U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the ICI 2004 Securities Law Developments Conference


Paul F. Roye1

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

Washington, D.C.
December 6, 2004

Mutual Fund Regulation: What Happens Next

I. Introduction

Good morning and thank you for welcoming me here today. Before I begin, I would like to remind you that, as always, my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I have used the occasion of many of my recent speeches, including my speech at this conference last year, to detail the abuses that occurred in the mutual fund industry and the Commission's efforts to put in place a regulatory framework to enhance internal mutual fund governance, oversight and compliance--as well as to improve the meaningfulness of disclosures provided to mutual fund investors. Today, however, as we approach the end of 2004, my remarks have a different focus. Rather than reviewing the past, today I would like to discuss the future and answer the question, "Mutual Fund Regulation: What Happens Next?"

II. Implementation of the New Rules

The immediate answer to the "what happens next" question is, in one sense, obvious: you and your colleagues in the mutual fund industry robustly implement the new rules recently adopted by the Commission. I understand, however, that implementation of new rules is not always as easy as it sounds. I know that your summer and fall months were very busy and were filled with efforts to meet the October 5th compliance rule deadline and the December 5th effective date for the new disclosure rules related to market timing, fair valuation and selective disclosure of portfolio holdings. In addition, a week from today-December 13th-marks the compliance date for the new directed brokerage ban, and there are several new rules that have compliance dates in the first part of next year. Thus the critical task of implementing the new rules is far from over.

As you well know, if our new rules are to serve their intended purpose-and if investor confidence in mutual funds is to be fully restored, the industry must implement the new rules in a way that gives them meaning and life. The next step of the mutual fund reform effort, therefore, is for the most part in your hands.

As Chairman Donaldson recently commented when discussing the Commission's mutual fund reforms, "[R]ulemaking alone cannot reform an industry. An industry must be motivated and committed to reforming itself." I believe that the mutual fund industry has shown a desire to "clean house," and I want you to know that we in the Division of Investment Management stand ready to assist you as you work toward full and meaningful implementation of the new rules. When you have questions, whether regarding the legal interpretation or practical implications of our rules, you should contact us. Having an industry that is uncertain about what is required by a specific rule serves no one's interests-and certainly does not further our goal of developing a compliance-oriented industry and restoring investor confidence. Thus, I encourage you to reach out to the staff as necessary.

I further encourage you to commit the energy and resources that are necessary to fully implement the reforms so that they will foster an ethical atmosphere at fund firms and a focus on the needs and interests of fund investors. As the scandals revealed, many fund firms were not focused on their core responsibilities of serving their investors. Instead they were cutting unlawful quid pro quo deals to grow assets under management and maximize fund fees. Greed overtook integrity and a focus on profitability triumphed over firms' focus on fiduciary obligation and responsibility.

All of us involved in managing, distributing and overseeing mutual funds must guard against these types of unhealthy attitudes from again infiltrating the fund business. When I asked one industry executive about the reason for the late trading and market timing abuses, he attributed the problem to the rapid growth of, and new entrants to, the fund business. But our enforcement docket is replete with names of old-line mutual fund organizations.

I hope that the recent effort to review compliance policies and procedures has been therapeutic and an opportunity to rethink practices and ways of doing business, and that you have addressed or eliminated conflicts of interest and practices that can compromise investor interests. The fund business was built on trust and integrity, and trust and integrity must again become funds' hallmarks, if they are to continue to serve as the primary investment vehicle of American investors. That is why I challenge you to work seriously to implement not just the letter, but the spirit of the Commission's new mutual fund reforms.

III. Finalizing the Mutual Fund Reform Agenda

Also on the horizon is the finalization of the three remaining items on the Commission's mutual fund reform agenda, namely, the 2% redemption fee, hard 4:00 close and point of sale/fund confirm proposals. As is well known, all three of these proposals generated significant comment that has caused the staff to search for ways to achieve the goals of the proposals while minimizing costs to the industry and unintended consequences to investors.

On the redemption fee proposal, the staff is in the process of weighing a voluntary versus a mandatory approach to redemption fees. I continue to believe that a redemption fee can have a positive deterrent effect on abusive market timing. I also believe that one of the merits of a redemption fee is that it is paid to the fund for the direct benefit of fund investors harmed by the costs associated with frequent trading. However, in light of the comments the Commission received on this proposal, especially concerns voiced by fund investors, the staff is considering whether there is a regulatory approach toward redemption fees that would be preferable to a mandatory rule.

I believe that any rule in this area should be structured in such a manner that, if a fund board determines that a redemption fee is necessary for a particular fund to combat potential abusive market timing, the intermediaries selling the fund will work with the fund to facilitate collection of the fee. I further believe it is important in this rulemaking to address the problem of omnibus accounts so that funds have a means to identify abusive market timers hidden in these accounts.

In addition, the Commission has stated that meeting a fund's statutory duty with respect to fair value pricing is critical to addressing market timing. Consequently, the staff is considering whether to recommend that the Commission issue an interpretive release or other guidance with respect to fair valuation.

With respect to the hard 4:00 close proposal, the staff is continuing to review the alternatives to a hard 4:00 that commenters have suggested. The staff also is analyzing the technological controls that could be put in place, perhaps combined with third party audits, to effectively guard against late trading. Again we are seeking an effective solution to the problem of late trading that does not unnecessarily disadvantage average mutual fund investors.

For the point of sale/fund confirm initiative, the staff is examining how best to get meaningful information into the hands of investors about broker conflicts and compensation, without overwhelming investors with detail-and without imposing prohibitive costs on the broker-dealer and fund industries. In seeking to achieve this goal, the staff has been working with investor focus groups to obtain a better sense of what investors need and expect from this type of disclosure.

The staff is actively working on each of these mutual fund reform initiatives, and I believe you can expect to see the Commission take action on these items in the near future.

IV. Looking Ahead

Now for the more intriguing answers to the "What happens next" question. Certainly, Chairman Donaldson's tenure has been marked by "action" in the investment management area. So, looking ahead, here are the initiatives that I expect the Commission to take up in the coming year.

A. Soft Dollars

One of the most important initiatives that will likely receive Commission review in the coming year involves the issue of soft dollars, which is under study by a staff task force. Next year marks the 30th anniversary of enactment of the section 28(e) soft dollar safe harbor. Thus, 2005 is certainly an appropriate time for the Commission and its staff to engage in a full re-consideration of the use of soft dollars, the impact of soft dollars on our nation's securities markets and whether soft dollars further the interests of investors. It is also appropriate for the Commission to examine the nature of conflicts of interests that can arise from money managers' use of soft dollars to purchase research and other products and services. In addition, the Commission and its staff are concerned about the disclosure challenges presented by soft dollars and whether the disclosure currently required adequately informs investors about the use of soft dollars, and the benefits received.

In making recommendations to the Commission regarding changes that are necessary with respect to the regulation of soft dollar practices, the Soft Dollar Task Force, which is comprised of senior SEC staff members, will take into account the views of the helpful report presented last month by the NASD's Mutual Fund Task Force, which is comprised of senior industry executives of broker-dealer and mutual fund management companies as well as representatives from the academic and legal communities.

The Soft Dollar Task Force will be paying particular attention to the NASD Task Force's recommendation that the Commission consider and perhaps narrow the definition of what constitutes "research" for purposes of the section 28(e) soft dollar safe harbor. In addition, as recommended by the NASD Task Force, the staff plans to closely examine whether soft dollar disclosure can be improved: for both fund boards, on a more detailed and comprehensive basis, and fund investors. With respect to fund investors, the question remains of whether narrative or quantitative disclosure, or a combination of both, is most helpful to investor understanding of soft dollar arrangements.

B. Portfolio Transaction Costs

A related issue-and one I expect the Commission to consider in 2005-involves mutual fund portfolio transaction costs and whether there are improved disclosures that would be meaningful to investors and enhance investor understanding of these costs. Last December, the Commission issued a concept release requesting comment on measures to improve disclosure of mutual fund transaction costs. As you know, this issue poses a particular challenge for regulators because there is no single universally agreed upon approach or method for measuring transaction costs. Narrative disclosure of these costs could be complex, and quantified disclosure could be incomplete because not all types of transactions costs are easily quantified.

However, the Division staff is not deterred. If there is a way to better inform investors about the impact and actual amount of portfolio transaction costs, we want to make sure that it receives Commission consideration. Thus, our staff is carefully reviewing the comments on the concept release with a view toward making a recommendation to the Commission on enhanced portfolio transaction costs disclosure. Again, the staff also is closely examining the recommendations of the NASD's Mutual Fund Task Force in this area and in particular the transaction costs disclosure chart recommended by the Task Force. As with all of our disclosure recommendations, our goal will be to provide investors portfolio transaction cost information that is meaningful, easy to understand and relevant to their investment decision.

C. Review of Mutual Fund Disclosure Regime

This disclosure standard brings me to my next, and possibly most important item on what I believe will be the Commission's upcoming mutual fund regulatory agenda. That is a top-to-bottom, full scale review of the mutual fund disclosure regime. In the wake of the recent scandals, the Commission has adopted a number of new mutual fund disclosures in the past year. While each of these individual disclosure initiatives has been important disclosure that has generally been supported by commenters, the Commission and its staff are sensitive to investor-and industry-concerns about "information overload."

It has been over six years since the Commission adopted its mutual fund prospectus simplification reforms. In the intervening years, prospectuses have started to bulk up again-containing information that is no doubt useful, but perhaps in a format and in a level of detail that may be overwhelming for many mutual fund investors. During the same period, we have witnessed the continued acceptance of the Internet, e mail and other disclosure mediums from which to obtain information, including investment information.

In our review of the mutual fund disclosure regime, I hope that the Division can take a comprehensive approach: focusing on more than just the mutual fund prospectus and Statement of Additional Information, but all mutual fund disclosure vehicles, including annual and semi-annual reports, fund advertising, point of sale and fund confirm documentation, account statements, mutual fund websites, profile prospectuses, prospectus stickers and disclosures made available on the SEC's website-and upon request to investors.

I believe that there is a role for "layered" disclosure in the mutual fund regime. By layered, I mean getting critical, key information into the hands of investors when they are making an investment decision or reviewing a fund investment, while providing investors-and their advisors and the financial press-access to more detailed information that can flesh out some of the details for those investors who have particular areas of interest and concern.

In the case of mutual fund disclosure, the old 1990s adage that "less is more" may continue to apply. The challenge, however, lies in identifying which streamlined disclosures are most meaningful and helpful to investors-and placing those disclosures in the disclosure format and disclosure vehicle that is most appropriate. There also needs to be an assessment of the timing of delivery of various documents, like the prospectus, and consideration of the mode of "delivery" of these documents, further recognizing the increasing and widespread use of the internet as a means to make information available.

When the staff turns to this disclosure review, nothing should be off the table initially, and creative ideas will be welcomed. In addition, I am hoping that we can use much of what we have learned about investor needs and understanding from the investor focus groups for the point of sale/fund confirm initiative and use investor focus groups as we shape a recommendation for a disclosure regime for the years ahead. Finally, I am hopeful that the fund industry can be a constructive partner in SEC efforts to re-vamp the mutual fund disclosure regime. You are the ones who prepare the disclosure and, in many ways, you are closer to the end users of the disclosure-fund investors-and therefore have a good sense about the types of disclosures that are effective in communicating information to investors.

D. Mutual Fund and Investment Adviser Surveillance

In addition to getting better information about mutual funds into the hands of investors, the Commission is focused on getting better information about funds and advisers into the hands of the Commission. Chairman Donaldson has launched task forces that are examining how best to improve our oversight of funds and advisers and, in particular, what information we can use to enhance our ability to police the fund and adviser industries. In addition, the task forces are reviewing how to leverage technology in order to obtain information from funds and advisers in a way that is simple for you to provide-and useful for our staff to analyze.

These two initiatives are part of the Chairman Donaldson's broader risk-based approach to regulation and oversight. As you know, Chairman Donaldson has established an Office of Risk Assessment headed by Charles Fishkin (who by the way is from the fund industry), and in the coming months, this focus on risk review will shape a number of the Commission's initiatives.

E. Rule 12b-1

I cannot complete a discussion of the Commission's likely future regulatory priorities without mentioning rule 12b-1. When the Commission proposed its ban on directing brokerage for distribution, the Commission also requested comment regarding whether rule 12b-1 should be revised more broadly or even eliminated. The request for comment was certainly heard. To date, the Commission has received over 2,000 comment letters on the future of rule 12b-1-and they continue to come in.

In August, when the Commission adopted the directed brokerage ban under rule 12b-1, the Commission stated that it wanted to continue analyzing rule 12b-1. There is no doubt that our review is an important one. Rule 12b-1 has been on the books for over 20 years, and the industry has evolved significantly since then. The idea of using rule 12b-1 fees as a substitute for a sales load--which in many cases they have come to be--is different than the use of 12b-1 fees for advertising and marketing purposes, which was envisioned when the rule was adopted. In light of these changes in the industry and in the use of 12b-1 fees, the future of rule 12b-1 is a topic worthy of a full and thorough review.

The Commission in the release adopting the directed brokerage ban indicated that it has asked the staff to explore alternatives to rule 12b-1 addressed in the comment letters, including the alternative set forth by the Commission that would refashion rule 12b-1 to provide that mutual funds deduct distribution-related costs directly from shareholder accounts rather than from fund assets. In addition, one of the staff's ongoing concerns is that investors do not adequately understand rule 12b-1 fees, despite the disclosure that exists today. It is believed that the account-based approach to deducting distribution fees would help address this lack of understanding.

I should emphasize that the Commission requested comment on whether to propose additional changes to rule 12b-1. Thus, any significant further changes to the rule would be subject to the notice and comment process. Again, this is an area where constructive input from the industry will be extremely valuable in enabling the staff to prepare an informed recommendation to the Commission. This is another area where I look forward to the views of the NASD Mutual Fund Task Force. On this note, I should say that we greatly appreciate the efforts of Robert Glauber and Mary Schapiro and the staff of the NASD in putting together the Mutual Fund Task Force, as well as other task forces on issues like breakpoints and omnibus accounts. These task forces have been extremely helpful in enabling us to get thoughtful, expert input on a variety of challenging issues, and we look forward to the results of their future efforts.

F. CCO Outreach

In addition to consideration of potential rulemaking, I believe that the Commission's and the staff's upcoming agenda will include a number of initiatives targeted toward Chief Compliance Officer outreach. The new chief compliance officer requirement is one of the most significant mutual fund reforms that the Commission has adopted in recent years. It also is an initiative that requires effective implementation in order to have its desired effect of enhancing oversight and focusing effort and energy on compliance. In addition, I believe that an effective CCO must reach out beyond his or her own fund organization to the broader fund industry in order to understand how new rules are being implemented, what new compliance challenges are facing the industry as a whole, and how other CCOs are approaching their role.

In this regard, I believe the staff can be a helpful resource for CCOs-serving in some ways as a repository for the latest compliance-related issues and developments. I believe we can best serve CCOs-and promote their effectiveness-if we have opportunities to reach out to them and engage in a meaningful dialogue on compliance developments and other issues. I do not believe that CCOs should be working in isolation. There can be no doubt that outreach and a healthy sharing of ideas and experiences will enable CCOs to better perform their important duties on behalf of fund investors. CCOs should be our partners in keeping the industry free of major compliance lapses in the future, and we want to foster that partnership.

G. Other Issues

In addition to these principal future agenda items, there are a number of other issues that the SEC may soon have on its plate. One is the work of our College Savings Plan Task Force. Others include the nature of eligible portfolio securities for business development companies, a review of closed-end fund listing standards and final consideration of the manager-of-managers and fund-of-funds proposals. On the advisers side, there are several important initiatives to consider, including the so-called broker-dealer rule and the revisions to Part 2 of Form ADV. In addition, the Division hopes to soon implement a new regime for review of exemptive applications that will streamline the processing of those applications that are on all fours with previously granted relief. Thus, it is quite possible that 2005 may rival 2004 in terms of the number and significance of investment management initiatives considered by the Commission.

V. Conclusion

I conclude today with the following warning: Don't let down your guard. When it comes to compliance, it can be easy to become complacent. When the spotlight fades from mutual funds and re-focuses on another industry, some fund firms may be tempted to let their zeal for compliance subside. They may once again pay more attention to gathering assets by any means necessary rather than gaining investor trust. They may devote more energy to chasing easy profits rather than fostering integrity. Don't let this happen at your firm. I can assure you that our Enforcement Division stands ready to hold you accountable if these warnings are not heeded.

We have all witnessed the damage that results when the bond of investor trust is broken. Thus, you must remain vigilant and forceful in your dedication to meeting your compliance goals and your fiduciary obligations to investors-even when the spotlight has shifted elsewhere. But perhaps it is incorrect to suggest that the spotlight will be off the mutual fund industry. Since over 90 million investors today depend on the mutual fund industry for their financial well-being, the industry will likely always be on the radar screen of Congress and certainly the regulators.

So, as you gather here this week with your industry colleagues, what standards will you demand of yourself, your firms and your colleagues in the industry? The future of the mutual fund industry is in your hands. I urge you to use your best efforts, combined with your sense of integrity, to move the industry forward and restore it to a position of trust and respect.

Thank you for your attention.



Modified: 12/07/2004