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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the Investment Company Institute
2002 Securities Law Developments Conference


Paul F. Roye

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

Washington, D.C.
December, 2002

The Securities and Exchange Commission disclaims responsibility for any private publication or statement by 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.

I. Introduction

I greatly appreciate the invitation to discuss with you today some of the Commission's recent initiatives in the investment management area. However, before I begin, I must, as always, indicate that 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.

Since I last spoke to this group, the Commission has faced new challenges in adapting investment management regulation to the broad-ranging mandates of the Sarbanes-Oxley Act of 2002 and the USA Patriot Act of 2001. In responding to the aftermath of 9/11, a number of major corporate failures, a variety of market developments, and innovation in the fund industry, the Commission is in the process of shaping new regulatory initiatives having a broad impact on the fund industry. So this is a very timely and aptly named conference, since there have been a number of securities law developments that should be of interest.

You, the professionals working in this industry, also face new challenges. You are charged with advising your companies or clients on how to comply with the new regulatory requirements being implemented under these legislative mandates and new Commission regulations. In some cases, you must help your companies comply with these requirements in the face of personnel cut-backs in a difficult market environment. We recognize that your burdens are increasing and I can assure you that we want to be helpful to you in addressing your questions and concerns arising from these new requirements. That is why we welcome the opportunity to participate in conferences such as this one.

II. Recent Developments

If one were to read only the headlines of the newspapers, it is easy to get the impression that the Commission has been distracted from its mission. While, in fact, under Chairman Pitt's leadership, the Commission has experienced a remarkably productive year, launching the most aggressive reform agenda in the history of the Commission. The Commission has undertaken numerous initiatives in the areas of enforcement, corporate governance and disclosure, regulation of market participants and accounting reform. The Commission brought a record number of enforcements cases, 24% more than in FY 2001, including a record number of actions for financial reporting and issuer disclosure violations. The Commission has called for accelerated filings of periodic reports of operating companies, timely disclosure of insider transactions and required CEO/CFO certifications of companies' quarterly and annual reports. The Commission has also launched investigations into the implications of hedge fund growth and held hearings on the performance of rating agencies and market structure issues.

To stem declining investor confidence in our markets that resulted from the spate of recent corporate scandals, the Commission has made more useful, reliable and understandable disclosures a priority, and the Commission has undertaken a number of initiatives to further this goal in the investment management area. These include proposed rules regarding mutual fund and investment adviser proxy voting disclosure, proposed amendments to the mutual fund advertising rules, the launch of the Investment Adviser Public Disclosure Website, whereby disciplinary and other information regarding advisers is readily accessible over the Internet, and the adoption of a new registration form for variable life insurance policies.

Chairman Pitt has also stressed the need to update and modernize our rules. To further this objective, the Commission proposed amendments to the custody rules for investment companies and investment advisers, expanded the scope of the fund merger rule, proposed amendments to allow certain affiliated transactions consistent with investor protection and proposed a rule permitting Internet investment advisers to register with the Commission. As part of its continuing efforts to further innovation within the fund industry, the Commission also issued a concept release on actively-managed exchange traded funds, approved the first exchange-traded funds based on fixed-income indices and declared effective the registration of an all-electronic variable annuity product. A few weeks ago, the Commission issued a proposed rule to exempt research and development companies from the provisions of the Investment Company Act, recognizing that the Commission's traditional approach of analyzing investment company status issues needed re-thinking in the new millennium.

I thought it would be useful for you this morning if I examined some of the recent significant actions of the Commission affecting the mutual fund industry.

III. Statutory Mandates

As I mentioned earlier, driving many of the Commission's recent actions are two pieces of sweeping legislation in response to the events of September 11, and the rash of corporate frauds and failures occurring earlier this year. These statutes, the USA PATRIOT Act of 2001 and the Sarbanes-Oxley Act of 2002, together mandate far-reaching reforms in the regulation of our financial markets. The Commission has been devoting substantial time and attention to fulfilling these mandates under tight implementing deadlines imposed by each Act.


The Patriot Act is aimed at preventing, detecting and prosecuting international money laundering and terrorist financing activity. The Act's requirements generally apply to all financial institutions, including investment companies. The Treasury Department, with the assistance of the Commission and other federal financial regulators, has adopted, and proposed for adoption, rules designed to adapt the anti-money laundering program requirements of the Bank Secrecy Act to particular financial institutions. Mutual funds have been a major focus of these rules, in part because mutual fund assets represent such a large percentage of assets held by all financial institutions. One of our principal roles has been to assist Treasury staff in understanding the fund industry and fashioning an anti-money laundering framework consistent with the requirements of Congress' mandate, while recognizing the unique characteristics of the fund industry.

In April of this year, Treasury, through its Financial Crimes Enforcement Network or FinLEN, issued an interim final rule requiring mutual funds to develop and implement anti-money laundering programs reasonably designed to prevent funds from being used to launder money or finance terrorist activities. We also worked closely with Treasury on their rule proposal issued on September 26, 2002, that would require certain unregistered investment companies, commodity pools and REITS to develop and implement anti-money laundering programs.

The Commission also proposed in a joint rule-making with the Treasury Department to require mutual funds to adopt procedures to verify the identities of their customers and to keep records related to their customer identification programs, along with a parallel proposal that would cover broker-dealers, to curb money laundering activity. Several weeks ago, the Commission approved a joint report to Congress with the Treasury and the Federal Reserve Board recommending effective regulations to apply the anti-money laundering requirements of the Bank Secrecy Act to various types of investment companies.

We expect that more rulemaking implementing the Patriot Act will be forthcoming in the weeks ahead.

B. The Sarbanes-Oxley Act

With the enactment of Sarbanes-Oxley, President Bush and the Congress set the tone for broad, swift reform designed to restore investor confidence in our markets through sweeping corporate disclosure and financial reporting initiatives. Among other things, the Act creates a new oversight board for the accounting profession, mandates new measures intended to promote auditor independence, adds new disclosure requirements for public companies, and strengthens the criminal penalties for securities fraud.

Section 302 of the Sarbanes-Oxley Act also imposes certain certification requirements to enhance the direct responsibility of senior corporate management for financial reporting and for the quality of financial disclosures made by public companies, including investment companies. This past August, the Commission adopted rules under Section 302 to implement the certification requirement for registered investment companies. Rule 30a-2 requires the principal executive and financial officers of a registered investment company that files periodic reports under the Securities Exchange Act to certify the company's semi-annual reports on Form N-SAR, as well as the financial statements on which the financial information in Form N-SAR is based.

The Commission also has pending a proposed rule designed to better implement the intent of Section 302 of Sarbanes-Oxley by requiring registered management investment companies to certify the shareholder reports that they file with the Commission. This certification would be made on proposed new Form N-CSR. The Commission also proposed a rule that would require every registered investment company to maintain disclosure controls and procedures designed to ensure that the information required in disclosure documents is recorded, processed, summarized, and reported on a timely basis. We are currently reviewing the comments on these proposals, including the issue of whether certification should be required for both Forms N-SAR and N-CSR. Most commenters opposed certification of both forms and noted that Form N-SAR, does not contain financial statements, is not designed for investors, and contains little, if any, information directly relevant to investment decision-making by investors.

There are a number of other issues under Sarbanes-Oxley that will have an impact on investment companies. On October 16, the Commission proposed new rules that would require registered management investment companies to disclose whether the companies, their investment advisers and principal underwriters have each adopted a code of ethics for their senior executive and financial officers. The rules would not require companies to adopt codes of ethics, but only to disclose whether they have such codes. We recognize that under Rule 17j-1 of the Investment Company Act, funds are already required to have codes of ethics designed to deter conflicts of interest by advisory personnel when they buy or sell securities for their own accounts. However, the proposed new disclosure requirements are designed to address a broader range of ethical conduct issues including: the handling of conflicts of interest between personal and professional relationships; full, fair, and accurate filings with the Commission; and compliance with applicable laws and regulations. Indeed, many codes of ethics of funds and advisers already go beyond the requirements of Rule 17j-1, and funds may wish to integrate any codes of ethics that would be adopted in connection with the Sarbanes-Oxley requirements together with the pre-existing codes of ethics that they have under Rule 17j-1.

The Commission also proposed rules that would require a management investment company to disclose whether its audit committee includes at least one member who is a "financial expert." Specifically, proposed Form N-CSR would require a registered management investment company to disclose annually: (i) the number of financial experts serving on the investment company's audit committee; (ii) the names of the financial experts; (iii) whether the financial expert or experts are independent; and (iv) if the investment company does not have a financial expert serving on its audit committee, the fact that there is no financial expert and an explanation of why it has no financial expert.

The proposal defines "financial expert" to include individuals with certain attributes specified in the statute, and includes a number of factors that a board of directors must consider when determining whether an individual has all of the required attributes. The Commission specifically asked for comment on whether this definition should be modified in any way in the case of investment companies.

The Commission also proposed rules under Sarbanes-Oxley that would prohibit officers and directors of an issuer, and anyone acting under their direction, from taking action to fraudulently influence the auditor of an issuer's financial statements. The proposed rules would cover officers and directors of investment companies, as well as those of other entities, such as advisers, that may be in a position to fraudulently influence an auditor of an investment company.

The Commission several weeks ago proposed a rule that would require auditors of funds to maintain work papers and certain other documents relevant to their audits and review of financial statements, require disclosure to investors of information and fees related to audit and non-audit services performed by auditors, require the reporting of certain matters to a fund's audit committee, including critical accounting policies, require partner rotation, and establish conditions under which auditing firms would not be considered independent for purposes of performing audits of public company financial statements.

The scope of various of these requirements, such as the partner rotation requirement and approval of non-audit services, recognizes the external management of funds and would cover an investment company complex, consisting of the investment adviser, other services providers and sister funds.

C. The Attorney Conduct Rule

Of particular interest to this audience should be the rule proposals under Sarbanes-Oxley that set forth minimum standards of conduct for attorneys appearing and practicing before the Commission in their representation of issuers. In the proposing release, the Commission noted that attorneys play a varied and crucial role in the Commission's processes. The materials that attorneys prepare that are filed with the Commission on behalf of issuers are relied upon by the public in making investment decisions and therefore "the Commission and the investing public must be able to rely on the integrity of in-house and retained lawyers who represent issuers."

The actions of some attorneys in the recent corporate debacles have brought increased scrutiny on the legal profession. Indeed, the preliminary report of the ABA's Task Force on Corporate Accountability (also known as the "Cheek Report") this past July concluded that "the system of corporate governance at many public companies has failed dramatically." This very thoughtful Report also acknowledged that attorneys representing and advising corporate clients "bear some share of the blame for this failure." Apparently concluding that these issues were sufficiently serious that they should not be left to the legal profession alone to resolve, Congress enacted Section 307 of the Sarbanes-Oxley Act.

Section 307 of the Sarbanes-Oxley Act provides that the Commission should adopt a rule requiring an attorney to report "evidence of a material violation of securities laws or breach of fiduciary duty or similar violation by the company or any agent thereof" to the chief legal counsel or the chief executive officer of the company (or the equivalent); and, if they do not respond appropriately to the evidence, then the attorney must report the evidence to the audit committee, another committee of independent directors, or the full board of directors.

The rule proposed by the Commission responds to Congress' mandate that the Commission adopt an effective "up the ladder" reporting system, recognizing that attorneys interact with the Commission on behalf of issuer clients in a number of ways and protects investors by reaching attorney conduct that may threaten the Commission's processes and harm investors. At the same time, the proposed rule does not attempt to articulate a comprehensive set of standards regulating all aspects of the conduct of attorneys who appear and practice before the Commission. The Commission indicated that it does not intend to supplant state ethics laws unnecessarily, particularly in areas where the Commission lacks expertise.

We will be very interested in your comments on this proposal, and in particular, how the rule will apply to lawyers representing clients in the investment management area.

In each of the Sarbanes-Oxley rule proposals, the Commission has endeavored to apply the statutory requirements in a manner that carries forth the intent of Congress in enacting these provisions. In some cases the requirements go beyond application to funds as "issuers" and extend the requirements to a fund's investment adviser, underwriter or their officers and directors. Given the external nature of typical fund management, the Commission determined that extending the reach of certain of the provisions in this manner was necessary to implement Congressional intent. We look forward to reviewing your comments on these pending rule proposals.

IV. Other Division Initiatives

Beyond our statutory mandates, Chairman Pitt has made more useful, understandable and accessible disclosures to investors a priority within the Commission, and we have engaged in a number of initiatives to further this objective.

A. Advertising

In May, the Commission proposed amendments to improve mutual fund advertising disclosure. Prompted by the Commission's concerns that performance advertising could create unrealistic expectations by investors, the amendments are intended to convey more balanced information to prospective investors, particularly with regard to past performance, to ensure that investors are informed and not misled.

The proposed amendments would require funds that advertise to make available to investors a toll-free or collect telephone number (and if available, a website) where they may obtain the most recent month-end performance information for the fund's 1-, 5- and 10- year periods, thereby giving investors access to the most current performance information available. The proposed amendments also reemphasize that fund advertisements are subject to the antifraud provisions of the federal securities laws, and would increase funds' flexibility in advertising, by eliminating the requirement that advertisements contain only information the substance of which is included in the prospectus.

We are actively working towards making a recommendation to the Commission for final adoption of these rule amendments.

B. Variable Products Registration Statements

The Commission also has taken steps to improve and simplify disclosure in the insurance products area. In April, 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. The Commission recently adopted revisions to Form N-4 to conform the treatment of underlying fund expenses in a variable annuity prospectus with the format used in Form N-6. The new format will require disclosure of the range of expenses for all of the mutual funds offered through the separate account, rather than disclosure of the expenses of each fund. This will simplify the fee table for variable annuities and variable life insurance contracts. However, investors in these products will continue to have access to information about underlying fund fees in the fund prospectuses. It will now be up to the variable products segment of the industry to embrace the requirements of those forms to draft useful and understandable disclosure for their investors.

C. Disclosure of Proxy Votes and Policies

I now would like to turn to an important Commission initiative aimed at increasing transparency in the investment management industry and encouraging adherence to fiduciary principles, two elements fundamental to investor confidence. In late September, in response to multiple rule-making petitions, the Commission proposed rules requiring mutual funds to disclose to investors their proxy votes, and the policies and procedures they use in voting proxies. The proposal is designed to enable fund shareholders to monitor their funds' involvement in the governance activities of portfolio companies.

Under the proposal, a fund would disclose its proxy voting policies and procedures in its registration statement, including the procedures it uses when a vote presents a conflict between shareholders' interests and those of the fund's investment adviser, principal underwriter, or its affiliates. Funds' proxy voting records would be filed with the Commission and would indicate whether a matter on which a fund was entitled to vote was proposed by the issuer, or a security holder, whether and how the fund voted, and whether its vote was for or against management. If a fund makes a vote that is inconsistent with its policies, this fact would need to be disclosed in shareholder reports. Information on how shareholders may obtain a fund's voting information - through a toll-free number, on its website, or the Commission's website - would also need to be disclosed.

The proposal would also cover investment advisers who would be required to have written policies and procedures governing how they vote their clients' securities. The policies and procedures would need to be designed to ensure that the adviser votes proxies in its clients' best interests and they must address material conflicts of interest between the adviser and its clients. Advisers would also be required to describe their voting policies to clients, provide a copy of them when requested, and inform clients how to obtain information from the adviser on how it voted their proxies. The proposal also requires advisers to keep records of their proxy votes.

As the Commission noted in the proposal, shedding light on fund proxy voting could illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders' best interests. The comment period for the proposed rules closed on December 6th and we received approximately 7,500 letters on the proposals, the most letters the Commission has received on any investment company rule proposal in recent memory, indeed more than the comments the Commission received on the Regulation FD proposal.

D. Portfolio Holdings Disclosure and Shareholder Report Reform

In addition to disclosure of proxy votes, the rule-making petitions in this area also included a request for more frequent disclosure of the portfolio securities holdings of funds. In response to this request, the Commission will consider on Wednesday the Division's recommendation on this issue. In conjunction with this effort, we also will be submitting recommendations to the Commission to improve the format of reports to fund shareholders. The Commission will consider proposals that would (1) require a registered management investment company to file a schedule of its complete portfolio holdings with the Commission on a quarterly basis; (2) permit a registered management investment company to include a summary portfolio schedule in reports to shareholders and exempt money market funds from including a portfolio schedule in reports to shareholders, provided that the complete portfolio schedule is filed with the Commission and available to shareholders upon request; (3) require a registered management investment company to include a tabular or graphic presentation of a fund's portfolio holdings in its reports to shareholders; (4) require a mutual fund to disclose in its reports to shareholders fund expenses borne by shareholders during the reporting period; and (5) require a mutual fund to include Management's Discussion of Fund Performance in its annual report to shareholders.

While I can't predict how the Commission will react to these proposals, they like the proxy voting proposal, raise the fundamental question of what should transparency mean in the mutual fund context. As owners of a fund, what information should an investor be entitled to? Our hope is that these proposals will engender a public dialogue on this question and approaches to improving communication of important information to investors regarding their funds.

V. Delayed Exchange Policy To Combat Market Timers

We understand that market timing activity continues to present problems for the efficient management of portfolios. Mutual funds have engaged in a number of methods to deter market timers such as imposing redemption fees, limiting frequent trades and conditioning exchange privileges. The Investment Company Institute recently requested that the staff concur with the ICI's view that a fund may, consistent with Section 11(a) of the 1940 Act, offer its shareholders the opportunity to exchange their shares for the shares of another fund on a specified delayed basis. In other words, the exchange would be executed at a specified time after the day that the fund receives a shareholder's exchange order.

We responded to the ICI confirming the staff's view that a registered open-end investment company may, consistent with Section 11(a), make an exchange offer on a specified delayed basis, so long as the offer is fully and clearly disclosed in the fund's prospectus. Hopefully, delayed exchanges will prove to be a helpful tool in efforts to curb the disruptions that may result from market timing activity.

VI. Conclusion

Mutual funds are the primary vehicles that connect millions of Americans to the securities markets. Fortunately for all of us, they are not filling the headlines involving corporate scandals. But they are an important element in the Commission's efforts to restore confidence in our markets. In the Division of Investment Management, we are as busy as we have ever been, focusing on Commission directed initiatives to respond to the needs of fund investors to ensure that investors invested in mutual funds and other investment companies, have access to full and reliable information on which to base their investment decisions, and that the regulatory framework affords appropriate flexibility to facilitate and not stifle innovation consistent with investor protection.

With your help, input and support, we can maintain the confidence that investors have in the mutual fund industry.

Thank you.



Modified: 12/11/2002