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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks before the Investment Company Institute, 2002 General Membership Meeting


Chairman Harvey L. Pitt

U.S. Securities and Exchange Commission

Washington, DC
May 24, 2002

These remarks reflect solely the personal views of Mr. Pitt, and do not necessarily reflect the views of the Commission, the individual members of the Commission, or its Staff.

Before I begin, let us all note, as we celebrate Memorial Day, that thousands of innocent victims, including many who worked in the securities industry, tragically and senselessly lost their lives on September 11th. As we celebrate those who gave so much in so many past wars for our freedom, let us also remember the non-combatants who died tragically in a war we still fight — the war against terrorism.

I appear before you today with some trepidation, stemming from my first day at the SEC as a young lawyer, thirty-four years ago. Then, I sat in my office and, having nothing better to do, began reading the Investment Company Act. After reading through the first few sections, I resolved not to unpack any more boxes, because it was unlikely I would be staying in Washington very long. Even though the '40 Act appeared to be written in English, I couldn't understand a word of it! I was sure I wouldn't make it through the week. Imagine how much worse I would have felt if I had started reading the Commission's '40 Act rules! Fortunately, I resisted that temptation for several years.

But, putting trepidation aside, I can tell you that it does not take a '40 Act expert to talk about the negative forces afflicting our securities markets, that have eroded the critical reservoir of investor confidence. Even my younger children can cite chapter and verse about the lack of public confidence in the securities industry, the accounting and legal professions, and those of us who regulate them. We have witnessed a period when traditionally dry issues, like accounting and off-balance sheet liabilities, have become fodder for front-page news articles. Remarkable!

This morning, I want to convey three important messages. First, I want to share my deep concern for the challenges we all face at this time in the history of our nation's capital markets. The challenges are great. While we must keep an open mind on the many legal issues that remain unresolved, the aftermath of Enron and Arthur Andersen have left Americans in all walks of life understandably shocked and repulsed by allegations of conduct that is completely unacceptable.

Second, I want to explore with you the SEC's important role, and the solutions we envision, as we seize upon this historic opportunity to create fundamental, long needed, changes in our capital markets and system of securities regulation — changes in corporate disclosure; changes in financial reporting, changes in corporate governance, and changes in the regulation of accounting practices and the accounting profession.

And third, I want to discuss some of our initiatives regarding the role each of you play in the mutual fund industry. Because you are the interface between so many individuals and the securities markets, your role is especially critical in our efforts to restore investor confidence and improve the functioning of our capital markets.

The challenges we collectively face are dramatic. Recently, at the SEC's first ever "Investor Summit," we responded to questions from individual investors all across America. Let me share with you their perceptions of our markets. In brief, they are terribly concerned — they have had their confidence shaken. "Are the markets fair?" they ask. "Do companies tell me what I need to know to invest, or do they hide the ball?" "Can I trust company numbers — are their accounts really accurate?" "Is anyone who runs a public company, or audits one, or regulates one, really interested in what I think, what I need and how I feel?"

Somehow, in the euphoria of the 80's and 90's, in the long bull market we enjoyed, some in the securities industry and corporate America grew complacent and forgot their responsibility of single-minded devotion to the needs and interests of American shareholders. Throughout the past decade, the seeds of current distrust and shaken confidence investors now feel were sown. Because these seeds and the concomitant warning signs have now bubbled to the surface, we must not delay in addressing the critical need to effect a massive restructuring of the regulatory regime that governs our capital markets, nor can we be cavalier about fulfilling our obligation to restore investor confidence and trust.

Lest we take this lack of trust too lightly, let me paint a picture of what investors tell us they perceive and believe — and, of course, their perceptions and beliefs are their reality. Investors tell us they are appalled that:

  • securities analysts tout securities, but don't believe the recommendations they make, and don't mention that fact in giving their recommendations;
  • valued brokerage firm customers are given investment opportunities, but only in return for kickbacks to the brokerage firms that made the opportunities available;
  • public companies comply with disclosure obligations solely for the purpose of fending off potential liability claims, rather than for the purpose of telling investors how the company really is doing;
  • public companies employ accounting principles designed to obscure the real performance of the company, rather than elucidate it;
  • public companies issue so-called pro forma financial statements to convert losses into the appearance of profits; and
  • accountants make it possible for companies to engage in alchemy to convert a sow's ear into a silk purse — that is, to permit corporate clients to use accounting principles to obfuscate a company's true financial posture and hide impending disaster.

This conference is entitled "Continuing a Tradition of Integrity in Challenging Times." But the real challenge of these times is restoring and rebuilding our traditions of integrity, ethical behavior, fiduciary obligations, basic honesty and decency. All of us must join together and demand or support the changes necessary to restore integrity, to restore investors' faith in our capital markets.

Disclosure and Accounting Reforms

While I am confident we have already entered a period of heightened awareness by officers and directors of their duties to shareholders, the Commission has a responsibility to drive these reforms and see that they are permanent in order to ensure that our markets are safe and fair for investors.

There are three key areas that need substantial improvement if we are to restore investor confidence. First, disclosure by public companies must be truly informative, timely, and honest. Second, oversight of accountants and the accounting profession must be strengthened and accounting principles that underlie financial disclosures must be made more relevant and comprehensible. Third, corporate governance must be upgraded.

We have already taken or announced a number of significant initiatives in these three areas. Of course, we don't have a monopoly on wisdom and we are actively seeking input from all constituencies about these initiatives, especially from those who represent individual investors.

Corporate Disclosure Reforms

Last year we began the needed enhancement of our corporate disclosure system. All of the reforms that we have initiated, and those we will initiate shortly, are aimed at improving the quality and timeliness of financial disclosure.

We have initiated a number of changes in the Management's Discussion and Analysis section of disclosure documents. MD&A is meant to be, for investors, a narrative explanation of, and provide the context for, companies' financial statements so they may see the companies in which they invest "through the eyes of management" and understand the risks to a company's earnings and cash flow. MD&A is the cornerstone of our system of corporate disclosure, and it must be improved.

Among other things, we have proposed a rule requiring companies to discuss the adoption of new accounting policies and to identify the impact of their most critical accounting policies.

Moreover, as announced on February 13th, we will soon propose a significantly extended list of items that companies will be required to disclose at intervals more frequent than the current quarterly and annual reporting requirements.

In addition to substantive disclosure reform, we have proposed rules to get key information to investors far more rapidly than at present. One proposal is the acceleration of the deadline for public companies to file annual reports with us from 90 to 60 days after the end of the fiscal year, and quarterly reports from 45 to 30 days after the end of the quarter. Another proposal would impose obligations on companies to report immediately any transactions in the company's securities by corporate insiders, including transactions with the company. This would quickly address an issue that is circumscribed by statutes and rules — that corporate insiders need not file reports of their activities in their company's stock for periods up to 410 days.

Also, we intend to improve the quality and utility of our corporate disclosure system, taking advantage of new technology along the way. Investors will benefit if companies are able to produce and disclose financial information in "layers," yielding clear and concise financial statements that allow readers to explore whatever layer of detail they wish.

Corporate Governance Reforms

We also believe it is critical to strengthen the resolve of honest managers.

One way of achieving that is by implementing the President's directive to us to require CEOs to certify their company's annual and quarterly filings, in a meaningful way. We will consider rulemaking on this next month, along with a requirement that corporations adopt procedures designed to bring important information to the CEO's attention.

Improving corporate governance standards is another way to shift corporate priorities. On February 13th, we called upon the New York Stock Exchange and Nasdaq to review and amend their listing standards to address important issues, such as officer and director qualifications and codes of conduct for public companies. Their efforts are nearing completion, and we are confident the new standards they propose will give great assurance to investors. As part of our effort to strengthen the regulation of the accounting profession, we also contemplate proposing Commission rules addressing the need for all public companies to have active and appropriately structured audit committees.

We've also attempted to influence corporate behavior by reminding companies and their officers about their responsibilities, and discouraging rewarding them for poor stewardship. For example, on March 13th, we brought an action against the former CEO of a public company, seeking to recoup bonuses, options and salaries paid for financial performance that was a sham. This was a landmark effort by the Commission's Enforcement Division, and we plan to continue to seek such disgorgement aggressively.

The Public Accountability Board

One of the most pressing needs for reform is our accounting system. Outside auditors play a critical role in ensuring that the companies they audit present an accurate, complete and current picture of their financial condition. Regulation of outside auditors must, and will, be enhanced.

As we announced earlier this year, we have been moving forward with our commitment to develop a new independent oversight board to govern the public accounting profession. While there have been a number of proposals for legislation to establish such a board, this board is sufficiently important to investor confidence in public company financial statements that we must move forward to establish it at the earliest possible moment. If legislation is enacted, we will, of course, recede. But, if final legislation is not forthcoming, we want to be in a position to commence our new regulatory system before year-end.

We have in mind creating a "Public Accountability Board" that:

  • is separate from, and independent of, the profession,
  • operates under rigorous SEC oversight,
  • is a mandatory requirement for auditors of SEC registrants' financial statements,
  • is dominated by public members,
  • sustains itself by involuntary funding from those who benefit from the audits of public companies' financial statements,
  • directly reviews accounting firms' quality controls over their accounting and auditing practices,
  • is empowered to discipline firms and individuals for deficiencies noted during quality control reviews, that the Commission refers to it, or that otherwise come to its attention, including the right to strip a firm of clients it does not audit at the highest standards of the profession, and
  • issues public reports, making its activities transparent.

Accounting Standard-Setting

In addition, accounting standard setting itself must be improved. For over 60 years we have looked to the private sector to assume the initiative in establishing accounting principles. We continue to support private sector standard setting but, the SEC has, in the past, abdicated far too much of its obligation to ensure that accounting standards meet the objectives of the federal securities laws. We will take a more active role to ensure that standards are implemented that benefit markets and investors.

Going forward, we plan to

  • broaden funding sources and make funding involuntary;
  • meaningfully participate in setting the agenda of the Financial Accounting Standards Board;
  • exercise our authority to review adopted standards; and
  • ensure that FASB promulgates principle-based standards, which adapt faster to changing business environments and emphasize overall accuracy and completeness.

Mutual Fund Industry

All the things I have just talked about have taken a lot of our time in recent months, but they are — or should be — of enormous concern and interest to the mutual fund industry. In addition, a number of current issues before the Commission are of direct consequence to the industry.

The nature of the Investment Company Act places the SEC in the role of enforcing a statute whose general response to most issues is: "you can't do that." This negativism is coupled with the grant to us of broad exemptive authority. Of course, exemptive authority requires us to issue rules or orders, a time-consuming process. I will not regale you with statistics on the length of time requests for exemptive relief wait in the queue before being addressed. But, the number is incredibly high.

An example of how our exemptive authority works is the recent action we took with respect to certain affiliated transactions; there, we propose to loosen restrictions governing affiliated fund mergers, and provisions that prohibit certain affiliated transactions involving fund sub-advisors and portfolio affiliates. The need for relief in these areas has been fueled by consolidation in, and globalization of, the fund industry. More can, and should, be done in this area if our efforts do not weaken investor protection. Indeed, in exercising exemptive authority, our chief focus is always investor needs. It is our challenge as regulators to find new approaches to keep pace with changed circumstances, innovation and the increasing role of technology.

Although other initiatives undertaken in my brief tenure haven't garnered headlines, they are significant.

Mutual Fund Advertising and Disclosure

As we move forward with our vision for the fund industry in the 21st century, we need to focus on making disclosure more understandable and accessible to investors. We have made great progress with the prospectus and want to improve shareholder reports. We are also interested in increasing the utility of profile documents. It is a shorter, more concise document than the prospectus, so it could serve as a vehicle for delivering information to a wider actual readership among shareholders.

On May 14th, we proposed amendments to fund advertising rules. The intent behind the proposals is to encourage fund advertisements to convey more balanced information to prospective investors, particularly with respect to past performance. The proposed amendments would require fund advertisements that contain performance information:

  • directing investors to a toll-fee or collect telephone number (and perhaps Web site) to obtain the most recent month-end performance information for a fund's 1-, 5- and 10-year periods, giving investors access to the most current performance information available;
  • requiring advertisements to improve narrative disclosures to explain the limits of past performance data and the importance of fund fees and expenses;
  • requiring advertising to highlight explanatory information more prominently; and
  • emphasizing that fund advertisements and sales literature are subject to antifraud protections.

The proposals also increase flexibility by eliminating requirements that advertisements be limited only to information whose substance is included in the prospectus. We also have asked for comment on whether our current approach to advertising can be revamped without diminishing protections for public investors.

Adoption of Form N-6

In April, we adopted a new registration form for insurance company separate accounts offering variable life insurance policies, an increasingly important insurance industry sector. The new form makes variable life insurance disclosures consistent with disclosures for variable annuities and mutual funds; our goal is to help investors better understand the product's fees, risks and benefits.

Internet and "All Electronic" Offerings

In approving an "all electronic" variable annuity offering last fall, we faced the issue of access to disclosure documents exclusively over the Internet. Our decision there is only a beginning. We are anxious to undertake a fresh look at our prior guidance concerning electronic delivery of information under the federal securities laws. Our regulations must keep pace with product innovation as well as investor demands and needs.

Exchange-Traded Funds

Exchange traded funds are a new and innovative product available to fund investors today. The existing ETFs, currently numbering over 100 with about $90 billion in assets, track the performance of various domestic and foreign equity market indices. Recently, market participants have raised the prospect of an ETF that would not be index based, but would have an actively managed portfolio.

Last November, we issued a Concept Release on Actively Managed ETFs, to enable us to evaluate these proposed products with the benefit of the public's/industry's perspectives, knowledge and experience. The concept release raises important issues, including the extent to which actively managed exchange-traded funds should inform investors of their portfolios' contents and whether arbitrage mechanisms for actively managed exchange-traded funds are effective in moderating any premium or discount to a fund's NAV. Next week, we will consider authorizing ETFs that match the returns of various fixed income indexes — the next step in the development of ETFs.

Apart from our activity, there are three specific areas of concern to us relating to your industry: first, private investment funds; second, fund distribution practices, and, finally, proxy voting by investment advisers.

Private Investment Funds

The term "private investment fund" is not a defined term, but it generally refers to pooled investment vehicles in the form of limited partnerships or limited liability companies that invest in securities, commodities or both. Typically, private investment funds, which include hedge funds and private equity funds, compensate managers based on investment performance. Private investment funds are structured to avoid direct regulation.

By all accounts, private investment funds have experienced a seismic boom in both number and total assets under management. But, since these entities are not subject to reporting requirements, the information we have about them is sketchy. We are concerned about the implications flowing from the growth in these private investment funds. Accordingly, we will seek a better understanding of the issues currently affecting these vehicles by commencing a formal fact-finding investigation to enlighten us about:

  • incidents of fraud that we have seen with certain of these vehicles, particularly hedge funds;
  • conflicts associated with managing these vehicles alongside mutual funds; and
  • marketing these vehicles directly and indirectly to retail investors.

Our goal is to determine whether the present state of regulation — or perhaps more accurately the lack thereof — is in the public interest.

Fund Distribution Practices

In addition to reviewing the regulation of private investment funds, I believe that the Commission needs to reexamine certain issues concerning fund distribution practices.

Practices that some mutual funds and their investment advisers have implemented to pay for the marketing and distribution of fund shares have changed since Rule 12b-1 was adopted in 1980. Rule 12b-1 essentially requires fund directors to view a fund's rule 12b-1 plan as a temporary measure even in situations in which the fund's distribution arrangements would collapse if the 12b-1 plan were terminated. Today, many funds adopt a Rule 12b-1 plan as a substitute for, or supplement to, the sales charge or as an ongoing method of paying for marketing and distribution arrangements.

We will reexamine certain aspects of the rule in the context of today's distribution practices. We also intend to examine indirect methods of financing distribution that we see emerging to assure that these arrangements are appropriately considered by fund directors.

Proxy Voting by Investment Advisers

We have received, and are considering, rulemaking petitions from the AFL-CIO and others, requesting that mutual funds disclose proxy-voting policies and the way votes are cast. We are also considering whether investment advisers must disclose proxy-voting policies and their votes, particularly on contested matters. Whatever the outcome, investment advisers must vote client shares consistently with the antifraud provisions of the Advisers Act, and with federal and state law obligations to act in the best interests of their clients. This is an important topic, since we have seen that the exercise of proxy votes can have dramatic consequences on the future life and format of a fund

Special Study concerning SEC resources

We are also looking inward in our quest to improve our capital market system. In March, we commenced a special study to examine our operations, resources, efficiency and productivity. Some of you have been contacted by the study team for your thoughts on how we can improve our service to both investors and the industry.

The Division of Investment Management's staff is hard working and dedicated, as many of you have recognized in your comments. One area where the investment management industry has spoken with some criticism, though, is about the length of time it takes to receive exemptive orders and responses to no-action and interpretive letters. Rest assured that one of the areas the study team is reviewing, on an agency-wide basis, is our response time to requests for relief.

Those requesting relief can play a critical role in expediting the process, however. Too often we receive no-action requests or exemptive applications that are incomplete, contain little or no analysis, cut corners, purport to be routine when they are novel, or are otherwise blatantly deficient. This adds processing time. Help us help you by ensuring that your requests for relief are full, complete and, of course, accurate.

I end where I began. We are charged with a vital public trust. Our role is to ensure that markets operate, and market professionals act, in the best interests of public investors, the bedrock of our markets. Their interests are a critical touchstone for us when deciding whether regulatory action is necessary or desirable. The challenges that lie ahead are exciting. Together we can improve the mutual fund regulatory framework, and reshape the essence of corporate disclosure, corporate governance and accounting regulation with thoughtfulness, care and creativity.

But, we can't do this alone; we need your help in this endeavor. Join with us in advancing the interests of America's investors.

Thank you.



Modified: 05/24/2002