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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks at the FSA Asset Management: Risk, Opportunity and Regulation Conference


Susan Nash

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

London, England
September 28, 2004

The U.S. 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.


Good morning. I would like to begin by expressing my appreciation to Dan Waters and the FSA for inviting me to share my perspective today. This conference is a great opportunity to exchange views on the asset management industry and the regulatory and other challenges that confront us all.

Just over a year ago, allegations about late trading and abusive market timing surfaced in the U.S. mutual fund industry. Unfortunately, some participants in the mutual fund industry, as well as intermediaries who sell fund shares, lost sight of the fiduciary duties that they owe to fund shareholders. The acts of those who sought to profit at the expense of fund shareholders damaged the reputation of the entire U.S. fund industry. Moreover, firms involved in the scandals have been punished in the marketplace by investors who have withdrawn assets. The scandals have been a painful reminder that good ethics and good business go hand-in-hand.

Over the past year, we have been hard at work at the Commission implementing Chairman Donaldson's vision for addressing the abuses that came to light and for taking steps today that will prevent abuses tomorrow. Our guiding mission throughout this work has been that investors deserve a brokerage and mutual fund industry built on fundamentally fair and ethical legal principles.

The Commission has taken vigorous enforcement action to address the market timing and late trading abuses that have occurred as well as other abuses that have occurred in the distribution of fund shares. The Commission has also looked hard at its own internal risk management processes, with a view to improving its ability to uncover potential problem areas before they reach crisis proportions. Finally, the Commission has undertaken an aggressive regulatory agenda that is aimed both at deterring the sorts of abuses that have been uncovered in the past and at proactively improving our system of regulation for the future. My remarks today will focus on the Commission's regulatory agenda, which has spanned six broad areas: first, late trading and market timing abuses; second, fund governance, ethical standards, and compliance; third, conflicts of interest; fourth, cost disclosure; fifth, hedge funds; and sixth, soft dollars.

Market Timing and Late Trading

I will turn first to market timing and late trading. Around this time last year, allegations surfaced of abusive market timing and late trading of U.S mutual funds. Abusive market timing involves rapid trading in and out of funds that results in dilution of long-term holders' interests when a fund's share price does not accurately reflect the current values of its portfolio securities. For example, a market timer may purchase shares of a mutual fund that invests in overseas markets based on events occurring after foreign market closing prices are established, but before the fund's share price calculation, that are likely to result in higher prices in foreign markets the following day. The market timer would redeem the fund's shares the next day when the fund's share price would reflect the increased prices in foreign markets, for a quick profit at the expense of long-term fund shareholders. Late trading involves the placement of trades after 4:00 that are given the share price determined as of 4:00, thereby permitting the late trader to profit from new information in the market place at the expense of other fund shareholders. Regrettably, in too many cases these practices occurred with the complicity of those charged with protecting investors.

To put an absolute halt to late trading, the Commission proposed the so-called "hard 4:00" rule. Typically, funds price their shares at 4:00 p.m. Eastern Time. Investors submitting orders before 4:00 p.m. receive that day's price; investors submitting orders after 4:00 p.m. receive the next day's price. Under the current system, various intermediaries, including broker-dealers, pension plan record-keepers, and insurance companies, are permitted to transmit orders to trade fund shares to a fund after 4:00 p.m provided that the intermediary receives the orders by 4:00 p.m. The current system failed to prevent late trading when intermediaries allowed select shareholders to receive the 4:00 p.m. price, even though their orders were placed after 4:00 p.m.

The "hard 4:00" rule would provide for a secure pricing system that would be largely immune to manipulation by closing off the ability to transmit orders to a fund after 4:00 p. m. Specifically, the proposed rule would require that orders be placed with the fund itself or its primary transfer agent or clearing firm by the time set by the fund for pricing, typically 4:00 p.m. To date, the Commission has received more than 1,000 comment letters on this proposal, many raising concerns about how the proposal might adversely affect certain fund investors such as 401(k) plan participants and investors in different time zones across the country. As an alternative to the proposal, some have advocated a system of controls that would better prevent and detect late trading. Others have recommended the use of more sophisticated technology to create tamper-proof time stamping of trade tickets that would help eliminate, or at least better detect, late trading. The Commission staff is hard at work analyzing whether there is an effective alternative to the "hard 4:00" rule proposal.

To address market timing, the Commission has stressed that "fair value pricing" is critical to reducing or eliminating the profit that many market timers seek and the resulting dilution of long-term shareholders' interests. A U.S. mutual fund is required to calculate its share price using the fair value of its portfolio securities, as determined in good faith by the fund's board, when market quotations for a portfolio security are not readily available, including when they are unreliable.

In addition, the Commission has proposed that funds impose a mandatory two percent redemption fee when investors redeem their shares within five days of purchase. The proposal is designed to reduce the opportunity for short-term traders to exploit other investors by requiring short-term traders to reimburse a fund for costs incurred by the fund as a result of their trades and by discouraging short-term trading by reducing its profitability. Along with the mandatory redemption fee, the Commission also proposed a process that, for the first time, would give mutual funds a weekly pass-through of buyer and seller information from intermediaries. That process was designed to permit funds to identify market timers and apply the funds' anti-market timing procedures when the trading occurs through an intermediary who submits a single net purchase or sale order on behalf of a large number of investors. The redemption fee proposal has been controversial, and we are continuing to consider the comments we have received.

Fund Governance, Ethical Standards, and Compliance

The second major area of Commission activity has been fund governance, ethical standards, and compliance, where the Commission has adopted three significant initiatives.

The Commission recently adopted a comprehensive rulemaking package to bolster the effectiveness of independent directors and solidify the role of the fund board as the primary advocate for fund shareholders. The rules enhance the independence of the board of directors of any fund that relies upon certain exemptive rules that allow funds to engage in transactions that would otherwise be prohibited by statute and that present conflicts of interest between the fund and its management company. Funds relying on these exemptive rules are required to have an independent board chairman and a board comprised of 75 percent independent directors. The rules also require that the board perform a self-assessment at least once a year, that the independent directors meet separately at least once a quarter, and that the independent directors have the authority to hire their own staff.

In addition, the Commission recently adopted a requirement that all registered investment advisers adopt codes of ethics. The code of ethics must set forth standards of conduct for advisory personnel and address conflicts that arise from personal trading by advisory personnel. The rule requires advisory personnel to report their personal securities transactions, including transactions in any mutual fund managed by the adviser. This reporting requirement is designed to help advisers, as well as Commission examiners, identify abusive trading in a mutual fund by personnel who have access to information about the fund's portfolio.

Finally, the Commission adopted a new rule that requires funds and their investment advisers to have comprehensive compliance policies and procedures in place and to appoint a chief compliance officer. The chief compliance officer of a mutual fund must be answerable to the fund's board and can be terminated only with the board's consent. This requirement will provide fund boards with a powerful tool to identify and prevent misconduct that could potentially harm funds and their shareholders. Funds and advisers must designate their chief compliance officers and adopt compliance policies and procedures that satisfy the rule not later than October 5 -- one week from today.

Conflicts of Interest

The third area of recent Commission focus has been conflicts of interest involving mutual funds and those who distribute fund shares. The Commission recently adopted a rule amendment to prohibit the use of brokerage commissions from a fund's portfolio securities transactions to compensate broker-dealers for distribution of a fund's shares. These rules target a practice that potentially compromises best execution of a fund's portfolio trades, increases portfolio turnover, and corrupts broker-dealers' recommendations to their customers.

The Commission also adopted enhanced disclosure standards that are designed to provide greater transparency regarding portfolio managers' incentives and potential conflicts of interest. The standards require a mutual fund to disclose the structure of its portfolio managers' compensation. For each type of compensation (e.g., salary, bonus, or deferred compensation), a fund is required to describe with specificity the criteria on which that type of compensation is based, for example, whether compensation is fixed or whether (and how) compensation varies based on the fund's pre-or after-tax performance or the value of assets held in the fund's portfolio. Funds must also disclose their portfolio managers' ownership of shares in the fund. In addition, they must disclose the number of other accounts (and the total assets in those accounts) that are also managed by the portfolio managers. The accounts required to be disclosed include hedge funds and pension funds.

At the end of August, mutual funds were, for the first time, required to disclose all of the proxy votes that they cast for the year ended June 30. Shining a light on mutual fund proxy voting may illuminate potential conflicts of interest - such as when a fund's adviser also manages the retirement plan assets of a company whose securities are held by the fund -- and discourage voting that is inconsistent with fund shareholders' best interests. Press reports indicate that a variety of third-party analysts have already begun to review the recently disclosed proxy vote data.

Cost Disclosure

A fourth area targeted by the Commission is cost disclosure. Costs have a tremendous impact on the returns ultimately realized by a fund investor. For that reason, this has been a key area of disclosure reform. The Commission has recently completed three initiatives focused on cost and has two more significant initiatives underway.

First, the Commission adopted a requirement that semi-annual shareholder reports include the costs of a fund investment over the most recent six months stated in simple dollars and cents terms. This disclosure, which reveals the ongoing costs for a $1,000 investment, is intended to permit investors to readily estimate their actual costs and to compare the ongoing costs of fund ownership among different funds. Parenthetically, I would note that when the Commission adopted this new cost disclosure, it made another significant change in mutual fund reporting - requiring that funds disclose their complete portfolio holdings four times a year rather than two as previously required.

The Commission's second cost disclosure initiative is a requirement that mutual funds describe in their prospectuses available breakpoints on front-end sales loads and the eligibility requirements for obtaining breakpoints. Breakpoints are the investment levels required to obtain reduced sales loads offered by funds for larger investments. The amendments address concerns that surfaced in late 2002 regarding the failure to provide mutual fund investors with the breakpoint discounts to which they were entitled. The new disclosure is intended to assist investors in understanding the breakpoint opportunities available to them and broker-dealers in accessing information about available breakpoint discounts.

The final cost disclosure rule adopted by the Commission was designed to increase the transparency of the evaluations made by fund boards when they approve investment advisory contracts. These rules require a mutual fund to provide disclosure in its shareholder reports regarding the material factors that form the basis for the board's approval of the fund's advisory contract.

The Commission has also requested public comment on two additional initiatives targeted at enhancing the transparency of costs associated with mutual fund investing. Last December, the Commission requested comment on methods for improving the information that mutual funds disclose about the transaction costs that funds incur when they buy or sell portfolio securities. In doing so, the Commission noted that transaction costs are significant for two reasons. First, for many funds, the transaction costs incurred are substantial, with estimates placing commission and spreads alone for the average equity fund as high as 75 basis points. Second, commissions, which are paid out of fund assets, may pose conflicts for fund managers. For example, soft dollar commissions may be used to pay for research that might otherwise be paid by the fund's investment adviser.

In January of this year, the Commission proposed rules that would, if adopted, require broker-dealers to provide their customers with information, both at the point of sale and in transaction confirmations, regarding the costs and conflicts of interest that arise from the distribution of mutual fund shares. The proposed confirmation disclosure would be received by the customer after a transaction has been effected. By contrast, the point of sale disclosure would provide investors with information that they could use as they determine whether or not to purchase shares of a particular mutual fund. The Commission is currently considering the comments received on both the transaction costs and confirmation/point of sale initiatives.

Hedge Funds

The fifth area of recent Commission activity is one that I know is of significant interest to members of this audience: namely, the proposed registration of hedge fund advisers under the Investment Advisers Act. Hedge funds have become one of the fastest growing segments of the investment management business - with assets fast approaching $1 trillion. In addition, hedge funds have played significant roles in some of the most notorious mutual fund scandals that have come to light. We have seen hedge fund managers engaged in illegal behavior that takes advantage of the long-term investors in mutual funds.

In July of this year, the Commission proposed a new rule that would require advisers to hedge funds to register under the Advisers Act. Currently, hedge fund managers are investment advisers, but can avoid registration with the Commission by counting each hedge fund as a single client for purposes of the exemption from registration for advisers that have fewer than 15 clients. The Commission proposed to require that hedge fund managers count the individual investors in their hedge funds for purposes of determining whether they have fewer than 15 clients. Registration is intended to provide the Commission with important information about this growing segment of the U.S. financial system and give the Commission authority to conduct examinations of the adviser's hedge fund activities, while at the same time imposing minimal additional burdens on hedge fund advisers.

The proposal would require hedge fund advisers located offshore to look through the funds they manage, whether or not those funds are also located offshore and count investors that are U.S. residents as clients. An adviser to any hedge fund that, in the course of the previous twelve months, has more than 14 investors that are U.S. residents would generally have to register under the Advisers Act. In proposing the rule, the Commission indicated that it did not want to require advisers to offshore publicly offered mutual funds or closed-end funds to register simply because more than 14 of their investors are now resident in the United States. To address this situation, the Commission included an exception for a company that has its principal office and place of business outside the United States, makes a public offering of its securities outside the United States, and is regulated as a public investment company under the laws of a country other than the United States. In addition, the Commission proposed to limit the extraterritorial application of the Advisers Act. Specifically, an offshore adviser to an offshore fund that would be required to register under the proposal would not be subject to most of the substantive provisions of the Advisers Act.

We appreciate the very thoughtful comments that we received regarding the effect of the proposed hedge fund adviser registration rules on non-U.S. advisers, such as those from the European Commission, the Investment Management Association, the European Fund and Asset Management Association, and others. The staff of the Commission is considering these comments seriously. We are sensitive to the concerns that have been expressed and look forward to a continuing dialogue on these issues with our U.K. counterparts and other interested parties.

Soft Dollars

The final area of Commission activity, soft dollars, is also one of significant interest to many of you. The term "soft dollars" typically refers to arrangements under which an investment adviser directs client brokerage transactions to a broker and, in exchange, obtains research products or services in addition to brokerage services from or through a broker. Soft dollar arrangements create incentives for fund advisers to direct fund brokerage based on the research provided to the adviser rather than the quality of execution provided to the fund, forego opportunities to recapture brokerage costs for the benefit of the fund, and cause the fund to overtrade its portfolio to fulfill the adviser's soft dollar commitments to brokers. The area of soft dollars is a very high priority for the Commission, and Chairman Donaldson has formed a Task Force on Soft Dollars, comprised of SEC staff. The Task Force has met with a number of industry representatives as it tackles this complicated issue. Its goal is to fully understand how soft dollars are used and the pros and cons of various alternative reform approaches.

The area of soft dollars is complex, and the Task Force is considering a variety of approaches. In the U.S., there is a statutory safe harbor that applies to soft dollars. One approach under consideration is to narrow the definition of "research" that qualifies under the safe harbor so that only research that has valid, intellectual content would qualify. The Task Force is also considering whether the costs of research and execution should be quantified and other ways in which the costs of research could be made more transparent. Another approach would involve enhanced requirements for maintaining books and records that would facilitate the Commission's ability to police this area. The Task Force has met with a number of parties, including the FSA. We are following with interest the related developments in the United Kingdom and look forward to continued dialogue with the FSA regarding developments with respect to soft dollars in our respective countries.

* * *

Before I close, I would like to say a few words about access to the U.S. markets by foreign funds. It is important for all of us, regulators and private sector participants alike, to remember that we live and operate in a larger world. We cannot put on blinders and ignore the inevitable interaction that occurs with those who are outside our borders.

The U.S. applies a level playing field approach to access to our markets. Under Section 7(d) of the Investment Company Act, only funds organized under the laws of the United States, or any state, are permitted to offer shares in the United States. However, Section 7(d) authorizes the Commission to issue orders permitting foreign-organized funds to offer shares in the United States if the Commission finds that, by reason of special circumstances or arrangements, it is both legally and practically feasible effectively to enforce the provisions of the Investment Company Act against the foreign fund and that permitting the foreign fund to offer shares in the United States is consistent with the public interest and the protection of investors. Thus, Section 7(d) ensures that U.S. investors receive the same essential investor protection whether they acquire shares in a foreign fund or U.S.-organized fund.

In practice, the requirements of Section 7(d) have not posed a problem for foreign managers in penetrating the U.S. market, although few orders have been granted under section 7(d). Foreign funds have been reluctant to have all the provisions of the Investment Company Act apply to them, especially because there are other mechanisms for access to U.S. markets. Many foreign fund managers have responded by acquiring U.S. investment management organizations or by setting up their own U.S. affiliates. A foreign investment manager may organize and register a U.S. mutual fund to be sold in the United States on the same basis as a U.S. investment manager. Moreover, it is relatively easy for a foreign firm to establish funds in the United States to replicate an existing foreign fund, which can be managed and administered outside the United States. I should also note that the Commission staff has shown flexibility in permitting performance information, such as that of a comparable foreign fund, to be included in prospectuses of the U.S. funds, greatly aiding foreign managers in marketing their U.S. funds. Also, the National Securities Markets Improvement Act of 1996 facilitated a true national market in the United States, eliminating substantive regulation of mutual funds by states, making it considerably easier for foreign firms to access the U.S. markets.

* * *

Under Chairman Donaldson's leadership, the U.S. Securities and Exchange Commission has engaged in an aggressive regulatory agenda aimed both at addressing the past abuses that have come to light in the mutual fund industry and at acting now to reduce the potential for other abuses to occur in the future. The Commission's initiatives have covered a broad array of areas, ranging from reforms that directly attack the abuses of market timing and late trading to fund governance, ethical standards, and compliance; conflicts of interest; cost disclosure; hedge funds; and soft dollars. As we continue our work at the Commission, we look forward to continued cooperation with our counterparts at the FSA on issues of mutual concern and to continued dialogue with parties in the United Kingdom and elsewhere outside the United States that are affected by our regulations.

Thank you.


Modified: 10/01/2004