"Mutual Funds and the International Marketplace: A Regulatory Challenge" Remarks By Isaac C. Hunt, Jr., Commissioner, U.S. Securities and Exchange Commission Sixth Annual Conference on International Issues The University of Tulsa March 6, 1997 Good evening. It's my pleasure to be with you. It's also an honor for me to deliver the Second Annual John W. Hager Lecture. I understand that Professor Hager was a master teacher, a consummate professional, and an inspiration to his students. As a former law school professor and dean, I know that these are special qualities. I see from the Conference agenda that you will be covering many of the cutting edge issues concerning international business. This evening, I'd like to consider an area of regulatory challenge that the international marketplace presents: the regulation of mutual funds. As a Commissioner at the Securities and Exchange Commission, I am responsible for protecting the interests of American investors -- while promoting an environment where businesses can flourish. The challenges that the SEC faces in carrying out these responsibilities will be the focus of my comments. The Importance of Mutual Funds to Americans Over the last several decades mutual funds have taken on tremendous importance in the lives of everyday Americans. I'm sure that many of you here tonight invest in funds, either directly or through your retirement plans. For many of you, mutual funds are the primary investment vehicle for saving a down payment on a home, preparing to send your children to college, and planning for retirement. Let's look at the big picture: * One out of every three American families invests in mutual funds -- that's more than 30 million households. * Fund assets, at approximately $3.5 trillion, exceed insured commercial bank deposits, which stand at about $2.5 trillion. * Americans today have more wealth invested in funds than in real estate. A few years ago this would have been unthinkable. * Millions of fund investors across the country read magazines and watch TV programs that are devoted to personal finance topics, such as mutual funds. * And, billions of dollars in retirement savings is invested mutual funds. As a matter of fact, approximately half the assets in the world's largest mutual fund -- Fidelity's Magellan Fund -- are comprised of investments through 401(k)-type retirement plans. As you can see, the U.S. mutual fund industry is as American as Tulsa barbecue and high school football. Fund groups have become household names. And some of their TV ads are as memorable as ads from companies that have come to symbolize America, like IBM and Coca-Cola. The pervasive scope of the U.S. fund industry has been good for Americans. We have more investment options and are able to participate in a stock market that was once like a private club. Mutual fund have also been good for business because of the new money being invested in our capital markets. In addition, funds have enabled Americans to invest in the international marketplace like never before. U.S. investors now own more than $450 billion of foreign stocks; this is up from approximately $40 billion in 1985. Along with these opportunities, come added challenges for regulators. From the point of view of protecting our citizens as they look for investment opportunities in the international marketplace, we have several concerns: _ First, when U.S. funds groups, such as Fidelity, Vanguard, and T. Rowe Price, invest in foreign securities, those assets should be held in a safe manner and valued properly. And, whatever added risks are involved when a domestic fund invests in foreign issuers, American investors should understand those risks. _ Second, when foreign funds, such as ones sponsored by European and Asian companies, want to sell their shares to the American public, Americans should have the same protections that come with investing in domestically sponsored mutual funds. U.S. Funds Investing Abroad Like most publicly sold securities in the United States, mutual fund shares are subject to disclosure requirements under the Securities Act of 1933. To sell shares, a mutual fund must have an effective registration statement on file with the SEC, and it must deliver a prospectus to each investor. We -- at the SEC -- are engaged in an ongoing campaign to make fund prospectuses more user-friendly. In connection with this effort, the Commission recently proposed a major overhaul of the existing prospectus form. We hope to make prospectuses easier for investors to use and easier for funds to prepare. The Commission also proposed to provide investors with a "fund profile;" this would be a couple of page document that would summarize key fund information. The primary disclosure document would continue to be the prospectus. In both the fund prospectus and the summary fund profile, we hope to provide investors with better risk disclosure. You should consider the risks associated with an investment -- as well as its potential return. We want to emphasize the risk of a fund's investments as a whole. This would be a shift away from today's approach of giving detailed, technical descriptions of the risks of individual securities that the fund holds, which tells an investor little about how risky a fund may be. Good risk disclosure takes on heightened importance when a U.S. fund invests in foreign securities. Funds that invest in foreign securities take on risks that are not ordinarily associated with domestic investments. For instance, changes in foreign currency rates will, to the extent a portfolio is not adequately hedged, affect the value of a fund's portfolio securities. There also may be the possibility of a foreign government imposing exchange controls. In some countries, there may be the possibility of a government expropriating assets. Moreover, there may be less publicly available information about a foreign company relative to a U.S. company; and some foreign companies may not have to comply with accounting, auditing, and financial reporting requirements that are comparable to those of U.S. companies. The trading volume of some foreign issues may be low. Consequently, the market for certain foreign securities may be less liquid and share prices may be more volatile. But not all of these risks apply to all foreign securities. Through appropriate disclosure, we want investors to have a good understanding of the risks associated with the securities held by a particular fund. For example, the primary risk of a fund buying shares of a foreign issuer in developed counties, like Germany or Japan, most likely would be foreign exchange rate risk. The price of a particular foreign company's stock may be increasing; but because of the value of the U.S. dollar relative to the currency in the foreign county, an investor may lose money. On the other hand, in emerging market countries, in addition to currency exchange risks, less rigorous accounting and financial reporting practices may present significant risks. Another area of concern when a U.S. fund invests in foreign securities is the safe custody of the fund's portfolio securities. Fund assets must be safe and secure. We want to make sure that assets are in today's equivalent of a vault-- and not behind a screen door. Generally, a bank regulated under the laws of the United States may serve as a fund custodian. The SEC adopted a rule under the Investment Company Act of 1940 that permits funds to maintain their assets with certain categories of "eligible foreign custodians." These include: financially sound foreign banks, and transnational foreign securities depositories, and centralized securities depositories. The Commission has been aggressive in helping fund groups to be successful overseas. Sometimes we have to address special custody situations that are presented by certain counties. For example, Russia has a unique share registration system. Securities of Russian issuers are maintained in book-entry form by an estimated 3,000 registrars located throughout Russia. In a no-action letter, the staff of the Commission stated that the Templeton Russia Fund could hold equity securities of Russian issuers with these registrars in accordance with certain procedures to safeguard fund assets. These safeguards included a written agreement between the Fund's custodian and the registrar of each issuers. In addition, the Fund's board would provide enhanced oversight. A third compliance concern that has heightened importance in the international marketplace is the proper valuation of portfolio securities. The price of a mutual fund's shares are a direct reflection of its portfolio securities. For example, if a mutual fund held 5 shares of IBM stock and the stock was trading at $100 per share, the aggregate value of the fund's shares would be $500. A U.S. fund manager is required to ensure that a fund's portfolio securities, including its foreign issues, are priced correctly. In developed markets, pricing is relatively easy -- the last trade price is used. However, in emerging markets, pricing gets a bit more tricky. In Pakistan, for instance, a stock trade takes 6 months to settle. This situation presents more of a challenge in determining the correct price at which a fund should carry the stock on its books. Should the security be carried at the sale price? Or should it reflect the possible affect of exchange rate movements six month down the road? Our objective, of course, is to ensure that portfolio shares are correctly priced so that investors receive the correct price when they buy or sell a fund's shares. * * * * * Foreign Funds Selling to Americans Let me shift gears for a minute and address investor protection from a different perspective -- the perspective of a foreign fund that wants to sell its shares to U.S. investors. In this regard, the SEC believes that Americans should have the same protections that come with investing in domestically sponsored mutual funds. The Investment Company Act prohibits a foreign fund from selling its securities in the United States in a "public offering" unless the SEC approves the transaction. The Act authorizes the Commission to give this approval only if we find: (1) that it is both legally and practically feasible to enforce the provisions of the Investment Company Act against the foreign fund, and (2) that the issuance of the order is consistent with the public interest and the protection of investors. Congress has indicated this provision was intended to subject foreign funds that access the U.S. market to the same type and degree of regulation that applies to U.S. funds. The SEC has issued very few orders to permit foreign funds to publicly sell their shares here. As a case study of the difficulties that may arise, let's consider two foreign funds that had some compliance problems, which were reported in 1996. A Hong Kong fund, which is managed by Jardine Fleming, got into trouble with its trade allocations. Jardine Fleming is a prominent money manager based in Britain. The fund had a rogue trader who would buy portfolio securities -- and wait a couple of days before he allocated them. If the trade turned out to be profitable, the trader would allocate the security to his personal account or Jardine Fleming's flagship mutual fund. If, however, the trade lost money, the trade would be allocated to another public fund. The firm's management found out about the rogue trader's activities in 1993; however, the regulators did not become aware of the problem until 1995. British and Hong Kong regulators fined the firm several millions dollars, and now the firm is trying to regain its reputation by instituting a strong compliance program. In the other case, a foreign fund got into trouble because it didn't follow its stated investment objective and it incorrectly priced its portfolio securities. This fund was sponsored by Morgan Grenfell, an old-line London merchant bank, which is owned by Germany's Deutche Bank. The fund's manager invested a high proportion of the fund's assets in a little known high-tech company whose share were unlisted. Problems resulted because these investments were improperly valued on the fund's books, and they violated the fund's investment objective. When the investments took a dive, the fund's sponsor was left to pick up the tab. The recent problems of Jardine Fleming and Morgan Grenfell are not unique to foreign funds. Our domestic funds have had similar problems in the past. However, what is important is that if foreign funds publicly sell securities to U.S. investors the SEC must have jurisdiction to enforce the U.S. federal securities laws. Foreign funds, however, may sell their shares in the United States though "private" sales. Private sales to a few select investors do not raise the same policy concerns as offerings to the general public. In 1984, the staff of the Commission issued a letter that concluded that a foreign fund could make a private offering in the U.S. without violating the Investment Company Act if, after the private sales, the fund's shares were held by no more the 100 persons who reside in the United States. Congress recently amended the Investment Company Act to create another type of private investment company -- one that sells its shares only to "qualified purchasers." In general, a qualified purchaser is defined to be a person with at least $5 million dollars in investments or an institution with $25 million or more in investments. Last week, the Commission staff issued a letter that stated the staff's view that a foreign fund could also rely on the qualified purchaser provision in making private sales in the U.S. With these two limited exceptions from the jurisdiction of the Investment Company Act, you can imagine that U.S. law has been a bone of contention with many foreign funds that would like access to the U.S. market. Nevertheless, our citizens must be protected. * * * * * Conclusion Mutual funds have presented terrific opportunities for you and me. We get professional money management at a reasonable cost. Americans have entrusted a great deal of their assets to the mutual fund industry -- and the fund industry has been good for American business. Earlier, I talked about the amount of money in funds: $3.5 trillion. Sometimes, numbers of this magnetite don't resonate unless they're put in context. Let me give some idea of how big this number is: * In 1996, General Motors' net income was $4.9 billion. However, the dollars in U.S. funds was 713 times this amount. * The dollars in funds are more than twice the size of the 1995 capitalization of the 50 stock markets located in emerging markets. * Lastly, the cost of a new F355 Spider Ferrari is about $150,000. At this rate, the money in the fund industry is equal to 23.6 million Ferraris. That's a lot of money. These numbers mean that U.S. regulators must shoulder a great deal of responsibility. In my many years of studying the federal securities law, I have yet to see an exception to the risk/reward dynamic of investments. The international marketplace presents new opportunities, along with some additional risks. We -- at the SEC -- will do our best to keep these risks to a minimum. Thank you. # # # # #