Speech by SEC Chairman:
Remarks before the Independent Directors Council

by

Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Washington, D.C.
October 21, 2004

Good afternoon. Let me begin by thanking you, the Independent Directors Council, and the Investment Company Institute for giving me an opportunity to speak today. It is a pleasure to be with you.

I want to salute ICI for creating this new entity, which will help to deepen the involvement of independent directors in the many important public-policy debates affecting the mutual fund industry. The Council also provides a forum for communication among independent directors, and valuable opportunities for professional development and educational advancement. As independent directors, you all perform a critical oversight function in the service of the nation’s 91 million mutual fund investors.

Before I go any further, let me applaud James Bodurtha for taking on the leadership of the Independent Directors Council, and offer public congratulations to Paul Stevens on being named ICI’s president. Paul has a record of strong leadership, and I am confident that in this new position he will represent the interests of investment companies, and investors, alike. And finally, let me also issue the standard disclaimer that the views I express here today are my own and do not necessarily represent those of the Commission or its staff.

I have great admiration for the job you are doing as independent directors, but I also believe that as overseers, whether as regulators or directors, we all should continually look for ways to improve our effectiveness. In that vein, I would like to make the following four suggestions or challenges: first, enhance your oversight functions; second, always serve as investor advocates in the boardroom; third, stand up to management as appropriate; and finally, help shape mutual fund regulatory policy. By living up to each of these, I believe you will be well on the way to achieving our shared goal of restoring investor confidence in the mutual fund industry.

The past year has been a difficult and troubling period for all of us. Over the past 13 months, the Commission has brought 51 enforcement cases related to the mutual fund scandals and levied $900 million in disgorgements and $730 million in penalties. Fund firms have had an even higher price to pay in the markets, as investors express their anger and frustration by withdrawing money from funds. Mutual funds have traditionally been a trusted investment vehicle, and while that trust has not evaporated, it has certainly declined. While investors are unlikely to forget the betrayal, I believe that our actions—both at the Commission and on the part of independent directors—can help the fund industry regain investors’ trust and confidence.

Prominent on our mutual fund regulatory agenda has been fund governance reform and enhanced internal oversight of fund activities. Our reforms require that funds relying on certain exemptive rules must have an independent chairman, and 75 percent of board members must be independent. These reforms will enhance the critical independent oversight of the transactions permitted by these exemptive rules. Each of these transactions involves potentially serious conflicts of interest between the funds and their managers, and would otherwise be prohibited by the Investment Company Act. For many years, the exemptive rules have been conditioned upon the judgment and scrutiny of the funds’ independent directors to oversee these inherent conflicts of interest. I continue to believe that these fund governance enhancements will realign fund boardrooms for the benefit of investors. I further believe they will encourage independent thinking, lively debate, and an unqualified focus on the needs and interests of mutual fund investors.

Not only will each independent chairman set each board’s agenda and establish the tone and tenor of board meetings, the independent chairman can direct a board’s attention to the matters most in need of critical review and oversight. Furthermore, with independent directors representing 75 percent of a fund’s board, these independent directors will be positioned to significantly influence board discussion and analysis—and to stand up to management if necessary. For independent directors, being a rubber stamp is never appropriate. You must critically review each proposal that comes before you and ask how it affects investors, and what management conflicts, if any, are presented by the proposal.

Another cornerstone of our mutual fund reform agenda is the new compliance policies and procedures rule, and the chief compliance officer requirement. I believe the presence of a designated chief compliance officer, who is answerable to a fund’s board, will lead to a greater focus on compliance controls and procedures. I encourage you to work closely with your chief compliance officers and highlight for them — and for all of fund management — the compliance-oriented atmosphere that you expect fund management firms to foster.

Another significant initiative that will help to foster an ethical, compliance-oriented atmosphere is the new requirement that all registered investment advisers, including advisers to funds, adopt a code of ethics. The code of ethics must set forth standards of conduct for advisory personnel and address conflicts that arise from personal trading by advisory personnel. As directors, you should be reviewing the ethical limits that advisory firms place on their portfolio managers and other employees. In addition, you should consider whether fund investors’ interests are taken into account when advisers establish their internal standards of ethical behavior. I believe that development of a code of ethics gives advisory firms and their executives an opportunity to examine the firm’s “moral DNA” and to establish standards of behavior that make ethical aspirations a reality. Our nation’s mutual fund investors deserve nothing less.

Our reform agenda has also focused on improving the information fund investors receive, so that they can meaningfully examine the operations of a fund and its board. Recent initiatives include enhanced disclosure of market timing, disclosures regarding fair value pricing, and selective disclosure policies and procedures; dollars-and-cents expense disclosure in shareholder reports; and improved disclosure regarding portfolio managers and their conflicts of interest.

The new disclosure that most directly affects you is the requirement that a fund’s annual report include a discussion of the considerations a fund board took into account when voting to approve or renew a management contract. And let me emphasize one point: we are expecting that the discussion in shareholder reports will bring clarity to your deliberations and the factors you considered when voting. In approving this new requirement, the Commission was motivated by a desire to enhance this type of disclosure for investors.

As part of our reform agenda, we have also revamped the SEC’s oversight function. With limited resources, in an expanding world of responsibilities and challenges, we are seeking to create an enhanced oversight regime that will equip the Commission to better anticipate, find, and mitigate areas of financial risk, potential fraud, and malfeasance. The effort is designed around so-called risk mapping — a running list of potential risks identified by our field staff — and the creation of a new Office of Risk Assessment, which brings together professionals experienced in seeking out potential areas of concern. We want our efforts and oversight to be more anticipatory and preventative in nature — to look over the hills and around the corners of the securities markets.

A prime example of this forward-thinking approach is the SEC’s hedge fund adviser registration initiative. The Commission is scheduled to vote on final adoption of this rule next week. If it is adopted, the Commission will gain greater insight into the activities of hedge fund advisers, at a time when hedge funds are growing in size and influence in the securities markets. I believe we need to know more about the activities of hedge fund managers and the impact their trades have on what I call the “other side of the transaction.”

Hedge funds were central figures in the late trading and market timing abuses that left long-term mutual fund investors financially disadvantaged and more distrustful of our markets. We need to consider proactive measures now to avoid this type of harm in the future.

It’s clear we need smarter, more efficient oversight of mutual funds, hedge fund managers, and other investment advisers. And as we develop a new oversight and risk based approach to our work, we seek your input.

The Role of Independent Directors

As I outline the Commission’s recent mutual fund initiatives, I am reminded that rulemaking alone cannot reform an industry. An industry must be motivated and committed to reforming itself. And its frontline gatekeepers — the independent directors — must be committed to performing their watchdog role. Fund directors have a critical role to play in restoring investor confidence, and they are responsible for overseeing implementation of many of our new rules. I know that your board meeting agendas have grown more extensive recently, with new compliance policies and procedures to review; new mutual fund disclosures to discuss; and new controls on distribution, market timing, and late trading to consider. The job of an independent fund director is not for the inattentive. It requires time, commitment, and dedication.

The independent director role also is not for the faint of heart. Mutual fund investors rely on your vigilant oversight to ensure the responsible management of their assets. Your responsibility is significant – and the consequences if you fail can be severe, especially for the investors you are charged with protecting.

I am pleased to see the work of the mutual fund industry to rebuild its reputation for integrity, and I hope that the Commission’s reform agenda is setting the course for an appropriate restructuring of the industry’s mindset. But it is really you, the independent directors, who are intimately involved in overseeing the workings of the industry—from the inside. You can guide decisions and promote a focus on the investors’ interests over those of management. While I encourage you to imbue your board discussions with a focus on the needs and interests of investors, I remind you that you have more than the power of words. You have the power of your vote. Use your vote wisely, and withhold it or vote “no,” if necessary. Do not be forced to vote for an initiative for the sake of expedience or efficiency if, in your judgment, there could be negative implications for fund investors.

I am encouraged by the signs that many in the fund industry are embracing reform and focusing on the need to restore investor confidence in mutual funds. I am particularly impressed by the example ICI has set among prominent industry organizations in working with our rulemaking process. In particular, while ICI may have opposed some aspects of the fund governance rules when they were proposed, ICI is now working with us diligently to ensure the full and effective implementation of these rules.

As you know, the Commission has long engaged in a dialogue with representatives of mutual funds, and investors in those funds, to ensure that the objectives of the securities laws are fully realized. We have sought, over time, to identify constructive ways to use our exemptive and other authority to reflect the changing conditions that prevail in the mutual fund marketplace – a recent example being the Commission’s adoption of fund governance rules. While not everyone will always agree with our policy choices, I hope that we all can agree on the importance of preserving the Commission’s ability to maintain a flexible regulatory framework that will allow for innovation and creativity in the fund industry, for the benefit of fund investors.

Independent Directors Council

I would also like to say a few words about the important role that can be played by each of you, as members of the Independent Directors Council. Because you serve on the “front lines” in protecting investors, you have a unique perspective on a range of policy issues. We at the Commission value your opinion and encourage you to comment on our proposals and make suggestions for regulatory actions we can take to better protect investors or help you do your jobs.

We also need your input on compliance problems and emerging compliance issues. In many cases, you — and a fund’s chief compliance officer — are best positioned to identify these types of issues at an early stage. We encourage you to maintain open lines of communication with us so that we can fashion solutions that are meaningful and workable — before an emerging compliance issue becomes a significant problem.

I also encourage the Independent Directors Council to identify areas where additional best practices or industry standards should be established. The mutual fund industry is constantly evolving, and you are best suited to help identify new trends and practices. In addition, you can fashion standards or practices on your own with a view toward ensuring that investors are accorded fair treatment and that directors can engage in adequate oversight.

Finally, I think we can all agree that director education programs, such as this one, are more important now than ever. I believe that the education function of the Independent Directors Council’s should be one of your core missions, especially as directors work to implement the Commission’s recent reform initiatives. Hopefully you will also work to hone their oversight skills so that we can avoid a repeat of the anti-investor activities that have been uncovered over the past year.

Conclusion

I recognize that significant changes have been ushered in during this period. There are a number of new rules emerging from the Commission and there is an increased focus on director responsibilities. With change comes anxiety, and perhaps a sense of being overwhelmed by a number of new requirements.

At the Commission we stand ready to assist you during this transition period. It is in our interest, and the interest of fund investors, to ensure that our new rules are implemented in a meaningful way. We want to work with you, and answer your questions, as you continue to implement the rules.

Together — and I emphasize the word together — we can restore investor confidence. Let us know how we can help and support you. I hope and believe that the worst of the fallout from the mutual fund scandals is behind us. But we cannot give up the fight. At the Commission, we still have to take final action on two significant rule proposals: the hard 4:00 close and the 2% redemption fee rule. For the industry, there are still several rules to implement and policies and procedures to be improved. As we continue this joint effort to restore mutual fund investor confidence, I look forward to working with both the Independent Directors Council and the Investment Company Institute to reach our common goals.

Thank you very much. And now I would be glad to take your questions and hear your observations.