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Operational Risk Among SEC Concerns

WASHINGTON-The Securities and Exchange Commission is interested in reducing mutual fund operational risk, improving disclosure and helping boards better assess soft dollars, according to Andrew J. Donohue, director of the division of investment management.

Because technology has been an incredible force in shaping the way the fund industry does business, it has become a key driver of regulatory concerns, Donohue told attendees at the Investment Company Institute's 2007 Operations and Technology Conference.

"According to recently reported data, there was $34 trillion outstanding in credit default swaps at the end of last year, their value having grown 240% in 18 months," he said. "From a risk standpoint, a notable aspect of this incredible growth is that these complex instruments are becoming more widely traded, with traditional long-only asset managers increasing their exposure to them."

The escalating trading volume of complex derivative instruments has also put tremendous constraints and exposed weaknesses in firms' systems for clearing complex products, Donohue continued.

"We have heard reports of huge backlogs in periods of particularly heavy trading; in one case confirmations had fallen as much as one week behind," he said.

Donohue said there have been relatively few reported cases of serious system glitches in fund complexes. However, when there are glitches, even small errors cost firms tens of millions of dollars in restoring customer accounts and in regulatory fines.

"When something does go wrong, we are often taken by surprise at how quickly it happens, and how quickly a relatively small error can multiply into disastrous results," he said.

Donohue compared looking to past performance for guidance in managing market risk to driving down a winding mountain road at top speed, using only the rearview mirror for guidance.

With the increasing trend of firms moving toward a more horizontal structure, where critical functions are increasingly outsourced to third parties, coordination becomes more difficult, he said.

"Some firms that do not have sufficient staff to deal with complex investments have addressed this constraint by restricting the number of these trades that can be executed," Donohue said. But the more common approach has been to outsource settlement and confirmation functions to third parties, such as custodian banks or fund administrators.

This trend of outsourcing critical functions has led to another operational risk deriving from firm structure, he said.

"In the mutual fund area, I think we are just at the beginning of seeing growth mismatches of these types as technology continues to drive and reshape the fund industry as we know it," he said.

"We in the division have a similar responsibility to evaluate the SEC's rules to determine if they are relevant and whether they are achieving their intended purpose," Donohue said. That is why, he said, one of the SEC's top priorities this year is to revisit Rule 12b-1.

"This rule, adopted in 1980, was intended to stem the problem of net redemptions, spur fund growth, and reduce overall shareholder expenses," he said. But today, in many cases, 12b-1 fees are used primarily as a substitute for sales loads and for servicing. With these uses, it's unclear whether this rule continues to serve its originally intended purpose.

The SEC hosted a roundtable in June and requested public feedback on Rule 12b-1, receiving more than 1,400 comments.

Donohue said SEC staff is reviewing these comments and suggestions and is currently preparing a recommendation on Rule 12b-1.

The SEC is also looking into streamlined fund disclosures provided directly to investors, with more detailed information available on the Internet or in paper upon request.

"The streamlined disclosure initiative is designed to enhance the current prospectus/SAI [statement of additional information] regime by providing investors with key information in plain English in a clear and concise format," Donohue said. "This information may include investment objectives and strategies, costs, risks and historical returns. The more detailed information in the current forms would continue to be available to investors and others who desire it, including in an easily accessible electronic form."

Although the SEC issued guidance last year on what types of execution services and research fund companies can accept from brokerages through soft dollars, the SEC will now give fund companies and their boards guidance on how to more precisely value soft dollars.

"Additionally, the use of new technologies has created increased transparencies and is allowing greater opportunities for virtual unbundling' of research and execution services," Donohue said.

"Our goal is to provide fund boards with helpful guidance to assist them in monitoring the conflicts of interest inherent in soft-dollar arrangements, while being careful to avoid recommending guidance that will adversely affect the evolution of the trading markets in an unintended way," Donohue said.

The SEC has also been working on data tagging, an easy way to search, retrieve and analyze large amounts of text.

Donohue also advocated for faster approval of exchange-traded funds and updated recordkeeping requirements that would permit electronic records such as e-mails and voice messages.

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