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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the NAVA Regulatory Affairs Conference


Paul F. Roye

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

Washington, D.C.
June 14, 2004

I. Introduction

Good afternoon. As always, let me remind you that the views I express are my own and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I'd like to begin my remarks by sharing with you a discussion I had with my twelve-year-old son earlier this year. He was having some difficulty in math at school and I decided to buy him a math book geared to his grade level. I told him, "Son, if you use this book regularly, you'll be halfway there." Without batting an eye and showing that he didn't even need the book, he replied, "that's great, Dad, can I have two of them?"

Obviously, I have work to do with my son, but the point I want to make here is simply that there are often no short cuts, and when you take short cuts or compromise standards and principles, the results can be disastrous. As we have observed recently, the cost to the mutual fund industry of not living up to fiduciary standards and principles, and the resulting mistrust on the part of investors, regulators and legislators, is very real and brings serious consequences. Much of what I would like to discuss this afternoon unfortunately has to deal with problems generated by those who have taken short cuts and lost sight of their obligations to investors.

II. SEC/NASD Staff Report

Before I discuss issues we have been dealing with in the mutual fund area, I would like to discuss the Joint SEC/NASD Staff Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products, which was released last week. Mary Ann Gadziala of our Office of Compliance Inspections and Examinations is going to discuss the Report in detail tomorrow, and I hope you will read the Report carefully.

The Report identifies both "sound" and "weak" broker-dealer practices in the areas of suitability, disclosure, supervision, training and records maintenance. Among the more disturbing weaknesses identified in the Report were instances of brokers making unsuitable recommendations to senior citizens and to individuals who could not afford the products without mortgaging their homes.

These are the kinds of abuses that appall investors, alarm regulators and should spark outrage throughout the industry. In light of the Report, the SEC and the NASD are committed to focusing our examination and enforcement efforts on these issues and promoting a regulatory framework that effectively protects investors, as evidenced by the NASD's proposal last week of new rules tailored specifically to sales of deferred variable annuities. These proposals include new sales practice standards, disclosure, supervisory approval and sales training requirements.

I noted that, in a statement responding to the Report, NAVA stated, "There is no indication in the report that improper sales practices were widespread throughout the variable-annuity industry." However, the Report notes that the SEC, NASD and other regulators have received a large number of complaints from individual investors, many indicating that the customer was sold a variable product without fully understanding the product, or that the product was not appropriate given the customer's investment objectives and liquidity needs.

Moreover, in the past two years, the NASD alone has brought 80 variable products sales abuse cases and, along with the Commission, is investigating others. These enforcement actions involved excessive switching, misleading marketing, failure to disclose material facts, unsuitable sales, inadequate written supervisory procedures, failure to maintain adequate documentation, and failure to supervise variable product transactions. Although many firms offer and sell variable products consistent with the rules and employ best practices, too many firms do not. So, make no mistake, there is a problem with the sale of variable products. As my colleague Lori Richards, who heads the Office of Compliance Inspections and Examinations, recently pointed out, the problem in large measure is that people who don't understand variable insurance products are selling them to people who also don't understand the products. This is clearly unacceptable.

You should be as appalled as we are when you read about any instances of these abusive sales practices. The variable products industry cannot pretend that there are no problems. You must confront the issues head on and work to effect change from within your industry for the benefit of America's investors.

I know that there are those of you who are of the view that variable products should not be singled out for special suitability and sales practice standards. However, given the complaints that regulators have received, the findings in the Joint Report, the number of enforcement actions and the fact that previously issued "best practices" guidelines have not been sufficient, targeted standards, I believe, are merited. I am sure that part of the concern is that additional requirements will "chill" the sale of variable products, but the complexity of the products dictates that salesmen must devote diligence and care to the appropriate marketing of these products.

Nevertheless, the new NASD rule proposal should be thoroughly vetted, including the necessity for a separate risk disclosure statement, the requirement for prospectus delivery before consummation of a transaction and the intersection of these requirements with the Commission's proposed point of sale and confirmation requirements, which would apply to variable annuity transactions. I urge you to work with the NASD and the Commission to develop final rules that ensure that investors in variable annuities are adequately protected.

For reform to be meaningful and effective, the regulators cannot do it alone. It also requires the variable products industry to embrace appropriate reforms. We can write rules, but we cannot change attitudes. We can examine compliance systems, but we cannot examine the conscience of those selling your products. We can bring enforcement cases, but we cannot develop firm cultures. In many ways, the more difficult reform task belongs to you. Will you meet the challenge? What are you prepared to do to address the problems? What will you demand of the brokers that sell your products? How can insurance company sponsors assert more control over brokers selling your products? Will you refuse to do business with firms when there is continuing evidence of your products being improperly sold?

For the well being of your industry, I hope you can find appropriate answers to these questions. I submit that when your products are being missold by brokers and insurance salesmen, it is the problem of the insurance company sponsors of these products as well.

III. Year in Investment Management

Now, I'd like to discuss the recent scandals involving the late trading of mutual fund shares and abusive market timing arrangements.

As I am sure you know by now, "late trading" refers to the practice of placing orders to buy or sell mutual fund shares after the time as of which the fund calculates its net asset value (typically 4:00 p.m.), but receiving the price based on the prior NAV already determined. Late trading also refers to the practice of placing conditional trades with the option of withdrawing or confirming the trades after the fund has struck its NAV.

Late trading enables the trader to profit from market events that occur after 4:00 p.m. but that are not reflected in that day's price. In particular, the late trader obtains an opportunity for a virtually risk-free profit when he learns of market moving information and is able to purchase mutual fund shares at prices set before the market moving information is released. Much of the late trading activity that has been alleged occurred through broker dealers and other fund intermediaries who were willing to facilitate or even set up late trading platforms in order to attract select, large clients. These practices are clearly illegal.

Like late trading, abusive market timing also negatively impacts long-term shareholders. Mutual funds that invest in overseas securities markets are particularly vulnerable to market timers who take advantage of time zone differences between the foreign markets on which international funds' portfolio securities trade and the U.S. markets which generally determine the time that NAV is calculated. Funds that invest in small cap securities and other types of specialty investments, including high yield bond funds, also can be the targets of market timers.

Although market timing is not per se illegal, mutual fund advisers and fund directors have an obligation to ensure that mutual fund shareholders are treated fairly and that one group of shareholders (i.e., market timers) is not favored over another group of shareholders (i.e., long-term investors). In addition, when a fund states in its prospectus that it will act to curb market timing, it cannot knowingly permit such activities.

Fund management companies in some cases agreed to permit select market timers to engage in abusive short-term trading of certain funds in violation of stated policies or in exchange for placing so-called "sticky assets" in other financial vehicles managed by the company. Both of these practices involved a blatant violation of fiduciary principles, and both have harmed long-term fund shareholders. One of the most alarming parts of the recent fund scandals is that some portfolio managers and fund executives were allegedly market timing the very mutual funds they managed.

Recent allegations also indicate that some fund managers may have been selectively disclosing their portfolios in order to curry favor with large investors. Selective disclosure of a fund's portfolio can facilitate fraud and have severely adverse ramifications for a fund's investors if someone uses that portfolio information to trade against the fund.

Of course, the appropriate regulatory responses to these abuses are not limited to the issuance of new regulations. Indeed, we have focused our inspections and enforcement offices on these areas of concern. In the past year, the Commission and state regulators have taken action against nearly half of the 25 largest mutual fund companies, and the NASD is also bringing enforcement actions in this area.

For example, the NASD recently brought its first enforcement action against a broker dealer for facilitating market timing and late trading through variable annuities. For almost a year and a half, beginning in April 2002, the broker dealer assisted two hedge funds in market timing in sub-accounts funding variable annuities. The broker dealer continued to sell variable annuity contracts to the hedge funds even after receiving notice from the affected insurance companies and mutual fund managers of the market timing activities. During approximately the same time period, the broker apparently also repeatedly submitted trading orders received after 4:00 p.m. as if those orders had been received before 4:00 p.m.

Our enforcement staff is currently investigating other situations involving market timing and late trading abuses involving variable products.

IV. SEC Initiatives

In response to the various abuses that have been revealed in the past year, the Commission is engaged in a comprehensive overhaul of the regulatory environment in which investment companies operate. These reforms not only are designed to address the specific abuses that have been identified but also to encourage a culture of integrity and compliance that must, in my view, be the cornerstones of the business of investment management. We also endeavor to improve disclosure to investors to facilitate intelligent decision-making by them.

A. Response to Late Trading

To address the late trading problem, the Commission proposed the so-called "hard 4:00" rule. This rule would require that a fund or a certified clearing agency, such as NSCC - rather than an intermediary such as a broker-dealer - receive a purchase or redemption order prior to the time the fund prices its shares for an investor to receive that day's price.

We believe that this rule would provide for a secure pricing system that would be highly immune to manipulation by late traders. It would substantially narrow the universe of those who are accountable for the timing of fund orders and better enable examiners to monitor compliance with 4:00 p.m. cut-off restrictions. Many of those commenting on the proposal oppose this approach, particularly the intermediaries who would no longer have until 4:00 p.m. to accept orders for fund transactions as they currently do. They argue that it will require some intermediaries to have cut-offs for orders well before 4:00 p.m. and limit investor opportunities to place orders for fund transactions.

Some have suggested alternatives, noting for example that available technology could permit unalterable time stamping of transactions that could ensure the effective verification of compliance by intermediaries selling fund shares. We are considering these suggestions and others as we seek to formulate the best possible regulatory solution to the late trading problem. We do not want to adversely impact fund investors if there are alternatives that effectively address late trading abuses.

It is important to note that the proposed rule essentially leaves unchanged the current operations of variable product separate accounts with regard to transactions in underlying fund shares. As long as an insurance company receives an order by 4:00 p.m., the order will receive that day's price, even when the orders are not submitted to the underlying funds until later.

B. Response to Market Timing and Selective Disclosure of Portfolio Holdings

With respect to market timing, especially so-called "arbitrage market timing," which seeks to exploit discrepancies between a fund's NAV and the value of its underlying portfolio securities, the Commission has stressed that, "fair value pricing" is critical in effectively reducing or eliminating the profit that many market timers seek and the dilution of shareholders' interests. In addition to reiterating the obligation of funds to fair value their securities to reduce market timing arbitrage opportunities, the Commission on April 13th adopted amendments requiring improved disclosure of a fund's (and management separate account's) policies and procedures regarding fair value pricing. This disclosure will force funds and their boards to be accountable to their shareholders regarding when, how and under what circumstances they are fair valuing their portfolio.

We are currently gathering information regarding funds' fair value pricing practices and evaluating whether to recommend additional measures to improve funds' fair value pricing. The Commission has also sought public comment on the need for additional guidance or rulemaking in this area.

The Commission also adopted a final rule and form amendments requiring investment companies, including insurance company separate accounts, to disclose in their prospectuses both the risks to shareholders of frequent purchases and redemptions, and the company's policies and procedures with respect to such frequent purchases and redemptions.

In a further effort to reduce the profitability of abusive market timing, the Commission, in March of this year, put forth a proposal that would require funds to impose a mandatory two percent redemption fee when investors redeem fund shares within five business days of their purchase. This fee would be payable to the fund, for the direct benefit of fund shareholders; it would not be retained by the principal underwriter, management company or any other fund service provider, or by the insurance company. The two percent redemption fee would charge those who frequently trade mutual fund shares for the approximate cost of their frequent trading activity, rather than forcing long-term shareholders to pick up these costs. With respect to arbitrage market timing, the two percent fee, combined with fair value pricing, would make market timing less profitable, and therefore reduce the incentive to engage in market timing.

A significant feature of the proposed rule, which has largely been overlooked in the commentary on the proposal, is the information pass-through that the rule would facilitate. The proposed rule would require that, on at least a weekly basis, a financial intermediary provide to a fund certain identifying information and the amount and dates of all purchases, redemptions or exchanges made during the previous week for each shareholder trading through an omnibus account. This information would not only enable the fund to confirm that fund intermediaries are properly assessing redemption fees, but also could assist funds in identifying market timers to ensure compliance with their restrictions on sales to market timers.

The Commission received over 350 comment letters in response to the rule proposal, including comments from NAVA and several insurance companies. Some of you have expressed concern that the proposed rule may raise significant legal issues under existing variable annuity contracts and variable life policies. You have pointed out that state insurance laws require that variable contracts specify maximum and guaranteed charges and pricing formulae under the contracts. In addition, contract provisions detail limitations and/or charges applicable to transfers among subaccounts. Although we are not aware of an insurance company having been sanctioned by state regulators or found by a court to be in breach of contract or otherwise liable for facilitating the collection of a fee by an underlying fund, we are evaluating these and other comments as we consider a recommendation to the Commission for a final rule.

Finally, open-end management investment companies, including managed separate accounts, are now required to disclose both their policies and procedures with respect to the disclosure of their portfolio holdings, and any ongoing arrangements to make available information about their portfolio holdings to address the problem of selective disclosure of portfolio holdings.

C. Initiatives to Enhance Fund Oversight

As part of our effort to promote accountability in the mutual fund industry, the Commission is pursuing several initiatives to improve fund oversight and compliance. These initiatives are designed to strengthen the hand of independent directors and to provide them additional tools with which to protect fund investors, reinforce ethical standards, and promote a culture of regulatory compliance.

1. Compliance Policies and Procedures

I expect that the Commission's new compliance policies and chief compliance officer rules will have a far-reaching positive impact on the operations and compliance programs of mutual funds and separate accounts. As we know, however, compliance procedures are meaningless if they are not enforced. We envisioned the compliance officer not only as the primary architect and enforcer of compliance policies and procedures, but also as the eyes and ears of the board on compliance matters. All too often in the Commission's recent enforcement cases, we have seen fund directors denied information about compliance matters. The rule will change this as a compliance officer reports to, and is accountable to, the fund's directors or, in the case of the compliance officer of a separate account, the insurance company personnel responsible for oversight of the separate account's operations.

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.

2. 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 revising many of our exemptive rules so that funds relying on them must have (i) a board comprised of 75% independent directors; (ii) an independent chairman of the board; (iii) independent director authority to hire, evaluate and fire staff; (iv) quarterly executive sessions of independent directors outside the presence of management; and (v) an annual board self-evaluation.

For some complexes, these provisions would require a significant overhaul of the composition and workings of fund boards. The proposal is intended to reinforce the dominant role of independent directors on a fund's board and facilitate independent director control of the board agenda, the power to control the outcome of board votes, and serving as an effective check on management, particularly when much of the board's responsibility includes policing the management company's conflicts of interest.

3. Adviser Codes of Ethics and Fund Transactions Reporting

In another effort to promote accountability and reinforce the fundamental importance of integrity in the investment management industry, the Commission recently adopted new Rule 204A-1 under the Investment Advisers Act and related amendments to the Advisers Act and the Investment Company Act rules. This new rule and related amendments require all registered investment advisers to adopt and enforce codes of ethics. Investment advisers are fiduciaries and as such must place their clients' interests before their own. This bedrock principle, which historically has been a core value of the money management business, again appears to have been lost on a number of advisers and advisory personnel.

The Commission believes that prevention of unethical conduct by advisory personnel is part of the answer to the problems we have encountered recently. In this regard, the code of ethics will 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.

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 closes 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.

D. Initiatives Aimed at Conflicts of Interest

In addition to enhancing mutual fund oversight and compliance, the Commission is undertaking a series of initiatives aimed at certain conflicts of interest involving investment companies.

1. Directed Brokerage

Last February, for example, the Commission voted to propose an amendment to rule 12b-1 to prohibit the use of brokerage commissions on fund portfolio transactions to compensate broker-dealers for distribution of a fund's shares. Effectively, the proposal would ban these types of directed brokerage practices by mutual funds. Such a ban would force advisers to be more accountable to fund investors about the fees they are paying for distribution and about their stewardship of fund brokerage, which is a fund asset. Advisers would no longer be able to mask their distribution payments by using a fund's commission dollars, which are not currently reflected in a fund's expense ratio or fee table. This change would eliminate a practice that in some cases compromises best execution of portfolio trades, increases portfolio turnover, and improperly influences broker-dealers' recommendations to their customers.

2. Rule 12b-1

In addition, the Commission has requested comment on the need for additional changes to rule 12b-1. Since 1996, many funds underlying variable insurance products have adopted 12b-1 plans in connection with the distribution of fund shares through the sale of variable contracts. The Division noted at that time that the unique offering structure and hybrid nature of variable insurance contracts may complicate investor understanding of the use and effects of 12b-1 plans in this context. We urged special care on the part of fund boards and insurance company sponsors in ensuring compliance with the rule, including the rule's requirement for a finding of a reasonable likelihood that the plan will benefit the fund and its shareholders. Over time, rule 12b-1 has come to be used in ways that exceed its original purpose, by retail funds as well as insurance product funds. Consequently, the Commission is seeking comment on whether rule 12b-1 should be further revised or even repealed.

3. Soft Dollars

Another conflict that merits review in the current environment is soft dollar arrangements. Chairman Donaldson has made the issue of soft dollars a priority and has directed the staff to explore the problems and conflicts inherent in soft dollar arrangements and the scope of the safe harbor contained in Section 28(e). The Divisions of Market Regulation and Investment Management are working together on this review, and are conducting a thorough analysis in order to make meaningful and informed recommendations to the Commission on this important issue.

E. Initiatives to Improve Disclosure

In the course of our efforts to improve fund compliance and oversight and address conflicts of interest, we have also taken a hard look at the effectiveness and usefulness of fund disclosure. Long before mutual fund scandals hit the headlines, Chairman Donaldson identified improved disclosure, particularly disclosure about fund fees, conflicts and sales incentives, as a priority for the Commission's mutual funds program. The Commission has undertaken several initiatives in this area.

1. Shareholder Reports

The Commission has wrestled for years with the problem of how to convey expense information to investors in a cost-effective way that permits investors to compare funds and to understand and appreciate the effect that expenses have on their investment.

Recently, the Commission took a leap forward in addressing these issues by requiring that shareholder reports 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. For comparative purposes, 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 five percent. Using this second dollar-based number, investors can compare the level of expenses across various potential fund investments.

The new shareholder report revisions also include significantly improved disclosure about a fund's investments. The recent amendments will replace a one-size-fits-all approach to portfolio holdings disclosure, where all funds deliver their full portfolio schedules to all their shareholders twice a year, with a layered approach that will make more information available, while permitting investors to tailor the amount of information they receive to meet their particular needs.

Information about a fund's portfolio holdings will now be available on a quarterly basis. This will enable interested investors to better monitor whether, and how, a fund is pursuing its stated investment objective and adhering to its stated investment policies. I believe the Commission's approach to portfolio holdings disclosure can become a model for us as we reassess our disclosure framework generally, to ensure delivery of essential information to shareholders, while at the same time making more comprehensive information available to those who want it.

The Commission also proposed to require disclosure in shareholder reports about how fund boards evaluate investment advisory contracts. A fund's board of directors plays a key role in negotiating and approving the terms of a fund's advisory contract. The Commission is proposing to make this process more transparent to fund shareholders. The proposed 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. Disclosure of this type is currently required in the statement of additional information, which is delivered only on request. I believe that the more prominent placement of the disclosure in the shareholder report will encourage better drafting and hopefully the elimination of the boilerplate type of disclosure we see in some SAIs. Some of the disclosure out there is little more than a laundry list of factors covered in the board materials, and it could lead one to think that all board meetings are rote exercises conducted off a standardized script. 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. This proposal should encourage fund boards to consider investment advisory contracts more carefully and promote the accountability of directors for the performance of their contract review function.

2. Confirmations and Point of Sale Disclosure

In a major proposal issued in January, the Commission proposed significant revisions to the form and contents of broker-dealer confirmations regarding transactions in fund shares and variable insurance contracts, and also proposed a new point of sale disclosure document for broker-dealers. Together, these two proposals would greatly enhance the information that broker-dealers provide to their customers in connection with mutual fund and variable contract transactions. They would also highlight for customers many of the conflicts that broker-dealers face when recommending certain investments, such as commissions and revenue sharing arrangements. The enhanced disclosure, therefore, should have the further effect of enhancing the accountability of broker-dealers to their customers when making recommendations for a particular fund or variable contract.

3. Other Disclosure Initiatives

I should also note other recent disclosure initiatives that I believe you may be reviewing during the course of this conference, such as the modernization of fund advertising rules, improved breakpoint disclosure, improved portfolio manager disclosures and the concept release that the Commission issued on improving transaction cost disclosure.

V. Conclusion

I'd like to conclude my remarks by stating what should be obvious to all of us: Investors are asking whether they can trust the investment management industry. Winning back the trust of these investors will require effort and commitment: commitment to compliance, commitment to ethics, commitment to reform. As I have said before, the status quo is no longer acceptable to America's investors. Nor will they accept empty promises of reform. They are looking for action; they are looking for meaning behind the words; they expect a reinvigorated, investor-oriented investment management industry.

This is a time in which variable product issuers, along with others in the investment management industry, will be tested, and watched, like never before. The theme for this year's NAVA Regulatory Affairs Conference is "The Dawning of a New Era in the Industry: Will you be Prepared?" I certainly hope you will be and that you, and those who sell your products, redouble efforts to meet the highest standards. I believe that investors will reward insurance companies and fund sponsors who champion investors' long-term interests as their own. I can promise you that we at the Commission will do all we can to assist you in this effort.

Thank you very much for listening and enjoy the rest of your conference.


Modified: 06/14/2004