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U.S. Securities and Exchange Commission

Speech by SEC Staff:
The Evolving Mutual Fund Landscape: Adapting to the Challenges of Change

Remarks by

Paul F. Roye

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

Before the ICI 2001 Securities Law Developments Conference

December 6, 2001

I. Introduction

Good morning, and thank you for inviting me to speak to you today. As you are aware, my remarks this morning represent my own views and may not represent the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

Science fiction writer Isaac Asimov once said, "It is change, continuing change, inevitable change, that is the dominant factor in society today. No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be." Mr. Asimov's words are particularly relevant to the fund industry, which has been through a remarkable period of change since I spoke to you at this conference one year ago, and to the Commission, as we adapt to meet the regulatory challenges posed by the changes impacting the fund industry. For starters, the economic downturn is being felt by fund groups. 2001 has seen declining market indices, increasing fund redemptions and lower net inflows. According to a recent ICI release, mutual fund assets dropped from nearly $7 trillion at the beginning of this year to $6.6 trillion at the end of October, a decrease of approximately 5%. Even more telling: stock funds at the end of October held $3.1 trillion in assets, down from nearly $4 trillion at the beginning of the year, a decrease of over 20%.

With the economic downturn, the trade press this year has, unfortunately, been full of stories about layoffs at fund firms. Recent reports indicate that these layoffs seem to be cutting a wider swath. Yesterday's Wall Street Journal noted that the targets of layoffs are expanding from service personnel to investment personnel, including portfolio managers, the so-called "rock stars" of the investment management industry. In light of this news, I hearken back to my warning in May at the ICI General Membership Meeting. At that time, I urged that when considering personnel layoffs, fund firms keep in mind that compliance and compliance staffing should not be unnecessarily compromised because of the market downturn. I am sure that this is a sentiment shared by those in this room. But seriously, cutting corners in compliance now could result in significant problems for fund firms in the long run. Compliance problems can lead to a loss of confidence and public trust, which can lead to a loss of assets under management, which can jeopardize a fund group's business.

One year ago, the Federal Reserve Board's federal funds rate stood at 6.5%. In the intervening months, it as been reduced to just 2%. One result of the Fed's ratecutting is that some money market fund yields are reported to be near 0%--a level few previously ever imagined, causing some firms to reduce fees in order to assure a positive return. The market downturn, and the resulting decrease in fund assets, is even affecting rule 12b-1 fee revenue--making it difficult for some firms to recoup their outlays to brokers from previous years' periods of heavy fund inflows.

In addition to these economic changes, the tragic events of September 11th have impacted funds, as they have affected all people across America. We now have the confidence of knowing that we can withstand a major disruption to our financial systems, but the September 11th experience also teaches us that we cannot overlook the criticality of having appropriate back-up systems, business continuity plans and related procedures in place.

Another piece of the changing landscape is the continued consolidation within the fund industry. Based on the number of recent filings of Form N-14, the form used to register securities issued in fund mergers, we have seen a 75% increase in the number of fund mergers in each of the last two years from the previous two-year period. Passage of the Gramm-Leach-Bliley Act in November 1999 has, in part, spawned this increased merger activity. As you know, the Gramm-Leach-Bliley Act eliminated the decades-old barriers between banking and securities-related activities. An outgrowth of the Gramm-Leach-Bliley Act has been, and likely will continue to be, increased consolidation among various financial service providers, including banks, insurance companies, wirehouses and advisory firms.

The fund industry also is experiencing change influenced by technology and new investment vehicles. This past year saw a focus on web-based portfolio investment programs. The Commission also accelerated the registration of the first "electronic-only" variable annuity and issued a concept release regarding actively managed exchange-traded funds.

This year has also seen change at the Commission. In August we welcomed our new chairman, Harvey Pitt. Chairman Pitt, a former SEC General Counsel and renowned securities lawyer, brings an outstanding level of experience and expertise to guide the Commission through the many challenges that lie ahead. I have a sense that our new chairman would subscribe to the philosophy of Rear Admiral Grace Hopper, co-developer of the COBOL computer language and one of the few women admirals in the history of the U.S. Navy, who said, "The most damaging phrase in the language is: `It's always been done that way.'" Chairman Pitt has expressed a strong desire to modernize and update Commission rules and bring securities regulation into the 21st Century.

II. Rule Proposals

A. Rule 17a-8

Along these lines, the Commission last month proposed amendments to rule 17a-8, an exemptive rule permitting mergers of affiliated funds. I believe that the panel following me will discuss the rule in greater detail.

In a nutshell, the proposed amendments would significantly expand rule 17a-8 to allow mergers of funds affiliated for any reason, as well as facilitate mergers of bank common trust funds and collective trust funds into registered investment companies. Currently, rule 17a-8 permits mergers of registered funds affiliated solely because of a common adviser, directors and/or officers. I believe the scope of the rule can be substantially expanded in view of the cornerstone protections of the proposed rule: (1) independent director review (which already is required by the rule) and (2) a proposed shareholder approval requirement.

1. Independent Director Approval

An expanded rule 17a-8 would rely on independent directors, rather than the Commission, to determine the appropriateness of affiliated fund mergers. Since I spoke to you last year, the Commission amended several exemptive rules, including rule 17a-8, to require that fund boards contain a majority of independent directors, that those directors be self-nominating and that any legal counsel to the independent directors be truly independent. This enhanced independence paved the way for the proposed expansion of rule 17a-8 and could lead to similar exemptive rulemakings for other types of affiliated transactions. As I mentioned, with increasing consolidation in the fund industry, we expect to see an increase in the number of situations requiring relief from the Act's affiliated transaction prohibitions.

2. Shareholder Voting

The second core protection of the Commission's proposed amendments to rule 17a-8 is shareholder voting. The Commission proposed that shareholders of a merging fund approve any merger of affiliated funds. The shareholder vote requirement was not previously part of the rule because the regulatory landscape did not call for it. State law generally required that merging funds hold a shareholder vote. A case can be made that the shareholder vote requirement is necessary now, however, because developments in state law, such as the adoption of the Delaware and Maryland business trust statutes, permit funds to merge without holding a shareholder vote, and some funds are effecting mergers that are not approved by shareholders. The 1940 Act, however, expresses Congress' expectation that a shareholder vote occur for these types of reorganizations. Section 1(b) of the Act states, "The national public interest and the interest of investors are adversely affected ... when investment companies are reorganized, become inactive, or change the character of their business ... without the consent of their security holders."

A merger or reorganization is a fundamental change in a fund's operations. Indeed, it is hard to imagine a transaction that is more fundamental to a fund's operations, and it is the type of change in which fund shareholders arguably should participate.

3. Fund as Corporation Versus Fund as Financial Product

Proposed rule 17a-8's two core protections of independent director approval and shareholder voting rights are consistent with the corporate governance model of fund organization on which the 1940 Act is predicated. That model has been challenged from time to time by proponents of a financial product based approach. David Silver, former head of the ICI and ICI Mutual Insurance Company, highlights this issue in an excellent paper he prepared for the SEC Historical Society Program held in November. Critics of the corporate governance/shareholder rights model argue that independent directors have limited effectiveness and that there is little value in shareholder voting, since many fund shareholders do not vote.

After serious review and reflection, the Division staff rebuffed these criticisms and advocated the continuation of the corporate governance approach in its 1992 Report "Protecting Investors: A Half Century of Investment Company Regulation." The Commission itself strongly endorsed the corporate governance model earlier this year when it effected the most far-reaching changes to fund governance in at least 30 years by adopting exemptive rule conditions designed to strengthen the independence and effectiveness of independent directors. Going forward, however, as we face an evolving investment management landscape, the Commission and the industry will continue to wrestle with the fund as corporation versus fund as financial product dichotomy. There is tension, but they are not necessarily mutually exclusive. The direction the Commission follows on this issue will fundamentally shape fund regulation in the future.

4. Alternative Protections if No Shareholder Vote

If the Commission determines not to require a shareholder vote in the context of an affiliated fund merger under rule 17a-8, how can the Commission assure that fund investors are at least informed of fund mergers and that investors have an opportunity to react as to whether a merger is in their best interests? The Commission could require advance notice of fund mergers to investors of the fund being acquired. Or the Commission could require advance notice to investors and an opportunity to "vote with their feet" by redeeming without penalty. Alternatively, the Commission could rely solely on independent director approval of the merger on the theory that director scrutiny is sufficient in this area. The Commission has posed questions regarding the utility of shareholder voting in this context. We look forward to the comments of the fund industry and fund investors on this important issue.

B. Rule 17f-4

Last month, the Commission also proposed amendments to rule 17f-4, which governs funds' use of domestic securities depositories. Rule 17f-4 has not been overhauled since it was adopted in 1978. In the ensuing years, custody practices and commercial law relating to custody arrangements with securities depositories have changed substantially. With the proposed amendments, the Commission seeks to modernize and simplify rule 17f-4. As I mentioned earlier, this modernization type of rulemaking is something Chairman Pitt has established as a priority for the Commission. While these rulemakings may not in every case have a revolutionary effect on the fund industry, they will make our rules more understandable, logical and meaningful, which I think we all can agree is a very laudable goal. Again, I believe that the next panel will conduct a more detailed review of the proposed amendments to rule 17f-4.

III. Influence of Technology and New Products

At the opening, I mentioned the downturn in the economy, which has spilled over into the fund industry. However, I also acknowledged the impact of the Internet and new technology on our lives. When it comes to innovative products, it seems the influence of ingenuity and technological drive are overwhelming weak economic prospects. This past year has seen a wave of new delivery vehicles for investment services. And as our Chairman has stated, the Commission staff will not stand in the way of innovation, as long as investor protections are not compromised. We are committed to working with you to iron out novel issues posed by new technology and new products. The Commission understands and has generally embraced the role of new technology in the marketplace. Just last week before the Consumer Federation of America, Chairman Pitt stated that when rethinking our current disclosure system, we need to recognize the benefits of technology to put user-friendly information into investors' hands more promptly. We will explore this in the context of the mutual fund framework.

A. New Technology-driven Products

In the past year, the Commission has acted on several innovative, technology-driven products. For example, the Commission accelerated the effectiveness of an "electronic-only" variable annuity-the first product of its kind. This new variable annuity delivers all "documentation" electronically, including prospectuses, proxy statements and transaction confirmations. As a result of the "paperless" delivery, the new annuity represented that it is able to charge lower fees than the average variable annuity. The Commission is currently reviewing whether its guidance regarding electronic delivery of information under the federal securities laws should be modified.

The Commission also is reviewing issues associated with exchange-traded funds. Unlike current exchange-traded funds, which track an equity index, we have applications pending for exchange-traded funds based on fixed-income indices and exchange-traded products that would be subject to active portfolio management. The Commission recently issued a concept release seeking industry input on actively managed exchange-traded funds so that we can evaluate these proposed products with the benefit of your perspectives and knowledge and experience. The concept release raises a number of complex issues, and I encourage you to respond to the Commission's request for comment. In the meantime, our staff is continuing to work with applicants to resolve issues related to the evolution of these products.

B. Convergence of Products and Services

Technology and innovation also have resulted in a convergence of investment vehicles, products and services. It is not so clear anymore where the lines are between broker-dealers and investment advisers or even between brokerage accounts, investment advisory accounts and fund investments. The Commission is carefully reviewing these convergence issues to ensure that securities products and securities market participants are appropriately regulated. Along these lines, the Commission has proposed a rule exempting from the definition of investment adviser certain brokers that charge an asset-based fee, even though historically brokers have charged commissions while advisers have charged asset-based fees. This proposed rule was precipitated by the development of new brokerage compensation systems and the development of on-line trading at reduced brokerage rates. As you can imagine, the proposal generated numerous comments from brokers supporting the proposed rule and from financial planners and others opposed to it.

In another example of a blurring of the lines, this year brought focus on web-based portfolio investment programs and a petition from the ICI that the Commission regulate these investment programs as investment companies. The Commission denied the rulemaking petition after careful consideration and review of these new products. The sponsors of these programs generally are registered as broker-dealers or investment advisers, and the Commission determined that further regulation of the programs as investment companies was not warranted at this time. We have limited experience with these products, however. Therefore, the Commission has directed the staff to continue monitoring their development and operations, to assure that they are appropriately regulated.

Web-based portfolio investment programs followed on the heels of wrap accounts and mini accounts, which raise issues about when the management of investor assets in a like fashion becomes an investment company. In 1997, the Commission adopted rule 3a-4 to provide a non-exclusive safe harbor from the definition of investment company for certain advisory programs that provide clients individualized treatment.

Rule 3a-4 contains conditions designed to ensure that each client receives individualized treatment and that each client's account is managed in accordance with the client's financial situation and investment objectives. For example, each client must have the ability to impose reasonable restrictions on the management of his account, and sponsors of programs relying on the rule must annually contact each client to determine if there have been changes in the client's financial situation or investment objectives.

It has been four-and-a-half years since the adoption of rule 3a-4, and, in that time, technology has advanced significantly. Technology enables managers to offer portfolio management programs meeting the conditions of rule 3a-4 to larger and larger numbers of investors for lower and lower investment minimums. Given the technological advances, and the evolution of these investment management programs, I think we should consider whether the conditions of rule 3a-4 continue to provide effective assurance that clients in those programs receive truly individualized treatment and whether the conditions of rule 3a-4 should be revisited.

As we all know, innovation and technology create opportunities. Without innovative thinkers, investors would not have index funds, money market funds or exchange-traded funds available to them today. However, we must keep in mind that each advance in technology or new innovation often presents a new set of investor protection issues that the staff and the Commission—and the innovators—are duty-bound to consider.

IV. Service Agency

I want to assure you that we in the Division of Investment Management are here to work with you as you create new products, and as you revise your disclosure documents, struggle with valuation issues or even as you submit an Edgar filing. The Division has a practice of providing ongoing assistance following the adoption of major rulemakings. The Division provided on-line frequently asked questions regarding revised Form ADV, the new privacy regulations and the after-tax rule. And earlier this week, we published frequently asked questions about rule 35d-1, the fund names rule. As Chairman Pitt has stated several times, we do view ourselves as a service agency, and we would rather assist you ahead of time, than send in our enforcement team after the fact.

Division staff maintains several telephone hotlines so that we can be responsive to issues you face on a daily basis. In addition, we are conducting a major overhaul of our Division's website that should present information to you in a more complete and logical format. We also plan to launch a pilot program to include no-action letters on our Division's webpage. Currently, Commission releases are available, but there has been great demand for no-action letters as well. We also have a new website that enables you to review the most recently filed Form ADV (Part 1) of any adviser registered through the Commission. Just as you are using technology to better service shareholders, we are using technology to more efficiently and more effectively inform investors and registrants and respond to their needs.

As I reflect on the Division's efforts to serve, however, I am reminded that one of the industry's biggest complaints is that it takes too long to get exemptive applications and no-action letters through the regulatory pipeline. We are sensitive to your timing concerns because we do not want to needlessly impede your operations. On the other hand, we take our investor protection responsibilities very seriously, and we will not "fast track" a product or a transaction to the detriment of investors. Going forward, the Commission will be able to act with more flexibility, and rely on the sound judgment of independent directors, now that the Commission has acted to enhance the independence and effectiveness of directors. Together, we can move the process along. I therefore ask for your assistance and your cooperation when you are requesting a no-action letter or an exemptive order. We will work with you, and the more you have done to identify and thoroughly address issues, the better opportunity we have to expedite the process.

V. "Real-time" Enforcement

I must remind you that, while the Commission views itself as a service agency, we will not shirk our enforcement duties. Chairman Pitt and the staff of the Enforcement Division are committed to "real-time" enforcement of the federal securities laws. Earlier this week, the Commission announced that it had obtained ex parte orders from a U.S. district court to shut down an oil and gas investment scam. The Commission filed the lawsuit and obtained the orders within just four days of initially learning of the scam. The case is but one example of the Commission's resolve to move quickly to squelch securities law violations, especially those that involve an ongoing fraud when investor funds are at risk.

At the same time, however, the Commission has announced an initiative to encourage companies, including funds and advisers, to police themselves and to report and correct misconduct when it is discovered—rather than waiting for the Commission to discover and act upon a violation. Funds are encouraged to responsibly assess their compliance programs and to act quickly to remedy problems. Fund firms should be able to identify and correct compliance shortcomings before they rise to the level of an enforcement action, and fund shareholders can be protected from the dangers that result from a lax compliance environment. Steve Cutler, the Commission's Director of Enforcement, likely will have additional details on the Commission's new enforcement initiatives when he addresses you at your luncheon later today.

VI. Aftermath of September 11th

As I have stated, 2001 was a year of substantial change brought about by economic and technological influences. For most people, however, the year's single most significant change occurred on September 11th. The impact of September 11th on all our lives is immeasurable. Never again will we take our security for granted. And never again will we turn a blind eye to the threat of terrorism.

Never again will the financial services industry take its communications systems, its record storage facilities and its back office infrastructure for granted. September 11th heightened our awareness of the importance, indeed the necessity, of having back-up systems and disaster recovery/business continuity plans in place. Our Inspections Office has committed to making funds' contingency planning a focus of future inspections. When they come knocking on your door, our inspections staff will ask you for a copy of your contingency plan and likely will ask questions about alternative physical facilities, back-up records storage and back-up communications systems. The inspections staff will also focus on the extent to which you test and evaluate your contingency preparedness.

We understand, however, that there cannot be a "one size fits all" approach to contingency planning. Different firms, depending on size, investment style, location and reliance on technology, have different needs and different capabilities. Each firm should thoughtfully assess what its back-up and contingency needs are and should act to improve disaster recovery and business continuity planning as expeditiously as possible.

Funds also should reassess their fair valuation procedures in light of the events of September 11th. Funds should assure that they can continue to appropriately value securities in the wake of a disaster like September 11th, whether that disaster takes place on U.S. or foreign shores.

VII. Conclusion

I conclude on a simple note. These are changing times: a new chairman, new commission members, a new economy, new technology and new products and services. But in the midst of the tumult, some things remain constant. Funds continue to be the primary investment vehicle of the average American. Despite market volatility, fund investors have provided stability and resiliency to our securities markets. Investors continue to have confidence in mutual fund investing because the fund industry remains free of scandal. And integrity and responsibility continue to be hallmarks of the fund industry. The fund industry is an industry of which you can be proud, and it is an industry that can adapt to the changes of 2001, just as it has adapted and evolved in the six decades following adoption of the Investment Company Act. As Isaac Asimov said, we must not only take into account the world as it is, but the world as it will be. We can assure ourselves that the mutual fund industry of the future will be a beacon for the rest of the financial services industry, if we remain focused on maintaining investor trust. I thank you for inviting me here today and hope you have an informative and productive conference.



Modified: 12/10/2001