Remarks Of Richard Y. Roberts Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "Current SEC Issues of Interest" State of Mississippi Secretary of State's Investor Education Program Mississippi Business EXPO '95 Jackson, MS January 18, 1995 ____________________ */ The views expressed herein are those of Commissioner Roberts and do not necessarily represent those of the Commission, other Commissioners or the staff. I. Introduction I appreciate the opportunity to participate in this conference. It is my intention today to touch upon three areas which I hope will be of interest to this audience. First, the SEC's consumer initiative underway, including a brief discussion of some mutual fund issues. Second, some issues surrounding the recent municipal bankruptcy filing by Orange County, California. Finally, I will discuss briefly some disclosure developments with respect to derivatives activities. II. Consumer Initiative I know that for some of you, this may be the first time you've had occasion to meet anyone from the Securities and Exchange Commission ("SEC" or "Commission"). Maybe no one thought we had many interests in common. I'm here today because I think we do. In the 1990s, more than ever before, the people of America are investing in America. There is a startling new economic fact of life in our nation: This past year, for the first time in history, investment company assets surpassed the deposits of the entire banking system. Through mutual funds and other investments, individuals are the biggest holders -- directly and indirectly -- of American stocks and bonds. Not the banks, not the insurance companies, not big businesses -- but people like you. The massive movement into our securities markets has provided new opportunities for investors -- and new opportunities for America. But it's also increased risk -- and it's created confusion and a greater potential for abuse. Investors are not as informed as they should be. It's a complicated field, and there are many misconceptions even about such simple products as mutual funds. The new realities of our marketplace call for a new approach. We're not going to stop any of the things we do -- instead, the SEC is doing more every day to forge a partnership with investors. Chairman Levitt has recently created an SEC Consumer Affairs Advisory Committee to advise the SEC on the issues facing the public in our markets. The Commission was created to protect investors; now we're asking investors to tell us about the issues they face in our markets. At the same time, I recognize that there's too much information out there for even 100 brochures to cover. That's why the most important investment lesson I can convey to you today from an investor's standpoint comes down to two simple words: Ask questions. What kinds of questions should you ask? Some are about products, especially mutual funds, and some are about those who sell them. I do wish to spend a few minutes talking more specifically about mutual funds. Let's start with a specific kind of mutual fund, a money market account. Banks offer a "money market deposit account," which is FDIC insured; but many now also offer a type of mutual fund known as a "money market fund," which is not FDIC insured. Those names sound awfully similar... I'm not saying that one is better than the other -- just that you should know which one you're buying. Ask the salesperson. When I look at the names of money market funds, I see a lot of reassuring words like "trust," "liquid," "government," "cash," "U.S.," "ready assets." Well, I don't care what a fund is named -- in any market investment, you stand a chance of losing your principal. Just a year ago, surveys revealed an astonishing number of people who believed that federal deposit insurance prevents them from losing money. The problem has since received plenty of attention in the industry, among regulators, and in the press, and a new survey shows that the tide may have turned -- a majority of those surveyed understood that mutual funds are not FDIC insured. An informed investor looks beyond the packaging of a fund, and also sees what's inside. Some funds do use high-powered investments known as derivatives -- a household word today, because they've led to some notorious problems. Derivatives are not inherently bad or good -- they're just volatile. A wise investor will ask whether a fund holds any derivatives, and if so, how much the fund could be hurt if they backfired. There are lots of other questions to ask about mutual funds. How often does the portfolio change? Heavy buying and selling can maximize return -- but it can also generate lots of commissions for brokers, and lots of expenses for investors. Look at the prospectus or the annual report. Too much money chases last year's results. The truth is, past performance is not a reliable indicator of future performance. A fund that is number one in its category this year, or over the past five years, may be just average next year. Assuming a fund's investment strategy has remained the same, the only thing you can predict from past behavior is volatility - - that is, if its value has tended to rise and fall rapidly in the past, it's likely to do so in the future. That's all you can tell. Know what kind of sales charge, or "load," you'll pay -- front-load, back-load, or no-load. What annual fees? You should look at a "load" like a handicap in sports -- a fund with a 3 percent load is effectively starting out at minus 3 percent against a comparable no-load fund. There's a mistaken impression that funds with a higher load or higher fees must perform better because they cost more -- call it "the Tiffany effect." It's just not true: front-loaded funds, for example, have not performed better overall than comparable funds without a load. There may be other reasons to buy a fund with a load -- having access to a broker's services, for example -- but performance is not one of them. Fees, too, can cost you: Again, there may be very good reasons for the higher fee -- an international fund is far more difficult to manage than a fund that's tied to an index. You have to decide if the fee makes sense. Once you do own a fund, keep track of how it's performing relative to others of its type -- not just quarter by quarter, but also over the long term -- and evaluate it against an index such as the Dow Industrial Average, for stock funds, or the Salomon bond index, for bond funds. A journalist once poked fun at Wall Street indexes by saying they "predicted nine of the last five recessions." They're not infallible -- but they're the best benchmarks we have. Use them. III. Orange County I wish to change gears at this juncture and talk about some current securities public policy issues that the SEC is wrestling with. I will start with the tragedy which unfolded in Orange County last year. As a result of the bankruptcy filing by Orange County, California, and the events leading thereto, municipal securities investors around the country were rattled, leaving the muni market with the jitters. The municipal securities market has undergone periods of great stress before when liquidity was absent from the market. On each occasion, in time, the muni market rebounded to be stronger and even larger than before, and most expect this to be the result from the Orange County adversity as well. Certainly, as the level of information has improved about the extent of Orange County's troubles, the muni market has become less nervous and more stable. The usual reaction to any financial market disaster is to call out for an increase in the federal oversight of the areas involved, which, in the case at hand would include the municipal securities market. Much of the reaction to the Orange County tragedy has followed this traditional pattern, and there have already been a number of calls for additional federal legislation to reform, among other areas, the muni bond market. More specifically, some have suggested imposing on the municipal securities market the initial registration and continuing disclosure requirements applicable in the corporate securities area. Upon reflection, any such response should be resisted, at least for the immediate future. Notwithstanding the Orange County problems, historically, defaults in the municipal area have lagged considerably behind those in the corporate area, so right off the bat serious cost- benefit concerns arise about the necessity for corporate style registration in the municipal area. Further, while the municipal securities market does need more information about bond issuers, especially on an ongoing basis, and more information about bond prices, again particularly in the secondary or trading market, the SEC already has in progress an ambitious program designed to eliminate those information deficiencies. The SEC's muni effort underway may preclude the necessity for any additional federal intervention in the marketplace, and, in my opinion, the SEC municipal securities projects either recently completed or in substantial progress should be implemented before any new initiatives are considered. At this juncture, it may be helpful to review the SEC muni program currently underway. Last March, the SEC approved and published an interpretive release emphasizing to municipal securities issuers and underwriters their disclosure responsibilities, both at the offering stage and on an ongoing basis, under the federal securities antifraud laws. As this release merely clarified existing law, it was effective immediately. In November, the SEC approved a stringent set of rules, developed with the assistance of a wide array of muni market participants, which limit the ability of brokers to sell municipal bonds unless the issuer of those securities agrees to make available, and does make available, certain information on an ongoing basis to the marketplace. These new regulations, unprecedented for the municipal securities market, will be phased in over the course of 1995. Finally, the SEC is developing, again with the assistance of the municipal securities industry, a pricing information system which should result in vastly improved price transparency for municipal securities investors interested in trading muni bonds. This latter project will take several years to complete. Once effective and implemented, the SEC program underway may result in an adequate cure for the information deficiencies now present in the municipal securities market and exposed by the recent events in Orange County. Of course, muni market participants can elect to ignore whatever rules are in place, but by doing so, they run the risk of being subjected either to an SEC enforcement action or to a private suit from a disgruntled investor. Chairman Levitt has made it clear that the municipal securities market is now, and will remain so for the next several years, a focus of the SEC's enforcement resources. For the last year or so, the SEC has aggressively pursued a program designed to eliminate the information deficiencies which exist in the municipal securities market, and this program is well on its way to completion. More may need to be done from a regulatory or legislative perspective as a result of the events which unfolded in Orange County, especially at the state level. However, rather than saddle the participants in the municipal securities market with even more rules or new laws, the more responsible, immediate reaction would be to allow those participants a reasonable length of time to digest the massive regulatory changes either already initiated by, or forthcoming soon from, the SEC. For the present, the calls for a response to the Orange County fiasco with new federal laws or rules, at least so far as the municipal securities market is concerned, should be resisted. All the municipal securities market reforms necessary may already be underway. IV. Derivatives Disclosure My final topic, derivatives disclosure, has also received quite a bit of attention of late. Hardly a day went by in 1994 without another development pertaining to the topic of derivatives. Early in 1994, the news was filled with stories of companies declaring multi-million dollar charges against earnings as a result of losses incurred in various derivatives activities. Later in the year, in September, the impact of derivatives activities on the part of some money market mutual funds came to the fore when an institutional money market fund announced that it would liquidate due to losses incurred as a result of certain aggressive derivatives activities. In October, witnesses representing a Texas college, a Maryland county, and an Indian tribe described to Congress how various imprudent investments in derivative financial instruments resulted in losses for their respective organizations. In the early days of November, the news was of lawsuits on the part of dissatisfied institutional derivatives investors. And, as I indicated earlier, in December, the news was centered around the aggressive investment philosophy and ensuing bankruptcy of Orange County, which utilized derivatives extensively in its investment portfolio. Now, other than with respect to money market mutual funds, I am inclined to believe that, as a general proposition, the marketplace and not the Commission should determine the success or failure of the various potential investment products available, even if those products are highly volatile. But the experiences I recited should make it clear how important accurate and adequate disclosure of an organization's derivatives activities is to the marketplace. In particular, potential investors need to know what the derivatives activities of a company are and of a mutual fund are, and the nature and level of risks involved, in order to make an informed investment decision. Having already mentioned mutual funds, I will now stick to the corporate side; and the first corporate derivatives disclosure- related development that I intend to mention is the October issuance by the FASB of Statement No. 119, entitled "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments" ("Statement 119"). Statement 119 requires improved disclosures about derivative financial instruments, which would include futures, forwards, swaps, options contracts, or other financial instruments with similar characteristics. I also should point out here that the FASB intends to issue guidelines regarding hedge accounting at some future date, and the FASB apparently has reached some tentative decisions as to how this project should proceed. Recent reports suggest that such guidelines will not be finalized for some time, which is an unfortunate development. However, I recognize that many issues with respect to hedge accounting are very complex, time-consuming to deal with, and not susceptible to quick, easy answers. While Statement 119 will improve substantially the current state of derivatives disclosure, and guidelines on hedge accounting should prove very helpful when finally issued, a strong argument can be made that more needs to be done to improve disclosure and accounting practices relating to derivatives. I am troubled by guidelines in Statement 119 that would encourage but not require end-users to disclose quantitative information about their derivatives positions and point out that Chairman Levitt offered a similar view in congressional testimony earlier this year. It should be no surprise therefore that another regulatory development deserving your attention in this area is the current consideration by the staff of the Commission to provide guidance supplementing Statement 119. That guidance could take the form of a release that is part interpretive and part rulemaking. While I cannot predict at this time what action eventually will be taken, I suspect that, among other things, strong consideration will be given to clarifying the MD&A disclosures required by Item 303 of Regulation S-K, as those disclosures relate to issuers active in the derivatives market. The objective would be to make sure that the disclosures are adequate to convey the risks assumed. I recognize that many may not welcome the Commission's help in the corporate derivatives disclosure area; and I do acknowledge that there has been some improvement recently in the disclosure by companies in Commission filings of their derivatives activities. Further, additional improvement should result from the FASB's issuance of Statement 119. However, the staff of the Commission apparently is of the view, and I am inclined to agree, that further disclosure guidance from the Commission is necessary to ensure consistent and comprehensive disclosures to enable investors to better understand the business purposes and effects of a company's derivatives activities. V. Conclusion There are many other initiatives ongoing at the Commission these days, but time does not permit me to mention them. I have chosen two subjects that I thought may be of interest to the member of this audience. Further, I felt compelled to mention the SEC's ongoing investor awareness program. I am not here today just to offer help, but to ask for it; not just to give advice, but to receive it; not just to speak, but to listen. I want to hear from you about the state of our securities markets, and I want your help in making them better. For when all is said and done, the SEC is not about this rule or that regulation -- it's about hardworking people seeking a better life -- buying that new home, sending the children to college, enjoying a decent retirement, taking that much-needed vacation. It's about the promise of America. Please help America fulfill that promise, and, at a minimum, become a more educated investor.