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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the
American Law Institute/American Bar Association


Paul F. Roye

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

Investment Company Regulation and Compliance Conference
Washington, D.C.
June 19, 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 inviting me to be with you here today for this important program. Planning Chairs Tom Harman and Karen Skidmore have put together an interesting and comprehensive agenda for you, and I am sure you will benefit from the many experienced practitioners who are providing their insights on topics ranging from the "whys" and "hows" of starting a mutual fund, to fund governance, distribution practices and disclosure.

The program today and tomorrow is very timely as well, given the recent interest from Congress and others in the activities of mutual funds. However, before I get into a detailed analysis of recent events, I need 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. Importance of Mutual Funds and Overview of Mutual Fund Regulation

In the program today and tomorrow, you are focusing on the "nuts and bolts," so to speak, of mutual funds and their regulation. Mutual funds have become a mainstay of the investment landscape in America. Millions of Americans use mutual funds to attain their goals of paying for higher education, saving for retirement and strengthening their financial security. In fact, according to the ICI, 95 million Americans invest in mutual funds, representing approximately 54 million U.S. households. Mutual funds have a combined $6.5 trillion in assets, far exceeding the nearly $4 trillion on deposit at commercial banks.

Mutual funds serve as an entry-point into our securities markets for many first-time investors and, with a single investment, provide investors asset diversification, liquidity, transparency and professional management. Mutual funds also offer investors a variety of investment choices, from money market funds to high-yield corporate bond funds to index funds to emerging markets funds-and a wide variety in between.

The Investment Company Act, the principal statute that regulates investment companies, including mutual funds, is perhaps the most complex of the federal securities laws. A reason the Investment Company Act is somewhat daunting is the fact that it specifically addresses a wide cross section of investment company operations. Fortunately, the securities lawyer just beginning to delve into the regulation of investment companies will find some familiar territory. The regulation of investment companies is based on the same principles of full and fair disclosure that are the foundation of the federal securities laws. Therefore, investment companies are subject to substantially similar disclosure and reporting requirements that apply to other issuers, embodied in the Securities Act of 1933 and the Securities Exchange Act of 1934, with one major difference. Mutual funds typically offer their shares continuously and thus must maintain current prospectuses.

However, the reach of the Investment Company Act extends beyond mere disclosure and reporting requirements. The Investment Company Act is, in effect, a comprehensive corporate statute. It places substantive restrictions on virtually every aspect of the operations of investment companies: their valuation of assets, their governance and structure, their issuance of debt and other senior securities, their investments, sales and redemptions of their shares, and, perhaps most importantly, their dealings with service providers and other affiliates.

One source of the Investment Company Act's highly regulatory nature is the unique structure of the typical investment company. Unlike a regular operating company, investment company employees do not operate investment companies. Instead, funds typically rely on external service providers, like the fund's investment adviser, to conduct the fund's day-to-day business, including managing the fund's portfolio and providing administrative services. Additionally, the officers of funds are usually affiliated with the fund's adviser, or the other outside service providers, such as the fund's administrator or underwriter. Consequently, the interests of fund management and shareholders of a fund may diverge in important ways.

A fund's investment adviser has a separate interest in maximizing its own profits. In contrast, officers of an operating company are paid directly by the company, often have an equity interest in the company, and are devoted to profit maximization to benefit both the company and themselves. While a fund's management and its shareholders have some common interests, such as seeking outstanding investment performance, there are important areas in which these interests may conflict, such as the level of management fees.

III. Role of the Commission

The Commission is charged with overseeing the investment management industry, including mutual funds and their investment advisers. As part of its mission, the Commission administers the Investment Company Act and Investment Advisers Act, which regulates fund advisers. My division, the Division of Investment Management, is the primary office that assists the Commission with these duties.

We review certain mutual fund disclosure documents, such as fund prospectuses. We recommend new rules and rule changes under the Investment Company and Advisers Acts. We respond to inquiries and requests for interpretive assistance under the Acts from investors, the industry, Congress and others. From time to time, the staff issues no-action letters stating that it would not recommend enforcement action if a fund or adviser engages in a particular activity that may implicate a provision of the Acts or their rules. In addition, we issue exemptive orders to funds and their advisers if they plan to engage in an activity that technically would violate the Acts or their rules, if the Commission, or the staff through delegated authority, determines that the exemption is necessary and appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Acts. Finally, we serve as a liaison with the Commission's inspection and enforcement staffs when they are probing investment management issues.

IV. Response to Inquiries from Congress

I mentioned that one of the staff's duties is responding to inquiries from Congress and others. I believe we may have set a new length record in responding to inquiries last week, having sent a 120-page response to one of our Congressional inquiries.

Let me give you a little background on this. In March, the Commission received two separate letters of inquiry from members of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the House Financial Services Committee, one from the Chairman of the Subcommittee, Richard Baker, and the other from Congressmen Robert Ney and the ranking minority member of the Subcommittee Paul Kanjorski. We submitted our responses last week.

The letters evidence a continuing concern on the part of some in Congress regarding the degree to which investors understand mutual fund fees and expenses, notwithstanding existing disclosure requirements and educational efforts, certain conflict of interest issues, and the adequacy of the mutual fund governance framework.

The Congressional concerns regarding the adequacy of mutual fund disclosure in certain areas are consistent with those of our Chairman, William Donaldson. Chairman Donaldson has indicated that he wants to move forward on a review of practices in the mutual fund industry, with emphasis on questions of disclosure, transparency of fees and expenses and sales practices. He stated in a speech earlier this month that the degree to which investors understand mutual fund fees and expenses is a significant source of concern. He further stated that these costs should be readily understood by investors and that our disclosure regime must facilitate this understanding.

While transactional fees, such as sales loads, tend to be relatively transparent, ongoing fund fees and expenses are less so, in part because of the fact that they are deducted from fund assets and are expressed as a percentage of net assets and reflected in reduced account balances. Surveys have indicated that investors may not understand the nature and effect of these ongoing expenses. It appears that, for whatever reason, current disclosure documents are not conveying this information effectively. Clearly, more can and should be done.

Having said that, I am proud of our efforts to date in improving the quality of disclosure. Notable among the various initiatives we have taken was the introduction of the Mutual Fund Cost Calculator, an Internet-based tool available on the Commission's website that enables investors to compare the costs of owning different mutual funds. More recently, we have a pending rule proposal that would require mutual funds to disclose in their reports to shareholders the amount of fund expenses borne by shareholders during the reporting period. We indicated in our response to the Congressional inquiries that we continue to believe that use of shareholder reports to convey additional fee information to fund investors, from a cost/benefit standpoint, provides a better approach than use of account statements as recommended by the General Accounting Office in its review of this issue.

Questions were also raised in the Congressional inquiries about the adequacy of disclosure in other areas, such as portfolio trading costs, soft dollar arrangements, portfolio manager compensation, revenue sharing arrangements and fund performance. The questions were wide ranging, and we hope our responses will further the process of identifying areas where improved disclosure can advance investor protection interests.

With regard to portfolio transaction costs, some have called for reflection of those costs in a fund's expense ratio or a quantification of these costs. Our response noted that, although such proposals are attractive in theory, they may not be feasible in practice, given that transaction costs not only include commissions, but also spreads, market impact costs and opportunity costs. Nonetheless, we indicated that investors would benefit from better, more understandable disclosure of transaction costs, and we suggested a variety of approaches that we will consider.

We also thought that investors could benefit from having information regarding the compensation structure for fund portfolio managers. This information could be helpful in assessing the incentives of individuals managing a fund, such as whether the manager is compensated for short-term or long-term performance or performance based on pre-tax or after-tax returns.

We expressed concern about the growth of soft dollar arrangements and the conflicts they may present to fund advisers. Certain soft dollar arrangements are protected by Section 28(e) under the Securities Exchange Act. However, the general effect of Section 28(e) is to suspend the application of otherwise applicable law, including fiduciary principles, and to shift the responsibility to fund boards to supervise the adviser's use of soft dollars and the resulting conflicts of interest, subject to best execution and disclosure requirements.

We expect to continue our efforts to improve disclosure regarding soft dollar arrangements and expect to ask the Commission to propose changes to the record-keeping rule under the Investment Advisers Act to require advisers to keep better records of the products and services they receive for soft dollars. But we also noted that, after 28 years, it may be appropriate to reconsider Section 28(e) or, alternatively, amend the provision to narrow the scope of the safe harbor.

One other issue raised in the Congressional letters that I would like to highlight deals with the recovery of distribution expenses under rule 12b-1. Rule 12b-1 permits funds to use fund assets to pay for distribution. However, while an assumption underlying the original adoption of rule 12b-1 was that distribution fees authorized by the rule would be temporary, many in the industry have argued that this assumption is now obsolete. In many cases, 12b-1 fees are used to compensate brokers for selling fund shares on an ongoing basis, in lieu of or as a supplement to, a sales load. Further, when a fund pays asset based fees for a combination of distribution and non-distribution services (such as account maintenance), it can be difficult to determine precisely when and how rule 12b-1 applies to those fees. In light of these realities, we are currently considering whether the requirements of rule 12b-1 should be modified to reflect fund practices as they exist today.

We also have concerns as to the use of so-called revenue sharing arrangements where a fund's adviser makes payments out of its own resources to finance the distribution of the fund's shares. One issue raised by a fund investment adviser's revenue-sharing payments is whether the payments are an indirect use of the fund's assets to finance the distribution of its shares and therefore must be made in accordance with the requirements of rule 12b-1. In our view, a fund indirectly finances the distribution of its shares within the meaning of rule 12b-1 if any allowance is made in the fund's investment advisory fee to provide money to finance the distribution of the fund's shares. In that case, the investment advisory fee essentially serves as a conduit for the indirect use of the fund's assets for distribution, and the portion of the advisory fee that is used to finance the distribution of the fund's shares must be paid in compliance with the requirements of the rule.

In this regard, a fund's board of directors, particularly its disinterested directors, is primarily responsible for determining whether revenue-sharing payments are an indirect use of the fund's assets for distribution or whether they are paid out of the "legitimate profits" from the investment adviser's contract with the fund. If the fund's board of directors determines that the payments are an indirect use of the fund's assets for distribution, it must ensure that the payments are made in accordance with the requirements of rule 12b-1.

Shortly after we submitted our responses to the Congressional inquiries, Chairman Baker introduced legislation entitled the "Mutual Fund Integrity and Fee Transparency Act of 2003." The bill calls for improved disclosure to mutual fund investors regarding estimated operating expenses incurred by shareholders, soft dollar arrangements, portfolio transaction costs, sales load breakpoints, as well as directed brokerage and revenue sharing arrangements. The bill also would require disclosure of information on how fund portfolio managers are compensated and require fund advisers to submit annual reports to fund directors on directed brokerage and soft dollar arrangements, as well as revenue sharing. It also would impose fiduciary obligations on fund directors to supervise these activities and assure that they are in the best interest of the fund. In addition, the Bill would require the Commission to conduct a study of soft dollar arrangements to assess conflicts of interest raised by these arrangements and examine whether the statutory safe harbor in Section 28(e) of the Exchange Act should be reconsidered or modified.

Yesterday, I had the privilege of testifying on behalf of the Commission before the House Capital Markets Subcommittee regarding this new legislation. In the testimony, the Commission commended Chairman Baker and the other co-sponsors for this legislative initiative and stated that the Commission supports Congressional efforts to improve transparency in mutual fund disclosures, to provide mutual fund investors with the information they need to make informed investment decisions and enhance the mutual fund governance framework. The testimony indicated that the Commission particularly supports the goals of enhancing disclosure and the expanded authority the bill would provide the Commission to define which directors can be considered independent.

With respect to fund audit committees, the bill would apply the audit committee standards contained in the Sarbanes-Oxley Act for listed companies to mutual funds. These standards include that audit committee members meet a specified standard of independence; that the audit committee be directly responsible for hiring and overseeing the auditor; that the audit committee establish procedures for the receipt and treatment of employee complaints and concerns about auditing matters; that the audit committee have the authority to engage independent counsel and other advisors; and that the audit committee be appropriately funded. As the Commission stated to Congress, extending these audit committee requirements to mutual funds is one way to further benefit and protect mutual fund investors. The Commission will be working with the Subcommittee to further these important goals.

V. Compliance Rule Proposal

Since much of this conference is focused on the statutory provisions and regulations that funds must adhere to, I'd like to discuss briefly another important regulatory initiative, proposed compliance program rules, which the Commission published for comment in February. These rules would require investment companies and investment advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the federal securities laws. The proposal also would require investment companies and investment advisers to designate a chief compliance officer.

I would point out that the proposed rules do not enumerate specific elements that funds or advisers must include in their compliance policies and procedures, simply because funds and advisers are too varied in their operations for the Commission to impose a single list of required elements. What is important is that policies and procedures be in place and that they be reasonably designed to lessen the likelihood of violations, detect any violations that do occur, and provide guidance on appropriate responses to such violations for fund officers.

In many cases, the proposal would codify the prudent compliance practices followed by fund complexes that already have a dedicated compliance officer and effective compliance procedures. In fact, some investor advocates have singled out the fund industry for a remarkably clean record when it comes to investor fraud generally.

Nonetheless, it is common knowledge that industry growth has substantially exceeded the growth in Commission resources. Our ability to exercise meaningful oversight plainly depends on the establishment and implementation of internal procedures and controls reasonably designed to ensure compliance with the law. Surprising as it may sound, some mutual funds have virtually no compliance controls in place. In fact, many of our enforcement cases in the investment management area are the result of weak or nonexistent compliance controls. We want to raise the compliance standards of all funds to the standards already adopted by the more responsible and proactive fund complexes.

If adopted as proposed, these rules should help protect investors by improving day-to-day compliance with the federal securities laws, while at the same time increasing the efficiency and effectiveness of our examination program. Again, these rule proposals do not ask anything that any well-managed adviser or fund complex is not already doing today.

VI. Conclusion

In conclusion, you have chosen an exciting time to review investment management regulation. In the course of 10 days, we have submitted our response to Congress on a variety of important regulatory issues, assessed new legislation and testified before Congress. And now I am taking a breather to review it all here today.

As we review the prospect of regulatory change and the direction of mutual fund regulation for the future, I can assure you that the Commission will do so with an eye toward how best to protect investors. Where we see deficiencies in disclosure or practices that should be improved, we will act to make sure that investors are better served. Investors deserve a regulatory regime that puts their interests first, and we will work with Congress, the industry and others to make sure we can achieve this common objective. If you are new to the world of investment company regulation, I hope you will help us in this effort.

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



Modified: 06/19/03