finra

Remarks by Robert Glauber

Chairman and CEO

 

ICI Annual Meeting

Washington
May 18, 2006


Good morning.  Thank you, John [Murphy, CEO, Oppenheimer Funds], for the introduction and many thanks to ICI for inviting me to be a part of your annual meeting.

 

We chose a rather provocative title for this speech: "Are Regulators Done with the Mutual Fund Industry?"  We batted around some others - "We're Not Done with You Yet," and "We're Just Getting Warmed Up" were offered, but we thought those might not go down too well.

 

Kidding aside, my answer to the question is: "We've still got some more to do."  I don't mean a host more investigations or enforcement actions.  From what I know now, the worst of it from the fund industry's perspective is likely over.  But there is still some unfinished business in doing more to better inform investors.  We need to do this in a way that doesn't increase the regulatory burden on those who sell funds, and perhaps can reduce it.  Regulators will have to do some of this, but both the mutual fund and broker-dealer industries can help lead the way.

 

That is the gist of what I'm going to talk about today.  But first, I want to briefly discuss some of the changes that have taken place at NASD during my six-year tenure as Chairman and CEO, as that tenure is nearing its end.

 

I think I'm on solid ground in saying that these changes have been remarkable, and not just to those of us who work there, but also to the industry we oversee.  NASD is a markedly different place than the one I took control of in 2000.  At that time we owned both Nasdaq and the American Stock Exchange.  We have since sold them and realigned ourselves as only a regulator, but one with a unique relationship with the industry we regulate.

 

But I think the change in our modus operandi that has been most evident to the industry and to the public has been a marked increase in regulatory and enforcement activity.  This is not because I have a bias for regulatory aggressiveness.  Quite the contrary.  I've always been an advocate of free markets and limited government.  But faced with the prolific abuses of the bubble era, and the mutual fund scandals that closely followed them, we and other regulators were left with no choice but to do everything we could to protect investors and renew their confidence in the markets.

 

An unavoidable by-product of this more assertive posture has been a significant increase in the investor-protection requirements that we impose upon the securities industry, and an attendant increase in the industry's costs of doing business.

 

That's the bad news.  The good news is that the tide of ever-increasing regulation and enforcement seems to have crested and begun to ebb.  The level of investor complaints, as measured by requests for arbitration filed with us, peaked in 2003.  New rule filings peaked at about the same time.  Last year was a record year for enforcement cases initiated and fines levied, but that is almost certainly a lagging indicator, as many of the cases closed in 2005 had been opened years earlier.

 

This is not to say that we're standing down.  We're not.  NASD will continue to be a vigilant and forceful regulator.  That is the heart of our mission.  But at the same time, we will continue the work we've been doing to minimize the costs and burdens that our regulatory actions place on the backs of the people and firms we regulate.

 

That work has been substantial and has taken on many forms, from a suite of on-line compliance tools and tutorials to a modernized and streamlined firm examination program to a more efficient way of running our own operations, which has enabled us to send about $150 million back to the industry in rebates over the last five years.

 

We have also mounted an ambitious effort to educate investors and equip them to protect themselves.  The principal vehicle for that is our Investor Education Foundation, which now has an $85 million endowment from which to make grants to universities and non-profits that produce research and programs that help make mainstream investors more enlightened and more confident.

 

And our work to level the playing field of sales rules that cover nearly identical products has been a high priority for us, as well. Neither broker nor investor is well-served when sales rules for two or more products that look pretty much the same to investors are different for each product.

 

Earlier this month, NASD and the Minnesota Department of Commerce hosted a public roundtable discussion in Washington on annuities - fixed, variable and equity-indexed - each of which falls under a different regulatory approach.  The participants, who represented the securities and insurance industries and their state and federal regulators, agreed almost to a person that this was not a good state of affairs and that simplification and harmonization of rules and regulatory approaches covering these products was a goal we should all strive to achieve.  How to go about it was another matter.  There were almost as many ideas about that as there were participants in the roundtable, so we're setting up a series of working groups in which the various interested parties can work toward agreement.

 

I called on the working groups to consider developing a simple disclosure statement, modeled on recent proposals in the mutual fund area, and tailored to each type of annuity.  It seems to me that such a disclosure statement could help customers better understand these products.  And with less customer confusion, there would be less sales abuses.

 

A similar question is presented by the regulation of mutual funds and 529 college savings plans. From the investor's perspective, a 529 plan is a mutual fund with some added state tax benefits.  Yet sales of the two products are governed by different sets of rules written by different regulators.  This regulatory disparity makes no sense.  So NASD, which regulates mutual fund sales, and the MSRB, which regulates 529 plan sales, are working together to erase it and put both products under one rulebook.  We've already made significant strides forward.

 

Yet another effort at replacing complexity with simplicity is our on-line breakpoint search tool.  I could hardly neglect to discuss this here, since so many of you helped create it.  Brokers can use the search tool to determine easily whether customers who buy Class A fund shares are eligible for volume discounts.  NASD has been building an on-line database to contain all the information, and it's been quite a chore.  But thanks in no small part to ICI's help, we're almost all there.  Nearly all of the big funds have supplied their data and many of the smaller ones have, too. 

 

Of the top 100 NSCC participants by asset flow through the dealer channel, there are 73 unique fund groups.  Of those, 68 have provided breakpoint schedules and linkage rules to the database.  Those 68 fund groups represent approximately 94% of 2004 new front-end load fund sales.  There are 14 more load fund groups, not included in the largest 100, that also have provided data.  With these funds included, the total participation rate is over 95 percent of 2004 front-end load fund sales.

 

ICI has really stepped up to the plate and pushed the fund industry to get the data to us, and we're very grateful for that.  Brokerage firms have now begun the process of pulling these data into their trading systems as well, and that will provide a second check to ensure that investors receive the right sales charge.

 

If our registered reps have trouble using the website - in fact, if they have any compliance-related questions at all - help is now, or will soon be, just a phone call away.

 

We're in the process of deploying a firm liaison program, through which registered reps and compliance officers can call a specific NASD employee who has been designated as the point of contact for their firm and ask any compliance-related question that's on their minds.  The liaison person will either answer the question or quickly find someone who can.  We've been testing this project with a pilot program in five of our 15 districts.  Since January, the program has logged about 2,000 calls and e-mails from 900 firms. We plan to have full, nationwide coverage of our 5,100 regulated firms by the end of September.

 

So, let me return now to Topic A - regulation of mutual funds.  As I said at the beginning, I hope regulators are not finished with mutual funds, because there's still much to do.  I know the fund industry would rather we went fishing in another pond.  And I can well understand that, given the scrutiny that's been directed at market-timing, late-trading, front-running, directed brokerage and other issues over the last few years.  But the fact is that mutual funds are not just another product on the shelf.  They are the overwhelming favorite among mainstream American investors.  Yours is a $9 trillion industry, in which half of American households own shares.  And that's hardly surprising; mutual funds are a great product, offering professional management, diversification and a wide range of investment strategies, all at reasonable cost.

 

But being the king of the hill draws attention to you, requires a high level of diligence and responsibility and subjects you to particularly harsh criticism when you falter.

 

Two years ago, following on our breakpoints and omnibus accounts task forces, NASD formed another task force with leaders of the mutual fund and brokerage industries to look at a number of mutual fund issues - particularly distribution arrangements and portfolio transaction costs.  The task force accomplished a lot, but in my view it left some work undone.

 

When the task force reviewed distribution issues, it spent a good deal of time on point of sale disclosure for mutual fund sales.  As I said earlier, much of NASD's focus is on providing investors with better information so they can be the frontline of their own protection.

 

And in that regard, the current state of mutual fund disclosure to investors leaves a lot to be desired.  The centerpiece is the prospectus, which is delivered at confirmation, after the purchase decision has been made.  It's dense and tedious and has no pictures.  It's a lousy read, about as much fun as the Federal Register.

 

The SEC has properly focused on improved point of sale disclosure for mutual fund sales.  What the average investor needs is information he can understand, in a form he can use, delivered at a time that helps him make a decision and in a way that doesn't unnecessarily get in the way of his purchasing the fund he wants.  I understand the commission is going to re-release for comment a modified version of its one-page disclosure document, which includes information about costs and potential conflicts of interest for a fund, all in a standardized format.  It's fine as far as it goes, but we think it's time for the SEC to go further.

 

First, the document should not be limited to disclosure about conflicts and expenses.  Investors would be much better informed by a document that also describes the important features of the fund, such as its investment strategies, objectives, performance and risks.  The task force recommended such a document, which we call the Profile Plus.  It would be a concise, two-page summary, containing the fund's strategies, objectives, performance and risks on the first page and the conflicts and costs on the second.  This is the minimum amount of information investors should be able to easily compare from one fund to another, and having it would make them far better informed about the funds they consider buying.

 

Second, Internet delivery should be an integral part of the point of sale disclosure process, not an afterthought.  According to ICI research, 90 percent of mutual fund shareholders have Internet access, two-thirds of them go on-line every day, and they are more likely than other Internet users to use the web to get financial information or make transactions.1   A survey we commissioned last year showed that of all American adults who connected to the Internet from home, 70 percent could do so while talking on the phone, such as with a broker.2  That percentage will certainly increase as broadband access more completely replaces dial-up.

 

Since the majority of investors who deal with reps to purchase mutual funds do so by telephone, we support a practical approach that permits Internet delivery and avoids lengthy and generally confusing oral disclosure.  Specifically, every customer should be permitted to opt in to Internet delivery of the Profile Plus.  Suppose a customer opts in.  When her broker calls her to recommend a particular fund, the broker would either refer the customer to a web site for the disclosure or offer to email it to the customer.  The broker could then ask: "Have you already reviewed the Profile Plus or would you like to review it while we talk?"  If the answer to either question is "yes," then the sale can proceed.  If the answer is "no" to both, the broker can ask "Do you want to proceed anyway, and review the document later?"  Again, if the answer is "yes," the sale can proceed.  By making the Internet an integral part of telephone delivery, this protocol assures investors can get concise mutual fund disclosure in a form they can understand without materially slowing down the sales process. 

 

Having on-line access to the Profile Plus would also increase an investor's ability to compare different funds.  And because the Profile Plus would contain hyperlinks to a fund's prospectus, the investor could determine how much information he wants and click through to get it.  Giving investors the ability to click through to the prospectus should put to rest any fund industry concerns about liability for the information in Profile Plus.  So clearly, Internet delivery for these point of sale documents must be a ready choice for those investors who want it.

 

The industry will benefit as well if investors will already have reviewed the point of sale documents when the sales process begins.  To that end, I hope the fund industry will take the lead in populating an on-line database of point of sale documents as it did with the breakpoints database.  To meet the industry halfway, and as a reaffirmation of NASD's commitment to providing investors with the information they need, NASD is prepared to help build and finance this database, as we did with the Breakpoint database.

 

To his credit, Chairman Cox has scheduled for June 12 a public roundtable discussion at SEC headquarters on how to use interactive data to improve disclosure for mainstream investors.  He has said there would be a special emphasis on mutual funds.  I hope and expect that this question of on-line point-of-sale disclosure will be much discussed, and that commission staff will be informed by those discussions.  This will be the first in a series of SEC roundtables on using the Internet to make information about investing and the markets available and comprehensible to investors.  This is a very good and timely idea, and Chairman Cox is to be commended for proposing it.

 

I understand that ICI, too, has called for Internet disclosure and for reform of the mutual fund disclosure process.  That being the case, it's time for the mutual fund industry to get behind the Profile Plus and integrated delivery of it over the Internet.  Prominent representatives of your industry served on our task force and supported this approach.  The Profile Plus simply represents the most promising way to get concise, meaningful, mutual fund disclosure into the hands of the retail customer.  And making the Internet the primary delivery mechanism will allow investors to get more information, more easily and sales reps to do their job with less cost and burden.  NASD is certainly willing to do its part to get this job done.

 

The other set of issues the task force considered focused on portfolio transaction costs, which are, of course, important to investors in that they reduce returns.  High on the list of transaction-cost issues was the handling of soft-dollar commissions.  The task force members felt that regulators should not do anything to ban the practice of paying for legitimate research services with fund commissions, and I completely agree.  During the task force's deliberations, the brokerage firm members argued forcefully that it was impossible for them to un-bundle the pricing of research services and transaction services that are wrapped together in a soft-dollar payment.  The task force concluded that cost allocations simply couldn't be made.

 

But subsequent events in the marketplace have, I believe, reduced the force of these arguments.  Lehman Brothers and other firms have been reported in the press to be providing unbundled transaction services, so it seems reasonable to expect that brokers more broadly could find a way to provide information on un-bundled pricing. 

 

This information would be important to mutual fund directors at a time when the composition and effectiveness of mutual fund boards has been the focus of investor and regulator concerns.  Without unbundled cost information, directors must find it harder to determine whether the value to the fund of research services bought with soft dollars is worth the cost.  With this information, fund directors can do their jobs better.  In light of the changed practices in the marketplace, it's time for fund managers to work to get information on unbundled pricing and put that information in front of their directors.

 

One last word about the regulation of mutual fund sales practices and disclosure.  Because mutual funds are the pre-eminent retail investor product, they have received a disproportionate amount of the regulatory focus on sales practices and disclosure, as I said earlier.  This intense focus threatens to cause some migration away from mutual funds and toward similar products, such as equity-indexed annuities and separately managed accounts, that are more lightly regulated.  This is a consequence that regulators need to be aware of.  An investor should be sold a security because it's right for him or her, not because it's easier to sell than something else.

 

Effective point of sale disclosure for mutual funds can and should inform disclosure requirements for similar products.  This is in keeping with NASD's focus, which I mentioned earlier, on harmonizing rules that apply to products that look the same to investors and on leveling the regulatory playing field.  This does not mean easing up on regulation of the more tightly-regulated product.  It means the opposite.  As we move ahead with this, we'll be looking to raise standards, not lower them.  This is very much in keeping with our mandate to protect investors and ensure that the deck is not stacked against them. 

 

So, I'll close with this proposal: let's not limit the Profile Plus concept to mutual funds.  Let's extend it first to Exchange Traded Funds and Separately Managed Accounts.  And let's also extend it, in some form, to annuities - fixed, variable and equity-indexed.  These are popular products and getting more so.  There is no reason why those who buy them shouldn't have the same level of disclosure protection as those who buy mutual funds.  And, the fact that fixed annuities are more lightly regulated than mutual funds should not be an incentive for brokers to sell them.

 

I hope I've given you a good picture of where things stand and what lies ahead in terms of fund sales regulation.  And I hope you see our positions as fair and well-balanced, with an eye to regulatory burden as well as investor protection.

 

I'm eager to hear your thoughts on what I've said this morning and to discuss them with you.  So, I'll say thanks to ICI for inviting me to be with you and invite your questions and comments.

 

1 "Mutual Fund Shareholders' Use of the Internet, 2005," ICI "Research Fundamentals," February 2006
2 "Mutual Fund Point Of Sale Disclosure Implementation Research," Applied Research and Consulting LLC, Aug. 18, 2005