Remarks at the SIA Mutual Fund Reform Conference

Mary L. Schapiro

Vice Chairman, NASD President, Regulatory Policy and Oversight

September 23, 2005


Good morning and thank you for inviting me to speak today.

As you are no doubt aware, the regulation of mutual funds and the intermediaries that sell them has changed tremendously over the last few years.  We all know the reasons for these changes:  scandals that shocked the industry, regulators and investors alike, particularly impermissible late trading and market timing arrangements with institutional investors.  These scandals led regulators to examine not just their causes, but also other mutual fund issues that had been percolating for some time, such as soft dollars, revenue sharing, sales of B and C shares, and the payment of differential compensation to registered representatives.

Those of you who heard me speak at conferences last year heard me express dismay that the fund and brokerage industries could have engaged in practices that were so clearly adverse to investors' interests and that greatly undermined the public's confidence in what had been a crown jewel of the financial services sector.  While these issues continue to remain important for NASD, I'd like to focus today on some of the successes of our self-regulatory model in the mutual fund area.

Working together, members of the securities industry and NASD staff have convened several task forces that have addressed important issues and submitted reports of their findings to the SEC.  In addition, industry members have provided invaluable insight to NASD's regulatory processes through service on NASD boards and standing committees and commentary on rule proposals.  These success stories have reaffirmed my faith that the self-regulatory model works, and works very well.

I'd now like to spend a few minutes describing some of these initiatives.  I'd also like to take a moment at the end to entirely switch gears and talk about NASD's response to the devastation wreaked by Hurricane Katrina.

Mutual Fund Task Force

I'd like to begin with our most recent NASD-industry collaboration, the NASD Mutual Fund Task Force.  The Task Force is a group made up of senior industry executives, mutual fund managers, academics and attorneys that met on a number of occasions during 2004 and 2005.  The Task Force divided its mission into two phases, with the goal of producing policy recommendations to the Commission in several important fund-related areas.

During Phase One, the Task Force considered mutual fund portfolio transaction costs and soft dollar issues.  The Task Force's Phase One report, which we issued in November 2004, recommended better disclosure of soft-dollar arrangements and portfolio transaction costs, narrowing the Section 28(e) safe harbor, and preserving the use of soft dollars for both for third-party and proprietary research.  On Wednesday, the SEC agreed to publish for comment new interpretive guidance that would narrow the Section 28(e) safe harbor, but preserve the ability of money managers to pay for third-party research with soft dollars.  This proposed guidance is largely consistent with the Task Force's recommendations, and we are very pleased that the SEC followed its advice.

In March of this year, the Task Force submitted its second report to the SEC.  I want to spend a bit more time talking about this portion of the Task Force's proceedings, because I think they could have a profound impact on how funds are sold in the future.

The Task Force made its recommendation knowing that the Commission is considering a proposal to require greater disclosure of fees and conflicts of interest to investors at the point of sale and in confirmations.  Building on the Commission's proposal, the Task Force agreed that costs and conflicts need to be more visible to investors.  But the Task Force also felt strongly that investors need more than just expense information to make an informed decision, and that this information needs to be accessible to both intermediaries and investors.

Given these parameters, there are two major differences between the Task Force's recommendations and the Commission's proposal:

  • The Task Force believed that point of sale disclosure should give an investor a snapshot of the fund, including investment risks and strategies.  In contrast, the SEC's proposal would require disclosure of fees, expenses and conflicts only.
  • And, the Task Force believed that providing this information through a broker's web site would make it easy for investors to compare different funds and customize the level of detail 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, performance and other significant features.

Under the Task Force's proposal, whenever a broker would recommend a fund to a customer, the broker would refer the customer to the web site for this information.  Of course, investors could opt out of electronic delivery.

This summer, we tested the Profile Plus with a number of consumers with different levels of education and investment sophistication.  The results show that investors strongly prefer getting this information through a web link to having it read to them orally, or delivered to them in paper format.

And these test results make complete sense.  Web site delivery has a number of distinct advantages.  Posting information on the web allows investors to compare funds offered by their broker-dealer very easily and 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.

For those of you who are interested, you can take a look at the Profile Plus on our web site-where the Task Force report is also posted.

I'm very pleased to report that the reaction to the Profile Plus so far has been quite positive.  We've also had a number of meetings with SEC Commissioners to demonstrate and discuss the benefits of the Task Force's proposal.  We're hopeful the SEC will consider our idea carefully and adopt many, if not all, of its features before acting on its disclosure proposal.


I'd also like to update you on the progress we have made in the area of sales charge breakpoints.  This issue arose when examiners in our Philadelphia District Office discovered that some of the brokers they were examining had failed to deliver the correct sales charge breakpoint in sales of Class A mutual fund shares to investors.  As our inquiry expanded, we learned that the failure to deliver the correct sales charge breakpoint to customers was in fact a widespread problem.

At the request of the SEC, NASD convened and led a Joint NASD/Industry Breakpoint Task Force to examine the difficulties in delivering fund sales charge breakpoint discounts and to recommend better ways to more completely and accurately deliver breakpoint discounts in the future.

As is often the case with complex problems, the Task Force determined that there was no single "silver bullet" that would cure the industry's woes.  Accordingly, the Task Force recommended improvements to a variety of practices within the financial services industry that would facilitate the delivery of correct breakpoint discounts, such as better ways to identify breakpoint opportunities, process fund transactions, and improve public awareness of these opportunities.

Since the Task Force's report came out in July 2003, the industry has taken a number of steps to implement the report's 13 recommendations.  For example, there are now better prospectus and web site disclosures regarding breakpoints, improved order verification procedures, a more standardized lexicon of linked account terms (such as "minor child"), records of customers' linkage information, written disclosure statements, training of registered representatives, and investor education efforts.

One key recommendation that we have not completely implemented is a central database that contains breakpoint information for all funds that impose front-end sales charges.  NASD has worked closely with NSCC to create such a database, and has strongly urged the fund industry to populate the database with information on each fund's breakpoint discounts.  Earlier this year, the Investment Company Institute promised to encourage as many fund groups as possible to populate the database by August 31, 2005.

According to the ICI, to date, 66 fund families, representing over 90% of 2004 new front-end load fund sales, have posted to the database critical information on breakpoint schedules and aggregation terms.  Other fund families have committed to populate the database in the coming months.  We are encouraged by these results, but our goal is 100%, and we will continue to push for this.

Once the database is significantly populated, NASD intends to offer an online Mutual Fund Breakpoint Search Tool that will allow broker-dealers and investors to obtain critical information related to mutual fund breakpoint discounts that may be available.  With online access, investors and particularly registered representatives will have an easier means to ensure that they know the breakpoint discount schedule of any fund they offer.  Our plan is to make this tool available to the public and the industry next month.

In many instances, individual breakpoint discounts are relatively small. Nevertheless, firms should never lose sight of their obligations to deliver on promises made, and the sum of broken promises can add up: to date, over $125 million has been returned to customers under the breakpoint restitution program.

Omnibus Task Force

Omnibus accounts are another area where, at the request of the SEC, NASD directed the focus of a Task Force.  Many broker-dealers, banks, insurance companies and pension plan administrators utilize omnibus processing for mutual fund transactions, which generally does not disclose the individual identities of transacting mutual fund shareholders to fund companies.

In March 2004, the Commission published for comment its proposal to require funds to impose a two percent fee on all redemptions within five days of purchase, subject to certain conditions and exceptions.  The idea behind this proposal was that the use of redemption fees deters market timers that take advantage of fund share pricing disparities through short-term trading.  The SEC expressed concern that the use of omnibus accounts would impede implementation of a mandatory redemption fee, however, since funds cannot identify the transactions of individual clients.  In support of this initiative, and at the request of then SEC Chairman Donaldson, NASD convened a task force to determine how omnibus processing would affect the imposition of a mandatory redemption fee.

The Omnibus Account Task Force, which, again, was made up of representatives from brokerage, clearing, fund, banking and transfer agency firms, produced a report to the Commission in January 2004, which you can find on our web site.  The Task Force agreed on certain principles, such as that redemption fees should be imposed at the record-keeper level and that redemption fees should not be imposed on small trades.  The Task Force did not reach consensus on other issues, such as the appropriate length of any required holding period.  Some Task Force members warned that simply imposing mandatory redemption fees would not deter sophisticated market timers.

The issues the Omnibus Account Task Force addressed were both complex and difficult to resolve.  Nevertheless, I think its efforts had a material impact on the SEC staff's deliberations regarding the rule proposal, and resulted in a better rule.

The SEC's final rule, which came out in March, does not require funds to adopt a redemption fee.  Instead, funds must enter into written agreements with intermediaries that hold investor shares under which the intermediaries must agree to provide certain shareholder identity and transaction information at the fund's request.  This result allows funds to determine how best to deter market timing based on their facts and circumstances, rather than imposing a one-size-fits-all approach as originally contemplated.

Where Are Things Going?

I've spent quite a bit of time so far talking about the past, and that's important, because the past is often a prologue to the future.  One thing I hope that will continue is cooperation between regulators and the industry to solve issues that must be addressed.  Just as we have worked together to improve application of the correct sales charge breakpoint discounts and disclosure of fees and conflicts, we also hope that we can work together in the future to solve other problems.

A key feature of solving problems is correctly identifying them before they explode out of control.  At NASD, we have an internal Ahead of the Curve Task Force that is constantly seeking out new issues that may require a regulatory response.  In some cases, these issues arise as new products enter the marketplace.  In other cases, old practices that have heretofore flown under the radar rise to the surface and present new challenges.  This internal group cannot succeed without cooperation from the industry to help us recognize upcoming trends.  For those of you who either serve on NASD committees or have helped us in other ways, we thank you immensely for your help.  For those of you who have not yet worked with us, we always welcome new ideas and new faces.

Let me just mention a few of the fund-related issues that we are focusing on and that I think will continue to be important for us in the future.  First, for many years the securities sales culture has been awash in gifts and other non-commission incentives.  Sales incentives are of course part of the bread and butter of the brokerage industry, but they cannot be used as a substitute for doing what's best for the customer.  In some cases, fund firm personnel have accepted gifts from brokers in return for directing large portfolio trades to those brokers, perhaps instead of directing trades based on an evaluation of which firms do the best job of execution.  This I'll-scratch-your-back-if-you scratch-mine mode of thinking just won't fly.  NASD has rules on both gifts and cash and non-cash compensation, and we will continue to enforce these rules and change them when necessary in order to protect investors.

We've also focused our attention on non-traditional products.  Innovation is a good thing, and we want to encourage the marketplace to continue to offer products that may improve on what is available today.  But anytime a firm decides to offer a new product, its sales personnel must understand the product's risks and costs as well as its benefits.  Sales personnel also must be able to accurately and understandably explain these features to their customers.

Quasi-securities products like equity-indexed annuities also are on our radar screen, and we recently issued a Notice to Members on EIA's to our membership.  Despite what you may read in the press, our goal is not to extend our jurisdiction to insurance companies.  Rather, we simply believe that our members need to be aware of the regulatory and supervisory risks that can arise when their registered representatives sell these products, particularly when they are marketed as securities products and offer substantially greater sales compensation than traditional registered securities.  To ignore this important issue would be, in our view, irresponsible.

We also have been keeping our eye on restrictions some firms impose on the transfer of proprietary funds.  While there may be legitimate reasons for these restrictions, we are concerned that many investors purchase proprietary funds without fully appreciating portability restrictions, which may cause them to later liquidate their interests and incur tax liability, or restrict them from moving the funds to their brokers of choice.  We are quite pleased to see a trend towards the elimination of these restrictions and encourage those few remaining firms that severely restrict portability to revisit their positions.

Hurricane Katrina

Last, I want to talk for a moment about how NASD is responding to Hurricane Katrina.  Our New Orleans District Office is now closed until further notice.  Fortunately, we have accounted for and are in the process of relocating all 47 of our New Orleans employees.  Members designated to the New Orleans office may direct inquiries to either the Dallas, Florida or Atlanta District Offices.

There are 24 broker-dealers with main offices in the impacted region.  We have been able to communicate with all of them, assess their ability to operate, and offer our assistance in directing their customers to their clearing firms, where necessary.  Virtually all of the firms are at least minimally operational and some are fully so.  After the floods recede and the dust settles, we will talk with the firms about how well their business continuity plans worked and what they would do differently. We'll share that learning with the industry.

In addition, within a few days after the hurricane, we issued Notice to Members 05-57, which provides guidance to members that have been impacted by Katrina.  The notice provides extensive regulatory relief and guidance regarding updating Forms U-4, margin requirements, confirmations, customer statements, qualification examination and continuing education requirements, books and records and customer funds and securities.  We will provide whatever additional regulatory relief, consistent with investor protection, is needed for firms in the impacted region.  Finally, we have developed a web bulletin board where firms that were not impacted by Katrina could offer office space and other support to firms that were.  Eight firms posted available office space, computers and even licensed personnel.

And, of course, there are the inevitable scams that flourish in the aftermath of catastrophe.  We have taken the step of warning investors, and, working with the SEC, pursuing those who have engineered the latest investment get-rich-quick schemes.

Thanks for listening to my remarks, and I appreciate the opportunity to see you today.  I would be happy to take a few questions.