Securities and Exchange Commission Historical Society

Investment Company Regulation: The Intricacies of an "Enlightened Partnership"

“Successful and Safe,” 1980-2002

Distribution and Disclosure

At the beginning of 1980 some 1,508 registered investment companies held about $156 billion in assets.  At the end of 2002, 31,100 investment companies had $6.7 trillion under management, and about half of all U.S. households owned mutual funds.  Midway through this period the SEC was confident about mutual funds, noting that “their soundness is demonstrated by the successful and safe operation of investment companies.”38  This was not the result of a “hands-off” policy, however; throughout these years the SEC continued to fine-tune its regulations to accommodate innovation and promote investor interests.

The first major initiative of the period appeared to be a delayed response to the net redemption crisis but was more an effort to resolve a regulatory anomaly.  It all stemmed from the need for mutual funds to constantly sell shares to new investors—“distribution” in industry parlance.  Through the 1970s both regulators and fund managers assumed that it was a conflict of interest for funds to pay for distribution themselves, forcing new investors to cover the cost in the front-end load.  The problem was, there was nothing in the 1940 Act that supported this interpretation.  “It was kind of like the elephant in the living room,” said Director of Investment Management Joel Goldberg.  No one was looking—that is “until the pressure to increase sales became so great that some in the industry effectively challenged the Commission’s position.”39 

The pressure came from two places: Vanguard, which had no commission-paid sales people and so could not fund distribution the usual way, and from the new no-load money market funds.  Faced with applications for exemption from a practice that was not illegal, the SEC held two rounds of hearings.  The result, implemented in October 1980, was creation of the “12b-1 fee,” enabling funds to pay directly for distribution.   The Commission had assumed that the fees would remain low and pay only for advertising.  But as the decade went on 12b-1 fees grew and began to take the place of the front-end load,revolutionizing the business by beginning the shift from front-end charges to asset-based fees. 

Although 12b-1 provided the resources enabling funds to better advertise, there was no comparable rule that marked off safe territory for the content of fund advertisements, only Section 206 of the Advisers Act which prohibited misleading advertising.  The funds, therefore, relied on precedent set by no-action letters, the most important of which, issued in 1986, provided Clover Capital Management Incorporated with assurance that it could use model or actual results so long as they were not misleading under the terms of Section 206.

The 1980s and 1990s were generally deregulatory years, and in tune with the times, the SEC allowed funds to innovate.  Why, for example, should purchasers of large blocks of funds pay the same distribution costs as purchasers of smaller blocks?  Starting in 1985 the Commission began allowing individual exemptions, and finally wrote an exemptive rule allowing multiple classes of funds with different distribution and expense arrangements.  A 1995 exemptive rule enabled funds to charge a “contingent deferred sales load” to shareholders who exited a fund early.

Despite the SEC’s generally deregulatory bent, as former Senior Counsel to the Director in the Division of Investment Management Angela Goelzer later put it, “there was certainly a great deal of concern that investors were not as financially sophisticated as one would hope.”40  They were not helped by fund prospectuses that had become impenetrable.  The SEC offered a way through the thicket in 1983 with the creation of form N-1A which split the document into a simplified prospectus that investors could readily understand and a statement of additional information of less urgency.  In early 1988 the SEC required that a fee table, including standardized performance calculations, be placed at the front of the simplified prospectus along with a summary of potential expenses over a multi-year period.


Although no period would ever match the 1970s for mutual fund innovation, the late 20th century was marked by efforts to improve old innovations and spur new ones.  Richard Breeden came to the SEC in 1989 after drafting Savings and Loan Crisis legislation.  He knew that public confidence in money market funds was essential, and so he was determined to make them as safe as practicable—while ensuring that investors did not believe them safer than they were.  In 1991 the Commission adopted revisions to Rule 2a-7 (which allowed money market funds to maintain their $1 NAV) requiring prominent disclosure that the funds—unlike bank money market accounts—were not insured by the government.  The revisions also shortened the average time of maturity for money market investments and restricted them to particularly safe classes of investments.  Still, there were a few close calls in the 1990s when money market funds came close to “breaking a buck.”  The SEC allowed sponsors to buy portfolio holdings from money markets funds with no action letters.  In 1994 and 1996 the Commission again fine-tuned 2a-7 to ensure diversity, boost quality, and shorten maturity.

The chief mutual fund innovation of this entire period was the rise of the exchange traded fund, an index fund that could be bought and sold throughout the day.  The first practicable exchange traded fund was the State Street Global Advisors S&P 500 Depository Receipt (SPDR), which debuted on the American Stock Exchange in 1993.  As in the 1970s, the flexibility of the 1940 Act fostered the growth of this unexpected new industry—the SEC provided exemptive relief necessary to enable SPDR shares to be traded on the secondary market without issuance of a prospectus.  The success of SPDR soon spawned imitators.  In 1997 exchange traded funds had some $2.4 billion in assets—by 2000 that number had jumped to more than $38 billion.

Exchange traded funds were being developed at about the same time that the SEC was looking closely at investment company innovation in its study Protecting Investors: A Half Century of Investment Company Regulation, released in May 1992.  This study was another initiative spurred on by Richard Breeden who believed that an assessment was overdue.  There was some reason for concern.  In the wake of the October 1987 market crash, the Brady Report found that while most mutual funds had purchased some $134 million worth of shares during the event, three of the largest mutual fund complexes, including Fidelity, had sold some $913 million, helping to destabilize the market.  Less than five years later, however, the SEC’s “Red Book” (so-called because Breeden insisted that Stanford cardinal be the color used on the cover) found investment companies to be “successful and safe.”

Included in the Red Book were suggestions of a deregulatory nature such as permitting foreign investment companies to sell shares in the United States, allowing more options for distribution, and expediting the exemptive process.  The study also suggested creation of three new types of funds: extended payment companies, interval funds, and unified fee investment companies.  The former two were intended to create more liquid funds, the latter to spur price competition.  None of these options were taken up by entrepreneurs.

Other recommendations proved to be of greater import.  One dealt with “structured finance,” the securitization of assets which was then being pioneered in the mortgage market and would one day help lead to the Great Recession.  Since these instruments could not function like investment company products, the SEC recommended that they be exempted from the 1940 Act.  This was one of the first items dealt with in Rule 3a-7 issued in late 1992.  Another recommendation was to redefine private investment company exemption.  The 1940 Act defined a private investment company as having no more than 100 shareholders.  The study recommended instead excluding private investment funds with any number of “highly sophisticated persons,” thus paving the way for the growth of hedge funds.41

Market Improvement

It took Congress to redefine exempt investment funds, which it did four years after release of the Red Book in the National Securities Markets Improvement Act of 1996 (NSMIA).  SEC Chairman Arthur Levitt was critical of the developing legislation, intended chiefly to limit the right of private action in securities cases, but he was able to convince Senate Banking Committee Chairman Phil Gramm to work some more welcomed measures into the bill.42

Up to 1996 investment companies were regulated by both the federal government and the individual states.  This created endless headaches for new funds, with the most idiosyncratic of state regulations applying, in the end, across all 50 states.  The Investment Company Institute had tried unsuccessfully to get these barriers removed, working with state regulators for a uniform securities law and arguing for a “blue chip exemption.”

The SEC Division of Investment Management worked closely with congressional drafters, and the resulting legislation, signed in October 1996, furthered the Commission’s efforts to reduce unnecessary regulatory barriers.  In addition to excluding a new category of private investment funds from the 1940 Act, NSMIA removed jurisdiction over mutual funds from the states.  It also distinguished between investment advisors who managed a mutual fund of more than $25 million in assets (who remained registered with the SEC) and advisors with smaller assets who were henceforth regulated solely by the states.  NSMIA also empowered the SEC to create an electronic database for advisor registration which became known as the Investment Advisor Registration Depository (IARD).  But even as the Levitt Commission was undertaking post-NSMIA rulemaking, it was also taking steps to improve disclosure and governance.

Simplifying the prospectus remained a challenge.  Despite initiatives in 1983 and again in 1988, what the ICI’s Matt Fink termed “disclosure creep” continued.43  In the 1990s the effort gained additional momentum as part of Levitt’s overarching insistence on using “Plain English” in the affairs of the SEC.  He also criticized fund prospectuses for being written in “impenetrable legalese, by and for securities lawyers.”44  In 1995 the SEC and the ICI agreed upon an 11-item “profile” that could be issued along with a simplified prospectus.  This approach, along with another round of simplification of the primary disclosure form, was authorized in 1998.

During 2001 the SEC pushed for more transparency on two new fronts.  One problem was that taxes could vary widely depending on how a fund was structured.  Following a failed legislative attempt to mandate the disclosure of mutual fund tax burdens, an SEC rule required disclosure of after-tax earnings at increments of 1, 5, and 10 years.  At the same time the Commission required more accuracy in the naming of funds—requiring a fund that called itself a “Large Cap” fund, for example, to have at least 80 percent large cap stocks.

By far the most important of the Levitt-era mutual fund regulatory initiatives was the imposition of governance reforms—part of a broader Commission concern.  Levitt’s call for mutual fund directors to be more aggressive in protecting shareholder interest culminated in 1999 with the creation of the Mutual Fund Directors Education Council, later renamed the Mutual Fund Directors Forum.  The ICI, in turn, organized the Independent Directors Council, which later became a freestanding entity.  In 1999, following an SEC Roundtable on the  subject, the Commission proposed three new rules: that funds have majority independent directors, that those independent directors be nominated by other independent directors, and that funds have independent legal counsel.  Normally this would have been left up to Congress—the 1940 Act specified that only 40 percent of directors had to be independent.  But Investment Management director Paul Roye took a cue from predecessor Joel Goldberg.  Funds, Goldberg had stipulated, could take advantage of 12b-1 only if they had a majority of independent directors.  The 2001 rules provided that for funds to take advantage of any of ten specific exemptions they would have to have majority independent directors.45

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(38) Protecting Investors: A Half Century of Investment Company Act Regulation, SEC Division of Investment Management (May 1992), xxii.

(39) Securities And Exchange Commission Historical Society Roundtable On Investment Company Regulation, December 4, 2002, 86.

(40) October 17, 2013 Interview with Angela Carcone Goelzer, 18.

(41) June 16, 2011 Interview with Marianne Smythe, 25.

(42) June 7, 2016 Interview with Robert Plaze, 26.

(43) Matthew P. Fink, The Rise of Mutual Funds, An Insider’s View (Oxford, 2008), 161.

(44) Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance (New York, 2003), 649.

(45) June 21, 2016 Interview with Paul Roye, 25.

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August 17, 2017
August 17, 2017

Oral Histories

17 October 2013

Angela Goelzer

20 April 2016

Joel Goldberg

07 June 2016

Robert Plaze

21 June 2016

Paul Roye

16 June 2011

Marianne Smythe

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