Speech by SEC Staff:
Keynote Address at the Ninth Annual Advanced ALI-ABA Course of Study: Investment Management Regulation

by

Paul F. Roye

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

Washington, D.C.
October 16, 2003

I. Introduction

Good morning and thank you for inviting me to be with you here today. I would also like to thank Planning Chairs Tamar Frankel and Cliff Kirsh for including me, and my colleagues from the SEC staff, on the program and providing an opportunity to discuss current issues related to investment management regulation. However, before I begin, I need to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

As Director of the Division of Investment Management, I believe it is important to participate in public forums that enable the Commission staff to share with you the Commission's regulatory priorities and areas of concern. I view this type of public interaction with the industry as an essential part of our job, especially when we can use the opportunity to encourage the industry to follow the law, establish meaningful compliance controls and procedures and-above all-do the right thing with regard to investors.

In a speech I gave in May of this year, for example, I urged the fund industry to "redouble its efforts to be proactive in identifying and addressing issues and problems that confront the industry and its investors." I also noted that "the mutual fund industry should approach issues with the simple philosophy that what is best for fund investors is best for the fund industry."

In remarks I made in March, I focused on the importance of promoting accountability within the fund industry. I stated that "every fund organization must have a conscience. Every fund organization must be accountable for its business decisions and the impact they have on fund investors."

Alluding to the scandals that had plagued corporate America, I concluded my remarks in March by stating, "I believe that you as fund professionals and we as fund regulators can persevere through this difficult period in our nation's markets, and restore investor confidence--if we keep in mind that we are accountable to America's investors."

Unfortunately, since these earlier speeches, a cloud now hangs over the fund industry. Funds find themselves not on the periphery of the latest financial scandal, but sadly at the heart of it. It appears that some fund firms and various intermediaries that sell fund shares are now being held accountable by their investors, and they will likely pay a heavy price. In addition, these firms will be held accountable by regulators if they violated the securities laws. As allegations about late trading and abusive market timing are surfacing, investors are rightly asking some very pointed questions about whether their trust in mutual funds is misplaced.

It appears that some in the mutual fund industry, and some intermediaries that sell fund shares, have lost sight of their fiduciary obligations and, even worse, it appears that perhaps in some cases they may have facilitated what amounts to outright "theft" of fund assets. Unfortunately, the reputation of the entire fund industry is being sullied by the activities of these firms. Funds now face the challenge of demonstrating to America's investors that their trust in the fund industry is not misplaced.

Immediately following the first allegations of late trading and abusive market timing, Chairman Donaldson put in place an action plan to vigorously investigate the charges, assess the scope of the problem and hold wrongdoers accountable, all of which we are doing in close coordination with state regulators. Chairman Donaldson sent letters to major mutual fund and broker dealer trade associations, such as the ICI, the SIA, and the Mutual Fund Directors Forum, as well as the NASD, asking them to notify their members and request that they review and reassess their procedures regarding pricing of shares and market timing and obtain assurances that these procedures and the law are being followed.

In addition, the Office of Compliance Inspections and Examinations sent detailed information requests to broker-dealers, transfer agents and mutual fund complexes seeking information on their policies and practices related to late trading and market timing, and, for the fund firms, fair value pricing. Our Examination staff is in the process of reviewing and analyzing this information and making referrals to our Enforcement Division for appropriate follow-up.

The Commission already has brought civil actions against a former salesperson at Bank of America Securities and a former trader at Millennium Partners, LP, a hedge fund.

II. Commission Agenda

I am confident that the Commission will do its part to ensure that investors' interests are aggressively protected if we conclude that there were flagrant abuses of the law, such as those alleged in the current late trading and market timing matters. The Commission must vigorously pursue enforcement actions against persons who have defrauded fund investors in violation of the federal securities laws. I can assure you that our Enforcement Division will continue to vigilantly pursue these cases.

Yesterday, the Division staff met with a group of independent fund directors, and one of the directors in reflecting on recent events paraphrased Napoleon, stating that "this is a situation where you have to `hang' a few to ensure discipline." The actual quote from Napoleon is, "The art of policing is, in order to punish less often, to punish more severely." Again the alleged conduct we are examining, if proved true, calls for severe punishment in my view.

On a more far-reaching policy level, however, I believe that the regulatory agenda recently outlined by Chairman Donaldson to confront late trading and market timing abuse will have the effect of strengthening the regulatory regime to help restore investor confidence in the fairness of mutual fund operations and practices and the practices of intermediaries selling fund shares. It is important to note that a number of the issues that we are addressing in the mutual fund area (late trading, market timing, breakpoint issues) flow in large measure from intermediaries or middlemen who are in the chain of distribution for selling fund shares.

A. Late Trading

First, let me discuss the issue of late trading. "Late trading" refers to the practice of placing orders to buy or sell mutual fund shares after 4:00 p.m. east coast time, when most mutual funds calculate their NAV, but receiving the price based on the prior NAV already determined at 4:00 p.m. Late trading also refers to the practice of placing conditional trades prior to 4:00 p.m. with the option of withdrawing or confirming the trades after 4:00 p.m.

Late trading enables the trader to profit from market events that occur after 4:00 p.m. but that are not reflected in that day's price. In particular, the late trader obtains an opportunity for a virtually risk-free profit when he learns of market moving information and is able to purchase mutual fund shares at prices set before the market moving information was released.

Commission rules prohibit late trading by requiring funds, their principal underwriters, dealers and others authorized to consummate transactions in fund shares to assign the next computed net asset value to any order to purchase or redeem a fund's shares. This process is known as forward pricing. The forward pricing requirement is also typically reflected in dealer or selling agreements between funds and those who sell their shares.

Based on Chairman Donaldson's concern over recent allegations of late trading in fund shares, and circumvention of the forward pricing requirement by some intermediaries, he has requested that the staff prepare rulemaking recommendations to prevent or curb late trading abuses in the future. The Chairman requested that the staff prepare these recommendations for Commission consideration no later than next month. We are working diligently to meet the Chairman's timetable with the goal of recommending considered and comprehensive proposals designed to eliminate or significantly minimize the potential for late trading abuses and assure fund investors that the value of their investments will not be diluted through this practice.

In preparing our recommendations, we are examining the feasibility of amending current Commission rules to require that a fund (or certain designated agents)-rather than an intermediary such as a broker-dealer or other unregulated third party-must receive a purchase or redemption order prior to the time the fund prices its shares for an investor to receive that day's price. For most funds, this approach would mean that the fund would have to receive the order by approximately 4:00 p.m., east coast time, for the investor to receive that day's price. A rule amendment along these lines would effectively eliminate the potential for late trading through intermediaries that sell fund shares and would put control of the process squarely on the fund, or its designee such as an affiliated transfer agent or principal underwriter. While this approach would minimize late trading opportunities, we are gathering information to understand the ramifications of such a change.

We are also considering addressing late trading issues in connection with a recommendation that the Commission adopt its proposed compliance policies and procedures rule. This rule would require funds and investment advisers (i) to have comprehensive compliance policies and procedures in place to prevent violations of the federal securities laws, (ii) to annually review those policies and procedures and (iii) to designate a chief compliance officer. The staff is considering whether to recommend that the Commission, in adopting the rule, indicate that funds should have procedures and controls in place regarding the pricing of fund securities so as to guard against the late trading of their shares. These were the kinds of policies and procedures contemplated by the proposal. The fund industry has long been aware of the forward pricing requirement and, I believe, should be undertaking to do all that it can to ensure that forward pricing obligations are being met.

B. Market Timing

As I noted earlier, recent events have also exposed abuses related to market timing, including the alleged overriding of stated market timing policies by fund executives to benefit large investors at the expense of small investors, or to benefit the fund's adviser. Mutual funds that invest in overseas securities markets are particularly vulnerable to market timers who take advantage of time zone differences between the foreign markets on which international funds' portfolio securities trade and the U.S. markets which generally determine the time that NAV is calculated. Thus, market timers frequently purchase or redeem shares of mutual funds that invest internationally based on events occurring after foreign market closing prices are established, but before the funds' NAV calculation, typically at 4:00 p.m. Market timers generally then purchase or redeem the fund's shares the next day, for a quick profit at the expense of long-term fund shareholders. Funds that invest in small cap securities and other types of specialty investments, including high yield funds, also can be the targets of market timers.

Although market timing itself is not illegal, mutual fund advisers should assure that mutual fund shareholders are treated fairly and that one group of shareholders (i.e., market timers) is not favored over another group of shareholders (i.e., long term investors). In addition, when a fund states in its prospectus that it will act to curb market timing, it cannot knowingly permit such activities.

The staff has been working with the industry to address the negative impact of market timing on long-term shareholders. Last year, the staff issued an interpretive letter permitting funds to provide for delayed exchanges of shares from one fund to another in order to combat market timing. In addition, in a letter issued in 2001, the staff clarified funds' obligations to fair value their portfolio securities, including international securities, if a significant event occurs between the time that a security's closing price on an exchange is established and the time that the fund calculates its NAV. Fair valuation addresses the problem of a portfolio security's market closing price not accurately reflecting its value because of a significant intervening event.

Chairman Donaldson has also instructed the staff to prepare rulemaking recommendations related to market timing for Commission consideration by the end of next month. In particular, Chairman Donaldson requested that the staff prepare recommendations to require explicit disclosure in fund offering documents of market timing policies and procedures. Many funds currently disclose their policies on these matters but such disclosure is not mandatory. The disclosure requested by Chairman Donaldson would enable investors to assess a fund's market timing practices and determine if they are in line with the investors' expectations. The disclosure requirement would permit flexibility among funds to adopt policies and procedures that are best suited to the funds investments and the needs of its investors. For example, some funds welcome market timers, and other funds such as money market funds cannot be timed. These funds would not be required to adopt policies to prevent market timing, but instead would be required to disclose their open policy with respect to these practices, if relevant.

The rule recommendations requested by Chairman Donaldson would have a further component of requiring funds to have procedures to comply with their representations regarding market timing policies and procedures. Thus, if a fund's disclosure documents stated that it discouraged market timing, the fund would be required to have procedures outlining the practices it follows to keep market timers out of the fund. Investors expect and deserve this level of follow up on fund representations. The establishment of formal procedures would also enable our examination staff to review whether those procedures are being followed and whether the fund is living up to its representations regarding market timing activity.

Chairman Donaldson also indicated that, while promoting new rules to address market timing--including the adoption of the compliance policies and procedures rule--the Commission should emphasize the obligation of funds to fair value their securities to minimize market timing arbitrage opportunities. As I stated, in 2001, the staff reminded the fund industry of funds' obligation to fair value their holdings under certain circumstances. In making this reminder, the staff cited Commission precedent. However, I believe recent events warrant a reiteration of the Commission's views regarding fair value pricing.

Finally, Chairman Donaldson also stated that, in connection with its rulemaking initiatives, the Commission should reinforce the obligation of fund directors to consider the adequacy and effectiveness of mutual fund market timing practices and procedures. As with other fund policies, directors must assess the utility, and oversee the implementation, of fund policies related to market timing. I hope that fund boards already are asking questions like: Are our market timing policies adequate? Are they followed routinely? Do they allow for overrides and, if so, under what circumstances and by whom? And, most importantly, is there more we can do to protect our shareholders from abusive market timing? I also hope fund directors are asking hard questions about the efficacy of their funds' fair valuation policies and procedures.

C. Additional Recommendations

Needless to say, given the end-of-November time frame that the Chairman has established, our attention is focused on fulfilling the Chairman's request to prepare recommendations along the lines of what I just outlined for you. However, these are not the only measures under consideration by the staff. The Chairman has asked us to consider whether funds should have additional tools to thwart market timing activity, and we will continue our analysis of whether there are additional regulatory steps that should be taken. In addition, we will closely consider any regulatory recommendations from the ICI's task force on abusive short-term trading of fund shares, as well as those from the task force on late trading.

D. Selective Disclosure

Recent allegations also indicate that some fund managers may be selectively disclosing their portfolios in order to curry favor with large investors. It goes without saying that selective disclosure of a fund's portfolio can facilitate fraud and have severely adverse ramifications for a fund's investors if someone uses that portfolio information to trade against the fund. Consequently, Chairman Donaldson has asked the staff to consider whether additional requirements are necessary to reinforce funds' and advisers' obligations to prevent the misuse of material, non-public information, including selective disclosure of portfolio holdings information. Fundamental questions must be asked when fund advisers selectively disclose fund portfolio information: Who benefits from release of this information? Does it benefit the fund or the adviser? And what are the risks to the fund of this disclosure?

E. Other Mutual Fund Regulatory Agenda Items

In addition to the Chairman's regulatory agenda to combat the abuses that can flow from late trading, market timing and selective portfolio disclosure, the Chairman outlined a broad-based mutual fund agenda in testimony before the Senate Banking Committee last month. As will undoubtedly be discussed later in this conference, the Commission recently took action to (i) modernize mutual fund advertising rules, (ii) update adviser custody requirements, (iii) propose a rule that would exempt various fund of funds arrangements under the Investment Company Act, as well as enhance disclosure of fund of funds fee levels, and (iv) propose director nomination proxy rules that would apply to closed- and open-end funds.

I will leave a discussion of the details of those initiatives to the Regulatory Developments Panel that follows my remarks, but I do think this series of actions signals that the Commission is committed to developing regulatory policies in the investment management area that modernize the regulatory framework, provide meaningful investor protections and consider the needs of America's investors.

1. Breakpoints

To supplement these actions, Chairman Donaldson has signaled some other regulatory objectives that we are pursuing. First, following up on the Joint NASD/Industry Report on Breakpoints issued in July, the Chairman has directed the staff to prepare rule amendments for Commission consideration that would enhance the disclosure of breakpoint opportunities in fund prospectuses. This is another area where we have seen a breakdown in procedures, and the Commission and the NASD, with the help of the industry, have moved aggressively to address this issue.

2. Shareholder Reports and Improved Fee Disclosure

We are also moving to improve disclosure to investors in other areas.

The staff is preparing a recommendation regarding adoption of the shareholder report proposal. Under this proposal, mutual funds would be required to disclose in their shareholder reports the "dollar amount" of fund expenses paid by shareholders on a prescribed investment amount. This "dollar disclosure" would enable investors to determine the amount of fees they paid on an ongoing basis, as well as to compare the amount of fees charged by other funds. The goal of the proposal is to educate investors about the fees they pay when investing in a fund and to encourage cost competition among funds.

This proposal also would require more frequent disclosure of portfolio holdings (i.e., quarterly rather than semi-annually) to enhance investor understanding of the securities in the fund's portfolio so that investors can make better asset allocation decisions. We also hope to improve the overall presentation of information in fund shareholder reports through this rulemaking.

3. Mutual Fund Confirmations

Another issue Chairman Donaldson has asked the staff to consider is how to increase investor understanding of the incentives and conflicts that broker-dealers have in offering mutual fund shares to investors. Initiatives the staff is considering in this area include a comprehensive revision of mutual fund confirmation form requirements. Chairman Donaldson has stated that he envisions that a revised confirmation would include information about revenue sharing arrangements, incentives for selling in-house funds and other inducements for brokers to sell fund shares that may not be immediately transparent to fund investors.

4. Manager of Managers Rule Proposal/Expedited Processing of Exemptive Applications

In addition to these initiatives, the Commission later this month will consider a staff recommendation to propose a rule codifying the manager of manager exemptive orders. These orders, which permit a fund's board to hire and fire sub-advisers without a separate shareholder vote, have become routine. A rule in this area, with the appropriate board oversight and investor protections in place, will relieve funds of having to obtain exemptive relief in this area and free some of the staff's time to focus on more innovative exemptive requests.

I should also note that we are close to submitting to the Commission a proposal to expedite the processing of routine exemptive applications, which would facilitate the Division's ability to process applications more efficiently.

III. Hedge Fund Report

I would be remiss if I did not mention another major event that took place in the last few weeks, and that is the release of the staff's report titled Implications of the Growth of Hedge Funds. As many of you know, since June of last year, the staff conducted a comprehensive study of the hedge fund industry, with a view toward assessing the current regulatory framework applicable to hedge funds and their managers. The report represents the culmination of that study and is the product of countless dedicated hours of staff time and effort.

As will be outlined in more detail today during the panel on Unregistered Investment Companies, the staff's study was prompted by the tremendous recent growth in the hedge fund industry, currently estimated to have approximately $600 to 650 billion in assets and predicted to reach $1 trillion in the next five to ten years. The study identified an "information gap" that we believe impinges upon the Commission's oversight of hedge funds and their investment advisers. This information gap is especially troubling given the significant recent growth in hedge funds and the increase in hedge fund investments by pension plans, funds of hedge funds and other institutions. The current regulatory regime does not provide for routine Commission examination and oversight of hedge fund advisers. Consequently, the Commission has only indirect information about these entities and the vehicles they manage and, we believe, is hampered in its ability to develop regulatory policy at the very time that hedge funds are becoming increasingly important participants in our financial markets.

The study further asserts that the Commission's inability to examine hedge fund advisers has the direct effect of putting the Commission in a "wait and see" posture vis-à-vis fraud and other misconduct. We believe the Commission's ability to routinely examine hedge fund advisers would assist the Commission in the earlier detection of fraud and prevent certain misconduct and compliance lapses from developing into fraud, as well as encourage a culture of compliance at these firms.

Consequently, the report's key recommendation is that the Commission consider requiring hedge fund advisers to register as investment advisers under the Investment Advisers Act, which would provide the Commission the ability to conduct compliance examinations of hedge fund advisers. The staff believes that registration of hedge fund advisers will enable the Commission to effectively oversee hedge fund activities, without impeding the manner in which an adviser operates a hedge fund. The Commission is in the process of reviewing the staff's recommendations.

IV. Conclusion

As is readily apparent, Chairman Donaldson has laid out an ambitious regulatory agenda in the investment management area. And it is a challenge we are committed to meeting. I similarly challenge the industry to be assertive in addressing the issues that have come to light in recent weeks. As evidenced by the establishment of the ICI's task forces, the industry does not have to stand by and wait to see what regulators do to combat abusive practices that harm shareholders. Each firm in the investment management industry should be reviewing its own policies and practices and searching for ways to maximize investor confidence in this industry, an industry in which millions of Americans have chosen to place their trust. Is that trust misplaced? I hope not. Does the industry need to reassess its commitment to putting investors first and thereby regaining investor trust? I hope it will.

Thank you for your attention, and I wish you an informative and productive conference.

Endnotes

¹ The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

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