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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Mutual Funds and Investment Management

Keynote Address of

Paul Roye

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

2001 Mutual Funds and Investment Management Conference

March 19, 2001

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 for that kind introduction, and thank you Matt for the kind words and those thoughtful remarks. In my perhaps not so unbiased view, the Commission and the Division of Investment Management, in particular, have been extremely productive over the last year. I believe this is a testament to the dedication, drive and ability of a talented SEC staff. Many of our staff are constantly wooed by many in this audience to join your companies and firms but resist these overtures because they love the work they do and appreciate the importance of public service. You all have an interest in maintaining a high quality SEC staff. The mutual fund industry continues to grow and thrive because of the confidence that individuals have in the mutual fund industry, in the regulatory framework governing the industry and the competence and vigilance of the SEC in maintaining the integrity of that framework. The SEC's ability to be "wise on time" and function and maintain its effectiveness is being threatened principally by the disparity in pay between what our attorneys and accountants are paid, versus what their skills and expertise will command in pay in the private sector or even within comparable federal agencies. During the last two years, the Agency has lost 30% of its attorneys, accountants and examiners. The Division of Investment Management alone lost 20% of its staff attorneys in fiscal year 2000. This is why we hope that efforts underway in Congress to promote pay parity for SEC staff comparable to that of the pay levels of other regulators of the financial services industry are successful. The pay of employees of the federal banking agencies is as much as 39% higher than the pay rates of SEC Staff. Again, I submit that it is in your interest, the mutual fund industry's interest, that the SEC be able to attract and retain the talent and expertise necessary to fulfill the agency's mission and be "wise on time".

The Commission has recently taken several significant actions impacting the mutual fund industry. So this morning, I thought it would be useful if I discussed some of those actions and their significance going forward. These actions represent the completion of an important agenda set by former Chairman Levitt in the last few years of his tenure with the strong support of the other members of the Commission. But of course in the wake of his departure and those actions, the Commission will develop new priorities. While a new SEC Chairman will shape the agenda for mutual fund regulation in the months and years ahead, I also want to share with you my thoughts on some unfinished business and important issues that I hope will be, or out of necessity will be, on the investment management agenda during the next year.

While we await a new era at the SEC, it is important that we analyze and assess the recent regulatory developments in the mutual fund area, but we also need to identify those issues that must be addressed in the future in order to preserve and improve a regulatory framework that has served investors and the industry so well. I should point out, however, that while we await the President's naming of a new SEC Chairman, our Acting Chairman, Laura Unger, has made it clear that the day-to-day work of the Commission will go forward. While new initiatives will await consideration by a new SEC Chairman, during this interim period, registration statements and disclosure documents will be reviewed, exemptive applications and no-action and interpretative letters will be processed and necessary rulemaking will proceed. The dynamics of the securities markets and the investment management business do not permit us to stand still.

Fund Governance

Earlier this year, the Commission adopted a comprehensive set of rules and rule amendments designed to enhance the ability of mutual fund independent directors to fulfill their most important role - the protection of investors. These rules represent the culmination of the Commission's examination of the role of mutual fund independent directors that began in May 1998 with the announcement that the Commission would host a roundtable on fund governance to work toward a consensus on whether changes were needed. At the roundtable in February 1999, the Commission brought together investor advocates, independent fund directors, fund managers, academics and legal counsel. After evaluating the suggestions offered by roundtable participants, the Commission proposed a set of initiatives in October 1999 to enhance the independence and effectiveness of mutual fund directors. At the same time, the Commission published an interpretative release expressing the views of the Commission and Division staff concerning a number of issues that related to independent fund directors. The focus on independent directors also spurred several significant efforts in the fund governance area. The Investment Company Institute organized an Advisory Group, which developed a set of best practices for fund directors. Former SEC Chairman David Ruder founded the Mutual Fund Directors Education Council, administered by Northwestern University, in response to former Chairman Levitt's call for improved fund governance. The Council's mission is to foster the development of programs to promote a culture of independence and accountability in fund boardrooms. The American Bar Association formed a Task Force which prepared a very useful report offering guidance to counsel and fund directors regarding standards of independence for counsel and guidelines for handling potential conflicts of interests.

I believe the rules and rule amendments ultimately adopted by the Commission reaffirm the important role that independent directors play in protecting the interests of mutual fund shareholders, strengthen their hand in dealing with fund management, reinforce their independence and provide investors with more information with which the can assess directors' independence.

Indeed, I believe that the fund governance initiative is an excellent example of the SEC being "wise on time". The Commission recognized the important role that independent directors play in protecting the interests of mutual fund shareholders. From negotiating investment advisory contracts and overseeing fund fees, to policing potential conflicts of interests between the fund and affiliated parties, fund directors are charged with safeguarding fund investors' interests. The Commission recognized that if you empower fund directors, benefits inure to fund shareholders.

Our fund governance initiative was a recognition that the SEC continually faces the formidable challenge of applying the existing regulatory framework that helped ensure the integrity of the industry, while providing a regulatory scheme that can keep pace with the increased competition and the vast technological changes that have been ongoing in the securities markets. As we work to keep pace and modernize the regulatory structure to accommodate the increased competitiveness and globalization of the fund industry, we will need to increasingly rely on fund directors to vigorously perform their "watchdog" duties on behalf of fund shareholders. Without the necessary tools to perform these duties, or if they fail to use them effectively, the inevitable result will be less flexibility and more government intervention in the regulatory regime.

Although no set of regulatory initiatives can ensure director independence and effectiveness, the initiatives adopted by the Commission in my view provide fund directors with the tools, the access, and the power to fulfill their legal duty and moral mandate as shareholder representatives. The rules establish a sound foundation for the Commission to respond to calls for increased flexibility under the statute in various areas, such as in the area of affiliated transactions.

Now that our rules are out, it is incumbent upon you to understand what they require and to review your fund governance framework. In my judgment, this review should also embrace the ICI's best practice recommendations for fund governance. It is my understanding that a number of fund groups have not considered the ICI's best practices, awaiting action by the SEC on the fund governance rules. Well, now they have no excuse. The SEC has acted and it is time to review your fund governance framework. In some instances, our rules did not go as far as the ICI recommendations. But that does not necessarily mean that fund boards should in all cases be content to just satisfy the minimum standards established by the Commission's rules. For example, we did not require that independent directors have legal counsel - the rules only require that if they have counsel, the directors make a reasonable determination that their counsel is independent. However, the ICI recommends that independent directors have independent legal counsel. That is a recommendation that I strongly urge independent directors to consider favorably, given the complexity of their responsibilities.

In adopting these rules, the Commission recognized that there are limits to what SEC rules can and/or should do. Nevertheless, fund groups should strive to employ the "best practices" in their operations, particularly in the area of fund governance. I suggest to you that best practices in the fund governance area will lead to best practices in other areas of your firm's operations.

Fee Study

Another area of recent focus has been mutual fund fees. At the end of last year, the Division released its report on mutual fund fees and expenses. The report describes the legal framework with respect to mutual fund fees, analyzes how fees have changed over time, identifies factors that may influence the current level of fees, and recommends initiatives that are designed to improve the oversight of fund fees and the disclosure that investors receive regarding fees. Our goal in conducting the study was to provide objective data describing trends in mutual fund fees that would be useful to the Commission and the Congress in overseeing the mutual fund industry and to others focusing on the effect of mutual fund fees on investor returns. Our hope is that the report will contribute to the public dialog about mutual fund fees and thereby help to educate investors on the impact that fees have on their investment returns.

We concluded 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 intervention, is sound and operates in the manner contemplated by Congress. But we concluded that this framework could be improved in certain areas.

We believe that the Commission has achieved considerable success in requiring funds to disclose information about their fees in a format that is understandable to investors and that facilitate comparison with the fees charged by other funds and other investment alternatives. We nevertheless recommended that the Commission consider requiring the disclosure of additional types of fee information that would facilitate investors' awareness of fund fees and investors' ability to understand their effects.

The report also addresses a recommendation by the General Accounting Office to require disclosure of the actual dollar amount of fund fees paid by each fund investor on quarterly statements. We agreed with the GAO that investors need clear and understandable information about the fees that they pay, and that the fund industry and the Commission should encourage fund shareholders to pay greater attention to fees and expenses. The report recommends that an approximation of the dollar amount paid by investors be disclosed in semi-annual and annual shareholder reports. The staff believes that this approach would enable investors to not only compare the expenses of funds, but also to evaluate the fee information that would be contained in the reports to shareholders alongside other key information about the fund's operating results.

We also recommended in the study that the Commission continue to emphasize that mutual fund directors must exercise vigilance in monitoring the fees and expenses of the funds that they oversee. Fund directors should, for example, attempt to ensure that an appropriate portion of the cost savings from any available economies of scale are passed along to fund shareholders. Our study noted that in a sample of the 100 largest mutual funds, most of the funds had some type of fee breakpoint arrangement that automatically reduces the management fee rate as the asset size of the individual fund or the fund family increases. However, most of the funds in the sample with management fee breakpoints had assets above the last breakpoint. If the fund or fund family is experiencing economies of scale, fund directors have an obligation to ensure that fund shareholders share in the benefits of the reduced costs by, for example, requiring that the adviser's fees be lowered, breakpoints be included in the adviser's fees, or that the adviser provide additional services under the advisory contract. Directors that ask pertinent questions about investment management costs can more effectively represent the interests of the shareholders they represent.

Finally, with regard to the fee study, I wanted to note that we recommended that the Commission consider whether it would be appropriate to review the requirements of Rule 12b-1 that govern how funds adopt and continue their distribution plans.

We believe that modifications to Rule 12b-1 may be needed to reflect changes in the manner in which funds are marketed and distributed and the experience gained from observing how Rule 12b-1 has operated since it was adopted in 1980. The rule essentially requires fund directors to view a fund's 12b-1 plan as a temporary measure even in situations where the fund's existing distribution arrangement would collapse if the Rule 12b-1 plan was terminated. The adopting release for Rule 12b-1 included a list of factors that fund boards might take into account when they consider whether to approve or continue a Rule 12b-1 plan. Many of the factors presuppose that funds would typically adopt Rule 12b-1 plans for relatively short periods in order to solve a particular distribution problem or to respond to specific circumstances, such as net redemptions. Although the factors may have appropriately reflected industry conditions as they existed in the late 1970s, some argue that many have subsequently become obsolete because today many funds adopt a Rule 12b-1 plan as a substitute for, or supplement to, sales charges or as an ongoing method of paying for marketing and distribution arrangements. NASD rules recognize that in effect the funds are paying the equivalent of a sales load.

The mutual fund industry utilizes a number of marketing and distribution practices that did not exist when Rule 12b-1 was adopted. Multi-class distribution structures permit investors to choose whether to pay for fund distribution and marketing costs up front, over time from their fund investment, when they redeem or in some combination of these methods. Some industry observers argue that fund principal underwriters and boards of directors may have good reason to view this type of 12b-1 plan as an indefinite commitment because a multi-class distribution arrangement could not continue to exist if the associated Rule 12b-1 plan were terminated or not renewed.

Other funds offer their shares primarily through fund supermarkets. Many funds that offer shares through fund supermarkets adopt Rule 12b-1 plans to finance the payment of fees that are charged by the sponsor of fund supermarkets. Again, some argue that because these 12b-1 plans are essential to the funds' participation in fund supermarket programs, these 12b-1 plans may be legitimately viewed as indefinite commitments.

Also, some fund distributors are now able to finance their distribution efforts by borrowing from banks, finance companies or the capital markets because they can use anticipated 12b-1 revenues as collateral, or as the promised source of payment. Although the independent directors of a fund have the legal right to terminate a fund's Rule 12b-1 plan, the independent directors may be less likely to do so if the fund's future 12b-1 fees have been pledged to secure a bank loan or to pay principal and interest on asset-backed securities.

Because of these issues, we believe the Commission should consider whether to give additional or different guidance to fund directors with respect to their review of Rule 12b-1 plans, including whether the factors suggested by the 1980 adopting release are still valid. We also believe the Commission should consider whether the procedural requirements of Rule 12b-1 need to be modified to reflect changes in fund distribution practices that have developed since the rule was adopted twenty years ago or may be developed in the future. Our hope is that the industry and others will weigh in and provide thoughts and ideas as to how Rule 12b-1 should be modified.

After-Tax Returns

Our fee study also recommended that the Commission adopt proposed amendments to our rules and to Form N-1A that would require disclosure of standardized mutual fund after-tax returns. Due to the significant impact that taxes have on investors, we believe that investors would benefit greatly by receiving better disclosure concerning the effect of tax expense on returns. In April 2000, the U.S. House of Representatives passed by a vote of 358-2, the "Mutual Fund Tax Awareness Act of 2000", a bill that would enhance the information that mutual fund shareholders receive about after-tax returns. Consequently, earlier this year the Commission adopted rule amendments designed to improve disclosure to investors of the effect of taxes on the performance of mutual funds. These rules 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 are required to be disclosed in the risk/return summary of the prospectus.

After we proposed these rules, many commenters raised a number of compelling issues. I believe the final rules represent careful consideration of these comments. For example, we dropped the requirement contained in the proposed rules to require disclosure of the after-tax numbers in shareholder reports. We also dropped the proposed requirement to disclose after-tax returns for all classes of fund shares. In addition, we did not require that all performance information in advertisements be accompanied by after-tax returns.

The ICI has continued to press three points that were made during the rule-making process, which we carefully analyzed. First, it has argued that the rule overstates the effect of taxes on fund returns for some investors because it requires that the highest federal tax bracket be used for the calculation.

We truly struggled with this issue. But, we ultimately determined to use the highest tax rate because:

1. computing after-tax returns with maximum tax rates would provide investors the "worst case" federal income tax scenario and, when coupled with the before tax return, will effectively provide investors with the full range of historical after-tax returns;

2. We concluded the benefits of using an intermediate tax rate would be outweighed by the complexity of determining the appropriate intermediate rate from one year to the next, as tax rates and the income of a typical mutual fund investor changed. An intermediate rate would require the Commission to continually monitor the changing demographics of mutual fund investors, as well as changing tax laws, and be prepared to update the rule as appropriate not the best use of Commission resources;

3. The use of an intermediate rate also would require that funds include complex narrative disclosure about how the intermediate rate had been selected or what intermediate rate had been used from year to year; and

4. The concern is mitigated by the fact that the after-tax returns will not reflect state and local taxes, which can be as high as 12%.

The standardized after-tax returns were not intended to determine a particular investor's after-tax return, but simply to serve as a useful guide to understanding the effect of taxes on a fund's performance and allow investors to compare funds' after-tax returns. I would point out that funds are free to disclose their after-tax returns calculated with different tax brackets in their prospectuses.

A second complaint is that the one-year after-tax return number uses a short-term capital gains rate and that most investors would reduce their tax liability by holding their shares for at least one day longer so that a long-term tax rate should be used in the formula. Whether it makes sense or not, the fact is that many fund shareholders do redeem their shares within one year. Therefore, disclosure of this number is relevant for informing those investors of the tax consequences of such short-term trading. Again funds are free to inform investors in their prospectuses that, under the current tax code, their actual, after-tax returns will be greater if they held their shares for longer than one year.

The third argument is that disclosure of the after-tax returns should only be required in the tax section of the prospectus. We concluded that the most logical place for disclosure of these numbers, and certainly where they will be the most help to investors, is alongside the fund's pre-tax returns.

We recognize that there are those of you who disagree with the need for this disclosure. However, a virtually unanimous House of Representatives was of the view that this type of disclosure would be useful to investors. The fact is, taxes can be the most significant cost of investing in a mutual fund. This requirement addresses the gap between the importance of taxes to mutual fund investors and the knowledge that investors have about taxes.

* * *

Now, I would like to discuss three issues that I hope we can address during the next year: improving shareholder communications, providing flexibility in the affiliated transactions area and revision of the rules governing fund advertising.

Shareholder Communications

We continue studying how to improve shareholder report and financial statement presentations. I believe that the management discussion and analysis portions of shareholder reports can be improved and should be mandated in the shareholder report. 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 analyzing 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.

I 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 to 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.

Affiliated Transactions

As the financial services industry undergoes consolidation on a global scale, we are increasingly being called on to provide flexibility in the area of affiliated transactions. As we have in the past, we remain open to dealing with a variety of issues relating to transactions between funds and their affiliates on a case-by-case basis through interpretative letters and exemptive orders. We recognize that there are areas where the restrictions on affiliated transactions no longer make sense, or that with the appropriate conditions and safeguards should be allowed to proceed. As Matt Fink has indicated, the ICI submitted recommendations to us for new rules and rule amendments in the affiliated transactions area. To the extent possible, we have tried to provide flexibility with regard to affiliated transactions through the no-action and interpretative letter process. 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 staff recognized that there are benefits to redemptions in kind and that redemptions in kind to affiliated persons can be affected fairly without implicating the concerns underlying Section 17(a) under certain circumstances. This letter significantly reduces the need for funds to seek exemptive relief for such transactions.

We also issued a letter to Massachusetts Mutual Life Insurance Company that expanded the position we took in the SMC letter that indicates it is not a violation of Section 17(d) and Rule 17d-1 if an investment company aggregates orders with affiliated persons for the purchase or sale of private placement securities, such as securities issued in reliance on Rule 144A, under certain conditions.

In November last year, the Commission proposed 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.

We are continuing our review of the need for rules that would permit certain other affiliated transactions to proceed without the need for exemptive relief. One specific initiative relates to proposed amendments that would expand the scope of Rule 17a-8, which involves fund mergers. Any rule amendments in this area would place heavy emphasis on the fund's board to assure the fairness and appropriateness of the transactions.

We also are working on a rule that would codify exemptive relief given to permit funds to invest cash in affiliated money market funds. But quite frankly, for some of the other suggestions on the ICI's list for rulemaking in the affiliated transactions area, we have received only a handful of exemptive applications, so we see a less pressing need for rulemaking.

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 the antifraud prohibitions of the federal securities laws. The antifraud rules make it unlawful for a fund advertisement to omit to state any fact necessary to prevent the statements made from being materially misleading. Thus, mere disclosure of standardized performance information, even though literally true, may nonetheless materially mislead an investor if it does not include additional facts necessary to provide an investor with an accurate picture of the fund's performance. The Van Kampen and Dreyfus enforcement actions emphasize this point.

Pending rulemaking in this area, we hope to publish a staff legal bulletin that will remind funds that their advertisements should not mislead investors and that mere compliance with Rule 482 is not the end of the analysis. Advertisements must be written in a manner consistent not only with the specific advertising rules, but also with the more general antifraud rules of the federal securities laws. Special circumstances may make it unlikely that a fund will be able to sustain previous performance, and should be disclosed.

In considering the proposed rulemaking, we have been exploring how to promote the use of more current performance information. Rule 482 requires that total return information be calculated as of the most recently completed calendar quarter. Should this calculation be as of the most recently completed month end, or the most current date practicable, to promote currency of the information? Much more information is available to investors today about current fund year-to-date performance, through newspapers and fund websites. Should fund advertisements be required to refer investors to this more current information? In any event, our goal will be to seek to promote in these rule amendments, balance and responsibility in fund advertising.

Hedge Funds

Matt Fink in his remarks made some thought-provoking comments regarding hedge funds. If one needs a reason to appreciate the regulatory framework governing the mutual fund industry, you need only look to the recent miniboom we have experienced in hedge fund fraud. The SEC has brought a number of cases this past year exposing schemes that siphoned hundreds of millions of dollars from investors in these largely unregulated funds. Some have mistakenly concluded that hedge funds are beyond our reach, because they are not subject to registration or reporting requirements. Nonetheless, hedge funds are subject to the antifraud provisions of the federal securities laws. While it is difficult to prevent those otherwise intent on engaging in fraudulent activity from doing so, I submit that the regulatory framework governing the mutual fund industry makes such types of fraud more difficult to commit and easier to detect.

We also have observed that more and more mutual fund managers are sponsoring and advising hedge funds and other alternative investments. These new opportunities raise conflict of interest issues and the potential for abuse, which Lori Richards assures me we are monitoring carefully in our inspection process. Management arrangements for hedge funds can be structured to enable portfolio managers to participate directly in the profits generated by the funds that they manage. The conflicts in these arrangements result from the differing fee structures of hedge funds and mutual funds, and the fact that greater profits can be earned by the adviser from the performance based compensation of a hedge fund. The differing fee structures create a real risk of favoring a hedge fund over a mutual fund when allocating trades. Conflicts can also arise when a hedge fund effects short sales of securities, if such securities are held long by mutual funds managed by the same advisory firm. Such trades could adversely affect long positions held by mutual funds. Or mutual trades could be used to benefit a hedge fund, when mutual fund long positions are sold after the hedge fund sells the same security short. We expect firms to have compliance procedures in place to address these concerns.

We also are monitoring carefully those mutual funds that are using hedge fund type strategies, such as short selling, the aggressive use of leverage and derivatives. Changes in Subchapter M of the Internal Revenue Code, which eliminated the "short-short" test, have made it possible for mutual funds to use a wider range of investment strategies and financial instruments. However, the Investment Company Act nevertheless imposes limits on the use of these strategies and we are checking for compliance with these limitations.

New Products and Technologies

Exchange Traded Funds

One of the hallmarks of the investment management industry is its creativity. In the coming months, we expect to continue addressing issues involving new fund products. One of the areas where innovation continues is with regard to Exchange Traded Funds. Since these new fund hybrids were introduced on the American Stock Exchange in 1993, interest has steadily increased in these products. Some 80+ ETFs currently trade on the AMEX, totaling over $65 billion in assets. And this past December, cash flows into ETFs nearly equaled mutual fund inflows. Each of the products approved thus far has been based on an equity securities index. We currently have pending an application for a bond index ETF and there are those trying to figure out how to structure an actively managed ETF. The products approved to date have obvious utility for investors. They can be traded throughout the day, bought on margin and sold short. Moreover, these products typically have low costs and have tax efficiencies. But the possible evolution of these products will present complex and novel issues for the staff's consideration. The prospect of actively managed ETFs appears to raise many issues:

  • What purpose would such a fund serve for investors?

  • Would an actively managed ETF have the same low expenses and tax efficiencies as an index-based ETF?

  • Would the portfolio of an actively managed ETF be transparent enough to permit the arbitrage discipline that has generally kept the market price of shares close to the fund's net asset value?

  • Should existing actively managed mutual funds be permitted to introduce exchange-traded classes?

We at the Commission want to ensure that any regulatory approval of actively managed ETFs is in the public interest and consistent with the protection of investors. I am announcing today that we are working on a concept release regarding actively managed ETFs. We hope that this concept release will generate comments and ideas from a wide range of parties. We would hope to hear from individual and institutional investors, shareholder organizations, financial planners, investment advisers, fund organizations, market makers, arbitrageurs, product sponsors, and securities exchanges. Our goal is to gain a better understanding of the various perspectives on the issues surrounding actively managed ETFs. We then will be able to better evaluate any proposals for these types of products as they are presented to us through the exemptive process on a case-by-case basis.

The Internet

The Internet has also spurred a flurry of new products and ways of offering and delivering investment advisory services. Indeed, it is probably an understatement to say that the Internet is a fundamental development affecting all aspects of the investment management business. Yet the explosive growth of the Internet and the movement of investors and advisers online does not mean that our statutes do not apply to products and services offered whether they are in print or on the web. Unfortunately, the expanded use of the Internet has been accompanied by a rise in Internet fraud. Consequently, the Commission has devoted significant resources to fighting Internet securities fraud and brought well over 200 actions since we began policing the Internet in 1995. The recently settled suit against Yun Soo Oh Park, better known as "Tokyo Joe", illustrates our concern. Mr. Park, formerly the manager of a burrito restaurant, had become an online celebrity, first giving stock picks away for free in chat rooms and then selling them to subscribers to a web site he created. In the Complaint, the Commission alleged that Park defrauded his clients by engaging in illegal scalping (purchasing securities that he was recommending and planning to sell his shares into the buying flurry and price rise created by his recommendations), touting or recommending a stock of a company without disclosing that he had received shares of stock in the company in exchange for his recommendation, and computing his advertised investment returns using winning trades that he did not actually make. Before submitting his settlement offer, Park moved to dismiss the Commission's complaint, arguing primarily that, since he dispensed his stock picks and investment advice over the Internet, he was not an "investment adviser" within the meaning of the Investment Advisers Act and that the antifraud provisions of that Act could not be constitutionally applied to him. The District Court denied Park's motion to dismiss in its entirety and held that the Commission's complaint sufficiently alleged that Park was an "investment adviser" under the Advisers Act and that Park was subject to that Act's antifraud provisions. Park was required to give up all illegal profits and pay a penalty of more than $400,000. This case is significant because of its precedental value but also because it sends a strong message that the Commission will not tolerate fraudulent conduct by those offering investment advice over the Internet.

Our Office of Compliance Inspections and Examinations is currently engaged in a sweep of Internet advisers, to better understand how these advisers operate and to monitor their compliance with the federal securities laws. We are focusing on the same issues that we would with any other adviser, along with other issues such as electronic delivery of information to clients. We are also examining whether these programs are providing individualized investment advice and ascertaining whether they are complying with Rule 3a-4 under the Investment Company Act. If not, their advisory programs could be the equivalent of unregistered investment companies. Our Internet surveillance activities will assure that Internet advisers will not slip below the radar screen.

The development of so-called web-based baskets of securities has caused some concern in the mutual fund industry, with the ICI asserting that certain of these products are unregistered investment companies. We are analyzing whether these products are appropriately regulated and how they fit within the federal securities laws. However, the fact that a product competes directly with mutual funds is not a legitimate reason to regulate it as a mutual fund. In the case of these products, the legal issue for the Commission to decide is whether the baskets of stocks offered to investors through these products constitute the creation of new securities and result in the creation of an investment company within the statutory definitions. There is time for us to see how these various products work and make our judgments accordingly. The Commission's response to the development of these products will be based entirely on its analysis of the facts and the legal principles as applied to these facts.

Review of the Division's Processes

As many of you know, a recurring theme in my addresses to the investment management industry is to issue a challenge to the industry to set higher standards for itself than the minimum proscriptions of the Commission's regulations and to meet the competitive pressures of evolving financial products with innovation and constant improvements in investor service and reduced costs. I have again today emphasized the importance of rising to that challenge.

I want you to know that I have also issued a similar challenge to the staff of the Division of Investment Management. Just as the fund industry and the ICI have many reasons to be proud of the way they serve investors, I am extremely proud of the Division's staff. My brief remarks today about their many recent rulemaking initiatives and other actions are a testament to how hard they work and to the passionate, but balanced, manner in which they approach their regulatory responsibilities.

But I am sure we can do better. Earlier I mentioned the attrition rate the Commission has experienced lately, and I am sure that you can imagine the difficulties and delays this can cause for getting the Division's work done. I have asked the Division's Deputy Director, Cindy Fornelli, to review our systems and procedures and to make recommendations as to how we can improve the way in which we service registrants, respond to investors and fulfill our responsibilities. The goal will be to identify steps we can take to improve the quality and efficiency of our operations. This review will be comprehensive, covering how we process requests for no-action and interpretive letters, exemptive applications, and disclosure filings, and how we proceed with rule making. In private practice, I had a client who constantly admonished his employees to "work smart". I hope this effort will enhance our ability to "work smart". We welcome your thoughts and suggestions as to how we can improve our operations.


As we embark on a new era at the SEC, I hope we can count on the mutual fund industry, as we have in the past, to help us maintain the public's trust in our securities markets and their confidence in the mutual fund industry. As Matt indicated, being "wise on time" for investors is more challenging than ever before - and we will need your help.

Thank you.