Institute Testifies on State-Federal Regulation of Mutual Funds

Table of Contents

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

Before the Subcommittee on Telecommunications
and Finance Subcommittee
U.S. House of Representatives on the
"Capital Markets Deregulation
and Liberalization Act of 1995"
H.R. 2131

December 5, 1995

I am Matthew P. Fink, President of the Investment Company Institute, the National association of the mutual fund industry.

I am pleased to testify on provisions in H.R. 2131 that would redefine the roles of federal and state governments in the regulation of mutual funds. This is an extremely important and timely initiative. It offers the opportunity to revise the current system of federal and state mutual fund regulation in the interest of all fund shareholders.

The Institute has always supported strong federal regulation of our industry and a well-funded SEC. We do so because history shows this is essential to keeping public confidence in mutual funds. We also believe there is an important role for state regulators. But we are convinced that a new and different division of labor between federal and state regulators will serve fund investors far better than the current system does.

Today, virtually every mutual fund sells its shares to investors in every state. The mobility of American investors, the widespread application of new technologies to communicate with shareholders, the extensive coverage of mutual funds by the media, and the use of nationwide distribution networks-these and other factors 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-most notably the Investment Company Act of 1940, which imposes detailed substantive requirements on the structure and operations of mutual funds.

We have devoted years to attempting to remedy this problem at the state level. We have worked with the states, both individually and collectively through NASAA, the association of state securities administrators. But these efforts have been unavailing.

Thus, while we commended NASAA for establishing a task force to review the general issue of federal and state securities regulation, there is no need to delay Congressional action regarding mutual funds pending outcome of the NASAA study. As my written testimony indicates, regulation of mutual funds at the federal and state level is a matter that already has been the subject of exhaustive study. The facts are out on the table, a consensus has emerged, and the solution is clear.

Specifically, the review of mutual fund prospectuses and advertisements should be lodged exclusively with the SEC and NASD. Investment limitations and other substantive requirements should 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.

SEC Chairman Levitt has proposed this very solution. In testimony before this Subcommittee last week, he stated that state-federal regulation of mutual funds could be restructured in this manner "without comprising investor protection."

Supplement to the
Statement of Matthew P. Fink
President, Investment Company Institute

Before the House Telecommunications and
Finance Subcommittee U.S. House of Representatives
on "The Capital Markets Deregulation
and Liberalization Act of 1995"
H.R. 2131

December 5, 1995

I am Matthew P. Fink, President of the Investment Company Institute, the national association of the mutual fund industry. I am pleased to testify in support of legislation that would establish a new partnership between federal and state governments in the regulation of mutual funds. This is an extremely important initiative. It offers the opportunity to revise a system that has resulted in regulatory conflict, duplication, inefficiency, and, most importantly, confusion and disservice to investors. The mutual fund industry has always supported strong regulation of our industry and well-funded federal and state regulators. It is against such a background that we believe mutual fund investors need a regulatory regime based on a reallocation of federal and state responsibilities-one that first, reflects the fact that shareholders buy mutual funds in a national marketplace; second, maximizes the respective strengths of the SEC and the sates while eliminating unnecessary duplication, inconsistency, and inefficiencies; and third, enhances investor protection.

As is befitting for a national industry, mutual funds are extensively regulated at the federal level under four separate securities acts, the most important of which is the Investment company Act of 1940 (the "1940 Act"), which imposes detailed substantive requirements on the structure and operations of mutual funds. Through these four securities acts and the implementing regulations adopted by the Securities and Exchange Commission ("SEC") and the National Association of Securities Dealers, Inc. ("NASD"), mutual funds are subject to a national system of regulation that is applied uniformly to all mutual fund companies, regardless of where they have their primary place of business. Notwithstanding this federal regulation, mutual funds must also comply with the regulations of every state in which they offer their shares. Because mutual funds are typically sold on a nationwide basis, this results in mutual funds having to comply with the securities laws of 50 different states.

Fortunately for the fund industry and fund shareholders, however, the majority of states have recognized the effectiveness of federal law and the benefits of a uniform system of regulation. As a result, most states either exempt or exclude mutual funds from registration or review, or review fund registrations in a manner that is consistent with federal law.¹

Unfortunately, however, an important and sizable group of sates cling to unique state law provisions governing mutual fund investments, prospectus disclosure, operations, and/or advertising. Many of these state regulatory requirements are inconsistent with regulations administered by the SEC. The impact of these requirements is not limited to the particular state's investors but affects all the fund's shareholders nationwide. There is no evidence to suggest that such state requirements provide any additional investor protection. But there is strong evidence that these state requirements actually disserve investors.

Clearly, it is time to revise and renew the federal and state partnership in the regulation of mutual funds. Idiosyncratic state disclosure requirements result in fund prospectuses that are overly lengthy, complex and difficult to comprehend. Unique state restrictions on what a mutual fund can invest in inhibit innovation. The diversion of very limited state regulatory resources to review matters that have already been reviewed at the federal level detracts from needed state enforcement and education efforts.

The North American Securities Administrators Association ("NASAA") over the years has recognized the problems inherent in the current system. For example, NASAA has attempted to remedy the lack of uniform state regulation by adopting various resolutions that recommend uniform regulation of mutual funds in particular areas. These remedies, however, have been unsuccessful because the resolutions adopted by NASAA are themselves inconsistent with SEC regulations and are not uniformly adopted or applied by individual states. NASAA's resolutions will not remedy the problems in the current system so long as each state reserves the right to determine how to regulate mutual fund prospectus disclosure, advertising, investments, and operations.

More recently, NASAA created a "Task Force on the Future of Shared State and Federal Securities Regulation" to define " the future of how the U.S. federal and state governments divide up regulation of the securities marketplace." The Task Force's report and recommendations are expected in the spring of 1996. While the Institute supports the work of the Task Force, we strongly encourage the Subcommittee to move forward to redefine the roles of federal and state governments in those areas where there now exists a consensus on the proper reallocation of regulatory responsibilities-namely, in the mutual fund and investment adviser contexts.

With respect to mutual funds, this allocation would be as follows: the review of fund prospectuses and advertisements would be lodged exclusively with the SEC and the NASD, and limitations on what mutual funds can invest in and other substantive requirements would established exclusively at the federal level. States would retain the authority to receive notice filings and fees from mutual funds, and likewise the authority to investigate and prosecute fraud and sales practices abuses, as well as to provide investor education. Such a reallocation of federal and state regulatory efforts would benefit investors throughout the nation by establishing uniform standards, improving disclosure, encouraging innovation, and providing for a rational allocation of limited federal and state resources. Additionally, it would give proper recognition to the important role that states play in policing sales practices and in educating investors. And it would ensure that states continue to receive the revenues necessary to support such activities.²

This approach to regulation was most recently endorsed by SEC Chairman Arthur Levitt in testifying before this Subcommittee. While noting that "the current system of dual federal-state regulation is not the system that Congress-or the Commission-would design today if creating a new system" and that "state oversight of investment companies can be reduced without compromising investor protection," Chairman Levitt proposed an approach "under which a state could not prohibit any company registered under the Investment Company Act from selling securities in the state if the company satisfied certain requirements of federal law."³

We support legislation that would achieve this result. Such legislation would not diminish investor protection but rather would serve the interests of investors. This very model of regulation has been adopted in many states, without risk to their investors. By enacting legislation that adopts such a regulatory scheme nationwide, Congress can ensure that all investors in all 50 states receive the full benefits of this rational approach to mutual fund regulation.

Accordingly, we strongly urge that Congress proceed forthwith to implement a new system of federal and state mutual fund regulation in the interest of all mutual fund investors.

Statement of Matthew P. Fink
President, Investment Company Institute

Before the House Telecommunications and
Finance Subcommittee U.S. House of Representatives
on the "Capital Markets Deregulation
and Liberalization Act of 1995"
H.R. 2131

October 1995

Summary of Principal Points
No segment of the securities industry is more strictly regulated at the federal level than mutual funds. Mutual funds uniformly are subject to the four principal federal securities acts, notably the Investment Company Act of 1940, which imposes a series of detailed substantive requirements and restrictions on the structure and operations of mutual funds.

In addition to this comprehensive regime of federal regulation, mutual funds also must comply with regulations in every state where they sell shares. Such regulations vary substantially from state to state, from year to year, and even from fund to fund-the result, a "crazy-quilt" of duplicative, conflicting and inconsistent requirements.

The mutual fund industry is national in character. Unfortunately, however, the inconsistent actions of a single state can thwart the SEC's uniform national policies to protect investors.

For example, although the SEC extensively regulates how and in what a fund can invest, several states impose their own unique restrictions on what a fund can invest in. Because a mutual fund's portfolio must be managed in the same way for all of its investors, the portfolio restrictions imposed by a single state will dictate how the portfolio will be managed for investors in all states.

Similarly, although the SEC strictly regulates the contents of mutual fund prospectuses, at least a dozen states actively comment on fund prospectuses, often in a manner inconsistent with SEC requirements. This adversely impacts disclosure to investors in all 50 states.

This dual system of federal-state regulation of mutual funds hurts fund investors. It frustrates national policies designed for their benefit, such as prospectus simplification. It hinders innovations in products and services permitted by federal law and beneficial to fund shareholders. It imposes needless compliance burdens on funds. And, it diverts resources away from areas where state action is genuinely needed to protect investors.

The introduction of H.R. 2131 provides an excellent opportunity to remedy the worst aspects of the current dual system of federal-state regulation of mutual funds, while preserving the best features. Since individual and collective state action has not proven successful in establishing the uniformity necessary to serve the interests of fund investors, Congressional action is need.

Specifically, we recommend that regulation of mutual fund prospectuses and advertising, and of the structure and operations of mutual funds, be the exclusive province of the federal government. Congress should reserve to the states the right to receive notice filings and to collect fees, as well as jurisdiction over fraud and sales practice abuses.

One step that it is not needed is further study of this issue by a commission. The problems inherent in the current system of regulation of mutual funds at the state level are well known. A study would merely serve to delay action that is long overdue.

V. 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.

I am pleased to testify on the provisions in H.R. 2131 that would redefine the roles of federal and state governments in the regulation of mutual funds. The mutual fund industry has always supported strong federal regulation of our industry and a well-funded United States Securities and Exchange Commission. We continue to do so because history demonstrates that strong regulation is essential in maintaining public confidence in the mutual fund industry. We also believe there is an important role for state governments in regulating aspects of the securities market. But we are convinced that the current system of dual federal-state regulation of mutual funds is harmful to our investors, and hence to our industry.

My testimony today will describe the current regime of mutual fund regulation by state governments-a system of disparate, inconsistent and often conflicting requirements that harms investors. The minority of states that currently impose such requirements presumably do so in the honest-but mistaken-judgment that their actions are necessary to protect investors. Likewise, it should be noted that the regulatory approaches of some states do respond to the need for national consistency and uniformity by relying upon the SEC in matters of mutual fund disclosure and portfolio management. Unfortunately, the objectives of these states and the SEC are frustrated by idiosyncratic actions by other states-all it takes is one state to thwart uniform policies for investor protection. I will provide specific example illustrating this problem, including: (1) substantive limitations by states on what a fund may invest in, which are inconsistent with federal requirements, and (2) requirements by states that fund prospectus disclosure already cleared by the SEC staff be rewritten, supplemented, or rearranged.

My testimony will demonstrate how the current system disserves investors by frustrating national policies designed to benefit investors (such as prospectus simplification), hindering innovations in products and services permitted under federal law, imposing needless burdens on funds and diverting resources away from areas where state action genuinely is needed to protect investors. Despite strenuous efforts by the fund industry, the SEC, and some state officials, neither the states individually nor collectively through the North American Securities Administrators Association ("NASAA") have achieved the degree of uniformity necessary to ensure efficient and effective protection of investors. As a result, a Congressional solution is needed to eliminate the bad features of the current system of dual federal-state regulation while enhancing the desirable ones.

Specifically, such a solution should delegate the regulation of mutual fund prospectuses and advertising, and the structure and operation of mutual funds (including what a fund may invest in) exclusively to the federal government. Congress should expressly reserve for states the right to receive notice filings and to collect fees, as well as jurisdiction over fraud and sales practice abuses. This division responsibility is already reflected in the approaches taken by a substantial number of states.

Some suggest that Congressional action should be delayed pending a study. The problems inherent in the dual federal-state regulatory system over mutual funds, however, are well known and indeed have been studied ad nauseam. The solution is apparent, sorely needed and long overdue.

VI. The Current System of Mutual Fund Regulation
A. Federal Regulation
No segment of the securities industry is more strictly regulated at the federal level than mutual funds. Mutual funds are subject to four federal securities acts-the Securities act of 1933, which requires the registration of fund shares, requires prospectus disclosure and strictly regulates the contents of advertising; the Securities Exchange Act of 1934 and the regulations of the National Association of Securities Dealers, Inc., which regulate distributors of mutual funds as broker-dealers; the Investment Advisers Act of 1940, which provides for the registration and regulation of investment advisers to mutual funds; and the Investment Company Act of 1940.⁴

Unlike the other federal securities laws, which are designed to protect investors primarily through disclosure, the Investment Company Act imposes a series of detailed, substantive requirements and restrictions on the structure and day-to-day operations of mutual funds. The core objectives of the Act are to: (1) ensure that investors receive adequate, accurate information about the mutual fund; (2) protect the physical integrity of the fund's assets; (3) prohibit or regulate forms of self-dealing; (4) restrict unfair and unsound capital structures; and (5) ensure the fair valuation of investor purchases and redemptions.

This extensive scheme of SEC regulation at the federal level imposes a strict discipline on mutual funds to which other pooled investment vehicles generally are not subject and provides an important source of investor confidence in the integrity of the mutual fund industry. Moreover, it should be noted that these SEC-mandated investor protections apply to all fund shareholders and all mutual funds, regardless of the state in which they are incorporated or organized, where they or their advisers are located, or where fund shareholders reside.

B. State Regulation
On top of this extensive system of federal regulation, mutual funds also must comply with regulation by all states in which they are sold. In contrast to federal regulation, the manner in which the individual states regulate funds varies tremendously state by state.

The Institute has identified eighteen variants on mutual fund regulation at the state level-and the result is a crazy-quilt of inconsistent regulation. For example:

I would draw your particular attention to the attached map that illustrates in graphic detail the different standards applied by the states. Moreover, the pattern of regulation at the state level varies not only state-by-state, but also year by-year and, not infrequently, fund-by-fund. A state that has previously commented on fund prospectuses may elect to defer to the SEC's review of these documents. At the same time, another state that had not previously conducted its own review may suddenly elect to issue comments. These shifts rarely are preceded by changes in states' rules and often simply reflect the approaches taken by different state personnel. Moreover, two different mutual funds, even within the same fund complex, can be treated very differently by the same state at the very same time.

The mutual fund industry today is quintessentially national in character. Virtually all funs, in order to serve their investors, offer their shares on a nationwide basis. The reasons for this include, among other things, the increasing utilization of nationally available telecommunications and computer networks to communicate with investors; extensive coverage of mutual funds by the national media, which generates inquiries from investors in every state; and the increasingly mobile nature of American investors who may move their place of work and residence from one state to another many times during their lives.

Supreme Court Justice Louis Brandeis, in discussing the proper balance of powers and limitations between state and federal regulation, stated:

It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory, and try novel social and economic experiments without risk to the rest of the country.⁵

Applying the Brandeis test, the experiment of permitting states to regulate mutual fund portfolios, prospectus disclosure and advertising alongside the federal government clearly has failed. Despite manifest problems and costs to investors, states exercise their regulatory authority in a manner inconsistent both with federal law and with each other. Moreover, it is virtually impossible to confine the impact of a state's activities to its citizens. Portfolio limitations imposed on a fund by a single state affect all the fund's shareholders nationwide. Similarly, one state's unique prospectus disclosure requirements often affect the disclosure received by all shareholders everywhere. Continuing the "experiment" is, in Justice Brandeis' terms, fraught with "risk to the rest of the country."

In the section that follows, we provide detailed examples of how certain states regulate mutual funds in two areas-first, the unique limitations they place on what mutual funds may invest in; and second, the disclosure requirements they impose on fund prospectuses and other shareholder communications. These examples are based on reports by Institute members across the country of the real-life consequences of the dual regulatory system as it exists today. I should emphasize that these examples-troubling though they are- are not an indication of any ill-will. In may own experience, individual state regulators genuinely intend to serve the interests of the investing public. The result, however, of their activities within the current dual federal-state system in which they operate is often harmful to investors and antithetical to this purpose.

VII. State Regulation of Mutual Portfolios and Disclosure Document
A. Portfolio Limitations
As noted earlier, the Investment Company Act, together with the rules and regulations promulgated by the SEC under the Act, imposes detailed substantive standards on the operations of mutual funds. Many of these standards are specifically directed to what a fund may invest in. For example, the SEC limits a fund's investments in illiquid securities. Certain types of investment techniques-such as engaging in short sales and writing options-are subject to various restrictions. The manner in which a fund's investments are valued is strictly regulated by the SEC. Money market funds are subject to extensive limitations on their portfolios pursuant to Rule 2a-7. In addition, fund investments in certain instruments are limited by the rules of Commodity Futures Trading Commission.

Even in the face of the SEC's national standards, widely-recognized for their effectiveness, states can and do impose unique restrictions on the management of a fund's portfolio-the essential service our industry provides to shareholders. Funds are offered on a nationwide basis and portfolios must be managed identically for all of a fund's investors, without regard to the state where they live. Thus, the portfolio restrictions imposed by one state will dictate how the portfolio will be managed for investors in all states. Accordingly, so long as even one state insists upon imposing a condition that will restrict the ability of a portfolio manager to invest his or her fund in a manner consistent with federal law, investors in all states will be adversely affected.

At least eight states have express provisions that impose on funds certain substantive portfolio limitations that are inconsistent with federal law.⁶ Although each of these states has been urged repeatedly by mutual funds and NASAA to conform their provisions to federal law, to date, only one-Wisconsin-has taken affirmative steps to eliminate this inconsistency.⁷

Some of these limitations restrict a fund's ability to invest in various assets, including commodities, restricted securities, oil, gas or mineral programs, options and warrants, interests in real estate, and other securities. For instance, Arkansas, California, South Dakota and Texas each limit a fund's investments in options and warrants-though no two of these states do so in the same way. In Texas, a fund may not invest more than 5% of its assets in warrants, and no more than 2% of this 5% may be invested in warrants not listed on the New York or American Stock Exchanges. In California, funds may only invest in options that are issued by the Options Clearing Corporation, which means that a fund may not invest in over-the-counter options or in options listed on foreign exchanges. In Arkansas, a fund may invest up to 5% of its assets in options without further restriction. In South Dakota, a mutual fund may not invest more than 5% in options, other than hedging positions or positions that are covered by cash or securities.⁸

Complying with these various state provisions is not easy or inexpensive. It often requires utilizing complex specialized computer tests to ensure that each investment made by the fund conforms to all applicable unique state limits. More importantly, a state's adherence to its unique limitations can frustrate national initiatives of the SEC. For example, in 1992, the SEC issued a policy statement providing that not all restricted securities held by a fund would be treated as per se illiquid.⁹ In the three years since the SEC issued this change in policy, every state but one has followed suit. The one exception is Ohio, which has remained wedded to an approach first adopted in 1971. As a result, funds that want to be sold in Ohio (which has the sixth largest concentration of mutual fund shareholders after New York, Florida, California, Texas and Pennsylvania) must either conform to Ohio's unique restriction, thereby in effect overriding the SEC's policy, or add a sticker to their prospectus directed "To Ohio Residents" and informing them of Ohio's unique limitation. While the sticker is explicitly directed to Ohio residents, using a sticker for residents of one state is costly and administratively difficult for funds sold nationwide.

B. Disclosure Requirements
Under federal securities laws, the key disclosure document, which must be provided to all fund investors, is the prospectus. Pursuant to its regulatory authority, the SEC dictates, in Form N-1A, the type of information that must be included in a fund's prospectus. For example, Form N-1A requires that the prospectus include all important information about a fund-including its investment objectives and policies, expenses, financial information, management, and how to purchase and redeem shares. It also specifies the order of presentation of certain information and requires certain matters to be included on the cover page. Form N-1A recognizes the importance of presenting this information in a manner that is useful to investors:

Because investors who rely on the prospectus may not be sophisticated in legal or financial matters, care should be taken that the information in the prospectus is set forth in a clear, concise, and understandable manner. Extensive use of technical or legal terminology or complex language and the inclusion of excessive detail may make the prospectus difficult for many investors to understand and may, therefore, detract from its usefulness.¹⁰

Yet, in spite of these extensive federal standards, approximately a dozen states routinely impose on fund prospectuses their own unique disclosure requirements that differ markedly from those under Form N-1A.¹¹ As a result, prospectus information must be rewritten, supplemented with additional information that an individual state deems important, rearranged, or relabeled irrespective of the fact that the disclosure has been thoroughly reviewed by the SEC staff. Moreover, the effect of these requirements often is to frustrate the SEC's direction that information included in the prospectus be presented "in a clear, concise, and understandable manner."

Mutual fund advertising also is subject to detailed regulation under various SEC rules. In addition, most funds are required to file their advertising with the NASD, which reviews them for compliance with federal law, as well as with its own Rules of Fair Practice. (Funds that are not affiliated with members of the NASD do not file their advertising with the NASD but with the SEC.) In recognition of this extensive layer of federal regulation, most states do not require funds to file their advertising at the state level. However, six states-California, Indiana, Massachusetts, Texas, Vermont and West Virginia¹²-require funds to file their advertising and one of those states, Vermont-actively reviews mutual fund advertising.

1. Requiring that Prospectus Disclosure Be Rearranged
Form N-1A requires that mutual funds organize the information in their prospectuses in a way that makes it easy for investors to understand important information about the fund. For example, the SEC requires that the cover page be immediately followed by the fee table, which must then be followed by condensed financial information. Notwithstanding the SEC's requirements to ensure the prominence of certain information, it is common for state examiners to insist that particular information in the prospectus be reordered or moved to the "front" (and often times to the cover page) of the prospectus. Placing too much information on the cover page, however, can confuse investors or give undue prominence to relatively less significant information.

Reported examples of states arbitrarily "rearranging" prospectus disclosure to suit their own preferences, after the SEC staff has cleared the prospectus, include the following:

One state required a fund to move the "Investment Practices," "Investment Restrictions" and "Risk Factors" sections of the prospectus to the front of the prospectus.

A second state required that a section discussing the funds' investment policies be set forth prior to a section on management of the fund.¹³

A third state required that a fund move disclosure regarding the speculative nature of some securities from page 17 of the prospectus to page 8.

A fourth state required that discussion of a fund's investments in repurchase agreements and foreign securities be written to appear within a section labeled "How the Fund Invests" rather in the section "Restrictions on the Fund's Investments."

Some state comments concern the allocation of disclosure between a fund's prospectus and its statement of additional information (or "SAI"), which is a document that contains more detailed information and that is available to investors upon request. The SEC developed the SAI in 1983 in order to ensure that information that would not be relevant to most retail investors did not needlessly encumber the prospectuses they received.¹⁴ Neverthelesss, it is not uncommon for states to require funds to move information from the SAI to the prospectus. For some period, one state even required all funds to deliver the SAI to all investors in the state in direct contravention of SEC requirements.

2. Requiring that Prospectus Disclosure be Rewritten or Relabeled
Although the format and information that must be included in a fund's prospectus is expressly provided by Form N-1A, states often require that prospectus information be rewritten or relabeled. For example, one state recently required a fund to amend its fee table to add parenthetical information that was already included elsewhere in the table as well as in footnotes to the table. Other reported examples of state comments requiring that fund disclosure be rewritten or relabeled include the following:

One state requires funds that invest in debt securities rated BBB by Standard & Poor's to rewrite their prospectuses to label such securities "speculative," notwithstanding that BBB rated securities are considered to be investment grade.

Another state has asked a fund to replace or modify "phrases describing `reasonable' and `excessive' risk with words that are easily definable and understood by the investor."

3. Requiring Additional Prospectus Disclosure
States often require that more disclosure be added to a mutual fund's prospectus or SAI. For instance, a fund that intended to invest in real estate investment trusts ("REITs") was told by a state that if these REITs included any long term health care properties, such as nursing homes, retirement homes and assisted living homes, the prospectus must include disclosure that such investments may be impacted by any new federal regulations concerning health care. Also, in February of this year, a state required a fund that was investing half of its portfolio in zero coupon bonds and half inactively managed securities to add boldfaced disclosure to its prospectus cover page informing investors that they could achieve the same investment results by dividing their investment dollars in half and putting half in zero coupon bonds and half in an actively traded funds. It also required another fund to include disclosure that dealers selling the fund must be registered in that state in which such sale is to be made.

Comments such as these make prospectuses longer and more complicated. They result in disclosure of information that is either confusing or immaterial to investors. They frustrate the prospectus simplification efforts of the SEC and the fund industry.

C. The Ever-Changing Nature of State Requirements
The restrictions imposed on what funds invest in, as well as requirements governing prospectus disclosure, not only vary among the individual states, but also frequently change over time. A modern mutual fund complex, often consisting of scores if not hundreds of mutual funds, thus, can never be sure which standards will be applied to any of its funds by a given state at a particular point in time.

For instance, Ohio has a rule stating that a fund may not invest more than 15% of its assets in the securities "of unseasoned issuers or securities of issuers that are restricted as to disposition." In 1993, a fund wrote to the Ohio Division of Securities to ask whether this 15% limitation was cumulative or whether a fund could invest up to 15% in securities of unseasoned issuers and up to 15% in restricted securities. The fund received a written response from the Division stating that the "Division does not interpret the 15% limitation to be cumulative." In renewing its registration statement for 1995, however, the fund received a letter from the Division taking the opposite position and asking that the fund demonstrate its compliance with this cumulative limitation.

In another example, this year one state started requiring funds to include additional disclosure concerning investments in derivatives without providing any guidance as to what the securities department considered to be a derivative and what type of disclosure would accommodate its concerns. The Institute worked with the department to develop such guidance in the form of written guidelines. Within a week of the department's approval of such guidelines and their being disseminated to Institute members, the department's staff began deviating from them. When asked about this, the department responded that the guidelines were not binding and that it could exercise its own discretion about when the guidelines should be applied.

VIII. The Harmful Consequences to Investors
This crazy-quilt of conflicting, duplicative and inconsistent regulatory requirements harms investors in many important ways. First, it frustrates the implementation of national regulatory policies that are clearly beneficial to investors. Second, it retards innovations in products and services that are permitted under federal law and are beneficial to investors. Third, it imposes needless burdens on mutual funds. Fourth, and not least importantly, it diverts scarce state governmental resources away from regulatory priorities, where state action is required to protect investors. Each of these is discussed briefly below.

A. Frustrating National Regulatory Policies
The crazy-quilt system frustrates national policies designed to benefit investors. This is best illustrated in the area of shareholder communications. The SEC has launched several initiatives designed to enhance the readability of mutual fund prospectuses. In an October 1994 speech to the National Press Club, SEC Chairman Arthur Levitt discussed initiatives of the SEC to ensure that prospectuses are more readily understandable to investors:

If you didn't before, you know now that prospectuses can be tough to read. The prose trips off the tongue like peanut butter.... I wish I could say that the SEC had nothing to do with the status quo, but I can't. We've contributed to the situation, albeit with the best intentions-and so have our fellow regulators.... The law of unintended results has come into play: Our passion for full disclosure has created fact-bloated reports, and prospectuses that are more redundant than revealing.... For our part, I've asked the staff to re-evaluate the process by which it comments on prospectuses. I've emphasized the need to limit the number and nature of the comments we give.... [I]n commenting on fund registration statements sent to us for review, we're going to feel free to talk about the clarity of language used.... We want a higher standard of clarity.¹⁵

The Investment Company Institute and its members strongly subscribe to the principles set out by Chairman Levitt. We have undertaken extensive efforts to assure that all our communications with shareholders are clear, concise and accessible. The examples of state intervention in the disclosure process, set forth in section VI.B. above, amply demonstrate the difficulty of achieving this objective within the current regulatory system, in which disclosure issues are the province of numerous contending government authorities, each with its own preferences and inclinations. The problem here is not one of resources; the SEC has sufficient resources to implement effective disclosure policies in the interests of investors. What it lacks is sufficient authority. Until and unless the SEC is put squarely and exclusively in charge of mutual fund disclosure, fund prospectuses will remain needlessly long, complex and difficult for the average investor to decipher.

B. Retarding Product and Service Innovation
It is widely recognized that mutual funds have been leaders in responding to changing investor needs during the past several decades by introducing new products, by improving shareholder services and by providing many new services.¹⁶ In not a few cases, however, state regulation has made paradox innovations approved by the SEC far harder to deliver to shareholders.

One example concerns the so-called "master/feeder" structure, an organizational framework that many funds have adopted in recent years as a means to reduce shareholder expenses and achieve economies in fund management while facilitating distribution of their shares. The master/feeder structure was accepted by the SEC after rigorous examination and after it had fashioned a system of regulation and disclosure that it believed would fully protect shareholders. Several state securities regulators, however, refused to accept the SEC's judgment and sought to impose their own idiosyncratic requirements. In an effort to obtain uniformity among the states, NASAA adopted its own guidelines on master-feeder funds. These NASAA Guidelines, according to the counsel to many such funds, require the addition of approximately one to two pages of additional prospectus disclosure, beyond that required by the SEC. Even worse, despite the promulgation of the NASAA Guidelines, a number of states require still more disclosure. For funds that have chosen to adopt the master/feeder structure, state regulation has produced delay, operational difficulties and needless legal and compliance costs.

In addition to concerns about the way in which state regulation impedes innovation in fund products, there is serious and growing concern in the mutual fund industry about the impediments state securities regulators will erect to the use of electronic communications. Mutual funds now use sophisticated electronic and telecommunication systems to offer their funds nationwide and to provide enhanced services to shareholders. Many fund groups have established sites on the Internet or on one of the major on-line services. Moreover, a preliminary survey by the Institute, based on a sample of approximately 1500 randomly selected shareholders, showed that over 50% owned personal computers (as opposed to one-third of the general population), and approximately one-half of them subscribed to an on-line service. To encourage this important, fast-developing trend, the SEC recently issued a release endorsing the use of the electronic media as a means for dissemination of information to investors and setting forth national standards for such communications.¹⁷ We applaud the efforts of Chairman Levitt and Commissioner Steven Wallman to encourage the use of such technologies by mutual funds shareholders. The problems that state regulation pose for mutual funds in a "paper environment," however, are sure to pale before those that will arise in cyberspace. The losers will be fund shareholders. A national regulatory system under the SEC is imperative.

C. Imposing Needless Compliance Burdens on Funds
The crazy-quilt of state regulation is costly and burdensome for mutual funds that must comply with the diverse state requirements. Mutual funds must commit substantial resources

and personnel to manage the requirements of the various states. The recent experience of one fund, related to us by its counsel, is illustrative. This fund received comments from approximately sixteen state securities administrators on its initial registration. After the fund responded to these comments, several state examiners made further comments. In total, the fund was forced to respond to 36 comment letters addressing 102 comments or requests for documents from various state regulators. This was, of course, in addition to the comments received by the fund from the SEC staff.

This example is not unique. It illustrates the reason why many fund groups must employ a special staff dedicated to dealing with the demands imposed by state regulators, and why all funds are forced to bear significant additional legal and compliance costs as a result of inconsistent state regulation.

D. Diverting Resources From Areas Where State Action is Needed to Protect Investors
Finally, the crazy-quilt of state regulation results in the inefficient use of states' resources. Indeed, a recent annual survey by a NASAA Committee identified only 350 complaints nationwide relating to mutual funds. None of these complaints involved fund prospectus disclosure or advertising,¹⁸ but instead concerned primarily the manner in which fund shares were sold. Former NASAA President John Perkins said in a recent interview that "states don't have large enough staffs to investigate all complaints."¹⁹ One reason may be that many states unnecessarily devote resources to duplicating federal regulation of mutual funds, rather than directing their resources to other targets where state action is needed to protect investors.

IX. The Need For a Congressional Resolution
The introduction of H.R. 2131 provides an excellent opportunity to remedy the worst aspects of the current dual system of federal-state regulation of mutual funds, while preserving the best features. The "experiment" of idiosyncratic state regulation has been a failure and should be discarded.

The individual states, through experimentation, long have had the opportunity to come up with a practical approach, and they have not done so. They also have had the opportunity, through concerted action, to rationalize the current system. Years of effort by the mutual fund industry and the SEC to work with the states individually and with NASAA collectively to obtain a uniform system of regulation have been unavailing.

In fact, in recent years, the clear trend among NASAA's leadership has been to actively oppose the cause of uniformity. In 1985, the National Conference of Commissioners on Uniform State Laws adopted a model act for state securities regulation. The model contained an exemption from state regulation for mutual funds with experienced investment advisers, but left undisturbed the states' authority to require filings, collect fees and enforce sales practices. Since 1985, twelve states have adopted some form of such exemption. But, in 1991, the NASAA Board approved a resolution opposing the Uniform Securities Act exemption and "strongly encourag[ing]" those states that had already adopted exemptions to abandon them and hence resume active regulation of mutual funds. More recently, NASSA and certain state regulators cite their efforts to develop an electronic filing system for registrations and renewals known as the Securities Registration Depository ("SRD") as evidence that they have been working towards a more uniform national marketplace. In fact, the opposite is true. The SRD intentionally has been designed by NASAA not to promote uniformity, but to accommodate-and hence perpetuate-conflicting and inconsistent state filing requirements.

Given that these attempts at the state level to establish uniformity have failed, only Congress can remedy the situation. A national problem requires a national solution. The interests of fund shareholders and the nature of the investment company marketplace command the creation of a new federal/state partnership.

Specifically, the regulation of fund prospectuses and advertising and the structure and operations of investment companies should be delegated exclusively to the federal government.²⁰ States could require notice filings receive fees and concentrate on fraud, sales practice abuses and investor education. Such a reallocation of federal and state responsibilities would be of immense benefit to investors throughout the nation. In fact, many states have already recognized the benefits of this regulatory scheme. In those states, mutual funds generally make notice filings, pay fees and are subject to anti-fraud jurisdiction, but their prospectuses and advertisements are not subject to state review and the states do not impose substantive limits on fund operations. There is no evidence that investors in these states are at any greater risk-to the contrary, investors benefit because their state securities regulators apply their resources to other areas where state action is required for their protection.

Some suggest that problems with the current system should be reviewed and studied by a commission, and presumably that we should await its judgments before Congress acts. State mutual fund regulation, however, has been a matter of study and debate for years, including by NASAA. In September 1983, for example, join hearings were held by NASAA and the SEC on the need for greater uniformity in federal and state securities laws and regulations, including those with respect to mutual funds. After the hearings, NASAA appointed an Investment Companies Committee to study the issue further and make recommendations. In the Committee's Final Report, the Committee acknowledged that the problems resulting from lack of uniformity could be rectified without compromising investor protection, and found that uniformity would permit states to "allocate their staff's time and resources more productively and efficiently." The Committee recommended that states adopt a more uniform approach to mutual fund regulation and eliminate duplicative or inappropriate substantive provisions.²¹ Although the recommendations were endorsed by NASAA in September 1984, this did not produce the system of uniform regulation that even NASAA found to be desirable. Eleven years later, the crazy-quilt is more crazy and harmful to investors than ever.

In short, the problems with the current dual system of federal-state regulation of mutual funds are extensively documented. Yet another study would add little to the wealth of information already available, and likely would serve only to delay action that is long overdue. The problems that I have described are so inherent and ingrained in the current system of regulation that they can only be solved by Congress-and they should be solved now.

¹ Eighteen states and the District and Columbia either provide some form of exemption or exclusion from registration or review for mutual funds or do not require the registration of any securities. Another twenty or so states require the registration of such offerings, but generally review them in a manner consistent with federal law.

² With respect to regulation of investment advisers, in his testimony before this Subcommittee, SEC Chairman Levitt suggested an approach he referred to a "reverse preemption" whereby the states would assume primary responsibility for examining advisers with assets below $5 million and larger advisers would remain registered with the SEC and would be relieved of state registration and regulation. See, Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, before the House Telecommunications and Finance Subcommittee on H.R. 2131, "The Capital Markets Deregulation and Liberalization Act of 1995" (November 30, 1995) (hereinafter referred to as "Chairman Levitt's Subcommittee Testimony"). The Institute believes Chairman Levitt's approach should be given serious consideration by the Subcommittee. At the same time, we recommend that the authority to regulate all investment advisers to mutual funds be vested exclusively in the SEC.

³ See, Chairman Levitt's Subcommittee Testimony.

⁴ In addition to the federal securities laws, almost all mutual funds qualify as "regulated investment companies" under Subchapter M of the federal Internal Revenue Code in order to avoid the imposition of double taxation on the funds and their shareholders. Subchapter M imposes a number of substantive requirements concerning asset diversification, sources of income and current distribution of income to fund shareholders.

⁵ New State Ice Company v. Liebmann, 285 U.S. 262, 279 (1932) (Brandeis, J., dissenting).

⁶ The eight states are Arkansas, California, Missouri, Ohio, South Dakota, Texas, Washington, and Wisconsin.

⁷ Actions taken by the Wisconsin Commissioner of Securities over the past year should result in complete uniformity between Wisconsin law and federal law by January, 1996.

⁸ Not all limitations on fund portfolio investments are expressly provided for under state law. It is not uncommon for examiners in those states that actively review prospectuses to request, through the comment process, changes in a fund's investment program.

⁹ In particular, the SEC's policy, which was intended to facilitate institutional transactions, permitted mutual funds to determine which of certain restricted securities (i.e., those that meet the conditions of Rule 144A under the Securities Act of 1933) held in their portfolios were illiquid and, thus, subject to the SEC's 15% limit on investments in illiquid securities. Prior to this change, all Rule 144A securities were considered illiquid.

¹⁰ SEC Form N-1A, GeneralInstruction G.

¹¹ Based on the recent experiences of our members, the twelve states whose examiners most frequently issue their own comments on prospectuses are Arizona, Arkansas, California, Maryland, Massachusetts, Minnesota, Missouri, New Jersey, Ohio, South Dakota, Texas and Vermont. (New Jersey and South Dakota both exempt some funds from registration, but often comment on prospectuses of funds hat do not claim the exemption).

¹² West Virginia only requires funds that do not claim the "blue chip" exemption to file advertising.

¹³ This state also has required that sections covering risk factors be included near the front of the prospectus. It gives inconsistent comments, however, on whether this must be within the first five pages or the first ten pages.

¹⁴ In the adopting release, the SEC stated that the information included in the SAI "does not appear to be of fundamental importance to most investors" and is intended to meet the needs of investors such as "institutional investors" and "financial analysts." See Investment Company Release No. 12927 (Jan. 7, 1983).

¹⁵ Remarks by Arthur Levitt, SEC Chairman, "Taking the Mystery Out of the Marketplace: The SEC's Consumer Education Campaign," National Press Club, Washington, DC (Oct. 13, 1994) (emphasis added.)

¹⁶ These services include, for example, national toll-free (800) telephone numbers; 24-hour telephone access; consolidated account statements; shareholder newsletters; shareholder cost basis information; and investor information provide through the Internet and on-line computer services.

¹⁷ Investment Company Release Nos. 21399 and 21400 (Oct. 6, 1995).

¹⁸ NASAA Investment Companies Sales Practices Committee, Annual Survey of Investor Complaints Involving Investment Company Products (Sept. 15, 1994).

¹⁹ Jane Bryant Quinn, Broker's File Can Disclose Trouble, For Now, Cincinnati Enquirer (Oct. 1, 1995)

²⁰ It is interesting to note that the benefits of a national marketplace have been recognized in other areas, where it has been determined that exclusive federal regulation is appropriate. For example, the Commodity Exchange Act vests the CFTC with exclusive jurisdiction over commodities transactions, but preserves the capacity of state regulators to redress fraudulent activity perpetrated in their jurisdictions. Commodity Exchange Act §§ 2(a)(1) & 6d, 7 U.S.C. §§ 2 & 13a-2(7).

²¹ Predictably, the Committee's recommendations topped short of recommending complete uniformity: "The Committee does not wish to imply that it is in any way inappropriate for a [state] to apply substantive requirements. However, the Committee believes that it is proper to review this area to determine if the requirements are currently useful and appropriate."