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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Priorities in Investment Management Regulation


Paul F. Roye

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

Keynote Address at the Eighth Annual
Advanced ALI-ABA Course of Study:
Investment Management Regulation
Washington, D.C.
October 17, 2002

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


Thank you and good morning. It is a pleasure to be here today to discuss the work of the Commission in the investment management area. Following the extraordinary events of this past year, a climate for reform exists in our capital markets unlike any I have experienced since beginning my career in this area almost 24 years ago. With Congress acting in record time to pass legislation aimed at restoring financial integrity to our markets, and the commitment of the Commission under Chairman Pitt's leadership to the same goal, restoring investor confidence has become a clear priority.

Mutual funds are the primary vehicles that connect millions of Americans to the securities markets. Fortunately for all of us, they are not filling today's headlines regarding corporate scandals. But they are an important element in the Commission's efforts to restore confidence in our markets. In the Division of Investment Management, we are as busy as we have ever been, focusing on Commission directed initiatives to ensure that investors invested in mutual funds and other investment companies, have access to full and reliable information on which to base their investment decisions, and that the entities they invest in are operated in the same spirit of full and fair disclosure. This morning I would like to highlight some of the Commission's recent initiatives for you, and also discuss priorities over the next few months. Before I begin, 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.

As I mentioned, we have been extremely busy in the Division over the past months. Many members of the staff of the Division are here this morning and I would first like to thank them for their hard work. We have an extremely dedicated staff who believe deeply in the mission of our agency and its role in protecting investors. They don't always get the credit they deserve, so I am pleased to publicly applaud their efforts here this morning.

Implementation of the Sarbanes-Oxley Act

This spring, President Bush and Congress set the tone for broad, swift reform with the enactment of the Sarbanes-Oxley Act, designed to restore investor confidence in our markets through sweeping corporate disclosure and financial reporting reform. The Commission has been busy fulfilling Congress's mandate under the tight deadlines set forth in the Act. Chairman Pitt has made it clear that the Commission will fully implement the letter, as well as the spirit, of this legislation.

In late August, the Commission adopted rules requiring CEOs and financial officers to certify the accuracy of reports their companies file with the Commission under Section 13(a) or 15(d) of the Exchange Act. In the investment company area, the rule applies to a fund's annual and semi-annual reports on Form N-SAR, as well as the financial statements on which information in the Form is based. The certification requirement was intended to improve the quality of the disclosure that a company provides about its financial condition in its periodic reports to investors. Since shareholder reports are the primary means by which Funds provide financial statements to investors, the Commission has also proposed a new form designed to better implement the intent of the Sarbanes-Oxley Act. On the proposed form, called Form N-CSR, funds would file copies of required shareholder reports, information about the fund's internal controls and disclosure controls and procedures, and required CEO and CFO certifications. The comment period on this proposal ended yesterday. As we move towards a final rule, one issue we will be considering is whether certification of both forms N-SAR and N-CSR are necessary to fulfill Congress' mandate to enhance investor protection through executive and officer certification. We will be very interested in the comments on this question.

There are a number of other issues under Sarbanes-Oxley that will have an impact on investment companies. Yesterday, the Commission proposed new rules that would require registered management investment companies to disclose whether the companies, their investment advisers and principal underwriters have each adopted a code of ethics for their senior executive and financial officers. The rules would not require companies to adopt codes of ethics, but only to disclose whether they have them. We recognize that under Rule 17j-1 of the Investment Company Act, funds are already required to have codes of ethics that are designed to deter conflicts of interest by advisory personnel when they buy or sell securities for their own accounts. However, the disclosure requirements that the Commission voted to propose are designed to address a broader range of ethical conduct issues including: the handling of conflicts of interest between personal and professional relationships; full, fair and accurate filings with the Commission; and compliance with applicable laws and regulations. Indeed, many codes of ethics of funds and advisers already go beyond the requirements of Rule 17j-1 and funds may wish to integrate any code of ethics that would be adopted in connection with the Sarbanes-Oxley requirements together with the pre-existing code of ethics that they have under Rule 17j-1.

The rules proposed yesterday would also require a management investment company to disclose whether its audit committee includes at least one member who is a "financial expert." Specifically, proposed Form N-CSR would require a registered management investment company to disclose annually:

(i)  the number of financial experts serving on the investment company's audit committee;
(ii)  the names of the financial experts;
(iii)  whether the financial expert or experts are independent; and
(iv)  if the investment company does not have a financial expert serving on its audit committee, the fact that there is no financial expert and an explanation of why it has no financial expert.

The proposal defines "financial expert" to include individuals with certain attributes as set forth in the statute and includes a number of factors that a board of directors must consider when determining whether an individual has all of the required attributes. We have specifically asked comment on whether this definition should be modified in any way in the case of investment companies.

The Commission also proposed rules under Sarbanes-Oxley regarding prohibiting officers and directors of an issuer, and anyone acting under their direction, from taking action to fraudulently influence the auditor of an issuer's financial statements. The rules proposed yesterday would cover officers and directors of investment companies, as well as those of other entities, such as advisers, that may be in a position to fraudulently influence an auditor of an investment company.

In each of the Sarbanes-Oxley rule proposals the Commission has endeavored to apply the statutory requirements in a manner that carries forth the intent of Congress in enacting these provisions.

Implementation of the USA Patriot Act

The Commission has also been working to implement the requirements of the Patriot Act to make it easier to prevent, detect and prosecute international money laundering and terrorist financing activity.

We assisted the Treasury Department in drafting the rules requiring that mutual funds adopt anti-money laundering programs. Additionally, in July of this year, the Commission proposed in a joint-rulemaking with the Treasury Department to require mutual funds to adopt procedures to verify the identities of their customers and to keep records related to their customer verification programs. The names of mutual fund customers would then be cross-checked with lists of known or suspected terrorists. The SEC and the Treasury issued a parallel proposal that would cover broker-dealers, while other financial institutions would be subject to similar requirements under rules proposed by the other federal financial regulatory agencies. The comment period for the proposed rule closed in September. We received a number of thoughtful comments, which generally concerned the scope and depth of the rule's requirements. We continue to work with Treasury to develop a final rule with the goal of having the customer ID program be an important step in efforts to deter the use of financial institutions for money laundering and financing of terrorist activities. As for implementation, Treasury announced on October 11th that financial institutions will not be required to comply with the customer ID rules, or those proposed under the Patriot Act (which have an October 25th deadline), until the final rules are issued and become effective. Treasury also noted that financial institutions will be allowed a "reasonable time" to comply with the final rules.

I should also note that last month Treasury, with technical assistance from the staff of the Division, issued a proposal to require certain unregistered pooled investment vehicles, such as hedge funds, to adopt anti-money laundering programs. The proposed rule would require these vehicles to file a notice with Treasury identifying themselves, their principal investments and contact information. Comments on this proposal are due by November 25th. Also, the investment advisory industry has approached Treasury to indicate that the industry would support a rule that would require advisers to establish anti-money laundering programs, so that could be on the horizon.

We are also busy working with Treasury and the Federal Reserve Board on a report required by Congress covering effective anti-money laundering regulations for investment companies, including unregistered investment companies.

Other Division Initiatives

Beyond our statutory mandates, Chairman Pitt has made more useful, understandable and accessible disclosures to investors a priority within the Commission, and we have engaged in a number of initiatives to further this objective.


In May, the Commission proposed amendments to improve mutual fund advertising disclosure. Prompted by the Commission's concerns that performance advertising could create unrealistic expectations by investors, the amendments are intended to convey more balanced information to prospective investors, particularly with regard to past performance, to ensure that investors are informed and not misled. The amendments would require that all fund advertisements that contain performance information include:

  • Disclosure that past performance does not guarantee future results and that current performance may be lower or higher than the performance quoted;
  • Disclosure that would direct investors' attention to a fund's charges and expenses; and
  • Disclosure of important information, such as the dates during which quoted performance occurred.

In addition, the proposed amendments would also require funds that advertise to make available to investors a toll-free or collect telephone number (and if available, a website) where they may obtain the most recent month-end performance information for the fund's 1-, 5- and 10-year periods, thereby giving investors access to the most current performance information available. The proposed amendments also reemphasize that fund advertisements are subject to the antifraud provisions of the federal securities laws, and would increase funds' flexibility in advertising, by eliminating the requirement that advertisements contain only information the substance of which is included in the prospectus.

The comment period for these proposals closed this summer and we are working towards making a recommendation to the Commission for final rule adoption.

Variable Life Insurance Registration Statements

The Commission has also recently taken steps to improve and simplify disclosure in the insurance products area. In April, the Commission adopted new Form N-6 -- the registration form for insurance company separate accounts offering variable life insurance policies. The new Form focuses on information important to variable life insurance investors and makes variable life disclosures consistent with those of variable annuities and mutual funds. In conjunction with the adoption of Form N-6, the Commission proposed revisions to Form N-4 to conform the treatment of underlying fund expenses in a variable annuity prospectus with the format used in Form N-6.

Disclosure of Proxy Votes and Policies

I now would like to turn to an important Commission initiative aimed at increasing transparency in the investment management industry and encouraging adherence to fiduciary principles, two elements fundamental to investor confidence. One month ago, in response to multiple rule-making petitions, the Commission proposed rules requiring mutual funds to disclose to investors their proxy votes, and the policies and procedures they use in voting proxies. The proposal is designed to enable fund shareholders to monitor their funds' involvement in the governance activities of portfolio companies.

Under the proposal, a fund would disclose its proxy voting policies and procedures in its registration statement, including the procedures it uses when a vote presents a conflict between shareholders' interests and those of the fund's investment adviser, principal underwriter, or its affiliates. Funds' proxy voting records would be filed with the Commission and would indicate whether a matter on which a fund was entitled to vote was proposed by the issuer, or a security holder, whether and how the fund voted, and whether its vote was for or against management. If a fund makes a vote that is inconsistent with its policies, this fact would need to be disclosed in shareholder reports. Information on how shareholders may obtain a fund's voting information - through a toll-free number, on its website, or the Commission's website - would also need to be disclosed.

The proposal would also cover investment advisers who would be required to have written policies and procedures governing how they vote their clients' securities. The policies and procedures would need to be designed to ensure that the adviser votes proxies in its clients' best interests and they must address material conflicts of interest between the adviser and its clients. Advisers would also be required to describe their voting policies to clients, provide a copy of them when requested, and inform clients how to obtain information from the adviser on how it voted their proxies. The proposal also requires advisers to keep records of their proxy votes.

While noting the power of proxy votes in influencing the governance of U.S. companies, as well as the impact they have on the financial well-being of ordinary investors, Chairman Pitt outlined the fundamental rationale for this proposal stating that "mutual fund securities are held for the benefit of the investors who are the fund shareholders. They belong to fund investors, who are entitled to know how their property is being voted." Chairman Pitt described this rule proposal as an important element in exposing and discouraging conflicts of interest in this area. The comment period for the proposed rules closes on December 6th.

In addition to disclosure of proxy votes, the rule-making petitions in this area also included a request for more frequent disclosure of the portfolio securities holdings of funds. In response to this request, Chairman Pitt has directed the Division to complete its recommendation to the Commission on this issue. In conjunction with this effort, we are also working on recommendations to improve the format of annual and semi-annual reports to fund shareholders.

Affiliated Transactions

We continue to work to eliminate unnecessary regulatory requirements that may hinder efficiency and innovation. In this regard, the Commission recently acted on rulemakings in the area of affiliated transactions. In July, the Commission amended Rule 17a-8 to allow mergers of funds affiliated for any reason. The amendments also facilitate mergers of bank common and collective trust funds and unregistered insurance company separate accounts into registered investment companies, and require that the acquired fund have the merger approved by a majority of shareholders when the merger would result in a change that would otherwise require a vote under the Investment Company Act. We expect that the rule will significantly reduce exemptive applications in this area.

Also, in April, the Commission adopted amendments to Rule 10f-3 to allow funds to purchase U.S. government securities when an affiliate is a member of the underwriting syndicate offering those securities. On the same day, the Commission proposed amendments to rules facilitating certain affiliated transactions involving fund sub-advisers and portfolio affiliates, when the 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.

Innovation in the Mutual Fund Industry

Exchange-Traded Funds

As the mutual fund industry adjusts its products to changing market conditions, we are constantly challenged to adapt our regulatory framework to allow for innovation without compromising necessary investor protections. An area in particular that continues to evolve is that of exchange-traded funds or ETFs. ETFs based on equity indices were introduced in 1993, but in recent months the Commission has permitted the first ETFs based on bond indices. These first bond ETFs track indices based on government securities and investment grade corporate bonds, and are already very popular. We have also received exemptive applications for ETFs that would seek to return a multiple or an inverse multiple of an index. We believe these types of ETFs involve elements of active management, an ETF variation that has attracted considerable interest. Last year we requested comment on the regulatory issues raised by actively-managed ETFs in a concept release. The comments that we received on the release are helping to inform our review of specific applications for these new products.

Principal-Protected Funds

Recently, we have seen increased interest in so-called "principal protected funds." These funds can take a variety of forms, but they generally offer their shares to investors who, if they hold their shares for a set amount of time - usually about five to seven years - will receive at least their principal back at the end of the period. Many of these funds accomplish their principal-protected strategies through guarantees, insurance or various other hedging strategies with counterparties. To the extent any of these arrangements involve affiliated parties, we encourage practitioners to be attentive to any potential affiliated transaction issues that may implicate the Investment Company Act's restrictions in this area. Other issues also are raised, including the need for financial statements of the guarantor in the registration statement, and depending on the structure of the guarantee, whether it needs to be registered as a separate security.

Funds of Hedge Funds

Another type of new fund worth mentioning are funds of hedge funds, which are also garnering considerable interest. These registered funds invest shareholder assets in private hedge funds. While hedge funds have long been a product for wealthy investors, funds of hedge funds are now being made available to a broader investor base because the original investment is placed in a registered investment company. These funds could thus pool smaller investors together to meet the high minimum investments hedge funds require. However, these types of funds are suitable only for certain investors given the nature of their investments. We have been carefully scrutinizing these funds for appropriate disclosure and we are particularly interested in how these funds value their investments in the underlying hedge funds in determining their own net asset values.

Investigation Into Private Investment Funds

Developing a greater understanding of the operations of private investment funds, including hedge funds, has been a Division priority. In May, Chairman Pitt noted that these funds were experiencing tremendous growth in both assets and numbers, but, because they are not registered with the Commission, we have limited information about them. The Chairman announced that the Commission would commence a formal fact-finding investigation to consider the investor protection implications of growth in these funds, particularly in light of incidents of fraud with these funds, conflicts associated with managing these funds alongside mutual funds, and the increasing retailization of these funds. We are currently in the middle of this investigation and expect to have a comprehensive record to present to the Commission.

Other Investment Company Act Matters

With respect to other matters in the investment company area, we will continue to seek to codify frequently-requested forms of exemptive relief, such as those concerning manager of managers orders and fund of funds orders. Chairman Pitt has also mentioned that it may be time to think about fund distribution practices and revisions to Rule 12b-1 under the Investment Company Act.

Regulation of Investment Advisers

Custody Rule

Since the beginning of Chairman Pitt's tenure at the Commission, he has stressed the need to update and modernize our rules. Consistent with this goal, the Commission proposed amendments to the custody rule under the Investment Advisers Act. This rule, which concerns the assets that clients entrust to their adviser's custody, had not been substantively revised since 1962. The proposed amendments are intended to bring the rule up-to-date with modern custodial practices and enhance the protections for clients' assets.

Under the current rule, advisers with custody are required to deposit client funds in bank accounts and segregate and identify client securities and hold them in a safe place. There is no requirement that the adviser keep client securities with a broker-dealer or other financial institution. Although almost all advisers do keep their clients' securities in banks or with brokers, our examiners have on occasion discovered an adviser keeping certificates in an office file or safety deposit box where they may be easily lost or destroyed. To prevent this, the amendments would require advisers that have custody to maintain both client funds and securities with a broker-dealer, bank or other "qualified custodian."

Also, advisers are currently required to send a quarterly account statement to each client whose assets it holds in custody, and to have an independent public accountant conduct an annual surprise examination of the custodied assets. These requirements were originally intended to deter advisers from misusing their client's assets. However, in today's environment, we found these requirements to have limited deterrent effect, and are costly to advisers. The amendments therefore propose to exempt advisers from these requirements and instead rely on qualified custodians to deliver account statements to clients directly on a monthly basis. In this way, clients may be confident that any improper transactions or withdrawals by the adviser will be reflected.

In addition, the proposed amendments rule would add a definition of "custody" to the rule which conforms to the definition in Form ADV - the investment adviser registration form. The proposed amendments also would exempt advisers to registered investment companies, which are subject to their own custody requirements under the Investment Company Act, as well as advisers to limited partnerships and other pooled investment vehicles that, by contract, have a means to protect themselves from the misuse of their assets.

The comment period for the amendments closed on September 25th. We received over 40 comments on the proposal, virtually all of which generally supported our approach. The issues raised by the commenters included the breath of the term "qualified custodian" and other issues of scope. We will consider the comments carefully as we move towards making a recommendation to the Commission on a final rule.

Internet Adviser Rule and ADV Part II

In the investment adviser area, we also are preparing recommendations to the Commission for the adoption of both the Internet adviser rule and Part 2 of Form ADV. The Internet adviser rule would permit those investment advisers that provide advisory services through interactive websites to register with the Commission. These "Internet advisers" typically would not otherwise qualify for Commission registration under the Advisers Act, but instead would be required to register with state securities authorities. The rule is intended to alleviate the burden of multiple state registrations for advisers whose business is unconnected with any particular state.

As you know, Part 2 of Form ADV 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. We expect to present our recommendations for both these rules before the year's end.

Enforcement Developments

There have also been a number of enforcement developments this year. Consistent with the Commission's emphasis on accurate disclosure, we have seen enforcement cases focusing on the facts behind a fund's performance numbers, and also on the timeliness of the disclosure to ensure that it is not misleading. For example, in one case, the Commission found that a fund's website contained out-of-date performance returns. Although the website prominently proclaimed returns for the fund of 422%, this information, while factually accurate, was deemed misleading by the Commission, which found that the fund had failed to disclose that its total returns had declined by more than half during its most recent quarter. In another case, the Commission found that a sub-adviser to a registered investment company had failed to disclose that the fund's performance was significantly impacted by IPO trading. In that case, although IPO trading accounted for a significant percentage of its total return, neither the fund's prospectus nor its annual reports mentioned IPO trading as a significant factor in its performance.

Another case arose when a portfolio manager was found by the Commission to have defrauded two funds by inflating the value of certain securities, causing one of the funds to overstate its net asset value. The case was unusual because the Commission determined that not only the sub-adviser, for whom the portfolio manager worked, but also the primary adviser failed to reasonably supervise the portfolio manager.

The Commission has also brought several recent cases involving best execution. In one case, the Commission found that the adviser failed to seek best execution in securities transactions for certain advisory clients by systematically interposing a broker-dealer between clients and a market maker on over-the-counter trades to compensate for client referrals. In another case, the Commission found that the adviser failed to seek best execution in securities transactions as a result of an undisclosed trading practice involving cross trades between clients. And, we continue to bring cases against broker-dealers when engaged in switching and churning activity in fund shares.


At the beginning of my remarks, I had the opportunity to thank the staff for all their hard work. I want to close by taking a moment to thank all of you. Just as we at the Commission are busy with the various initiatives I've outlined today, I know you are busy as well implementing them. Yet you've taken time out of your schedule to be here today - to keep abreast of developments and regulatory issues in the investment management industry. You have a wonderful faculty to guide you through these recent developments, with representatives from the SEC staff, as well as some of the industry's most knowledgeable and respected practitioners. We welcome the dialogue and your comments on pending Commission rule proposals. It's what we learn at conferences like this and through your thoughtful comments that we can assist the Commission in promulgating balanced and sensible regulations.

Enjoy the rest of the conference and thank you for listening.




Modified: 10/17/2002