Remarks at the ICI Securities Law Conference

Elisse B. Walter

Senior Executive Vice President

December 13, 2005

Good morning and thank you, Elizabeth, for your kind introduction. I'm always pleased to have an opportunity to talk about NASD's mutual fund initiatives, and there is no better place to do that than this conference.

Unlike many of you, I'm a relative newcomer to mutual fund regulation. I've spent most of my career in public service - first at the SEC, then the CFTC and now at NASD - dealing with almost every aspect of the federal securities laws except mutual funds. But, for several years now, I have found myself drawn into mutual fund regulation.

NASD of course has no jurisdiction over mutual funds or their advisers. We do, however, regulate the broker-dealers who sell funds -- including the underwriters. I can assure you that there is no higher priority for NASD than ensuring the integrity of the fund sales process. And, I like to think that my diverse background in other aspects of federal securities law and regulation has brought a fresh perspective to mutual fund issues.

Broker-dealer participation in illegal or unethical practices in the sale of mutual funds is, of course, unacceptable. NASD reviews mutual fund advertisements, whether they appear in a magazine, newspaper, radio or television commercial. We vigorously enforce our suitability rule and our prohibition against compensation arrangements that create unacceptable conflicts of interest in the sale of mutual funds. We do not hesitate to discipline brokers who fall short of our expectations.

But our interest in mutual fund sales practices is not limited to enforcing the status quo. We are constantly studying ways to make the sales process work better for investors. We also devote considerable resources to investor education and online tools that help average Americans understand mutual fund investing.

This morning, I'd like to update you on some of our key efforts in the mutual fund area, and give you a glimpse at some issues on the horizon.

Over the last couple of years you've heard a lot about breakpoints. As you know, we discovered in 2002 that many investors in front-end load mutual funds were not getting the volume discounts that were owed to them. While some of these failures on the part of brokers were inexcusable, and resulted in enforcement action, most of them were the result of confusion, operational breakdowns and lack of easy access to basic information. 

So, we took disciplinary action where needed and ordered firms to reimburse investors who had been deprived of their discounts, with over $125 million refunded to over 450,000 investors to date. But, we also set out to take the confusion out of this process.

At the request of the SEC, NASD, joined by ICI and SIA, convened 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 more accurately — deliver breakpoint discounts in the future. As is often the case with complex problems, the Task Force determined that there was no simple cure. So, the Task Force recommended improvements to a variety of practices within the financial services industry to facilitate the delivery of correct breakpoint discounts, such as better ways to identify breakpoint opportunities, process fund transactions, and improve public awareness of breakpoints.

Since the Task Force's report came out in July 2003, the industry has worked hard and effectively to implement the report's recommendations. For example, there are now standardized definitions of commonly used terms, better prospectus and web site disclosures regarding breakpoints, better recordkeeping and required new training of registered reps.

Most significant, the Breakpoint Task Force recommended that the industry develop 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.

That database is now significantly populated. The ICI has been enormously helpful in encouraging fund group participation and NASD is very appreciative of that. The ICI has informed us that thus far 66 fund families, representing over 93% of 2004 new front-end load fund sales, have posted information on breakpoint schedules and aggregation terms.

Given the significant information that is now available, we have launched an online Mutual Fund Breakpoint Search Tool, which allows broker-dealers and investors to obtain information about the breakpoints that may be available. With online access, it is easier for investors and registered reps to get information on breakpoint schedules, aggregation rules and letters of intent. We developed this search tool in cooperation with NSCC and you can find it on our website. It is available to the public and to the industry at no cost. Hopefully, in the near future, the remaining funds will provide their information so that the database will be comprehensive.

Next, I'd like to turn to our most recent NASD-industry collaboration, the NASD Mutual Fund Task Force. The Task Force was made up of experts from the mutual fund and broker-dealer industries, as well as academicians and attorneys. The Task Force's goal was to provide recommendations to the Commission in two phases. In Phase One, the Task Force considered portfolio transaction costs and soft dollars. In Phase Two, the Task Force considered Rule 12b-1 fees and other distribution payments.

In its Phase One report, the Task Force recommended that the SEC require improved disclosure of soft-dollar arrangements and portfolio transaction costs, and that the SEC narrow the Section 28(e) safe harbor for soft dollar research. In September, the SEC requested comment on new interpretive guidance narrowing the safe harbor but preserving the ability of money managers to pay for third-party research with soft dollars. We were pleased to see that the Commission's proposed guidance is largely consistent with the Task Force's recommendations.

The SEC is now moving on to the disclosure issues. The Task Force had a number of recommendations for improved disclosure both to fund boards and fund shareholders, but stopped short of recommending unbundling.

A lot has happened since the Task Force report. Not only has the SEC issued its proposed interpretive guidance, but in the last few months, there has been some voluntary action moving toward unbundling and, in the UK, the FSA has taken action. We are watching these developments with great interest. Although concerns about soft dollars have been raised ever since the time that brokerage commissions were unfixed, recent market and regulatory developments in tandem are changing practices. Like you, we anxiously await the next phase of the SEC's guidance.

The Task Force's Phase Two report addressed 12b-1 fees and other distribution payments. I want to spend a bit more time talking about Phase Two, because it could have a profound impact on how funds are sold in the future.

As you know, the Commission has proposed to require point of sale disclosure to mutual fund investors. Although the Commission's proposal is focused on dealer issues, it also appears to reflect some concern about using the mutual fund prospectus as the means for communicating certain critical fund information to retail investors.

The Commission proposal would require disclosure about fees and conflicts of interest. In particular, the Commission would require disclosure by broker-dealers concerning revenue sharing, and differential payouts to registered reps for the sale of different mutual funds.

In its report, the Task Force built upon the Commission's proposal and developed a prototype point of sale document that reflects its recommendations. If you'd like to take a look at it, that document (which we affectionately call the Profile Plus) and the Mutual Fund Task Force reports are available on our web site.

The Task Force proposal, which NASD itself strongly endorses, differs from the Commission's proposal in two main respects:

  • First, the Commission would require disclosure about only fees, expenses, revenue sharing and differential compensation -- essentially the costs of investing and the conflicts presented by the way that the dealer is paid. The Task Force determined that point of sale disclosure should give an investor a broader understanding of the fund. So the Task Force's two-page disclosure document explains not only fees and conflicts, but also the fund's investment strategies, risks and performance history.
  • Second, the Commission proposed that a registered rep either hand the document to the customer, or read its content to the customer over the telephone. The Task Force and NASD believe that it is preferable to use the Internet to provide the information, unless an investor is uncomfortable with that form of disclosure.

This summer, we tested the Profile Plus with consumers, and found that investors strongly prefer getting this information on-line rather than having it read to them orally, or delivered to them in paper format.

These test results make complete sense. Internet disclosure would allow an investor a simple way to compare different funds. Moreover, the Task Force's document would be hyperlinked to the fund prospectus. Each customer could determine what level of detail he or she wanted. And our prototype even provides a link to NASD's enhanced mutual fund fee analyzer, which gives investors the ability to obtain a graphical picture of the impact of different expense structures. Most important, web disclosure is an effective method of getting the right information to investors at the right time - before they buy.

We have provided the SEC with the results of these consumer tests, and we have met with the Commissioners and Commission staff. We hope that when the SEC acts on its proposal, it will accept the Internet as an acceptable method of disclosure.

But, whatever form the SEC rulemaking takes, as with breakpoints, the mutual fund and broker-dealer industries will need to work together to ensure that the requirements work, both from the standpoint of an investor and the standpoint of fund and broker operations. NASD has committed to provide financial and other resources to help ensure that this effort is successful.

I'd like to spend a few moments mentioning NASD's investor education efforts because investor education is a critical component of investor protection. Between the NASD Investor Education Foundation and our own internal investor education programs, we've created or funded programs on topics ranging from 401(k)s to 529 plans, to annuities. We publish Investor Alerts, which briefly inform investors about new products that may be complicated and need a plain-English explanation, and about frauds and scams that are prevalent in the market at the moment. For example, we recently put out an alert dealing with stock fraud in the aftermath of Hurricane Katrina.

In the fund area, recent Alerts have addressed NAV transfers, breakpoints, fund share classes and principal-protected funds. We also have on our website about a dozen calculators that investors can use. Some relate directly to mutual funds, such as our recently enhanced fund expense analyzer. Others relate to investing generally, such our college cost calculator.

I could continue for a long time because educating investors is so important to what we do and what you do. But, let me turn to the future.

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 gone undetected 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 those of you who have not yet worked with us, we always welcome new ideas and new faces.

In terms of the future, it's not surprising that fund-related issues will remain prominent on our agenda. Some of these issues are new twists on perennial topics. For example, for many years the securities sales culture has included gifts and other non-commission incentives. You won't be surprised to hear me say that sales incentives cannot be used as a substitute for doing what's best for the customer. An 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.

We'll also continue to revise these rules as needed. One anomaly that needs to be fixed is in the rules governing cash sales contests. Currently, NASD members can't sponsor a mutual fund sales contest that awards non-cash prizes unless the contest meets certain criteria, including principles of equal weighting and total production. Those rules don't apply to cash sales contests. We published a proposal to correct this inconsistency in April.

Our fund-related concerns extend beyond registered funds. We are also taking a hard look at hedge funds. Hedge funds are more popular than ever - the SEC estimates they have about $870 billion under management, and other estimates run as high as $1 trillion. 

NASD doesn't regulate hedge funds. But we do regulate brokers who sell them. And we are increasingly concerned about the so-called retailization of these products. As Bob Glauber has said, the farther downstream they float, the more concerned we'll be.

Today, to invest in a hedge fund, you need to meet financial thresholds that vary depending on the type of fund and whether or not it charges a performance fee, but, generally speaking, they all require at least a million dollars of net worth, or annual income of $200,000 for an individual and $300,000 for a married couple. These thresholds were set as a proxy for a "sophisticated investor." But they were set way back in 1982. With the rapid economic growth and the huge run-up in residential real estate values over the last couple of decades, a lot more people are worth a million dollars or more today than 15 or 20 years ago. So a lot of people who might not really be very sophisticated investors are now eligible to invest in hedge funds. However well these monetary thresholds worked in the early 80's, they make much less sense in the face of the economic realities of 2005.

We are concerned that, for some, the SEC's thresholds for exemption from registration have become, inappropriately, litmus tests for suitability, which is a cornerstone of NASD's regulatory program. Our suitability rule generally outlines factors that should be taken into consideration when making a recommendation and determining whether a particular transaction is suitable, such as the investor's financial status and investment objectives.

We are considering whether NASD should adopt a rule setting a floor - setting a higher minimum net worth and income for investors to whom registered reps can recommend hedge fund shares and perhaps other risky products. Wealth is not a proxy for sophistication and suitability, but it can be a valuable tool.

In my remarks today, I have spoken about what we expect the brokerage industry to do. I can assure you that NASD will continue to emphasize that a broker-dealer has important responsibilities when it sells mutual funds. Last month, we issued an alert to broker-dealers, advising them that their sale of mutual funds must be consistent with their dealer agreements. Dealer agreements should delineate the respective responsibilities of the parties in a manner reasonably designed to protect investors. We reminded broker-dealers that the failure to adhere to the dealer agreement could violate NASD rules, particularly if the failure results in financial harm to investors.

However, the broker-dealer industry cannot bear the responsibility alone. In each of the areas that I have discussed, the mutual fund industry must police itself. Mutual fund companies also must provide brokers with the information and assistance that they need to ensure that their customers are adequately protected.

Take the breakpoint issue, for example. In many instances, individual breakpoint discounts are relatively small. Nevertheless, both mutual fund companies and their distributors cannot lose sight of their obligations to deliver on promises made, and the sum of broken promises can add up. As I mentioned earlier, over $125 million has been returned to customers under the breakpoints restitution program.

Like broker-dealers, funds have learned from the breakpoints example. As I've noted, with ICI's most welcome assistance, many of you have populated NSCC's breakpoint database. I encourage the rest of you to do so as soon as possible. And there are other lessons that can be learned as well. When new products are created, or old ones changed, funds should think carefully about whether the benefits offered can be delivered correctly and whether restrictions, such as portability, are justified given their negative impact on investors.

Of course, breakpoints are not the only area in which we have called on the mutual fund industry to shoulder its responsibilities. We have, for example, brought an enforcement action against a mutual fund distributor in connection with market timing. The distributor did send block letters to a dealer to stop market timing by the dealer's customers, but those letters were ignored and the distributor had reason to know that. Yet, the distributor did not take appropriate action.

This list could go on and on, but I won't take more of your time. My point is a simple one -- that the mutual fund industry, working with the broker-dealer community, can ensure that customers are protected. I am proud of the fact that through our Task Forces, NASD has brought together experts from both industries who hashed out their differences and found common ground - all in order to help investors.

NASD will continue to promote this type of cooperation between the mutual fund and broker-dealer industries. I am certain that working together we can ensure that broker-dealer customers, who are your shareholders, will be treated fairly. Thank you.