Thank you, Paul [Stevens], for that generous introduction. It is an honor to be here to help you kick off your 2008 annual conference. I have been many times to your conferences in Palm Desert and one time in Orlando when I was in the audience, but this is certainly the largest ICI conference yet. At first I was a bit worried about my early time slot this morning until I saw that I would be speaking after Paul, whose witty speeches are always sure to wake people up. His remarks this morning were certainly no exception. I would like to touch briefly this morning on several of the topics that you will discuss in much greater detail over the next few days. Before I go any further, I must remind you that, as with any speech given by any person associated with the Commission, regardless of the office or division or how long that person has been with the Commission, the views expressed here are personal and do not necessarily represent those of the Securities and Exchange Commission or my fellow Commissioners.
As all of us in this room know too well, the financial market conditions in the past several months have been challenging. We are living through unprecedented events, with the collapse of Bear Stearns. The liquidity drought that we are experiencing has had widespread ramifications on the markets. When viewed from a historical perspective, a period like this is not necessarily surprising, considering the attributes of the period leading up to it. Markets periodically go through difficult times — they cannot always rise. Did we experience a period of irrational exuberance in the credit markets? I certainly would hope that we are not experiencing an equal and opposite reaction: wallowing in a period of irrational pessimism. Our economy has much strength and depth, corporate balance sheets are generally strong, and the Federal Reserve and the Administration have been taking serious and responsible steps to address general market conditions and specific firm-related liquidity issues.
Last week, the President's Working Group on Financial Markets issued a Policy Statement on Financial Markets Developments.1 The PWG's objectives in issuing the statement were "improved transparency and disclosure, better risk awareness and management, and stronger oversight." 2 The Statement offers a preliminary diagnosis of the current situation, recommendations for the mitigation of the challenges that we face, and steps for the prevention of similar issues in the future. Appropriately, the PWG emphasizes that many parties — financial institutions, investors, credit rating agencies, and regulators — have a part to play in restoring the dynamism of our capital markets. Financial institutions, for example, should devote more attention to risk management and valuation. Investors on the whole should conduct better due diligence before investing. Credit rating agencies are already undertaking a review of their processes for producing ratings and their level of transparency. Regulators should implement enhanced prudential regulatory policies to encourage and channel the efforts of market participants.
Regulators, however, must be mindful — particularly in times of market uncertainty — that they not give in to the urge to do something if that something would be harmful. The proper balance is critical. As Treasury Secretary Paulson explained in announcing the PWG's Policy Statement last week, "regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."3
Given that it is St. Patrick's Day, it seems appropriate to quote from an Irishman on this point. Charlie McCreevy, who is the European Commissioner for Internal Market and Services, made the argument for deliberation in a speech last month: "This time 15 months ago I nearly had to go to an ear, nose and throat specialist for a check up because I feared my ear drums were getting bruised in Brussels by the army of pro-regulation junkies and lobbyists who wanted me to 'tackle' private equity, hedge funds, and sovereign wealth funds for what they considered was the damage they could do to the European economy."4 McCreevy acknowledged that problems in the markets "provoke an immediate scramble for more regulation," but wisely cautioned against "jump[ing] for the regulatory toolbox in panic."
The thoughts of European regulators are increasingly relevant on this side of the Atlantic. This fact is evident from your first panel this morning, which, I understand, will be a discussion of global fund regulation and its effect on U.S. money managers. I arrived yesterday in Phoenix from a week of meetings in London, Berlin, Paris, and Brussels. We share with the Europeans the realization of the importance of looking at our markets from an international perspective. Investors are willing and able at the click of a mouse to send their money across the world in search of diversification, service, innovation, and higher returns. Should regulators facilitate this internationalization of the financial markets? I would say that the answer is not just "Yes, we can," but, "Yes, we must."
We must forge ahead with efforts to assess ways to enhance the competitiveness and openness of U.S. markets. I commend the work of the various groups that have produced in the past year and a half four well-researched studies making observations and recommendations in this regard. Each one took a slightly different approach and focus, but all delivered virtually the same message. Add to that the Treasury Department's efforts and those of the SEC's Smaller Public Company Advisory Committee and Committee on Improvements to Financial Reporting. I appreciate the contributions of all of these groups.
We must do our best to ensure that steps taken to address today's market issues are undertaken with an appreciation for their long-term effects on our financial markets. Of course, times of market dislocation sometimes point up ways in which existing regulations need to be augmented or amended, issues on which our examiners should focus, and matters in which enforcement action needs to be taken. Refinements in regulatory approach, however, should be undertaken with due deliberation and an appreciation for the international ramifications.
For example, we cannot afford another misstep like Audit Standard 2, the ill-conceived implementation of the internal control documentation requirement of Sarbanes-Oxley section 404 by the Public Company Accounting Oversight Board. AS2 did so much to damage the reputation and status of the United States as an attractive international financial marketplace. We have undertaken many changes to try to correct that impression abroad, most notably repeal of AS2 in favor of AS5, which is scalable and better grounded in materiality.
Internationalization makes the job of the regulator more difficult in some ways. It can be quite a challenge, for example, to pursue the perpetrators of frauds who operate from outside of our borders. Fortunately, through cooperation with foreign regulators, we are often successful in these cases. So, in some ways, internationalization actually has made the regulator's job easier. The establishment and solidification of financial ties between nations serves as an impetus for greater regulatory cooperation. Regulators from multiple nations can work with each other to combat fraud and to strengthen international capital markets.
Regulatory cooperation in turn aids market participants by providing them greater certainty as they participate simultaneously in the financial markets of multiple nations. By working together, regulators lower the chances that market participants will face overlapping or conflicting regulatory obligations. Lack of consistency increases costs, which ultimately are paid by investors. For the past 20 years or so, we have discussed the possibility that two regulators could agree to rely on each other's regime to perform a regulatory function that otherwise each would have to perform itself.
We are in the process of exploring ways to allow foreign investors to interact directly with U.S. financial service providers and U.S. investors to interact directly with foreign financial services providers. The issue is clearest for broker-dealers and markets. In the discussions of mutual recognition, however, the possibility of allowing foreign investment companies access to the American marketplace has not enjoyed much attention. In 1992, the Staff of the Division of Investment Management concluded that Section 7(d) "presents a formidable challenge" to a "foreign fund seeking to market its securities in the United States."5 The staff accordingly recommended that Section 7(d) be amended to allow for mutual recognition in the investment company regulatory realm through bilateral memoranda of understanding.6 Is it time to take another look at the feasibility of mutual recognition under the current Section 7(d) or seek legislative changes? Would investors have more choice with the same protections under such a regime, as long as the other jurisdiction has equivalent standards and enforcement? Would investors experience the benefits of increased competition, including innovative products and pricing? Would a national regulator be less inclined to take unilateral moves, heedless of costs versus benefits and of the unintended consequences of its actions?
Regulatory cooperation within the U.S. is important as well. The ICI has made this point in its comments on the competitiveness of U.S. markets. Inefficiencies can result if market participants face overlapping or conflicting regulatory obligations at the state and federal level. As the ICI noted in its comments in connection with Treasury's Review of the Regulatory Structure Associated with Financial Institutions, Congress sorted these state-federal issues out in 1996 in the National Securities Markets Improvement Act (NSMIA). Particularly troubling are the attempts to augment SEC disclosure requirements through state enforcement actions. Are these types of actions contrary to NSMIA? Well, they certainly can create regulatory uncertainty and undermine the common federal disclosure scheme that was Congress's clear purpose in the Act. States have authority under NSMIA to pursue fraudulent sales practices, but they are pre-empted from imposing idiosyncratic disclosure requirements. Will these actions serve to undercut the SEC's attempts to reform disclosure so that investors get the information that they need in a format that they can use?
Along those lines, one issue that, judging from Paul's remarks, is likely to generate a lot of discussion during this conference is the SEC's mutual fund prospectus disclosure reform proposal. The comment period for the proposal closed several weeks ago. The number of comment letters — less than 150 — is rather few in comparison to the volumes of letters generated in response to many of our recent rule proposals. Perhaps this is fitting for a proposal that is about wasting less paper while ensuring that investors receive the information that they need! The letters that we received represent much careful thought about our proposal and will be very helpful in focusing our attention on a number of issues that warrant serious consideration.
I was particularly pleased to see that the ICI and others responded to our calls for empirical data. The ICI's extensive cost-benefit submission is part of a broader, commendable push by the ICI to encourage the SEC to accord greater weight to cost-benefit considerations. In the context of this proposal, the ICI's work will be useful in helping us to analyze our own cost-benefit estimates, which were based on a smaller group of respondents. In the past few years, the SEC certainly has learnt the hard way from the D.C. Circuit Court of Appeals just how important cost-benefit analysis is.
The ICI and others also undertook to assess investor reactions to the proposal. The SEC received preliminary results from a study by four academics that suggested that members of their test group of investors, armed with the proposed summary prospectus, were slightly more likely to select lower fee funds than they were without it.7 The ICI surveyed more than 500 investors to assess their reaction to the proposed summary prospectus and their level of internet use.8 I am happy to report that the summary prospectus fared well in what might be called the "trash can test": nearly 95 percent of survey respondents agreed that they would be more likely to read the summary prospectus than a longer, more detailed prospectus. In other words, the Summary Prospectus may be less likely to land in the trash can before being read than its longer counterpart. More than 45 percent of the respondents believed, however, that the longer, more detailed prospectus is needed to convey facts that they would want to know. For these investors, the internet availability of the statutory prospectus that the proposed rule would require is likely to be important.
These survey findings are important because of greatest concern to me is that we adopt a summary prospectus that will truly help investors and that they will use. This question cannot be answered, however, without first ascertaining whether funds will actually make the business decision to supply investors with the Summary Prospectus. As our decade-long experience with the fund profile has taught us, if we do not get it right, funds will not use it, and investors will not benefit. Instead, investors will be left with a slightly modified version of today's unwieldy prospectus. Liability concerns appear to have been a primary factor in the low rate of use of the fund profile. The summary prospectus proposal attempted to address liability concerns, but some commenters believe that we may need to do more on that front.
The requirement that Summary Prospectuses be updated quarterly with respect to performance and portfolio information has been cited as particularly problematic. Commenters have expressed serious concerns about the cost and feasibility of this proposed requirement. Indeed, the ICI found in a survey of its members that only 30 to 45 percent of funds would use the Summary Prospectus with the quarterly updating requirement.9 Without that requirement, an estimated 80 percent of funds would use it.10 If these predictions are accurate, then quarterly updating could be a real obstacle to achieving the prospectus reform that we envision. A more practical alternative to quarterly updating might be simply a requirement that shareholders be referred to the fund's website for the latest information.
We will have to consider a number of other issues such as the wisdom of prescribing a standardized format, whether we should allow multiple-fund Summary Prospectuses, possible technological implementation difficulties, and the meaning of "greater prominence" in the requirement that the Summary Prospectus be given greater prominence than other materials with which it is mailed. On that last point, one commenter reminded us of the difficulties of putting a subjective standard like that into practice, asking "[w]ould a violation depend on whether an investor opens a fulfillment package from the bottom or the top?"11
Getting the content of the Summary Prospectus right is very important. Should it include the top ten portfolio holdings? The ICI's survey indicates that sector allocation information might be more useful to investors.12 We also should consider whether we need to eliminate certain disclosure items in order to shorten the document.
Like Paul Stevens, I have long been interested in bringing better disclosure to investors. During my almost six years as commissioner, I have continued Chairman Levitt's practice of listening to investors through town hall meetings — so far having done almost 40, including at almost a dozen military installations. Invariably at each one, I hear complaints that mutual fund prospectuses are incomprehensible, just as Chairman Levitt heard 15 years ago. That was one impetus for the fund profile. Well, I dare say that most of us in this room would admit that prospectuses are certainly less than clear — and I used to draft them for clients! We simply cannot allow this situation to persist, especially since it is the SEC that has helped to create the situation — thanks to the SEC's year-after-year layering on of disclosure requirements. I am optimistic that we can succeed in this effort with the help of the lessons learned from the profile, the improvements in technology over the last decade, and the insights that commenters offered.
As the SEC considers the comments on the summary prospectus proposal, I hope that you will take a look at the proposal on exchange traded funds that we posted last week. The ETF proposal is an attempt to codify the exemptive relief that we have been providing to exchange traded funds since their inception more than fifteen years ago. To a large extent, the relief is consistent with what we have done in exemptive orders. The ETF proposal is a technical one, and I look forward to comments on it so that we can ensure that it works effectively. The proposal does not include all actively-managed ETFs — only those with full transparency. Are there ways to expand the scope of the proposal? The intent is to consider broadening the rule as we see more actively managed ETFs. But, we have seen how tortuous it seems to be to adopt rules or rule changes — witness the soft-dollar issue for the buy-side, e-mail retention, BDC reform, and changes to Form ADV. In any event, I hope that the long queues in which ETF applicants have had to wait for exemptive relief will soon be a thing of the past.
ETFs filled a market need for mutual funds that are tradable on an exchange throughout the day. Are there other market needs that cannot be met because of regulatory or statutory obstacles? Some recent notable calls for greater structural flexibility for mutual funds suggest that the answer to that question might be yes.
Last year, Peter Wallison and Robert Litan put forward a proposal for a new form of fund that would be based on a contractual model rather than a corporate model. Hence, it would function without a board of directors.13 Wallison and Litan drew their inspiration from other countries in which the corporate form is not dominant. The so-called "managed investment trust" would add the attributes of active management and redeemability to a unit investment trust-like form of organization. The advisor to the managed investment trust would charge one comprehensive fee, would not be able to shift other costs to the trust, and would be monitored by the trustee depository bank . Investors, it is argued, could benefit from more transparency, and there would be fewer opportunities for conflicts of interest to work against them such as we have seen in recent incidents. Similarly, the ICI has called recently for legislation to offer a new form of registered fund with an eye towards facilitating the competitiveness of U.S. fund firms abroad and offering U.S. investors options.
These latest calls for structural options for funds are not necessarily new. Others, including Stephen West, Richard Phillips, and the SEC itself were contemplating ways to enhance the organizational flexibility of mutual funds in the 1980s and 90s. Indeed, this was the subject of the speech of one of my predecessor commissioners at the Mutual Funds and Investment Management Conference 25 years ago almost to this very day.14 Variety benefits investors, so I am in favor of exploring new options for funds as long as we do not attempt to force all funds into any particular form.
Before I close, I would like to thank you for your efforts, particularly as you navigate our current market conditions. Regardless of the state of the market, managing the money of approximately 90 million people is no easy task. Your expertise and innovations have served investors well over the years. It is important that we at the SEC recognize your contributions. All of us have an interest in seeing that investors are served well. Investor protection is, of course, central to the SEC's mission, but we must allow you the flexibility to explore new ways of helping investors to meet their investment objectives.
In that vein, we must work to eliminate groundless impediments to new products. Investors benefit from having the opportunity to choose products that believe may serve them well. What might work for one investor might not work for another. Too often, the SEC has wandered into merit-type regulation of investment management products. Speedier processing of exemptive applications to preserve the first-mover advantage is one way to encourage the development of new products. Because the SEC historically has been organized according to statute, our functions do not reflect how investors invest or how the marketplace functions. Witness the problems that we have had with the investment advisor/broker-dealer issue. We should have a new products czar, who would be responsible for project management of new products and shepherding them through the SEC process and that of other agencies, if necessary.
Finally, I note that the ICI has recently made an assessment that the SEC's "highly prescriptive regulatory regime, administered with the blunt trauma of aggressive enforcement sanctions … has served to keep the SEC and regulated entities at arms' length," which, in turn, has impaired the flow of information to the SEC.15 Certainly, a "gotcha" approach by any regulator does not serve anyone well, and we should avoid that ignominious attribute by retribution or deed. We would do well to assist regulated entities with improving compliance. Recent initiatives from our Office of Compliance Inspections and Examinations such as the CCOutreach seminars and more general transparency about what examiners will look for have been efforts in this direction. A question that is bigger than the minute I have left is whether real change can occur in the SEC's approach without more fundamental changes in the SEC's organizational structure. We will have to save that for another day, but you probably can guess my preferences there.
Thank you for your attention this morning. I wish you an enjoyable and productive conference. I am always interested in hearing your thoughts and concerns, so please feel free to call or stop by my office if you find yourself in Washington.