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IM Chief Lays out Investor Protection Initiatives

Last week, in an address before a meeting of the Business Law Section of the American Bar Association Committee on Federal Regulation of Securities, Andrew J. Donohue, Director of the SEC's Division of Investment Management, described the investor protection focus of the agency's and his division's recent activities.

. . . we are working to craft regulations from the investor's perspective — what information do investors need to make informed decisions and in what form would that information be most accessible and easy to use? What protections do investors need to instill confidence and allow them fair and easy access to the markets through pooled assets?

During his address, Donohue highlighted nine areas he is concerned about, and where the Commission has acted, or is considering action, in the interest of protecting investors.

Investment Adviser/Broker-Dealer Harmonization.  The Commission is exploring ways to harmonize the way investment advisers are regulated with the way broker-dealers providing similar services are regulated.  From the standpoint of retail investors, the services provided by each, and the way fees are assessed, can be quite similar. The Commission is keeping an eye on provisions in the financial reform bills working their way through Congress that would give the SEC the authority to make regulation of broker-dealers providing services with asset-based fees rather than traditional brokerage commissions more consistent with the regulation of investment advisers providing similar services. 

Hedge Fund Advisers.  The Commission is also concerned about the regulation of hedge funds, in particular, steps that can be taken to protect investors by subjecting hedge fund advisers to more disclosure and regulation. 

With the growth of hedge fund assets and their market influence, the question of whether the registration requirement should be extended to hedge fund advisers has been considered by the Commission and staff for a number of years. In many ways, the registration of private fund advisers remains a regulatory gap that I believe should be filled. This issue also is now being considered as part of the comprehensive reform package in Congress.

Sophisticated Products.  Donohue has made no secret of his deep concerns about the increasing use of derivatives and sophisticated financial instruments by mutual funds.  Although these instruments, effectively used, can be quite profitable and efficient, they can add significant levels of risk and raise investor protection issues. 

With so many derivative instruments available to enhance an investment strategy, a fund's manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds. It is to assess and respond to this challenge that the Division has undertaken to review derivatives activities of investment companies and the implications of those activities for the regulatory framework.

Rule 12b-1.  As he has stated before, Rule 12b-1 distribution fees remain a great concern to the Division of Investment Management.  Donohue has stated on other occasions that reform of these fees is high on the Division's agenda.

As 12b-1 fees typically now constitute a meaningful cost of an investment in a fund and their use has changed significantly, I believe the role of fund boards and the factors they must consider when approving or renewing a rule 12b-1 plan need to be revisited. We hope to recommend to the Commission shortly an investor-oriented reform proposal that better reflects the current market environment and enhances investor awareness of the amounts and uses of these fees.

Target Date Funds.  As 401(k) plans and other retirement programs including target date funds among their offerings, and some including them as the default investment option for participants, Donohue identified these kinds of funds as an area of concern. 

. . . there is concern that investors may hold these funds without in fact appreciating the associated risks.

The Division is working on a number of other projects as well that further a continuing effort to improve the quality of mutual fund disclosure and assist investors in making better-informed decisions.

Summary Prospectus and Shareholder Report Reform.  Because of the key role disclosure plays in protecting and informing investors, Donohue's division will continue to focus on making disclosure reform a priority, focusing on access and clarity.

In 2008, the Commission voted to adopt a Summary Prospectus for mutual fund investors. The concept behind the Summary Prospectus was to devise a brief, informative document for fund investors with key information presented in a concise, user-friendly manner, with additional information on-line or in paper upon request, for those who want it. The Summary Prospectus was a revolutionary change in mutual fund disclosure, and in the Division we are working on a recommendation for a similar type of disclosure document for variable annuities.

The Division is also looking at whether the current annual and semi-annual shareholder report disclosure can be made more streamlined and user-friendly for fund shareholders. As part of our work, we are considering how the Internet and other technology may be used to provide better delivery and accessibility of this information. For example, one idea being considered is to revise fund shareholder reports to include the information that is most important to the typical shareholders, while the more detailed information could be made available on the Internet.

Form ADV Part 2.  Donohue stated that his division has been working on improvements to Form ADV, the disclosure form for investment advisers giving investors information about advisers' background, qualifications, and activities.  Mr. Donohue promised a proposed revision to Part 2 of this form soon. 

Money Market Funds. According to Mr. Donohue, the money market reforms adopted in January are the first step the Commission plans to take in making these funds more transparent and safe.  He, promised that "more is to come."

The Commission has asked more fundamental questions about money market funds and their ability to maintain a stable net asset value of one dollar per share, and I expect to see a robust policy discussion of these questions. I appreciate the proactive work of the industry in developing meaningful recommendations for the important changes the Commission has made. I encourage the industry to continue this work as we consider recommendations for further change.

Advisers Act Initiatives.  Donohue outlined the Commission's actions taken in the wake of the Madoff and Stanford scandals, including a series of enforcement actions brought against advisers and broker-dealers misusing investors' funds, adoption of rules governing advisers' custody of client assets, and rules proposed to reign in "pay to play" practices by investment advisers that manage public pension fund assets. 

The full text of Donohue's April 24, 2010 speech is available at: