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U.S. Securities and Exchange Commission

Speech by SEC Staff:
The Challenge of Making Best Practice, Common Practice

Remarks by

Paul Roye

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

2000 Securities Law Developments Conference
Washington, D.C.

December 4, 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.

I. Introduction

Good morning. Thank you for that kind introduction, Amy. It is a pleasure to be here with you this morning at the Investment Company Institute's 2000 Securities Law Developments Conference, formerly known as the Procedures Conference. Since this conference was known for so many years as the Procedures Conference, for me and others who have attended the conference year after year, we will have to adjust to the new name. But for those of us involved in the mutual funds industry, either as regulators or as participants in the industry, we know that we must constantly adapt to change. As history shows, only those industries and companies that are responsive to change and innovation stand the test of time. Those that do not, either wither or fail.

This point is illustrated very clearly in the classic story of the Swiss Watch industry. In 1970, there were 1600 firms, employing 90,000 people in watchmaking in Switzerland. At the time, the Swiss controlled about 90% of the world's watch market. Within a 10 year period, half or these Swiss firms had gone out of business and roughly 50,000 people lost their jobs. Not only a business catastrophe but a national catastrophe for the Swiss. What happened? Well, along came the invention of the electric quartz movement, originally a Swiss invention. The Swiss demonstrated this invention at a trade show as a novelty. Although the quartz movement improved accuracy to unheard of levels and reduced costs, the Swiss did not act on this opportunity. Their focus was on defending the traditional art of watchmaking based on skill-intensive, mechanical movements. The Japanese capitalized on this opportunity and successfully commercialized quartz watches. The Swiss Watch industry nearly evaporated until it adapted quartz technology for major market niches and came up with fashion innovations that recaptured a portion of lost market share. The Swiss watchmakers came to recognize that there is benefit in linking innovation to what consumers value.

The mutual fund industry has proven itself over and over again to being resilient, creating value for fund shareholders and facilitating the rise of the individual investor as a major force in our securities market today. Approximately one-half of all American households own shares of mutual funds. The mutual funds industry continues to grow, innovate, and thrive because of the confidence of the individual investor in the industry. I agree with Chairman Levitt who has stated that it is the emergence of the retail investor who has done more for the long-term health of the securities industry, that any other single factor. He stated in a speech last month before the Annual Meeting of the Securities Industry Association that:

"Nothing more than the power of an informed investor increases competition. Nothing more than the power of pragmatic, but demanding investors boosts innovation. And, nothing more than the power of confident investors guarantees a steady flow of business."

So this morning, to those of you who are charged with assuring that your firms are complying with the Federal Securities laws, I would like to issue to you a series of challenges. A challenge that in key areas of mutual operations, that you work with us to maintain the highest standards, so as to preserve and bolster the trust that mutual fund investors have in the industry. In the course of making these challenges, I would also like to give you some idea of various initiatives that you can expect to emerge from the Commission in the coming weeks.

II. The Challenge of Self-Regulation

Last month I was fortunate enough to address a group of independent directors at the ICI's Investment Company Directors Conference. I reminded that group that Chairman Levitt has characterized the relationship between the SEC and fund directors as a partnership in the public interest. I see no reason why we shouldn't extend that partnership to include all of you. Matt Fink has said on several occasions that the success of the fund industry depends on emphasizing high fiduciary standards even when they may conflict with short-term business goals. I challenge all of you today to keep your focus on what is best for fund shareholders. I challenge you to recognize that the industry must take responsibility for good compliance practices and honest and fair dealings with fund shareholders. Fulfilling this responsibility is not only good for investors, but it makes good business sense. It will strengthen confidence in the industry and foster continued success, and you inevitably will reap benefits for your bottom line.

From our vantage point at the SEC, we do not have to look very far to see the benefits of self-regulation. Self-regulation has been a cornerstone in the securities industry. Indeed, the fundamental principle of self-discipline predates the securities laws. In fact, the old "shingle theory" was founded on the principle that, if you held yourself out to the public as offering to do business, you were implicitly representing that you would do so in a fair and honest manner. As former SEC Chairman and Supreme Court Justice William O. Douglas said, "self-discipline is always more welcome than discipline imposed from above." He summarized the benefits of self-regulation in an address before the Bond Club of Hartford in 1938 as follows:

"From the broad public viewpoint, such regulation can be far more effective [than direct regulation] self-regulation can be persuasive and subtle in its conditioning influence over business practices and business morality. By and large, government can operate satisfactorily only by proscription. That leaves untouched large areas of conduct and activity; some of it susceptible of government regulation but in fact too minute for satisfactory control, some of it lying beyond the periphery of the law in the realm of ethics and morality. Into these large areas, self-government and self-government alone, can effectively reach. For these reasons, self-regulation is by far the preferable course from all viewpoints."

There's a limit to what SEC rules can do. We will regulate where warranted. But many of the areas that need to be addressed are gray, not black and white, and don't lend themselves easily to rulemaking. That is where you and your firms can make a huge difference. The mutual fund industry should strive for a culture that considers SEC rules as merely a starting point – a culture in which we enforce the minimum standard of behavior, while you insist on the highest – a culture in which best practice becomes common practice.

The Investment Company Institute has taken the lead in a number of areas to raise industry standards and foster best practices. In the areas of personal trading and corporate governance, for example, the ICI's guidelines serve as a mark against which all funds should measure themselves. I challenge all of you today to take the ICI's lead and strive to maintain best practices in all aspects of your businesses.

III. The Challenge Regarding Personal Trading Procedures

For example, various amendments to our Code of Ethics Rule, Rule 17j-1 will go into effect soon. The amendments to the rule do not go as far as the ICI's best practice guidelines in the personal trading area. The Commission made a judgment to give you flexibility in designing personal trading rules for your firms. But just because the Commission didn't incorporate all of the provisions of the ICI's best practices into the Rule amendments shouldn't end your analysis. Your procedures should strive to be comprehensive in preventing personal trading abuses.

In the personal trading area, you should be aware that a few days ago, the staff released a series of questions and answers regarding the Code of Ethics amendments, involving the scope of the rule, issues involving adopting, approving, and filing Codes of Ethics, annual certification procedures, holdings and transaction reports, and addressing the validity of prior interpretative advice.

IV. The Challenge of Improving Fund Governance

I'm sure all of you are interested in the status of our pending fund governance initiative. Our rule proposal was 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. As I'm sure all of you know by now, 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 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 those shareholders will know the identity and experience of all directors.

We received about 150 comment letters on our proposal, including 82 letters from independent directors. Commentators generally commended our efforts to enhance the independence and effectiveness of fund directors, although many offered recommendations for changing portions of the proposal, especially the independent legal counsel provisions and certain disclosure provisions.

Our efforts to improve the governance of mutual funds on behalf of mutual fund investors have borne fruit. Our roundtable discussions and proposed rules have provoked a great deal of discussion among directors, advisers, counsel, and investors about governance practices and policies. After our roundtable, an advisory group of the ICI made recommendations regarding fund governance in a "best practices" report. Former SEC Chairman David Ruder established the Mutual Fund Directors Education Council, a broad-based group of persons interested in fund governance, whose purpose is to foster the development of educational activities designed to promote the effectiveness, independence, and accountability of independent fund directors. The American Bar Association formed a task force to examine the role of counsel to independent directors, and the task force released a report offering guidance to counsel and fund directors regarding standards of independence for counsel and guidelines for handling potential conflicts of interests. All of these initiatives have focused attention on the important role of independent fund directors and their importance in promoting and protecting the interests of fund shareholders.

Soon the Commission will consider our recommendation for a final rule. While I can not predict how the Commission will react to our recommendations, I can say that our recommendations will reflect many of the suggestions we received in the comment letters. Specifically, we found persuasive some of the criticism of the proposed disclosure requirements, especially as they related to directors' 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. We agree with the ABA Task Force that independent directors benefit from the advice of counsel who can render objective and unbiased advice, and that independent directors can only effectively assess the independence of their counsel when that counsel has thoroughly disclosed all of the relevant information regarding conflicts and potential conflicts of interest. However, we disagree with those who say that a rule in this area is not required. Commissioner Carey, in an address before the American Bar Association last month stated that he was persuaded that our investor protection mandate dictates that we strengthen the role of independent directors and that we stay the course and adopt a rule regarding independent counsel for fund directors.

Regardless of the requirements of the final rule, I challenge all of you to consider going beyond what the rules require and to consider if there are other measures you can take with regard to fund governance that will improve your operations and protect shareholder interests. Many of the ICI advisory groups' best practices recommendations were excellent ideas but inappropriate for SEC rulemaking. Many Boards, we understand, have adopted the recommendations set forth in the best practices. However, others are waiting to see the final SEC rules before taking action. Again, I challenge you to simply view our rules in the governance area as a starting point. For instance, our rule proposal did not require independent directors to retain independent legal counsel. The ICI's recommendation in this area is for all independent directors to have legal counsel. And, as Commissioner Carey has stated, "any independent director who serves on a fund board and understands the importance of his or her role, should view independent counsel as a condition for serving as a director, just as one would not serve on a Board without D&O liability insurance."

V. The Challenge of Improving Disclosure

In addition to the protections that will be afforded to shareholders as a result of the fund governance proposals, we are 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. As I discuss each of them, again I challenge you to consider how you may go beyond our rulemaking to enhance the disclosure that you make to fund shareholders.

A. Mutual Fund Fees

Unfortunately, too many investors today focus on a fund's past performance and pay too little attention to how fund fees and charges impact their investment over time. At the request of Congress, the General Accounting Office completed a study this past summer of mutual fund fees and expenses. The study concluded that additional disclosure could help increase investor awareness and understanding of mutual fund fees and, thereby, promote additional competition by funds on the basis of fees. The report recommended that the Commission require that periodic account statements include additional disclosure about the portion of mutual fund expenses that the investor has borne.

The Division is also in the process of completing its own review of mutual fund fees and expenses. We hope to issue our study in the next few weeks. The goal of our report is to provide objective data, reviewing trends in mutual funds fees that may be useful to the Commission and the mutual fund industry, including fund directors. We believe that the current statutory framework's primary reliance on disclosure and procedural safeguards to determine mutual fund fees and expenses, rather than on fee caps or other regulatory initiatives, is sound and operates in a manner contemplated by Congress. We believe, however, that the framework can be enhanced in certain areas. We have considered the GAO's recommendations, as well as other alternatives that may provide better information to shareholders regarding fund expenses. Our recommendation will be to make the actual impact of fees more visible, and to allow investors to quickly and effectively determine the actual dollar amount they have paid in fund expenses during a given period. We believe that with more information regarding fees and expenses, investors will make better investment decisions.

As you review our fee study, and as we go through the rulemaking process, I challenge all of you to consider how we can provide fund shareholders better information about mutual fund fees and improve investor's financial literacy with respect to mutual funds and their costs.

B. Fund Names

We also expect to be recommending in the next few weeks that the Commission adopt a new Rule 35d-1 to guard against the use of misleading names, and to implement Congress' intent when it amended Section 35(d) of the Investment Company Act. In amending Section 35(d), Congress reaffirmed its concern that investors may focus on an investment company's name to determine the company's investments and risks. While we feel strongly that investors should not rely on an investment company's name as the sole source of information about a company's investments and risks, the name of an investment company may communicate a great to an investor. Our view is that the current staff position, that an investment company with a name suggesting that the company focuses on a particular type of investment invest only 65% of its securities in the type of investment suggested by its name, is too low. We believe that investors need greater assurance that a company's investments will be consistent with its name. We believe increasing the investment requirement will help reduce confusion for investors in selecting an investment company for their specific needs and in making asset allocation decisions. However, an investment company seeking maximum flexibility with respect to its investments will be free to select a name that does not connote a particular investment emphasis. One of our goals in this rulemaking will be not to discourage the use of descriptive fund names.

C. After Tax Disclosure

I am sure you are aware that the Commission has outstanding 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. We believe our proposal can 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 a standardized formula, 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.

We are completing our analysis of the comments on the proposal and expect to be making a recommendation to the Commission regarding adoption early in the New Year.

D. Fund Advertising

At the same time that we are acting to give investors more information relevant for their investment decisions, we also want to improve the rules governing fund advertising. We expect to recommend that the Commission propose amendments to Rule 482, to enhance funds' ability to provide investors with better and timelier information in fund advertising. The proposal would eliminate the requirement that the substance of the information contained in advertisements be included in the statutory prospectus. Rule 482 revisions also will serve as an occasion to remind funds that technical compliance with the rule may nevertheless run afoul of antifraud prohibitions of the federal securities laws. We also expect to consider modifications to Rule 156, the antifraud rule that applies to fund sales literature. We will seek to promote in these rule amendments, balance and responsibility in fund advertising.

A number of funds achieved extraordinary, even triple digit returns, in 1999. Few investment professionals, including the fund managers who achieved these returns believed that these numbers were sustainable. This year's performance numbers have proved them right. Early this year, the Commission issued an Investment Alert urging investors not to over emphasize performance in making fund investment decisions. Chairman Levitt called on fund directors to monitor more closely fund advertising, particularly with regard to the aggressive use of performance information. The NASD issued a notice to its members reminding them of their responsibility to base their communications with investors on principles of fair dealing and good faith and to avoid statements that are exaggerated, unwarranted or misleading. The ICI issued a series of public service advertisements in major newspapers that cautioned investors not to place too much emphasis on mutual funds past performance. Those fund groups who heeded these cautions and managed their shareholders expectations regarding performance, are in much better stead with their shareholders today, than those who sought to exploit to the maximum extent possible, extraordinary short-term performance.

E. Shareholder Communications

We continue studying how to improve shareholder report and financial statement presentations. We believe that the management discussion and analysis portions of shareholder reports can be improved. We are also taking a hard look at disclosure of fund portfolio holdings, with the goal of improving the quality of portfolio schedule information. As I am sure many of you know, we have received several rulemaking petitions asking us to increase the frequency with which portfolio holdings are disclosed. We independently had been looking at this issue, and have been considering both the format and frequency of portfolio disclosure. Our goal here is to provide information to investors that they desire, when they need it, while avoiding information overload.

We recognize that in analyzing this issue there are costs, burdens and risks that must be considered. Printing and mailing a list of portfolio holdings to every shareholder in a fund more frequently than semi-annually can result in significant costs that would be passed on to shareholders. And there are shareholders that don't want this information provided more frequently, and certainly don't want to pay for it. These shareholders take the view that they hired an investment manager to manage their portfolio and they don't want more frequent information on the portfolio. However, other shareholders, as well as professionals investing their clients in mutual funds, desire more frequent information to make better asset allocation decisions. A better alternative to more frequent disclosure to all shareholders might be to provide the information more frequently only for those shareholders that request it, or use technology such as the Internet, to meet the needs of shareholders who want this additional information. But then disclosure should not be so frequent as to reveal an investment manager's proprietary investment strategies, or to facilitate "front-running" of the fund. Our consideration of this issue requires us to balance the needs and desires of various types of investors, against imposing undue burdens or causing adverse impacts on funds and endangering their investment strategies.

VI. Key Areas for Additional Focus

Now, I would like to highlight three areas that merit increased focus by fund management, compliance personnel and fund directors: the areas of valuation, best execution, and problematic portfolio management practices.

A. Valuation

As you know, valuation is extremely important for mutual funds because they must redeem and sell their shares to the public at net asset value. If fund assets are incorrectly valued, fund investors will pay too much or too little for their shares, and redeeming shareholders will receive too much or too little for their shares. In addition, the over-valuation of a fund's assets will overstate the performance of the fund, and will result in overpayment of fund expenses that are calculated on the basis of the fund's net assets, e.g. the fund's investment advisory fee.

The Investment Company Act requires funds to value their portfolio securities by using the market value of the securities when market quotations for the securities are "readily available". When market quotations are not readily available, the 1940 Act requires fund boards to determine, in good faith, the fair value of the securities. The Commission has stated that, as a general principle, the fair value of a portfolio security is the price that the fund might reasonably expect to receive upon its current sale. Thus, ascertaining fair value requires a determination of the amount that an arms-length buyer, under the circumstances, would currently pay for the security. Accordingly, fair value cannot be based on what a buyer might pay at some later time, or prices which are not achievable on a current basis on the belief that the fund would not currently need to sell those securities and bonds may not be priced at par based on the expectation that the securities will be held to maturity. Failure to adhere to the requirement to fair value portfolio securities when required has resulted in enforcement actions against some funds and even fund directors.

At the end of last year, we issued an interpretative letter to the ICI providing additional guidance that supplements the SEC Accounting Releases on the fair value pricing process. The letter emphasizes that while no single standard exists for determining fair value in good faith, fund boards should satisfy themselves that "all appropriate factors" have been considered, and should take into account" all indications of value available to them" when fair value pricing a portfolio security. The letter further recognizes that fund boards typically are only indirectly involved in the day-to-day pricing of a fund's portfolio securities, and notes that most boards fulfill their obligation by reviewing and approving pricing methodologies, which may be formulated by the board, but more typically are recommended and applied by management. The letter suggests that funds may use a number of techniques to minimize the burdens of fair value pricing on their directors, such as delegating certain responsibilities for fair value pricing decisions to a valuation committee. If a fund's board has approved comprehensive procedures that provide methodologies for how fund management should fair value price portfolio securities, it would need to have comparably little involvement in the valuation process in order to satisfy its good faith obligation. On the other hand, the Board's involvement must be "greater and more immediate" if it has vested a comparatively greater amount of discretion in fund management, or when pricing procedures are relatively vague. Nevertheless, the letter stressed that in any event, the fund's board retains oversight responsibilities for the valuation of the fund's assets.

It is important therefore that fund directors receive periodic reports from fund management that discuss the functioning of the valuation process and that focus on issues and valuation problems that have arisen. Fund directors should ensure that appropriate operational procedures and supervisory structures are in place with respect to both "market value" and "fair value" determinations. Funds typically obtain most of their pricing data from third party sources, such as pricing services and dealers, some of which involves "fair valuation" methodologies, such as matrix pricing. But even prices provided by third parties should be subject to appropriate controls. Controls should be incorporated at each level of the valuation process. Periodic cross-checks of prices received from pricing services should be conducted, such as checking quotes received against quotes from other pricing services, from dealers making a market in the relevant securities, or actual sales in particular securities against prices for comparable securities. These crosschecks should generate red flags when there are questions regarding the reliability of prices.

This is an important area for board and management focus, since proper valuation of fund portfolio securities is critical to ensure that the fund share prices derived from those valuations will be fair to purchasing, redeeming and existing shareholders. This is another area where the ICI has provided useful guidance to its members. I urge you to revisit your valuation policies and procedures against our recent guidance and that provided in the ICI's comprehensive paper on valuation. Issues related to valuation will be a continuing focus of the Commission, as we consider whether additional guidance in the valuation area is needed. Moreover, this is an area that we will continue to pay particular attention to in the inspection process. The challenge with respect to valuation is that you keep the focus. Be vigilant in your valuation policies and procedures, keep the board informed, look for the red flags.

B. Best Execution

Last month, Chairman Levitt gave a speech entitled "Costs Paid with Other People's Money". In this speech, the Chairman focused on the cost of investing, noting that among the most significant costs of investing today are brokerage commissions. He noted the good news that retail commissions have dropped to only a fraction of what they were just a few years ago. He pointed out, however, that "full service commissions paid by mutual funds have remained steady at five to six cents a share for nearly a decade." He questioned whether fund portfolio managers are bringing to bear the pressure they should on brokerage rates today. While the Chairman acknowledged that there is more to execution quality than the Commission rate, he asked why the emergence of electronic markets has not driven commission rates lower for funds?

Fund directors have a duty to inquire about the execution process. Fund managers need to drive hard bargains with their brokers. There is no substitute for asking hard questions about order routing arrangements, to ensure investors reap the full benefits of the dynamic competition unfolding in our markets. Brokerage is an asset of the fund and its shareholders. In other words, as the Chairman noted, those who spend other people's money must exercise the same care as they would in spending their own.

C. Portfolio Pumping and Window Dressing

We have been alerted to two practices that apparently go on to some extent in the management of funds, "portfolio pumping" and "window dressing". Portfolio pumping is the practice of increasing a fund's stake in portfolio securities at the end of the financial period solely for the purpose of fraudulently driving up the NAV of the fund. Academic studies have suggested that the practice goes on in the fund world.

We have not yet brought a case in this area, but it is something we are paying close attention to. Our office of Compliance Inspections and Examinations has formed a task force to look into the practice. The task force is carefully evaluating trading data of fund portfolio securities that would indicate manipulation. And this concern extends beyond our borders our colleagues in Canada, the Ontario Securities Commission, recently brought a case of this sort against Royal Bank of Canada's investment management arm.

We are also concerned about the misleading practice known as "window dressing." Here, advisers buy or sell portfolio securities at the end of a reporting period for the purpose of misleading investors as to the securities held by the fund, the strategies engaged in by the advisers or the source of the fund's performance. For example, an adviser may cause the fund to hold significant positions in securities that are not permitted under the fund's disclosed investment objectives. As the reporting period draws near, the adviser liquidates these positions to come into compliance with its stated objectives. OCIE is examining trading patterns to detect violations in this area. We view this as an antifraud violation. Investors are misled if they are told that the fund is investing consistent with prospectus disclosure when it is not.

Window dressing may also occur when an adviser replaces investments in otherwise permissible securities with investments in high performers just before the end of the reporting period to make it appear as though the adviser had a winning hand.

We urge fund directors to encourage compliance personnel and the fund's auditors to scrutinize trading near the end of reporting periods, to be on guard for portfolio pumping and window dressing.

VI. Conclusion

Last year, this meeting occurred near the end of the 20th century. We all had to meet the challenge of making sure that our computer systems were prepared for the new millennium. We met this challenge and we learned from this challenge. Computer systems were evaluated, modernized and improved. We often benefit by being challenged. The forces of competition are continually challenging the mutual fund industry. Competition is one of the most important forces shaping our securities markets and influencing the mutual funds industry. In the words of Chairman Levitt,

"It's a genius that has given life, sustenance, and rebirth by the relentless demands of America's investors. There is simply no disputing the powerful, coalescence of these multiple forces--the ingenuity, innovation and integrity of market professionals and the demands of an increasingly informed customer base."

This has produced a synergy resulting in the most successful investment management industry in the world. I would caution the industry however that in the face of competition from new products and new participants, members of the financial services industry often complain that there is an unlevel playing field; that some segment of the industry has a regulatory advantage. Sometimes the level playing field argument has merit and sometimes it doesn't. But in responding to competition, one thing that is usually effective is taking steps to be more competitive, by providing value for your shareholders through high quality service and performance at competitive fee levels.

One of our roles as primary regulator of this industry, is to challenge you to conduct your business in accordance with fundamental fiduciary principles. In meeting the challenge of increased competition, we ask that you work with us to maintain the highest standards for the fund industry, creating a culture whereby best practice becomes common practice. Thank you.