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U.S. Securities and Exchange Commission

Speech by SEC Staff:
"Maintaining the Pillars of Protection in the New Millennium"

Remarks by

by Paul F. Roye1

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

Before the Investment Company Institute
1999 General Membership Meeting
Washington, D.C.

May 21, 1999

Thank you and good morning. It's a pleasure to be at this year's ICI General Membership Meeting.

I. Dramatic Growth of Industry

As everyone in this audience is well aware, we are in the midst of an extraordinary period in the mutual fund industry. To say the industry has experienced substantial growth in the last few years is a little like saying "Star Wars -- The Phantom Menace" had a pretty good opening at the box office. I guess you could say mutual fund assets have grown to cosmic proportions -- with almost $6 trillion in assets, compared to a "mere" $1.3 trillion in 1991 when Matt Fink became President of the ICI.

As we consider the emerging issues for the mutual fund industry beyond the Year 2000, I think it is important to consider the factors that have contributed to the success of the industry today. One obvious factor has been the longest bull market in history -- the Dow has now hit 11,000 and everyone, including the mutual fund industry, is enjoying the ride. Another significant factor has been the dramatic shift in retirement assets from defined benefit pension plans to defined contribution plans. Other factors include new distribution channels, new products and improvements in shareholder services. And the list goes on and on . . . .

In my mind, however, the one factor that has been at the very heart of the industry’s success is the fundamental integrity and credibility of the mutual fund industry.

II. Role of Investment Company Act in Industry’s Success

As we approach the dawn of the new century and the 60th anniversary of the enactment of the Investment Company Act of 1940, I would like to spend this morning reflecting on three things: (i) the 1940 Act; (ii) a proposal to amend the statute; and (iii) some challenges confronting the mutual fund industry.

Let me begin with what I consider one of the most successful statutes regulating financial institutions -- the Investment Company Act of 1940. An extensive Division of Investment Management study of the Act came to the same conclusion in 19922 and the Congress made only minor changes to the statute after it took a hard look at it in 1996. Trillions of dollars have been invested in U.S. mutual funds, without the benefit of a single dollar of government guarantee, subsidization or bailout. Over the years, mutual funds have contributed untold amounts to capital formation in the United States, as well as in many foreign markets, including developing markets.

But, to borrow liberally from the disclaimer, past performance is no guarantee of future results, I believe that the success of this industry, was and will remain, dependent on its ability to command the confidence of investors. That confidence is based in no small measure on the effectiveness of the 1940 Act in preventing many of the abusive practices that prompted its adoption.

The 1940 Act created what I would call the "four pillars of protection" for mutual fund investors. These protections give investors confidence that:

(i) Their investments will be managed in accordance with the fund's investment objectives;3

(ii) The assets of the fund will be kept safe;4

(iii) When they redeem, they will get their pro rata share of the fund’s assets;5 and

(iv) The fund will be managed for the benefit of the fund’s shareholders and not the fund's adviser or its affiliates.6

We would all agree, I think, that the 1940 Act successfully addressed the abuses that occurred before its enactment. But the true genius of the Act was its drafters' understanding that markets and circumstances change, and that industries evolve. The exemptive authority given to the Commission in the 1940 Act makes the Act flexible and allows it to accommodate change and innovation in ways that preserve the Act's underlying principles7. This flexibility permitted the development of money market funds, variable insurance products, expanded international investing, alternative distribution arrangements, securities lending programs, and unique exchange-traded products like SPDRS that serve particular investor needs.

Another unique aspect of the 1940 Act is the requirement that investment companies have independent directors. As far as I know, investment companies are the only U.S. companies that are required by law to have independent directors. Investment company directors are called upon to safeguard the interests of fund shareholders and ensure that the "pillars of protection" I mentioned earlier are not breached. As you probably know, the Commission has undertaken a broad initiative to determine what problems independent directors are encountering and how their effectiveness can be enhanced. In February, the Commission hosted a roundtable on the role of independent investment company directors. As a result of the roundtable, and at the urging of Chairman Levitt, we expect that later this summer we will be recommending that the Commission propose rules that strengthen fund boards and the corporate governance provisions of the 1940 Act by, among other things, providing for a majority of independent directors, self-nominating independent directors and director access to independent counsel.

Additionally, in response to Chairman Levitt’s call for action, the ICI has created a special committee to develop best practices regarding investment company governance. We urge this committee to take a hard look at recommendations which would significantly improve the governance structure and go beyond what we could properly propose as regulators. Together, through these initiatives, we can make sure that independent directors have the tools needed to fulfill their role as representatives and guardians of the shareholders’ interest.

We were also pleased by ICI Mutual’s quick response to another issue that has caused concern -- the existence of joint liability insurance policies for directors and fund management that exclude coverage regarding claims brought by co-insureds. What this means is that if management and directors have a joint liability policy and management sues the directors, the directors will not be covered. It seemed clear to us that independent directors who find themselves in litigation with management cannot be effective representatives of shareholders if they’re worried about funding costly litigation out of their own pockets. Soon after the Chairman spoke about this issue publicly, ICI Mutual announced it was modifying its co-insured exclusion to address this problem. I want to thank ICI Mutual, and the leadership of Dave Silver, for the timely response to these concerns.

Some of you may be thinking that there is no need to strengthen the governance structure; however, we collectively have an interest in ensuring that this $6 trillion dollar industry remains free of the scandals that, over recent years, plagued other segments of the financial services industry. Strengthening the governance structure by enhancing the role of independent directors is an important step towards ensuring the continued vitality of the industry.

As we look toward the new millennium, I believe the basic regulatory structure of the 1940 Act, established almost 60 years ago, is alive and well. It has served American investors well; it has served the mutual fund industry well; and it has served the capital markets well.

But we all know that in some areas changes need to be made. Changes that reinforce the goals of the 1940 Act and changes that respond to today’s marketplace. Some, however, have proposed amendments to Section 17(a) of the 1940 Act. I believe these legislative recommen- dations have the potential to open the door to overreaching, self-dealing, and the other abusive practices that prompted enactment of the statute. It is my view that any problems that are posed by Section 17(a) can be addressed administratively by the Commission through its broad exemptive authority. But before substantial modifications to Section 17(a) are made, we need to give careful consideration to the reasons for the Act and the purposes of the affiliated transaction prohibitions.

The 1940 Act’s provisions concerning affiliated transactions were enacted in response to the Commission’s exhaustive five-year study on the investment company industry. The Investment Trust Study devoted over 200 pages to the discussion of specific instances of overreaching by affiliates in the 1920s and 1930s. The Commission found that affiliates not only sold securities to investment companies to realize profits as principal, but also sold securities to these companies for a variety of other reasons. Underwriters of securities formed funds into which they could dump underwritings. Dealers in securities formed funds into which they could dump their inventories. Banks formed funds in order to make loans to them. Frequently, sponsors of funds also sold securities to their affiliated investment companies in order to secure, facilitate or maintain control over portfolio companies, or to aid in mergers, consolidations or other objectives of the sponsors. As a result, the regulatory framework included restrictions on transactions involving investment companies and their affiliates.

Perhaps it would be useful to briefly review Section 17(a). Section 17(a) of the statute makes it unlawful for an affiliate of a registered investment company knowingly to sell securities or property to the company, purchase securities or property from the company, or to borrow money or property from the company. Section 17(a) seeks to protect the fiduciary relationship, by deeming it better to foreclose principal transactions rather than attempt to separate the beneficial and harmful transactions and allow the fiduciary to justify representation of two conflicting interests. Section 17(a) also reflects the common law theory that disclosure alone cannot satisfy the duty of loyalty of a fiduciary. Even with complete disclosure, a fiduciary must act in a manner that the fiduciary believes to be in the beneficiary’s interest. As managers of investment companies, you are fiduciaries entrusted with the savings of millions of investors, to whom you owe a fiduciary duty in the handling of those savings. Therefore, the highest standards of care, loyalty and judgment are not the most a shareholder can ask for, but rather the very least of what they should expect. From an investor protection standpoint, the 1940 Act’s provisions concerning affiliated transactions are at its heart and serve as a fundamental protection.

The provisions of Section 17(a) have not prevented the growth of mutual funds nor their attractiveness as the investment option of choice for millions of small investors. The importance of the prohibitions against affiliated transactions to mutual fund investors and to the mutual fund industry cannot be underestimated and the consequence of their demise cannot be overestimated. We need to proceed cautiously. Let us not forget that the loosening of restrictions on savings and loans in the early 80s contributed to and exacerbated the S&L crisis, which ultimately led to the collapse of that industry. In addition, some sources have concluded that forms of "insider abuse" played a significant role in various bank failures.

Of course, the proposal recently put forth would not entirely repeal Section 17(a), but it would represent a breach of the wall that was built around mutual fund assets. This wall -- one of the pillars of protection I referred to earlier -- protects funds from being used for the benefit of fund sponsors and their affiliates.

We need to carefully consider the risks and consequences of opening the door to principal transactions with affiliated funds. Even in situations in which the transactions would be in the best interests of the fund, the adviser runs the risk that with 20/20 hindsight, the principal transactions will be questioned if the securities drop in value, exposing the advisory firm to risk. Plaintiffs’ lawyers could have a field day, suing everyone connected to the transaction, the affiliated dealer, the adviser, the portfolio manager and even the independent directors who presumably have signed off on the transactions. While Section 17(a) protects the fund and its investors, it also protects management companies by drawing a clear line.

I believe the fund industry recognizes the importance of strong rules to prevent abusive practices. And from the start, I believe that the fund industry has recognized this. In fact, President Roosevelt noted at the signing ceremony for the Investment Company Act in 1940 that "the investment trusts have themselves actively urged that an agency of the federal government assume immediate supervision of their activities."8 (Since 1940, I bet they haven't heard that one very often in Washington!).

And before you start growing concerned that we at the SEC are trapped in some sort of 1940’s time warp -- I want to make clear that we are very sensitive to the fact that our rules must keep pace with the changes in the marketplace. We realize additional flexibility is needed in this area, and believe we have the regulatory tools to tailor Section 17(a) to the changes taking place. We have granted individual exemptive orders to funds to allow transactions that would otherwise be prohibited under Section 17(a) when the terms have been fair and reasonable. Right now, we are carefully reviewing a series of exemptive rule proposals under Section 17 submitted by the ICI for our consideration, as well as examining the possibility of an exemptive rule under Section 206(3) of the Investment Advisers Act, which imposes conditions on principal transactions involving private advisory accounts. Of course, any proposals we would make to remove restrictions under Section 17 and Section 206(3) would need to be consistent with the underlying policy and purposes of these sections.

III. Challenges to the Industry in the New Millennium

Some may say Section 17 and the other "pillars of protection" represent a competitive disadvantage for the mutual fund industry. Not surprisingly, I disagree. I actually believe the opposite is true -- that these "pillars of protection" represent a competitive advantage for the industry. As the choices available to investors multiply daily, I believe that adherence to the standards and principles reflected in the statute are one of the best marketing tools available to the fund industry.

And as you are well aware, the industry will be facing many challenges in the 21st century, including, among others, new technology, consolidation of the financial services industry and increased competition.

Take technology for example -- it has allowed the mutual fund industry to achieve incredible growth, and to manage this growth. The industry has effectively used technology to better communicate with investors, improve services and lower trading costs. Technology has made it possible for funds to engage in increasingly sophisticated trading techniques, and to expand the number and types of funds available.

And while technology has helped the mutual fund industry grow, it has also helped its competitors grow. Technology has, and will continue to, revolutionize how people invest, how funds do business and how markets function. Investors are now tempted by on-line trading, chat room hype, market cheer-leading on television and the explosive volatility in, for example, Internet stocks. Some mutual fund shareholders are moving their money out of stock funds to buy stocks directly. A marketing executive at an on-line brokerage firm was quoted as saying that "[o]n-line investing is a national pastime. Baseball was fueled by radio. Football fueled by TV. On-line investing is fueled by the Internet."9 Will this on-line trading explosion last? How will the fund industry convince investors to stick with their mutual funds, and not to jump into the stock market directly? One brokerage advertisement for an on-line brokerage firm even plays up this issue by showing an embarrassed jogger admitting to a stock trading friend that she still invests in mutual funds.

Another challenge for the industry will be increased competition from other financial services companies. As banks and other financial institutions consolidate, create new alliances, and increase their participation in the mutual fund industry, competition for the investor's dollar will intensify. It is assumed that financial modernization legislation would pave the way for one-stop shopping for financial services. The question investors will ask is "where should I make this one-stop?" Will it be at the bank, the fund complex, or some other service provider? With or without financial modernization legislation, it is clear that the fund industry can expect increasing competition from other financial services providers. It is for this reason that functional regulation is necessary to protect the interests of mutual fund investors, and to ensure that there is a level playing field. Bank regulation is traditionally more concerned with the safety and soundness of the bank rather than the interests of investors. All parties that provide investment advice to mutual funds, including banks, should be subject to the same oversight, including Commission inspections and examinations. Any type of entity that is affiliated with a mutual fund should be subject to the conflict of interest provisions of the federal securities laws. Additionally, we are concerned about the unique conflicts of interest resulting from increased bank involvement in the mutual fund business. The conflict-of-interest provisions in the 1940 Act were drafted at a time when Congress could not have anticipated the dramatic change in the scope of bank securities activities, such as bank lending to affiliated mutual funds. Financial modernization legislation must adequately address these conflicts of interest. Public investors would be better off with no legislation, rather than legislation that fails to address these important conflicts of interest.

IV. Meeting the Challenges of the New Millennium

In meeting the challenges of the new millennium, you must remember how you reached the enviable position you are in today. In this day and age when investors can choose among an amazing array of financial professionals and investment opportunities, and have access to alternative trading systems and information technology, the fund industry will need to distinguish itself in a very crowded field.

By adhering to the fundamental principles in the 1940 Act, and by ensuring that your relationship is still based on trust and integrity between a fiduciary and a client, the mutual fund industry will continue to succeed. This is why I believe in the area of principal transactions we need to proceed cautiously.

V. Conclusion

Let me close by saying that the mutual fund industry should be proud of its achievements but at the same time it should be mindful of the key ingredients of its success -- investor trust and confidence. I caution the industry not to lose sight of the important role the 1940 Act has played in its success and not to let others who do not appreciate the importance of the standards reflected in the Act dictate the course of the industry. The Act holds the industry to the highest standards, making it absolutely clear that managing a mutual fund is no ordinary business -- but the business of a fiduciary. As the industry moves into the new millennium, the industry would be well advised to heed the wisdom that "those who do not remember the past, are condemned to relive it."

Thank You.

1 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 the author's colleagues upon the staff of the Commission.

2 Protecting Investors: A Half Century of Investment Company Regulation (May 1992), p. xxii ("The soundness [of the fundamental principals underlying the 1940 Act] is demonstrated by the successful and safe operation of investment companies ").

3 Sections 5(b)(2) (fundamental investment policies) and 13(a) (changes in investment policies).

4 Sections 17(f) (custody of fund assets) and (g) (bonding of employees).

5 Sections 22(c) and (d) (redeemable securities), 22(e) (right of redemption), and 2(a)(32) (definition of redeemable security). See also Section 18(f) (senior securities).

6 Sections 17(a) (affiliated transactions), 17(d) (joint transactions with affiliates), 17(e) (affiliates effecting transactions in portfolio securities), 10(f) (participation in affiliated underwritings), 15 (advisory contracts), 16 (boards of directors), and 36 (breaches of fiduciary duty).

7 Sections 6, 17(b), and 10(f).

8 Statement by the President of the United States upon the signing into law H.R. 10065, Aug. 26, 1940, 86 Cong. Rec. 5230-31 (1940) (Appendix).

9 Ianthe Jeanne Dugan, "Brokerage Ads Veer From Mainstream; Industry Touting Online Services," The Washington Post , April 23, 1999, at El.