William H. Donaldson, chairman of the SEC, spoke on Wednesday morning before the Senate's Committee on Banking, Housing and Urban Affairs, addressing the "State of the Securities Industry."
Donaldson's comments on soft dollars indicated that a proposed rule would likely give independent and proprietary research the same treatment.
On the topic of 12b-1 fees, Donaldson was pretty mum, but said that the use of the fees have "evolved significantly" since the rule was drafted, from fees for marketing and advertising to another sales load. "In light of these changes in the industry and in the use of 12b-1 fees, the future of rule 12b-1 is a topic that should receive a thorough and reasoned review," Donaldson stated.
The relevant excerpt is included in full below:
III. Mutual Fund Rulemaking
I turn now to another area of significant Commission focus and reform activity - mutual funds. Last year, in the wake of the mutual fund late trading and market timing scandals, the Commission undertook an aggressive mutual fund reform agenda. The reforms were designed to (1) improve the oversight of mutual funds by enhancing fund governance, ethical standards, and compliance and internal controls; (2) address late trading, market timing and certain conflicts of interest; and (3) improve disclosures to fund investors, especially fee-related disclosures. It is my hope and expectation that, taken together, these reforms will minimize the possibility of the types of abuses we witnessed in the past 18 months from occurring again.
When I last testified before this Committee on mutual fund reform on April 8, 2004, we had taken final action on just two of our mutual fund reform initiatives, although many were in the proposal stage. Today, I am pleased to announce that we have adopted 10 of our initiatives and expect to complete the few remaining matters on our reform agenda in the coming months. I would like to review for you the significant steps we have taken to strengthen and improve the mutual fund regulatory framework.
A. Enhancing Internal Oversight
Fund Governance Reforms: With respect to enhancing mutual fund governance and internal oversight, a centerpiece of the Commission's reform agenda was the fund governance initiative. In July 2004, the Commission adopted reforms providing that funds relying on certain exemptive rules must have an independent chairman, and 75 percent of board members must be independent.  In addition, the independent directors to these funds must engage in an annual self-assessment and hold separate "executive sessions" outside the presence of fund management. The Commission also clarified that these independent directors must have the authority to hire staff to support their oversight efforts. These fund governance reforms will enhance the critical independent oversight of the transactions permitted by the exemptive rules. Funds must comply with these requirements by January 16, 2006.
As I have said before, I believe that a management company executive who sits as chair of a fund's board is asked to do the impossible - serve two masters. There are times when the executive's duties to the management company and its shareholders simply conflict with what is in the best interest of fund investors. This is the case, for instance, when fund boards review many of the transactions permitted by our exemptive rules. I believe that an independent chairman and a 75% majority of independent directors level the playing field on behalf of fund investors and blunt the control and dominance that many management companies historically have exerted in fund boardrooms. Our fund governance reforms will also facilitate the effective implementation of other mutual fund initiatives the SEC has adopted and will put forward.
Compliance Policies and Procedures and Chief Compliance Officer Requirement: One of the most important of these initiatives, adopted in December 2003, requires that funds and their advisers have comprehensive compliance policies and procedures and appoint a chief compliance officer. In the case of a fund, the chief compliance officer is answerable to the fund's board and can be terminated only with the board's consent. The chief compliance officer must report to the fund's board regarding compliance matters on at least an annual basis. Funds and advisers were required to comply with these new requirements beginning October 5, 2004. We believe that making these changes to the mutual fund compliance infrastructure, and the increased focus on compliance that comes from the new chief compliance officer requirement will help to minimize the kinds of compliance weaknesses that led to the mutual fund scandals.
Code of Ethics Requirement: In July 2004, the Commission adopted a new rule that requires registered investment advisers, including advisers to funds, to adopt a code of ethics that establishes the standards of ethical conduct for each firm's employees. The code of ethics rule represents an effort by the Commission to reinforce the fundamental importance of integrity in the investment management industry. Investment advisers were required to comply with the new code of ethics requirement as of February 1, 2005.
B. Addressing Late Trading, Abusive Market Timing and Directed Brokerage for Distribution
Late Trading/Hard 4:00 Proposal: To address the problems associated with late trading (which involves purchasing or selling mutual fund shares after the time a fund prices its shares-typically 4:00-but receiving the price that is set before the fund prices its shares), the Commission proposed the so-called "hard 4:00" rule. This rule would require that fund orders be received by the fund, its designated transfer agent or a clearing agency by 4:00 p.m. in order to be processed that day.
We have received numerous comments raising concerns about this approach. In particular, we are concerned about the difficulties that a hard 4:00 rule might create for investors in certain retirement plans and investors in different time zones. Consequently, our staff is focusing on alternatives to the proposal that could address the late trading problem, including various technological alternatives. The technological alternatives could include a tamper-proof time-stamping system and an unalterable fund order sequencing system. These technological systems could be coupled with enhanced internal controls, third party audit requirements and certifications.
Our staff has been gathering information from industry representatives to better understand potential technological systems that could be used to address the late trading problem. Given the technological implications of any final rule in this area, it is important that we get it right. Thus, I have instructed the staff to take the time necessary to fully understand the technology issues associated with any final rule. Consequently, the Commission likely will not consider a final rule in this area until mid-2005.
Market Timing/Redemption Fee Rule: Last week, the Commission adopted a "voluntary" redemption fee rule, which permits (but does not require) funds to impose a redemption fee of up to 2%. The rule requires that fund boards consider whether they should impose a redemption fee to protect fund shareholders from market timing and other possible abuses. The voluntary rule represents a change from the "mandatory" approach proposed by the Commission. Many commenters opposed a mandatory redemption fee rule because of concerns that investors would inadvertently trigger the fee's application and because a 2% redemption fee may not be appropriate in all cases.
When the Commission adopted the new rule, we also requested comment on whether to require that any redemption fee imposed by a fund conform to certain uniform standards. This standardization may facilitate imposition and collection of redemption fees throughout the fund industry. I am hopeful that we will quickly reach a decision on this part of the rule, after we hear back from commenters.
The new rule also mandates that funds be able to access information from intermediaries operating omnibus accounts, so that funds can identify shareholders in those accounts who may be violating a fund's market timing policies. Under these arrangements, the intermediaries and funds would share responsibility for enforcing fund market timing policies. I should also note that fair value pricing remains critical to eliminating arbitrage opportunities for market timing.
Directed Brokerage Ban: In September 2004, the Commission adopted amendments to rule 12b-1 under the Investment Company Act to prohibit mutual funds from directing commissions from their portfolio brokerage transactions to broker-dealers to compensate them for distributing fund shares. The Commission's concern was that this practice can compromise best execution of portfolio trades, increase portfolio turnover, conceal actual distribution costs and inappropriately influence broker-dealer recommendations to investors. In adopting the ban, the Commission determined that directing brokerage for distribution represented the type of conflict that was too significant to address by disclosure alone. The directed brokerage ban went into effect December 13, 2004.
C. Improving Disclosures to Fund Investors
Improved mutual fund disclosure-particularly disclosure about fund fees, conflicts and sales incentives-has been a stated priority for the Commission's mutual fund program throughout my tenure as Chairman, even before the mutual fund scandals came to light. As such, disclosure enhancements have been an integral part of our reform initiatives. As part of our mutual fund reform agenda, we have adopted the following disclosure reforms, all of which have become effective.
Shareholder Reports: In February 2004, the Commission adopted significant revisions to mutual fund shareholder reports. These revisions include dollar-based expense disclosure, quarterly disclosure of portfolio holdings and a streamlined presentation of portfolio holdings in shareholder reports. These requirements became effective in August 2004.
Disclosure Regarding Market Timing, Fair Valuation and Selective Disclosure of Portfolio Holdings: In April 2004, the Commission adopted amendments requiring funds to disclose (1) market timing policies and procedures, (2) practices regarding "fair valuation" of their portfolio securities and (3) policies and procedures regarding the disclosure of their portfolio holdings. Each of these disclosures specifically addresses abuses that came to light in the mutual fund scandals. These requirements became effective in May 2004.
Breakpoint Discounts: In June 2004, the Commission adopted rules requiring mutual funds to provide enhanced disclosure regarding breakpoint discounts on front end sales loads, in order to assist investors in understanding the breakpoint opportunities available to them. This initiative addresses the failure on the part of many broker-dealers to provide sales load discounts to mutual fund investors who were entitled to them. The requirement became effective in July 2004.
Board Approval of Investment Advisory Contracts: Also in June 2004, the Commission adopted rules requiring that shareholder reports include a discussion of the reasons for a fund board's approval of its investment advisory contract. The disclosure is intended to focus directors' and investors' attention on the importance of the contract review process and the level of management fees. This requirement became effective in August 2004.
Disclosure Regarding Portfolio Manager Conflicts and Compensation: In August 2004, the Commission required that funds provide additional information regarding portfolio manager conflicts and compensation, including information about other investment vehicles managed by a fund's portfolio manager, a portfolio manager's investment in the funds he or she manages and the structure of the portfolio manager's compensation. These requirements became effective in October 2004.
Point of Sale/Fund Confirmations: In addition to these adopted reforms, last week, on March 1, the Commission requested additional comment on a proposal requiring brokers to provide investors with enhanced information regarding costs and broker conflicts associated with their mutual fund transactions. The proposal would require disclosure at two key times - first at the point of sale, and second at the completion of a transaction in the confirmation statement. We tested our proposal with investor focus groups, and based on the very helpful feedback we received from these focus groups, we issued our request for additional comment. We also are sensitive to the concerns expressed by brokerage industry commenters about the costs associated with our original proposal. Our staff therefore is examining more cost-effective methods of providing investors with the disclosures they need. I am hopeful that the Commission can move quickly on this initiative after we have an opportunity to review the comments that respond to our recent request for input.
D. Upcoming Mutual Fund Initiatives
Having outlined the Commission's progress on our mutual fund reform agenda, I would like to highlight some additional mutual fund related initiatives that are on the horizon.
Portfolio Transaction Costs Disclosure: In December 2003, the Commission issued a concept release requesting comment on measures to improve disclosure of mutual fund transaction costs. In many cases, investors do not understand how the costs associated with the purchase and sale of a mutual fund's portfolio securities affect their bottom-line investment in the fund. These transaction costs can include the payment of commissions and spreads as well as costs associated with soft dollars and other brokerage arrangements. Transaction costs also can encompass costs that are difficult to quantify, such as opportunity costs and market impact costs. Using feedback that we received in response to our concept release, our staff is preparing a proposal to improve disclosure of mutual fund transaction costs.
Soft Dollars: I believe it is necessary to examine the nature of the conflicts of interest that can arise from soft dollars, which involve an investment adviser's use of brokerage commissions to purchase research and other products and services. Consequently, I have formed a Commission Task Force that is reviewing the use of soft dollars, the impact of soft dollars on our nation's securities markets and whether soft dollars further the interests of investors. In addition, the Task Force is reviewing whether we can improve disclosure to better inform investors about the use of soft dollars and whether there are enhanced disclosures that can be made to fund boards to enable them to better evaluate funds' use of soft dollars. The Task Force also is examining the definition of "research" as used in section 28(e) of the Securities Exchange Act of 1934. Soft dollar arrangements present many of the same concerns irrespective of whether research is provided on a proprietary basis, or by an independent research provider, and I expect that any recommendations from the staff would accord similar treatment to both types of arrangement.
Rule 12b-1: When the Commission proposed to ban directed brokerage for distribution under rule 12b-1, it also requested comment on the broader question of whether rule 12b-1 (which allows mutual fund assets to be used to promote the sale of fund shares) should be revised more broadly or even eliminated. The Commission received numerous comments on this issue. The Commission adopted rule 12b-1 over 20 years ago, and the mutual fund industry has evolved significantly since then. The idea of using rule 12b-1 fees as a substitute for a sales load--which in many cases they have come to be--is different than the use of 12b-1 fees for advertising and marketing purposes, which was envisioned when the rule was adopted. In light of these changes in the industry and in the use of 12b-1 fees, the future of rule 12b-1 is a topic that should receive a thorough and reasoned review.
Mutual Fund Disclosure Reform: As I outlined above, the Commission has adopted a number of new mutual fund reform initiatives designed to improve the disclosures made to fund investors. Each of these disclosure reforms was merited. However, I believe it is time to step back and take a top-to-bottom assessment of our mutual fund disclosures. I have asked the staff to carry out a comprehensive review of the mutual fund disclosure regime and how we can maximize its effectiveness on behalf of fund investors. The staff also will examine how we can make better use of technology, including the Internet, in our disclosure regime. Throughout this review process, we will solicit input from mutual fund investors.