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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the Securities Law Procedures Conference, Investment Company Institute

by Paul F. Roye

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

December 7, 1998

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its emplolyees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

I.  Introduction

Good morning. I feel a bit strange being up here in my new role as Division Director. In past years, I was sitting where you are, listening and taking notes as my predecessors spoke. I am hopeful that I can bring to bear my years of experience working with investment companies and advisers upon the regulatory challenges that lie ahead. Now, I would like to take this opportunity to share some of my thoughts with you as I assume my new responsibilities.

I come to my new responsibilities at a time when the mutual fund industry can look back on a period of tremendous success. It is a larger, much more complex and diverse industry than when I first started as a lawyer at the SEC in 1979. At the end of October, over 7,000 mutual funds held more than $5 trillion in assets, and mutual funds now serve as the primary investment vehicle for millions of Americans.

As we approach the 21st century, and come to the end of a rather turbulent year in the financial marketplace, I ask you to pause for a moment and consider the principal reason for the industry's recent success – the individual investor. It is an appropriate time to renew our commitment to the well-being of the individual investor. The protection of the interests of individual investors is the raison d'être of the Commission and the foundation of the mutual fund industry's success; indeed the basis for the success and livelihood of many people here today. The mutual fund is, more and more often, the chosen investment vehicle for smaller investors – and the appropriate and effective federal regulation of these funds is among the most fundamental reasons investors have the confidence to invest in mutual funds.

Today I ask you to look forward with me – forward to your goals for the fund industry – and forward to the responsibilities you must fulfill to the individual investor in order to make your goals a reality. And I will look forward to what I expect the Commission will be doing for the individual investor in the coming months.

Chairman Levitt has been a tireless champion of the individual investor. Let me assure you that the Commission will not rest in its pursuit of investor protection. We will continue to promote investor protection with the tools that Chairman Levitt has so often spoken about – adequate disclosure to investors, education of investors, effective oversight by fund directors and appropriate regulatory measures applied to fund managers and service providers. I look forward to working with each of you in pursuit of this goal.

II.  Implementation of New Form N-1A and Profile

In the near-term, implementation of the new Form N-1A and fund profile is one of the more important challenges facing the industry and the Commission. Through Chairman Levitt's leadership and the considerable vision and efforts of my predecessor, Barry Barbash, we have a solid foundation on which you can build better, more understandable communications with your investors. Now it is up to you to finish the job.

The Commission did a top-to-bottom overhaul of Form N-1A. We expect nothing less from the industry. I am confident that if you do a thorough overhaul of your fund prospectuses using the new Form N-1A, the result will be a prospectus that focuses on information essential to an investment decision, emphasizes the risks of the portfolio as a whole, and provides key information about the fund's investment objectives, strategies, risks, costs, and performance – all in a user-friendly, plain English format.

In that regard, I would remind you of Chairman Levitt's admonition to the industry last spring, that those of you who intend to make only a few cosmetic changes and mostly leave your prospectuses as they are – the same dense, legalistic presentations that investors don't want, don't understand, and don't read, will receive a failing grade from us.

The Division has now started to receive registration statements, post-effective amendments, and profiles complying with the new rules. We are pleased by some of what we see, and disappointed by other things we see. The funds that do the best job are the funds that have not lost sight of the audience – the individual investor. They are the funds that focus on what the individual investor needs to know in deciding whether to invest in a particular mutual fund and, just as important, how to communicate that information effectively.

We have found that there are some fairly common pitfalls. Some funds provide disclosure about principal investment strategies and risks that are too generic. Disclosure that is limited to general statements, such as "we invest in common stocks" or "the value of your shares could go up or down," does not really help an investor determine whether to invest in your particular fund. Other funds are at the opposite extreme, putting detailed narrative information about investment strategies and risks into the risk/return summary, undercutting its usefulness. Still other funds have done a good job of drafting the risk/return summary, but have not significantly changed the balance of the prospectus. None of these approaches was intended by the new Form N-1A and, more importantly, none of them serves investor needs.

The Division is committed to the goal underlying the disclosure initiatives: that investors receive clear, concise, understandable disclosure that assists average investors in making investment decisions. Our staff will be flexible when this goal is not compromised. But if you have not made a serious effort to rewrite your prospectus for the benefit of the individual investor, the staff will ask you to go back and try again. I encourage you to take the initiative and draft your prospectuses in the spirit of the new Form N-1A, that is, with the individual investor as your intended audience.

III.  Other Disclosure Initiatives

An investor's initial decision to invest in a fund is only the beginning of the life cycle of the investment and the prospectus is only one part of the information an investor needs. In the coming months, we intend to give greater attention to other parts of the investment life cycle – to make sure that investors obtain all the information they need, when they need it and in a format they can use.

We will take a hard look at shareholder reports. In my view, this potentially effective tool for communicating with shareholders is too often left unused or underutilized. In a shareholder report, fund management can tell the story of what it has done for shareholders. Our goal will be to facilitate getting that information from management to shareholders.

One area that bears reevaluation is the schedule of portfolio investments. In my view, the schedule – along with management's discussion of fund performance and other information – should help an investor understand how his or her fund has been managed. Our goal will be to improve the quality of the portfolio schedule information. We will look at the possibility of adding summary information about the portfolio to help investors understand the wealth of data in the schedule. We also will consider whether the quantity of detail in the schedule can be reduced without reducing the valuable information that is available to shareholders.

When we reexamine shareholder reports, we expect to take a broad view – to determine whether we can move from prospectus-focused disclosure to a better integrated system. Our goal will be to make the prospectus and shareholder reports work together to provide the information that investors need, when they need it, and in a format they can use. We welcome your ideas in this area. We also will consider other forms of disclosure, such as significant event reporting (akin to 8-K reports for corporate issuers), if we conclude that this will contribute to our goal of better informed investors.

Another subject that bears reevaluation is the information that shareholders receive about the tax effects of portfolio activity. Many fund shareholders, of course, hold their fund shares through 401(k) plans and other tax-deferred vehicles. But, for those shareholders whose fund holdings are taxable, we will be asking whether the required disclosure of portfolio turnover adequately conveys the tax effects of a fund investment or whether this information can be improved or better explained.

Advertising is another area where you can expect to see changes. In 1996, Congress amended the Investment Company Act to authorize the Commission to permit funds to use an "advertising prospectus" that includes information the substance of which is not included in the statutory prospectus. We expect to recommend rules to the Commission making the "advertising prospectus" a reality. Eliminating the requirement to include the contents of fund advertisements in the registration statement should result in funds providing investors with better and more timely information.

The increased flexibility of the "advertising prospectus" will bring with it increased responsibility on the part of the industry. Those who use an "advertising prospectus" to sell a fund will, of course, remain subject to liability for fraud under Section 12 of the Securities Act. And the Commission will work with the NASD to make sure that the increased flexibility of the "advertising prospectus" is not abused. Funds that take a long-term view and advertise responsibly will, we believe, be rewarded in the marketplace by satisfied and loyal customers.

Responsible advertising includes responsible use of performance information. Recent volatility in the markets has served as a potent reminder that investments can go down as well as up and that funds are well-advised to educate their investors about risk in the marketplace. If you sell your funds based on one part of the story – stellar short-term performance – without explaining costs or risks or your investment strategy – you can expect your customers to desert you at the first sign of downturn in the market.

Performance advertising is an area where you can expect continued scrutiny from the disclosure review and inspection staffs. We simply will not tolerate the misuse of performance information to mislead investors. Division positions issued in the last several years permitting the use of certain performance information should not be misread as signaling an "anything goes" attitude. Rather, those positions recognize that performance information can be useful to investors when the information is used appropriately, substantiated, and presented in a fair and balanced way. We will, however, act quickly to stop any misuse of performance information.

IV.  Fees

We are also interested in a number of other important substantive areas. One of the most talked about topics has been mutual fund fees and expenses. There is considerable debate about whether these fees and expenses are increasing and whether fund investors are paying too much for the services they receive. In late September, Congress held hearings on this important subject.

Some argue that the tremendous growth in fund assets has created economies of scale that are not being passed on to investors. Some respond that fund expenses have increased along with fund asset growth. Others contend that the cost of investing in mutual funds has, in fact, decreased. They also point to a number of factors that suggest shareholders are getting more for their money, including enhanced shareholder services and more investment opportunities, such as international and sector funds.

The question of mutual fund fees and expenses will receive a good deal of our attention in the coming months. The Division has undertaken a review of trends in the overall levels of fund fees, the manner in which fees are assessed and whether economies of scale are passed on to shareholders. This review will be completed early next year. We also will consider the just-completed Investment Company Institute study of trends in the costs of equity mutual funds and a study being undertaken by the General Accounting Office in response to a congressional request. I also expect that we will look at the implications of fund distribution methods on costs to investors.

Whatever we find when the statistics are analyzed and the studies completed, there is already general agreement that fund fees and expenses are important to investors.
The industry should act now based on this general agreement. Funds can do several things today, without waiting for the results of any study of fund costs.

First, provide your investors the information they need about fees and expenses. Information about fund fees generally is accessible in the fee table required by the Commission in every fund prospectus. And the Commission's recent disclosure initiatives extended the fee table requirement to the profile and made several improvements to the fee table. But you can, and should, go beyond the fee table. You can make sure that your sales presentations are balanced, focusing on costs as well as other aspects of the fund. You can make sure that investors are aware of sales load breakpoints or classes of your fund that may be beneficial to them. You can make sure that your advertisements don't lead investors to focus exclusively on performance. Since many funds are sold through financial intermediaries, you should make sure they get this message too.

Second, educate your investors about the effect that costs have on returns. You know that fees can have a significant impact on account performance over time. Make sure your investors know this. You jeopardize your customer base when you sell based on short-term performance to investors who don't understand what they are buying and how much it costs. Consider whether you can find a way to explain to each and every investor in your fund how much, in dollars, his or her investment costs. The Commission, too, will be focusing on fund fees in its investor education efforts. Our goals are to teach investors what questions to ask about fees and to understand their impact before they buy.

Third, make sure that your fund directors are fully informed in fulfilling their role in providing adequate oversight of fund fees and expenses. Independent directors, under the 1940 Act, are the "watchdogs" and one of the directors' most important roles is in reviewing and approving fund fees. While fund directors have an obligation to request information regarding fees, advisers and distributors have a duty to provide information to fund directors as to the appropriateness of fee levels. The completeness and quality of information provided directors regarding fees is an area that I expect to be of continuing interest to the Division and the inspection staff in the coming months. The 15(c) process is not a routine review. It should be a serious assessment of the level of fees and expenses, in the light of shareholder needs and benefits. Directors must be vigilant in protecting the interests of fund shareholders, and we are going to work hard to ensure that they fulfill their statutory role on a fully informed basis.

Recent challenges to the role of independent directors are of concern to us. Directors must be free to exercise their statutory and fiduciary responsibilities without being hamstrung by management. This is an area we will be examining further.

We will also follow up on the issues raised by the recent Soft Dollar Report. The Report and its recommendations are not the last word on this matter - just a step in the direction of addressing the issues raised by the use and allocation of fund brokerage.

V.  Technology

Many of the issues that concern us today – disclosure, fees and expenses – have been with us since before the Investment Company Act was enacted. But one issue that occupies a great deal of our time and yours today – technology – is a product of more recent history.

Perhaps the most pressing technology issue confronting the industry today is Y2K. You have just over a year to rid yourself of the millennium bug – and you have only a matter of hours to file your first ADV-Y2K reports with the Commission.

Y2K is an important compliance and business issue for the fund industry. Funds and their advisers and service providers are very dependent upon computer systems. If those systems are not Y2K compliant, mutual funds and their advisers may face difficulties calculating net asset value, redeeming shares, providing account statements and other information to their shareholders, and communicating with fund custodians, transfer agents, and distributors.

To date, the Commission has taken a multi-pronged approach to Y2K readiness in the fund industry. The Commission has issued guidance to advisers and mutual funds regarding their Y2K disclosure obligations and has established a task force to monitor disclosure compliance. The Commission's Office of Compliance Inspections and Examinations has conducted nationwide examinations to obtain information on the Y2K problem. The Commission also has announced a moratorium on the implementation of Commission rules that would require major reprogramming of computer systems by mutual funds, their advisers, and other securities industry participants so that industry resources can be focused on remedying the Y2K problem.

Most recently, the Commission adopted the rule I alluded to earlier – requiring registered investment advisers to report on their Y2K readiness and the readiness of any funds they advise. The reports will be available to the public on our web site and will be used by the staff to obtain a more complete picture of the industry's Y2K preparedness and to identify firm-specific problems for further follow-up inspections. I would caution you that the Commission takes these reports seriously. You may have noted that the Commission recently brought enforcement actions against 37 broker-dealers for failure to file similar reports on their Y2K preparedness.

As we approach the millennium, our Y2K focus will continue. When we find deficiencies, we will address them aggressively with funds and their advisers.

Beyond the Y2K problem, technology offers tremendous potential to the fund industry and fund investors. The use of the Internet is revolutionizing the way funds and investment advisers communicate with, educate, and market their services to investors. As a result, investors can have instantaneous access to enormous amounts of information and tools to analyze that information. They can trade shares with a few keystrokes.

The Commission has a keen interest in technology and is supportive of technological advances in the fund industry. Our role in the fast-moving and ever-changing world of technology will be as facilitator of industry innovations that do not diminish investor protection. The Commission's interpretive releases on the electronic delivery of information demonstrate the Commission's willingness to foster the use of new technology. In those releases, the Commission indicated that the extent to which disclosure is made, as opposed to the medium for providing it, is most important in determining whether disclosure is sufficient under the federal securities laws.

Recently, the Commission issued an interpretive release regarding the use of Internet web sites to disseminate offering and solicitation materials for offshore sales of securities and investment services. Market participants had expressed uncertainty about the application of the registration provisions of the federal securities laws to offers over the Internet that by their terms were not made to U.S. persons. By addressing issues like this, the Commission can eliminate impediments to the use of technology without diminishing investor protection concerns.

As the Commission moves to address technology issues, we will remain mindful of investor protection concerns. The potential of the Internet to reach so many investors at a low cost brings with it the potential for fraud on an enormous scale. The Commission will take steps to prevent internet fraud and to prosecute it when we find it. This past October, following an unprecedented nationwide sweep, the Commission announced the filing of 23 enforcement actions against 44 individuals and companies across the country for committing fraud over the Internet and deceiving investors around the world. The Commission will continue this sort of enforcement activity directed to protecting investors and preserving the Internet as a venue for investors and funds to communicate and transact business.

We also will be mindful of privacy and security issues associated with Internet use. When the Internet is used to transmit personal information and effect business transactions, there is potential for misuse of the information and misappropriation of funds and securities.

In the coming years, I invite you to work with the Division when technology-related issues arise. You will be blazing new trails, and we are eager to facilitate innovation that serves investors.

VI.  Conclusion

I look forward to working with you as we address many issues important to the fund industry and its investors in the coming months. The fund industry has a record of which it should be rightfully proud. The industry has prospered, and it has a solid reputation for integrity. You can maintain that reputation, and continued business success, if you always keep in mind that the individual investor is at the center of the industry's success. Ultimately, what's in the interests of investors is in the best interests of the mutual fund industry. Thank you.