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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Proactive Initiatives to Protect Mutual Fund Investors


Paul F. Roye

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

Remarks Before the ICI General Membership Meeting
Washington, DC
May 23, 2003

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 be here with you at the ICI's annual General Membership Meeting and trust that you have had an interesting and informative conference thus far focusing on helping investors meet today's challenges.

Before I begin, I would like to remind you that, as always, 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. Proactive Regulator

This morning, I would like to talk to you about the Commission's efforts to be a more proactive regulator and about the ways the mutual fund industry can become more proactive for its own benefit and the benefit of fund investors.

Our new Chairman, William H. Donaldson, began his tenure at the helm of the SEC in February. During Chairman Donaldson's first major address, he discussed his vision of the SEC as a proactive regulator. Comparing the SEC to one of his "alma maters," the U.S. Marine Corps, Chairman Donaldson stated that he hoped the agency "can play offense more often, be more proactive, and anticipate the problems we may face."

In this vein, the Division of Investment Management has been engaged in a coordinated effort to identify challenges and high-risk areas within the investment management industry and address them before they become significant investor protection issues. We have already revised certain regulatory approaches in order to address various areas of concern. For example, our disclosure office has been conducting "integrated reviews" in the fund area where, in addition to reviewing a fund's registration statement and updates, we also analyze a fund's website, reports to shareholders and other pieces of information to make sure the fund is creating a consistent and coordinated system of disclosures to investors and potential investors. And, just as important, to verify that a fund's investments and strategies are consistent with the fund's disclosures.

The Commission's outstanding rule proposal on compliance programs and compliance officers also exemplifies a proactive approach to overseeing the industry. This proposal would require funds and investment advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the securities laws. The proposal also would require funds and investment advisers to designate a chief compliance officer. Many have asked, why this proposal now? Quite simply because we want to take steps to prevent the types of scandals that have plagued other segments of the securities industry from tainting the investment management industry. Today, funds and advisers control over $21 trillion in assets. Industry growth has substantially exceeded the growth in Commission resources. Unlike the brokerage industry, the Commission has sole oversight responsibility for the 34,000 investment company portfolios and 7,800 investment advisers that are registered with us.

Our oversight is predicated on the assumption that those who manage investment companies and advisers have procedures to comply with the law. But in fact, with the exception of a few discrete areas, there is no requirement that funds or advisers have a comprehensive set of compliance controls, although most do. Many of our enforcement cases in the investment management area, however, are often the result of weak or nonexistent compliance controls. If adopted, these rules should help protect investors by improving day-to-day compliance with the federal securities laws. These rule proposals do not ask anything that any well-managed fund or adviser should not be doing today.

In addition to being forward-looking in our regulatory initiatives, the Commission also is being proactive by targeting its resources to the areas that seem to warrant the most attention. In the area of investment management, this is best evidenced by the Office of Compliance Inspections and Examination's new examination approach. Under this new "risk-based" approach, the staff will target the funds that present the greatest risk of compliance issues, because of weak compliance controls or other factors, for inspections every two years, with others being examined on a less frequent basis.

Another example of the Commission's proactive approach is the Commission's fact-finding review of hedge funds. Last week the Commission engaged in the most recent phase of the review of hedge funds by hosting a two-day public Roundtable. Discussions focused on key aspects of hedge fund operations, how they are structured and marketed, the investment strategies they use and how they impact our markets, how hedge funds are regulated, and whether the regulatory framework should be modified. The significant growth in this sector of the investment management industry justifies the Commission's consideration of investor protection issues raised by hedge funds.

III. Proactive Industry

A proactive approach should not be limited to regulators. The mutual fund industry should redouble its efforts to be proactive in identifying and addressing issues and problems that confront the industry and its investors. But I recognize that the fund industry already has a good track record of being proactive in various areas.

Recently, the ICI has weighed in and provided its views to the Commission on a variety of issues relating to investment companies as investors, such as NYSE and NASDAQ corporate governance initiatives, Commission accounting and financial reporting disclosure proposals, stock option proposals, market structure initiatives such as decimalization, municipal securities disclosure issues and issues relating to credit rating agencies. Industry comments on these important issues inform the Commission and help the Commission shape its rules in a manner to provide maximum benefit and protection for all investors, including funds through whom many investors access the securities markets.

The mutual fund industry identified market timing as an issue, especially for funds that invest in foreign securities. Many funds have implemented various approaches to address the disruption and negative impact of market timing activities on their shareholders. In connection with the ICI's efforts to assist the industry in addressing market timing concerns, the ICI requested staff guidance regarding delayed exchanges to combat market timing. The staff responded by stating that we would not recommend enforcement action if a fund makes an exchange offer on a specified delayed basis, so long as the offer is fully and clearly disclosed in the fund's prospectus. Because the ICI brought this approach to our attention, we were able to provide the industry another tool in dealing with this problem.

The mutual fund industry, working through the ICI, has taken proactive approaches to other issues. For example, in 1999, the ICI issued a Report of the Advisory Group on Best Practices for Fund Directors. This Report, which was forward-looking and far-reaching and issued well in advance of the reports of corporate governance pitfalls that have been identified in recent operating company debacles, underscored the importance of fund governance and the critical role of independent directors. The Report also recommended several fund governance initiatives — such as a super-majority of independent directors, a lead independent director and evaluation of board performance — concepts that were not part of the fund governance rules adopted by the Commission but nevertheless were identified by the industry in an effort to promote improved governance of mutual funds.

Mutual funds took similar responsible measures in 1994 when the industry, again working through the ICI, issued a Report of the Advisory Group on Personal Investing, which made a series of recommendations to limit the potential conflicts associated with the personal trading activities of mutual fund industry personnel. Again, some of the recommendations, went beyond the actual requirements imposed by the Commission.

While both the ICI's independent director and personal investing initiatives represented thoughtful and responsible work, each was intended, in part, to address concerns that had been raised by the Commission, and perhaps to forestall the Commission from imposing even harsher requirements on the industry. The industry should take the same kind of proactive approach to other issues, whether or not identified as concerns by regulators, so that the industry can operate in ways that are best for its shareholders-based on its own insights and perception of problem areas.

The industry is in the best position to monitor and address issues before they reach the point of requiring Commission intervention on behalf of investors. I believe that through this type of responsible action, the mutual fund industry can distinguish itself as an industry that is not focused on skating up to the line of what is legal and what is not, but instead promotes a fiduciary culture where investor interests come first.

As we consider how we, the regulators and the regulated, can be more proactive in protecting investors, I believe we can learn lessons from the experience in other industries. One such example is in the history of the railroad industry in this country. One-hundred years ago, few industries wielded as much power as America's railroads. The rail monopolies opened the country to settlement and fostered what would become the strongest economy in the world. But by the 1950s, they were nearly in a state of collapse. What happened?

The industry continued to prosper through World War I, when the country had low inflation and an abundant source of cheap labor. Things began to change when the fabled railroad barrons who ran the railroads began to suffer a national backlash because of their ruthless business practices. Under President Theodore Roosevelt, the government began breaking up the rail empires in 1912. Whatever need for extensive government regulation there may have been in the early days of the railroad industry was long gone by the end of World War II. The advent of a U.S. government funded highway system, the rapid development and expansion of the trucking industry, and the explosion of federal investment in the airport, airway, highway and waterway systems following World War II, created intense competitive pressures on the railroad industry. At the same time, the existing regulatory regime denied the railroad industry the price and service flexibility needed to respond effectively to competitive conditions and the ability to rationalize existing infrastructure to levels that the market would support. As a result of intense competitive pressures and the rigidity of the regulatory system, the railroad industry lost much of its freight and passenger business in the period after World War II. The industry weakened sharply in the 1970s, as exemplified by the bankruptcy of the once mighty Penn Central Railroad.

Many experts blamed the decline of the railroad industry over this period on the industry itself, as well as outdated laws and heavy-handed regulation. Some contend that the industry was too slow and ineffective in shedding bloated and bureaucratic business practices, that management failed to react to the realities of a competitive environment, and that the industry was not attuned to addressing the needs and concerns of its customers.

Some subscribe to the view that the Interstate Commerce Commission, which regulated the railroad industry, hastened the decline of the industry through over-regulation. The regulatory constraints applicable to railroads became so out of touch with economic reality that a vital and once robust mode of transportation had been relegated to federal subsidies and bail-outs for its continued existence. The ICC was criticized not only for its role in imposing unnecessary constraints on the industry, but for taking years to make decisions in areas that were vital to the viability of the industry. While the ICC was officially eliminated in 1995, its fate was sealed in 1980 when Congress deregulated the railroad industry and stripped the ICC of its most pervasive powers.

Needless to say, there are lessons here for all of us. I certainly don't want to see the Commission over-regulate in ways that are detrimental to the industry and impede competitiveness and the provision of attractive investment products to investors. Nor do I want to see the SEC go the way of the ICC because of heavy-handed regulations and failure to adjust to changing circumstances.

The mutual fund industry must be mindful of the fact that its position in our economy and securities markets is not guaranteed and that you have to continually respond to a competitive and changing environment. You can do this by focusing on the needs and interests of your shareholders.

IV. Role of the Fund Industry

From my point of view, the mutual fund industry should approach issues with the simple philosophy that what is best for fund investors is best for the fund industry. Thus, when addressing issues such as the current breakpoint sales-load problem, funds and their boards cannot simply say, we are not at fault, therefore it is not our problem. When any issue impacts fund investors, it is "our" problem and we should all be focused on ensuring that fund investors get a fair deal.

I recognize that the fund industry is competitive and is not made up of a series of homogenous institutions. However, there are instances, such as with the breakpoint situation, when we have to work for the good of the industry and fund investors as a whole. Sometimes, we see examples of a single fund group requesting an across-the-board policy change that would advantage their particular fund group but very likely would not be advantageous for the industry as a whole. Just as the Commission cannot be shortsighted and must think through the full ramifications of its actions, I would ask the industry to do the same.

In February, along with the compliance rule proposal, the Commission issued a concept release on ways to expand the role of the private sector in fostering compliance by funds and advisers with the federal securities laws. This concept release requested comment on the utility of establishing one or more self-regulatory organizations in the investment management area. While the staff has collected and is analyzing comments on this idea, I would note that an industry does not need to have a formal self-regulatory organization in existence in order to respond collectively to issues of concern to the industry and its investors.

An industry also does not necessarily have to designate a self-regulatory organization to root out practices that are on the fringe of being responsible or are not in the best interests of investors. As we saw with the recent research analyst situation, even firms that may not have engaged in the same types of nefarious conduct get caught up in the public backlash against such conduct. Thus, it is in the industry's best interest to police itself and question those who operate on the fringes. A responsible industry cannot stick its head in the sand when it is aware that some of its members are engaging in questionable practices.

As regulators, we like to think that we are on the front lines in protecting investors, but unfortunately, we are always one step removed. We are not at the trading desk when a trade is being placed, or in the boardroom when a decision is being made, or a part of the marketing team meeting when a new product is being designed to be pitched to the public. But you are. And you, therefore, are in the best position to question and stop irresponsible practices before they harm investors and cause a black eye for the industry. And I would note that just because an activity is legal, it might not be appropriate. It may not be in the best interests of investors and, as fiduciaries, fund managers must always consider their investors first.

There are many issues that the industry can address on its own and others that require the assistance of regulators. We value the constructive relationship the Commission has with the industry through the ICI. In many instances, we have worked together to meet our common goal of protecting America's investors, and I am happy to report that this approach has, I believe, resulted in a stronger industry.

V. Investment Strategies

In addition to managing compliance activities and monitoring conflicts of interest, the industry should be asking whether there are better ways to meet the investment needs of its shareholders. The Division staff is also considering whether there may be benefits to expanding the kind of investment strategies that are offered to mutual fund investors.

Throughout the course of last week's Hedge Fund Roundtable, the issue arose of whether average investors could benefit from having access to professional management of certain market neutral strategies, which typically have been the province of hedge funds. As we all know, investors with a substantial portion of their portfolios in long equity funds have had a rough ride during the past three years.

Commissioner Campos in recent remarks has asked whether the time may have come for the Commission to review whether the investment restrictions imposed on funds through the Investment Company Act continue to be appropriate and necessary for investor protection purposes-or whether some of these restrictions place unnecessary constraints on fund managers. By making these observations, he was not suggesting that we should turn mutual funds into hedge funds or vice versa, but that we should consider whether the current investment restrictions unnecessarily limit mutual fund managers. Of course, the staff would welcome comment from the industry on this issue.

VI. Investor Education

As I reflect on ways to better serve investors, I always return to the importance of investor education. I would imagine that all of you want investors who are informed and knowledgeable and understand the risks associated with their investments. But very few investors reach this level of understanding on their own. It requires effort and outreach on the part of regulators, brokers, advisers, consultants and the mutual fund industry. In this connection, I applaud the ICI's investor education efforts. You perform a valuable service. When investors are better educated, they, and we, all benefit.

We also can be proactive in our pursuit of investor education, identifying areas where investors would benefit from additional information and understanding as market conditions change. For example, do your investors appropriately understand the risks of investing in bond funds and the effect an increase in interest rates would have on the value of their holdings? Investors widely perceive bond funds as a relatively "safe" investment and, without additional education efforts, may be ill-prepared for a decrease in bond fund values in the wake of interest rate increases.

Finally, we also must help mutual fund directors in their educational efforts. I applaud the ICI and The Mutual Fund Directors Forum for their efforts in keeping directors up to date and providing them with the necessary information, guidance and tools to fulfill their vital role in protecting investors.

VII. Conclusion

In conclusion, I would note that we seem to be emerging from a very uncertain period for the mutual fund industry and our securities markets as a whole. I know that fund companies feel burdened by the new requirements imposed by the Sarbanes-Oxley Act, anti-money laundering requirements and new disclosure obligations under the proxy voting rule. But you will get through this period, and I personally believe that mutual fund investors will be better off as a result of the time and energy you have dedicated to complying with these new requirements.

The Commission continues to stand by as a resource for you as you grapple with how best to implement these new regulatory requirements. We would much rather be involved on the front end as you draft new disclosures and institute new procedures and processes, than have to come in after-the-fact when there is a problem.

We look forward to working with the ICI on these issues and to working with fund companies directly. Once again, I thank you for your attention and thank you for your continued dedication to serving America's investors.



Modified: 05/28/2003