finra

Remarks by Elisse B. Walter

Senior Executive Vice President

Independent Directors Council

Directors Workshop

April 7, 2005

 

Good afternoon.  Thank you for the opportunity to be with you today.  With so much attention focused on mutual funds and the role of fund directors  -- and with so much happening in the regulatory environment - this is a particularly opportune time for me to both learn from you and explain what we at NASD are doing.

 

I want to update you on some of the things on NASD's agenda that affect your work as fund directors, but first I'd like to put my comments in perspective by talking a bit about the current regulatory environment and how NASD fits into the picture.

 

First, the environment.  It is almost obligatory to start out every speech by observing that these last several years have been an extraordinary time for the financial services industry in general and the mutual fund industry in particular.  I have been a regulator - with the SEC, the CFTC and now NASD - for most of my professional life - more years than I am willing to admit.  From my perspective, the events of the past few years have had a fundamentally different impact on regulators, industry and investors than the problems I encountered earlier in my career.

 

I think the difference in the regulatory environment is that the crises we dealt with in the past - such as insider trading or penny stock fraud - tended to be viewed as anomalies. Today we are living with a very different dynamic. Rightly or wrongly, many of the problems that have come to light in the past few years are viewed as systemic. Thus, the regulatory responses are likely to be more sweeping, the structural changes imposed on the industry more profound, and the impact on investor confidence more pervasive and less fleeting.

 

It has become a standard practice for regulators to recite the litany of mutual fund scandals of the past three years. I will spare you that trauma.  Suffice it to say that the wide range of mutual fund problems have seriously undermined investor trust in both funds and those who sell them.  These illegal and unethical practices helped launch an extensive mutual fund reform agenda at the SEC - perhaps the most ambitious since the 1970 amendments to the Investment Company Act.  Adding to this, scandals in other segments of the financial services industry  - including blatant accounting and corporate fraud and investment banking-research conflicts of interest  - have helped shape the intense regulatory environment that the fund industry finds itself in today.

 

We regulators are hopeful that the pain of these scandals has transformed the thinking of the fund and brokerage industries in a lasting manner.  I worry, however, that too many on the business side cling to a belief that "this too shall pass," that at some point we will return to the "good old days" of lessened regulatory scrutiny and that some sense of "business as usual" will be regained.

 

Such thinking, if it does exist, is a serious miscalculation.  In my view, the fund industry and the broker-dealer community will, for the foreseeable future, face heightened scrutiny.  There is no reason to suppose that the regulatory spotlight will soon shift to other products and services, and serious risks if any in the industry fail to recognize this.

 

I am optimistic that regulators -- and the industry -- will do what is necessary to restore and maintain investor confidence.   I think that we are living through this rebuilding today - in the consideration of new legislation, the adoption of new regulation, enforcement cases and their settlements, and through healthy competition as firms seek to re-claim the moral high ground by voluntarily changing questionable business practices.

 

Where does NASD fit into all of this?  In the midst of the scandals, NASD's focus has remained on investor protection and what needs to happen to restore the trust of the investing public. Increasingly, this focus has prompted us to devote more of our attention to mutual fund reform.

 

NASD of course doesn't regulate mutual funds but we do regulate brokers who sell them and the sales practices they use.  In fact, our jurisdiction in the mutual fund area is confined to sales practices and the relationship between mutual funds and broker-dealers - we have absolutely no direct jurisdiction over mutual funds or advisers.

 

In the mutual fund arena, we are concerned about the suitability of the mutual fund share classes that brokers recommend; the disclosures they make to investors; and the compensation they receive from mutual funds, including so-called shelf space payments.  The bottom line for us is this: when a brokerage firm or its registered representative has a financial incentive to sell or recommend a particular fund, investors should know about it. And investors should also know the costs -- all the costs - of buying a fund.  Plain and simple.

 

The mutual fund scandal has caused us to redouble our efforts to ensure the fairness and integrity of mutual fund sales practices.  In the past few years, we have concentrated our examination, investigative and enforcement focus on five main areas -- cash and non-cash compensation practices, including directed brokerage; the suitability of the mutual funds that brokers sell, in particular B shares and, more recently, C shares; whether brokers are delivering to their customers the benefits to which they are entitled, such as breakpoint and net asset value transfer discounts; market timing and late trading abuses; and soft dollars.  We have brought more than 200 mutual fund cases over the last two and a half years.  In addition, our Advertising Department annually examines more than 80,000 pieces of advertising and sales material for potentially misleading information.

 

Few things would delight me more than to see the number of cases we bring involving mutual funds diminish.  But, the product is too important to the US investing public for our industry to tolerate anything less than the most scrupulous sales practices.

 

I'd like to use the rest of my time today to describe some of NASD's other initiatives in the mutual fund area.  I believe that these are critically important because they have brought together industry and regulatory expertise.

 

As we become far more active in fund issues, we have found that our likelihood of success in addressing major questions is furthered by bringing together as much industry expertise as possible to inform our thinking and to assist us in advising the SEC on how best to achieve the desired result.

 

When we discovered, through our examination program, that investors were routinely not given the benefit of breakpoint discounts, we not only—as is traditional—analyzed securities firm performance and took action against those who performed poorly—we also required our broker-dealer member firms to implement an industry-wide refund program.  And, we convened, at the request of the SEC Chairman, an industry task force, composed of fund leaders, large and small broker-dealers, transfer agents, DTCC and others and hammered out the necessary technological, operational and other changes needed to ensure that a widespread failure in this area could not happen again.

 

A few months later, we undertook another task force initiative, again at the request of the SEC, to provide input on the impact of omnibus accounting on the Commission's proposal to implement mandatory redemption fees as a response to market timing.

 

Last spring we went to the SEC to propose a third industry Task Force.  The goal of that group is to provide guidance as the Commission tries to resolve issues related to the transparency of portfolio transaction costs and those surrounding mutual fund distribution arrangements.  The Task Force separated its work into two phases - in Phase one, we tackled soft dollars and portfolio transaction costs; in phase two, mutual fund distribution.

 

Phase I - Soft Dollars.  The Task Force submitted its first report to the Commission last November.   Soft dollars was one of the most critical topics of discussion and we considered all options concerning the appropriate scope of soft dollar payments, from maintaining the status quo to advocating a repeal of the safe harbor in Section 28(e).  The Task Force studied a number of important questions about soft dollars, among others,

  • Has the safe-harbor outlived its usefulness?
  • Is it possible to accurately quantify soft dollar payments?
  • Should a fund be required to disclose the total amount of soft dollar payments that it makes?  To fund boards?  To investors?

The Task Force unanimously agreed that the safe harbor set forth in Section 28(e) of the Exchange Act should be preserved.  And, every member of the group agreed that investors are better off if research of all types, including both proprietary and third-party research, continues to be widely available to investment managers.  The safe harbor may be especially important to the clients of smaller investment advisers. These smaller advisers can afford neither a large internal research staff nor extensive hard dollar payments for research. They can, however, supplement their internal research efforts through the use of soft dollar arrangements.

 

But, even though the Task Force strongly supported the safe harbor, each of its members recognized that the advantages must be balanced against the potential conflicts of interest and disclosure issues that the practice raises.

 

The Task Force's consideration of these issues led to a number of specific recommendations.  That the SEC:

  • Narrow its interpretation of the scope of research for purposes of the safe harbor, to better tailor the safe harbor to the types of services that principally benefit clients rather than the adviser.
  • The Task Force rejected a return to the SEC's pre-1986 standard limiting permissible soft dollar products and services to those that not readily commercially available.  They reached this view in large part because the 1986 changes opened the door to the use of soft dollars to obtain third-party research.  And, the Task Force was adamantly opposed to discriminating against third party research.
  • Instead, the Task Force recommended that the safe harbor be limited to the intellectual content of research - ideas, analysis, strategies - and should not protect the means by which that content is provided.
  • Of particular interest to this audience, the Report urges that the SEC mandate expanded disclosure to fund boards about soft dollars.  Among other things, the Task Force urged that this information include comparative information about commission rates paid to brokers that provide soft dollar services versus the rates paid to brokers that do not provide those benefits.  And, the Task Force's position is that this disclosure should extend to commission equivalents paid in over the counter transactions.
  • Some, much less extensive, additional disclosure to investors in fund prospectuses was also recommended in the Report.
  • Finally, the Task Force urged the Commission to consider the soft dollar issues raised by other managed advisory accounts, such as hedge funds.

Last December, shortly after the Task Force submitted its report to the SEC, this Council issued a Statement of Policy Concerning Soft Dollars.  In it, the IDC advocates a narrowing of the interpretation of the scope of the Section 28(e) safe harbor and better disclosure to fund directors and investors about a fund's payment of soft dollars. As I've outlined, both of these points are fundamental to the Task Force's recommendations.

 

The IDC and the Task Force differ, however, on the Council's third recommendation  -- that the SEC require brokers executing transactions for funds to "unbundle" research and execution costs.   A minority of the Task Force agreed with the unbundling position later adopted by the Council.  But, the Task Force majority drew a distinction between third party and proprietary research, recommending dollar disclosure only for third party soft dollar benefits. This is an objective number that is easily determined.     In the case of proprietary research, however, the majority of the Task Force believes that that there is no meaningful way for brokers or advisers to provide good faith estimates of the breakdown of total commissions into research and execution components.

 

We in the US are not the only ones grappling with these issues.   The Financial Services Authority in the UK, which has been studying soft dollars for years, just last week issued new proposed rules that would narrow the scope of permissible "research" and "execution" services that may be obtained with soft dollars.   The changes contemplated by the FSA are not far off from many of the changes recommended by NASD's Task Force, and, like the Task Force, would preclude the use of soft dollars to obtain computer hardware, dedicated telephone lines and the like.

 

Like the Council, the FSA diverges from the Task Force on unbundling commission payments into their research and execution components.   The FSA charged the UK industry with coming up with a policy on unbundling. Three private groups in the UK - the Investment Management Association, the London Investment Banking Association and the National Association of Pension Funds  -- have been involved in this process.

 

While these groups have developed policy statements that call for investment managers to disclose unbundled commissions to their clients, and encourage brokers and managers to develop an appropriate split between research and execution, they have not grappled with the Task Force's concern about the value of this information in the absence of consistent valuation techniques.  Unless we can agree upon some definite standards for calculating unbundling, we run the risk that fairly arbitrary and meaningless estimates will be provided to clients.

 

Phase I - Portfolio Transaction Costs.  Before I move on to the second phase of the Task Force's work, I'd like to mention briefly its position on portfolio transaction costs.
The Task Force recommended enhanced disclosure here too.

  • First, to Fund boards:  The recommendation is for mandated disclosure to fund boards including, at a minimum, information about:
    • The adviser's policies and procedures for monitoring transaction costs and brokerage allocation; and
    • Information concerning the reasonableness of all transaction costs, including commissions, commission equivalents, mark-ups and markdowns, market impact costs, opportunity costs, and other intangible trading costs.

Many fund boards already receive this type of information, but the Task Force believed a specific requirement was appropriate to assure that there is no exception.

  • And, second, to shareholders.  The Task Force recommended that the SEC require a brief narrative description in the prospectus of the various types of trading costs incurred by the fund, including intangible as well as tangible costs.  In a  recommendation that has potential implications for other types of disclosure as well, the Task Force urged the SEC to move the existing disclosure concerning total Commissions from the SAI to the prospectus.
  • Last, but not least, I'd like to mention that the Task Force recommended that the prospectus include a five-year chart including data on average commissions, commissions as a percent of net asset value and portfolio turnover.

Phase II.  And now, Phase II:

 

On March 23, the Task Force submitted its second report to the SEC.  As I mentioned earlier, in phase two the Task Force considered mutual fund distribution arrangements, including revenue sharing and its impact on sales practices, 12b-1 fees and all of the attendant issues raised by keeping them, or by abolishing them.

 

The Task Force concluded that the most important changes that the Commission could make are those that make the costs and potential conflicts associated with mutual fund distribution more visible to the retail investor.  Basically, what the Task Force did was take the Commission's existing point of sale disclosure proposal and build upon that initiative.   I'll get into some of the details of the Task Force proposal in a moment, but first I'd like to emphasize that there are two major differences between the Task Force's recommendations and the Commission's proposal:

  • The Task Force believes that point of sale disclosure should give an investor a snapshot of the fund, including investment risks and strategies. In contrast, the Commission's proposal would require disclosure of fees, expenses and conflicts only.
  • And, the Task Force believes that the SEC should require a broker to post this information on its web site for every fund that the broker offers.  Internet access will make it easy for investors to compare different funds and, as I'll explain in a moment, obtain more detailed information about a fund if desired.  In contrast, the SEC release expresses serious reluctance to use the web as the primary mechanism for delivery of point of sale information.

The Task Force developed a prototype point of sale document, - the Profile Plus - that describes key features of a fund. Like the SEC proposal, the Profile Plus would include expenses and dealer conflicts, but also would summarize information about the fund's investment strategies, risks and other significant features.

 

The Task Force believes that whenever the broker recommends a fund to an investor, the registered representative should refer the investor to the web site for this information.   Of course, investors should be able to opt out of electronic delivery.  But, I think that most investors will not.  They will choose web site delivery.  It has a number of distinct advantages for them. Posting information on the web would allow investors to compare funds offered by their broker-dealer very easily.   Through hyperlinks to other documents, primarily the fund prospectus, the Profile Plus would allow an investor to review as much or as little detail about a fund as he or she may desire. Perhaps most important, it gets this information - the right information - to investors at the right time - before they buy.

 

So what does this Profile Plus look like?  You can see it for yourself on our web site - where the Task Force report is also posted.  For now, let me give you a very brief description of the highlights.

 

The first page sets out a short statement of the fund's principal investment strategies and principal investment risks, with hyperlinks to the prospectus for more information.

 

It also includes a chart showing past returns.

 

Page Two highlights the costs associated with fund ownership and possible conflicts of interest. Tables would show the total fees and expenses paid by a shareholder - both transaction fees and fund operating expenses - in dollars and percentages, based on $1,000, $50,000 and $100,000 hypothetical investments.

 

Unlike the SEC's proposal, the Profile Plus would present total fund operating expenses as a single number, not broken down into components (e.g., Rule 12b-1 fees, transfer agency fees).   We conducted investor testing to fine-tune the Profile Plus, and one of the findings is that investors really don't seem very interested in a breakdown of annual operating expenses. Of course, those that do want this information would have easy access to it through a hyperlink to the fund prospectus.

 

Page two also would:

  • disclose the availability of breakpoint discounts and a hyperlink to further information. 
  • briefly describe portfolio transaction costs and portfolio turnover rate. 
  • include a "Potential Conflicts of Interest" section that provides information about revenue sharing and differential compensation arrangements.  This disclosure is made through two "yes/no" questions that, in the event of a "yes" answer, would include a hyperlink to more information provided by the broker-dealer.

I'm very pleased to report that the reaction to the Profile Plus so far has been quite positive.

 

Phase II - Other Recommendations. Before I close, just a word on the other recommendations in the most recent Task Force report.

 

As to 12b-1, the Task Force recommends

  • Updating and modernizing the findings a fund board must make in approving a plan -- and
  • Changing the reference to those fees in the prospectus fee table to a less confusing title (distribution and shareholder servicing fees).

The Report also recommends better disclosure about the costs of B shares and consideration of regulatory caps on B share sales and limitations on conversion periods.

 

Finally, the Task Force urged the Commission to reconsider unified fees.

 

In closing, I'd like to go back to the role of the industry for a moment.

 

NASD will continue to be extraordinarily busy this year, as we have been for the last several years, but the harder task remains with the industry. In order to restore investor trust, what's truly critical is for the fund industry and brokerage firms to recommit to the principle of putting the investor first.

 

The U.S. capital markets are the most efficient and resilient in the world because we operate in a market economy in which risk-taking that culminates in innovation, efficiency and consumer satisfaction is richly rewarded with profits. Regulators are not at war with profit seeking. But, profit seeking must not prevent any in this industry from honoring the responsibilities that arise from the trust placed in them by investors. I trust that the mutual fund and brokerage industries are up to this challenge. Thank you.