Remarks of Richard Walker before the Investment Company Institute Washington, D.C., December 7, 1998 Good afternoon. I am pleased to be here this afternoon to talk with you about some of the current issues facing the mutual fund industry. When I accepted the ICI's kind invitation to be your luncheon speaker, I realized that today is the first opportunity I've had since joining the Commission 7 years ago to address representatives of the mutual fund industry. I hope it won't be my last, though I recognize that my position as Enforcement Director tends to limit the number of invitations I receive. As all of you know, the Mutual fund industry has witnessed meteoric growth. Mutual fund assets now total more than the deposits of commercial banks. When I joined the Commission in 1991, total mutual fund assets were in the range of $1.2 trillion. Seven years later, the total now exceeds $5 trillion. In 1991, approximately 3,200 mutual funds were in existence. Now, there are about 8000 different funds and about 30,000 different investment companies. In fact, there are so many funds now that they come in every size, shape and flavor. For example, if you want funds with a patriotic name, our records indicate you can choose from funds named Franklin, Hancock, Jefferson, Pilgrim, Independence, and Flagship. If you like trees instead there are funds named Evergreen, Oak, Golden Oak, White Oak, Sequoia, and Acorn. And with the rise of hedge funds, I wonder whether there will soon be, say, a privet fund or a boxwood fund. Another indicator of the dramatic growth of this industry is found in a 1966 Commission report to Congress entitled, "Public Policy Implications of Investment Company Growth." The transmittal letter from then-SEC Chairman Manny Cohen described the growth of the investment company industry as "dramatic." Section 14(b) of the Investment Company Act authorizes preparation of such a report when the Commission believes growth in the industry is happening so rapidly that it could hamper investor protection. At the time the report was prepared, the total level of investment company assets _ which was what triggered preparation of the report _ was $46 billion. Given today's level of $5 trillion, we might have pulled a false alarm in 1966. Happily, the mutual fund industry has avoided scandal over the years. The fact that the industry has attracted a greater number of individual investors - including many who are new to the market and relatively unsophisticated - has led, however, to closer scrutiny of the industry by regulators, such as myself. Many of you probably don't know very much about enforcement types like me. So I thought it would be useful to share with you some of my views and philosophies about the role of enforcement generally and about the areas that are of greatest interest to me. Of course, the views I express are my own and not necessarily those of the Commission or its staff. I became Enforcement Director in May of this year, after having served 2 1/2 years as General Counsel and 4 years prior to that as Director of the Commission's Northeast Regional Office. During my time at the Commission, we have brought a number of significant cases in a variety of areas. We have done much to clean up the municipal bond market, to continue our war against insider trading, and in recent times, to tackle fraud in the micro-cap market and over the Internet. While we have brought fewer cases involving `40 Act registrants, the cases we have brought have been highly significant. They include cases such as ú First Investors - in which we charged a large mutual fund complex and its senior management with sales practice violations; ú Mitchell Hutchins Asset Management and Piper -- two cases involving alleged inadequate procedures that led to disclosure and pricing violations; ú Account Management and Monetta -- cases involving allocations of hot issue IPO's; and ú Parnassus and Rockies Fund --which focused on the fiduciary duties of fund directors. More about some of these cases and the issues they raise later. It is sufficient to note at this juncture that these cases go to the core of our enforcement program. They involve fundamental concerns that cut across industry lines. For example, they underscore that mutual fund shares -- like all other types of securities -- must be sold in a fair and ethical manner with proper disclosure of their risks and other characteristics. The cases also demonstrate that mutual fund directors, like directors of public companies, must perform the duties required of them without conflicts of interest and in strict observance of their fiduciary duties. Before addressing our current priorities, let me spend a few minutes talking about the enforcement process. Although I've only been Enforcement Director for a few short months, if you look at some of the things the Division of Enforcement has done during this period, you will begin to understand my approach to the enforcement process. At the outset, I believe that every enforcement action we bring has 3 important components: ú First, enforcement actions must address specific violations of law and result in sanctions that will protect the public from future harm; ú Second, every enforcement action must also carry a broader message that will help to deter others from engaging in similar misconduct; and ú Third, enforcement actions should serve as a vehicle to alert and educate the public as to how to protect themselves from harm. We've worked to fulfill these goals in a number of ways. We've brought cases that involve, not only misconduct by specific individuals and entities, but also are illustrative of problems prevalent in the industry. And we've coupled our enforcement efforts with investor alerts and other educational efforts such as investor Town Meetings, postings on our Web site and printed pamphlets offering advice to investors. One technique that I have found to be particularly effective in drawing attention to a problem is to bring several cases involving similar violations at the same time. We employed this approach earlier this Fall when we brought 13 cases against micro-cap issuers and promoters on the same day, and again when we named 37 broker-dealers who had failed to make required Year 2000 filings. More recently, we conducted a successful Internet sweep in which we initiated actions against 44 individuals and entities who engaged in illegal touting of securities without disclosing they were receiving compensation for their efforts. I have found that by grouping cases thematically, our message is delivered more forcefully and effectively than sometimes occurs when we bring cases separately. In addition to making sure that our enforcement program provides strong deterrent and educational messages, it is important for us to send these messages in a timely fashion. With staff turnover at a high level, industry growth at a record pace and broad markets over which to maintain our watch, this is a formidable challenge. And yet, it is a challenge that we have demonstrated we can meet by selectively focusing on issues of the greatest concern, and prioritizing and expediting our investigations of those matters. Again, our Y2K broker-dealer sweep and our Internet sweep are good examples of how we will be approaching enforcement issues of high priority. Both of those sweeps were originated and executed in just a few short months. Effective law enforcement requires us to shorten the time period between our discovery of illegal conduct and imposition of deterrent sanctions. Of course, expediting investigations takes its toll. We simply do not have the resources to prioritize every investigation. We must be selective. And just as we put pressure on our own staff to meet tight schedules, we must also be firm about deadlines for Wells Submissions and for compliance with our subpoenas. This means we need your cooperation more than ever. I'd be remiss if I didn't take a minute to talk about the May 1998 letter the ICI sent to Commissioner Laura Unger in connection with her review of the Enforcement Division. I commend the ICI for offering its views on how to make the process work better. Let me tell you about some of the matters the ICI raised and what has been done to address them. First, the ICI stressed that it is important that enforcement actions not be used as a substitute for rulemaking or the issuance of interpretative guidelines. I completely agree. I believe that the cases we have brought in the '40 Act area are all based on violations of clearly established principles of law. I'd be curious to hear from you which cases you feel are not. The ICI also suggested that we consult with the Division of Investment Management before recommending any '40 Act case. In fact, we do. IM reviews and comments on every recommendation. We give great deference to their comments and often re-shape recommendations based on what they have to say. The ICI further suggested that our staff receive extensive '40 Act training. Our staff already receives training in all areas of the law, not just the '40 Act. We recently worked with the SIA to provide greater training for our staff by the broker-dealer community. We would welcome the ICI's participation in such training as well. Another suggestion raised by the ICI is that IM designate more enforcement liaisons to review our cases. . . . Are you beginning to see a theme to the ICI's comments or is it just me? If I were a suspicious guy, I'd say the ICI must think we in enforcement don't know very much about what we've doing in the `40 Act area. If it gives you all any comfort, you should know that every enforcement recommendation is reviewed by half the civilized world -- not only IM, but every other division, the Commissioners and the Commissioners' legal counsel. As you can see, there are alot of checks and balances built in to the process. As to the question of more enforcement liaisons from IM, IM has a staff of four, headed by Liz Osterman, who are both exceptional and adequate in number. IM provides more liaisons than any other division, even though fewer cases fall into their domain. Finally, the ICI asks that we create a specific unit in Enforcement solely to focus on '40 Act cases. We tried this in our New York Office when I was its director and it did not work well. We frankly do not have enough of a need to justify such a unit. In 1997, we initiated 489 enforcement actions - 7 involved Investment Company Act violations and 45 involved Investment Advisers Act violations. So much for our processes - let's talk about our priorities. In preparing my remarks for today, I gave a lot of thought to how I would rank my enforcement priorities in the mutual fund area. While I concluded that a precise ranking was not really possible, there are several areas that top the list. Sales practice violations The first is sales practice abuses. The Commission has long regarded such abuses -- in all areas of the securities industry -- as among the most serious violations that we deal with. This is particularly true under Chairman Levitt who has devoted every resource available to insure investor protection. I too have had a serious distaste for sales practice violations dating back to the time I viewed and old episode of the TV sitcom, Taxi. Danny DeVito's unsavory character was laid off as taxi dispatcher. He landed a job as a broker and while cold calling quickly found himself talking to a boy about 10 years old. He said to the boy, "Is your mommy home?" After the boy responded "no," Danny DeVito asked, "Do you know where her checkbook is?" In recent years, the Commission has meted out tough sanctions in the sales practice area. These include stiff monetary penalties and industry bars for securities professionals. The kinds of cases we will be on the lookout for include those involving misrepresentations about the risks of investing in, or the characteristics of, a particular fund. In addition, I am concerned about situations in which brokers and advisers place their interests ahead of the interests of their customers when they recommend the purchase of specific funds. For example, you can expect to hear from us soon on the subject of fraudulent mutual fund switching. We will also be looking closely at failures to disclose up front fees, contingent deferred sales loads and breakpoints in sales materials used to sell funds, particularly at the point of distribution. And we are also studying, together with our Office of Compliance Inspections and Examinations, arrangements for the distribution of fund shares where compensation is paid for distribution services, including in "step out" transactions. Duties of Directors A second area of enforcement priority is ensuring that fund directors properly fulfill their duties. Like any corporation, the board of a mutual fund is generally responsible for overseeing the management of the company. But the board is responsible for much more. As amply stated by the noted academic Thomas Lee Hazen, "[D]irectors serve primarily as `watchdogs' over an investment company to protect the interests of shareholders against abuses by investment advisers and others in a position to profit illegally from the company." Well-trained watchdogs can help to keep "attack dogs" - - as I've heard my staff referred to on occasion -- at bay. Investors must be able to depend on vigilant and well- informed directors to "keep their fund's house in order." Recent experience makes plain that we will hold directors' feet to the fire. Three cases in particular stand out: Parnassus, Monetta, and the Rockies Fund. The Commission's Orders in each of these cases are "must" reading for everyone in this room. Parnassus Parnassus is an administrative proceeding in which we sued two outside directors of the Parnassus Fund. We alleged that they aided and abetted and caused the Fund to overstate its net asset value by failing to value in good faith the Fund's holding in a thinly traded stock. For two years, the Fund valued the stock at 34 cents per share. This price was based on the last available Nasdaq market quote - a quote issued before the company was de-listed after its equity turned negative and before the company filed for bankruptcy. Thereafter, the company's shares traded in the pink sheets at prices as low as one cent per share. Nonetheless, the Fund continued to value the stock at 34 cents per share. The Fund also carried a $100,000 promissory note of the same company at an inflated price. The bloated valuations caused the fund to overstate its NAV, which in turn provided redeeming shareholders a windfall and shortchanged those buying new shares. In addition, the adviser received more than it was entitled to. ú On September 3 of this year, ALJ Robert Mahony handed down his decision. We won. Now, Parnassus is a case that led to a hue and a cry from the industry and the bar. "The SEC is seeking to impose new duties on directors," our critics complained. Not so. The responsibility of directors to assure that the assets of their Fund are fairly valued goes to the core of a director's duties under the '40 Act and Rule 2(a)(41)(b). You should not draw comfort from the fact that the ALJ declined to impose money penalties in this case. His decision on penalties was guided largely by the fact that the directors received no unjust enrichment and otherwise had a clean record. The Rockies Fund Our case against the Rockies Fund reinforces the lesson of Parnassus. In this litigated administrative proceeding, we sued two independent directors of the Fund. We charged these directors with anti-fraud violations for misstatements and omissions appearing in the Fund's annual and quarterly reports concerning, among other things, the value of certain restricted and unrestricted securities held by the Fund. Monetta While Parnassus and the Rockies Fund focused on the fair valuation of Fund securities, fund directors of course have other duties, many of which arise outside the `40 Act. Front and center among these is the common law duty of loyalty. The importance we attach to this duty is well illustrated by our February 1998 case against three directors of mutual funds advised by Monetta Financial Services. We allege in this case that during an eight month span in 1993, Monetta received profitable short term trading opportunities in "hot" IPOs from certain broker-dealers. The allocations were made based on business Monetta had directed to the broker-dealers, principally on behalf of the funds. We allege that Monetta, the adviser, allocated portions of the IPOs to certain fund directors even though the funds were legally and financially able to invest in the IPOs. As you know, directors owe a fiduciary duty of loyalty to their companies and shareholders. We allege that the Monetta directors who received preferential IPO allocations without making disclosure and obtaining the consent of disinterested representatives of the funds breached their fiduciary duty of loyalty. Acceptance of this benefit from the fund's adviser placed the fund directors in a position where their judgments - including reviewing the performance of the fund's adviser and deciding whether to retain or replace the adviser -- could be influenced by considerations of personal gain dispensed by the adviser. Compliance Procedures A final area of priority relates to the effectiveness of compliance and internal procedures. We addressed the adequacy of such procedures in the Mitchell Hutchins case and the Gabelli case. I think it's fair to say that if a fund has an effective compliance program and internal procedures that are closely observed, the Enforcement Division's response to any violations of law will be very different than if no procedures are in place or the procedures are ignored. This brings me to preparations for the Year 2000. We have been discussing the Y2K problem with the ICI and the industry for several years. In addition, SEC examiners visited more than half of all SEC registered advisers this summer, reviewing their Y2K readiness. Our former Director of Investment Management Barry Barbash discussed the topic at this very conference one year ago. It is now time to revisit the issue and assess where we are a year later. Though I've heard some dismiss the threat of Year 2000 failures in this industry, I join Matt Fink in urging you to, continue to treat Year 2000 readiness as an issue of high priority. Today's luncheon comes at a fortuitous time and will help to serve as a reminder of the importance of this issue. It just so happens that today marks the deadline for filing with the Commission Form ADV-Y2K. This form must be filed by advisers registered with the Commission as well as advisers to registered investment companies. Completed forms will be publicly disclosed and will contain vital information concerning, among other things, compliance plans, resources and personnel to address the Year 200 issue, progress to date, and contingency plans. Now while I hope I do not trigger a stampede to the door, let me offer some friendly advice _ file the form. We will recommend that every adviser that does not file timely be sued. I tell you this today because our goal is not to sue you, but rather to ensure compliance. If you or your clients have not made this filing, make sure you do so by day's end. Conclusion I've spent most of my time this afternoon talking about the past and the present enforcement program. What about the future? What can you expect in the months and years ahead? One thing you can expect is greater scrutiny of hedge funds. The Commission believes that it is time to reexamine the risks posed to our markets by the activities of hedge funds. Indeed, the President's working group is currently looking at hedge funds and the circumstances surrounding the acquisition of Long Term Capital Management. While few have advocated strict new regulatory controls over hedge funds, a number of observers have suggested that enhanced disclosure of some hedge fund activities would be beneficial and would promote greater transparency. For the most part, hedge funds operate outside the Commission's regulatory framework. Like regulated entities, however, they are subject to our antifraud jurisdiction. This is where the Enforcement Division comes in. You can expect that we will pay close attention to the possibility of fraudulent conduct in connection with hedge fund activities, particularly in view of the impact which we've seen hedge funds can have in a global economy. And what does the future hold for those of you in this room? I hope that it will bring a continued, perhaps even more vigorous, commitment to maintaining the trust of the investing public. This can only be achieved if investors have confidence that those who create, sell, manage, advise and regulate mutual funds bring the highest standards of honesty and integrity and a commitment to the protection of investors to their jobs. You cannot afford to rest on your laurels and become complacent about what you do simply because the mutual fund industry has avoided the taint of scandal. The reputation of this industry has been earned through the good faith and diligent efforts of a great number of people. It is up to you to make sure that that reputation is maintained.