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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the Tenth Annual Advanced ALI-ABA Course of Study:
Investment Management Regulation


Paul F. Roye1

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

Washington, D.C.
October 28, 2004

I. Introduction

Good morning and thank you for inviting me to be with you here today. I would also like to thank ALI-ABA and Planning Chairs Tamar Frankel and Cliff Kirsh for including me, and my colleagues from the SEC staff, on the program and providing an opportunity to discuss current issues in the investment management area. However, before I begin, 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.

There can be no doubt that this past year has been one of the most significant in the history of the investment company industry. For much of the past year, the Commission has focused on pursuing enforcement actions against wrongdoers involved in the mutual fund scandals and on fashioning an improved regulatory system for the mutual fund industry to minimize the possibility that we will have these types of fiduciary breakdowns in the future. Today, I would like to talk to you about ensuring the effective implementation of our new rules, focusing on several key new requirements, and our efforts to finalize two other rule proposals: the hard 4:00 and 2% redemption fee proposals. In addition, I would like to discuss the Commission’s new hedge fund adviser registration rule and some future Commission initiatives in the investment management area.

II. Implementation of a New Mutual Fund Regulatory Regime

Under Chairman Donaldson's leadership, the Commission this past year has undertaken an aggressive mutual fund regulatory agenda that has focused on four main goals: (1) addressing late trading, market timing and related abuses; (2) improving the oversight of funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) addressing or eliminating certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) improving disclosure to fund investors, especially fee-related disclosure. This conference is timely in that it presents an opportunity to review and discuss these regulatory actions.

The work we have accomplished on Chairman Donaldson’s mutual fund reform agenda represents a comprehensive effort to restore investor confidence in the mutual fund industry. However, as Chairman Donaldson stated recently, “Rulemaking alone cannot reform an industry. An industry must be motivated and committed to reforming itself.” That is why your role in implementing the new rules is so critical. Your focus and attention to the effective implementation of the new rules is essential to ensuring that the new rules achieve their investor protection goals.

However, we understand that the responsibility for implementing the new rules cannot fall to the industry alone. Thus, we stand ready to help you. As Chairman Donaldson recently commented,

It is in our interest, and the interest of fund investors, to ensure that our new rules are implemented in a meaningful way. We want to work with you, and answer your questions, as you continue to implement the rules. Together — and I emphasize the word together — we can restore investor confidence.

So now let me discuss several of the key rules that you are undoubtedly focusing on.

A. Compliance Rule

Earlier this month, we passed a historic date for the mutual fund industry: the October 5th compliance date for the new compliance policies and procedures rule, which also includes the new chief compliance officer requirement. The importance of this new rule cannot be overstated, and many industry observers believe that the rule will in time prove to be one of the most significant of the industry reforms the Commission has put in place over the past year. While this point is certainly open to debate, there can be no doubt that the role of the chief compliance officer underscores the importance of internal attention and focus on compliance at investment management firms.

Compliance is about more than creating a thick binder stuffed with exquisitely crafted policies and procedures. While the development of well-considered policies and procedures is an important first step, it is just that: a first step. Now comes the hard part—implementing your recently updated or newly adopted compliance policies and procedures.

On this point, I have a few pieces of advice. First, pay attention to detail. The breakpoints situation, in which a large number of investors did not receive the front-end sales load breakpoint discounts to which they were entitled, in many ways was a failure to pay attention to the details of stated policies and procedures. As we learned from that example, details cannot be glossed over. In addition, when you make a promise to investors, you better have the systems and procedures in place to ensure that the promise can be met. Compliance policies and procedures do not operate on auto-pilot. You must be committed to getting involved in the details for them to be effective.

Second, test your policies and procedures. Make sure they are working. A fund’s compliance policies and procedures should be designed to accomplish three goals: (1) prevent violations of the securities laws, (2) detect violations when they occur, and (3) promptly correct violations that have occurred. Don’t just focus on prevention, and don’t ease up on your compliance efforts now that your procedures are in place. I strongly recommend that you periodically test your procedures to ensure that they are working and that investor protection is not being compromised. I further encourage you to analyze information over time in order to identify unusual patterns that may point to compliance problems or deficiencies.

Third, don’t allow exceptions to your compliance policies and procedures to compromise their effectiveness. As we saw in the recent scandals, some firms had policies and procedures in place, but undercut the effectiveness of those policies and procedures by permitting exceptions that were not in the interests of a fund’s investors. Our inspections staff is sensitized to this issue and will be asking probing questions about the exceptions that are allowed under your compliance policies and procedures, who is authorized to approve any exceptions and whether a fund’s board is notified of exceptions to the fund’s compliance procedures.

With respect to the new role of the chief compliance officer, I want to emphasize that we view the chief compliance officer as our partner in the protection of investors, not our adversary. We look forward to working with those of you in the audience who are serving as chief compliance officers of funds and advisory firms. It is a critical function, and we want to make sure that you have the support you need from the SEC. We are actively considering ways to ensure regular communications with compliance officers to alert you to new developments and areas of concern. We welcome your ideas in this regard.

B. Directed Brokerage Ban

I would like to say a few words about the new ban on directed brokerage for the distribution of a fund’s shares, which the Commission adopted as part of amendments to rule 12b-1. I imagine that this issue is on many of your minds, since the new rule amendment has a compliance date of December 13th. When adopting the ban, the Commission was clear that trades can be placed with brokerage firms that also distribute a fund’s shares. Indeed, in some cases it may be necessary to place trades with distributing brokers in order to achieve best execution. I believe that the Commission understands and is sensitive to this issue. The release adopting the new rule amendments states that the new ban is not intended to compromise best execution.

However, funds that execute trades through selling brokers must implement policies and procedures designed to ensure that those selections are based on the quality of the execution rather than the selling of fund shares. Reliance on claims of best execution is not enough. Firms must have policies and procedures that essentially provide for strict and secure separations between those responsible for fund distribution and those responsible for executing a fund’s trades. Similarly, funds must also guard against the cross-distribution of fund shares. For example, Fund A cannot direct brokerage to compensate for Fund B’s distribution.

As with all your compliance policies and procedures, firms should monitor the effectiveness of the policies and procedures they have in place to implement the new ban on directing brokerage for distribution. In testing a fund’s procedures, you should be looking for any brokerage patterns that might indicate that brokerage is being sent to a broker for any reason other than best execution. In addition, chief compliance officers should report to a fund’s board on their directed brokerage ban procedures in connection with the CCO’s annual report to the board on the operation of the fund’s compliance policies and procedures.

C. Disclosure Regarding Market Timing Policies, Fair Valuation and Selective Disclosure

Another of the Commission’s new rules that you are very likely focused on right now is the new required disclosure regarding a fund’s policies and procedures regarding the frequent purchase and redemption of a fund’s shares. This new disclosure is required for any fund filing a registration statement, or an amendment to its registration statement, on or after December 5th. The Commission purposely picked this date— which is two months from the October 5th compliance rule date—on the theory that funds and their boards would have reviewed, updated and approved their procedures and be in a position to provide good disclosure about them two months later.

Under the new rules, fund prospectuses must state the risks that frequent purchases and redemptions may present to fund investors, if any; whether the fund’s board has adopted policies regarding frequent purchases and redemptions and if not, why not; and describe policies and procedures for deterring frequent purchases and redemptions. In preparing this new disclosure, you should seek to make sure that the disclosure provides an appropriate level of specificity so that it is meaningful for investors.

In addition, a fund’s Statement of Additional Information must describe arrangements to permit frequent purchases and redemptions. In the SAI disclosure describing any arrangements to permit frequent purchases and sales, a fund must disclose the identity of the person and any consideration (including sticky assets) received. In addition, the Commission has been very clear that disclosure of your practices in this area will not make lawful conduct that would otherwise be unlawful.

If any restriction on market timing will not be imposed uniformly, a fund’s prospectus disclosure must describe the circumstances when it will not be applied—including whether it will be imposed on trades placed through omnibus accounts. The Commission’s release adopting these new requirements indicated that applying anti-market timing procedures to omnibus accounts can be extremely important to ensuring the effectiveness of those procedures.

I should note that funds may continue to reserve the right to reject a purchase or exchange request for any reason—but this possibility must be disclosed in a fund’s prospectus. In addition, I want to make one important point: funds do not have to disclose policies and procedures for detection of persons who may be violating their frequent purchase and redemption procedures. The Commission did not want this type of disclosure to provide a road map to market timers. This position represents a change from the proposal in response to concerns expressed by commenters. However, I think you can expect examination staff—when they come in—to ask what practices you use to detect market timing, how they are employed and who is responsible for them.

In addition to the enhanced disclosure regarding frequent purchases and sales of fund shares, the Commission required enhanced disclosure of a fund’s use of fair value pricing. I would point out that the Commission has made clear that it believes that fair value pricing is an important ingredient in combating market timing. Fair value pricing is required under the Investment Company Act, and Chairman Donaldson has asked the staff to explore ways in which we could provide additional guidance to the fund industry in meeting its fair valuation obligations.

The new disclosure requirements also require disclosure of the policies and procedures regarding when a fund or its service providers may selectively disclose the fund’s portfolio holdings. I urge all fund personnel to pay particular attention to this issue to ensure that they do not inappropriately divulge portfolio information either purposefully or inadvertently. Significant harm could come to a fund’s investors if unscrupulous persons gain access to this information and use it to trade against a fund.

III. Finalization of the Commission’s Mutual Fund Reform Agenda

Just as you are working to implement the new rules that have fast-approaching compliance dates, the staff of the Division of Investment Management is working hard to make final recommendations to the Commission on two outstanding rules proposed as part of Chairman Donaldson’s mutual fund reform agenda: the hard 4:00 proposal and the 2% redemption fee.

A. Hard 4:00 Close

Last December the Commission voted to propose what has come to be called the hard 4:00 close. Under the proposal, all fund purchase, redemption and exchange orders would have to be received by a fund, its designated transfer agent or NSCC by 4:00 p.m., east coast time to get that day’s price, rather than merely received by a fund intermediary by 4:00 p.m., as is permitted now.

Under the current regime, funds have dealer agreements with intermediaries that distribute their shares. These dealer agreements require the intermediaries to segregate pre-4:00 orders from post-4:00 orders and only forward the pre-4:00 orders. The orders then may not be sent on to a fund’s transfer agent for several hours. As we all know, however, there were traders and fund intermediaries who were taking advantage of this system and forwarding orders that were placed after 4:00 as if they had been received prior to 4:00. In many cases, late traders placed those orders because of market-moving information that was announced after the market’s close at 4:00 but was not reflected in the “as of” 4:00 valuations of mutual funds.

The Commission is concerned about the regulatory restrictions on the processing of fund orders because the temptation for an easy, essentially “risk free” profit from late trading is substantial. The hard 4:00 proposal, many believe, would provide for a secure pricing system that would be largely immune to manipulation by late traders. This level of effectiveness is one of the primary advantages of the hard 4:00 approach to addressing late trading.

Needless to say, however, the hard 4:00 proposal has raised concerns for many commenters. Some of the commenters who were most concerned about the hard 4:00 proposal were investors on the west coast and those representing them. These west coast investors already have to submit their mutual fund orders by 1:00 west coast time, but under the hard 4:00 approach, that cut-off potentially would be pushed back even earlier.

We also received a large number of comment letters from commenters concerned about the impact of a hard 4:00 rule on intermediaries. Many intermediaries stated that they would have to invest significantly in systems upgrades, if a hard 4:00 rule was adopted. In addition, commenters raised significant concerns regarding the impact of a hard 4:00 rule on investors in 401(k) plans and similar vehicles that may have difficulty achieving same-day processing of mutual fund orders in a hard 4:00 environment.

In response to the concerns of commenters, the staff is reviewing the technological capabilities of retirement plan administrators and other service providers and fund intermediaries so that we can obtain a more complete understanding of various systems issues and alternatives to a hard 4:00 rule. The staff also is examining the suggested approach of imposing procedures and controls on the acceptance and cancellation of fund trades, combined with an independent annual audit of the procedures. In addition, we are considering the extent to which there are tamper-proof time-stamping systems.

The staff is analyzing these approaches to determine whether there is an effective alternative to the hard 4:00 rule proposal that would not disadvantage certain investors and would not distort competition in the marketplace. Indeed, Chairman Donaldson has stated that it may very well turn out that we adopt a combination of some of the alternatives that have been presented to us during the notice and comment process. A challenge for the staff is that any rule that the Commission adopts in this area potentially may have significant implications for order processing systems and costs. Thus, we need to consider the financial and systems impact of our approach, while at the same time keeping an eye on our goal of eliminating late trading.

B. 2% Redemption Fee Rule

Earlier this year, the Commission proposed a mandatory 2% redemption fee for investors that redeem their shares within five business days of their purchase. The purpose of the rule would be to allow funds to recover the administrative costs of rapid trading and help deter abusive market timing. Importantly, a redemption fee is paid to a fund, for the direct benefit of a fund’s investors, rather than to a fund’s manager or other service providers.

Aside from some mutual fund industry commenters, most commenters opposed the mandatory 2% redemption fee rule. However, based on our market timing reviews and examination findings, there is a strong indication that imposition of a redemption fee can have a positive effect on deterring market timing. Consequently, the staff is trying to weigh the advantages and disadvantages of a mandatory versus a voluntary approach to imposition of redemption fees. If voluntary, the decision of whether to impose a redemption fee would essentially be left to fund boards to decide on a fund by fund basis.

A concern of the mutual fund industry is how to gain leverage to require intermediaries, especially those intermediaries who process their trades through omnibus accounts, to impose redemption fees. It seems clear that addressing the omnibus accounts issue is important to creating an effective deterrent to abusive market timing. Thus, we are looking closely at this issue.

Another concern is a controls issue—if every fund has its own provisions for redemption fees, there is the potential for a breakdown in controls, with redemption fees not being imposed correctly. We saw a situation similar to this with the failure to credit applicable breakpoint discounts on mutual fund shares purchased with a front-end load.

However, some commenters have noted that a 2% redemption fee may not be appropriate for every fund, such as, perhaps, a short term bond fund. Many people believe that boards are in the best position to determine whether a redemption fee is appropriate for their individual funds and their investors. Consequently, the staff is in the process of weighing the various considerations and preparing a recommendation to the Commission.

I should note that the 2% redemption fee was never intended by the Commission to be a comprehensive or complete solution to the problem of abusive market timing. As I mentioned, the Commission has stressed the importance of fair value pricing in reducing the profit that many market timers seek. When proposing the redemption fee rule, the Commission asked for comment on additional guidance that could be provided to firms with respect to fair valuation. Consequently, we expect that, in connection with any final action on a redemption fee rule, the Commission would also issue an interpretive release or other guidance to assist funds with their fair valuation obligations under the statute.

IV. Advisers Act Rulemaking

A. Code of Ethics Rule

As part of our reform agenda, the Commission adopted the new code of ethics requirement under the Investment Advisers Act. We think this rule is important in requiring an industry-wide re-assessment of ethical standards and reminding employees of their legal, fiduciary and ethical obligations.

B. Hedge Fund Adviser Registration Rule

However, the most recent development under the Advisers Act is that the Commission on Tuesday voted to adopt a new rule and rule amendments under the Investment Advisers Act that would require certain hedge fund advisers to register with the Commission as investment advisers. The rule adoption was the result of a process that began over two years ago and included an extensive staff study of hedge funds and their advisers that we released last year. The staff study raised a number of concerns that lead us to recommend that the Commission require registration of certain hedge fund advisers under the Advisers Act.

One concern is the tremendous growth in the hedge fund industry. While no one knows for sure, it is estimated that in the last five years, hedge funds have grown by 260 percent, with assets of approximately $870 billion in approximately 7,000 funds. Some predict that hedge fund assets will soon reach one trillion dollars. In the last year alone, hedge fund assets have grown over 30 percent. Hedge funds are one fifth the size of equity mutual funds, but are growing at a much faster rate.

Moreover, hedge funds tend to be very active traders. One study estimates hedge funds are responsible for up to 20 percent of equity trading volume in the United States. It is clear that hedge funds advisers are significant market participants, both as managers of assets and traders of securities. However, neither the Commission nor any other government agency has reliable data on the hedge fund industry, including data on the number of hedge funds or the amount of their assets. We only have third party surveys and reports, which often conflict and may be unreliable.

Another significant concern is the growing exposure of smaller investors, pensioners and other market participants, directly or indirectly to the impact of hedge fund investing. Hedge funds are no longer for the very rich. More and more, we see hedge fund investments pouring in from a new type of investor who can’t afford to absorb the large losses as a result of frauds. Lower minimums and the rise of funds of hedge funds are permitting smaller non-traditional investors into hedge funds, directly or indirectly. Moreover, a growing number of public and private pension funds, as well as universities, endowments, and other charitable organizations have begun to invest larger amounts of money in hedge funds. It is reported that these types of institutions may soon increase their investments in hedge funds to over $300 billion.

Investors such as pension plans that have millions of beneficiaries are now exposed to the risks of hedge fund investing. Losses resulting from hedge fund investment strategies and possible hedge fund frauds could affect these institutions’ ability to satisfy their obligations to their beneficiaries or to meet other intended goals.

The growth in hedge funds has unfortunately been accompanied by troubling growth in the number of our hedge fund enforcement cases. In the last five years, the Commission has brought 51 cases involving hedge fund fraud, resulting in losses of more than $1.1 billion. These cases are more than ten percent of cases against investment advisers over the same period.

In addition, we are seeing hedge funds used to defraud other market participants. Hedge fund advisers were key participants in the recent scandals involving mutual fund late trading and inappropriate market timing. The staff has counted almost 400 hedge funds and 87 hedge funds advisers involved in these cases. They were most of the late traders and market timers. They picked the pockets of every-day mutual fund investors.

The Commission determined that registration under the Advisers Act would give us the tools we need to monitor the activities of hedge fund advisers without imposing burdens on the legitimate investment activities of hedge funds or interfering with the important role that hedge funds play in our financial markets. The Advisers Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. It will not hamper hedge funds.

Advisers Act registration will, however, enable the Commission to address the various concerns we identified regarding the hedge fund industry.

1. Census Information

First, registration under the Advisers Act will provide the Commission with the ability to collect important information that we now lack about this growing component of the U.S. financial system.

2. Deterrence of Fraud

Second, registration under the Advisers Act will give the Commission the ability to conduct examinations of hedge fund advisers. Examinations permit us to identify compliance problems at an early stage, identify practices that may be harmful to investors and provide a deterrent to unlawful conduct. The prospect of a Commission examination increases the risk of getting caught violating the law and thus will deter wrongdoers.

3. Barring Unfit Persons from Hedge Fund Industry

Third, registration permits us to screen individuals associated with an adviser and to deny registration if they have been convicted of a felony or had a disciplinary record subjecting them to disqualification. This authority can be used to help keep fraudsters and scam artists out of the hedge fund industry.

4. Adoption of Compliance Controls

Fourth, registration would require hedge fund advisers to adopt policies and procedures designed to prevent violations of the Advisers Act and to designate a chief compliance officer. In other words, hedge fund advisers would have to develop a compliance infrastructure—just like other advisers of similar size.

5. Limits on Retailization

Fifth, registration under the Advisers Act will have the salutary effect of requiring many direct investors in most hedge funds to meet wealth standards under our performance fee rule that are higher than the current minimums applicable to accredited investors.

6. Proper Administration of Advisers Act

Finally, the new rule and rule amendments close a loophole in our regulations that allowed an exception designed for advisers providing advice only to a small number of clients, and therefore not representing a substantial federal interest, to be used by hedge fund advisers to manage in some cases billions of dollars for potentially thousands of investors.

We deeply appreciate the beneficial role that hedge funds play in our markets, and we do not want to impede the industry’s ability to flourish and grow. We simply want to be able to monitor this fast growing segment of the investment management industry so as to fulfill our mission to protect investors and the securities markets. Now that the rule has been adopted, we look forward to working with the hedge fund industry to make this initiative work for the industry and ultimately strengthen hedge funds’ role in our securities markets.

V. Upcoming Initiatives

While we are discussing Advisers Act initiatives, I should note that the Commission in August re-proposed the so-called broker-dealer rule. This rule proposal addresses whether the Advisers Act applies to full-service brokers charging an asset-based fee, instead of traditional commissions, mark-ups and mark-downs.

Brokers who charge their customers asset-based fees may be subject to regulation under the Advisers Act and the Exchange Act. The proposed rule would make the nature of the services provided, rather than the form of compensation, the primary factor in determining if the Advisers Act applies. Under the proposal, if a broker does not have discretionary authority to trade securities in an account, the Advisers Act generally would not apply to that account. If the broker has discretionary authority and charges an asset-based fee, the account would be subject to the Advisers Act.

We received numerous comments on the re-proposal, which had a comment period closing date of September 22nd. The Commission has stated that it intends to make a final decision on the proposal by year-end.

As far as other items upcoming on our agenda, the staff is continuing to analyze the comments we received on the Commission’s portfolio transaction costs concept release so that we can make a recommendation to the Commission regarding potential further action in this area.

VI. Conclusion

In conclusion, the Commission continues to be committed to establishing a regulatory framework for mutual funds that best serves the interests of fund investors. A top priority for the Commission and the staff is working with the industry to ensure effective implementation of our new rules.

We look forward to continuing to work with you, and appreciate the effort and dedication that you have put in to revamping your internal processes and procedures—and your public disclosures. These are important efforts to regain the trust and confidence of America’s mutual fund investors. We still have more work to do, however. And I encourage you to continue your efforts and vigilance.

Thank you, and have a productive and informative conference.

1 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.



Modified: 10/28/2004