MUTUAL FUND DISTRIBUTION

AND SECTION 22~d) C)F THE

INVESTMENT COMPANY ACT OF 1940

Su~mitter.: f3}•

OIVISlON OF

iNVESTAIENT MANAGEMENT REGULATION

SECURITIES AND EXCHANGE COMMISSION

AUGUST 1974
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OFFICE OF

THE CHAIRMAN

N OV 4 1974

Honorable John Sparkman

Chairman'of tNe Committee on Banking,

Housing and Urban Affairs

United States Senate

Washington, D.C. 20510

Dear Mr. Chairman:

When the Senate Committee on Banking, Housing and Urban Affairs

considered the 1970 Amendments to the Investment Company Act (the

"Act"), it requested the Commission`s views on the repeal of

Section 22(d), which requires retail price maintenance.* Because

the Commission indicated that it lacked sufficient information

upon which to base a recommendation, the Committee asked that

the Commission study the consequences of repeal and report to it

as soon as practicable:

Such a study was conducted by the Commission's staff and its report,

~ entitled "The Potential Economic Impact of the Repeal of Section 22(d)

of the Investment Company Act," was transmitted to the Committee in

November 1972. Neither it nor the Commissions letter of transmittal

made any express recommendations as to what should or should not be

done about Section 22(d). Before making any definitive recommendations,

the Commission determined to hold public hearings to explore the major

issues in the marketing of mutual funds and to reexamine traditional

administrative positions which affect them. The hearings were held in

February and March of 1973 and dealt not only with whether Section 22 (d)

should be repealed but also with the broader question of what can and

should be done to enable investment companies to bring their message to

the investing public more economically and effectively than has heretofore been the case.

* The term "retail price maintenance",has been generally used, and

is used in this letter, to describe the pricing practices required

by Section 22(d). However, this type of pricing is different

from retail price maintenance for consumer and other goods.

_ The price of mutual fund shares has two components: the net

asset value which fluctuates depending on the value of the fund's

portfolio and, in many cases, a sales charge. Sales of shares

at less than net asset value would result in dilution of the

assets of the fund, and would clearly be detrimental to the

interests of existing shareholders. Therefore the only aspect

of the practice required by Section 22(d) which bears any

~,,., resemblance to retail price maintenance for consumer goods is

the requirement that the sales charges specified in the prospectus

be binding on all dealers.
Honorable John Sparkman

Chairman of the Committee on Banking,

Housing and Urban Affairs

United States Senate ii.

As a general policy, the Commission believes it appropriate to

promote efficiencies in securities distribution through retail

price competition. However, implementation of this policy in the

distribution of mutual fund shares is not an easy task. Simply

stated, it is our judgment that neither the industry nor the

investing public would benefit from the disruption that might

arise upon immediate repeal of Section 22(d). Accordingly, the

Commission does not recommend such a drastic step. Instead, we

intend to exercise our available administrative authority to

encourage the industry to move toward competition. At the same

time, we are requesting that Congress provide the Commission with

clear administraCive authority to modify the operation of

Section 22(d) in light of experience gained with the initiatives

we propose.

We are pleased„ to transmit a report prepared by our Division of

Investment Management Regulation which reviews the mutual fund

distribution system today and discusses the elements of our

recommended program in greater detail.

BACKGROUND

The subject of mutual fund distribution has been an important part

of a series of reports and studies made for and by the Commission

over more than a decade. _As early as 1962, it was considered as part

of.a Study of Mutual Funds conducted for the Commission by the

Securities Research Unit of the Wharton School of the University of

Pennsylvania. This was followed i.n 1963 by the Special Study of

the Securities Markets,_which included discussion and recommendations

with respect to certain aspects of the marketing of mutual funds.

Following the Special Study, the Commission dealt more .specifically

with the marketing of mutual fund shares in its 1966 report on the

"Public Policy Implications of Investment Company Growth." There

the Commission found that the sales charges for mutual fund shares

bore "no reasonable relationship to the cost of investing in other

types of securities." The Commission reasoned that the recommendations

of securities firms and their salesmen could be unduly influenced,

perhaps subconsciously, by major differences in sales compensation

and that some degree of equalization in the level of compensation for

selling different types of securities might be appropriate. Therefore,

the Commission concluded that the cost of purchasing mutual funds .

should be lowered.
Honorable John Sparkman

Chairman of the Committee on Banking,

Housing and Urban Affairs

United States Senate iii.

At that time, the Investment Company Act effectively insulated mutual

fund sales charges from price regulation and price competition. That

r is, until 1970, Section 22 (b) of the Act gave the National Association

of Securities Dealers (the "NASD") and the Commission rulemaking

authority to prohibit only "unconscionable or grossly excessive" sales

charges on mutual fund shares. This permissive standard, combined

with the retail price maintenance provisions of Section 22(d), prevented

both effective price regulation and effective price competition.

In connection with the legislative recommendations growing out of its

1966 Report, the Commission considered having sales loads determined

by competition among retail dealers through repeal of Section 22(d}.

However, the Commission was uncertain what effects repeal of Section

22(d) would have on mutual fund distribution, and it also considered

a variety of regulatory solutions to the problems it saw in the sales

load area. As a compromise, the Commission acquiesced in a proposal

to amend Section 22(b) to give the NASD rulemaking authority, with

Commission oversight, eo prevent mutual funds from being sold at a

sales load which is "excessive." Congress adopted this solution.

At the same time, your Committee requested that the Commission study

the consequences of repeal of Section 22(d).

In a related development, in February 1971, the Commission completed

its Institutional Investor Study Report. In its letter transmitting

that report to Congress, the Commission recognized that, to the extent

that elimination of fixed minimum commission rates would reduce or cut

off an important source of income for distributors of mutual fund shares,

direct sales charges or payments to fund sellers would have to be

increased -- or mutual fund distribution would have to be curtailed --

unless lower cost distribution meChods were developed. The Commission

indicated that it preferred the development of such lower cost distribution methods.

THE HEARINGS

At the February and March, 1973, hearings, some seventy persons appeared

and more than 100 written comments were filed. The testimony and

comments made clear that the mutual fund industry is beset by new - and

serious difficulties quite different from the spectacular growth which

the Commission reviewed in its 1966 Mutual Fund Report. Record sales

of earlier years have given way to net redemptions; competing products
Honorable John Sparkman

Chairman of the Committee on Banking,

Housing and Urban Affairs

United States Senate iv.

have made substantial inroads; fund managers have diversified into

other fields; many fund underwriters have allowed their relationships

with small broker-dealers to deteriorate; and the industry has become

increasingly dependent for sales upon large broker-dealers to whom

mutual funds are a relatively unimportant source of income. Moreover,

in man}' cases retailers fail to provide adequate service to fund

shareholders after the initial sale. At the same time, the mutual

fund distribution system continues to cause many purchasers to pay

for services which they do not want or need.

In reexamining our traditional administrative positions with respect

to mutual funds, we found that the operation of the regulatory system

has made it difficult for funds to take advantage of some of the

marketing practices traditionally used to stimulate demand, including

effective advertising and mass-merchandising techniques such as group

discounts. In addition past restrictive Commission interpretations.

with respect to Section 22 (d) not only prohibit price competition

among retailers but also discourage price competition among funds,

unde nariters and complexes. In sum, the regulatory framework has

encouraged funds to rely upon intensive personal selling efforts -- an

inefficient and expensive method of distribution.

Meanwhile, changes in brokerage allocation practices of mutual funds,

the reduction in mutual fund brokerage resulting from the onset of

fu11y competitive stock exchange rates, and competition from other

financial products which can be more easily sold on the basis of current

yield (and which also offer attractive incentives to salesmen), make it

increasingly difficult for mutual funds to compete successfully for the

salesman's favor, even while they are hampered in developing market

demand among investors. In shorC, the mutual fund industry's historic

reliance upon high fixed sales charges to induce salesmen to "push." fund

shares, besides being expensive for investors, is simply not working

today.

THE COMMISSION'S REASONING

It is clear that the present retail price maintenance system has

produced a distribution system which can and should be improved upon,

The Commission has concluded that price competition at the retail level.

is a desirable goal. It appears to us, however, that the _immediate

abolition of Section 22(d) would serve the interests of neither the

public nor the industry.
Honorable John Sparkman

Chairman of the Committee on Banking,

Housing and Urban Affairs

United States Senate w.

For more than three decades, the marketing strategy of the mutual

fund industry has been to rely almost exclusively upon a sales "push"

rather than a demand "pull;" or, as is often said, fund shares are

"sold, not bought." In this environment, it would be unrealistic

to suppose Chat a sudden end to retail price maintenance would be

accompanied by the level of investor sophistication and sensitivity

to sales loads that would be needed to make a price competitive

distribution system work. The more likely result of a precipitous

end to retail price maintenance would be an end to widespread

distribution of mutual fund shares, and most Americans would not

have an opportunity to consider investing in mutual funds. As a

consequence, many mutual funds - which by their nature tend to be

self-liquidating and, therefore, require continuous distribution -

would be adversely affected.

No issuer of securities is subject to more detailed regulation than

a mutual fund. Implicit in the decision of Congress to establish a

thoroughgoing sCatutory scheme to govern mutual funds is, we think,

a determination that mutual funds are a product which, with appropriate

safeguards, should be made available to the public. While the

Commission would not suggest that any particular investor should buy

mutual funds, neither is it presently prepared Co take or recommend

action which might result in an abrupt end to fund distribution.

Therefore, the Commission has chosen a middle path, intended to reduce

or eliminate many of the inequities and inefficiencies of the present

fund distribution system while, at the same time, avoiding the dangers

of a sudden abolition of retail price maintenance. We have decided to

exercise fully our existing administrative powers to lay the groundwork

for the. gradual and orderly introduction of retail price competition

into the mutual fund distribution system.

The Commission`s aim is to allow the industry to adopt voluntarily programs

designed to seC the stage for retail price competition. In order to

assure that the Commission will have adequate authority to move the

industry in this direction in a meaningful way if such action should

prove to be in the public interest, we shall also request that Congress

expand the Commission's authority to select from a broad variety of

Long-range options for administrative actions which mzght later be

taken to remove any lingering inhibitions upon competition. Such action

would be taken if experience indicates an undue lack of willingness in

the industry to take advantage of the opportunities which we intend to

provide or if the Commission concludes that regulatory action should be

taken to hasten movement toward a more competitive environment.
Honorable John Sparkman

Chairman of the Committee on Banking,

Housing and Urban Affairs

United States Senate vi.

OUR PROGRAM

As first steps, we will permit greater opportunities for the culCivation

of public demand for mutual fund shares by allowing greater flexibility

in fund advertising and more meaningful portrayal of investment results

in fund sales literature. Our program will also provide greater

opportunities for mass-marketing by allowing quantity discounts and

other price variations for a wide variety of groups including all

employer-employee groups. Certain proposals for rule amendments

necessary to implement these recommendations have already had long

exposure and are at a point where immediate action can be taken°

In addition, we will shortly publish for comment proposed rules which

will be designed to a11ow investment companies and their underwriters

increased opportunities to initiate price variations. These wi.li

include a rule which would allow underwriters to provide for periodic

"open seasons" during which persons who have held shares for at least

a specified period could buy additional shares at a reduced price, and

a rule relieving issuers of variable annuities from the restrictions

of Section 22(d), provided that they do not engage in any unjust price

discrimination. We will also view favorably applications for exemption

from Section 22(d) to permit combination discounts where mutual funds

and other financial products distributed by the same undenariter are

purchased from the same retailer.

Moreover, two steps are planned which will permit some price fle.xibilY~y

at - the retail level through increased opportunities for brokered transactions. We intend to ask the NASD ro adopt a rule to prohibit contractx;al

restrictions which could prevent dealers from engaging in brokered

transactions in fund shares. If necessary, we might adopt a complement_a.r;

rule under the Investment Company Act td prevent funds from restricting

the transferability of their shares in a secondary brokered market. In

addition, we. will authorize our staff, on an experimental basis, to view

favorably interpretive requests with respect to proposals that brokers

which act independently of funds and their underwriters be permitted,

under certain circumstances, to charge reasonable fees for services

rendered in connection with the purchase of shares of "no-load" funds.

Finally, we are notifying the NASD that we would not object to the

adoption, with certain minor changes, of the full service maximum sales

load rule which it formulated pursuant to the 1970 amendments to the Act.

the rule permits a sales load of up to 8 1/2 percent to be charged oe~l~
Honorable John Sparkman

Chairn►an of the Committee on Banking,

Housing and Urban Affairs

United States Senate vii.

by those funds which offer dividend reinvestment at net asset value,

rights of accumulation and certain volume discounts. Funds failing

to offer such features would be subject to lower maximum sales loads.

We endorse the basis of this proposal, not because we wish to promote

further regulation in this area, but because it is a worthwhile

measure which can provide improved protection to investors in the

form of a more rational sales load structure. It is an expedienC

method to promptly remedy certain aberrations in the present structure

by assuring that only those funds which offer the full range of ancillary

services may charge the maximum sales load.

Each of the administrative steps described above is feasible at the

present time. The Commission believes that all of these measures are

within its existing authority, and each is aimed at improving the

existing mutual fund distribution system while at the same time allowing

the industry volunfiarily to move toward price competition.

At the appropriate time, when these programs have been implemented and

the industry has had a fair opportunity to function under them, we will

be in a position to consider adoption of more far-reaching administrative

actions. These could go as far as prohibiting retail price maintenance

in the fund industry and establishing a secondary dealer market in fund

shares, or they could stop short of that but, for example, permit contract

dealers to sell fund shares at any sales load they chose above the

underwriter's spread, provided such a pricing structure is indicated in

the fund's prospectus. We believe, however, that legislative action is

necessary to clarify our authority to implement these possible future

measures to achieve more effective price competition in the sale of fund

shares. In the near future, we shall forward a specific legislative

recommendation to accomplish this.

We fully recognize that the approach we have determined to follow does

not represent the simplest means of dealing with the problems of mutual

fund distribution. We could have elected to forego any attempt to

modify substantially the fund distribuCion system, preferring instead

continuation of the status quo, perhaps with slight modifications. At

the other extreme, we could have concluded that Congress should promptly

repeal Section 22(d) and let the mutual fund industry sink or swim in

sudden and complete price competition. The middle path we have chosen

will enable the Commission and the industry to move toward the goal of

price competition in an orderly manner. With our authority clarified,

we will be in a posiCion, if we determine to do so, to establish a timetable for adoption of further-reaching programs aimed at eventual

eliminatiAn of all retail price maintenance. A regulatory agency seems
Honorable John Sparkman

Chairman of the Committee on Banking,

Housing and UrbaiY Affairs

United States Senate viii.

particularly well-suited to perfoxm Che task of adapting the re~ula.tory

framework in response to changed conditions. It is the geniYis of the

administrative process that the intent of Congress can be effectuated

in a complex and specialized area by an agency which is provided with

flexibility and discretion to adjust the ?aw as circumstances demand.

In transmitting the report, the Commission. wishes to express its .

gratitude to Allan S. Mostaff, the Director of the Division of Inv~~stsnent

Management Regulation, Anne P. Jones, the Associate Director cif the

Division, and Lewis J. Mendelson, an Assistant Director of the D~.vision

who supervised the overall staff effort. A special acknowledgment 'is duE

to Joel H. Goldberg, Acting Special Counsel, who provided the principal

writing and editorial effort. Many other members of the C~mmi_ssion~s

starf, both within and without the Divisicn of Investment Management

Regulation, were of incalculable assistance, While all of them brought

great talent and devotion to the task, special mention is due the

following present and former members of the Division's stiff:

Alan Rosenb~at, Chief Counsel; Sidney Cimmet, Assistant Chief Counse~;

Seymour. Spolter, Stanley B. Judd and John Ake, Special Counsel ;

Michael R. Virga and Richard Q. Wendt, Actuaries; John P. Freernan,

Richard Grant, Herbert Haywood, and Marcia Newman, Attorneys;

Samuel S. Stewart, Jr., Chief Financial Analyst; Paul J. Heaney,

Financial Analyst; Sandra S. Monje, Staff Assistant; Kenneth ~e.Y~t4~:~.n,

Student Legal Assistant; and Paula J. Milasi, Debra J. RistoiY,

Karen C. Ryan, and Edith Bobby, Secretarial A,sistants.

By direction of the Commission:

~~ t' ~~,

Ray Garrett, Jr.

Chairman
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DIVISION OF

INVESTMENT MANAGEMENT

REGULATION

August 1974

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

To: The Chairman and Members of the

Securities and Exchange Commission

I am pleased to transmit the Division's report with respect to

mutual fund distribution and Section 22 (d) of the Investment

Company Act of 1940.

When the Senate Committee on Banking, Housing and Urban Affairs

considered the 1970 Amendments to the Investment Company Act,.

it -requested the Commission's views on the repeal of Section 22(d),

which requires retail price maintenance in the sale of mutual fund

shares. Because the Commission indicated that it lacked sufficient

information upon which to base a recommendation, the Committee asked

that the Coimnission study the consequences of repeal and report to

it as soon as practicable.

Such a study was conducted by the Commission's staff, and -its report,

entitled "The Potential Economic Impact of the Repeal of Section 22(d)

of the Investment Company Act," was transmitted to the Committee in

November 1972. Neither it nor the Couanission's letter of transmittal

made any express recommendations as to what should or should not be

done about Section 22(d). Before making any definitive recommendations, the Commission determined to hold public hearings to explore

the major issues in the marketing of mutual funds and to reexamine

traditional administrative positions which affect them. The hearings

were held in February and March of 1973 and dealt not only with

whether Section 22 (d) should be repealed but also with the broauer

question of what can and should be done to enable investment companies

to bring their message to the investing public more economically and

effectively than has heretofore been the case.

The attached report presents an overview of the posiCions taken by

the participants at the hearings, and sets forth the conclusions

which the Division feels should be drawn. In brief, it is ttie Division`s view that the retail price maintenance requirement has produced

a distribution system which can and should be improved upon. Although

we do not believe that full price competition at the retail level is

a practical alternative today, the Division recomm~ends that the Commission exercise fully its existing administrative powers to lay the
- 2

groundwork for the gradual and orderly introduction of retail

price competition into the mutual fund distribution system

while i~nediately alleviating some of the problems resulting

from the present regulatory framework. At the same time, the

Division recommends that the Commission request that Congress

expand the Commission's authority to select from abroad variety

of long-range options for administrative actions which might

later be taken to move the industry to a more competitive environment.

In forwarding the report, I wish to especially acknowledge the

assistance of Anne P. Jones, the Associate Director of the Division and Lewis J, Mendelson, an Assistant Director of t-he Division

who supervised the overall stafg effort in preparing the report,

Particular credit is due Joel H. Goldberg, Acting Special Counsel,

who provided the principal writing and editorial effort. Many

other members of the Commission's staff, both withan and without

the Division of Investment Management Regulation, made important.

contributions. While all of them brought great talent and devotion

to the task, special mention is due the following present and farmer

members of the Division's staff: Alan Rosenblat, Chief Counsel;.

Sidney Cimmet, Assistant Chief Counsel, Seymour Spolter, Stanley

B. Judd and John Ake, Special Counsels; Michael K. Virga and Richard

Qo Wendt, Actuaries; John P. Freeman, Richard Grant, Herbert Haywood

and Marcia Newman, Attorneys; Samuel S. Stewart, Jr., Chief Financial

Analyst; Paul J, Heaney, Financial Analyst; Sandra S. Monje, Staff

Assistant; Kenneth Gerstein, Student Legal Assistant; and Paula J.

Milasi, Debra J. Riston, Karen C. Ryan and Edith Bobby, Secretarial

Assistants.

Respectfully submitted,

~ -. _. ~.

Allan S. Mostoff

Director
MUT[JAL FUND DISTRIBUTION AND SECTION 22(d)

OF THE INVESTMENT COMPANY ACT OF 19 0
TABLE OF CONTENTS

I. Introduction, Background and Summary of Recommendations 1

A, Introduction 1

B. Background 3

1. Prior Studies &'Legislati_ve Efforts 3

C. Summary of Report a:~d Rpccmmendations 9

II. The Industry Tod~.y 17

A. Vigorous Gompetitien from Other Financial Products 20

1. Sales Compensation 23

2. A Strift in Investor Interest 27

3. Another R~c~nt Comp~icitive Developa~entDiversification. of Fund Managers 29

Be Distribution Margins Narrow £or the Principal Underc~rriters 30

C. A New P.oad to Market 33

1. NYSE Member Firms-"We Could Do without" 33

the Funds

2. Small Brflker-Dealers Taken for Granted ox 36

Cut 0£f

D. Facing up to Investor Skepticism 39

1. 1°Reupi_ng the Bitter Harvest" 39

2, Shareholder Service 41

F.. The Shift to Big Ticket Investors 41

III, Regutati.on o~ Fund Sales Under Section 22(d) Today 44

.A.. Exemption from Section 22(d) 44
- ii -

Pale

B. Anomalies Resulting from Section 22(d) 48

1. "Orphaned" Accounts ~8

2. Investors Who Select Funds on Their Own 49

3. Repeat Investors 49

IV. The Positions of the Participants In the Proceeding 51

A. Mutual Fund Industry Representatives 51

1. ICZ 51

2. Managers of Major Funds 53

3. No-Load Mutual Fund Association 60

4. Broker-Dealers b~-

a. I3ASD 61

b. Securities Industry Association 63

c. Large Broker-Dealers E3

i. National Mutual Fund 6~

Managers Association

ii. Merrill Lynch, Pierce, 64

Fenner & Smith, Inc.

d. Small Broker-Dealers 66

B. Variable Annuities -- American Life 68

Insurance Association

C. Participants Not Representing Z'he Industry 69

1. Department of Justice 69

2. Henry C. Wallich 7~.

3. Donald Farrar 72

4. John L. Asling 73
- iii -

Pale

V. The Recommendation of the Division: Gradual

Changes in the Distribution Process Through

Administrative Action 76

A. The Choices Available to the Commission 76

1. Continuation of the Present System of

Retail Price Maintenance With Greater

Emphasis on Price Regulation Under

Section 22(b) 76

2. Immediate Abolition of the Retail

Price Maintenance System 78

3. Gradual Program Designed to Improve the

Competitive Environment, With a Continuation

of Retail Price Maintenance, But With the

Ultimate Goal of Retail Price Competition 81

VI. Recommended Program 

84

A. Measures Designed to Encourage a Degree of

Voluntary Price Competition 84

1. Steps to Permit Funds to Communicate more

Effectively with Investors 84

a. Advertising 84

b. Portrayal of Performance 8A

2. Measures Designed to Introduce More

Price Variations Into the Sales Load

Structure 

88

a. Expanded Group Sales 89
1V

Pale

b. Unsolicited Purchases 93

c. Purchases of Fund Shares in

Combination With Other Financial

Products Distributed By the Same

Principal Underwriter 97

d. Exemption of Variable Annuities

from Section 22(d) 102

e. Price Flexibility in Brokered

Transactions 104

i. Sale of Fund Shares by One

Person to Another Through

an Agent 104

aa. Background and the Situation

Today 104

bb. Would Professionals Partici~

pate in a Secondary Market? 108

ii. Purchase of No-Load Shares Through

a Broker Charging a Fee 110

L. Recommended Legislative Proposals for Expanded

Authority to Take Subsequent Administrative

A ctions 115

1. Limited Retail Price Competition 118

a. At the Option of the Underwriter 118

b. Required by Commission Rule 119

2. Full Retail Price Competition, Including

a Secondary Market 119

C. Recommended Regulatory Safeguards 122

1. The NASD's Proposed Sales Load Levels

for Mutual Funds 122

2. Impact of the NASD Rule Proposal 124
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Page

3. Our Recommendation 125

a. Policy Reasons 125

b. Practical Problems

Lack of Meaningful Tconomic Date Base 126

c. Benefits of NASD Rule 127

d. Recommended Modifications of the NASD

Rule Proposal 128

(i) Exchange Privilege 128

(ii) Sales Charges on Cash Management

Funds 129

e. Contractual Plans 131

f. Variable Annuities 131

g. Continuous Discounts 133

h. Dealer Discoiaits - Regulation Not

Recommended 134
- vi -

~'HA RTS

Page

CHART I: Percentage of Total Assets of Mutual Funds

by Largest Complexes 18

CHART II: Net Sales (or Net Redemptions).,in 1971,.1972, and:1973

of Load and.No-Load Funds,. and .Offerings. of Closed-End

Companies, REIT'S and Unit Trust fond k'unds 22

CHART III: Comparison of Features of Mutual Funds and Competing

Products 2~

TABLES

TABLE I. Net Sales (or Net Redemptions) in 19?1, 1972, and 1973

of Load and No-Load Funds, and Offerings of Closed-End

Companies, REIT'S and Unit Trust Bond Funds 21

TABLE II. Load Fund Sales Made Pursuant to Exemptions from Section

22-(d) in 1973 .. 46
- vii -

A P P E N D I C E S

Letter to Chairman Sparkman, Committee on Banking, Housing and

Urban Affairs from Chairman Casey, November 1972.

Investment Company Act Release No. 7475, November 3, 1972.

Investment Company Act Release No. 7635, January 18, 1973.

Rules Proposed by NASD for the Regulation of Sales.

Charles in the Di:>t.ribution of Investment Company

Shares.

Alphabetical Index of Participants in Mutual Fund Distribution

Hearings.

Chronological Index of Participants in Mutual Fund Distribution

Hearings.
I• .~NTRbDUGT ON, BACKGROUND AND SiIMMARY OF RECOMMENDATIONS

A. INTRODUCTION

In November 1972, the Commission published a study prepared by its

then Office of Policy Research, which considered the impact of a possible

repeal of Section 22(d) of the Investmene Company Act of 1940. 1/ The

study dealt with, among other things, the costs of distributing mutual

funds, the significance of revenue derived by brokerage firms from mutual

fund sales, and the significance of mutual fund sales to the securities

markets.

In transmitting the report to the Senate Committee nn Banking, Housing

and Urban Affairs, which had requested the study, 2/ the Commission said

that:

"[I]ts findings certainly suggest there is no compelling

public interest in continued retail price maintenance in

this field and that the repeal of Section 22 (d) would on

balance be desirable." 3/

However, the Commission pointed out th~•,t the report; contained no express

recommendations, and that:

"Before making any definitive reco~xnendations to the Congress

as to what should or should not be done about Section 22(d),

the Commission will hold public hearings at which interested

persons will be asked to direct our attention to aspects of

the mutual fund sales compensation problem that the report may

have overlooked or to which it may have given insufficient

weight." 4/

Public hearings conducted in February and March of 1973 provided

an opportunity for in-depth exploration of the major issues in the

marketing of mutual funds and the laws and regulations which affect

them. In addition to focusing on Section 22(d}, and in order to view

the question of the impact of repeal in the total context of fund

distribution processes, traditional administrative positions were reexamined bn light of changing conditions in the securities markets and the

mutual fund industry. Abroad range of subjects were covered including

further liberalization of advertising rules, measurement and portrayal

1/ SEC, Report of the Staff on the Potential Economic Impact of a

..Repeal of Section 22(d) of the Investment Company Act of 1940

(1972), ("OER [Office of Economic Research] Report").

2/ S. Rep. No. 91-184, 91st Cong., lst Sess. 8 (1969), ("1969 Senate

Report").

3/ Letter of Transmittal of OER Report from William J. Casey to the

Honorable John Sparkman, Chairman of the Senate Committee on Banking,

Housing and Urban Affairs, November 1972, at vi (Appendix A).

Ibid.
- 2 -

of investment results and the possible reexamination of the Statement

of Policy, and proposed rules to permit grouping or pooling of orders

for the purpose of obtaining quantity discounts.l~ The hearings also

provided an opportunity to consider the NASD's full service maximum

sales load rules.~~

In addition, one of the principal thrusts of the inquiry was to

determine whether the situation with respect to mutual fund distribution today is comparable to that in 1966, when the Commission was

wary that mutual fund distribution practices could possibly distort

1 ICA Rel. No. 7 75 (November, 1972 (Append.ix B), outlined. the

matters to be considered as follows:

A. Reveal of Section 22(d) of the Act.

1. Complete repeal.

2. Partial repeal.

3. Price competition within a limited range.

4. A current public offering price described in the prospectus.

5. Prohibiting price competition from non-contract dealers.

B. Rules under Section 22 (b) and other provisions of the Act.

1. Lower breakpoints reflecting the reduced cost of diversification

on larger purchases.

2. Regulation of the dealer discount.

3. Continuous discounts.

4. The value of additional product features.

5. Contractual plans.

C. Further liberalization of advertising rules.

1. Advertising.

2. Statement of Policy.

D. Simplified.more readable mutual fund prospectuses.

E. Gro~~ sales.

F. Reducing page naork in small transactions.

G. No-load sales.

H. Development of an adequate economic data base.

2/ The NASD's proposed rules pr~~vide for ma.xi.mum sales lard schedules.

For those funds which offer certain product Features -- dividend

reiTtveskment at net asset val~ie, lower breakpoints for volume discounts and rights of accumulation -- the maximum load would be

8-1/2/ of the offering price. Without those features, the NASD has

described the ceiling for sales of up to $25,000 as no higher than 6%.
3 -

Che investment recommendations of dealers selling fund shares 1/ and impose

excessive costs upon iavestors,~! ~~r whether different conclusions

are appropriate at this time,

Fifteen days of hearings were held, beginning nn February 12, 1973, and

ending on March 28, 1973. Some seventy persons appeared, including

representatives of the Department of Justice, the National association of

Securities Dealers ("NASD', mutual ~.ind underwriters and managers, trade

~.ssociations (including the Investment Company 1nst;~tute ("ICI"), the

No-Ipa,d Fund Association, the Securities Industry Asscciation, the Independent

Broker Dealers Trade Association, the National Mutual ~`und Ma.riagers Association„ and the .American Life Insura.n.ce Associa+ion), leading distributors,

insurance industry representatives, large a.nd sma11 broker-dealers, independent econornasts, and financial ana],ysts specializing a.n the flzx~d management

industry. In addition to the oral pz•esentations, where were more -than 100

written s'abmissions, ma,riy of which were quite extenUi~-e.

The presentations and questioning of persons at the hearings

were supplementEd by panel discussions on the following topics:

advertising, grouping €or quantity dis~ount~, measuremerr and portrayal of investment performance, value of service as an element of

the NASD sales charge rule, the consequences of complete repeal of

Section 22(d), possible modifications of Section 22(d), and trends

in mutual fund distribution. Additional panels consisted of representatives of small broker-dealers and of the Na~ional MuCual Fund

Managers Association, whose members are heads of the mutual fund

departments of New York Stock Exchange member firms.

This Report discusses the issues presented ii7 the ~taff study and

the hearings, analyzes the different options with respect to them, and

sets forth the Division's reco~nendations on each.

B, BACKGROUND

1. Prior Studies & Legislative Efforts

The hearings were the culmination of a series of stus3i~s and reports

describing mutual fund distribution which traced back to the Study of Mutual

Funds by the Securities Research Unit of the Wharton Sc~.00l of The University

of Pennsylvania ("Wharton Report"). 3/ The Wharton £report concluded with

respect to fund distribution that "[i]ntensive sa7~es effort has been one of

the important characteristics contributing to the ex~;ansion of mutual funds." 4/

1/ Report of the SEC on the Public Policy Implications of Investment Company

Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. 1&U (1966), ("Mutual

Fund Report"). The Commission's concern in this area arose in the

context of the then prevalent practices of reciprocal brokerage

business and "give-ups''.

2/ Id., at 21.

3/ H.R. itep. No. 2274, 87th Cong., 2d Sess. (1962).

4/ td., at 31.
- 4 -

It found a significant relationship between fund asset size and the size

of the sales load. 1/ It also indicated that in a substantial number of

cases advisory income was being used to subsidize the underwriting function. 2/

Apart from the rivalry between load. and no-3oad i'unds, the Wharton Report

observed that there has been little price competition in the mutual fund

industry at the investor level. ,3J

Shortly thereafter, in 1963, the Commission delivered to Congress

the Special Study of the Securities Markets, 4/ which included a

discussion of aspects of the marketing of mutual funds. The Special.

Study's recommendations with respect to mutual fund selling practices

have largely been acted upon. They included improved supervisory

controls and surveillance of selling practices, 5/ refinement of

prospectus requirements to assure that basic information would be

brought clearly and conspicuously to the attention of the prospective

investor, 6/ and increased protections with respect to fronC-end load

contractual plans. 7/

Following the Special Study, the Commission in 1966 dealt more

specifically with the marketing of mutual fund shares in its Mutual

Fund Report. ~ At that time, Section 22(b) gave the Commission

and the NASD rulemaking power to prevent only "unconscionable or grossly.

excessive" sales loads on mutual fund shares. That permissive standard,

combined with the retail price maintenance provisions of Section 22(d),

meant that federal law effectively insulated mutual fund sales charges from

both price competition and price regulation. As was stated by former

Chairman Budge:

"The fact that a given product ultimately benefits the

purchaser does not justify a price for it which is neither

competitively determined nor subject to a type of regulatory

control which is an adequate substitute for such competition."

1/ Ibid.

2/ Td, at p. 32.

3/ Id. at p. 35.

4/ H.R. Doc. No. 95, 88th Cong., 1st Sess. (1963).

5/ Id.; part 5, at 1%d.

6/ Id. at 170-7I.

7/ ... .Id... at 171.

P, ,3, n. 1, su ra

j/ Hearings on H.R. 11995, et aI. Before the Subcommittee an Commerce

and Finance of the House Committee on Interstate and Foreign

Commerce, 91st Cong., 1st Sess., 91-34, pt. 2, at 864 (1969),

("1969 Hearings").
5 -

In the Mutual Fund Report the Commission found that the sales

charges for mutual fund shares displayed "no reasonable relationship to

the cost of investing in other types of securities." 1/ It concluded

that, although some difference between such sales charges and those

on listed securities may be warranted, 2/ the existing disparity had

consequences which extended beyond the matter of costs in that

they could lead securities firms and their salesmen to recommend and

sell mutual fund shares rather than other securities. ~ The

Commission reasoned that the recommendations of securities firms

and their salesmen could be unduly influenced, perhaps supconsciously,

by major differences in sales campensa.tion and that some degree of

equalization in the level of compensation for selling different types

of sQcurities may "avoid a possible distortion of investment decisions

and a resulting impact upon the functioning of tYie markets fJr. reasons

extraneous to relative investment merit." 4/ Therefore, the romrtission

in 1966 concluded that the cost of purchasing mutual fund shares should

be lowered. 5/

The Commission had considered four approaches to this problem: 6/

1/ Mutual Fund Report at 221.

2/ Id. at 21.

3/ Id. at 221.

4/ Id. at 222,

5/ Tbid. The Coirunission also concluded, in part because of the

retail price maintenance provisions of Section 22(d), that principal

underwriters competed for the favor of retail dealers in the sale

of fund shares and that this has had the effect of raising rather

than lowering prices to the investor. It reasoned that because

Section 22(d) suppresses the downward pressures that normal market

forces might otherwise exert, there is nothing to offset the upward

presslare on sales loads that results from vigorous competition among

principal undertariters for the favor of dealers and salesmen. As a

result of Section 22(d):

"the investor who is already convinced of the investment

merits of mutual fund shares and has already decided to

buy a particular fund's shares must - if he chooses a

load rather than a no-load fund - pay sales charges

designed to cover selling efforts that he does not want,

does not need, and does not get."

During the 1967 Senate hearings on S. 1659 former Chairman Cohen

summed up this problem very simply as one of "excessive costs."

Hearings on S. 1659 Before the Committee on Banking; Housing and

Urban Affairs, 90th Cong., 1st Sess. 51 (1967), ("196'7 hearings").

o/ See 1967 hearings, Statement of the SEC by Chairman Cohen, appendix,

at 173-174.
- 6 -

(1) A regulatory solution -- imposing a 5% maximum on fund sales

loads or graduated reductions from present levels until the 5'/ level was

reached;

(2) Having sales loads fixed b~ competition among retail dealers --•

repeal of the price maintenance provisions of Section 22(d);

(3) A combination of the first two approaches i.e., pe nnitting

competition on the portion of the load in excess of 5%; and

(4) Authorizing the NASA, with Commission oversight, to adopt rules

preventing "excessive " sales loads and req~ring "reasonable" maximum sales

loads.

While admitting t:iat repeal of Section 22 (d) appeared in many ways more

attractive, 1/ tree Commission nevertheless recommended the direct regulatory

solution -- a 5% maxim~iR, sales load with Commission power to raise or lower

the maximum when circumstances or conditions warrant. 2/ It also recommended

that the Act be amended to permit the Commission to prohibit sales loads on

the reinvestment of dividends. 3/

The Senate Committee on Banking, Housing and Urban Affairs, when it

considered the Commission's recommendations, also gave thought to deleting

Section 22 (d) from the Investment Company Act. 4/ When asked for its views

or. this question, the Commission indicated that it was uncertain what

repeal would mean. to the market and to mutual fund sales organizations. It

s~iggested that it lacked s~sfficient information., particularly economic

fn.formation, for recom~enditz~, that '?2 (d) be eliminated. 5/

1% Id, at 1;4.

2/ Mutual Fund Report, at 223. The. 5% figure was considered by the NASD to

be the outside limit on the mark-up tYtat ordinarily can be charged on

a securities transaction, includinb a transaction in which the customer

sells one security anS buys another. See 1969 hearings, statement of

Chairman Budge, at 865.

3/ Mutual Fund Report, at 2L3.

!~/ 1969 Senate report, at p. 8.

5/ liearings on S. 34 and S. 296 before the Committee on Sanking, Housing and

urban Affairs, 91st Cong., 1st 5ess. 18-19 (1969), testimony of Commissioner

Oc,*ens .
-7 -

As a compromise, the Corrmiission acquiesced in a proposal to amend

Section 22(b) to give the NASD rule-making authority to prevent mutual

Hinds f'roan being sold at a sales load. wlZi ch i s "excessive" . l ~ Congre s s

adopted this solution. It also amended Section 22(b) to provide that

the NASD rules governing mutual fund sales loads must allow fir reasonable

compensation for sales personnel, broker-dealers and underwriters, and

reasonable sales loads to investors.2/The 1970 amendments gave the NASD,

with Commission oversight, authority to promulgate rules to achieve such

sales loads and further provided an 18-month interval between passage of

the Act and the effective date of the section, to permit the NASD to

See 1968 hearings, statement of Chairman Budge, at 865.

As amended in 1970, Section 22(b) now provides in pertinent part:

"(b)(1) Su.ch a securities association ma.y also, by rules adopted and

in effect in accordance with said section 15A, and notwithstanding

the provisions of subsection (b)(8) thereof but subject to all other

provisions of said section applicable to the rules of such an association,, prohibit its members from purchasing, in connection with a

primary distribution of redeemable securities of which any registered

investment company is the issuer, any such security from the issuer

or from any principal underwriter except at a price equal to the

price at which such security is then offered to the public less a

commission, discount, or spread which is computed in conformity

with a method or methods, and within such limitations as to the

relation thereof to said public offering price, as such rules may

prescribe in order that the price at which such security is offered

or sold to the public shall not include an excessive sales load but

shall allow for reasonable compensation for sales personnel, brokerdealers, and underwriters, and for reasonable sales loads to investors.

The Commission shall on application or otherwise, if it appears that

smaller companies are subject to relatively higher operating costs,

make due allowance therefor by granting any such company or class of

companies appropriate qualified exemptions from the provisions of

Chis section."
-8 -

study "all relevant factors" in order to provid¢~a basis for its rule

proposals. ~ At the same time, the Senate Committee requested that

the Cormnission study the consequences of repeal of Section 22(d) and

report to it as soon as reasonably practicable.

Following the 1970 Amendments, the Conm►ission, in its February

1971 letter of transmittal accompanying its Institutional Investor

Study Report, gave some indication of the approach it thought the

NASD Study should take. It pointed out that to the extent the'

elimination of fixed minimum rates would cut off an important

source of income for distributors of mutual fund shares, the

direct charges for selling fund shares would have to be increased --

or mutual fund distribution would have to be decreased -- unless -

lower cost methods of distribution were developed. The Commission

indicated that it favored the development of such lower cost alternatives, and iC suggested that the ivASD Study focus upon ways, in

which existing costs of distribution might be reduced and savings

passed on to fund purchasers. The Commission also said that it

would consider the feasibility of ach~.eving this result in connection

with its own study of Section 22(d). 3/

Both the NASD study pur sua.nt i~o 22 (b ) and the Corrnni s si on' s staff

study of the Potential Economic Impact of Repeal of Section 22(d) were

concluded during 1972. Although the Commission and the NASD shared'

certain facilities in making tYiese studies, they were conducted independently

of each other.

The NASD Study, entitled "Ari Economic Study of the Distribution of

Mutual F'~znds and Variable Annuities", was prepared pursuant to contract

wish Booz-Al.l~n & Hamilton, Tnc. Portions of the 1~IASD Study and recammendations were submitted to the Commission in June and August of 1972,

and the remainder in October of that year. Both that study and the

Commission's Staff Report,~7hich was published in .November of 1972, were

the subject of considerable discussion at the 19;3 hearings.

1969 Senate report, at p. 18.

2/ Id. at 8.

3/ Institutional Investor Study Report of the SEC, House Doc. Nn.

92-84, 92d Cong., lst Sess., pt. 8, ae xix-xx (1971)("Institutional

Investor Study Report").
-9-

C. Suxrm~a.ry of Report and Recommendations

The Industry Toda

The hearings confirmed that the mutual fund industry is Faced with

a disrupted marketing system. Record sales of earlier yeaxs have given

way to net redemptions; competing products have made substantial inroads;

fund m~axiagers have diversified into other fields; and the find industry,

which in many cases has operated at a distribution deficit, has allowed

its relationships with small broker-dealers to deteriorate, while it

has became increasingly dependent for sales upon large broker-dealers to

whom imztual minds are a relatively unimportant source of inccame. Moreover,

the Rands' relationships with some investors have been strained by tYze

excesses of the "go-go" era of the 196ots and a failure to provide adequate

service to many small shareholders.

Z'he Positions of the Participants

Representatives of the mutual fund industry, including the Investment

Company Institute and man.a.gers of major funds, generally opposed repeal

of Section 22(d), arguing that the ~.ind distribution system depends upon

retail price maintenance. Broker-dealers, while in some cases complaining

of mutual flznds' practices, also opposed repeal of Section 22(d).

~- On the other hand, the Department of Justice urged an immediate end

to retail price maintenance, either b,y legislative or administrative

action. fro economists, Professor Henry C. Wallich and Dr. Donald Farrar,

favored eventual retail price competition but were of the view that immediate

repeal of Section 22(d) would not be feasible. Dr. Farrar recommended

gradual erosion of the section while Professor Wallich recommended a transition to negotiated sales loads by stages.
- 10

The Recommendation of the Division: Gradual Changes in the Distribution Process Through Administrative Action

The Commission is committed to the general proposition that the

securities industry should operate -- to the extent possible -- in an

environment of free and vigorous price competition. In the mutual Rand

industry, however, the Division does not believe that it would be

possible to move quickly to retail price competition without seriously

disrupting the distribution of fund shares. In view of the open-end ~,

self-liquidating nature of mutua,7: flznds, such disruption should be

avoided, if at all possib]_.e, and certainly minimized. Accarding~y, the

Report reconnnends a program pursuant to which the industry could move

toward price competition on a limited basis at first and the Commission

could assess the effects of that competition before ~:aking further

action.

1 In addition to the program described herein, a number of possibilities

have been discussed since the hearings which could affect the clistribution of Hind shares, but which are not included in this Report.

'the Commission held hearings on September 10-12, 197+, to review

sugges~eci interpretations and amendments to the NASD Anti-Reciprocal

Rule. (Securities Exchange Act Rel. No. 10867, June 20, 197+)•

TYiose hearings considered a broad range of issues, including the

amount and methods of compensating dealers for the sale of fond

shares; possible anti-competitive effects of sales reciprocals;

whether fund shareholders (as distinguished from purchasers of

Rand shaxes) should beax selling expenses; and, of course, questions

of best price and execution and possible distortion of broker-dealer

recommendations of find shares. The matter is now under review .by

the staff.

Representatives of the broker-dealer community have also suggested

that sales load ceilings should be raised in order to pay for the

follow-up services they render or that follow-up services should be

purchased separately.

Finally, representatives of fund complexes have asked the staff

to consider the possibility that funds be permitted to beax some

of ~;he cost of distribution directly, pursuant to rules which

might be drafted under Section 12(b) of the Act.
11 -

In the initial stages of the reca~rnnended program, the basic retail

price maintenance system would be retained, but the Commission

would take various actions to encourage voluntary price competition.

The Report proposes a number of rule-making and interpretive steps

designed to make it possible for funds and their underwriters to get

their story across in a manner not now possible and to encourage the

use of price variations in the sale of fund shares.

Relaxation of advertising restrictions is recommended as well as

proposed modifications of the Statement of Policy. This should. provide

more useflal information to investors and permit flznds and their underwriters td cotrununicate with them directly in a more ef~'ective way.

These two proposals should encourage th.e development of more of a demand

"puL" to supplement -- and possibly replace -- -L-he present heavy

reliance on sales "push".

In another area, the report recommends that the Corrmzissian pro~,ri.de

opportunities for mass-marketing by allowing discounts for a wide

variety of groups including all employer-employee groups. This should

also lead to greater competition among underwriters and funds through

price variations.

"~ 'The report also proposes a number of other steps designed to afforr~

funds and their underwriters increased opportunities to iizitiate price

variations. Such variations should make possible increased economies and

efficiencies in fund distribution and enable the industry to reduce certain inequities caused by the present pricing structure. The recommended

variations include: (1) a rule which would allow funds and their underwriters to provide for periodic "open seasons" during which persons who

have held shares for at least a specified period, say, one year, could

buy a specified amount of additional shares at a reduced price; (2) an

indication that the Commission would view favorably applications for

exemption from Section 22(d) to permit combina~;ion discounts where

mutual flznds and other financial products distributed by the same underwriter are purchased £rom the same retailer; (3) a rule relieving issuers

a.nd distributors of variable annuities from the restrictions of Section

22(d), provided they do not engage in any unjust price discrimination;

and (~+) steps which will permit some price flexibility at the retail

level through increased opportunities for brokered transactions with

respect to both load and no-lo~.d funds.

The report also recommends that the Commission request an amendment of

Section 22(d) to enable the Commission to take further steps towazd the

ultimate goal of retail price competition. As the final element of the

program, the Report takes the position that the CoY►anission should not

object to the adoption of the NASD's proposed full service maximum

sales load rule, provided certain minor changes are made in it,
- 12 -

Recommended Program

A. Measures Designed to Encourage a Degree of Voluntary Price Competition

1. Steps to Permit F~znds to Communicate More Effectively With Investors

a, Advertising

Advertising can be an effective merchandising tool, but current

restrictions inhibit its use by mutual funds. For this reason, and

Because one result of increased price competition might be that less emphasis

would be placed on salesmen so that funds would have to rely on other means to

stimulate dema,na for their products, 'the Report proposes, as an integral

part of the recommended program, that the Commission liberalize the

advertising restrictions in Rule 13~+: (1) to allow Hand advertising to

be more interesting by permitting the use off' attention getting devices

and designs; (2) to allow flznd advertising to be more informative by

permitting the inclusion of more objective details about the fund; and

(3) to permit joint tombstones and more objective information about the

adviser, thus placing greater emphasis on the adviser.

b. Portrayal of Performance

In addition to liberalized advertising rules, flznd sales literature

should permit investors to make more meanangf'ul comparisons of past

investment re~Yurns, risks and costs. To achieti~e ;his goal the Commission's Statement of Policy, which prescribes methods for portraying investment results, needs revision. Accordingly, the Report recotarnends publication

for comment of an amendment to the Statement of Policy which would allow

the use of proposed charts permitting portrayal of investment results on

a total return basis. As proposed, "total return" would permit a single

figure which includes the compound effects of capital gains distributions,

dividends, and changes in the value of the original share over ten years,

provided that risks, including variability in returns from year to year,

and the effects of expenses are also clearly shown. This should facilitate

more meaningful comparison of fund results and a clearer understanding of

how differences in expenses can affect compound returns. Applying

the.same principles to the investment results and expenses of variable

annuities should foster greater understanding of how costs affect variable

annuity investment results as well.
- 13 -

2, Measures Designed to introduce More Price Variations

into the Sales Load Structure

a. Expaxided Group Sales

Ru7.e 22d-1 permits quantity discounts to "any person," a

term defined to include corporations, qualified employee retirement

plans and certain other entities, but which excludes a group of individuals established for the purpose of buying Fund shares. `i'he Report

recommends that the Rule be amended to permit certain adclitional groups

to take advantage of volume discounts and other price variations. 'Phis

recommendation will enable funds and their underwriters to introduce

mass-marketing techniques and to pass on ~;o investors economies of

scale and cost savings from group sales. Greater uta.lization of this

marketing technique should also lead to increased public awareness of

mutual flznds and cause both the industry and the public to become more

sensitive to price and product variations.

b. Unsolicited Purchases

The Report recommends an exemptive rule which would permit

a fund and its underwriter to utilize "open seasons" during which

repeat investors could invest in the fund in wl-iich they already

hold shares, at a reduced load or at no-load, thereby enabling qualifying

investors to avoid paying for selling services they do not need or get.

Such a rule would provide for adequate notice to existing shareholders,

and since "open seasons" would be optional, they could be discontinued

if they tended to discourage dealers from selling fund shares by depriving

them of commissions from follow-up sales. A holding period would be

required before -L-he open season could be availed of and the amount

which a repeat investor ~ou1d purchase under the arrangement woul..d be

limited. This proposal should encourage fluids a.nd their underwriters

to give more attention to existing shareholders, and those Rands with

an adequate performance record and large numbers of satisfied shareholders should find it particularly h~lpflzl. The Report also recommends

that; the Commission indicate that it will show greater flexibility in

the fli.ture in reviewing individual applications for exemption from

Section 22(d) to permit reduced or eliminated sales charges to unsolicited new investors where it can be shown that such arrangements would

be in the best interests of investors and would not disrupt fund distribution.
- 14 -

c, Purchases of Fund Shares in Combination With

Other Financial Products Distributed by the

Same Principal Underwriter

The Report recommends that the Commission indicate a willazgness to go somewhat beyond the exemptions which already have been granted

with respect to combination sales Co pexZnit, on application, price reductions

to purchasers who have previously or contemporaneously purchased, £rom the

same retailer, another investment product or an insurance product, distributed by the same underwriter, Such exemptions would permit cost

savings from selling several products during one sales effort to be passed

on to investors and mould also permit underwriters to experiment with

varied financial packages. In addition, they would introduce another price

variation which in itself could help cultivate price sensitivity among

investors. With adequate experience, it may be feasible ultimately to

develop an exemptive rule in this area.

d. Exemption of Variable Annuities from Section 22(d)

The Report recommends that the Commission propose a rule

to exempt completely the sale of variable annuities from Section 22(d),

provided their sales load structure does not discriminate unjustly, In

this area, such an approach is preferable to the gradual approach recommended for mutual funds, since the removal of mandatory retail price

maintenance would probably not have and negative impact upon the distribution of variable annuities, a product which is not easily transferable

in a secondary market.

e. Price Flexibility in Brokered Transactions

1. Sale of Fund Shares by One Person to

Another Through an Agent

By its terms, Section 22 (d) does not apply to brokered

transactions. Nevertheless, no secondary market in mutual funds has_

developed largely because uniform sales agreements between underwriters and

broker-dealers effectively prevent such a secondary market.

T1-ie Division believes that a brokered secondary market would

be beneficial. 1~ Although such a market is not likely to become so significant as to disrupt the primary distribution system, it would introduce

retail price variations in the industry and perhaps also provide some

insight into whether a secondary dealer market could function effectively.

1/ The ReporC takes the position that pending litigation as to the legality

of such restrictions in sales agreements need not delay implementation

of this recommendation,
- 1.5 -

The Report therefore recommends that the Commission request the NASD

to amend its Rules of Fair Practice to prohibi~ restrictions against

a seconcla,ry bxokered.market. It flzrther recommends that, if necessary,

the Commission propose a rule under Section 22(f) to prevent flznds

fYom accomplishing the same result as is presently obtained in sales

agreements by restricting the transferability of their shares.

2. Purchase of No-Load Shares through a Broker

Charging a Fee

Permitting a broker to make a reasonable charge in connection with

purchases of no-load shares could (1) provide him with a,n incentive tc

recommend no-load securities; (2) compensate brokers for services

rendered in connection with no-load purchases; a,nd (~) encourage same

load fUnds.to become no-load. For these reasons, the Report recommends

that the Commission clarify' the circumstances under which such a charge

ma.y be appropriate.

B. Recommended Legislative Proposals for Expanded Aui;hority to

Take Subsequent Administrative Actions

The above recommendations are designed to provide an environment in which

the industry can and will voluntarily adopt programs designed to set the

stage for retail price competition.

The Commission already has sufficient authority to take the recommended

administrative actions outlined above. As contemplated, none wou.l.d require

a fund or its underwriter to revise its marketing strategy; at the outset

this would be left to competition. If this does not work, however, and if

effective retail price competition does not develop, the Commission should

have the authority to move the industry in that direction by making some

of the optional steps mandatory, if such action should appear appropriate.

The Report therefore recommends that the Commission request legislation

to clarify its administrative authority in this regard, as well as to take

further steps to require competition among funds and underwriters, permit

competition at the retail level, or even require an end to retail price

maintenance.

C. Recommended Regulatory Saf ~,uards

Pursuant to the 1970 Amendments to Section 22(b), the NASD has formulated

a proposed rule which would provide maximum sales load levels. As i.t has

described the rule, the maximums which would be permitted are:

8.50% for purchases of up to $10,000 or $15,000;

7.75'/o for purchases between $10,000 and 525,000; or

7.50°'/ for purchases between $15,000 and $25,000; and

6.00% for purchases of $25,000 and over.
- 16 -

The right to charge a maximum load would be contingent on the fund

offering: (1) dividend reinvestment at net asset value; (2) rights

of accumulation; and (3) volume discounts, The NASD has deferred

action on this proposal pending Commission reco~nendations.

The Report takes tKe position that it would not be appropriate to

impose tighter limits at this time, and, as a practical matter, sufficient

economic data are not available to permit formulation of better rules.

Since the NASD rule ties the right to charge the maximum sales load to

the product features offered by a fund, its implementation, as an interim

measure, would introduce some rationality into the sales load structure.

For these reasons, the Report recommends that the Couunission not object

to adoption of the NASD rule subject to modification to require (a) a sales

load reduction for fl~nds which fail to offer, exchange privileges; and

(b) lower sales charges for so-called cash management funds.
- 17 -

II. THE INDUSTRY TODAY

Z'he mutual fund industry today is vastly different from that

portrayed in the Carrmission's 1866 mutual ~.ir~d Report although there

are, of course, certain sa.milar3,ties. For example, the Mutual I'uz~~ Report noted

that though the industry's total assets were spread over 379 cozrrpar.~aes, ~[~

the 52 ftiinds making up the ten largest complexes accounted for more ~;har~

half of the total. ~ While the number of active mutual funds has

risen to 798 as of June 30, 197+, the phenomenon of industry

concentration, as depicted in G'hart I below, continues as in the

past. ~ There is likewise a marked similarity between the industry°s

merchandising stx•ate~y today and in 1966. The 1966 Report obserzr~c3 a

clear tendency of load fund underwriters to direct their appeal to

campensation conscious fund retailers rather than price conscio~ss is:ve:;t~ors.4/

1 Mutual Fund Report

~1s of June 30, 1966, flznd industry .assets were 38.2 and the j2 ~'uiids in

the ten largest complexes held 55 perc~ri~ of al mutual flznd.a,sse~s,

Paralleling the 1966 concentration situation, as of June 30, 197+,

the seventy-four Hands making up the ten largest camplexes accounted

for roughly half of the industry's assets.

Although the complexes comprising the groups of largest firms have

varied somewhat over the years, it is fair to say that, in gen.rai,

the largest complexes have maintained their positions. That fs, o;

the S largest complexes, 4 have been in the top 5 steadily sine

1968; similarlq, 7 of the present top 10 have been in the top 10

since 1968. Of the 3 complexes which have not been in the toy lid

throughout this period, two have been in the top 10 for S our of

6 years, each of them being eleventh in one year. The third is a

no-load fund complex which was eighteenth in 1968, and has risen

each year to its position of ninth. Finally, 16 of the 24 large;;

complexes have been among the top 24 each year since 1968, and 4 m~;ra.

have been among the top 24 in S of those six years.

4/ Mutual Fund Report at 209.
- 18 -

CIiART I

Percentage of Total Assets of Mutual Funds By largest Completes

(Dollars Billions)

7

6

5

4

3

2

1

7etal Industry

Larq.~t 24 eompl~x~~

~~~ Lorq~sf 10 eompleY~•

I.arq~st S comply:.•

ss~.o

(ioox)

l~

S~Z.S

(75x)

sSZ.6

(1008) =50.7

(100:.)

362.5

(100A)

ssa.s

ctoa~)

=17.9

(77R)

543.E

(757i]

~~~~

i

~;.,.,.,

....

.... :... ....

~~~~i~~ 'i'iRi'i i~i~i~i .~i,'~'

36 0

cioax> ~

s36.a

c~s~c~

ii~~

~~♦

%%

i~i~i~

►~i~i~ ♦ ~

••~

~~

1968 1969 1970 1971 1972 1973

Nots : In 1973 the 24 largest complezea managed 170 Sunda out fan industry tool of 736 funds.

SOURCES

1. Wiesenberger Services, Inc., Investment Companies (1969-74 editions).

2. SEC, "Classification, Assets, and Location of Registered Investment Companies (1969-73 editions).

3. `Vickers Directory of Investment Companies" (March, 1974 ed.).

De-6 oaf
-19-

Though the no-load segment of the fund industry has enjoyed substantial

growth since the time the Report was published,l~ it is clear that price

inelasticity ~ and the concomitant premise._that load flu~.d shares are sold,

not bought are still key characteristics of the mutual fund merchandising.

approach.~~

While these characteristics remain, and the industry today is sti]1 domzna.ted

by a hand~.i1 of complexes and i.s sti1.1 dependent upon the basic sales "~us$'stx•a~c;y

of the load funds, the distribution hearings disclosed important differences from the situation that prevailed in 1966. The most telling contrast

is at the bottom line: net redemption status has lately replaced the sales

records Che industry earlier enjoyed. Net redemptions totaled $3.2 billion

in 1972-73,~ and between February 1972 and Ju1.y 195 ICI members as a

group were in net redemption every month but four.

But even the net redemptions do not tell the full story. The hearings developed the picture of an industry Faced with a disrupted marketing

system:

(A) Many other financial products are now competing actively

for investment dollars the funds previously had much to themselves;

1/ The Report listed total fund industry assets at $38.2 billion as of

June 30, 1966, with no-load funds accounting for only $2.Z billion

(5.1%) of that total. Id, at 52. Mutual fund assets were $54.4

billion as of June 30, 1973, with no-load funds making up $7.1 billion

(13.1%) of that amount. SEC, 39th ANNUAL REPORT 149 (1973). The

growth enjoyed by the no-loads is discussed further at pages 20-22 beloTl.

Price inelasticity is used in tree sense that investors have not been

encouraged to develop a sensitivity to sales load variation,

3/ Dr. Stephen F. Sherwin, a consultant to the NASD, testified on this

Y point at the fund distribution hearings:

STAFF QUESTION: "Is it also your assumption, if 22 (d)

were repealed, that investors would be price conscious,

that the sales would be affected because investors would

be price conscious?"

DR. SHERWIN: "....I doubt very much that there is a high

elasticity. I would be willing to go further. I think

there is an extremely inelastic demand fox load funds.

I think the industry said in one respects it is

true all along, that load funds are sold, but not bought."

Tea 54-55e

~'/ See ICI "1974 Mutual Fund Fact Book," p. 9 (hereinafter "ICI Fact Book").

The impact of the unique fund redeemability feature ~,nd the importance

of continuing sales of fund shares is underscored by the fact

that funds experienced these net redemptions in spite of gross

sales for ICI member tU.nds of $g.3 billion during those years.

~,~ ICI, "Open-End Company Monthly Statistics." 7n Ma,y and June of 197+ net

sales of ICI member companies totaled $59.5 million. The funds' net

sales status for those two months is in large part attributable to sales

by c~.sh management funds of $16 .3 million for the period. TCI News

Release, July 22, 1974. Cash management funds are discussed ~,t pp. 133-35.
- 20 -

(B) ~znd distribution, seldom profitable in and of itself in

the best of times, seems to have become even less profitable

(or more unprofitable) lately, thus requiring greater subsidization of distribut9.on from advisory profits;

(C) The inchistry's "road to market," traditionally through

small broker-dealers, has changed significantly as the fluids

have placed increasing emphasis on selling through NYSE

member firms;

(D) The excesses of some fund complexes during the "go-go" era

of the 1960's, and the failure of some brokerage firms and Hind

complexes adequately to serve the needs of their customers, seem

to have generated among some investors a distrust of mutual

funds as an investment medium; and

(E) At a time when it is reported that only three out of every

ten households "knave something" about mutual flznds, 1;~ _indicating

a large untapped potential demand for the fund concept among

small investors, the sales efforts of the flznd industry have

increasingly ignored this potentially lucrative market in favor

of the relatively sophisticated "big ticket" investor.

A. Vigorous Competition From Other Financial Products

As pointed out by the ICI in its written submission, many financial

products are now competing actively for the investment dollars mutual funds

previously captured.?/ Relatively new equity products such as REIT's,

oil and gas drilling .funds and mass merchandised discretionary accounts

have been built around the valuable fund characteristics of

professional management and diversification of investment and have

enjoyed significant marketing success. Brisk competition for investor

favor is not just a result of pressures from outside the investment company

industry. Within the industry itself, load funds have been losing sales

to no-load funds, offerings of closed-end companies and unit trust bond

funds. The magnitude of the load funds' marketing problems is illustrated

by Tabie I and Chart II set forth below which show the net sales over

1971-73 of load funds, no-load funds, closed-end investment company offerings, registered offerings of REIT`s and new offerings of unit trust bond

funds.

The Y•eputation and success of one large no-load fluid complex provides a plausible

explanation for ~:he contrast between the net redemption status of load fU.nds and the

net sales enjoyed by the no-loacfi. As for other investment media, their

relative success at a Cime when load fund demand has waned can be seen as

attributable, at least in part, to two factors. First, some competing

products offer substantial compensation to the salesman, thus tending to diminish

or even eliminate the traditional sales push edge of the load funds. Second,

some of these competing products are better positioned to exploit the

recent shift in investor demand for safety of principal and a high yield

in the face of the disappointing performance of the equity markets.

1/ ICI, "The Public's Attitude Toward Mutual Funds," prepared by National

Analysts, Inc. (1971), p. 2.

2/ Written Eomment of ICI, File No. 4-164, p. 37-38.
-2~-

TABLE I

NET SALES (or Net Redemptions) in 1971, 1972 and 1973 of

LOAA AND i~0-LOAD FUNDS, AND OFFERINGS OF CLOSED-END COriPANIES, REIT's AI~iD

UNIT TRUST BONL~ FUNDS

1971 1972 1973 Three

mil mil mil. Year Total

Load fun3s 1/

net sales

(redemptions) $138,90 ($1,987.80) ($1,49be70) ($3,345,6(

No load funds 1/

net sales 258.20 317.60 204.70 780.SC

Closed-End Companies 2/ 2/ 3/

(new offerings) ~: 420.00 1,119.55 1,517.00 3,056.55

Real Estate Investment

Trusts 2/ '^

(equity shares)** 878.50 565.20 507.50 1,951,20

Unit Trust Bond Funds 2/

(new offerings)* 540.80 985.18 1,309.55 2,835.53

1/ Includes only companies reporting sales to the Investment Company

Institute. Source: .Chart 2, ICI Monthly Statistical Analysis Reports.

2/ Source: Commission records of e€fective registrations.

3/ Source SEC, "SCatistical Bulletin",_V. 33, No. 11, p. 309 (riarch

13, 1974).

* Data for actual sales not available.

^k Registered public offerings are primarily equity shares. r~~ she 1 73

hearings, the staff presented statistics shoring REIT sales o~ o~-ex•

$1 billion for 1971 and 1972 (ir. 13)• However, those figures

included sales of deb shares, which have been omitted here becwuse

Fw1.T's nor:~~.1~y sell debt obli~~.tions in private placements, <<~~:•:a.ril;y

to large financial institutions.
-22—

CHART T[

NET SALES (a~ Net R~d~m~tic~s) in 1971, 192 and 1973 0#

lOAD AND t~0-LOAD FUNDS, APED OFFERINGS 0~ CLOSED-EMQ COMPANIES, REIT'S

~h~D !lNIT T~IJS~ st~Wl~ F9~NDS

(Dollars Billions)

2.0

1.5

1.0

.J

~-

-5

-1.0

-1.5

~2.~

,.sz

1.31

1.12

~.~— -- — __— 

~i X99 —'---

.88

... 

I 

/

..~ 

.SI 

— — 

.57 .S1

.42 

...

..: .3~

.26 :::

.ZO ..

.~e ..

::: 

~ 

~

Load Funds

No.Load Fvnds

Closed-End Cee~pani~~

:: R E I T's ---` — — - (1.50)

Unit Truax Sand Furds

19'1 ..~., 197 1933
-23-

1. Sales Compensation

It is argued by one industry source that:

'~o close one's eyes to the reality of the fact that

salesmen in the industry have tradiCionally sold

products which pay the most money is to regulate

without a sense of what the industry is about:`1~

If this evaluation has merit, it may help explain why load fund sales

have lagged, while competing products have enjoyed sales success

It appears that in today's market, the dealer selling mutual ~p~-x~cls often

sells competing products as well, each of which offers him different amounts

of compensation ranging generally from 7'/0 on load mutual funds1~ and ai.l.

and gas drilling funds, down to a spread of 1% to 5'/o for secondary :~~iies

lisCed on exchanges and in NASDAQ. An examination of the varying 1~~rFls

of dealer compensation offered by competing products, as shown bel.c~ra _i.n

Chart III, casts some doubt on the continued validity of the findirig in

1966 that the disparity between the level of compensation for se11~~~

mutual fund shares and thelevel of sales compensation for other secu~:ir.:i,~.s

"lead[s] securities firms and their salesmen to recommend and sell m~.c:~~~l.

fund shares rather than other shares."~ As the Chart indicates, this n:isp~rity

no longer exists. Initial offerings of closed-end investment companie;:~ generally

return 6% to the dealer (a.nd often more where there is no cli stributor

retention) . Oil and gas drilling funds typically return 7°~ to the ~e1.1er. The

absence of a volume discount on some of these other new issues is also ~i.gnificant;

it means that unlike the case of the mutual fixnd, the maximum cha~~;~ i.~ not

reduced for lgrger purchases. 5/

1 Written comment of the Seaboaxd Corp., File No. 4-164, p, 2, w

See text at p. 30 infra.

Mutual fund Report at 221.

It was suggested during the hearings that compensation earned b~>•:~.

salesman might be doubled if he sold a closed-end bond fund rat-her

than. a mutual fund. ( Tr.. ~+0-~+l

The volume discount offered by mutual flznds reduces the overall

sales compensation by a significant amount. In 1970, the typical

maximum sales chaxge for mutual flznds was 8.5°fo but, largely

because of the volume discount, the average sales charge for cash

sales excluding reinvestment of dividends and taxable exchanges

was 5.7fo. NASD Study, Volume I, Summary at III-103 Table III-4.
a ~ c

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FOOTNvl'ES TO CHART' III

1~IASD Study, Vol. I, teary, at III-59•

Based upon data From selected prospectuses. It should be noted

that although the typical maximum management fee is 0.5°fo for

both load Hands and no-loa.d ftiuids, load funds had a 1970 weighted

expense ratio of 0.5~+% of total assets against a corresponcling

expense ratio of 0.72°fo for the no-loads and lcrw-loads. (pER

~~port, F'a.rt I, a.t A-95) • -

1973 Securities and Exchange Com¢nission Annual Report, at 149.

Figures for load funds exclude 52 variable annuity separate

accounts,

Based upon data from prospectuses of selected closed-end investment

companies.

Based upon data from prospectuses of selected unit trust bond funds.

Based upon registrations effective during 1873.

SEC, "2'he Emergence of the Real Estate Investment Trust Industry"

("REIT Study"), April 1973, at 8.

Id., at 25. Based upon a study by the SEC Office of Economic Research

of riew offerings during 1971. The spread on equity was dependent

to a large extent upon the size of the issue and ranged from 5°fo to

10°fo on individual. issues.

Estimate by Kenneth D. Campbell, author of The Real Estate 'I'ru.sts:

America's Newest Billionaires (1971). (Staff telephone inquiry,

June 2 , 197

10 REIT Study, at 39, and Campbell, The Real Estate Z`.ru.sts: America's

Newest Billionaires, at 135.

REIT Study, at 8.

12 Yd., at 3. There are also numerous intrastate REIT's for which

no information is available.

Source: SEC registrations effective during 1973.

l~ SEC, "Tabul.a,tion and Analysis of Questionnaire on Sma,l1 Account

Inve sf~nent Ma,n,agement Serv3.ce s" ( May 11, 1973) , at 8 . A minority f

of firms bunch orders of their clients affording same savings in

brokerage costs.
-26 -

Average fees range froQn. 5.3°fo at $5,000 under management to 1.2°fo

at $200,000 managed (Id., Table IXa, p. 8). The average

account size is $38,505 and the median is $29,000 (Id., at ~+).

A fee of greater than 2°fo is higher than that normally chaxged,

and the staff ha,s taken the position that any adviser chaxging

such higher fee ma,y violate the antifraud provisions of the

Investment Advisers Act unless he makes adequate disclosure

to e~.sting and potential clients. See p e. ., Steve Stein, CCH P'ed Sec.

L. Rep, pa.ra. 79,663 current binde] (197~+~.

16 Id., Table IIa, p. 1.

Based upon a yet unpublished SEC study of all registrations

effective during 1971 and 1972. The average spread of comnnon

stock primary offerings was 9.39°fo, but such factors as the size of

the issue, degree of risk and tenor of the market minimize the

importance of an average. The spread cited may have widened

during 1973• Most sales efforts were limited to the underwriting

syndicates.

18 1973 Securities and Excharsge Co~.ssion Annual Report at 163.

2'he typical max~.iuum co~nissions for exchange listed stocks is

spread between l~f and 4°fo (see NYSE Constitution, Art. XV at

81702) but ha,s been noted above as 1°fo - 5°f to include onrer-thecounter securities which fa11. under the so-called 5°~ maxk-up

policy. (See NASD Manual, Rules of Fair Practice, Art. III,

Section ~+, Paxagraph 215+) . ~.e NASD Stucky (at III-~+g) noted

tha-~ the average size mutual fund sale transaction was about

$2,900 in 1970. Applying NYSE minimum commission rates to a

similar size sale of coffinon stock (assuming a round lot order)

would result in a c~nmission of about 1.8°fo.

20 Based upon 6,353 issues as the unduplicated corunt of securities

on exchanges (1973 Securities and ExcYiange Co~nission Annual

Report, at 162) and 2,932 issues quoted on NASDAQ on December 31,

1973 ~ x-973 NASD Aru~.ual Report, at 10) .

21 Genera7.ly no sales charge on governmental issues. An SEC stuc~y

of all corporate registrations effective during 1971 and 1972

showed an average spread of 1.14°f with a range fr~n 0.83 to

~+. 02°fo. ( See footnote 17, above) .
-27-

E~,irthermore, to the extent that the abolition of give-ups and

the adoption of the NASD's rule prohibiting sales reciprocity arrangements affect dealer compensation, there is at least an implication

that the relative selling compensation received by mutual flxnd retailers

has been reduced even farther than an examination of maximum dealer

concessions would indicate. 'Thus, the prohibition of give-ups and sales

reciprocals since the writing of the 1966 Report can be viewed as

making fund sales less remunerative in an absolute sen~~ and, in the

case of sales reciprocals, in a relative sense vis-a-vis certain

cca~rpeting products with respect to which sales reciprocals have yet

to be prohibited (See Chart III).' As is discussed at pages 3[x._36

infra, the outlook suggests continued reduction of compensation

opportunities derived from the sale of fund shares.

To further tip the scales away from the situation in 1966, participants

in the hearings maintained that many competing products which offer

competitive or, in some cases, more favorable compensation are now

easier to sell. While the NASD Study found that the average time required

to complete a mutual fund sale was greater than for a cocmnon stock sale, 1/

and the Study did not consider the time involved in selling such products

as REIT's or closed-end bond funds, testimony revealed that these products

are often sold over the telephone. Also, the existence of a closing date

-- on a new offering, a factor generally not present in the case of an

open-end fund, tends to reduce the sales effort regaired since it compels

an investor to make a quick decision. 2/

2. A Shift in Investor Interest

As Gha.rt III indicates, the investor today ha.s a laxge variety of

financial products from which to select, each with its own combination

of special features. mom the standpoint of an investor appraising

these different investment meclia, ~o of the most critical considerations

axe anticipated return and degree of risk. Tt may well be that many

mutual funds a.re now perceived by investors as offering low dividend

1/ The longer time was reported to be in part attributable to the difficulties

of explaining mutual funds, which salesmen consider more complex than

some of the competing products they sell.

2/ Tr. 41-42.
r~';`',.

-2~

yields while at the same time being subject to the risks inherent in

the market.l~

It is possible that the disappointing performance of the equity

markets and the current extended era of increasing interest rates

have turned many prospective mutual fund owners to other more secure

producCs. Debt instruments are now offering relatively high yields

and in many cases are risk free or present considerably lower risks

than those found in the equity markets. Consequently, investors have

turned in significant numbers to unit trust bond funds, closed-end

investment companies specializing in bonds, and the more recent cash

management funds.

Aside fr-om the likelihood that some potential fluid investors have

turned to competing products because of the more appealing investment

characteristics they offer, it may be that the funds have lost some

potential customers due to investor mistrust or misunders~anding of

the mutual Eland investment concept. A Louis riarris - poll indicated

that in the public's eye s, mutual funds trail such investment media as

bonds, stocks and savings accounts in categories ranging from liquidity

appeal to "best for growth" and "best protection from inflation."~

Another stiue~y of the public's views on investment conduced

for the Securities Industry Association showed a similarly low esteem

for mutual funds in comparison with other vehicles competing for

savings dollars.

1 Of course, many competing products, despite their relatively large

sales in recent years, also involve risks. With only a few exceptions,

closed-end investment companies, including "bond funds," are now

selling at a discount from net asset value. REIT's, as recent events

indicate (see Greer, Realty Investment Trusts Again Falling by Wayside,

The Washington Post, June 2~+, 197 , p. D-11 and Metz, Market Place:

REIT's Suffer As Rates Soar, The New York Times, Judy 5, 197T+, p. 32),

ma,y involve considerable risk and have fallen from investors favor.

Harris, Building Public Confidence in Financial Institutions in the

Seventies, FINANCIAL ANALYSIS J. Mar-April 1973 at 2~+, 26.

OPINION RESEARCH CORP., 'IxE PUBLIC AND INVESTORS EVALUATE THE SECURITIES

INDUSTRY (1972).
-2g-

~^ 3, Another Recent Competitive Development

.Diversification of F~znd Managers

A decade a,go f~.ind managers, for the _most part, were only that.

Perhaps same were also investment counselors or broker-dealers whose

fund activities were a na,t'usal.adjunet to their other business. In

contrast, many fund management companies today are part of a much larger,

broadly diversified complex of financial holding companies, insurance

c~rpanies, or even major conglomerates, often publicly held. This

trend to diversification is also appaxent at the level of the imrestment adviser itself. Besides serving their mutual funds, advisers

today also provide a host of other money management products, including

traditional private counselling, so called mini-accounts, investment

advisory subscription services, unit trust bond funds and closed-end

income or venture capital companies, real estate syndications and othex

tax sheltered programs and variable annuities, and, in the fliture,

variable life insurance.

It is hard. to say whether competition with other products ha.s forced

the industry to diversify or whether diversification created the competition, but it is clear that diversification is a fact of 'life for the

mutual fund industry.. Donald Patti, of Wiesenberger Services, presen~ed

this view of the situation:.

"The immediate result of this increasing commitment that

we see to the :i.nte~rated selling of different kinds of

financial products is that, realize it or not, like it or

not, we are in the midst of a new kind of marketing

battle for the consumer's financial services dollar.

Unlike the railroads, who never understood that they

were really in the transportation business, financial

service executives must realize .that they are no longer

in the insurance business, the brokerage business, the

bar~~ing business, or the mutual fund business; they are

in the money business. The wrenching problems of negotia.~;ing

ce~nnnisions, mutual fund sales charges, institutional access 'to

the major stock exchanges, and the :cope of bank holding companies are only skirnv.shes in this bigger distribution

~--
-3~-

battle, and the resolution of these problems will only

serve to speed up the implementation of the financial

services concept. These and other changes will ultimately

force all the traditional sellers of single financial products

into same -kind of combination selling because the only

way they will be able to maintain their sales thrust in the

kind of c~npetitive en~i.rorunent these changes will create

will be to increase their marketing effectiveness while

offering their services at less cost to the consumer. They

are only going .to be able to do that, in my opinion, by

selling five products to one prospect rather than one

product to five prospects."~

Summary

It appears that mutual funds are subject to vigorous competition

for the investor's dollar with different investment media, many of

which offer similar features, can be more easily sold on the basis of

current yield, and also offer attractive compensation Eo dealers and

salesmen.

B. Distribution -Margins Narrow for the Principal Underwriters

A key feature of the mutual fund merchandising strategy has been to

offer Large rewards to broker-dealers who enter into dealer agreements to

distribute fund shares. Much of the reward -- the dealer discount --

derives from the sales load (typically 8.5'/0). Year by year the dealer's share

of the sales load has risen from 4 or 5% in 1940, to in some cases, as much

as g'/o or 8-1/4'/e today -- but typically T/o. 2/ This trend has left little

for the principal underwriter to finance the wholesale effort or to use for

advertising or building product recognition and demand for fund shares, or

providing other services. At the hearings, H. Bridgman Griswold, President

of Union Service Distributor, Inc., described some of the other services

performed by principal underwriters as including training salesmen, supplying

prospectuses, reports, and performance guides, and assisting in closing

complicated sales. 3/ Mr. Griswold commented as to the effect of this s~uee~~;

"In recent years ~nion Servic~ Distributor has

operated at a loss, which loss, within limits is now provided

for by the investment companies in the group. This shift in

operating results has taken place even though the 'basic sales

charge was increased from seven and a half percent of the

offering price to eight and a half percent in May of 1970.

1t results primarily from the substantial reduction in the

sales chaxge actuary realized by Distributor, reflecting

cumulative discounts, etc., and increased clistributing

costs of personnel, materials and services."_~

JT'1~'~ 2363-64.

2 Based upon 1971 N1-R reports. As recently as 1966, the typical

discount was sti71 6-1~2°fo. Mutual wand Report at 207.

3/ Tr. 2209-10.

=~/ Tx. 1822.
- 31

_. i'he notion of a distribution system which is, in itself, not profitable seems to have become accepted as a fact ~f life by the mutual

~~fund industry, and more and mere complexes have been forced

to finance essential wholesaling services and the sale of ~znd shares

out of the pxofits generated fro¢n investment advisory fees:

"The economics of this business is such that distribution

is not a means of making a profit, not to a company such as

IDS nor~to most underwriters in this business. It is

really an adjunct or a method of marketing your money

management services for which you charge and out; of which

you make a profit .

"Our distribution organization is essentially nothing but

a mechanism by which to market those services out of

which we make a profit to bring the money into the

house. ~ ~ ~"~

Indeed, some fund complexes have from time to time offered dealers the entire sales load on certain of their funds. As an example, Putnam Management Company advertised such an offer to dealers with regard to The Putnam Income Fund from January 15, 1974 to March 14, 1974 in the following manner:

- 1 'Testimony of Robert M. Loeffler, ern behalf of Investors Diversi ed`

Services, Inc., Tr. 2190-91.
I'_:~'~:Sii~~'.ii~'I r~"_....;L':zi ~ DTGEST 2-5-7!+ ~ - 32' - , .

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VDU ~~~~« au~l~il~ab~ C~~~rll~ ~~i~0~ 1U~1l+i.j,!

Cut nci.e ~~~~~this sr~cial ~r~i~a~~~~~►~~~nt is ~v~ila~l~ only

dui r~ ~hz ~~;~ ly pay ~ of 1a%4,

~_oi Tui~

#~'l~~u=~"~l~~~lt (~; C ~~~ ~!Ct:`~ ~~,l~~.~~'"1 ."E~~ t,~~~l~~~l\~~,.. Ot v~~< «P.

P- -, ar., Fu~:j Dlst-:b:ro~s.

!~ 17! ~23 :f:~o~ '

Y~:_•t o" t.:iss~>si~~p;: fSC4122~ :s.l

~1
-33-

__ Paying the entire sales load to dealers apparently resulted in a

marked increased in sales of The Putnam Income Fundts shares during the

period of the special offer. Sales of the ~fLind during that 2-month

period amounted to $5 million, campa.red with slightly more than $3

million for all of 1973 and $680,000 for the first quarter of 1973.

Moreover, the fl~nd's improved sales did not end at the conclusion of

the special offer. For the four weeks following March 15, the Hand

recorded sales of $1,110,000, this was nearly double its sales for all

of March and April, 1973•

The willingness of major Eland complexes such as this one ,3J to

forego any share of the selling compensation of one of its mutual flznds,

albeit for a limited period of time, dramatica7.],y underscores the fact

that flznd sponsors may regard the underwriter's spread as negotiable

and look instead to advisory fees; rather than distribution profits,

for their compensation.

C. A New Road to Market

1.. NYSE Member Firms - "We Could Do without" the Funds

One of the most significant findings of the OER Study wa,s that the

f~znd industry over the past decade has came to rely more and more heavi7~y

on large broker-dealers -- NYSE member firms -- for the bulk of its gross

sales. The ICY estimates that, before 1960, approxi.mate~y 65°fo of

cli stribution thxou.gh independent broker-dealers was accounted fox by

non-members of the New York Stock Exchange; whereas now this balance

ha.s been reversed and about 65°~ of broker-dealer sales are presently

accour.Led for uy exchange r~lembers. ~ however, mutual itiznd retailing

does not represent a particularly important part of 1VYSE member Firms' total

1 Letter to staff from. Lynford M. Richardson, Controller, Putnam

Management Company, April lg, 197+.

Ibid.

As of June 30, 1973, 'the total assets of all the mutual funds in

the Putnam complex were approximately $1.96 billion, of which the

Putnam Income Fund represented some $131.6 million. SEC, Classification, Assets and Location of Registered Investment Companies

under the Investment Company Act of 19+0 as of June 30, 1973, at 17.

ICI comment, at 23. On the other hand, it might be noted that

slightly more than two-thirds of the revenues earned through

retailing investment compar~y securities in 1970 went to non-exchange

firms, including captives. OER report, at A-28, n. 2. But this

percentage also seems to be declining; in 1971 the portion of such

revenues which went to exchange firms had risen to ~+2°~. Office of

Economic Research. "Broker-Dealer Community: Historic Treizds in

Current Financial Structure," March, 1973 at 52.
revenues: only 1.6°fo of exchange firms' total dross revenue in 1970.~J

The relative unimportance -- from a monetary standpoint -- of mutual

f~zr~d sales to exchange. firms was pointed up in the testimony of

Bradley Baker, President of the National Mutual Fund Managers Association,

a group of mutual :~lznd sales managers of member firms. Mr. Baker, wl~.le

praising the mutual fund as "the finest single product ever devised

by the investmen~c community for John Q. Public," nevertheless stated that,

looking at the contribution of mutual fund sales to total revenues, member

~~S "could do without them:"

"Member firms are important to the: mutual flznd industry

as they account for a very large portion of the total

mutual fund sales. However, mutual flznd commissions axe

not of too great importance to member firms as they account

on average per firm for only three percent of member firms'

total incame. What I am imp],ying is that if mutual

flznds were deleted from our product mix, we could do

without them,"~

Another problem for existing funds is that a number of member firms

which formerly acco~r'~ed for a large volume of flznd sales have collapsed.

Also, of those which remain, Merrill Lynch, Pierce, Fenner & Smith, Inc.,

which has in the past accounted for large fund sales, has organized its

own fund. 3/

Yet another problem facing ids who rely on NYSE member firms for

sales is that the introduction of Hilly-negotiated stock exchange commission rates for portfolio securities may we11 have a further dampening

effect upon the marketing of mutual fund shares.. As indicated at p. g above,

the Commission recognized in the Letter of Transmittal of its 171 Institutional

Investor Study Report, that to the extent the elimination of fixed

minimum rates cuts off an important source of income for selling fund

shares and fund distribution methods continue unchanged, the direct

charges for selling funds would have to be increased or mutual fund

distribution would be decreased,4~

1/ OER Report, at A-27 to A-28. Of course, 1970 was a depressed year for

mutual fund retailing. However, while revenue from mutual fund retailing

made a somewhat larger contribution to aggregate NYSE member firms' gross

income in earlier years, it has never been a really substantial factor.

2/ Tr. 1022-23.

3/ Lionel D. Edie Capital Fund. Of additional significance is the fact that

Merrill Lynch is marketir_g this fund with a 6.5% maximum sales load, i.e.,

mare than 20°fo less than the 8.5~fo maximum typical of the industry, and

a maximum dealer discount of 6°fo. During the first weeks of its initial

public offering late in 1973, the flznd had sales of some $225 million.

However, sales dropped sharply after this initial success; as of

March 31, 197+, the flznd's total sales had risen to only $230.5 million

and net sales were $225.6 million. (Data based on Staff inquiry).

Institutional Investor Study Report, Paxt 8 at xix.
-35-

__ It is of course true that negotiated rates already prevail for

sales under $2,000 and for that portion of any sale in excess of

$300,000 and, to this extend, the marketing of flznd shares already

may have been affected. However, the f'u]1 impact of reduced brokerage

costs will not be felt until flzlly negotiated rates take effect across

the board. Presently, brokerage houses can continue to receive fixedrate patronage from the Elands so long as such patronage is not given

in return for sales of flznd shares. Consequently some profits from fixedrate transactions performed for funds are still available for those

who sell f'usid shares, even though reciprocity as such is not allowed.

Thus, although reciprocal brokerage is no longer permitted to be used

as an incentive to market fund shares, a broker-dealer receiving fund

brokerage at non-negotiated rates (on orders, or portions of orders,

less than $300,000) can view the profits of such business as a supplement to the profits realized directly from the sale of fund

shares. But when fly-negotiated rates take effect, the remaining

"fat" arising from portfolio transactions should be gone.

Another result of fully-negotiated rates should be the "unbundling"

of brokerage services. That is, brokers will like]~y begin imposing

separate charges for various services which were previously performed

at no extra charge -- or not offering the services at- all -- because their

cost was included within the f7.xed sales co~nission. In some cases,

this has already begun. As both broker-dealers and customers begin

to view such separate charges as a usual way of doing business, it is

to be expected that broker-dealers will wish to imrpose -- and customers

~~ may be willing to accept -- separate charges fox' various services

rendered in connection with sales of flznd shares, which are now covered

by the fixed sales load. 'Thus, if viewed as separate from an original

1/ That is, under the NASD rule, sales of fund shares by a particular

brokerage house can be neither a qualifying nor a disqualifying factor

for the receipt of brokerage business from the fund. Thus, a fund

may continue to direct fixed-nee (and thus highly profitable)

business to a broker which sells its shares, provided that the fund's

choice of that broker does not interfere with the fund receiving

best price and execution and can be justified on some other ground

e. ., the brokers professional capability or thorough research.

2/ For example, Merrill Lynch offers a "Sharebuilder Plan" account for

small investors, with cormnission charges l6-24% less than the old

rates for orders under $2,000. However, investors taking advantage

of such discounts must sacrifice certain services which theq would

otherwise have received. Specifically, they must transmit all orders to

buy or sell through the mail, with no telephone orders being accepted;

moreover, any subscription rights for additional shares may not be

exercised, but are instead automatically sold by Merrill Lynch on

behalf of the customer. In addition, certificates, which would

~- othenaise be sent ~ the investor, are held by the firm unless the

customer pays a separate transfer charge for having them sent to him.
-36 -

purchase, ser~rices rendered by flzrid dealers could tend to undergo the

same "unbundling" as services associated with sales of other securities.

Stunmax'y:

It appears that, as long as the funds remain largely dependent upon

NYSE member firms and those firms can afford to be indifferent in their

efforts to sell end shares, the outlook for improvement in the merchandizing of fund shares will be, at best, uncertain.

2. Small Broker-Dealers Taken £or Granted or G~Zt Off

The funds have not strengthened their relationships with small broker

dealers to compensate for the growing indifference of member firms. Mutual

fund retailing is considerably more significant to non-NYSE firms than it

is to exchange members. Non-members received approximately 11.6 percent of

their total gross revenue from this source in 1970. 2/ Moreover, the ICI

points out that the non-exchange broker, by virtue of his very lack of

exchange membership, has a limited line of financial products to offer,

and thus has a great incentive to be "loyal" to mutual fund retailing. 3/

In 1970, according to the ICI, 182 non-NYSE Firms obtained 90 percent of

their gross incoane from the sale of mutual funds. Horwever, this on]~y

serves to demonstrate that, as the Commission noted in the letter o~

1/ Although the term "unbundling" is generally used with respect to

secondary market transactions and mutual fund shares are sold in a

nominally primary offering, their distribution is Auite analogous to

secondary market transactions in other securities. A mutual fund

primary offering is continuous; there is no need for an underwriter

to guarantee, or even attempt, the sale of a given number of shares

within a fixed period of time. Furthermore, unlike other securities

in a primary offering, the price of mutual fund shares does not, and

cannot remain, fixed; it varies with net asset value. Hence, only

that portion of a fund share's price which is designed to cover selling

services remains fixed. Section 22(d) precludes dealers from unbundling

these services -- and the charges for them -- to the same extent

that brokers af' other securities unbundle their services and charges.

2/ OER Report, at A -28.

3/ ICI comment, at 23.
-37 -

transmittal acc~npar~y:ing the OER Report, "the imztual fluid industry

is far more important to these firms than they axe to it."

At the hearings, small broker-dealers complained of receiving little

assistance from fund wholesalers, 2/ and that fund underwriters have

organized their own captive sales forces 3/ thus cutting off the brokerdealers. The testimony of Robert Roth of Mark Securities, an over-thecounter dealer in Hartford, Connecticut, suggests the flavor of what can

happen:

"We lave had one large case where a certain fluid

decided to eliminate 1,500 dealers, take our commissions,

use it to finance their own captive organization. With

it, probably, I would say from our sales in firms that

we took over represented $4 to $5 to $8 million of their_

fund, a lot on voluntary sales where we completely

lost that ccIImaission.

"They in turn had our accounts, had the names, I

am sure, and I am not going to get into this area,

that they then sent those customers to their own captive

organization, and we had absolutely no recourse, and I

don't even want to think about how much money we lost on

this situation." 4/

Another bone of contenfiion has been the minimum dealer allotment on sales

~-' loads for dividend reinvestments. That is, where a sales load is charged nn

reinvestment of income dividends, dealers receive a portion of the sales

load (i.e., the dealer discount) on Che reinvestment. Certain fund principal

underwriters which had previously remitted all such dealer discounts, or at

least all amounting to not less than $1 per quaxter for each account, have

more recently held back the dealer discount on accounts for which the dealer's

l~ OER Report at ~_v-v.

?/ Tr. 935-36.

~/ Keystone Custodian Fund, Inc., of Boston for example, has established

its own direct selling organization. Tr. 309, That is not to say,

however, that the captive sales force will be the wave of the flzture.

Massachusetts Fins,neial Services, for example, moved in the opposite

direction when it~berminated distribution of its family of funds and

set out to build an independent dealer izetwork with its "~o for broke~~'

campaign.

Tr. 936
-3a -

portion totaled less than $5 per quarter. 1/

Fcr same dealers, loss of this comanission incarne has been signilicant, and at least two separate comrpla3.nts have been filed with the PIASD

against various underwriters with regard to the practice of raising the

rninimvm amount on which the dealer discount would be paid on di~r3dend

reimrestments. 2J In both cases, the complaints were dismissed by the

I~IA.SD's Board of Governors, and the Commission declined to review the

dismissals.

Mr. Roth left little doubt as to how he felt about the $5 minimum

payment rule:

"* * * /F/rom a little fund the commission was $4.65, that

is below the minimum amount, they are not going to pay it.

"I have to pay my salesmen, but they decide that is too

small an amount.. Sure, .if I had known this was going

to happen, we should have negotiated a contract, and I

doubt we would have sold any of the funds. Bud they are

all standard contracts, as far as I know.* * *"~/

1/ The institution of the $5 minimum appears to have been based partly

upon a desire to decrease the cost of handling and distributing these

conanissions to investment dealers by minimizing paperwork, and partly

to offset increased dealers discounts on new sales instituted in

response to competitive pressure. See testimony of Robert Riley,

President of Putnam Management Company, Tr. 229.

2/ Wurzburger, Morrow & KeouQh, Inc, v. Putnam Fund Distributors, Inc. and

Vance, Sanders & Co „ Inc.,, Complaint No. B-268, District 13, filed

June 19, 1971; and James M. Smith d/b/a J.M. Smith & Company v. The

Keystone Comnanv of Boston, complaint No. B-277, District 13, filed

July 29, 1971.

Tr. 938-39•
-39-

D. Facing Up to Investor Skepticism

It has already been noted that surveys of investor sentiment have indicated

what may be tatcen as a misunderstanding o€ the mutual fund form of investment, While the existence and extent of any investor confusion is speculative, i:f the phenomenon is real it may have its roots in two occurrences

in certain fund industry quarters during the 1960~s. The first matter relates to

the so-called "go-~o" boom of the late 1960's; the second pertains to the failure

of some funds properly to service their shareholders.

1, "Reaping the Bitter Harvest"

Mutual funds have •established themselves as investment programs which

are designed for the long term. Nevertheless, attracted by spectacular short

term investment results of the so called "go-go" funds and the glamorous

reputations of their managers, large numbers of investors bought funds in

the late 60`s in hopes of quick success. Some of the best selling funds,

many of them operated by newcomers to the business but a number of them

also organized and promoted by the older more established management

organizations, followed the then popular trends and employed a number of speculative

devices -- high portfolio turnover, leverage, and purchases of restricted

securities, options, new issues and stocks with very thin floats -- in the

hopes of achieving dramatic success. As a result, when the stock market

declined, many o£ those highly volatile funds which had climbed faster than

the market, declined equally as fast. These funds conveyed an impression of

mutual funds as a short-term, speculative, high risk investment -- a far cry

from the program upon which the fund industry had been built. Z/ This

__ phenomenon was described by Roger McCollester who was the partner at W.E.

Hutton & Co. in charge of its mutual fund sales:

1! Tra 2399. Mr. Pitti stated at the hearings:

!'The 1967, X68, X69 boom in interest in mutual funds Z think

was an extension of that concern about inflation and ... a

revival of what happens in every speculative boom. The greed and

fear of people wanting to make money when everybody else is,

And I think that at that time, although we all know that tha

funds contributed a great deal to the problems that ,.. developed

.,., I think the funds were the victim of that greed and fear in the Late

~60's. I think the public in a collective sense and in an amorphous

sense decided that that was a horse to ride at this time.

"I~m 43 years old and i have been through three market cycles

and I have seen it happen and I know it will happen again. The

next time we get into a speculative boom some other investrnent

medium will be singled out as the horse to ride this timed

"And then we had the ,a. disenchantment that always comes

after a speculative blow-off, and the funds now are

reaping the bitter harvest, I think mainly because the industry

was not mature enough and sophisticated enough to withstand

the te~nptation that was afforded by this thirst '=hat cried

to be satisfied." Tr, 2398-99.
"We only have to go back to the 'go-gd era when people

were buying the portfolio managers of their choice, their

track records, and in those days you couldn't give enough

away, if you will. --- ~ZJt was sold as a stock, but

didn't that come back to haunt the salesman who did it,

because in effect he was doing it for the wrong reason. He

was selling an individual the aura of his performance and

was not following what all of us here believe to be the

proper method of offering, a concept -- a long-term investment concept. He was selling a short-term quick appreciation

to a hungry guy who wanted to make a buck fast, and who

Found that his own trading account wasn't doing as well as

Mr. XYZ's or Mr. ABC'S. We all know the names." 1/

In adcli tion, many of the flznds whose sales suddenly increased

during this era, and their transfer agents, were i11-equipped to cope

with success. ~ Their back-office staffs were overwhelmed ~r.~th

paperwork. The chaotic effect upon investors and retailers was well

described by Orv~11e F~. Lauver, an independent broker-dealer from `%orY_,

Pennsylvania:

"Have you ever had problems with your checking account,

with the bank coming back with a different balance? Can

you imagine an individual who doesn't understand in depth

as much as perhaps we would like them to understand, and

then getting a statement where they see shares being

taken away or not credited to their account. You know,

that is a nightmare. I. took us a year and a half of

correspondence°" 3/

The excesses of the 'go-go`funds tended to spill over onto the more

conservative funds which avoided sudden declines in value and serious backoffice problems. This is suggested by a comment of John Weller, an independent

broker-dealer from Camden, New Jersey:

"[Y]ou have two funds that a person might be going into.

And if one creates a tremendous amount of headache for the client,

they tend to get leery about the other one. This is one of the

problems ." ~+/

Tr. 1071-72.

As one illustration of the problems that arose where there was

such a paperwork crunch, on February 27, 1970, the Commission announced

(Litigation Release No. ~+5~!7) the resolution of an action involving

Enterprise Ftiind, Inc., in which the Carmn.~ission alleged, atnorlg

other things, that on January 1~+, 1970, 853,000 of the Fund's appro:~imately 95 million outstanding shares were not posted to shareholder

accounts.

~. 877. These problems s~i11 occur. On April 2~+, 1974, International

Investors Incorporated voluntarily suspended sales because it was

experiencing a major back-office problem. Sales were resumed on

June 17, 1974.

'~r . 877 .
- 41 -

2, Shareholder Service

While some investors may have experienced frustration over backoffice chaos, others experienced inadequate or nonexistent salesman followup after the sales presentation.

George Washburn, Vice President in charge of fund sales for

Reynolds and Co., testified:

~~Right now we get very lithe continuing service after

a fund sale. Even people who still have on their,

say, dividend reinvestment notice both a dealer and

e salesman, there is very little service being done

two or three years, five years down the pike in

helping a person understand and evaluate what he ownso "1/

Mr. Washburn later added that:

"I would say tinere is a large portion o£ the say

five or six million fund holders we have are not

getting the service they need, if not getting none

at all. All of us have experience of contacting and

running into people who have had a fund for 5, 10

years and they never heard from the salesman that

sold it to them. And I know many of the funds have

large blocks of what they call - orphan accounts."2/

E. 1'Y~e Shi f~ to Big Ticket Investors

IIistorically the f~znds' most important market has been the small investor.

Funds have provided e valuable service for such investors who otherwise might

not be able to afford professional management and a share in a portfolio of a

large number o£ listed securities. However, the trend over the last decade

has been toward larger sales. In 1960 sales of $25,000 and over accounted

xor 20% of total load fund sales volume. 3/ By 1970 sales of $25,000 or more

1/ Tr. 1117,

2/ Tro 1128

3/ NASD Study, Table III-6, at III-14.
- 42 -

accounted for 347 of total load fund volume l./ and by 1972 they were 52%, 2/ Even

more dramatic evidence of the changing relationship between the fund industry

dnd small investors can be found in the fact that about 80% of the fund sales of

the last quarter of 1972 by rlerrill Lynch, Pierce, Fenner & Smith were in

amounts of $25,000 or more and nearly 60% were in amounts of $100,000 or more,,/

Roder McCollester placed the following interpretation on this kind of

data:

"I think what it means is twn things. I think

that obviously mutual funds for many good reasons are

attractive to the large investor maybe even more so to

him with his sophistication and his knowledge that he needs

professional management .

"I think that it is also an evidence of the fact L-hat

the salesmen of our firms are definitely concentrating

on the big ticket through installment sale purchases .

I think the sophisticated dollar is a more attractive

dollar for a salesman with the amount of time he has

available to offer his serrices, and I think it is also

evidence of the fact that we are not scratching the surface of the small investor as well as we should. And

yet he is the guy who probably needs our help more than

anybody.±/

3/ NASD Study, Table III-6, at III-14.

2/ Written comment of W.E. Hutton & Co., File No. 4-164, p. 3. While inflation

may have had a hand in the increase {.n lay er sales, '.t does not appear

that inflation alone explains the phenomenon. The 1966 Report,

relying on TGI data, pointed to a figure of $1240 as representing

a typical mutual fund purchase in 1966. See Mutual Fund Report

pg 206-207 and fn. 20, 21. The NASD Study reported that in 1970

the average size fund sales transaction was about $2,900 according

to q~iestioned broker-dealers. NASD Study, III-49.

3/ Testimony of Robert Cleary, Vice President of Merrill Lynch, Tr. 256.

According to the NASD, sales of $1 million or more accounted for 8.2%

of the volume of Load funds' cash sales in 1970. This contrasts with

a 1/10 of 1% figure for such sales in 1960. NASD Study, Table I'II-6,

at III-14.

Tr. 1033-3~+. On the ot?~er hand, we would point out that a Ia.rge

number of small shareholders is not an unmixed blessing for a f1~.nd,

in view of the relatively high cost of servicing small accounts.

The difficulty is compounded where state expense limitations

force the flznd's management to choose between providing limited

service or returning a portion of its fee to keep the find's

expenses within the prescribed limits.
-~+3-

SUMM~1FtY:

the mutual flznd distribution system is being influenced by forces

over which it ha,s little or no control. Other investment products

cc~npete aggressively to meet present-day investors' demand for high yield

and relative safety of principal. At the same time, retailers who distribute such competing products can realize compensation corrrparable or

even superior to that which _could be earned by selling flznds. Farther,

the Hand industry's ability to retain the loyalty of retailers becomes

more uncertain as the percentage of ~zn.d sales made by large brokerdealer firms, to whom such sales are a relative~r unimportant source of

income, rises. As if these difficulties were not enough, the flznd.

industry must also cope with the fact that the public appears sti11

sensitive to the sudden declines in value in some funds, and the backoff`ice problems of others, wha.ch resulted from the excesses of the "gogo" era of the Zg6ots.

In response to this combination of forces, fund underwriters have

surrendered greater portions of sales cottm►issions to dealers, to the

point that underwriting profits have all but disapp~a:~:~d. More than

ever, fund advisers axe subsidizing distribution out of advisory profits.

Perhaps for this reason, with small broker-dealers accounting for fewer

fund sales, some in the industry have allowed their relationships with

such retailers to deteriorate. Moreover, the fund industry seems to be

unable to assure proper follow-up service to shareholders. Whether as a

result of these factors or of the condition of the market in general,

ftin.ds have lost ground with their traditional best customer, the small

investor; a rising percentage of flznd sales are ir. laxge amounts.

Tn o-~her words, the industry is not prospering with the marketing

strategy which was so successful in past years. Hence, changes in the

pattern of Hind distribution seem inev~.table, partic'ulax~y as changes

iri brokerage practices might cause more investors and broker-dealers "to

begin to look upon an expensive "bundle" of selling services as unnecessary

and obsolete.
- ~F~F -

II.. Regulation of Fund Sales Under Section 22(d) Today

A. Exemption from Section 22(d)

Section 22 (d) prohibits mutual funds, underwriters, and dealers

from selling fund shares to the public "except at a current public

offering price described in the prospectus." In other words, the

section requires retail price maintenance. However, tie Co:7:~~ission

ha.s issued many general and individual exemptions from Section 22(d)

so as to make the retail price maintenance requirement inapplicable

in a wide variety of circumstances.

The broadest such exemption is Rule 22d-1 which, among other things,

permits the sales load to be reduced or even e7.iminated k*here shaxes are

purchased in 1Jarge quantities dividends or capital gains are reinvested,

or shares are purchased by certain tax-exempt organizations or officers

or employees of the investment company or its investment adviser or

principal underwriter. Amore limited general exemption from Section 22(d)

is contained in the recentJ~y adopted Rule 22d-2,which permits mutual

Elands to allo~~r their shareholders to reinvest without a sales load, within

30 days, the proceeds of a redemption of the f'und's shares. The no-load reinvestment can be in the same fund or in a "sister" investment company offering shareholders in the former a no-load exchange privilege.

In effect, by these two rules, the Commission has dispensed with

the retail price maintenance requirement where a lower price would be

justified by distribution economies (in the case of Rule 22d-1), or

would avoid penalizing a shareholder who has mistakenly redeemed his

shares and wishes to repurchase them almost immediately (in the case

of Rule 22d-2).

Farther price va:c~iations beyond a single offering price have been

permitted by the numerous and varied individual exemptions which have

~~~~~-~i grail~ed From Section 22(d). '-'_hese exemptions have been based. upon

differences in cot and service, or considerations of basic fairness,

•~~ational economic policy, or sound business practice. Flhile the

individual exemptions are not easily cla;~:;i£ied, a large number of them relate

to variable annuities. In this regard, the exemptions fall
_~~.5_

mainly into four categories where a full sales effort is not required:

(1) transfer of insurance proceeds or cash values to a variable annuity

operated by the same company; (2) refunds of excess charges or divisible

surplus in the form of variable annuity shares, in a manner similar to

a dividend reinvestment plan; (3) transfer. of funds from a fixed annuity

separate account to a variable annuity separate account; and (4) investment

by a beneficiary of life insurance proceeds in variable annuities. A number

of exemptions have been granted outside the variable annuity area. Thus, the

Commission has also provided exemptions 'relating to sales of

mutual fund shares in foreign countries. Many exemptive orders have also

been issued to permit the exchange of fund shares for the assets of personal

holding companies. Other exemptions from Section 22(d) have been granted

where the applicant has changed its method of distribution, and a failure

to vary the price for certain repeat investors would result in unfairness to

them .

Sales made pursuant to exemptions from Section 22(d) are a substantial

part of the fund distribution picture. During 1973, gross sales of the mutual

fund industry were $4.4 billion, of which $3.6 billion were made by load

flznds. Of the load fund sales, an estimated $1.2 billion, or approxima,tely one-third, were made pursuant to exemptions worm Section 22(d).

This figure must be viewed as conservative because the data, as

shown. in Table II below, does not include the value of exempted sales

to employees for other than the organizations ~ queried by

the staff, nor does it include sales to certain tax-exempt organizations pursuant to Rule 22d-1(e).

1 The staff inquired of five large fund complexes. Of these, three

had made no significant sales to employees pursuant exemptions Barn

Section 22(d).
-- 46 -

TABLE II

LOAD FUND SALES MADE PURSUANT TO EXEMPTIONS FROM

SECTION 22(d) IN 1973

1973 Total Load Fund Sales (ICI Members) (mil) 3 550.E

Load Funds' Estimated Reinvested Distributions

at No-Load Pursuant to Rule 22d-1(b) and (c):

Net Investment Income x/$474.9

Capital Gains b/ 645.4

Subtotal $1,120.3

Foreign Sales Pursuant to Exemptions from

Section 22(d) by: _~

Keystone Custodian $ 51.6

Funds, Inc.

Investors Diversified 21.6

Services, Inc.

Capital Research.& 20.2

Management Co.

Dreyfus Corporation 15.0

Subtotal 108.4

Estimated Value of Shares Exchanged for

Personal Holding Companies Pursuant to

Exemptions from Section 22(d): d~ 13.2

Exempted Sales to Company Employees and

Company Benefit Plans by: e/

Investors Diversified $ 5.9

Services, Inc.

Keystone Custodian Funds, 1.9

Inc.

Subtotal 7,g

TOTAL $1,249.7

35.2/

SOURCES: Total industry sales and reinvested distributions from 1974

ICI Fact Book.
-~+7-

Footnotes to Table II

a~ Load funds accounted for 90.6% of the industry's total income

dividend reinvestments (based upon staff inquiry of ICY). An

estimated 74'/ of total reinvested income distributions by load

funds were at net asset value, based upon 1970 data, which is

the most recent available (NASD Study, Vol. I, Summary, p. III-~3).

b/ This data was constructed by determining the amounts of

capital gains reinvestments reported on Forms N-1R for fiscal

1973 by all no-load funds which are members of the ICI and

removing that amount ($138 million) from the industry total as

reported by the ICI.

Exempted foreign sales based upon staff inquiries of particular

companies.

d/ Represents the total of .the amounts estimated i-n the

iLtdividual notices of applicat~.on.

~_/ Exempted sales to compar~y employees and cc~pany benefit plans

based upon staff inquiries of particular co~anies.
._ ~~ rg

It is important to note that the exemptions tahich the Commission has

granted from Section 22(d) result in investors paying different sales loads

for the same fund. In other words, notwithstanding Sectian 22(d) the Commission

has permitted variations in the public offering price which result in a form

of price discrimination, as long as the discrimination is not unjust.

For example, under Rule 22d-1, discounts for certain tax-exempt organizations

are justified by the public policy in favor of charitable and educational

institutions; reduce$ sales loads for fund employees are based upon the

importance of the fund being able to further employee incentive and goodwill.

:"owever, one of the most important ,justifications for price discrimination

is differences in cost and service.

~, Anomalies Resulting from Section 22(d)

Although a. sales load is intended to pay for various selling

services provided to investors, it is not uncommon for customers to

be forced to pay sales charges given where little or no service is in

fact provided. The imposition of asalesload undt~r such circumstances

is not necessarily due to a conscious decision or motivation on the part

of underwriters and dealers; it is required by Section 22(d), as presently

interpreted and appl~+.ed.

1, "Orphaned" Accounts

An "orphaned" customer is one who owns fund shares purchased from

a dealer who is no longer available, usually because he has gone out of

business. If such a customer buys additional shares of the fund under

an accumulation plan, he must frequently pay a sales load to a brokerdealer with whom he has had no contact. Dr. Robert Perez, a vice

president of F. Eberstadt & Co.'s management and distribution companies

as well as its two funds, testified :is follows concerni~ig his company's

practice in this regard:

STr~FF QUESTION: "Under present practices what do you

do with an investor wYeose dealer has gone out of business, .

or has died, in terms of crediting sales charges on repeat

investments made by the investor?"

DR PEREZ: "Well, he has to get a successor broker-dealer."

ST~'F QUESTION: "How does he do this?"
- ~9 -

DR. PEREZ: "We11, if he wishe8 to make another purchase

he will perhaps send a check to our transfer agent Bradford

who at that pint will advise him that the broker-dealer

that he had been using is no longer in business, no longer

has an effective sales agreement with the fund, and that

he should seek out another. dealer, and if they wish

to get our assistance in directing them to a dealer we will

be glad to do so."

4, Investors Who Select F~zn.ds on Their Own.

Another ex-ample of a customer having to pay an essentially

gratuitous sales load is f ouiid in a letter to the editor of Fundscope

mo.gazine, which appeared in the November, 19.3 issue at p. 2 The

reader wrote:

"I currently own four mutual funds, three of which

I started after studying the information in Fundsco

Although these three funds, Over-The-Counter, Istel,

and Vanderbilt, are 'load' funds, I purchased my shares

directly from the fund. Since I did my own research and

selection and did not use a broker or mutual fund representative, I would like to know what happens to the

broker's share of the commission?"

In response, the editor of Fundscope explained that the reader's

purchases had actually been made through the funds' underwriters, and

" that the latter had retained the sales commission.

Thus, where a fund "sells itself" without the intervention of a

salesman, either because the fund is particularly well-known or well

performing or because it has come to the attention of the customer for

some other reason, the prescribed sales load must nevertheless be paid.

3. Repeat Investors.

An individual who requires the services of a salesman when he

first buys mutual fund shares may, after his initial purchase,

acquire sufficient sophistication to dispense with such service in

connection with future purchases of the same or even a different

load fund. In such a case, however, the investor must still pay the

full sales load to cover a selling effort which, presumably, he no longer

wants, needs or gets.

1/ Tr. 764.
_5p_

An example of such a shareholder is John L. Asling, who testified

at the hearings. When Mr. Asling made his first investment in a mutual

fund -- Wa.sh~n~ton Mutual Investors -- in 1955, he required the services

of a bro'.~er to explain:

"basically the operation of the fund. I never knew anything about funds." l~

However, with regard to Mr. Asling's subsequent purchases of

the same fund, the broker

"didn't solicit me. All he had to do was pick up the

phone and I said I am placing an order with you to

buy X number shares of Washington Mutual Investors

Fund." 2/

Yet Mr. Asling was required to pay a fu11 sales load on these

repeaC orders, until•

"after learning about the 'no-load funds,. I really

didn't buy any more shares of the Washington Mutual

Investors Fund." 3/

~r . 696 .

~r. 700.

Tr. 701. Mr. AsLing's testimony is discussed in soQnewhat more

detail at pp. 73-75, infra.

:.r
- 51

IV. THE POSITIONS OF THE PARTICIPANTS IN THE PROCEEDING

~. Mutual Fund Industry Representatives

Briefly stated, the position of representatives of the mutual fund

industry is that mutual funds are a good product, the distribution of

which could be seriously impaired by repeal of Section 22(d). .This

posiCion was articulated as follows by Robert Augenblick, President

of the ICY, during the first day of .the hearings:

"[0]ur position is based on the fundamental premise

that mutual funds are a sound and worthwhile medium for

public investing. This is a premise which has had the

approval of the investing public, the Commission and

the Congress. Therefore, to our thinking it follows that

those who would propose regulatory changes which would

adversely affect the system of distributing mutual fund

shares to the public have a heavy burden to establish that

the proposal on balance will serve the public interest.

In our view the SEC staff report falls woefully short of

satisfying such a burden, despite its suggestion that

repeal of Section.22(d) would on balance be desirable." 1/

However, although the mutual fund industry wa.s all but unanimous

3.n a.ts opposition to repeal of Section 22(d), various segnents of the

industry did favor certain limited modifications of the present distribution system, such as increased advertising and grouping and, to a

much lesser degree, even same form of price competition. Following is

a representative selection o-" some of the views expressed by various

industry representatives. 2/

1. ICI.

3/

In its written comment, the ICI stated its belief:

"that the repeal of Section 22(d) could be a substantial

step towards disruption of the mutual fund industry.

Repeal would substitute a chaotic for an orderly system

of distribution of mutual fund shares, would be harmful

to mutual funds and the investing public, and would ignore

the lessons of pre-1940 days.

1/ Tr. 104.

2/ This section discusses some of the views expressed in the written

comments and oral presentations of certain participants, in an

attempt to set forth a general overview of the positions taken

concerning the major issues. Tt is riot intended as a summary of

the presentations.

3/ The participants' written comments are in File No. 4-164. Except

as otherwise noted, the comments were filed in advance of the hearings.
- 52 -

"More specifically, repeal of Section 22(d) would tend to produce

the following results:

(1) The ability of mutual fund sales to keep pace with

redemptions would be endangered;

(2) The redeemability feature of mutual funds would be

jeopardized, as would be the availability of other

important investor services;

(3) A secondary market would develop which would adversely

affect mutual fund distribution without satisfactory

distribution alternatives;

(4) There would be a growing trend to selling mutual

funds as a speculative vehicle;

(5) There would be pressure not to comply with standards

of suitability;

(6) Programs for training mutual fund salesmen would

suffer for lack of available financial support;

(7) Many t~roker-dealer firms and registered representatives

would be forced to abandon the mutual fund business;

(8) Discrimination between sophisticated and unsophisticated

investors would result;

(9) The availability of mutual funds to the investing public

would be seriously curtailed." 1/

The ICI added that retail price maintenance is not unique to the

fund industry; to the contrary, price protection is enjoyed by many

financial products with which funds compete and is basic to the distribution

of corporate securities in syndicated underwritings. 2/

In genera., the TCT also found difficulties with the various modifications of the present distribution system suggested in Investment Compe,ny

Act Release No. 7+75. ~ However, certain moclifications, such as relaxa- ~

tion of advertising restrictions, updating of the Statement of Policy,

and permitting certain groups of persons - employees of a single employer

only - Co take advantage of .quantity discounts, might~be of some value,

according to the ICI.4/

1/ ICI comment, at 5-7.

2/ Id, at 10.

3/ Id, at 54-79.

4/ Id. at 67-73, 74-76.
-53 -

The ICI later filed a post-hearing memorandum, in which it concluded

basically "that the overwhelming weight of the informed testimony and

written submissions confirm the points expressed in our [earlier written

submission]." 1/

2. Managers of Major Funds.

Both in their written submissions and oral testimony, managers of

mayor funds generally opposed repeal of Section 22(d), mainly for the

reasons articulated by the ICI. For example, Philip C. Smith, Chairman

of the Board of National Securities and Research Corporation, said at

the hearings:

"We are convinced that a repeal of 22(d) at this time

will mean the end of the mutual fund industry as a viable

industry, though I can`t give you the time frame." 2/

Consistent with the industry's oft-repeated dictum that "mutual

funds axe sold, not bought " Mr. Smith, while favoring liberalization

of advertising rules, said that "advertising alone will not get ttie

job done." 3/

Similarly, James D. Fullerton, Senior Vice President end director

of Capital Research and Management Company, favored increased use of

advertising but said that:

"The salesman. performs a valuable and essential economic

function. ConsequenCly, for the foreseeable future I see the

major objective of mutual fund advertising being to make the

product easier for the salesman to sell:'4/

Carl Frischling, Senior Vice President of the Charming Management

Corporation, warned that if Section 22(d) were repealed and a secondary

market in Hand shares established, secondary dealers might accu~u_late

large blocks of shares and then, because of market fluctuations, redeem

them for reasons completely extraneous to the value of the shares.

He added tha.~:

"The effect of lumped redemptions, especially on small

and medium-sized funds, could be very substanCial, and affect

redeemability vis-a-vis the normal shareholder. Such redemptions

could adversely affect shareholders by requiring portfolio risks

and force changes in investment position and strategy which would

disadvantage the fund and fund shareholders." 6/

1/ ICI post-hearing memorandum, at 1.

2/ Tr. 2123.

3/ Written comment of Philip C. Smith, at 10.

4/ Tr. 2387-88.

5/ Tr. 2135.

6/ Ibid.
54 -

Nor would restrictions on redeemability solve the problem, in

Mr. Frischling's view:

"If the Commission bars a market-making broker from

redemption of fund shares, such brokers will simply lay off

their shares to banks ox other institutions at a quarter oz

half-point discount, and those banks oz institutions will in

turn be able to put their shares to the fund for redemption

at net asset value. Such a restriction, then, is just not

realistic." 1/

Mr. Frischling also urged the Commission to consider:

"the decrease in net revenues to the fund-distributing

organizations which would necessarily result from the

diversion of underwriting income from fund distributors

to the broker-dealer market-makers." 2/

Other adversities which Mr. Frischling saw resulting from a

repeal of Section 22(d) included:

"a substantial reduction in the number of firms selling

fund shares, a resultant diversion of effort from the

sale of fund shares to sales of other vehicles (stocks, REIT'S,

etc.), a consequent strengthening of Exchange member firms

over the generally smaller fund-selling firms, [and] the

possibility of higher net redemptions. :' 3/

The notion that a repeal of Section 22(d) could result in the

elimination of many small dealers, thus producing an undesirable concentration

of fund sales in the hands of large dealers, was reflected in the written

comment of the Putnam Management Company, Inc. After conceding, arguendo,

the possibility that repeal of Section 22(d) would lead to reduced sales

loads, they proceeded to consider the effects of such reduced sales

charges:

"There would be an adverse impact upon two classes

of selling dealers; the first being those to whom mutual

fund shares are a significant portion of their business and

who simply cannot exist without the profits to be made on

fund shares at present commission levels, and the second

those brokers who provide additional services to their

customers which cannot be paid for at lower commission

levels. It is not enough to say that more efficient

brokerage practices will result in savings to the brokers

who may then pass these on in the form of lower competitive

1/ Tr. 2135-36.

2/ Tr. 2136.

3/ Written comment of Channing Company, Inc., and Channing Management

Corp, , at 18.

Nor_
- 55 -

charges, for, even if this were so, it would encourage a

trend toward larger and larger dealers; we question

whether this is desirable from the point of view of the

industry as a whole. Concentration of economic power

is seldom a desirable end and is a particularly unpleasant

prospect in an industry which deals directly with so many

million individual consumers who are less able to cope

with the effects of such increasing concentrations than a

more concentrated consumer group. More important, however,

than the impact of this competition on selling dealers

would be its impact on investors. Commission price

competition wi11 cause dealers' profit margins to shrink,

in turn causing the quality of the sales effort to decline.

Mutual funds must be sold properly if the investor is to

be sold funds and programs suitable to his needs.

Approximately 85'/0 of mutual fund shares are currently sold

through independent dealers; reduced commissions will force

those dealers to divert to selling alternative products

which will probably nod be as appropriate for the small

investor as mutual funds or to do a poor job of mutual fund

selling. Either way, the small investor will surely lose." 1/

At the hearings, George Putnam, chairman of the company, elaborated

upon the argument that, insofar as repeal of Section 22(d) might tend

to concentrate fund sales among large dealers, investors would be

"-' adversely affected:

"[T]o the extent they would be large brokerage houses

selling mutual funds, they would be selling them along

with many other products and not by people who are

specialists in mutual funds. And I think for many

potential mutual fund clients, he should in his initial

experience, in buying them, should be exposed to a

professional expert on mutual funds." 2/

Franklin R. Johnson, Senior Vice President and General Counsel of

Keystone Custodian Funds, Inc., also suggested that repeal of Section 22(d)

wou3d, in ad3ition to causing a decline in overall sales, impose a special

hardship upon small dealers:

"We cannot foresee any possible consequences of the repeal

of Section 22(d) that would not result in further reductions

in sales and further increases in losses or alternatively, a

discontinuance of active selling efforts to reduce losses.

Ie is our experience and common knowledge that mutual fund

shares are on the whole sold and not bought.

1/ Written comment of the Putnam Management Company, Inc., at 4.

2/ Tr. 209.
56 -

"Further, they are only sold if the salesman is

adequately compensated for his effort. Based on discussions

with dealers over the last several years, we are convinced

that the reduction in overall compensation from selling

our funds' shares has contributed to the decline in sales.

If 22(d) is repealed we think there will be enough fund

share selling at reduced commission rates by large dealers.

who sell mutual fund shares only as a minimal part of their

business to make it difficult or impossible for dealers, to

whom mutual fund sales would be significant, to compete." 1/

Other fund managers, while also not favoring repeal~of ,

Section 22(d), did see merit in certain modifications of the present

distribution system. For example, F, Eberstadt & Co., in its written

comment, suggested, inter alia, liberalization of rules governing

advertising and group purchasing.2/ During the hearings, the company's

president, Robert C. Porter, expressed the hope that increased

advertising would, besides increasing sales, result in reduced sales

loads:

"I think we would hope that if we did this kind of

advertising that the salesmen wouldn't have to work quite

so hard and hopefully the spreads might come down a

little bit. I mean that would be the optimum idea.

"I mean there is no question in my mind that having to

absorb an 8-1/2 percent sales charge and having to perfo nn

to make that up is a hindrance. I mean thaC is a hurdle to

get over. And therefore you have to balance that hurdle

against whether you can sell the fund some other way. And I

think this type of advertising that [another of Eberstadt's

witnesses] has suggested would go -- taould certainly open up a

lot of leads for us and a lot of interest that we d on~t have at

the moment." 3/

The Eberstadt presentation suggested that, assuming "a positive

relationship between advertising and merchandising and lower distribution

costs," Section 22(d) could ultimately be abolished, provided that the

fund sponsor is afforded certain protections. ~• Specifically, the sponsor

should set the amount of its initial service fee, and impose a fee on

transfers and redemptions. ~ The purpose of the transfer fee, according to another of Eberstadt's witnesses, would be to "eliminate the

bootleg market in mutual fund shares" by in effect penalizing "a

secondary market maker by adding on a layer of cost of 1-1~2 percent...."

1/ Tr. 306-307.

2/ Written comment of F. Eberstadt & Co., at 6.

3/ Tr. 753.

4/ Written comment of F. Eberstadt & Co., appendix, at 2.

5/ Ibid.

6/ Testimony of Robert Perez, Tr. 829.
s~ -

The Union Service Corporation, representing a group of four mutual

flzn.ds, while opposing repeal or modi#'ication of Section 22(d), nevertheless saw "other routes ~o be followed if it is determined that we have

come to the end of Section 22(d)." ~ Specifically, the company suggested

that -- if Section 22(d) must be altered -- contract dealers be permitted

to set their awn retail prices up to a maximum of 8.5f; however, they

would be required to set the same price scale and salesmen's compensation

for a]1 fund shaxes ~Chey sold., and a secondary market would not be perm:itted.

At the hearings, however, the compa,ny~s president, H. Brid~na,n

Griswold, emphasized that Union Service's basic position was that

Section 22(d) was a valuable provision which should not be repealed:

" ~- ~ ~ I think that there is good c~npetition in the

industry, and I think that prices are coming down in

the industry through this competition, and I think

that 22(d) is necess~.ry to protect the pricing in the

industry so that z,~e can control our distribution,

so that we can have our Bands sold by dealers who se11

them properly.

"One of the great benefits of being able to work

_.. with the dealers that we choose via the 22(d) xoute

is that we are able to have our product sold correctly,

we are able to have our product represented at a time

when a customer l~.as a ques ;io_7 a~ to whether he should

continue in the funds, and one of the results of that

has been that our redemption rate is considerab]~y lower

than the industry. So that our selling techniques have

benefited the organization and our shareholders, we

believe."

Nor did Mr. Griswold think that gradual repeal would be a suitable

alternative:

"I found great problem with [another witness's suggestion

of) partial repeal of 22(d) because I think one of our great

difficulties today is that the question of 22(d) is overhanging

the industry, and a partial repeal with the end objective of

total repeal would overhang the industry like a sword of

Damocles. Nobody would want to buy today because prices may

be reduced later." 4/

1/ Written comment of Union Service Corporation, at 11.

2/ Ibid.

3/ Tr. 2205-06.

4/ Tr. 2204.
-58 -

Investors Diversified Services, Inc., strongly opposed repeal of

Section 22(d), arguing that such repeal would require the end of retail

price maintenance and limit the availaNlity to the public of mutual

funds and related services.

"In our view 'maximization of the opportunities for

open and fair competition' requires preservation of the

right of every participant in the competitive area to

determine for itself how it competes. It means the

right to determine how it sells, to whom it se11s, and at

what price it sells in competiCion with others who should

have the same right of self-determination. IDS has chosen

to compete in the sale of mutual funds through a distribution

system which emphasizes the furnishing of personalized

financial services .•.• We believe that fox ourselves

this is the right way to compete. If others choose to compete

in a different way, that is their business. Because

Section 22(d) protects our freedom to compete in the way

we believe is right, and allows us to maintain control over

our distribution organization in a manner commensurate with

our responsibilities under the securities laws, we support

its retention." 1/

IDS added that expanded grouping would be administratively unenforceable,

unless it were limited to employee/employer relationships; and that even

if grouping were so limited, its discriminatory consequences should be

considered. ~/ At the hearings, Robert Loeffler, Senior Vice President

of TD:3, elaborated upon his misgivings tirith regard to grouping:

"I think what disturbs me with the grouping propos•sl

is that I am fearful that in the development of it we msy

destroy the distribution system which exists for the

service of the non-group market, which is the principal

market today that is being served. Let me put it this way:

Certainly if you go beyond a very restricted definition of a

group and we get into the airline charter type things, I don't

think you can maintain the distribution system we have today,

because then everybody is a member of both systems and is a

target for both systems.

1/ Written comment of Investors Diversified Services, Inc., at 79.!

2/ Id. at 52-83.
-59-

"I discovered the other day, for example, that I am

a member of the Swedish-American Club, and I found that

was because my wife sent $2 to be a member of the SwedishAmerican Club once when she was looking at airline charters

to some place or another. Every parson can be. And I

don't know how you go to a customer and try and service

him with his financial services under a distribution

system such as exists today to give him a full service

and full information and all that data and then end up

saying, oh, but by the way, for $2 you can join something

and get the same result now without paying me anything."

STAFF QUESTION: "Isn't the difference, though, that he

probably will get different services if he buys the fund

shares through the Swedish-American Club or its equivalent?"

MR. LOEFFLER: "I don't think the services will continue

to exist on a dual basis. In other words, this is what I

am saying: That you will destroy the distribution system,

the individualized distribution system iE you want to call

it that, as it exists today. To go back thirty years, to

my co~irse in elementary economics, the ~resham's7 law that

says bad money drives out the good or something 3~ike that." 1/

IDS did favor liberalization of the restrictions on advertising,

although it cautioned that advertising should not be regarded as a substitute

for the personalized services provided by salesmen. 2/

At another point in the hearings, Mr. Loeffler, though arguing against

repeal of Section 22(cl), suggested that retail. price maintenance might not

always be so important to IDS:

1/ Tr. 2249-50.

2/ Written comment of IDS, at 84.
"Now, as time goes on and the public becomes more and

more aware of mutual funds -- and they are -- and mutual funds

do not have to be explained to the extent that they are today,

and they don't have to be sold in the sense that they are sold

today, to that extent, then in actuality the sales representative isn~t going to be spending that much time on them, he

won't have to, which means that his time, which is what he has

to sell to earn a living, really, will produce more volume of

sales for the same amount of Cime, which means that from an

income standpoint you can drop the commission necessary for

him per dollar of sales to still sustain the distribution

system.

"There will come a time when that would probably reach

a point where it would be competitive with what the spread

might be on just as a shelf product, which it would be

in the secondary market, at which point you could repeal

22 (d) and it probably wouldn't make any difference because

your levels would be the same.

~ ~~ ~~ ~~~

"Now I don't know when that time is going to come. Z suspect

that I probably may feel it is longer -- further distant than

[one of the other witnesses] does. But I think ultimately

that is where it comes, because I think you have competition

in the industry today with 22(d). And self-interest is going

to take us there. I look at it from the standpoint of the

self-interest of IDS, and we are trying desperately to get the

sales load down to make more efficient our own distribution

system. And I think we wi11. But I don't know how long this

is going to take, but ultimately I would see that coming out

at that point and then I think 22(d) becomes immaterial." 1/

3. No-Load Mutual Fund Association

Since the no-load funds' interest in sales charges is indirect at

most, the No-Load Mutual Fund Association had no definitive position on

the question of whether Section 22(d) should be repealed. ~ :its Executive ~~~ice

President, Donald Samuel, stated at the hearings that the no-load funds'

"principal concern" was "with the still archaic and inhibiting advertising

rules for all mutual funds as contained in the SEC Rule 134."

'I`r . 2201-02 .

Charles W. Shaeffer, President of the No-Load Mutual F~znd Association,

while taking a "neutral" position on amendment or repeal of Section

22(d), did say at the mutual fund distribution Yiearings:

"I would like to underline one comment in ovs position

paper and that is the necessity to 'spread the word about

mutual funds.' ::ot nver,~o~~.e is inclined to 'do it yourself.'

There has been in the past and will be in the flztuse many

people who need the assistance of a third party. If we go

to an environment totally without corrm~ission salesmen, I

think the mutual f~znd industry will not reach the broaa

public which needs to be served." ir. X99•

Tr . ~+Ol .
- 61 -

With respect to advertising, Mr. Samuel left no doubt as

to the no-ioa'd industry~s position:

"We are simply asking that advertising for mutual funds be

liberalized sufficiently, and this in our opinion would

require substantial lilieralization, the prospective

investors would be induced or, if you will, seduced into

sending for a prospectus, not the check, -- the prospectus.

"Or in the case of a load fund, would be more likely to

listen to a salesman.

'~Te are still laboring with a 40-year old tombstone type

of advertisementt, just as though our securities were new and

unseasoned." 1/

Mro Samuel then pointed out- that aggressive advertising fs used

in marketing other financial products such as savings deposits and U.S.

savings bonds. 2/ _

4. Broker-Dealers.

a. NASD.

The NASD apposes reveal of Section 22(d). It argued that,

on the one hand, retail price maintenance has not precluded

price and product competition among funds, and has not resulted in

excessive earnings by underwriters, broker-dealers, or salesmen. 3/

On the other hand, whatever limited benefits might derive from a repeal

of Section 22(d) would be more than offset by the adverse effects of

a secondary market in fund shares, in the view of the NASD. 4/ The

NASD says that the existence of such a secondary market, with resulting

cut-price compeCition, would induce underwriters and contract dealers

to reduce their sales efforts and services to investors, and would.

drive many smaller retail firms from the mutual fund business, thereby

accelerating the trend toward concentration. 5/ The NASD adds that

the adverse impact on sales efforts would likely be far greater than

the stimulgtion of demand resulting from lower sales charges, and

therefore an increase in net redemptions would be probable. 6/

1/ Tr. 402.

2/ Tr. 403-404.

3/ Letter summarizing statement of NASD, at 3.

4/ Ibid.

6/ Id. at 4.
b~

However, the NASD did say that it supported "the evolution toward

enhanced competitor":

"We do not contend that the present distribution

system is of optimum efficiency. We believe that improvemente are possible in the areas of group sales and

advertising. We favor a redefinition of the concept of

a 'group' purchase, provided that any relaxation of

current sales is limited and does not degenerate into

massive discrimination among buyexs and a means of undercutting the incentive necessary for the individual sales

effort. .

"GJe support the evolution toward enhanced competition

and improvements in the efficiency of the distribution

system. We believe the modification of regulations that

have stifled competition, particularly in the areas of

administration and advertising, will aid that evolution.

If the removal of these stifling forces result in substantial

economies, we would expect the competitive forces in the

industry to pass on these savings to investors in the form o~

lower sales charges. Pending tangible results, we oppose

modification of 22(d)." 1/

With respect to the Statement of Policy, the NASD agreed:

"that the existing provisions of the Statement of Policy should

be reviewed in light of current conditions and, while we

believe that most of the provisions of the Statement of Policy

have served, and are now serving, to clarify acceptable

approaches to the preparation and distribution of sales

literature, there are certain provisions which should be

reevaluated." 2/

1/ Ibid.

2/ Statement of NASD at 59.

_ . .. :.~
-63-

b. Securities Industry Association.

The SIA warned that repeal of Section 22(d) would not provide

any real benefits for investors, but rather would discourage fund sales.

The nature of fund purchasers, and of the product itself, makes funds

particularly expensive and difficult to sefil. 1/ Firms located in

small communities, serving small investors; would be hardest hit by

a repeal of Section 22(d), according to the SIA. 2/ Furthermore, the

SIA was of the view that repeal of Section 22(d) could harm investors:

"If the effect of repeal is to reduce the sales charge,

and therefore the salesman's compensation, we may find

salesmen unwilling to denote their professional efforts to

selling fund shares on the basis of suitability, proper

fund choice, and an explanation of all the features of

each fund. The salesman may merely write the order ticket,

without giving the investor full, in-depth investment

counseling." 3/

On the other hand, the GIA did see merit in some of the suggestions

set forth in Investment Company Act Release No. 7475, such as liberalized

advertising, revision pf the Statea►ent of Policy, and broadening the

definition of "group" for purposes of discounts. 4/

c. Large Broker-Dealers.

~- i. National Mutual Fund Managers Association.

The members of this association are mutual fund sales managers of

New York Stock Exchange member firms. The Association's President,

Bradley Baker, testified that, although mutual fund sales commissions

represent only about 3% of member firms' total income, such firms regard

the sale of mutual funds as an important service for their customers. 5/

Accordingly, the .9,ssociation opposed repeal of Section 22(d), arguing that

negotiated rates would lead to less compensation for salesmen, and this in

turn would discourage salesmen from making the extensive effort needed to

sell fund shares. 6/

1/ Written comment of Securities Industry Association, at 3.

2/ Id. at 4.

3/ Id. at 5.

4/ Id. at 7-8.

S/ Tr. 1022-23.

6/ Testimony of Mr. Baker, Tr. 1023-24.
-64-

ii. Merrill Lynch, Pierce, Fenner & Smith, Inc.

Unlike most of the industry participants, this large broker-dealer was -

not sure that Szction 22(d) should be retained. In its written comment,

the firm stated that it is:

"not certain that the fixed price system as it has developed,

has always functioned equitably in the past nor that a

negotiated price system would lead to the utter destruction

of the industry and to complete chaos in our various markets." 1/

Merrill_ Lynch offered three suggestions for consideration in lieu of

the present distribution system:

"a) The first alternative would allow a fund to elect in

its prospectus to be sold at ret~1 at net asset value

plus negotiated prices only.

"b) The second alternative would allow a fund to elect

to be sold at negotiated prices within a maximum

and minimum structure established by the fund, 't he

difference between such maximum and minimum never

exceeding five percentage points.

"c) The third alternative would permit a fund which meets

the standards proposed by the NASD in their November 6,

1972 statement for charging the maximum rates, to

elect to be sold at a fixed price schedule, again

imposing a five percentage point limitation on the

spread between the maximum and minimum loads." 2/

At the hearings, Joel Matcovsky, an attorney for Merrill Lynch,

indicated that the company thought its proposal would introduce an element

of price competition in the sale of fund shares while at the same time

allow fonds to maintain some control over their prices. ~ Mr. Matcovsky

also suggested that, insofar as a fund elects to be protected from

retail price competition, it should be willing to accept regulation as

a substitute:

1/ Written comment of Merrill Lynch, Pierce, Fenner & Smith, Inc., at 3.

2/ Ibid.

3/ Tr. 254.
-65 -

"Basically, I think the philosophy underlying this

proposal is that in our society competitive prices should be

the norm. And as Someone moves away from this for

every step away they take from this norm something should

be given back in return. So, for example, if they elect

negotiated rates, well that is that.

"If they elect negotiated rates within a floor and

ceiling which they would establish, then perhaps the

floor and ceiling, the difference between them should be

regulated and we suggest five percentage points.

"We, [threw] Chat out for discussion and consideration.

But if they want to go an additional step and not have

only a floor and ceiling but have a fixed rate structure

within the floor and ceiling, then perhaps the maximum

actual figures should be regulated.

"We suggested in our proposal that only funds which

met the requirements [f]or the imposition of the maximum

charge under the NASD proposals would be permitted to

elect the fixed schedule alternative C." 1/

Ho~w~ever, at a later point, Robert Cleary, Vice President of Merri]1

-- I~mch, made clear that the comxpar~y' sympathized with the concerns expressed

by other industry witnesses with regaxd to the consequences of paxtial or

total re~a.il price competition:

STAFF QUESTION: "What would you think of. a proposal that

would permit competitive pricing for the large orders?"

MR. CLEARY: "Well, I think we have got a can of worms .

This, I think, is why we still have not made a determination. If we go out and sell for the sake of discussion

a ten million dollar order which will take six to eight months

and more to put together, to a pension fund, whose trustees

have a fiduciary responsibility, and. Merrill, has spent

the time and talent to convince these people and show them

that this is the proper product for their retiring employees,

and if they walk out of their meeting in the Cleveland Plain

Dealer, a little squib, say Bob Cleary will sell you any

mutual funds for a half of one percent As a fudiciary trustee

Merrill Lynch will have to say, 'Look, we are going to have

to sell it at two, you have to buy it from me at 1-1/2 percent.

1/ Tx. 254-55.
" That is going to happen to one of my guys one tine,

that is all. Then he can't afford to take the time and spend

the effort to go after something and then be cut out because

of the price." 1/

Later, Mr. Cleary was asked how total. repeal of Section 22 (d) might

affect Merrill Lynch. He said:

"I have to agree with the previous speakers,

and emphatically agree funds are sold, they are not bought.

Of our 29 products, I would like to add one of the very few

things that all Merrill Lynch people agree with, and I

assure you there are precious few, they all agree a mutual

fund is the toughest product we have to sell.

"So, if we get into negotiated rates, and i£ there

is some manner or means whereby these can be undercut, be

there a small dealer in Cleveland that doesn't need any

capital to do mutual funds, it could certainly slow down

our efforts particularly in the bigger tickets which take

the most amount of time, and talent.

"I am not saying it would, but I am saying it could." 2/

d. Small Broker-Dealers.

Of all the industry representatives who opposed repeal of Section 22(d),

perhaps none expressed such opposition more strongly than the smstll

broker-dealers. Raymond C3o~chi, President of the Independent BrokerDealers Trade Association,— stated his organi2ation's view as follows:

"We oppose complete or partial repeal of Section

22(d), as the adverse impact would fall most heavily on

independent broker-dealer firms, particularly the smaller

ones. Further diminution of mutual fund selling incentives

will only speed up the trend of mutual fund sellers to find

other financial products, some regulated by the SEC and

NASD and some not." 4/

Mr. Cocchi also asked the Commission to~

"bear in mind that the Congress has made it clear that

reasonable sales loads to investors is only one of the

policy goals the SEC must take into account. Congress

saw to it in Section 22(b) of the Investment Cmmpany

Act that mutual fund sales charges must also allow for

reasonable compensation for sales personnel, brokerdealers and underwriters.5/

1/ Tr. 258-59.

2/ Tr. 260.

3/ Mr. Cocchi has since been appointed Commissioner of Securities of

the Cor~mionwealth of Massachusetts.

4~ Tr. 836.

5/ Tr. 837.

.. _ _ _ .,.. .. -.. .._ _.-,. _ ..--rte ~ _ - ~ ....

~~ ~' "~ ~~:~~
- 67 -

"I find it particularly disturbing that Chairman

Casey states in the letter [of transmittal accompanying

the staff report] that with respect to these ~independent~

dealers: 'It should be noted that the mutual fund industry

is far more important to these firms than they aze to it.'

"With all due respect to Chairman Casey, I must say

that this statement seems to be inconsistent with a broad

national policy of our federal government.

"It would seem to me that the SEC cannot, within the

broad policy goal of Congress to encourage small business,

simply write off the small business segment of the securities

industry." 1/

Mr. Cocchi concluded that:

"Implementation of the NASD sales charge study, coupled

with further relaxation of advertising restrictions and

an evenhanded application of the 'anti-reciprocal' rule,

given time, could help a crippled industry get back on its

feet." 2/

The notion that small dealers subject to relatively high operating

costs might need higher sales loads to survive was explored in an exchange

between the staff and Carl L. Shipley, counsel for the Independent BrokerDealers Trade Association. When asked whether Section 22 (b) of the Act

might enable the Commission to allow such small dealers to charge

relatively higher sales loads,3~ he responded that it would, but that

such a dual pricing system would be unworkable.4~ however, upon further

analysis he took the position that such a dual (or multiple) price

system might be both feasible and justifiable, although it would be

necessary to devise some means of protecting small d5~lers from the

effects of large dealers charging lower sales loads.-

1/ Tr. 539-40.

2/ Tr. 840.

3/ Tr. 880. The concluding sentence of Section 22(b)(1) reads: "The Commission shall on application or otherwise, if it appears that smaller

companies are subject to relatively higher operating costs, make due

allowance therefor by granting any such company or class of companies

appropriate qualified exemptions from the provisions of this section."

4/ Tr. 881, 882.

5/ Tr. 883-87.
In any event, the basic thrust of the small broker-dealers' argument

was that retail price competition would effectively put them out of

business, and that this would be undesirable not only for them but also

for investors who need their services. Orville H. Lauver, an independent

broker-dealer in York, Pennsylvania, stated the matter in personal terms:

"The several thousand clients I have introduced to

funds would not have been introduced to funds had Y not

gotten into the market, they are these low income elements

Merrill Lynch is not touching. Yet, if they are able to

now with the greater advertising plans and things that

people are doing, having introduced a lot of these people

to funds, I think I will lose those clients because they are

now [knowledgeable] and sophisticated enough to go elsewhere.

I have put in the legwork, and hopefully _- agsin, it sounds

greedy on my part -- to continue to benefit. I perform the

service and I continue to perform it every day in the form

of service. I am sure you have been besieged with discount

stores and if you can find something at a discount you

naturally try to pick it up. That still puts me out of

business that I am not able to at least introduce someone

new who has never heard the story and will never hear

the story, regardless of whether they can get it for

nothing. But th at is not like most people who buy a

mutual fund. We try to take our time to inform them. I

lose a -lot of sales to no-loads, where people say you

told me all about it, I don't want to pay the 8-1/2, so I

will buy something else. I understand that. I

lose sales in that fashion. I still feel what I am doing

is providing a service to my clientele and I feel I have

performed help to people

" I am trying to be helpful to my fellow man,

and I feel my days are quite numbered if this goes into

effect." 1/

B. Variable Annuities -- American Life Insurance Association.

'IThe ALIA, whose interest in this proceeding was ]invited to Section

22(d)'s effect upon vaxiable annuities fended in registered sega,rate

accaunts,~ 2/ said that the section should not be applied to the sale of this

product._~~ They argued that Section 22(d) was aimed at preventing essentially

two results: disruption of the distribution system, and discrimination

in sales loads. ~ The ALIA contended that disruption of the distribution

system could not occur if Section 22(d) did not agp.]~y to variable

1 I Tr . 896- 98 . 

- — - —.~ _ .~,_ _ ..... _ . _ ..,......~~_.,..._. __T....l.:.

2/ Although some life insurance companies have mutual

ALIA expressly disclaimed any intention to present

positions. Written comment of ALIA, at 1.

3/ Written comment of ALIA, at 2.

4/ Ibid.

fund affiliates, the

such mutual funds'
- oy

~--

annuities because, in part, variable annuities are not, and by their

nature cannot be, traded in a secand.ary maxket. ~ Nor is the section

necessary to prevent discrimination in variable annuity sales, according

to the ALIA. They poznted out that the Co~nission has already granted

numerous exemptions pexmitting variable annuity sales charges to vary

where the variations are not unfair. ~ Accordingly, the ALL4 recommenced

., that variable annuities be exempted From Section 22(d) subject to appropriate

safeguards against unfair discrimination. 3%.

The ALIA also suggested:

"a new approach to investment company advertising by simply

adopting rules ~,~hich would permit the use of any advertising

which was not fraudulent and, in this connection, we recommend

the formulation of a new Statement of Policy." 4/

With respect to the Statement of Policy, the ALIA urged that issuers

of variable annuities be permitted to present illustrations of hypothetical

investment results. 5/

C. Partic~ants Not Representing the Industry.

The participants who were not directly associated with the mutual

fund industry or fund distribution generally favored an elimination of

retail price maintenance in the sale of fund shares, although most of

them suggested that this be accomplished eventually rather than immediately.

1. Department of Justice.

The Department of Justice favored a complete end to retail price

maintenance:

"Resale price maintenance of the sales load on mutual fund

shares increases the cost of buying fund shares without

any compensating benefit to the- investor and should be

ended." 6/

1/ Id. at 5-6.

2/ Id. at 10-13.

3/ Id. at 14.

4/ Id. at 16.

Testimony of Robert Routier, Tr. 1521. The Commission has separately

taken action to permit such illustrations. Investment Co. Act Re]..

No. g43g, July 1974.

6/ Written comment of Department of Justice at 2.

~."
-70 -

The Department was of the further view that retail price maintenance

should be abolished immediately,.and that a gradual phasing out was not

necessary. 1/

In addition, the Justice. Department took the position:

"that; the Commission has the power under ~6(c) of the Investment,Company. Act to eliminate the adverse effects of the resale

price maintenance provisions of ~22(d) and need not wait for repeal."2/

At one point the Department "urge[d] the Commission to use this power'," 3/

but at the hearings its spokesman characterized such administrative action

as "a less satisfactory alternative to outright repeal of Section 22(d)," 4/

The Justice Department found no justification for the anticompetitive

effects of Section 22(d). On the one hand, it argued that retail price

maintenance results in unnecessarily high prices, 5/ directs competition

into the undesirable arena of short-term performance, 6/ and exacerbates

y a conflict of interest : on the part of broker-dealers in advising investors. j'/

On the other hand, repeal of Section 22(d) would not disrupt the

distribution system, according to the Justice Department, because contract

dealers, like secondary dealers would not be required -- or even permitted

under the anti-+trust laws -- to sell shares at fixed prices and therefore

would have no reason to cancel their contracts as they did prior to

1940. 8/,Moreover, the Department argued that lower sales loads would

increase, rather than decrease, sales. 9/ With respect to the possibility

of unfair discrimination, the Department said that competitive forces

would prevent a dealer from charging higher prices to particular investors

except where such higher. prices are required by cost differences. ZO/

The Justice Department conceded that .retail price competiCion might

force some salesmen out of the business, but it contended that marginal

salesmen account for only a small portion of industry revenues and that the

1 / Id . at 23 . ~~~

2/ Id. at 2-3.

3/ Id. at 3.

4/ Statement of Barry Grossman, Tr. 2020.

5/ Written comment of Department of Justice, at 5-7, 8-9.

6/ Id. at 8.

7/ Id. at 9-10.

8/ Id. at 15-17.

9/ Id. at 17-19.

10/ Id. at 20-21.
71

"investing public should not be saddled with perman~nkly

high sales `toads in order to preserve this small proportion

of industry revenues in the hands of inefficient salesmen

who could not survive the rigors of competition." 1!

Since the Justice Department favored full retail price competition,

it favored expanded grouping only as a "decidedly inferior" alternative. 7_/

It did favor more informative advertising and more easily understandable

prospectuses. 3/

2. Hence C~Wallich.

Mr. Wallich, Knox Professor of Economics at Yale i~niversify, ~ Submitted a statement in which he indicated that his "overall conclusion''

with respect to mutual fund sales charges was in favor of a free market

and flexible price. ~/ However, Mr. Wallich did not recommend an

immediate implementation of fully-negotiated sales loads, since in

his view such an:

"immediate move would work hardship on at least sorr~e parts'

of the industry. It might also have a very undesirable effect

in increasing net redemptions of funds ." 6/

Instead, Mr. Wallich advocated a

"transition to negotiated sales loads in a period of

stages. This could be done by gradually reducing the maximum

size of transactions for which a fund or its principal

underwriter could fix the sales load. This would resemble

the procedure employed b~ the New York Stock Exchange with

respect to negotiated commissions. Alternatively, it might

be possible to reduce, year by year, the minimum sales

load that the fund or its principal underwriter could

stipulate. This would not interfere with the negotiation

of higher sales loads if competition permits. At some point,

presumably the competitive rate would tend to establish

itself above the minimum, if funds are to be sold by

salesmen at all." 3/

1 Id. at 23.

J za. at ~-~+.

Td. at ~+3-~+4.

Mr. Wallich has since been appointed a Governor of the Federal

Reserve Board.

Written carnment of Henry C. Wallich, at 1:

;- J za. at 5.

~ pia.
-~aMr. Wallich went on to suggest that the transition to retail price

competition could be eased by simplification of prospectuses, group sales,

reduction of ;pa per work, and . volume~iscounts. 1/ Mr. Wallich also favored

greater freedom.t.o advertise, alChougli he cautioned that adve.rtisi.ng o~

performance would be,undesirsble: 2/ He argued:

"that. good perf ormance, when it occurs, is as likely to

be the 'result of`raridom'~vents gs of skillful managetaent.,

Funds selling performance•a-re-selling something that.,

they cahhot ~prbmfse to deiiu~.r ..: Per~ozmance adverti.s- ,

ing, moreover, tends to produce switches from one fund to ''

another, which in the case of funds charging substantial

sales loads surely is harmful for the investor on average.

An institutional form of advertising, stressing the

benefits ,o.f. mu.tysl ,fund investment .as such, would be

~.' Donaid Farrar.

_ •.

Ar. Fart`ar• is 8n:~e,conomist "wk~a directed the Commission's Institutional

Investor Study in 1969 and 1970, and at the time he testified was a senj.or

research associate at the National Bureau of Research. 4/ EIe stated his

position as fo1 i.ows.:. .

"I do not at this point favor the repeal of .[Section] 22(d).

I do, however, believe that [Section] 22 (d) sfiould'over time

be eroded and at some time perhaps in the nqt too far distant

future it could actually be repealed.'" S/ '

Dr. Farrar expressed tine view Chat mut~tial funds are a suff3cienG~ly

good product ~to` survive 'in a 'competitive environment, 6/ but that: ' ~:

"[t]here~a~te'som~ - very serious problems in the distribution - - .

system at the present time which are an accumulation of an

evolutionary process over time and which must be dealt with.'!.7l,

Dr. Farrar suggested 'that the problems could be dealt with "by attempting

to change one''s• general direction .:away from price fixing. .," 8/ in

order to reach'. sggments of the .market which cannot be developed under the

present system.: He'indicated •that .the growth of such a. market might be

"partially at the expense of the more traditional market that does rely upon

a one-to-one contact between the salesman and the customer." 9/

1/ Ibid.

2/ Ibid.

3/ I id.

4/ Dr. Farrar is currently a professor of economics at the University'pf

of ,California at Los Angeles.

S/ Tr. 2193.

6/ Tr. 2195-96.

7/ Tr.. 2196.

8/ Ibid.

9/ Ibid.
- 73 -

In advocating the "erosion" of section 22(d}, Dr. Farrar suggested

the followin.giniti.al steps: -.increased advertising, including advertising

of performances;' 1/ expanded group sales; 2/ incentives for broker-dealers

' to recommend no-load funds; 3/ and price competition on puTehases larger

than a prescribed amount. 4/

The contention that eventual retail price competition would lead to

a concentration of fund sales among large broker-dealers was rejected by

Dr. Farrar:

"I don't believe that Merrili Lynch has any particular

competitive advantage over any other broker-dealer in the

sale of fund shares. It has and would have the same types

of suitability requirements that other brole~ r'-dealers

would have. Other broker-dealers like Merrill Lynch also

will have their own sales network. They also will have their

own customers.

"I see nn evidence in the regular brokerage area that

Merrill Lynch is going to emerge as the sole participant

in the brokerage industry. I would be equally surprised if

Merrill Lynch would emerge as the sole distributor of mutual

fund 'shares ." 5/

4. John L. Aslin~.

The appearance of Mr. Asling provided the only opportunity du~cing

the hearings to obtain an investor's view of Section 22(d). M r.,Asli.ng

made his first purchase of fund shares -- in the amount of $1yC100 --

in 1955, 6/ when by his admission he "was an uninformed investor and

. knew absolutely nothing about it "7/ To the best of his

uncertain recollection, his interest in contacting a broker was inspired

by a newspaper advertisement; 8/ in any event, his decision to buy the

shares came after he had received extensive selling service from the

broker:

1/ Tr. 2229-30.

2/ Tr. 2L30.

3/ Ibid.

4/ Tr. 2230-40.

5/ Tr. 2224.

6/ Tr. 694.

7/ Tr. 696.

8/ Tr. 694.
- 74 -

"I would say that we probably kicked this thing around

for ~apgroxirnatel}~ two hours, because I had hi~n to explain

the.csitu~tion o~ the fu.n~,•the operation. Of .course~,.I

di~dn;':t read ,the prospectus. at that particular tim.~ .so, it was ,. ,,_k

more or less. ;I .god:. my, infor~ation from h.im.ve~bally." 1/

Mr. Asling did not appear to resent paying a sales load on this

inita.a~, pur.chaSe,.;. I~Awever, he d. d question the fairness of ,being required

to pay.a~sales load,.±whar~ he liter decided to purchase additional shares

of the same fund, and neither needed nor received further selling service ,

from the broker:

STAFF QUESTxQN:, "S.urely you ;expected Mr. Thomas [the broke r

to receive .some c9mpensation for the time he spent with you."

MR. ASLING;: !',!Yes, I did. Like I say, he probably spent

a couple tour.:s. in.my+..ozignal purchase. From then on,

in all the purchases of shares of Washington Mutual Investors

Fund [the same fund which had been purchased initially ,

he didn't -solici;~ . me,. AL1 he had to do was pick, up the

phone and I s,ai~d•.I am placing an order with you to buy X

number share~,of Washington Mutual .Investors Fund. And

that is~.a.pretty high reward to sit back there and pick up

the phone and draw 4, 4-1/2 percent sales commission."

STAFF QUESTION: "So your quarrel is not with the sales

commission he received on the first sale, but on the repea"t

sale,S:'~~,. ~ 

'

MR. A,S~.I,~NG: , "I would say yes.- Z would say basica.l,ly this:

That ~},rk•;tl~e.:ori.g•inal sales,.ef~ort no dpubt that the broker

did.s.pend considerable time, and of course nobody.works:for

n.othi,n~. And .I `thi.nk that; probably, he_ would be rightly

rewarded-,}n.that: respect. However,. on al 1. future purchases

I had_,m~de .up my. own mind and I decided which fund I was.

going to buy [I ]t doesn't take but approximately

a minute, I would say, to place this order of his time, and _ .. ..

I think it is very high compensation for the amount of time

spent." 2/

Subsequently, Mr. Asling learned about

began investing in them to the exclusion of

even after his movement to no-load funds, Mr

concern with tYie retail price m~.intenance sy

no-load funds, and eventu~ll;r

load funds. 3/ However,

. Asling continued his

stem. At the time of the

1/ Tr. 697.

2% Tr. 700-01.

3; Tr. 702-05.
75 -

hearings, Mr. Asling's largesi;flu~.d holding- was sti11 Washington

Nfutual, ~ ard:.

"About a year ago I began to wonder. why I should have to

redeem my Washington Mutual shares at 9.3% less than other

people were buying them for and who could just as easily

buy them from me and profit everyone." 2/

Whereupon, Mr. Asling commenced an attempt to sell his shares on a

brokered basis, ~As Qf the date of his testimony "certain ttiirgs Thad/ not

been worked out ye~~and he still owned his shares. 4/

1/ Tr. 684.

2/ Ibid.

3/ Tr. 684-93.

Tr. 692. Uniform sales. agreements between principal underwriters

and broker-dealers typically contain provisions which prevent

broker-dealers i~'rom acting as agent for the purchase and sale c~'

shares in a secondary market. A U.S. District - Court has

dismissed antitrust complaints against such provisions. U.S. v,

NASD CCH Fed. Sec. L. Rep. 9+,319 973-7~+ Transfer Binder? 1873.

,_ The Department of Justice is appealing the decision to the U.S,

Supreme Court.
- 76 -

V. THE RECOMMENDATION OF THE DIVISION: GRADUAL CHANGES I,N THE

DISTRIBUTION PROCESS TEIROUGH AIyMINISTRATIVE ACTION.

We start with the premise that mutual funds are 'a worthwhile

investment medium-'and tfiat~the basic €u~td~concept should be fostered:

No type of security is subjecr~to'more detailed regulation than mutual

funds. Implicit in the decision of Congress to establish a thoroughgoing

statutory scheme to govern mutual funds is a determination that mutual

funds are a product which; with appropriate safeguarc1s,`should be made

available to~the public. While the Didision would not suggest that

any particular investor should buy mutual funds, neither would it

recommend action which would disrupt the fund distribution system.

Thus the Division's proposals are designed to deal with the inequities

and inefficiencies in the current mutual fund distribution system in

a manner which will accommodate, to the extent possible, the interests

of both investors and the industry.

A. The Choices Available to the Commission.

Broadly stated, the courses of action available to the Commission

fall into three categories: (1) accept continuation of the retail price

maintenance sysCem with greater emphasis on price regulation under

Section 22(b); (2) urge immediate abolition of the present system; and (3)

adopt a gradual program designed to move toward a more competitive

environment.

1. Continuation of the Present System of Retail Price

Maintenance WiCh Greater Emphasis on Price Regulation

Under Section 22(L').

This would involve no major modifications of the law presently

governing fund distrihation except implementation of a meaningful

maximum sales load rule; the mutual fund distribution system's basic

reliance upon fixed sales loads to encourage intensive personal selling

efforts would remain unchanged. This approach would have two principal

drawbacks. It would perpetuate the inefficiencies and inequities of the

current distribution system, and it would be based upon a presumption that

the NASD recommended maximum sales charge rule, or a revised version of its

recommendations, would be an appropriate substitute for increased price competition, a presumption contrary to our own analysis and judgment of the situation.

We believe that increased competition would improve efficiency and

is Cho best way to establish meaningful sales charges as well. As the

SenaCe Securities Subcommittee put it,~in~the context of -stock exchange

commission rates:

"Vigorous competition is a vital element'in~creating

an efficient' industry. In a freely competitive marketplace, efficient firms prosper and grow and inefficient firms

wither .and die. ;By rewarding the capable.-competitor and
- 77 -

eliminating the inept, this winnowing benefits the

public in a number of important ways. The efficient

firms have a salutary effect on all prices in the industry

preventing, to .some exter..t, the inefficient £rom raising

prices to a level reflecting their inefficiency," 1/

The Commission itself has framed the question of competztion.in.tne

fund industry this way:

"The system of retail price maintenance under

which mutual funds axe distributed tends to raise rather

than lower prices. Under it, fund distributors compete

for the favor of dealers - and salesmen through a system

of sales 'incentives which creates a constant pressure to

raise sales loads or reduce the principal underwriter°s

margin .

"The question is whether there is any longer sufficient

public interest in the continuation of this system as an

exception to the general rule of free competition which

prevaiis in most other segments of our economic life," 2/

At the mutual fund hearings the Department of Justice suggested

that rest~ietions on price competition tend fo encourage "less

desirable forms o£ competition: 3/

_ "The absence of vigorous price competition in sales

loads has directed rivalry, particularly in the past £ew

years,'to short-term fund performance, ignoring possible

detriment to fund shareholders from such action." 4/

1/ U.S. Senate Committee on Banking, Housing and Urban Affairs, Re~;o~~~:

of the Subcommittee on Securities, Securities Industry Study, 93~d

Cong., Yst Sess. 44 ("Senate Securities Study") (1973).

citing Cesti~nony of Dr. Farrar, 6 Study of the Securities In.dustrp,

Hearings Before the Subcomm. on Commerce and Finance of the House

Comm. ort'Interstate and Foreign Commerce, 92nd Cong., 2d ~~ss~, ~~~:

2947. .

2/ Investment ,Company Act Release No. 7475, at: 4.

3/ Written comment of Department of Justice, at 8.

4/ bid. In this regard, the Senate Securities Study also noted (a.Y p, ~r~:i;

"Where prices are fixed, firms cannot compete by offering

laver prices to their customers. Therefore, firms com~aete by

offering their customers additional services. These additiona?

services often are expensive and add to fixed costs. In maY~y

cases, the value of these services to customers is not propaytionatQ

to the.cost of providing them. Moreover, the steady growth of fixLd

costs resulting from this service competition creates continuous

upward pressure on the commission rate schedule."
-7~-

,.

2. Immediate Abolition of the Retail Price Maintenance

System. ,

The Commission could recommend~to Congress that it take action

immediately to eliminate Section 22(d) c.omplete]~y in order to permit

the establishment of price competition in the sale of mutual fund shares;

or, it could attempt to accomplish that goal administratively by

developing rules now which would, to the extent possible, exempt underwriters from the requirements of the section Either approach would

be in accord with the recommendation of the_Department of Justice.

Without Section 22(d) retailers would lie pextnitted to sell shares of_

any fund at whatever mark-up they chose, although it might also be

necessary specifically to prohibit unjust discrimination at the same

time. 1/ In addition, since the NASD and tie Commission have the

power to impose ceilings on sales loads under Section 22(b)(1), which

authorizes rules prohibiting "excessive" sales charges, to prevent such

a ceiling from also becoming a fixed minimum rate it might be necessary

to ask the Congress to modify -that section if the Commission chose full

retail price competition. 2/ On Ehe other hand, it would seem, in theory

at least, that there would be no need to adopt any rules under Section 22(b)

since, if the competitive market pricing mechanism, is able to function,-

it should prevent both.ea~cessive charges and price differentials wh~.ch

are not economically rational. "`

1/ For an example of such an approach, see our recommendations with

respect to exempting variable annuities from Section 22(d) at pp. 102-

103, infra.

2/ A literal reading•of Section 22(b)(1) might suggest that it would .

permit the NASD or the.Comm,ission to issue rules prescribing fixed,

or at least minimum, sales loads notwithstanding the absence,of

Section 22(d). The preferred view, however, is that Section 22 (b) is

intended only to authorize rules prescribing maximum sales loads.

See letter from Assistant Attorney General McKevitt to chairman

Staggers of the House Committee on Interstate and Foreign Commerce,

undated, concerning H.R. 6821 (the OiI and Gas Investment Act of

1973); and letter from the Corunission to Chairman Stagers,

?ovember 2,173.
,- -

- 79 -

We do not believe it would be wise to move precipitously to a fu11y

competitive environment. For more than three decades, the marketing strategy

of the mutual fund industry has been .to rely almost exclusively upon a saXes

"push" rather than the development of a demand "pill;" ox, as the industry puns

it, fund shares have been "sold, not bought," The. tact that the z.ndustry

has not yet succeeded in producing a demand, '!pull" for fund shires is

dramatically. illustrated by the ICI's finding in 1970 ghat more than

two-thirds of American adults know nothing about mutual funds. ~/

Tn this regard, the present regulatory system, while fai~i,ng to foster an

adequate sales:'fpush;' has inhibited the development o~.a demand "pull"

by prohibiting the fund industry from using the marketing; devices

relied upon by. most other businesses: lower prices, effective

advertising;. and mass-merchandising techniques such as

grpup discounts. Dr. Farrar suggested that this puts the industry, in

an awkward position:

"It appears to me that the mutual funds are

essentially caught between the stools, if you

will. They are not effective competitors who are

becoming increasingly less effective competitors

for the salesman's favor, and yet they are not

sufficiently competitive for the investor's favor to

develop a market demand rather than a sales push.

"If the industry is to maintain or develop a

viable distribution network under present circumstances,

where the losses of revenue to them are substantial, due

to the dwindling of brokerage payments, it seems on a

logical basis they must go one.way or the other, toward

higher loads for the investors or toward. lower cost

distribution methods. I favor the latter.

1/ ICI, "The Public's Attitude Toward Mutual Funds", prepared by

T National Analysts, Inc., (1971), at 2.
X30 -

"And I don't think it is realistic to spend a great

deal of time Ednsd~erifig tF~e foxtner:"'1J ` ~• ' ~ ~ ~'

,.. ..

.,

'- This is an :apt desci`iptian of"the s ttiation~~ 'T'~ie fund i~dustr~~~s '

.vi:rtually total- reliance 'upon ' nceriti'ves Eo "sell ''' 'fund ~share's ' ' 7 ""

has nod fox~esta~le~'~~~statie o~ extended net redemptions; and Chere`~~: e °gib'

clear signs ~hat~ the situation pis likely' to improve' under the -present ~ "~'''

marketing §trategq`,~ ~ If ~ariytlii~ng, ~ tt~e sales picture ilia}i' ~iecome even - ~ A ~ -• ~ ~ ~'

more difficult as the ccririp~~iron from-other financial products - -'~`

becomes more intense and'~hariges in bro~erage~practices'and~`the~ -

erosion of the cinderairiter~s'~sp~ea8 prevent •ariy ic~rease in selling

rewards for reeailers.~~2~`~•At~ the'sa~xe~~time, sh2reYrolders 'sometiates' ~''

do not receive p~`oper' 'service 'aiid in' other cases ~ as we Have noted, ~ ~•

an investor- may be compeilei}~'~d "pay' Sales charg~s~ a~s~gn~a to eo~er ~ ~ ~ `~ ~~

selling efto~ts`tttat K~'dges not vrant, does not 'heed, and does trot ~~ '~ r ''` ~~ ~ `~`

get." 3/ 

~, ,..... r:.

:. • ...

We believe that mutual fund.~shares ; could ~.ot_be sold effectively

under a system of full re~ai~~.:.pr,~e:competition~in the present.,distribuEon

environment; nor is it like~y.t~at;the public would signi~i~an,tly be}Zeft

from an attempt to institute su¢h~a:system without an appropriate foundation

having first been laid:. far a=~.;~' As•;~'rgfessor Paul .A, Samuelson: commentgd,.

in 1969: , .~ mac,- .. .

"[W]hen we are.d~ealing' with~~an;fridustrq like the.

securities industry,~~whi_ch is:recognfzably 'affEcted:.

with public fnterest-' ~~ai~d.: in which :imperf.ections o.f ...

knowledge will S.nevi~zably ExiS~: ~im:sAme ~deg~re~e fox- •,

everyone, and;:- inexorab3y; -exist i~ gxea~,er degx'ee.. fort - :.:, ~ -

the small investor;• ~all~~~~.th~ pxri~aciples:•of economies teil.;,u,~ :. ~ .,. _

that laissez-faire -- leav,ing: -i.t ta° coenpe.tat~on. ,of the

marketplace,., which will not. be, the free ,and perfect

competition of the economics textbook marketplace --

cannot be. coanted ~upat► .;ko :b~~ng<:dawn;.exc~essive <sel~Tng ,. . ; ,;

charges." 4/ .-.. }:~:

Eliminating the sales "push" before there has been an opportunity to

develop a demand "pull" could seriously harm the mutual fund industry.

1/ Tr. 2272.

2/ Logic, of course, suggests that the redemption situation will

eventually stabilize, but whether, under existing regulatory constraints,

the industry will be likely to move into another period of explosive

growth of the net asset base through heavy net sales is certainly not clear.

3/ Mutual Fund Report at 221.

4/ Hearings before the Senate Committee on Banking, Housing and Urban

Affairs on S. 34 and S. 296, 91st Cong., lst Sess. 54 (1969).
- 81 -

As noted above, Professcsr Wallich cautioned that an immediate move to

negotiated sales loads might increase net redemptions. 1/ He added that;

"The need of the economy £or equity capital also.

requires consideratic~, and at a time when stock issues

- are increasing while individual investors ara leaving

the stock market it would be wise to go slow in measures

that might have the effect of further reducing the supply

of equity money." 2/

Such a demand "pull" might be established by educating a much

broader segment of the public concerning mutual funds, and accustoming

more people to ownership, or at least considering ownership, of fund

shares. As the 0ER Report put it:

"[T]he deterrent to competition in sales loads is an

absence of investor knowledge of the available alternatives.

Ela.mination of Section 22(d) by itself will not change that.",~/

However, this educational process cannot be accomplished overnight.

3. Gradual Program Designed to Improve the Competitive

Environment, With a Continuation of Retail Price

Maintenance, But With the Ultimate Goal of Retail.

~' Price Competition.

The Division recommends a multifaceted program which would enable

the Commission to deal with many of the more troublesome features of

fund distribution now without immediately uprooting the existing retail

price maintenance concept of Section 22(d). This program would

1/ Page 71, supra.

2/ Written comment of Henry C. Wallich, at 5.

3/ OER Report at 251.
- 82 -

help the industry move. to a stage where it might be able to adjust to ,.

full price_ coinp~~it~bn by` easing somewhat 'the regulation under Section 22.(xO ,,

without,'~t `Y ~a`~'t' nitially basically changing the distribution system.

We recommend that the ~omin~iss :on' immediately exercise its, exigking.,,~.,

administrative authoYit~ td permit increased price variat,on~~3n.mu.tual~.,,

fund sales loads under Yeguiated~.cond'itions. One of the, most s,igni,~icant

of these actions would~b2 an amendment to Rule 22d-1 permitting wider use

of discounts in the sale to `certain groups. Other impartant measures J~

would include removal of certain of the existing restrictions on advertising,

and a program,to modify the Statement of_Policy to_allow,mo,re precise ..

measurement and`'illus'tra~tion and 'thus, greater understanding, 'off. fund

:..~~;

,.. ~,.

investment,'res:ults: 'these isteps will, promote .increa"sed sophistication ,:i ~ i(

among investdrfi and thereby gradually lessen the .rieed for`intensivs ,

personal selling efforts. By the same token, such 'sophistication,

coupled with the availability of opportunities^to purchase fu~d-sha~es

at lower than ueual:sales.loads in certain'circumstances, should l~ead:to ~;

greater prf~e"eT2t~ti~it}z:and_=significat~.t`eost savings to investors ~~~an-i

important change from the present environment. All of the actions which

we recommend- he~ taken at fhr's~ ~i~e wou'ld' be within th~~ Gommissiot~~s • '

e~emptive and other administrative power.

We also recomcnen~ fT~at "'the Commissionrequest, the ena:c,tment ,,of

legislation which would authorize the Commission,, if and when it deems -~

appropriate, to introduce retail ~grice 'competition' in the mu~C{ial fund

industry tt}rough administrative actions. This legislative action should ;

be taken now 'in order . to'`proui,de the Commission with stand-by authority ,_~.~

to move ~he''in~ustry in this direction by removing~the;inhibtions against,

competitve'priczng`"at: the retail. level. We. would not, however, recomme,~d

the exercise of such authority to'require retail coatipeEition until such

time as the Commission might be able to satisfy itself that the preconditions

for ~s+ore-~effee~ive price-compe~i~ion have-•been-successfully estab}fshed ' ~"

or the industry has demonstrated such an undue lack of willingness

voluntarily to experiment with the flexibility we propose that it becomes

clear that further regulatory action is needed. , . _. ,.. •; =~`.~ `,,~.

,_

.. . 

`?;
-83 -

It is important to note that our approach relies in major part

upon the use of the Commission's existing rulemaking, interpretive

and exemptive powers, and that legislation would be required only to

implement the later stage of the program. Under such an administrative

approach, the Commission could begin immediately to take steps which

would permit price sensitivity and greater understanding of the fund

concept Co develop. Resulting benefits to investozs -- and to the

indusCry -- can be available now.
-84-

yj., RECOMMENDED PROGRAM

The Division recommends that the Commission take the following

actions to modify the mutual fund distribution system. Some of these

recoaanendations, such as those concerning advertising.and.grouping, have already

been the subject of extensive public comment and,del,iberation and are set

forth in action-oriented form. Others, however.are new,.and their

ramifications are discussed in somewhat more detail.. .

A. Measures Designed to Encourage a Degree of Voluntary

Price Co::ipetition

1. Steps to Permit Funds to Communicate More

Effectively With Investors

a. Advertising.

As previously indicated, the ICI study seems to demonstrate that

the majority of Americans are unfamiliar with mutual funds. It hardly

needs to be said that an important element in establishing a demand

"pull" for funds is to acquaint more people with the existence and nature

of the product. Hence, funds must communicate their message more effectively to the public on a mass b$sis. The Commission's Rule 135A under

the Securities Act already contains liberal provisions for generic fund

advertising, which were adopted with this objective in mind. ~-

However, making more people aware of the fund concept generally

will not by itself lead to the development of a demand "pull". It is

also necessary that persons become sufficiently interested in one or

more particular funds to request the fund's prospectus and inform

themselves of its characteristics, without having the information

"pushed" on them by a salesman. In order to achieve this goal, the

Division recommends that certain of the existing restrictions on

individual fund advertising contained in Rule 134 be eased, subject

of course to the basic policy against inviting persons to buy

securities until they have had an opportunity to examine the

prospectus.

In connection with the mutual fund distribution hearings, a release proposing, inter alia, an amendment to Rule 134 to permit greater

flexibility in investment ~ompany advertisements was published for comment on January 17, 1973.1 Upon analysis of the public comments, we

1/ Investment Company Act Release No. 7632.
- 85 -

.-

recommend that the Cornmi.ssion amend Rule 13~ to make flznd advertising

more informative by permitting the inclusion of certain objective

information. Our recommendation is also designed to make such advertising more interesting by permitting the use of certain pictures as

well as other attention-getting devices. In addition, the amendment

would allow the presentation of certain objective information concerning the adviser, thus focusing greater attention upon the adviser.

Nonetheless, the importance of the prospectus would continue to be

emphasized, and the release would make clear that this amendment is

not ~.ntended to indicate any change in the Commission's views with

respect to general publicity concerning offerings subject to the

registration requirements of the Securities Act or 1933• In additYon

to these important changes, our proposal includes codification of

certain previous interpretations. More specifically, we stz~gest that

Rule 13~+ be amended as Follows:

1. The following items would be permitted in a funds tombstone

advertisement for a registered company;

(a) the name of the investment adviser;

(b) the logo, corporate symbol, or trademark of

the fund and its adviser; and

(c) designs or devices or an attention=getting.

headline not involving performance figures.

2. In addition, if (1) the fund's registration statement has become effective and (2) the advertisement also includes either a legend

directing the reader to examine the prospectus for information on

charges and fees and emphasizing the importance of reading the prospectus,

or a coupon for use in ordering a prospectus which includes such a legend,

the following items would be permitted in an advertisement:

(a) a description of the fund's investment objectives

and policies, services, and method of operation;

(b) identification of the fund rs principal officers;

(c) the year of incorporation or organization or period

of existence of the fund and its adviser;

(d) the fund's aggregate net asset value;

(e) the aggregate net asset value of all registered invesCment

companies under management of the adviser, whether or

not in the same complex; and

(f) pictorial illustrations (not involving performance

figures) contained in the company`s prospectus.

3. Joint tombstones for two or more funds having the same investment adviser or principal underwriter would be permitted.

4. The term, "principal officers", would be defined for purposes

of the rule.
-86-

b. Portrayal of Performance

A rousing the public's interest in mutual funds through more effective advertising is only a first step toward cultivating a more competitive environment for the distribution of fund shares.. If a climate is

to be developed where funds will be "bought" instead of."sold", potential

investors must have an opportunity to learn more about a mutual fund

investment from sales literature without the assistance of a salesman --

or at least, with less assistance than salesmen should now provide. Greater

investor understanding and more meaningful comparisons of past investment

returns, risks, : and costs,and their effect upon investment returns could

lead to greater competition to improve the features which make up the mutual

fund package -- by improving management services, reducing costs, and

offering additional ancillary services.

The methods currently used for portraying investment results, which

are prescribed in the Commission's Statement of Policy, ~ do not

facilitate meaningful analysis and comparisons, ~ and ma.r~y imrestors

are not provided with information adequate to give them an understanding

of the long-term nature of a mutual fund investment or of the risks

involved in purchasing a particular fund's shares.3~ The record developed

during the hearings clearly indicates the desirability of revising the

Statement of Policy to provide more meaningful information on fund investment results.. We are not convinced that improvements in mutual fund distribution,or the competitive environment would be an immediate a nd

direct result of such an effort, but, in the long run, such changes leading to a more infoxzned investor should also provide a basis for more

effective price and product competition.

1/ The Statement of Policy sets forth guidelines to assist issuers, underwriters, and dealers in understanding what types of advertising and

sales literature might violate statutory standards. It has not been

revised since 1957.

2/ The participants in the Panel Discussion on Performance Measurement

and the Statement of Policy were in general agreement on this

matter. (Tr. 1622-1817)

The return an investor .receives from a variable annuity also

depends to a 1~a.rge extent on the investment results achieved

by management.. Thus, it also is ~nportant that prospective

investors in variable annuities have an understanding of the

results which might be obtained i'rom an investment in a

variably annuity separate account..
-87 -

Therefore, the Division recommends that the Commission propose a

revision of the Statement of Policy to, permit improved portrayal of fund

investment returns, risks, and.costs.l~ Briefly Stated, our suggested

- additions to the Statement of Policy would utilize four sample charts

for performance portrayal which would:

(1) Portray investment results on a total return basis,

including a single figure expressing a compound rate

of return, which would state the result of investing

distribution income, dividends and capital gains over

a ten-year period, provided that certain conditions

are met. Specifically, variations in the return and the

relative effects of income and appreciation would have

to be indicated. The return would have to be

shown both excluding and incldding sales charges and

expense deductions in order to show the effect of

such charges on returns;

(2) Compare individual fund investment results over a

ten-year period with a market index on semi-logarithmic charts of standard dimensions. The comparisons

would be on a year-by-year and market-high to marketlow basis. and

(3) Allow investors to analyae and compare the investment

returns, risks, expenses, and tax charges of variable

annuities during the accumulation or pay-in period.

SUMMARY- Measures to Improve Communication •With Investors

If funds axe to establish a demand ".pull" they must be- able to

communicate their message more effectively. To this end, we recommend

liberalization of the advertising restrictions in Rule 134 in order

to: (1) permit the use of attention-getting devices and designs

to allow. fund advertising to be more interesting; (2) permit the

inclusion of more objective details about the fund to allow fund

advertising to be more informative; and (3) permit joint tombstones

and'more objective information about the adviser, placing greater

emphasis upon the adviser. As proposed, such advertisements also

highlight the importance of reviewing the prospectus prior to making

an investment decision.

1 A more detailed exp]~,na~ion of our suggestiDns for revising the

Statement of Policy wi11 be set forth in the relEase requesting

public comment on proposed sample charts for the portrayal of

investment per:Forma,nce which would supplement those presently

permitted under the Statement off' Policy.
We also recommend that steps be taken to make sales literature more

informative by pgrmitting meaningful.comparieons of past investment returns, risks. and costs and putting beneficial competitive pressure on

funds with respect to costs and services. Funds must be able to show

their investment results to investors in a straightforward way that :makes

risks and rewards immediately clear. To accomplish this, the Cocmnis~sion's'

Statement of Policy,,which.prescribes. methods for portraying investment results,

should be revised to perm~.t sales literature which would: (1) portray

investment results on~a total return basis,; .(2) compare fund results over

a ten-year period; and .(~3.) foster greater understanding of~variable annuity

posts and investment, results.

2. Measu.xes Desi•Qned to Introduce More Price Variations

into the Sales Load Structure.

Although we are of the view that retail price maintenance must be

retained, at least £or the present, we believe it is imperative that more

variations be permitted in the mutual fund price structure at this time.

Such variations could lead•to significant economies and efficiencies in

fund distribution; enable £u~ds and their un~leisaritera to eliminate

certain inequities now experienced by some fund investors; and

tend to encourage price sensitivity among investors by familiarizing

them with the notion that a particular funds sales charge is not necessarily uniform.

Industry representatives argue that retail price competition would

lead to decreased, rather than increased, sales of mutual fund, s$ares.;.

The premise of their position is the contenUi~n that most people twill not invest in

a mutual Hand unless the :investment is explained to them by a salesman in

a lengthy -- and costly -- interview, and this service must be paid for

in the sales loadr Yet, they 'argue, if other salesmen who provide little or nn

selling service are ;able.,to offer the same shares at lower sales loads to customers

who have first received. the necessary selling service from salesmen charging

a higher sales load, the latter will be deprived of compensation for their

efforts because the customers will make their purchases from the discount

retailer. Thus, the argument runs, salesmen will be discouraged from'
-89 -

engaging in the necessary primary sales efforts and ultimately fewer

~- people will buy mutual funds. 1/

The pronram recommended by the Division is designed to meet this

argument by avoiding a sudden and involuntary end to retail Dries maintenance. The price variations proposed for initial action should lead to

competition, but mainly among underwriters rather than at the retail level.

Further, - most of the variations would be available only at the ~o t~ion of a fund

or its underwriter. In other worts, a fund complex coulc~n generT,

offer the price variations so long as, and to the extent that, it found

such action beneficial. A fund which found that dealers were discouraged

from promoting its shares, and that as a result its sales were declining,

could remedy the situation by ceasing to make available most of

the opportunities for purchasing shares at less than a full sales load.

Finally, it should be emphasized that the introduction of price variations

into the sales load structure would not be occurring in a vacuum. As

already explained, other measures also should be taken to help stimulate

broader interest in, and understanding of, mutual funds. Therefore, it

is reasonable to anticipate that many of the sales at variations in the sales

charges will represent not diversion of income from regular retail

dealers, but rather sales which would otherwise not have taken place at all.

a. Expanded Group Sales

Rule 22d-1 presently permits investment companies to offer group

discounts on the sale of shaxes to "any person". In addition to individuals, the term "any person" includes corporations, qualified employee

retirement plans, and certain other entities. However, it does not

include-- and hence quantity cliscounts may not be extended to -- groups

of individuals who combine their purchases in order to reach a breakpoint.

In December 1972, the Corrunission proposed to amend Ru1.e 22d-1 to

relax partially the restrictions upon discounts for groups. 2/

That proposal is still pending; consideration of whether to adopt it

has been deferred in connection with the current mutual flznd distribution

project. We believe that the rule amendment should now be adopted, subject to certain modifications. In brief, we suggest that Rule 22d-1

be amended to permit -- but not require -- sellers of flznd shares to

offer discounts to the following additional groups, provided that in

each case the group also satisfies uniform criteria selected by the issuer

relating to the realization of economies of scale in sales effort and salesrela.ted expense

1 Of course, mutual fund salesmen already must accept the risk that

investors whom they have introduced to mutual £ands wi]1 make fliture

purchases elsewhere; it appears that many no-load investors first

became familiar with the find concept through load flznd salesmen.

(Testimony of Donald Samuel, Executive Vice President of the No-Load

s pual~ znd Association, Tr. 434; and testimony of John L. Asling, ppo 33-75,

Investment Compa.r~y Act Release 7571, December 21, 1972. In the same

release the Commission withdrew a 1968 proposal dealing with this

- subject.
.~

(1) A11 employer-employee groups. This would be a modification of the present exemption for employer-employee groups,

which naw applies only to those which are tax-qualified under

Section x+01 of the Internal Revenue Code; and

(2) Any organized group of individuals which has been in

existence for at least six months and has some purpose other

than buying mutual Hand shares. This discount would be based

on quantity. However,, in order to limit the availability of

quantity discounts, at least in the context of the present amendment, such discounts would be specifically denied to certain groups

of individuals: credit card holders of a credit card company or

other business concern, policyholders of an. insurance company,

customers of a bank or broker-dealer, or clients of an

investment adviser. The Commission might narrow or expand

this listing by flarther amendment if experience shows that

it would be appropriate.

With respect to the requirement that the group discounts be based

upon economies of scale, the Commission has already adopted a relaxation

of the confirmation requirements in Rule 15c1-4 under the Securities

Exchange Act so as to permit cost savings in the case of certain group tr&nsactions. 1/ Such a relaxation is consistent with the provision in

our recommended revised amendment to Rule 22d-1 to permit issuers to

specify criteria relevant to the realization of economies of scale

in sales effort and sales related e~ense.

It should be noted that, except for that portion of the proposed

amendment to Rule 22d-1 which would make possible the sale of fund ~~

shares at a discount to non-tax-qualified employee plans, the

industry is generally opposed to the grouping proposal. 1Hembers of the

industry cite problems of suitability. discrimination, and "disorderly distribution." However, we believe that the core of the industry's objections

is a fear that the broad availability of relatively low group prices

might discourage retailers from making an effort to aell fund shares on

an individual basis. Obviously, the extent to which this would occur

cannot be predicted with certainty until the experiment has begun. In

our judgment, however, it is unlikely that retailers would be discouraged

from exerting sales efforts to any significant degree beyond that to

which they are already discouraged. ~ In any event, the Division sees

no justification for confining the availability of the group discount

to employer-employee relationships, and we believe that the grouping

Securities Exchange Act Release 1vo. uu~7, Invesr~nenL company xcti

Release No. 8514 (September 2~+, 197+). In addition, the staff, pursuant to Commission authorization, has informed the Investment

C~npa.ny Institute that it would not object in connection with group

transactions, if, inter alia, certain cost-saving modifications

were made in the paperwork procedures required by Rules 19a-1,

20a-i and 30d-1 under the Investment Company Act. Letter from

Director, Division of Imrestment Management Regulation, to

President, TCI, March 13, 197+•

It is paxticu7.arly relevant in this context to emphasize ghat group

discounts would be optional for the issuer; a mutual fund which

found that group sales were adversely affecting its regular retailers'

sales could cut back or even eliml.nate such sales.
91 -

proposal .we-sa~gges.t would result in significant benefits for both

investors and the industry. 1/

Fran the standpoint of imtestors, the proposal would provide an.

opportunity to avoid paying f1a11 sales charges by purchasing f1u1d shares

without a complete "bundle" of selling services. Obvious]~y, financial

counseling would not be as feasible in connection with group sales as it

would be with individual sales. Presumably, paperwork and other dealings

with the underwriter would be handled, in many cases, by the group's common

remitter, and a particular investor may or may not find this to be as

satisfactory as if it were done by a regulax Hand dealer. It would be up

to the imrestor to decide if such differences in service are worth the

sava.ngs in sales charge; the imrestor who feels he needs individual

services prestunab]~y would not bl;y throtagh a group. However, for the

investor who finds that group Service would be adequate, group discounts

would present an opportunity to avoid. paying for personal services which

he does not need or want and, very often, also does not get.

1 In the future, as the industry moves to a more competitive

price conscious environment, it ma.y be appropriate to provide

quantity discounts to any group whose combined purchase results

in economies of scale, even if the group has been organized

sole]~y to pool orders Eor mutual fund shares, since the price

differences wolald be based upon differences in cost and hence would

not be unjustly discriminatory. Such unrestricted grouping would,

of course, be similar to that which prevailed bez"ore 1958, but

it would be permitted under vastly different competitive circumstances.

r-
92 -

Ultimately, the existence of expanded opportunities for group

discounts might benefit even those investors who buy on an individual

basis by s-~imulating price a,nd product competition among Hind wholesalers or complexes. At the present time, much of the competition among

mutual flznds.seems to take the form of ever-increasing efforts to encourage dealers to "push" finds harder. However, a fund complex which sees

its competitors successflally marketing to groups might respond by attempting to make its own individual sales program. relatively more attractive,

through such measures as improved service to shareholders or even lower

sales loads.

Retailers, wholesalers and complexes themselves also could benefit

from opportunities for expanded group sales. As various civic, social

or business organizations inform their members of opportunities for

gr azp purchases, people who were previously unaware of Hinds will be

introduced to the concept; u1t~.mately, such expanded awareness might

lead to increased individual sales. In addition, the easing of th e

present restrictions on grouping, together with the cost savings which

group sales would make possible for underwriters, will render it feasible

for mutual finds to experiment with new mass-marketing strategies. Therefore, if the expanded opportunities for group sales do lead to some

reallocation of selling effort, in the long run this should result in

wider, more economical and more efficient clistribution of mutual fluid

shares. Although some Hand retailers might actual7,y be hurt if they ase

not able to seL1 effectively to groups, the net effect on the distribution system -- underwriters, wholesalers, retailers and font line

salesmen -- should be beneficial.
--93 -

'y Moreover, the proposed grouping rule would be consistent with the

Commission's historic application of Section 22(d). The basic policy of

retail price maintenance would be retained, since the rule would introduce no price competition among retailers with respect to the shares of

any particular fund. Underwriters would not be deprived of any commissions

and, of equal importance, they would retain complete control over their

distribution ;systems; no fund complex would be required to offer group

discounts. Finally, there would be no unjust discrimination among investors

because differences in sales charges would relate to differences in both

costs and services.

b. Unsolicited Purchases

Although expanded opportunities for group sales should lead to some

increased economies and efficiencies in mutual fund distribution, grouping is insufficient, by itself, to remedy one of the inequities in the

present mutual fund distribution system. This is the problem of the

unsolicited individual investor, who decides upon his own initiative to

purchase mutual fund shares. Broadly speaking, there are two types of unsolicited load fund purchasers: new investors who decide to purchase shares of a

particular load fund for the first time without ever having consulted a

salesman, and "repeat" investors, i_e., persons who have previously

purchased fund shaxes, usually upon the advice of a salesman, and then

decide, by themselves, to purchase additional shares of the same f~.ind.

Unsolicited repeat investors are frequent.~y "orphaned" accounts; that .

is, the dealer who originally sold them their find shares has died or

gone out of business.

Under present practice, an order from an unsolicited investor --

whether new or repeat -- must be routed through a retailer; if the

customer does not know a dealer who handles the shares being purchased,

the fund s management might recommend one. ~ Thus, the dealers receive --

and the unsolicited investor pays -- a full sales commission, notwithstanding the fact that the customer might have had little or no contact

with the dealer before deciding to matte the purchase.

Manifestly, it would be desirable to permit such customers to

receive, price reductions reflecting the absence of selling effort with

respect to their purchases. However, simply permitting mutual funds to

reduce or eliminate sales loads for all customers who claim to be

unsolicited would present serious practical difficulties. Pa,rticular]~y with respect to new investors, a customer ~~h~ receive

~~1zL1 selling service from one dealer, then place an ostensibly

unsolicited order with another dealer, thus depriving the first

dealer of compensation for his efforts. This possibility that retailers

could, by itself, discourage selling efforts, and thus

impair the fund distribution system. These

1 See exchange between staff .and, an official of F. Eberstadt o~ Co.,

Tr. 764-772, quoted in part at pp. ~+8-~+g, supra.
-9~+-

difficulties would be less likely to arise in the case of a repeat

investor, since a person who buys additional shares of a fund m~.y not

need or receive extensive selling service. Nonetheless, providing

reduced prices for repeat investors without limitation could have an

adverse impact upon retailers' selling efforts with regaxd to new customers

as well. A salesman who has no opportunity for additional commissions

from follow-up sales may decide that the "one-shot" earnings from an

initial sale do not justify an extensive effort.

The Division therefore recommends that the Commission propose to

adopt an exemptive rule from Section 22(d) which would allow underwriters

to provide for periodic "open seasons" during which persons (except holders

of contractual plans) who have held shares of the Hind for at least a

a specified period, say, one year, could buy additional shares at a

reduced price while shares were being offered at the same time to new

investors at x.11 sales loads.

Such a rule would, to a significant degree, allow unsolicited

repeat investors to avoid paying unjustified sales charges, without at

the same time clisrupting the re~u].ax retail distribution system. 'That

is, dealers would not be deprived of compensation for efforts expended

in introducing new investors to the fund. Only persons who already o~m

shares of the fund would be eligible for the reduced price. A waiting

period such as one yeax, before an investor becomes eligible for the

privilege, would discourage customers mom taking unfair advantage of a

salesman by placing a sma11 initial order wi+h him, then baying more

shares directly from the underFrz~iter at a lower price.

It is true that "open seasons" would deprive dealers of opportunities

to earn sales co~nissions from Follow-up sales, and this could discourage

some dealers from engaging in efforts to introduce new investors to the

ftzrid. However', the extent to which this occurs should be minimal,
95 -

assuming that sales loads are high enough to provide salesmen with reasonable

compensation for each sale. In other words, if salesmen receive enough compensation from a sale, it should not be necessary to offer the salesman the

prospect of additional unrelated and perhaps unearned compensation from future

purchases by the customer. In any event, since an open season also would not

be mandatory, but would be entirely at the discretion of the fund and its

underwriter, if it were found that "open seasons" were interfering with

dealers' selling efforts, the fund could cease offering them. In the alternative,

the fund could innpose more stringent limitations upon the amount of shares which

could be purchased at the discount than would be imposed by the rule itself;

the Division contemplates that at least at the outset the rule would limit an

"open season".purchase to an amount not in excess of the amount of shares already

owned.

An "open season" proposal should have other features a,s we11,

designed to limit, insofar as pos ible,, the number of repeated investors

paying unjustifie3 sales loads. ~ .The most important would be adequate

notice to shareholders of an "open season." If "open seasons" are planned

at regular intervals, it is contemplated that this fact would have to be

disclosed in the prospectus. ~herwise, appropriate notification of the

"open season" would have to be mailed to shareholders. As a further

~ After the rule has been in effect for a period of time, experience

might show that it is unnecessary to have a legal maximum on the

amount of shares which can be purchased in an "open season," and

any such maximum can be left to the sole discretion of the fund

and underwriter.

Holders of contractual plans would be required to pay the regular

sales load on purchases made pursuant to the plan notwithstanding

an open season, since they specifically agreed to pay such charges

when they purchased tYie plan.
-96-

~afegua.rd, we also contemplate that all money received From shareholders

during the "open season" would have to be invested at the reduced price.

A dif~'erent question is.presented with respect to reduced prices

for unsolicited new investors. We do not recc~imend that the Commission adopt

an exemptive rule permitting such discounts. In the 'Divis.ion's view, the

likelihood. that dealers could be deprived of compensation for their

services, and that f`un:d distribution might thus be impaired, .outweighs_.

the argument in favor 'of providing price reductions for.genuine],y unsolicited new investors. Flarthermore, any unfairness inherent in -requiring

1 Certain-mutual fund's have previously indicated interest in making

special no-load offerings to repeat investors for limited periods

of time. For example, last year the Manhattan ~Znd, Inc., requested

a no-action position to the effect that it could make a special no-load

offering of its shares to its existing shareholders for one month

only. However, the end represented that, during the period of the

special offeri ng,the Hand's shares would not be offered to other

persons. Letter from Chief Counsel, Division of Investment

Management Regu]ation, to James H. Ellis, October 3~-, 1973.

Even more recently, the Charming Management Corp. made a special noload offering of shares of three of its funds,whicli were formerly

underwritten and managed by Equity Funding Corp., during tre month

of March, 197L~, to persons who had been shareholders of record as of

April 2, 1973, as well as to existing shareholders. The purpose of the

special no-load offering was to encourage the return of former shareholders who had previously redeemed as a result of adverse publicity

involving the parent of the former management company. I?uring- the

period o~ the special offering, all other sales (except for contractual

plans) were suspended.

It might be noted that, although both Manhattan Fund and the Charming Funds

suspended regular sales during their special offerings, we are now of the

view that such action is not necessary. We do not helieve that unjust

discrimination would necessarily occur if repeat investors, receiving no

selling service, were excused from paying the full sales load while new

investors, who presumably do receive full selling service, were required

to pay for it,

See also Rule 22d-2 under the Investment Company Act which, in permitting a mutual fur~.d to allow its shareholders to reinvest, at no

load, is an example of shares being sold without a sales charge to

repeat investors where no selling effort -- and, in Fact, no salesman --

is involved.
-97 -

such investors to pay a f~71 sales load should be reduced to the extent

that at least same persons who, on their own initiative, select a particular fund, choose a no-loa.d Eland. On the other hand, we also recommend

that the Co~lssion indicate a willingness to consider individual applicati aris for exemptions to permit underwriters to reduce or eliminate

sales laa.ds for unsolicited new investors, if underwriters are able to

forumlate methods for overcoming the practical difficulties and can

demonstrate that such price reductions are in the public interest and

consistent with the protection of investors.

c. Purchases of Find Shares in Camb~.na~ion With Other Financial Products Distributed By the Same Principal Under~,ar~.ter

A considerable portion of the sales charge on a mutual Fund covers

the costs of initially soliciting the customer, ascertaining his financial

needs, and counseling him. However, if a retailer sells fund shares to an

investor to whom he has previously or contemporaneously sold some other

financial product, such as insurance, it is clear that much of the necessary solicitation- and financial counseling will ~.lready have taken place

and need not be repeated in connection with the sale of the mutual fund.

It, is desirable to recognize such cost savings and allow fund distributors

to pass them along to investors.

This principle is already well recognized. For example, Rule 22d-1

permits volume discounts to be based upon the aggregate purchase of shares

of different funds in the same complex. The same rule also permits

volume discounts to be based upon the aggregate quantity of shares previously

purchased, together with new purchases, of different funds in the same

complex. ~ The Commission has also granted individual exemptions to permit

insurance or fixed annuity proceeds or cash values to be invested, without

a sales charge, in variable annuities issued by the same company.

~rn~s seems particular3y appropriate in view of the increasing diversity ~~i

the mutual fund salesman's product mix. See pp, 23-27, supra.

In Westminster Bond Fund, Inc., et al. Investment Company Act Release

No. X20%, January 30, 1974, the Commission granted an individual exemption permitting the dividends of one fund to be invested in shares of

another fund in the same complex without a sales charge.

See, ems., ITT Variable Annuit Insurance Com an Se rate Account,

Investment Company Act Release No. 5841 October 1/~, T969 , and The

Franklin Life Insurance Com an , et al., Investment Company Act Release

,No. 6616 July 14, 1971 .
- 98 -

More recently; the Commission ha.s permitted variable annuities to be

purchased under these circumstances where the sales charge is merely

reduced instead of eliminated, ~ and the staff, pursuant to delegated

authority, ha,s perm9.tted reduced sales loads to be applied where mutual

fund shares are purchased with the proceeds of insurance issued by a

compax~.y in the same complex as the flznd.

There are, of course, certain dangers associated with combination

discounts. First, underwriters might be tempted to use mutual ftiinds

as "loss-leaders•~~ That is, the fund shares might be offered at noncompensatory .sales loads, while excessive sales charges are imposed for

the other non S.E.C.-regulated product in the package. Nat only would

this be misleading to investors, but it would represent unfair competition against distributors of other mutual funds. Moreover, we should

point out that combination packaging is oi' the most benefit to large

underwriters which distribute a wide variety of financial products.

However, neither of these disadvantages appears to outweigh the

savings that might be possible through appropriate combination packages.

The Division therefore recorrnmends that the Commission carry the principle

of combination discounts somewhat farther than has been the case to date,

and indicate a willingness to consider exemptive requests along the lines

discussed below. 3/

We propose that underwriters be permitted to offer reduced or eliminated

sales loads on mutual fund shares where the investor has (1) previously or

'contemporaneously purchased (2) from the same retailer (3) certain other

types of investment products (including but not limited to insurance).4/

(4) which are available at a separately stated price and which are (5)

distributed by the same principal underwriter or a company affiliated

1/ The Mutual Benefit Life Insurance Company, Investment Company Act

Release No. 8008 (September 25, 1973).

2/ Connecticut General Life Insurance Company, et al,, Investment Company

Act Release No. 7570 (December 20, 1972).

3/ In the future, it may be possible to develop an exemptive rule in this

regard, but before doing so, further experience with individual situations

is required.

4~ 13owever, it should be noted that where one of the products i.n the

package is insurance, difficulties might be encountered under the laws

of some states. For example, some states might regaxd discounts on

such combination packages as unlawful rebates of insurance premiums,

,or "tie-in" sales. In addition, although.price differences based upon

cost savings seem justified, some states might view any price

differentials on the same product as unlawful discrimination.

Obviously, any combination package which includes insurance could be

so~cl only in those states Which permit it.
-99-

-_ with such underwriter. 1/ The fund shares might be purchased with the

proceeds of an earlier investment, or they might represent an additional

investment on the part of the customer. In order to ensure that thF

other product is in the nature of an investment which requires some of

the same type of selling service as mutual funds so that cost .savings

could be realized when the two products are sold to the same person,

we would propose to require that the other product be either a security

registered under the Securities Act of 1933, life insurance, or fixed

annuities.

Such an approach to combination packages should afford two basic

advantages. First, it would permit economies and efficiencies in selling

effort to be passed on to investors in the form of lower sales loads~?,~

i/ Heretofore, the exemptions permitting price reductions where variable

annuities or mutual fund shares are purchased in combination wi-Eh~

another financial product (i.e., insurance), have generally been

limited to eases where the variable annuities or fund shares are

purchased. with the proceeds, of insurance previously acquired. (But

cf. Mutual Benefit Life, n. 1, p. 98, supra where quantity discounts for variable annuities were permitted even though some portion

of .the purchase necessary to reach the breakpoint might be allocated

to fixed annuities.) However, it seems that the policy arguments in

favor of combination discounts are equally valid where the other

financial product represents an investment other than insurance, and

where it is purchased contemporaneously rather than previously. In

~ all such cases, savings in selling expenses will be possible which

can properly be passed on to the investor.

It might be noted that, in a recently granted exemption, two mt~tuaZ

funds,.Aetna Fund, ?nc.,-and Aetna Incovice Shares, Inc.; and their

principal. underwriter, Aetna Financial Services, Inc., which is a

wholly-owned subsidiary of an insurance company, Aetna Life and

Casualty Company, have been permitted to offer shares of the funds

at half the usual. sales charge to customers whose purchase represents

the application of proceeds of insurance or annuity contracts issued

by Aetna or a company Controlled by Aetna Investment Com~iany Act

Release No. 8360, May 28, 1974.

2/ It might be noted that combination discounts would have a somewhat

different theoretical basis from that of discounts for repeat

investors. .The latter is premised upon the supposition that the

sales "push" would be replaced by a demand "pull", with the customer

taking the initiative in order to obtain a lower price. Combination

discounts, however, would be based not upon an elimination of the

sales "push;" but merely upon more efficient delivery of the

selling service. Quantity discounts for groups axe based upon a

carnbixLation of these two theories; that is, paxt of the cost saving

results froQn the fact that less selling service is supplied to the

customer, and part fro¢n the fact that the seLlin.g service which is

supplied is delivered more efficient]y i.e., on a group basis.
- 100 -

Second; combination discounts would provide underwriters with an

additional opportunity to experiment with new distribution strateg~.es,

based upon price.

Of course, restricting the availability of the exemption to

cases where the ffnztual fund and other financial products axe purchased

f~o~ the same retailer and distributed by the same underwriter (or an

affiliate thereof) would tend to limit the use which could be made of

the exemption. Both qualifications appear necessary, however, at least at the

beginning.. In view of. the considerable administrative difficulties

inherent in .basing combination discounts upon purchases of financial

products distributed by different underwriters or retailers, it would

not be practical to permit 'such discounts. ~ The condition that

1 It is likely that at least same underwriters would be willing to

engage in such experiments. For example, in a registration statement pending as of Ju7~y 30, 197 (No. 2-50+12, filed March 13, 197+),

-the Bayrock Capital Preservation Fund, an open-end bond Hind, proposes

to offer a limited number of shares at a 4°fo sales load. However, the

s~.res ma,y be purchased on7,y in2,000 "units" consisting of certain

quantities of the bond ftuid shares and shares of the Bayrock Growth

Fland, Inc. The latter, which may be bought separately, has a sales

load of 8.5°fo for the smallest purchases; the sales 1oa.d for a combined "unit" would be 5.35°x• 'chasers of "units" would be permitted

to invest dividends of the bond find in shares of the growth fund .,

without a sales charge.

Additional evidence of the viability of combination packaging as

a distribution technique is found in the fact that at least one

no-load fund, the PRO Fund, Inc., is apparently being sold mainly

by salesmen in combination with retirement plans or insurance.

See testimony of G. Richmond .McFarland, Jr., Tr. x+06-07, x+30.

However, our reference to the administrative difficulties in this

area should not be taken as a suggestion that the difficulties are

insurmountable in all cases. In fact, in a recent case, because of

special facts, a number of mutual fluids in a Hand complex and their

underwriters have filed an application for exemption from Section 22(d)

and Rule 22d-1 to permit tax-exempt organizations purchasing Eland

shares to receive volume discounts based upon previous purchases

of one or more of the other flznds, even though a7..~ of the funds are

not distributed by the same underwriter. The application is based

upon the fact that, until July 1, 1973, all of the funds did have

the same underwriter (Vance, Sanders & Co., Inc.); shares of f~znds

which axe now in a different complex from the find being purchased.

will be counted for purposes of the volume discount only if they

were held by the purchaser on July 1, 1973. (File No. 812-3541.
- 101 -

~- the mutual flznd shares be distributed through the same underwriter as

the other financial product, or an affiliate of such underwriter, also

would leave the Bands and their underwriters in f~.il.l control of the marketing of all combination packages which might affect them, while allowing

the flexibility to design combination packages to meet the varied needs

of inves~;ors and give the retailer more options in meeting his customer's

needs.

Finally, to minimize the loss-leader possibility, each product

in a combination package also should be available separately at a

stated price, as noted previously. In determining whether to grant

a ga,rticular application for exemption, the Co~unission could consider

whether the sales charges on the separate products are realistic,

and whether the price of the combined package reflects a genuine cliscount.~

SUMMARY -- Measures to Introduce Price Variations

Rule 22d-1 permits quantity discounts to "any person," which term

is defined to include corporations, qualified employee retirement plans,

and certain other entities. The Division recommends adoption, with

certain modifications, of an already published amendment to Rule 22d-1

to permit (but not require) discounts to: (1) all employeremployee groups;'and (2) any organized group (with certain exceptions)

which has been in existence for more than six months and has some purpose

other than buying fund shares. Section 22(d) has also been interpreted

to preclude a fund from making a special offer of its shares to existing

shareholders at a sales load more favorable than that charged new investors.

The Division recommends that the Commission propose a rule allawin~ such

discounts for exis~;ing shareholders, subjec~ to ceri;ain safeguards The Division

also recormnends that the Commission indicate a willingness to consider

individual applications for exemptions permitting reduced sales loads for

unsolicited new investors, where the applicants are able to ~,emozstxate that

such an exemption would be in the public interest and consistent Frith the protection

of investors.

In addition, the Division believes that the Commission should

incli cate a willingness to consider applications to permit underwriters

to offer discounts to mutual fluid purchasers who have previously or

contemporaneously purchased, from the same retailer, another irnrestment product distributed by the same underwriter: Such exemptions

would permit cost savings to be passed on to investors, and permit

underGrriters to experiment with varied financial packages. They would

also introduce price variations which in themselves could help cultivate price sensitivity among investors.

1 Making each financial product in the package available separately

would also help eliminate the possibility that the package itself

could be regarded as a separate security which must be registered

under the Securities Act of 1833. Cf. Investment Company Act

Release No. 5510, October 8, ~g6g.
- 102 -

d. Exemption of Variable A~~ties from Section 22(d)

Although registered sepaxate accounts finding vaxiable annuities

are conceptually different fry mutual funds, a variable annuity is a

"redeemable security" and therefore within the purview of Section 22(d).

However, for several reasons, Section 22(d) ha,s little relevance to the

marketing of variable annuities. To begin w~.th, Section 22(d) is not needed

to prevent dilution since variable annuities could not be sold at less

than net asset value. Nor is there a possibility of "disorderly

distribution". Each insurance company underwriter of a variable annuity

can maintain the order of its cam distribution system, since variable

annuities axe typical]y sold through vertically integrated "captive"

sales organizations, and thus retail prices can easily be maintained

on most sales even without a statutory requirement. 7~/ Moreover, the

nature. of-the product precludes the development of a secondary market.

Variable annuity contracts are not general],y assignable, and, even in

cases where they might be assignable, they are nevertheless based upon

the continuin.~ life of a paxticular individual and thus do not lend

themselves to public trading.

Therefore, the Division recommends that the Commission adopt a

rule general],y exempting the variable annuity industry from Section

22(d), provided that all prices or pricing formulas are described in

the vaxiable annuity's registration statement and prospectus. However,

since Section 22(d) also seems intended to prevent unjust price discrimination, arty such exemptive rule should require underwriters of variable

annuities t.o justif~r ariy price variations on the basis of differences

in costs .or services. ~ We do not suggest that the Commission attempt

more spe.ci~ic regulation in this area because of the difficulty of

anticipating all possible price variations. ~ In any event, should

experience indicate that unjust price discrimination is occurring in

the sale .of variable annuities, the Commission could undertake flirther

rulemaking action at that time.

1 Section'22 d does not preclude arice competition between underwriters or ccamplexes.

In addition, as e~lained at pp. 131-32, infra, variable annuities

would be subject to the NASD's maximum sales load rule.

In other areas subject to Commission jurisdiction where price competition e~sts or is contemplated -- notably stock exchange commission

rates -- the Commission has issued no regtitla tions concerning discrimina~;i on .

State.la:ws prohibiting unjust discr~mi.nation in the sale of insurance might apply to variable annuity sales charges. However, even if

such laws are held not to apply, i~7surance companies'~experience

in dealing with them should render insurance co¢npanies par~icular7~y

sensitive to the need to avoid unjust discritni.nation. A71en 'Thaler,

Senior Vice President of the Prudential Insurance Cmnpa,ny of America

commented during the hearings:

"~A~s an insurance company we have dealt with

these questions of price discrimination at the

state level for many years. Every State in the

Union has some kind of a law wh3.ch prohibits price

cliscrimination. And this is certain7~y one of the

things we must consider in pricing our variable

annuities, which is the product we sell." Z'r. 1396•
- l03 -

We believe that significant benefits would result from a rule

generally exempting the variable annuity industry from Section 22(d).

Such a rule would enable insurance companies and underwriters to design

and offer investment vehicles which relate sales charges to services

offered and to take into account savings in selling effort and costs.

This would result in additional price options for investors which could

help to foster a competitive environment. Furthermore, insofar as

vaxiable annuities may be sold by independent broker-dealers, an industrywid.e exemption from Section 22(d) could permit farther price variations

at the retail level and conceivably could result in a degree of price

competition aanong individual brokers.

Because the Conunission has issued numerous orders exempting

variable annuities from Section 22(d) to permit them to reduce or

eliminate sales charges under particular circumstances, ~ it is

particularly appropriate to consider a general exemptive rule ~ which

would provide administrative benefits by making it unnecessary for

variable annuity issuers to file, and the Commission to pass

upon, applications for any flzrther individual exemptions.

SUMMARY -- Variable Annuities

With the Commission's approval, we will develop a rule to exempt

variable annuities from Section 22(d) immediately. Such an approach

is preferable here to the gradual approach which we are recommending

~ for mutual ftznds,~since the removal of mandatory retail price maintenance

would probably not have any negative impact upon the distribution of

variable annuities.

1 Forty-five such exemptions were granted between July, 1 g, and

September, 1973.

Although we are not prepared to argue that the Commission could

exempt the entire mutual f1~nd industry from Section 22(d) wa.thout

additional authority, such a sweeping exemption for the variable

annuit industry (subject to a prohibition against unjust discrimination would seem to be consistent with the purposes of the Act,

and within the Commission's authority under Section 6(e). This is

because, as we have explained, the anti-dilution and orderly

distribution purposes of Section 22(d) are largely inapplicable to

variable annuities.
10~ -

e. Price Flexibility in Brokered Transactions.

1. Sale of Fund Shares by One Person to Another

Through ari A~enC.

aa. Background and the Situation Toda

The development of a secondary brokerage market 1/ for mutual fund

shares has been effectively prevented by various provisions contained in '•

the uniform sales agreements between principal unde nariters and brokerdealers.

Such provisions generally require, inter alia, either that a brokerdealer refrain from acting as agent in the sale of shares to tine pubic

or, if it does act as agent, that it nevertheless maintain the public

offering price. ~/ ,.

The Commission and its staff have consistently taken the position -

that Section 22(d) is inapplicable where an individual fund shareholder

sells his shares through a broker to another person. 3/ In other words,

there is no statutory requirement that the offering price in the prospectus

be maintained in a brokered transaction. 4/

1/ As used herein, a secondary brokered market refers to a market where

one individual sells shares to another, through an agent; it does not

refer to a secondary market where dealers, acting as principal, purchase shares for their own account from shareholders, and then sell them

to other investors. .

2/ Contractual provisions of this kind are currently being challenged under

the federal antitrust laws. See Haddad v. Crosby Corp., [1973-1974 Transfer

Binder] CCH Fed. Sec. L, Rep. ¶94,319 (D. D.C., 1973), probable jurisdiction

noted sub nom. United States v. NASD, (October 14, 1974).

3/ Opinion of the General Counsel, InvesCment Company AcC Release No. 87,

March 14, 1971; Oxford Company, Inc., 21 SEC 681 (1946); letter from

Director, Division of Corporate Regulation to Edward J. Esap, March 18,

1966; and letter from Chief Counsel, Division of Investment Management

Regulation to George A. Bailey, Jr., April 24, 1973.

4/ In view of the fact that by definition the secondary brokerage market in

a fund's shares is not part of that fund's primary distribution system

an;+ differences in price that may occur between the secondary brokerage

market and the primary distribution market cannot be said to be the

product of a discrimination by the fund between similarly situated

investors. Accordingly, we are in disagreement with the court'`'

in Haddad, supra at 94,106 insofar as that court reasoned that the

Commission's prior pronouncements respecting the applicability of

Section 22(d) to brokered transactions were somehow defective because

those pronouncements failed to deal with the problem of discrimination

between similarly situated investors.

The Court in Haddad also criticized the Commission's pronouncements

concerning the applicability of Section 22 (d) to brokered transactions on

the ground that those pronouncements did not address the effect of

brokered transactions at other than the stated offering price on the regulated

distribution system. As we indicate in the text, infra, we do not think

the existence of a brokerage market will have a material effect on the

primary distribution system.
- l05 -

As a matter of sound regulatory policy, we think it appropriate

• to e]sminate the kinds of contractual restraints on a secondary brokered

maxket in mutual fund shares described above. While it is difficult

to predict the actual impact of a limited secondary brokered market

for fluid shares, we do not believe it would da.srupt the prim,ary distribution system. Further, at the present time, and in the context of the

Co~r¢n3.ssion's total regulatory scheme respecting fluid distribution, we

think that there are sound policy reasons for permitting such a maxket,

First, a secondary brokered market would introduce an additional possibility for .price variations, thus helping to develop price sensitivity

among investors. Secondly, such a market would provide imrestors and

broker-dealers Frith some experience in secondary market transactions,

thus providing important insight into whether a secondary dealer

market could function effectively.

According]~y, the Division recommends that the Commission request

the NASD to amend its Rules of Fair Practice to prevent Hand underwriters

from providing in dealer agreements that flu~.d dealers cannot also act as

brokers in secondary market sales of fund shares at negotiated ccanurLission

rates. ~ In addition, if it appeared that Hands were attempting to

defeat the intent of such an NASD rule by restricting transferability of

tYleir shares in a secondary brokered market, we would recommend that the

Commission propose a rule under Section 22(f) of the Act to prohibit

such restrictions.

-- We believe that provision should be made to help neutralize any adverse

impact upon the Funds' primary distribution systems, and to ensure that

transactions in a brokered market do not injure existing shareholders. Thus,

we propose that a mutual fund be permitted to impose a reasonable flat service

1 If the NASD declined to amend its rules in the manner requested,

the Corrur~i.ssion may effect the same result by acting under Section

15(c}(2) of the Exchange Act or Section 22(f) of the Investment

Company Act. Section 22(f) prohibits open-end investment companies

from restrict~n~ "the transferability or negotiability" of its

securities urLless such restrictions are described in its registration statement and are not "in contravention of such rules and

regu]ra,tions as the Commission ma,y prescribe in the interests of

the holders of all of the outstanding securities of such investment company."

No exemption from Section 22(d) would be required to permit price

competition in a secondary brokered market since as noted above

Section 22(d) does not app~}r to bxokered transactions in fund

shares.
- 1Q6 -

fee (the upper limit of which may be fixed by the Commission), when

ownership of its shares is transferred. Such a fee would presumably

cover the cost of recording the transfer on the fund's books, and

might also include an amount to compensate the underwriter, at least

in part, for the absence of any underwriter's spread on the sale. 1/

As a technical matter, the Commission could provide for this merely

by stating in a release that it would consider the imposition of such

a fee reasonable. If any fund imposed a fee higher than that which

the Cotmnission considered reasonable, the Commission could prohibit

it by a rule pursuant to Section 22(f},

1/ It may be argued that the services performed by underwriters do

not directly benefit investors who purchase shares from ether

individuals through a broker. However, mutual fund offerings,

unlike new offerings of other securities, are continuous; therefore, persons who buy and sell shares in the secondary market do

benefit indirectly from the underwriter's services, £or example,

advertising, in that the underwriter helps to create the cantinuing demand which is basic to the functioning of such a market. ._.

Therefore, they should help pay the cost of such serviceso

As previously indicated (p. 56, supra), F. Eberstadt & Co., suggested

in its written and oral presentations that funds should be permitted

to charge a transfer fee if Section 22(d) were eventually repealed.

However, the company's representatives expressed the opinion that

such a fee should be as high as 1-1/2"/0, and they indicated that they

viewed one of its purposes as being the discouragement of a secondary

market. By contrast, our suggestion of a transfer fee is not intended

to inhibit a secondary brokered market, but merely to help ensure that

all shareholders, regardless of £rom whom they purchase their shares,

bear a fair share of mutual fund distribution costs.
- l07 -

We also propose a safeguard against the secondary brokered market

functioning like a dealer market by making clear that brokers should not

fill orders to buy or sell fund shares more than one full business day

after such orders are received. 1/ This would ensure that the brokers

engage only in the genuine matching of orders, and do not, in effect,

maintain an inventory of buy or sell orders until "matching" orders are

received.2/

1/ Brokers would be required to inform both buyers and sellers that the

price paid or received for shares in such. a market might be different

than if the purchaser had bought them in the primary distribution system,

and the seller had redeemed them. Such differences could relate to. more

than the sales charge; they could relate also to net asset value. Since the

price of shares pu:cchased from the Hand would be based upon their

net asset value next computed after the order had been placed (Rule

22c-1), in a declinir~ market the price of such shares might be

l~~rer than the price oi' shares purchased from another individual

through a broker, Conversely, in a rising market, a seller of

shares might receive more if he redeemed them. It would not appear

possible for the Corrunission to require brokers to deliver prospec~;uses

in the case off' all seconc~,ry m~.rket transactions, although the

broker would be required to do so under the Securities Act of 18.33

i£ he happened also to be a dealer of the fund being purchased.

Section 1+(1) of the Securities Act states that the provisions of

~- Section 5 (relating to, inter alia, the de]ivery of prospectuses)

do not apply to "transactions by any person other than an issuer,

underwriter, or dealer."

'I`here is, of course, a distinction between an inventory of orders

and an inventory of shares, and maintaining an inventory of orders

might not make one a dealer in securities. If it became necessary,

however, to prevent such inventorying of orders, the Commission cou p

adopt a rule., pursuant to Section 38(a) of the Investment Company Act,

defining as a "dealer" a person who holds mutual fund orders for more

than one full business day. A dealer (as opposed to a broker) would

have to comply with both Section 22(d) and the forward pricing requirement of Rule 22c-1.
•:

Finally, we wou]~d recatrdnend that, if a rule under Section 22(f)

proved necessary, it contain a provision permitting particular mutual

finds, upon application, to be excused from the operation of the rule.

That is, the Cam¢n:is.sion could issue an order permitting the fund to

restrict the transferability of its shaxes so as to prevent their

sale in a secondary brokered market if the fund could show that such a

market in its shaxes had became so extensive and price-competitive as

to present a signif`i.cant threat to the fluid's primary distribution

system.

bb. Would Professionals Participate in a

Secondary Brokered Market.?

'i'heore~ical].y, ~~tchi:~ orders could ~ai:e place on a broad sc~.le

if, for e_~;arrple, large broker-dewlers used coripu~ers ~o m.~.tch b~,T ar_d

se11 orders zoom t?-leir branch offices, or ii brokers used a ca~puier

nett•;or': t~o ~~ve t~i~:~ access to other brokers' buy a_nd se11 orders for

a particul,~.r - day. Such computer +echnolo~y is already aJailabl~. Sore

large broker-dealers may allceady possess ~h~ necessary equipment ~o

enable thers to'r.~,tch or~?zrs ~r o.^~; their brancr offices, acid com_pttter

networ:.s such as INSTTI~tLT could be used to link broker-dealers iii a

seconc]ary brokerage. market for fluid shaxes.

In determining whether or not to match orders, ~ one

consi~~~r~.tio:: sthich might influence abroker-dealer's dec.~.sion ~toi:ld be

the derand for mutuwl flznd shares. Another factor wh_ch a b~o~er-dealer.

might consider in determining Tahe ~ner to engar~z in tt~e r,~a~tening or riutu~i

f~Znd orders would be, of course, the size oi' the fee which could be eaxned

from this service. We anticipate that such fees wrnzld have to be fair

Such a procedure ~~ould be similar to one rresertly set forth ~n P,ule

17d-1, ~rhich generally prohibits investment company und.erwrii;ers

and affiliated persons of either the compar~y ox underwriter from

participating in joint enterprises or arrangements or certain profit

sharing plans with the company, unless the Commission has, Ltpon

application, granted an order permitting such activity.

However, although broker-dealers who axe not paxties to mutual fluids

sales agreements are not bound by the restrictions challenged in

Haddad, supra, there ha,s not been matching of mutual ~znd orders

~O .Et_1;j o=.,=~ i'i C.'..:1+ C?_"Z'•'e. Cri Li,~2 Otr~'3' 1':^.Y'_Q~ i.Y1F' 2.bS~~?'C P_ Cis ^w ~CYl:in~

by nor_-contract dealers may be due~to the fact that nosy irve~tors

SY'E UI"lw.;•i~:;._^~ 'i.P.3,u IS1U..?~,.1 i.'.~iu 5::32'eS Cu.I1 G'~ bOLiori~i. c~..:1C1 £O~ ~. __. t!:iS

manner; if the Commission were to tale the actions we su~~est, the

resultant pu~licity :night lead to ir_creased interest in a secondary

brokered market.

Some may argue that establishing a secondary brokered market would

place brokers who are also fund dealers in a dilett~a, with respect

to their fiduciary obligations to secure best price. Any such

problems should be no"d.ifferent foam those confronted by every

broker-dealer in the industry today, when, for example, their

customers engage in •tY~ansactions in over-the-counter securities

in which the firms themselves are also making markets.
- 109 -

and reason,able..~ They would, of cou~~se, be filly competitive and

brokers and customers could agree upon charges in accordance with

the services actually rendered.

~~y __ A Secondary Brokered Market

By its terms, Sectio~i 22(d) does not apply to brokered transactions.

Nevertheless, no secondary market in mutual flzn.ds ha.s developed because

uniform sales agreements between underwriters and broker-dealers effective~jr prohibit such a secondary market.

The Division reco~nends that the Commission now act in this area and

request the NASD to amend its Rules of Fair Practice to prohibit restrictions

against a secondary brokered market. We also recommend that, if necessary,

the Co¢mnission promulgate a rule under Section 22(f) to prevent fl~.nds

f`ram accomplishing the result presently obtained in sales agreements

by restricting the transferability of their shares. However, steps.

should be taken to prevent a secondary brokered market from having an

adverse impact on the primary distribution system. .Specifically:

(1) a ~.ind should be able to impose a reasonable flat transfer fee;

(2) orders should not be filled more than one f`ul.l business day after

they were received; and (3) a fund should be able ~o obtain an exemption mom any rule under Section 22(f) upon a showing of a threat to

F

its distribution system.

Development of a secondary brokered market would depend on demand

for Hand shares and the compensation available, vrhich would be campetitively determined. The fee for executing transactions in fund.shares

would have- to be "fair" and f'u7.1~ competitive. Such a limited seeoncla,ry

brokered market. would not disrupt the primary distribution system, and

it would 'introduce possible price variations anci provide insight into

whether a secondary dealer market could function effective],y.

1 Article III, Section of the NASD's Rules of Fair Practice

requires that a brokerage carrunission for over-the-counter transactions be not mare than that wha.ch is "fair , taking into

consideration all relevant circtiunstances including market condi-

~ions with respect to such securities at the time of the transaction, the e~ense of executing the order and the value of any

service ~he broke] may have rendered by reason of his experience

in. and knowledge of such security and the market therefor"
- 110 -

ii. Purchase of No-Load Shares Through a Broker Charging a Fee

Investment Carnpany Act Release No. 7+75, in outlining the issues

to be considered in this proceeding, pointed out that: .

"~]nder present administrative interpretations

brokers and dealers have no direct incentive to

recommend 'no-load' funds._. the imposition of

any charge for reco~nneriding the shares or for effecting the purchase of such a t'und, especially if the

fund encourages or has knowledge of the practice,

has been viewed as an impermissible deviation from

-'the prospee`~u:s representations as to no-load status

as well. as a violation of Section 22(d)."

In the release,the Commission went on to ask whether it should:

"re-examine its present administrative interpretations in order to remove disincentives operating

against recommending no-loa.d flznds L n~ permit brokers

and dealers to charge a normal stock exchange co~nission

for recommending anfl effecting an investment in a no-load

flznd . "

There are policy arguments in favor of permitting a broker to charge

a fee for services rendered in connection with purchases of no-load shares.

First., such a £ee would provide brokers who recommend no-load funds with

payment at ,least somewhat comparable to that which they would have received

if they had reco~nended an alternative investment, such as a blue-chip

stock or a load fund. In other words, brokers would have less disi.neentive

to consider no--load shares when determining what would be a suitable investment for a particular customer. Secondly, such charges on purchases of noload shares would compensate brokers fox services rendered when they do

recosn~nend no-load shares. Such services might involve selection and suit

ability determination and the preparation of forms.

1/ Page 9..

2/ Ibid.
111 -

On the other hand, in the past the staff believed that charging

brokerage fees for effecting purchases of no-load shares might be

fraudulent as well as a violation of Section 22(d). 1/ Although the NASD

indicated that it was "not opposed to broker-dealers being compensated for

their sales effort in connection with no-load funds," 2/ the NASD also

expressed the view that brokerage fees on purchases of no-load shares

should be permitted only if "funds availing themselves of broker-dealer

services drop the 'no-load'la.bel and inform the investors of the sales charges

through the prospectus." 3/

The NASD's suggestion that funds being sold through brokers should not

be permitted to represent themselves as no-load was based upon the argument

that:

"the designation of 'no-load' constitutes

the backbone of..the marketing strategies for those

funds. If broker-dealers were allowed to make a

charge for 'recommending and effecting' a sale,

it would be misleading to characterize such a

f~znd as a ' no-load' . "

Another argument advanced by the NASD wa,s that, if a find

is sold through brokers charging a fee, all investors -- including those purchasing direct]~y from the fund -- should be required

to pay the same sales charge. '.Phe NASD claimed that such a

result was required to avoid discrimination prohibited by Section

22(d), and it added that brokers would be unlikely ac~ively to

sell funds which could be purchased d3rect7,y from the fund withcnzt a sales chaxge .

~ '.~

1/ See,e•g•; Investment Company Act Release No. 7475, quoted at p.11'l y

supra; cf. letter from Chief Counsel, Division of Investment Management

Regulation to Edward J. Costigan, November 27, 1973.

2/ Written .comment of NASD, at 64. "[I]t is in the public interest

that brokers be in a position to offer the greatest possible diversity of

investment alternatives, including no-load funds," Id. at 65.

3/ Ibid. 'IThe NASD noted that "the compensation of broker-dealers for their

continuing efforts on behalf of no-load funds is a Cimely

subject for inquiry," since the prohibition of reciprocal brokerage

"removes existing incentives to broker-dealers to recommend such fv.nds

to their customers." Id, at 64.

Ibid.

~/ Id. at 65.
- 112 -

The No-Load Mutual Fund Association said that, while a

number of no-load fluids have used the services of brokeas and

dealers for the distribution of their shares, most no-load funds

prefer to deal directly with the custc~ner without the in~erpositioning

of a third party.

The No-Load.Fun.d Association said that its:

"basic concern in this matter is the confusion which

would arise in the minds of prospective investors

who would find that the no-load mutual ftuzd of his

choice was in fact not a no-loa.d fund. With the

interposition of the broker and dealer, the direct

marketing by no-load mutual flzilds would become even

more difficult."

Therefore, the No-Load ~xnd Association reco~¢nended that the

imposition of any charge for recommending or effecting the purchase

of no-load shares be permitted where a particular flznd. desires it,

but that no regulation be issued concerning the subject. 3~ At

the hearings, the No-Load Fund Associaii~n's Executive Vice-President,

Donald Samuel, who is also President of the no-load Energy ~znd,

expressed his personal view as being somewhat different from that

of the Ito-Load Fund Association. He said that a no-load fund should

not "be distributed with a load and still be allowed to be called a

no-load flznd. "

Nonetheless, the Division believes that it would be proper for a

broker -- acting independently of the fund -- to make a reasonable charge

for services rendered in connection with the purchase of shares of a noload fund, provided the customer is informed that he .could order the

shares directly from the fund without paying any sales charge. If the

broker's charge is not required by the fund, no part of it is received

by the fl~nd, and it is something over which. the flznd has no control,

it may be viewed as being separate and apart from the price of the fund

1 Written co~nnent of No-Load Mutual Fund Association, at 17• However, certain no-load funds indicate in their prospectuses that

shares may be purchased either directly from the Hand without a

sales charge or through brokers who wi]1 charge a fee, not~•riths.'tanding the fact that the legala.ty of such charges ha,s heretofore

been uxiclear.

Written continent of No-Load Mutual Fund Association, at 17.

Ibid. The Association's position is appaxent]~y based upon the

assumption that brokerage fees on purchases of no-load shares

are legal, where the fund chooses to permit them.

' 4 Tr . x+78. _
- X7-3 -

shares. Such a fee would be one which the customer would pay voluntarily to a third person in order to compensate him for certain

services not offered by the flznd. These characteristics distinguish

such a charge from a sales load which is not only retained in paxt

by the flznd underwriter, but is mandated by the fl~nd to cover the cost

of the selling effort which is an integral part of the fund's disCribution system.

The Division recormnends that we be authorized to respond to

interpretive requests by indicating our view that a broker who makes a

charge for services rendered in connection with effecting the purchase

of sha res of a no-load Fund would be acting neither fraudulently nor

in violation of Section 22(d), provided that the following conditions

are met:

b

(1) The broker is acting independently (i.e., he is

unaffiliated with the flznd and has no formal or informal

agreement with the fund or its investment adviser to distribute the fund's shares). The fund must not encourage

brokers to make such a charge or give any special treatment to orders received through brokers. Otherwise, the

charge would be regarded as a sales load; J/

(2) The broker, as part of his normal description of the

product, informs the customer that the shares could be

purchased direct]~y from the fund at no-load; and

1 Section 2 a 35 of the Act defines "sales load", in part, as:

"the difference between the price of a security to the

public and that portion of the proceeds from its sale

which is received and invested or held for investment

by the issuer , less any portion of such difference

deducted for administrative expenses or fees

which are not properly chargeable to sales or promotional activities."

This view of the brokert s charge as something distinct from a

sales load would not permit a bxoker-dealer to make a similar

charge on the purchase of a load fli.nd. The public offering price

of a load fund, unlike that of a no-1oa,d flzn.d, includes a charge

for selling service. ~'Y~ refore, the imposition of a chaxge in

addition to a sales load would be unjustified, since the brokerdealer in effect would be demanding double payment for his services.

In contrast, where such a charge is made in connection with. a

purchase of no-load shares, it would cover services which are

not otherwise paid for or provided.

Although the fund must have no interest in or control over whether

.-~~ a brokerage fee is charged, the possibility of such a fee should

be disclosed in the Hand's prospectus.
-11~+-

(3) .The charge is reasonable considering the size of

the transaction and the extent of the services

provided.

To the extent the number of no-load Hinds increases, ~ and to the

extent that fund ,investors who need service are able to obtain

such service from brokers in connection with purchases of no-load

shares, additional price variations -- and indeed, opportunities for

price competition -- will have been introduced into the mutual fund

distribution system. In other words, mutual fund customers who are unable.

or unwilling to invese in a no-load fund without any assistance will not

be limited to buying a load fund at a fixed sales charge; they will have

the additional choice of paying a broker a competitively deteYtnined fee

to assist them with the purchase of a no-load fund. The increasing

availai~lity of such an option could, itself, assist in cultivating price

sensitivity among mutual fund investors.

Shy __ Brokerage Commissions on Purchases of No-Load Shares

There are two basic policy arguments in favor of permitting brokers

to make reasonable charges for services rendered i n connection with the

purchase of no-load shares: (1)doing so would prcrride brokers with an

incentive to recommend no-load f1u7d shares; and (2) doing so would compensate brokers for their services. On the other hand, both the Comtnission staff and the NASD have taken the position in the past that charging brokerage co~unissions is inconsistent with the designation, "no-load."

Nevertheless, on balance, the Division believes it would be neither

fraudulent nor violative of Section 22(d) to impose a reasonable charge

for services rendered in connection with the purchase of no-load shares

prrnri.ded: (1) the broker is unaff`i.liated with the flznd and has no

formal or informal agreement with the fund or its investment adviser

to distribute the fund's shares; (2) the broker advises the customer

that the shares are available Pram the fund at no-load; and (3) the

charge is reasonable in terms of the size of the transaction and the

services rendered.

1 The fact that the charge would be negotiable, and the customer

V:ould be awaxe that the shares could be purchased on a no-load

basis would likely serve to control the size of the charge. It

appears that certain brokexs are charging, or proposing to charge,

a flat "transaction fee" of approximately twenty dollars on purchases

of no-load shares, regardless of the amount of the purchase. 'I'hi.s

would seem reasonable; because even on a relatively sma11 purchase

of $j,000 the fee amounts to onitiy 0.~+°fo.

With the increasing popularity of cash management funds, most of

which a,re no-load, the number of such ftiinds is likely to increase

significantly.
- ].15 -

B. Reco~nended Legislative Proposals for Expanded Authority

' to Take Subsequent Administrative Actions

Most of the recommended price variations would be made possible by use

of the Co~nission's authority to grant exemptions from Section 22(d).

They wc~u]..d be avai]~able at the option of Hinds and their underwriters and,

presumab],y, utilized to the extent deemed in the best in~;erest of the

distribution system.

It is to be hoped that the industry will make f'~LL1 use of these opporttuv.ties proposed to provide for the cultivation of a more competitive fund

distribution system. If, however, the industry unduly .resists implementing th~>

price variations which would be necessary first steps taurard retail price

competition, the Coiran:ission should have the authority to make such price

variations mandatory rather than merely optional. There is, o~ course, a

necessity to avoid disruption of the fund distribution system. However,

an exaggerated fear of disorderly distribution should not be permitted to

form a pretext for avoiding the introduction or price competition which,

while perhaps difficult and even unprofitable for paxtic't~l..ax funds and

their underwriters, and certain dealers, would be to the benefit of investors

and the fund industry generally. Therefore, we recommend tY~a~ the Co~nission

ask Congress to asn~nd Section 22(d) to pro~de the Co~nission with adegaate

authority to require price variations such as those we have described.

Such authority could be exercised upon a finding that .the industry Fiad

failed to mrnre tovra,rd price competition voluntarily, and that such failure

was not justified by the likelihood of serious adverse consequences z'or

-- the fund cli stribution system.

After improved mass carrnminication with investors and limited price

variations (whether introduced valunt~.rily or by administrative requirement) ha'v~e accomplished their goal of lhelping to foster a more competi-~ive

distribution emrironment, it then would be appropriate to consider whether

other, more far-reaching modifications of the retail price maintenance system,

including, ultimately, the establishment of retail price competition in the

sale of fund shares both in primary distributions and a secondary market, might

be appropriate. ~ Again',. however, the Commission would have Hill administrative

1 the or17.,y price variations which would not be based upon exemptions

from Section 22(d) -- and thus wo't~1.d not be optional with funds and

Their underwriters -- are those involving transactions executed by

brokers. 'Thus, ftuide would have no power to prevent brokers from

matching orders to bar and se11 shares in a secondary zna.rket, nor

would. funds have any control over the charging of brokerage cammissions for effecting purchases of no-load. shares.

At some point, it might be useful to consider promulgating a

precise timetable for the establishment of Hill price competition.

Clear7_y, however, the formulation of any such timetable would not

be feasible at least until our earlier proposals have been

implexriented, and a more competitive environment has begun to

develop.
- 11G -

authority to take such action only if Congress amends the Act. According],y,

it would be advisable also to ask Congress nc~w to amend Section 22(d) to

give the Co~3ssion increased administrative discretion to deal flexibly

with imztual Fund pxicing in the maivler outlined below. ~ Obvious],y, a

1 Such legislation would be somewhat analogous to the authority

which S. 2519, the National Securities Market System Act of 197+,

would provide the Commission to deal with problems relating to

third market trading. Section 11A(m)(1) of that bi11 provides

as follows:

"If the Carrn~u.ssion finds, after notice and

opportunity for hearing and such consideration

as it deems necessary or appropriate of conditions

arising after the rules of national securities

exchanges fixing rates of commission have been

eliminated, that as a rEsult of transactions in

securities registered pursuant to section 12(b)

of this title effected otherwise than on a national

securities exchange the fairness or orderliness of

the markets for such securities has been or is iiiceiy

to be affected in a manner contrary to the public interest

or the protection of investors, the Commission, in accordance with its powers under this title, shall prescribe such

rules and regulations as it deems necessary or appropriate

in the public interest or for the protection of investors

to restore or maintain the fairness and orderliness of the

markets for such securities. In addition to its other

powers under this title, the Conunission is authorized, in

prescribing rules and regulations under this subsection, to

prohibit brokers and dealers from effecting transactions in

such securities otherwise than on a national securities

exchange, if it makes the findings Herein above specified

and further finds that no rule of any national securities

exchange unreasonably impairs the ability of any dealer

to solicit or effect transactions in such securities for

his own account or unreasonably restricts competition

am.~ng dealers in such securities or between dealers which

are specialists in such securities and dealers which are

not specialists in such securities. The Cou~ission may conditionally or unconditionally exempt any security or transaction or any class of securities or transactions from any

such prohibition if the Coiimiission deems such exemption

consistent with the public interest and the protection of

investors."

Footnote Contd.
- 117 -

~ Footnote. 1/ Contd.

In its report on the bi11, the Senate Committee on Banking; Housing and Urban Affairs co~nented upon this provision as follows:

"~he Committee realizes that it is impossible

for anyone to predict with absolute certainty the

results of instituting competitive commission rates

in the securities industry. As the ~~C stated to

the Committee, '... the NYSE's serious reservations

about the implications of these changesmakes i~

obvious that reasonable men can differ concerning

such predictions.'

"In light of the possibility that the fears expressed by

the NYSE and others may be realized, the CommYttee believes that

the SEC should be vested with flexible and effective power to

deal with any serious disruptions in the operation of the

markets for listed securities caused by trading in the third

market. Section 11A(m) embodies this proposition and would serve

two purposes: First, it would direct the SEC to take all steps within ite existing powers and those provided by the bill to correct

any adverse affect on the fairness or orderliness of the markets

for listed securities caused by third market trading. Second, the

~-- provision would authorize the SEC, upon carefully prescribed

factual findings, to confine trading in listed securities to

national securities exchanges." S. Rep. No. 93-865, 93d Cong.,
precise determination of what actions should betaken in the flzture can

only be based upon the facts appearing at that time, but the possibilities

include the following:

1. Idsaited Retail Frice Competition

a. At the Option of the Underwriter

At sc~e point in the flzture, it might be appropriate to proan~lgate a

rule exempting underwriters and contract dealers from Section 22(d) so as

to permit mutual fund shares to be sold by such dealers at ar~,y desired

sales load above the underwriter's spread, subject to a possible maximum

set by the tanderwriter, provided the under~miter and the flxn.d, at their

option, provide for such price competition in the Eland's prospectus.

Given the conclusion that there should ultima.te]~y be retail price

co¢npetition in the sale of mutual fund shares, this could be an appropriate way to begin.. Price competition would not be forced upon the

industry; rather, underwriters and Hands would be permitted to leave the

shelter of retail price main-ten,ance when they feel that the competitive

entrironment is 'such that their dealer networks can flanc~ion more efficiently

wa.thout it. ~ Under such an approach, to protect contract dealers from

the price competition of a secondasy. ma.rket, the Conunission might, pursuant

to the e~pauded authority we suggest, prohibit fluid shares dam being

traded in a secondary market. ~hi.s would meet the problem of the di.ff`iculty contract dealers would obvious],y have in competing on the basis

of price with secoric3ary market-makers who would not have to include an _.,

underwriter's spread in the sales charges and could obtain shares ~`ro¢n

investors, to who¢n they would pay only a slight premium truer net asset

v81ue .

1/ As a variation of this concept, it might be desirable to experiment

with retail price competition starting with orders over a certain

size and gradually expanding downward. Investment Corrrpany Act Release

No. 7475 announcing the mutual fund distribution hearings posed this

possibility by suggesting, as an alternative the retenCion of retail

price maintenance on smaller sales only, with negotiated rates and

price competition prevailing on any portion of a purchase exceeding a

fixed amount, such as those over $300,000. Subsequently, as feasible, the

Commission could gradually reduce the size of purchases above which

competition would be permitted. Of course, it would be necessary to

maintain a flexible approach to this problem and adapt to the situation

as it developed. For instance, price competition might turn out to be

more disruptive on large orders than on small orders because large investors might have the market power to force sales loads to uneconomic

levels.

2/ As investor sophistication generally increases and more customers

find that they do not need the full range of services offered by

mutual fund salesmen, they might begin to "shop for bargains "

choosing to buy shares £rom a certain dealer, not because he offers a

fu11 range of selling services, but rather because he offers a

lower price. Some dealers might find it profitable to "unbundle"

their services, offering reduced sales charges to the investor who

"does not want, does not need, and does not get" intensive selling

service. Conversely, the customer who is not prepared to invest

in funds unless he receives all of the selling service traditionally

provided by mutual fund retailers could continue to receive such

service, and he would pay the full sales load to cover its cost.
- 11.9 -

~-

b. Required bjr Commission Rule

It is possible, even after the mutual f'uizd clistribution environment

has become suf~.cient~}r competitive to make feasible a move to retail

price competition, that the industry will not take advantage of the opportunities we recommend and will not provide for it in most cases. If

this should occur, it then may be desirable and necessary for the Cammission to require unfixed sales charges on the part of contract dealers

with the same protection against a seconci.ary market. It would be pre~'erable, however, if retail price competition could be introduced on a

voluntary basis, since this would permit each underwriter to determine

when its p~,rticula,x distribution system is ready for such competition.

2, FL~11 Retail pr~.~e Competition, Including a Secondary Market

A broader form of price competition might be practical if the competiti~ve environment fbr the distribution of mutual Eland shares improves

and the distribution of fund shares becomes less dependent upon. intensive

efforts by salesmen. If that point is reached, it should be feasible to

eliminate retail price maintenance with respect to all mutual Band retailers;

the secondary market would not be prohibited and contract as we11 as noncontract dealers would compete with each other.

Even in a fu.11~y competitive environment, however, the nature of the

mutual fla.nd industry will demand that flznd underwriters and contract

dealers be protected from unfair competition on the part of secondary

market-m~.kers. That is, since mutual flznds shares are continuously issued,

1 Even if the Corrunission received and exercised the authority to prohibit retail price maintenance in the sale of mutual fund shares,

Elands could sti11 distribute their shares at a fixed price thrnu.gh

"captive" sales organizations. This should not give a ma,rl~ Ling

advantage to funds with captive sales organizations, however, since

the Commission would not require - or even permit - retail price

competition until it became clear that the necessity for a sales

"push" had been largely replaced by a demand "pu11."

Exercising the expanded statutory authority we recommend, the

Commission might choose to permit undenariters and contract

dealers to enter into voluntary price maintenance agreements,

although such agreements would not prevent funds from being

sold at different prices by non-contract dealers. However,

even such limited, voluntary detail price maintenance might be

unnecessary in a fully competitive environment, and it is

questionable whether underwriters would desire to bind contract

dealers to price maintenance agreements.
-120-

undexwrieers must bear continuing distribution costs; these costs world

be present even if a competitive envirorunent has largely eliminated the

need to recruit and train a sales force, since an underwriter would

still have to ,pay for such .items as the preparation of prospectuses and

advertising. .Since an underwriter would receive no spread on shares

sold in a secondary market, it would be necessary to provide underwriters

with some subseitute.compensation. Similarly, since contract dialers do

share a portion of the sales load with the underwriter, it .would be unjust

if competing..secondary market-makers were not also required to bear certain

costs to sustain - the mutual fund distxibuti.on system and to bear certain

burdens in ordez to assure, even in a price competitive envixonment, that

they do not enjoy an unfair competitive advan-fage onrer contract dealers

to the point of drying u~ ,fund distribution at the primary level..

To accomplish this a ftiind might be perir~.tted to impose a

reasonable fee when, ownership of its.sha.res i.s transferred

from a non-contract dealer to a customer. ~ his won~l.d be

designed to compensate the -fund for the administrative costs o#' transferring ownership on its books, and some of it might be allocated to

subsidize the sales effort to help offset the underwriter°s general

distribution costs: At the same time, such a fee would reduce a

secondary market-maker's price advantage vis-a-vis a contract dealer.

Also, in order to prevent secondary market makers from "dumping" their

inventories of shares upon the fund by redeeming them when sales are

slow, funds could prevent such market-makers from redeeming shares for

a reasonable period of time after purchasing them, such as three months,

or in more than I.3.mited amrnznts for stated periods. ~ This wotiil.d force

secondary. market-makers to absorb same risk from the funds during periods

of sltyw sales and would thus help compensate for the fact that the fluid's

underWx~iter receives no spread on sales by non-contract dealers. And, -

again, the cost .of bearing this risk would help na.rraw the gap between

the minimlun prices which contract and non-contract dealers.ca,n pro~`i.tably

chaxge.

1 These cox~sid.erations are siay. r to t ose w ' c ave underlain

historic 'objections to a secondary market in mutual florid shares.

Funds could impose such fees if the fees were provided for in

the fluid''s registration statement, so long as the Coimnission does

not adopt a rule prohibiting them pursuant to Section 22(f).

Cf. Section l2(d)(1)(F) of the Act, which Limits the free redeemability of fuhd'``sha.res held by a flznd holding company.

,,
- 121 -

.~--

SUMMARY -- Recommended Zegislat3.ve Proposals for Additional Administrative Authority

2'he Division recorr~nends that the Cormnission ask Congress to ameMd

Section 22(d) ~o provide the Ccet~nissian~ur~th increased administrative

discretion to deal flexib.7~y with mutual fund pricing in the future. The

Com¢~i.ssion's at~.thority should be expanded sufficiently to enable it to

take some or all of the following actions:

(1) Require mutual funds to institute - price variations

such as those described earlier in this memorai~dtun;

(2) Permit or require limited price campe-Eition among

contract dealers only; and

(3) Abolish retail price maintenance among both contract

and non-contract dealers, subjEc~ to certain provisions designed to prevent a secondary dealer

market from injuring •funds and their distribution

systems.
- 122 -

C. Reco~nended Regu]~,tory Safeguards

In addition to determining what steps to take to foster competition

in the distr~.bution of fund shares, the Commission must also pass upon the

NASD's proposed rule which wauld~place ceilings on the sales loads which

funds may charge. As .indicatted above, in 1966 the Commission had urged

that Congress set a 5% maximum on fund sales loads. Instead of repealing

Section 22(b) or imposing a maximum on fund sales loads, Congress amended

Section 22(b) to give the NASD the authority, with Commission oversight,

to promulgate rules which would prevent the price at which mutual fund

shares are sold from being "excessive." Such sales loads must allow for

"reasona.ble" compensation for sales personnel, - broker-dealers and underwriters and for "reasonable" sales loads for investors.

In the 18-month interval between adoption o.f amended Sec~ion 22(d)

and the point at which the Commission could have adopted its own rules

to implement the..section, Booz.- Allen & Hamilton conducted a study for.

the NASD which provides a basis for its rule proposal: Z'he portions of

that study, "An Economic Study of.Distribution of Mutu~.l Funds and

Variable Annuities" (Parts I; II, and III); dealing with mutual fund

and variable annuity sales loads were submitted to the Commission in

June 1972 along with the NASD's proposed maximum sales load rule.

1. The NASD's Proposed Sales Load Levels for Mutual Funds

As the NASD has described its Rule proposal, it would permit mutual

funds to charge maximum sales loads of:

8..50% for purchases of up to $10,000 or $15,000;

7.75% for purchases between $10,000 and $25,000; or

7.50'/o for purchases between $15,000 and $25,000; and

1/

6.00P/ for purchases of $25,000 and over.

1/ The NASD states that a fund offering neither dividend reinvestment

at net asset value, rights o~ accumulation, nor quantity discounts

would be limited to a 6~/ maximum sales charge. However, the proposed

rule is ambiguous on this point, and can be read as permitting a

6.25% sales load on purchases of $25,000 even where none of the

above features are offered. When this anomaly was called to the

attention of the staff of the NASD, the Division was advised that it

was an oversight and that the rule would be clarified to reflect 6.25%

as the maximum pextnissible charge when all three features are lacking.
- 123 -

However, the right to charge that maximum would be contingent ugan.

the fund offering:

(1) Dividend reinvestment at net asset value. If the fund

elects to charge for dividend reinvestment, the maximum load

it could charge would be reduced by 1.25 percentage points.

(2) Rights of accumulation. (The right to purchase additional

shares at breakpoints when the cost or the value of an investors

holdings plus any additional purchases reach the breakpoint level.)

If a fund should choose not to offer a right of accumulation, the

maximum load would be reduced by .5 percentage points.

(3) Volume Discounts. The rule requires volume discounts at

either the $10,000 or $15,000 purchase level end at the $25,000

purchase level. Failure to provide such discounts could reduce

the othenaise allowable sales load by as much as .75 percentage

points.

The 1.25%, .5% and .75% penalties are intended to correct the

imperfections which ehe NASD perceived in the mutual fund pricing structure in order that it correspond more fully to a pricing structure which

would exist under a system of effective competition.

-- On November 3, 1972, the Commission advised the NASD that it would

be desirable to publish the proposed rules for couanent ~ The Cornris~ian

also indicated it would hold hearings on its staff study of the Economic

Impact of the Repeal of Section 22(d) and on related aspects of mutual

fund distribution and that the comments the NASD received, and the

testimony we would receive, would provide a public record on tt~.e basis

of. which the NASD and the Commission could discharge their respective

responsibilities with respect to Section 22(b).~2,~ The NASD, by letter

of November 6, 1972 sent to All NASD Members and' Interested Persons

"Proposed Amendments to Regulations Governing Sales Charges on Mutu~.l

Fund Shares and Variable Annuity Contracts," and requested comments on

the Rule proposals. The NASD has deferred Further action pending

recommendationsUy the Commission

NP_SD Stucky, pt. I, p. II- ; Tr. 1937 and 19F9-70. ~~~

Letter of Chairman Casey to C7ordon Macklin, President of the

NASD, November 3, 1972.
The discussion below sets forth our conclusions and recommendations with

respect to the NASD proposed rule package.

2. Impact of the NASD Rule Proposal

The NASD estimates that its proposed rule wo~~ld reduce sales

charge income of fund underwriters and distributors by 9 or 10 percent

based upgn 1970 non-contractual cash sales (including dividend reinvestments). ~ 'Phis conclusion was based upon its analysis of the economic

effects of the following alternative assumptions:

Alternative 1 - That no fund would alter the bundle of

features and services it offered in 1970; but would

instead incur the price reductions imposed by the rule.

This would have resulted in an estimated reduction in

sales charge income of about 9 percent.

Alternative 2 - That each fund would adopt thou features

and services listed in the rule rather than incur the

price reductions imposed by the rule. This would have

resulted in an estimated reduction of sales charge income

of slightly more than 10 percent.

This approach does not make allowance for another alternative: the

possibility that each underwriter will choose that mix of product

features which would result in the least reduction of its income, or

that underwriters of funds with sales loads now below the maximum level

pex~ni.tted under the rule would increase them to -the ma,x~~+~m permissible

levels. On that basis, under Alternative 1 we estimate that,

based upon 1970 sales, the total reduction in industry sales revenues

would not exceed 7'/0. The 10'/o reduction would fall unevenly on various

fund underwriters. The NASD's consultants estimated that dividead

reinvestment income could amount to as much as 25 °~ of the income

of underwriters of funds which now charge a sales load on dividend

reinvestments. For those which do not charge a sales load on dividend

reinvestments, we estimate that the total reduction in income would be

approximately 1'/0 - under either Alternative 1 or 2. The 10% figure is

subject to a number of additional variables. It would depend upon fund

dividend yield rates and the ratio of dividend reinvestments to other

1 NASD, Estimated Effect NASD's Proposed Rule As Approved By Board

of Governors, May g, 1972) on Sales Charges on Mutual ~d Shares,

August, 1972. Transmitted to SEC, September 20, 1972.
-125 -

sales. FQr example, mutual fund dividend yields were higher in 1470

than in any of the previous 10 years. Similarly, the ratio of dividends

reinvested to total sales in 1970 was almost double the immediately

preceding years' ratios, indicating that the 1 ~/o figure might be slightly

higher.

The NASD explained that if all funds elected to provide full

services under the rule, assuming sales remained at 1970 levels:

24% of the funds would have to reduce their maximum

sales charges (a reduction of approximately 0,25

percentage points which would be about 3°fo of an 8.75°fo

sales load);

22% of the funds would have to provide dividend reinvestment at net asset value; and

38% of fun~~ would have to make rights of accumulation

available.-

3, Qur Recornmenda;~ion

We do not recommend that the Commission oppose adoption of the

-~ NASD's proposed maximum sales load rule.

a. Policy Reasons

As a matter of policy, we do not believe it would be appropriate

to impose tighter limits on sales loads than those proposed by the

NASD at a time when the securities industry is entering a period of

negotiated rates and while we are attempting to develop an improved

competitive environment for mutual ~znds. As indicated above, conditions in the mutual fund industry have changed drastically since 1866

when the Corrunission found that mutual fund sales charges bore "no

reasonable relationship to the cost of investing in other types of

securities." ~ Although the sales charges on Eland shares are sti11

greater than the cost of purchasing listed securities, especially

at the $5,000 to $25,000 levels, today's problems relate less to costs

than to the nature of the distribution system. We believe it more

important in the long run to attempt to establish greater opportunities

for competition than to impose a more restrictive regulatory pattern.

1/ Testimony of John C. Bogle, Chairman, Investment Companies Committee

of NASD, Tr. 26.

2/ Mutual Fund Report, p. 221.
-Z26 -

b. Practical Problems -- Iack of Meani fu1. Economic Data Base

As a practical matter, we find it impossible to arrive at any

better sales load maximums to meet the standards of Section 22(b)(1)

on the basis of existing data. We have examined in great detail the

OER Study, the testimony presented at the hearings, and additional

materials concerning appropriate maximum sales loads. Lde feel that the

only reasonable conclusion that can be reached from this ext►sustive

study is to echo Investment Company Act Release No. 7635 concerning the

development of an adequate economic data base in saying that: "Information

currently available concerning the financial environmene of mutual fund

management companies is both incomplete and inconsistent....~~~ The

inadequate data available simply do not provide clear and convincing

evidence that any particular sales loads are optimal. As indicated above,

Section 22(b)(1) requires that sales loads shall allow for reasonable

compensation for sales personnel, brother-dealers and underwriters and for

reasonable sales loads ~o investors.? Under this standard, a sales

load reasonable to investors from the standpoint of the value of the service

they receive might ba so low that it would offer inadequate compensation to

sales personnel, broker-dealers and underwriters for their time and effort.

On the other hand, a sales load which offers reasonable compensation to

fund sellers might be so high that it would not provide reasonable sales

loads to investors.

1/ Investment Company Act Release No. X635, January 18, 1973, p. 2

(Appendix C ~ ,

The Senate Committee Report indicated that the "reasonable compensation"

requirement was intended:

"To assure that fair consideration is given to the interests

of both sellers and investors This does not mean that

such rules must preserve the current level of profitability

of every salesman, broker-dealer, or unde ~rriter in the business,

irrespective of efficiency. It does mean, however, that

consideration must be given to the nature and quantity of

services necessary to effect the proper distribution of fund

shares to the public." (Investment Company Amendments Act of

1969, Report of the Committee on Banking and Currency United

States Senate to Accompany S. 2224, Report No. 91-184) (91st

Cong., lst Sess., May 21, 1969).

The House version of the bill (H.R. 14737, 91st Cong., Zst Sess.) had

provided that any rules should allow "reasonable opportunity for

rp ofit for broker-dealers and underwriters,~~ The bill as enacted

adopted the Senate version, "reasonable compensation." (Investment

Company Amendments Act of 1970, Conference Report to ticcompany S. 2224,

Report No. 91-1631) (91st Cong., 2d Sess., Nov. 25, 1970).
- 127 -

Either way, one should know the costs of the services furnished

by the salesman ar~d received by the investor. Bo$~the Commission and

the NASD have recognized the need for reliable cost data. In the

announcement of Hearings on Nfutual Find Distribution, ~ the Comm~.ssion

recognized that "if mutual f~uld sales charges are to be regulated,

reliable data as to the industry's costs, profitability and general

economic structure is necessary". It later released a Discussion of

De~r~lopment of An Adequate Economic Data Base ~ which cited same of

the data sources currently available for the purpose of monitoring.

econo¢nic trends and. their limitations. Various methods of cost allocation and reporting formats were discussed. Subsequently, the NASD

concurred "in the need to develop a comprehensive data base that will

enable us to ezercise continuing surveillance in a timely manner."

It stated that after new rules have become effective it intended to

initiate a da-Ea collection system, but it also indicated concern

that the 'development of a uniform system of ~,ecounts would entail a,

Heavy financial burden on the industry unwarranted by the quality of

the results. 4

c. Benefits of the NASD Rule

Rather than pursuing a regulatory approach flzrther, we recommend

that the Commission accept the NASD rule as what 'we hope wiL1 be an

interim measure which adds some rationality to the sales load structure by requiring those .funds which charge the most to provide the

'^ Rill range of anci:ilaxy services. In so doing, the rule appears to

correct one o~ the more flagrant deficiencies of the present sales

load structure, which the Commission criticized in i~;s Mutual Find

Report, she charging of a sales load on reinvested dividends. Under

the rule, Hinds which do not offer .dividend reinvestment at net asset

value may not charge a sales load in er>cess of 7.25°fo.

Another possibility, and one perhaps worthy of serious consideration at ;ome time in the flzture, would be to clispense with prescribed

maximum sales loads altogether. In other words, the Commission might

tell the NASD ~;o adopt a ru~.e prohibiting "excessive" sales loads,

without translating that term into numbers. Such an undefined ceiling

migh~L be> appropriate when increased price sensitivity among the public,

coup.Zed with improved disclosure of the effect of all charges upon total

return, render investors more able to recognize -- and thus protect

themselves against -- urLreasonably high sales charges. Certainly for

the present, however, the Division believes that excessive sales

charges can be prevented only by stating a definite ceiling on such

charges.

1 Investment Company' Act Release No. 7 75 Tdov. 3, x-972 , P• 9

Investment Company Act Release No. 7635 (Jan. 18, 1973)•

Sta-tem~nt of the NASD to the SEC (Feb. 2, 1973), PP. 66-6g.

r ~ Ib1d.
- 128 -

d. Recommended Modifications of the NASD Rule Proposal

There are certain respects in which the Division believes the

proposed rule should .be modified:

(i) Exchange Privilege

We bel:i.eve that the rule should require a reduction if a Hand

fails to offer an exchange privilege. The NASD Study noted that

the exchange privilege is one of the most valuable product features

c~'fered by mutual flznds. ~ Nevertheless, it did not include a penalty

provision in its rule to encourage exchanges at net asset value

because of the burden it assumed such a penalty would place on single

fund underwriters -- who account for about 10% of total industry

assets. ~ .However, single f'un.d underurriters might be able to avoid

penalties by arranging excriange priva.leges with another complex if they

wish to do so. Although exchanges at net asset value involving flznds

f~~ different complexes axe permissible under Section 11(a) of the Act,

funds have not engaged in such practices (except pursuant to agreed upon

mergers a.ncl reorganizations) because it would smack of stealing another

fund's shareholders. In arty event, the fact remains that the privilege

can be valuable. As a service provided by mar~y~funds, under the NASD

standard its presence or absence should be reflected in the sales load.

The argument for making the exchange privilege part of the rule

was put by Mr. Bogle, speaking on behalf of Wellington Management Co.

rather than the NASD. He pointed out that:

"The exchange privilege is such a significant part

of the competitive framework of this business, and such

a significant benefit to investors, people should either

be allowed to derive it more or less uniformly in the

industly, or not allowed to do it." 3/

NASD Study, p. III-32•

1bid.

~f ~r . 1906 .
- 129 -

The Division agrees. The exchange privilege provides additional

protection and flexibility in rapidl;T changing markets. ~in.ds which

do not offer an exchange privilege are less attractive and less valuaole.

'Therefore, applying the NASD's value oT service standard, such flznds

should not ,charge the same sales load as f'tzn.ds that do offer an exchange

privilege.

(ii) Sales Charges on Cash Management ~1a.n.ds

We tether recommend that the NASD's proposed rule be modif'ie~. in one other respect: - the maximum sales load permitted on the

sale of shares in cash management funds. The cash management flan.d

concept emerged. re]_atively recently as a probable response to an

environment off' high short-term interest rates and anemic stock market

performance. The portfolios oi' these f`~znds consist primarily of shortterm U.S. government obligations, bankers' ~,eceptances, certificates of

deposit and commercial paper. They enable the small investor to benefit

from high interest rates in the short-term money market which would

otherurise be unavailable to him.

Although a relatively new phenomenon, cash management funds

already account for a significant portion of industry sales and a growing

portion of industry assets. 1/ But for the rapid growth of these

funds, the industry as a whole would be in a net redemption

position. 2/ Fifteen of the twenty funds with effective registration

'~ statements as of September 30, 1974 were no-load. We are concerned

with the remaining S funds since they impose sales loads ranging from

1% to 8-3/4%.

1/ As of September 30, 1974, twenty cash management funds were offering

shares to the public and nine more were in registration at that date.

During the six month period from April through September, 1974, net

sales per month of the nine cash management funds which were members

of ~Iie ICI rose from $29 million to $242 million and their net assets

climed from $61 to - $867 million, an amount equal to almost

3% of the $32 billion total assets for funds which are members

of the IG"I. (Investment Company Institute Release, May through

October, 1974). The net sales and assets of the other eleven cash

management funds were also substantial. Reserve Fund, the largest nonICI member cash management fund, alone reported net sales

of $27 million and net assets of $369 million at September 30. Thus

cash management funds now account for well over one billion dollars in

industry assets.

2/ During the five month period May through September, 1974, all ICI

member funds other than cash management funds reported monthly net

redemptions ranging from $20 to $101 million.
130 -

The Anchor Reserve Fund chaxges an 8-3/~+°f sales load on the first

$10,000 invested (miniYmun initial purchase $100), the Kemper Income and

Capital Preservation Fund, Inc., charges a 6°fo sales load on the first

$25,000 invested (minimum initial gurcha.se $100), a,n.d Oppenheimer

Monetary Bridge, Inc., charges 4-1~~+% on the first $25,000 invested

(minitrnam initial purchase $1,000). ~ These sales loads, one of which

even exceeds the permissible level under the NA.SD's proposed ma,.x3mum

sales charge rule for a traditional f1md, appear to be excessive when

applied to the purchase of cash management fund shares which are general7~y

held out to be short-term investment vehicles.

It would seem that salts charges on such investments should 'be

consistent with their short-term horizon. Unlike longer-terns investments

sales charges on such an investment cannot be amortized over a period of

years as charges of traditional fL~nds can, For an investor to "pa.rk"

his money for 3 months with a flznd which charges a sales load of 8-3/~+%

and merely break even, the f'un.d must have an annualized yield of about

35°~o net of maxia,gement expenses. Even assuming current returns of 10°fo

per annum continue, a shareholder of Anchor Reserve would be "locked-in"

to this investment for over 10 months before such returns offset expenses.

By similar calculations, for an investor in a find which charges a

~+-1~~+°fo sales load to break even after 3 months, the flznd must produce

~.n annualized net yield of about 17°fo; assuming a yield of lOd/9 this

investor would be""locked-in" to his investment for over 5 months in

order to break even. 3/

Fidelity Dai]~y Incarne 'I`rust, although no-load, charges a monthly

$2.50 "account service fee". On a $5,000 investment this amounts

to .6 of 1°fo per. annum. In addition, this FLind states in its

prospectus that if shares are purchased through a broker, he may

charge a commission.

2/ New York Times, June 20, 1974, p. 57, and Wall SCreet Journal,

April 16, 1974, p. 46. The fact that these funds are short-term

vehicles is also evidenced by their high ratio of redemptions to

net assets. During the six months from April through September,

1974, ICI member funds reported redemption ratios ranging between

10% and 11`/, on an annualized basis. However, during the same

period, the cash management funds which were members of the

ICI reported a redemption ratio ten times larger. Investment

Company Institute Releases, May through October, 1974.

3/ The only justification claimed for these sales charges is

that shares of the cash management fund can be exchanged for

shares of an equity fund within the same complex when short-term

rates drop or when the stock market becomes more appealing.

See N.Y. Times, June 20, 1974, p• 58. This may be true, but it

ignores the heavy front-end feature of such a sales charge. It

is hard to rationalize a sales load, equal to the ordinary Hand

sales load, simp],y on speculation that the investor wi71, in the

t~zture if he desires, thereby be able to exercise his exchange

privilege and switch at no-load into the more traditional fluid.
- 131 -

r--

When the NASD proposed its 8-1~2% maxi.rmzm sales load rule, the cash

management fund concept was in its infancy. However, the recent development of sel]ing such Hands at a load suggests tha~L the PdASD should modify

its proposed rule to set different and presumably significant]~y lota~r

maximum sales 1.oa,ds foz the purchase of cash management fund shares,

taking into account the short-term nature of investment in such ~un.ds.

e. Con-EractUal Plans

Single payment contractual plans would b~ subject to the same 8.5% maximum

charge as mutual funds. However, the NASD deferred formulating rules for

periodic payment contractual plans until sufficient time had elapsed to

permit a better assessment of the impact of the 1970 Amendments to Section 27

of the Act on the contractual plan industry. 1/ Since many contractual

plan sponsors have deemphasized the sale of front-end load plans or switched

to spread load p]~an~ we concur with the NASD's recommendation. Sufficient

data should be available in .Tune of 1975 to permit a reexamination of the

NASD Rule and our reserve requirements under Rule 27d-1. The Division

intends to do so a~ that time.

f, Variable Annuities

The NASD proposal also provided the following maximum sales load for

variable annuities:

i. Single Payment

8.5'/a of the first $25,000

7.5% of the next $25,000; and

6.5'/0 of any payments over $50,000,

ii. Multiple Payment

Sales ch~.rges are restricted to 8.5~/ of the total paymenfis as of a

date not later than the end of the 12th year after the purchase.

1/ This would permit sales charges on such periodic payment plans to remain at

their present levels which tend to cluster above 8.8'/0 (assuming lull payments

are made over the life of a plan). The. 1970 amendments to Section 27(d) and

(e) of the Act provide for a refund only on those sales charges in excess

of 15% and only for persons who redeem during the first 18 months after

starting a plan.
- 132 -

We reco~nend a comprehensive approach to variable annuity charges

based upon the total of administrative, investment management and insurance charges and sales loads. 1n the interim, we conclude that the NASD

rule should be accepted as providing a modicum of protection for investors.

However, we do not reco~nend that the Cormnission adopt a co~pa.rable SECO

rule. ~ A comprehensive approach to variable annuity chaxges is needed

because a sales chaxge greater than that disclosed can be imposed either

by characterizing it as an administrative charge; building it into the

charges against assets of the sepaxate accrnznt; or using an annuity table

which is less favorable to the contractholder than is dictated by conservative mortality estimates. Since the economic effect of these other

charges is generally much greater than that of the sales charge, and

because it is difficult to separate out the various charges accurate]y,

we believe the on]~y effective way to evaluate variable annuity sates

charges is on a catrrprehensive basis.

As a first step in this effort, the Commission has already published for

comment a. proposed amendment to the Statement o:f.Po.lic.Y that would pernLit

vaxiable annuities to disclose the combined economic effect of all charges based

upon hypothetical investment experience, i.e., illustrations,in sales

literature and prospectuses. ~ If such disclosure were required, the

various regulatory authorities (the Commission, the NASD and State

Insurance Administrators) and the investing public could better understand and compare various plans and overall charges. After we have had

an opportunity to analyze such charges, we Will be in a position to determine

what ceilings, if any, would be appropriate and how they ought to be

applied.

1 The only variable annuity companq which would be affected in any significant

way by maximum sales load restrictions similar to those proposed in the NASD

Rule for variable annuities is Aetna Variable Life Insurance Company, a

SECO registered broker-dealer and not a member of the NASD One of Aetna's

contracts has an average sales load of 8.79'/0 over a 12 year period. If the

period was increased to 13 years, the average sales load on this contract

would. drop below 8.5'/0. Since changing this contract would require

approval by all of the states, we question whether the benefits too the

contract holders outweigh the costs of making this change.

In addition to the Commission's authority under Section 22(b)(1) to

prevent excessive sales loads, Section 26(a)(2) of khe Act permits the

Commission to prescribe reasonable fees for trustees or custodians of

unit investment trusts "as compensation for performing bookkeeping

and other administrative services."

3~ Securities Act Release No. 5516 (July 30, 1974).

The NASD Study also indicated the need for a comprehensive approach.

It noted that "regulation of sales charges could become a 'sieve'

unless adequate surveillance also was maintained to guard against

the possibility of attempts to evade the rule by shifting a portion

of the Sales Charge to the Adini.nistration Charge." (NASD Study,

Vol. I, p. III-9~+.)
- 133 -

g. Continuous Discounts

One of the questions raised in the announcement of hearings was

whether Rule 22d-1 should "be amended to require that volume discounts

be provided only where continuous schedules are in effect under which

reductions fall only on that portion of the order in excess of the breakpoints?" 1I Under existing sales load structures, purchasers of iarge

volumes of mutual Hind shares receive a volume discount when purchases axe

made in amounts exceeding specified breakpoints, e.g., $10,000, $25,000

or $50,000. The reduced charge applies to the entire purchase, not merely

to the portion in excess of the breakpoint. This means that,for a fund

with a basic sales charge of 8.5% which drops to 7.5% on purchases in

excess of $10,000 or more~a $9,900 purchase will produce gross revenue of

$84j.50 for the selling organization. If the purchase were $100 greater,

i.e., $10,000 ,total selling compensation would drop to X750. The announcement

of hearings expressed the Commission's concern that such a system tends to

cliscoura.ge_sellers from alerting prospects to the economies produced by

breakpoints and places ethical strains on dealers and we]1ers.

The P1ASD recognized the Com~nission's concern but wa.s of the view

that the problem was not of sufficient magnitude to warrant amendment of Rule 22d-1. It concluded "that the practical drawbacks

of a shift to such a structure outweigh the advantage of avoiding

the hitherto insignificant number of abuses of sales slight7~y

below the breakpoints induced by salesmen's self-interested advice." 3f

The "practical drawbacks" objection refers to the way in which the

fund business is conducted, particularly the manner in which shareholder

accounts are kept. To introduce a continuous discount would require

those fl~nds which offer rights of accumulation to keep a running record

of the amounts paid by investors rather than the number of shares held --

a figure frarn which the value of a shareholder's account may be computed.

F~.inds selling through independent dealers would find it difficult

to reconstruct what an imrestor paid in the first instance.

Considering the fact that fund shares may be transferred in street

1 Investment Company Act Rel. No. '7 75 November 3, 1972 .

rbia.

Statement of the NASD to the SEC concerning Mutual F`un.d Distribution and the Potential Impact of the Repeal of Section 22(d) of

the Investment Company Act of 191+0, Febrtizax~y 2, 1973•

~±/ 'I`he right of accumulation might be based upon the value of a shareholder's account rather than cosh to the shareholder.•
- 134 -

name this may be pa.rticularl~y difficult. "All the technological ability

in the world will not tell you the anstirer to ~, question that is not in

the carn~nzter," Mr. Bogle explained. ~ "If you want to give him a

price on the next investment you have to know what he bougr~t."

The practical problems with the implementation of a continuous

discount requirement covrpel the conclusion that it should not be adopted

at this time.

h. Dealer Discounts -- gegulation Not Recommended.

One of the issues posed in Investment Companq Act Release 7475

was whether the size of the dealer discount should be regulated. ~/

The release posed the questions whether:

(1) Varying dealer discounts might unduly influence

dealers' recommendations of the funds, and

(2) Present practices contribute to pressure to

raise sales loads or reduce distributors' margins.

The NASD has declined to regulate the dealer discount separately

from the sales load, largely on the ground that such regulation

would unduly interfere with the distribution process.

On the other hand, there is much to reco~nend direct regulation

of the dealer discount. Many of the steps which are regarded as

necessary to develop a competitive environment, such as inczeased

advertising and expanded group sales, will require vigorous efforts

on the part of the underwriters. The typical underwriter's spread has

already been seriously eroded, and it might well be argued that,

if some action is not taken to assure underwriters a profit, they

will simply not have the wherewithal to undertake the new marketing

strategies needed.

1 Tr. 1952.

~ 'rr • 1953 .

P. 6. It wa.s suggested that the Cca~ission could deal with this

matter "by classif'yIng as an 'underwriters under Section 2(a)(40)

of the Act anyone who receives more than the 'usual and customary

distribu~;or's or seller's caum~ission' on the sale of mutual fund

shares." In the alternative the release asked whether the NASD

or the Cc~nission should limit dealer discounts pursuant to

Section 22(b).

The pressure upon underwriters to surrender ever-increasing portions

of their profits to dealers is illustrated by those instances where

dealers have been offered the entire sales load for certain periods

of time. See pp. 31-33, supra.
- 135 -

Nevertheless, the Division does not reco~nend that the Co~ni.ssion

regulate the dealer cliscrnznt. Although such regulation would tend to

insulate underwriters foam pressure to sY~are more of their revenues with

retailers, it would also tend to remove what would otherwise be an incentive to experiment with new marketing techniques. The discomfort which

underwriters can experience f`roan dealers demanding ever larger cli scounts

may encourage them to experiment with alternative marketing strategies

which rely less upon the dealers' selling "push". Such experimentation

and innovation is essenti.a.l if the industry is to move toward the goal

of retail puce competition.

SUNII~IARY -- Regulatory Sa,feg~uards

Although the Division recognizes certain shortcomings in the NASD's

proposed ~-~ mm~ sales load rule, we do not believe that a significant]ar

better approach to the regulation of sales charges crnzld be developed

at th3.s time, given the limitations of available cost data. Accordingly,

the Division recoa~ends that the Cou~nission not oppose adoption of the

proposed rule by the NASD, subject to certain limited modifications, since

it does add some rationality to the mutual fund sales load structure.
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OFFICE OF

THE CHAIq MALI

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON. O.C. 20549

~ionorable John Sparkman

Chairman of the Committee on Banking,

Housing and Urban Affairs

United States Senate

Washington, D.C. 20510

Dear Mr. Chairman:

I am pleased to transmit for your committee's

consideration our staff's study of the potential economic

impact of the repeal of section 22(d) of the Investment

Company Act of 1940. That section permits mutual fund

managers to fix the prices at which fund shares are sold to

the public and requires that all retail dealers adhere

rigidly to such prices.

The wisdom of this 32-year old resale price maintenance

provision has been hotly debated. Many think that it simply

raises investors' casts without conferring any compensating

benefits on them or on the public interest. Others maintain

that resale price maintenance is so basic to the mutual fund

distribution process that its removal would have a devastating

impact on the investment company industry, the capital

markets, and perhaps on the economy as a whole. This

controversy figured prominently in the debates on investment

company reform engendered by the Commission's 1966 report ot~~

the Public Policy Implications of Investment Company G~owth—

and by the earlier studies on which that report built.2~ When

your committee addressed itself to this thorny subject and

considered deleting section 22(d) from the Investment Company

l~House Report No. 2337, 89th Cong., 2d Sess. (1966).

~~Those studies were the so-called "Wharton Report" (Wharton

School of Finance and Commerce, A Study of Mutual Funds,

House Report No. 2274, 87th Cong., 2d Sess. (2962)) and the

Coiranission's Special Study of the Securities Markets,

H. Doc. No. 95, 88th Cong., 1st Sess. (1963).

1
ii.

Act, it concluded that the consequences of this step dad been

insufficiently studied. Accordingly, your committee asked the

Commission to ~~view the subject and to submit a report with

respect to it._ Responding to that request, the Coctm~ission

directed its Office of Polio Research to make this study,

This document is a report to the Commission from its

staff. It is an analytical study that makes no recommendations

for legislative or administratYve action. But my colleagues

and I believe that the data here assembled and the analyses

here presented can contribute substantially to rational

policymaking in this important field.

There are inherent limitations in any attempt to predict

the economic consequences of legislative action. Those

limitations are especially marked when, as is here the case,

one attempts to assess the impact of retail price competition

on :~ se,~ment of the economy where it has traditionally been

suppressed. It must also be remembered that the investment

company industry is dynamic; its public acceptance is continually

influenced by basic socio-economic forces such as changes in

the economy and markets, availability and awareness of

alternative products and general investors attitudes as well

as by the intricate regulatory framework within which it

operates. Hence precise assessment of the consequences of a

legislative or an administrative change may well be difficult

even after the change has been made--let along before. For

example, it has often been asserted that the abolition of retail

price maintenance fn this field would lead to a marked diminution

of selling incentives, causing the sale of new fund shares to

fall below the level of redemptions. Thus fixed prices for

mutual fund shares have been viewed as a safeguard against net

redemptions. Yet recent experience shows that net redemptions

can coexist with retail price maintenance and that the level of

sales compensation is but one of a number of factors affecting

the popularity of mutual fund investment.

Certainties being hard to come by, we must assess

probabilities as carefully and as intelligently as we can.

3~5. Rep. No. 91-184 to accompany S. 2224, at p. 8.

2
111.

That this report, based as it is on a survey of pertinent

economic data, does. Its salient conclusions are these:

(1) Impact on investors

(a) The repeal of section 22(d) would result

in lower acquisition costs for many mutual fund investors.

(b) But it is highly unlikely that the very

small investor (one who puts a thousand dollars or less into

a fund distributed by dealers and salesmen) would reap any

immediate benefit.

(c) The above conclusions relate to funds

distributed by independent dealers. Not all funds fall into

this category. Some, among them two of the largest in the

industry, are sold through so-called captive sales forces.

These captive organizations are the sole distributors of the

funds they se11. Because each such fund is sold by only one

organization, there is no scope for direct price competition

in this substantial segment of the industry. Moreover, buyers

of captive-distributed funds are often unaware of alternative

investment opportunities. This means that the repeal of

section 22(d) will, in itself, do little, if anything, to lower

these investors` acquisition costs. But other measures leading

to wider public awareness of mutual funds and of what they offer

(thus reducing the need for intense personalized sales effort)

might eventually have a significant impact here.

(2) Impact on mutual fund sales organizations

(a) Captive sales organizations

As has already been pointed out, the nature

of their distribution system and of the market that they serve

would insulate captive sales organizations from the impact of

retail price competition among independent retail dealers in

mutual fund shares.

(b) No-load funds

The shares of these funds are sold at net

asset value without the addition of any sales charge. Lower
1V.

distribution costs elsewhere in the industry would have no

appreciable effect on its no-load sector.

(c) Independent broker-dealers

The impact of the cost-saving that investors

would realize from the repeal of section 22(d) would fall almost

entirely on the independent broker-dealers who made threefourths of all load fund sales in 1970 and who during that year

derived gross revenues of $150 million from this source.

(d) Gravity of impact on independent brokerdealers

Although the great bulk of the sales charges

that mutual fund purchasers pay goes to independent brokerdealers, these charges are not a significant revenue item for

m~~t brokerage fi nns or for the securities industry as a whole.

When one looks at the total income of all brokerage firms that

sell mutual fund shares, one finds that revenue from this source

accounted for 7.6% of 1969 aggregate gross revenue and for only

5.3% of 1970 aggregate gross revenue. And the New York Stock

Exchange member firms that sell mutual fund shares derived

only 3% of their total gross revenue from this source in 1969

and a mere 2% in 1970. Looking at the securities industry as

a whole, i.e., at fines that do not sell mutual fund shares as

well as at those that do, mutual fund sales accounted for only

5.8Q/o of 1969 gross revenue and for 3.8% of 1970 gross revenue.

These figures show that the reductions in mutual fund sales

charges that would probably result from the repeal of section

22(d) would have an extremely modest impact on the securities

industry and on most retail sellers of mutual fund shares.

There is, however, a group of broker-dealer

fins whose business consists almost entirely of selling mutual

fund shares. Any significant change in prevailing levels of

mutual fund sales compensation would, of course, have a serious

impact on these firms. That impact would fall most heavily on

the firms that obtained more than 90'/0 of their 1970 gross

revenue from selling mutual fund shares. They represent about

13% of the broker-dealer community. Tt should be noted that

the mutual fund industry is far more important to these firms

~n
►~~

than they are to it. Only about one-fifth of the independent

broker-dealer conununity's 1970 mutual fund sales revenue went

to them. And even these firms are not nearly so dependent on

mutual fund sales as they at first blush appear to be. Many

of them are parts of larger sales organizations which sell

such non-equity financial products as life insurance and real

• estate in addition to securities, primarily mutual funds.

The financial data with which our staff worked relates only

to these firms' securities activities, which in many cases is

only a small part of the firm's overall business.

(3) Impact on salesmen

For most full-time securities industry salesmen

section 22(d) is of little moment. Most salesmen who sell

securities on a full-time basis receive less than 10% of their

total income from mutual fund sales. The salesman who

concentrates on selling funds tends to be a part-timer. And

whether full-time or part-time, his income today under price

maintenance is much lower than that of other professionals in

the securities business.

~- (4) Impact on the investment company industry

(a) Improbability of extended net redemptions

The repeal of section 22(d) is unlikely to

lead to protracted net redemptions on an industry-wide basis.

Any lessening of sellers' incentives would be offset to some

extent at least by the diminished sales resistance normally

associated with lower prices. Pertinent in this connection is

the marked recent growth of the industry's no-load sector. A

competitive regime would permit group sales on a low-load basis.

It would also tend to reduce the extent of the sales charges

that many funds now impose when existing shareholders reinvest

their dividends--transactions involving no fresh sales effort.

The available evidence shows that when shareholders are

pern~itted to reinvest dividends free of charge, they are more

likely to make such reinvestments.

(b) The possible development of a secondary market

Under the existing statutory scheme, load

mutual funds are distributed through fund underwriters which
V1.

are either captive sales organizations or independent dealers.

Repeal of section 22(d), it is sometimes suggested, will lead

to the development of a secondary market which would end-run

existing distribution procedures. It is not at all clear that

this ~~iould happen. To the extent such a market may develop

concern over adverse consequences which might result seems

exagK~rated.

(5) Impact on the capital markets and on the economy

Reductions in mutual fund selling compensation

would have no significant impact on the stock market or on the

economy. Mutual funds figure prominently in the marketplace.

But they are more significant as traders switching from one

security to another than they are as net investors. The funds'

trading activities add liquidity and depth to the market. But

a free price system for mutual fund shares will not detract

fro- r_heir ability to do this.

~s previously noted, this staff report makes no express

reco*nmendations. But its findings certainly suggest there is

no c.~~pelling public interest in continued retail price

maintenance in this field and that the repeal of section 22(d)

would on balance be desirable. Whether that step should or

should not be taken is, of course, for the Congress to decide.

This Commission, however, as the agency charged with administering

the Investment Company Act, protecting investors under that and

other statutes and safeguarding the public interest in the

investment process is under a duty to give the Congress the

benefit of its own judgment. That responsibility we intend to

discharge.

Before making any definitive recommendations to the Congress

as to what should or should not be done about section 22(d),

the Commission will hold public hearings at which interested

persons will be asked to direct our attention to aspects of

the mutual fund sales compensation problem that the report may

have overlooked or to which it may have given insufficient weight.

The Commission wishes to hear from all segments of the

investment company and the securities industries, from the

economic profession, from the Department of Justice, and from

anyone else who appears capable of enlightening us before we

make a judgment of our own on the basis of an adequate record,

including this report. The hearings that we propose to hold
V11.

will focus in large measure on the pros and cons of section

22(d}. But they will not be confined to that topic. They

wi11 go into the whole mutual fund sales picture and will help

us to develop a program that will enable investment companies

to bring their message to the investing public more effectively

and more economically than they are now doing. In addition to

a r.e-examination of section 22(d), this entails a re-examination

h this Conm~ission of some traditional administrative positions

tk~at may have outlived their usefulness.

Among the areas calling for review on our part, a review

in which the forthcoming hearings will assist us, are these;

A. Advertising--Advertising, an effective and a relatively

low-cost method of conveying inforn►ation to prospective

purchasers, has been confined to a minimal role in the marketing

of investment company securities. Rigid restrictions on

advertising have been deemed compelled by the Securities Act's

prospectus provisions, which apply to all issues of new securities.

For most issuers, however, those restrictions are temporary and

sporadic. They seldom issue new securities. And when they do,

the duration of the offering period--and therefore of the

Securities Act's restrictions--is short. But the overwhelming

majority of mutual funds are continuously offering their own new

shares to the public for cash. Hence they are always subject to

the restraints that the Securities Act imposes on advertising.

Those restraints have made it extremely difficult for the mutual

fund industry to make much of an educational effort by means of

the printed word and- the mass media. The industry operates in an

environment in which time-consuming face-to-face contact between

a salesman and a more or less uninformed prospect is crucial.

This makes for high selling costs. We recently liberalized our

rules with respect to the advertising of investment company

securities. But appreciable further liberalization would seem

to be in order.

B. Simplifying mutual fund prospectuses and making them

more readable--The advertising restrictions to which I have just

referred rest on the premise that the statutory prospectus

will. be the key selling document. At present that premise is

highly unrealistic. Selling practices typically relegate the

prospectus to a backseat, secondary role and, very often the

legal requirements result more in confusing the ordinary

investor than assisting him in reaching an informed judgment.

We must pare our mutual fund prospectus requirements down to

r
viii.

essentials and develop an administrative program that will

elicit simple, clear prospectuses geared to the ordinary mutual

fund investor's needs.

C. Group Sales--Mutual fund sales charge schedules provide

for quantity discounts on larger orders. But the Commission's

rules under section 22(d) preclude the grouping or pooling of

orders for the purpose of obtaining such discounts. There is a

serious question as to whether this anti-grouping rule, which

superseded contrary administrative positions, has outlived its

usefulness.

D. Reducing Paperwork in Small Transactions--Payroll

deduction plans and other voluntary plans for accumulating

mutual fund shares by means of periodic small purchases have

a great area of potential usefulness. Unfortunately, however,

some of the present rules under the federal securities laws

make such plans more expensive than they need be. The rules

in question require that each fund shareholder receive such

individual notices and services as individual confirmations,

dividend statements, and shareholder reports. We propose to

examine whether altering these rules to make for lower costs

on small transactions would diminish the basic investor

protections they provide.

E. Volume Discounts--The discounts given volume purchasers

of mutual fund shares must be re-examined. When such levels as

$10,000, $25,000, $50,000 are reached, the sales charge drops.

At present the reduced charge applies to the entire purchase

and not merely to the portion in excess of the so-called breakpoint. This makes for strange results. Take, for example, the

quite common case of a fund with a basic sales charge of 8,5/4/,

which drops to 7.5% on purchases of $10,000 or more.5~ In this

situation a $9,900 purchase will produce gross revenue of $841.50

for the selling organization. If the purchase goes up just

another hundred dollars to $10,000, total selling compensation

drops rather sharply to $750. And even on an $11,000 purchase,

total sales revenue comes to $825, which is still less than

4~Ac~ually, 9.3% when viewed as a percentage of the net amount

invested rather than as a percentage of the total offering price.

S~Actually, 8.1% when computed on the basis described in the

preceding footnote. ~
ix.

"- the $841.50 produced by a $9,900 purchase. Such a system

discourages sellers from alerting prospecfis to the economies

produced by the breakpoints. The status quo thus places

unnecessary ethical strains on dealers and salesmen. We must

cpnsider replacing it with schedules that fall only on the

portion of the order in excess of the breakpoint.

F. No-Load Sales--Under present administrative

interpretations brokers and dealers have no direct incentive

to recommend so-called "no-load" funds, i.e., funds that sell

their shares directly to the public free from any sales charge.

Since these funds' prospectuses state that there is no sales

charge, the imposition of any charge for recommending the

shares or for effecting the purchase has been viewed as an

impe nnissible deviation from the prospectus. Consideration

will be given to the desirability of altering this position so

as to pe~nit brokers and dealers to charge a no renal stock

exchange commission for recommending and effecting an investment

in a no-load fund.

G. Rules with Respect to Excessive Sales Loads--So long

as section 22(d) remains in effect, legal controls on sales

- charges are necessary so as to compensate for the absence of

normal competitive restraints. And even i~ that section should

be repealed, there might well continue to be a strong case for

legal controls to protect the unsophisticated mutual fund

investor against excessive charges. The 1970 amendments to

sections 22(b) and 22(c) of the Investment Company Act authorize

the rational Association of Securities Dealers, Inc. ("NASD")

and the Commission to prescribe rules aimed at assuring

investors of reasonable sales loads but allowing for reasonable

compensation to sales personnel, broker-dealers, and underwriters.

The NASD has developed rule proposals on this subject and will

shortly publish those proposals for comment by its membership.

We expect the hearings to assist the Association and the

Commission in evaluating their proposals in order to strike the

fair balance between the interests of mutual fund buyers and

those of mutual fund sellers that the Congress has directed us

to seek.

H. Development of an Adequate Economic Data Base--If

mutual fund sales charges are to be regulated, the regulators

must be well supplied with reliable data as to the industry's

:>
X.

costs, profitability, and general economic structure. Such

data must be available on a continuous basis so as to enable

the regulators to monitor trends, thus avoiding the undue

regulatory lag that has plagued other types of regulation. t

By direction of the Commission:

William J, Casey

Chairman

10
FOR RELEASE November 3, 1972

SECURITIES AND EYCHANGE COMMISSION

WASHINGTON, D. C, 20544

Investment Company Act of 1940

Release No. 7475

Ser_urities Exchange Act of 1934

Release No. 984!

ANNOUNCIIKENT OF HEARINGS ON MUTUAL

FUND DISTRIBUTION AND THE POTENTIAL

IMPA CT OF THE REPEAL OF SECTION 22.(d)

OF THE INVF,STMENT COMPANY ACT OF 1940

The Securities and Exchange Commission, having reviewed the Study

of the Potential Economic Impact of the Repeal of Section 22 (d) conducted

by its Office of Policy Research and the Economic Study of the Distribution

of Mutual Funds and Variable Annuities conducted for the National Association

of Securities Dealers, Inc. ("NASD") by Booz Allen & Hamilton, Inc, has

determined that it would be appropriate to re-examine traditional administrative positions and to explore new possibilities in order that mutual funds

may be marketed more efficiently at a reasonable cost to investors.

Section 22(d) require s, in part, that in the sale of a mutual fund security

to the public the principal underwriter and any dealer must sell the

security at a current public offering price -- net asset value plus stated

sales charge - set forth in the prospectus.

In order to obtain a wide range of viewpoints with respect to the

justification for this retail price maintenance provision in the distribution

of mutual funds, as well as the options which would be open to the industry

if Section 22(d) were eliminated and how the industry would adjust to such

a change, th'e Commission has determined to commence public hearings on

December 11,1972.

Background

A. Study of the Potential Economic Impact of the Repeal

of Section 22(d) of the Act.

In the Investment Company Amendments Act of 1970 (the "1970 Act")

Congress took steps to improve the protection afforded mutual fund investors

in the area of sales co~nissions. The Senate Committee on Banking, Housing

and Urban Affairs indicated that "Partly because of Section 22(d) and partly

because of the way in which mutual fund shares are sold, competition has

tended to operate in reverse in the sale of mutual fund shares -- raising

11
- 2 - IC-7475

prices rather than lowering them". 1/The Committee gave serious consideration

to deleting Section 22(d) from the Investment Company Act of 1940 (the"Act").

However, it was uncertain what that would mean to the investing public and

mutual fund sales organizations. Therefore, it requested that the

Cormniesion review the cor►sequencea of such a proposal and report to it

as soon as reasonably practicable.

Qur staff is about to complete this study which will be released

shortly. It deals among other things with the costs of distributing mutual

funds, the earnings of those who sell mutual funds, the significance of

revenue derived by brokerage firms from mutual fund sales and the significance of mutual fund sales to the securities markets. Before making any

definitive recommendations to the Congress as to retail price maintenance

the Commission believes it imperative to have the views of all interested

persons with respect to the staff's report and the impact on the industry

of various changes in the distribution system that may be desirable.

B. NASD Stud and Rule Proposals

The 1970 Act gave the NASD rule-making authority to prevent mutual

funds from being sold at a sales load which is "excessive". Under amended

Section 22(b) of the Act mutual fund sales charges must allow for reasonable

compensation for sales personnel, broker-dealers and underwriters, and

reasonable sales loads to investors. The amendments also provide the

Commission with the power to alter or supplement such NASD rules at any time

after June 14, 1972 -- the effective date of this amendment. It was

contemplated that during this period the NASD would study "alI relevant

factors" in order to provide a basis for its rule proposals. At the outset

the Commission mgde clear that the NASD study should consider ways in which

the existing distribution system could be improved with the resulting

efficiencies and lower coats passed on directly to benefit investors and

that the Conanieaion would consider the feasibility of achieving this result

in connection with its staff study of the impaet of eliminating Section 22(d)

from the Act.

1/ S. Rep, 91-184, 91st Cong. lat Sess. 8 (May 2.1, 1969).

1~
_ 3 _ TC-7475

The NASD has now completed its study and has drafted rule proposals

based upon it. That Study is, of course, a survey of mutual fund distribution

as it has existed and the resulting rule proposals are premised on the

continuation of that system and the existing regulatory framework. The

authors of the Study indicated that "If Section 22(d) were repealed and

sellers were able to set the prices of funds at levels other than their

current offering price described in the prospectus, then the analysis

presented needs to be re-evaluated".

C. Other Developments

In our Statement on the Future Structure of the Securities Markets

we announced that the practice of investment company managers using

portfolio brokerage of mutual funds to reward broker-dealers for sales of

fund shares must be terminated. The NA SD has published for comment an

amendment to Article III, Section 26 of its Rules of Fair Practice designed

to implement this policy and is moving ahead expeditiously to adopt the

necessary rule change.

The Commission recently liberalized the rules with respect to advertising of investment company securities. In the release announcing the changes

we described them as a modest first step in this direction and requested

further suggestions. 1/ Several have been received and are now under

- consideration.

It also is timely now to renew consideration of group merchandising of

fund shares at reduced sales loads, long a controversial subject. Rule 22d-1

permits quantity discounts to be provided in connection with the sale of a

mutual fund to any person but excludes from the definition of '"person" any

group whose funds are combined for such purchase. In 1968, the Commission

proposed a revision of this anti-grouping provision. 2/ That proposal was

held in abeyance pending completion of our staff study of Section 22(d).

The Commission has recently been asked to consider rule changes which would

result in lower administrative costs on payroll deduction plans and other

i/ Securities Act Release No. 5248, May 9, 1972

2/ Investment Company Act Release No. 5507, October 7, 1968

13
~-

- 4 - IC-7475

voluntary plans for accumulating mutual fund shares by means of periodic

small purchases. These rules now require that shareholders receive individual notices, confirmations, dividend statements and shareholder reports.

Our staff is exploring whether these rules can be revised without

diminishing the basic shareholder protections they provide as well as reexamining the earlier grouping proposal and the comments received on it,

Issues to be considered

A. Repeal of Section 22(d~ of the Act

1, Complete Repeal

The system of retail price maintenance under which mutual funds are

distributed tends to raise rather than lower prices. Under it, fund

distributors compete for the favor of dealers and salesmen through a

system of sales incentives which creates a constant pressure to raise

sales loads or reduce the principal underwriter's margin.

The question is whether there is any longer sufficient public interest

in the continuation of this system as an exception to the general rule of

free competition which prevails in 'most other segments of our economic

life.

2, Partial Repeal

Should retail price maintenance be retained but only for smaller sales,

allowing negotiated rates and free competition to prevail on that portion

of any purchase in excess of a fixed amount, for example $300,000? Or,

should a sysCem of negotiated rates be instituted gradually over a period

of time permitting data to be assembled as to the effects of repeal on

various segments of tY►e mutual fund market? If such gradual reductions

are appropriate, can theq be achieved under the Commission's exemptive

power or would legislation be needed?

1~,
~.

- 4 - IC-7475

voluntary plans for accumulating mutual fund shares by means of periodic

small purchases. These rules now require that shareholders receive individual notices, confirmations, dividend sCatements and shareholder reports.

Our staff is exploring - whether these rules can be revised without

diminishing the basic shareholder protections they provide as well as reexamining the earlier grouping proposal and the comments received on it,

Issues to be considered

A. Repeal of Section 22(d) of the Act

1. Complete Repeal

The system of retail price maintenance under which mutual funds are

distributed tends to raise rather than lower prices. Under it, fund

distributors compete for the favor of dealers and salesmen through a

system of sates incentives which creates a constant pressure to raise

sales loads or reduce the principal underwriter's margin.

The question is whether there is any longer sufficient public interest

in the continuation of this system as an exception to the general rule of

free competition which prevails in 'most other segments of our economic

life.

2 , Par t is I Re_pea 1

Should retail price maintenance be retained but only for smaller sales,

allowing negotiated rates and free competition to prevail on that portion

of any purchase in excess of a fixed amount, for example $300,000? Or,

should a system of negotiated rates be instituted gradually over a period

of time permitting data to be assembled as to the effects of repeal on

various segments of the mutual fund market? If such gradual reductions

are appropriate, can they be achieved under the Commission's exemptive

power or would legislation be needed?

1~,
- 5 - IC-7175

.-

3. Price Competition Within a Limited Mange

Should retail price maintenance be retained with respect to a

minimum schedule of sales loads, with the statute also specifying a

maximum sales load, but allowing ror price co~hpetition in the range

between the specified maximum and minimum loads?

4. A Current Public Offering Price Described in the Prospectus

Section 22(d) states that "no registered investment company shall sell

any redeemable security except either to or through a principal underwriter for distribution or at a current public offering price described in the

prospectus." Dealers are also required to sell at "a current public

offering price described in the prospectus." There is no explicit

requirement that there be a single uniform offering price, though that has been

the long-standing interpretation of the provision. Would the statute

be satisfied if the prospectus described different offering prices for

different dealers or in different situations and thus permitted price

competition in a manner sanctioned by the investment company itself?

S. Prohibit Price Competition from Non-Contract Dealers

Historically,a principal reason given for the enactment of Section 22(d)

was the need to prevent price competition and secondary or "bootleg"

markets made by non-contract dealers. Such dealers allegedly ~xndermined the

distribution structure by obtaining fund shares from sources other than

the principal underwriters and selling them for lower prices than contract

dealers could. In this way they could short-circuit the distribution process

and destroq the underwriter's ability to promote the fund. Is it desirable

or necessary to prevent this and, if so, if Section 22(d) is repealed should

the legislation also provide that only contract dealers would be entitled to

sell shares at prices ot~~er than the current offering price described in

the prospectus?

B. Rules Under Section 22~b) and Other Provisions of the Act

1. Lower Breakpoints reflecting the Reduced Cost of Diversification

on Larger Purchases

Section 22(b) of the Act gives the NASD and the Commission rulemaking authority to prevent mutual funds being sold at a sales load which

is excessive. Under ttn t section, as amended, mutual fund sales charges

must allow for "reasonable compensation for sales personnel, broker-dealers,

15
- 6 - IC-7475

and underwriters, and reasonable sales loads to investors". It is clear

that, whether or not Section 22(d) is repealed, mutual fund investors

require the protection of a statutory ceiling on sales loads. One of

the principles upon which the NASD study was based was that the cost of

fund shares should not exceed the alternate cost of a similar investment.

One measure of alternate cost used by the NASD's consultants was the

round-trip cost of purchasing a diversified stock portfolio. However,

on purchases in excess of $5,000 the alternate cost of diversification

appears to be significantly less than the load suggested by the NASD

rule proposal. Sales in excess of $5,000 accounted for about 70%

of the total volume of mutual fund sales in 1970. Should any NA SD

rules take into account the reduced cost of diversification on purchases

above the $5,000 1eve1?

2. Regulation of the Dealer-Discount

The Commission in its Statement on the Future Structure of the

Securities Markets expressed its concern over the effect of varying sales

incentives available from different funds. In theory there seems to be

widespread agreement that it is undesirable to allow an individual salesman

to participate in the brokerage generated by an investment company complex

whose funds he sells. The same kind of problem exists when fund distributors

pay different dealer discounts. When one fund offers a dealer discount

of 6 percent and another 8 percent, sellers are invited to recommend the fund

that pays them best rather than the one that is best for their client. This

practice also contributes to the pressure to raise sales loads or reduce

the distributors margin. Is this an area of concern and, if so, does the

Commission have authority to deal with it by classifying as an "underwriter"

under Section 2(a)(40) of the Act anyone who receives more than the "usual

and customary distributor's or sellers commission" on the sale of mutual

fund shares. In the alternative, should the NASD or the Commission take

action under Section 22(b) to limit dealer discounts? If dealer discounts

should be limited, in what respects?

3. Continuous Aiscounts

Under existing sales load structures purchasers of large volumes of

mutual fund shares receive a volume discount when purchases are made in

amounts exceeding specified breakpoints, e.g., $10,000, $25,000 or $50,000.

The reduced charge applies to the entire purchase, not merely to the portion

in excess of the breakpoint. This means that for a fund with a basic

sales charge of 8.5'/a which drops to 7.5% on purchases in excess of $10,000

or more, a $9,900 purchase will produce gross revenue of $841.50 £or the

selling organization. If the purchase were $100 greater, i.e., $10,000,

total selling compensation drops to $750. Such a system discourages sellers

from alerting prospects to the economies produced by breakpoints and places

ethical strains on dealers and salesmen. Should Rule 22d-1 be amended to

require that volume discounts be provided only where continuous schedules

are in effect under which reductions fall only on that portion of the order

in excess of the breakpoints? 16
7 - IC-7475

4. The Value of Additional Product Features

The NASD Study suggests that the maximum load be determined by the

value of the product and that only those funds which offered certain

product features -- dividend reinvestment at net asset value, lower

breakpoints for voltmme discounts and dividend reinvestment at net asset

value -- should charge the maximum loads. Is this ~ desirable approach

in the light of the fact that a significant proportion of investors do

not take advantage of these features? Is this approach desirable assuming

a system of continuous discounts?

5. Contractual Plans

Thy toCal sales loads on contractual plans and the breakpoints on

such plans are higher than the typical loads and breakpoints on mutual

funds generally. T~xe effective load on contractual plans may be significantly

higher when the effects of lapses and persistency is taken into account.

Is it premature at this time to take any action with respect to maximum

salsa charges applicable to contractual plane in light of the changed

conditions fn which the plan industry now operates, and in view of the

protections afforded td contractual planholders by amended Section 27

of the Act?

C. Further Liberalization of Advertising Rules

1. Advertising

Advertising, an effective and a relatively low-cost method of conveying

informatiAn to prospective purchasers, has been confined to a minimal role

in the marketing of investment company securities. Restrictions on

advertising have made it difficult for the mutual fund industry to tell

i'ts story through the mass media. The Commission recently liberalized

its rules with respect to the advertising of investment company securities.

What further liberalization would be in order? Is legislation necessary

in this area?

17
- 8 - IC-7475

2. Statement of Policy

The Statement of Policy which governs ~nvestmentcompany advertising

and sales literature has not been amended since 1957. A number of its

basic approaches have been questioned over the years. These include

limitations on projections, use of mountain charts to convey cumulative

performance, prohibitions against a total yield approach, absence of

data upon which to base conclusions as to average annual performance

and variability of performance from year to year. To what extent are

these elements of the Statement of Policy no longer appropriate?

D. Simplified More Readable Mutual Fund Prospectuses

Advertising restrictions rest on the premise that the statutory prospectus

will be the key selling document. However, selling practices typically

relegate the prospectus to a secondary role and very often legal requirements

result more in confusing the ordinary investor than assisting him in reaching

an informed judgment. The Commission has designated an Advisory Committee

to make suggestions with respect to this and related subjects. Assuming

simple clear prospectuses geared to the ordinary mutual fund investor's

needs, will the prospectus be used more extensively a.nd earlier in the

distribution process and will this affect selling?

E. Group Sales

Mutual fund sales charge schedules provide for quantity discounts

on larger orders. But the Commission's rules under section 22(d) preclude

the grouping or pooling of orders for the purpose of obtaining such discounts.

Has t~~is anti-grouping rule, which superseded contrary administrative positions,

outlived its usefulness?

F. Reducing Paperwork in Small Transactions

Payroll deduction plans and other voluntary plans for accumulating

mutual fund shares by means of periodic small purchases appear to offer

great potential. Some of the present rules under the federal securities

laws make such plans expensive. The rules in question require that each

fund shareholder receive such individual notices and services as individual

confirmations, dividend statements and shareholder reports. To what

extent can the Commission amend these rules to achieve lower costs on small

transactions without diminishing the basic investor protections they provide?
_ g _ IC-7475

G. No-Load Sales

Under present administrative interpretations brokers and dealers have

no direct incentive to recommend "no-load" funds, i.e., funds that sell

their shares directly to the public free from any sales charge. The impoaition of any charge for recommending the shares or for effecting the

purchase of such a fund, especially if the fund encourages or has knowledge of

the practice, has been viewed as an impermissible deviation from the prospectus

representations as to no-load status as well as a violation of Section 22(d).

Should the Commission re-examine its present administrative interpretations

in order to remove disincentives operating against recommending no-load

funds? Should it permit brokers and dealers to charge a normal stock

exchange commission for recommending and effecting an investment in a

no-load fund?

H. Development of An Adequate Economic Data Base

I£ mutual fund sales charges are to be regulated, reliable data as

to the industry's costs, profitability, and general economic structure

is necessary. Such data should be available on a continuous basis so as

to enable the regulators to monitor trends, thus avoiding the undue

regulatory lag that has plagued other types of regulation. Is it possible

- to develop s system of cost allocation and other accounting procedures

necessary to provide such data in a meaningful fashion? What burdens would

be involved in moving the industry to such a uniform system?

Procedures

The policy implications of these and other related questions are

of great significance to the securities industry generally and particularly

to investment companies, their principal underwriters, the broker dealers and

salesmen who distribute them, and to the investing public. Accordingly,

all persons interested in, affected by or concerned with the distribution

of investment company shares and the role of investment companies in the

securities markets are invited to provide their views to the Commission

with respect to all such issues.

19
- 10 - 

TC-7475

The proposed public hearings will be policy making proceedings.

They are designed to give the Comanission further insight into the major

issues and alternatives facing the industry in the area of mutual fund

distribution in order that the Co~nission may formulate its own legislative

recommendations, propose new rules and amend existing rules to the extent

appropriate under its present authority. Of course, as in so many areas

of the securities laws, the issues are largely interrelated and actions

in one respect may deeply affect others. Thus, the full impact of a

particular rule or legislative change may be difficult to gauge and all

of the questions raised will not be resolved definitively at one time.

These hearings are concerned with the formulation and establishment

of policy and the rules necessary to implement it. The procedures will be

tailored to this end. Because of the wide ranging scope of the inquiry

it appears appropriate and expeditious to require written submissions

in the first instance. Conmaents should be addressed to the enumerated

questions or other relevant issues the commentator may care to ca11 to the

Commission's attention. Persons comanenting may feel free to submit any

relevant data or other information relating Co these issues, and reference

may be made, where appropriate, to the Commission`s Staff Study, the NASD

Study, to prior hearings, policy statements or testimony. All such

submissions will be available for public inspection. After the Commission

has had a chance to review all submissions, brief oral statements will be

invited from among those who have made submissions and requested to be

heard. Persons making oral presentations should be prepared to respond

to inquiries from the Commission and its staff.

Interested persons are requested to submit their views, any data or

other comments or information in triplicate, to Allan S. Mostoff, Director,

Division of Investment Company Regulation, Washington, D, C. 20549,

no later than December 6, 1972. All such material should be designated

"Mutual Fund Distribution Hearings", File No.4-164.

By the Commission.

Ronald F. Hunt

Secretary
SECURITIES AND EXCHANGE COMMISSION

~" WASHINGTON, D.C. 20549

INVESTMENT COMPANY ACT OF 1940

Rel. No. 7035/Jaiiiiury lti, .I')7 i

SECURITIES EXCHANGE ACT OF 1934

Rel. No. ')95 3/,laiitiary 1R, 1073

INVESTMENT ADVISERS ACT OF 1940

Rel. No. 357/,Jarniary 18, 1~)7~i

ACCOUNTING SERIES

Rel. No. 140/Jarniary 18, l~)73

DISCUSSION OF DEVE~,OPMENT OF AN ADEQUATE ECONOMIC DATA BASE WITH

RESPECT TO MUTUAL FUND SALES CHARGES IN CONNECTION WITH HEARINGS

ON MUTUAL FUND DISTRIBUTION AND THE POTENTIAL IMPACT OF THE

REPEAL OF SECTION 22 (d) OF THE INVESTMENT COMPANY ACT OF 1940

(15 U.S.C. 80a-22(d))

File No. 4-164

On November 3, 1972, the Commission announced hearings on mutual fund

distribution and the potential impact of the repeal of Section 22(d)

of the Investment Company Act of 1940 (Investment Company Act Rel.

No. 7475; 37 FR 24449, 11-17-72). Section H of that release discussed

the desirability of developing an adequate economic data base with

respect to mutual fund sales charges. Such data could facilitate the

Commission in monitoring trends in the industry's costs, profitability,

and general economic structure. If this data were made publicly available

by the Commission on a timely basis, it could provide mutual fund

directors with information which would be of value to them in the

discharge of their duty in evaluating investment advisory and principal

underwriting contracts. A threshold question is whether it is necessary

to develop procedures for the full allocation of expenses to revenue in

order for the Commission and .mutual fund directors to discharge their

responsibilities. In this connection, particular attention is called

to the December 29, 1972, report to the Commission by the Advisory

Committee on InvesCment Companies and Advisers. Of course, in order to

embark on any such program of data collection analysis and dissemination,

the Commission would have to develop adequate sCaff resources and review

capability.

This release is intended to provide a focal point for discussion during the

hearings and to articulate some of the possible approaches in this area.

21
2 - IC-7635

A. Inveatmeat Advisers wcid Principal Undexwxit~xe

I. Information Presently Available

Information currently available concerning the financial environrient of

mutual fund management companies is both incomplete and inconsistent in

terminology and foYtnat. Far example, Foxm 10-K's (17 CFR 249.310), which

contain financial schedules, are filed by publicly-held investment

advisers and principal underwriters, but most investment advisers and

principal undsxwriters are not publicly held and therefore do not file

such information. Furthermore, although the information contained in

the Form 10-K's permits an evaluation of profitability, it does so only

for total operations, which often include non-mutual fund operations such as

real estate or insurances The terminology used within the income statement

is often inconsistent from one company to another. For example, "Management fees•, etc." may include fees other than investment company advisory

fees. Expense items are usually consolidated under accounting titles too

general to permit an outsider to relate such expenses to a specific

revenue source.

Form N-1R, (17 CFR 274.101) filed by most registered management investment

companies, provides information on the gross revenue received by an

investment adviser and principal underwriter from advisory fees and from

underwriting operations. Although in certain circumstances income statements of the investment adviser or principal underwriter are required in

the report, a breakdown of expenses between underwriting and advisory

£unctions is not required.

II. Data Base Desirable

A. Background

The "Economic Study of the Distribution of Mutual Funds and Variable Annuities"

released by the ?NASD in May 1972 suggested that expenses were an unreliable

element in determining the reasonableness of mutual fund sales charges.

These expenses are difficult to measure precisely; past expenses are not

necessarily a measure of future expenses; and expenses need not be

functionally related to income since expenses in one area may be incurred

to obtain revenue for an unrelated function. For example, expenses may be

incurred in underwriting to obtain future revenue through increased advisory

feeso While this may be presently the case, it may nevertheless be feasible

to develop an income and expense reporting system for the industry which

could facilitate future economic analyses.

B. Functional Breakout

1) Undex~rritins~ v. Advisory E:~penses

Is it feasible and desirable to account separately for the profitability

of distributing and advising mutual funds? Would such a separation be

helpful to management or to shareholders in measuring relative profitability

of the advisers or underwriter's operations? What burdens on management

would the requirement for separate accounting produce?

22
- 3 - [(:-7(~i5

2) Areas of Profitability

One approach to constructing a data base to provide a meaningful

delineation of profits would be to require separate identification of

income and expenses for particular Functions of investment companies such

as:

(a) sales charges (gross or net) from underwriting,

(b) sales charges from retailing,

(c) fees for investment advisory services,

(d) fees for administrative services,

(e) income from brokerage generated by an investment

company's portfolio transactions, and

(f) other income.

3) Components

The components of each function could be accounted for separately to show

(a) revenue items, (b) direct expenses and (c) indirect expenses.

Sa) Revenue. Can gross revenue be identified for each income area of

concern?

(b) Direct Expenses. Some expenses are directly attrib~stable to

specific revenue producing functions and can be identified with them if

records adequate for the purpose are maintained. Sucli expenses could include:

(i) sales charges paid to dealers,

(ii) sales representatives' compensation,

{iiil salaries of other sales department personnel,

(iv) sales promotional expense,

(v) salaries of investment research personnel -- analysts,

economists, statisticians, etc., and

(vi) cost of execution facilities for brokerage.

Is accounting or recorclkee~~i.no for direct expenses maintained in such a way

as to permit an accurate breakdown of such expenses among functions? If not,

would it be practical and how costl} would it be to do this?

(c) Indirect Expenses. Various expenses cannot be assigned directly to a

single function. These must be a1l.acated, at least in part, among functions

to arrive at separate profit figures. Such expenses could include:

23
- 4 - 1C-7f~35

(f) salaries (for executives engaged in more than one function),

(ii) general administration e.~penses,

(iii) occupancy and equipment expense,

(iv) depreciation and amortization,

(v) dues, fees and assessments paid to exchanges, associations

and regulatory •sgencies,

(vi) interest expense,

(vii) income taxes and other taxes, and

(viii) other allocable expenses.

What is the most reasonable method for allocating these expenses? Since

indirect expenses must be allocated with some discretion, there are various

methods that could be considered. For example, could they reasonably be

allocated on the basis of total direct expenses incurred by the various

revenue producing functions? Could direct labor hours, total payroll dollars

or revenue dollars received from each function serve as a basis? Could a

method of allocation be devised separately by each firm on the basis of

"reasonableness," and sufficient consistency within the industry still be

maintained? What approaches would result in a fair statement of profits

among functions and a reasonable degree of consistency throughout the

industry? Should such approaches be subject to Commission or NASD approval?

4) Other Expense Considerations

Ys it relevant to break down expenses to the individual fund level?

Certain management expenses are now allocated among funds in a complex

based on each fund's assets relative to the total assets of the advisory

complex. However, many complexes consist of funds of varying sizes and with

different investment objectives, gnd management effort may not be actually

expended in direct proportion to asset size. Under these circumstances,

should some basis other than relative assets be devised?

III. Reporting

Would a periodic reuort by principal underwriters and advisers of

investment companies, stating the revenues, expenses and profits associated

with each revenue producing function be the most effective means of disclosure?

What would be the least burdensome method of such disclosure? Revision of

an existing report form to provide for the submission of additional financial

information could be considered. The alternatives available are:

c
A. Form N-1R (17 CFR 274.101). This report is now submitted by most

management investment companies and is generally reviewed by the directors

of mutual funds. Also, the Form N-1R has been designed for computer entry

and would thus lend itself to statistical study. However, is a report

submitted by the funds a proper vehicle for reporting profit data of the

management and principal underwriting organizations?

B. Form 1C-K (17 CFR 249.310). Th~.s report, by its nature, lends itself

most easily to the type of information required.- However, it is filed by

only a small percentage of mutual fund management and principal underwriting

organi2ations and would thus provide only a limited sampling.

C. Form ADV (17 CFR 279.1). The registration statement~of investment

advisers would permit the management to report in a more direct fashion

than a vehicle such as Form N-1R which is submitted by the funds. However,

Form ADV is filed by all registered investment advises, not just those

which advise mutual funds. Further, Form ADV is required to be filed only

once and updated only when any of .the information becomes inaccurate. The

Advisory Co~nittee on Investment Companies and.Adv~sers has recommended

that this form be filed on an annual basis and revised -and. expanded to

serve as the basic adviser reporting dorm. If the resources necessary

for the monitoring and utilization of the .data wexe available, would the

recommended replacement report be a proper reporting instrument?

D. Form X-17A-10 (17 CFR 249.618). This report is -the basic source of

financial information concerning the operations of broker-deaJ.ers and is

filed annually by all broker-dealers with at least $20,000 of gross

securities income. The report requires the disclosure of details of income

but does not allocate expenses. It is submitted for the calendar year on

a non-public basis. Should this form be amended to include profit data

for underwriting and managing mutual fuc~ds? O,r,,should such information

be obtained more directly since the brokerage business may be ocily a small

part of a larger mutual fund operation and may be organized separately?

In light of the limitations of each of these reports, should a new report

format be devised which would be used only by the principal underwriter and

adviser to mutual funds? In order t~ be useful to all concerned, the data

must be reported in a timely manner. This would permit monitoring earlier

in the development stage of new trends. Would an annual basis be the 1~roper

interval? Would fiscal year rather than calendar year be preferable?

25
6 - IC-7637

B. Broker-Dealers

Many of the considerations in the foregoing discussion relating to the

profitability of managing and underwriting mutual funds apply also to

broker-dealers engaged in the retail sale of mutual fund shares.

The sale of mutual fund shares generally represents a relatively small

percentage of the gross revenues of broker-dealers. However its relative

significance to them cannot be evaluated since reported expenses are not

allocated to this and other revenue sources. For example, is the profit

per dollar of revenue or per transaction greater or less than the profit

on other segments such as co~~esion business or underwriting, particularly

of such competing investment products as closed -end funds and certain real

estate and tax shelter investments? Could the necessary allocation methods

suggested in the instructions to the New York Stock Exchange revised Income

and Expense Reporting Form be adapted for this purpose?

For those broker-dealers to whom revenue from the sale of mutual funds

constitutes a high percentage of gross revenue, there should not be a

problem in ascertaining costs allocable to those sales; however, these

represent only a relatively small fraction of the total number of brokers.

Does allocation of expenses become more difficult in larger concerns which

conduct a diversified securities business in which the sale of mutual fund

shares is only one of several sources of revenue? For such a firm, can

certain direct expenses, such as sales executivies and employees

compensation and sales promotion, be related to a revenue source? Is the

current practice with respect to allocation sufficient to impart an

appropriate understanding of the relative significance to such firms of

the retail sales of mutual fund shares?

This discussio-~ is not intended to zepresent a formal proposal for a rule

amendment but rather only to stimulate additional comments during the

forthcoming hearings.

By the Co~nission.

Ronald F. Hunt

Secretary

~_
`~ ~, ~;

NATIONAL ASSOCIATION- OF SECURITIES DEALERS, INC.

1 7 3 5 K STREET NORTHWEST WASHINGTON D. C. 2 0 0 0 6

November 6, 1972

TO: All NASD Members and Interested Persons

RE: Pro ose3 Amendments to Re ulations Governing Sa3.es

harges on Mutu~,i Fund Shares and Variable Annuity Contracts

1. Proposed Amendments to Subsections (a) and (d) of

Article III, Section 26 of Rules of Fair Pract;.ce

2. Proposed Amendment to Subsection (c) of Article~III,

Section 29 of Rules of Fair Practice

The Board of Governors of the Association has proposed

amendments to existing regulations, as referenced above, which

are being published aL this tirx~e to enable all interested persons to

comment thereon. Such comments must be in writing and received

by tlle_Associ~tion on or before December 6, 1972, in order to

receive consideration. After the comment period has closed, the

proposed amendments must again be reviewed by the Board taking

into consideration the comments received. Thereafter, upon

approval by the Board, they must be submitted to the membership

for a vote. If approved, the proposals must be submitted to and

not disapproved by the Securities and Exchange Commission prior

to becoming effective.

The authority for these proposals is contained in Section 15A ,

(b} (8} of the Securities Exchange Act of 1934, as amended (the

Maloney Act), 15 USC ?80-3 (b) (8); Section 22 of the Investment

Cornpany Act of 1940, as amended, 15 USC 80a-22, and ArticJ.e `'II

of the Association's By-Laws.

Background and Explanation of Proposals

Under i:he 1.970 Amendments to Section ~2 (b) of the Investmeiit Company Act of 1940, the NASD has the oLligati.on to formulate

and enforce rules preven~in~ sales charges on mutual fund shares

which are "excessive". In establishir_b such rules L1lF: allo~~~ance of

"reasonable compensation for sales personnel, br~lcer-dealers, and

,^, underwriters", and the imposition of "reasonable" sales charges for

i.nveGtors is GrPcif.icaJ.l.~T provided for in the legislation. To assist

27
-2 -

in the objective formulation of sales charge rules, the Association

engaged a firm of independent consultants to undertake an intensive ~ ~

"Economic Stucly of the Distribution of Mutual Funds and VariaUle

Annuities" ("Study") with the objecti~~e of formulating criteria for

the appraisal of sales charges in light of all relevant factoi s.

As originally understood, the Study was to leave covered

sales charges only for open-end investment company shares.

However, at the request of the SEC, the scope of the Study was

widened to include contractual plans and variable annuity coni:racts,

as well as consideration of alternative methods of distributing

mutual fund shares. All phases o~ the Study have now been completed. Without necessarily endorsing all aspects of the Study, the

Association has, after review of the Study facts and conclusions,

accepted the regulatory approach recommended by the consultants

and the proposed amendments to Article III, Sections 26 and 29 of

the Association's Rules of Fair Practice.

The guiding considerations that underlie the proposed rules

are the protection of investors and the maintenance of an industry

structure that will promote services of a high quality. To insure

trese objectives, the proposals are not the result of a particular

formula, but reflect a judgmental weig:iing of factual evidence

bearing on the following four standards used for evaluation of the

reasonableness of the sales charges:

1. Effective competition: Competition may take the form

of price and product competition. The Association is directing its

regulatory authority, as a supplement to market forces, to~~var~

remedying imperfections in the market so as to assure a priceproduct structure consistent with effective competition. The objective is to maintain a sales charge structure where the sales charge

declines as the size of the purchase increases and where higher

sales charges are accompanied by better terms.

2. Value of Service; Charges to the investor must not

exceed the value provided to the investor by diversification plus:

(a) the value of various product features; and (b) the value of

services rendered coincident with the sale of investment company

securities. The value to the investor is measured by the cost

that the investor would incur if he sought on his own to purchase

tl~e Uenefits and services he received through the acquisition of

inv~;stment company securities.

3. Salesmen's Compensation: Sales c}iar~,es must allow for

compensation levels that are sufficient to attract personnel commensurate with the quality of the service required, ~ivin~ consideration

to the time spent in the sellinb effort, the level of education, and

professional experience of sales personnel.

4. Cost of Distribution: Sales charges should be sufficient

to cover the costs incurre~c by underwriters and broker-de~ilers plus

28
- ~

a reasonable allowance for profit. The relevant costs are those functionally related to the sales of investment company securities within

an industry structure characterized by a sufficient number of efficiently managed large and small firms to insure effective competition.

The results of the application of these standards, both in terms

of conclusions expressed in the Study and in terms of the relationship

of these conclusions to the proposed amendments to the rules, are

discussed separately as they relate to sales charges on mutual fund

shares, variable annuity contracts, and contractual plans.

Sales Char es on Mutual Fund Shares --

Proposed Amendments to Section 2

Proposed Amendment to Subsection (a)

The proposed amendment to subsection (a) of Section 26 is a

conforming amendment necessitated by those provisions contained in

the proposed amendments to subsection (d) pertaining to "single paynnent" investment plans issued by a unit investment trust registered

under the Investment Company Act of 1940.

Proposed Amendment to Subsection (d)

The proposed amendment to subsection (d) of Section 26 would

prevent members from selling shares of an open-end investment

company or a single payment investment plan issued by a unit investment trust registered under the Investment Company Act of 1940 if

the public offering price includes a sales charge which is excessive

taking into consideration all relevant circumstances. Following this

general prohibition are several provisions which if not conformed to

would deem a sales charge to be excessive. These provisions were

developed taking into consideration the four regulatory criteria

discussed above.

The application of the four regulatory criteria to the distribution of mutual fund shares reflects the following:

1. Effective Competition: During the decade of the 1960's,

the competitive forces in the industry brought about significant

improvements in the terms on which investors are able to acquire

mutual funds. The Study clearly indicates that there has been a

decline in the minimum purchases needed to benefit from quantity

discounts; the availability of cumulative quantity discounts has

become more widespread; an increasing proportion of funds offer

reinvestment of dividends without sales charges; and exchange and

combination privileges are now offered by virtually all underwriters

selling several funds. These improvements in the terms, together

with other factors, have resulted, despite a rise in maximum sales

charges, in a 30 percent decline in the average sales charge to

~~
~'~

investors, from 6. 3 percent in 1960 to 4.4 percent in 1970. The

investor has also benefited from lower minimum purchase requirements, a wi.deapread offering of retirement plan services, and an

improvement in the conditions of eligibility for withdrawal plans.

While. the Study shows that the price-product structure is

generally consistent with conditions of effective competition, the

proposed amendments to subsection (d) of Section 26 are intended

to improve competition in the following areas:

(a) The disparities in maximum sales charges among the

various funds were not generally found to be product

related; i. e. , funds with a higher maximum sales

charge do noL- generally offer better terms than funds

with a lower maximum. Proposed subsection (d) (1)

of Section 26 therefore prohibits sales charges which

exceed an established maximum level under any

circumstances.

(b) The Study revealed that- a significant proportion of

mutual funds offering reinvestment of dividends at

regular sales charges do not have lowex maximum

sales charges or offer better terms than funds offering dividend reinvestment without sales charges

(i. e. , at net asset value}. Consequently, proposed

subsection (d) (2) of Section 26 provides that if

reinvestment of dividends at net asset value is not

offered, there shall be a stated reduction from the

maximum sales charge otherwise authorized. If

dividends are reinvested at net asset value, a

reasonable service fee may be charged for each

dividend reinvestment transaction.

(c) According to the Study, a significant proportion o£

mutual funds that do not offer cumulaL•ive quantity

discounts to individuals do not have lower maximum

salsa charges or offer investors better terms than

funds that do offer such discounts. Accordingly,

proposed subsection (d) (3) of Section 26 provides

that if cumulative quantity discounts are not offered,

there shall be a stated reduction from the maximum

salsa charge otherwise authorized.

(d) The Study found considerable variance in the discounts

granted for volume purchases. As a result, proposed

subsection (d) (4) of Section 26 establishes minimum

standards for quantity discounts for the first and

second gradations, or breakpoints. If the quantity

discounts offered do not meet these minimum standards,

there shall be a stated reduction from the maximum

sales charge otherwise authorized,

30
The reductions in maximum sales charge required by the

above proposals are cumulative so that if, for example, none of

the specific services offered meet the minimum requirements of

'~ the rule, the maximum permissible sales charge on any Lransaction

would be 6 percent.

2. Value of Service; The Study supports the conclusion that

the proposed rule amendments will result in a structure of sales

charges where the value of service received by the investor exceeds

the cost of acquisition, giving consideration to the diversification

needed to reduce risk, the benefit of other product features, and the

services rendered by salesmen. This i.s particularly true for the

smaller investors.

3. Salesmen's Compensation: The Study shows that relatively

few salesmen earn substantial incomes from the sales of mutual fund

shares. It is pointed out as well that, in relation to the sales effort

involved, the structure of sales charges does iio~ peg rniL or encourage

"excessive" compensation to mutual fund salesmen.

4. Cost of Distribution: According to the Study, the existing

structure of sales charges did not provide "excessive" compensation

for underwriters or broker-dealers in recent years. Moreover, in

1970, the last year for which data are available, only the largest,

diversified, broker-dealer firms achieved profitable operations

from their mutual fund business.

The proposed rule amendments are in the form of alternatives

and have been limited to the four most important variables that bear

on the effective sales charge paid by investors: the maximum sales

charge, quantity discounts, dividend reinvestment, and rights of

accumulation. The proposals are intended to be sufficiently flexible

to permit adjustments based on an assessment of changing competiti.ve conditions in the particular market that is served and to allow

innovations in product features, services, and distribution methods.

It is recognized that other aspects, such as exchange and

combination privileges, and letters of intent, also influence the

effective sales charges. The Association intends to keep these

and other product features offered under surveillance and, if

necessary, make such features the subject of specific rules. The

surveillance is intended to guard against attempts to circumvent

the effect of the proposed amendments by changing the terms on

which product features are now offered to investors or by instituting charges or special fees for the redemption of outstanding mutual

fund shares, or for other services or features not covered specifically in the proposed rule amendments.

Sales Cl~ar~es on Variable Annuities --

roposed men ments to ection

In view of the fact that variable annuities differ suUstantially

from mutual funds, parti~~xlarly with respect to industry structure,

31
~~

degree of matuxity, regulatory aspects, and price-product characteristics, separate rules are required for variable annuity sales .

charges. Nevertheless, the same four criteria or standards of

regulation are relevant to an appraisal of sales charges in order to

protect the investor and assure the viabi.iity of the variable annuity

industry. Important considerations, too, in formulating the xules

are the "infant industry" status of the .variable annuity business and

the dual natuxe of the product (i. e. , securities and insurance)

resulting in a complex regulatory framework that involves the SEC,

State Insurance Commissioners, and the NASD.

With respect to the four regulatory criteria adopted, some

primary Study conclusions and their relationship to the proposed

rules follow:

1.• Effective Competition: Given the present deo.ree of

industry maturity, competition is generally developing satisfactorily

with respect to rate of entry and on aprice-product basis. Because

of the "infant industry" status of the industry, the nature of developing competition rather than the status of existing competitio~i, is the

relevant yardstick. The Study concluded as well that the existing

level of charges on variable annuities generally is not excessive

either from the investor's or the industry's viewpoint.

However, the existence of certain market imperfections was

disclosed by the SL-udy, which the Association's proposed rules are

intended to remedy:

(a) A wide diversion of prices and price structures

currently exists in a market where higher sales

charges may not always be accompanied by better

terms. Consequently, proposed subsection (c) (1)

of Section 2g provides that sales charges on variable

annuity contracts shall not exceed an established

percentage of purchase payments in the first Lwel.ve

contract years.

(b) It was brought out in the Study that approximately

three-fourths of single payment variable annuity

contracts provide for graduated sales charges

based on the size of purchase payments. Therefore,

proposed subsection (c) (2) of Section 29 requires

Lhat a specific minimum scale of graduated sales

charges be offered.

(c) In a very few contracts, deductions from purchase .

payments are not separated according to the nature

of the expens<~s that they cover. Consequently, the

Study concluded that in such cases it is not possible

to det~:rmine what part of Llle charge is for sales

and what part is for administrative e~;penses. Proposed subsection {c) (3) of Section 29 therefore

requires Li~aC if i:he charges are not stated separately,

32
-~-

the total charge shall be regarded as a sales charge

and brought within the established limitations.

(d) A further conclusion of the Study was that future

competition may be enhanced through the establishment of more stringent disclosure requirements

and lifting of the current "blanket" restrictions on

hypothetical illustrations. The Association agrees

with that conclusion; however, it is believed that

these issues will require additional work and

separate recommendations by the Association to

the SEC.

2. Value of Service: It was concluded that the value of

ser~•ice provided to investors by variable annuii;ies through portfolio

diversification and dividend reinvestment alone, i, e. , without consideration o.E any other product fea~ures, exceeds the sales charge

for most plan purchasers. This conclusion is based on calculations

using the average monthly purchase payment of approximately $100

under periodic payment variable annuity contracts. Moreover,

variable annuities provide a "bundle" of product features, which

cannot be assembled through alternative retirement-planning instruments at the present time.

3. Salesmen's Compensation: The Study concluded that

compensation earned by full-time agents on sales of variable annuity

_. contracts is not excessive when compared with compensation from

available alternative sources.

4. Cost of Distribution: Because of the newness of variable

annuity operations for most carriers, costs of these operations

could not be considered in the Study as an appropriate standard for

regulating sales charges. Current costs are not representative of

future long-term costs and owing to the product mix of carriers there

are limitations in distinguishing those costs arising from variable

annuity operations. Tlie Study makes clear from available cost data,

however, that current sales charges fall far short of covering current

distribution costs.

The conclusions reached in the Study, and the proposed amendments to Section 29 regarding sales charges on variable annuities, are

largely influenced by the early stage of development of variable annuity

operations. Consequently, they must be re-evaluated as regulatory

experience is gained in this area and as the industry grows. However,

the Association believes that the proposed rule will have a strengthening

influence on competition in the course of future industry development.

Too, the proposed rule addresses only the maximum sales

charge and the structure of sales charges. It has been formulated in

light of the belief that Lhe Association has no jurisdiction over charges

made against purchase payments other than sales charges, Such other

33
charges would include those for administration and those for investment management and for the mortality and expense risks assumed

by the insurance company, that are generally made against the assets ~'

of the separate account. The Association understands that the SEC

has already assumed surveillance over charges for administration

and in most instances requires issuers of variable annuities to disclose in their prospectuses that charges for administration will not

exceed the cost of providing administrative services.

Contractual Plans

One of the principal areas of regulation changed by the 1970

Amendments to the Investment Company Act was the regulation of

periodic payment contractual plans, particularly the levels of first

year sales charge deductions on such plans.

Specifically, amended Section 27 of the Act provides a contractual plan sponsor with the choice of offering the conventional

periodic payment contractual plan with up to 50 percent of the sales

charge deducted from thz first year's payments, but only if coupled

with a refund offer to the planholder of hip entire sales charge plus

the underlying net asset value of the related matual fund shares if

requested 45 days from the start of the plan (this provision being

commonly referred to as the 45-day "free look" privilege), and the

right to receive a refund within 18 months after the start of the plan

representing any excess paid for sales charges over 15 percent of

the payments made by the planholder to that date plus the net asset

value of his shares. Alternatively, the sponsor may offer a spreadload plan, pursuant to which not more than 20 percent of any payment

may be deducted for sales charges from any of the first 36 monthly

payments and not more than an average of 16 percent may be deducted

from the first 48 monthly payments. Under this spread-load alternative, the sponsor is also required to offer the 45-day free look

privilege.

As authorized by Section 27, the Commission also prescribed

forms of notice to be furnished with the refund offers and substantial.

reserve requirerz~ents for plan sponsor companies with respect to the

refund obligations. These new provisions were added to provisions in

the original 1840 Act which, among other matters, fixed a 9 percent

nnaximum sales charge on the total payments to be made and provided

that not more than one-half of the-first twelve monthly payments, or

their equivalent, could be deducted for sales charges.

The Study clearly demonstrates that the amendments to Section

27 have contributed to major changes in the structure of the contractual

plan industry, as described in the Study, l~s recently as early 1970,

there were approxiTnately 50 contractual plan sponsors offering 77

separate periodic payment contractual plans; at the beginning of 1972,

only 30 sponsors were offering 49 separate plans. Prior to the 1970

Amendments, only one sponsor offered periodic payment contractual

3~+
plans on a spread-load basis; at the beginning of 1972, 21 of the 49

contractual plans still being offered were available on a spread-load

basis. However, due to the limited amount of time that had elapsed

since passage of the 1970 Amendments, the Study could not reflect

either comprehensive data relating to the distribution of new contractual plan sales as between front-end and spread-load plans, or

comprehensive data relating to the cost impact on plan sponsors

associated with compliance with the provisions of amended Section

27. Moreover, since compensation arrangements of many plan

sponsors and Uroker-dealers were still in a state of flux, it was

impossible to assemble meaningful data with respect to the changes

which have taken place in modes of compensation to sales personnel

and broker-dealers on new plan sales as a result of the Amendments,

and the consequences of such changes in sales incentives.

One of the most significant £actors contributing to these

changes, as recognized by the Study, is the 18 month refund provision. The first 18 months after the effectiveness of the Act will

not have passed until December 24, 1972, and it will only be sometime thereafter, when analyses can be made of the significance of

refunds during successive 18 month periods, changes in levels of

compensation, and changes in the level and distribution of new sales

between front-end load and spread-load plans, that the impact of the

refund provision on the viability of the plan industry can be measured.

In these circumstances, and in view of the protection afforded

to planholders by amended Section 27 of the Act, the Board has decided

to defer the formulation of rules with respect to sales charges on

periodic payment contractual plans until sufficient time has elapsed

to permit an assessment of the impac:.~ of the amendments on the

contractual plan industry and a determination of whether the level and

structure of sales cl-iarges meet the standards specified by Section 22

(b) of the Act, While the proposed rules do not therefore apply to

pexiodic payment plans, the Association will be monitoring further

developments in the industry and rules may be necessary at some

future time.

With respect to single payment contractual plans, the application of the four standards or criteria of regulation (i. e. , effective

competition, value of service, salesmen's compensation, and cost of

distribution) led to conclusions similar to those drawn from the Study

with respect to open-end investment company shares. Since these

plans were essentially unaffected by the 1970 Amendments, the proposed amendments to Section 26 would apply to single payment

contractual plans as well as regular purchases of mutual fund shares.

Comments on the. proposed rules should be addressed to Mr.

Donald H. Burns, Secretary, National Association of Securities

35
- 10 -

Dealers, Inc. , 1735 K Street, N. W, , Washington, D. C. 20006, ~ 1~'

on or Uefore December b, 1972. All comrr~unications will be

considered available for inspection,

Very tru -ours,

./, ,

~' ~~ .~. 

, a~

Go don S. MackJ.in

~esident

~~

36 ~~j ~
- 11

Text of Proposals

Pro osed Amendment to Article III,

Section 2 of Rules of Fair Practice

New material indicated by underlining

Deleted material indicated by striking out

Subsection (a) of Section 26 is proposed to be amended as follows:

(a) Except for the provisions of subsection (d), this rule

shall apply exclusively to the activities of membexs in

connection with the securities of an "open-end managemen1: irvcstr~ez:t company" ~s defined in the T.nves~tnent

Company Act of 1940.

Subsection (d) of Section 26 is proposed to be amended as follows:

Erross-~ellzxg-Ge~rr~sg~o-r~ Sales Chaxge

(d) No member v~~~ i-s-aa-~nvarrte-r shall pa~rit~.erp~~t~-ii3~~e

offerir~- or rrr~~e-sale sell e~~.3ry-steek-ge~c~x~i.~~ tie shares

of any open-end investment company or any "single pay-

__ ment" investment plan issued by a unit investment crust

registered under the Invest~ner~t Company Act of 140 if

the puUlic offering price ir_cludes a gi~s~~s-e3.~i~rrb-er~rYrr~seit~4x-~{r.e: ;-~Yre-fly.€f,.~~~ee-be~vaee~-t~~e-g~.b~-i~-

e€fe~ixg-~+r~ic-e-a~~ tie-p~it~-~~eei.vec~-b}~~13e is~tze~~ sales

char e which is e~x€a~i~ excessive, taking into consideration

all relevant circumstances. i~re~xc~rrrg ~~ie-e~.rrx e~x:t x~•a~x-l~e~t~a-

~tl~~}~o€-~u.~e-Y~~~tt~3~~~.mod-ail-ex~eaaes-i~~vo~.ded Sales

charges shall be deemed excessive if they do not conform

to the ~'olle~~•inR provisions:

(1) The maximum sales char eon a.n transaction

shall not exceed £3. 50 0 of the offering price.

(2) (a) Divi.dei~.d reinvestment shall be made available at

net asset value per share to "any person" ~vho

regtie;sts such reinvestment wit}iin LO days~rior

to P«Yment date, suUject only to the ri~;tit- to limit

the availability of dividend reinvestment Lo holders

of securities of a stated minimum value, i;ot

greater than ~1, 100, and provided that a reasonable service char?e may be applied against each

reinvestment of dividends.

(b) If dividend reinvestme:~t is not made available on

terms at least as favorable as those svecified in

37
- 12 -

subsection (2) (a), the maximum sales char eon

any transaction shall not exceed 7. 5 0 of off.eri.ng

rice.

(3) (a) R~thts of ~.ccumulation (cumulative quantity discounts) shall be made available to "an erson"

for a period of not less than ten 10) years from

the date of fi~•st`~urchase in accordance with one

of the alternative quanti.t discount schedules pro_

vi ed in subsection 4) a) below, as i.n effect on

the date the ri.~ht is exercised.

(b) If Rights of Accumulation are not m~.d~ available

on terms at least as avora e as t. ose spec~£iecr

in subsection :i a the maximum sa.e~s charge

Oil ii.YZ~' t1i;1i~lJtwG1.LV11 il~:l.l:. .1 C% C:::C:Ci.;:..

(I) 8. 0°fo o£ offering price if the provisions

o su section a are met; or

(2) 6.75% of offering price if the prc~isions

o subsection a. a.re not met. r~~

(4) (a) QuanY.i,ty discaur~ts shall he made availa~~le on sink le

purchases by "any perso~i~~ in ?..Cr UTU~.'f:CC. Wlih ones

o the of owing two alt~~rra?:ivies:

(1) A maximum sales char ;e of 7.75%a on

purchases of .~~ .0, UOU or more an- a

maximum sales chax~;e of~L~ ~o on

~urcha.ses ~'bb or more; or

(2) A maximum sales char e of 7. 50 ~'o on

Purchases o 0 ox more.an

ma~:irnu-r_~ sales chafe of , c.5~i o ir

~urcha~es o 25, OOU or more.

(b) Lf quantity discounts are not made avzilable. on terms

at east as avora e ast ose specs ie i ii suT~sect~.on

a ti ie maximum sales c :arge on any tra.nsuction

s ~a not e~:cee

(1) 7.75°jo of offering price if the provisions

o ~:,ections a aii a arc. met;

(2) 7. 25% of offering price if the provisions

o~ subsection a are met gut t e provisions o su section a re not met;

(3j 6. 50 jo v£ offering price if the provisions

o u.~sec aon a are met u e provisions o~su S~C~l0I1 a are no me ;

,,

,; ;

V
- 13 -

- (4) 6. 00% of offerin rice if the rovisions

of subsections 2 a and 3) a are not met.

(5) The term "any erson" as used in this rule shall mean "an

person" as defined in Rule 22d-1 a under the Investment

Company Act of 1940. .

Pro osed Amendment to Article III,

ection 29 of Rulc;s of Fair Practice

New material indicated by underlining

Deleted material indicated by striking out

Subsection (c) of Section 29 is proposed Lo be amended as follows:

Sales mead Charges

(c) No member shall participate in the offering or in the sale

of variable •annuity contracts if the purchase payment

includes a sales k~c~ charge which is x~fa-ice excessive:

~l~i~rg-rr3-t~-eeris~r-a-taox-mil -z~le~~a.~~-c-i-~~z~ska~c-e~s.

(1) In contracts providing for multiple payments a

sales charge sha11 not be deemed to be excessive

if the contract rovides for a sales charge which

will not exceed 8. 5 0 of the total payments to be

made thereon as of a date not later than the end

of the twelfth year of such payments, provided

that if a contract be issued for anv stipulated

shorter ayment eriod, the sales char e under

such contract shall not exceed b. 5 0 of the total

payments thereunder for such period.

(2) In contracts providing for single payments a sales

charge shall not be deemed to be excessive if. the

contract provides for a scale of reducing sales

charges related to the amount of i;ize purchase pavment which is not greater than the fol.lowin~Y schedule:

Fii st $25:OOQ - 8. 5% of urchase a ment

Next 5, 000 - 7. 5 0

Over 50, 000 - . 5 0

(3) In contracts where sales charges and other deductions from purchase payments are not stated

separa.tiely, the total deductions from purchase

payments excluding; those Ior insurance prcmi.ums

39
E1LP'HABETICAL INDEX OF PARTICIPANTS IN

MUTUAL FUND DISTRIBUTIOtd HEARINGS

~~ NAME PAGE

Thomas Anderson, Vice President 1820

Supervised Investors Services, Inc.

John Asling, rho se 683

Robert Augenblick, President 103, 1831

Investment Company Institute

David Babson, President 1638

David L. Babson & Company

Bradley Baker, President 1022

National Mutual Fund Managers Assn.

Samuel Ballin, Senior Vice President 965

Zenith American Securities Corp.

Paul Baris, Esquire 627

First Investors Corp.

Richard Bassuk, Chairman of the Board 1381

Side Fund, Inc.

"- A rthur Blakeslee, IIT, President 1581

Aetna Variable Annuity Life Insurance Co.

John C. Bogle, President I9, 1651, 18?_0

Wellington Management Co.

S. Whitney Bradley, Senior Vice President 538

Securities Industry Association

David Burke, Vice President 1164

Dreyfus Corp.

Robert Cleary, Vice President 252

Merrill Lynch, Pierce, Fenner & Smith, Inc.

Raymond Cocchi, President 834

Independent Broker Dealers Trade Assn.

Robert Cody, Senior Vice President 1381

Capital Research & Management Co.

Ralph Coleman, president 358

Over-the-Counter Securities fund, Inc.

Kenneth Cutler, House Counsel 2360

__ Lord, Abbett & Co.

41
- ii -

Ted Davie, Vice President g~2

Capital Sponsors, Inc.

David Dievler, Financial Vice President 577, 733

F. Eberstadt & Co.

Leonard Epstein, Esquire 62~

First Investors Corp.

Spencer Everett, General Counsel 492

No-Load Mutual Fund Association

Dr. Donald Farrar/Economist 2186

Carl Frischling, Senior Vice President 2120

Channing Management Corp.

James Fullerton, Senior Vice President & Director 2360

Capital Research Group

Robert M. Gardiner, Chairman 

538

Securities Industry Assn.

Paul Gartland, President 1381

J & H Equity Corp.

Everett Gille, Presa.dent 2186

Security Management Co.

George Gingold, Counsel 1820

Aetna Life & Casualty Co,

Manuel Glassman, Executive Committee 1022

National Mutual Fund Managers Assn.

Raymond Grant, Senior Vice President & General Counsel 1820

Waddell & Reed, Inc.

David Grayson, President 627

First Investors Corp.

Gordon Greer Department Manager 

185

Putnam Management Co.

H. Bridgman Griswold, President 1820, 2186

Union Services Distributors, Inc.

Barry Grossmann Chief 2019

Antitrust Division/Department of Justice

Daniel Hunter Esquire 

2019

Antitrust Division/Department of Justice 42
- iii -

'~ Franklin Johnson, Senior Vice President

Keystone Custodian Funds, Inc,

Paul Johnston, Vice President

Wiesenberger Services

Gerald Jeremias, President

Empire Planning Corporation

Orville Lauver president

Lauver & Co.

A. Michael Lipper, President

Lipper Analytical Services

Robert Loeffler, Senior Vice President

Investors Diversified Services

Gordon Macklin President

National Association of Securities Dealers

William Margeson, President

Family, Industry & College Planning Co., Inc.

Paul Mason, General Counsel

-- American Life Insurance Association

Joel Matcovsky, Esquire

Merrill Lynch, Pierce, Fenner & Smith, Inc.

Roger McCollister, Vices President

National Mutual Fund Managers Assn.

Richmond McFarland, President

No-Load Mutual Fund As:~ociation

William McCrann~ President

Family Income Planning, Inc.

Robert Perez, Vice President

F. Eberstadt & Co.

Donald Pitti, President

Wiesenberger Services

Robert Porters President

F. Eberstadt & Co.

George Putnam, Chairman

Putnam Management Co.

304, 1381

1649

1624

834

1631, 2120

2186, 2360

19

965

1507

252

1022

399

902

733, 1164

2360

577, 733

185

43
1V

Robert Riley, President 185

Putnam Management Ca.

Robert Roth, President 

902

Mark Securities

Robert Routier, Ass~.stant General Counsel 1507

American Life Insurance Association

Frank Rozanski, President 

965

Franklin Planning Corp.

Carol Sabel, Assistant General Counsel 538

Securities Industry Association

Daniel Samuel, Executive Vice President 399

No-Load Mutual Fund Associatbn

Henry Satchwell, President 1164

League Investment Distributors Co.

Charles Shaeffer, President 492

No-Load Mutual Fund Association

Stephen Shezwin, Vice President 19, 1820

National~Association of Securities Dealers

Carl Shipley 

834

Independent Broker Dealers Trade Association

David Silver, General Counsel 

103

Investment Company Institute

Phillip Smith, Chairman of the Board 2120

National Securities & Research Corp.

Donald Spiro, President 2360

Oppenheimer Fund, Inc.

Allen Thaler, Senior Vice President 1381

Prudential Insurance Co. of America

William Thompson, Officer 492, 1164

T. Rowe Price Co.

George Washburn, Vice President 1022

National Mutual Fund Managers Association

John Weller, President 

834

J.D. Weller Company, Inc.

l~rancis Williams, President g77

F. Eberstadt & Co.

44 _.
CHRONOLOGICAL INDEX OF PARTICIPANTS IN

MUTUAL FUND DISTRIBUTION HEARINGS

PAGE

FEBRUARY 12

NATIONAL ASSOCIATION OF SECURITIES DEALERS 19

Gordon Macklin, President

John Bogle, President

Stephen Sherwin, Vice President

INVESTMENT CIX~IPANY INSTITUTE 103

Robert Augenblick, President

David Silver, General Counsel

FEBRUARY 13

THE PIJTNAM MANAGEMENT CO., INC. 185

George Putnam, Chairman

Robert Riley, President

Gordon Greer, Department Manager

MERRILL LYNCH, PIERCE, FENNER & SMI^tH, INC. 252

Robert Cleary, Vice President

Joel Matcovsky, Esquire

KEYSTONE CUSTODIAN FUNDS, INC. 304

Franklin R. Johnson, Senior Vice President

FEBRUARY 14

OVER-THE-COUNTER SECURITIES FUND, INC. 358

Ralph Coleman, President

NO-LQAD MUTUAL FUND ASSOCIATION 399

Daniel Samuel, Executive Vice President

Richmond McFarland, President

Charles W. Shaeffer, President 492

William Thompson, Office of Price Organization

Spencer Everett, General Counsel

FEBRUARY 15

SECURITIES INDUSTRY ASSOCIATION 538

Robert M. Gardiner, Chairman

S. Whitney Bradley, Senior Vice President

Carol Sabel, Assistant General Counsel

F. EBERSTADT & COMPANY 577

Robert C. Porter, President

Mr. Williams, Vice President

Mr. Dievler, Financial Vice President

Dr. Perez, Vice President

45
- 11

"AGE

FEBRUARY 15 cont.

FIRST INVESTORS CORPORATION 627

David Grayson, President

Paul Baris, Esquire

Leonard Epstein, Esquire

FEBRUARY 26

John Asling, pro se 683

F. EBERSTADT & COMPANY 733

Robert Porter, President

Mr. Dievler, Financial Vice President

Dr. Perez, Vice President

FEBRUA RY 27 -- Small Broker-Dealers

INDEPENDENT BROKER DEALERS TRADE ASSOCIATION 834

Carl Shipley of Shipley, Akernian, Stein & Kaps

Raymond Cocchi, President

J.D. WELLER COMPANY, INC.

John Weller, President

LAWER & COMPANY, INC.

Orville H. Lauver, President

CAPITAL SPONSORS, INC. 902

Ted Davis, Vice President

FAMILY INCOME PLANNING, INC.

W illiam McCrann, President

MARK SECURITIES, INC.

Robert Roth, President

FRANKLIN PLANNING CORPORATICEN 965

Frank Rozanski, President

ZENITH AMERICAN SECURITIES CORPORATION

Samuel Ballin, Senior Vice President

FAMILY, INDUSTRY & COLLEGE PLANNING CO., INC,

William Margeson, President

:~
111 -

PAGE

FEBRUA RY 28 -- New York Stock Exchange Member Firms

NATIONAL MUTUAL FUND MANAGERS ASSOCIATION 1022

Bradley Baker, President

Robert McCollester, Vice President

George Washburn, Vice President

Manuel Glassman., Member of Executive Committee

MARCH 13

T. RCJWE PRICE COMPANY 1164

William Thompson, 4ice President & Director

F. EBERSTADT & COMPANY

Dr. Robert Perez, Vice President

DREYFUS CORPORATION

David Burke, Vice President

LEAGUE INVESTMENT DISTRIBUTORS COMPANY

ftenry Satchw211, President

MARCH 14

J & H EQUITY CORPORATION

Paul Gartland, President

SIDE,FUND, INC.

Richard Bassuk, Chairman of the Board

KEYSTONE CUSTODIAN FUNDS, INC,

Franklin Johnson, Senior Vice President

CAPITAL RESEARCH &MANAGEMENT COMPANY

Robert Cody, Senior Vice President

INVESTMENT COMPANY INSTITUTE

Robert Augenblick, President

PRUDENTIAL INSURANCE COMPANY OF AMERICA

Allen Thaler, Senior Vice President

1381

MARCH 15 -- T_nsurance Industry

AMERICAN LIFE INSURANCE ASSOCIATION 1507

Paul Mason, General Counsel

Robert J. Routier, Assistant General Counsel

AETNA VARIABLE ANNUITY LIFE INSURANCE COMPANY 1581

A rthur Blakeslee, III, President

47
- iv

PAGE

MARCH 16 -- Performance

EMPIRE PLANNING CORPORATI013 1624

Gerald S. Jeremias, President

LIPPER ANALYTICAL SERVICES 1631

A. Michael Lipper, President

DAVID L. BABSON & COMPANY 1638

David Babson, President

WIESENBERGER SERVICES 1649

Paul Johnston, Vice President

WELLINGTON MANAGEMENT COMPANY 1651

John Bogle, President

MARCH 19 -- Value of Services

SUPERVISED INVESTORS SERVICES, INC. 1820

Thomas Anderson, Vice President

WELLINGTON MANAGEMENT COMPANY

~ John Bogle, President

FOSTER ASSOCIATES, INC,

Stephen Sherwin, Vice President

pADDELL AND REED, INC.

Raymond Grant, Senior Vice President and General Counsel

AETNA LIFE & CASUALTY COMPANY

George Gingold, Counsel

UNION SERVICE DISTRIBUTOR, INC.

H. Bridgman Griswold, President

MARCH 21

U.S. DEPARTMENT OF JUSTICE 2019

Barry Grossman, Chief, Evaluation Section

Antitrust Division and

Daniel Hunter, Esquire

CHANNING MANAGEMENT CORPORATION 2120

Carl Fris~,hling, Senior Vice President

LIPPER ANALYTICAL SERVICES

A. Mir_hael Lipper, President

48
+~

PALL

MARCH 21 cont.

NATIONAL SECURITIES & RESEARCH CORPORATION 2120

Phillip C. Smith, Chairman of the Board

MARCH 22

Br. Donald Farrar, Economist

SECURITY MI~NAGII~IENT CdMPANY

Everett Gille, President

UNION SERVICE DISTRIBUTORS

H. Bridgman Griswold, President

INVESTORS DIVERSIFIED SERVICES

Robert Loeffler, Senior Vice President

1186

MARCH 28

WIESENBERGER SERVICES 2360

Donald Pitti, President

LORD, ABBETT & COMPANY 236h

Kenneth Cutler, House Counsel

INVESTORS DIVERSIFIED SERVICES 2374

Robert Loeffler, Senior Vice President-Law

CAPITAL RESEARCH GRQUP 2385

James Fullerton, Senior Vice President & Director

OPPENHEIMER MANAGII~IENT CORPORATION 2381

Donald Spiro, President

49