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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Recent Regulatory Developments Under the Investment Company Act

Remarks by

Paul Roye

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

Practicing Law Institute – The ‘40 Act Institute
New York City

May 15, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Thank you and good morning. It's a pleasure to be here with all of you today. It is difficult to overstate the importance of the fund industry to our securities markets and to the financial futures of millions of investors. As everyone in this audience is well aware, we are in the midst of an extraordinary period in the mutual fund industry. By any measure, the fund industry has enjoyed tremendous success in the last several decades. The fund industry has become the principal trustee of the nation's savings, with 83 million investors having invested their hard earned dollars in mutual funds. Over half of all American households own mutual fund shares. Open and closed-end funds today own nearly 17% of the value of all equity securities trading in the United States -- more than any other type of institutional investor. Clearly the growth of the industry to almost $7 trillion has not only been beneficial for the mutual fund industry, it also has been beneficial for the U.S. economy and fund investors.

The financial services industry is in the midst of a technological revolution and mutual funds are at the forefront. The Commission faces the formidable challenge of applying the existing regulatory framework that has helped ensure the integrity of the industry, while at the same time providing a regulatory scheme to keep pace with the increased competition and technological revolution underway in the securities markets. My intention this morning is to discuss the regulatory reforms currently proposed by the Commission, as well as a number of recently adopted rules, and to identify other areas of reform that we intend to carefully examine in the future. The regulatory initiatives currently before us today are aimed at promoting the integrity of fund governance, enhancing disclosures made to investors, and modernizing the regulatory structure to accommodate the increased competitiveness and globalization of the fund industry.

I. Fund Governance

One of the most significant initiatives we have undertaken is in the area of fund governance. Last year at this conference, which followed the Commission's Roundtable on the Role of Independent Investment Company Directors, I spoke about our preliminary findings and the possible avenues for reform. Since then, the Commission has issued a comprehensive proposal of fund governance reforms and a staff interpretive release providing guidance on specific issues relating to independent directors.

The rule proposal is designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with better information to assess the independence of directors. The proposal would amend certain exemptive rules under the Investment Company Act by adding a number of conditions to the exemptive rules that any fund must meet to rely on the rules. These conditions are: (1) independent directors must constitute at least a majority of their board of directors; (2) independent directors must select and nominate other independent directors; and (3) any legal counsel for the independent directors must be an independent legal counsel. We also have proposed rules that would prevent qualified individuals from being unnecessarily disqualified from serving as independent directors, protect independent directors from the costs of legal disputes with fund management, and monitor the independence of directors by requiring funds to keep records of their assessment of director independence.

We also have proposed a number of disclosure requirements that will enhance shareholders' ability to evaluate whether the independent directors can act as an independent, vigorous, and effective force in overseeing fund operations. These proposals would require funds to provide basic information about directors to shareholders annually so that shareholders will know the identity and experience of all directors. They also would require disclosure of directors' ownership of fund shares, information about director's potential conflicts of interest, and would provide information to shareholders on the board's role in governing the fund. By requiring funds to provide this information, the proposals will give shareholders the tools to determine how effectively the directors serve their interests.

We have received many thoughtful comments on this initiative that will enable us to improve upon the proposed rules. Many commenters felt that the disclosure requirements, especially as they related to directors' family members, went too far. It is likely that our recommendation to the Commission will be to scale back the proposed disclosures in several areas, particularly with regard to family members. Many commenters also believed that the proposal regarding independent counsel for directors was too paternalistic or that our definition of independent counsel was too rigid. However, we believe that encouraging the use of truly independent counsel by independent directors is one of the strongest pieces of our proposal. We are encouraged by the formation of the American Bar Association Task force to provide guidance to independent directors of funds regarding choosing and retaining legal counsel, as well as to provide guidance regarding counsel's professional responsibilities when representing independent directors. Their recommendations should be helpful as we continue in the process of refining the proposed amendments.

The interpretive release that accompanied the rule proposal also is designed to enhance the effectiveness of independent directors. Some persons have questioned whether fund directors have the authority to participate in a proxy fight with a fund's adviser. On a broader level, some have questioned whether fund directors who take an action on behalf of the fund that somehow also benefits the directors may be engaging in a prohibited "joint transaction" under the Investment Company Act. The staff interpretation clarifies that actions taken by fund directors that are within the scope of their duties as directors, do not constitute prohibited "joint transactions." The staff interpretation also addresses when a fund may pay an advance of legal fees to its directors in light of the Investment Company Act's limits on indemnification of legal fees. The staff also has provided guidance concerning when and how mutual funds may compensate directors with fund shares. We believe that the relationship between fund shareholders and fund directors can be strengthened when their financial interests are aligned, i.e., when fund directors own shares in the funds on whose boards they serve.

II. Disclosure Initiatives

In addition to the protections that will be afforded to shareholders as a result of the independent director proposals, the Commission has issued a number of rule proposals, and is considering a number of other proposals, that further our continuing effort to improve the quality of mutual fund disclosure in order to help investors make better-informed decisions.

In March, the Commission issued a rule proposal to improve disclosure to investors of the effect of taxes on the performance of mutual funds. Taxes are one of the largest costs associated with a mutual fund investment. Estimates show that over two and a half percentage points of the average stock fund's total return is lost each year to taxes, an amount significantly in excess of average expense ratios for these funds. Our proposal will help investors to understand the magnitude of tax costs and compare the impact of taxes on the performance of different funds. The proposed amendments would require mutual funds to disclose after-tax returns for 1-, 5-, and 10- year periods, based on standardized formulas comparable to the formula currently used to calculate before-tax average annual total returns. The after-tax returns would be required to be disclosed in the risk/return summary of the prospectus and in Management's Discussion of Fund Performance, which is typically contained in the annual report. The proposal also would require funds that include after-tax returns in advertisements and other sales materials to include standardized after-tax returns in those materials.

The proposal would require funds to disclose after-tax returns on both a "pre-liquidation" and "post-liquidation basis. Pre-liquidation after-tax return assumes that the investor continues to hold fund shares at the end of the measurement period. Post-liquidation after-tax return assumes that the investor sells his or her fund shares at the end of the measurement period. Thus, pre-liquidation after-tax return reflects the tax effects on shareholders of the portfolio manager's purchases and sales of portfolio securities, while post liquidation after-tax return also reflects the tax effects of a shareholders' individual decision to sell fund shares. We believe both measures are important for shareholders to gain a better understanding of the tax consequences of investing in mutual funds. Pre-liquidation after-tax return is important because it provides information about the tax-efficiency of portfolio management decisions. Post-liquidation return also is important for shareholders, many of whom hold shares for a relatively brief period, to understand the full impact that taxes have on a mutual fund investment that has been sold. The comment period on the proposal ends June 30.

The Commission also has proposed amendments that would permit funds to "household" proxy and information statements. The proposed amendments would allow funds to satisfy the proxy and information statement delivery requirements of the Securities and Exchange Act of 1934, by sending or forwarding a single proxy or information statement to two or more shareholders sharing the same address. The proposed amendments are designed not only to save trees, and reduce costs to fund shareholders, but to deliver information to investors in quantities that are manageable and more likely to be actually read. The proposal also would allow, for the first time, intermediaries to household proxy and information statements as well as annual reports, to beneficial shareholders. In a companion release, that was issued on the same day as the proposal, the Commission adopted similar amendments to the proxy rules that govern the delivery of prospectuses and annual reports to shareholders, and to the rules under the Investment Company Act that govern the delivery of semiannual reports to investment company investors. Under the amendments, the rules no longer require companies to get written consent from shareholders for the householding of prospectuses, annual reports and semiannual reports provided the document is delivered to members of the same family with the same last name sharing a common address, the shareholders receive advance notice, and they do not object to householding.

We also are exploring ways to eliminate the need for funds to annually deliver updated prospectuses to existing shareholders. Most funds deliver updated prospectuses to existing shareholders annually in order to avoid having to keep records of shareholders who have received updated prospectuses and deliver prospectuses throughout the entire year when new investments are made by these shareholders. In addition, we also are examining whether the profile could serve the purpose of an annual updating document. In other words, funds would be deemed to have delivered a current prospectus to existing shareholders if they deliver to them the profile. This could be a more effective way of communicating updated information to shareholders than delivering an entire new statutory prospectus. Of course, any fund shareholder wanting the full prospectus could request one from the fund. Such as approach could result in significant savings to funds and their shareholders.

In our continuing efforts to improve disclosures to shareholders, we also are working on revisions to the shareholder report and financial statement requirements. Our goal is to make the prospectus and the shareholder reports work together to provide information that investors need, when they need it, and in a format that is useful. In a shareholder report, fund management can tell the story of what it has done for shareholders. Our goal will be to facilitate getting that information from management to the fund's shareholders.

We also will continue our efforts to simplify and streamline mutual fund prospectuses, as we expect to proceed with further amendments to Form N-1A to address issues that we have identified in working with the new form over the last year.

III. Industry Competitiveness

In addition to enhancing disclosures to shareholders, the Commission also is faced with the regulatory challenges of industry competitiveness, brought about by rapid technological advances and consolidation of the financial services industry. As funds face increased competition, one fear we have is that funds will respond to the competitive environment with overly aggressive advertising. A recent example of this can be seen in the Commission's administrative proceedings last week against The Dreyfus Corporation and a portfolio manager for one of its funds. The Commission settled with Dreyfus and its portfolio manager on charges that Dreyfus failed to disclose its practice of preferentially allocating IPOs, and in particular hot IPOs, to one fund over other funds managed by the same portfolio manager. The fund's prospectus disclosed that investment opportunities would be allocated equitably among the funds. The fund that received preferential treatment had exceptional returns during its first fiscal year in large part because of the investments in IPOs. The Commission also found that the fund's failure to disclose in its advertisements the large impact of the IPOs on its performance, when it was questionable whether the fund could replicate that performance, made the advertisements materially false and misleading. This latest action continues to reflect the Commission's increasing concerns regarding fund advertising in the wake of the Van Kampen case this past year, in which the Commission instituted similar charges against Van Kampen for failure to disclose that a fund's high performance was generated by investing in hot IPOs.

This is an area of particular concern to Chairman Levitt. He has asked the Division of Investment Management and our Office of Compliance, Inspections and Examinations to conduct a special review of fund marketing including websites, sales literature and advertisements. The purpose of the review is to determine whether a fund's actual portfolio performance and investment strategies are consistent with its website statements, its advertising and its prospectus disclosure.

Nevertheless, we are proceeding with amendments to Rule 482, to enhance funds' ability to provide investors with better and more timely information. The proposal would eliminate the requirement that the substance of the information contained in the advertisement be included in the statutory prospectus. The Rule 482 revisions also will serve as an occasion to remind issuers that technical compliance with the rule may nevertheless run afoul of antifraud prohibitions of the federal securities laws. We will seek to promote in the rule, balance and responsibility in fund advertising. We have indicated however that we will not tolerate the misuse of performance information to mislead investors, and our recent enforcement actions and the penalties associated therewith, most notably the $1 million penalty in the Dreyfus case ($2 million to settle with the New York Attorney General) demonstrates that we are indeed serious about this issue.

The industry has responded to competitive pressures and rapid technological changes by creating and marketing new types of funds. We need to ensure that the rush to develop attractive products does not come at the expense of products and services that offer investors real financial benefits and value. An area that presents a unique regulatory challenge is the evolution of exchange-traded funds. Assets in exchange traded funds listed on the American Stock Exchange, where almost all of these funds are traded, have risen from $2.4 billion three years ago to over $38 billion. These funds, with names like SPDRs, WEBs, Diamonds, and Cubes, have obtained exemptive relief from the Commission to facilitate secondary market trading in their shares. They are bought and sold throughout the day and are priced continuously, rather than once a day at 4 p.m., which is the pattern for conventional funds. Unlike mutual funds, they can be sold short. Their expense ratios are a fraction of those charged by an actively managed mutual fund.

There are many issues to consider as these products evolve. For example, we must consider whether the development of these products would encourage investors to view mutual funds as something other than long-term investments and encourage short-term trading of mutual funds. So far, relief has been extended only to index funds but not to managed funds. Is there even a framework pursuant to which a managed exchange traded fund can work? And what impact, if any, would an exchange traded class of a managed fund have on an existing non-exchange traded class?

We also have begun to examine the status under the Investment Company Act of a variety of Internet Holding Companies or Internet "Incubator" Companies. The challenge before us is applying the traditional "tests" for whether an entity is engaged primarily in a business other than that of an investment company, in new and different factual circumstances involving internet companies.

The Commission recently issued an interpretive release in an effort to clarify the application of the federal securities laws to electronic media. The increased use of the Internet by issuers as a means of widespread information dissemination has resulted in uncertainty about the application of the federal securities laws to these communications. The release builds on previous Commission interpretations and seeks to remove interpretively some of the barriers to the use of electronic media, while preserving important investor protections. The release provides guidance on the use of electronic media to deliver documents under the federal securities laws, addresses an issuer's liability for website content and hyperlinks and outlines basic legal principles that issuers and market intermediaries should consider in conducting online offerings. We recognize, however, that continuing guidance will be necessary in this area as use of electronic media continues to evolve.

Competition in the mutual fund industry also is being fueled by a wave of consolidation so as to provide "one-stop shopping." The recent passage of the Gramm-Leach-Bliley legislation is likely to heighten the industry's need to consolidate. The Commission recently issued a release proposing Regulation S-P, which would implement provisions of the legislation regarding the privacy of personal financial information. The legislation limits the instances in which a financial institution may disclose nonpublic personal information about a consumer to nonaffiliated third parties, and requires the institution to disclose to all of its customers its privacy polices and practices with respect to information sharing with both affiliated and nonaffiliated third parties. The legislation also requires the Commission and other federal financial regulatory agencies to establish appropriate standards for financial institutions subject to their jurisdiction to safeguard customer information and records. The proposed rules would require brokers, dealers, investment companies, and registered investment advisers to disclose to individuals their policies concerning the protection of personal information and how individuals can opt out of the transmission of personal information to unaffiliated persons. They also would require these entities to establish procedures reasonably designed to protect the security, confidentiality, and integrity of customer records and information. The release adopting the rules should be issued in the next few days.

We recognize the competitive pressures facing funds and are considering proposing rules that would facilitate funds in their efforts to proceed with certain transactions without the need for an exemptive order. For example, we intend to propose amendments that would expand Rule 17a-8, which involves fund mergers. Any rule in this area would place heavy emphasis on the fund's board to assure the fairness and appropriateness of the transaction. We also are planning on proposing amendments to Rule 10f-3, which allows a fund to buy securities from an affiliated underwriting or selling syndicate. The proposal would permit funds to buy government securities issued by government agencies or government sponsored enterprises such as Fannie Mae. The rule has not permitted purchases of these types of securities, because they typically have not been offered through syndicates. The amendment would respond to the fact that some government sponsored enterprises have begun to issue their securities through syndicates.

IV. Industry Globalization

We also have been working on a number of rules that will help funds keep pace with, and be responsive, to the increasing globalization of the mutual fund industry. The Commission recently adopted amendments to Rule 17f-5 and a new rule 17f-7, which establish new standards governing the maintenance of a fund's assets with a foreign securities depository. The rule and rule amendments together will permit funds to maintain their assets in foreign securities depositories based on conditions that reflect the operations and role of these depositories. They generally require that a fund's contract with its global custodian obligate the custodian to analyze and monitor the custody risks of using a depository, and provide information about the risks to the fund or its adviser, as well as any information regarding material changes in the risks.

The Commission is likely to adopt a rule later this week that would permit Canadians who reside in the United States and hold certain tax-deferred retirement accounts in Canada, to manage the investments by purchasing and selling foreign securities in those accounts. These Canadian "snowbirds" have recently found they cannot buy and sell securities for these accounts because the Canadian mutual funds or other securities in which they would like to invest are not registered in the United States. As a result, they are unable to reallocate assets in their accounts as they approach retirement or their financial needs change. The new rule would permit Canadian funds to offer and sell their securities to U.S. participants without having to register as investment companies under the Act.

V. Insurance Products

Heightened competition in the area of insurance products has caused insurance companies that sell variable annuities to distinguish themselves from their competitors through bonus programs. In these programs, a contract owner receives an immediate credit equal to a percentage of purchase payments. We are concerned by the fact that bonus credits are often coupled with higher CDSLs, longer CDSL periods, and higher asset based charges all of which can make a bonus more apparent than real. For that reason, we have been focusing on the suitability of bonus transactions through the Commissions' own inspections program, to pay increased attention to disclosure regarding the benefits of these programs, and to undertake investor outreach to heighten awareness of the trade-offs between bonus credits and product fees and charges. To this end, we are working on an investor brochure that will describe variable annuities and their fees and charges in an easily understandable manner. The brochure also will caution investors that bonus programs may have higher expenses that can outweigh the benefit of the bonus credit offered.

We recently approved the terms of an order under Section 11(a) of the Investment Company Act, which generally prohibits a fund from making an exchange offer on any basis other than net asset value, that allows an insurance company to offer to their current variable annuity contract owners new variable annuities in exchange for the contracts they currently hold. The new products would add a 2% bonus to the amounts transferred to the new contracts, and the new contracts would be subject to a new CDSC Schedule. The exemptive relief allows the insurance company to compete with other insurance companies that are soliciting its annuity contract owners to switch to their competitors' product by paying a bonus. The competitors are not subject to the Section 11 prohibition under the Division's 1994 Alexander Hamilton no-action position, which says that Section 11 generally does not apply to exchanges between unaffiliated companies.

We are also continuing to work constructively with the industry on our efforts to improve disclosure for variable products. These efforts are part of the Commission's broader initiative to bring sweeping revisions to prospectus disclosure for all public companies to make all prospectuses simpler, clearer, and more useful. Toward that goal, the Commission has proposed Form N-6 to improve disclosure to variable life insurance investors by developing, for the first time, a disclosure form specifically tailored for variable life insurance. We have reviewed the comments on the proposal, and are considering certain revisions to the form as originally proposed in response to those comments. We are working diligently to finalize the adopting release so that variable life registrants will be able to file under the new Form the next time they update their registration statements. We believe the new Form will further our goal of providing clear, understandable disclosure to investors about fees and expenses in these products.

VI. Interpretive Guidance

Late last year the Chief Counsel's office issued two important letters providing interpretive guidance in the areas of fair value pricing and affiliated transactions.

In a letter to the Investment Company Institute the Division expressed its views on fair value pricing. The letter clarifies that market quotations for portfolio securities are not readily available, when the exchanges or markets on which those securities trade do not open for trading for the entire day. On those days, the fund must price those securities based on their fair value. The letter also provides guidance regarding the process of fair value pricing, and describes certain factors that funds should consider when fair value pricing portfolio securities. It also discusses the obligations of fund boards of directors for fair value pricing of securities, and discusses measures that boards may take when discharging those responsibilities.

The staff issued a no-action letter under Section 17(a) of the Investment Company Act to permit a mutual fund to satisfy a redemption request from an affiliated person by means of an in-kind distribution of portfolio securities. The letter clarifies the staff's position that while cash redemptions to affiliated shareholders do not trigger Section 17(a) of the Act, that section governs redemptions in kind to affiliated shareholders. The staff recognized that there are benefits to redemptions in kind, and that redemptions in kind to affiliated persons can be effected fairly without implicating the concerns underlying Section 17(a) under certain circumstances. As a result, the staff stated that it would not recommend enforcement action to the Commission if a fund satisfies a redemption request from an affiliated person by means of an in-kind distribution of portfolio securities, provided certain conditions are met. Several of the conditions focus on the role of the board of directors, and specify that the board, including a majority of the fund's independent directors, must approve the redemptions upon making various findings. We expect that the letter will significantly reduce the need for funds to seek exemptive relief for such transactions.

VII. Modernization of Investment Advisers Act

While this conference is the '40 Act Institute, focusing on Investment Company Act issues, I did want to mention the other '40 Act, the Investment Advisers Act. We are currently engaged in revising our regulatory approach on many issues under the Advisers Act, in a comprehensive effort to modernize our regulations to respond to changes affecting the investment advisory industry. We have several pending rule proposals that reflect this effort and other ideas that will generate rule proposals in the near future. Many of you may be aware that the Commission is hosting a roundtable on May 23rd for the purpose of eliciting opinions and exploring a wide variety of perspectives regarding key issues under the Advisers Act. We have taken a significant step to modernize the adviser regulatory regime in proposing the Investment Adviser Registration Depository, an electronic filing system for investment advisers, representing the first major update of the form since Uniform Form ADV was adopted in 1985. We have a rule proposal pending that addresses the circumstances under which broker-dealers would not be subject to regulation under the Advisers Act and a rule to address pay-to-pay practices in connection with the management of public pension plans. We are examining the modernization of the rules governing advertising by investment advisers, and exploring updating the books and records rule and the custody rule under the Advisers Act. We will examine these and other issues as we seek to modernize and improve the investment adviser regulatory regime.

VIII. Conclusion

I've discussed what I believe are the Commission's and Division's major regulatory priorities for the year ahead in the investment management area. I believe strongly that the Commission must respond to the changes in technology and the markets in order to permit the fund industry to evolve and compete. The Division of Investment Management is working diligently to modernize the regulatory structure governing funds and advisers in preparation for the challenges that lie ahead. As we move forward on these important proposals, we look forward to your input and ideas.

Thank you.