Congressional Hearing on H.R. 1495,
the Investment Company Act Amendments of 1995

Table of Contents

1. Investment Company Institute Views on State Regulation of Mutual Funds
2. Investment Company Institute Proposals to Improve Investment Company Regulation (July 19, 1995)

Oral Statement of Matthew P. Fink
President, Investment Company Institute

Before the Subcommittee on Telecommunications
and Finance U.S. House of Representatives
on "The Investment Company Act Amendments of 1995"
H.R. 1495

October 31, 1995

I am Matthew P. Fink, President of the Investment Company Institute, the national association of the mutual fund industry. I commend Chairman Fields and Congressman Markey for introducing legislation designed to modernize mutual fund regulation.

Since Congress last considered legislation in this area over 20 years ago, our industry has experienced steady growth. Technological advances are revolutionizing the way funds do business with their shareholders. Thus, it is appropriate to examine whether changes are needed to modernize mutual fund regulation.

The overriding objective of modernizing mutual fund regulation must be to serve the best interests of investors. To do so, legislation should promote four goals: facilitate communications with investors; promote cost-effective regulation; enhance corporate governance; and encourage innovation. Provisions in H.R. 1495 would help achieve all of these goals.

I would like to emphasize two points related to investor protection.

First experience teaches that unregulated investment pools can pose significant dangers to investors. The Orange County municipal investment fund, the New Era foundation, and the Askin hedge fund are some recent examples. The Investment Company Act has proven to be extremely successful in protecting investors in pooled funds. There should be a strong presumption against exemptions for various types of pooled funds, and any exemptions should be narrowly and carefully tailored.

Second, Congress should establish a sensible reallocation of responsibilities for mutual fund regulation between the SEC and the states.

The mutual fund industry has always supported strong federal regulation of our industry and a well-funded SEC. We do so because history shows this is essential to maintaining public confidence in mutual funds. We also believe there is an important role for state regulators. But we are convinced that the current system of dual federal-state mutual fund regulation does not help, but rather hurts fund investors.

Today, virtually every mutual fund sells its shares to investors in every state. And as befits a national industry, mutual funds are extensively regulated at the federal level by four separate securities laws, notably the Investment Company Act of 1940, which imposes detailed substantive requirements on the structure and operations of mutual funds. As indicated in the first map, every mutual fund-no matter where it does business or where its shareholders live-is subject to the same strict and uniform scheme of regulation by the SEC and NASD.

But in addition, mutual funds must comply with regulation in every state where they sell shares. Regulations differ significantly state to state. As you can see from this second map, the Institute has identified 18 different approaches currently taken by states. These differences make a bewildering patchwork quilt of inconsistent regulation. Eighteen states (including those shaded in blue) grant some form of exemption to most or all mutual funds. Many other states frequently comment on mutual fund prospectuses. Of these states, some (for example, the ones shaded in violet and red) also impose substantive limits on what a fund can invest in.

Still other states (for example those in green) require funds to register, but do not review their prospectuses.

Under this system, the idiosyncratic requirement of a single state often affects investors in 50 states. For example, because a fund's portfolio must be managed in the same way for all fund shareholders, a portfolio restriction imposed by one state dictates how the portfolio will be managed for investors in all states.

This "crazy-quilt" system of state regulation hurts investors. It undermines SEC initiatives to improve investor protection. It helps produce fund prospectuses that are lengthy, complex and difficult to comprehend. It hinders innovations permitted by federal law. It imposes undue compliance burdens. And it diverts state resources from enforcement and education.

Years have been devoted, unsuccessfully, in attempting to remedy this problem at the state level. Only Congress can provide a national solution to this national problem.

Specifically, the review of mutual fund prospectuses and advertisements should be lodged exclusively with the SEC and NASD, and investment limitations should be established exclusively at the federal level. The valuable role states play in enforcement and education should be preserved. Accordingly, the mutual fund industry does not object to paying state fees and making notice filings. This model of mutual fund regulation has already been adopted in a number of states, to the benefit of their citizens. By enacting legislation that adopts such a scheme nationwide, Congress can ensure that investors in all 50 states receive the full benefits of this rational approach to mutual fund regulation. SEC Chairman Levitt recently endorsed this solution, stating that it "makes a great deal of sense" and constitutes "a good beginning on which to build a broader agreement" regarding federal and state roles in securities regulation generally.

In closing, I again commend the Subcommittee for considering legislation that would modernize the Investment Company Act and the securities laws in general. Some issues before the Subcommittee may require more consideration and study than other, but none has been more carefully studied and documented already than the problems caused by the current system of dual federal-state regulation of mutual funds. The need for Congressional action to resolve these problems is widely recognized-as is the nature of the action Congress should take. I therefore respectfully ask the Subcommittee, as you consider all of the issues associated with modernizing the securities laws, to retain the option of addressing the problem of dual federal-state regulation of mutual funds in the context of H.R. 1495.

We will work with you to ensure success because resolution of this issue is our number one priority. The Subcommittee has provided a tremendous opportunity to enact legislation that will modernize the Investment Company Act both to make it more effective and to better protect investors.

We appreciate the opportunity to testify and would be pleased to respond to any questions. Thank you.

Statement of Matthew P. Fink
President, Investment Company Institute

Before the Subcommittee on Telecommunications
and Finance U.S. House of Representatives
on the "Investment Company Act Amendments of 1995"
H.R. 1495

October 31, 1995

Summary of Principal Points
The Investment Company Act of 1940 has been, and continues to be, a very effective governing statute for the mutual fund industry. Nevertheless, due to the industry's size and economic impact, and to new developments in the markets and changing investor needs, it is timely and appropriate to examine whether changes are needed to modernize mutual fund regulation. H.R. 1495 recognizes the importance of such an examination.

The primary objective of modernizing mutual fund regulation must be to serve the best interests of investors. Legislation seeking to modernize such regulation should (1) facilitate communications with investors, (2) promote cost-effective regulation, (3) enhance the highly effective system of corporate governance and (4) permit innovation in mutual fund products and services.

The "advertising prospectus" concept proposed in H.R. 1495 is an important step toward facilitating and improving communications with investors. SEC Chairman Levitt's "profile prospectus" initiative also represents a significant improvement and innovation in effective communication with investors; its use should be encouraged through legislation.

Legislative changes also should reduce undue costs and burdens on mutual funds while fully maintaining investor protection, and several provisions of H.R. 1495, if modified in certain respects, would do so. Other provisions of the bill could result in additional, unwarranted costs and burdens for mutual funds if adopted as proposed.

The corporate governance structure provided in the Investment Company Act has worked well and continues to protect and advance the interests of fund shareholders. Certain modifications, including the changes to various shareholder voting provisions proposed in H.R. 1495, could further enhance the effectiveness of the existing governance structure.

Mutual funds have been leaders in responding to changing investor needs by introducing new products and services. While most innovations can be accommodated under the existing regulatory framework, as contemplated by H.R. 1495, certain statutory amendments could further facilitate this process.

The Institute generally supports the proposed exemption in H.R. 1495 for "private investment companies,' because it provides appropriately high, statutory thresholds governing the eligibility of potential purchasers. A complete exemption of any pooled investment vehicle from Investment Company act regulation implicates important public policy concerns; thus, Congress should proceed cautiously with any such exemption.

The current overlapping system of federal and state mutual fund regulation presents a formidable obstacle to achieving the goals of modernizing such regulation. This inefficient system is harmful to investors. It thwarts efforts to improve communications with investors, impedes innovation by mutual funds and is the antithesis of cost-effective regulation in the interests of investors, Congress should enact legislation to redefine the roles of federal and state mutual fund regulators in a more rational and beneficial manner.

IV. Introduction
My name is Matthew P. Fink. I am President of the Investment Company Institute, the national association of the American investment company industry. The institute's membership includes 5,664 open-end investment companies (mutual funds), 449 closed-end investment companies and 11 sponsors of unit investment trusts. The Institute's mutual fund members have assets of over $2.5 trillion, accounting for approximately 95 percent of total industry assets, and have over 38 million individual shareholders. These shareholders reside in all 50 states and the District of Columbia.

Today, I will discuss the Institute's views on how to modernize mutual fund regulation so that it continues to provide effective investor protection while also responding to developments in the markets and changing investor needs. It has been over 20 years since Congress considered major mutual fund legislation. As the oversight hearings last Congress under Congressman Markey demonstrated, this is a testament to the continuing effectiveness of the Investment Company Act of 1940 as a governing statute. As is well known, during this time, the industry has experienced strong and steady growth. Today, nearly one in every three American households owns mutual funds. In addition, computer, telecommunications and other technological advances are forging a truly global marketplace and revolutionizing the way mutual funds do business with their shareholders. As the 21st century approaches, it is timely and appropriate for Congress to examine whether changes to the regulatory structure for mutual funds¹ are needed to meet the challenges ahead. The Institute commends Chairman Fields and Congressman Markey for their bipartisan initiative, as embodied in H.R. 1495, which aptly recognizes the importance of such an examination.

In my remarks today, I will briefly describe the growth of the mutual fund industry and its importance to our nation's economy. I will outline the institute's vision of the goals of modernizing mutual fund regulation. I will recommend that Congress take a very cautious approach to the exclusion of any securities pools from the investor protections of the Investment Company Act. Finally, and perhaps most importantly, I will urge that Congress establish, in the interest of investors, a more sensible allocation of responsibilities in mutual fund regulation between the SEC and the states.

V. The Growth and Role of Mutual Funds
A. The Growth of Mutual Funds
Since passage of the Investment Company Act in 1940, the mutual fund industry has grown from 68 funds with assets of $448 million to over 5,500 funds at the end of 1994 with assets of $2.2 trillion.² As indicated in the chart below, contrary to reports that mutual funds suddenly "boomed" in the 1990's, fund assets grew at an annual rate of 23 percent throughout the 1980s, while growth thus far in the 1990s has been at a 19 percent annual rate.

Source: Investment Company Institute

Many factors have contributed to the growth of the mutual fund industry over the years. These include the capital appreciation of portfolio securities owned by funds; additional purchases of fund shares by existing shareholders; new fund products and services designed to meet changing investor needs; the growth of the retirement plan market; increased investment in mutual funds by institutional investors; a broadening of the channels of distribution through which mutual funds are sold; and a shift by individuals and institutions from direct investment in securities to investment through mutual funds. Some of these factors are reflected in the chart below.

In our view, however, the most important factor contributing to the growth of the industry is the stringent regulation imposed upon mutual funds by the Investment Company Act. This regulation has led to unprecedented investor confidence in mutual funds and to an environment characterized by strong industry compliance systems, full disclosure to investors and swift SEC enforcement.

Source: Investment Company Institute

B. The Role of Mutual Funds in the Capital Markets
Mutual funds are major financial intermediaries-bridges linking American investors with securities issuers. As such, they contribute to the financial well-being of millions of mutual fund shareholders, and help to fuel our nation's overall economic growth. Mutual funds play an important and highly positive role in the U.S. securities markets.

Mutual funds are an important source of capital for U.S. business. They have been the largest institutional buyer of corporate equities over the past five years. In addition, the growing popularity of aggressive growth and growth funds has stimulated the issuance of many new equity offerings by making it easier and less costly for new companies to issue stock.

Further, the development and growth of tax-free money market and municipal bond funds have contributed significantly to the municipal securities market, helping to supply money to build schools, highways, bridges and other elements of the U.S. infrastructure. Over the past five years, mutual funds have made net purchases of nearly $170 billion in municipal securities, representing about three-fourths of net issuances of new municipal securities. Finally, mortgage-backed securities funds have expanded the market for securitized mortgage loans, thereby increasing the availability of residential mortgage financing for homeowners and lowering the cost of owning a home for millions of Americans.

VI. The Goals of Modernizing Mutual Fund Regulation
The growth of the mutual fund industry and its increasingly important role in our capital markets suggest that there is a strong national interest in making certain that the regulatory scheme remains as effective in the future as it has been in the past. While the existing federal regulatory framework is fundamentally sound, we believe that it should be modernized in certain respects in light of developments in the markets and changes in investors' needs. In considering what the goals of modernizing regulation of mutual funds should be, the Institute submits that the primary objective must be to serve the best interests of investors. To this end, legislation seeking to modernize mutual fund regulation should: (1) facilitate communications between mutual funds and investors; (2) promote cost-effective regulation of mutual funds; (3) further enhance the highly effective system of corporate governance of mutual funds; and (4) permit innovation in mutual fund products and services. Each of these is discussed briefly below.

A. Facilitating Communications with Investors
As H.R. 1495 recognizes, one of the most important ways in which mutual funds serve their investors is through various types and means of communications. These communications include the mutual fund prospectus, which, under the federal securities laws, is the key disclosure document that must be provided to all investors. They also include the reports that mutual funds are required to send to their shareholders on at least a semi-annual basis, as well as proxy materials on matters for shareholder voting. Finally, mutual funds also typically provide investors with a wide variety of other materials, including educational materials that cover such topics as saving for retirement or college education, the state of the securities markets and how mutual funds are operated and regulated. Funds often include information of this kind in newsletters, prospectus "wrappers," advertising and sales literature, as well as in their prospectuses and shareholder reports. Funds also are increasingly using the Internet, computer on-line services and other technologies as means of communicating with investors.

The quality of communications with investors is a matter of critical importance to the mutual fund industry-effective communication helps investors make informed investment decisions and ultimately helps maintain investor confidence. Well-informed investors understand the importance, and therefore reap the benefits, of investing for the long term. In this regard, there has been growing recognition on the part of both the industry and the SEC that, to be effective, such communications must be not only complete, but also clear and understandable.

The "advertising prospectus" concept propose in H.R. 1495 is an important step toward facilitating and improving communications with investors, and the Institute strongly supports it. SEC Chairman Levitt's "profile prospectus" initiative also represents a significant improvement and innovation in effective communication with investors. Its use, as well as other efforts to facilitate and enhance communications with mutual fund investors, should be encouraged through legislation.

B. Promoting Cost-Effective Regulation
To promote cost-effective regulation, legislative changes should reduce undue costs and burdens on mutual funds wherever this is possible without diminishing investor protection. In an era of more limited government resources, it is especially important to consider new, more effective means of accomplishing regulatory missions. Modern day regulators must be able to "think smart," taking into full account the relative costs and benefits of their regulations and strongly promoting industry self-compliance efforts. We are pleased that the stated purposes of H.R. 1495-"to promote more efficient management of mutual funds, protect investors, and provide more effective and less burdensome regulation"-are fully consistent with these premises.

In order to achieve these goals, however, changes need to be made to rules adopted by the SEC under the Investment Company Act, as well as to the governing statute. Many of these rules have not been amended in many years, despite significant changes in the industry and the marketplace. The Institute recently filed a comprehensive package of regulatory proposals with the SEC, which, if adopted, would significantly help to eliminate costs and burdens on mutual funds while fully maintaining investor protection.³ H.R. 1495 also contains important provisions that, if modified in certain respects, would reduce unnecessary costs and burdens on mutual funds while enhancing investor protection. These include, for example, the proposed elimination of certain outdated and unnecessary shareholder voting requirements (Sections 2(b) and (c) of the bill), the proposed revised definition of a majority vote (Section 2(g)) and the proposed "advertising prospectus" (Section 3). We are concerned, however, that other provisions of the bill, such as those concerning books, records and inspections (Section 4) and reports to the SEC and to shareholders (Section 5), could result in additional, unwarranted costs and burdens for mutual funds if adopted as proposed.

Like the Subcommittee, we are mindful that the current regulatory framework for our industry has proven notably successful and resilient, and changes should not be made at the expense of key investor protections. Thus, for example, Congress should proceed cautiously with any proposed exception of certain pooled securities vehicles from all provisions of the Investment Company Act, such as the "private investment company" proposed in H.R. 1495. I will address this topic in greater detail later in my testimony.

C. Enhancing the Corporate Governance System
One of the most important features of the Investment Company Act is a corporate governance structure that was well ahead of its time. The Act requires every mutual fund to have a board of directors or trustees, at least 40 percent of the members of which must be independent of the fund's adviser. In addition, the Act imposes a series of specific duties and obligations on fund directors, over and above their duties under state corporate law.⁴ The independent directors, in particular, are charged with policing the potential conflicts of interest that occur in the investment company structure. Thus, the directors serve a critically important role in overseeing fund operations and safeguarding the interests of fund shareholders.⁵ In addition, the Investment Company Act provides protections to investors in the form of shareholder voting rights.

The system of corporate governance provided in the Investment Company Act has worked well and continues to protect and advance the interests of fund shareholders. Nevertheless, we believe that certain modifications, including the changes to various shareholder voting provisions proposed in H.R. 1495, could further enhance the effectiveness of the existing governance structure. In particular, we strongly support: (1) the proposed revision of the definition of a majority vote in the Investment Company Act; (2) the proposal to require a shareholder vote in connection with a proposed change in a fund's fundamental investment objective; and (3) the proposals to eliminate certain outdated shareholder voting requirements that do not relate to investor protection concerns (i.e., there ratification of fund auditors and the initial approval of a fund's investment advisory contract.)

D. Permitting Innovation in Products and Services
Mutual funds have been leaders in responding to changing investor needs over the past several decades by introducing new products and services. For example, taxable money market funds were developed in 1972; long-term tax-exempt funds were first offered in 1976; tax-exempt money market funds were introduced in 1979; and during the 1980s, international funds, precious metal funds, Ginnie Mae and government income funds were developed. In addition, in recent years the industry has developed several new structures for mutual funds- including funds with multiple classes of shares and so-called master-feeder funds-that are designed to achieve economies in fund management and facilitate distribution. Among the many new services funds have introduced for their shareholders are toll-free (800) telephone numbers, 24-hour telephone access, consolidated account statements, shareholder newsletters, shareholder cost basis information, automatic withdrawals and reinvestment of fund dividends and investor information provided through the Internet and on-line computer services.

For the most part, such innovations can be accommodated under the present regulatory framework. The SEC has broad authority to adopt rules and to issue individual orders that permit the industry to respond in a timely manner to market changes and investor preferences. Nevertheless, as contemplated by H.R. 1495, certain amendments to the Investment Company Act could further facilitate this process.

The Institute strongly supports Section 9 of the bill (concerning "funds of funds") because it would give investors access to a broader array of investment products, while still maintaining important investor protections. We are encouraged by the SEC's recent grant of expanded exemptive relief to certain mutual fund firms currently operating "funds of funds." To make this increased flexibility available throughout the industry, without the need for funds to obtain exemptive orders, we urge that legislation along the lines of Section 9 of H.R. 1495 be adopted.

The Institute also supports the concept of a "unified fee investment company," as an optional new type of mutual fund. If properly structure, the "UFIC" could provide investors an attractive alternative investment vehicle, which would feature a prominently disclosed single fee that is readily understandable and easy to compare. Nevertheless, we believe that several changes to the provision in the current bill are needed if it is to achieve its intended purpose.

VII. Private Investment Companies
The Institute generally supports the proposed exemption for "private investment companies"" in Section 8 of H.R. 1495. This provision would exempt from regulation under the Investment Company Act an investment company that is owned exclusively by institutional investors and wealthy individuals meeting certain thresholds, on the theory that such persons can fend for themselves and do not necessarily need all of the protections provided under the Act.⁶ In concept, this provision is consistent with the goal of cost-effective regulation, because it contemplates that the SEC should direct its regulatory efforts and resources toward those investors who most need the protections of the securities laws.

Nevertheless, the proposed exemption implicates important public policy concerns. In the past, Congress has been reluctant-rightly, we believe-to exempt pooled investment vehicles from the Investment Company Act unless sufficient protections have been established. When it has provided exemptions, Congress has done so cautiously and deliberately, appreciating the perils to the public investor and the American capital markets that can arise when pooled vehicles are relieved from the protections of the Investment Company Act.⁷ The mass marketing and sale of unregulated pooled vehicles can pose significant dangers to the investing public and the American capital markets.⁸ The abuses that led to enactment of the Investment Company Act and the problems that have since arisen from the marketing of unregulated pools should discourage the adoption of any but a narrow and very carefully tailored exemption from the Act. Indeed, it should be noted that the losses incurred by investors recently in exempt pools have prompted governmental authorities to consider or require applying the principles of the Investment Company act to these vehicles.⁹

The proposed exemption from the Act-based upon the presumed financial sophistication or acumen of the investors-is unprecedented. Because the concept is so untested and the potential risks attendant to such an exemption are so significant, Congress itself-not the SEC-should prescribe the terms on which the exemption is available. This is the approach taken by Section 8 of H.R. 1495, and we believe it is the appropriate one. In addition, Congress should be wary of efforts to delegate to regulators the authority to weaken the standards under the exemption. In this regard, the Institute notes that a bill recently was introduce in this Subcommittee that would create a new exception to the Investment Company Act of 1940 for collective investment funds that are maintained by charitable organizations.¹⁰ We understand that that bill also correctly contemplates a narrowly-tailored exemption that does not give the SEC discretion to expand its scope.

In establishing the standards of a wholesale exemption from the Investment Company Act, Congress should seek to ensure that only those investors who truly are capable of fending for themselves will be eligible to purchase securities issued by these unregulated pools. As noted above, Section 8 of H.R. 1495 establishes $100 million and $10 million in securities holdings as the statutory thresholds for institutions and individuals, respectively. These thresholds, in our judgment , provide the necessary assurance that investors in such private investment companies have the requisite sophistication to be "qualified purchasers." We recommend that these standards be maintained.

In prescribing the terms on which the exemption is available, however, Congress also should seek to guard against situations where unsophisticated investors might be drawn inadvertently into an exempt pooled vehicle and subjected to the risk of loss that only qualified purchasers are in a position to bear. This might occur, for example, if financial institutions or fiduciaries were permitted to aggregate the individual accounts of small investors and thereby to satisfy the "qualified purchaser" threshold. In our view, this result would be completely inconsistent with the purposes of the exemption. We therefore would urge that Section 8 be amended to clarify that an offering to institutional investors who are "qualified purchasers" as a result of having aggregated the interests of non-qualified purchasers would not be permitted.

In addition, because unsophisticated or unqualified individuals could be inadvertently drawn into an exempt pooled vehicle if it were made available to the public through a public offering, Section 8 of H.R. 1495 should require that "private investment companies" be sold only in nonpublic offerings. In this way, Congress could better ensure that sponsors will control the offering and adequately determine that all potential investors qualify under the exemption.¹¹ Such a limitation further might clarify to the public and securities regulators the differences between these exempt pools and publicly-offered, fully regulated investment companies.

VIII. Rationalization of Federal-State Regulation of Mutual Funds
One particular aspect of the existing mutual fund regulatory scheme-the current dual system of federal and state regulation-stands out as a formidable obstacle to achieving many of the goals of modernizing mutual fund regulation. This duplicative, conflicting and inefficient system is harmful to investors, thwarts efforts to improve communications with investors, impedes innovation by mutual funds permitted by federal law and is the antithesis of cost-effective regulation. Progress in modernizing mutual fund regulation requires rationalizing this dual regulatory system. To this end, the Institute supports the adoption of legislation to redefine the roles of federal and state governments in the regulation of mutual funds. Such an initiative is important and long overdue.

A. Federal Regulation
The Institute has always supported strong federal regulation of mutual funds and a well-funded SEC. History has shown that effective regulation is essential to keeping public confidence in mutual funds. The current system of overlapping federal and state regulation, however, does not help, but rather hurts fund investors.

Today, virtually every mutual fund sells its shares to investors in every state. The extensive coverage of mutual funds by the national media, the use of new technologies to communicate with shareholders, the mobility of American investors, and the national distribution networks through which funds are offered are but some of the factors that make the mutual fund marketplace quintessentially national in character. As befits a national industry, mutual funds are extensively regulated at the federal level by four separate securities laws, notably the Investment Company Act, which imposes detailed substantive requirements on the structure and operations of mutual funds, as well as containing disclosure and reporting requirements.

Among the specific requirement to which mutual funds are subject under federal law are those governing what a fund may invest in and those relating to the contents of fund prospectuses and advertising. For example, the Investment Company Act imposes limitations on certain types of fund investments, such as illiquid securities, and investments that money market funds can make. SEC Form N-1A dictates the type of information that must be included in a fund's prospectus. Form N-1A also prescribes the order in which certain items must be presented and specifies which items must be set forth on the cover page of the prospectus. The instructions to the form emphasize the need to ensure that information in the prospectus "is set forth in a clear, concise and understandable manner."¹² Moreover, all mutual fund prospectuses are reviewed initially by the SEC staff, as are material amendments. Finally, mutual fund advertising is subject to detailed requirements under various SEC rules. Most mutual funds also are required to file there advertisements with the NASD, which reviews them for compliance both with SEC rules and with the NASD's Rules of Fair Practice.¹³

It is important to note that under federal law, every mutual fund-no matter where it does business or where its shareholders live-is subject to the same strict and uniform scheme of regulation by the SEC and NASD. This uniform system of regulation is graphically illustrated in Appendix 1 to my testimony.

B. State Regulation
Despite this comprehensive scheme of uniform federal regulation, under the current system, a mutual fund also must comply with regulation in every state where it sells shares. These regulations differ significantly from state to state, year to year, and even fund to fund. The Institute has identified 18 different approaches currently taken by states to mutual fund regulation. These differences make a bewildering patchwork quilt of inconsistent regulation. Eighteen states, for example, grant some form of exemption to most or all mutual funds. Many of the other states frequently comment on mutual fund prospectuses. Of those states, some also impose substantive limits on the investments a fund can make. Still other states require funds to register, but do not review their prospectus. A graphic illustration of this "crazy quilt" of state mutual fund regulation also is include in Appendix 1 to my testimony.

Under this system, the idiosyncratic requirement of a single state often affects investors in all 50 states. For example, because a fund's portfolio must be managed the same way for all fund shareholders, a portfolio restriction imposed by one state dictates how the fund's portfolio will be managed for investors in all states. Similarly, because mutual funds use a single prospectus nationwide, a single state's unique disclosure requirement can affect the disclosure received by all investors.

C. Resulting Harm to Investors
The "crazy-quilt" system of state mutual fund regulation hurts investors. First, it needlessly duplicates, and often undermines, the SEC's national initiatives to improve investor protection. Perhaps the best example of this problem is in the area of communications with investors. While the mutual fund industry and the SEC have recognized the importance of ensuring that prospectuses and other written communications are clear, concise and accessible, efforts in this regard are frustrated by a system that allows individual state regulators to demand adherence to their own unique disclosure requirements. The result is often a prospectus that is unduly long, complex and difficult to comprehend.

Second, the current system hinders innovations in products and services that are permitted by federal law and beneficial to investors. In this regard, I am concerned that many of the provisions of H.R. 1495 that are intended to facilitate product innovations, such as those proving more flexibility with respect to the creation of "funds of funds," will come to naught as a result of the objections of even a single state regulator. There also is great concern within the industry that one or more states will impede the growth of electronic communications as a means of disseminating information to shareholders, notwithstanding the fact that the SEC has just issued a release endorsing this trend and setting forth national standards in this area.¹⁴

Third, the system imposes undue compliance burdens on funds. Many fund groups must employ special staffs dedicated to complying with the myriad varieties of state regulation. This is in addition to the demands on other legal and compliance personnel within fund organizations, who invariably must devote a portion of their time to state regulatory matters, as well as the need to retain outside counsel in many cases.

Finally, the existing system diverts state resources away from enforcement and education, areas where state involvement clearly benefits investors. Reviewing fund prospectus and advertising, and otherwise duplicating actions undertaken at the federal level, is an inefficient use of these limited resources.

D. Recommendations for Change
The mutual fund industry has devoted years to attempting to remedy this problem at the state level. We have worked with the states, both individually and collectively through North American Securities Administrators Association ("NASAA"). Unfortunately, these efforts have been unavailing.

Thus, we have concluded that this national problem requires a national solution-which only Congress can provide. We are aware that NASAA recently has announced a Task Force on federal-state securities regulation. The Task Force has a distinguished membership. The Institute looks forward to working with it and welcomes its efforts to address, on a wide-ranging basis, the problems posed by the current dual system of regulation. I must emphasize, however, that at least in the case of mutual funds, much study already has been done-including by NASAA. The problems with state regulation of mutual funds, and the harmful consequences for investors, are well documented-and the solution is clear. Not more study and delay, but prompt Congressional action, is required.

Specifically, the Institute urges that the review of mutual fund prospectuses and advertisements be lodged exclusively with the SEC and NASD, and the investment limitations be established exclusively at the federal level. The valuable role states play in other aspects of securities regulation, such as enforcement and education, should be preserved. Accordingly, the mutual fund industry does not object to paying state fees and making notice filings. We note that SEC Chairman Levitt recently endorsed this very solution, stating that it "makes a great deal of sense" and constitutes "a good beginning on which to build a broader agreement" regarding federal and state roles in securities regulation.¹⁵

The Institute submits that this approach to mutual fund regulation would promote many of the goals of modernizing the mutual fund regulation, thereby benefiting investors throughout the nation. It would facilitate mutual fund communications with investors, encourage innovation in mutual fund products and services and allocate in a sensible and cost-effective manner the limited resources of federal and state governments. Indeed, this model of mutual fund regulation already has been adopted in a number of states, to the benefit of their citizens. By enacting legislation that adopts such a regulatory scheme nationwide, Congress can ensure that investors in all 50 states receive the full benefits of this rational approach to mutual fund regulation.

In closing, we commend the Subcommittee for considering legislation that would modernize the Investment Company Act and the securities laws in general. One can expect that some issues before the Subcommittee may require more consideration and study than others, but none has been more carefully studied and documented already than the problems caused by the dual federal-state regulation of mutual funds. The need for Congressional action to resolve these problems is widely recognized-as is the nature of the action Congress must take. We therefore respectfully ask the Subcommittee, as you consider all of the issues associated with modernizing the securities laws, to retain the option of addressing the problem of dual federal-state regulation of mutual funds in context of H.R. 1495.

We will work with you to ensure success because resolution of this issue is our number one priority. The Subcommittee has provided a tremendous opportunity to enact legislation that will modernize the Investment Company Act both to make it more effective and to better protect investors.

¹An estimated 30.2 million U.S. households owned mutual funds in 1994. This estimate comprised households that owned money market, stock, and bond and income mutual funds, including those invested in 401(k), IRA and Keogh accounts. Mutual Fund Fact Book, Investment Company Institute (1995), p.80.

²Mutual Fund Fact Book, Investment Company Institute (1995), pp. 24-31.

³The Institute's recommendations would codify various SEC staff interpretive positions, clarify certain regulatory issues, eliminate regulatory burdens imposed on activities that do not raise the concerns the Investment Company Act is intended to address, and modernize certain requirements to reflect current market conditions and contemporary industry practices. A copy of the Institute's submission is attached as Appendix 2 to this testimony.

⁴The specific responsibilities of the directors include, among others, considering fund contractual arrangements with the fund's investment adviser and other outside service providers, valuing securities for which market prices are not readily available, establishing policies for evaluating the liquidity of portfolio instruments, selecting fund auditors, overseeing fund compliance with applicable regulatory requirements, and adopting procedures to govern transactions with affiliated parties.

⁵In recognition of the increasingly complex and challenging responsibilities placed on mutual fund directors, the Institute offers a variety of educational programs and services for the director community. In addition to an annual conference as well as special workshops for fund directors, the Institute has developed an Introductory Guide for Investment Company Directors, and regularly publishes a newsletter for fund directors, Board Bulletin.

⁶Specifically, Section 8 would provide an exemption for "private investment companies," the outstanding securities of which are owned solely by "qualified purchasers." A "qualified purchaser" is defined generally to mean (1) a natural person who owns at least $10 million in securities, or (2) any other person, acting for its own account or the account of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis at least $100 million in securities.

⁷For Example, Congress' willingness to exempt bank common trust funds under Section 3(c)(3) of the Investment Company Act was largely due to the fact that, since 1937, federal banking regulators have authorized banks to operate common trust funds solely as aids to the administration of bona fide trust accounts already managed by the bank. Because the funds are intended to be administrative devices rather than vehicles for general investment by the public, bank regulators have prohibited banks from advertising their common trust funds and from charging a fee to the common trust fund in addition to fees already assessed against the beneficiaries.

⁸As the recent Askin hedge fund collapse, New Era scandal and Orange County municipal investment pool bankruptcy demonstrate, many so-called "sophisticated investors" are quite susceptible to dangers resulting from investing in unregulated pooled vehicles. See In the Matter of Asking Capital Management, L.P. and David J. Askin, Investment Advisers Release No. 1492 (May 23, 1995); Lewis, "Separating Rich People from Their Money," N.Y. Times Magazine (June 18, 1995); "Orange County, Mired In Investment Mess, Files for Bankruptcy," Wall St. J. (Dec. 7, 1995).

⁹For example, the California Treasurer reportedly expressed strong support for requiring that local governmental pools mark their portfolio securities to market, reasoning, "By marking to market, I think those in the Orange County pool would have known much sooner...that they were in deep trouble." California Treasurer Urges Regular Pool Fund Reporting to Flag Portfolio Risk, The Bond Buyer (Jan. 17, 1995) (comments of Matt Fong, Treasurer). Mutual funds, of course, are generally required to mark their portfolios to market on a daily basis.

¹⁰The "Philanthropy protection Act of 1995" (H.R. 2519).

¹¹We note that today, hedge funds successfully issue their interests in private offerings exempt under Section 3(c)(1) of the Investment Company Act.

¹²SEC Form N-1A, Instruction G.

¹³Funds that are not affiliated with an NASD member file their advertisements with the SEC.

¹⁴Investment Company Act Release No. 21399 (Oct. 6, 1995).

¹⁵"The SEC and the States: Toward a More Perfect Union," Remarks by Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, at the Annual Conference of the North American Securities Administrators Association, Vancouver, British Columbia (October 23, 1995), at p.5.