TESTIMONY OF LAURA S. UNGER, COMMISSIONER U.S. SECURITIES AND EXCHANGE COMMISSION BEFORE THE SENATE SPECIAL COMMITTEE ON THE YEAR 2000 TECHNOLOGY PROBLEM Chairman Bennett and Members of the Committee: I am pleased to be here today to testify before the Special Committee on behalf of the Securities and Exchange Commission ("Commission") on matters relating to the Year 2000 technology problem. My testimony focuses on one of America's most successful and important businesses -- the mutual fund industry - - and its progress in addressing the Year 2000 challenge. I also will outline the considerable number of steps that the Commission is taking to promote Year 2000 preparedness by mutual funds. As you well know, mutual funds play a key role in the economic life of many Americans. Over one-third of U.S. households now own shares of mutual funds.[1] Mutual funds have more than $5 trillion in assets,[2] over a third of which are estimated to be retirement plan assets.[3] Through the efforts of this Special Committee and others, most people are aware by now that a large percentage of the world's computer systems will need to be modified to ensure that they recognize the year 2000. Mutual funds and their investment advisers and other service providers, like most other securities- related enterprises, are heavily dependent upon computer systems. If their computer systems are not Year 2000 compliant, mutual funds and their investment advisers could face difficulties performing various functions such as calculating net asset value, redeeming shares, providing account statements and other information to their shareholders, and communicating with fund custodians, transfer agents, and distributors. As I discuss below, the Commission has actively considered and taken steps to address the Year 2000 problem for funds, and will continue to do everything that it reasonably can to ensure that funds correct any potential Year 2000 concerns before the turn of the century. The Commission's Response The Commission has approached the Year 2000 problem from many directions in recognition of the potential for adverse consequences to so many investors if funds do not act and act soon to address the Year 2000 problem.[4] Early on, the Commission took steps to raise industry awareness of the Year 2000 problem and to collect information about mutual funds' readiness for the Year 2000. Commissioners and staff have addressed the Year 2000 issue in virtually every recent major speech to the fund industry.[5] The Commission and its staff have issued extensive guidance to issuers, including mutual funds, regarding their Year 2000 disclosure obligations, and have established a Task Force to monitor compliance with the Commission's disclosure directives. Over the past three months, the Commission's Office of Compliance Inspections and Examinations staff has conducted nationwide examinations that are dedicated to obtaining information on the Year 2000 problem. Most recently, we announced a moratorium on the implementation of new Commission rules that would require major reprogramming of computer systems by, among others, investment advisers and funds.[6] The moratorium is designed to facilitate and encourage securities industry participants to allocate sufficient resources to remediation of the Year 2000 problem. In the next few weeks, the Commission expects to take final action on a proposed rule that would require all registered investment advisers, including advisers to mutual funds, to report on the funds and the investment advisers' readiness for the Year 2000. The information that the Commission staff has gathered to date shows that the mutual fund industry is quite aware of the potential problems that the Year 2000 presents and is preparing to meet this challenge in a timely manner. As we approach the millennium, the Commission will continue its Year 2000 program, taking any actions we believe will help ensure that the mutual fund industry is prepared for the Year 2000. We will continue to raise the industry's awareness of the Year 2000 issue, gather information about Year 2000 readiness, and evaluate the status of the industry's readiness. If we find deficiencies, we will aggressively address them with the funds and their investment advisers, conduct further examinations and, as appropriate, bring enforcement actions. We believe that, in addition to the Commission's actions and other government initiatives, the disciplining effect of market forces and self interest will promote Year 2000 compliance in the mutual fund industry. Mutual funds and their service providers have compelling business incentives to expend the resources necessary to protect themselves, their clients, and their investors. We believe that strong and effective government oversight together with market forces will foster widespread Year 2000 compliance in the mutual fund industry. Education and Information Gathering One of the Commission's top Year 2000 priorities has been to educate mutual fund industry participants about Year 2000 issues and to gather information on their progress in becoming Year 2000 compliant. Since 1996, Commission examiners have raised Year 2000 concerns during adviser and fund examinations to increase awareness of the problem and encourage corrective action. In 1997, Chairman Levitt sent a letter to all registered investment advisers, including advisers to mutual funds, warning of the consequences of not being Year 2000 compliant, and urging them to make preparations for the Year 2000 their highest priority. The Commission staff has been working with the Investment Company Institute ("ICI"), the mutual fund industry's principal trade group, to obtain data to monitor the progress of the industry in addressing the Year 2000 problem. The Commission staff has met regularly with the ICI to promote Year 2000 readiness and discuss the status of the industry's Year 2000 assessment, remediation, and disclosure efforts. A recent ICI survey indicates that 80% of funds responding to the survey plan to complete their Year 2000 programs by the end of this year.[7] The ICI also has urged its members to participate in the Securities Industry Association's industry-wide testing program, which is scheduled to begin in March 1999. Several major mutual fund complexes participated in the Association's initial round of beta testing this July, which involved simulating a trading cycle (i.e., from order entry to settlement) for various types of securities, including mutual fund shares. The funds that participated in this testing experienced no significant problems. Disclosure The Commission has taken a number of steps to promote useful disclosure about Year 2000 issues by mutual funds. To impress upon mutual funds their disclosure obligations, the Commission's Division of Investment Management jointly issued a Staff Legal Bulletin with the Division of Corporation Finance in 1997. Under the bulletin, funds and advisers must disclose any material effect that the Year 2000 problem may have on their businesses, including the cost of remediation, the consequences of incomplete or untimely resolution of the problem, and the risk that the problems of third parties will affect their business. After the bulletin was issued, the Division of Investment Management formed a Year 2000 Disclosure Task Force to assess the quality of Year 2000 disclosure being made in disclosure documents. The Task Force was directed to assess the disclosure not simply through the eyes of a regulator, but also through the eyes of an investor. When appropriate, the Task Force instructed funds to provide disclosure in plain English, and more user friendly, terms. The funds selected for review by the Task Force represented over 50 fund complexes and over 59% of mutual fund assets. The Task Force found that the number of mutual funds that are disclosing Year 2000 information has increased substantially in the last year. During 1997, few mutual funds made any Year 2000 disclosure. In contrast, through May 1998, 81% of the new or amended registration statements filed by funds during 1998 contained Year 2000 disclosure. In addition, 24 of the 25 largest mutual fund complexes have made Year 2000 disclosure to their shareholders.[8] In the course of its reviews, the staff became concerned that, while more funds were discussing Year 2000 issues in their disclosure documents, the documents in many cases could be made more useful to investors seeking to understand the Year 2000 readiness of their funds. In attempting to improve the quality of Year 2000 disclosure, the Commission issued an Interpretive Release on Year 2000 disclosure requirements in July 1998. The release sets forth the factors that the Commission expects all mutual funds to address in providing Year 2000 disclosure. In particular, the release states that if mutual funds determine that their Year 2000 risks are material, they must disclose these risks in their registration statements and other public documents. According to the release, a fund should consider, in assessing its potential Year 2000 risks, whether Year 2000 issues affect its own operations, its ability to obtain and use services provided by third parties, or its portfolio investments. The Task Force will continue to evaluate industry compliance with this guidance, and will direct funds to improve their disclosure, as needed. Examinations The Commission believes that one of the most effective means of directly evaluating the readiness of mutual funds for the Year 2000 is through the examination process. Beginning in 1996 and continuing through 1997, our investment management examination program focused on awareness: getting the message out to funds and their investment advisers that they needed to address the Year 2000 problem. In 1996, the Commission's Office of Compliance Inspections and Examinations sent a letter to the ICI alerting it to the seriousness of the problem and that remediation efforts would be reviewed during on-site examinations. Reviews of mutual funds and their advisers at that time were designed to alert them to the problem and to gauge whether they had plans to remediate their computer systems that were not Year 2000 compliant. Of the 757 investment advisers and mutual funds examined in 1996 and 1997 of which Year 2000 inquires were made, 93% (731) were aware of the Year 2000 problem, and 83% (627) had already taken or planned corrective actions. During late 1997, our examiners conducted in-depth reviews of selected advisers' remediation programs. The staff generally found that these advisers were taking the Year 2000 problem seriously, had plans in place to deal with Year 2000 issues, and were actively working on implementing their plans. Beginning in the spring of this year, our examinations began determining the extent of each fund's reliance on third parties to ensure Year 2000 compliance, whether the fund has a written plan to deal with Year 2000 issues, the date that the fund expects to complete systems testing, and whether the fund plans to participate in testing with outside parties or in industry- wide testing. Our examiners have collected information concerning, for example, progress on meeting completion dates and testing for a significant percentage of registered advisers. The information gathered through this process serves both to identify specific areas of potential difficulty that will need close monitoring and to validate information provided from other sources. As of this past August 31, our examination staff had conducted inspections of mutual funds representing over one- third of fund assets. Our data show that most funds plan to have any Year 2000 problems corrected by the end of 1998 or during early 1999, which is generally consistent with industry statements that corrections should be completed by December 1998.[9] Only a small number of funds indicated that they did not expect to complete their corrections until mid-1999. The staff is treating those advisers and funds with late completion dates and those not planning to conduct internal testing as potentially requiring additional action. We will be asking them to explain any problems that we find, and we may follow up with on-site examinations of some of these entities in the future. Thus far, data that we have collected show that funds are making significant progress in addressing their Year 2000 problems. Ninety percent of funds indicated that they were taking steps to correct their Year 2000 problems. Of the remaining funds, some had already completed their corrections or indicated that they had identified no problems.[10] We found that 77% of funds have written plans to address Year 2000 compliance, and that 95% of the funds have made inventories of all of their computer systems affected by the Year 2000 problem. Only 1% of funds had neither a plan nor conducted an inventory. Proposed Reporting Requirement In recognition of the urgency of the Year 2000 problem, the Commission intends to take every reasonable step to encourage the mutual fund industry to address the Year 2000 challenge. To supplement our examination program, the Commission has proposed to require that all registered investment advisers, including fund advisers, report their progress on making their systems Year 2000 compliant.[11] The reports would be similar to our recently- adopted reporting regulations for broker-dealers and transfer agents. If the advisers have mutual funds as clients, the advisers also would be required to provide information about the readiness of the funds for the Year 2000, as well as their own readiness. As proposed, the reports would address the scope and status of the advisers and funds' Year 2000 plans and their commitment of resources and personnel to address the problem. Advisers to funds would report on the systems that may be affected by the Year 2000 problem and the progress that they have made in addressing these problems, including the extent to which they have conducted internal and external testing of their systems. The reports also would include information on contingency plans in case of system failures and the readiness of third parties upon which the adviser or fund relies for its critical systems. The Commission believes that the proposed Year 2000 reports will further encourage advisers to proceed expeditiously in preparing for the Year 2000. We expect that advisers will be required to file the reports in early December and again in June 1999. The Commission has proposed to make the reports available to the public on our website and will use the information gathered in the reports, among other things, to fulfill Congressional requests for information regarding the securities industry's readiness for the Year 2000 problem. The Commission staff intends to use the reported information to obtain a more complete picture of the industry's overall Year 2000 preparations and to identify firm-specific problems. Advisers that report questionable or inconsistent information will be asked to explain any problems that we find and could be subject to follow-up compliance examinations. Information in the reports, in conjunction with information obtained from industry groups and through the examination program, will enable the Commission staff to target its efforts for the rest of 1998 and 1999 on particular industry segments or firms that appear to pose the greatest risk of non-compliance. The Commission is currently reviewing staff recommendations on the proposed rule and expects to take final action on the rule by the end of the month. Mutual Fund Portfolio Investments Thus far, I have discussed the Year 2000 to the extent that it presents potential operational risks to mutual fund shareholders. Such a risk would be, for example, that a fund's computer systems may fail at the turn of the century. I understand that the Special Committee also is examining the important issue of the Year 2000 to the extent that it presents potential investment risks to mutual fund shareholders. These risks would include, for example, the risk that the operations of a company in which the fund invests would be adversely affected by the Year 2000 problem. The Year 2000 risks presented by the companies in which mutual funds invest, like any other investment risk, will be a factor that investment advisers to mutual funds may consider as part of their investment decision-making process. In discussions with major fund complexes, we have learned that their investment advisers are increasingly considering companies' Year 2000 compliance when they evaluate the merits of the particular companies as potential investments. One major fund complex advised us that its analysts ask standard questions about all prospective portfolio companies' Year 2000 readiness, including questions about the priority assigned and assets committed to the companies' Year 2000 program, the companies' consideration of risks posed by third parties (e.g., suppliers), and the current status of their progress in identifying and eliminating Year 2000 problems. Another major fund complex reported to us that its investment adviser's portfolio managers systematically address Year 2000 issues by carefully reviewing publicly available information about a company's Year 2000 readiness, and then following up with on-site visits for further fact gathering.[12] Fund complexes generally advised us that they expect Year 2000 analyses to become more refined as more information about Year 2000 becomes available. We believe that this kind of Year 2000 due diligence is, or will become, typical of the investment decision-making process used by many funds' investment advisers.[13] The Commission will continue to develop a more complete picture of the steps that funds' investment advisers are taking to address Year 2000 investment risks. The Commission staff has recommended to the Commission that the Year 2000 reports discussed above require fund advisers to indicate whether and how they consider Year 2000 investment risks in making investment decisions. This requirement will provide us with more information about the role of Year 2000 issues in fund advisers' investment decision-making process, and help focus advisers' attention on this issue. We believe that, based on the information that we have collected to date, no further action by the Commission is needed at this time to address fund advisers' consideration of Year 2000 investment risks. The role that Year 2000 investment risks should play in advisers' investment decision-making process depends heavily on the particular context. Fund advisers are legally required to manage their portfolios consistent with their stated investment objectives and strategies. In some cases, it may not be consistent with a fund's investment objectives (e.g., to invest in the S&P 500) or strategies (e.g., to rely exclusively on quantitative analysis) for the fund's adviser to take a companies' Year 2000 readiness into account in making investment decisions. The Commission believes that, because of the fact-specific nature of the investment decision-making process, imposing specific obligations on fund advisers regarding their consideration of Year 2000 investment risks would likely be impractical and potentially inconsistent with the way in which shareholders expect their funds to be managed. The Role of Investors One of the Commission's primary goals historically has been to apprise investors of the importance of understanding the risks of the investment vehicles in which they invest. Toward this end, the Commission has sponsored numerous public meetings to educate investors about the importance of understanding their investments. The Commission also has published on its website a list of eight questions that investors should ask their mutual funds about the Year 2000, including a question regarding the Year 2000 exposure of the portfolio companies in which funds invest. Anecdotal evidence that we have gathered to date suggests that investors are aware of this issue and many of them are contacting their advisers and funds to ask about Year 2000 issues. One major fund complex, for example, reported to us that it had received over 600 questionnaires from investors asking, in part, about steps that the fund's investment adviser was taking to incorporate Year 2000 considerations into its investment decision-making process. Conclusion We believe that the mutual fund industry is well aware of the potential problems that the Year 2000 presents, and is preparing to meet this challenge in a timely manner. Funds and advisers generally appear to be expending the effort and resources necessary to ensure Year 2000 compliance. The Commission will continue to actively evaluate the industry's readiness on Year 2000 issues, and will take further action as necessary against those advisers and funds that appear to present problems. Many fund shareholders and advisory clients are aware of this issue, requiring funds and advisers to view the Year 2000 problem not just as a regulatory issue, but as a business issue. In this regard, although we at the Commission will continue to monitor progress and do everything that we can to address the Year 2000 issue, funds and advisers will ultimately have to answer to the market and their clients if they are not ready for the coming millennium. *****FOOTNOTES***** [1]: The Investment Company Institute, 1998 Mutual Fund Fact Book (May 1998). [2]: The Investment Company Institute, Current Statistical Releases, Trends in Mutual Fund Investing (April 1998). [3]: The Investment Company Institute, Retirement Statistics, Retirement Plans Hold 35 Percent of Mutual Fund Assets (Oct. 14, 1997). [4]: See, e.g., Revised Staff Legal Bulletin No. 5 (pub. avail. Jan. 12, 1998); Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, Investment Company Act Release No. 23366 (July 29, 1998); Investment Adviser Year 2000 Reports, Investment Advisers Act Release No. 1728 (June 30, 1998) ("Form ADV-Y2K Proposing Release"). [5]: See Remarks of Chairman Arthur Levitt at the Investment Company Institute (May 15, 1998); "Mutual Fund Consolidation and Globalization: Challenges for the Future" - Remarks by Barry P. Barbash, Director of the Commission's Division of Investment Management, Mutual Funds and Investment Management Conference, Sponsored by the Federal Bar Association and the ICI Education Foundation (Mar. 23, 1998); "Remembering the Past: Mutual Funds and the Lessons of the Wonder Years" - Remarks by Barry P. Barbash, Director of the Commission's Division of Investment Management, 1997 ICI Securities Law Procedures Conference (Dec. 4, 1997); "Mutual Funds in the New Millennium: The Opportunity To Invent Their Future" - Remarks by Barry P. Barbash, Director of the Commission's Division of Investment Management, 1997 ICI General Membership Meeting (May 16, 1997). [6]: Commission Statement of Policy on Regulatory Moratorium to Facilitate the Year 2000 Conversion, Investment Advisers Act Release No. 1949 (Aug. 27, 1998). [7]: Data provided by the ICI. This information reflects responses to the ICI's questionnaire dated March 16, 1998. Responses were received from 77 investment company complexes between March 16 and June 3, 1998, and represent 66% of industry assets. Two of these firms did not provide a response to the question by the completion date. The program completion date for funds broke down as follows (percentage of funds): 1998 2d Q or earlier -- 3%, 1998 3d Q -- 5%; 1998 4th Q -- 72%; 1999 1st Q -- 8%; 1999 2d Q -- 11%; 1999 Post 2d Q -- 1%. [8]: The remaining fund complex informed the staff that it believes that Year 2000 issues will not materially affect its ability to provide the services described in fund registration statements. The complex has been working on Year 2000 corrections since 1996, reports frequently to the fund boards, and continues periodically to review the need for disclosure. In addition, the fund complex is considering providing supplemental communication to shareholders about Year 2000 issues. [9]: See ICI Survey supra note 7. [10]: Some advisers that answered that they had identified no problems explained that they either had new systems that were Year 2000 compliant or had contracted with third parties for virtually all of the services that might be affected by the Year 2000. The Commission staff will send letters to other funds that provided this response asking them to explain whether their responses indicate that they need to take additional steps to address their Year 2000 readiness. [11]: Form ADV-Y2K Proposing Release, supra note 4. [12]: Public information about the Year 2000 exposure of some portfolio companies only now is becoming widely available. See, e.g., Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, Investment Company Act Release No. 23366 (July 29, 1998). [13]: Our view is confirmed by a recent article, which outlines the decision-making process of the advisers to a number of larger fund groups. Fund Managers Hunt for Clues, Morningstar (June 16, 1998) (reporting fund portfolio managers efforts to obtain information about companies' Year 2000 readiness) (available at http:\\www.morningstar.net) .