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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Investment Management Regulation

Remarks by

Paul F. Roye

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

Keynote Address
American Law Institute — American Bar Association
Conference on Investment Management Regulation

October 11, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

I. Introduction

Thank you for that kind introduction. This is my first occasion to speak publicly since the tragic events that recently touched all of us in so many ways, and our financial markets so profoundly. Many of us grieve for lost friends and relatives and all of us grieve for our fellow Americans. In these trying times, we have all been tested and as Americans we have united to move forward after the terrible events of September 11th. While in many respects, we can never be prepared for the horrible events of September 11th, we learned that there is much value in preparing for emergencies, and in our world that means emergencies or events that can affect our securities markets and the operation of investment companies. Through diligent planning and preparation there is much that we can do to ensure the confidence of investors in the resiliency and operational capabilities of our markets and financial institutions.

Today I want to discuss some of the preparations that paid off during the last few weeks and some of the actions that the Commission took during recent weeks to assure the smooth operation of investment companies. Also, I wanted to discuss various issues that confronted some funds during this period, as well as some recent actions by the Commission in the investment management area, including significant enforcement actions. But as you know, I am obliged to state that the views that I express are may own and do not necessarily reflect the views of the Commission or my colleagues on the Commission's staff.

II. Actions Taken to Address the Crisis

Immediately following the attacks of September 11th, Chairman Pitt met in Manhattan with officials from the Treasury and the Federal Reserve Board; the leadership of major markets, securities firms, banks, and clearing agencies; and representatives from the offices of the Governor of New York and Mayor of New York City, Con Edison and Verizon to assess the situation and determine readiness for a reopening of the markets. As Chairman Pitt indicated in recent testimony before Congress, "our role in arranging this meeting was not to dictate a decision, but to facilitate a market solution. The decision on when to reopen the markets was made by the private sector — the markets and major market participants — in consultation with the Commission." As a result of these meetings, the industry representatives determined that the fixed income markets and futures markets should resume trading on Thursday, September 13. It was determined that the equities and options markets would reopen on Monday, September 17. Deferring the resumption of equities and options trading until Monday, September 17, permitted extensive testing by market participants of their systems. The tests ultimately verified that all systems were functioning and operational and, indeed, the market systems performed smoothly when trading resumed on the following Monday. Clearly, the securities industry's success in meeting the demands of this crisis was due in part to the hard work and effort that had previously been devoted to emergency and contingency planning, including earlier efforts that had been made in connection with Y2K. Many securities firms had in place contingency and disaster recovery plans, and emergency procedures, which saw them through the events of September 11th.

You may remember that when January 1, 2000 came and went without any significant problems, some questioned whether the substantial investment that firms had made in developing contingency plans had been worthwhile. I don't believe that anyone now questions the wisdom of that investment.

Chairman Pitt has emphasized from the outset of his tenure that the Commission is a service agency. All of us at the Commission worked hard to fulfill that mission during an extraordinary crisis. We made ourselves accessible to investors and market participants. The Commission placed additional information for investors and market participants on our website regarding market recovery efforts. Investors were invited to e-mail questions to our staff or call a special toll-free investor telephone line. The Commission also established dedicated telephone lines for inquiries from market participants and for firms seeking relief. The Commission reached out to major market participants -- both directly and through industry groups such as the Investment Company Institute, the Securities Industry Association and the Bond Market Association -- to determine whether it could provide appropriate temporary regulatory relief to facilitate the reopening of fair and orderly markets. For the first time, the Commission invoked its emergency powers under Securities Exchange Act Section 12(k) and, on Friday September 14th, issued several orders and an interpretive release to temporarily ease certain regulatory restrictions.

III. Commission Actions Pertaining to Investment Companies

Certain of the emergency actions taken by the Commission focused on investment companies.

A. Borrowing Restrictions

First, the Commission took steps to insure that when the U.S. equity markets reopened, funds would have adequate means to meet any short-term increase in redemption activity. Under normal circumstances, funds maintain enough cash to meet anticipated redemptions. Many funds also have established bank lines of credit for emergencies or to avoid selling into a falling market. Firms have seven days to pay shareholders who redeem shares, so lines of credit are usually a viable way to generate cash to pay redemptions.

But, of course, the fund industry was not confronted with normal circumstances. To address fears that funds might be faced with abnormally high redemptions when the markets reopened, the Commission used its exemptive power to provide funds options to obtain additional cash in case their lines of credit were exhausted or were nonexistent.

The Commission permitted registered mutual funds and insurance company separate accounts registered as unit investment trusts to borrow money from affiliated persons that were not themselves registered investment companies, notwithstanding sections 12(d)(3) and 17(a) of the Investment Company Act. Borrowing under these circumstances required a reasonable determination by the board of directors, including a majority of the independent directors, (or the insurance company) that the borrowing was in the best interests of the registered investment company and its shareholders or unitholders.

Similarly, the Commission's exemptive order permitted mutual funds to borrow money from entities other than banks (notwithstanding section 18(f)(1) of the Investment Company Act). Again, the Commission's relief was contingent upon a reasonable determination by the directors, including a majority of the independent directors, that the borrowing was in the best interests of the investment company and its shareholders.

The Commission also expanded the amounts that could be borrowed pursuant to interfund lending and borrowing orders received by some fund groups. The Commission allowed funds to loan an aggregate amount up to 25 per cent of their net assets at the time of the loan, notwithstanding any lower limitation in the original exemptive order, as long as the loan otherwise satisfied the terms and conditions of the original order. Without that relief, the lending fund could not loan more than 15 per cent of its net assets to a borrowing fund.

After the Commission granted this relief, we did get some inquiries about whether the relief could be extended to funds that did not have an exemptive order permitting interfund lending and borrowing. We were open to discussing expeditious relief in this area.

Finally, the Commission permitted registered mutual funds to enter into borrowing transactions that deviated from a fundamental policy discussed in a fund's prospectus without prior shareholder approval (notwithstanding sections 13(a)(2) and 13(a)(3) of the Investment Company Act). Again, the Commission's order required that any such transaction be based upon a reasonable determination by the directors, including a majority of the independent directors, that the transactions were in the best interests of the fund and its shareholders. The Commission also required funds to promptly notify its shareholders of the deviation in policy.

All of the Commission's relief relaxing borrowing and lending restrictions for registered investment companies was temporary. By the terms of the original order, the relief was to last for five business days beginning on Monday, September 17th, when trading on the U.S. equities and options markets resumed. However, responding to industry requests, the Commission extended the relief until September 28th.

The Commission's relief, and the extension of that relief, was designed to be proactive. The Commission wanted to do everything it could to help the industry avoid a possible liquidity problem. However, most mutual fund shareholders appropriately adopted a long-term view of their investments in funds and redemptions during the first week after trading resumed were not extraordinary. Since funds typically hold sufficient assets to meet redemptions, our sense is that few funds needed to rely on the Commission's emergency borrowing relief. I believe that this is due to the fact that when the markets reopened, all market and investor protection mechanisms were squarely in place, and consequently the markets did not give way to panic selling.

B. Requirement that Directors of Funds Meet In-Person

The Commission also recognized that funds and their advisers might face problems convening in-person meetings given disruptions to the transportation system. As you know, the Investment Company Act requires significant actions such as renewing advisory contracts, distribution agreements and distribution plans to be taken at in-person meetings. Consequently, the Commission exempted for a period of thirty days, beginning on September 14, 2001, SEC-registered investment companies, their advisers, and their principal underwriters from the requirement that votes of the investment company's Board of Directors with respect to the renewal of any existing advisory or distribution contract, distribution plan or arrangement be cast in person. Instead of in-person meetings, directors were allowed to cast their votes on a conference call or other means of communication that allowed all of the participating directors to communicate with each other simultaneously during the meeting. In addition, any action taken by a board during such an alternative meeting format could not result in any material change to an existing contract, plan or arrangement. Finally, any such action would have to be ratified within 90 days by the board, including a majority of independent directors, at an in-person meeting. Now that the transportation system is functioning, there are no plans to extend this relief, which expires this Saturday, October 13th.

While I believe that the Commission was able to respond appropriately on an emergency basis to the events, I should note that legislation was recently introduced in the House of Representatives to provide the Commission broader emergency powers for longer periods to respond to a crisis. These proposed powers specifically extend to emergencies involving investment companies.

IV. Reopening of Funds

Another example of how the industry and Commission staff worked together to restore normalcy to the financial markets was the quick reopening of money market funds. Most money market fund prospectuses stated that the funds would not be open for business when the New York Stock Exchange was closed. However, many funds wanted to allow shareholders in these funds to have access to their cash as soon as possible, given the widespread use of money market funds as alternatives to bank checking accounts.

With herculean efforts, a number of money market funds resumed trading on Wednesday of that week and many more were open on Thursday after the tragedy. For the industry, trading limited types of funds is a challenge. The systems of most transfer agents are designed to trade all the funds in a complex simultaneously. Modifying these systems, particularly under the circumstances, was a difficult task. One that was spectacularly achieved by the operations staff of these firms. I am not aware of any money market funds that had significant operational difficulties when they reopened.

For the Commission staff, getting the money market funds reopened as soon as possible meant the staff needed to assure these funds that no action would be recommended against funds that traded when their prospectuses indicated that they would be closed. Of course, these fund firms were encouraged to inform their investors that the funds were open for business.

Reportedly, redemptions of cash in money market funds were light during the first few days after they reopened. But I don't believe that that is an indication that the funds' actions were not crucial to maintaining shareholders' confidence. Consequently, we applaud the firms and their service providers for their actions, including their efforts to inform their shareholders that their funds were open.

As I mentioned, the bond market reopened on September 13. Some bond funds resumed trading on Friday, September 14, even though they were permitted to be closed pursuant to Section 22(c) under the Act.

All funds resumed operations on September 17 with few difficulties. It truly was the result of a tremendous effort of the many participants in our securities markets to have our markets functioning as soon as possible after the events of September 11th.

V. Valuation

One issue that confronted a number of funds after the event, particularly funds with fixed income holdings, was the pricing of their holdings. Trading volumes in the bond market were relatively light. Moreover, the pricing services that some funds normally used to assist them in their valuation procedures were located in downtown Manhattan. A number of funds found it necessary to use back-up pricing services and other pricing sources to value their portfolio securities and compute their net asset values.

As you know, valuation is extremely important for mutual funds because they must redeem and sell their shares at net asset value. If fund assets are incorrectly valued, shareholder accounts will pay 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, such as 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.

As you know, the staff has recently focused on fair value policies. I believe that this focus paid dividends during these events. We issued a letter at the end of April to the ICI that provides guidance on firms' obligations to fairly price foreign securities. This letter followed up on our December 1999 letter on valuation related issues. This new letter focuses on the need for funds to avoid dilution of its long-term shareholders by those seeking arbitrage opportunities that may arise when significant events occur in foreign markets. Funds generally calculate their net asset values by using closing prices of portfolio securities on the exchange or market on which the securities principally trade. Many foreign markets, however, operate at times that do not coincide with those of the major U.S. markets. As a result, the closing prices of securities that principally trade on foreign exchanges may be as much as 12-15 hours old by the time of a fund's NAV calculations and may not reflect the current market value of those securities at that time. In particular, the closing prices of foreign securities may not reflect their market values at the time of a fund's NAV calculation if an event that will affect the value of those securities has occurred since the closing prices were established on the foreign exchange, but before the fund's NAV calculation. Dilution of the interests of a fund's long-term shareholders could occur if fund shares are overpriced and redeeming shareholders receive proceeds based on the overvalued shares. The risk of dilution increases when significant events occur because such events attract investors who are drawn to the possibility of arbitrage opportunities. Fair value pricing can protect long-term fund investors from those who seek to take advantage of funds as a result of a significant event occurring after a foreign market closes. The letter highlights a fund's obligation to monitor events that might necessitate the need to use fair value pricing to protect fund shareholders.

Before September 11th, we urged that funds promptly begin reviewing their valuation procedures. Now I believe that need is even more urgent. No fund's contingency plans could be considered complete without adequate fair valuation procedures.


Now, I would like to turn to some other recent actions taken by the Commission.

A. After-Tax Returns

Earlier this year, the Commission adopted rule amendments to require disclosure to investors of the effect of taxes on the performance of mutual funds. Specifically, funds will be required to disclose in their prospectuses after-tax returns based on standardized formulas comparable to the formula currently used to calculate before-tax average annual total returns. In addition, if funds advertise themselves as tax efficient and/or include after-tax performance numbers in their advertisements, then those advertisements will be required to include after-tax performance numbers calculated using the same standardized formula.

As adopted, funds were required to comply with the advertising requirements by October 1st of this year and to comply with the prospectus requirements by February 15th of next year. However, on September 25, 2001, the Commission extended the compliance date for fund advertisements and other sales literature until December 1, 2001. The Commission took this action because some in the fund industry had raised some technical, interpretive issues regarding the standardized calculations. The Division has met with industry representatives and service providers to discuss these issues and is currently developing answers to frequently asked questions regarding the after-tax rules that will address these issues. I expect that these answers will be issued very soon and will be available on the Commission's website.

Consequently, I do not expect that there will be any need for further extensions of the compliance date for fund advertisements. With respect to the compliance date for prospectuses, the Commission did not entertain extending that deadline, and I don't believe there will be any reason for such consideration in the future.

B. Portfolio Investment Programs

In another development, the Commission has asked the Division to monitor the development of so-called "portfolio investment programs" sponsored by broker-dealers and investment advisers. Investors participating in these programs typically use the sponsor's web site to create personalized portfolios (also referred to as baskets) of securities.

The development of these products has caused some concern in the mutual fund industry, with the Investment Company Institute asserting that certain of these products are also unregistered investment companies, prompting a rulemaking petition to regulate these products under the Investment Company Act. On August 23, 2001, the Commission denied the ICI's rulemaking petition, stating that the programs described in the petition did not at this time appear to raise interpretive issues that warranted the Commission undertaking rulemaking. In the denial letter, the Commission juxtaposed the characteristics of an investment company with those of the portfolio investment programs described in the rulemaking petition.

The Commission noted that an investment company, or typically an external adviser, invests and manages the investment company's securities portfolio and that investors have no ability to direct the specific investment decisions made with respect to the investment company's portfolio. It further noted that investment company investors hold shares that represent an undivided interest in the pool of securities in which the investment company invests and that they have no beneficial ownership interest in the individual securities comprising the pool.

In contrast, the Commission stated that the programs described in the petition provide investors with the opportunity to make their own investment decisions and to create and manage portfolios of securities based on each investor's individual needs and objectives. It was further noted that each investor in the programs described in the petition is the beneficial owner of the securities in his or her portfolio, does not hold an undivided interest in a pool of securities, and has all of the rights of ownership with respect to such securities, including the right to vote, receive dividends, confirmations, proxy statements and other documents required by law to be provided to security holders.

The Commission further pointed out that sponsors of portfolio investment programs generally are subject to regulation and oversight under the federal securities laws, including the Securities Exchange Act of 1934, as sponsors of the programs have generally registered as broker-dealers, and in some cases, are required to be registered as investment advisers regulated under the Investment Advisers Act.

Finally, the Commission noted that it was aware that there are few such programs in existence and that they had not been in operation for a significant period of time. The Commission stated that it intends to monitor the development of these programs for compliance with the federal securities laws, and consider taking further action, if necessary. Consequently, through the inspection process and otherwise, the evolution of these products will be scrutinized carefully to assure that they are appropriately regulated under the federal securities laws.

C. Significant Enforcement Actions

Finally, I thought I would highlight several recent significant enforcement actions.

1. Portfolio Pumping

On August 10, 2001, the Commission brought, and settled, its first major "portfolio pumping" case. The Commission instituted and settled four separate but related administrative proceedings against a registered investment adviser, a portfolio manager formerly employed by the adviser, a registered broker-dealer and the former head of the broker-dealer's international equity trading desk. These proceedings resulted from a trading strategy in which the portfolio manager and the trader placed purchase orders in five securities heavily owned by the portfolio manager's advisory clients shortly before the close of the market with the purpose of increasing the closing price of those securities.

Using trading records and tapes of contemporaneous telephone conversations, the Commission found that the portfolio manager and the trader attempted to "mark or marked the close" of several securities in violation of the federal securities laws. The order states that the portfolio manager and the trader discussed which stocks to purchase, focusing on stocks in which the portfolio manager held large positions and chose target closing prices for these stocks. In some cases, the trading resulted in short-term increases in the overall value of certain securities held in the accounts managed by the portfolio manager when performance results were reported to advisory clients at the end of various quarters. The Commission found that the trading strategy was not disclosed to clients and was not authorized under investment guidelines that applied to the accounts. As a result, the Commission found that the portfolio manager willfully violated section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, and willfully aided and abetted violations of sections 206(1) and (2) of the Advisers Act.

The Commission also found that the investment adviser failed reasonably to supervise the portfolio manager with a view to preventing these securities law violations. The Commission found that although the adviser had in place written policies and procedures regarding trade processing, portfolio compliance and other issues, the adviser failed to adequately implement its policies that prohibited manipulative trading. While the portfolio manager's trades were reviewed on a daily basis, his trading methods were not effectively reviewed for compliance with this aspect of the adviser's policies. Similarly, the Commission found that the broker-dealer failed reasonably to supervise the trader, indicating that the trader's activities were not effectively reviewed for compliance with the firm's policies and procedures, which would have barred such trading activity.

I think it is significant that in the Commission orders against the adviser and the broker-dealer, the Commission noted that in accepting each firm's Offer of Settlement, it took into account the firm's remedial acts and its cooperation with the Commission staff. The adviser undertook an internal investigation of the portfolio manager's trading after receiving an inquiry from a foreign exchange, and the investigation led to the portfolio manager being placed on administrative leave and subsequently resigning. In addition, the adviser voluntarily paid clients about $6 million as compensation for any possible adverse effects of the portfolio manager's trading. Finally, the adviser implemented a series of reforms, including enhancing its segregation of functions and requiring that all equity trades be initiated and monitored by the trading department and not by portfolio managers. The broker-dealer likewise conducted an internal investigation in response to a foreign exchange inquiry, placed the trader on administrative leave and eventually terminated him for cause, and enhanced its compliance procedures by requiring review and approval by a supervisor, other than the securities trader, of any significant size order received for execution in the final 30 minutes of a trading day and review of any such order taken directly by the head trader by his or her supervisor.

2. Failure to Supervise Sub-Adviser

In view of the increasing use of sub-advisers in the industry, I would direct your attention to administrative proceedings against a fund's investment adviser and its sub-adviser made public on September 28, 2001. The matter arose from a portfolio manager who the Commission found defrauded a mutual fund and an offshore fund, by concealing from the funds and their investment advisers that issuers of securities held by the funds were suffering some financial problems. The portfolio manager inflated the value of the troubled securities and caused one of the funds to materially overstate its net asset value.

From July 1994 to April 1998, the portfolio manager caused the funds to purchase from one broker-dealer $32 million in notes through private placements. The Fund had pricing procedures that required the portfolio manager to obtain bid and asked quotes from two brokers for securities that could not be priced by a pricing service. However, with respect to the notes purchased from the broker-dealer, the portfolio manager provided the fund's accountants two fictional bid and asked price quotes, based on discussion with the broker-dealer that sold the notes and without consulting other brokers. In 1995, the broker-dealer took over from the portfolio manager the responsibility of providing prices on the notes to the fund's accountants, continuing to provide two fictional bid and asked quotes for the notes purchased from the broker-dealer. Five of the issuers, which sold a total of $15.7 million par value notes to the registered fund, had severe financial trouble from 1996 through 1998, which resulted in the issuers' defaulting on interest payments, being forced into voluntary bankruptcy and/or having all their assets taken away in foreclosure proceeds.

In 1997 and 1998, the portfolio manager and the broker-dealer principal rolled up the five troubled notes into shell companies controlled by the broker-dealer principal. In these roll-up transactions, the portfolio manager had the funds purchase from the broker-dealer $14 million in notes issued by the shell companies. The shell companies then used a portion of the proceeds to purchase from the registered funds five of the problem notes. The pricing of the five notes and the shell companies' notes failed to reflect the notes' performance and the original issuers' financial condition, and consequently the value of the notes was overstated. As a result of the overpricing, the registered fund materially overstated its NAV. The fund's NAV was overstated from at least August 30, 1996 through November 30, 1998, by amounts ranging from $.09 to $.20 per share.

The Commission concluded that the portfolio manager violated section 17(a) of the Securities Act, section 10(b) and Rule 10b-5 under the Securities Exchange Act, section 34(b) of the Investment Company Act, and aided and abetted violations of sections 206(1) and (2) of the Investment Advisers Act, 34(b) of the Investment Company Act and Rule 22c-1 under the Investment Company Act.

The Commission further found that the fund's adviser and sub-adviser failed to reasonably supervise the portfolio manager. The Commission has repeatedly emphasized that the duty to supervise is a critical component of the federal regulatory scheme. The Commission has sanctioned advisers that did not establish and implement procedures reasonably designed to prevent and detect violations of the federal securities laws. Moreover, the Commission has made it clear that supervisors must respond vigorously to indications of possible wrongdoing. Accordingly, supervisors must inquire into red flags and indications of irregularities and conduct adequate follow-up and review to detect and prevent future violations of the federal securities laws.

The Commission found that the sub-adviser had not established or implemented adequate procedures regarding the purchase, monitoring and pricing of private placement securities. Specifically, the Commission found that the sub-adviser did not have procedures: 1) to enforce a policy that agreements to purchase securities in private placements be approved and signed by officers other than portfolio managers; 2) to ensure that the portfolio manager was, in fact, monitoring securities and properly reporting and acting on any defaults, and 3) to ensure that the fund's securities were priced in accordance with the fund's offering documents.

Significantly, the Commission also found that the primary adviser also failed reasonably to supervise the portfolio manager. The commission emphasized that the written agreement between the adviser and the sub-adviser provided that the sub-adviser's advisory services were subject to the supervision of the primary adviser. The Commission also noted that the primary adviser had indications of irregularities regarding the problem notes, including stale prices and knowledge of proposed roll-up transactions, but did not adequately follow-up and review these irregularities. Furthermore, the primary adviser had not established or implemented procedures for such follow-up and review.

In view of the growth in the industry of using sub-advisers, I would urge careful review of this enforcement action and emphasize that primary advisers should have adequate procedures in place to monitor and oversee the actions of sub-advisers.

VII. Future Actions of the Commission

Chairman Pitt has made it clear that much of the Commission's focus in the future will be updating and modernizing the regulatory framework that we administer. The Chairman observed in his confirmation that "our securities laws are, in the main, nearly seventy years old. They reflect a time, and a state of technology, that's light years away from where we are today." While the Commission has made significant strides towards modernization in the past few years, there is much left to be done, and I expect that the pace will quicken towards reconciling the Commission's regulations with the realties of how investment companies conduct their business and meet the needs of today's fund shareholders. We will be looking to advise the Commission as to how regulations can be streamlined to ease regulatory burdens, as well as facilitate creativity, all of course as long as investor protection is not compromised. We would appreciate your thoughts and input as we move forward with this effort.

VIII. Conclusion

I want to conclude by again applauding firms for the manner in which they responded to the recent events. I believe that your response has bolstered, not diminished, the confidence that fund shareholders have in the fund industry. But while we fervently hope that nothing like September 11th will ever again trigger the implementation of your contingency plans, it is likely that someday, some event, perhaps as simple as a power outage, will again do so. While our recent experience is fresh in your minds, I urge you to review your plans and procedures with an eye towards learning from our recent experience and making appropriate modifications and improvements in your contingency planning and emergency procedures. I can assure you that, at the Commission, we will do the same. We should all be mindful of the age old wisdom that "those who do not remember the past (or learn from the past) are condemned to relive it." We stand ready to assist you in this process and in all matters you have before the Commission.

Thank you.



Modified: 10/24/2001