securities lawyer

David W. Grim, Director, Division of Investment Management

Washington, D.C.

Nov. 4, 2016

Good morning every one and thank you, Steve, for that kind introduction and for inviting me to join you here this morning. Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.[1]

I am honored to deliver the keynote address at this very significant conference for the second time now. I understand that this is the 34th year of the conference and the 34th time that the Division Director has addressed this important group. I am also delighted that several of my colleagues from the Division of Investment Management are participating as panelists in this program. Generally, I’ve found it unwise to presume to speak for others, but I have no hesitation in telling you that my coworkers and I believe it’s a tremendous honor to serve American investors by working on the staff of the SEC. We share a commitment to the Commission’s vital mission of protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation. I also think it’s a great thing for the staff to participate in events like this one because they provide opportunities to share not only news of regulatory developments, but also the staff’s views regarding market developments in the dynamic investment management industry. Hopefully, our participation promotes transparency as to how the Division of Investment Management works to promote the Commission’s mission through the regulation of investment companies, investment advisers, and of course, of particular interest to all of you, variable insurance products.

As I prepared for my remarks today and looked back over the course of the year that has elapsed since I last spoke to this group, I found it very gratifying to take stock of the Division’s productivity over that time. I am pleased to be able to share with you some important recent rulemaking developments. I would also like to share with you some thoughts about developments and trends in investment management, including trends affecting investment products offered by insurance companies.

Rulemaking

Let me start off by noting two very significant recent developments in the rulemaking area. October 13th was a great day for fund investors, it was on this day that the Commission adopted critical final rules to modernize and enhance reporting of information by registered investment companies, [2] and to strengthen liquidity risk management. [3] This followed the new rules adopted by the Commission in August to modernize reporting requirements for investment advisers. These new rules are part of a series of transformative initiatives Chair White publicly outlined in December 2014, to enhance the SEC’s oversight and regulation of the asset management industry.

Reporting Modernization

First, a little background as to why the Commission determined it appropriate, at this time, to adopt and amend certain rules and forms to modernize the reporting and disclosure of information by registered investment companies. As you probably know, the Commission and the staff rely on information that funds and investment advisers report for a number of purposes, including monitoring industry trends, identifying risks, informing policy and rulemaking, and assisting examination and enforcement efforts. Many investors also rely on this information to compare funds and to make more informed investment decisions. As Chair White noted, however, in the open Commission meeting in October, many of our current reporting requirements do not capture the volume and complexity of information relevant to the Commission and investors, nor enable the use of up-to-date technology to report and analyze it. The final rules recently adopted by the Commission address these concerns by updating and enhancing reporting requirements for most registered investment companies.

I would like to highlight three principal changes the reporting modernization rules bring to the current regime. First, the Commission adopted a new portfolio holdings reporting form, Form N-PORT, which requires registered funds, with the exception of money market funds and small business investment companies, to report information about their portfolio holdings to the Commission. New Form N-PORT requires a fund to report information about each investment held by the fund as of the close of the preceding month, including entity and security identifiers, and asset and issuer type. Funds will also report, as relevant, additional information about specific types of investments. For example, Form N-PORT will require the terms of funds’ derivatives investments, including the counterparty, underlying reference assets and notional amount, and information about securities lending and repurchase agreements. Form N-PORT also includes certain risk metric calculations that measure a fund’s exposure and sensitivity to changing market conditions, such as changes in asset prices, interest rates, or credit spreads.

Significantly, reports on Form N-PORT will be filed in a structured data format with the Commission on a monthly basis, with every third month available to the public 60 days after the end of the fund’s fiscal quarter.

Second, the Commission adopted, largely as proposed, amendments to Regulation S-X, which will require standardized, enhanced disclosure about derivatives in investment company financial statements, as well as other amendments. While many fund groups provide disclosures regarding the terms of their derivatives contracts, the lack of standard disclosure requirements has resulted in inconsistent disclosures in fund financial statements. These amendments to Regulation S-X not only enhance and standardize derivatives disclosures in financial statements, but were designed to allow comparability among funds and help all investors better assess funds’ use of derivatives.

Third, is the Commission’s adoption of a new annual reporting form, Form N-CEN, and rescission of old Form N-SAR. New Form N-CEN will require registered investment companies, other than face-amount certificate companies, to annually report certain census-type information to the Commission in a structured data format. Form N-CEN streamlines and updates information reported to the Commission to reflect current information needs, such as requiring more information on exchange-traded funds and securities lending. Of particular interest to you and your industry, I would note the following:

  • First, Form N-CEN requires management companies to identify whether their underlying funds are offered as investment options under a variable annuity or variable life insurance contract.
  • Second, Form N-CEN includes an item that asks whether a UIT is a separate account of an insurance company and, depending on the response to this item, elicits further information about the separate account. While Form N-SAR generally did not differentiate between variable separate accounts and other types of UITs, Form N-CEN makes this distinction, and thus more effectively elicits information appropriate to the type of UIT. I also believe this new approach will allow filers to better understand the information being requested because it will be more reflective of their operations and should thus improve the consistency and usefulness of the information reported.
  • Third, the form includes new questions for insurance company separate accounts offering variable annuity and variable life insurance contracts. For the most part, these new questions focus on eliciting information on the activity experienced with respect to variable contracts, such as the level of sales, redemptions, and Section 1035 exchange activity during the reporting period.

Where Form N-SAR did not reflect the basic differences between separate accounts and other types of UITs, Form N-CEN, , applies a keen focus on these differences. This means that the new form will provide the Commission and the staff with valuable information about separate accounts and the securities they issue, which will inform our monitoring in the variable annuity and variable life insurance markets and the Commission’s policy decisions going forward.

We also understand that many are interested in the Commission’s proposal to permit electronic delivery of shareholder reports, including the unique issues raised by that proposal in your world. The proposed measures received considerable comment. The issues raised are important ones and we are considering them carefully as we prepare a recommendation for the Commission.

Investment Company Liquidity Risk Management Programs

Turning to liquidity, the Commission issued a set of comprehensive reforms designed to promote robust and effective liquidity risk management across the open-end fund industry. These significant reforms strengthen our securities markets and the protection of investors by reducing the risk that funds will not be able meet their redemption obligations and mitigating potential dilution of non-redeeming fund shareholders’ interests.

As I am sure you have heard, the Commission adopted a new rule that requires each registered open-end fund, including open-end ETFs, but not including money market funds, to establish a written liquidity risk management program, reasonably designed to assess and manage the fund’s liquidity risk, which will be overseen by the fund’s board.

As part of the liquidity program, funds must classify the liquidity of their portfolio holdings into four categories on at least a monthly basis, and report the liquidity classifications to the Commission. They will also publicly report the aggregate liquidity profile of their portfolio to the public on a quarterly basis. In addition, the final rules include a new codified 15% limit on purchases of illiquid assets. Should a fund exceed this 15% level of illiquid assets, it would need to notify its board and confidentially notify the Commission. The liquidity program also requires funds to establish a “highly liquid investment minimum”. If a fund falls below its minimum for more than a brief period of time, the new rules also require board and Commission notification.

It might be of particular interest to this group that the new rule requires principal underwriters and depositors of UITs to engage in a tailored liquidity review. More specifically, a UIT’s principal underwriter or depositor will now be required to determine, on or before the initial deposit of portfolio securities into the UIT, that the UIT’s portfolio holdings are consistent with the redeemable nature of the securities it issues.

In the release adopting the final rule, the Commission noted the fact that most UITs serve as separate account vehicles used to fund variable annuity and variable life insurance contracts. These UITs essentially function as pass-through vehicles, investing principally in securities of one or more open-end funds that are themselves subject to the rule. Moreover, the Commission recognized the unmanaged structure of UITs and the fixed nature of their portfolios. Balancing concerns that UITs do issue redeemable securities—and thus may be subject to liquidity risk—with the unique structure and features of UITs, led to the tailored liquidity risk management requirement for UITs.

Finally, the Commission adopted new rules permitting funds to use swing pricing. A fund using swing pricing adjusts its NAV by a specified amount — the swing factor— if the level of net purchases into or net redemptions from the fund has exceeded a specified percentage(s) of the fund’s NAV — the swing threshold. Swing pricing is a new tool that allows funds to better allocate the costs of managing purchases and redemptions.

Derivatives

Shortly after I spoke at this conference last November, the Commission, in December 2015, proposed a new exemptive rule, which is designed to provide an updated and more comprehensive approach to the regulation of the use of derivatives by registered investment companies.[4] This proposed new rule is intended to result in investor protections. More specifically, funds would be required to comply with one of two alternative portfolio limitations designed to limit the amount of leverage that a fund may obtain through derivatives and certain other transactions. In addition, funds would be subject to asset segregation requirements to manage risks associated with derivatives transactions, and certain funds would be required to establish risk management programs for their derivatives activities.

One example of this is that many variable products offer living benefit guarantees to address investment as well as mortality risk, and insurers often engage in hedging programs to manage the risks they assume under those products. As I discussed last year, we have also noted some of the guarantees require allocation of contract value to funds that themselves take positions in derivatives to limit volatility and to mitigate the risks insurers incur with the guarantees.

So, while variable separate accounts do not directly hold derivatives, this proposed rulemaking may still have an impact in the variable products space. The Commission is now carefully reviewing the many comments it has received on this matter, which, as of the close of last month, numbered over 190. As I have said before, I believe that the most successful rulemaking process includes a dialogue between the Commission and all of the various stakeholders and so, to those of you who have weighed in on this very significant proposal, I thank you for doing so.

Disclosure Effectiveness

While we’ve been busy working on new rules on liquidity risk management and fund reporting and the proposal on derivatives, we are also focused on what’s next. A key area of focus is our disclosure effectiveness initiative. We are considering ways to improve the form, content, and delivery of mutual fund prospectuses. And although we are still prioritizing our focus areas, I expect that we will be considering ways to enhance disclosure about fund risks, strategies, and fees.

Trends in the Insurance Products Space

Buyout Offers

As the dust continues to settle after the financial crisis, insurers continue to move away from the offering of variable insurance contracts that feature the significant types of guaranteed income benefits and death benefits previously offered and sold . In this regard, the staff continues to see buyout and exchange offers, which I spoke briefly about last year. The staff believes these sorts of offers should remain under a spotlight given our ongoing concern that they may not be beneficial for all, or even most, contract owners. It is difficult to quantify the value of a living benefit, which changes over time with market movements and other variables. It is thus difficult to compare contracts in an exchange offer, or to assess any offer for a buyout of one’s contract. Accordingly, let me reiterate my encouragement to you “to carefully monitor sales practices associated with these offers.” Additionally, I remind you that the staff remains diligent in reviewing disclosure concerning these offers, analyzing for clear and comprehensive documents that include all applicable risk disclosures. Along these lines, let me quote something Warren Buffet wrote in the Preface to the Commission’s Plain English Handbook about the need for well-written disclosure documents. Specifically, he indicated “[t]o succeed, [you] don’t need to be Shakespeare; [you] must, though, have a sincere desire to inform.” [5]

On a related note, I would like to draw your attention to a new publication that should help in the protection of investors faced with a variable annuity buyout offer. In collaboration with our disclosure review staff, the SEC’s Office of Investor Education and Advocacy has put forth a new SEC investor bulletin designed to explain some of the pros and cons of such offers. That bulletin (titled, Variable Annuities-Should You Accept a Buyout Offer?), was issued this past July and while I cannot cover all of the points it makes, let me note that it highlights for investors the fact that these offers are optional, and that insurance companies may make such offers because doing so is in the companies’ best interests. [6] Moreover, the bulletin warns investors to accept such offers only upon determining, after knowing all of the facts, that it is better to take such an offer rather than to continue to own a variable annuity with a particular benefit.

Risk Disclosure

During the past year, the staff of the Division has continued to issue IM Guidance Updates, which I think have become an effective way for the staff to share its thinking about important issues. I’d like to spend some time discussing one of the most recent updates, which provides guidance intended to help funds provide risk disclosures that remain robust when market conditions are changing.

Effective fund disclosures are a pillar of the Investment Company Act’s investor protection framework, and I believe nowhere is the need for effective disclosure more acute than with respect to the various risks associated with funds’ investment policies.

But most risks are not static concepts etched in stone; risk often has a fluid quality. Changing market conditions can dramatically heighten certain risks, while simultaneously causing other risks to wane. As a result, whenever market conditions begin to shift materially, I believe funds should consider whether their risk disclosures need to be revised to warn of a changing risk profile.

To help ensure that funds provide adequate risk disclosures during changing markets, the Division’s recent guidance emphasizes basic practices that funds should consider.[7] For example, the guidance stresses the importance of effectively monitoring market conditions and assessing the impact of changing conditions on the fund and its investments. The guidance goes on to note that funds should assess whether any changed conditions are material to investors. If so, the guidance encourages funds to review whether their risk disclosures are adequate in light of the changed conditions.

In the event that a fund deems it necessary to update its risk disclosures, the guidance encourages funds to update its communications with investors as needed. Specifically, the guidance notes that funds should provide any communications to investors, at the time and in the manner required by the federal securities laws and as otherwise appropriate such as prospectuses and shareholder reports, as well as less formal methods, including posting updates to the fund’s website or sending letters directly to shareholders.

The guidance also shares examples of how some funds have revised their risk disclosures to address current market developments, including disclosure of rising interest rate risk, liquidity risk, and duration risk, as well as disclosure by funds relating to investments in debt securities issued by Puerto Rico. I hope these examples will help other funds gain insights into how they can disclose other consequential events. As always, if you have additional views on this topic, I encourage you to share them with me or others on the staff.

Filing Process/Rate Sheet Supplements

As we move towards the busiest time of the year for filings for variable products, I would like to point out that the staff seeks to be flexible and responsive in the filing review process. If there are numerous filings making virtually identical changes, do not hesitate to contact the staff to discuss the appropriateness of expedited review and/or limited review of duplicative filings.

One development that is indicative of a flexible approach on the part of the staff is the increased use of rate sheet supplements by variable insurance products issuers. A rate sheet is a short supplement used to change current withdrawal percentages, credit rates, or other moving parts of a living benefit that may change frequently to an extent that makes post-effective amendments with each change impractical.

The staff believes that any issuer using a rate sheet to ensure that their related prospectus clearly discloses, among other things, how the rate sheet works; that the fees and rates may change; how to obtain the current rates; and how existing contract owners can obtain the rate applicable to them, for example, through a web-site or by calling a specific phone number. The staff also believes that historic rates should be disclosed in an appendix to the issuer’s prospectus or statement of additional information. Again, when in doubt, contact the staff as these disclosures are being formulated.

Conclusion

Thanks for listening, and I hope I have brought something to the table that is of interest to you. As always I encourage your input into what we are doing. Formal comments on rulemakings are frequently pivotal for the staff in formulating recommendations for the Commission on pending rules. As I just mentioned, informal inquiries and suggestions can also be very helpful, and a heads-up about filings we can expect can go a long way to smooth the process. We value your input at all levels.

Enjoy the rest of the conference.

Thank you.


[1] I would like to thank my colleagues, Bill Kotapish and Kimberly Browning, for the valuable help they provided in assisting with the preparation of these remarks. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.

[2] Investment Company Reporting Modernization, Investment Company Act Release No. 32314 (Oct. 13, 2016) (“Reporting Modernization Final Release”), available athttps://www.sec.gov/rules/final/2016/33-10231.pdf.

[3] Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016) (“Liquidity Risk Management Final Release”), available athttps://www.sec.gov/rules/final/2016/33-10233.pdf.

[4] Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80884 (Dec. 28, 2015)], available at https://www.sec.gov/rules/proposed/2015/ic-31933.pdf.

[5] See Preface by Warren E. Buffet to A Plain English Handbook: How to Create Clear SEC Disclosure Documents, (August 1998), available at https://www.sec.gov/pdf/handbook.pdf.

[6] SEC Investor Alert and Bulletins, Variable Annuities-Should You Accept a Buyout Offer? (July 14, 2016), available at https://www.sec.gov/oiea/investor-alerts-bulletins/ib_buyvarannuities.html.

[7] Fund Disclosure Reflecting Risks Related To Current Market Conditions, IM Guidance Update No. 2016-02 (March 2016), available at https://www.sec.gov/investment/im-guidance-2016-02.pdf.