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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address before the 21st Annual Advanced ALI-ABA Conference on Life Insurance Company Products


Paul F. Roye1

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

Washington, DC
November 20, 2003


Good morning. Thank you for inviting me to be here today. As always, I appreciate a forum like this where my colleagues on the SEC staff and I have an opportunity to discuss current investment management regulation issues with professionals like you, particularly in the current environment. I should give my usual disclaimer before I start. My remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.

The last time we met for this conference, I discussed issues then facing the variable products industry in the wake of Enron, WorldCom, and the other corporate scandals, and the various regulatory initiatives the Commission was taking in response to those events that also would impact the variable products and mutual fund industries. When I last addressed these issues with you, fund firms and their intermediaries had not played roles in any of the current scandals of the day. Sadly, this has changed.

Recent investigations undertaken by the SEC and state regulators have revealed widespread late trading, market timing and related abuses that represent a monumental betrayal of America's mutual fund investors and fundamental breaches of fiduciary obligations. Consequently, Chairman Donaldson has put in place an aggressive action plan to investigate the charges, assess the scope of the problem, and hold wrongdoers accountable.

With regard to holding wrongdoers accountable, the Commission recently brought an enforcement action against a salesperson at a broker-dealer who the Commission alleges played a key role in enabling certain hedge fund customers to engage in late trading of mutual funds. The Commission charged a senior executive of a prominent hedge fund with late trading, and barred him from association with an investment adviser. The Commission also levied a $400,000 civil penalty on a mutual fund executive in connection with his alleged role in allowing certain investors to market time his company's funds. The Commission instituted an action against a major investment management firm and two of its portfolio managers who allegedly market timed their own mutual funds. The Commission also charged five brokers and a branch manager with having misrepresented or concealed their own and their clients' identities in order to facilitate market timing. And that's just the recent actions related to late trading and market timing abuses.

I should note for this group that, although the enforcement actions to date have involved late trading and market timing of mutual funds, we have been gathering information and investigating late trading and market timing abuses in the variable products area, in view of the fact that variable products are particularly attractive to frequent traders and market timers because of the tax deferral offered by these products.

Late trading and market timing are not the only areas where the Commission has been bringing enforcement actions involving mutual funds and those who sell fund shares. Earlier this week, the Commission announced an enforcement action against a major broker-dealer arising out of the firm's mutual fund sales practices. The broker-dealer has agreed to a settlement of the action that calls, in part, for it to pay a total of $50 million dollars, all of which will be returned to investors. The Commission's investigation uncovered two distinct, firm-wide disclosure failures by the broker-dealer.

The first relates to an exclusive program involving 16 mutual fund families that the broker-dealer sold to its customers. Under the program, the broker-dealer gave these fund families what is sometimes called "premium shelf space." The firm encouraged its sales force to sell shares of the funds in the program and even paid its salespeople special incentives to sell those funds so that the broker-dealer would receive from those funds a percentage of the sales price over and above ordinary commissions and loads. The broker-dealer's customers did not know about these special shelf-space payments, nor in many cases did they know that the payments were coming out of the very funds into which these investors were putting their savings.

Few things are more important to investors than receiving unbiased advice from their investment professionals. The broker-dealer's customers were not informed of the extent to which the broker-dealer was motivated to sell them a particular fund. Our investigation also uncovered, and the enforcement action we have filed includes, another practice at the broker-dealer involving conflicts of interest in the sale of mutual funds. This practice, which has been the subject of other Commission cases during the last several months, involves the sale of Class B mutual fund shares to investors who were more likely to have better overall returns if they bought Class A shares in the same funds.

It should be noted that the abuses that are addressed in this case are significant and are not necessarily limited to this particular broker-dealer. So-called shelf-space payments have become popular with brokerage firms and the funds they are selling. Thus, the Commission is conducting an examination sweep of some 15 different broker-dealers to determine exactly what payments are being made by funds, the form of those payments, the "shelf space" benefits that broker-dealers provide, and most importantly, just what these firms tell their investors about these practices. The potential disclosure failures and breaches of trust are not limited to broker-dealers. We are also looking very closely at the mutual fund companies themselves.

Now, if all of this was not enough, our enforcement and examination staffs also have been addressing abuse of so-called "breakpoints." As you know, breakpoints are the specified investment levels at which the discounts available on front-end loads for large purchases of Class A shares increase. Earlier this year, examiners at the SEC, NASD and NYSE completed an examination sweep and outlined the results in a report, "Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers Regarding Discounts on Front-End Sales Charges on Mutual Funds." Together with the NASD, we have under active investigation instances in which it appears that investors were entitled to receive breakpoint discounts based on the size of their purchase of Class A shares, but where the firms failed to provide discounts.

I can assure you that the Commission is committed to seeking redress for investors and meting out the appropriate punishment in these matters to send a strong message that these types of abuses will not be tolerated.

On Tuesday, in testimony before the Senate Banking Committee, Chairman Donaldson outlined his vision of "Mutual Fund Investors' Rights" and the critical initiatives underway at the Commission to ensure that these investor protections are realized for investors. Chairman Donaldson outlined these rights as follows:


1. Mutual Fund Investors Have a Right to an Investment Industry that Is Committed to the Highest Ethical Standards and that Places Investors' Interests First.

Chairman Donaldson stated that every brokerage and mutual fund firm (and for that matter, every insurance company offering variable products) needs to conduct a fundamental assessment of its obligations to its customers and shareholders. He further noted that these assessments must be put forth at the highest levels, and implemented so as to reach all employees and that senior management and the boards of directors must be ready to lay down and vigorously enforce rules that define an immutable code of conduct.

In this regard, Chairman Donaldson sent letters to NAVA and the ACLI, asking them to notify their members and request that they review and reassess their policies and procedures with regard to preventing abuses in transactions in fund shares underlying variable insurance products. The Chairman also sent letters to the major mutual fund and broker-dealer trade associations, including the ICI, the SIA, and the Mutual Fund Directors Forum, as well as the NASD, with regard to share-pricing and market timing procedures, to obtain assurances that these procedures and the law are being followed.

As professionals working in the variable insurance products industry, you and your companies are deeply affected by these allegations about late trading and abusive market timing. Many investors are rightly questioning whether their trust in mutual funds and your products is misplaced. Issuers of variable products, along with other industry participants, now face the challenge of facilitating the restoration of America's investors' trust in the industry.

2. Investors Have a Right to Equal and Fair Treatment by Their Mutual Funds and Brokers.

The Chairman noted that our examinations and investigations of late trading and market timing abuses have revealed instances of special deals and preferential treatment being afforded to large investors, often to the detriment of small investors and that arrangements of this kind will not be tolerated as they violate fundamental principles of fairness.

3. Investors Have a Right to Expect Fund Managers and Broker-Dealers To Honor Their Obligations to Investors in Managing and Selling Funds.

Our examinations and investigations into the current abuses have revealed instances of fund managers placing their interests - and in the case of some portfolio managers, placing their personal interests - ahead of those of fund investors. Again, I refer to abusive activity by broker-dealers and their representatives in connection with the sale of fund shares, including failure to give investors the breakpoint discounts to which they are entitled, recommendations that investors purchase one class of shares over another in order for the salesperson to receive higher compensation and other sales practice abuses. The Chairman has made it clear that this cannot and will not be tolerated.

4. Investors Have a Right to the Assurances that Fund Assets Are Being Used for Their Benefit.

Clearly, fund assets, including use of a fund's brokerage commissions, must be used in a manner that benefits fund investors. Chairman Donaldson has indicated that the Commission should engage in a reassessment of how fund commission dollars are used, including various soft dollar arrangements and the lack of transparency to investors of these payments.

5. Investors Have the Right to Clear Disclosure of Fees, Expenses, Conflicts, and Other Important Information.

Mutual fund investors and investors in variable products must have the tools and the information to make intelligent investment decisions. To that end, the Commission will consider recommendations to enhance disclosure to fund investors of fees and expenses, and the conflicts that arise as a result of the various arrangements between funds and brokers regarding the sale of fund shares, as well as other important information.

6. Investors Have a Right to Independent, Effective Boards of Directors Who Are Committed to Protecting Their Interests.

As you know, independent directors are the "independent watchdogs" that provide a critical and necessary check on fund management. Investors need to be assured that their mutual fund directors have the independence and commitment necessary to carry out this crucial function. Chairman Donaldson indicated that the Commission will be considering enhanced standards for board independence and measures to strengthen the fund governance framework.

7. Investors Have a Right to Effective and Comprehensive Mutual Fund and Broker Compliance Programs.

Programs designed to ensure compliance with the federal securities laws are an essential tool in the protection of investors. Fund investors need to be assured that all funds, advisers, insurance companies and selling brokers have internal programs to ensure compliance with the federal securities laws. We are making final recommendations to the Commission to complete the pending rulemaking to strengthen procedures at mutual funds and advisers.

8. Investors Should Expect that Aggressive Enforcement Actions Will Be Taken When There Are Violations of the Federal Securities Laws.

I earlier outlined the recent enforcement actions the Commission has taken, which I think makes clear that there will be serious consequences to those who violate the federal securities laws to the detriment of investors.

* * * * * * * * * *

Now that I have outlined the Mutual Fund Investors' Rights," let me outline Chairman Donaldson's plan for ensuring that these Rights are realized.


Late trading and market timing abuses represent the most recent violations against investors' rights. How does this problem play out in the context of variable insurance products? The usual practice is that the insurance company accepts orders for transactions in fund shares, such as transfers between underlying funds, or the allocation of new purchase payments, each business day before 4:00 p.m. and transmits these orders to the underlying funds, usually after 4:00 p.m., and often not until the next morning. This leaves open a window of opportunity for the inclusion of late orders in those fund transactions. I urge you to review your policies and procedures regarding transactions in mutual fund shares within variable insurance products, particularly the procedures designed to ensure the integrity of the 4:00 p.m. cut-off.

While the Commission is vigorously pursuing enforcement actions regarding this misconduct, it also will be taking a number of regulatory steps immediately to deal specifically with these abuses. On December 3, the Commission will consider the staff's proposal to require that a fund (or certain designated agents) - rather than an intermediary such as a broker-dealer or other unregulated third party - receive a purchase or redemption order prior to the time the fund prices its shares (typically, 4 PM) for an investor to receive that day's price. This "hard" 4 o'clock cut-off would effectively eliminate the potential for late trading through intermediaries that sell fund shares.

We are aware of the concern of the variable products industry that insurance companies not be considered intermediaries for purposes of any such requirement. Industry representatives have discussed with the staff the specific attributes of the separate account and underlying fund arrangement that would make a strict application of the proposed rule problematic in the variable products context. We are considering this information carefully as we work on the rule proposal.

With respect to market timing abuses, the Commission will consider the staff's recommendation that the Commission require additional, more explicit disclosure in fund and insurance company separate account offering documents of market timing policies and procedures. This disclosure would enable investors to assess a fund's market timing practices and determine if they are in line with their expectations.

We also will be asking the Commission to consider similar disclosure in Forms N-3, N-4 and N-6, the registration forms for insurance company separate accounts that issue variable annuity and variable life insurance contracts, with respect to both the risks of frequent transfers of contract value among sub-accounts, as well as the separate account's policies and procedures with respect to such frequent transfers with appropriate modification to address the different structure of these issuers.

The staff's recommendations will have a further component of requiring funds to have specific procedures to comply with their representations regarding market timing policies. Thus, if a fund's disclosure documents stated that it discouraged market timing, the fund would be required to have procedures outlining the practices it follows to keep market timers out of the fund. While our examination staff will use a variety of techniques to police for market timing abuses, the establishment of formal procedures would also enable the Commission's examination staff to review whether those procedures are being followed and whether the fund is living up to its representations regarding curbing market timing activity. We also intend to recommend that the Commission emphasize the obligation of funds to fair value their securities so as to avoid "stale pricing" to minimize market timing arbitrage opportunities as an important measure to combat market timing activity.

Also on December 3, the Commission will consider adopting new rules under the Investment Company Act and the Investment Advisers Act that will ensure that mutual funds have strong compliance programs. Specifically, the rules that the Commission will consider would require each investment company and investment adviser registered with the Commission to: (1) adopt and implement written policies and procedures reasonably designed to prevent and detect violations of the federal securities laws; (2) review these polices and procedures annually for their adequacy and the effectiveness of their implementation; and (3) designate a chief compliance officer to be responsible for administering the policies and procedures and to report directly to the fund's board of directors. A chief compliance officer reporting to the fund's board of directors will strengthen the hand of the fund's board and compliance personnel in dealing with fund management.

Allegations of certain portfolio managers market timing the funds they personally manage or other funds in the fund complex raise issues regarding self-dealing. Recent allegations also indicate that some fund managers may be selectively disclosing their portfolios in order to curry favor with large investors. Selective disclosure of a fund's portfolio can facilitate fraud and have severely adverse ramifications for a fund's investors if someone uses that portfolio information to trade against the fund. You can expect that these issues will also be addressed in the rulemaking recommendations that the Commission will consider on December 3.

The package of reforms that I've just outlined for you is designed to provide immediate reassurances and protection to mutual fund and insurance product investors. These critical reforms not only will tackle the immediate problem of late trading and market timing abuses that we've seen so far during our investigation, but also will provide powerful tools to prevent the types of abuses identified to date. However, the Chairman has directed us not to stop here.

For instance, while the Commission's actions regarding fair value pricing should address the problem of stale pricing (which facilitates market timing), we will consider more in this area. Accordingly, we will study additional measures for Commission consideration, including considering a mandatory redemption fee imposed on short-term traders and developing a solution to the problem of trading through omnibus accounts.

With respect to the mandatory redemption fee, which would be paid to the fund (and, ultimately to the fund's long-term investors), it is a fee that would apply to short-term traders getting in and out of a fund over a short period of time, for instance 3 or 5 days. Such a fee could decrease the likelihood of market timers profiting from arbitrage activity.

The Chairman has also asked that we address the omnibus account problem, which also exists in the insurance products context. Mutual fund shares often are purchased and redeemed through omnibus accounts held at intermediaries such as broker-dealers. Typically, a brokerage firm has one omnibus account with each of the mutual funds with which it does business and through which all of its brokerage customers purchase and redeem shares of those mutual funds. Consequently, these mutual funds do not have information on the identity of the underlying brokerage customer who is purchasing or redeeming the funds' shares.

This arrangement often makes it difficult for funds to fulfill certain of their obligations to their shareholders. In the breakpoint context, omnibus accounts make it difficult for funds to track information about the underlying shareholder that might have entitled the shareholder to breakpoint discounts. In the market timing context, funds are not able to assess redemption fees, limit exchanges or even kick out a shareholder who is market timing through an omnibus account because they don't know the identity of that shareholder. Indeed, many of the market timing abuses identified through our examinations and investigations indicate that shareholders were market timing through omnibus accounts.

Requiring broker-dealers, insurance companies and other intermediaries to provide information to funds regarding the funds' investors would allow funds to police for abusive market timing activity and to further provide for appropriate breakpoints. An alternative would be to require that broker-dealers, insurance companies and other intermediaries enforce funds' policies with respect to market timing and the offering of breakpoints.


To assist the staff as it moves forward in considering this issue, the Chairman has called upon the NASD to head an Omnibus Account Task Force consisting of members of the fund and brokerage industries, as well as other intermediaries to further study this issue and to provide the SEC staff with information and recommendations that will assist us in developing a proposal that will adequately address the omnibus account issue.


As I noted, a fundamental right of investors is a strong, effective, independent board of directors. The statutory framework governing mutual funds envisions a key role for boards of directors in light of the external management structure typical for funds. The directors, particularly the "independent directors," are responsible for managing conflicts of interest and representing the interests of shareholders. The problems that recently have come to light underscore the need for enhanced effectiveness of independent directors in carrying out their responsibilities. Therefore, the staff will recommend to the Commission a number of ideas for reform, including:

  1. requiring an independent chairman of the fund's board of directors;
  2. increasing the percentage of independent directors under SEC rules from a majority to three-fourths;
  3. providing the independent directors the authority to retain staff as they deem necessary so they do not have to necessarily rely on the fund's adviser for assistance;
  4. requiring boards of directors to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure; and
  5. adopting a rule that would require boards to focus on and preserve documents and information that directors use to determine the reasonableness of fees relative to performance, quality of service and stated objectives, including a focus on the need for breakpoints or reductions in advisory fees and comparisons with fees and services charged to other clients of the adviser.

We recognize, however, that we cannot, through out rulemaking, "legislate independence." Directors themselves must understand and carry out their responsibilities to protect fund investors. We need to take the necessary steps to educate directors regarding this crucial role and to ensure that they understand their role. Accordingly, in addition to asking the staff to develop these reforms for consideration by the Commission in January, the Chairman called upon fund independent directors themselves to be active participants in the reform effort. Specifically, he asked former SEC Chairman David Ruder's non-profit mutual fund director's organization, the Mutual Fund Directors Forum, to develop guidance and best practices in key areas of director decision-making, such as monitoring fees and conflicts, overseeing compliance, and important issues such as valuation and pricing of fund portfolio securities and fund shares. Mr. Ruder and the Board of Directors of the Forum - an organization geared toward independent directors and that promotes improved fund governance through continuing education programs and other activities that assist independent directors in advocating for fund shareholders - have agreed to develop this guidance and these best practices to assist independent directors.

In addition to these initiatives, yesterday the Commission adopted rules regarding disclosure of fund nominating committee functions and communications between fund investors and fund boards, as part of the Commission's broader proposal on nominating committee disclosure. And just last month, the Commission, as part of its broader proxy nomination proposal, proposed rules to improve access of fund shareholders to the director nomination proxy process.

Chairman Donaldson has also instructed the staff to consider rules that would better highlight for investors the basis upon which directors have approved management and other fees of the fund.


Another fundamental right of mutual fund investors is clear, easy to understand disclosure. At the end of September we adopted amendments to mutual fund advertising rules that require that fund advertisements state that investors should consider fees before investing and that advertisements direct investors to a fund's prospectus to obtain additional information about fees. The rules also require more balanced information about mutual funds when they advertise performance. The Commission also recently proposed rule amendments regarding fund of funds products (including amendments to Forms N-3, N-4 and N-6) that would require these products to include additional disclosure in their prospectus fee table of the costs of investing in underlying funds. The Commission also adopted rules that require funds and advisers to disclose their proxy voting policies and procedures and, in the case of funds, disclose to investors the voting records of the funds.

Another key concept of the disclosure principle is clear, easy to understand disclosure to mutual fund investors of the fees and expenses they pay. In April of last year the Commission adopted new Form N-6 - the registration form for insurance company separate accounts offering variable life insurance policies. The new Form focuses on information important to variable life insurance investors and makes variable life disclosures consistent with those of variable annuities and mutual funds. In particular, the Form prescribes a simple and straight-forward tabular presentation of all fees and expenses under a variable life contract, which promotes clear understanding of the cost of investing in these contracts, as well as facilitating comparison of fees among competing products.

In conjunction with the adoption of Form N-6, the Commission also revised Form N-4 to conform the treatment of underlying fund expenses in a variable annuity prospectus with the format used in Form N-6.

I anticipate that in January, the Commission will consider adopting rules that would require "dollars and cents" fee disclosure to shareholders, coupled with more frequent disclosure of portfolio holdings information. This is an important reform, as it will allow investors to determine not only the fees and expenses they are paying on their particular funds, but will also greatly facilitate comparison among different funds. The Commission also will be considering in December a proposal to improve disclosure to shareholders regarding the availability of sales load breakpoints. We also want to provide investors better information on portfolio transaction costs so that they can factor this into their decision-making. Consequently, the staff is developing for Commission consideration in December a concept release to solicit views on how the Commission should proceed in fashioning disclosure of these costs.

Investors not only deserve to know the fees and expenses their funds pay, they also deserve to know how much their broker stands to benefit from their purchase of a particular fund. Thus, we also plan to improve disclosure about mutual fund transaction costs through the confirmations that broker-dealers provide to their customers. The Chairman has directed the staff to prepare a new mutual fund confirmation statement that will provide customers with quantified information about the sales loads and other charges that they incur when they purchase mutual funds with sales loads. I expect that the Commission will consider this proposal before the end of the year.

To address an investor's right to know about conflicts of interest that brokers may have when selling fund shares, the new mutual fund confirmation statement also will include specific disclosure regarding revenue sharing arrangements, differential compensation for proprietary funds and other incentives such as commission business for brokers to sell fund shares that may not be readily apparent to fund investors.


The Chairman also announced earlier this week his new risk management initiative. This critical initiative - the first of its kind at the Commission - will enable us to analyze risks across divisional boundaries, focusing on early identification of new or resurgent forms of fraudulent, illegal or questionable behavior or products. This initiative seeks to ensure that senior management at the Commission has the information necessary to make better, more informed decisions.

The new initiative will be housed within a newly created Office of Risk Assessment, and will be headed by a director who reports directly to the Chairman. The director will coordinate and manage risk assessment activities across the agency, and will oversee a staff of professionals, who will focus on the key programmatic areas of the agency's mission.

The duties of the Office of Risk Assessment will be focused on the following areas:

  • Gathering and maintaining data on new trends and risks from a variety of sources - including external experts, domestic and foreign agencies, surveys, focus groups, and other market data, including both buy-side and sell-side research.
  • Analyzing data to identify and assess new areas of concern across professions, companies, industries and markets.
  • Preparing assessments and forecasts on the agency's risk environment.

The work of the Office of Risk Assessment will be complemented by a Risk Management Committee, whose primary responsibility will be to review the implications of identified risks and recommend an appropriate course of action.

Additionally, each Division and major Office will have risk assessment professionals on staff, who will work closely with the Division Director as part of risk management teams to conduct risk assessment activities within each division.

This important initiative will fundamentally change the way the Commission assesses risk and hopefully will enable us to head off major problems before they occur.


Before I close, I also would like to touch on the staff's current review of asset allocation programs offered by insurance companies to their variable annuity and variable life insurance contract owners.

It is our understanding that these programs provide for the allocation of contract value among available mutual fund investment options according to a portfolio model developed by the insurance company or a third party. Insurance companies generally offer a variety of models that are suitable for contract owners with different risk profiles. The insurance company informs contract owners how each available model would allocate their contract value among investment options offered under the relevant contract, and each contract owner selects the particular model to be used.

We also understand that some asset allocation programs provide for reallocation of contract value to conform to changes in the model made by the insurance company or third party. Such changes may include the addition to, or removal of, mutual funds from the model as well as changes in the relative weights of the funds. In some programs, it appears that a contract owner's account value is reallocated automatically, with subsequent notice to the contract owner. In other programs, it appears that the contract owner is advised in advance of the proposed reallocation and provided with the opportunity to accept or decline the proposed reallocation.

We are reviewing whether programs that provide for such reallocations to conform to the new model allocation constitute a form of investment advice or asset management that is provided outside the context of a registered management investment company or individual advisory relationship that conforms to the requirements of the Investment Advisers Act of 1940 or raise other issues under the federal securities laws.

Just this week, we sent letters requesting information on asset allocation programs to insurance companies that we believe might have such programs. Specifically, we asked each company for its analysis of whether its asset allocation programs that provide for reallocation of contract value involve the provision of investment advice to contract owners by the insurance company or third party responsible for changing the model, the insurance company that issues the contract, or another party. In addition, we asked companies offering these programs for some analysis as to whether, in the case of programs providing for reallocation of contract value, a pool of assets invested according to a particular model constitutes a management investment company.


As you can see, we on the staff have been hard at work implementing an ambitious regulatory agenda for the Division laid out by Chairman Donaldson. Some of these initiatives are in response to very recent events and are on a fast track, making this a particularly challenging time for the Division. But we are committed to meeting this challenge. In the areas of late trading and market timing as with our other initiatives, notwithstanding the urgency and the fast track for these matters, our response to the current challenge will be grounded in the same bedrock principle that guides all our initiatives: our commitment to investor protection. At this time as always, we will chart and follow a course designed to result in better disclosure and better practices, all in the service of investors' interests. We hope we can count on your best efforts to this end as well.

Thank you for your time and attention, and enjoy the rest of the conference.



Modified: 11/20/2003