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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Compliance Professionals: The First Line of Defense

Remarks by

Cynthia M. Fornelli

Senior Advisor to the Director
Division of Investment Management
U.S. Securities & Exchange Commission

2000 Mutual Fund Training Conference
Sponsored by the Investment Company Institute
Capital Hilton
Washington, D.C.

June 5, 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 Ms. Fornelli 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. Itís a pleasure to be here with all of you today. The purpose of this conference is very important to us at the Commission. We truly view professionals such as you as the first line of defense, and in most cases the only necessary line, for accomplishing our mission of investor protection. I know that the Investment Company Institute also appreciates the significance and challenges of your jobs. Matt Fink has said on several occasions that the success of the fund industry depends on emphasizing high professional standards even when they may conflict with short-term business goals.

There is no denying that many of the issues you confront in your work can be complicated, particularly in light of the accelerating changes in how your firms do business and how the Commission regulates that business. There is also no denying that sometimes those issues subject you to conflicting pressures. Given these realities, adequate preparation -- through training programs such as this conference -- is essential to keep you, and the funds you work for out of, shall we say, unnecessary legal entanglements with my employer.

I am impressed with the scope and the depth of the agenda for this conference. Not surprisingly, many of the topics covered over the next few days coincide with major outstanding Commission initiatives. I thought I would use this opportunity to briefly discuss those initiatives, and the types of compliance issues you may face with respect to those initiatives. I also want to alert you to some other issues that our experience indicates you may confront.


Fund Governance

Tomorrowís first session is on the role of mutual fund directors. One of the most significant initiatives we have undertaken at the Commission is in the area of mutual fund governance. Mutual fund directors, particularly the independent directors, play a critical role in the governance of a fund and act as the watchdog for the interests of fund shareholders. The Commission has issued a comprehensive package of fund governance reforms and a staff interpretive release providing guidance on specific issues relating to independent directors.

The rule proposal is designed to strengthen the position of independent directors when dealing with fund management by reinforcing their independence, and to 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 those rules that any fund must meet to rely on the exemptions. 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 in turn be independent.

We also have proposed a number of disclosure requirements that will enhance shareholdersí 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. The proposals also would require disclosure of directorsí ownership of fund shares, information about directorsí potential conflicts of interest, and would provide information to shareholders on the boardís 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. However, many commenters felt that certain of the disclosure requirements, especially as they related to disclosure regarding the directorsí 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 restrictive 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 counselís professional responsibilities when representing independent directors. Their recommendations should be helpful as we continue in the process of refining the proposed amendments.

You as compliance professionals also have an obligation to work with your fundsí directors to ensure that the governance structure is working effectively. You should make directors aware of the importance of, and the need for, strong compliance, and at some point you will need to educate them regarding your compliance systems and procedures. Perhaps your most important task with respect to fund governance is to ensure that directors are getting the information they need to do their jobs effectively. Our Office of Compliance, Inspections, and Examinations (or "OCIE") regularly scrutinizes the quality and quantity of materials provided to the directors, particularly focusing on critical issues like the advisory contract and distribution plans.

Some problems that OCIE has found in the past during its examinations in this area include: (1) responsibilities of the directors that, by statute or rule, cannot be delegated, have been delegated to the fundís adviser; (2) directors that are classified as "independent," in fact are not; (3) contracts requiring approval by the board have not in fact been approved; and (4) certain directors are frequently absent from board meetings.


Tax Issues

Another outstanding Commission proposal, if adopted, would require additional diligence on your part. In March of this year, 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 fundís 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 Managementís 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 managerís purchases and sales of portfolio securities. Post liquidation after-tax return, in addition to including the effects of the portfolio managerís decisions, also reflects the tax effects of a shareholdersí 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.

While the calculations required by the proposal and the presentation of the results are perfectly straightforward, you will need to be diligent in checking the accuracy of your fundís reported after-tax returns. For example, the information currently required to be included in the prospectusí fee table is similarly straightforward. Yet, one of the most common mistakes that OCIE finds during its exams is inaccurate information in that table. It is your job to make sure that such information, and any required after-tax return disclosure, is correct.

Fund Advertising

I notice that another panel topic at this conference is fund advertising. This topic is on the Commissionís radar screen as well, and is being addressed on several different fronts. Todayís rapid technological advances and consolidation of the financial services industry have increased competition in the mutual fund industry. As funds face increased competition, one fear we have is that funds will respond to the competitive environment with overly aggressive advertising. An example of this can be seen in the Commissionís recently settled administrative proceeding against a fund adviser and a portfolio manager. The fund had 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 Ė a problem that I will discuss in more detail a little later. The Commission also found that the fundís failure to disclose in its advertisements the larger 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 reflects the Commissionís increasing concerns regarding fund advertising in the wake of another case this past year, in which the Commission instituted similar charges against a fund for failure to disclose that its high performance was generated by investing in hot IPOs.

The issue of fund advertising is of particular concern to Chairman Levitt. A few months ago, he asked the Division of Investment Management and OCIE to conduct a special review of fund marketing Ė including websites, sales literature and advertisements. The purpose of the review is to determine whether a fundís actual portfolio performance and investment strategies are consistent with its website statements, its advertising and its prospectus disclosure.

Concurrently with our advertising review, we are considering amendments to Rule 482 that would improve the quality of information that investors see in fund ads. Specifically, we are considering eliminating 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. In any revised rule, we will seek to promote 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 case I discussed plus a $2 million settlement with the state authority, demonstrates that we are indeed serious about this issue.

Separately, OCIE has found some troubling practices in a few fund ads. As you may know, if funds use performance numbers in ads, they must show a fundís 1-, 5- and 10-year total return numbers, current as of the last quarter. OCIE has found some funds using total return numbers for odd one-year periods -- such as the one-year period ending April 13 or May 3, or June 10, in addition to the standardized returns. These ads donít include additional disclosure as to why the odd one-year period was chosen or why the total returns for the odd period were significantly higher than the total return for the quarterís end.

Upon further review of these situations, OCIE found that the dates chosen by these funds coincided with days on which the fundsí net asset value reached a new high. They also found that the NAVs of these funds were very volatile and were significantly lower by the time the ads appeared in print. It seems that these funds were gerrymandering the one-year period to come up with the best performance figures. This is not a fair presentation to potential investors.

Another problematic practice that OCIE sometimes finds during its exams is the advertisement of returns as of the most recent quarter end, even though the fund knows that those returns have deteriorated materially since the end of that quarter. Not only is the practice troubling to us, it also is in violation of guidance issued by the National Association of Securities Dealers.

Short of problematic ads, OCIE sometimes finds other compliance problems with fund ads that you should be aware of, including: (1) failure to file the advertising materials with the National Association of Securities Dealers and (2) advertising expenses that were inappropriately paid for by the fund.

It is your responsibility to help ensure that your fundís advertisements not only comply with the letter, but also the spirit, of the law. This means that your fundís ads must be fair, balanced and not misleading.

IPO Allocations

I have already touched on the advertising issues that can arise when a fund employs questionable procedures for allocating IPOs, but as you know such situations pose serious problems for compliance employees irrespective of advertising issues. "Hot IPOs" can boost a fundís performance, and participation in certain IPOs is highly desirable.

In the case I mentioned earlier, the Commission imposed sanctions on an investment adviser and a portfolio manager in connection with the allocation of shares in initial public offerings among the fundís managed by the portfolio manager. At issue was four funds --while each fundís net asset size was significantly different, all four had the same stated investment objective and could invest in IPOs. Incredibly, the prospectus for the newest fund stated that if other funds advised by the investment adviser invested in or sold the same securities as it did, "available investments or opportunities for sales would be allocated equitably to each investment company." However, the Commission found that during the newest fundís first fiscal year, the managerís IPO allocations favored that fund over the other funds, particularly with respect to hot IPOs.

Failure to disclose the preferential allocation of IPOs was found to be a material omission and the newest fundís prospectus disclosure regarding equitable allocation of investment opportunities was found to be false and misleading.

Independent of this case, OCIE has found several problems with how fund groups allocate IPO shares internally. Sometimes these problems are intentional. Intentional misallocations include allocating all or a disproportionate number of IPO shares to principals or favored clients without disclosure. But sometimes the misallocations are unintentional, and partly the result of poor compliance procedures or the result of adequate procedures not being followed.

Most fund complexes have a procedure by which hot IPOs are allocated among managed accounts or funds -- generally shares are allocated pro rata, based on the number of shares requested, to the accounts requesting participation, or are allocated according to a rotation system. The Commission has acknowledged that allocations that are not made on a pro rata or rotational basis can still, under certain circumstances, be fair, and even preferable. As a result, most fund procedures allow for some deviations from pro rata or rotational allocations.

In allocating a limited number of hot IPO shares received, some complexes give greater weight to different funds or accounts based on the type of portfolio and the size of the account or fund. Administering such exceptions places a serious responsibility on the fundís compliance and legal staff. You will want to review the allocations not only individually, but also over time, to ensure that they are fair and equitable.

Personal Trading

Personal trading is back in the news again, if it ever left. Over the course of the last several months, certain provisions of amended Rule 17j-1 under the Investment Company Act have gone into effect. Rule 17j-1 requires, among other things, that all funds have codes of ethics containing provisions reasonably necessary to prevent its access persons from engaging in fraudulent or deceptive acts. Even given all of the attention in this area by the press, the industry, and by the Commission (including the Enforcement Division), OCIE still sees problems in codes of ethics and compliance procedures in this area. These problems include: (1) lack of policies designed to prevent the use of inside nonpublic information (including no restricted list or watch list); (2) pre-clearance procedures that exist, but are not implemented, or are not implemented effectively (for example, the fund does not maintain a list of access persons or the transactions listed on personal transactions reports are not compared to the transactions for which pre-clearance was sought); and (3) fundsí boards were not actively involved in reviewing the appropriateness of, or enforcing, the codes. One of the best internal controls OCIE has found in this area is a procedure that requires access persons to place all personal trades through an affiliated broker; then the trades can be checked against fund trades for conflicts prior to execution.

Again, it is the responsibility of all fund employees to comply with the fundís policies and procedures regarding personal trading. You must be ever vigilant in administering the code and monitoring compliance with the provisions of the code. Donít let violations occur on your watch.


I hope that my brief discussion this morning of some current Commission initiatives that will affect your duties, and other issues that I expect you will face, will prove useful. I make no claim that my remarks have covered every compliance issue with which you will struggle. Even as exhaustive as the agenda for this conference is, and as exhausted as you will be at its conclusion, it cannot cover all of those issues. You will leave here well prepared to face the challenges of your jobs, but ultimately your effectiveness depends on your integrity, judgment and good sense.

The fact of the matter is that all of the protections provided to investors by the securities laws and regulations are only effective if they are implemented by appropriate supervisory and compliance procedures and carried out by dedicated compliance and legal staff. That is why the Commission has a great deal of respect for each and every one of you, and for all of the staff at your funds that perform similar duties. I wish you success. Thank you.