Speech of Commissioner Norman Johnson * Securities and Exchange Commission to the National Organization of Investment Professionals May 5, 1997 Washington, D.C. * The views expressed here are my own and do not necessarily reflect those of the Commission, any individual Commissioner or the staff. Thank you. I am very pleased to speak at your Organization's annual meeting. The past year has been particularly exciting for me as a member of the regulatory agency that oversees our country's securities markets. As members of the securities industry and investment management community, you too have probably found that the past year brought significant changes, both on the business and regulatory fronts. One of the more important developments occurred about six months ago, when President Clinton signed into law the National Securities Markets Improvement Act of 1996 known as NSMIA. The Improvement Act modernized our securities laws in several important ways. It fundamentally altered the way the securities industry is regulated in the United States by more rationally allocating responsibilities between the states and the Commission. In recognition that the securities markets are national in scope, Congress appropriately preempted state Blue Sky laws in this area. The Improvement Act also reallocated the responsibilities of Federal and State regulators with regard to investment advisers. The Improvement Act also brought changes to the regulation of investment companies. The legislation gave the Commission new tools, such as enhanced inspection authority, to improve its oversight of the industry. The legislation also gave the industry greater flexibility in certain areas, such as advertising and the development of new variations on existing products, such as funds of funds. I am sure you have discovered that the new law affects you in many ways. One change that I found intriguing, and which I would like to focus on today, is the legislation's new approach to unregulated investment vehicles such as hedge funds and venture capital pools. Up to now, hedge funds, venture capital pools, and certain other types of financing vehicles have relied on an exemption from investment company regulation that limited each pool to no more than 100 investors. The Improvement Act now permits, as an alternative to the 100-investor pool, something called a "qualified purchaser" pool. Section 3(c)(7), the new section of the Investment Company Act that contains this provision, does not impose any limitations on the number of investors in these pools. Rather, it provides only that all of the pool's investors must be "qualified purchasers." Qualified purchasers are considered to be investors with a high degree of financial sophistication. They are in a position to appreciate the risks associated with investment pools that do not have the protections afforded by the Investment Company Act. Congress believed that these investors are likely to be able to evaluate on their own behalf such matters as the level of a fund's management fees, investment risk, leverage and redemption rights. Just who is a qualified purchaser? Congress considered a number of alternatives in deciding what type of investor is likely to have the financial sophistication to invest in an unregulated pool. Ultimately, Congress decided that the best, or most practical, measure of financial sophistication was the amount of "investments" that a person owned or managed on a discretionary basis. Thus, an institutional investor can be a qualified purchaser if it owns $25 million in "investments." A natural person also can be a qualified purchaser if he or she owns $5 million in "investments." But what is an "investment" for this purpose? Lots of questions were raised about this issue while the legislation was making its way through Congress. Most people agreed that the term "investments" generally should include securities. But what about securities that represent an ownership interest in a closely-held family business, like a dry cleaner? What about real estate? What about commodities? What about art work, antique automobiles and other collectibles? The legislation left many of the details concerning qualified purchaser pools to Commission rulemaking. In particular, the Commission was required to define what is an "investment" for purposes of determining whether an investor is a qualified purchaser. Last month, the Commission issued a comprehensive set of regulations to implement the provisions for qualified purchaser pools, including a rule defining the term "investments." Using the legislative history as a guide, the Commission defined the term "investments" broadly, but limited it in ways designed to reflect the investor's experience in the financial markets. Thus, the term investments includes securities, real estate, futures contracts, physical commodities, and cash and cash equivalents held for investment purposes. It does not include control interests in certain smaller businesses. The term also does not include the investor's personal residence. And finally, the term does not include non-financial assets, such as art works and other collectibles. This latter provision does not reflect a judgement on the part of the Commission that smart people do not buy art or jewelry for investment purposes. Rather it reflects a judgement, shared by many of the commenters, that these types of holdings do not necessarily suggest any experience in the financial markets or investing in unregulated investment pools. The Commission's rules were detailed and sought to respond to a range of issues that had been raised in connection with qualified purchaser pools. The rules generally were designed with the goal of making the qualified purchaser pool provisions user-friendly and reducing administrative burdens to the extent possible. Section 3(c)(7) became effective on April 9. It is still too early to tell whether this provision will achieve Congress's objectives. From the Commission's standpoint, I think that one of our major concerns was that our rules not create any unnecessary impediments to the development of these new pools. I hope that we have achieved this objective. I am sure that we will find out soon. The new qualified purchaser pools and the Commission's rules received significant attention from the industry and the press. There were at least three major themes in the public debate over section 3(c)(7) that suggest widely different perceptions of the importance of the new provision. First, there was the venture capital theme. The legislative history of section 3(c)(7) emphasized the role that unregulated investment pools can play in capital formation and providing financing for small businesses. Small businesses, often backed by venture capital, have come to be perceived as the real engine for job growth in this country. One recent study concluded that, between 1991 and 1995, venture-backed firms increased their staffs an average of 34% each year while Fortune 500 companies cut employment by about 4% a year. This study also found that the amount of capital that an average venture-backed company needs during its first five years of operation has increased by almost 130% since 1985. When the qualified purchaser provisions were pending in Congress, representatives of the venture capital industry testified extensively about how "crucial" these provisions were to their industry and capital formation in general. Thus, for many people, section 3(c)(7) is all about venture capital pools and the vital role they play in our economy. Then there was the hedge fund theme. Many commentators focussed on the potential that section 3(c)(7) held for hedge funds. The operation of hedge funds, and the role they play in the markets, often is questioned because they provide little public disclosure. It is not surprising to find a certain amount of ambivalence about the prospects that section 3(c)(7) will increase the size of hedge funds. It is also not surprising that commentators raised concerns about hedge funds becoming increasingly accessible to high-end retail investors. My point, though, is that for many people, section 3(c)(7) is all about hedge funds. What I found to be most intriguing, however, was the third theme -- the relationship of section 3(c)(7) to retirement plans. More and more often, whenever the Commission addresses an issue in investment company or investment adviser regulation, we find ourselves dealing with the question of how what we are doing will affect retirement plans. The issue of retirement plans loomed over section 3(c)(7) almost from the beginning. When the venture capital industry representatives testified to Congress on the legislation, they pointed out that one of their major sources of capital, pension plan money, was becoming increasingly less available. They attributed this trend, in part, to the growing shift from defined benefit plans, a major source of venture capital, to 401(k)-type defined contribution plans. Thus, they viewed qualified purchaser pools as a vehicle that would enable venture capital pools to seek investors other than pension plans. When the Commission came out with its proposed rules, the focus had shifted. The issue, in many people's minds, became whether a self-directed retirement plan could be treated as a qualified purchaser if it had $25 million of investments, even if the people who were directing the plan's investments -- the employees -- did not. Some commenters suggested that if a plan holds $25 million of investments in the aggregate, participants in the plan should have the opportunity to invest in a qualified purchaser pool offered as an investment option. Other commenters argued that the pool should "look through" the 401(k) plan to its participants to determine whether each investor in the pool is a qualified purchaser. The Commission made its view very clear. We concluded that the critical issue was not whether the employee is directing his or her investments through a 401(k) plan or a similar intermediary, but whether the employee owns the requisite amount of investments. Congress determined generally that the person making the decision to invest in a qualified purchaser pool had to own a certain amount of investments. A 401(k)-type plan is usually an intermediary through which an employee directs his or her investments. Therefore, if a 401(k) plan were to offer a qualified purchaser pool as an option, the pool must "look through" the 401(k) plan to see whether the employee who would be selecting that option is a qualified purchaser. On the other hand, a defined benefit plan, where the investment decisions are not made by the participating employees, can itself be a qualified purchaser if the plan has $25 million in investments. I would note, however, that it is important for the plan fiduciary, in exercising its responsibilities, to be in a position to evaluate the risks of the investment, whether it be an unregulated investment pool or another financial instrument. I view the Commission's approach to investment in the new pools by pension plans as both logical and prudent. Section 3(c)(7) is premised on the notion that the decision to invest will be made by a person with financial sophistication necessary to understand the risks of unregulated investment vehicles. When the investor is an institution, the investment decision may or may not be made on the institutional level. Sometimes, you have to look behind the institutional structure to its participants. This is the case with 401(k) plans. Of course, the line is not always simple to draw. The Commission recognized that, in some instances, defined contribution plans can be structured to function like defined benefit plans, with a fiduciary playing a greater role in selecting investments. The Commission has requested the staff to look into this issue further. I suspect that we will be hearing more about the interplay between section 3(c)(7) and retirement plans in the future. My larger point, however, is that this aspect of the debate over section 3(c)(7) is yet another instance that illustrates the growing importance of pension money and retirement plans in our securities markets. Retirement assets invested in pension plans and IRAs have reached over $5 trillion and clearly have assumed front-page importance. We have seen impressive recent growth in the 401(k) industry and the growing trend of defined contribution plans displacing the traditional defined benefit plan. The Investment Company Institute has declared that "[t]he retirement plan market is one of the most significant engines driving the mutual fund industry's unprecedented growth." At the end of 1995, retirement plans, excluding variable annuities, accounted for over one third of the mutual fund industry's assets. More than a third of the $525 billion of assets held in 401(k) plans were invested in mutual funds. The growing importance of investing for retirement has raised a host of policy issues that go beyond the traditional concerns of the securities laws. Commentators emphasize the role of pension funds as shareholder activists and the issues of socially responsible investing. Regulators and the financial community worry about state pension plans being underfunded. More recently, concern has been expressed about outside managers of these plans making political contributions to get the plans' business. And then there is the overriding issue of the future of the Social Security system. Even as we consider a new investment vehicle for sophisticated investors, the fact is that more average Americans, without much investment experience, are investing in the markets than ever before, in large part through their pension plans. Pension plans, in turn, increasingly find themselves serving as a structure that facilitates investment decisions by individual investors. Whether investors are in a position to evaluate their ever- growing number of investment options, therefore, is the crucial policy concern. I think that it is in all of our interests to assure that people get the right information, understand the risks, and invest wisely. Investment professionals generally have come to recognize the importance of providing guidance to individual investors. As Americans have assumed greater responsibility over their pensions and other investments, demand for financial guidance has increased. The last several years have seen a marked rise in the amount of assets invested in vehicles that make asset allocation decisions for investors, such as wrap accounts, asset allocation funds, and mutual funds that invest in other funds. Financial planners, paid for the advice they provide rather than for the sales they make, are capturing an increasing share of the financial advice market. For the Commission, the protection of individual investors is always the top priority. While the enforcement of our securities laws is fundamental to investor protection, investor education has become vitally important too. This is due in large part to the fact that the changing nature of pension plans is turning more and more Americans into active investors. In the past several years, the Commission has carried out its crusade of investor education with renewed vigor. The Commission created an office devoted exclusively to investor education and assistance. The Commission also has a toll-free telephone number to answer commonly asked questions, and a host of educational materials. Chairman Levitt has held town meetings with thousands of investors across the country. We have an effort underway to provide investors with prospectuses in Plain English, and major proposals to make mutual fund prospectuses a better tool for investors. The education of investors is not a task that the Commission can undertake alone. As investment professionals and members of the financial community, you too have probably come to realize the importance of educating the individual investor about our securities markets. I find evidence of this in today's intensely competitive field of investment management of pension plan assets. Increasingly, the place where service providers go head-to-head with their competitors is in the quality of the educational services they provide to plan sponsors. Companies are taking a cue from Madison Avenue and using sophisticated marketing strategies to reach participants or potential participants. Outside communications consultants are being called in to help. State-of-the-art advertising techniques, such as market segmentation studies and targeted audiences, are becoming the norm. Visits to the web sites of several mutual funds and financial services companies reveal that almost all of them have links to pages that deal specifically with retirement planning. Some of these sites provide interactive services, enabling investors to determine, based on their own circumstances, how much they need to save for retirement. Many of these web sites also have pages that explain the nuts and bolts of investing. Clearly, these firms have taken a hint from well-known clothing retailers and concluded that an educated investor may be their best customer. There is no shortage of innovative ideas on reaching investors and providing them with the education they need to make informed investment decisions. I encourage you to continue implementing those ideas. Thank you.