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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the Glasser LegalWorks' Investment Management Regulation Conference


Paul F. Roye

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

New York, NY
June 6, 2002

I. Introduction

The SEC, 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 or the staff of the Commission.

Good afternoon, and thank you for inviting me to be with you today. I plan to discuss various initiatives the Commission is undertaking with regard to investment management regulation. But before I do that, I must remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual commissioners or my colleagues on the Commission staff.

Chairman Pitt has been on the job now for nine months. That nine-month period has been a very dynamic time for the securities markets, with the Commission as busy as it has ever been in recent history. We have seen renewed emphasis on improving corporate governance, corporate disclosure and the accounting framework in the public company area, as well as focus on ensuring that those who act as corporate gatekeepers fulfill their responsibilities. We have seen an increase in enforcement activity, with a focus on real-time enforcement. The investment management industry has not been immune from this enforcement activity as the Commission has brought an important action highlighting the responsibility of fund advisers to oversee sub-advisers and a major portfolio pumping case.

In the Investment Management area, we have seen a flurry of activity under Chairman Pitt's leadership. Some of these regulatory actions have been spurred by events, such as the emergency relief that the Commission issued in connection with September 11th and the post-Enron actions necessitated by the circumstances surrounding Arthur Andersen LLP. The Division has issued guidance regarding the implementation of the funds name rule, the after-tax rule and the independent counsel provisions of the fund governance rules. The Commission declared effective the registration statement for an all-electronic variable annuity and commenced a review of the Commission's electronic delivery positions. In the investment adviser area, the Commission and NASAA implemented the Investment Adviser Public Disclosure system, making information about investment advisers, including disciplinary information, readily available to investors. In addition, there have been major initiatives involving affiliated transactions, fund advertising and shareholder communications, as well as steps to modernize other Commission rules. It is in these areas that I would like to discuss some recent developments.

II. Affiliated Transactions

A. Rule 10f-3

With respect to affiliated transactions, on April 30, 2002, the Commission adopted amendments to rule 10f-3 to allow funds to purchase U.S. government securities, including securities issued by Fannie Mae and Freddie Mac, when an affiliate is a member of the underwriting syndicate offering those securities. This rule amendment became effective on May 10th and responds to the fact that government agency securities are now being sold in syndicated offerings.

B. Portfolio Affiliates/Sub-Adviser Affiliates

Also on April 30th, the Commission proposed amendments to the rules facilitating certain affiliated transactions involving fund sub-advisers and portfolio affiliates when such transactions do not present investor protection issues. These proposals were fueled in part by the emergence of large fund complexes with multiple affiliated funds within a single fund family, as well as consolidation and globalization of the fund industry.

A portfolio affiliate is a company that is affiliated with a fund because the fund owns more than 5% of the company's shares. Under the proposal, a portfolio affiliate of one fund would be able to enter into transactions with other funds in the fund complex. Similarly, the proposals would permit a subadviser of one fund to enter into transactions with other funds in the complex-but not with any fund it manages. Comments on these affiliated transaction proposals are due July 19th.

C. Fund Mergers

With respect to mergers of affiliated funds, the Commission proposed to amend rule 17a-8 to allow mergers of funds affiliated for any reason. Currently, rule 17a-8 permits mergers of registered funds affiliated solely because of a common adviser, directors and/or officers. The proposed amendments also facilitate mergers of bank common and collective trust funds into registered investment companies.

Commenters expressed general support for the proposed amendments but also provided several specific suggestions. As proposed, rule 17a-8 would contain factors for fund boards to consider when approving an affiliated funds merger. Commenters generally opposed including the factors in the rule, noting that the factors could become outdated and that including the factors is redundant with general state law requirements for boards of directors.

The Commission also proposed a new condition of rule 17a-8 that would require that shareholders of an acquired fund vote to approve an affiliated funds merger. This proposal was precipitated by the emergence of state laws that permit some funds to merge without holding a shareholder vote, relying solely on board approval. However, one of the fundamental policies underlying the Investment Company Act is that investment companies not be reorganized without the consent of their security holders. Commenters generally recommended limiting the shareholder vote condition to mergers that have a material effect on a shareholder's investment, such as when the merger would result in the change of a fund's adviser, an increase in fees or a change in investment objectives or strategies.

The Commission also proposed adding a so-called "echo voting" condition to rule 17a-8. The echo voting condition would require an owner of five percent or more of a merging fund's shares-who also is an affiliate, through ownership or otherwise, of another merging fund-to vote its shares in the same proportion as the non-affiliated shareholders vote. The purpose of this proposed condition is to prevent affiliates that have a pecuniary interest in affecting the outcome of a merger vote from doing so. Some commenters raised concerns about this condition, arguing that it conflicted with a shareholder's right to vote and was unnecessary given the other investor protection measures included in the rule.

Currently, rule 17a-8 is available only for mergers of registered funds, and commenters supported the Commission's proposed extension of the rule to permit mergers of unregistered common or collective trust funds into registered funds. In addition, some commenters urged that the rule be expanded to permit mergers of any type of affiliated unregistered entity into a registered fund. Some commenters also disagreed with the Commission's proposal to require an independent evaluator to prepare a report on the current fair market value of assets transferred from an unregistered entity in an affiliated merger. Commenters instead suggested that the registered surviving fund use its own valuation policies to value the assets of the unregistered entity.

Generally, the proposed amendments to rule 17a-8 were well-received and generated insightful comments. The staff currently is analyzing those comments in an effort to make a recommendation to the Commission regarding adoption of the rule 17a-8 amendments. In addition, as Chairman Pitt has stated, we are examining other areas where the Commission can take action to alleviate some of the restrictions of the affiliated transaction provisions, without sacrificing investor protection. The staff plans to make additional recommendations to the Commission regarding affiliated transactions.

III. Advertising and Investor Communications

A. Fund Advertising

During Chairman Pitt's tenure, advertising by funds and advisers has been a subject of Commission and staff attention. On May 17, 2002, the Commission proposed amendments to the fund advertising rules. The proposed amendments would require fund advertisements that contain performance information to include a toll-free or collect telephone number, and a website if available, that would provide one-, five- and ten-year performance information for the fund as of the most recent month-end. Advertisements that include performance would continue to require performance information for the one-, five- and ten-year periods as of the most recent quarter. The proposal is intended to ensure that investors have access to the most current performance information available, even if that information does not appear in the actual advertisement. Often, magazines and other publications have long lead times for advertisements. Thus an advertisement must be "finalized" well in advance of the print date. The proposal enables funds to meet publications' timetables while also enabling investors to obtain more up-to-date performance information.

The fund advertising proposals also would require that fund advertisements containing performance provide additional information to give context to investors when reviewing that performance. For instance, the advertisements would state that past performance does not guarantee future results and that current performance may be higher or lower than the performance quoted. There also would be disclosure that would direct investors' attention to a fund's charges and expenses and more prominent disclosure of the dates during which the quoted performance occurred. In addition, the proposed amendments reemphasize that fund advertisements are subject to the antifraud provisions of the federal securities laws. Many of these proposals are intended to address some of the questionable advertising practices witnessed in 1999 and 2000 in the wake of the major market upswing and steep run-up in technology stocks.

The proposed amendments also increase funds' flexibility in advertising by eliminating the requirement in rule 482 that fund advertisements relying on the rule contain only information the substance of which is included in the prospectus. This requirement had resulted in laundry lists and boilerplate statements cluttering fund prospectuses and statements of additional information. Thus, the Commission hopes that the proposed change will both make fund advertisements more informative and streamline fund prospectuses.

When announcing the fund advertising proposals, Chairman Pitt noted that, as the proposals are analyzed, the Commission also wants to consider whether the current approach to mutual fund advertising can be improved, without diminishing the protections investors receive. Comments on the fund advertising proposals are due on July 31, 2002.

B. Adviser Advertising

In addition to reviewing the fund advertising rules, we have received a request from the Investment Counsel Association of America to revise the investment adviser advertising rule. I also believe that the investment adviser advertising rule is in need of revision. The ICAA advocates modernizing the rule and eliminating its specific prohibitions in favor of a general anti-fraud standard-similar to the standard applicable to mutual funds. The staff is carefully reviewing the ICAA's request and is focused on the issue of improving investment adviser advertising.

C. Shareholder Reports

Advertising is not the only form of investor communication drawing the Commission's attention. The staff is working on recommending a proposal to the Commission to improve annual and semi-annual reports to fund shareholders. As part of this effort, the staff is reviewing rulemaking petitions to require that funds disclose their portfolio holdings more frequently. We also have received, and are considering, rulemaking petitions requesting that funds disclose proxy voting policies and the way votes are cast.

D. Form ADV, Part 2

In addition, the staff is preparing a recommendation to the Commission for the adoption of Part 2 of Form ADV. Part 2 is the principal disclosure document investment advisers use to communicate with their clients. As proposed, Part 2 would be a plain English narrative brochure, rather than the current check-the-box format with additional information provided on schedules. I believe that both the shareholder report and Part 2 initiatives will result in investors receiving more meaningful disclosure from their funds and advisers.

E. Form N-6

In the variable products area, the Commission on April 12th adopted new Form N-6, a registration form for insurance company separate accounts registered as unit investment trusts that offer variable life insurance policies. New Form N-6 replaces two forms that were not specifically designed for variable life insurance policies with a new form tailored for these products. Those offering variable life insurance policies will no longer have to fit a square peg into a round hole in order to register their securities with the Commission. The new form also updates variable life insurance disclosure to be more consistent with the disclosure required for variable annuities by Form N-4 and for mutual funds by Form N-1A. For example, Form N-6 requires a standardized fee table.

F. Profile Prospectus

Finally, as Chairman Pitt has stated, we are interested in increasing the use of the profile prospectus as a vehicle for delivering information to fund shareholders. Greater use of the profile may provide a more concise and straightforward disclosure option for investors. This is consistent with the concept of "layered" disclosure that the Chairman is advancing in the operating company area, with the goal being that investors will benefit if companies are able to produce disclosure information in "layers." "Layered" disclosure hopefully would yield clear and concise disclosure that allows readers to explore whatever layer of detail they wish.

IV. Modernization of Investment Management Rules and Response to Innovation

Chairman Pitt has announced that the Commission will engage in a full-scale review of all the federal securities regulations, including the regulations governing mutual funds and investment advisers, with a view to update rules that have become outdated. Commissioner Glassman has been put in charge of this comprehensive effort, and a number of the Commission's recent actions reflect the Commission's goal of modernization. Chairman Pitt also has expressed his concern that the Commission not stand in the way of product innovations, to the extent that those innovations do not sacrifice investor protections.

A. Internet Advisers Proposal

Consistent with these goals, on April 12th, in response to an increasing number of investment advisers providing advice primarily through the Internet, the Commission proposed rule amendments under the Advisers Act that would permit an adviser that conducts substantially all of its advisory business through an interactive Internet website, to register with the Commission rather than registering with all of the states. As you may be aware, under the National Securities Markets Improvement Act's amendments to the Advisers Act, advisers that have $25 million or more in assets under management generally register with the Commission, and advisers that have less than $25 million generally register with the states. However, so-called Internet advisers typically do not have "assets under management" because they provide intermittent securities advice rather than "continuous and regular supervisory or management services." Therefore, most Internet advisers currently do not qualify to register with the Commission. Instead, they potentially must register with all states because, unlike a "bricks and mortar" adviser, Internet advisers cannot predict from which geographic location their clients will come.

The Commission's proposal was driven in part by the development of Internet technology that was not prevalent in 1997 when the NSMIA split between federal and state registration was implemented. As part of the Chairman's modernization effort, I believe that we should revise our rules, as necessary, in the wake of technological developments in the marketplace. The comment period on the Internet advisers proposal closes today.

B. Proposed Amendments to Rule 17f-4

In an effort to modernize the custody rules, the Commission also has 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 have changed substantially. Commenters generally supported the update of rule 17f-4, and the staff currently is working on a recommendation to the Commission for adoption of the updating amendments.

C. Exchange-Traded Funds

The Commission also has taken significant actions regarding exchange-traded funds. There are over 100 exchange-traded funds in the United States with combined assets of nearly $90 billion. Just over two years ago, at the end of 1999, there were just 30 U.S. exchange-traded funds with combined assets of approximately $30 billion. All of the current exchange-traded funds in the United States track an equity market index. However, last week the Commission approved an exemptive application of certain exchange-traded funds that track the performance of fixed income indices.

In addition, in November, the Commission issued a Concept Release on Actively Managed Exchange-Traded Funds. The concept release raised a number of important issues, including the extent to which an actively managed exchange-traded fund would inform investors of the contents of its portfolio and whether the arbitrage mechanism for actively managed exchange-traded funds would be effective in moderating any premium or discount to a fund's net asset value. While the staff assesses the comments received in response to the concept release, we will continue to work with applicants proposing actively managed exchange-traded funds to resolve issues presented by their applications.

V. What Does the Future Hold?

So what does the future hold for investment management regulation under Chairman Pitt? I generally try to avoid predictions. My skills as a fortune-teller are limited. However, you can expect to see a continuation of the effort to update and modernize the Commission's rules under the Investment Company Act and Investment Advisers Act. Some of these rules have been in place for decades and certainly could benefit from having the cobwebs dusted off. For example, Chairman Pitt has announced his belief that the Commission needs to reexamine certain issues concerning fund distribution practices, including a review of rule 12b-1. Chairman Pitt also has stated that the Commission is commencing a formal fact-finding investigation regarding implications of the growth of private investment funds.

As I mentioned, I think you also will see additional action in the areas of affiliated transactions and improving communications with shareholders. In addition, I can commit to you that the Division will continue to work with you to provide guidance when you have questions and to assist you in speeding along your no-action letter and exemptive order requests. As Chairman Pitt has stated, we view ourselves as a service agency, and you should be able to expect courteous, prompt and competent service in your interactions with the Division. As you probably are aware, the Commission has undertaken a Special Study to review Commission resources and productivity. I expect that, as an outgrowth of the Special Study, the Commission and the Division will identify ways in which our processes can be updated to improve our efficiency, streamline our operations and reaffirm our commitment to protect America's investors.

VI. Conclusion

Thank you once again for including me in your program today. You have a comprehensive agenda for the conference with an impressive slate of knowledgeable and experienced panelists. I hope you enjoy your conference, and we appreciate your interest in the work of the Commission.

Thank you.



Modified: 06/07/2002