Speech by SEC Commissioner:
Remarks before the National Association for Variable Annuities
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 28, 2005
Thank you for that kind introduction and thanks to everyone for getting up so early to be here. It is an honor to be here at your annual conference since variable products, though often relegated to the footnotes in our releases, are such an important part of many investors' portfolios. As your conference title -- "Living in the New Regulatory World" - suggests, you certainly have a very long list of items for discussion. We at the Commission have done our part to give you something to talk about; as Commission observers know, our enforcement, inspection and regulatory dockets have been very full over the past year. This morning, I plan to address a few of the issues on the SEC's plate. Before I begin, I must remind you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
This conference falls in the middle of what promises to be an interesting week at the Commission. I am referring, of course, at least in part, to the Commission's scheduled consideration of the Securities Act reform amendments at tomorrow's open meeting. These amendments, if adopted, should dramatically liberalize and modernize the offering process, which, in turn, should ease the capital formation process. The Commission also will consider amendments related to shell companies, which should strengthen the Commission's ability to combat fraud by cutting out some weaknesses in our rules that invite gamesmanship and fraud.
Unfortunately, the celebratory mood that should have characterized the consideration of these significant changes in the offering process and the important shell company amendments is likely to be clouded by the third item on the agenda. We are asked to "consider the matters remanded to the Commission by the U.S. Court of Appeals for the District of Columbia Circuit on June 21, 2005 in its decision in Chamber of Commerce v. SEC regarding the Commission's 'Investment Company Governance' rules."
Only a week ago today, the circuit court remanded the fund governance rule to us so that we could "address the deficiencies with the 75% independent director condition and the independent chairman condition." Tomorrow, we commissioners will be asked to vote again to readopt this flawed rule that we adopted last June. I have not been shy about my opposition to these mandatory fund governance requirements. Matters of substance aside, however, I am very disappointed in the cavalier attitude with which the Commission is responding to the court's directive.
This case adds to a growing list of our actions in which we have given short shrift to fundamental concepts of due process. The court in the independent chairman case has basically ordered us to take the letter and spirit of the Administrative Procedure Act seriously. It has directed us to look again at the costs of - and a less drastic alternative to - our rule. This is the heart and soul of how regulatory agencies are supposed to provide due process to the public.
I am not at all opposed to funds' having non-executive chairmen; I am not at all opposed to funds' having 51%, 67%, 75% or even 100% independent boards. Indeed, I have heard from several directors - some of whom are newly appointed non-executive chairmen - that the environment in their boardrooms, while not bad before, is now a little better. Does this improvement result from an increased share of independent directors? The presence of a non-executive chairman? The general change of attitude of directors and management in this post-Sarbanes-Oxley world (not to mention post-Canary Capital world)? Factors specific to those particular funds? The answer is certainly not clear. I suggest that we must be asking that question and trying to find out the answers in an open, systematic way before we jump to conclusions.
But, to a person, these same directors and independent chairmen have told me that they are very much troubled by this one-size-fits-all mandate from the SEC. They believe that they as independent directors - already required by SEC rules to be a majority on their respective boards - can decide how best to organize the governance of their funds and how most effectively they can represent the shareholders, whom they are duty-bound to protect.
The important point is that I have heard only separate, isolated, random stories. The SEC has done no comprehensive, deliberate, thoughtful review in which we have sought input from the public. In our earlier rulemaking, we gave only perfunctory, half-hearted, and even disingenuous nods to economic analysis. In fact, the Chairman himself famously said in our public meeting regarding this rule in June of last year - and quoted by the court in its opinion - that he thinks that "there are no empirical studies that are worth much." I hope that we take a much more thorough, thoughtful, studied approach as we consider further regulatory actions, some of which I will discuss this morning. In the case of fund governance, our failure to do so will be a clear snub to the court and an act of contempt of its directives.
However, before I leave this discussion of the fund governance rule, I must emphasize what is the bottom line for me - the shareholders' bottom line. That is essentially my problem with our action in this case: the Commission's slim majority has decided that their instincts and beliefs tell them that every mutual fund ought to be governed in a particular way and that the shareholders ought to pay for it. I am troubled by mandates from an agency in areas where investors in the marketplace - empowered by information - can make their own decisions about what they want to pay for. All of our myriad rules for investment managers and investment companies boil down to one thing: cost to the shareholder. And, as you well know, these costs add up over time and act as a drag on performance. We also cannot forget that investors are hurt in other, less direct ways. Our complicated rules, resulting in additional costs, serve as barriers to entry to small, entrepreneurial managers. These barriers benefit the established players, who already have the legal and compliance infrastructure, not to mention the capital, to bear these costs, regardless of whether or not the market allows them to pass the costs on to the shareholder. The shareholder pays for all of these rules through lower net returns and fewer choices. There certainly are benefits, but they need to be closely related to - and judged according to - the costs.
Another action in which the Commission ought to act judiciously and with plenty of input and creativity is our point-of-sale and confirmation disclosure proposal. This proposed rule was published for a second round of comment at the end of February, a year after it was proposed. Despite an abbreviated comment period, many commenters responded to our very long list of questions. Although not characterized as a reproposal, the renewed request for comment reflected a broadening of the kinds of information that the point of sale and confirmation documents were intended to convey. The focus shifted from providing investors a summary of distribution-related costs and conflicts-of-interest to providing them with comprehensive cost information. This broadening reflects the reality that investors tend to care more about the bottom line - how much am I going to have to pay - than the component parts of the aggregate payment.
Providing investors with clear and concise information is a worthy goal, but the point-of-sale disclosure might not be the place to do it. Would it not make more sense for the Commission to revise existing disclosures rather than adding a new layer of disclosures? Do we run the risk of confusing investors with multiple, overlapping disclosure documents? If comprehensive information is what investors want, we should undertake a comprehensive look at disclosure for mutual funds and related products.
One certainly has to admit that our rules complicate disclosure. How many investors actually read their mutual fund prospectus? How about the Statement of Additional Information? I would respectfully submit that very few do. Again, investors eventually pay for all of this complexity, one way or another.
With litigation on everyone's mind, disclosures are becoming longer and increasingly impenetrable. Much of it is boilerplate. Investors would be better served if we focused our efforts on facilitating the provision of clear and concise information on fees, conflicts and returns in a single document that provides them with bang for their buck; they need plain English recitals of the risks and costs associated with investing. Of course, our disclosure initiatives will only be successful if we educate investors so that they can use the information that they receive to make suitable decisions.
Among the concerns that the thousands of commenters on the 2004 proposal raised were concerns that the proposed forms were not appropriate for variable products. In response to these concerns, the Commission, in the February release, published new disclosure forms, including point-of-sale and confirmation forms that are tailored for variable annuities. Some commenters, however, have raised concerns about how well even these forms work in the variable insurance context. The complexities and nuances of these products may overwhelm the disclosure forms that we have proposed. The last thing that we want to do is to mandate the use of a form that will simply add to investor confusion in an area that is already a challenge for investors to navigate.
One of the aspects of the point of sale rule discussion that has been encouraging to me is the new focus on the internet. Discussions surrounding this rule have brought home the great potential of the internet in conveying information to investors. Although I do not know whether the Commission will embrace the internet in connection with this rulemaking initiative, it seems that the internet could be the key to making this work. Investors could have easy access to information in the desired degree of detail if they were provided with summary information and more detailed information only a hyperlink click away. The internet also would afford investors access to sophisticated cost calculation tools that would allow them to manipulate the variables and compare results across different investment options. The NASD's internet-based approach, which was demonstrated to me recently, is one promising approach. If we determine to pursue internet-based disclosure, we, of course, will have to make provisions for investors that do not have access to, or simply prefer not to use the internet.
Last April, we adopted a final rule to draw a line of separation between broker-dealer and investment advisory activity. This is an area that we entered with some reluctance. Line-drawing is not easy, particularly when nearly seventy years have passed since the statute that provides the basis for our line-drawing was put in place. Not surprisingly, our actions in this area have sparked considerable controversy, including litigation. As adopted, the rule first provided a framework within which broker-dealers, without being subject to regulation as investment advisers, can offer brokerage accounts that charge asset-based fees to customers for whom such accounts would be appropriate. Second, the rule also provides guidance about activities that would not qualify as "solely incidental" to a broker-dealer's brokerage business and hence would trigger the Advisers Act.
The first part of what the Commission did has provoked criticism from the investment adviser community and the second part of what the Commission did has provoked criticism from broker-dealers. Even those who generally like all or part of what the Commission did, have raised practical implementation concerns. I worry that our rulemaking may have unintended consequences such as duplicative regulation. Or, dissuading people from becoming financial planners. Or, scaring brokers away from asking the right questions, and gathering the right information, to make the necessary suitability determinations. Or, generally further confusing investors. While the process of line-drawing admittedly has been difficult for us, it has had the positive effect of inspiring us to take a broader look at issues beyond the scope of the rulemaking. The Commission, with the input of people like you, plans to look into the current obligations and regulatory schemes for broker-dealers and investment advisers and any necessary changes to those schemes.
In the Spring of 2004, the Commission adopted a rule that required enhanced disclosure by funds and insurance company separate accounts with respect to market timing risks and policies and with respect to fair valuation. As with any new disclosure requirement, it has been a challenge for you to figure out exactly what needs to be disclosed and in how much detail it should be disclosed. I hope that your having worked through disclosure issues with our staff this year will provide you comfort and guidance as you craft your disclosures in the future.
In the Spring of this year, the Commission supplemented the disclosure approach by adopting a rule that governs the imposition of redemption fees by mutual funds. Unlike the redemption fee rule that the Commission proposed, which I opposed because of its mandatory nature, the final rule is voluntary. However, the rule requires all funds to enter into agreements with their financial intermediaries, defined very broadly, that require the financial intermediaries to provide information to the fund about shareholder transactions and execute the fund's market-timing prevention instructions. The purpose of these provisions, of course, is to enable funds to reach market timers behind the omnibus accounts through which they conduct their trading.
The rule's compliance date is not until October of next year. Unfortunately, I have been hearing from funds that have begun to tackle the task of modifying their agreements with intermediaries. They are concerned about the feasibility of this provision. From the perspective of intermediaries, the rule also poses substantial difficulties. Some commenters, like NAVA, favor uniform standards to mitigate these difficulties, but uniformity could preclude funds from designing tailored, effective redemption fees. We requested comment on, and are still considering, the need for uniform parameters.
Implementation difficulties are likely to be exacerbated in the variable product context. The separate account structure, together with the overlay of insurance regulation, complicates rule implementation. I hope that the Commission can work with you to address the practical implementation obstacles in a manner that allows the rule to function as intended. Funds should be permitted to impose redemption fees when needed without undue costs to the shareholder or unnecessary constraints on redeemability.
In addition to a long list of regulatory changes, recent years have brought many significant enforcement actions. I hope that this wave of enforcement actions will instill a new and needed discipline among our registrants. But we too must be disciplined in bringing enforcement actions. Firms with strong compliance policies and procedures and individuals who abide by those policies and procedures should not live in fear of enforcement actions. We should expect the subjects of our enforcement actions to assert legitimate defenses of their actions. We need to avoid rulemaking through enforcement and instead assess behavior against the laws and regulations in place at the time it took place. We may, in the course of a compliance examination or an enforcement proceeding, conclude that our rules need to be strengthened or better articulated, but, until we have adopted a clear standard with the requisite public input, we cannot enforce it.
This sounds like a basic principle, but it is easy to fall into the trap of avoiding tackling complex, controversial issues until problems have manifested themselves and then doing so through enforcement actions. Not everything is black and white, but we should not overshadow the marketplace with a perpetual cloud of gray, the outlines of which are established piecemeal through enforcement actions. From a long-term, good-governance perspective, the regulator's failure to provide clear standards compromises private-sector compliance efforts, because compliance officers cannot speak to their business colleagues with authority as to what is improper conduct.
Finally, many are speculating about how the impending arrival of a new chairman will affect outstanding agenda items, such as fair valuation and the "hard 4:00 close" proposal. Although there will undoubtedly be a transition period, we and our staff will continue work on these initiatives. Regardless of what ultimately happens, it is sure to be an interesting time, and, as always, you can play a valuable role in assisting the Commission, whatever it may look like, in working through the many important issues that it will face.
Please feel free to contact me with any ideas or concerns. I make this offer with some trepidation in light of the recent experience of Indonesian president Susilo Bambang Yudhoyono. He gave out his cell phone number as a complaint line for those with gripes about the government and encouraged people to call or text message him to air any complaints. Much to his chagrin, he received so many messages that his cell phone was crippled, which, of course, just aggravated the already aggrieved callers. Nonetheless, I look forward to hearing from you. My new telephone number at the Commission's brand new building is 202-551-2700.
Thank you for your attention.