KEYNOTE ADDRESS AT INVESTMENT COMPANY INSTITUTE 2014 MUTUAL FUNDS AND INVESTMENT MANAGEMENT CONFERENCE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
SPEECH

Keynote Address at the Investment Company Institute 2014 Mutual Funds and Investment Management Conference

Craig M. Lewis, Chief Economist and Director,
Division of Economic and Risk Analysis
Orlando, FL

March 18, 2014

Encouraging Economic Discourse

Thank you for inviting me here today to deliver the keynote address at this important conference.  I am particularly pleased to be sharing this honor with Norm Champ, the Director of the Division of Investment Management.  As I will touch on today, my Division’s work with him and his staff exemplifies the type of detailed and in-depth economic thinking that I believe currently is – and should continue to be – a hallmark of the SEC’s approach to rulemaking.  Before I go further, however, let me remind you that the remarks I make today are my own and do not necessarily reflect the views of the Commission, Commissioners, or of SEC staff.[1]

The Impact of the Guidance

Two years ago this month – in a memorandum dated March 16, 2012 to be exact – my Division and the Office of the General Counsel laid out what we believed to be best practices in performing economic analysis in support of Commission rulemaking.  That memorandum, now publicly available and entitled Current Guidance on Economic Analysis in SEC Rulemaking – known as “the Guidance” for short – was, on paper at least, limited in its scope.  At its base, the Guidance does just two things.  First, it lays out the basic principles underlying a robust and transparent economic analysis in support of rulemaking.  Second, it states the fundamental precept that economists are part of the rulemaking process from the very start, and thus involved in those crucial policy discussions that occur before words are ever committed to paper.

You can see how in one version of the world the Guidance could have remained a document with a limited purpose, one that provided useful tips on structuring an economic analysis within a rule release and got DERA economists invited to more meetings.  But the Guidance of this world is much more than that.  Let me be clear:  The Commission has always considered the economic effects of its rules and policy choices.   But over the past three years that I have been Chief Economist and the last two that I have overseen my Division’s work with the Guidance, I have come to believe that this seemingly simple document has focused and enhanced how the Commission and its staff approach economic thought and utilize the expert staff of DERA.  Today I’d like to talk about the Guidance a bit, and also consider what it might mean for the public’s engagement with the Commission.

So stepping back for a moment, in case not all of you have committed the Guidance to memory, let me take a few moments to review what the document actually says.  The document emerged from a particular moment in time, when the Commission was reviewing its approach to economic analysis in rulemaking, and Congress and other constituencies were asking questions about the integration of economics into the rulemaking process.  During this time, with the passage of the Dodd-Frank Act, the Commission was responsible for promulgating a large number of rules covering a vast array of topics.  So after months and months of work, my staff and staff in the Office of the General Counsel circulated the Guidance within the Commission.

Clocking in at 17 pages, the Guidance explains the four basic elements of a robust economic analysis.  First, identify the need for the regulatory action.  Second, articulate the “baseline” against which any potential economic effects can be measured.  (In other words, describe what the world looks like today, in the absence of the regulatory action.)  Third, explain alternative approaches to reaching the regulatory goal.  And fourth, lay out the economic impacts, including the costs and benefits, of the regulatory action and its principal regulatory alternatives.  The Guidance concludes with a discussion of the integration of economic analysis into the rulemaking process.  To quote the Guidance, “[DERA] economists should be fully integrated members of the rulewriting team, and contribute to all elements of the rulewriting process.”

And that’s the recipe for an SEC economic analysis.  Sensible and straight-forward.  But just like with many recipes, there is a secret to the success of the Guidance.  A secret ingredient that isn’t listed.  As you may have heard, my time at the Commission is drawing to a close and with that comes certain freedoms.  And so I’m going to give away that secret.

The truth is that the Guidance would never have been successful without the incredible staff at the Commission.

Of course, I must acknowledge the unwavering support for these efforts that was given by former Chairmen Schapiro and Walter, as well as by Chair White.  Each of the Commissioners also has been crucial in ensuring that our rule releases have complete and even-handed economic analyses.  And senior staff from all Divisions are due credit for consistently emphasizing the importance of the Guidance.

But the people who deserve most of the credit are the staff attorneys and staff economists who do the vast majority of the work to actually implement the Guidance.  These were the individuals who, cloistered in windowless conference rooms, hammered out the narratives that added up into the high-quality economic analyses that the public eventually sees.  I would be remiss if I did not take this opportunity to publicly express my heartfelt admiration for all of those who were and continue to be part of the success of the Guidance.

As a result of all that hard work, I believe our rules are strong, robustly supported, and transparently demonstrate the unparalleled expertise of the Commission and its staff.

But now recall what I said about the scope of the Guidance.  The Guidance by its terms only applies to the development and drafting of rule releases.  While certainly central, rule drafting is only one part of what the Commission does every day.  Indeed, there are many other policy initiatives that are bubbling away on the proverbial stove.  So if the Guidance has this seemingly limited scope, why did I talk in the beginning about its importance to the agency?  To answer that question I need to speak as an economist in the language of economists.  In economic theory, there exists the concept of “spillover effects.”  Wikipedia tells us that these effects are “externalities of economic activity or processes that affect those who are not directly involved.”  In layman’s terms, it’s a secondary effect.

Well, the Guidance has had a rather significant spillover effect.  As DERA became larger and the Guidance became integrated into the rulewriting process, it became natural for DERA to similarly be included in the dozens upon dozens of other initiatives that didn’t directly involve drafting a rule.  We started proposing projects in a variety of spaces and found receptive audiences across the Commission.  To run through the myriad ways that DERA contributes to the mission of the Commission would take all of my time and probably the rest of the day and night, and if I had a captive audience I would be more than happy to regale you with myriad examples.  But in an effort to stay within my allotted time, I’ll refrain.  But I do not think that it is an overstatement to say that ‘economics’ is a common language that we speak at the Commission.  I’ve heard attorneys comfortably and correctly deploy technical terms such as “externalities,” “economic rents,” and “efficient allocation of capital.”  (Of course, I’ve also heard my economists engage in arcane legal discussions, so language barriers are dropping on both sides!)  But nothing brings greater satisfaction than hearing someone simply say, “Just call DERA.”

Of course this means that DERA has had to up its game as well.  It’s all well and good to sit in an ivory tower and talk about economic effects in the abstract.  It’s another matter entirely to translate what we studied in graduate school into grounded and meaningful work that directly responds to the hard questions the Commission faces.  There are a variety of ways in which we can do that.  Most obviously, we can contribute robust analyses to rule proposals and adoptions.  For example, in several releases we have worked very hard to describe in quantitative terms current market conditions.  We have analyzed the types and levels of capital-raising activities in both the public and private markets.  We have performed sophisticated and novel analyses of the credit default swap market.  And when analyzing the potential effect of our rules on efficiency, competition, and capital formation, we have sought to describe, in an even-handed manner, the economic trade-offs that often come with effective regulation.

But that is not the only way that DERA has demonstrated the expertise of its staff.  I oversee a vibrant culture of original research.  By engaging in research on topics of interest in the Commission, my economists stay abreast of the latest techniques and approaches to economic analysis, contribute directly to the intellectual capital of the academic community regarding complex market issues, and showcase the Commission’s sophisticated understanding of the markets it regulates.  The DERA website has many white papers, working papers, and links to published articles and I certainly hope you take a quick moment to take a look.

All of these analyses are public.  And that’s an important theme here.  Encouraging public awareness of and involvement in these economic conversations is central to DERA’s mission.  One way we are seeking to ensure public engagement throughout the rulewriting process is by, when appropriate, making analyses of particular economic issues available to the public as we refine and expand our thinking regarding a particular rule.  To illustrate our efforts in this regard, I will focus on DERA’s work to assist the Commission as it considers further money market fund reform.

The Example of Money Market Fund Reform

As many of you may know, the Commission has been considering the question of what, if any, further reforms to money market funds may be appropriate.  As I’ll describe, this process has been marked with a high level of public engagement with relevant economic issues by DERA.

For example, before any policy choices were even proposed, DERA staff authored a memorandum intended to assist in formulating a well-considered proposal.  That memo contained both a quantitative and qualitative analysis responding to certain questions regarding money market funds raised by Commissioners Aguilar, Paredes, and Gallagher.  Those questions focused on three issues:  (1) What were the determinants of investor behavior and its effect on MMF performance during the 2008 financial crisis; (2) What has been the effect of the 2010 money market fund reforms; and (3) How future reforms might affect the demand for investments in money market fund substitutes and the implications for investors, financial institutions, corporate borrowers, municipalities, and states that sell their debt to money market funds.[2]  That staff memorandum, which was made public, helped inform the subsequent proposal.

Now let’s turn to the proposal itself.  The proposing release itself exemplifies the way that the Commission, rulewriters, and economists are working closely together to develop rule releases.  The proposal contained a fully integrated qualitative and quantitative analysis.  For example, the release contained an analysis of the economics of money market funds, including the combination of MMF features that may create an incentive for their shareholders to redeem shares in periods of financial stress.  The release considered the economic consequences of a floating NAV and liquidity fees and gates as well as effects on efficiency, competition, and capital formation.  And we examined the potential implications of these proposals on current investments in money market funds and on the short-term financing markets.  The analyses indicated, in part, that the economic implications of the floating NAV and liquidity fees and gates proposals depend on investors' preferences, and the attractiveness of investment alternatives.

DERA also placed additional data analyses into the comment file as part of the proposal process.  For example, one of the many issues that the Commission thought through as part of the proposal is determining the appropriate size of diversification limits in money market funds.  To assist the Commission and to inform the public, DERA staff developed memoranda that quantitatively evaluated the exposure and concentration money market fund portfolios have to the parent companies of guarantors and the parent companies of issuers.[3]  Those memos were included in the public comment file.

Moreover, as I mentioned earlier, DERA has a strong research program designed to focus on issues of importance to the Commission.  Flowing from my work on the money market fund release, I have authored a working paper entitled, The Economic Implications of Money Market Fund Capital Buffers.[4]  That working paper has more recently been included in the public comment file.  I’ll briefly describe its principal findings.  If one considers the possible rationales for employing a capital buffer, which was discussed but ultimately not proposed by the Commission, one possible objective is to protect shareholders from losses related to defaults in concentrated positions, such as the one experienced by the Reserve Primary Fund following the Lehman Brothers bankruptcy.  If complete loss absorption is the objective, a substantial buffer would be required.  For example, it has been suggested that a 3% buffer would accommodate all but extremely large losses.  While such a capital buffer could make a money market fund better able to withstand significant credit events, it would be a costly mechanism from the perspective of the opportunity cost of capital because those contributing to the buffer would deploy valuable scarce resources that are being used elsewhere in presumably more valuable opportunities.

Moreover, a basic precept of financial economics is that rational investors demand compensation for bearing risk. Since a capital buffer is designed to absorb the risk associated with credit events, it follows that those investors contributing funds to a capital buffer will demand compensation for bearing this risk.  My paper illustrates that to the extent a capital buffer could insulate money market fund shareholders from adverse credit events, it would have the additional result that money market funds would only be able to offer shareholders returns that mimic those available for government securities, thus effectively converting prime money market funds into “synthetic” Treasury funds.

Looking Ahead to Further Conversations

So now the question is why does any of this matter to you?  Why should you care about a simple memorandum on economic analysis authored two years ago?  Of course, I imagine that some of you might be interested in the outcome of the Commission’s consideration of money market fund reform.  And so at a minimum I hope you can see how much significant, rigorous thought has already gone into that process.  But beyond this single rule, I challenge you to become an active part of the Commission’s engagement with economic thought.

As I have described, the Commission and staff are exploring different ways to demonstrate publicly our thinking on various issues.  We will continue to have robust and transparent analyses in rule proposals.  And importantly, we will continue, as appropriate, to put additional analyses into the comment files.  Thus, the most obvious way you can become part of this is through engagement in the comment process.  I have said this in many settings and I will say it again – I encourage you to submit comment letters that contain robust qualitative and quantitative economic analyses of our rules.

I too often read a comment letter that engages only with the policy discussions in a rule and see a missed opportunity to respond to the entirety of the rule release.  The economic analyses that are crafted as part of the Commission’s rule releases are not simple tabular accountings of costs and benefits that are after-the-fact calculations and monetizations of the effects of our rules.  They are wide-ranging, sophisticated analyses that reflect months (or maybe years) of engagement among DERA, the rulewriting staff, the Office of the General Counsel, and the Commissioners.  They animate and fully explain the Commission’s thinking on particular policy choices.  When commenters offer a rigorous and full engagement with the economic analysis – and I don’t mean with a throw-away line about benefits or burdens – it helps to ensure that the public is fully engaged in the same, economically driven discourse that is flourishing within the walls of the SEC.  And the end results of that conversation can only be positive for investors and our markets.

Again, thank you so much for having me here today.


[1]               The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees.  The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

[2]               Response to Questions Posed by Commissioners Aguilar, Paredes, and Gallagher (Nov. 30, 2012), available at http://www.sec.gov/news/studies/2012/money-market-funds-memo-2012.pdf.

[3]           See The Exposure Money Market Funds have to the Issuers of Parents (July 10, 2013), available at http://www.sec.gov/comments/s7-03-13/s70313-20.pdf; Clarification on the memo dated July 10, 2013 entitled “The Exposure Money Market Funds Have to the Parents of Issuers” (July 25, 2013), available at http://www.sec.gov/comments/s7-03-13/s70313-38.pdf.; and The Exposure of Money Market Funds Have to the Parents of Guarantors (July 10, 2013), available at http://www.sec.gov/comments/s7-03-13/s70313-21.pdf.  

[4]               Available at http://www.sec.gov/divisions/riskfin/workingpapers/rsfi-wp2014-

SEC OFFICIAL'S REMARKS TO INDEPENDENT DIRECTORS COUNCIL ANNUAL FALL MEETING

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
Remarks to the Independent Directors Council Annual Fall Meeting
 Norm Champ
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Chicago, IL

Oct. 22, 2013

Good afternoon.  Thank you, Susan, for your kind introduction, and thank you for inviting me to speak at the Independent Directors Council Conference today.  Before I continue, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.[1]

It is a privilege to appear before a group that is so important to the strength and integrity of the fund industry.  Independent directors have significant responsibilities, and it requires tremendous effort and time on your part to do your job well.  I applaud your efforts to learn from the professionals who are participating in this conference.  The insights of the panels you heard yesterday and this morning, and those you will hear after lunch will provide valuable information.

The importance of mutual funds in the lives of American investors is clear.  Mutual funds hold close to $14 trillion of the hard earned savings of over 53 million American households.[2]  The majority of Americans access the markets through mutual funds.  They invest in funds, and hope their investments will grow, for many reasons -- to make a down payment on a house, to save for a college education, and ultimately to pay for a retirement.

The Commission’s mission in this landscape is clear.  It is charged with protecting investors, ensuring fair and orderly markets, and promoting capital formation.  Every one of us in the Division of Investment Management takes seriously how our work fits into that mission.  Indeed, our mission statement was drafted with the help of the entire Division.  In drafting our mission statement, we wanted to determine how our efforts fit in the overall SEC mission.  And we agreed that we work to protect investors, promote informed investment decisions, and facilitate appropriate innovation in investment products and services through regulating the asset management industry.  As I consider the Division’s mission, I see common themes to our mission in the role that independent directors play.  Although you do not regulate the asset management industry, you are first and foremost “independent watchdogs.”  As watchdogs, you oversee funds to protect the shareholders you serve.  You also help facilitate innovation in new products that are designed to meet investor needs.  And you monitor the information your funds provide that helps investors make informed decisions.

Today I want to talk about our common purpose, and how we can work together to advance it.  Specifically, I will talk about the key role communication can play in helping us collaborate to protect investors.  First, I will focus on your role in overseeing funds and how it complements ours at the Commission.  Then I will discuss developments in our efforts to oversee the industry.  Finally, I will highlight how we are striving to improve communication with you to support the mission that we share.

The Role of Independent Directors

Like any corporate director, mutual fund directors must abide by the duties they owe to shareholders under state law.  That is, they are subject to the state law duty of care and the duty of loyalty.[3]  The duty of care requires independent directors to act with the care that an ordinarily prudent person in a similar position would use under similar circumstances.[4]  In satisfying the duty of care, directors should be well informed.  They also should base their decisions on reasonable diligence.[5]  Your duty includes overseeing corporate management and overseeing service providers.[6]   Your oversight includes asking questions when there are red flags.[7]

Under the duty of loyalty, a director must place the best interests of the corporation and its shareholders before his or her own interests or those of anyone else, whether it is a person or an organization.[8]  As the Delaware Supreme Court has stated, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”[9]  Directors stand in a fiduciary relationship to the corporation and its shareholders.[10]  This relationship requires directors not only to protect the interests of the corporation and its shareholders, but also to refrain from doing anything that would cause injury to the corporation.[11]

In fulfilling their obligations, mutual fund directors must apply those general state law principles in the context of the specific responsibilities and restrictions imposed under the federal law.[12]  Federal law doesn’t generally preempt state laws that govern the powers of corporate directors.  But federal law does preempt state law if the state law permits action that federal law prohibits, or if the application of state law would be inconsistent with the federal policy underlying the federal cause of action.[13]  Because of the “extensive layering” of federal regulation under the Investment Company Act, “fund directors must, as a practical matter, consider their responsibilities under state law as inextricably linked to those under federal law.”[14]

Under the Investment Company Act, as independent directors, you have express duties in the governance of mutual funds.  These responsibilities arise because mutual funds are formed and operate so differently from other corporations.  As you well know, conflicts are inherent in a fund’s structure.  The potential for abuses are ever present because the fund is organized by a sponsor -- an investment adviser -- whose primary loyalty and financial interests lie outside the fund, and because third parties provide all the services that allow the fund to operate, including investment management, distribution and custody.

Congress gave fund directors, and particularly independent directors, specific responsibilities to address the conflicts of interest that arise because of the way funds are formed and operate.  Under the Investment Company Act, you are the “independent watchdogs” for shareholder interests by being a check on management.  You address the potential for abuse that accompanies those conflicts of interest.

Your responsibilities under the Act flow from the same underlying purpose as do your duties under state law -- to protect the fund’s shareholders.  The purpose underlying the Commission’s responsibilities is the same.  To achieve our common mission of protecting investors, we both oversee funds, but in different ways.  While you are on the front lines overseeing the funds you serve, we are monitoring the entire fund industry.

Division Improvement Initiatives

As the investment landscape changes, with evolving investor needs and new products designed to meet those needs, we as regulators are challenged every day -- to provide effective oversight and to protect investors.  And in the Division, we are working to meet those challenges.  We are focusing our energy, trying to become smarter, more strategic and more targeted.

One area where we have spent a lot of time focusing our energy is on rulemaking initiatives.  To ensure that we are allocating our resources wisely, over the past year, we have taken a fresh look at policy initiatives with a view to analyzing those matters based on four factors:  First, the risk to be mitigated; Second, the urgency associated with a particular initiative; Third the potential impact of an initiative on investors, registrants, capital formation, efficient markets, and the Division’s and the SEC’s operational efficiency; and Fourth, the resources associated with a policy initiative.  We’re looking at factors that we believe would further the SEC’s mission as well as the impact that various regulatory initiatives would have on investors, capital formation, and efficient markets. The analysis has helped to inform the Chairman, in collaboration with the Commissioners, in her determination of which regulatory priorities the Commission will pursue.

I am pleased to report that we have completed the first of the priorities that we identified early this year.  In April, the Commission adopted the “Identity Theft Red Flags Rules” -- rules to detect and prevent theft of the identities of mutual fund investors and clients of asset managers.[15]  I want to mention two other regulatory projects that the staff is focused on now.  The first is additional money market fund reform.  As I’m sure you know, the Commission proposed additional money market fund reforms in June.[16]  The comment period officially closed on September 17, although we continue to receive comments.  The staff is currently reviewing and analyzing the more than 1300 letters we have received to date.

Another rulemaking initiative we’re focused on involves ETFs.  In 2008, the Commission proposed a rule that would basically codify certain exemptive relief that we routinely grant for these funds.[17]  The proposed exemptive rule would have allowed certain ETFs to launch without having to file an exemptive application -- a process that, while important for novel products, can be costly and time-consuming.  If ETFs of new sponsors could come to market without having to obtain their own exemptive relief, the Division could reallocate staff resources from the review of these “plain vanilla” applications to more novel applications.  The Division is considering how to advance consideration of this type of ETF rule.

In our efforts to work smarter, we also focused on the Division as a whole.  During the past year, we began a process to better understand our strengths and areas for improvement.  Enhanced communication and collaboration are key elements of that initiative.  We gathered input from inside the Division as well as from our colleagues throughout the Commission.  We identified and prioritized issues confronting the Division and created teams of managers and staff to address these issues.  These teams have made recommendations, and I am pleased at the number of creative ideas that were generated.  As a result, we have implemented a number of initiatives, which are designed to – First, encourage an inclusive collaborative working environment within IM, across the Commission, and with outside stakeholders.  Second, increase information and knowledge sharing.  And third, provide transparency into our work processes.

An important tool in our efforts to increase communication and collaboration is our newly created Risk and Examinations Office, or “REO.”  REO supports the Division’s work primarily through two functions.  REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers and accountants.  REO maintains an industry monitoring program that provides ongoing financial analysis of the investment management industry.  In particular, REO is charged with monitoring activities of investment companies, investment advisers and investment products.  REO intends to conduct rigorous quantitative and qualitative financial analysis of the investment management industry, with a particular focus on strategically important investment advisers and funds.  The REO monitoring program’s work includes analysis of the information the industry provides through various regulatory reports, including Form ADV, the form that investment advisers use to register with the Commission, Form PF, the form that certain investment advisers to private funds use to report risk data, and Form N-MFP, the reporting form that money market funds use to report their portfolio holdings and other key information.  REO also draws on industry information from third party providers.  In addition, REO conducts an examination program that gathers additional information from the investment management industry to inform the Division’s policy making.  Although REO may conduct its own exams, where practical, REO will join examiners from the Commission’s Office of Compliance Inspections and Examinations (OCIE) on their examinations of firms.  So far all REO exams have been in association with OCIE.

All of REO’s work will inform the initiatives to which the Division devotes resources and will help inform the rules we are drafting.

I am excited at the prospect that REO can help the staff to be proactive and get out in front of new industry trends, rather than reacting to past practices.  We hope to use the work of REO to make our oversight more efficient and effective.  REO represents a new area of focus for the Division of Investment Management, and I expect REO to complement the work of the SEC as a whole.

I also believe that we can make REO even more effective with enhanced information.  We are working to do this in two ways.  First, we are seeking to be more in tune with industry developments and investors’ experiences.  This effort involves getting a better and more first-hand understanding of the workings of the investment management industry through meeting with fund boards and senior fund management.  I will talk more about this in a moment.

Second, we are working to enhance REO and the Division’s ability to collect and analyze data.  As you know, as part of the money market fund reforms adopted by the SEC in 2010, we now receive monthly data on money market fund portfolio holdings through Form N-MFP.  This new data has been extremely valuable.  We are able to use it to monitor trends, identify outliers and better inform our rule-writing efforts.  What we don’t have, however, is similar information on other mutual funds, closed-end funds and ETFs.  Instead, we have a hodgepodge of data collection and reporting forms with outdated technology behind them.  These forms provide only a patchwork of data that does not tell us detail about mutual funds but often allows rounding and summary information.  That is why Division staff is undertaking an initiative to consider potential ways to streamline the fund reporting forms and develop reporting for funds other than money market funds that could give us timely and accurate information about their operations and portfolio holdings.

In addition to our focus on communication within the Division, we are working on better communication with our colleagues throughout the Commission.  For example, we have worked intentionally towards better coordination and cooperation with other offices in connection with major initiatives, doing this as an integral part of the process, rather than a late stage check-in with another office after the essential work on the matter has been completed.  This involves comparing notes with others on our initiatives early and often, and seeking meaningful substantive input at all stages of a major undertaking like a rulemaking.

We are also working to enhance our communications with the outside.  To further this goal, we are issuing guidance updates in addition to our traditional no-action and interpretive letters.  A recent example that may be of interest to fund directors addresses the merger of two affiliated exchange traded funds – a transaction that is generally not covered in the exemptive orders that the Commission issues to ETFs and their advisers in response to applications.  The guidance provides staff views regarding such a merger that is executed in accordance with the Commission’s exemptive rule permitting fund mergers and where all applicable disclosure and other requirements are met.[18]

The staff also has issued guidance on complying with the representations and conditions of exemptive orders issued to funds and advisers.  The staff noted that funds risk violating the federal securities laws if they fail to comply with the conditions and representations in their orders.  The guidance observed one way to address those risks, and offered approaches on how a fund’s compliance program might address conditions relating to board of directors’ review.[19]

The staff’s guidance and issues of interest are posted on the Division’s recently redesigned website.  They are easy to find on the Guidance Updates section, which we are using to get more information out quickly.  In addition, the IM website has a section that highlights the Division’s current news, which makes it easy to find the most recent guidance.

Communication and Support on Fund Governance

I have just outlined several ways in which we are working toward continuous improvement in the Division, including how we oversee funds.  As independent directors, you have a special perspective that makes your oversight different from but complementary to ours.  You are monitoring the funds you serve rather than the entire industry, and you best understand those funds.  You know the funds’ investment objectives and thus the shareholders’ expectations.  You scrutinize the funds’ advisory contracts and fees.  You oversee fund distributions, the valuation and pricing of fund shares, custody arrangements, securities lending, and many other fund activities.  You confer regularly with fund management.  You are on the front lines, seeing new developments and troubleshooting problems as they arise.  As a result of all your interactions, you are closer to the needs of investors than we can be and you are better positioned to understand how best to serve their interests.  Just as I expect the Commission will benefit from the work that REO will do, I believe that we already benefit from the work of independent directors.  And to help you be the most effective in your work, we want to do what we can to support you.

Our interest in this collaboration is not new.  The Division and the Commission have considered fund governance and have engaged with independent directors on how to maximize their value over many years.  For example, more than twenty years ago, in 1992, the staff reviewed the role of independent directors.  It concluded that the governance model embodied in the Investment Company Act is sound, and that the “watchdog” function you perform has served investors well at minimal cost.[20]  But the staff also recognized that independent directors faced increasing responsibilities, and so it made recommendations, many of which were adopted by the Commission, to reduce those responsibilities that involved more ritual than substance.

Several years later, in 1999, the Commission held a roundtable devoted to examining the role of independent directors.  Many recommendations emerged from the roundtable on ways to improve the mutual fund governance structure.  Following the roundtable, the industry and the Commission both worked to enhance the role of independent directors.  In June 1999, the ICI’s Advisory Group on Best Practices for Fund Directors published a report identifying best practices for fund boards to enhance the independence and effectiveness of investment company directors.[21] And I note the success of that effort because by 2003, a significant portion of mutual funds had followed all or most of the recommendations of that report.[22]  In November 1999, the Commission proposed rule changes, which it adopted in 2001, “designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with greater information to assess the directors’ independence.”[23]

More recently in 2007, one of my predecessor’s as Division Director began a series of meetings designed to determine what the Commission and its staff could do to enable fund directors to be more effective in their oversight role.  We gained valuable insights in these meetings, and learned how we might be able to assist directors.  For example, in response to concerns we heard, the Division issued guidance on approaches a fund board could take regarding determinations they must make when they perform their quarterly review of certain transactions permitted under our exemptive rules.[24]  

This type of communication, I believe, is essential to a successful collaboration.  I mentioned earlier that the Division has been reaching out to boards of directors and senior fund management.  Our meetings with the industry have started with the largest or most strategically important funds.  We have identified a number of potential firms, and at this point we have conducted a number of visits.  Our outreach will extend to other funds as well.  In these discussions, we want to learn from directors and fund management about specific fund risks and how they manage those risks.  We also want to know what you perceive to be the critical risks to the industry as a whole.  I have been joined by REO in these meetings because we believe this information will further inform REO’s work, and REO’s work in turn will inform the initiatives to which the Division devotes resources and the rules we are drafting.

I think that the conversations between us can be the most productive when we can speak with you and your fund management directly and get to know you better.  To illustrate our commitment to the process, we have met with fund management and boards at their headquarters.

These meetings allow us to obtain a first-hand view of the systems, controls, personnel, and even a sense of the culture of an individual firm.  And we find we can learn more about a firm’s business operations by seeing the board and fund management at their offices.  We will be better regulators to the extent that we better understand the workings of the industry we regulate.  And if you and fund managers see our willingness to reach out and to listen, we hope you and they will respond with increased cooperation and more effective communication.

The discussions we have had with fund management and directors to date have already borne fruit.  Boards have shared with us their different perspectives on a variety of issues, including risk management, valuation and compliance, and how those perspectives inform many of their fund practices.  Those perspectives help us understand the different methods that might be brought to bear in addressing pressing fund issues and implementing compliance programs.  And in turn, if it’s appropriate we are sharing the good practices that we learn about from one firm with other funds.

In addition, we encourage directors to share with us ways in which the Division could help them be more effective.  If we hear ideas in our meetings on where you need additional guidance or where you have uncertainty about the law, we will work diligently to get the appropriate guidance out there.

We will continue to seek ways in which we can provide guidance or otherwise assist fund boards, and particularly independent directors, in fulfilling their duties.  This is one way we can better serve the public and industry participants.

I look forward to future meetings as our initiative advances.  I am particularly glad to have an opportunity today to share views with you and receive feedback.  In addition, as I have mentioned, the Division’s door is open, and we want to hear from you what we can do to help make you more effective.  Working together, we are better positioned to accomplish our common mission of protecting investors.

Thank you for your time today.


[1]              The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees.  The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.

[2]              See Investment Company Institute (“ICI”), Trends in Mutual Fund Investing August 2013 ( http://www.ici.org/research/stats/trends/trends_08_13 ); ICI, Profile of Mutual Fund Shareholders 2013, available at ( http://www.ici.org/pdf/rpt_13_profiles.pdf ).

[3]              Edward Brodsky & M. Patricia Adamski, Law of Corporate Officers and Directors:Rights, Duties and Liabilities 6 (2013).

[4]              Graham v. Allis-Chalmers Mfg. Col, 188 A.2d 125, 130 (Del. Ch. 1963); see also Shenker v. Laureate Educ. Inc., 983 A.2d 408, 419 (Md. 2009).

[5]              See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

[6]              See Robert A. Robertson, Fund Governance: Legal Duties of Investment Company Directors § 2.04[1] (2011) (“Fund Governance”).

[7]              See id., at § 2-04[2][b](ii); see also Graham, 188 A.2d, at130.

[8]              See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993), modified on reargument, 636 A.2d 956 (Del. 1994).

[9]              Guttman v. Huang, 823 A.2d 492, n.34 (Del. Ch. 2003).

[10]            Guth v. Loft, 5 A.2d 503, 510 (Del. 1939).

[11]            Id.

[12]            Burks v. Lasker, 441 U.S. 471, 486 (1979).

[13]            Id. at 479.

[14]            Fund Governance, supra note 6, § 2.01.

[15]            Identity Theft Red Flags Rules, Investment Company Act Release No. 30456 (Apr. 10, 2013), 78 FR 23637 (Apr. 19, 2013), available at http://www.sec.gov/rules/final/2013/34-69359.pdf.

[16]            Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013), 78 FR 36834 (June 19, 2013), available at http://www.sec.gov/rules/proposed/2013/33-9408.pdf.

[17]            Exchange-Traded Funds, Investment Company Act Release No. 28193 (Mar. 11, 2008), 73 FR 14618 (Mar. 18, 2008), available at http://www.sec.gov/rules/proposed/2008/33-8901.pdf.

[18]            Merger of Two Exchange-Traded Funds, IM Guidance Update No. 2013-06 (Sept. 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-06.pdf.

[19]            Compliance with Exemptive Orders, IM Guidance Update No. 2013-02 (May 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-02.pdf.

[20]            Division of Investment Management, Protecting Investors:  A Half Century of Investment Company Regulation 253 (1992), available at http://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf.

[21]            Investment Company Institute, Report of the Advisory Group on Best Practices for Fund Directors:  Enhancing a Culture of Independence and Effectiveness (June 24, 1999), available at http://www.idc.org/pdf/rpt_best_practices.pdf .

[22]            See Richard M. Phillips, Mutual Fund Independent Directors: A Model for Corporate America?, Investment Company Institute Perspective, Aug. 2003, at 3, available at http://www.ici.org/pdf/per09-04.pdf .

[23]            Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 (Jan. 2, 2001), at paragraph preceding section I [66 FR 3759 (Jan. 16, 2001)].

[24]            See Staff Letter to the Independent Directors Council and the Mutual Fund Directors Forum (Nov. 2, 2010), available at http://www.sec.gov/divisions/investment/noaction/2010/idc-mfdf110210.pdf.

GRIM'S REMARKS TO INVESTMENT MANAGEMENT INSTIITUE 2013

FROM: U.S. SECURITIES AND EXCHANGE COMMISSION
Remarks to the Investment Management Institute 2013

by
Norm Champ, Director, Division of Investment Management
as delivered by
David W. Grim, Deputy Director, Division of Investment Management
U.S. Securities and Exchange CommissionNew York, NY
March 7, 2013
Introduction
Good morning. I am pleased to be here today on behalf of Norm Champ, Director of the Division of Investment Management. Norm very much wanted to be with you today, and I am very pleased to have the opportunity to step in for him and deliver these remarks on his behalf.

Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.

As I said, it is a privilege to deliver Norm Champ’s keynote address at this year’s Investment Management Institute. It is a privilege because I have the opportunity to open up the conference on behalf of a number of seasoned and expert legal practitioners who are speaking to you today. They are very knowledgeable and highly regarded in their fields.

It is a privilege because I have the opportunity to hear from and interact with two prior Directors of the Division of Investment Management, each of whom used his time and energy in that job to shape the regulatory landscape for the benefit of investors.

But most of all, it is a privilege to be here today because we have an audience comprised of professionals who want to learn more about the law; improve your own legal skills; and take back practical, real-world lessons and implement them at your own firms and offices.

Programs of this type are always enriching and beneficial to those who are willing to take the time to improve their own legal skills and add to their base of knowledge. Both Norm and I genuinely commend you for it.

* * *

Norm Champ has been on the job as Director of the Division of Investment Management for eight months. And I have been serving as Deputy Director for nearly two months.

For those of you who are not familiar with the role of the Division of Investment Management at the SEC, our mission is to work for American investors by:
protecting investors
promoting informed investment decisions and
facilitating appropriate innovation in investment products and services
through regulating the asset management industry.

The issues we work on are interesting, but more importantly, they have great consequence for America’s investors. I would hazard that nearly everyone in this room has invested in a mutual fund, an ETF or another investment product regulated under statutes administered by the Division of Investment Management.

The rules we help construct; the disclosure we review; and the new products we analyze have an impact on you and on millions of American investors like you. We have a lot of responsibility on our plate. And we take it very seriously.

Regulatory Initiative Process

What most SEC-watchers are always interested in hearing about is rulemaking activity, so, on behalf of Norm, I plan to focus on that. But that is in no way intended to diminish the important disclosure review; exemptive applications analysis; data review; and development of legal guidance that the Division of Investment Management performs.

Like the rest of the SEC, our Division is focused on implementation of our statutorily mandated rulemaking under the Dodd-Frank Act and the JOBS Act. In most cases, however, the bulk of statutorily required rulemaking that affects entities regulated within the Division of Investment Management’s jurisdiction is either complete, such as the required registration of advisers to private funds, or is being led by other parts of the agency and we are serving as consultants to assure that the asset management industry is covered consistently, such as in the general solicitation rules. In other areas, such as the Commission’s review of the standards of conduct and regulatory requirements that apply to broker-dealers and investment advisers, we are partnering with other parts of the SEC and are not the sole lead.

Where the Division of Investment Management has, under Norm Champ’s leadership, spent a lot of time focusing our energy and trying to become smarter, more strategic and more targeted, is on so-called "discretionary" or non-mandated rulemaking initiatives.

The Division of Investment Management, in close consultation with the Chairman and the Commissioners, went through a very thoughtful and deliberate approach to analyze potential regulatory initiatives.

In this era of limited budgets, one of my goals since taking the helm of the Division has been to ensure that we are allocating our resources wisely. Toward this end, Norm Champ asked the staff to take a fresh look at policy initiatives with a view to analyzing those matters based on four factors. These factors also will be used to analyze potential policy initiatives going forward.

The first factor is identification of the risk to be mitigated or the problem to be solved. This is key to the discussion of any policy initiative.

The second factor is the urgency associated with a particular initiative. Urgency may arise from risks to investors, registrants, efficient markets, or capital formation.

The third factor is the potential impact of an initiative on investors, registrants, capital formation, efficient markets, and the Division’s and SEC’s operational efficiency.

The fourth and final factor is the resources associated with a policy initiative. As with all our activities and projects, senior staff in the Division need to assess how best to allocate scarce resources.

We’re looking at factors that we believe would further the SEC’s mission as well as the impact that various regulatory initiatives would have on investors, capital formation, and efficient markets. The analysis has helped to inform the Chairman, collaborating with the Commissioners, in her determination of which regulatory priorities the Commission will pursue.

At this point you are probably asking yourselves what specific future regulatory priorities came out of this process. There are three short term and five longer term core priorities.

Short-Term Regulatory Priorities

Potential Money Market Mutual Fund Reform

The first short-term regulatory priority is money market funds, which may be the most high-profile issue on the Division’s plate these days.

Late in 2012, the SEC’s economists published a significant study on money market funds that responded to questions posed by three SEC Commissioners. The results of that study have served as a catalyst for renewed and energized focus by the SEC staff and Commissioners on additional structural reform of money market funds.

At the direction of the Chairman, the staff is engaged with the Commissioners and hard at work on developing a money market fund reform recommendation.

Identity Theft Red Flags Rules

The second of the Division’s short-term rulemaking priorities involves rules to detect and prevent theft of the identities of mutual fund investors and clients of asset managers. The growth and advancement of information technology and electronic communication have made it increasingly easy to collect, maintain and transfer personal information about individuals. Advancements in technology, however, also have led to increasing threats to the integrity and privacy of personal information.

In February 2012, the SEC proposed rules and guidelines jointly with the CFTC to require many of the entities we regulate to establish identity theft detection and prevention programs. These proposed rules were designed to help protect individuals, and help individuals protect themselves, from the risks of theft, loss, and abuse of their personal information.

The rules would give effect to the transfer of authority, under the Dodd-Frank Act, from the Federal Trade Commission to the SEC and CFTC for responsibility for overseeing the identity theft and protection programs of the entities we regulate. The comments on the proposed rules were generally supportive, and the Division is working on final identity theft red flags rules to recommend to the Commission.

Valuation Guidance

Striking an appropriate and accurate net asset value each trading day is one of the most important, and often one of the most challenging, functions that mutual funds and other investment companies perform. It is one thing to identify prices for a large cap equity fund that is investing in frequently-traded, highly-liquid securities. It is quite another for a fund that is heavily invested in thinly-traded bonds, derivative instruments and other securities that have no readily-available market price to draw from.

The Division is working to provide the fund industry, fund directors, and the public with guidance under the Investment Company Act regarding funds’ and fund directors’ valuation responsibilities. In addition to wanting to assure accuracy of mutual fund transaction prices, valuations also affect performance claims. Furthermore, fund advisers’ fees are usually calculated and paid based on asset valuations. There is a natural incentive for advisers to want those valuations to be as high as possible.

Inaccurate valuations will lead to inaccurate performance claims; inaccurate fee payments; inaccurate transaction prices and ultimately mis-pricing can muddy the integrity of the fund industry. When it comes to valuation, the Division of Investment Management believes that we need to level set requirements and make sure funds and their directors are aware of prudent practices that will lead to fair and accurate valuations.

In developing valuation guidance, the staff recognizes the benefit of input from the public and those who work hard every day to strike an accurate NAV. We therefore are exploring ways to assure that the staff and the Commission get meaningful public input on any valuation guidance.

Longer-Term Regulatory Initiatives

Each of the three short-term regulatory priorities I mentioned is actively being worked on by staff in the Division of Investment Management. In addition, there are five longer-term rulemaking projects that we are scoping the terms of and allocating resources toward. These projects are in a less advanced stage, but we want to share them so that investors, funds and advisers, taxpayers and others are aware of where we are focused and devoting resources.

Variable Annuity Summary Prospectus

A few years ago, the Commission adopted a streamlined "summary prospectus" for mutual fund investors. That document contains key information about fund investment objectives and strategies, risks, and fees and provides the ability to "click through" or request more detail for those who want it. This initiative was a revolution in communicating to investors the core information they most want while simultaneously making more detailed information readily accessible to investors, intermediaries, the financial press, and others who are interested.

The Division is beginning work on a rule that would create a similar summary prospectus for variable annuities, a type of hybrid insurance and investment product. The insurance benefits offered by these products, and the limitations on those benefits, are often complex; their costs can be difficult to understand; and they frequently offer a wide array of investment options. These and other factors often result in disclosure that is long and difficult to understand. Our goal is to facilitate the communication of concise, user-friendly information to investors considering variable annuities and enhance the transparency of the benefits, risks, and costs of these products.

ETF Rule

In 2008, the Commission proposed a rule that would basically codify exemptive relief that we routinely grant for exchange-traded funds. This rule would allow ETFs to operate without obtaining individual exemptive relief -- a process that, while important for novel products, can be costly and time-consuming.

If ETFs of new sponsors could come to market without having to obtain their own exemptive relief, the Division could reallocate staff resources from the review of "plain vanilla" applications to more novel applications. The Division has renewed its efforts to pursue implementation of this type of ETF rule.

Enhancements to Fund Disclosures about Operations and Portfolio Holdings

As part of the money market fund reforms adopted by the SEC in 2010, the SEC required new monthly reporting on portfolio holdings by those funds to both investors and the SEC. This new data has been invaluable. Some have called it a game-changer. We are able to use it to monitor trends, identify outliers and better inform our rule-writing efforts.

Many believe we need similar structured data reporting for other mutual funds and investment companies. The patchwork of outdated data collection and disclosure forms is not working, and the staff is examining how to enhance and streamline our data collection efforts.

The purpose of this initiative is to improve the quality and usefulness of information that funds provide to investors and to the SEC, and to eliminate duplicative filings or disclosures. It could make the SEC a better regulator and it could make investors better informed.

Review of the Rules that Apply to Private Fund Advisers

In 2012, approximately 1,500 advisers to hedge funds and other private funds registered with the Commission as investment advisers as a result of the Dodd-Frank Act. Private fund advisers now account for nearly 40% of our registered investment advisers.

Given the increase in the number and variety of registered private fund advisers, the Division is reviewing Advisers Act rules for aspects that should be updated to address investor protection concerns and the business models of private fund advisers.

Derivatives Concept Release

And finally, the Division also continues to consider the numerous issues raised in the Commission’s 2011 concept release on funds’ use of derivatives. When the Investment Company Act was enacted in 1940, it did not contemplate funds investing in derivatives as many do today. Indeed, the use and complexity of derivatives have grown significantly over the past two decades.

Over the years, the SEC and the Division have addressed a number of issues raised by the use of derivatives on a case-by-case basis. The purpose of the derivatives concept release was to elicit public input on a variety of regulatory issues raised by funds’ use of derivatives, including valuation, diversification and leverage limitations.

The staff is now analyzing the feedback on the concept release to assess whether, and if so how, the mutual fund and investment company regulatory regimes should be revised to adequately account for the role of derivatives and incorporate more targeted requirements.

Conclusion

Having just gone through our priorities list, it feels a little daunting. But it is important work and these are issues that must be tackled.

In addition, neither Norm Champ nor I would not want to leave you with the misimpression that rulemaking is all we do. The reality is far from it. We have numerous staff devoted to reviewing disclosure; answering investor and industry questions; helping to shape enforcement cases and examination priorities; analyzing requests for exemptive relief and no-action guidance. It is this entire body of work that makes the SEC an effective regulator.

And as Director of the Division of Investment Management, Norm Champ has been committed to continuous improvement in all phases of the Division’s work – not just the rulemaking phase. Norm and I are hopeful, however, that the remarks today showed the benefit of a coordinated and thorough analysis of potential policy initiatives. And we further hope that our approach leads to effective results and achievable goals.

We look forward to the challenging work we have ahead of us. And we look forward to a continued dialogue with our stakeholders: investors; taxpayers; industry leaders and, of course, legal practitioners such as yourselves.

Thank you.