Speech by SEC Staff:
Remarks Before the American Bar Association Section of Business Law Spring Meeting
by
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Washington, D.C.
March 16, 2007
I. Introduction
Good morning. It is a pleasure to be here and I would like to thank Jay Baris and the ABA Section of Business Law for arranging this program and for inviting me to speak with you today. I am pleased to see so many familiar faces and fellow bar members.
Throughout my career, I have found bar association events to feature engaging and lively discussions that truly serve to further the dialogue and advance the ball on critical legal issues. I expect that today's discussion will be no exception. Before we begin our discussion, however, I am obligated to remind you that my remarks today represent my own views and not necessarily the views of the U.S. Securities and Exchange Commission, the individual Commissioners or my colleagues on the SEC staff.
Yesterday marked my 10-month anniversary as Director of the SEC's Division of Investment Management. It is difficult to believe that I have been on the job for nearly a year. I am no longer trying to figure out the government bureaucracy or get used to the ways of Washington. Thanks to the hard work of a highly talented and dedicated staff, the Division is now in a position to make recommendations to the Commission to shape policy going forward. And I emphasize going forward.
From my perspective, much of the Division's focus and attention during the past few years has, of necessity, been backward-looking. The Division either was making recommendations to the Commission to respond to fund industry abuses, as it was when it developed rulemaking recommendations to address the mutual fund scandals. Or the Division was focusing on past backlogs, such as in exemptive applications, or pent-up rulemaking projects, like the fund of funds rules, that were put on hold pending resolution of the scandal-related rulemakings.
At this point, however, the Division is in an enviable position. We now have the luxury of looking forward. We can make recommendations to the Commission based on what we believe the mutual fund and investment adviser regulatory landscapes should be.
Looking forward, there are certain regulatory areas that I believe can be shaped, simplified and modernized to better serve investors. These include the mutual fund disclosure regime, the information that 401(k) participants receive, rule 12b-1, the work of fund directors and international issues to name a few.
II. Mutual Fund Disclosure Regime
First, concerning the mutual fund disclosure regime, mutual fund disclosure reform and interactive data tagging are a top priority for the Division and for Chairman Cox. There are a number of developments in this area. One of the most exciting is that on January 4th, the ICI released for public review the draft taxonomy that it developed for tagging the data in the risk/return summary that is at the front of every mutual fund prospectus. As you are aware, the risk/return summary contains information that is important to an investor's informed investment decision, including investment objectives and strategies, costs, risks, and historical performance information.
I am appreciative of the ICI's efforts to create a technological tool that has the potential to enhance greatly the way in which information is provided to mutual fund investors. On February 6th, following a January 31st Open Meeting, the Commission issued a proposing release requesting comment on permitting funds to use the new ICI taxonomy for purposes of tagging their risk return summaries in the Commission's voluntary interactive data filing program. The comment period closed on March 14th, and we are in the process of reviewing the comment letters.
I am very hopeful that the risk return summary tagging program will be successful and encourage fund industry participation in the voluntary program, so that we can fully test the usefulness and utility of the interactive tagging system – as well as identify any kinks in the system that need to be worked out.
Turning to mutual fund disclosure reform, I should emphasize, as I always do that mutual fund disclosure reform and interactive data are closely tied. I believe it is difficult to pursue significantly streamlined disclosure reform without the ability for fund investors to access more detailed information through the interactive data initiative.
In previewing the mutual fund simplified disclosure initiative, I have stated that the ultimate goal of the initiative is Giving Investors the Information They Need, in a Form They Can Use–which is the title of a speech Chairman Cox gave a few months ago. A more long-winded way of describing the goal is facilitating more user-friendly, plain English mutual fund disclosure and streamlining the delivery of mutual fund information through the increased use of the Internet, interactive data, and other electronic means of delivery.
As part of the disclosure reform initiative, the staff is considering whether to recommend that the Commission permit funds to offer securities pursuant to a streamlined disclosure document that would be required to be delivered to investors (electronically or on paper), while requiring a more detailed document to be available on the Internet or delivered in paper upon request. As I envision it, the streamlined disclosure document could include key information necessary for an investor to make an investment decision, such as fees and expenses, risks, investment objectives and strategies, and historical returns.
One model the staff is looking at closely is the current profile prospectus. The staff is also examining why the current profile has not been fully successful. In this context, we are reviewing liability, updating and delivery issues. Another issue the staff is examining is whether to update and streamline shareholder report requirements, including whether to recommend rules that permit mutual funds to provide a streamlined report with more detailed information available via Internet posting or in paper form upon request.
In order for this forward-looking endeavor of revising the mutual fund disclosure regime to be successful in benefiting fund investors, the fund industry's input and the fund industry's participation in interactive data tagging will be necessary. By volunteering to file prospectuses in the proposed voluntary program using the new XBRL taxonomy, fund groups can greatly enhance our understanding of how interactive tagging works to assist fund investors – as well as the limitations or deficiencies of the proposed program.
Furthermore, if we are to be successful, we also must change the mindset of many in the industry–but most particularly you, the attorneys–when it comes to the primary purpose of disclosure. The mutual fund prospectus is viewed by many in the industry primarily as a litigation protection document, rather than a tool to effectively communicate with shareholders and prospective investors. We need to work to change this viewpoint. In my view, the fund prospectus can and should serve both purposes.
As an attorney myself, I understand that you–and your clients–have legitimate liability concerns. I also understand that it will be difficult to make disclosure reform that benefits investors a reality, unless we can address liability concerns. The staff is exploring incorporation by reference and related ideas to address these issues. However, I do not want attorneys' liability concerns to become so paramount that they preclude investors from receiving meaningful and significantly streamlined disclosure about funds. Speaking of significantly streamlined disclosure, I have a personal preference for a two-page document with only a single fund discussed in the short-form document. I believe this type of format will remove much of the confusion and "clutter" about which many fund investors legitimately complain.
III. Improvements for 401(k) Investors
An ever growing percentage of fund investments continue to come through 401(k) plans. In 2005 (the most recent year for which data are available) mutual funds accounted for just over half of the $2.4 trillion in 401(k) plan assets. Ten years earlier, less than one-third of a much smaller 401(k) pie was invested in mutual funds.2 Looking toward the future, I expect the trend of increasing 401(k) investment in mutual funds to continue. I also believe that we need to consider the mutual fund regulatory regime's application to 401(k) plans and those investors that invest in funds through 401(k) plans.
One issue the staff is considering closely is the type of disclosure that 401(k) participants receive about the funds they invest in or are considering investing in. Different 401(k) participants receive varying levels of information, from full prospectuses and shareholder reports to one-page charts containing limited data and information. I believe that 401(k) participants investing in funds would benefit greatly from standardized information about fund investments – if that standardized information is clear and meaningful. In fact, I am hopeful that, working with the Department of Labor, the streamlined mutual fund disclosure document that the staff plans to recommend to the Commission could become the type of standardized mutual fund disclosure document that 401(k) investors receive as they consider mutual fund investment options.
As regulators and as fund counsels, we should have a fundamental focus on getting clear, helpful, meaningful disclosure into the hands of any investor making a mutual fund investment decision – whether that investor is investing directly in a fund, investing through a broker-dealer, or investing through their employer-sponsored 401(k) plan. All investors need this information. And all investors need information that is clear and meaningful and, most importantly, information that is not overwhelming. I am hopeful that our efforts to get better, standardized fund information to those investors that invest through 401(k) plans are successful. Once the Division is further along with its mutual fund disclosure reform initiative, I look forward to working with the Department of Labor on this type of joint endeavor.
Another 401(k) related issue that the staff is examining is the fees that are charged for the administration of 401(k) plans, about which plan participants may not be aware. While this is not principally the Division of Investment Management's responsibility, we are reviewing our role with respect to these fees and considering whether we should recommend any regulatory revisions–again in conjunction with the role of the Department of Labor.
IV. Rule 12b-1
Speaking of fees and speaking of crafting a forward-looking regulatory regime, I have said that rule 12b-1 is an issue I would like to see the Division address during my tenure as Director. Looking backward to the time when rule 12b-1 was adopted in 1980, the fund industry was in a very different state. There had been a period of net redemptions, and there was a concern among some industry observers that if funds were not permitted to use a small portion of their assets to facilitate distribution, funds might not survive.
Fast forward to today, and at over $10 trillion, the fund industry does not seem to be in imminent threat of extinction. Furthermore, the industry has not been through a recent period of sustained net redemptions, and with the growing popularity and acceptance of mutual funds by average American investors, the fund industry's demise seems unlikely. Not surprisingly, the primary use of 12b-1 fees has shifted from the limited marketing and advertising purposes that were originally envisioned. Instead, it appears that, in many cases, rule 12b-1 fees are used primarily as a substitute for a sales load or for servicing. Against that backdrop, and with a forward-looking perspective, it would seem wise to reconsider rule 12b-1, both the rule itself and the factors that fund boards must consider when considering approval or renewal of a rule 12b-1 plan.
V. Director Outreach
Speaking of director responsibilities under rule 12b-1, I am committed, in 2007, to undertaking the beginning of a review of fund director responsibilities under the Investment Company Act, Commission rules and Commission exemptive orders. I have begun to engage in a dialogue with fund directors to see whether the Division should consider recommending that the Commission amend its rules to revise requirements that may not make the best use of director time. Throughout the year, I expect to focus on reaching out to fund directors to hear from them what the Commission can do to make directors more effective.
Along these lines, I am interested in rule revisions that are (1) easy to do–i.e., quick fixes and (2) important to do–i.e., not necessarily easy, but could have a significant impact. I am also interested in whether there are areas for which fund directors could benefit from additional guidance. Possibilities include fair valuation and soft dollars.
In engaging in this exercise, I think it is worthwhile to hear directly from fund directors, rather than having the Division staff guess at what would be helpful to fund boards. I approach this exercise with the idea that blindly following tradition does not always lead to the most effective regulatory landscape or director oversight structure. Just because fund directors have been performing a certain task, or undertaking a certain review, in the past, does not mean that it is the most effective way for fund directors to serve investors going forward. I truly believe it is time for a forward-looking review, from a fund director viewpoint, regarding fund board responsibilities. And I look forward to listening to what fund directors have to say.
VI. International Issues
The final topic I would like to raise with you today is international issues. As Director of the Division of Investment Management, I have engaged in interaction and dialogue with some of my foreign regulatory counterparts–and I hope to do so with many more. In my mind, it is important that U.S. regulators consider effective regulatory techniques from foreign jurisdictions and incorporate them into our regulatory approach where beneficial and appropriate. We can learn a great deal from the regulatory systems in other jurisdictions.
Based on my experience, U.S. markets, including funds, are on some practical level open to foreign competitors. According to recent ICI statistics, as of June 2006, over $1 trillion of U.S. fund assets were advised by foreign-owned asset managers (at that time about 13.7% of the U.S. market). In addition, the United States has exported its fund management talent. For example, many U.S. fund groups looking to sell their products in Europe have set up European domiciled funds.
Interestingly, internationalization of the fund industry became an issue for the SEC well over 50 years ago. In the early 1950s, four Canadian investment companies applied for orders to sell their shares in the U.S. under section 7(d) of the Investment Company Act. Those applications led the Commission in 1954 to adopt rule 7d-1 setting forth the conditions that Canadian applicants must meet to obtain an order under section 7(d).
The Commission has also addressed international issues as it has administered the Investment Advisers Act. Unlike some foreign regulatory regimes that impose limitations on foreign ownership, require a local presence, or an assessment of adviser qualification, the Investment Advisers Act and Commission rules impose minimal, if any, objective or subjective barriers to entry for foreign advisers that want to do business in the United States. Based on a spring 2006 report, 630 SEC-registered investment advisers, representing approximately 6% of the SEC-registered adviser population, have their primary office outside the United States.3 The U.S. regulatory regime has been adapted for these foreign advisers so that it does not apply to the non-U.S. clients of foreign-based advisers.
As we are all aware, our marketplaces are becoming even more global, and international issues will continue to present themselves to fund firms, investment advisers and those who provide them legal counsel. As a regulator, my primary concern when evaluating increased globalization, and the Division of Investment Management's primary responsibility in this area, will be issues of investor protection.
VII. Conclusion
In conclusion, when it comes to crafting an effective regulatory regime, a forward-looking focus is exciting and even liberating. But it is most definitely also a challenge. At least when one is looking backward, correcting problems or holes, the task is defined and the goal identified. When looking forward, one must be quite careful, having a sense of history, understanding of the industry, as well as applying a dose of creativity and ingenuity.
I believe that the Division of Investment Management is up to the challenge, but I also know that we certainly cannot do it alone. We rely on esteemed groups, such as the American Bar Association, to provide us with legal insight and to identify legal issues. The staff may not always agree with you, but we certainly will always listen, and sometimes maybe even learn.
On that note, as you may be aware, the comment period on the Commission's two proposed hedge fund related rules closed recently. The two rules are an anti-fraud rule that would address the Commission's ability to bring fraud charges under the Investment Advisers Act when an adviser defrauds the investors in a fund it manages. The second rule would raise the financial sophistication standards for natural person investors in certain private investment vehicles relying on section 3(c)(1) of the Investment Company Act. The Commission received numerous comment letters on these proposals. I look forward to reviewing and analyzing these letters.
For now, however, I plan to stop talking about the forward-looking Division of Investment Management priorities and start listening to you, my fellow bar members, about ideas, thoughts and constructive criticisms you may have regarding how we can develop a mutual fund and investment adviser regulatory regime that best serves America's investors.
Thank you very much.
Endnotes
http://www.sec.gov/news/speech/2007/spch031607ajd.htm
