent abuses, and (4) the responsibility and accountability that comes from no taxpayer guarantees like the banking industry has.

But, the recent focus on the fund industry has also uncovered some issues that will receive further attention. For example, a joint examination sweep by the SEC, NASD and New York Stock Exchange found that many investors have not been given "breakpoint" discounts for which they are entitled. The joint report, issued last month, found that 32% of the eligible transactions reviewed by the regulators did not receive the appropriate breakpoint discount, to the tune of an average of $364 per transaction. When you multiply that times millions of transactions, that's real money.

Although this is more of an issue for broker-dealers who failed to share information about their customers' holdings, than for funds themselves, it affects investors' perceptions of their investments in funds and keeps the focus on fees, which of course is of great importance to investors — some economists would argue of most importance — particularly in a down market. Also, the GAO's recent report gives some support to those who contend that funds' expense ratios increased at a time when economies of scale should have resulted in lower fees to investors.

These are basic issues that the fund industry will have to address. I hope that I am not painting too bleak of a picture for you. Remember, the first line of defense against more regulatory activity is to get your own house in order by re-examining your own policies, procedures, and practices. Be engaged in Washington, through the ICAA and through the comment process. The ultimate goal of everyone concerned — you, Congress, and the SEC — is to restore investors' confidence in the marketplace, for when investors have confidence, they will return to the markets. When they do, history shows that the vehicles they will use will often be mutual funds.

Hedge Funds

I realize that not all of you here are associated with the registered fund industry, so I don't want to limit my remarks to that area. I also know that another area that is of great interest to many of you and that has received significant attention in the press is the hedge fund area.

The SEC historically has sought to help investors protect themselves by focusing on disclosure, rather than trying to regulate the merit of an investment product. The basic principles of transparency, quality of financial information, and avoidance of conflicts of interests should apply to registered issuers, including registered investment companies, and private investment companies. A breach of these principles, by even a few bad apples, that might lead to heavy losses by unsophisticated investors may cause the public pressure I mentioned earlier for the SEC or Congress to tighten regulation.

For example, the SEC generally did not adopt new regulations after the collapse of Long Term Capital Management. At the time, the SEC may have determined that additional regulation was not necessary because the investors and counter-parties involved were sophisticated enough to have requested additional protections. However, I question whether the risk of further regulation would have been greater if a number of retail investors had lost money in LTCM. Congress outlined in detail the definition of a qualified purchaser and I believe that the risk of regulatory control increases as individuals not meeting the standards established by the definition own a stake in a hedge fund. The increased media attention regarding potential hedge fund abuses including short selling, volatility, fraudulent representation of performance numbers, and the "retailization" through funds-of-hedge funds places all of us on notice of the potential for problems to arise that may harm investors.

The hedge fund industry grew from $311 billion to about $600 billion in a little over four years. According to a recent survey, hedge fund investors currently place one-third of their investable net worth in hedge funds and 43% of those investors will increase their hedge fund investments during 2003. This growth is the direct result of an increase in personal wealth as well as the hard-fought exceptions granted to the industry in the National Securities Market Improvement Act of 1996. This legislation provided the industry with the "qualified purchaser" exception to the Investment Company Act of 1940, which represented an alternative to the historical private investment company exception that was limited to no more than 100 investors.

From its inception, Congress designed the "qualified purchaser" exception to limit investment in such private investment companies to those investors with a high degree of financial sophistication who should be in a position to appreciate the risks associated with the investment pools not subject to the Investment Company Act. This carve-out for sophisticated investors is consistent with the structure of the securities acts from the beginning.

Of course, the SEC always has the authority to chase fraud wherever it may be found through the antifraud provisions in the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, regardless of whether the person or entity is registered or not. Theft and deceit is where the Division of Enforcement steps in. Previous enforcement actions brought by the Commission include Ponzi schemes that masqueraded as hedge funds, material misrepresentations regarding asset valuations made in offering documents and customer statements, and misappropriation of customer funds. Regardless of any future regulatory framework — fraud will always be fraud but the victims may not remain the same.

The tremendous growth of the hedge fund industry is expected to continue as the investor base diversifies. The perceived above-average returns that investors have obtained in private investment companies have increased the demand for hedge fund products since the market's downturn from its high in March 2000. Thus, the retail investor that for the past ten years believed that he could be and should be on the same level as professional traders in the equity markets is now requesting access to hedge fund products. Financial services firms are responding by offering products that allow investment in hedge funds products for as little as $25,000.

The financial services firms creating these mass-market products through registered funds should be sensitive to the adequacy of disclosure regarding (but not limited to) the funds' use of leverage, asset valuation, redemption risks and fees. Funds should establish processes and procedures to protect against conflicts of interests and fraudulent behavior. Specifically, financial firms that offer both mutual funds and hedge funds must manage the potential conflicts arising from affiliated transactions or differing trading strategies. In addition, strong internal controls should be established to safeguard the financial disclosure process. The directors or trustees of the funds should monitor the fund's operational processes for effective functioning and actively oversee the use of leverage.

The sales forces for these products also have their own duties. The NASD has been vocal in this area. In February of 2003, the NASD issued a Notice to Members, reminding firms of their obligations when selling direct and indirect interests in hedge funds. The NASD focused on the lowering of the minimum investment through registered funds of funds and what they fear is an over-reliance on the accredited investor thresholds in Regulation D. Just because someone has money does not make that person "sophisticated" and does not mean that a product is necessarily suitable for that investor. The ability of the investor to understand the risks is the key consideration.

It is fortunate for the growth and development of our financial markets that Congress in 1940 carved out private investment companies from the Investment Company Act. But, the demand for flexible trading strategies and the broadening investor base creates the risk of future regulation. Times change and products evolve but it seems as though the abuses always remain the same. So, industry should take the lessons from previous financial services scandals and corporate scandals and implement voluntary safeguards. Market forces driven by capital leverage, distribution rights, and litigation risk should encourage all to protect their interests.

The common perception is that the hedge fund industry is doing something secretive and that secrecy creates an appearance of mischievous behavior. I encourage the industry to be proactive in educating the media, the regulators, and the American public on how hedge funds operate, the controls that are in place, and their efforts to increase disclosure and transparency.

The House Financial Services Committee announced that it will hold hearings on hedge funds in the near future. And, just yesterday, the Senate Banking Committee held hearings on recent developments in hedge funds at which Chairman Donaldson testified. Chairman Donaldson noted that the SEC staff has been engaged in a fact-finding investigation of hedge funds since last June. He stressed that the investigation is continuing and that the SEC will hold a roundtable on May 14th and 15th, after which his goal is to produce a report summarizing the findings.

So, similar to the registered fund arena, an emphasis is also being placed upon unregistered funds. These are big challenges in challenging times. Decisions that hedge fund managers make regarding how they conduct their business and now interact with their customers may affect the political landscape and regulatory situation in the US financial markets for years to come. But, the good news is that it is a growth sector, and you all are in the business to manage risk and obtain the best outcomes. Use your time and resources wisely. We at the SEC want to work with you to make sure that you get it right.

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Before I close, there are just a few more items that I want to briefly raise with you: (1) our recently enacted proxy voting rules; (2) our pending proposals requiring written compliance policies and procedures from investment companies and investment advisers; and (3) our pending concept release regarding, among other things, establishing a fund/adviser self-regulatory organization.

Proxy Voting Rules

I'm sure that most of you are aware that, in late January, the SEC adopted a new rule and rule amendments that would require registered advisers, among other things, to adopt proxy voting procedures, including procedures to address material conflicts of interest that may arise between the adviser and its clients. The SEC noted that the rule and amendments are designed to ensure that advisers vote proxies in the best interest of their clients and provide clients with information about how their proxies are voted.

As adopted, we noted the rule did not impose a "one-size-fits-all" requirement for the written proxy voting procedures. Instead, we left advisers with the flexibility to craft suitable procedures. Further, I should emphasise that the final rule reduced certain record-keeping burdens — largely pursuant to comments by the ICAA. I supported the adoption of this rule, concluding that it was a measured means of ensuring that the proxies are voted in the clients' best interests. I also believed that it struck an appropriate balance to ensure that clients obtain information to which they are entitled — the proxy votes of their securities — and to ensure that any material, potential conflicts of interest are resolved.

Briefly, I should note that this support contrasts with my opposition to the rule and rule amendments requiring the disclosure of proxy votes of mutual funds. While I can see a rule requiring funds to disclose their proxy voting policies and procedures, I objected to a "one-size-fits-all" approach regarding the actual disclosure of proxy votes. I also did not believe it had been shown that the benefits to shareholders outweighed the costs that would be passed on to them.

The crucial point for me was that our rulemaking appears to impose significant costs when the marketplace is already responding to the goals of the rulemaking and that there is a danger of unintended consequences — particularly to the movement for confidential voting. I felt that this issue could be better addressed by allowing the market to work. In any event, I believe that the Commission's ultra-fast-track adoption undermined the staff's ability to gather and evaluate information before concluding that the benefits outweighed the costs. Still, there is a rule in place now, and I hope that experience finds my concerns to be unfounded.

Written Compliance Policies and Procedures

In early February, we proposed new rules requiring investment companies and registered investment advisers to:

  • Adopt compliance policies and procedures reasonably designed to prevent violations of the federal securities laws and violations by advisers of the Advisers Act;
  • Review the policies and procedures annually; and
  • Designate a chief compliance officer to administer the policies and procedures.

The proposing release notes that these proposals would formalize the practical requirement that funds and advisers establish control systems designed to prevent violations of important investor protection provisions of the federal securities laws. The release also noted that the proposed rules would provide funds and advisers flexibility to tailor their programs to fit the scope and nature of their operations.

Despite our attempts to provide this flexibility, I do note that good arguments have been advanced that the proposals might be unduly burdensome on smaller advisers, in particular. To those individuals, I say that the comment period for these proposed rules is still open; so, please provide us any input that you might have in order to ensure that we do, in fact, provide appropriate flexibility, while seeking to ensure the protection of investors.

Additional Private Sector Fund and Adviser Oversight

Concurrent with the proposed rules I just discussed, we also asked for comment on additional ways in which mutual funds and investment advisers would be encouraged to comply with the federal securities laws. In particular, we asked for comment on such possibilities to supplement SEC oversight of mutual funds and investment advisers, including:

  • Requiring that advisers and funds obtain periodic compliance audits from third party compliance experts;
  • Relying upon independent public accountants that audit fund financial statements to examine fund compliance controls in connection with the audit;
  • The formation of one or more self-regulatory organizations to oversee the activities of funds and/or advisers; and
  • A requirement that advisers obtain fidelity bonds.

I am aware that many of you have concerns over this request, particularly the self-regulatory comment portion. I, too, have concerns regarding this concept — not the least of which is whether the SEC has authority to empower a new self-regulatory organization for advisers. Still, the number of funds, advisers, and assets under their control has grown significantly. The SEC's resources and the resources that we have been able to allocate to our fund and adviser programs have not grown commensurately. Accordingly, even though I may, too, have some concerns, I believe we would be remiss not to at least raise the issue, and seek input from the public. Again, the comment period on this matter is still open — as I always do, I encourage your input and hope that you will provide your comments on all aspects of the concept release publicly.

*     *     *

So, those are some of the current matters that are before us. I've only touched on a few, and certainly I look forward to working with Chairman Donaldson and my other colleagues on the many other issues facing us in our role of the investors' advocate. Again, thank you for the honor of speaking here today. I'd be happy to take any questions.



Modified: 05/12/2003