REVIEW OF CURRENT INVESTIGATIONS AND

REGULATORY ACTIONS REGARDING THE MUTUAL FUND INDUSTRY

S. HRG. 108–711

REVIEW OF CURRENT INVESTIGATIONS

AND REGULATORY ACTIONS REGARDING

THE MUTUAL FUND INDUSTRY

HEARINGS

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST AND SECOND SESSION

ON

INVESTIGATIONS AND REGULATORY ACTIONS REGARDING THE

MUTUAL FUND INDUSTRY AND INVESTORS’ PROTECTION

NOVEMBER 18, 20, 2003, FEBRUARY 25, 26, MARCH 2, 10, 23, 31, AND

APRIL 8, 2004

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001

97–186 PDF 2004

S. HRG. 108–711

REVIEW OF CURRENT INVESTIGATIONS

AND REGULATORY ACTIONS REGARDING

THE MUTUAL FUND INDUSTRY

HEARINGS

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST AND SECOND SESSION

ON

INVESTIGATIONS AND REGULATORY ACTIONS REGARDING THE

MUTUAL FUND INDUSTRY AND INVESTORS’ PROTECTION

NOVEMBER 18, 20, 2003, FEBRUARY 25, 26, MARCH 2, 10, 23, 31, AND

APRIL 8, 2004

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

DOUGLAS R. NAPPI, Deputy Staff Director

BRYAN N. CORBETT, Counsel

DEAN V. SHAHINIAN, Democratic Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

(III)

CONTENTS

TUESDAY, NOVEMBER 18, 2003

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 4

Senator Enzi ..................................................................................................... 5

Senator Reed ..................................................................................................... 7

Senator Allard ................................................................................................... 7

Senator Corzine ................................................................................................ 8

Senator Bayh .................................................................................................... 9

Senator Dodd .................................................................................................... 10

Senator Miller ................................................................................................... 50

WITNESSES

William H. Donaldson, Chairman, U.S. Securities and Exchange Commission,

Washington, DC ................................................................................................... 11

Prepared statement .......................................................................................... 110

Matthew P. Fink, President, Investment Company Institute .............................. 37

Prepared statement .......................................................................................... 118

Marc E. Lackritz, President, Securities Industry Association ............................. 39

Prepared statement .......................................................................................... 125

THURSDAY, NOVEMBER 20, 2003

Opening statement of Chairman Shelby ................................................................ 135

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 136

Senator Dodd .................................................................................................... 138

Senator Johnson ............................................................................................... 139

Senator Corzine ................................................................................................ 141

Senator Reed ..................................................................................................... 142

WITNESSES

Eliot Spitzer, Attorney General, the State of New York ...................................... 142

Stephen M. Cutler, Director, Division of Enforcement, U.S. Securities and

Exchange Commission ......................................................................................... 146

Prepared statement .......................................................................................... 167

Robert, R. Glauber, Chairman and Chief Executive Officer, National Association of Securities Dealers .................................................................................... 149

Prepared statement .......................................................................................... 173

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter to Senator Richard C. Shelby from John W. Snow, Secretary, U.S.

Department of the Treasury and Alan Greenspan, Chairman, Board of

Governors, Federal Reserve System dated November 18, 2003 ....................... 179

Page

IV

WEDNESDAY, FEBRUARY 25, 2004

Opening statement of Chairman Shelby ................................................................ 181

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 184

Senator Crapo ................................................................................................... 185

Senator Carper ................................................................................................. 186

Senator Hagel ................................................................................................... 186

Senator Sununu ................................................................................................ 186

Senator Corzine ................................................................................................ 215

Senator Enzi ..................................................................................................... 224

WITNESSES

Tim Berry, Indiana State Treasurer and President, National Association of

State Treasurers ................................................................................................... 187

Prepared statement .......................................................................................... 225

James S. Riepe, Vice Chairman, T. Rowe Price Group ........................................ 189

Prepared statement .......................................................................................... 230

Don Phillips, Managing Director, Morningstar, Inc. ............................................ 192

Prepared statement .......................................................................................... 240

Gary Gensler, former Under Secretary for Domestic Finance, U.S. Department of the Treasury ........................................................................................... 194

Prepared statement .......................................................................................... 245

James K. Glassman, Resident Fellow, American Enterprise Institute ............... 196

Prepared statement .......................................................................................... 253

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

The Non-Correlation Between Board Independence and Long-Term Firm Performance by Sanjai Bhagat and Bernard Black ................................................ 263

THURSDAY, FEBRUARY 26, 2004

Opening statement of Chairman Shelby ................................................................ 307

Opening statements, comments, or prepared statements of:

Senator Bayh .................................................................................................... 322

Senator Sarbanes .............................................................................................. 323

Senator Sununu ................................................................................................ 324

Senator Allard ................................................................................................... 330

WITNESSES

David S. Ruder, former Chairman, U.S. Securities and Exchange Commission,

William W. Gurley Memorial Professor of Law, Northwestern University

School of Law, and Chairman, Mutual Fund Directors Forum ........................ 308

Prepared statement .......................................................................................... 346

David S. Pottruck, Chief Executive Officer, The Charles Schwab Corporation . 311

Prepared statement .......................................................................................... 354

Mellody Hobson, President, Ariel Capital Management, LLC/Ariel Mutual

Funds .................................................................................................................... 313

Prepared statement .......................................................................................... 362

John C. Bogle, Founder and former Chief Executive, the Vanguard Group,

President, the Bogle Financial Markets Research Center ................................ 316

Prepared statement .......................................................................................... 393

TUESDAY, MARCH 2, 2004

Opening statement of Chairman Shelby ................................................................ 407

Opening statements, comments, or prepared statements of:

Senator Allard ................................................................................................... 408

Prepared statement ................................................................................... 448

Senator Hagel ................................................................................................... 409

Senator Sarbanes .............................................................................................. 420

Page

V

Opening statements, comments, or prepared statements of—Continued

Senator Bennett ................................................................................................ 423

Senator Carper ................................................................................................. 426

WITNESSES

William L. Armstrong, Independent Mutual Fund Director and Chairman,

the Oppenheimer Funds, former U.S. Senator (1979–1991) ............................ 409

Prepared statement .......................................................................................... 448

Vanessa C.L. Chang, Independent Director, New Perspective Fund .................. 411

Prepared statement .......................................................................................... 452

Marvin L. Mann, Chairman of the Independent Trustees, The Fidelity Funds 414

Prepared statement .......................................................................................... 455

Michael S. Miller, Managing Director, The Vanguard Group, Inc. ..................... 416

Prepared statement .......................................................................................... 463

Ann E. Bergin, Managing Director, National Securities Clearing Corporation . 436

Prepared statement .......................................................................................... 471

William A. Bridy, President, Financial Data Services, Inc., on behalf of the

Securities Industry Association .......................................................................... 438

Prepared statement .......................................................................................... 495

Raymond K. McCulloch, Executive Vice President, BB&T Trust, on behalf

of the American Bankers Association ................................................................. 440

Prepared statement .......................................................................................... 499

David L. Wray, President, Profit Sharing/401(k) Council of America on behalf

of the ASPA, Association for the Financial Professionals, Automatic Data

Processing, Inc., Committee on Investment of Employee Benefit Assets,

The ERISA Industry Committee, Flint Ink Corporation, Florida Power &

Light Company, Hewitt Associates, ICMA Retirement Corporation, Intel

Corporation, Procter & Gamble, Profit Sharing/401k Council of America,

Small Business Council of America, and Sungard Corbel ................................ 441

Prepared statement .......................................................................................... 503

WEDNESDAY, MARCH 10, 2004

Opening statement of Chairman Shelby ................................................................ 505

Opening statements, comments, or prepared statements of:

Senator Schumer .............................................................................................. 507

Senator Sarbanes .............................................................................................. 521

Senator Dodd .................................................................................................... 529

WITNESSES

David M. Walker, Comptroller General, U.S. General Accounting Office .......... 506

Prepared statement .......................................................................................... 536

Lori A. Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission ............................................. 508

Prepared statement .......................................................................................... 566

Paul F. Roye, Director, Division of Investment Management, U.S. Securities

and Exchange Commission .................................................................................. 511

Prepared statement .......................................................................................... 628

Mary L. Schapiro, Vice Chairman and President, Regulatory and Oversight,

National Association of Securities Dealers ........................................................ 517

Prepared statement .......................................................................................... 635

Response to a written question of Senator Johnson ...................................... 642

TUESDAY, MARCH 23, 2004

Opening statement of Chairman Shelby ................................................................ 645

Comments of Senator Sarbanes .............................................................................. 667

WITNESSES

Mercer E. Bullard, President and Founder, Fund Democracy, Inc., Assistant

Professor of Law, University of Mississippi School of Law .............................. 646

Page

VI

Mercer E. Bullard, President and Founder, Fund Democracy, Inc., Assistant

Professor of Law, University of Mississippi School of Law—Continued

Prepared statement .......................................................................................... 681

William D. Lutz, Ph.D., J.D., Professor of English, Rutgers University ............. 653

Prepared statement .......................................................................................... 698

Robert C. Pozen, Chairman, MFS Investment Management, Visiting Professor, Harvard Law School ................................................................................ 656

Prepared statement .......................................................................................... 704

Barabra Roper, Director, Investor Protection, Consumer Federation Of America .......................................................................................................................... 661

Prepared statement .......................................................................................... 707

WEDNESDAY, MARCH 31, 2004

Opening statement of Chairman Shelby ................................................................ 777

Opening statements, comments, or prepared statements of:

Senator Allard ................................................................................................... 778

Senator Enzi ..................................................................................................... 778

Senator Sarbanes .............................................................................................. 803

Senator Schumer .............................................................................................. 807

WITNESSES

Harold Bradley, Chief Investment Officer, Growth Equities, American Century Investment .................................................................................................... 779

Prepared statement .......................................................................................... 814

Geoffrey I. Edelstein, CFA, CIC, Managing Director and Co-founder, Westcap

Investors, LLC, on behalf of the Investment Council Association of America 782

Prepared statement .......................................................................................... 879

Howard M. Schilit, Ph.D., CPA, Chairman and Chief Executive Officer, Center for Financial Research & Analysis (CFRA) .................................................. 784

Prepared statement .......................................................................................... 889

Benn Steil, Ph.D., Andre ́ Meyer Senior Fellow in International Economics,

Council on Foreign Relations .............................................................................. 787

Prepared statement .......................................................................................... 892

Grady G. Thomas, Jr., President, The Interstate Group, Division of Morgan

Keegan & Company, Inc. ..................................................................................... 790

Prepared statement .......................................................................................... 910

Response to written questions of Senator Enzi .............................................. 953

Joseph M. Velli, Senior Executive Vice President, The Bank of New York ....... 792

Prepared statement .......................................................................................... 914

Response to written questions of Senator Enzi .............................................. 955

AFTERNOON SESSION

Opening statement of Chairman Shelby ................................................................ 957

Opening statements, comments, or prepared statements of:

Senator Fitzgerald ............................................................................................ 958

Prepared statement ................................................................................... 993

Senator Collins ................................................................................................. 960

Prepared statement ................................................................................... 997

Senator Levin .................................................................................................... 962

Prepared statement ................................................................................... 999

Senator Akaka .................................................................................................. 964

Prepared statement ................................................................................... 1000

WITNESSES

Paul G. Haaga, Jr., Executive Vice President, Capital Research and Management Company, Chairman, Investment Company Investment ........................ 970

Prepared statement .......................................................................................... 1003

Chet Helck, President, Raymond James Financial, Inc. ...................................... 972

Prepared statement .......................................................................................... 1039

Page

VII

Thomas O. Putnam, Founder and Chairman, Fenimore Asset Management,

Inc./FAM Funds .................................................................................................... 974

Prepared statement .......................................................................................... 1045

Edward A.H. Siedle, President, Benchmark Financial Services, Inc. ................. 976

Mark Treanor, General Counsel, Wachovia Corporation, on behalf of the

Financial Services Roundtable ............................................................................ 978

Prepared statement .......................................................................................... 1051

THURSDAY, APRIL 8, 2004

Opening statement of Chairman Shelby ................................................................ 1057

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 1058

Senator Bunning ............................................................................................... 1060

Senator Reed ..................................................................................................... 1061

Senator Corzine ................................................................................................ 1062

Prepared statement ................................................................................... 1091

Senator Stabenow ............................................................................................. 1062

Senator Carper ................................................................................................. 1063

Senator Sununu ................................................................................................ 1067

Senator Santorum ............................................................................................ 1080

Senator Enzi ..................................................................................................... 1091

WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange Commission . 1064

Prepared statement .......................................................................................... 1092

Response to written questions of:

Senator Reed .............................................................................................. 1102

Seantor Corzine ......................................................................................... 1105

Senator Enzi .............................................................................................. 1107

Senator Miller ............................................................................................ 1111

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter from William H. Donaldson, Chairman, U.S. Securities and Exchange

Commission to Senator Corzine, dated June 29, 2004 ...................................... 1112

Letter from various U.S. Senators to William H. Donaldson, Chairman, U.S.

Securities and Exchange Commission, dated April 8, 2004 ............................. 1116

(1)

REVIEW OF CURRENT INVESTIGATIONS

AND REGULATORY ACTIONS REGARDING

THE MUTUAL FUND INDUSTRY

TUESDAY, NOVEMBER 18, 2003

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10 a.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing shall come to order.

This hearing is part of the Committee’s ongoing oversight of the

mutual fund industry. Today, the Committee will review current

investigations and enforcement proceedings and examine regulatory actions taken to date in order to fully inform and guide the

Banking Committee’s consideration of possible legislative reform.

On September 30, 2003, this Committee first examined the scope

of problems confronting the mutual fund industry. At that time,

Chairman Donaldson testified about the SEC’s ongoing enforcement actions and described the SEC’s regulatory blueprint for

adopting new regulations aimed at improving the transparency of

fund operations and stopping abusive trading practices. Since

Chairman Donaldson’s testimony, we have learned that improper

fund trading practices are a widespread problem that fund insiders,

brokers, and privileged clients have profited from at the expense of

average investors.

In early September, New York Attorney General Spitzer uncovered arrangements through which brokers facilitated improper

trades for their clients in certain prominent mutual funds in exchange for large, fee generating investments. Since this initial settlement, we have learned the extent to which both intermediaries,

such as brokers, and fund executives have engaged in illicit trading

activities. We have read about the backhanded ways by which the

brokers colluded with their customers to disguise improper trade

orders to make them appear legitimate, thus evading detection by

mutual fund policing systems.

Even in situations where mutual funds attempted to halt improper trading activity, certain brokers created fictitious names

and account numbers to fool fund compliance officers and to continue trading. Recent investigations have also revealed that mutual

fund executives and portfolio managers have actively engaged in

2

improper trading activity. And these allegations are particularly

troubling because fund executives and portfolio managers have

represented themselves as protecting client assets, but they failed

by either knowingly permitting improper trading by brokers or

actively engaging in illegal trading activities themselves.

Such practices may not only violate prospectus disclosures, but

also violate the fiduciary duties that funds owe to their shareholders—the duties to treat all shareholders equitably and to protect shareholder interests. Further, regulators have indicated that

they may soon file charges against funds that have selectively

disclosed portfolio information to certain privileged investors and

fund executives that may have engaged in illegal insider trading by

acting on the basis of nonpublic information.

As this Committee made clear during Chairman William H.

Donaldson’s September 30 appearance here, a regulatory response

to improper trading activities is just one of the many actions that

the SEC must take to address the many troubling issues that have

come to light in the mutual fund industry. This Committee remains

concerned with the transparency of fund operations and ensuring

that investors can learn how their fund is being managed. It has

become very, very apparent that many of the questionable fund

practices that are now being examined are not just the result of a

few bad actors, but are longstanding industry practices that have

largely gone unregulated and not well disclosed to, or understood

by, most investors.

Therefore, this Committee must take a comprehensive look, I believe, at the industry to determine if the industry’s operations and

practices are consistent with investors’ interests and the greater

interests of the market. It may be that we must consider possible

realignment of interests to ensure that mutual funds are operating

as efficiently and fairly as the market and investors demand. We

will examine fund disclosure practices regarding fees, trading costs,

sales commissions, and portfolio holdings. So, we will continue to

question the conflicts of interest surrounding the relationship between the investment adviser and the fund and how potential

changes to fund governance and disclosure practices may minimize

these conflicts.

We will also focus on fund sales practices to ensure that brokers

sell suitable investments to their clients, provide adequate disclosure of any sales incentives, and give clients any breakpoint discounts to which they are entitled.

Chairman Donaldson has told this Committee that the SEC has

the necessary statutory authority to reform the mutual fund industry and is in the process of conducting a comprehensive rulemaking. As we have learned in other contexts, however, additional regulation is not the only answer. Late trading is clearly illegal and

market timing is actively deterred and policed. Despite prohibitions

and warnings, these activities continued unabated because of the

inadequate compliance and enforcement regimes at the SEC, the

mutual funds and the brokers. Whether due to a lack of resources

or other pressing priorities, mutual fund abuses simply did not receive adequate attention from the SEC. Although recent enforcement actions indicate that priorities have changed, we need to

3

understand how the SEC will revise compliance programs to detect

and halt future fund abuses.

Vigorous enforcement remains the key to restoring integrity to

the fund industry, and Attorney General Spitzer’s timely actions

once again demonstrate, I believe, the significant role that States

play in prosecuting fraud and abuse in the securities markets. Regardless of the number of rules or amount of resources, it would

be impractical to expect the SEC to detect every single fraud and

manipulation in the fund industry. Therefore, the mutual funds

and the brokerage houses themselves must proactively adopt new

compliance measures to detect fraud and abuse. For many years,

participants in the mutual fund industry maintain industry ‘‘best

practices.’’ These practices, however, have clearly proven to be inadequate as brokers and funds have disregarded conflicts of interest and colluded at the expense of investors without detection.

Although funds and brokers owe different types of duties to their

investors, both groups have an obligation to refrain from knowingly

ignoring their clients’ interests and profiting at their expense.

With over 95 million investors and $7 trillion—yes, $7 trillion—

in assets, mutual funds have always been perceived as the safe

investment option for average investors. America has become a Nation of investors, but there is no doubt that recent revelations

about mutual funds have caused very many to question the perceived fairness of the industry. Many are surprised to learn that

the mutual fund industry is plagued by the same conflict that was

at the root of the Enron scandal and the global settlement—one set

of profitable rules for insiders and another costly set for average

investors.

Beyond the legal concepts of fiduciary duties and transparency,

there is a more fundamental principle that should underlie the

operation of the mutual fund industry and our securities markets

in general.

This principle is that securities firms and mutual funds should

not neglect investors’ interests and knowingly profit at their expense. Until firms can demonstrate an ability to abide by this

ideal, investors will not trust the markets, nor should they. In our

own way, Congress, the SEC and regulators, and industry participants must collectively work to reform the mutual fund industry in

order to restore investor confidence. I believe, we must reassure investors that mutual funds are a vehicle in which they can safely

invest their money and not fall victim to financial schemes. The

mutual fund industry is simply too important to too many Americans to do otherwise.

Examining the mutual fund industry is a priority for this Committee, and I look forward to working with my fellow Committee

Members, especially Senators Enzi, Dodd, and Corzine, all of whom

have already expressed significant interest in this issue.

Our first witness today is Chairman Bill Donaldson, and on the

second panel we will hear from Matthew Fink, President of the Investment Company Institute, and Marc Lackritz, President of the

Securities Industry Association.

Now, I will call on my Members.

Senator Sarbanes.

4

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Chairman Shelby, and

Chairman Donaldson, we are pleased to welcome you back before

the Committee.

Chairman Shelby, I want to thank you for scheduling this important and timely hearing, the first in a series of hearings on mutual

funds the Committee will hold this Congress. We have a second one

scheduled on Thursday afternoon, I believe.

Chairman SHELBY. That is right.

Senator SARBANES. As concerns mount through the country about

unfair, improper, and illegal practices in the mutual fund industry,

today’s hearing gives us the opportunity to examine the status of

current investigations and the regulation of the mutual fund industry. I also look forward to Thursday’s hearing when we will hear

from the Director of Enforcement at the SEC, Stephen Cutler, New

York Attorney General Eliot Spitzer, and NASD Chairman and

CEO Robert Glauber.

Already, as you have noted, Mr. Chairman, a number of Senators

have indicated their intention to work on this issue or have introduced legislation, including on our own Committee, Senators

Corzine and Dodd. I am well aware of the strong interests of Senator Enzi, Chairman of the Subcommittee on Securities, with this

matter, and I look forward to working with all of them. I should

also note the strong interest of Senators Fitzgerald, Lieberman,

and Akaka on the Government Affairs Committee, where a hearing

was held just a short while ago.

Chairman Shelby, I appreciate your undertaking hearings on this

issue and your expressed interest to work with the Subcommittee

and all Members of the full Committee, as you have consistently

done in the past on many of the issues that have come before us.

Almost 100 million Americans, representing 54 million households—more than half of all U.S. households—own mutual funds.

The funds have a total, as Chairman Shelby noted, of more than

$7 trillion in assets. Millions of small investors—savers—entrust

their investment decisions to fund managers who are not only more

knowledgeable and experienced, but also, at least in theory, honest

and fair. Many people have looked upon mutual funds as a reliable

alternative to traditional savings accounts.

In the last few months, deeply disturbing practices involving a

growing number of funds have come to light. The disclosures began

with New York Attorney General Spitzer’s announcement on September 3, 2003, that a hedge fund, Canary Capital Partners, had

engaged in illegal trading involving ‘‘late trading’’ and ‘‘market timing.’’ And every week since then, we have been getting additional

disturbing revelations.

At the time of the Canary Capital Partners’ settlement, Attorney

General Spitzer said, ‘‘I think it is a near certainty that other mutual fund companies will be named as having participated in these

types of improper trading activities.’’ Unfortunately, his prediction

has turned out to be all too accurate.

Chairman Donaldson said, on October 30, only a few weeks ago,

‘‘The market timing and late trading issues are quite widespread.

We are still gathering data on this and we think it is more wideVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 97186.TXT SBANK4 PsN: SBANK4
5

spread than we originally anticipated.’’ Chairman Donaldson, we

are looking forward to your update on these issues this morning.

The revelation of these mutual fund practices are eroding investor confidence in some firms in the mutual fund industry. For example, The Wall Street Journal reported on November 11, 2003, a

week ago, that ‘‘Assets under management at Putnam Investments,

the first firm charged in the mutual fund trading scandal, dropped

$14 billion in the week ended Friday.’’ At least five States reportedly have dropped Putnam Investments as the manager of their

retirement accounts.

Just yesterday, the SEC announced a $50 million settlement

with Morgan Stanley. The allegations in that particular case were

that Morgan Stanley received incentives to push certain funds on

investors instead of others, either through payments or through

brokerage commissions that were paid in part to compensate the

sale of funds.

As the Committee launches these hearings, we must determine

whether new laws, new regulations, or more effective enforcement

of existing laws, or all of the above are needed to address these

problems. Areas that need thorough examination include: late trading; market timing; fund governance; conflicts of interest; investor

awareness of fund fees; special incentives to sell proprietary funds;

fund structure; selective disclosure of portfolio holdings; trading by

fund insiders; breakpoint discounts; sales practices; portfolio turnover; the effectiveness of the current regulatory scheme, including

whether sufficient coordination exists at the SEC between the Divisions of Inspections and Compliance, Investment Management, and

Enforcement; and whether an additional regulatory organization or

board for the mutual fund industry would be beneficial.

As we review these areas and others, we must ensure that managers of mutual funds and the broker-dealers that sell mutual

funds are not profiting unfairly at the expense of their investors.

Mr. Chairman, I think the witnesses we are starting off with

today are uniquely positioned to address these issues, and I look

forward to their testimony this morning.

Chairman SHELBY. Senator Enzi.

STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Thank you, Chairman Shelby, and thank you for

holding this hearing today.

During the past few months, I am not sure that a single day has

passed without the abuses of the mutual fund industry appearing

on the front pages of newspapers and being featured in television

and radio interviews. The situation seems a little reminiscent of

the scandals that led up to the passage of the Sarbanes-Oxley Act.

You can tell there is a lot of interest by the number of Committee

hearings that are being held by Committees of nonjurisdiction——

[Laughter.]

Senator ENZI. —as well as the number of bills being written both

in the House and in the Senate to deal with this, even before extensive hearings have been held. I do hope that the same methodical, balanced process of hearings as with the accounting reform

will be done on this issue.

6

The troubles with the securities industry also bear a strange resemblance to the troubles that faced the banking industry in the

late 1980’s and in the early 1990’s. During the early and the mid1980’s, the banking industry encountered a sizzling economy and

a set of banking regulators that was considerably weak. The banking industry took advantage of the situation, and our Nation was

faced with one of the most severe banking crises since the Second

World War.

In the late 1980’s and the early 1990’s, Congress passed a series

of banking laws to give the banking regulators a much stronger

regulatory scheme and enforcement authority to set the industry

straight. Today, our banking system is very strong, and sound, and

investor confidence in the primary banking business is high.

Today, the securities industry mimics the banking industry of

the early 1990’s. The securities industry, like their banking counterparts, took advantage of a very strong economy of the late 1990’s

and a weakness with the regulator. Law changes came. Last year,

when accounting irregularities surfaced, we started with the passage of the Sarbanes-Oxley Act to restore investor confidence. It

appears almost certain that legislation will be necessary to restore

investor confidence in the mutual fund industry now.

The major difference that I would like to see in Congress’ reaction to the crisis in the securities industry is to thoroughly evaluate

the problem to find the right solution. One of the major problems

that Congress had with passing several large pieces of legislation

with the banking legislation in a relatively short period of time is

today the banking industry may be overregulated, and that hurts

community banks’ ability to survive and to grow, and that is very

important in the rural areas.

With respect to the securities industry, we should not rush to

pass legislation, as we may do undue harm to the industry. However, we should take the approach that we used in the SarbanesOxley Act. Typically, for every action, Congress has a tendency to

overreact. In this situation, we need to thoroughly review the problems to find the right solution. We know that the legislation that

we pass is never perfect. With the Sarbanes-Oxley Act, we are still

trying to be careful of the cascading effect that it can have on small

entities.

There may be unintended consequences to solutions that we now

consider for mutual funds. Currently, the SEC has the authority

under existing law to handle the late trading and timing issues.

There is a record trail of all of these transactions. What needs to

be done is to adjust the current regulatory scheme and to have

greater enforcement of those rules.

I welcome Chairman Donaldson here yet again. We thank you for

appearing before the Committee. I know this has been a hectic year

for you, and hopefully with the passage of laws to increase the appropriations and the hiring authority for the SEC, we have made

the SEC much stronger. The examination and enforcement arms of

the SEC are in need of greater assistance.

Again, I thank the Chairman for holding this hearing.

Chairman SHELBY. Senator Reed.

7

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Chairman Shelby, and I

welcome Commissioner Donaldson.

I want to thank Chairman Shelby for holding this important and

timely hearing, and I hope that we will use this as an opportunity

for a thoughtful discussion on effective and aggressive enforcement

and also to continue to encourage all of the regulators—the SEC,

the Nasdaq, and the Attorney General—to work collaboratively to

punish the wrongdoers.

The behavior we have observed represents a profound breach of

trust, and ultimately all markets rest on a foundation of trust. So

this is not merely an example of technical problems; these very

well could be existential problems if we do not move rapidly, aggressively and effectively, and I hope we can do that. There are approximately 8,200 mutual funds with over $7 trillion

in assets. Thirty-eight percent of those assets come from 401(k)s.

To many investors, mutual funds or for professional advisers, instant diversification, liquidity and a wide range of investment

choices, and the advantages of mutual funds would be hard to

achieve for the small investor on his or her own.

However, with these daily revelations of wrongdoing by some of

the most reputable mutual fund companies, by allowing the favored

investors to take advantage of rank and file, it is very clear that

average investors are becoming increasingly worried about their financial futures.

There was an article in last Sunday’s New York Times that said

it well: ‘‘Employees saving for retirement cannot seem to catch a

break. After nearly 3 years of painful bear market losses, revelations of improper trading by insiders and a few favored investors

began to raise fundamental questions about the trustworthiness of

mutual fund managers.’’

And if we do not rapidly and effectively answer those questions

about trustworthiness, then the market will be in a serious, serious

predicament. I hope this hearing will go a long way to start responding to the concerns of the investing public and maintain the

advantages of mutual funds without the trading that has discouraged people today from participating as they should.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, I would like to thank you for

holding this important hearing, and I appreciate your special attention to this matter, as well as Senator Enzi, as we witnessed a disturbing amount of misconduct that apparently has overtaken the

mutual fund industry in recent months.

I do not think anybody can dispute the fact that mutual funds

are a vital part of the U.S. economy. The $7 trillion in assets is a

substantial amount of money based on anybody’s standards. When

you look at the number of households that are participating in

mutual funds, I think Senator Sarbanes mentioned something like

50 percent or so, and that is my understanding too. And households

are using these dollars to meet the needs of the family. It is educational needs. It is retirement—especially retirement needs. That

8

is a big part—educational needs and in some cases to help afford

a house.

So it is absolutely vital that we can assure people who are participating in mutual funds that it is a fair process and that it is

something they can rely on for their future needs. In my view, all

investors should be treated fairly, both the small investor, as well

as the institutional investor. Recent events have proven that there

is not equal access to the handling of mutual funds. In order for

a fund to succeed and an investor to remain confident in his or her

investment, all aspects of the mutual fund business must be as

transparent as possible.

Investors need to be able to have confidence in their fund managers and know that their money is not being manipulated by the

manager. Therefore, investors need to be able to have confidence

that there are not other investors who have privileged access to the

handling of the mutual fund.

Again, I would like to thank Chairman Donaldson for coming before the Committee today to discuss the ways the Commission can

enhance the protection of the investor rights and prevent the

abuses that have seemingly become widespread.

I would also like to thank Mr. Fink and Mr. Lackritz for taking

the time to be here today, and I look forward to their testimony,

Mr. Chairman.

Chairman SHELBY. Thank you, Senator Allard.

Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman, and I appreciate

you holding the hearings and beginning this process of examining

both the issues and potential responses that we should be taking

to deal with a problem that is very real. I welcome the Chairman

as well. It has been an incredible year for you.

Mutual funds, as all of us know, are a fundamental vehicle for

investors to participate in America’s capital markets, not just the

equity markets, but also bond, real estate, and a whole series of assets. And we have heard that 95 million Americans invest nearly

$7 trillion. This is really key and a cornerstone of the success of

capital formation and savings in this country.

The industry, which is one of our oldest, and at least from my

perspective and understanding until recently, really one of the

most respected industries, entrusted by those 95 million shareholders, and I think, for the most part, has done well in promoting

those dreams and retirement and ability to pay a child’s college tuition, buy a home, all of the things that we talked about.

But it is quite clear that, in recent times, our mutual fund industry has moved away from some of those long traditions that I think

have been a part of it, and it has been brought on by many individuals, their own actions, their own sense of excess, and some would

even say greed. It started out as an investigation at the behest of

whistleblowers to the New York State Attorney General’s Office

and has become really, I think, one of the underlying most serious

scandals we have in the history of any marketplace, from my view,

given the broad retail participation, small investor participation

that goes on here.

9

I am not going to go through the laundry list of issues. We have

talked about them. I do think we need a very serious, thoughtful,

not overreaching response, but one that restores the confidence of

investors and participants in this market and needs to be done in

a relatively expeditious manner.

As the Chairman noted and others, Senator Dodd and I just announced a plan to introduce legislation at the end of this Committee’s series of hearings on the mutual fund industry. We have laid

out a number of the points of outline with regard to governance,

and disclosure, and fund governance, and I think that action will

be needed if we want to see what is an extraordinary asset in

America’s financial system to continue to prosper. And if we want

to see capital formation in this country prosper in a way that I

think makes us unique in the developed world, we need to get a

handle on this and move relatively quickly.

I thank the Chairman and I am looking forward to hearing the

remarks not only of Chairman Donaldson, but also of the other witnesses as well.

Chairman SHELBY. Senator Bayh.

STATEMENT OF SENATOR EVAN BAYH

Senator BAYH. I thank the Chairman, and I want to thank the

Committee for conducting this hearing today. You know a subject

is topical when we have a literally standing room only crowd in the

hearing room. So, I thank you for focusing on a matter of such importance.

Chairman Donaldson, thank you for your diligent efforts these

last 9 months to get on top of some very difficult problems. I am

tempted to ask if you have had any buyer’s remorse since accepting

this appointment. We thank you for your public service.

This is critically important because it affects the continued democratization of our capital markets, which has been one of the

great trends in American free enterprise over the last several decades. It would be truly unfortunate if average Americans concluded

that the only safe place for their savings was back in the mattress

once again, rather than in financial instruments on which they

could rely. Such a conclusion would be harmful to our economy. It

would be harmful to them. So it is this basic trust that convinces

ordinary Americans that they can invest with confidence that we

address here today.

In my own State, Senator Corzine and others have mentioned

the 95 million shareholders, we have 2.1 million mutual fund

shareholders just in the State of Indiana. So this is a matter of

great significance to ordinary people across the heartland of the

country, and we look forward to hearing from you about that today.

My colleagues have touched upon a variety of topics—two others

I would throw out, starting with I hope at some point, either in response to questions or in your testimony you can address what can

ordinary Americans do, what are ordinary investors to think? I suspect a lot of what we will talk about here today will sound like we

are speaking in Chinese to them, but in layman’s terms, what can

they do to protect themselves? How can they be intelligent participants in the investing marketplace and seek out vehicles on which

they can rely? What should they look at in terms of the companies

10

in which they invest? To the extent that you can address that, I

think it would be very helpful to empowering investors to protect

themselves.

Second, as a former Chief Enforcement Officer of my own State,

in terms of the securities laws, I am curious as to what you perceive to be the appropriate balance, in terms of jurisdictional responsibilities, between the Federal Government and the States, the

SEC and the various State authorities assigned to protect ordinary

investors from potential abuses? That has been a matter of some

controversy of late, particularly with regard to the Putnam issue,

which I understand Senator Sarbanes mentioned. So if you could

perhaps discuss what in your view is the appropriate balance of jurisdiction between the Federal and State authorities, I think that

could be very helpful.

I, again, commend you for your efforts and thank you for taking

the time to be here today.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you very much, Mr. Chairman, and welcome, Chairman Donaldson of the SEC. It is good to have you here

before the Committee again.

First of all, let me thank the Chairman of the SEC. You are

going to be appearing a couple of times this week, both on this

issue and on corporate governance issues. We appreciate your being

here before the Committee.

Chairman Shelby, let me thank you as well. The hearing today

and the hearing I guess on Thursday that we will be conducting

is very timely and important. With all we have going on, there is

a lot on our agenda this week. This is truly a critical issue, I appreciate the leadership of you, Chairman Shelby, and Senator Sarbanes on making this a matter before the Committee.

Just a couple of points. I presume some of these things have been

mentioned already by my colleagues. Obviously, the volume, the

number of Americans who seek out mutual funds as a way of producing wealth and also providing long-term financial security for

themselves has been well documented. It is critically important

that we not take this remarkable success story, which mutual

funds have been, and have them, in some way, have people start

to flee from them. I am sure all of us share that common thought.

It is hard these days not to pick up the newspaper and find yet another story of another fund that has had some serious problems.

My colleague from New Jersey has already mentioned the fact

that he and I have at least put together some ideas as a bill, which

we will be interested in your comments on, what you think of what

we have suggested. It is rather lengthy in its nature. It covers

about four major areas, in the area of governance, and cost, and

oversight and the like. So, we would be very interested in the comments of the SEC on it.

I respect as well the work that is being done by Senator Akaka,

my colleague, Senator Lieberman, I think has legislation in, as well

as Congressman Baker and Congressman Oxley as well are moving

on legislation. So there are some legislative vehicles that are movVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 97186.TXT SBANK4 PsN: SBANK4
11

ing through the Congress, and it seems to me we should try and

respond to those if, in fact, that is appropriate.

There are obviously some fundamental changes I think that are

going to be needed in the way of funds and how they are governed,

and I would like to hear your thoughts on that and your testimony.

The widening gap between what investors believe mutual funds

cost and the actual cost is one of the areas that we have addressed

very strongly in our proposed legislation, and I would be interested

in your thoughts there as well and looking at the current oversight

of the industry.

Finally, I would say to you here obviously restoring confidence in

the mutual fund industry is important. What also is important—

and I know you share this thought—is restoring confidence in the

SEC as well. I appreciate the article, the op-ed piece that you

wrote. But it is very important that we get in front of this so that

people will understand that the ‘‘cop on the beat,’’ as well as the

policy-setters, if you will, here are in tandem.

Let me underscore the comment that was made by Senator Bayh

as well. We need to get to the point where between what is going

on in the States—and we are going to hear from Eliot Spitzer later

this week—there are other attorneys general around the country

that are moving in this area, and I think in order to try and not

have this become more confusing for people to try and see to it that

we are coordinating these activities. And that should not be one

level of Government competing with another on this issue. We all

should be heading in the same direction, rowing in the same direction, and I hope that is an issue we can address as well.

So with that, Mr. Chairman, I thank you.

Chairman SHELBY. Now, Mr. Chairman, your written testimony

will be made part of the record in its entirety. You may proceed

as you wish.

STATEMENT OF WILLIAM H. DONALDSON

CHAIRMAN

U.S. SECURITIES AND EXCHANGE COMMISSION

Chairman DONALDSON. Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, thank you for inviting me

to testify on the Securities and Exchange Commission’s initiatives

to address problems in the mutual fund and brokerage industry.

When I testified before you on September 30, the discovery of late

trading and market timing abuses by personnel at the hedge fund

Canary Capital had just erupted. I will update you on recent developments since then. First, though, I would like to share with you

the fundamental rights that I believe every mutual fund investor

not only should expect, but also to which every investor is entitled.

We all—regulators, legislators, the brokerage and mutual fund industry, the financial press and investors themselves—have spent

much time lately wondering how the current abuses could have

happened. I believe that a significant reason is because the industry lost sight of certain fundamental principles—including its responsibilities to the millions of people who entrusted their confidence, the fruits of their labor, their hopes and their dreams for

the future to this industry for safekeeping. These investors are entitled to honest and industrious fiduciaries who sensibly put their

12

money to work for them in our capital markets. No one can argue

with the fact that investors deserve a brokerage and mutual fund

industry built on fundamentally fair and ethical legal principles.

Let me just briefly outline these rights, as I see them, and the

critical initiatives underway at the Commission to ensure that enhanced and crucial investor protections deriving from these rights

are put in place as quickly as possible.

First, mutual fund investors have a right to an investment industry that is committed to the highest ethical standards and that

places investors’ interests first. Every brokerage and mutual fund

firm needs to conduct a fundamental assessment of its obligations

to its customers and shareholders. These assessments must be put

forth at the highest levels, and implemented so as to reach all employees. Senior management and the boards of directors must be

ready to lay down and vigorously enforce rules that define an immutable code of conduct.

Second, investors have a right to equal and fair treatment by

their mutual funds and brokers. Our examinations and investigations of late trading and market timing abuses have revealed instances of special deals and preferential treatment being afforded

to large investors, often to the detriment of small investors. The

concepts of equal and fair treatment of all investors and the prohibition against using unfair informational advantages are embedded

in various provisions of the Federal securities laws, including the

Investment Company Act. The SEC will not tolerate arrangements

of this kind that violate these fundamental principles.

Third, investors have a right to expect fund managers and

broker-dealers to honor their obligations to investors in managing

and selling funds. Our examinations and investigations into the

current abuses have revealed instances of fund managers placing

their interests—and in the case of some portfolio managers, placing

their personal interests—ahead of those of fund investors. We have

also seen recent examples of abusive activity by broker-dealers and

their representatives in connection with the sale of fund shares, including failure to give investors the breakpoint discounts to which

they are entitled, recommendations that investors purchase one

class of shares over another in order for the salesperson to receive

higher compensation and other sales practice abuses. This cannot

be and will not be tolerated.

Fourth, investors have a right to the assurances that fund assets

are being used strictly for their benefit. Clearly, fund assets, including the use of a fund’s brokerage commissions, must be used

in a manner that benefits fund investors. The Commission must

engage in a reassessment of how fund commission dollars are used,

including various soft-dollar arrangements and the lack of transparency to investors of these payments.

Fifth, investors have the right to clear disclosure of fees, expenses, conflicts, and other important information. Mutual fund investors must have the tools and the information to make intelligent

investment decisions. To that end, the Commission will take action

to enhance disclosure to fund investors of fees and expenses, and

the conflicts that arise as a result of the various arrangements between funds and brokers regarding the sale of fund shares, as well

as other important information.

13

Sixth, investors have a right to independent, effective boards of

directors who are committed to protecting investors’ interests. Investors need to be assured that their mutual fund directors have

the independence and commitment necessary to carry out this crucial function. We are proposing to set enhanced standards for board

independence and are considering other steps in this area.

Seventh, investors have a right to effective and comprehensive

mutual fund and broker compliance programs. Programs designed

to ensure compliance with the Federal securities laws are an essential tool in the protection of investors. Fund investors need to be

assured that all funds, advisers, and selling brokers have internal

programs to ensure compliance with the Federal securities law. We

will complete our pending rulemaking to strengthen procedures at

mutual funds and advisers.

Eighth, investors should expect that aggressive enforcement actions will be taken when there are violations of the Federal securities laws. We will continue to take strong and appropriate action

against those who violate the Federal securities laws. So there will

be serious consequences to those who violate the law. Wherever appropriate, we will ensure that investors receive restitution.

By holding the industry—and I might add ourselves—to these

standards, we can significantly minimize the possibility of future

scandals that harm millions of mutual fund investors, and hopefully restore their confidence in the industry.

Now let me just outline specific initiatives to ensure that the mutual fund investors’ rights that I have outlined are realized.

For too long, the Commission has found itself in a position of reacting to market problems, rather than anticipating them. There

are countless reasons for this—not the least of which include historically lagging resources and structural and organizational roadblocks. The time for excuses has long passed.

Since the President nominated me to the Commission in February, one of my top priorities has been to reevaluate and determine

how the Commission deals with risk. Part of this evaluation has

been a thorough review of the Commission’s internal structure. The

results of our work form the basis for a new risk management initiative that will better enable the Commission to anticipate, identify, and manage emerging risks and market trends that stand to

threaten the Commission’s ability to fulfill its mission.

This critical initiative—the first of its kind at the Commission—

will enable us to analyze risk across divisional boundaries, focusing

on early identification of new or resurgent forms of fraudulent, illegal, or questionable behavior or products. Operating under the

‘‘Doctrine of No Surprises,’’ this initiative seeks to ensure that senior management at the Commission has the information necessary

to make better, more informed decisions.

The new initiative will be housed within a newly created Office

of Risk Assessment, and will be headed by a director who reports

directly to the Chairman. The director will coordinate and manage

risk assessment activities across the agency, and will oversee a

staff of five professionals, who will focus on the key programmatic

areas of the agency’s mission.

The duties of the Office of Risk Assessment will be focused on

the following areas: Gathering and maintaining data on new trends

14

and risks from a variety of sources—including external experts,

domestic and foreign agencies, surveys, focus groups, and other

market data, including both buy-side and sell-side research. Analyzing data to identify and to assess new areas of concern across

professions, companies, industries, and markets. Preparing assessments and forecasts on the agency’s overall risk environment.

The work of the Office of Risk Assessment will be complemented

by a Risk Management Committee. Additionally, each division and

major office will have one-to-two risk assessment professionals on

staff, who will work closely with the division director or office head

as a part of the risk management teams.

I believe this important initiative will fundamentally change the

way the Commission assesses risk and help us, I hope, head off

major problems before they occur.

In addition to fundamental changes in risk assessment, I have

ordered the Division of Enforcement to enhance its existing mechanism and processes for handling complaints. In particular, the

process of receiving, analyzing, and responding to all public tips

has been streamlined and standardized. We receive approximately

1,000 complaints and tips every day. We are upgrading our system

for handling these inputs to ensure that each one—regardless of

where it comes from, how it comes to us, via phone, Internet, or

e-mail—is analyzed, clearly logged detailing the nature of the complaint or tip, when it was received and how it was handled or disposed of by the SEC staff. To ensure speedy and appropriate

disposition of each tip or complaint, a senior manager will review

the log on a regular and frequent basis.

Now as to late trading and market timing abuses—late trading

and market timing abuses represent the most recent violations

against investors’ rights. In addition to those abuses, we have seen

other violations of investors’ rights, including, to name but a few,

violations of an investors’ right to high ethical standards, fiduciary

protections, clear disclosure, and equal treatment. While we are

vigorously pursuing enforcement actions regarding this misconduct,

we are also taking a number of regulatory steps immediately to

deal specifically with these abuses.

On December 3, the Commission will consider a package of reforms to combat late trading and market timing abuses. The package includes the staff’s proposal requiring that a fund or certain

designated agents—rather than an intermediary such as a brokerdealer or other unregulated third party—receives a purchase or redemption order prior to the time the fund prices its shares, which

is typically 4 p.m. Eastern Standard Time, for an investor to receive that day’s price. This ‘‘hard’’ 4 o’clock cutoff would effectively

eliminate the potential for late trading through intermediaries that

sell fund shares.

With respect to market timing abuses, the Commission will consider requiring additional, more explicit disclosure in fund offering

documents of market timing policies and procedures. This disclosure would enable investors to assess a fund’s market timing practices and determine if they are in line with their expectations.

The staff’s recommendations will have a further component of

requiring funds to have specific procedures to comply with the

representations regarding market timing policies. While our examVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 97186.TXT SBANK4 PsN: SBANK4
15

ination staff will use a variety of techniques to police for market

timing abuses, the establishment of formal procedures will also enable the Commission’s examination staff to review whether those

procedures are being followed and whether the fund is living up to

its representations. The Commission also will emphasize the obligation of funds to fair value their securities so as to avoid ‘‘stale

pricing’’ to minimize market timing arbitrage opportunities as an

important additional measure to combat market timing activity.

Also on December 3, the Commission will consider adoption of

new rules under the Investment Company Act and the Investment

Advisers Act that will ensure that mutual funds have strong compliance programs. Specifically, the rules that the Commission will

consider would require each investment company and investment

adviser registered with the Commission to: One, adopt and implement written policies and procedures reasonably designed to detect

and to prevent violations of the Federal securities law. Two, review

these policies and procedures annually for their adequacy and their

effectiveness. Three, designate a chief compliance officer to be responsible for administering the policies and procedures and to

report directly to the fund’s board of directors. A chief compliance

officer reporting to the fund’s board of directors will strengthen the

hand of the fund’s board and compliance personnel in dealing with

fund management.

Allegations of certain portfolio managers market timing the

funds they manage or other funds in the fund complex raise issues

regarding self-dealing. Recent allegations also indicate that some

fund managers may be selectively disclosing their portfolios in

order to curry favor with large investors. Selective disclosure of a

fund’s portfolio can facilitate fraud and have severely adverse ramifications for the fund’s investors. You can expect that these issues

will also be addressed in the rulemaking recommendations that the

Commission will consider on December 3.

The package of reforms that I have just outlined for you is designed to provide immediate reassurances and protection to mutual

fund investors, but we cannot stop there. We will explore the full

range of our authority, not only in the reforms discussed, but also

in additional areas to further address market timing abuses.

For instance, while the Commission’s actions regarding fair value

pricing should address the problem of stale pricing, which facilitates market timing, we will consider more in this area. As such,

I have asked the staff to study additional measures for Commission

consideration, including a mandatory redemption fee imposed on

short-term traders and developing a solution to the problem of

trading through omnibus accounts.

Let me just touch on omnibus accounts for a minute. Trading

through omnibus accounts, which are accounts held at intermediaries, such as broker-dealers, often means that mutual funds

do not have the information on the identity of the underlying brokerage customer who is purchasing or redeeming the fund shares.

This can make it difficult for funds to assess redemption fees, limit

exchanges, or even kick out a shareholder who is market timing

through an omnibus account because they just do not know the

identity of that shareholder.

16

To assist the staff as it moves forward in considering this issue,

I have called upon the NASD to head an Omnibus Account Task

Force consisting of members of the fund and brokerage industries,

as well as other intermediaries to further discuss and study this

issue and to provide the SEC staff with information and recommendations. Under the NASD’s capable leadership, I am confident that

working with the NASD and the industry, we will be able to develop a proposal that will adequately address the omnibus account

issue, which is complicated.

I also anticipate reforms in the area of fund governance. The

statutory framework governing mutual funds envisions a key role

for boards of directors in light of the external management structure typical for funds. The directors, particularly ‘‘independent

directors,’’ are responsible for managing conflicts of interest and

representing the interests of shareholders.

I believe we need to improve and enhance the independence of

fund directors, and there are a number of ideas for reforms including, but not limited to: Requiring an independent chairman of the

fund’s board of directors. Increasing the percentage of independent

directors under SEC rules from a majority to three-quarters. Providing the independent directors the authority to retain staff as

they deem necessary so that they do not have to necessarily rely

on the fund’s adviser for assistance. Requiring boards of directors

to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the

board’s committee structure; and adopting a rule that would require boards to focus on and preserve documents and information

that directors use to determine the reasonableness of fees relative

to performance, quality of the service and stated objectives, including a focus on the need for breakpoints or reductions in advisory

fees and comparisons with fees and services charged to other clients of the adviser.

I have also called upon the fund independent directors themselves to be active participants in the reform effort. Specifically, I

have asked former SEC Chairman David Ruder’s nonprofit mutual

fund director’s organization, the Mutual Fund Directors Forum,

which is geared toward independent mutual fund directors, to

develop guidance and best practices in key areas of director decisionmaking, such as monitoring fees and conflicts, overseeing compliance, and important issues such as evaluation and pricing of

fund portfolio securities.

Another fundamental right of mutual fund investors is clear,

easy-to-understand disclosure, including disclosure of the fees and

expenses they pay. I anticipate that in January the Commission

will consider the adoption of rules that will require actual dollarsand-cents fee disclosure to shareholders, coupled with more frequent disclosure of portfolio holdings information; this would allow

investors to determine not only the fees and expenses they are paying for their particular funds and would also greatly facilitate comparison among different funds. We also want to provide investors

better information on portfolio transaction costs so that they can

factor this into their decisionmaking. Consequently, the staff is

developing for Commission consideration in December a concept

17

release to solicit views on how the Commission should proceed in

fashioning disclosure of these costs.

Investors deserve to know what fees and expenses their fund

pays, and they also deserve to know how much their broker stands

to benefit himself or herself from the purchase of a particular fund.

Thus, we also plan to improve disclosure about mutual fund

transaction costs through confirmations that broker-dealers provide

to their customers. I have directed the staff to prepare for Commission consideration, by the end of this year, a new mutual fund confirmation statement that will provide customers with quantified

information about the sales loads and other charges that they incur

when they purchase mutual funds with sales loads.

Additionally, the staff will consider similar disclosures which will

provide more information to investors at the point of sale. To address an investor’s right to know about conflicts of interest that

brokers may have when selling fund shares, the new mutual fund

confirmation statement also will include specific disclosures regarding revenue sharing arrangements, differential compensation for

proprietary funds and other incentives, such as Commission business for brokers to sell fund shares that may not be readily apparent to fund investors.

To ensure that investors receive the benefits of fund assets to

which they are entitled, the Commission will examine how brokerage commissions are being used to facilitate the sale and distribution of fund shares, as well as the use of soft-dollar programs.

I have also instructed the staff to consider rules that would better highlight for investors the basis upon which directors have approved management and other fees of the fund.

The Commission long has recognized the importance of strong internal controls and will continue to explore additional approaches

the Commission might pursue to require funds to assume a greater

responsibility for compliance with the Federal securities laws, including whether funds and advisers should periodically undergo an

independent third-party compliance audit. These compliance audits

could be a useful supplement to our own examination program and

could ensure more frequent examination of the funds and advisers.

In addition to ensuring the funds’ shareholders receive their fundamental rights, we also have to ensure effective enforcement of

those rights and of the Federal securities law. Steve Cutler, the

SEC’s Director of Enforcement, will be testifying before you on our

enforcement efforts Thursday, I believe, and he can answer your

specific questions about the Commission’s enforcement actions, as

well as the results so far in our ongoing investigations.

Let me emphasize, however, that I am appalled at the types and

extent of conduct that is being revealed in our examinations and

investigations. It is conduct that represents fundamental breaches

of fiduciary obligations and betrayal of our Nation’s investors. I can

assure you we are committed to seeking redress for investors and

meting out the appropriate punishment in these matters to send a

strong message that these types of abuses will not be tolerated.

Now if you will let me go for a couple of more minutes——

Chairman SHELBY. Go ahead, Mr. Chairman.

Chairman DONALDSON. Let me just touch on, and I realize I have

been talking far too long.

18

Chairman SHELBY. Take your time.

Senator SARBANES. No, no. You should take all of the time you

need to fully present this.

Chairman SHELBY. Absolutely. It is important.

Senator SARBANES. This is very important, and we need to know

what the SEC has in focus.

Chairman SHELBY. Chairman, we are not rushing you at all. We

have all day.

Chairman DONALDSON. Thanks.

Senator DODD. To a point—this is not a filibuster. We just went

through that.

[Laughter.]

Chairman DONALDSON. I want to discuss, briefly, last week’s settlement of charges against Putnam relating to allegations of market-timing trades by certain Putnam employees. Among its many

roles, the Securities and Exchange Commission has, in my view,

two critical missions. The first is to protect investors, and the second is to punish those who violate our securities laws. Last week’s

partial settlement of the SEC’s fraud case against the Putnam mutual fund complex does both. It offers immediate and significant

protections for Putnam’s current mutual fund investors. Moreover,

by its terms, it enhances our ability to obtain meaningful financial

sanctions against the alleged wrongdoing at Putnam and leaves the

door wide open for further inquiry and regulatory action. And I

want to emphasize that.

Despite its merits, the settlement has provoked considerable discussion, and some criticism. Unfortunately, in my view, the criticism is misguided and misinformed, and it obscures the settlement’s fundamental significance.

By acting quickly, the SEC required Putnam to agree to terms

that produce immediate and lasting benefits for investors currently

holding Putnam funds. First, we put in place a process for Putnam

to make full restitution for the investor losses associated with

Putnam’s misconduct. Second, we required Putnam to admit its

violations for purposes of seeking a penalty and other monetary relief—an important point. And third, we forced immediate, tangible

reforms at Putnam to protect investors from this day forward.

These reforms are already being put into place, and they are working to protect Putnam investors from the misconduct we found in

this case.

Among the important reforms Putnam will implement is a requirement that Putnam employees who invest in Putnam funds

hold those investments for at least 90 days, and in some cases for

as long as a year, putting an end to the type of short-term trading

we found at Putnam. On the corporate governance front, Putnam’s

fund boards of trustees will have independent chairmen, at least 75

percent of the board members will be independent, and all board

actions will be approved by a majority or must be approved by a

majority of the independent directors. In addition, the fund boards

of trustees will have their own independent staff members who report to and assist the fund boards in monitoring Putnam’s compliance with the Federal securities laws, its fiduciary obligations and

duties to shareholders, and its Code of Ethics. Putnam has also

committed to submit to an independent review of its policies and

19

procedures designed to prevent and detect problems in these critical areas—now, and every other year.

This settlement is not the end of the Commission’s investigation

of Putnam. If we turn up more evidence of illegal trading, or any

other prohibited activity, including in the fee disclosure area, we

will not hesitate to bring additional enforcement actions against

Putnam or any of its employees.

Meanwhile, the Commission is already moving forward with rulemaking that will address fee disclosure issues, and others, on an

industrywide basis. Those lacking rulemaking authority seem to

want to shoehorn the consideration of fee disclosure issues into the

settlement of lawsuits about other subjects. But we should not use

the threat of civil or criminal prosecution to extract concessions

that have nothing to do with the alleged violation of law that we

are investigating.

Criticism of the Commission for moving too quickly, in my view,

misses the significance of the Commission’s action. While continuing our broader investigation of Putnam, we have reached a

fair and far-reaching settlement that establishes substantial governance reforms and compliance controls that are already benefitting Putnam investors. It is a settlement where the Commission

put the interests of investors first. As the Commission continues to

initiate critical and immediate reforms of the mutual fund industry, and while we investigate a multitude of other cases involving

mutual fund abuses, we will continue to seek reforms to provide

immediate relief to harmed investors.

In the meantime, as I noted earlier, our investigation of Putnam

is ongoing, active, and focused on market timing and related issues.

We will not hesitate to take additional actions if other wrongdoing

comes to light.

A few brief words on Morgan Stanley. I might note that just yesterday the Commission announced enforcement actions against

Morgan Stanley arising out of the firm’s mutual fund sales practices, a whole separate order of concern. Morgan Stanley has

agreed to a settlement of the action that calls, in part, for it to pay

a total of $50 million, all of which will be returned to investors.

The action grows out of an investigation begun last spring.

Few things are more important to investors than receiving unbiased advice from their investment professionals. Morgan Stanley’s

customers were not informed of the extent to which Morgan Stanley was motivated to sell them a particular fund.

Our investigation also uncovered conflicts of interest in the sale

of mutual funds at Morgan Stanley. This practice, which has been

the subject of other Commission cases during the last several

months, involves the sale of Class B mutual fund shares to investors who were more likely to have better overall returns if they

bought Class A shares in the same funds.

The abuses that are addressed in this case are significant and

not necessarily limited to Morgan Stanley. The Commission is conducting an examination sweep of some 15 different broker-dealers

to determine exactly what payments are being made by the funds,

the form of those payments, the ‘‘shelf space’’ benefits that the

broker-dealers provide, and most importantly, just what these

firms tell their investors about these practices. I also want to note

20

that the potential disclosure failures and breaches of trust are not

limited to broker-dealers. We are also looking very closely at the

mutual fund companies themselves.

Taken together, the reforms that the Commission has already

undertaken, and those currently being initiated are both substantial and far-reaching. We have, and we will continue to put the

needs of mutual fund investors first.

I appreciate the opportunity to share my views. I appreciate your

patience in listening to them, and I would be happy to answer any

questions you may have.

Thank you.

Chairman SHELBY. Mr. Chairman, we appreciate your comprehensive statement.

You brought up Putnam. Mr. Chairman, many people have criticized the SEC’s recent settlement with Putnam for, among other

things, failing to extract meaningful concessions from Putnam.

For example, the settlement, as I understand it, does not force

Putnam to change its fee structure or to disgorge the management

fees that it earned during the period of improper training. Some

have stated that the SEC rushed, as you anticipated here in your

statement, to settle the charges against Putnam and missed, Mr.

Chairman, a significant opportunity to create a template for reforming the whole fund industry. Some have even suggested that

the SEC set the standard so low for a settlement that many funds

will hurry to get the same deal.

How do you respond to these criticisms? You alluded to them a

minute ago. Is the Putnam settlement a model for the types of reform that the SEC is seeking? Why did you do it so quickly rather

than trying to seek an industrywide settlement?

Chairman DONALDSON. Well, let me say several things.

First of all, it is important to understand what the case against

Putnam was all about.

Chairman SHELBY. Sure.

Chairman DONALDSON. The case against Putnam was all about

failure to supervise the alleged actions of individual employees,

who were purchasing fund shares of the funds that they were managing, failure to super——

Chairman SHELBY. Is that all it was about?

Chairman DONALDSON. Second, fraud because they did not disclose this practice. The management company did not disclose the

practice to the directors of the funds themselves. Those were the

issues.

The issues of fees were not part of this settlement. They were not

brought up, and I believe, as I tried to say, perhaps inarticulately,

that these are other issues that need to be addressed as we find

them, and when we find them, but we do not think that we should

use a bludgeon at this time to bring in a whole lot of other reforms

that may pertain to the rest of the industry or may just pertain to

Putnam in this settlement.

We thought the higher good, if you will, was bringing these

charges to a conclusion, and in so doing, to hopefully begin to eliminate immediately the burdens that are currently being placed on

Putnam fund shareholders by the redemptions that are going on.

Clearly, the redemptions that are going on, and having to set aside

21

money, and having to sell stocks, and so forth are causing an

undue burden on existing shareholders; and we are very concerned,

in the immediacy of this settlement, for those shareholders.

I will say again that we have ongoing investigations at Putnam

in a number of areas.

Chairman SHELBY. Mr. Chairman, how many mutual funds do

we have in the United States, roughly?

Chairman DONALDSON. There are all sorts of different figures on

that. I think there are probably somewhere around 8,800 mutual

funds in the country.

Chairman SHELBY. How many are you investigating here, 15,

thus far?

Chairman DONALDSON. We immediately went out to 88 of the

largest fund groups, and that—I cannot give you the exact figure—

but that represented a substantial majority——

Chairman SHELBY. Of the money.

Chairman DONALDSON. —of the money in mutual funds. So, we

are into those funds, and we have been questioning them. Our inspectors are out there.

Chairman SHELBY. But of the 15 you are looking at very closely,

you have reason to believe that funny things have been going on

there, do you not, more or less?

Chairman DONALDSON. Yes. When we originally went in with our

inquiry, we felt that we found—not ‘‘feel’’ that we found—we found

that upward of 50 percent of these funds had some special arrangements, that 30 percent had helped, in one way or another, with

market timing, that 10 percent had helped with late trading, and

that 30 percent disclosed details of their holdings. Those were our

original survey. We are now back in there trying to put definitive

facts on——

Chairman SHELBY. But this investigation is just beginning, is it

not, into a lot of these?

Chairman DONALDSON. It is in full force, but it is early——

Chairman SHELBY. In full force, but I am speaking, in the time

frame of recent weeks, it is just beginning.

Chairman DONALDSON. Yes.

Chairman SHELBY. In that sense.

Chairman DONALDSON. It is. Let me say it is in full force, Senator.

Chairman SHELBY. But you are a long way from completing your

investigation.

Chairman DONALDSON. Absolutely. Absolutely.

Chairman SHELBY. Do you intend to look at every mutual fund?

I know you are looking at the big ones now, but are you going to

let some get swept aside?

Chairman DONALDSON. I think that we sent out Wells notices to

a number of funds where we found egregious evidence. We will attempt, one way or another, to get to all of these funds. We are

going to put some of the burden, in the early stages here, for having them come forward themselves by talking, as we have, to mutual fund directors, trustees, and the directors of management companies.

22

We have talked to all of the trade organizations and written letters to the heads, asking them to stimulate the self-policing that

should go on. So, we are going to get to all of them.

Chairman SHELBY. You do not believe these people can police

themselves, do you? You are not saying that here, are you? I hope

you are not.

Chairman DONALDSON. Well, I think we——

Chairman SHELBY. In view of all of what they have been doing,

abusing their mutual fund holders, trading for themselves and for

special——

Chairman DONALDSON. We are going to——

Chairman SHELBY. Are you suggesting—I hope you are not—that

they are going to police themselves?

Chairman DONALDSON. No, no, no. I am not suggesting that.

What I am suggesting is that, by the force of what we are doing

as we go about this methodically and with great intensity, we will

stimulate the fund leadership and directors to insist on their own

investigations, to insist on coming to us with their violations. We

are going to get to them one way or another.

Chairman SHELBY. But where is the SEC going to be? If you are

just waiting on them to come to you, you know, where is the SEC

going to be, and what role are you going to play? Are you just going

to wait for them to come to you or are you going to go, knowing

that the practice is so widespread. I hope you are going to go after

the culprits.

Chairman DONALDSON. Please be assured that we are going to.

Chairman SHELBY. Okay.

Chairman DONALDSON. I did not want to misrepresent to you

that—you know, we do have 450, close to 500 staff here, but we

also——

Chairman SHELBY. Absolutely.

Chairman DONALDSON. —have 8,000 and 6,000 or 7,000——

Chairman SHELBY. Mr. Chairman, we are going to furnish you

what resources you need, and I think it is going to depend on what

you want to do with those resources.

Mr. Chairman, we have two back-to-back votes, cloture votes on

the floor. You can tell by the absence of Members.

Chairman DONALDSON. I noticed that everybody disappeared.

Chairman SHELBY. What we are going to do, we are going to be

in recess until we get back. It will probably be at least 20 minutes

or more.

Chairman DONALDSON. Fine. Thank you.

[Recess.]

Chairman SHELBY. The hearing will come back to order.

Chairman Donaldson, when this Committee considered the global

settlement on research and analysts in May, we heard how the

State and the Federal regulators coordinated their investigations

and settlement efforts.

Given the size of the mutual fund industry, which you just described earlier, the scope of trading abuses, and the shared goals

of State and Federal regulators, it would seem to me that the regulators, that is, the SEC and the State regulators, should once again

coordinate efforts. I do not think, to date, a lot of that appears to

be happening, and perhaps you have a better view on it.

23

Are there, Mr. Chairman, ongoing discussions concerning how

State and Federal regulators, led by you, can coordinate investigations to more efficiently use resources and to implement broadreaching reforms, like you have done before? And if not, why not?

Chairman DONALDSON. Well, as I may have mentioned the last

time I appeared here, we have brought together a joint committee

of State regulators out of NASAA—their trade association—and

ourselves. We have met now formally early in November and have

an ongoing program of discussing with the State regulators how we

can cooperate with them in terms of the jurisdiction, overlap, et

cetera, and we are working toward that goal with them.

In terms of the bigger picture and rulemaking, I think, we can

do a lot of talking about what the rules should be, seek their advice

on that, but the final authority, in my view, must rest with the

Federal authority.

Chairman SHELBY. The SEC.

Chairman DONALDSON. The SEC.

Chairman SHELBY. That does not mean the investigations should

rest there, right?

Chairman DONALDSON. It does not.

Chairman SHELBY. You are not saying that, are you?

Chairman DONALDSON. As I have said before, and I will say

again, we welcome the local authorities. They operate in an area

that is an important supplement to what we are doing and, as has

been shown, it may not just be a supplement, it may be an initiating factor, and that is all for the good.

Chairman SHELBY. Mr. Chairman, some have suggested that the

recent fund abuses, and mutual fund abuses, demonstrate the pervasive conflict between interests of fund managers and fund shareholders. Some contend that these conflicts are a direct result of the

1940 Investment Management Act, which essentially created an industry structure in which each mutual fund more or less cedes control to the investment adviser. If the conflicts, Mr. Chairman, between the shareholders and fund managers are indeed institutionalized, then how do you propose to address these conflicts?

Chairman DONALDSON. I think there are several things that we

are doing or plan to do, the most important of which are the setting

up of Codes of Ethics at the manager level and at the fund level,

the setting up of people responsible for monitoring the ethical

guidelines in the management company, responsible for reporting

to the fund directors instances where rules have been broken or

about to be broken.

I think that the independence of the fund directors is perhaps

the most important——

Chairman SHELBY. An independent board?

Chairman DONALDSON. An independent board, independent

chairman of that board, and a recognition——

Chairman SHELBY. We do not have that today, do we?

Chairman DONALDSON. No, we do not. Some do, some do not, but

it is not——

Chairman SHELBY. It is not industrywide.

Chairman DONALDSON. It is not industrywide. Again, in terms of

our settlement with Putnam, although this will be a 75 percent

24

independent board, no decisions can be taken in certain areas without the approval of just the 75 independent and not the inside.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Chairman Shelby.

Chairman Donaldson, it seems clear that mutual funds, at least

in a number of instances, are paying commissions quite large in

comparison to other large investment managers, like pension funds

and that these inflated commission costs cost individual investors,

if you add it all up, it is small amounts for each investor, but there

is a lot of money involved, so you are really talking about billions

of dollars. Has the SEC studied the use of commissions by mutual

funds to finance the marketing and distribution of fund shares?

Chairman DONALDSON. It is very definitely an area of inquiry for

us and an area of concern, in terms of not only the disclosure of

that fact to mutual fund purchasers but also how Commission inducements, undisclosed, may be causing brokers to sell certain

funds rather than others.

Senator SARBANES. Well, now, Chairman Pitt announced publicly

that the Commission would review current distribution practices,

including indirect methods of financing and distribution. These

were remarks he made to the Investment Company Institute in

May 2002. I am now asking whether a study was done, pursuant

to that announcement.

Chairman DONALDSON. I am not familiar with that study. Paul

Roye tells me that our examination program has been looking at

these practices. I want to tell you that I am concerned about the

overall use of Commission dollars. As you know, there has been a

safe harbor provision for the use of brokerage dollars for the benefit of shareholders, for the benefit of mutual fund shareholders,

and I think that this is an area that has to be looked at very closely in terms of are those dollars being used for the benefit of shareholders or are they being used for other purposes, and clearly——

Senator SARBANES. I understand these Commission-generated

payments for marketing and distribution, that they are not being

itemized or disclosed to fund shareholders by their funds; correct?

Chairman DONALDSON. That is correct.

Senator SARBANES. If that is the case, is that not a violation of

Rule 12b–1, which only permits funds to use their assets to pay for

distribution, if such payments are made pursuant to a plan approved by fund shareholders and annually reviewed and approved

by the fund’s board? Would that not be contrary to 12b–1?

Chairman DONALDSON. The issue of 12b–1 is a complicated one,

and I would just say, generally speaking, that clearly the use of

commission dollars to induce sales of mutual fund shares is not

using those commission dollars for the benefit of the mutual fund

shareholders. It is using those commission dollars for the benefit

of the management company.

Now on 12b–1, that is a cloudy area, and I would like not to comment on that, but I will have to come back to you on the specifics

of 12b–1 and the potential violations there.

Chairman SHELBY. I understand there is a Greenwich study of 2002 that the mutual fund complexes with an average size of $32

billion paid an average of $92 million in commissions. This equates

to an average of 29 basis points of fund assets that were paid in

25

commissions. As I understand it, when large pension funds or

hedge funds buy or sell shares, they often pay 1 or 2 cents on the

stock trades, but the prevailing rate for mutual funds is 5 cents per

share. When you add all of that up, this is big money that is at

the expense of the investor.

Chairman DONALDSON. Yes. Again, there is a safe harbor aspect

of commissions, which allows commissions to be paid for services

that benefit the fund shareholders—research services and other

services that benefit——

Senator SARBANES. Yes, but don’t they have to have a plan in

order to do that, approved by fund shareholders, and does the

board not have to review and approve it each year?

Chairman DONALDSON. Senator Sarbanes, the board should be

approving those expenditures.

Senator SARBANES. Have they been doing that?

Chairman DONALDSON. That is what we are looking into right

now. I cannot give you a report fund-by-fund, but that certainly is

on our agenda.

Senator SARBANES. How do you respond to the allegations that

the SEC, including the Divisions of Investment Management Enforcement and the Office of Compliance Inspections and Examinations, have not been sufficiently aggressive in overseeing and in

policing the mutual fund industry?

Chairman DONALDSON. Well, let me put it this way. Those offices

have not been sitting on their hands. They have had a series of

things that are out, in terms of compliance and examinations, and

so forth, that they are examining for, a sense of priorities and so

forth. And I believe that, given the risk analysis work that we are

doing, that we can improve—vastly improve—the place where risk

lies, and I think we can vastly improve the quality and effectiveness of our inspections, and that goes without saying.

You know, we get back to this business of the numbers of funds

that we have to look at, and a number of advisers we have to look

at, do you have enough people to do it, and clearly the answer to

that is we have to be more effective in the way we do it. We have

to be more effective in identifying where the real risk areas are.

Senator SARBANES. Oh, I think we have identified a risk area

here with respect to the mutual funds.

[Laughter.]

I think that has been, regrettably, pretty well established over

the last 3 months. I am concerned about the questions that are

being raised about the effectiveness of the Commission of overseeing the mutual funds, whether there is sufficient coordination

amongst the divisions. Some have questioned whether the Office of

Compliance Inspection and Examinations has sufficient staff and

whether the staff is experienced enough to function effectively. I

think we have identified a problem area, much to the chagrin of

virtually everybody, and we need to get on it. Now, we are trying to get your budget. There is $841.5 million

in the House bill and in the Senate bill brought out of the Committee. We have not passed that particular appropriations bill, but

we are very hopeful we will be able to carry that money through

for you. You turned some money back in last year, as I understand

it, or did you keep it and put it to other use?

26

But in any event, it seems to me there is a real urgency here for

the Commission to get a real action program moving, and that is

what I am trying to impress you to do.

Chairman DONALDSON. Yes. Several questions you are putting

forth there. Number one is——

Senator SARBANES. I am doing that because my time has run out.

I am trying to be fair to my colleagues here.

Chairman DONALDSON. Let me just say that in the inspections

area, we have increased our personnel by 40 percent.

Senator CORZINE. Could the Chairman answer what that was

from to—you know, the 40 percent as against what?

Chairman DONALDSON. I am sorry, I did not get that, Senator.

Senator CORZINE. What does the 40 percent mean in absolute

numbers?

Chairman DONALDSON. In absolute terms, that means we have

gone, in just the area of mutual funds and investment advisers,

from 350 people to 500 people.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Corzine.

Senator SARBANES. Wait a minute. I think the Chairman is going

to add something else.

Chairman SHELBY. Oh, are you going to answer?

Senator CORZINE. The Ranking Member asked good and detailed

questions. There are probably a couple of dangling participles here

with regard to his questions. I do not want to interrupt.

Senator SARBANES. Did you want to add anything further? Otherwise, I will turn you over to Senator Corzine.

[Laughter.]

Chairman DONALDSON. I do not know which——

[Laughter.]

Chairman SHELBY. Mr. Chairman, you do not have to make that

choice. Senator Corzine is recognized.

Chairman DONALDSON. Let me just say that, clearly, we can improve the effectiveness of the way we go about things, and that is

what we are trying to do. That is what I was talking about in

terms of risk analysis. That is what we are talking about every day

in the agency—how can we do it better.

The only thing I was trying to say was that we have a whole

series of things that we do inspect for that are very important. We

did not inspect for late trading and market timing, nor has the

Commission inspected for that for many years. This is not a new

thing. This has been going on for a long time.

Chairman SHELBY. Was that widely understood to be going on in

the industry for a long time?

Chairman DONALDSON. I am sorry?

Chairman SHELBY. The late trading, was that widely understood

to be going on in the industry? Because it is so widespread.

Senator SARBANES. And the market timing.

Chairman DONALDSON. I can only quote from the press of a

former outstanding Chairman of the Securities and Exchange Commission, who publicly stated that it was a surprise to him.

Senator SARBANES. So it is not like Claude Raines in ‘‘Casablanca,’’ shocked that gambling was taking place in the back room?

It is not like that?

27

[Laughter.]

Chairman DONALDSON. I do not think so. I think that the extent

of this has come as a surprise to even the professionals.

Chairman SHELBY. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman.

Building on the questions of the Ranking Member, how often are

mutual funds inspected? These 350 going to 500 people, how often

do they sit down and examine?

Chairman DONALDSON. Are you talking about what it has been

or what it is going to be?

Senator CORZINE. What has been.

Chairman DONALDSON. I think that we have been trying to go on

a basis of once every 5 years, if I am not mistaken. Yes, 5 years.

And we are trying to cut that at least in half.

Senator CORZINE. I think one could, just on the common sense

of that, know that there is some personnel turnover over a number

of years inside those mutual funds, that it is a long time to go

without having any checks and balances or peeks into the kind of

behavior that has maybe happened.

Chairman DONALDSON. Yes. It also goes to trying to get smarter

about what you are looking for, through risk analysis, trying to get

at things that are going on or may be going on, trying to anticipate

that, as opposed to just doing a routine exam.

Senator CORZINE. I think risk analysis is a great idea inside any

organization. To some extent, I am not certain I can see how you

are going to be ahead of the most creative of those who want to

break the rules. There is some possibility that you will think of

every possible fraudulent kind of scheme that people can put forward, certainly know as one tried to manage an organization you

try to do that so that you could stop things happening before they

did. But I think it is a great concept and I welcome it, but I think

that actually going in and checking and actually having compliance

reviews and supervision reviews, which I think has been an issue

with regard to frequency that is really a function of resources and

the number of people that you have to be able to do that against

8,000 funds or whatever the number was that you talked about.

I think one of the things we have to do is make sure that we

have enough resources matched against the issue that you are trying to supervise and have responsibility for. Otherwise, I think you

create a moral hazard, that people think something is going on

when it really is not, and that is one of my worries.

One of the concepts that Senator Dodd and I have talked about,

which we are not yet recommending, although I am not certain

about it, I think a lot of people think the PCAOB is off to a good

start, that it is focused entirely on that aspect of our financial system, and will develop an expertise and targeted element, and it is

also a way to self fund in the inspection process. I wonder if you

thought about that at all at the SEC with regard to future directions, how you provide the oversight and secure it?

Chairman DONALDSON. The PCAOB has an indirect effect right

now in terms of the inspections of accounting, auditing standards,

et cetera, which will flow into the accounting that is used——

Senator CORZINE. I meant a mutual fund oversight board.

28

Chairman DONALDSON. If you are referring to a mutual fund

oversight board——

Senator DODD. Chairman Donaldson, just to pick up on this, Bill

McDonough yesterday made a public recommendation specifically

along these lines, to utilize the example in the Sarbanes-Oxley proposal included in the mutual funds. The Dow Jones yesterday reported in an interview with him. Just curious whether you may not

have known that.

Chairman DONALDSON. Two answers. Let me just go back for a

second to your statement that you are not going to be on top of everybody that is trying to do bad things. Those were not your exact

words. But I think that we can be a lot smarter than we are in

terms of being out in the field, understanding exactly what is going

on. There are a lot of things going on, as there are in any business,

and if you are out there and trying to understand—I am not saying

cavorting with the bad guys—but talking to people and so forth, I

think you can bring a new sophistication to your inspection work

that perhaps we have not had in the past.

In terms of an oversight board, as far as I am concerned, everything is on the table in terms of how we address some of the problems. I would be unwilling to say right now that we cannot move

ahead with the rules and regulations and remedies that I outlined

earlier this morning, and do a very good job doing that. I think we

have to prove to you and prove to the country that that cannot be

done before we go to the expense and the bureaucracy and so forth

of a whole new regulatory entity.

But that is just a personal opinion of mine right now, and, as I

say, we are willing to explore and discuss any remedy.

Senator CORZINE. Thank you.

Chairman SHELBY. Senator Dodd.

Senator DODD. Thank you, Mr. Chairman.

Chairman Donaldson, I think that your statement is very good.

I appreciated its thoroughness this morning as well—it covers a lot

of ground. I think the risk assessment idea is very sound and

makes a lot of sense. I agree with Senator Corzine in that regard.

One of my questions was about the Bill McDonough suggestion

in his interview yesterday about having a similar type of oversight

board here, and ask you to take a closer look at that to see what

you think. I did not expect you to necessarily endorse the idea this

morning, but we are told it is working pretty well in its present

construction in dealing with the accounting industry, and the reactions have been fairly positive, even from the industry, about it.

Chairman DONALDSON. I think that is true.

Senator DODD. It will be worthwhile to take a look.

I just want to, quickly if I can, I want to get to a third question.

But let me ask the second question. I reread your testimony here

during other questioning going on to see if I understood it pretty

correctly. I wonder if you might give us some greater clarity on the

independence of the board, and just very specifically independence

of the mutual fund boards. Should these boards be entirely independent, two-thirds, three-quarters? Have you given that any more

specific thought? How independent should the chairman of that

board be, totally independent? Can you be more specific?

Chairman DONALDSON. My own personal view?

29

Senator DODD. Yes.

Chairman DONALDSON. I think the board chairman should be totally independent, and the further you can go to a totally independent board the better. I think that has to be balanced with

some expertise, particular expertise that can be brought to the

board. So if we have a 10-person board, if there are a couple people

on that board that are ex-employees in the mutual fund industry

or that particular mutual fund complex, and bring knowledge of

that complex and so forth, I think that if you have 8 people that

are independent and 2 inside, that maybe the benefits of the two

are there. I would not say 100 percent, but that would be, I would

be shooting toward, rather, three-quarters, closer to three-quarters,

80 percent rather than 50 percent.

Senator DODD. What about certification of the accuracy and the

integrity of a fund’s financial statements?

Chairman DONALDSON. We have taken steps for those funds’

statements to be certified in accordance with Sarbanes-Oxley by

the chief financial officer and the chief executive officer.

Senator DODD. I wonder if you might look, if you get a chance—

we have not put this proposal in legislative form yet, but I think

we will sometime possibly this week, and obviously, we will want

to see legislative language in something that Senator Corzine and

I have put together, but I think we would appreciate getting a response from you about what you think of these ideas. We have covered a lot of ground. Some we have not. As we just mentioned, we

have been thinking about it. I would be very interested in what

your thoughts might be. Again, you are getting a lot on your plate

here, but nonetheless, we would be interested.

Let me jump to the question of the State and Feds. We are going

to have other witnesses here on Thursday. We have to break

through this in a way. I do not think it is helping the cause to have

people back and forth yelling at each other here when we have a

lot of work to do. It is not to suggest that people who are making

complaints are not without justification.

How do you deal with this thing? We have to break through this.

We cannot have you and Mr. Spitzer and the guy in Massachusetts

screaming at each other in a public forum every day. That does not

help in my view. So what are we going to do about that? How are

you going to solve that? Let us get right to it. What are you going

to do?

Chairman DONALDSON. I think the first step is for us to move as

expeditiously as we can to install the remedial efforts that we are

bringing to the table now. I think the faster we can get going the

better. I want to assure you that as we move along that path, if

we see things that we cannot do—and that gets pretty technical

here—but in terms of certain definitions of independence and so

forth, you know, that certainly would be helpful if we need legislation for that.

If you are addressing the issue of regulators, State and Federal

regulators, in some conflict, public conflict, I think that is very

counterproductive. I think it is unfortunate, and we certainly are

doing everything in our power to reduce that level of contention. As

I mentioned, we are bringing the State regulators together. We are

meeting with them regularly, and so forth and so on.

30

Senator DODD. Are there lines of communication? Is there anything, any effort being made? I mean just having competing op-ed

pieces and so forth, I am just worried about where this is going to

take us, if we are trying to fashion something here that makes

sense. Obviously, there are going to be times when you cannot stop

the differences appearing, but are there any structures you can put

in place on a regular basis so we can at least minimize where at

all possible?

Chairman DONALDSON. We are doing everything in our power to

work with the State regulators, and that includes all of them. Unfortunately, we cannot control what certain State regulators decide

they want to say publicly. I believe that it is very counterproductive, and we want to continue to work with the State regulators, and that includes all of them. We are doing everything in

our power to do that. It gets a little bit frustrating to be working

with somebody in partnership, and then read in a newspaper the

next day that they are attacking your agency. That does not help

the dedicated people in our agency who are breaking their necks

to address these problems. I do not know what can be done other

than to continue to try and work with them, to continue to recognize the role that they play, to be as candid as we can be, and that

is why I wrote the op-ed piece today, to try and explain exactly

what we did.

I believe that the criticism of the Putnam settlement was totally

unjustified and totally went to an issue of some other people’s desire to use the current powers of a State regulator to attack and

to bring to fore a whole series of remedies that did not pertain to

the specific issue at hand. I believe that we are very conscious of

our responsibility for developing remedies for the entire industry

and, insofar as we bring enforcement actions, to bring to bear in

the enforcement actions remedies that have to do with what we are

enforcing. In the case of Putnam, what we were enforcing was the

lack of supervision of some of their employees, and a lack of reporting of that, the knowledge of that to the fund directors. And to try

and bring in ideas of fees and other things, to that settlement did

not seem appropriate.

Senator DODD. But you made the point earlier that the Putnam

case is still very much open.

Chairman DONALDSON. Oh, absolutely.

Senator DODD. And the SEC is aggressively pursuing these other

questions?

Chairman DONALDSON. Absolutely, and that is part of my concern here with statements made that we have lost the opportunity

to pursue Putnam. It is just plain wrong. We have not. In fact, in

the other criticism coming out there is the language we use to ‘‘neither admit nor deny’’ and so forth; well, that is language that is

used in civil litigation across the Federal Government. It is language that has been used in New York State litigation. It is language that has been used in Massachusetts, so it is counterproductive.

Chairman SHELBY. What about Connecticut?

[Laughter.]

Chairman DONALDSON. I will check that.

Senator DODD. No, stay where you are. You are doing fine.

31

[Laughter.]

You understand that because this is the kind of stuff that it is

critically important we get to the bottom of this, and do what we

can to get this back on track again. Senator Corzine has said it better than I have. I think it sends so many different signals at a time

when you are trying to do what you can to restore confidence in

consumers, investors, in these very important instruments, and obviously we are going to have Mr. Spitzer here on Thursday to hear

that side of the equation. But I would just hope that a real effort

could be made here to achieve as much cooperation as possible.

I would add just briefly, if in fact the numbers in the staffing requirements are needed here, whatever the SEC needs to get on

track with this, I do not know what the schedule is, Mr. Chairman.

We have an omnibus appropriation bill coming along. We should

find out soon. I would hate to go through another whole year cycle

in all of this. So to the extent you can look at those numbers and

give us some idea, at least I would be interested to know what the

needs may be of the agency so that you can have the people on the

ground to do the job.

Thank you.

Chairman DONALDSON. We will do that.

Chairman SHELBY. Chairman Donaldson, I believe you used the

phrase earlier that the fund executives had lost sight of their duty.

I believe that was your phrase. How long ago did they lose sight

of their duty? Did they ever exercise that fiduciary duty, and if so,

when did they quit, or do you know?

Chairman DONALDSON. I do not know, is the bottom line. I do not

know, and I cannot make a judgment on when some of these practices began. I might say that the blanket indictment inherent in

your statement goes a little far. I mean I think there are lots of

fund executives out there who——

Chairman SHELBY. The ones who have not been neglecting their

duty or have not lost sight of their duty, they will prosper I am

sure. This will come out. But the ones that have lost sight of their

duty or never recognized their duty, they need to be exposed, for

what it is worth.

Chairman DONALDSON. Absolutely.

Chairman SHELBY. If I could borrow Senator Sarbanes’ paper,

your op-ed piece today in The Wall Street Journal, says ‘‘Investors

first.’’ I do not think the investors have been first in a lot of what

we have found out about the mutual fund industry. They should be

first just like your op-ed piece headline today in The Wall Street

Journal.

Along those lines, how much time and effort has been expended

by the SEC in supervising the mutual fund industry this year? I

know this is your first year there, but since you went on your

watch and were confirmed, it is not a long time in your tenure, but

I wonder how much time and effort by the SEC was spent looking

at the mutual fund industry. Maybe perhaps, well, even with your

predecessors too. Let us go back say 10 years, just use 10 years,

and if you do not know, could you furnish that for the record because we would be interested in this because if the mutual fund

groups were policing themselves, gosh, I do not think they had a

gun or a uniform on. It obviously has not worked for the most part.

32

But we would be interested in what the SEC has done, not only

on your watch, but also on Mr. Pitts’ watch, on Mr. Levitz’s watch

and others. I think that would be interesting.

Chairman DONALDSON. We would be very glad to try and put

some numbers——

Chairman SHELBY. We are not here to indict you. We are here

to learn.

Chairman DONALDSON. Sure. A totally legitimate request, and

we will try to do that for you. I think that it is only partially——

Chairman SHELBY. In other words, have you been on top of

things at the SEC, or did you think that the mutual funds, no complaints, no problems, everything is rosy. Seven trillion dollars, all

this money out there, 95 million Americans, everything was fine.

Is that the attitude, or has that been the attitude before the revelations of all the——

Chairman DONALDSON. I can only comment on my tenure, and

clearly, we have had an acceleration of attention to the mutual

fund industry. We have also, in our Investment Management Division, had an acceleration in our attention to the hedge fund industry.

Chairman SHELBY. Sure, and other scandals.

Chairman DONALDSON. I guess I would say that it is not just a

matter of time; it is a matter of the sophistication of the way you

go about it. And there is where I think we can do a better and better job.

Chairman SHELBY. Sophistication the way you enforce this and

supervise it?

Chairman DONALDSON. Oh, no, no, no.

Chairman SHELBY. What do you mean?

Chairman DONALDSON. I am not worried at all about our——

Chairman SHELBY. Sometimes you have to use a sledge hammer,

if it calls for it.

Chairman DONALDSON. What I am saying here is that I think

that our anticipatory power—I will make a statement now that

probably I have no right to make, but I will anyway, and that is

that had we had hedge funds under our purview, perhaps, just perhaps, we might have had a screening device to look at how hedge

funds were doing and how they were doing it, and we might have

discovered that certain hedge funds were getting a large portion of

their profits from market timing kinds of transactions, which might

have led us into looking at that issue.

We did not, and the fact of the matter was that in the case of

Canary that was a collusive arrangement that was purposely hidden and only came to the fore via a tipster, if you will, going in

and explaining it. But it is not something—but I think the chances

of having picked that up would have been enhanced had we had

more jurisdiction over hedge funds.

Chairman SHELBY. Mr. Chairman, I can tell you, we have had

hearings on that here. I think this Committee and this Senate will

give you as SEC Chairman, the tools, the legislation, the authority

to do whatever you need to do to police the securities industry, to

do it right, and that of course includes mutual funds, and what we

need is some guidance from you, some help, and we will certainly

continue to work with you and our staffs.

33

In your testimony, Mr. Chairman, you described a comprehensive

rulemaking initiative that calls for a number of rulemakings in December and January for additional study of certain issues. When

do you expect the SEC to complete its rulemaking addressing the

range of problems in the mutual fund industry?

Chairman DONALDSON. As I say, our first round of—I should say

second and third round because we have done a number of things

in the mutual fund industry up until now, in terms of mutual fund

advertising and so forth—first round in connection with late trading and market timing comes in early December, December 3. We

think right after the turn of the year we will be prepared on some

other things.

One of the challenges in rulemaking is to anticipate the unintended consequences of some of the rules that you make, and so it

is a deliberate process. And if it is rushed too fast, without properly

putting the rule out there for comment, then you make rules that

have unintended consequences.

Chairman SHELBY. Chairman, do you at the moment, or did you

say 3 months ago, have the authority to police the mutual fund industry had you focused on it, had the SEC investigators been involved in all aspects of it? Did you have the authority and did you

have the manpower? Did you have all the tools to do the job?

Chairman DONALDSON. Did we have those tools a couple months

ago?

Chairman SHELBY. Did you then and do you now? And if not, we

want to help you get those tools.

Chairman DONALDSON. I think we were building rapidly. We

have made substantial progress in adding to our staff. We have to

train that staff. So in effect, although we have more people there

in our inspection group, we have to train them to be good inspectors. That takes time. So, I think any of the inadequacies that are

there because of inadequate personnel are gradually being resolved. I think it is clear that we had other priorities that we were

inspecting for, and, in terms of what has developed now, we should

have had a higher priority on market timing and late trading.

Chairman SHELBY. How important is the problem that you are

facing with the mutual fund industry?

Chairman DONALDSON. How important is the——

Chairman SHELBY. How important is the problem that is facing

you with the SEC.

Chairman DONALDSON. Oh, I am sorry.

Chairman SHELBY. You are head of the SEC. How important is

that problem? Has it gotten to be one of the number one priorities?

Chairman DONALDSON. Hugely important. Very important. You

cannot have something affecting this number of people, this number of investors with their savings without having it right up at the

top of our priorities.

Chairman SHELBY. How do you get the word out to the mutual

fund people that you are not going to tolerate, the SEC is not going

to tolerate, the Congress is not going to tolerate cheating and stealing and all these things that go on in the industry, taking advantage of the mutual fund shareholder?

Chairman DONALDSON. I think the word is out there. I think it

is out there in a number of different ways. I have tried to speak

34

about it, as have the other professionals in the agency who speak

about these things. I believe that we have made it very clear in

terms of our examinations, our concern. I think we have made it

very clear in terms of our conversations with the trade organizations. I think the word is out there, and we will continue to push

it out there. It is a number one priority for us to remediate these

problems, and we are going to do it.

Chairman SHELBY. Thank you.

Senator Sarbanes.

Senator SARBANES. Thank you, Chairman Shelby. I know the

hour grows late and we want to move ahead and we want to get

at Mr. Fink and Mr. Lackritz. Actually, that is not a felicitous way

to express it.

[Laughter.]

I am sure that we want to hear their testimony and have a

chance to——

Chairman SHELBY. We look forward to their appearance.

Senator SARBANES. Yes. But before the Chairman leaves, I just

want to send maybe a somewhat different signal.

It is my perception that the State officials, securities commissioners and attorneys general, play a very important role in complementing and supplementing the work of the SEC. There is some

back and forth now, and I understand those sensitivities, but all

of you, they and the SEC, operate within a framework whose end

objective is to serve the public interest. And in the past I think we

have benefited from that. The SEC does not begin to have the kind

of resources and staff it would need to do all of the monitoring and

policing that is done at the State level by these various attorneys

general and securities commissioners. Would you agree with that

observation?

Chairman DONALDSON. Absolutely.

Senator SARBANES. There are some efforts in Congress, not here,

fortunately, but in some places, to pass statutory provisions which

seek to restrict or limit or knock these State officials, if not entirely

out of the picture, partly out of the picture. I take it the SEC is

not behind that or supportive of that in any way. Would that be

a right perception?

Chairman DONALDSON. The SEC has said in every way possible

that it welcomes collaboration with the State officials. Having said

that, the SEC says continually, and I have said continually, that

when it comes to writing the rules, that that has to be our responsibility, and insofar as State regulators step over the bound in settlements and attempt to write rules that should be Federal

rules——

Senator SARBANES. The rules that were written—I mean the only

thing that I understand that potentially fits in this category were

the rules on Wall Street where the analysts and the SEC participated in the writing of those rules, did it not?

Chairman DONALDSON. That was before my time, most of it was,

and the answer is yes. But as you know, the combination of regulators attempting to get together and write these rules does not

necessarily end up with exact rules that, if there was one regulator

there, that you would write. We know the issue of compromise and

adjustment and so forth inherent in that.

35

Senator SARBANES. I think one thing that has come through

rather clearly through all of this is that if a vacuum exists, if a

problem has developed, if investors are being abused, if the public

perceives that the public interest is not being addressed, then whoever moves into that vacuum is going to be welcome. And all this

does in effect is underscore some of the line of questioning I and

others were pursuing earlier of how imperative it is that the SEC

really be geared up in order to deal with these matters. Now, we

know you are trying to do that, and I think the risk analysis on

a broad basis is one thing. We have this risk and we need to address it, but I think it underscores the need for the SEC to move

ahead in a very vigorous fashion, and as the Chairman says, we

are supportive of that. We are prepared to support additional authorities if you judge that they are necessary, although some think

you have quite extensive authorities as it is, and of course a budget, which we are trying very hard to get for you. I mean the

budget of the SEC will virtually double over a 3-year period, and

we need to put those resources to work. We have tried to send a

signal to your employees that we are supportive of them. We want

to boost the morale. We think you have had that impact on the

agency in that regard, and we want to push that forward.

I understand a certain amount of this back and forth that is

going on. I know people are sensitive. No one is more sensitive to

criticism than Members of the Congress of the United States, that

is for sure. However, I do not think we should get so sensitive that

it in any way might impede the substantive work that is ahead,

because there is plenty of substantive work, in my view, for the

Commission and for the State Attorneys General and the State Securities Commissioners, wherever the particular State may place

the responsibilities.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman.

Let me congratulate Chairman Donaldson for what I think is

actually one of the most important issues, that while we focus on

mutual funds, the idea that almost every tough situation we come

in, the vacuum of lack of oversight of hedge funds. I do not think

all hedge funds are bad. There are all kinds of good players and

bad players in almost any industry. But the repetition of this without any kind of supervision I think is something that we all need

to pull together on and try to put together an oversight that does

not leave such an important part of our financial system completely

outside of those purviews. I do not understand how the risk analysis system would actually work when some of these ideas generate

outside of the purview of supervision. I congratulate you for focusing on that. I think it is a major step forward, to hear the Chairman of the Securities and Exchange Commission say that we

should be addressing this. I just want to be on record of supporting

that and looking forward to working with you on how that can be

done in a way that does not undermine liquidity and depth of markets, but gives people a little more confidence that every time there

is a problem in the industry, it does not somehow have some juxtaposition to what we have seen on a pretty regular basis. If you

go back in history, I think that can be identified pretty clearly.

36

One area that we have only touched on, but I think is extraordinarily important in this whole issue, and as you have identified

in the Putnam discussion, you deal with one issue and you carry

that through, at least from your perspective. It seems to me that

there is virtually no ability for someone, just a normal human

being, to sit down and do comparative shopping in this industry.

It is very hard to figure out what the total costs are to an individual for managing the funds. I think about management issues,

distribution issues or costs, management costs, distribution costs,

and service provision to the groups. It seems to me that that is virtually impossible for any shareholder to know what it is that they

are actually paying to get the investment services that they are

having.

I will take a little bit of both pride and probably shame in the

proposition that somehow we need to get to a composite cost of

what it is the investor is paying to get to the return that they are

asking for. Are you all working on concepts that will do that, more

than just giving a laundry list of what might be charged?

Chairman DONALDSON. Absolutely. First of all, I totally agree

with you in terms of the difficulty for a ordinary investor. I might

add, the difficulty——

Senator CORZINE. I do not know if you have to be too ordinary.

Chairman DONALDSON. Yes. It is difficult even for people who are

very sophisticated in finance to define exactly what is going on, exactly what those costs are.

Yes, we are working on that. We are working on a revised way

for the funds to put that forth to a perspective buyer, either in the

confirmation or better yet before the purchase is made, so that the

buyer knows exactly what they are buying. That is very, very much

front and center with us.

Senator CORZINE. I am sure Senator Dodd would say the same.

I really believe, and I am sure the Chairman and Ranking Member

feel the same way, this is an area that needs real depth to come

to the right answer, where people can actually do a comparative

shopping about how people are pricing the service that supposedly

it is giving, which is incredibly difficult to derive in this process.

I take that one step further on 12b–1 fees, were those originally

formulated to start a fund, or were they ever anticipated, do you

know from study and discussion inside the Commission whether

they were ever intended to be a permanent feature?

Chairman DONALDSON. I do not know the history of it, Senator,

but I do know that those fees have not always been there, and I

think there are probably people in the room who can give the history of just exactly when the 12b–1 fees came in. I think it had to

do with giving an assist to the funds and raising money which

would rebound to the benefit of all shareholders by having a broader base of capital, and therefore the expenses would be less because

you had a broader base of——

Senator CORZINE. Logic would say at some point that you have

captured some of those economies of scale, logic presumed.

Chairman DONALDSON. Logic presumed, that is an area to take

a look at, sure.

Senator CORZINE. Thank you, Mr. Chairman.

37

Chairman SHELBY. Chairman Donaldson, we appreciate your patience here with us today. We appreciate your statement, and I am

sure you will be back. We will continue working on this. This is not

an issue that is going to be swept away, and it is certainly not

going to be swept under the rug.

Chairman DONALDSON. Thank you. Delighted to be here.

Chairman SHELBY. We are now going to call up our second panel.

Matthew P. Fink, President of the Investment Company Institute,

and Marc E. Lackritz, President of Securities Industry Association.

Your written statements will be made part of the record. You

have sat through these hearings already today. If you could sum

up your opening statement within 5 minutes, it would help us

move along.

Mr. Fink, we will start with you.

STATEMENT OF MATTHEW P. FINK

PRESIDENT, INVESTMENT COMPANY INSTITUTE

Mr. FINK. Thank you, Mr. Chairman.

I have to say that I am appalled by the circumstances that made

you call this hearing. Like you and the other Members of the Committee, and most importantly, your constituents, I am personally

outraged by the betrayal of trust and fiduciary duties exhibited by

people in the fund industry.

I have represented the fund industry at the Institute for 32

years. I started when the industry had total assets of $54 billion,

which is less than 1 percent of what they have today. I have often

been asked over the years, including by Members of this Committee, why has the fund industry succeeded so well? There are a

lot of reasons, but I have always said the core reason is the 1940

Act, its tradition of integrity, and I regret to say with all my heart

that today that tradition of integrity is widely questioned.

The industry’s goal today is simple. We want to work with you

and other policymakers to rebuild trust, renew investor confidence

and reinforce our previous history of putting the interest of investors first.

I think action should be taken in three areas. First, Government

officials must identify everyone who violated the law. Those who

acted willfully against the interests of fund shareholders should be

sanctioned and sanctioned severely. And those who are found to

have violated the criminal laws should be sent to prison.

In response to a question, Mr. Chairman, you had of Chairman

Donaldson, what is the best way to get the message out to the fund

industry? That is the best way.

Second, shareholders who were harmed in any of these funds

should be made right. It is a particular outrage that some funds

permitted a few large shareholders to prey on smaller shareholders. This repudiates perhaps the most fundamental principle

underlying mutual funds, that every shareholder, large and small,

should be treated alike.

Third, effective reforms have to be put in place to make sure that

this kind of thing never happens again. Last month our Chairman,

Paul Haaga, said, ‘‘Everything’s on the table.’’ That was not just a

cute sound bite. It was a call to action for the industry, and indeed,

38

a few weeks after that, we called for major reforms in three of the

areas that have been revealed by the investigations.

First, with respect to late trading, trades coming in after 4

o’clock but getting the 4 o’clock price, we have urged the SEC to

require that all fund transactions must be received by the fund

itself by 4 p.m. I was very glad to hear Chairman Donaldson indicate that that is what the SEC will propose.

Chairman SHELBY. How would that work, Mr. Fink?

Mr. FINK. That would mean that presumably if you had an account with a broker, right now you can hit the broker by 4 p.m.

This would probably mean you would have to hit the broker by 2:30

p.m. If you are in a 401(k) plan, many of them take a day to process, so it would probably mean if you put your order in today, you

probably would not get today’s price, you might get tomorrow’s

price. But for 90 percent or more of fund shareholders who are buying for the long-term, you and I in our 401(k) plan or Government

Thrift Plan, we are not trying to buy today’s price or tomorrow’s

price, we are putting our money in for the long-term. I think to

stamp out late trading, which is against the law, but we found, according to Mr. Cutler, 10 percent of fund companies saying they

are aware of it, 25 percent of brokers surveyed saying they were

doing it, you are going to need some tough medicine like that.

I have to say though that if technological developments now or

later can occur which give the same assurance that if the order

reaches the intermediary, the broker or bank by 4 p.m., that that

can be as foolproof as reaching the fund by 4 p.m. We would support that as well. But for the moment, until somebody can show us

or the SEC or the Congress something as good as a hard 4 p.m.

at the fund, we will back a hard 4 p.m. at the fund.

The second reform is abusive short-term market timing, and

there we have urged the SEC to require all long-term mutual funds

to impose a 2 percent redemption fee on any sale of fund shares

within 5 days of purchase. All fees collected would go to the fund

and not to its adviser. I am convinced, as are people in the industry, that an across-the-board uniform 2 percent redemption fee has

to be mandated to stop abusive short-term trading. You heard

Chairman Donaldson before talk about the problems in omnibus

accounts. These are accounts by brokers or banks or 401(k) plans

where the fund has no idea who the individual shareholders are

and has no way to police their individual activities. Intermediaries

say rightly that they cannot police 20 different fund groups’ special

rules to get at these short-term timers, and that is why a 2 percent

across-the-board fee would get at that. Every intermediary could

impose it easily.

The third issue that came up in the investigations, Mr. Chairman, is the worst probably, and that is short-term trading of fund

shares, not by outsiders, not by hedge funds, but by fund portfolio

managers and indeed senior executives. And we stated our support

for any steps to make it clear that that kind of practice is not just

repellant, but should be made illegal.

These were our initial recommendations which were designed to

address the three major abuses that came out of the investigations.

I also have to say, the need for additional reform is absolutely

clear. Fortunately, we do not have to begin the process from

39

scratch. We have a strong foundation in the Investment Company

Act.

Today, I must say I heard Chairman Donaldson lay out a laundry list. Senator Dodd referred to the legislation he and Senator

Corzine are drafting. I would be happy to comment on the specifics

of any of that.

I just say, going back in history, this Committee passed unanimously the Investment Company Act in 1940, which set the foundation for the modern mutual fund industry. A number of observers including consumer advocates have pointed to the Investment

Company Act as one of Congress’ greatest achievements. I will

make three points about the Act. First, it is much more demanding

than the other securities laws, much more restrictive. Second, it is

the only securities law that passed the Congress unanimously, and

third, it is the only securities law that was supported by the industry it regulated, the mutual fund industry.

When the Act was signed in 1940, the President made mention

of the fact that it was supported by the industry, and asked that

the industry continue to cooperate with the SEC and the Congress

in the future. The Institute has done that for 63 years, and we

pledge to continue to do so.

On a personal note, I might say that just before these scandals

broke out, I announced that I would retire from the Investment

Company Institute at the end of 2004. I want to personally promise

every Member of this Committee that I will use all of my energies

during this time to ensure that abuses are effectively addressed

and regulatory weaknesses are remedied.

I have to say that revelations about corporate misconduct during

the past 2 years and about mutual funds since September 3, provide reason for all of us to be cynical about how American businesses approach their responsibilities. But I hope if my appearance

today is remembered for only one thing, it is the following. The

Investment Company Institute is truly horrified at the betrayal of

shareholders that has occurred at some mutual fund companies.

We understand completely that enduring trust and confidence in

funds will not be achieved by words or half measures. As the reform process continues, you and other policymakers should expect

a lot from us. I respectfully ask only one thing, that our commitment to reform be judged by our actions.

Mutual funds, as other witnesses have said, are where Americans invest. In over half of all households, more than 60 percent

of middle-income households, funds are an integral part of people’s

financial lives and an integral part of our capital markets. If we

all do not get together and fix these problems, I think we all will

suffer, and we cannot let that happen.

Thank you.

Chairman SHELBY. Thank you.

Mr. Lackritz.

STATEMENT OF MARC E. LACKRITZ

PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

Mr. LACKRITZ. Thank you, Mr. Chairman. I appreciate the opportunity to be here in front of the Committee to talk about these

40

issues involving the integrity of both mutual funds and the brokerdealers that I represent.

While regulation of the securities industry is really based on the

two principles of full disclosure and competition, the core bedrock

asset underlying the success of the industry in the markets is the

public’s trust and confidence in the markets and in the professionalism of the individuals participating. So, we find anything

that impugns the public’s trust and confidence to be of the most urgent nature, and therefore, we pledge to do everything we can, Mr.

Chairman, to work with you and the regulators to earn back the

public’s trust and confidence in this area.

Over the past 10 years our industry has raised more than $21

trillion of capital for economic growth, for new enterprises, for new

processes, for new systems, for hospitals, for roads, and for schools.

That is only possible if the public has trust in the integrity of the

markets so that the markets can efficiently and effectively channel

capital from institutions and individuals that have it to institutions

and individuals that need it.

Mutual funds are the vehicle by which an overwhelming majority

of investors participate in our markets, and as a result we are very

dependent on the health and integrity of the public’s continued robust participation in mutual funds and in the capital markets. The

most recent numbers indicate that mutual funds owned a little

more than one-fifth of the equity market capitalization. So, there

are significant participants in the capital markets, and our ability

to perform our roles as intermediaries depends on their continued

vitality.

Moreover, the retail investor is the backbone of both the mutual

fund industry and our markets, and investors, as has been stated

earlier by Chairman Donaldson and by Mr. Fink, have to come

first. Our core value that we have been pushing in our industry has

been to make sure to put clients’ interests and customers’ interests

first if we want them to continue to entrust their money to mutual

funds. They also must be assured that fraud, self-dealing, and dishonesty will not be tolerated in any way, shape or form. All investors have to be treated fairly and all aspects of the mutual fund

business, including fund fee structures, financial incentives offered

to intermediaries to recommend specific funds, fund investment

and redemption policies and fund governance, must be as transparent as possible to investors and to the public.

In addition, all investors should be assured of reasonably prompt

execution and fair pricing of their mutual funds transactions.

The recent behavior that has been addressed involves three

issues that I would like to speak to. One is late trading or market

timing in contravention of stated fund policies. Two is lack of full

disclosure, and three is operational shortcomings relating to breakpoints. All of these instances share one element, Mr. Chairman—

they hurt investors. Each of these issues has to be addressed

swiftly and comprehensively by tough enforcement actions first

and foremost where wrongdoing has occurred, by thoughtful regulatory revisions to make sure that these problems will never recur

again, and by legislation to fill in existing gaps in the law where

they may occur.

41

At the same time it is equally important that regulatory or legislative solutions do not create new problems or other unintended

consequences for investors in the course of remedying these existing ones.

First of all, with respect to late trading, we, like everyone else,

have been appalled by the number of instances of mutual fund late

trading. In addition to stringent, tough, sure enforcement actions,

we believe additional regulatory actions should be taken to ensure

that these abuses can never happen again. Any new regulation

here should make sure to be reliable and bulletproof to any new

forms of evasion, should make sure to give investors—all investors—the widest array of opportunities to trade on information in

the marketplace, and to treat all investors, large and small, institutional and retail, alike, equally. Finally, it should make sure to

synchronize any new mandates with the existing and well proven

operational systems that clear and settle these transactions today.

Several proposals have emerged to address late trading by establishing a hard close for open-end mutual fund purchase or redemption that assures that order acceptance could be later than the New

York Stock Exchange closing at 4 p.m. As discussed in greater detail in my written testimony, we think that a hard close that can

only occur at the mutual fund has some very significant drawbacks

for investors, and also may have some major operational difficulties. A hard close at the broker-dealer or other intermediary would

be preferable from the vantage point of most retail investors and

retirement plan participants. In any event, we must demonstrate

to the public not only that late trading will be punished severely,

but also that it will be foreclosed from ever happening again.

Now with respect to market timing, recent enforcement actions

and press reports of ongoing investigations appear to involve instances in which funds and intermediaries facilitated market timing transactions despite statements in the fund prospectuses that

the fund would not assist in such activities. We fully agree with

SEC Chairman Donaldson that rules regarding disclosure of fund

policies and procedures on market timing should be tightened, and

that funds should be required to have procedures to fully comply

with any representations that they make concerning their market

timing policies.

We would also propose a requirement that sufficient trade level

customer detail be provided to funds to assist them in identifying

market timing activities on transactions submitted by intermediaries on an aggregated basis by these omnibus accounts. A further

step would be to permit funds to impose a fee on any fund shares

redeemed within five days of purchasing them. And finally, we support SEC action to address the overall issue of stale pricing, because stale pricing really is at the core of these kinds of abuses.

People take advantage of the stale prices. If we could find a way

to eliminate the stale prices, that would go a long way to eliminating these abuses in addition to these other regulatory actions.

In the area of disclosure, Mr. Chairman, we favor clear, direct,

timely disclosure of all material information to investors in a central place or central document. It is important to make it investor

accessible and investor friendly, rather than a ‘‘where’s Waldo’’

search through fragments of disclosure for relevant information. In

42

that vein, we strongly support efforts to enhance transparency of

revenue sharing and differential compensation to mutual fund investors. We also believe investors should have full, complete, and

useful information on fund fees, since they can have a significant

effect on an investor’s return.

The most efficient means for providing this information to investors, and the basis on which they can do comparability surveys and

use comparison shopping to see what others are offering, is to calculate these expenses based on a hypothetical $1,000 investment.

We also believe that mutual funds should ensure effective disclosure of soft-dollar practices, both to investors and to fund trustees.

Finally, we have worked very closely with regulators to ensure

that broker-dealers and funds are adequately addressing breakpoint concerns. We are exploring additional ways in which breakpoint policies can be made easier to apply. In this way the risk of

any further operational problems regarding customers receiving the

correct breakpoint would be significantly reduced.

Like many investors, regulators and yourselves, we have been

surprised and extremely dismayed by the reports of abuses relating

to the sale of mutual funds to investors. We are fully committed,

Mr. Chairman, to addressing these concerns thoroughly by supporting vigorous enforcement of current rules and by supporting

appropriate legislative and regulatory reforms where appropriate.

We and our member firms will work with you, Mr. Chairman,

and your colleagues to ensure that mutual fund investors once

again can have justifiable faith in these products and our markets.

We look forward, Mr. Chairman, to working with you and the Committee to earn back the public’s trust and confidence.

Thank you very much.

Chairman SHELBY. Thank you.

Mr. Fink, some have stated that market timing and late trading

activities have long been open secrets in the fund industry. Prior

to the recent revelations regarding late trading and market timing,

were you, sir, aware of such practices, and how did the Investment

Company Institute advise its members to address such practices?

Mr. FINK. Late trading—I was totally unaware. Late trading is

a direct violation of the law. I could imagine or may have imagined

some inadvertent——

Chairman SHELBY. You did not know anything about it?

Mr. FINK. Never dawned on me, no, sir. Market timing, we knew

a lot—first of all, there is some innocent market timing where people are reallocating, but the abusive——

Chairman SHELBY. And some noninnocent market timing.

Mr. FINK. Sorry.

Chairman SHELBY. There is some noninnocent market timing.

Mr. FINK. Noninnocent is what I am talking about. We knew a

lot was going on because we could look at the redemption rates of

international funds, which were high. And we read Professor

Zitzewitz’s paper. Our members came to us and said, ‘‘We need

more tools to combat it.’’ So, we worked with the SEC. They came

out with a release on addressing fair valuation, to address stale

pricing. We did a compliance guide for our members. We went to

the SEC to get an increase in redemption fees. So, I knew a lot was

going on, but it never dawned on me, Mr. Chairman, that anybody

43

at a fund group was selling outsiders the privilege to market time

for a quid pro quo, no less than anybody in the fund group themselves were doing this abusive timing.

I did find, going back through our files, one member told us—a

couple of years ago—told one of my colleagues they were approached by an outside—it was a hedge fund or Canary—and dismissed it, told him to go away. I thought that was a fluke. It is

incredible, but nobody at the Institute, SEC, NASD, that I have

spoken to, ever had a clue that this stuff was going on.

Chairman SHELBY. Were they blind themselves, or were they

blind because they did not want to see anything?

Mr. FINK. Well, I do not know the answer to that.

Chairman SHELBY. Okay. Sir, I will ask you the same question.

You represent the broker-dealers and so forth, the people who

make the trades. Prior to the recent revelations regarding late

trading and market timing, were you aware in the securities industry of such practices? And if so, how did you react to them? Because they were going on with your people.

Mr. LACKRITZ. Mr. Chairman, with respect to late trading, I had

no knowledge whatsoever that that was going on. First of all, it is

clearly against the law. I mean, it is clearly illegal. And, therefore,

anybody engaged in this would have to expect to be prosecuted. I

had no knowledge of any of that.

Chairman SHELBY. No rumors, anything? Anything just widespread, this deep, as Senator Sarbanes said, involving the amount

of money involved?

Mr. LACKRITZ. I suspect in retrospect you could look back and

say if somebody were going to follow the money and try and figure

out where the money was going back during a period of time and

you saw assets building up in some part of the market that was

heavily engaged in certain kinds of trading, perhaps in retrospect

you would say, Ah, that is where we should have gone. But I can

tell you, I had no knowledge of it whatsoever, and I do not know

of anybody else either in our organization, in any of the self-regulatory organizations, in the Commission——

Chairman SHELBY. Had the SEC ever notified you or shown any

interest in this kind of stuff, late trading, market timing?

Mr. LACKRITZ. No, sir.

Chairman SHELBY. What about you?

Mr. FINK. Well, market timing, we knew a lot was going on with

stale prices, so the SEC sent out letters to me or to the industry

telling——

Chairman SHELBY. When was this?

Mr. FINK. Two or 3 years ago? I am losing my dates. In 2001.

Chairman SHELBY. By a letter, what do you mean?

Mr. FINK. There was a letter from an assistant director at the

SEC reminding people that on valuation of securities, foreign securities, after the foreign market closed there was a ‘‘significant

event,’’ the fund better consider not using those closing prices in

Tokyo but use fair value.

Chairman SHELBY. And what happened to that letter? It wasn’t

heeded, was it?

Mr. FINK. No, a lot of people did heed it. But I cannot tell you

the level of compliance, Mr. Chairman, because we, my colleague

44

behind me, prepared a compliance guide for our members to help

them comply. And so, I think people did comply. I cannot talk

about 100 percent, but there was compliance.

Chairman SHELBY. Senator Sarbanes, you have a question?

Senator SARBANES. Yes. Steven Cutler, the Enforcement Director

of the SEC, has said, ‘‘More than 25 percent of firms responding

to an SEC mutual fund inquiry report that customers have received 4 p.m. prices for orders placed or confirmed after 4 p.m.’’

More than 25 percent. ‘‘Fifty percent of responding fund groups appear to have had at least one arrangement allowing for market

timing by an investor.’’ Fifty percent.

‘‘Documents provided by almost 30 percent of responding brokerage firms indicate that they may have assisted market timers in

some way, such as by breaking up large orders or setting up special

accounts to conceal their own or their clients’ identities, a practice

sometimes called ‘cloning,’ to avoid detection by mutual funds that

sought to prevent abusive market timing. Almost 70 percent of responding brokerage firms reported being aware of timing activities

by their customers.’’

Now, I have just listened to both of you, and it is a problem for

all of us. Why weren’t we aware of this? Why wasn’t something

done about it? Why didn’t the Congress get at it? Why didn’t the

SEC get at it?

But you sit at the top of the pyramid of your industries, and you

are telling us here today, we did not know this was happening; it

came as a total surprise to us. Yet, as the Chairman indicated in

his question, we get reports now coming into us that say, well, it

was an open secret that this was taking place. You have this survey now by Cutler that has these, 30 percent, 50 percent, 70 percent. I mean, what was going on?

Mr. FINK. This is no defense, Senator, but remember, neither the

SIA nor the ICI are SRO’s. We are trade association lobby groups,

and we do not go out and inspect our members. So, we would hear

it almost as people would come to us with a problem. Again, we

knew about market timing. And you cannot tell from that response,

Senator, when Mr. Cutler said about funds or brokers, you cannot

tell was it abusive or not. I have it in front of me.

Chairman SHELBY. Well, you could tell if it was abusive if you

looked closely at it, though.

Mr. FINK. No, from what Mr. Cutler even said in testimony, I

think, he could not tell in each case was it abusive or not.

Chairman SHELBY. He did not look closely enough.

Mr. LACKRITZ. If I could just talk about it, the market timing per

se is not illegal. The problem here is that it was allowed to happen

selectively in exchange for a quid pro quo to the detriment of every

other fund shareholder.

Chairman SHELBY. So, they betrayed the shareholders, is what

they did.

Mr. LACKRITZ. I am sorry?

Chairman SHELBY. They betrayed the shareholders.

Mr. LACKRITZ. Absolutely. Right, that is correct.

Chairman SHELBY. They were dealing on the side.

Mr. LACKRITZ. That is correct.

45

Senator SARBANES. I take it, though, from your answer, Mr.

Fink, about being a trade association that neither you nor the SIA

feel any special or particular responsibility for the practices by your

members. I mean, you are simply there to lobby against legislation

or for legislation that affects their interests or to try to, I guess,

strengthen their position within the industry and so forth. But you

feel no responsibility with respect to addressing these——

Mr. FINK. No, not at all, Senator. I simply meant that my own

awareness of this issue, I do not go out and—we do not inspect and

know what is going on day-to-day. I feel full responsibility, more

than I can say, for these wrongs, and I and my organization will

do everything to correct them. That is why we have called for these

three tough measures that a lot of our members do not like, I have

to say, Mr. Chairman, a lot of intermediaries do not like. That is

why I am supportive of what I could hear Chairman Donaldson

say. So if I misspoke, I do feel responsibility. Simply on the narrow

issue of why I did not know, I am not out there, my staff is not

out there inspecting funds and brokers.

Senator SARBANES. Let me just close, if I could, Mr. Chairman,

with this one quote.

Chairman SHELBY. Okay. Go ahead.

Senator SARBANES. On March 12 of this year, the Chairman of

the ICI appeared before the House Financial Services Committee

and made the following statement: ‘‘The strict regulation that implements these objectives has allowed the industry to garner and

maintain the confidence of investors and also has kept the industry

free of the types of problems that have surfaced in other businesses

in the recent past. An examination of several of the regulatory

measures that have been adopted or are under consideration to address problems that led to the massive corporate and accounting

scandals of the past few years provides a strong endorsement for

the system under which mutual funds already operate.’’

Now that is your Chairman telling the Congress.

Mr. FINK. If I can try to speak on his behalf, Senator, he did not

know about these issues either. The legislation proposal that he

was talking about had nothing to do with late trading, market timing, selective disclosure. These issues blindsided him as much as

they did Mr. Lackritz and me. I think what he was referring to,

Senator, was that, for example, in 1940, the Congress mandated a

system of independent directors for mutual funds, and that model

I think was used in Sarbanes-Oxley, and then the New York Stock

Exchange using unlisted companies. That is what I took his remark

to mean, but I have to say he was as innocent—if that is the

word—or dumb as I was because none of us knew this stuff was

going on in March when he made the statement.

Chairman SHELBY. Mr. Lackritz, most individual investors, as

you know, do not have the same level of financial sophistication as

their broker. So, they trust or have heretofore trusted their broker

to place them in a good investment. That is the order of the day.

For this reason, and among others, I am very concerned about the

allegations that brokers sold investors more expensive Class B fund

shares in order to boost their own brokerage commissions. In these

situations, brokers knowingly took advantage of their clients who

may not have understood the technicalities of loads in 12b–1 fees.

46

How do you modify internal compliance programs to halt such activities? Further, how do you move beyond rules and regulations to

change the corporate ethics so that brokers do not feel like they can

take advantage of their clients? I believe myself that the mutual

fund industry—and I hate to say this—is deeply tainted right now.

You can see the exodus of money going out. Maybe not all funds,

but it is widespread. Do you want to respond?

Mr. LACKRITZ. Yes, absolutely, Mr. Chairman, and I think the

question you are speaking to is something where we have an obligation to do everything we can both to change the culture, to make

sure the values are right, and to drive that through organizations.

Chairman SHELBY. Not take advantage of the unsuspecting, innocent people who trust you to do these things.

Mr. LACKRITZ. A lot of it has to do with making sure that our

industry and our professionals understand that the most important

value is to put the interests of the customer first, and that we emphasize that over and over again. In addition, we at least as an organization provide a series of professional education programs for

our professionals so that they can continue to improve their level

of understanding.

I would also suggest that Steve Cutler’s notion that each firm

should do an internal audit of every single one of its business practices to identify conflicts and to either eliminate them or disclose

them, and then to manage them more effectively is what a number

of our firms are currently undergoing.

I know a number of our largest firms have already initiated internal audits so that they, in fact, go through every single one of

their processes, every single one of their products, to identify where

there are potential conflicts. Then they either work to eliminate the

conflict or to manage it and disclose it effectively to investors.

But I think it gets back, Mr. Chairman, to something you said

earlier. It gets back to a question of values and culture, and I think

that is the most important issue, where we have to recommit ourselves to a culture of putting the customers’ interests first.

Chairman SHELBY. It is going to be hard, too, isn’t it?

Mr. LACKRITZ. Well, yes, but I think this obviously has been a

wakeup call for all of us, and I know our industry and my members

take this very seriously. They are as appalled as anybody else at

this kind of behavior and committed to doing everything we can to

turn it around.

Chairman SHELBY. Is there any one thing that is more important

than trust?

Mr. LACKRITZ. No, there is nothing more important than trust.

Plus it takes a very long time to build up a relationship of trust,

and it just takes, you know, one incident to throw it away.

Chairman SHELBY. Absolutely.

Mr. Fink, many contend that the conflicts between fund managers and shareholders are institutionalized in the structure of the

fund industry. To address this conflict, some have proposed various

reform proposals such as requiring funds to have boards with a

super majority of independent directors and an independent chairman, and to submit the advisory contract to competitive bidding

process. What are your views on this and other governance reform

proposals?

47

Mr. FINK. I think there is an inherent conflict, but it is true in

every area of money management—pension management, bank

trust departments. It is what Justice Brandeis called ‘‘other people’s money.’’ The Investment Company Act attempts to put checks

and balances in, and I think they can be improved. The Act requires 40 percent of the directors to be independent. The SEC by

rule has made it a majority. The Investment Company Institute’s

best practices make it two-thirds. I think Senators Dodd and

Corzine’s legislation talks about 75 percent. I think increasing it

would be a good thing, to two-thirds to 75 percent.

The second thing that would be good would be a tougher definition of ‘‘independence.’’ Under the current statute, you can work as

a fund manager, leave, and in 2 years come back as an independent director. I think that is a mistake. Our best practices say

if you ever work for the manager, you cannot come back as an independent director.

There is a law that deals with relatives. You cannot have a blood

relative of somebody as the adviser. Somebody put his uncle on.

That should be extended so not just blood relatives but more extended relatives. So, I would do those things.

Chairman SHELBY. Well, what about the brother-in-law and stuff

like that?

Mr. FINK. I cannot do enough of that. I can never figure out who

is a great-uncle or—but it should be extended beyond parent-child,

brother-sister.

I think one thing to think about, though, Senator, are these

caused by a breakdown in corporate governance, which I am not

convinced, or the lack of the directors’ having tools to find out what

is going on. I am all for making better corporate governance, but

I think here, just reading the newspaper accounts, there were compliance systems and the head of the company said, well, do not

count me in the compliance system.

Chairman SHELBY. There are directors, and then there are directors that are involved. Aren’t there different types of directors?

Mr. FINK. Yes.

Chairman SHELBY. You can have directors——

Mr. FINK. But they could be 90 percent independent, the brightest men and women ever, but they do not have the tools to find

out what is going on. So, I think the most important proposal in

my mind is the SEC’s proposed compliance rule requiring every

fund have a compliance officer—so, I would do that.

The independent chair I am just wary of because it sounds like

a magic cure, but only about 20 percent of the industry today have

independent chairs.

In Canary, two of the four firms that Mr. Spitzer found had independent chairs, and if my count this morning is right, of the 11

firms total that have been charged by the SEC or the New York

Attorney General, four of the 11 have independent chairs. So it

sounds good, but I am not sure it does much. And, more importantly, when I speak to good independent directors I know and I

say, ‘‘Who do you want as your chair? You are a majority, you are

two-thirds. You can pick whoever you want.’’ They would prefer a

management company person because 90 percent of the matters

that come before a fund board are ministerial, administrative, and

48

the person regularly working there is better putting the agenda together. When they get to a conflict matter between the fund and

the adviser, the 1940 Act requires that the inside directors leave

the room and only the independent directors be there to decide.

They could say rather than an independent chair, I would require

that every fund’s group of independent directors choose a lead independent director.

I got long-winded, but I am all in favor of two-thirds to threequarters, tougher definition of independence, compliance officer. I

would prefer a lead independent director to a chair. Putting the

contract out for bid I think is weird. T. Rowe Price in Baltimore,

Mr. Price, decides to go into the money management business,

manages rich people’s money, foundations, and in 1950, he decides

to create T. Rowe Price Growth Fund, spends a lot of money and

energy, builds it up. There are directors there to watch out for

shareholders, but Mr. Price would not go in the business if any day

a T. Rowe Price director said, ‘‘Gee, we are going to Fidelity.’’

And look at us as consumers. Mr. Lackritz and I have lunch. He

has $100,000 to invest. We read Morningstar. We do a lot of research. We pick the Fidelity Growth Fund because Joe up there is

a great growth fund manager. We do not expect the Fidelity directors tomorrow to say, ‘‘We are taking the fund to Putnam.’’

I said in my testimony before the Committee without jurisdiction,

Mr. Chairman, that it is as if I ordered a Chevrolet and a Ford

showed up in my driveway. I think we need better directorial control, more fiduciary duties. I am in favor of tougher regulation, as

well as sending people to prison. But I think putting the contract

out to bid is upside down.

Thank you.

Chairman SHELBY. Mr. Lackritz, a recent report described the

multiple problems regarding the granting of breakpoint discount to

investors. In response to this report, what actions has the brokerdealer community, your people, taken to ensure that investors receive the discounts to which they are entitled? For example, are

brokerage houses considering changes to the way they use omnibus

accounts?

Mr. LACKRITZ. I am glad you asked that, Mr. Chairman. When

we were first notified about the breakpoint problem by the NASD

and the SEC last December, we participated, along with the Investment Company Institute——

Chairman SHELBY. Explain to the audience what a breakpoint

problem is.

Mr. LACKRITZ. The breakpoint problem is that mutual funds all

have a list of fees in which they will give a discount, if you will,

at certain breakpoints. If an investor is investing, say, $50,000——

Chairman SHELBY. Certain amounts.

Mr. LACKRITZ. Certain amounts, that is right, certain threshold

amounts. The challenge in this situation is investors sometimes

have multiple accounts at different brokerage firms, sometimes

deal directly with the fund families themselves. So it is very hard

sometimes to aggregate the information operationally to do that.

What the NASD discovered in their inspections and examinations indicated that there was a problem, and so we as an industry

organization, along with the Investment Company Institute, jointly

49

worked with the NASD on a series of measures to both figure out

how to organize the information better and how to make sure that

investors were getting the breakpoints they deserved, at the same

time our firms are in the midst of refunding to all of their investors

any breakpoint discounts that they did not receive that they should

have received. We are in the midst of getting that done now.

I actually think that the mechanism, this task force on breakpoints that was organized at the behest of the SEC by the NASD,

the Investment Company Institute, and the SIA actually was a

very good model for addressing a problem fairly quickly, fixing the

problem prospectively going forward, and remedying the problem

by refunding any overcharges that they found in the past. So, I

think it worked very effectively.

Chairman SHELBY. Could you elaborate on how the 4 p.m. cutoff

for trade orders would impact the trading activities of investors,

such as individuals making changes to their 401(k) funds?

Mr. LACKRITZ. Yes, sir. The proposal that there be a 4 p.m. hard

close to the mutual fund itself would mean that an intermediary

such as a broker-dealer, or a 401(k) plan administrator more particularly, would have to cut off trading a lot earlier in the day in

order to process everything and get it to the fund by 4 o’clock and

get it time-stamped. That means that a small investor, like my

mother, for example—although I appreciate Mr. Fink’s increasing

my investment assets earlier—but a small investor like my mother

would not be able to trade on information in the marketplace from,

say, 2 o’clock to 4 o’clock because the intermediary had to get all

the information to the fund by 4 o’clock.

That is why we suggested on the hard close that it would be

more effective for investors and much more effective from the

standpoint of retirement plan participants, like 401(k) beneficiaries, to have a hard close either at the intermediary, at the

broker-dealer, or, alternatively, to set something up with a utility

like the NSCC. That idea is in the process of being developed now.

That would be fairer to investors, and yet at the same time, we

would create an electronic audit trail to make sure that it would

not be gamed or evaded by anybody participating in it.

Chairman SHELBY. Gentlemen, we appreciate your appearance

and we certainly appreciate your patience today. This has been a

long hearing.

On behalf of Senator Zell Miller, who could not be here today, I

want to ask unanimous consent that his opening statement and

two studies published by two Georgia professors on market timing

be placed in the record. Without objection, it is so ordered.

Chairman SHELBY. This hearing is adjourned.

[Whereupon, at 1:25 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

50

PREPARED STATEMENT OF SENATOR ZELL MILLER

Chairman Shelby, the active trading (market timing) of mutual funds is an issue

that we will discuss quite a bit today. Two Georgia professors, Professor Jason T.

Greene, from the Business College at Georgia State University and Professor

Charles W. Hodges, at State University of West Georgia recently published two

studies entitled: ‘‘The Dilution Impact of Daily Fund Flows on Open-End Mutual

Funds’’ and ‘‘Trading at Stale Prices with Modern Technology: Policy Options for

Mutual Funds in the Internet Age.’’

I would like to commend to the Committee (and ask that both studies be included

in the record), these two studies on market timing issues. The first study examines

‘‘how mutual fund flows that are correlated with subsequent fund returns can have

a dilution impact on the performance of open-end funds and the second study looks

at the ‘‘economic and regulatory policy issues surrounding stale price trading in

open-end mutual funds.’’ And in particular the study looks at ‘‘International funds

as especially vulnerable to stale price trading because the prices they use to calculate their net asset value (NAV) are often 12 to 15 hours old.’’

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

PREPARED STATEMENT OF WILLIAM H. DONALDSON

CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

NOVEMBER 18, 2003

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

thank you for inviting me to testify today on the Securities and Exchange Commission’s initiatives to address problems in the mutual fund and brokerage industries.

When I testified before you on September 30, the discovery of late trading and market timing abuses by personnel at hedge fund Canary Capital had just erupted. I

will update you on recent developments since then. First, though, I would like to

share with you the fundamental rights that I believe every mutual fund investor

not only should expect, but also to which every investor is entitled. We all—regulators, legislators, investment advisers, mutual fund managers, broker-dealers, the

financial press and investors—have spent much time lately wondering how the current abuses could have happened. I believe that a significant reason is because the

industry lost sight of certain fundamental principles—including its responsibilities

to the millions of people who entrusted their confidence, the fruits of their labor,

their hopes and dreams for the future to this industry for safekeeping. These investors are entitled to honest and industrious fiduciaries who sensibly put their money

to work for them in our capital markets. No one can argue with the premise that

investors deserve a brokerage and mutual fund industry built on fundamentally fair

and ethical legal principles.

Let me outline my visions of ‘‘Mutual Fund Investors’ Rights’’ and the critical initiatives underway at the Commission to ensure that these enhanced investor protections continue to be carried out and that our new investor protections are put in

place as quickly as possible.

Mutual Fund Investors’ Rights

Mutual Fund Investors Have a Right to an Investment Industry that is Committed

to the Highest Ethical Standards and that Places Investors’ Interests First

Every brokerage and mutual fund firm needs to conduct a fundamental assessment of its obligations to its customers and shareholders. These assessments must

be put forth at the highest levels, and implemented so as to reach all employees.

Senior management and the boards of directors must be ready to lay down and

vigorously enforce rules that define an immutable code of conduct.

Investors Have a Right to Equal and Fair Treatment by Their

Mutual Funds and Brokers

Our examinations and investigations of late trading and market timing abuses

have revealed instances of special deals and preferential treatment being afforded

to large investors, often to the detriment of small investors. The concepts of equal

and fair treatment of all investors and the prohibition against using unfair informational advantages are embedded in various provisions of the Federal securities laws,

including the Investment Company Act. The SEC will not tolerate arrangements of

this kind that violate these fundamental principles.

Investors Have a Right to Expect Fund Managers and Broker-Dealers to

Honor Their Obligations to Investors in Managing and Selling Funds

Our examinations and investigations into the current abuses have revealed instances of fund managers placing their interests—and in the case of some portfolio

managers, placing their personal interests—ahead of those of fund investors. We

also have seen recent examples of abusive activity by broker-dealers and their representatives in connection with the sale of fund shares, including failure to give investors the breakpoint discounts to which they are entitled, recommendations that

investors purchase one class of shares over another in order for the salesperson to

receive higher compensation and other sales practice abuses. This cannot and will

not be tolerated.

Investors Have a Right to the Assurances that Fund Assets Are Being

Used for Their Benefit

Clearly, fund assets, including use of a fund’s brokerage commissions, must be

used in a manner that benefits fund investors. The Commission must engage in a

reassessment of how fund commission dollars are used, including various soft-dollar

arrangements and the lack of transparency to investors of these payments.

111

Investors Have the Right to Clear Disclosure of Fees, Expenses,

Conflicts, and Other Important Information

Mutual fund investors must have the tools and the information to make intelligent investment decisions. To that end, the Commission will take action to enhance disclosure to fund investors of fees and expenses, and the conflicts that arise

as a result of the various arrangements between funds and brokers regarding the

sale of fund shares, as well as other important information.

Investors Have a Right to Independent, Effective Boards of Directors

Who Are Committed to Protecting Their Interests

In the words of the U.S. Supreme Court, the independent directors are the ‘‘independent watchdogs’’ that provide a critical and necessary check on fund management. The investors need to be assured that their mutual fund directors have the

independence and commitment necessary to carry out this crucial function. We are

proposing to set enhanced standards for board independence and are considering

other steps in this area.

Investors Have a Right to Effective and Comprehensive Mutual Fund and

Broker Compliance Programs

Programs designed to ensure compliance with the Federal securities laws are an

essential tool in the protection of investors. Fund investors need to be assured that

all funds, advisers and selling brokers have internal programs to ensure compliance

with the Federal securities laws. We will complete our pending rulemaking to

strengthen procedures at mutual funds and advisers.

Investors Should Expect that Aggressive Enforcement Actions Will Be

Taken When There Are Violations of the Federal Securities Laws

We will continue to take strong and appropriate action against those who violate

the Federal securities laws. There will be serious consequences to those who violate

the Federal securities laws.

By holding the industry (and ourselves) to these standards, we can significantly

minimize the possibility of future scandals that harm our Nation’s millions of mutual fund investors, and help restore the confidence of those investors.

SEC Risk Management Initiative

For too long, the Commission has found itself in a position of reacting to market

problems, rather than anticipating them. There are countless reasons for this—not

the least of which include historically lagging resources and structural and organizational roadblocks. The time for excuses has long passed.

Since coming to the Commission in February, one of my top priorities has been

to reevaluate and determine how the Commission deals with risk. Part of this evaluation has been a thorough review of the Commission’s internal structures. The

results of our work form a new risk management initiative that will better enable

the Commission to anticipate, identify, and manage emerging risks and market

trends that stand to threaten the Commission’s ability to fulfill its mission.

This critical initiative—the first of its kind at the Commission—will enable us to

analyze risks across divisional boundaries, focusing on early identification of new or

resurgent forms of fraudulent, illegal, or questionable behavior or products. Operating under the ‘‘Doctrine of No Surprises,’’ this initiative seeks to ensure that senior management at the Commission has the information necessary to make better,

more informed decisions.

The new initiative will be housed within a newly created Office of Risk Assessment, and will be headed by a director who reports directly to the Chairman. The

director will coordinate and manage risk assessment activities across the agency,

and will oversee a staff of five professionals, who will focus on the key programmatic

areas of the agency’s mission.

The duties of the Office of Risk Assessment will be focused on the following areas:

• Gathering and maintaining data on new trends and risks from a variety of

sources—including external experts, domestic and foreign agencies, surveys, focus

groups, and other market data, including both buy-side and sell-side research.

• Analyzing data to identify and assess new areas of concern across professions,

companies, industries, and markets.

• Preparing assessments and forecasts on the agency’s risk environment.

The work of the Office of Risk Assessment will be complemented by a Risk Management Committee, whose primary responsibility will be to review the implications

of identified risks and recommend an appropriate course of action.

112

Additionally, each Division and major Office will have one-to-two risk assessment

professionals on staff, who will work closely with the Division Director or Office

head as part of risk management teams to conduct risk assessment activities within

each division.

I believe this important initiative will fundamentally change the way the Commission assesses risk and will enable us to head off major problems before they occur.

Plan of Execution

The SEC is dedicated to the underlying concept inherent in this statement: ‘‘Mutual Fund Investors’ Rights.’’ Let me outline what the specific initiatives to ensure

that Mutual Fund Investors’ Rights are realized.

Late Trading and Market Timing Abuses

Late trading and market timing abuses represent the most recent violations

against investors’ rights. In addition to those abuses, we have seen other violations

of investors’ rights, including (to name but a few) violations of an investor’s right

to high ethical standards, fiduciary protections, clear disclosure, and equal treatment. While we are vigorously pursuing enforcement actions regarding this misconduct, we also are taking a number of regulatory steps immediately to deal

specifically with these abuses. On October 9, I outlined a regulatory agenda to confront the abuses head-on to help restore investor confidence in the fairness of

mutual fund operations and practices. I asked the staff to submit rulemaking recommendations to the Commission this month to address these issues. As a result,

on December 3, the Commission will consider the staff’s proposal to require that a

fund (or certain designated agents)—rather than an intermediary such as a brokerdealer or other unregulated third party—receive a purchase or redemption order

prior to the time the fund prices its shares (typically, 4 p.m.) for an investor to receive that day’s price. This ‘‘hard’’ 4 o’clock cut-off would effectively eliminate the

potential for late trading through intermediaries that sell fund shares.

With respect to market timing abuses, we will consider the staff’s recommendation that the Commission require additional, more explicit disclosure in fund offering documents of market timing policies and procedures. This disclosure would

enable investors to assess a fund’s market timing practices and determine if they

are in line with their expectations.

The staff’s recommendations will have a further component of requiring funds to

have specific procedures to comply with their representations regarding market timing policies. Thus, if a fund’s disclosure documents stated that it discouraged market timing, the fund would be required to have procedures outlining the practices

it follows to keep market timers out of the fund. While our examination staff will

use a variety of techniques to police for market timing abuses, the establishment

of formal procedures would also enable the Commission’s examination staff to review whether those procedures are being followed and whether the fund is living

up to its representations regarding curbing market timing activity. The Commission

also will emphasize the obligation of funds to fair value their securities so as to

avoid ‘‘stale pricing’’ to minimize market timing arbitrage opportunities as an important measure to combat market timing activity.

Also on December 3, the Commission will consider adopting new rules under the

Investment Company Act and the Investment Advisers Act that will ensure that

mutual funds have strong compliance programs. Specifically, the rules that the

Commission will consider would require each investment company and investment

adviser registered with the Commission to: (1) adopt and implement written policies

and procedures reasonably designed to prevent and detect violations of the Federal

securities laws; (2) review these polices and procedures annually for their adequacy

and the effectiveness of their implementation; and (3) designate a chief compliance

officer to be responsible for administering the policies and procedures and to report

directly to the fund’s board of directors. A chief compliance officer reporting to the

fund’s board of directors will strengthen the hand of the fund’s board and compliance personnel in dealing with fund management.

Allegations of certain portfolio managers market timing the funds they personally

manage or other funds in the fund complex raise issues regarding self-dealing. Recent allegations also indicate that some fund managers may be selectively disclosing

their portfolios in order to curry favor with large investors. Selective disclosure of

a fund’s portfolio can facilitate fraud and have severely adverse ramifications for a

fund’s investors if someone uses that portfolio information to trade against the fund.

You can expect that these issues will also be addressed in the rulemaking recommendations that the Commission will consider on December 3.

The package of reforms that I have just outlined for you is designed to provide

immediate reassurances and protection to mutual fund investors. They deserve

113

nothing less than an immediate response from the SEC. These critical reforms not

only will tackle the immediate problem of late trading and market timing abuses

that we have seen so far during our investigation, but also will provide powerful

tools to prevent the types of abuses identified to date. However, we cannot and will

not stop here. We will explore the full range of our authority, not only in the reforms discussed above, but also in the additional areas to further address market

timing abuses.

For instance, while the Commission’s actions regarding fair value pricing should

address the problem of stale pricing (which facilitates market timing), we will consider more in this area. As such, I have asked the staff to study additional measures

for Commission consideration, including considering a mandatory redemption fee

imposed on short-term traders and developing a solution to the problem of trading

through omnibus accounts.

With respect to the mandatory redemption fee, which would be paid to the fund

(and, ultimately to the fund’s long-term investors), it is a fee that would apply to

short-term traders getting in and out of a fund over a short period of time, for instance 3 or 5 days. Such a fee could decrease the likelihood of market timers profiting from arbitrage activity.

As for omnibus accounts, I believe that there needs to be better information

shared between funds and brokers. Mutual fund shares often are purchased and redeemed through omnibus accounts held at intermediaries such as broker-dealers.

Typically, a brokerage firm has one omnibus account with each of the mutual funds

with which it does business and through which all of its brokerage customers purchase and redeem shares of those mutual funds. Consequently, these mutual funds

do not have information on the identity of the underlying brokerage customer who

is purchasing or redeeming the funds’ shares.

This arrangement often makes it difficult for funds to fulfill certain of their obligations to their shareholders. In the breakpoint context, omnibus accounts make it

difficult for funds to track information about the underlying shareholder that might

have entitled the shareholder to breakpoint discounts. In the market timing context,

funds are not able to assess redemption fees, limit exchanges or even kick out a

shareholder who is market timing through an omnibus account because they do not

know the identity of that shareholder. Indeed, many of the market timing abuses

identified through our examinations and investigations indicate that shareholders

were market timing through omnibus accounts.

The issue is further complicated because brokers are reluctant to release the underlying shareholder information to funds, citing privacy and competitive concerns.

The brokers fear that by releasing the names of their customers who are purchasing

fund shares to the funds themselves, the funds then can market directly to those

customers, cutting out the brokers.

Requiring broker-dealers and other intermediaries to provide information to funds

regarding the funds’ investors would allow funds to police for abusive market timing

activity and to further provide for appropriate breakpoints. An alternative would be

to require that broker-dealers and other intermediaries enforce funds’ policies with

respect to market timing and the offering of breakpoints.

Study

To assist the staff as it moves forward in considering this issue, I have called

upon the NASD to head an Omnibus Account Task Force consisting of members of

the fund and brokerage industries, as well as other intermediaries to further study

this issue and to provide the SEC staff with information and recommendations.

Under the NASD’s capable leadership, the Joint NASD/Industry Task Force on

Breakpoints was extremely beneficial in dealing with the breakpoint issue and I am

confident that, working together with the NASD and the industry, we will be able

to develop a proposal that will adequately address the omnibus account issue.

Fund Governance

As I noted, a fundamental right of investors is a strong, effective, independent

board of directors. The statutory framework governing mutual funds envisions a key

role for boards of directors in light of the external management structure typical for

funds. The directors, particularly the ‘‘independent directors,’’ are responsible for

managing conflicts of interest and representing the interests of shareholders. The

problems that recently have come to light underscore the need for enhanced effectiveness of independent directors in carrying out their responsibilities. Toward that

end, I believe there are a number of ideas for reform, including:

• Requiring an independent chairman of the fund’s board of directors.

• Increasing the percentage of independent directors under the SEC’s rules from a

majority to three-fourths.

114

• Providing the independent directors with the authority to retain staff as they

deem necessary so they do not have to necessarily rely on the fund’s adviser for

assistance.

• Requiring boards of directors to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the

board’s committee structure.

• Adopting a rule that would require boards to focus on and preserve documents

and information that directors use to determine the reasonableness of fees relative

to performance, quality of service and stated objectives, including a focus on the

need for breakpoints or reductions in advisory fees and comparisons with fees and

services charged to other clients of the adviser.

I recognize, however, that while the Commission can adopt rules to enhance and

strengthen fund governance, that is not enough. Directors themselves must understand and carry out their responsibilities to protect fund investors. We need to take

the necessary steps to educate directors regarding this crucial role and to ensure

that they understand their role. Accordingly, in addition to asking the staff to develop these reforms for consideration by the Commission in January, I have also

called upon fund independent directors themselves to be active participants in the

reform effort. Specifically, I have asked former SEC Chairman David Ruder’s nonprofit mutual fund director’s organization, the Mutual Fund Directors Forum, to develop guidance and best practices in key areas of director decisionmaking, such as

monitoring fees and conflicts, overseeing compliance, and important issues such as

valuation and pricing of fund portfolio securities and fund shares. Mr. Ruder and

the Board of Directors of the Forum—an organization geared toward independent

directors and that promotes improved fund governance through continuing education programs and other activities that assist independent directors in advocating

for fund shareholders—have agreed to develop this guidance and these best practices to assist independent directors. Rest assured, we will continue to consider

every viable idea, from whatever source, for improving the way that mutual funds

are structured and governed.

In addition to these initiatives, in August of this year the Commission proposed

rules regarding disclosure of fund nominating committee functions and communications between fund investors and fund boards, as part of the Commission’s broader

proposal on nominating committee disclosure. And just last month, the Commission,

as part of its broader proxy nomination proposal, proposed rules to improve access

of fund shareholders to the director nomination proxy process.

Disclosure

Another fundamental right of mutual fund investors is clear, easy to understand

disclosure. At the end of September, we adopted amendments to mutual fund advertising rules that require that fund advertisements state that investors should

consider fees before investing and that advertisements direct investors to a fund’s

prospectus to obtain additional information about fees. The rules also require more

balanced information about mutual funds when they advertise performance. The

Commission also recently proposed rule amendments regarding fund of funds products that would require these products to include additional disclosure in their prospectus fee table of the costs of investing in underlying funds. The Commission also

adopted rules that require funds and advisers to disclose their proxy voting policies

and procedures and, in the case of funds, disclose to investors the voting records

of the funds.

Another key concept of the disclosure principle is clear, easy to understand disclosure to mutual fund investors of the fees and expenses they pay. I anticipate that

in January, the Commission will consider adopting rules that would require ‘‘dollars

and cents’’ fee disclosure to shareholders, coupled with more frequent disclosure of

portfolio holdings information. This is an important reform, as it will allow investors

to determine not only the fees and expenses they are paying on their particular

funds, but will also greatly facilitate comparison among different funds. The Commission also will be considering in December a proposal to improve disclosure to

shareholders regarding the availability of sales load breakpoints. We also want to

provide investors better information on portfolio transaction costs so that they can

factor this into their decisionmaking. Consequently, the staff is developing for Commission consideration in December a concept release to solicit views on how the

Commission should proceed in fashioning disclosure of these costs.

Investors not only deserve to know the fees and expenses their funds pay, they

also deserve to know how much their broker stands to benefit from their purchase

of a particular fund. Thus, we also plan to improve disclosure about mutual fund

transaction costs through the confirmations that broker-dealers provide to their cusVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00126 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
115

tomers. I have directed the staff to prepare a new mutual fund confirmation statement that will provide customers with quantified information about the sales loads

and other charges that they incur when they purchase mutual funds with sales

loads. I expect that the Commission will consider this proposal before the end of the

year. The Commission also will direct the staff to consider how disclosure of quantified information about sales loads and other charges incurred by investors might

be disclosed in a document available prior to the sale of fund shares.

To address an investor’s right to know about conflicts of interest that brokers may

have when selling fund shares, the new mutual fund confirmation statement also

will include specific disclosure regarding revenue sharing arrangements, differential

compensation for proprietary funds and for other incentives such as commission

business for brokers to sell fund shares that may not be readily apparent to fund

investors.

To ensure that investors receive the benefits of fund assets to which they are entitled, the Commission will examine how brokerage commissions are being used to

facilitate the sale and distribution of fund shares, as well as the use of so-called

soft-dollar arrangements. Soft-dollar arrangements can create incentives for fund

advisers to: (1) direct fund brokerage based on the research provided to the adviser

rather than on the quality of execution provided to the fund; (2) forgo opportunities

to recapture brokerage costs for the benefit of the fund; and (3) cause the adviser

to over-trade the portfolio to fulfill its soft-dollar commitments to brokers. These are

areas that raise complicated issues, but that we will nevertheless examine.

I have also instructed the staff to consider rules that would better highlight for

investors the basis upon which directors have approved management and other fees

of the fund.

Compliance and Oversight

The Commission long has recognized the importance of strong internal controls.

For example, the Commission recently tailored the provisions of the Sarbanes-Oxley

Act to apply to mutual funds, including the provisions to improve oversight and internal controls, such as key officer certifications and Code of Ethics requirements,

thereby ensuring that mutual fund shareholders received the full protections of the

Sarbanes-Oxley Act.

In addition, I should note that the staff in September issued a comprehensive report on hedge funds, making a series of recommendations to improve the Commission’s ability to monitor the activity of these vehicles—the most significant being a

recommendation to require that hedge fund advisers register under the Investment

Advisers Act and thereby become subject to Commission examination and routine

oversight. This review of hedge funds, and the staff’s recommendations, become all

the more important when we consider that we have seen a number of hedge funds

allegedly engaging in late trading and market timing of mutual fund shares, serving

as the impetus for the current investigations and enforcement actions related to

these activities.

We will continue to explore additional approaches that the Commission might

pursue to require funds to assume greater responsibility for compliance with the

Federal securities laws, including whether funds and advisers should periodically

undergo an independent third-party compliance audit. These compliance audits

could be a useful supplement to our own examination program and could ensure

more frequent examination of funds and advisers.

Also, as an effective regulator, we must have clear rules as to what is unlawful

activity. We will continue to review our rules and our regulations to ensure that this

is the case, much as we are doing now to combat late trading and market timing

abuses.

Actions on the Enforcement Front

Again, I believe that these investor rights are critical. Equally critical is effective

enforcement of those rights and of the Federal securities laws.

When I testified before you in September, I noted that the Commission had taken

immediate enforcement action against a senior official at Bank of America. Since

then, we have taken a number of additional enforcement actions against those taking part in these trading abuses.

We have charged a senior executive of a prominent hedge fund with late trading,

and barred him from association with an investment adviser. We also barred and

imposed a $400,000 civil penalty on a mutual fund executive in connection with his

alleged role in allowing certain investors to market time his company’s funds. We

instituted an action against a major investment management firm and two of its

portfolio managers who allegedly market timed their own mutual funds. And we

charged five brokers and a branch manager with having misrepresented or conVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00127 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
116

cealed their own and their clients’ identities in order to facilitate thousands of market timing transactions.

Putnam Settlement

Among its many roles, the Securities and Exchange Commission has two critical

missions. The first is to protect investors, and the second is to punish those who

violate our securities laws. Last week’s partial settlement of the SEC’s fraud case

against the Putnam mutual fund complex does both. It offers immediate and significant protections for Putnam’s current mutual fund investors, serving as an important first step. Moreover, by its terms, it enhances our ability to obtain meaningful

financial sanctions against alleged wrongdoing at Putnam, and leaves the door open

for further inquiry and regulatory action.

Despite its merits, the settlement has provoked considerable discussion, and some

criticism. Unfortunately, the criticism is misguided and misinformed, and it obscures the settlement’s fundamental significance.

By acting quickly, the SEC required Putnam to agree to terms that produce immediate and lasting benefits for investors currently holding Putnam funds. First, we

put in place a process for Putnam to make full restitution for investor losses associated with Putnam’s misconduct. Second, we required Putnam to admit its violations

for purposes of seeking a penalty and other monetary relief. Third, we forced immediate, tangible reforms at Putnam to protect investors from this day forward. These

reforms are already being put into place, and they are working to protect Putnam

investors from the misconduct we found in this case.

Among the important reforms Putnam will implement is a requirement that Putnam employees who invest in Putnam funds hold those investments for at least 90

days, and in some cases for as long as 1 year—putting an end to the type of shortterm trading we found at Putnam. On the corporate governance front, Putnam fund

boards of trustees will have independent chairmen, at least 75 percent of the board

members will be independent, and all board actions will be approved by a majority

of the independent directors. In addition, the fund boards of trustees will have their

own independent staff member who will report to and assist the fund boards in

monitoring Putnam’s compliance with the Federal securities laws, its fiduciary duties to shareholders, and its Code of Ethics. Putnam has also committed to submit

to an independent review of its policies and procedures designed to prevent and to

detect problems in these critical areas—now, and every other year.

This settlement is not the end of the Commission’s investigation of Putnam. We

are also continuing to examine the firm’s actions and to pursue additional remedies

that may be appropriate, including penalties and other monetary relief. If we turn

up more evidence of illegal trading, or any other prohibited activity, we will not

hesitate to bring additional enforcement actions against Putnam or any of its employees. Indeed, our action in Federal court charging two Putnam portfolio managers with securities fraud is pending.

There are two specific criticisms of the settlement that merit a response. First,

some have charged that it was a mistake not to force the new management at

Putnam to agree that the old management had committed illegal acts. In fact, we

took the unusual step of requiring Putnam to admit to liability for the purposes of

determining the amount of any penalty to be imposed. We made a decision, however, that it would be better to move quickly to obtain real and practical protections

for Putnam’s investors, right now, rather than to pursue a blanket legal admission

from Putnam. The SEC is hardly out of the mainstream in making such a decision.

All other Federal agencies, and many State agencies (including that of the New

York Attorney General), willingly and regularly forgo blanket admissions in order

to achieve meaningful and timely resolutions of civil proceedings.

Second, some have criticized the Putnam settlement because it does not address

how fees are charged and disclosed in the mutual fund industry. While this issue

is serious, the claim is spurious. The Putnam case is about excessive short-term

trading by at least six Putnam management professionals and the failure of Putnam

to detect and deter that trading. The amount and disclosure of fees is not, and never

has been, a part of the Putnam case, and thus it would be wholly improper to try

to piggyback the fee disclosure issue on an unrelated matter.

If our continuing investigation of Putnam uncovers evidence of wrongdoing in the

fee disclosure area, we will not hesitate to act, and the Commission is already moving forward with rulemaking that will address this issue, and others, on an industrywide basis. Those lacking rulemaking authority seem to want to shoehorn the

consideration of the fee disclosure issues into the settlement of lawsuits about other

subjects. But we should not use the threat of civil or criminal prosecution to extract

concessions that have nothing to do with the alleged violations of the law.

117

Criticism of the Commission for moving too quickly misses the significance of the

Commission’s action. While continuing our broader investigation of Putnam, we

have reached a fair and far-reaching settlement that establishes substantial governance reforms and compliance controls that are already benefiting Putnam’s investors. It is a settlement where the Commission put the interests of investors first.

As the Commission continues to initiate critical and immediate reforms of the mutual fund industry, and while we investigate a multitude of other cases involving

mutual fund abuses, we will continue to seek reforms that provide immediate relief

to harmed investors.

I also want briefly to discuss yesterday’s announcement of the Commission’s enforcement action against Morgan Stanley arising out of the firm’s mutual fund sales

practices. Morgan Stanley has agreed to a settlement of the action that calls, in

part, for it to pay a total of $50 million, all of which will be returned to investors.

The action grows out of an investigation begun in the spring of this year.

The Commission’s investigation uncovered two distinct, firm-wide disclosure failures by Morgan Stanley. The first relates to an exclusive program involving sixteen

mutual fund families that Morgan Stanley sold to its customers under an exclusive

program involving 16 mutual fund families.

Under the program, Morgan Stanley gave these fund families what is sometimes

called ‘‘premium shelf space.’’ The firm encouraged its sales force to sell shares of

the funds in the program and even paid its salespeople special incentives to sell

those funds so that Morgan Stanley would receive from those funds a percentage

of the sales price over and above ordinary commissions and loads. Morgan Stanley’s

customers did not know about these special shelf-space payments, nor in many cases

they did not know that the payments were coming out of the very funds into which

these investors were putting their savings.

Few things are more important to investors than receiving unbiased advice from

their investment professionals. Morgan Stanley’s customers were not informed of

the extent to which Morgan Stanley was motivated to sell them a particular fund.

Our investigation also uncovered, and the enforcement action we have filed includes, another practice at Morgan Stanley involving conflicts of interest in the sale

of mutual funds. This practice, which has been the subject of other Commission

cases during the last several months, involves the sale of Class B mutual fund

shares to investors who were more likely to have better overall returns if they

bought Class A shares in the same funds.

I want to emphasize that the abuses that are addressed in this case are significant and are not necessarily limited to Morgan Stanley. So-called shelf-space payments have become popular with brokerage firms and the funds they are selling.

Thus, the Commission is conducting an examination sweep of some 15 different

broker-dealers to determine exactly what payments are being made by funds, the

form of those payments, the ‘‘shelf space’’ benefits that broker-dealers provide, and

most importantly, just what these firms tell their investors about these practices.

I also want to note that the potential disclosure failures and breaches of trust are

not limited to broker-dealers. We are also looking very closely at the mutual fund

companies themselves.

The SEC’s Director of Enforcement, Stephen Cutler, will be testifying before you

on our enforcement efforts this Thursday, and can answer your specific questions

about these and the Commission’s other enforcement actions, as well as the results

thus far in our ongoing investigation. While he cannot speak to specific entities that

the Commission has authorized the staff to investigate, he can brief you on the

types of cases you likely will be seeing brought by the Commission in the near

future. Let me emphasize, however, that I am appalled at the types and extent of

conduct that is being revealed in our examinations and investigations. It is conduct

that represents fundamental breaches of fiduciary obligations and betrayal of our

Nation’s investors. I can assure you that we are committed to seeking redress for

investors and meting out the appropriate punishment in these matters to send a

strong message that these types of abuses will not be tolerated.

Conclusion

As you can see, taken together, the reforms that the Commission has already undertaken and those currently being initiated are both substantial and far-reaching.

They are designed to address not only the immediate problems of late trading and

market timing abuses, but represent a reevaluation of the Commission’s oversight

of the mutual fund industry as a whole. Most importantly, they put the needs of

mutual fund investors first. I appreciate the opportunity to share with you my

views, and I would be happy to answer any questions you may have.

118

1State of New York v. Canary Capital Partners, LLC, Canary Investment Management, LLC,

Canary Capital Partners, Ltd., and Edward J. Stern (NY S. Ct. filed September 3, 2003)

(undocketed complaint) (Canary Complaint). 2See SEC Chairman Donaldson Releases Statement Regarding Initiatives to Combat Late

Trading and Market Timing of Mutual Funds, SEC Press Release No. 2003–136 (October 9,

2003) (Donaldson Statement).

PREPARED STATEMENT OF MATTHEW P. FINK

PRESIDENT, INVESTMENT COMPANY INSTITUTE

NOVEMBER 18, 2003

Introduction

My name is Matthew P. Fink. I am President of the Investment Company Institute, the national association of the American investment company industry. The Institute’s membership includes 8,664 open-end investment companies (mutual funds),

601 closed-end investment companies, 106 exchange-traded funds, and 6 sponsors

of unit investment trusts. The Institute’s mutual fund members have assets of about

$6.967 trillion, accounting for approximately 95 percent of total industry assets, and

90.2 million individual shareholders.

I appreciate the opportunity to appear before the Subcommittee today to discuss

the issues of late trading and market timing of mutual funds, and the industry’s

commitment to take whatever steps are necessary to make sure that the interests

of fund shareholders are fully protected.

The bedrock principle of the mutual fund industry is that the interests of mutual

fund investors always come first. Consequently, the industry has reacted with shock

and outrage to the allegations of late trading and market timing in the New York

Attorney General’s complaint in the Canary case 1 and other recent allegations of

abusive mutual fund trading practices. There can be no excuse for knowingly permitting the buying and selling of fund shares at old prices after the market has

closed. And while restricting market timing may be easier said than done, silently

selling to a select few the right to trade fund shares is deeply troubling. Even more

abhorrent is the notion that, in some instances, fund insiders themselves may have

engaged in market timing to reap personal benefits at the expense of other fund

shareholders. The industry commends the New York Attorney General’s office and

the Securities and Exchange Commission for their investigative efforts and forceful

responses to these alleged practices. It is imperative that the ongoing investigations

by the SEC and others of these allegations are thorough and successful in rooting

out trading activities that have compromised or harmed the interests of individual

mutual fund shareholders.

We cannot wait until those investigations are complete, however, to take the steps

necessary to restore and to reinforce investor confidence in mutual funds. Investor

confidence is every mutual fund’s most precious asset. The industry earned the confidence of millions of Americans by serving their interests above all other considerations. Unfortunately, the business practices that have been alleged are inconsistent

with this principle and are intolerable if mutual funds are to serve individual investors as effectively in the future as they have in the past. Forceful action will be the

key to restoring and reinforcing investor confidence. The broad elements of what

must be done to reassure investors are as follows:

• First, Government officials must identify everyone who violated the law. Forceful

and unambiguous sanctions must be delivered swiftly wherever punishment is

warranted.

• Second, if shareholders were harmed because of illegal or deceptive business

arrangements, these wrongs must be made right.

• Third, any gaps in the otherwise strict system of mutual fund regulation must be

identified and effectively addressed.

With respect to the last point, SEC Chairman Donaldson has announced plans to

propose tough new regulatory requirements addressing the late trading and abusive

short-term trading of mutual fund shares.2 The SEC also will consider whether

additional requirements are necessary to address the issue of selective disclosure of

portfolio holdings information. The industry pledges its full support of the SEC in

whatever course of action it determines will best protect mutual fund shareholders.

To help advance this objective, the Institute’s Board of Governors established two

separate task forces to identify specific options to address the issues of late trading

and abusive short-term trading involving mutual fund shares. Based on the findings

of the task forces, the Institute has developed several recommendations, which are

outlined below.

119

3See Investment Company Act Release No. 5519 (October 16, 1968). 4See, e.g., Investment Company Act Release No. 5569 (December 27, 1968). 5 As noted above, most funds price their shares as of 4 p.m. Eastern time. Thus, for simplicity,

the discussion below assumes that this is the case. A fund that prices its shares as of a different

time should be required to cut off orders by that time. 6 Institute data show that the vast majority (approximately 85–90 percent) of mutual fund

purchases are made through such intermediaries, including both the financial advisers and employer-sponsored retirement plans. See Investment Company Institute, 2003 Mutual Fund Fact

Book, at 38. A 4 p.m. cut-off time at the fund will require intermediaries to apply an earlier

cut-off time to the mutual fund orders they receive. This, in turn, will compress the time period

during which investors conducting fund transactions through intermediaries could receive sameday prices. The precise impact likely will vary among different types of intermediaries, and

among individual firms. In many cases, investors may no longer have the ability to obtain sameday prices.

Mutual funds themselves also have acted swiftly to determine whether wrongdoing occurred in their firms. They have initiated internal investigations, in some

cases aided by independent outside experts to investigate and judge the findings,

and communicated their findings and responses to their boards and shareholders.

In addition, some fund boards have retained independent third parties to conduct

investigations. As a result of these investigations, several funds have terminated

senior executives. Many funds have committed to taking remedial actions, including

compensating fund shareholders for any detrimental impact that improper or illegal

transactions may have had on their investments. These actions reinforce that funds

take very seriously their obligations under the Federal securities laws and the fulfillment of their responsibility to make sure investors’ interests always come first.

The remainder of my testimony will focus on the issues of late trading and abusive short-term trading of mutual fund shares. I also will discuss the practice of

selectively disclosing information about fund portfolio holdings to shareholders, and

oversight of hedge funds. Finally, I will discuss other initiatives to reinforce the protection and confidence of mutual fund investors.

Late Trading

A basic tenet of mutual fund investing is the concept of ‘‘forward pricing.’’ Mutual

funds are required to price their shares at least once each day, at a time or times

designated by the fund’s board of directors and disclosed in the fund’s prospectus.

Most funds price their shares as of 4 p.m. Eastern time, the close of regular trading

on the New York Stock Exchange. All purchase and redemption orders received by

a fund or its agents before 4 p.m. must receive that day’s price. All orders received

after 4 p.m. must receive the next day’s price. The requirement that a purchase or

redemption order be priced based on the fund’s net asset value (NAV) next computed after receipt of the order is known as the ‘‘forward pricing’’ rule. The SEC

adopted this rule in 1968 because it recognized that ‘‘backward pricing’’ (purchases

and sales of fund shares at a previously determined NAV) could lead to dilution of

the value of fund shares and could be susceptible to abuse in that it could allow

speculators to take advantage of fluctuations in the prices of the fund’s portfolio securities that occurred after the fund calculated its NAV.3 Unfortunately, the recent

allegations of late trading appear to bear this out.

Under current SEC rules and staff interpretations, funds may treat the time of

receipt of an investor’s order by a person designated by the fund (such as a dealer)

as the relevant time for determining which price the order will receive.4 Thus, it

is common industry practice for intermediaries such as broker-dealers, banks, and

retirement plan administrators to transmit their clients’ purchase and redemption

orders that were accepted before 4 p.m. to a fund for processing after 4 p.m. at that

day’s price.

Given the alleged abuses that recently have come to light, the Institute believes

that existing regulations should be tightened to better protect against the possibility

of late trading. The most effective solution to this problem would be to require that

all purchase and redemption orders be received by a fund (or its transfer agent) before the time of pricing (that is, 4 p.m. Eastern time).5 While such a requirement

could have a significant impact on the many investors who own mutual funds

through financial intermediaries,6 the recent abuses indicate that the strongest possible measures are necessary to ensure investor protection. A 4 p.m. cut-off time at

the fund would significantly limit opportunities for late trading by narrowing the

universe of entities responsible for applying a 4 p.m. cut-off time to include only the

funds and their transfer agents. In addition to limiting the number of entities

involved, it would restrict them to SEC-regulated entities. This would simplify both

funds’ compliance oversight responsibilities and regulators’ examination and enVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00131 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
120

7Donaldson Statement, supra note 2. 8 In the future, advances in technology may make it possible to devise systems (e.g., a system

for ‘‘time stamping’’ mutual fund orders in a way that cannot be altered) that provide a high

level of assurance regarding the time of receipt of an order by an intermediary. Nothing would

prevent the SEC from revisiting this issue in that event. 9We note that a reasonable period of time will be needed to allow all affected entities to make

the necessary systems changes to implement new cut-off requirements. 10Donaldson Statement, supra note 2. 11 Id.

forcement efforts with respect to potential late trading. In doing so, it would likely

enhance compliance.

We note that Chairman Donaldson has specifically asked the SEC staff to examine the feasibility of such a requirement.7 The Institute believes that applying order

cut-off requirements to funds and their transfer agents is the best way to address

late trading abuses at this time.8 We urge the SEC to proceed expeditiously to adopt

this approach.9

Market Timing

The ongoing investigations by the SEC and other governmental officials also involve issues relating to ‘‘market timing’’ of mutual funds. It is important to note

that ‘‘market timing’’ is not a precisely defined term. Generally speaking, the term

refers to a trading strategy involving frequent purchases and sales of mutual funds

in an effort to anticipate changes in market prices. There is nothing inherently

illegal or improper about such activity.

At some level, however, frequent trading activity can be disruptive to the management of a fund’s portfolio. For example, frequent trading may compel portfolio managers either to hold excess cash or to sell holdings at inopportune times in order

to meet redemptions. This can adversely impact a fund’s performance, and increase

trading and administrative costs. For this reason, many fund groups have sought

to employ a number of methods designed to limit short-term trading, such as imposing redemption fees, restricting exchange privileges, and/or limiting the number of

trades within a specified period. Many funds disclose in their prospectus that they

do not permit market timing or that they may take steps to discourage it.

Different types of funds are affected differently by short-term trading, and higher

turnover of smaller accounts has little effect on portfolio management. Funds also

may seek to serve different types of investors; some funds are designed specifically

to accommodate short-term trading. Thus, there is no ‘‘one size fits all’’ solution with

respect to market timing generally.

The specific concerns that have been raised about market timing are not that

funds did, or did not, have certain policies in place. Rather, it has been alleged that

some funds were not applying their market timing policies fairly and consistently.

A number of different steps can be taken to address these concerns, which are discussed below.

WRITTEN POLICIES AND PROCEDURES

SEC Chairman Donaldson has outlined various regulatory measures that the SEC

staff is considering to address the alleged practice of certain funds allowing a few

investors to engage in market timing activities in a manner inconsistent with their

policies.10 These measures include new rules and form amendments to: (1) require

explicit disclosure in fund offering documents of market timing policies and procedures and (2) require funds to have procedures to comply with representations regarding market timing policies and procedures. The industry fully supports these

measures.

While many funds already have market timing policies and procedures, requiring

funds to adopt formal and detailed policies and procedures in this area will ensure

that all funds have systems in place to address abusive activity. Such a requirement

should also provide a more effective mechanism for boards and regulators to police

compliance because more formal policies likely would limit discretion in dealing

with short-term traders.

Another element of Chairman Donaldson’s regulatory action plan is to reinforce

the obligation of fund directors to consider the adequacy and effectiveness of fund

market timing policies and procedures.11 For example, fund boards could be required to receive regular reports on how these programs have been implemented.

We strongly support reinforcing board oversight in this area.

Fund shareholders also will benefit from additional prospectus disclosure about a

fund’s policies on short-term trading by gaining an understanding of how the fund

will protect their interests from abusive activity. Requiring that such disclosure be

in a fund’s prospectus could serve to enhance compliance with the policies. The disVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00132 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
121

12 Id. 13Letter to Craig S. Tyle, General Counsel, Investment Company Institute, from Douglas

Scheidt, Associate Director and Chief Counsel, Division of Investment Management, U.S. Securities and Exchange Commission, dated April 30, 2001 (2001 Valuation Letter). 14The potential for these losses can be mitigated by imposing restrictions on market timing.

closure also could have a deterrent effect by alerting potential abusers to the fund’s

policies.

Additional steps are needed to address alleged abusive market timing activity by

fund insiders. As noted above, this conduct, if true, is especially reprehensible.

Thus, with respect to personal trading in fund shares by portfolio managers or a

fund’s senior executives, the Institute is urging all mutual funds to clarify or amend

their codes of ethics to require oversight of personal trading activity by these persons in any funds offered or sponsored by the company.

FAIR VALUATION

An issue related to market timing is the obligation of funds to determine the fair

value of their portfolio securities under certain circumstances. Much short-term

trading activity appears to be motivated by a desire to take advantage of fund share

prices that are based on closing market prices established some time before a fund’s

net asset value is set. It has been suggested that one way to address this concern

is to require funds to fair value their portfolio securities more often. As part of

Chairman Donaldson’s regulatory action plan, the SEC staff is considering rules

that would ‘‘emphasize the obligation of funds to fair value their securities under

certain circumstances to minimize market timing arbitrage opportunities.’’ 12

The Investment Company Act establishes standards for how mutual funds must

value their holdings. Funds are required to use market prices when they are available. This relies on the fact that market prices generally are objective and accurate

reflections of a security’s value. When market prices are not available, funds must

establish a ‘‘fair value’’ for the securities they hold. The Investment Company Act

places primary responsibility for fair valuation on a fund’s board of directors. There

is no definition of ‘‘fair value’’ provided in the Act, nor an established or required

uniform method for fair value pricing inasmuch as it necessarily calls for professional judgment and flexibility.

In 2001, the SEC staff issued guidance that, among other things, discussed situations in which funds might need to utilize fair value pricing of foreign securities,

even where those securities had closing prices in their home markets. In particular,

the SEC staff said that, in certain circumstances, a significant fluctuation in the

United States market (or a foreign market) may require a fund to fair value those

securities.13

The rationale underlying the SEC staff’s position is the same as that underlying

the forward pricing rule discussed earlier in my testimony. To the extent that prices

of foreign securities are correlated with changes in the U.S. market, a significant

change in the U.S. market that occurs after the time that a foreign market closes

can indicate that the closing prices on the foreign market are no longer an accurate

measure of the value of those foreign securities at the time the U.S. market closes

(i.e., 4 p.m. Eastern time). Certain investors may attempt to exploit this situation

by engaging in market timing activity. For example, a market timer might purchase

shares of an international fund on days when the U.S. market is up significantly,

and redeem shares of such a fund on days when the U.S. market is down significantly. Like late trading activity, this can hurt other shareholders in the fund by

diluting their interests.

Unfortunately, knowing when and how to fair value foreign securities in these

types of circumstances is not an exact science, as there is no way to know for sure

at what price those securities would be traded as of 4 p.m. Eastern time. Consequently, funds must exercise their best judgment in valuing these securities. In

designing procedures to determine fair value, funds must take care not to introduce

too much subjectivity into the valuation process. On the other hand, if fair value

procedures do not provide for sufficient (and frequent enough) adjustments, then

they run the risk of losing their effectiveness in protecting fund shareholders from

losses due to activity of the type described above.14

In order to appropriately balance these concerns, funds must have in place rigorous, board-approved policies and procedures concerning fair valuation. Some fund

groups have developed detailed fair value pricing methodologies in-house; others are

utilizing third-party service providers to assist them in valuing foreign and other

securities. Either way, fair value policies and procedures can, and should, be updated as needed; as the 2001 SEC staff letter states, ‘‘Funds should regularly evaluate whether their pricing methodologies continue to result in values that they might

122

15 2001 Valuation Letter, supra note 13, at 7. 16See Investment Company Institute, Valuation and Liquidity Issues for Mutual Funds (February 1997) and Investment Company Institute, Valuation and Liquidity Issues for Mutual

Funds, 2002 Supplement (March 2002). 17Investment Company Institute, 2002 SEC No-Act. LEXIS 781 (November 13, 2003). 18 Canary Complaint, supra note 1, at par. 46. 19Funds should retain the flexibility to impose more stringent redemption fee standards,

either in the form of higher redemption fees or longer minimum holding periods. As noted above,

different types of funds are affected differently by short-term trading; hence, flexibility remains

important. In addition, certain types of funds (e.g., money market funds and funds that are designed specifically for short-term trading) should not be required to assess redemption fees.

reasonably expect to receive upon a current sale.’’ 15 The ICI has published two compliance papers for its members on valuation issues, which are intended to assist

them in meeting their regulatory responsibilities and in ensuring that fund share

prices are fair to purchasing, redeeming, and existing shareholders.16

It is important to note that, while fair valuation can reduce the impact of harmful

market timing activity, it cannot by itself completely eliminate such trading. Accordingly, as mentioned previously and as discussed further below, funds often employ

additional methods to deter market timing activity.

TOOLS TO DETER MARKET TIMING

The investigations referred to above involved situations where funds allegedly

granted exceptions from, or did not enforce, policies against market timing. It is important to note that many funds that are susceptible to market timing have devoted

significant resources to efforts to combat such activity. Frequently, however, the

various means that funds have employed to deter harmful market timing activity

have not proved effective. Funds and their shareholders would benefit if funds had

additional ‘‘tools’’ to restrict trading activity that they determine to be harmful to

their shareholders. Last year, the SEC staff responded favorably to an Institute request to permit funds to delay exchange transactions, in an effort to deter some

market timing activity.17 There are additional methods for combating market timers

that the SEC staff should consider permitting funds to employ. One such method

would be to permit funds to impose a redemption fee (which is a fee paid directly

to the fund to offset the costs resulting from short-term trading) greater than the

2 percent limit currently imposed by the staff.

A particular challenge that funds face in effectively implementing restrictions on

short-term trading is that many fund investments are held in omnibus accounts

maintained by an intermediary (e.g., a broker-dealer or a retirement plan recordkeeper). Often in those cases, the fund cannot monitor trading activity by individual

investors in these accounts. The Canary Complaint describes this practice as follows: ‘‘Timers . . . trade through brokers or other intermediaries . . . who process

large numbers of mutual fund trades every day through omnibus accounts where

trades are submitted to mutual fund companies en masse. The timer hopes that his

activity will not be noticed among the ‘noise’ of the omnibus account.’’ 18

Steps clearly need to be taken to enable mutual funds to better enforce restrictions they establish on short-term trading when such trading takes place through

omnibus accounts. One possible approach would be to require intermediaries to provide information about trading activity in individual accounts to funds upon request.

Another approach would be to require most types of funds, at a minimum, to impose

a 2 percent redemption fee on any redemption of fund shares within 5 days of purchasing them. If funds had a standardized minimum redemption fee along these

lines, it should be easier for intermediaries to establish and maintain the requisite

systems to enforce payment of those fees.19

We look forward to working with the SEC and with other regulators and industry

groups on these matters.

Selective Disclosure of Portfolio Holdings

The SEC and other regulators are investigating allegations concerning the selective release by funds of their portfolio holdings to some but not all of a fund’s shareholders. In particular, it has been alleged that some funds may have provided

information about their portfolio holdings to certain shareholders in order to enable

them to trade ahead of the fund, to the potential detriment of the other shareholders. Such conduct, if true, is deplorable. The industry is committed to working

with the SEC to determine the best approach to deal with this matter.

One possible way to address this issue would be to require funds to adopt formal

written policies in this area. The SEC could require that the policies be approved

by the fund’s board and that reports of instances when the information was released

be provided to the board on a regular basis. In addition, funds could be required

123

20Staff Report to the U.S. Securities and Exchange Commission, Implications of the Growth

of Hedge Funds (September 2003) (Staff Report). 21 Id. at 92–95. 22See Investment Company Act Release No. 25925 (February 5, 2003). 23See Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Mr. Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, dated April 17, 2003. In

our letter we suggested certain modifications to ensure that the proposed requirement accommodates existing, effective compliance structures. 24See Investment Company Act Release No. 26195 (September 29, 2003).

to publicly disclose their policies for releasing portfolio information. This approach

would have many benefits. Similar to market timing, requiring funds to adopt formal policies would ensure that they have a system to prevent disclosure that is not

in the best interests of shareholders and to police compliance. Board oversight and

public disclosure would further enhance compliance with the policies. At the same

time, this approach would preserve some flexibility in how funds release information. This is very important because many funds release portfolio information for

purposes that benefit investors. For example, they may provide it to independent

services that analyze mutual funds and to certain intermediaries that provide professional assistance to help investors make decisions such as which funds to invest

in and how to allocate their assets among investments.

Hedge Fund Oversight

The action brought by the New York Attorney General against Canary Capital

also underscores the need for SEC oversight of hedge fund advisers. Currently, the

Commission generally has access to records of trading on behalf of hedge funds

through the records maintained by the brokers that the hedge fund advisers use and

the markets on which they trade. The records, however, are dispersed and it is difficult to detect improper trading activities conducted by a particular hedge fund if

such activities were effected through orders placed with multiple brokers and traded

on multiple markets. The SEC recently issued a staff report on hedge funds 20 that

included a recommendation to require hedge fund advisers to register under the Investment Advisers Act of 1940. The Institute supports this recommendation. As the

Staff Report indicates, by requiring hedge fund advisers to register, the Commission

would be able to more comprehensively and effectively observe the trading activities

of the funds managed by such advisers. As a result, the Commission would be in

a better position to detect improper or illegal trading practices.21

Other Initiatives

While the regulators have been actively involved in investigating and bringing

enforcement actions relating to abusive mutual fund trading practices, as well as

considering new regulatory requirements to prevent such practices in the future, it

bears noting that these efforts are not the only current regulatory initiatives on behalf of fund investors. Other regulatory reforms, as well as voluntary industry actions, that are underway or have recently been completed also form an important

part of overall efforts to reinforce the protection and the confidence of mutual fund

investors. Current initiatives include the following:

Fund Compliance Programs

In February, the SEC proposed a rule to require mutual funds to have compliance

programs.22 Generally speaking, the proposal would require: (1) written compliance

policies and procedures, (2) identification of persons responsible for administering

the policies and procedures, (3) regular review of the policies and procedures, and

(4) board oversight of funds’ compliance programs. Requirements along these lines

could provide an effective way to enhance protections against late trading, abusive

short-term trading, and selective disclosure. The Institute generally supports this

proposal.23

Mutual Fund Advertisements

The SEC recently adopted amendments to the mutual fund advertising rules to

require enhanced disclosure in fund advertisements, particularly advertisements

containing performance information.24 Under the new rules, fund performance advertisements will have to provide a toll-free or collect telephone number or a website

where an investor may obtain more current performance information (current as of

the most recent month-end). In addition, fund advertisements will be required to advise investors to consider the investment objectives, risks, and charges and expenses

of the fund carefully before investing and that this and other information about the

fund can be found in the fund’s prospectus.

124

25See Investment Company Act Release No. 25870 (December 18, 2002). 26 Report of the Joint NASD/Industry Task Force on Breakpoints (July 2003). 27See, e.g., Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Ms.

Joan Conley, Office of the Corporate Secretary, NASD Regulation, Inc., dated October 15, 1997. 28 NASD Notice to Members 03–54 (September 2003). 29See Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Barbara

Z. Sweeney, NASD, Office of the Corporate Secretary, dated October 17, 2003. 30 Report of the Advisory Group on Best Practices for Fund Directors (June 24, 1999) (Best

Practices Report).

Portfolio Holdings and Expense Disclosure

The SEC is expected to adopt soon a proposal that would require funds to disclose

their portfolio holdings on a quarterly (rather than semi-annual) basis, and that

would improve disclosure in fund shareholder reports.25 As part of this proposal,

funds would be required to disclose in their shareholder reports the dollar amount

of expenses paid on a $10,000 investment in the fund during the period covered by

the report. This disclosure, which would supplement the detailed fee disclosure currently required in fund prospectuses, would serve to remind investors about the impact of fund expenses and assist them in comparing the expenses of different funds.

The Institute supports this proposal.

Sales Charge Breakpoints

Many mutual funds that are sold with front-end sales charges offer discounts to

investors who invest specified amounts of money. The investment levels at which

investors qualify for the discounts are called ‘‘breakpoints.’’ In late 2002 and early

2003, regulatory investigations revealed instances in which investors did not receive

the benefit of sales charge reductions to which they were entitled. Most of these situations did not appear to involve intentional misconduct. These examination findings led to the formation of a Joint Industry/NASD Breakpoint Task Force, made

up of high-level NASD, mutual fund and broker-dealer representatives. The Joint

Industry/NASD Breakpoint Task Force recently issued a report making a series of

recommendations designed to ensure that processes are in place to ensure that investors receive applicable discounts.26 The recommendations include additional required disclosure concerning breakpoint discounts. The Institute is working with its

members, other securities industry participants and regulators on the implementation of the Breakpoint Task Force’s recommendations and is committed to resolving

the problems that have been identified for the benefit of mutual fund investors.

Revenue Sharing Arrangements

‘‘Revenue sharing’’ arrangements involve payments by a fund’s investment adviser

or principal underwriter out of its own resources to compensate intermediaries who

sell fund shares. The principal investor protection concern raised by these payments

is whether they have the potential for influencing the recommendations of the financial intermediary that is receiving them. Disclosure concerning revenue sharing

payments is already required in fund prospectuses, and the Institute has long

advocated additional, point-of-sale disclosure by broker-dealers to help investors

assess and evaluate recommendations to purchase fund shares.27 The NASD recently proposed new point-of-sale disclosure requirements in this area.28 The NASD

proposal also addresses differential cash compensation arrangements, in which a

broker-dealer firm pays its registered representatives different rates of compensation for selling different funds. The Institute supports the NASD proposal.29

Fund Governance

The recent disturbing revelations have caused some to question the effectiveness

of the fund governance system. We do not believe it is fair to place blame upon directors, or the fund governance system. Directors cannot be expected to unearth

every instance of wrongdoing, especially if such wrongdoing took place at an unrelated entity. At the same time, it seems apparent that steps need to be taken to

enhance the ability of directors to exercise their oversight responsibilities, and some

of those steps are discussed above.

Overall, we continue to believe that the system of mutual fund corporate governance has served investors very well through the years. It has even served as a

model for reforming the governance of corporate America. In recent years the fund

governance system has undergone several enhancements. For example, in June

1999, an Institute advisory group composed of investment company independent and

management directors recommended a series of 15 best practices—that went beyond

legal and regulatory requirements—to enhance the independence and effectiveness

of investment company directors.30 Subsequently, the SEC adopted rule amendments designed to further strengthen the independence and effectiveness of investVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00136 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
125

31SEC Release No. IC–24816 (January 2, 2001). 1The Securities Industry Association, established in 1972 through the merger of the Association of Stock Exchange Firms and the Investment Bankers Association, brings together the

shared interests of more than 600 securities firms to accomplish common goals. SIA memberfirms (including investment banks, broker-dealers, and mutual fund companies) are active in all

United States and foreign markets and in all phases of corporate and public finance. According

to the Bureau of Labor Statistics, the U.S. securities industry employs nearly 800,000 individuals. Industry personnel manage the accounts of nearly 93 million investors directly and indirectly through corporate, thrift, and pension plans. In 2002, the industry generated $222 billion

in domestic revenue and $356 billion in global revenues. (More information about SIA is available on its home page: www.sia.com.) 2 Investment Company Institute, 2003 Fact Book, at 42–43.

3www.sia.com/research/html/keylindustryltrendsl.html#securities.

ment company directors.31 Last month, at the behest of the Institute’s Executive

Committee, the Institute’s Board of Governors adopted a resolution recommending

that Institute member companies adopt additional best practices with respect to: (1)

the treatment of close family members of persons associated with a fund or certain

affiliates as independent directors and (2) the standards for investment company

audit committees. The resolution also recommended that Institute members, to the

extent they have not already done so, adopt the best practices set forth in the 1999

Best Practices Report.

Conclusion

The alleged abusive late trading and market timing activities recently uncovered

by the New York Attorney General and the SEC are deplorable. Swift and forceful

responses are necessary to make clear that there is no place in the mutual fund

industry for those who would put their own interests before those of fund shareholders. The industry pledges its commitment to take any steps necessary to make

sure that its obligation to place the interests of fund shareholders above all others

is understood and fulfilled.

—————

PREPARED STATEMENT OF MARC E. LACKRITZ

PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

NOVEMBER 18, 2003

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, I

am Marc E. Lackritz, President of the Securities Industry Association.1 I appreciate

the opportunity to testify before the Committee today on a number of issues relating

to the integrity of the mutual fund industry, as well as the broker-dealers that I

represent.

The securities industry is based on two bedrock principles—disclosure and competition. But the public’s trust and confidence are the indispensable elements for the

capital markets to play their effective roles in channeling capital to its most productive uses. Our industry has raised more than $21 trillion over the past 10 years to

finance innovation and growth—new enterprises, new processes, new products,

bridges, hospitals, roads, and schools. Without public trust and confidence, our market mechanisms cannot function effectively or efficiently. Our system has thrived

because all market participants must adhere to the same rules, vigorously and

fairly applied.

Mutual funds are the vehicle by which an overwhelming majority of investors participate in our markets. They offer many small investors an inexpensive way to

share in the benefits of owning stocks and bonds. Mutual fund portfolios give investors an avenue for diversifying a relatively minimal investment, thereby managing

their risk exposures. For these reasons, mutual funds are extremely popular products for small investors, as well as for retirement plans such as 401(k) plans. As

of January 2002, 89 percent of U.S. equity investors owned stock mutual funds, and

51.5 percent of equity investors held only stock mutual funds. Overall, 49.6 percent

of all households in the United States owned mutual funds directly or through a

retirement account.2 Twenty-six percent of all household liquid financial assets were

in mutual funds as of mid-year 2003.3

Broker-dealers and other intermediaries play a critical role in the distribution of

mutual funds. Third-party financial professionals such as full service broker-dealers,

financial planners, banks and insurance companies distribute approximately 55 percent of mutual fund assets. ‘‘Mutual fund supermarkets,’’ generally operated by disVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00137 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
126

4 Investment Company Institute, www.ici.org/stats/res/per09–03.pdf, at 5. By way of comparison, only 12 percent of purchases of mutual fund assets are made by individual investors

directly from the fund. 5SIA 2003 Securities Industry Fact Book, at 47, 59.

count brokers, distribute another 5 percent of mutual fund assets.4 Full-service and

discount brokers benefit investors and promote competition among funds by offering

investors a convenient and accessible way to compare and to select from a range

of different mutual fund families.

The health of our markets depends to a great extent on the public’s continued

robust participation in mutual funds. In 2002, equity mutual funds had a market

capitalization of $2.7 trillion dollars, roughly 22 percent of the total capitalization

of our equity markets.5 Retail investors, the backbone of both the mutual fund industry and our securities markets, put their trust in the integrity of mutual fund

managers and advisers, as well as in the financial advisers who assist their investment decisions and the brokers who implement their trade orders. The interests of

retail investors must come first if we want them to continue entrusting their money

to mutual funds. Investors must be assured that fraud, self-dealing, or dishonesty

will not be tolerated. All investors should be treated fairly, and all aspects of the

mutual fund business—including fund fee structures, financial incentives offered to

intermediaries to recommend specific funds, fund investment and redemption policies, and fund governance—must be as transparent as possible. In addition, all investors should be assured of reasonably prompt execution and fair pricing of their

mutual fund transactions.

In the past several months, State and Federal regulators have uncovered a number of instances of distressing behavior by some mutual funds and intermediaries.

These include: (1) late trading or market timing in contravention of stated fund policies; (2) lack of full disclosure; and, (3) operational shortcomings relating to breakpoints. All of these instances share a common element: They hurt investors.

In the remainder of this testimony, I will discuss each of these disturbing revelations and the measures that we strongly support to resolve these problems and to

earn back the public’s trust and confidence. Each of these issues must be addressed

swiftly and comprehensively by tough enforcement action where wrongdoing has

occurred, thoughtful regulatory revisions to make sure that these problems cannot

recur, and legislation to fill in existing ‘‘gaps’’ in the law. At the same time, it is

equally important that regulatory or legislative solutions do not create new problems or other unintended consequences for investors in the course of remedying

existing ones.

Late Trading/Market Timing

PROPOSALS TO ADDRESS LATE TRADING

Governing Principles

SIA is greatly distressed by the number of instances of mutual fund late trading.

We believe that stringent enforcement actions to ferret out and punish such illegal

activity will have a strong deterrent effect. We agree with the Securities and

Exchange Commission Chairman Donaldson, however, that additional regulatory

action needs to be taken to eliminate opportunities for such activity in the future.

Investors will not accept the status quo and mere promises to do better. New rules

must be put in place that do right by investors and ensure that these abuses will

never happen again.

Appropriate regulatory action should meet several key principles. The rules

should:

• Be reliable and ‘‘bulletproof’’ to new forms of evasion.

• Give investors the widest array of opportunities.

• Treat all investors—large and small; institutional and retail—equally.

• Synchronize new mandates with the complexities of existing and well-proven

operational systems that investors count on to seamlessly clear and settle many

millions of transactions per day.

Proposals for Reform

Several proposals have been advanced to address late trading by establishing a

‘‘hard close’’ for open-end mutual fund purchase or redemption order acceptance no

later than the New York Stock Exchange’s 4 p.m. ET close of business. Each of

these proposals is intended to ensure that no transactions accepted after that point

in time can receive the fund’s pricing for that day. The key difference among the

proposals is where they prescribe the ‘‘hard close.’’ One approach would require that

the mutual fund or its transfer agent must receive orders by 4 p.m. to receive sameVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00138 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
127

6 Broker-dealers that self-clear, or that act as introducing brokers and clear their transactions

through a third party, must process and batch these orders and perform breakpoint analysis

on the orders before they are sent on to NSCC, which processes and clears the orders and transmits them to the fund company through its Fund/Serv facility. Other entities that receive

mutual fund transactions from customers, such as banks, must perform similar steps prior to

sending the orders to fund companies. 7Moving fund holdings from intermediaries to the funds themselves may not be a viable option for many retail investors because they would lose the array of choices of different fund complexes that a broker-dealer can offer, as well as special execution services, such as the ability

to liquidate equity or debt securities to purchase fund shares (or vice versa) or to exchange

shares of funds of different fund complexes. 8This is because the 401(k) system has additional complexities than those faced by brokerdealer recordkeeping systems. For example, 401(k) recordkeepers must place trades collectively,

and perform a number of reconciliations at the participant and plan levels in executing transactions. In addition, recordkeepers perform other services that add time to the process such as

determining eligibility for loans since Federal law regulates the amount of a loan based on a

participant’s account balance.

day pricing. A second proposal has been circulated, but not finalized, under which

orders received by the National Securities Clearing Corporation (NSCC), the centralized entity through which most mutual fund orders are cleared, would also satisfy the ‘‘hard close’’ requirement. Finally, a third approach would permit the hard

close to occur at either the mutual fund, NSCC, or a broker-dealer or other SECor bank-regulated intermediary or other entity, so long as the order recipient has

a verifiable order capture system.

As discussed below, we think that a hard close that can only occur at the mutual

fund has some significant drawbacks for investors, and also may have some major

operational difficulties. A hard close at NSCC may best meet concerns about a

verifiable order entry deadline, while a hard close at the broker-dealer or other

intermediary would be preferable from the vantage point of most retail investors

and retirement plan participants. In any event, we must demonstrate to the public

not only that late trading will be punished severely, but also that it will be foreclosed from ever happening again.

(i) Hard Close at the Mutual Fund. One early proposal to emerge in response to

the revelations about late trading is a suggestion that the SEC require that only

orders that are received by a mutual fund prior to 4 p.m. ET should receive that

day’s pricing. This proposal may be an effective way of foreclosing late trading. However, measured against the principles that we articulated above it has several significant shortcomings.

Most importantly, it would be likely to create a two-tiered market, in which institutional investors that clear their transactions directly with funds would have the

ability to trade until 4 p.m. ET, while retail investors who generally hold their mutual funds through a broker-dealer or other intermediary, as well as administrators

of many 401(k) and similar retirement plans that generally rely on intermediaries

for processing participant orders would have to get in their orders by a much earlier

cut-off time in order to complete all processing necessary to transmit orders to the

fund by 4 p.m.6

Because of the multiple steps necessary to clear and settle mutual fund orders,

in general investors would face a cut-off time approximately 2 hours prior to the

4 p.m. ET hard close at the fund, although the exact cut-off would vary from firm

to firm. Individual fund investors that desire the service of broker-dealers or other

intermediaries should not be prejudiced by an early cut-off while other fund investors would be free to trade for approximately 2 additional hours solely by virtue

of their relationship with the fund.7 This could be a substantial hardship. These

investors would lose the ability to shape their investment decisions by observing

market developments in the last two hours of the trading day.

A 4 p.m. ET hard close could pose an even more serious disadvantage for the 36

million families who invest through employer-sponsored retirement plans. Institutions that provide recordkeeping services to 401(k) plans would likely need to cut

off order acceptance much earlier than broker-dealers.8 In the case of the west coast

participants, this could mean that trades would have to be placed in the early morning hours of the business day, and may only be able to receive next-day settlement.

This would place retirement plan participants at a marked disadvantage to other

institutions.

The durability of a hard close at the fund to attempts at evasion is also not clear.

Unless it is accompanied by a requirement to use auditable technology to ensure

that the order entry time at the fund is not subject to abuse, similar to what we

128

9 In a recent speech at SIA’s Annual Meeting in Boca Raton, Florida, SEC Chairman Donaldson noted that 10 percent of funds, as well as 25 percent of broker-dealers, have been involved

in enabling late trading by customers. Therefore, a verifiable order entry time stamp should be

an essential element of any response to late trading that relies on when orders are received by

a fund or an intermediary. Remarks of Chairman William H. Donaldson to the Securities Industry Association, November 7, 2003, http://www.sec.gov/news/speech/spch110703whd.htm, at

2–3 (Donaldson Boca speech).

propose in connection with the hard close at the broker-dealer alternative, concerns

about late trading may linger.9

This approach would also pose significant operational challenges. Currently, there

is no need for real-time capture, routing and execution of fund orders, since fund

pricing is only established once a day. Consequently, many firms extract such orders

to batch and route to the fund or NSCC. To require that firms present mutual fund

trades to the fund by 4 p.m. ET would result in many broker-dealers extracting a

day’s worth of orders and transmitting all of them to the fund near the 4 p.m. close.

This could create a huge technology jam that funds may not be prepared to manage.

Funds may also not be prepared to manage other aspects of the clearing process

that this approach may effectively shift onto them. For example, in today’s world

a broker-dealer might receive an order prior to 4 p.m., and after the 4 p.m. close

send a fund, via NSCC, an order to sell a certain number of shares (or a certain

dollar amount) of a fund, including a post-4 p.m. ‘‘enrichment’’ of the data by factoring the closing price into performing its breakpoint analysis and crediting the

customer’s account for the cash (or debit it for the shares). With a 4 p.m. hard close,

the fund itself would have to perform this enrichment function with the closing price

data. Funds are not currently set up to do this, and might seek to subcontract this

work back to NSCC. Thus, operationally the ‘‘hard close at the fund’’ approach could

start to closely resemble the ‘‘hard close at NSCC’’ proposal.

(ii) Hard Close at NSCC. We understand that NSCC (which operates the NSCC/

Fund/Serv mutual fund processing system) is considering proposing the development

of a centralized time stamp facility as an answer to concerns about late trading.

That facility would enable intermediaries to transmit fund orders throughout the

day to NSCC or batch them prior to 4 p.m., but still provide the opportunity to submit essential enrichment data which is necessary to complete the transaction after

the close. Among other things, this data would include information related to breakpoint entitlement, calculation of contingent deferred sales loads, and exchanges

between funds.

This approach, while still under discussion, is a very promising way to address

the late trading issue as measured against our key principles. It should be possible

to design this proposal so that it is reliable and resistant to evasion. This is particularly the case since NSCC, as a third-party processor with no relationship to the

customer and only a very limited relationship with the intermediaries and funds,

would have no motive to circumvent the order entry timing requirement. This proposal also builds directly on a well-tested and experienced clearing system. While

it would certainly require expanding some technology and systems, it appears to

pose a much less daunting operational challenge than a hard close at the fund.

The impact on investors would also not be as severe as under a hard close at the

fund. However, the NSCC approach would still face some drawbacks on this score.

Investors who transact mutual fund purchases and redemptions through brokerdealers and other intermediaries, and retirement plan administrators, would still

have to get their trades in at some point before the 4 p.m. close in order to get the

benefit of same-day pricing. We have not been able to determine how significant this

gap would be, but it would certainly be a much smaller disparity than would be created by a requirement that would only permit same-day pricing for orders received

by the fund by 4 p.m. ET.

(iii) Hard Close at the Intermediary. The third proposal, which SIA advanced in

an October 31 letter to the SEC, would permit same-day pricing for orders received

by the broker-dealer or other intermediary by 4 p.m., as well as orders received by

the mutual fund or by its processing agent by 4 p.m. This would be subject to the

qualification that the recipient of the order must have an electronic order capture

system, with verifiable order entry time aligned with an atomic clock to document

receipt. This requirement would eliminate a salesperson’s ability to either withdraw

a fund order after 4 p.m. or receive current day pricing for an order entering the

system after 4 p.m.

This proposal is the most attractive of the three from the standpoint of investor

fairness. Investors would receive same-day pricing under the same terms that they

do today, regardless of whether they are institutional or retail, trading through a

broker-dealer or other intermediary, or directly with a fund.

129

10 Additionally, in 2001, the SEC issued guidance suggesting that funds might have an obligation to apply methodologies to apply a fair value to fund assets in situations where changes in

the U.S. market create a potential discrepancy between an international mutual fund’s day-end

net asset value and the overseas closing price of foreign securities that it holds. Letter to Craig

S. Tyle, General Counsel, Investment Company Institute, from Douglas Scheidt, Associate Director and Chief Counsel, Division of Investment Management, U.S. Securities and Exchange Commission, April 30, 2001.

For broker-dealers this approach is also workable as an operational matter.

Broker-dealers are already required to use a verifiable order entry time stamp

aligned with an atomic clock for processing equity transactions. Mutual funds and

their processing agents, as well as banks and other intermediaries would need to

build similar systems, but the technology and processes already exist.

Bank regulators such as the Office of the Comptroller of the Currency would need

to impose a companion rule to require a hard close on order acceptance by 4 p.m.

together with a required electronic capture system. For entities which are unregulated, or unable to comply with the hard close time stamping requirement or other

comparable verification systems, orders would need to be placed with the fund directly, or some other designated regulated entity that has electronic time stamping

capability to ensure receipt by the hard close cutoff time.

We are confident that this approach would not be subject to abuse. It would rely

on the same electronic order audit system that the SEC and self-regulatory organizations required firms to adopt so that the regulators could monitor order-handling

processes for equity securities. Components of the system should also include written policies and procedures to insure compliance, with senior management sign-off

on the adequacy of those procedures, and an annual external audit to measure compliance with, and the effectiveness of, these procedures.

PROPOSALS TO ADDRESS MARKET TIMING

‘‘Market timing’’ refers to a trading strategy in which an investor engages in frequent transactions in mutual funds in anticipation of changes in market prices.

Usually this is done to try to profit from discrepancies between the time when an

underlying asset is priced and the time when a fund’s net asset value is set. A common example is a mutual fund investing exclusively in foreign securities traded in

markets that close prior to U.S. markets, and which may be sensitive to changes

in the U.S. market. A market timer may choose to buy or redeem fund securities,

depending on whether the U.S. market is going up or down substantially on the day,

in the hope that the opening price of the underlying asset will change as a result

of the U.S. market move. The investor would receive an arbitrage profit on the lag

between the pricing of the fund and of its underlying assets.

Market timing is not inherently illegal, but it can pose problems for many mutual

funds. For example, market timing activity can drive up a fund’s administrative

costs as the fund manager must either sell assets or hold extra cash to meet redemption demands of market timers. It also has the potential to dilute the interests

of other fund shareholders who do not engage in market timing. Because of these

drawbacks, many funds have policies and procedures to discourage market timing.

Recent enforcement actions and press reports of ongoing investigations by Federal

and State regulators appear to involve just such instances in which funds and intermediaries facilitated market-timing transactions despite statements in the fund

prospectus that the fund would not assist such activities. As a result of these developments, a number of regulatory proposals have been advanced to address markettiming transactions. Here are two potentially useful steps:

• SEC Chairman Donaldson has proposed that rules regarding disclosure of fund

policies and procedures on market timing should be tightened, and that funds

should be required to have procedures to fully comply with any representations

that they make concerning their market timing policies and procedures.10

• SIA has also proposed, subject to customer privacy rights, a requirement that

sufficient trade-level customer detail be provided to funds to assist them in identifying market-timing activity on transactions that are submitted by the intermediary on an aggregated basis.

Both of these steps would do a great deal to deter market timing in contravention

of fund policies. A further step would be to permit funds to impose a fee (of 2 percent or some other level) on any fund shares redeemed within 5 days of purchasing

them. The proceeds of this fee would go to the fund for the benefit of the fund’s longterm shareholders. As originally proposed, the only exceptions would be for money

market funds, and for a fund that prominently discloses that it is designed for shortterm trading and that secures a specific SEC exemption from the requirement.

130

11See H.R. 2420 mark-up dated July 24, 2003. H.R. 2420 focuses on additional customer statement disclosure or other nonprospectus disclosure. Proposals regarding revenue sharing and differential compensation appear in Section 12 of the bill. 12Letter to SEC Chairman Donaldson from Representative Michael Oxley (R–OH), Chairman,

House Financial Services Committee and Representative Richard Baker (R–LA), Chairman Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises (July 30,

2003). 13 NASD Notice to Members #03–54 (September 2003). The NASD proposal appears to require

additional disclosure to be delivered in some manner other than by means of the confirmation,

the customer statement, or prospectus.

While we generally disfavor regulatory approaches that involve pricing regulation,

the problems that have arisen are such that we support such a proposal. We think

it will be a very effective step toward ending abusive market timing transactions.

The only modification that we suggest is that the SEC provide a narrow exemption

for hardship cases, so that an investor can make a single transaction without incurring the 2 percent fee if the investor can demonstrate in writing that the transaction

is necessary to meet an unanticipated personal financial hardship.

In addition to these steps, the recent amendment to H.R. 2420 would require the

SEC to adopt regulations to eliminate stale pricing, the underlying source of both

late trading and abusive market timing. While the steps outlined above may be sufficient to address this issue, we believe that swift action on many fronts needs to

be considered. Therefore, we not only support the 2 percent redemption fee, but also

SEC action to address the overall issue of stale pricing.

We strongly support tough enforcement action against abusive market timing, as

well as prompt implementation of regulatory reform. This will go a long way toward

repairing the damage to public trust and confidence that revelations of abusive market timing have caused.

Disclosure Proposals

We favor clear, direct, timely disclosure of all material information to investors

in a central place. It is really important to make it investor-accessible and investorfriendly rather than a ‘‘Where’s Waldo?’’ search through fragments of disclosures for

relevant information.

REVENUE SHARING AND DIFFERENTIAL COMPENSATION

We strongly support efforts to enhance the transparency of revenue sharing and

differential compensation to mutual fund investors. At a minimum such enhanced

disclosure should embody the following elements:

• A balanced presentation of the nature of services received (including the inclusion

of funds on preferred or select lists, or provision of shelf space) and expenses reimbursed pursuant to revenue sharing arrangements.

• A listing of funds or of fund families with whom revenue sharing arrangements

exist.

• The aggregate amount of revenue sharing payments received during a specified

period.

• The funds or fund families with respect to which higher percentage rates of compensation are paid to associated persons.

• The extent, if any, to which associated persons may only recommend the purchase

of funds with respect to which the broker-dealer participates in revenue sharing

arrangements.

As you all know, a number of regulatory and legislative initiatives directed at

improving transparency have emerged in recent months. These include H.R. 2420

introduced by Congressman Richard Baker (R–LA),11 proposals made by Representatives Oxley and Baker in a letter to SEC Chairman Donaldson,12 an NASD rule

proposal regarding compensation for the sale of investment company securities 13

and testimony by SEC Chairman Donaldson on September 30, 2003, before the Senate Committee on Banking, Housing, and Urban Affairs, in which Chairman Donaldson stated that:

I envision that a revised confirmation would include information about

revenue sharing arrangements, incentives for selling in-house funds and

other inducements for brokers to sell fund shares that may not be immediately transparent to fund investors....

Meanwhile, as a by-product of the recommendation of the NASD Mutual Fund

Breakpoint Task Force—in which SIA has been an active participant and which I

will discuss in a moment—task force working groups are currently developing confirmation modifications and a new disclosure document prototype to enhance discloVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00142 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
131

14Letter to Barbara Sweeney, NASD from Stuart R. Strachan, Chair, SIA Investment Company Committee ‘‘Rule Proposal Regarding Compensation for the Sale of Investment Company

Securities’’ (October 17, 2003). 15Letter to Paul F. Roye, Director, SEC Division of Investment Management from Stuart R.

Strachan, Chair, SIA Investment Company Committee, ‘‘Revenue Sharing and Differential Compensation’’ (October 31, 2003). 16See Memorandum from Paul F. Roye, Director, Division of Investment Management, SEC,

to the Honorable William H. Donaldson, Chairman, SEC, June 9, 2003 at 13–18. See also, GAO,

Mutual Funds, Greater Transparency Needed in Disclosure to Investors, June 2003 (GAO–03–

763) at 11 et seq.

sure of breakpoint information to customers. Each of these different initiatives has

the potential to enhance the transmission of relevant information to mutual fund

investors. However, when considered together, there appears to be a substantial risk

of disclosure fragmentation and associated investor confusion, particularly if these

initiatives proceed without coordination and consistency of treatment.

Therefore, in submissions we have made to the NASD 14 and SEC 15 we have

urged that any rulemaking in this area be designed to:

• Achieve a uniform approach across regulatory entities regarding the disclosure

mechanisms for information on revenue sharing and differential compensation

arrangements.

• Focus disclosure on circumstances where such arrangements are likely to influence recommendations made to investors, or limit the scope of recommendations

that may be offered.

• Utilize disclosure vehicles that will facilitate, rather than inhibit or deflect, investors’ attention away from all material information that should be considered when

making a mutual fund investment.

DISCLOSURE OF OPERATING EXPENSES

SIA fully believes that investors should have full, complete, and useful information on mutual fund fees since they can have a significant effect on an investor’s

return. We believe that the most efficient means for providing this information to

investors is for funds to calculate expenses based on a hypothetical $1,000 investment. House Report 108–351 accompanying H.R. 2420 (November 4, 2003) notes at

11 that:

The SEC recently proposed a new rule requiring disclosure in a fund’s

semi-annual and annual report to include: (1) a dollar example of the fees

an investor would have paid on a hypothetical $10,000 investment, using

the actual exposes incurred by the fund and the actual return achieved by

the fund; and (2) the same dollar example using the actual expenses incurred but assuming a 5 percent return over the period so funds could be

compared against each other. * * * H.R. 2420 generally codifies the pending SEC proposal, but includes two important changes: First, the dollar example in the annual report must be based on a hypothetical $1,000 investment. The Committee believes that using $1,000 as the example will make

it easier for investors to calculate the amount of fees paid. Second, the legislation includes a requirement that account statements include a legend

prominently stating that: (1) the investor has paid fees on the mutual fund

investment, (2) those fees have been deducted from the amount shown on

the statement, and (3) the investor can find more information by referring

to documents disclosing the amounts of those fees.

SIA generally concurs with these provisions. Providing information on a $1,000

investment both with respect to that fund’s return and with respect to a hypothetical 5 percent return will facilitate exactly the type of comparison-shopping that

H.R. 2420 and the SEC contemplate. At the same time, the costs of these changes

(which ultimately investors bear) will be in proportion to the benefit that investors

derive.16

In addition, SIA appreciates the Report language noting that such disclosures

should indicate that the customer’s portfolio already reflects those charges and that

they are not additional charges that the broker-dealer or fund will deduct. Absent

such clarification, investors might be confused. SIA believes that any new disclosure

should afford funds appropriate flexibility and ensure that fee disclosures do not

receive disproportionate emphasis.

SIA also believes that this aspect of H.R. 2420 attempts to place an appropriate

emphasis on mutual fund fees as part of the larger investment decision. As noted,

fees can have an important effect on an investor’s return. But fees are only one aspect of an investment decision. Investors (and their brokers, in the case of brokerVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00143 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
132

17 E.g., Interpretive Release Concerning Scope of Section 28(e) of the Securities Exchange Act

of 1934 and Related Matters, Rel. 34–23170 (April 23, 1986) (1986 Release) and Inspection Report on the Soft-Dollar Practices of Broker-Dealers, Investment Advisers, and Mutual Funds,

September 22, 1998 (1998 Report). 18 Id at 4. 19 1998 Report at 13 (emphasis added in 1998 Report, not in 1986 Release). 20Testimony of Mary Schapiro, NASD Vice Chairman and President Regulatory Policy and

Oversight, Before the Subcommittee on Capital Markets, Insurance, and Government Sponsored

Enterprises, Committee on House Financial Services, November 3, 2003, at 4.

sold funds) need to consider not just expenses, but whether the investment is appropriate for the investor’s situation.

SOFT DOLLARS, DIRECTED BROKERAGE, AND RELATED ISSUES

SIA supports efforts to improve disclosure of brokerage arrangements between

funds, their advisers, and broker-dealers. When Congress enacted Section 28(e) of

the Securities Exchange Act of 1934, it recognized the need for money managers to

obtain research from a wide range of sources. Section 28(e) enables money managers

to pay for research and related services through commission (soft) dollars rather

than paying for them in cash. Such research helps money managers, including fund

managers, do a better job of serving their customers. Over the years, the Commission has issued interpretations on the scope of research services that may be provided and examined industry practices.17 The 1998 Report notes, ‘‘the vast majority

of products and services received by advisers are within the safe harbor established

by Section 28(e) of the Exchange Act.’’ 18 In general, SIA has viewed soft dollars as

both pro-investor and pro-competitive.

At the same time, we recognize that there are opportunities for abuse with respect

to soft dollars. The 1998 Report documented problems and abuses of significant concern. SIA strongly supports SEC and SRO enforcement efforts to curb soft-dollar

abuses and to deter others from engaging in such abuses. We also believe that mutual funds should ensure effective disclosure of soft-dollar practices both to investors

and to fund trustees. Section 3 of H.R. 2420 is intended to address these concerns

and we generally support those goals.

Directed brokerage also has been a subject of concern. The 1998 Report—in citing

the 1986 Release—states that unlike soft dollars, directed brokerage does not

present the same conflict of interest issues, since ‘‘the fund’s commission dollars [are

used] to obtain services that directly and exclusively benefit the fund.’’ 19 In these situations the fund directs the money manager to execute a portion of the fund’s

trades through a particular broker-dealer. In return for the brokerage commissions

the broker-dealer typically provides services directly to the fund or pays certain

fund expenses.

We believe that with respect to both soft dollars and directed brokerage, a key

investor protection issue is best execution. If fund investors received mediocre executions because of soft dollar or directed brokerage arrangements, the relationships

are indefensible. Poor executions in the absence of soft-dollar or directed brokerage

arrangements would be just as indefensible. In short, advisers, fund trustees, and

broker-dealers must serve the needs of fund investors with respect to research and

execution services.

SIA supports disclosure to investors and fund trustees to ensure that arrangements with broker-dealers are disclosed fairly and in context. Again, disproportionate emphasis on costs may confuse and distract investors or trustees from examining the investment and all relationships among service providers. Nonetheless,

balanced disclosure of material information is essential if investors and the trustees

acting on their behalf are going to make intelligent, informed decisions.

Breakpoints

OVERVIEW

Late in 2002, the SEC and the NASD became concerned that investors in mutual

funds were not receiving ‘‘breakpoint’’ discounts, which are essentially volume discounts for purchases. The NASD indicates that ‘‘during routine examinations of

broker-dealers by [the NASD’s] Philadelphia District Office, the NASD discovered

that broker-dealers selling front-end loaded mutual funds were not properly delivering breakpoint discounts to investors.’’ 20 The regulators’ concerns were first articulated in an NASD Notice to Members dated December 23, 2003, and a letter from

the SEC to senior brokerage firm executives. SIA, along with the Investment Company Institute (ICI), cooperated fully with the SEC and the NASD in an effort to

publicize regulators’ concerns and to help ensure that broker-dealers and funds adVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00144 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
133

21Staff Report: Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers Regarding

Discounts on Front-End Sales Charges on Mutual Funds, http://www.nasdr.com/pdf/-text/

bpljointlexam.pdf. 22Letter from then-SEC Chairman Harvey Pitt to the NASD Chairman Robert Glauber dated

January 15, 2003.

dressed the situation. For example, SIA subsequently urged its membership to review their breakpoint procedures and promptly take any necessary corrective action.

In March 2003, the SEC, the NASD, and the NYSE issued a report on breakpoint

practices.21 After examining 43 firms, the Report noted:

Most of the firms examined, in some instances, did not provide customers

with breakpoint discounts for which they appear to have been eligible.

Overall, examiners identified a significant number of transactions that

appeared to be eligible for a discount, though did not receive a discount

or incur other unnecessary sales charges. Three firms did not provide a discount in all sampled transactions that appear to have been eligible for a

discount, and two firms provided customers with all available discounts.

However, the Report also noted ‘‘many of the problems do not appear to be intentional failures to charge correct loads.’’

RECOMMENDATIONS

In response to a request from the SEC Chairman,22 the NASD organized a Task

Force to address breakpoint concerns. The SEC asked the SIA and ICI to co-chair

the effort. The Task Force was composed of a broad cross-section of the financial

industry, including representatives from the NASD, NYSE, NSCC, broker-dealers,

mutual funds, and transfer agents. SEC staff attended the meetings as well. On

July 22, 2003, the Task Force issued its report with the following recommendations:

(A) Common Definitional Standards: The mutual fund industry should adopt

common definitions of terms frequently used in defining breakpoint opportunities.

(B) Central Breakpoint Schedule and Linkage Database: The mutual fund industry should create a central, comprehensive database of pricing methods, . . .

breakpoint schedules, and the linkage rules used to determine when a breakpoint

has been reached and should make that database easily accessible to brokerdealers’ registered representatives....

(C) Mutual Fund Prospectus and Website Disclosure: Mutual funds should provide the critical data regarding pricing methods, breakpoint schedules, and linkage rules in their prospectuses and on their websites, in a prominent and clear

format.

(D) Confirmation Disclosure: Confirmations should reflect the entire percentage

sales load charged to each front-end load mutual fund purchase transaction.

(E) Standardized Checklists or Order Verifications: As an initial matter, brokerdealers should require registered representatives to complete electronic or paper

checklists or place notations on firm paper or electronic records.

(F) Record of Linkage Information: At the time an investor first purchases frontend load shares of a particular fund family, his broker-dealer should record the

investor’s linking information, preferably using a standardized worksheet.

(G) Prospectus Disclosure Regarding Customer’s Role in Assisting in Securing

Breakpoint Discounts: The SEC should mandate that a fund’s prospectus disclose

that investors may need to provide their broker-dealer with the information necessary to take full advantage of the breakpoint discounts.

(H) Confirmation Breakpoint Legend: Confirmations for purchases of front-end

load mutual fund shares should include a disclosure legend that alerts customers

that they may be eligible for breakpoint discounts and refers customers to the appropriate materials (that is, mutual fund prospectus or website) to determine

breakpoint discount eligibility.

(I) Written Disclosure Statement: Broker-dealers should provide to each investor

a disclosure statement at the time of or prior to the confirmation of his initial purchase of front-end load fund shares.

(J) Registered Representative Training: NYSE and NASD rules require brokerdealer registered personnel to undergo periodic training.

(K) Investor Education: The investing public should fully understand the availability of breakpoint discounts because there are particular instances, as cited

above, in which investors must be active participants in assuring their receipt of

an eligible breakpoint.

134

23SIA understands that these efforts range from letters of caution from self-regulators to SEC

notices of possible Enforcement action (so-called ‘‘Wells’’ notices). As a policy matter, generally

SIA does not involve itself with enforcement matters. 24Donaldson/Boca Speech.

The Task Force has appointed working groups led by the NASD, the ICI, and the

SIA to implement these goals. The Task Force met again on October 28, 2003, so

that each working group could report on its activities. Briefly, the groups have made

substantial progress in completing the effort, which will result in a better and more

extensive flow of information to investors regarding breakpoint opportunities, an

enhanced investor ability to determine whether they received the sales charge reductions to which they are entitled, improved systems for capturing and storing information regarding accounts entitled to be aggregated for breakpoint purposes, and

improved communication of information between funds and broker-dealers regarding

breakpoint policies.

While the development of standardized definitions of breakpoint terminology is

very helpful, the wide variation in breakpoint policies across hundreds of fund families and thousands of funds still poses a daunting challenge. While we do not advocate a standardization of breakpoint policies, we do believe it appropriate for the

regulators, the SIA and the ICI to continue to work together to explore ways in

which breakpoint policies can be made easier to apply, so that the risk of any further operational problems regarding customers receiving the correct breakpoint is

further reduced.

It is important to note that the SEC charged the Task Force with addressing

breakpoint problems prospectively. The SEC and the self-regulators have been

working with firms to ensure that mutual fund customers are made whole.23

Conclusion

Like many investors, regulators, and policymakers, we have been surprised and

dismayed by the reports of abuses relating to the sale of mutual funds to investors.

Although any report of malfeasance in the financial industry is one too many, these

reports have been particularly upsetting because mutual funds are the investment

vehicle of choice for many Americans. Reports of abuses in this aspect of the financial world have a particularly corrosive effect on public trust in the investing and

capital raising process. At SIA’s recent Annual Meeting, SEC Chairman William

Donaldson said:

I have spent many years in and around the securities industry, during

which time I have seen that we have the world’s most creative, and most

industrious workforce. I have also seen that this industry is populated by

fundamentally decent and honest people. Indeed, these traits provide the

foundation of our economic vibrancy. The securities industry has found

itself stuck in a legal and ethical quagmire, but I am confident that the industry will work together to pull the industry out of the muck and live up

to a higher ethical standard. You can be sure that if you do not, those of

us in Government will.24

We are fully committed to addressing these concerns thoroughly—by supporting

vigorous enforcement of current rules and by supporting appropriate legislative and

regulatory reforms. We and our member-firms will work with policymakers to ensure that mutual fund investors once again can have justifiable faith in these products and our markets. We look forward, Mr. Chairman, to working with you and

the Committee to earn back the public’s trust and confidence.

(135)

REVIEW OF CURRENT INVESTIGATIONS

AND REGULATORY ACTIONS REGARDING

THE MUTUAL FUND INDUSTRY

THURSDAY, NOVEMBER 20, 2003

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 2:14 p.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

On Tuesday, Chairman Donaldson provided an overview of the

SEC’s regulatory response to the abuses in mutual funds. This

afternoon, we will hear from the State and Federal regulators who

are on the front lines investigating trading abuses and other questionable practices in the mutual fund industry.

In late September, this Committee first discussed late trading

and market timing activities with Chairman Donaldson. Since

then, it has become apparent that revelations about late trading

and market timing activities were just the beginning of the abuses

that investigators would discover.

Following Attorney General Spitzer’s initial settlement, regulators have opened investigations into multiple fund and brokerage

practices. Regulators are now investigating funds that have selectively disclosed portfolio information to certain privileged investors

and fund executives that may have engaged in illegal insider trading. Regulators are also investigating brokers who receive additional payments and commissions to favor certain funds without

disclosing such incentives to their clients, sell more expensive fund

shares to unsuspecting investors in order to generate high commissions, or fail to give clients breakpoint discounts on fund purchases.

It seems that a day does not pass when we do not read shocking

new disclosures about fund executives and brokers neglecting their

investors’ interests and profiting at their expense. It seems as if

each fund or brokerage house that is investigated has engaged in

some level of misconduct, at least up to now.

The scope of the recent revelations is particularly troubling. One

has to question whether this is the result of a few bad actors, or

widespread industry practices. I hope that these revelations are not

evidence of the industry standard, but I am very suspicious. Nevertheless, we will get to the bottom of this.

136

However, as a result of the SEC’s recent examination survey, we

have learned that a shockingly high number of funds and brokers

have engaged in the practices now under investigation. For too

long, these practices have not been disclosed to investors and were

largely unchallenged. It is time, I believe, for the securities industry to realize that such practices cannot, and will not, be tolerated.

Vigorous enforcement is crucial to regaining investors’ trust and

restoring integrity to our markets and the fund industry. Investors

must be assured that fund executives and brokers who violate their

duties to investors will be punished. Vigorous investigations are

also critical to this Committee as we consider any potential legislative reforms. It is vital that we understand the full scope of the

transgressions, conflicts, and structural problems that are at the

root of the misconduct in the fund industry. Such an understanding

will only come as the regulators define the full scope of the problems confronting the industry.

The recent investigations into the fund industry demonstrate the

benefits of a dual regulatory structure in which both State and

Federal regulators protect the investors’ interests. Regardless of

who first initiated the probes, State and Federal regulators share

the same goal of stopping misconduct and restoring investor confidence in the fund industry. Toward this end, Federal and State

regulators have significant, yet distinct, roles to play as the investigations progress. State law enforcement and the SEC have different mandates and authorities, but should share a common

goal—assuring the rule of law and a fair deal for the ordinary investor. I believe that it is incumbent upon the State and Federal

regulators to find a way to coordinate their investigatory and enforcement efforts in a responsible and a professional manner that

always puts the investor first. Successful State and Federal collaboration is essential to the comprehensive investigation of this $7

trillion mutual fund industry.

The duty to protect investors is a long-term responsibility. Inherent in this duty is a responsibility not only to make sure that the

mutual fund industry operates in accordance with the highest

standards, but also to avoid rush actions that could cause unnecessary damage to an industry that holds the assets of nearly 100 million investors.

While Attorney General Spitzer’s timely actions and the recent

Federal investigations have raised the issues of mutual fund

abuses and the public awareness, much, much remains to be done.

I look forward to hearing the regulators describe their findings to

date and detail their road map of future actions.

Today, the Committee will hear from Eliot Spitzer, the Attorney

General of New York; Stephen Cutler, Director of Enforcement at

the U.S. Securities and Exchange Commission; and Robert Glauber, Chairman and CEO of the National Association of Securities

Dealers. I look forward to your testimony.

Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Chairman Shelby.

At the outset, I want to commend Chairman Shelby for the ongoing oversight of the securities industry being conducted by this

137

Committee. This year alone, under Chairman Shelby’s leadership,

the Committee and the Securities Subcommittee of the Committee,

of which Senator Enzi is the Chairman and Senator Dodd is the

Ranking Member, have held 11 hearings involving securities matters, which clearly demonstrates how important the integrity and

efficiency of the U.S. securities markets are in the estimation of the

Congress.

Today’s hearing gives us the opportunity to continue our examination of the status of current investigations into the mutual fund

industry. We must learn more about the nature and scope of the

misconduct, why it was allowed to continue undetected or

unpunished for so long, and what are the most effective and appropriate remedies.

Mr. Chairman, I join with you in welcoming today’s witnesses.

Stephen Cutler is Director of the Enforcement Division at the U.S.

Securities and Exchange Commission, an agency which in the past

has been referred to as a ‘‘jewel among Government agencies.’’ Although in recent years the SEC has been underfunded, the legislation we passed last year, the Sarbanes-Oxley Act, authorized and

the Congress appropriated a significant increase in budget, which

has led to more staff being hired in order to meet its regulatory

needs. On Tuesday, Chairman Donaldson described the Commission’s new regulatory initiatives, and I am looking forward this

afternoon to hearing Mr. Cutler describe the enforcement activities.

I should note that the SEC’s Division of Enforcement is today

bringing significantly more enforcement actions. It is my understanding that the number of cases has increased from 484 in fiscal

year 2001 to 598 in fiscal year 2002 to a current high of 679 in fiscal year 2003. It is also my understanding that with the significant

increases in funding granted by the Congress, we have gone from

$515 million in fiscal year 2002 to $716 million in fiscal year 2003,

and the legislation we are working on now has $841.5 million for

fiscal year 2004; that the SEC is working diligently to hire and

train new employees for key divisions and that since this time last

year, the Division of Enforcement has hired over 75 new attorneys

and accountants.

I also look forward to hearing from Eliot Spitzer, the distinguished Attorney General of New York, who has repeatedly spearheaded major initiatives to protect investors. These have involved

securities firms that issued fraudulent or misleading stock recommendations, which led to a landmark settlement agreement with

Merrill Lynch. This action was followed by the global settlement

entered into by 10 major securities firms, in which Federal and

State regulators worked closely together to reform stock analyst

practices. In September, just a couple of months ago, Attorney General Spitzer brought another landmark case against a major hedge

fund for improper late trading and market timing in mutual funds.

I think it is clear that his work and that of his counterparts in

other States, whether attorney generals or securities commissioners, shows the important role that States play in protecting the

investors.

Mr. Chairman, I want to commend both the SEC’s Enforcement

Division Director Steve Cutler, as well as Attorney General Spitzer

for their outstanding efforts in enforcement. Tension between the

138

Commission and the States may very well go with the territory on

occasion, but I think it is extremely important for investor protection, which is, after all, our prime goal, that the SEC and State

regulators both are working to identify potential securities law violations and seeking to coordinate their investigations and enforcement activity wherever possible. I want to applaud the aggressive

actions and competence of both of these dedicated public servants

who are here today and are on this panel.

Then I also, of course, want to express our appreciation to Robert

Glauber for joining us, the Chairman and CEO of the National Association of Securities Dealers, a self-regulatory organization for

broker-dealers. The sales practices of stock brokers selling mutual

funds have been a major focus of public attention and we are looking forward to hearing more about the NASD’s examination and

enforcement activities with respect to brokers. Mr. Glauber, we are

pleased to once again have you back before the Committee.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you, Mr. Chairman. Let me add my voice

to that of Senator Sarbanes and others and thank you for the series of hearings we have had on this subject matter. I certainly

welcome our witnesses. To you, Bob, good to see you again, Mr.

Glauber; and Mr. Cutler, Stephen, and Eliot Spitzer, the Attorney

General, whom I have had the chance to get to know on several

occasions. We thank all three of you for being here.

Again, Mr. Chairman, I want to thank you and thank our staffs

as well. This is a rather crowded time around here. There is an

awful lot going on, obviously, on the floor with major issues before

us: The Fair Credit Reporting Act, which I know the Chairman and

Senator Sarbanes and the staffs are working on, trying to resolve

that issue before we leave here. So the staff, both Majority and Minority, of the Committee deserve a serious thanks for their tremendous commitment and hard work, and we are all very appreciative

of the efforts being made, in addition to conducting these hearings.

Certainly, I want to thank our witnesses as well for the efforts

they have been making to pursue and prosecuting the myriad of

abuses that have been uncovered in and around the mutual fund

business. I especially want to commend Eliot Spitzer. Your work,

Mr. Spitzer, Mr. Attorney General, and the work of your staff has

been a critical component in this effort, and without your diligent

efforts as a ‘‘cop on the beat,’’ it is unclear how much longer these

abuses would have continued.

I would also be remiss if I did not express some concern over the

seeming lack of coordination, and you and I have had a chance to

talk about this already. I raised the issue the other day with Mr.

Donaldson. And I do not want to dwell on the point here. You may

want to address it in your own comments. The point Senator Sarbanes made is important, that the tension sometimes between the

States and the Feds can work to the benefit of investors, but obviously when you can coordinate activities, that also can accrue to

the benefit of everyone involved.

139

So while I do not doubt that both the SEC and the State enforcement officials have the best interests of investors in mind, I would

urge all the parties to work in a more complementary fashion in

order to fight securities fraud and abuse in our Nation.

Mutual funds, as we all know now, are a principal pathway that

most investors achieve financial security. Over 95 million Americans and over $7 trillion have been invested in mutual funds. In

the past, mutual funds have not only lived up to, but also in many

cases exceeded the grand expectations of their investors. They are

a true success story of our securities markets and our securities

regulation.

However, as we all know, in recent months a series of revelations

has shaken investor confidence and the promise of mutual funds.

I think it is our obligation collectively to restore the fair of investors in mutual funds and those who manage them.

Late last week, my colleague Jon Corzine and I introduced—or

announced an intention, rather, to introduce some legislation to address these abuses and shortcomings which have received so much

attention. We did so because we believe that there is much more

that needs to be done than just regulatory changes which address

market timing and late trading abuses.

We believe that fundamental changes are needed in the way the

funds are governed, and we intend to make substantive changes

that enhance the independence of boards as well as provide greater

accountability to fund shareholders. There is a widening gap between what investors believe mutual funds cost and the actual

costs associated with those funds. Investors should have, in our

view, a very clear, articulate understanding of what has become a

maze of fees, loads, and hidden costs.

We also believe that we must take a close look at the current

oversight of the mutual fund industry and determine if there are

sufficient resources and if the current structure and manner of regulation is appropriate.

Mr. Chairman, I am looking forward to working with all of our

colleagues here and addressing these issues, I hope in the not too

distant future as other issues may take over our attention. So, I

thank the Chair once again for having such a thoughtful set of

hearings on the subject matter before we begin to legislate here.

Chairman SHELBY. Senator Johnson.

STATEMENT OF SENATOR TIM JOHNSON

Senator JOHNSON. Thank you, Chairman Shelby and Ranking

Member Sarbanes, for holding today’s hearing, and welcome to this

distinguished panel. Frankly, Mr. Chairman, I am dismayed that

just 1 year after we passed landmark corporate governance reform

legislation, we are back again to deal with yet more wrongdoing in

the marketplace.

Mr. Chairman, I find this particular string of scandals especially

demoralizing because of the demographics of the victims. Until

now, the mutual fund industry has presented itself as the champion of the little guy, the embodiment of the democratization of the

capital markets. Mutual funds allow small investors to put their

money to work through a diversified portfolio of investments managed by financial professionals otherwise unavailable to the averVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00151 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
140

age family. And the model has truly revolutionized economic opportunities for millions of Americans.

According to the Investment Company Institute, of the 95 million

mutual fund shareholders, the median income of the mutual fundowning household is $62,000. And 33 percent, a third of all mutual

fund shareholders have household incomes under $50,000. Of these

shareholders, a staggering 44 percent of household financial assets

are held in mutual funds, almost half, a testament not only to the

power of the investment vehicle, but also to the trust of the typical investor.

In short, mutual fund companies have been extremely successful

at attracting their target demographic. What is now called into

question, however, is whether these mutual fund companies have

been as successful in fulfilling their fiduciary obligations to these

customers.

Now, I appreciate that it is not fair to tarnish an entire industry

because of the bad actions of some. But at this point, the theft

seems to be so widespread, and so brazen, that I do not know that

we can assume we are dealing with just a few bad apples. And the

examples that have cropped up over and over again all share a

theme: An imbalance of power that results in the relatively unsophisticated investor getting taken advantage of.

Among the most galling examples of fraud represent a sort of

reverse Robin Hood: Hedge funds giving special after-hours trading access at the expense of mutual fund holders. Or private

equity funds and hedge funds standing first in line for lucrative

IPO shares.

Another example of where those in positions of fiduciary responsibility took advantage of their customers had to do with steering

them to certain funds, not because they were appropriate for the

investor, but because they yielded bigger commissions for the

broker. I would be interested in survey results of how many investors understand the implications, for example, of buying ‘‘B shares’’

and the years of distribution fees that they imply.

In fact, this misuse of the professional investment adviser relationship bears close scrutiny. We know that mutual funds sell their

product not simply as a diversified portfolio, but as access to professional investment advice that would otherwise be unaffordable

to the average consumer. And if we look at all the statistics, yet

again the industry has been successful in targeting its marketing.

The ICI breaks out three categories of investors based on how they

purchase their funds: Nearly half through defined contribution

plans in the workplace, one-sixth through direct marketing from

fund companies or discount brokers, and over a third through socalled ‘‘sales force’’ channels.

This last category, the sales force channel, is the most vulnerable

to steering, and as one might expect, is the least educated investor

class. And not surprisingly, this category of investors typically pays

the highest fees. The sales force investors are on average 8 years

older than investors who purchase shares through retirement

plans. Almost 30 percent are retired, and nearly half lack a college education. By contrast, investors who use direct marketing

channels such as online brokerages are younger, wealthier, and

better educated.

141

Mr. Chairman, the point of these statistics is that both we in

Congress and the mutual fund industry have a special obligation

to ensure that this investor class is adequately protected. And

these protections need to extend well beyond simple corporate governance issues. The Investment Company Act of 1940, known by

most simply as ‘‘The Forty Act,’’ is clearly due for a comprehensive

checkup to make sure that it still works.

In addition to the governing statute, we clearly have a problem

with enforcement. Without pointing fingers, enforcement is a point

we need to address, and I hope the State and Federal enforcement

arms can take their energy and motivation and begin working together on behalf of investors. Self-policing, as we learned during

the Sarbanes-Oxley debates, is of limited use when good actors

turn a blind eye to fraud and abuse and where enforcement agencies lack the capacity or the will to follow through.

Finally, it is hard to overstate the importance of overhauling the

disclosure requirements related to fees, and perhaps even rethink

whether fees need to be restricted. Under current law, investors

have very good access to uniform performance and tax information,

which allows them to compare funds on these scores. And while

some of the fee arrangements are disclosed, investors do not have

access to the information they need to make an intelligent evaluation of the true costs of their investments. We also need to take a

hard look at the true characteristics of so-called soft-dollar arrangements, and I hope today’s witnesses will at least address that point

either in testimony or during the question period.

Mr. Chairman, the ICI’s 2001 Profile of Mutual Fund Shareholders reveals that 91 percent of all mutual fund shareholders say

the primary financial goal of their investment is to save for retirement. We have a special obligation to these investors, who work

hard and save responsibly, to ensure that they have access to the

marketplace in a first-rate, sound investment vehicle.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Corzine.

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. As my other colleagues have suggested, I congratulate you and the Ranking Member and others for cooperation

and focus on this vital issue that we have.

One of the great pieces of both savings and the ability to allocate

capital in this society is the mutual fund industry and mutual fund

practice. And it is unfortunate that an industry that, long respected, has developed and created a number of problems for itself

and really broken trust. I think I want to hear people that have

looked at that, in specific talking about it, but we really do have

to address the integrity if we want to have the kind of capital markets and savings structures that make this country great, getting

money and investments to the places that will make our country

really strong.

I look forward to working with all of you, and certainly Senator

Dodd and I have some ideas with regard to these issues. The elements that have been discussed so readily in the press—late trading, market timing, and other issues—I think are important to deal

with. But I think there is a fundamental problem here in just the

142

ability for any human being to understand actually what they are

buying and what they are paying for when they are buying. So, I

am hopeful we can get to comparative shopping and some kind of

ability for people to know what it is they are paying for.

I am anxious to hear all of the witnesses speak to this issue, in

particular, and there are a number of other issues that come to

mind. But I appreciate it very much, and I commend all of those

on the panel for, I think, their commitment to making our markets

stronger. And I think in general they work very well together.

Chairman SHELBY. Senator Reed.

COMMENTS OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman. Let me, too,

commend you and Senator Sarbanes for continuing these hearings

on a very important topic.

The obvious fact is that the securities markets rest on trust more

than anything else, and what we have witnessed is a massive

breach of trust. Let me commend Attorney General Spitzer and his

colleagues at the State level for aggressively protecting the rights

of investors. Thank you very much, Mr. Attorney General.

One of the issues that certainly will arise here is who should

take the leadership role between the Federal Government, the

SEC, the States. It reminds me of a saying that I learned as a

young infantry lieutenant: Lead, follow, or get out of the way.

If the SEC is to be the leader, then it needs the resources and

authority to do the job. Frankly, I think the resources are probably

the more pressing issue at the moment. And it is not just a few

more attorneys or a few more analysts. As Senator Corzine alluded

to, the sophistication and the use of technology is monumental in

terms of some of these products, and the SEC and the regulators

need the same type of information software, and that is a significant investment that we will have to make. If we do not make

those investments, then all of our exhortations to be more aggressive and more forceful I think will be just that—exhortations.

Thank you, Mr. Chairman. This is the beginning, I think, of a

very important process.

Chairman SHELBY. Thank you, Senator Reed.

Mr. Spitzer, we will start with you. All of the witnesses’ written

testimony will be made part of the record in its entirety. Mr.

Spitzer proceed as you wish.

STATEMENT OF ELIOT SPITZER

ATTORNEY GENERAL, STATE OF NEW YORK

Mr. SPITZER. Thank you, Mr. Chairman and esteemed Senators.

I appreciate the invitation to appear once again in front of you and

also to share the witness table once again with my great friend and

colleague, Mr. Stephen Cutler, with whom we work diligently on a

regular basis.

On September 3, my office announced the results of its investigation of the unlawful and improper trading practices of Canary Partners. Since that time, my office has worked closely with the SEC

and others to uncover the extent to which mutual fund directors

and managers breached their fiduciary responsibilities to the 95

million Americans who have invested $7 trillion in mutual funds.

143

Our continuing investigations reveal a systemic breakdown in

mutual fund governance that allowed directors and managers to

ignore the interests of investors. In fund after fund, what we have

seen is the wholesale abandonment of fiduciary responsibilities. As

Chairman William Donaldson put it to this Committee on Tuesday,

‘‘The industry lost sight of certain fundamental principles, including its responsibilities to the millions of people who entrusted their

confidence and the fruits of their labor . . . to this industry for

safekeeping.’’

Earlier today, my office, along with the SEC, brought actions

against the founders of the Pilgrim Funds, Gary Pilgrim and Harold Baxter. These individuals served as directors of the various Pilgrim mutual funds and as fiduciaries of their investors’ money.

Nevertheless, when offered an opportunity to personally profit at

the expense of their investors, they grabbed it. Although the Pilgrim Funds’ prospectus prohibited shareholders from making more

than four trades a year and their internal policies prohibited market timing, Mr. Pilgrim and his partners in another investment

fund were permitted to engage in frequent market timing trades.

Those trades were enormously profitable to Mr. Pilgrim and his

partners, but were costly and detrimental to his shareholders.

When Mr. Pilgrim was confronted with the choice between his lawful duty to investors and an unlawful opportunity for personal profit, he chose personal gain over his investors. That is the bad news.

Unfortunately, there is certainly going to be more bad news to

come as our investigations continue. But there is also good news.

The good news is that the process of addressing these systemic

failures by considering systemwide reforms has begun. These reforms would alter the current governance structure of most funds

by requiring them to have truly independent boards of directors.

Seventy-five percent of directors, including the chairman, would be

independent of the management companies that operate the funds.

The independent directors would also oversee a compliance staff

that will ensure that the fund’s managers are acting in the best

interests of the funds shareholders.

These reforms were all included in the package of proposals that

I discussed when I testified before House and Senate Committees

2 weeks ago. I certainly agree with Chairman Donaldson that they

are good ‘‘first steps.’’ Taken together, these reforms will hopefully

foster board action that is more for the benefit of shareholders and

not that of managers.

At the same time, it is necessary for us to take the logical next

step, which is to examine the fee arrangements between mutual

funds and their managers. As I have said before, the 95 million

Americans from 54 million households paid more than $70 billion

in advisory and management fees in 2002. That comes to an average of $737 in fees paid by each individual investor and $1,292

paid by each household invested in mutual funds. These fees are

in addition to the significant costs, such as trading costs, that are

passed on to investors.

Investors who paid those fees—via deductions from their account,

often without full disclosure—are entitled to know whether they

are fair.

144

Some have questioned whether there is a nexus between the inquiry into fees that I am proposing and the investigation into the

trading activities permitted by fund managers. The answer is yes.

The improper trading and the exorbitant fees charged are both

consequences of a governance structure that permitted managers to

enrich themselves at the expense of investors. We know that the

directors and the managers breached their duties to investors in

every conceivable manner. As regulators and law makers, our duty

to investors is to investigate every manifestation of that breach and

to return to investors any and all fees that were improper or inappropriate. This includes the fees that the managers received

during the very time that they were violating their fiduciary duties

to investors.

Moreover, the nexus between fees and the improper trading that

we have uncovered is demonstrated by the fact that the managers

who permitted late trading and market timing in many instances

did so in return for increased investments in other funds that they

managed. Mutual fund managers get paid a percentage of the

funds under management, and therefore seek to increase their

funds’ asset base to increase their compensation. As one mutual

fund manager put it in an especially memorable e-mail, ‘‘I have no

interest in building a business around market timing, but at the

same time, I do not want to turn away $10 to $20 million.’’

Simply stated, the desire for increased fees led the managers and

directors to abandon their duty to investors and to condone improper and illegal activity. Common sense demands that we at

least inquire whether the desire for increased fees also resulted in

fee arrangements and charges that were improper.

Common sense and a simple review of the numbers also dictate

that the fees charged to investors by the Putnam Funds continue

to deserve scrutiny. In 2002, Putnam had approximately $279 billion under management. The $279 billion was divided between mutual fund money and institutional investors.

Our investigation has revealed that Putnam charged higher advisory fees for the mutual fund money that it managed, and charged

lower fees for the advisory services that it provided to institutional

investors. Here is what we have learned:

There was an extraordinarily large disparity between the rate of

advisory fees charged to mutual fund investors and the rate paid

by institutional investors. Mutual fund investors were charged 15

basis points or 40 percent more for advice than Putnam’s other investors. In dollar terms, this fee disparity meant that in 2002, Putnam mutual fund investors paid $290 million more in advisory fees

than they would have paid had they been charged the same rate

that Putnam’s institutional investors paid for advisory services.

At a minimum, this disparity raises several fundamental questions: Why were mutual fund investors charged more than institutional investors for advisory services? What steps, if any, did the

directors who negotiated these fee contracts take to protect the interests of investors and to ensure that they paid the lowest possible

rate? Did managers take advantage of a conflicted and complacent

board to extract unjustifiably large fees?

145

These questions demand answers, and I will continue to insist

that funds answer these questions as part of any settlement with

my office.

Perhaps the most important question that needs to be answered

is this: What can be done to convince nervous and skeptical investors that the fees that they are charged in the future are fair and

subject to the competitive pressures of the marketplace? Let me

offer a few possible answers.

First, mutual funds must be required to disclose the precise dollar amount of the fees charged to each investor in a quarterly or

semiannual statement sent to the investor. This disclosure should

be itemized, and consist of the dollar cost to the investor of advisory, management, marketing, and other administrative costs.

Armed with this knowledge, investors can begin to engage in true

comparison shopping among funds. There is no other industry that

is exempt from informing their customers what they are being

charged. It is an understatement to note that there is nothing

about the manner in which the fund industry has conducted itself

to warrant such an exemption here.

Second, we must impose a fiduciary duty on fund directors that

requires them to negotiate fee contracts that are reasonable and in

their investors’ best interest. To determine reasonableness, directors must consider what institutional investors are charged for

similar services, and the actual cost of the service being provided.

While mutual funds do need some services that institutional investors do not require, there is no reason that they should pay more

than institutional investors for services such as core money management. Moreover, the directors should be obligated to make public a meaningful analysis that supports the fee agreements that

they have approved.

Third, we should consider requiring funds to obtain ‘‘most favored nations’’ clauses in their fee contracts. These contracts are

common in procurement contracts throughout industry, and should

not be ignored by the mutual fund industry itself. We should also

consider requiring funds to put certain contracts out for competitive bidding. This may be especially suitable for many of the backoffice and administrative services for which mutual funds pay.

Some in the industry question whether the competitive bidding

is appropriate. Perhaps they should be reminded that many fund

complexes already hire sub-advisors to perform the services that

investors pay for. What happens to the money saved when management companies sub-contract for the services that they are

charging investors for? We believe that the cost savings should be

passed along to investors and not pocketed by the managers.

These ideas are not meant to suggest an exclusive or exhaustive

list of the mechanisms available to achieve the goal of reducing

fees. Rather, they are aimed at beginning a dialogue which is very

necessary if we are to regain and retain the confidence of mutual

fund investors.

Please permit me to make one final point. My office and the SEC

have worked together cooperatively since the day I announced the

settlement with the Canary Hedge Fund. Each day since then,

there have been—and will continue to be—dozens of points of contact, coordination, and cooperation. On rare occasions we have

146

disagreed. As is the nature of these things, those rare moments of

disagreement tend to get far more attention than all of our weeks

of cooperation.

I will continue to speak up for investors when necessary, but that

should not obscure the productive and mutually beneficial relationship that my office has forged with the SEC. It is my desire and

intention to continue to foster that relationship.

Thank you.

Chairman SHELBY. Mr. Cutler.

STATEMENT OF STEPHEN M. CUTLER

DIRECTOR, DIVISION OF ENFORCEMENT

U.S. SECURITIES AND EXCHANGE COMMISSION

Mr. CUTLER. Thank you, Chairman Shelby, Ranking Member

Sarbanes, and distinguished Senators. Good afternoon. Thank you

for inviting me to testify today on behalf of the SEC concerning alleged abuses in the mutual fund area.

The growing number of illegal practices that have recently come

to light involving the sale, trading, and operation of mutual funds

is a betrayal of the millions of Americans who put their hardearned savings into mutual funds. The conduct we are finding is

unethical, it is illegal, and it is profoundly wrong.

Investors were led to believe that mutual funds were symbols of

trustworthiness and security, and to the outrage and disappointment of all of us, that belief was, in many cases, misplaced. Rather

than safeguarding the investors’ money, some mutual funds, the

brokers who sold them, and their personnel were busy feathering

their own nests.

I have in the past talked of the crisis of conflicts in the financial

services industry. What we are also seeing is a crisis of character.

The SEC will follow the facts wherever they lead. We will bring enforcement actions wherever we find violations, and I assure you

that the Commission is fully committed to ensuring that violators

are promptly and appropriately punished. That process has, of

course, already begun. Since Mr. Spitzer announced his action

against Canary Capital Partners, we have brought half a dozen

cases involving abusive market timing, late trading, and self-dealing practices. Indeed, just this morning, as the Attorney General

mentioned, the SEC and his office sued Pilgrim Baxter and its two

founders, Gary Pilgrim and Harold Baxter in connection with alleged market timing by a hedge fund in which Mr. Pilgrim was

himself a significant investor, and for providing nonpublic fund

portfolio information to a personal friend who was market timing

fund shares.

In each of these cases we have worked with State regulators who

have also filed their own charges. At the hearing on Tuesday and

again at this hearing, Members of this Committee quite appropriately have expressed the need for cooperation among the various

regulators working on these matters. I agree.

While regulatory competition has its place and its benefits, it is

also incumbent upon all of us to put investors first and to direct

all of our energies and efforts to that cause. That is what the investing public expects and that is what the investing public deserves. And while it might not always seem that way, as a general

147

matter I think we have been trying to do that. I know Mr. Spitzer

would agree that our staffs have worked very well together and

that our collaboration has resulted in stronger enforcement cases,

and has certainly allowed us collectively to cover more territory

than each of us could cover singly. As I have said before, we are

both striving to achieve the same basic goals, the protection of investors and punishment of the wrongdoers. Now, we might not always see eye-to-eye on the best routes to get there and each of us

has an obligation under those circumstances to do what we think

best serves the investing public. Our partial settlement of the Putnam matter is, of course, a prime example of that.

I will not repeat all of what Chairman Donaldson said about it

to you on Tuesday, except to say that we believe that it was important to get in place a restitution process and safeguards for Putnam’s mutual fund investors now, and that we took great care to

do so without sacrificing our claim for a substantial penalty against

the firm, our pending case against the individuals, or our ability

to bring additional causes of action and relief against Putnam or

others in the event that further wrongdoing comes to light.

We did not, as I know Mr. Spitzer would have liked, require Putnam to revamp its disclosure of fees or the way in which fees are

negotiated. We thought that was a subject better left to a case that

involves violations relating to fees or to regulation of the industry

as a whole, rather than the resolution of a case about fund trading

by portfolio managers. But I agree with the sense of this Committee that it is time to put our differences with respect to the Putnam matter aside and to redouble our efforts to work together to

bring cases expeditiously and to obtain meaningful relief and sanctions in all of our cases. I am committed to doing that, and I know

that Mr. Spitzer is as well.

I think it is important to point out that the Commission has also

been engaged in significant enforcement and examination activities

in the mutual fund area in addition to late trading and market

timing. The first area is mutual fund sales practices and fee disclosures. In particular, we are looking at just what prospective mutual

fund investors are being told about revenue-sharing arrangements

and other so-called shelf space incentives doled out by mutual fund

management companies and mutual funds themselves to brokerage

firms who agree to feature their funds.

On Monday of this week, in what opened a new chapter in the

Commission’s efforts to combat abuse in the sale of mutual funds,

we sued Morgan Stanley. Morgan Stanley had established an exclusive club of 16 mutual fund families in what it called its Partners Program. Under that program Morgan Stanley gave these

fund families premium shelf space. The firm encouraged the sales

force to sell shares of the Partners Program funds and even paid

its sales people special incentives to sell those funds. Here is why.

Under the program every time Morgan Stanley sold its customers

shares of funds in the club, the fund family was obligated to pay

Morgan Stanley a percentage of the sales price over and above the

ordinary commissions and loads, but customers did not know about

these special shelf space payments.

Morgan Stanley agreed to settle this action by paying $50 million, all of which, thanks to the Sarbanes-Oxley Act, will be placed

148

in a fair fund and returned to investors. In addition, Morgan Stanley has agreed to significant undertakings to enable customers to

see clearly and plainly what Morgan Stanley has to gain from selling them one fund over another.

In light of the issues raised by the case, the Commission is conducting an examination sweep of some 15 different broker-dealers

to determine exactly what payments are being made by funds, the

form of those payments, the shelf space benefits that broker-dealers provide, and most importantly, just what these firms tell their

investors about these practices.

And the potential disclosure failures and breaches of trust spotlighted in the case are not limited to broker-dealers. We are also

looking very closely at the role of the mutual fund companies themselves. Indeed, the aspect of the case that I find perhaps most troubling is this: Morgan Stanley said to the fund families that are part

of the Partners Program—you can pay us in one of two ways. Either the fund management company can pay us in cash, or the mutual funds you manage can defray the fund management company’s

obligation by giving us a multiple of that amount in the form of

extra commission business on fund portfolio transactions. Faced

with that choice, some of the fund companies, rather than reaching

into their own pocket to pay what they owed, reached into the

pockets of their mutual fund shareholders and paid in commission

dollars instead.

Mr. Chairman, you can be certain that we are pursuing that

issue, among others, as our investigation continues, and our exam

sweep goes forward.

Our second area of focus is the sale of different classes of shares

in the same mutual fund. Very frequently a fund will have issued

two or more classes of shares with different loads and other fee

characteristics. In the last 6 months we have brought three enforcement actions in connection with alleged recommendations that

customers purchase one class of shares when the firm should have

been recommending another. We charged Morgan Stanley with violations in this area too, by the way.

The third area is the abuse of so-called breakpoints, which I

know Mr. Glauber will speak about. Quite simply, we have found

numerous instances in which brokerage firms did not give investors

the volume discounts, sometimes called breakpoint discounts, to

which they were entitled. Earlier this month, together with the

NASD, we issued Wells notices concerning breakpoint violations to

a significant number of firms.

The fourth area I want to mention is the pricing of mutual funds

beyond the context of market timing. We are actively looking at a

number of situations in which funds dramatically wrote down their

net asset values in a manner that raises serious questions about

how they price their fund shares in the first place.

Before I conclude, I feel compelled to address one more topic.

These days it has become fashionable in some quarters not just to

critique the Commission, but also to question the will of the Agency

and its staff. Yes, the Agency, including the enforcement program

can and should continuously look for ways to improve our effectiveness, and I am steadfastly determined to do that. But I cannot

149

emphasize enough the dedication, the commitment, and the professionalism of our enforcement staff. I am proud to be one of them.

In our just concluded fiscal year, as Senator Sarbanes mentioned,

the Commission brought a record 679 enforcement cases, and that

is a 40 percent jump from just 2 years ago with a very limited increase in resources during that same period. With the recent badly

needed budget increase that you have been responsible for giving

us, we have now begun to see additional resources, and they will

allow us to look more proactively, to look around the corner for the

next fraud or abuse. Indeed, that is what Chairman Donaldson’s

risk assessment initiative is seeking to achieve. With respect to

mutual funds, I know that the Agency’s routine inspection and examination efforts will be improved by adding new staff, increasing

the frequency of examinations and digging deeper into fund operations. We are working aggressively to clean up the mutual fund

abuses that we have seen and are committed to making sure that

they cannot recur.

Thank you.

Chairman SHELBY. Thank you.

Mr. Glauber.

STATEMENT OF ROBERT R. GLAUBER

CHAIRMAN AND CHIEF EXECUTIVE OFFICER

NATIONAL ASSOCIATION OF SECURITIES DEALERS

Mr. GLAUBER. Good afternoon, Mr. Chairman and Members of

the Committee. I appreciate this opportunity to testify on behalf of

NASD about our ongoing investigations and actions regarding the

mutual fund industry.

The picture that has emerged from current investigations into

marketing of mutual funds is appalling and simply unacceptable.

While regulators are still investigating the contours of this behavior, it is clearly not just a case of a few bad apples.

At Tuesday’s hearing before this Committee, SEC Chairman

Donaldson announced a series of reforms in the realm of disclosure

that NASD supports. Investors deserve clear and easy-to-read disclosure that tells them of all the costs associated with their mutual

funds. Not just the load and fees, but also the other arrangements

that affect the price investors pay for the fund, including Commission expenses and compensation arrangements between the broker

and the fund. One of the bedrock principles of our free market system is that all participants have access to information about prices

and costs that can influence their decisions. When this information

is hidden or distorted, investors are not able to make the best decisions about where to invest their money.

When they have this information, investors can be in the best position to discipline the behavior of those who create and sell these

investment products. In line with Chairman Donaldson’s recommendations, NASD recently proposed a rule requiring disclosure

of two types of cash compensation, payments for shelf space by mutual fund advisers to brokerage firms that sell their funds, and differential compensation paid by a brokerage firm to its salesmen to

sell the firm’s proprietary funds. Customers have a right to know

that these compensation differences exist. They create a serious

potential for conflict of interest.

150

We are also looking at other areas for improved disclosure including soft-dollar arrangements. Again, soft-dollar payments both

affect the cost to investors from owning a fund and potentially create conflicts of interest between the fund adviser and shareholders.

The enormous growth in popularity of mutual funds in recent

years has led NASD to step up its oversight of how our regulated

firms sell these funds. While NASD does not have jurisdiction or

authority over mutual funds or their advisers, we do regulate the

sales practices of the broker-dealers who provide one distribution

mechanism for mutual funds.

Our regulatory and enforcement focus has been on the suitability

of the mutual fund share classes that brokers recommend, the sales

practices brokers use, the disclosures brokers make to investors,

compensation payment brokers get from funds and whether the

brokers give customers appropriate breakpoint discounts. We have

brought some 60 enforcement cases this year in the mutual fund

area, and more than 200 over the last 3 years.

Allow me to start with breakpoints. Through our routine examinations we have found that in one out of five transactions in which

investors were entitled to a breakpoint discount that discount was

not delivered.

Chairman SHELBY. Mr. Glauber, explain to us again what you

mean by ‘‘breakpoint.’’

Mr. GLAUBER. Very simply, Mr. Chairman, it is a volume discount that investors are entitled to if they buy, in many cases,

greater than $25,000 worth of a mutual fund, it is just that simple.

Chairman SHELBY. Sure.

Mr. GLAUBER. Thus many brokers charge the wrong sales load

to thousands of mutual fund investors, in effect, overcharging investors, by our conservative estimate, $86 million in the past 2

years. NASD has directed firms to make refunds.

In the next several weeks we will initiate a number of enforcement actions seeking significant penalties, and we have launched

an advertising campaign urging investors to seek proper restitution

for these overcharges.

Next let me focus on sales incentives. Brokers are prohibited

from holding sales contests that give greater weight to their own

companies’ mutual funds over other funds. These types of contests

increase the potential for brokers to steer customers toward investments that are financially rewarding for the broker, but may not

be the best fit for the investor. In September, we brought an enforcement action against Morgan Stanley for using sales contests to

motivate its brokers to sell Morgan Stanley’s own funds. The sales

contest rewarded brokers with prizes such as ticket to Britney

Spears and the Rolling Stones concerts. These cases resulted in one

of the largest fines ever imposed in a mutual fund sales case.

Just this week, NASD with the SEC announced further enforcement action against Morgan Stanley for giving preferential treatment to certain mutual fund companies in return for millions of

dollars in brokerage commissions. Over the last 2 years, NASD has

brought more than a dozen major cases against brokers who have

inappropriately recommended that investors buy Class B shares of

mutual funds in which investors incur a higher cost and brokers

151

receive higher commissions. We have more than 50 additional investigations of inappropriate Class B sales in the pipeline.

This kind of enforcement effort is continuing with great vigor at

NASD. We are now looking at about two dozen firms for their practices of accepting brokerage commissions in exchange for placing

particular mutual funds on a preferred list, and precisely what Mr.

Cutler referred to. In this effort we are investigating all types of

firms including discount and online brokers and fund distributors.

The role of brokers and late trading and market timing has been

a more recent focus of investigation at NASD. In September, we

sought information regarding these practices from 160 firms. Our

review indicates that a number of firms clearly received and entered late trades. These investigations, more than 30 so far, have

been referred to our Enforcement Division.

As we continue our examinations and investigations into these

matters, we will enforce NASD’s rules with a full range of disciplinary options including fines, restitution to customers, and the potential for expulsion from the industry. These issues in the areas

of broker sales and mutual funds go to the very heart of our mission to protect investors, strengthen market integrity, and rebuild

investor confidence.

I thank the Committee for its leadership and for asking me to

testify today.

Chairman SHELBY. Thank you.

Mr. Cutler, I will start with you. It appears that late trading and

market timing practices have long been open secrets in the fund industry. Some people have suggested that the SEC failed to stop the

abuses because it was out of touch with the markets and it could

not effectively coordinate among its internal divisions, that is in

the SEC. I recognize that you cannot speak to the operation of the

SEC’s Examination Division. You are head of the Enforcement Division, which is the division responsible, as I understand it, for

monitoring the funds’ ongoing legal compliance, is that correct?

Mr. CUTLER. It is.

Chairman SHELBY. With this in mind, how is it that such misconduct could continue for so long without detection and enforcement by the SEC? Was it a lack of attention, a lack of resources?

Assuming that in a $7 trillion interest like most of us, that everything was fine and rosy or what?

Mr. CUTLER. I think that is a very good and fair question. The

one thing I can assure you, Senator, and Chairman, is that it has

certainly not been a lack of will. And as you have rightly pointed

out, I think the Agency, and in particular our inspection program,

was severely underfunded for a number of years. There are approximately 8,000 mutual funds in America. We have had on the

order of 350 examiners responsible for inspecting that entire industry. That has not been enough.

Chairman SHELBY. Tell us, if you can, for the record, how many

examinations in the last say 3 years—just use that as a calendar—

have you done at the SEC of the mutual fund industry or the companies that make up the mutual fund industry, and if you do not

have that now, could you furnish this for the Committee?

Mr. CUTLER. That would be better, because I would be guessing,

Mr. Chairman. I think it is on the order of 2 to 300 complexes are

152

examined in any 1 year, but we need to get you the precise figures

because it is not my division.

Chairman SHELBY. Sure, I understand that. Along those same

lines, could you share with the Banking Committee, the Members,

and the staff would be interested in this, what your examinations

found, and were any of the areas, market timing, breakpoints, all

of this, was there evidence of that going on in your examinations?

And what did you do about it if anything?

Mr. CUTLER. I will start with the market timing question, because I think that is what launched all of this a couple of months

ago in that particular area, in the Canary Capital and what followed from it. Again, I have to give you my impressions given

where I sit. My impression of what happened here is that you had

an industry that over the years was beseeching the Commission to

give them more tools to combat market timing.

Chairman SHELBY. Well, how did they do that? You say you were

beseeching.

Mr. CUTLER. With greater redemption fees, right? Give us the

power to stop this. We hate it. I think that the mindset was—and

I am not trying to excuse it, I am just trying to explain it—was

that here you had a potential set of misconduct that the industry

was saying we hate, we are trying to do everything we can to stop.

The notion that the mutual fund industry was complicit——

Chairman SHELBY. Wait a minute. They said that they wanted

to stop. But you can stop misconduct if you want to, can you not?

I mean, not you. I am speaking of the industry themselves. They

were kind of self-regulatory to a certain extent, were they not?

Mr. CUTLER. There are ways to stop it, but I would submit, Mr.

Chairman, that there are ways to avoid being stopped.

Chairman SHELBY. We know that.

Mr. CUTLER. Yes. We have seen it, for example, by way of omnibus accounts.

Chairman SHELBY. Manipulation of the whole process.

Mr. CUTLER. Sorry?

Chairman SHELBY. Were they manipulating the whole process?

Mr. CUTLER. Well, we now know that there were many people

who were manipulating the process, and those people are going to

be severely punished.

Chairman SHELBY. Did you know any of this, say, about 18

months ago?

Mr. CUTLER. I do not believe that the Agency did.

Chairman SHELBY. You had no inkling?

Mr. CUTLER. I do not believe that the Agency knew that there

was wrongdoing in the market timing and late trading area. That

is my impression from where I sit.

Chairman SHELBY. But you are going to check the record and the

examinations and share this information.

Mr. CUTLER. I think the examination people have gone back and

checked their exams and this was something that—there are many

things to examine for. There are many, many different areas.

Chairman SHELBY. We want to know. We should be able to know

for sure, and I will ask Chairman Donaldson to furnish this information to us.

153

Mr. CUTLER. We will get you all the information you want, Mr.

Chairman. I should also add that in the area of breakpoints, in the

area of sales practices, those have been areas of acute focus by our

examination staff, and they have helped develop the cases that you

are now hearing about in those areas, the breakpoint cases, the fee

disclosure cases.

Chairman SHELBY. I guess my point is, in an industry of $7 tril- lion, $7 trillion is a little money, to say the least. If there were

open secrets that all this was going on, it looks to me like somebody in Enforcement or Examination would have known something

about it and would have acted on it. That is just a common sense

question, is it not? Because as widespread as it looks like it is

going to be in the industry, we are just trying to get to the facts.

Mr. CUTLER. I think it is a very fair question, and I can tell you,

Senator, that we are determined to assure that going forward we

have the tools to address just that question, that we are working

proactively and we are working in concert. That is, that people

from Enforcement, from our Division of Investment Management,

and from our Office of Compliance Inspections and Examinations,

have sat down together, have reviewed the examinations that have

taken place, in particular, any examination that has raised, for example, any enforcement question, and figured out what to do with

this and what it means to us, and thought about questions in a

broad way. Because you are right in the sense that clearly market

timing, and do not forget, market timing is not, per se, illegal, the

practice of market timing was not a secret. What was a secret was

that it was being used abusively, that it was being used in violation of law, and I think it is incumbent upon all of us to——

Chairman SHELBY. Was this investigated? If it was not a secret

was it investigated by the SEC, and if not, why not?

Mr. CUTLER. I do not believe it was, and again, all I can tell you

in that regard is I think that it was viewed as something that the

industry was trying to stop, not something that the industry was

actually complicit in facilitating.

Chairman SHELBY. I asked Chairman Donaldson a couple of days

ago this question. I will just touch on it with you. We wanted to

know for the Committee and the staff, the Members and the staff,

how much in resources were expended by the Securities and Exchange Commission, say, in the last 5 years—we will just use that

as a calendar date—on the oversight of the mutual fund industry?

You might want to do this for the record. I think the Chairman is

trying to get this together. In other words, was this an area that

was greatly neglected because there had not been any apparent

scandals that were widespread in the public, or what was it?

Mr. CUTLER. I can tell you from an enforcement perspective it

was not neglected.

Chairman SHELBY. Will you furnish this information for the

Committee?

Mr. CUTLER. Yes, we certainly will. Certainly we have a broad

mandate, and there have been lots of areas of focus, and I will tell

you that in the last 3 to 4 years, I think the Agency has rightly

been focused on the corporate scandals that we have read way too

much about, the Enrons and the WorldComs. But we have to be

everywhere——

154

Chairman SHELBY. You do not have to explain that to us who

have been on the Banking Committee a long time. We know you

have a broad mandate here, but we want to know what you are

doing or what you did, if anything, in the scope of that mandate

as far as these funds are concerned.

My next question is how can the SEC, Mr. Cutler, modify its internal operations to perhaps prevent another such industry-wide

abuse from going unaddressed, neglected, by any of the SEC’s internal division? In other words, how will Chairman Donaldson’s

risk management initiative affect a situation like this, if it will?

Mr. CUTLER. I think it will, in that he is looking from a 30,000

foot perspective to ensure that we do not miss anything through

whatever cracks might otherwise develop between divisions, and I

think that is critical.

At the same time, from my own parochial enforcement perspective, I too want us to be more proactive, and I have actually posted

jobs to bring substantive expertise within the Enforcement Division, someone who knows trading and markets, someone who

knows the investment company and investment adviser world,

someone who knows corporate accounting and disclosure, so that

they can help us from a strategic planning perspective where

should we be putting our resources? What might we be missing?

What should we take a flyer on and investigate even if we do not

have a referral from our examination program?

Chairman SHELBY. And what if you did have a referral and you

neglected it?

Mr. CUTLER. Well, I will not let that happen, and I will tell you

we have already put into place a mechanism I hope that will ensure that does not happen. We have a working group consisting of

my colleagues in those other divisions to review any exams that

produce enforcement related issues.

Chairman SHELBY. Mr. Spitzer, you have been very involved and

I thank you for your involvement in trying to bring investor confidence to the capital markets.

You have been quoted as saying that you will not enter into any

settlements until the mutual fund industry agrees to make significant structural changes such as reforms to fee structures, et cetera.

Former SEC Chairman Arthur Levitt was quoted as stating the

other day: ‘‘As to the longer term question of fees, that issue should

not be addressed in an enforcement action, but is an issue for the

SEC Commission.’’ What is your response to that statement and

the contention that the SEC is a primary policymaker for the national market?

Mr. SPITZER. Mr. Chairman, I am loathe to disagree with former

Chairman Levitt, who is not only a friend and a colleague, but also

somebody whom I respect enormously.

Having said that, let me take a stab at it, and the answer I think

is embedded in the testimony that I delivered today, that we see

fund abuse as part and parcel of the violation of fiduciary obligation, one other evidence of which is late trading, market timing,

failure to observe breakpoints, so that I would be loathe to enter

a settlement which addressed the particular manifestations of fiduciary breach without confronting the larger issue itself.

155

And I would note that Mr. Glauber referred to a very important

point of failure to observe breakpoints is reflecting, in their conservative estimate, an $86 million loss.

Chairman SHELBY. How many firms did he——

Mr. SPITZER. That was not——

Mr. GLAUBER. I did not give the number, but we have looked at

650 firms.

Chairman SHELBY. Over 600 firms.

Mr. SPITZER. But with respect merely to the differential between

fees charged mutual funds and institutional investors, the 15 basis

points at Putnam translated into $290 million net loss to those investors in one firm. Now, we have to massage those numbers. This

is based on their delivery of numbers to us.

The point is, the fee issue is so pervasive and cuts so deeply to

the heart of whether or not these entities are living up to their

fiduciary duty, that I do not want to settle with them unless and

until we begin to address that issue.

Chairman SHELBY. I am not indicting you. I am just asking you

a question.

Mr. SPITZER. I am glad of that.

[Laughter.]

I would go back to the statute book to see if you could, but——

[Laughter.]

The issue I would point out is that Mr. Cutler and I have had

a series of conversations about how, when, whether, and where to

begin to undertake this discussion of fees, and I know that many

of the Members of this Committee also are not only intrigued by

it, but also believe that it is perhaps the essential point we have

to address. So, I believe we are making real progress in moving

that debate forward.

Chairman SHELBY. Attorney General Spitzer, how do you respond to the contention that State regulators who lack rulemaking

authority are using the threat of prosecution to extract concessions

that have nothing to do with the alleged violations of law, or on

the other hand, are they all mixed together?

Mr. SPITZER. First, I would reflect back on the cases we have

brought over the last 2 years or so when we have tried to confront

structural issues in the securities markets that we thought needed

to be addressed that had not been addressed, and first was the failure of research, and more recently the failure of the mutual fund

industry to govern itself within fair bounds of fiduciary duty. I

think if you look at the remedies we have sought in each case, they

flow directly from the nature of the wrongdoing that we have seen.

Where we have verged into the area of rulemaking, we have done

so only in concert with the SEC. I have been very conscious of that

boundary line, and it is as a consequence of that that I early on,

both last year with respect to research and this year the same day

we began our post-Canary investigation, called Mr. Cutler and said

we have to get into this together.

Nobody, I would hope, at the State level has disputed or stated

other than that the SEC is the primary regulator and has the final

rulemaking authority. So, we are conscious of that divide and tried

to reflect it.

156

Chairman SHELBY. But sometimes you have a situation where

you have civil and criminal culpability, do you not?

Mr. SPITZER. Oh, absolutely. The boundary line between those

two is usually one of judgment calls rather than one of stark bright

lines that can be defined.

Chairman SHELBY. Mr. Glauber, given the apparent failure of

self-regulation in the context of the global settlement and of the

recent mutual fund trading abuses, do you think now is an appropriate time to reconsider the structure of our regulatory structure

and its reliance on self-regulatory organizations?

Mr. GLAUBER. Well, I think it surely is worthwhile to ask the

question.

Chairman SHELBY. Raise the level of debate on it.

Mr. GLAUBER. Oh, absolutely. I believe that self-regulation has

proven itself very effective in many, many areas. Indeed, in the

areas of sales practices related to mutual funds, I think the history

of self-regulation and of the NASD is one that is quite respectable.

I recited what we have done on breakpoints, on sales contests,

on inappropriate sale of Class B shares. So, I think really there has

been a great benefit to the investing public from what is an organization in our case which is over 2,000 people, with a budget of

roughly $500 million that is geared and directed toward protecting

investors. Do we catch everything? Of course not. But I think we

really have made a very important contribution to the protection

of investors and to the preservation of market integrity.

Chairman SHELBY. Absolutely.

Mr. Spitzer, I understand that the scope of your investigations

are continually expanding because one thing brings another, as we

all know.

Mr. SPITZER. Yes, sir.

Chairman SHELBY. What practices do you anticipate—or maybe

you cannot say—investigating next? And when do you expect to

complete your industry-wide probe? Or is it just too big to say at

this point?

Mr. SPITZER. Well, Mr. Cutler asked me that this morning, also.

[Laughter.]

Mr. CUTLER. Do I get a chance to object?

Mr. SPITZER. Mr. Chairman, I am not sure it is possible to say

what is next. As you suggested, unfortunately, one investigation begets another, and what began with Canary has spawned a range

of other abuses that have now been played out, some of them publicly, many of them not yet——

Chairman SHELBY. It runs right through the whole industry,

maybe not every fund, but it is very widespread. It is going to take

a while.

Mr. SPITZER. It will take a long time. Let me just merely throw

out one area that we are delving into, all of us collectively, that I

think is highlighted by the case we filed this morning, the Pilgrim

case, and that is the dual interest in a hedge fund and a mutual

fund, simultaneous investment or management that creates very

difficult and complex tensions that are often very difficult for people to mediate or temptations that they cannot resist or have been

unable to resist. And we are seeing, where there are those simultaVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00168 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
157

neous investments and interests, problems that emerge and that is

an area that we are pursuing.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

Mr. Cutler, has the SEC studied the use of commissions by mutual funds to finance the marketing and distribution of fund

shares?

Mr. CUTLER. I do believe that is an issue that has received a lot

of attention and focus by our other divisions, so I cannot speak to

it personally. But certainly if you look at the case we brought earlier this week, the case against Morgan Stanley, one aspect of that

case is the use of commission dollars by mutual funds who are part

of that Partners Program that Morgan Stanley had to pay Morgan

Stanley for shelf space. And we certainly do not think that Morgan

Stanley’s customers understood that when they were buying a mutual fund share, that part of their own investment was going to be

used by way of commission dollars to defray the obligations of the

mutual fund family in which they were invested. I think it is a

very important issue.

Senator SARBANES. These commission-generated payments that

you have just referred to of marketing and distribution, as I understand it, are currently not itemized or disclosed to fund shareholders by their funds as a general proposition. Is that correct?

Mr. CUTLER. Senator, I do not believe they are in the 12b–1 fees

that are ordinarily disclosed.

Senator SARBANES. Isn’t it a violation of 12b–1? As I understand

12b–1, it permits funds to use their assets, which is what is happening here, to pay for distribution only if such payments are made

pursuant to a plan approved by fund shareholders and annually reviewed and approved by the fund’s board. Apparently, that is not

happening in these cases, is it?

Mr. CUTLER. Not that I am aware of. And then I think what the

mutual funds would say is there is a difference between commission dollars and hard dollars, but I would take the different view.

I agree with you, Senator, I think it is quite problematic when mutual funds are using commission dollars on fund portfolio transactions to defray expenses or obligations relating to distribution.

Senator SARBANES. Does either of the other panelists want to add

anything on this issue? Mr. Glauber.

Mr. GLAUBER. Thank you, Senator Sarbanes. The use of directed

brokerage commission dollars actually does violate an NASD rule,

and that is why we joined Mr. Cutler and the SEC in the case this

week against Morgan Stanley.

Mr. SPITZER. No, sir, I have nothing to add on that.

Senator SARBANES. Okay. Let me see how to phrase this. I am

becoming increasingly concerned that a few firms, some of them, in

a traditional view, leading firms, seem to be getting into trouble

over and over again. And so, we read a case, the regulators come

in, and they do a $50 million fine or something, and a strong admonition, and then there is another case where something has gone

amiss and so they get punished there. But it all begins to smack

a little bit of the cost of doing business.

How do you propose to deal with these firms who seem to be

repeat offenders? You know, there is a bad action and they get

158

caught and admonished for it, and then they come along and something else happens, not too much later.

Chairman SHELBY. Something the next day.

Senator SARBANES. Yes.

Mr. SPITZER. Senator, if I could take a shot at that, it is obviously a concern we all share, and I think we are all loathe to believe that there is some notion of a ‘‘too big to fail’’ protection that

would extend to some of these entities and, therefore, almost an

immunity that permits them to pay a fine, move on, and, as you

say, build this into their cost of doing business.

In my conversations with a certain number of the senior executives at these firms over the last few months, I have made it really

quite clear to them that where there is recidivism, we will deal

with them the way that we deal with recidivists, whether it is a

robbery or any other street crime, and that is that there will be no

second chance.

I do not want to speak for anybody else. I am viewing this case

as one where the penalties should be presumed to be significantly

larger, sterner, perhaps even more draconian, than they were last

year when we dealt with the research issue.

To a certain extent, the rationale for that is that last year we did

at the end of the day in our global settlement change the rules by

which the investment houses were operating. This year, the violations we are seeing relate to rules that were reasonably clear, understood, and we have nothing more than new theories of larceny

that are being played out by the malefactors.

As a consequence, I think it is fair to presume that there will be

criminal cases brought against institutions, and that may be the

death penalty for those institutions. But, in my view, that is the

only option which we are now left with.

Senator SARBANES. Mr. Glauber.

Mr. GLAUBER. As I am sure you know, in the case generally of

smaller firms, we have actually used our sanction of putting them

out of the industry.

In the case of larger firms, where I think sanction would be inappropriate, we are giving very serious consideration to requiring

that they cease operation in certain lines of business for a fixed period of time, basically putting them in the penalty box, if you will,

for that line of business for a period of time, which I think would

be a very serious sanction, very serious economic sanctions, and in

some cases appropriate.

Senator SARBANES. But is the culture within those firms such

that the people who have been engaged in those practices have

kind of an attitude, well, it is too bad you got caught, you were

making a lot of money for us, and we know that, and we have to

now adjust somehow to take this into account? Are they developing

the kind of DNA that Donaldson talked about in terms of high

standards?

We had a witness here, the former head of Johnson and Johnson.

This was when we were doing the corporate governance issues. And

he was very good because he said they had a corporate culture that

really came down very hard, it just did not tolerate the transgressions. You have a sense here that there is a tolerance for these

159

transgressions, and people say, well, it is too bad and everything,

but that is that. What is your sense of the corporate culture?

Mr. GLAUBER. I think the best answer I can give you, Senator

Sarbanes, is that cultures differ a great deal from one firm to another, and the DNA differs, as you have said. In some firms, I

think sanctions of this sort really do change behavior and change

it dramatically. In other cases, it may not.

Senator SARBANES. Obviously, you need to think of developing

the kind of sanctions that will effectively change behavior everywhere; otherwise, you are still down this slippery slope.

Mr. GLAUBER. I think that is a perfectly fair point.

Senator SARBANES. Do you have any observations to make about

this, Mr. Cutler?

Mr. CUTLER. I think, Senator Sarbanes, that you have put your

finger on exactly the right question, which is: What is the corporate

culture? And is the problem that you saw 2 or 3 years ago and the

problem that you are seeing today reflective of a systemic failure,

of a problem at the top, of a corporate culture that is sick? Or as

can sometimes be the case, is it two separate problems? I think it

is incumbent upon us to weigh that, to figure it out, and to ensure

that we sanction appropriately, including determining whether

higher sanctions are appropriate if the conduct reflects a problem

that is systemic.

Senator SARBANES. Just one more?

Chairman SHELBY. Go ahead, Senator.

Senator SARBANES. Speaking of the culture of an institution, let

me ask you: What can you tell us about the coordination between

the Office of Compliance Inspections and Examinations, the Office

of Investment Management, and the Office of Enforcement? And,

particularly, has the Division of Enforcement been getting all the

assistance it needs from other divisions and offices within the SEC,

for example, the Office of Investment Management? If not, what

can be done to improve the coordination between and amongst

these offices?

Mr. CUTLER. I tried to address that a little bit earlier. We are

concerned about our ability to coordinate, and we are addressing

that and have actively addressed it in recent months. We are now

ensuring that all referrals that raise enforcement-related issues

connected to the mutual fund area are reviewed by a team that

consists of enforcement, investment management, and the inspection program.

We otherwise have gotten together or begun to get together on

a regular basis to determine whether there are common issues that

we should be addressing. And as you heard from Chairman Donaldson earlier this week, I think he has a risk assessment initiative

that is designed to ensure that there is more and better coordination among the various offices at the Commission.

Senator SARBANES. What is the perception, Mr. Glauber, in the

industry of the extent of or lack of coordination within the SEC in

order to address these issues?

Mr. GLAUBER. I really am at a loss to give you a good answer

to that. The SEC, like our organization, is a large organization divided into divisions. It is a challenge to coordinate them. We work

hard, and I know the SEC works very hard to do it.

160

Senator SARBANES. All right.

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

I want to pick up on some of what Senator Sarbanes talked

about. You found out or had reason to believe that people who look

at this misconduct and so forth as just doing business, you know,

a cost of doing business. Maybe they had not learned. They just figured they are going to maybe learn some other way to do it. And,

Attorney General Spitzer, you referenced street crimes. You are the

Attorney General, and you know a lot about street crimes, robberies, strong-arm robbery, thieving from the people and so forth,

stealing. But, gosh, this is one of the big heists of the country.

There are billions of dollars involved—millions, if not billions. We

do not know how much now. But we do know the treasury is great,

$7 trillion involved, about 100 million Americans involved in the

funds. So the street crimes of America, which are bad, but as far

as stealing and robbery and petty thievery, gosh, they would be

pikers when they are compared to what we could see here or we

will find out here. Do you agree?

Mr. SPITZER. Yes, sir, I agree entirely. If I could just add one

clarification. You suggested that because I was from New York,

therefore, I knew a lot about crime.

Chairman SHELBY. I think that you know a lot about crime as

a prosecutor.

Mr. SPITZER. I just wanted to clarify that. We actually have

among the lower crime rates in the Nation. I will be parochial and

add that.

Chairman SHELBY. That is because you have been vigorously

prosecuting it.

Mr. SPITZER. Absolutely, sir.

Senator SARBANES. We will be sure that Senator Schumer gets

a copy of this portion of the transcript.

[Laughter.]

Chairman SHELBY. We will.

Mr. SPITZER. Thank you, Senator. But I agree with the premise

behind your question. Comparatively, the dollars involved here are

exponentially greater than the economic harm that results from the

larcenies committed on the street level. And that is why I made the

point that the 15 basis points at Putnam in terms of the advisory

services translates itself into a $290 million cost.

Chairman SHELBY. You do not need a gun to steal from people,

do you?

Mr. SPITZER. Well, somebody made the observation, Senator, that

the smartest way to steal is one penny at a time from many people

so that nobody really objects to that small incremental fee. Yet by

the time you aggregate all that money, it is a vast sum of money.

And that, unfortunately, is what we have seen in the financial

services sector, incremental fees that are layered upon each other.

I think it goes back to Senator Sarbanes’ comment. It is that very

difficult interface between the 90 million investors whom we have

asked to come into the marketplace and the very few, the very

large institutions who look at these individual accounts and see

them as very small-margin returns and, therefore, keep saying:

161

How can we get more and more out of that customer? That is

where this drive for fees comes from.

Chairman SHELBY. You quantify that and you have a lot in the

aggregate, haven’t you?

Mr. SPITZER. Absolutely, sir.

Chairman SHELBY. Mr. Cutler, have you considered—and I know

this is not a complete deal; I hope it is just beginning—referring

certain investigations to the Department of Justice for criminal investigation and prosecution? And if you have not, will you under

the right circumstances?

Mr. CUTLER. Yes. I should add that my colleague to the right,

Mr. Spitzer, has criminal authority. We are working very closely

with him.

Chairman SHELBY. But so does the Justice Department.

Mr. CUTLER. That is right, but there probably can only be so

many criminal prosecutions of the same person at the same time.

Chairman SHELBY. I understand that.

Mr. CUTLER. Actually, the two of us together have been coordinating with U.S. Attorney’s Offices to the extent that they would

be involved, but already Mr. Spitzer has brought criminal cases

where we have brought companion civil cases. And I suspect that

that will continue.

Chairman SHELBY. I have a letter here from John Snow, Secretary of the Treasury, and Alan Greenspan, Chairman of the

Board of the Federal Reserve, to me as Chairman of the Banking

Committee outlining a number of their thoughts on this, including

criminals who use mutual funds to steal from investors or otherwise engage, as I read the letter, in fraud, and these must be apprehended and punished promptly in order to preserve the integrity of these financial institutions and preserve the trust placed in

them. I want to put this letter in the record and share it with you,

if I can.

Chairman SHELBY. Mr. Glauber, Chairman Donaldson, on Tuesday of this week, here in this Committee, called upon the NASD

to lead a study examining the use of omnibus accounts.

Mr. GLAUBER. Indeed so.

Chairman SHELBY. Would you elaborate on the problems created

by omnibus accounts and the end goal of the study.

Mr. GLAUBER. Certainly. The request came in conjunction with

the study of the abuses of market timing, and the problem is this.

In order to fully comprehend the abuses, it is necessary for investigators to be able to follow the trades of an individual investor,

whether that is a person or, for example, a hedge fund. Omnibus

accounts are a mechanism that brokerage firms use primarily to

save money to aggregate trades from many investors into one aggregate account.

In that aggregation process, it makes it difficult to follow the

trail of individual market-timing trades, and I think that is the

reason the Chairman asked us to put together a task force to work

on that, and we, of course, said we would, and we are in the process of doing that.

Chairman SHELBY. Thank you.

Attorney General Spitzer, one criticism of the global settlement

was that the terms of the settlement permitted the firms involved

162

to seek insurance payments for all monies other than those payments designated as fines and penalties. Are you crafting settlements, and I guess I should ask Mr. Cutler this, are you crafting

settlements that do not simply permit defendants to pass through

their costs to insurance companies? In other words, they do not feel

it if somebody else pays it, do they?

Mr. SPITZER. You are absolutely correct. If somebody can simply

pass it through to an insurance carrier, then the fine/penalty is less

painful—perhaps not painful at all.

Yes, we are very mindful of that as we move forward, and I

would agree there were moments, as we look back on the global

view of last year, that we wish we had been more refined in our

language to prevent accessing insurance coverage to cover any of

those costs. Frankly, it had been our view that under New York

law that would not have been permitted.

We have learned perhaps otherwise these issues are still being

litigated by the insurance company and the claimants, but certainly we are very mindful of that as we move forward, and we will

endeavor to ensure that insurance does not cover the fines and

penalties that are imposed.

Chairman SHELBY. Mr. Cutler.

Mr. CUTLER. Yes, I would echo Mr. Spitzer’s comments. We certainly want to make sure that penalties are felt and that the sting

of penalties is felt, and along those lines, penalties and fines should

not be insurable.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

Mr. Glauber, I want to put this question to you, but I want to

quote the Enforcement Director Cutler first. In testimony here in

the Senate, before the Subcommittee over in the Government Operations Committee, at the beginning of the month, he said: ‘‘More

than 25 percent—’’ that was of firms responding to an SEC mutual

fund inquiry report ‘‘—said that customers have received 4 p.m.

prices for orders placed or confirmed after 4 p.m. Fifty percent of

responding fund groups appear to have had at least one arrangement allowing for market timing by an investor. Documents provided by almost 30 percent of responding brokerage firms indicate

that they may have assisted market timers in some way such as

by breaking up large orders or setting up special accounts to conceal their own or their clients’ identities, a practice sometimes

called ‘cloning’ to avoid detection by mutual funds that sought to

prevent abuse of market timing.’’

‘‘Almost 70 percent—70 percent—of responding brokerage firms

reported being aware of timing activities by their customers.’’

Yet everyone, when they get asked about this, and we are not

immune from it, I mean, we were constantly being told that everything was okay in the mutual fund industry; in fact, that it was

unique to the—this arrived just in time. In a statement before the

House Financial Services Committee, the Chairman of the ICI,

Paul Haaga—this was in March of this year—said:

‘‘The strict regulation that implements these objectives has allowed the industry to garner and maintain the confidence of investors and has also kept the industry free of the types of problems

that have surfaced in other businesses in the recent past.’’

163

‘‘An examination of several of the regulatory measures that have

been adopted are under consideration to address problems that led

to the massive corporate and accounting scandals of the past few

years, provides a strong endorsement for the system under which

mutual funds already operate.’’

Now there is an element of Claude Raines in ‘‘Casablanca’’ about

all of this, that he is shocked to learn that gambling is taking place

in the back room of Rick’s casino. How do we explain this?

Some have said to us that it was an open secret that a lot of

these practices were taking place. The trade group, the ICI, says,

well, we did not know about it. In fact, they said they were, I think

they actually used the word ‘‘shocked’’ to discover all of this, and

now all of a sudden we are all operating on this premise—we were

being told that everything was working very well, and now we are

getting these incredible percentages here. There are not a few

outriders engaging in this. It is very prevalent. How was all of this

missed or what was happening?

Mr. GLAUBER. Well, first, as regards the issue of market timing

and late trading, we have been cooperating with the SEC in doing

investigations of member firms. We have had, in fact, a larger

number, although they tend to be smaller member firms, and thus

far we have referred 30 cases, from the 160 firms we have been

looking at, to our Enforcement Division, dealing with just these

issues.

How were they not seen? The fact is that market timing, the potential for market timing has been known for a long period of time.

Indeed, the fund industry sought and put in place the so-called fair

value pricing mechanisms a number of years ago, in principle, to

deal with this. What was not understood is that in a number of

cases, with favored customers, they were looking the other way.

And even perhaps more appalling, in cases inside the mutual

funds themselves, portfolio managers were doing market timing

and front-running their own customers or feeding, as the Chairman

said in his introductory remarks, nonpublic information to favored

customers.

The issue of market timing has been around for a long time, but

the level of abuses, I think you are quite correct were just never

evident in the way they are now becoming so.

Senator SARBANES. Mr. Cutler or Mr. Spitzer, do either of you

have any theories?

Mr. SPITZER. Senator, if I could voice one general observation and

one particular factual point. The general observation is that, over

the last 2 years—I hate to say this—but my skepticism about the

capacity of the SRO’s to provide meaningful regulation has merely

grown day-by-day as the magnitude and dramatic impact on investors of the abuses that ran rampant through the financial services

industry have fallen out into the public’s eye to observe.

I share the same concerns that you just articulated—given the

rampant abuse that we have seen, the percentage numbers that

are just staggering on the part of fund companies, how could it possibly not have been observed either in the regular examinations or

elsewhere.

I would add one other data point, and this is a factual observation, there were, until quite recently, a very significant number of

164

hedge funds—very significantly capitalized hedge funds—that very

openly stated that their strategy was one of market timing, mutual

fund timing. There is nothing wrong, of course, for the hedge fund

to participate in timing if it can get away with it. That observation,

observing the number of prospectuses and offering documents——

Senator SARBANES. Well, there is nothing illegal about them

doing that.

Mr. SPITZER. For the hedge fund.

Senator SARBANES. Yes.

Mr. SPITZER. The illegality in the——

Senator SARBANES. It may be wrong in terms of the impact it is

having on the workings of the market and the ordinary investor.

Mr. SPITZER. Precisely. But for the hedge fund, there is nothing

illegal about their trying to time the accounts. It is the burden that

falls on the mutual fund because of its fiduciary duty to its shareholder. But anybody seeing the number of hedge funds whose

prospectuses said we are going to be market timers, and the capital

that was allocated to these hedge funds should have said, ‘‘Where

is that money going? It is landing somewhere.’’

Senator SARBANES. I know that we are drawing to a close, Mr.

Chairman.

Chairman SHELBY. That is okay. Go ahead.

Senator SARBANES. I want to just put a couple of quotes to you

and get your reaction. One is Jack Bogle, the Vanguard founder,

on November 14, in an op-ed piece in The Wall Street Journal said:

There is a pervasive conflict between the interests of fund managers and fund shareholders that permeate the mutual fund industry and that the industry’s bizarre structure has resulted in a total

level of fund costs to investors that destroys any chance that the

industry can provide to its fund shareholders their fair share of financial market returns.’’

Then because everyone now is focused on this, and we are getting lots of I think rather interesting observations, Business Week,

in the November 17 issue, in an article entitled, ‘‘Funds Need a

Radical New Design,’’ said: ‘‘To retool fund governance to fit the reality of what the industry has become, Congress should scrap the

fiction that each fund is a separate company. Instead, funds should

be folded into the management company and funds and advisers

should be under the authority of one board. That would give directors authority over managers, with the information, muscle, and responsibility to watch out for investors’ interests.’’

I am interested in your reactions to these two comments. Mr.

Glauber, why don’t I start with you.

Mr. GLAUBER. I should start by saying, as you know, NASD’s jurisdiction does not extend to the structure of funds, of mutual

funds or the relationship with their management companies. Having said that, I think, at a minimum, there needs to be a strengthening of the governance structure as it now exists. And Chairman

Donaldson, before this Committee earlier this week, proposed an

increase in the number of independent directors and the proposal

that the chairman be independent, and I think those are both very

sensible proposals.

The Business Week notion is a very radically different approach

to the whole governance structure of mutual funds, very different

165

from the 1940 Act. And it is one thing I think that Congress should

consider. It is quite a radical change, and I think should be considered as one of a range of possible alternatives.

The first place I would look is where Chairman Donaldson talked

about strengthening the structure that we have in place now.

Senator SARBANES. Mr. Cutler, do you want to add anything?

Mr. CUTLER. Sure. I guess I would say, first, that I do agree that

conflict is endemic whenever you have someone managing someone

else’s money and getting paid for it. There is always going to be

a conflict between the adviser and the advisee under those circumstances, and the question is how do you appropriately manage

that conflict?

This is really not my bailiwick, the policy on where we go from

here, but I guess one thing I would caution is that the conflict will

not disappear just because you take the funds and the fund management company and collapse them. We will still have to be worried about that conflict, and it will still have to be managed, even

if we do change the structure. I know that nothing is off the table,

as far as Chairman Donaldson is concerned, but he has put forward, I think, some very, very powerful proposals on how we can

do better in the area of managing those conflicts.

Senator SARBANES. Mr. Spitzer.

Mr. SPITZER. Yes, sir. The comment from Mr. Bogle is reminiscent of the comment that Paul Samuelson made several decades

ago, when he looked at the 1940 Act structure and said, ‘‘The only

place to invest, to make money in the mutual fund business was

in the management companies,’’ and he, from day one, said that is

where they are going to be doing awfully well. Forget investing in

the underlying shares—buy a management company. So, I think,

for decades, people have observed this tension, and I think Jack

Bogle is correct there, as he is in most cases.

In terms of the Business Week notion, I think it is certainly

something that should be thought through. I have said to a number

of your colleagues, sir, that I do not pretend right now, as we sit

here, to have the answer or anything more than a few ideas that

are based upon the investigations we have done, but certainly,

based upon what we have seen, this fiction, as Business Week

called it, that there needs to be a division between the board and

the management company is a fiction that does appear to be increasingly useless and raise the possibility that collapsing the two

would be a sensible move as we restructure governance.

Senator SARBANES. Mr. Chairman, I know that you are drawing

the hearing to a close. I just want to thank our panel, and I just

want to say that, gentlemen, each of you is on the front line, as

far as this is concerned. If the American investor were to ask us,

‘‘Who are our champions? Who is there to be our gatekeepers and

try to protect us in the current situation,’’ it would be the people

at the table.

So, we encourage you on in your efforts. We appreciate what you

are doing. I know there is a great deal of pressure and stress, and

I know these offices are working to capacity or beyond capacity in

terms of the demands they are making on their staff, but we appreciate what you are doing, and we encourage you to keep at it. That

is the parting word I want to leave with you.

166

Thank you.

Chairman SHELBY. I want to associate myself with Senator Sarbanes’ remarks. You are on the front line, all three of you, and the

American investor is looking for relief. They are looking for honest

markets, and we are greatly challenged. And if we are greatly challenged, you are greatly challenged, but I think you are up to the

challenge if we back you, and we will.

Senator Sarbanes and I are committed to more hearings to find

out what is the answer to this, from a regulatory standpoint, or

perhaps a legislative standpoint. We do not want to rush to judgment in the waning days of a Congressional session. We might

have you back, as we have had Chairman Donaldson.

We thank you for your appearance, and we thank you for what

you share with us.

Thank you.

[Whereupon, at 3:59 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

167

PREPARED STATEMENT OF STEPHEN M. CUTLER

DIRECTOR, DIVISION OF ENFORCEMENT

U.S. SECURITIES AND EXCHANGE COMMISSION

NOVEMBER 20, 2003

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

thank you very much for inviting me to testify today on behalf of the Securities and

Exchange Commission concerning alleged abuses relating to the sale of mutual

funds. With more than 95 million Americans invested in mutual funds, representing

approximately 54 million U.S. households, and a combined $7 trillion in assets,

mutual funds are a vital part of this Nation’s economy and millions of investors’ financial security. For that reason, I share the outrage and disappointment of the

Commission, Chairman Donaldson, the investing public, and so many others, at the

misconduct that recently has come to light. It is intolerable when investment professionals—who have a duty to serve the best interests of their customers—instead put

their own interests first. That way of thinking is antithetical to the responsibilities

investment advisers, broker-dealers, and their employees owe to mutual fund investors. Mutual fund investors have a right to expect fair treatment, and when they

do not receive it, we at the Commission will demand it on their behalf.

Accordingly, the Commission has undertaken an aggressive agenda to identify and

address problems in the mutual fund industry. That agenda has both an enforcement component, which I will discuss, and a regulatory component, which Chairman

Donaldson discussed in his testimony before this Committee 2 days ago.

The enforcement piece of the Commission’s agenda relating to mutual funds currently is focused primarily on four types of misconduct, each of which may result

in the interests of financial services firms or their employees being placed above the

interests of investors. I will touch on each briefly, and then turn to the Commission’s response to the recent revelations of serious misconduct relating to the trading of mutual funds.

The first area of priority, which I will discuss in detail in a moment, is late trading and timing of mutual fund shares.

Our second area of priority focuses on fee disclosure issues in connection with the

sale of mutual funds. In particular, we are looking at what prospective mutual fund

investors are—or are not—being told about revenue sharing arrangements and

other incentives doled out by mutual fund companies to brokers selling their funds.

Do customers understand that their broker is being paid to sell a particular fund?

And when these payments are being made from fund assets, do customers understand that their own investment dollars are being used to foot the bill for the

mutual funds’ premium ‘‘shelf space’’ at the selling broker’s office? Such fees may

increase costs to investors, as well as create conflicts of interest between investors

and the financial professionals with whom they deal.

The Commission brought its first case in this area earlier this week. In that action, against Morgan Stanley DW (Morgan Stanley), the Commission found that the

firm had not adequately disclosed that certain mutual funds Morgan Stanley offered

to its customers were part of something it called the ‘‘Partners Program.’’ Under the

Partners Program, a select group of mutual fund families paid Morgan Stanley substantial fees for preferred marketing of their funds. To incentivize its sales force to

deliver the preferred marketing Morgan Stanley promised its partners, Morgan

Stanley paid increased compensation to individual registered representatives and

branch managers on sales of those funds’ shares. But when Morgan Stanley’s customers purchased the preferred mutual funds, they were not told about the Partners

Program, and were therefore not in a position to understand the nature and extent

of the conflicts of interest that may have affected their transactions. The Commission found Morgan Stanley also made inadequate disclosures in a second area,

which I will discuss in a moment.

Morgan Stanley agreed to settle this action by paying $25 million in disgorgement

and prejudgment interest, and civil penalties totaling $25 million. All $50 million

will be placed in a Fair Fund under the Sarbanes-Oxley Act and will be returned

to investors. In addition, Morgan Stanley has undertaken to, among other things,

place on its website disclosures regarding the Partners Program and provide customers with a disclosure document that will disclose specific information concerning

the Partners Program.

The abuses that are addressed in this case are significant and are not necessarily

limited to Morgan Stanley. So-called shelf space payments have become popular

with brokerage firms and the funds they are selling. Thus, the Commission is conducting an examination sweep of some 15 different broker-dealers to determine exVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00179 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
168

actly what payments are being made by funds, the form of those payments, the

‘‘shelf space’’ benefits that broker-dealers provide, and most importantly, just what

these firms tell their investors about these practices.

The potential disclosure failures and breaches of trust spotlighted in the Morgan

Stanley case are not limited to broker-dealers. We are also looking very closely at

the role of mutual fund companies themselves. In that regard, I want to return to

and finish with a point that I alluded to earlier. The aspect of the Morgan Stanley

case that I find perhaps most troubling is this: Morgan Stanley said to the fund

families that are part of the Partners Program: ‘‘You can pay us in one of two

ways—either the fund management company can pay us in cash; or the mutual

funds you manage can defray the fund management company’s obligation by giving

us a multiple of that amount in the form of extra commission business on fund portfolio transactions.’’ Faced with that choice, some fund companies—rather than

reaching into their own pocket to pay what they owed—reached into the pockets of

their mutual fund shareholders and paid in commission dollars instead. You can be

certain that we are pursuing that issue, among others, as our investigation continues, and our exam sweep goes forward.

Our third area of priority in the mutual fund arena is the sale of different classes

of mutual fund shares. Many mutual funds offer multiple classes of shares in a single portfolio. For each class of shares, a mutual fund uses a different method to collect sales charges from investors. Class A fund shares are subject to an initial sales

charge (front-end load); discounts on front-end loads are available for large purchases of Class A shares. Since the sales fee is paid up front, Class A shares incur

lower (or no) ‘‘Rule 12b–1 fees,’’ fees the mutual fund pays for distribution costs,

including payments to the broker-dealers and their registered representatives selling fund shares.

Class B shares, by contrast, are not subject to an up-front sales charge. Instead,

they become subject to a sales charge (a ‘‘contingent deferred sales charge’’ or

‘‘CDSC’’) only if they are redeemed before the end of a specified holding period. Because Class B share investors do not pay an up-front sales fee, the funds pay higher

Rule 12b–1 fees on Class B shares to defray the associated distribution expenses.

As a result, brokers typically earn larger payments on Class B shares than on Class

A shares. In addition, long-term mutual fund shareholders may pay higher sales

charges if they hold B shares rather than A shares, particularly when discounts, as

discussed below, are available on the A shares.

The Commission has brought three enforcement actions involving the sales of

Class B shares to investors who were not made aware by their registered representatives that they could purchase Class A shares of the same mutual fund at a discount (sometimes called a ‘‘breakpoint’’ discount). Indeed, in this week’s Morgan

Stanley case, the Commission found that Morgan Stanley’s disclosures to customers

concerning B shares were inadequate. To address this violation, the relief we obtained in this case includes an agreement by Morgan Stanley to convert to Class

A shares and otherwise make whole those customers who would have been entitled

to a breakpoint discount had they purchased A shares in the first place. In addition,

Morgan Stanley has agreed to retain an independent consultant to conduct a review

of, and to provide recommendations concerning, its disclosures, policies, and procedures and its plan to offer to convert Class B shares to A shares. The firm is

required to adopt the recommendations of the independent consultant.

Earlier this year, the Commission brought an action against Prudential Securities

for abuses in this area as well. In that case, filed in July, the Commission found

that Prudential’s supervisory system for overseeing practices in this area were inadequate. Prudential had in place policies and procedures requiring registered representatives to advise their clients of the availability of different classes of mutual

funds and fully explain the terms of each. Prudential branch managers were also

expected to approve all purchases greater than $100,000 and confirm the suitability

of the choice of fund class. The Commission found, however, that Prudential failed

to adopt a sufficient supervisory system to enable those above the branch manager

to determine whether these policies and procedures were being followed. Under

Prudential’s system, branch office managers were solely responsible for ensuring

that registered representatives followed the firm’s mutual fund policies and procedures. As a result, when the registered representatives’ branch manager failed to

abide by and enforce Prudential’s policies and procedures, the firm had no way of

detecting the lapse. In resolving the Commission’s action, Prudential was censured

and agreed to pay disgorgement and a civil penalty. The Commission’s action

against the registered representative and branch manager, which charges them with

fraud, is pending.

The fourth priority area is to address the failure of firms to give their customers

the discounts available on front-end loads for large purchases of Class A shares.

169

1The report is available at: http://www.sec.gov/news/studies/breakpointrep.htm.

Earlier this year, examiners at the SEC, NASD, and NYSE completed an examination sweep and outlined the results in a report, ‘‘Joint SEC/NASD/NYSE Report of

Examinations of Broker-Dealers Regarding Discounts on Front-End Sales Charges

on Mutual Funds.’’ 1 Together with the NASD, we have under active investigation

instances in which it appears that investors were entitled to receive breakpoint discounts based on the size of their purchase of Class A shares, but where the firms

failed to provide discounts.

Before I turn to abuses that have more recently come to light, I will mention two

types of misconduct, harmful to mutual fund investors, where the Commission has

both an active and aggressive track record and a roster of current investigations.

The first is the area of fund disclosures concerning the effect of hot IPO shares on

fund performance; the second is pricing and valuation practices of mutual funds.

The Commission has brought three actions in the last several years charging registered investment advisers with failing to disclose the substantial positive effect

that holding or trading hot IPO shares had on their funds’ performance, and, critically, the risk that such exceptional performance could not be sustained. In one

case, the investment adviser also did not disclose that a portfolio manager, who

managed multiple mutual funds, allocated securities purchased in initial public offerings—especially ‘‘hot’’ IPO’s—in a manner that had the overall effect of favoring

one fund over three others he managed. The adviser did not disclose this practice,

notwithstanding the fund’s prospectus disclosure that investment opportunities

would be allocated equitably among the fund complex’s funds.

These cases are an unfortunate part of an all-too-common theme—mutual funds

and their advisers often are reluctant or unwilling to disclose to investors important

performance-related information to which they are not only entitled, but which they

must have in order to make fair and reasoned investment decisions. With respect

to valuation, the problem more typically is a failure on the part of funds and their

advisers to adhere to the policies and procedures that they have disclosed. We are

actively looking at two situations in which funds dramatically wrote down their Net

Asset Values in a manner that raises serious questions about the funds’ pricing

methodologies.

This brief overview of the Commission’s enforcement agenda with respect to mutual funds is intended to give you a sense of the scope of our activities. I recognize,

however, that today’s hearing was prompted by recent revelations involving late

trading and timing of mutual funds. Accordingly, I will now turn to that subject.

SEC Response to Misconduct Relating to Mutual Funds

As you well know, the conduct of mutual funds and the financial intermediaries

with and through which they do business, recently came to the public’s attention

when New York Attorney General Eliot Spitzer announced an action involving

abusive mutual fund trading practices by a hedge fund, Canary Capital Partners,

LLC. The Canary action identified two problematic practices—late trading of mutual

funds and timing of mutual funds. Late trading refers to the practice of placing

orders to buy or sell mutual fund shares after the time at which the funds calculate

their net asset value (NAV)—typically 4 p.m. Eastern Time (ET)—but receiving

the price based upon the prior NAV already determined as of 4 p.m. Late trading

violates a provision of the Federal securities laws that dictates the price at which

mutual fund shares must be bought or sold and defrauds innocent investors in those

mutual funds by giving to the late trader an advantage not available to any other

investors.

‘‘Timing’’ abuses refer to excessive short-term trading in mutual funds in order

to exploit inefficiencies in mutual fund pricing. Although market timing itself is not

illegal, mutual fund advisers have an obligation to ensure that mutual fund shareholders are treated fairly, and they should not favor one group of shareholders (i.e.,

market timers) over another group of shareholders (i.e., long-term investors). In addition, when a fund states in its prospectus that it will act to curb market timing,

it must meet that obligation.

Abusive market timing can dilute the value of mutual fund shares to the extent

that a trader may buy and sell shares rapidly and repeatedly to take advantage of

inefficiencies in the way mutual funds prices are determined. Dilution could occur

if fund shares are overpriced and redeeming shareholders receive proceeds based on

the overvalued shares. In addition, short-term trading can raise transaction costs

for the fund, it can disrupt the fund’s stated portfolio management strategy, require

a fund to maintain an elevated cash position, and result in lost opportunity costs

and forced liquidations. Short-term trading can also result in unwanted taxable capital gains for fund shareholders and reduce the fund’s long-term performance. In

170

2 In connection with the SEC’s order, a hearing will be scheduled before an administrative law

judge to determine whether the allegations contained in the order are true and to provide Sihpol

an opportunity to respond to them.

short, while individual shareholders may profit from engaging in short-term trading

of mutual fund shares, the costs associated with such trading are borne by all fund

shareholders.

Following the announcement of the Canary Capital case, the Commission put in

motion an action plan to vigorously investigate the matter, assess the scope of the

problem, and hold any wrongdoers accountable. Specifically, the Commission is proceeding on three fronts, utilizing its enforcement authority, its examination authority, and its regulatory authority. I will address the first two areas of the Commission’s efforts.

Recent Enforcement Efforts Relating to Mutual Fund Trading

In the enforcement area, we are working aggressively to pursue wrongdoing, and

are doing so in coordination with State regulators. Thus far, the Commission has

brought actions against persons associated with three different types of entities—

broker-dealers, hedge funds, and mutual funds—each of which can play a role in

harming long-term mutual fund investors. Our actions to date address allegations

of both late trading and market timing. I will briefly summarize those actions.

On September 16, the Commission filed a civil action against Theodore Sihpol,

a salesperson at Bank of America Securities (BOA), who was Canary Capital’s primary contact at Bank of America. Specifically, the Commission issued an administrative order instituting proceedings in which the Division of Enforcement (the

Division) alleges that Sihpol played a key role in enabling certain hedge fund customers of BOA to engage in late trading in shares of mutual funds offered by Bank

of America, including the Nations Funds family of funds and other mutual funds.

Based on the conduct alleged in the Commission’s Order, the Division alleges that

Sihpol violated, and aided and abetted and caused violations of, the antifraud, mutual fund pricing and broker-dealer record-keeping provisions of the Federal securities laws. In its action, the Division is seeking civil penalties, disgorgement, and

other relief, which may include permanently barring Sihpol from the securities industry.2 Simultaneous with the issuance of the Commission’s order, Sihpol surrendered in connection with Attorney General Spitzer’s filing of a two-count complaint

charging him with larceny and securities fraud.

Less than 3 weeks later, the Commission and the New York Attorney General announced criminal and civil actions against Steven B. Markovitz, formerly an executive and senior trader with the prominent hedge fund firm Millennium Partners,

LP. In the New York Attorney General’s criminal action, Markovitz pleaded guilty

in State Supreme Court to a violation of New York’s Martin Act. The SEC’s administrative order finds that Markovitz committed securities fraud. In partial settlement of the SEC’s action, without admitting or denying the SEC’s findings,

Markovitz consented to cease and desist from violations of certain provisions of the

Federal securities laws, and to be permanently barred from associating with an investment adviser or from working in any capacity with or for a registered investment company. The SEC also is seeking disgorgement and civil penalties in

amounts to be determined later.

According to the criminal charges and the SEC findings, Markovitz engaged in

late trading of mutual fund shares on behalf of Millennium, one of the Nation’s largest hedge fund operators, with more than $4 billion under management. With the

assistance of certain registered broker-dealers, Markovitz placed mutual fund orders

after 4 p.m. ET, but obtained the prices that had been set as of 4 p.m. ET. By SEC

rule, Markovitz’s post-4 p.m. orders should have received the prices set on the following day. This illegal trading allowed Millenium to take advantage of events that

occurred after the markets closed.

In its first action against a mutual fund executive for permitting market timing,

on October 16, the Commission and the New York Attorney General announced the

arrest, conviction, and lifetime industry bar of James P. Connelly, Jr., former Vice

Chairman and Chief Mutual Fund Officer of Fred Alger & Company, Inc., a prominent mutual fund firm. Connelly pled guilty to the crime of Tampering with Physical Evidence. The criminal charges against Connelly stem from his repeated efforts

to tamper with an ongoing investigation of illegal trading practices in the mutual

fund industry, including by directing subordinates to delete emails called for by

subpoenas.

In its administrative order, the SEC found that Connelly approved agreements

that permitted select investors to ‘‘time’’ certain mutual funds managed by Alger,

a practice that violates an adviser’s fiduciary duties and adversely affects the value

171

of the fund being timed. In this case, the timing arrangements were also inconsistent with Alger’s public disclosures in prospectuses and Statements of Additional

Information filed with the SEC. According to the Commission’s order, Connelly was

involved in timing arrangements at Alger from the mid-1990’s until 2003. By early

2003, Connelly was requiring that investors seeking timing capacity agree to maintain at least 20 percent of their investment at Alger in buy-and-hold positions,

sometimes referred to as ‘‘sticky assets.’’

Connelly has been ordered to cease and desist from future violations of various

provisions of the Federal securities laws; has been barred from association with any

broker, dealer, or investment adviser; has been barred from serving in various capacities with respect to any registered investment company; and is subject to a

$400,000 civil penalty.

On October 28, the Commission brought actions against Putnam Investment Management LLC (Putnam) and two former Putnam Managing Directors and portfolio

managers, Justin M. Scott and Omid Kamshad, in connection with the personal

trading by those Managing Directors in Putnam mutual funds. The Commission

filed a civil injunctive action against Justin M. Scott and Omid Kamshad charging

each of them with securities fraud. The complaint alleges that Scott and Kamshad,

for their own personal accounts, engaged in excessive short-term trading of Putnam

mutual funds for which they were portfolio managers. According to the complaint,

Scott and Kamshad’s investment decisionmaking responsibility for those funds

afforded them access to nonpublic information about the funds, including current

portfolio holdings, valuations, and transactions. The complaint further alleges that

Scott and Kamshad’s short-term trading violated their responsibilities to other fund

shareholders, that Scott and Kamshad failed to disclose their trading and that, by

their trading, they potentially harmed other fund shareholders. In this action, the

Commission is seeking injunctive relief, disgorgement, penalties, and such equitable

relief as the court deems appropriate.

The Commission also issued an administrative order instituting proceedings

against Putnam. Subsequently, on November 13, the Commission issued another

order against Putnam reflecting a partial settlement with the firm. In connection

with that agreement, Putnam committed to undertake significant and far-reaching

reforms relating to excessive short-term and market timing trading by its employees. Putnam also agreed to a process for calculating and paying restitution to investors. The amount of civil penalty and other monetary relief to be paid by Putnam

remains open and will be determined at a later date.

In its Order against Putnam, the Commission found that Putnam committed securities fraud by failing to disclose potentially self-dealing securities trading by several

of its employees. The Commission also found that Putnam failed to take adequate

steps to detect and deter such trading activity through its own internal controls and

its supervision of investment management professionals. Putnam has agreed to

admit these findings for purposes of the penalty phase of the administrative proceeding, which has not yet taken place.

The reforms that Putnam agreed to implement, pursuant to the Commission’s

Order, are all designed to prevent the violations found by the Commission. They can

be broken down into three important areas: (1) restrictions on employee trading; (2)

enhancements of compliance policies, procedures, and staffing, including relating to

employee trading; and (3) corporate governance, including fund board independence.

Among the reforms Putnam will implement relating specifically to employee trading is a requirement that employees who invest in Putnam funds hold those investments for at least 90 days, and in some cases, as long as 1 year.

In the compliance area, Putnam will:

• Require Putnam’s Chief Compliance Officer to report to the fund boards’ independent trustees all breaches of fiduciary duty and violations of the Federal securities laws.

• Maintain a Code of Ethics Oversight Committee to review violations of the Code

of Ethics and report breaches to the fund boards of trustees.

• Create an Internal Compliance Controls Committee to review compliance controls

and report to the fund boards of trustees on compliance matters.

• Retain an Independent Compliance Consultant to review Putnam’s policies and

procedures designed to prevent and to detect breaches of fiduciary duty, breaches

of the Code of Ethics, and Federal securities law violations by Putnam and its

employees.

• At least once every 2 years, Putnam will have an independent, third-party conduct a review of the firm’s supervisory, compliance and other policies and procedures in connection with the firm’s duties and activities on behalf of and related

to the Putnam funds.

172

In the area of corporate governance, Putnam agreed:

• That the fund boards of trustees will have an independent chairman. • That the fund boards of trustees will consist of at least 75 percent independent

members. • That no board action may be taken without approval by a majority of the independent directors; and that Putnam will make annual disclosure to fund shareholders of any action approved by a majority of the fund board’s independent

trustees, but not approved by the full board. • That the fund boards of trustees will hold elections at least once every 5 years,

starting in 2004. • That the fund boards of trustees will have their own, independent staff member

who will report to and assist the fund boards in monitoring Putnam’s compliance

with the Federal securities laws, its fiduciary duties to shareholders, and its Code

of Ethics.

In sum, the reforms Putnam will undertake as part of the Commission’s order are

intended to provide real, substantial, and immediate protections for mutual fund

investors. The required enhancements to the board oversight and compliance

functions at Putnam should strengthen all aspects of Putnam’s fund operations and

provide investors with uncompromised representation by their fiduciaries in the

boardroom and at the management company. In addition, the Division of Enforcement fully intends to seek substantial penalties and/or other monetary payments

from Putnam, over and above the restitution Putnam already is bound by the Commission’s order to make. And, of course, the Commission’s investigation of Putnam

and its employees is active and ongoing. If additional misconduct comes to light, the

Commission will bring additional enforcement actions.

On November 4, in conjunction with the Secretary of the Commonwealth of Massachusetts, the Commission announced still another enforcement action, this one

against five Prudential Securities brokers and their branch manager. The Commission alleged in a civil action that the defendants defrauded mutual funds by misrepresenting or concealing their own identities or the identities of their customers

so as to avoid detection by the funds’ market timing police. This allowed them to

enter thousands of market timing transactions after the funds had restricted or

blocked the defendants or their customers from further trading in their funds. The

Commission is seeking injunctive relief, disgorgement, penalties, and such equitable

relief as the court deems appropriate.

The Commission’s Use of Examination Authority

As I noted, the Commission’s response to the revelations of misconduct in the mutual fund area is multipronged. The second area of authority that we are utilizing

aggressively is the Commission’s examination authority, which entitles us to obtain

promptly information and records from regulated entities. Accordingly, immediately

following the Canary announcement, relying on the Commission’s examination powers, the Commission’s staff sent detailed requests for information and documents to

88 of the largest mutual fund complexes in the country and 34 broker-dealers, including prime brokerage firms and other large broker-dealers. These written requests sought information on each entity’s policies and practices relating to market

timing and late trading. In the case of mutual funds and broker-dealers, we have

obtained information regarding their pricing of mutual fund orders and adherence

to their stated policies regarding market timing. We also have sought information

from mutual funds susceptible to market timing regarding their use of fair value

pricing procedures to combat this type of activity.

The examination staff is still analyzing the information received as a result of

these requests, and in many cases has sought additional details. Nevertheless, some

firms’ responses have warranted aggressive follow-up, and thus, the Commission

examiners have been dispatched to conduct onsite inspections and interviews at

a number of firms. Responses from some other firms have already led to referrals

to the enforcement staff for further investigation. All told, SEC staff across the

country are looking at the activities and practices of dozens of mutual fund and

broker-dealer firms.

As I noted earlier, the Commission’s examination and enforcement staff are examining and investigating other industry practices, such as the sale of B shares to

investors, payments for ‘‘shelf space,’’ and the failure to give breakpoint discounts.

Conclusion

The Commission’s investigations of mutual fund trading and sales practices

abuses are continuing on multiple fronts. I want to emphasize that we will aggressively pursue those who have violated the law and injured investors as a result of

sales practice and related disclosure abuses, failure to give breakpoint discounts,

173

improper valuation practices, illegal late-trading, market-timing, self-dealing, or any

other illegal activity we uncover. Those responsible for these practices will be identified and will be held fully accountable.

Wherever possible, the Commission also will seek recompense for investors in connection with mutual fund fraud. We will, of course, continue to work closely and

cooperatively with State officials who also are taking steps to protect investors.

I would be happy to answer any questions that you may have.

—————

PREPARED STATEMENT OF ROBERT R. GLAUBER

CHAIRMAN AND CHIEF EXECUTIVE OFFICER

NATIONAL ASSOCIATION OF SECURITIES DEALERS

NOVEMBER 20, 2003

Mr. Chairman and Members of the Committee, NASD would like to thank the

Committee for the invitation to submit this written statement for the record.

NASD

NASD, the world’s largest securities self-regulatory organization, was established

in 1939 under the authority granted by the 1938 Maloney Act Amendments to the

Securities Exchange Act of 1934. Every broker-dealer in the United States that conducts a securities business with the public is required by law to be a member of

NASD. NASD’s jurisdiction covers nearly 5,400 securities firms that operate more

than 92,000 branch offices and employ more than 665,000 registered securities

representatives.

NASD writes rules that govern the behavior of securities firms, examines those

firms for compliance with NASD rules, MSRB rules, and the Federal securities laws,

and disciplines those who fail to comply. Last year, for example, we filed a record

number of new enforcement actions (1,271) and barred or suspended more individuals from the securities industry than ever before (814). Our investor protection and

market integrity responsibilities include examination, rulewriting and interpretation, professional training, licensing and registration, investigation and enforcement,

dispute resolution, and investor education. We monitor all trading on the Nasdaq

Stock Market—more than 70 million orders, quotes, and trades per day. NASD has

a nationwide staff of more than 2,000 and is governed by a Board of Governors at

least half of whom are unaffiliated with the securities industry.

NASD’s involvement with mutual funds is predicated on our authority to regulate

broker-dealers. NASD does not have any jurisdiction over investment companies

or the fund’s investment adviser; rather, we regulate the sales practices of brokerdealers who sell the funds to investors. Our investor education efforts also place special emphasis on mutual funds due to their widespread popularity with investors.

The behavior that has been uncovered in the mutual fund industry has been reprehensible. The mutual fund industry was for years an example of a clean, disciplined industry. This reputation helped to foster growth in these products that

offered investors relatively low-cost professional management, diversification, and

risk control to fit a wide range of investor needs. But now the industry has seriously

undermined investor trust with a wide range of abuses—portfolio managers trading

ahead of mutual fund investors, differential release of portfolio information, deals

with preferred customers to permit market timing trades. Broker participation in

illegal or unethical sales practices is very much a direct concern of NASD.

Disclosure

This week during testimony before this Committee, Securities and Exchange Commission (SEC) Chairman Donaldson discussed a series of reforms in the realm of

disclosure that he intends to seek. NASD supports these SEC efforts. Investors deserve clear and easy-to-read disclosure that tells them of all the costs associated

with their mutual funds. Not just the load and fees that affect investor costs but

also the other arrangements that affect the price—including Commission expenses

and compensation arrangements between the broker and the fund. One of the bedrock principles of our free market system is that all participants have access to

information about prices and costs that can influence their decisions. When this information is hidden or distorted, buyers are not able to make the best decisions

about where to invest their money.

In August, NASD proposed greatly expanded disclosure of mutual fund compensation arrangements. The proposal is designed to alert investors to the financial incentives that a brokerage firm or its registered representatives may have to recommend

particular funds.

174

The proposal would ensure that investors receive timely information about two

types of compensation arrangements. The first consists of cash payments by fund

sponsors to broker-dealers to induce fund sales. Typically, these payments are made

in order to gain ‘‘shelf space’’ at the broker, or to secure a place for a fund on a

preferred sales list. The second is the payment by a broker-dealer of a higher compensation rate to its own registered representatives for selling certain funds. The

proposal would require firms to disclose these compensation arrangements in writing when the customer first opens an account or purchases mutual fund shares. The

proposal also would require member firms to update this information twice a year

and make it available on their websites, through a toll-free number, or in writing.

The comment period on the proposal ended October 17, 2003. NASD has received

approximately 40 comment letters on the proposal, which the staff is reviewing.

Recent Enforcement Efforts and Rule 2830

To combat abuses in the realm of our regulatory authority, we have concentrated

our examination and enforcement focus on five main areas: First, cash and noncash

compensation practices and arrangements; second, the suitability of the mutual

funds that brokers are selling, in particular B share abuses; third, whether brokers

are delivering to their customers the benefits to which they are entitled, such as

breakpoint discounts; and finally, market timing and late trading. All told, we have

brought some 60 enforcement cases this year in the mutual fund area, and more

than 200 over the last 3 years. We also have a large number of ongoing examinations and investigations involving these and other mutual fund issues.

Cash and Non-Cash Compensation Practices and Arrangements

Just this week, NASD announced an enforcement action against Morgan Stanley

for giving preferential treatment to certain mutual fund companies in return for

millions of dollars in brokerage commissions. This is the second action brought by

NASD against Morgan Stanley for mutual fund violations in the last 2 months and

is part of our broader effort to crack down on sales practice abuses. In conjunction

with a related action filed by the SEC, Morgan Stanley agreed to resolve the NASD

and SEC actions by paying $50 million in civil penalties and surrendered profits,

all of which will be returned to injured investors.

In the Morgan Stanley case, NASD found that from January 2000 until 2003,

Morgan Stanley operated two programs which gave favorable treatment to products

offered by as many as 16 mutual fund companies out of a total of over 115 fund

complexes that could be sold by the firm’s sales force. In return for these brokerage

commissions and other payments, mutual fund companies received preferential

treatment by Morgan Stanley, which included:

• Placement on a ‘‘preferred list’’ of funds that financial advisors were to look to

first in making recommendations of fund products.

• Higher visibility on Morgan Stanley’s sales systems and workstations than nonpaying funds.

• Eligibility to participate in the firm’s 401(k) programs and to offer offshore fund

products to Morgan Stanley customers.

• Better access to its sales force and branch managers.

• Payment of special sales incentives to Morgan Stanley financial advisors.

In addition, the participating mutual fund companies paid Morgan Stanley an

extra 15 to 20 basis points on each sale. This was over and above the normal fees

earned by the firm for selling the funds.

This extra compensation paid to Morgan Stanley for the preferential treatment included millions of dollars paid by the mutual funds through commissions charged

by the firm for trades it executed for the funds. These commissions were sufficiently

large to pay for the special treatment, as well as the costs of trade execution. This

conduct violated NASD’s Conduct Rule 2830(k), one important purpose of which is

to help eliminate conflicts of interest in the sale of mutual funds.

NASD is also conducting an examination sweep where we are looking at more

than a dozen broker-dealers, specifically with a view to determine how investment

companies pay for inclusion on firms’ featured mutual fund lists or why they receive

favored promotional or selling efforts. Thousands of funds are presented to investors

through discount and online broker-dealer ‘‘supermarkets.’’ We are looking at different types of firms, including full-service, discount, and online broker-dealers. In

addition, we are examining a similar number of mutual fund distributors, who are

also our members. Mutual fund sponsors and distributors that once marketed exclusively through a single, traditional distribution channel often now compete head-tohead in the same distribution channels vying for visibility and valuable ‘‘shelf

space.’’ We want to see what the distributors’ role may be in these types of practices.

175

As demonstrated in the recent case against Morgan Stanley, exchanging prominent placement of a fund or a family of funds on a firm’s website or in the firm’s

marketing material or placing a fund on a ‘‘featured’’ or ‘‘preferred’’ list of funds in

exchange for brokerage commissions from the funds constitutes a violation of the

NASD rules.

Another section of NASD Conduct Rule 2830 prohibits the award of noncash compensation, such as lavish trips and entertainment, to brokers for the sale of mutual

fund shares. In September, we brought another case against Morgan Stanley that

resulted in a $2 million fine against the firm. Morgan Stanley conducted prohibited

sales contests for its brokers and managers to push the sale of Morgan Stanley’s

own proprietary mutual funds. In addition to censuring and fining the firm, NASD

also censured and fined a senior member of the firm’s management—the head of

retail sales.

Between October 1999 and December 2002, the firm had conducted 29 contests

and offered or awarded various forms of noncash compensation to the winners, including tickets to Britney Spears and Rolling Stones concerts, tickets to the NBA

finals, tuition for a high-performance automobile racing school, and trips to resorts.

The obvious danger of such contests is that they give firm personnel a powerful

incentive to recommend products that serve the broker’s interest in receiving valuable prizes, rather than the investment needs of the customer. And one of the most

troubling things about this case is Morgan Stanley’s failure to have any systems or

procedures in place that could detect or deter the misconduct.

In January 2003, NASD censured and fined IF Distributor, Inc., and VESTAX Securities Corp. a total of $150,000 for failing to disclose special cash compensation

they paid to their sales force in the sale of mutual fund shares. Prior to disclosing

this special cash compensation, the brokers sold over $20 million in Class A shares

to over 200 customers. Brokers selling these shares received approximately $220,000

in special cash compensation.

Suitability of Mutual Fund Sales—Class B Shares

Many mutual funds offer different classes of the same investment portfolio. Each

class is designed to provide brokers and their customers with a choice of fee structure. Class A mutual fund shares charge a sales load when the customer purchases

shares. Class B shares do not impose such a sales charge. Instead, Class B shares

typically impose higher expenses that investors are assessed over the lifetime of

their investment. Class B shares also normally impose a contingent deferred sales

charge (CDSC), which a customer pays if the customer sells the shares within a

certain number of years. In addition, investors who purchase Class B shares cannot

take advantage of breakpoint discounts available on large purchases of Class A

shares.

NASD has found that some brokers have unscrupulously recommended Class B

shares in such large amounts that the customer would have qualified for breakpoint

discounts had the broker recommended Class A shares instead. In this instance, the

broker may receive higher compensation for the Class B recommendations. NASD

has vigorously prosecuted these violations, and we are continuing a comprehensive

review of Class B shares sales practices. Over the last 2 years, NASD has brought

more than a dozen enforcement actions against firms and individual brokers for

these types of violations. Presently, we have more than 50 open and active investigations in this area.

For example, in May the SEC affirmed a disciplinary action NASD took against

Wendell D. Belden, who was found to have violated NASD’s suitability rule by recommending that a customer purchase Class B mutual fund shares in five different

mutual funds within two fund families instead of Class A mutual fund shares.

Because of the size of his customer’s investment ($2.1 million) and the availability

of breakpoint discounts for Class A shares, Belden’s recommendations caused his

customer to incur higher costs, including contingent deferred sales charges.

Belden tried to justify his recommendations to customers that they purchase the

Class B shares instead of the Class A shares because he received greater commissions on the sales of these shares. He stated that he ‘‘could not stay in business’’

with lower commissions. Belden was fined, suspended, and ordered to pay more

than $50,000 back to his customers.

In June, we announced a settled action against McLaughlin, Piven, Vogel for violations in this area. The firm was fined $100,000 and ordered to pay restitution of

approximately $90,000 to 21 customers. In August, we announced five more actions

for unsuitable sales of Class B shares.

176

Breakpoint Discounts

Mutual funds typically offer discounts to the front-end sales load assessed on

Class A shares at certain predetermined levels of investment, which are called

‘‘breakpoints.’’ The extent of the discount is based on the dollar size of the investor’s

investment in the mutual fund. For example, breakpoint discounts may begin at dollar levels of $25,000 (although, more typically, at $50,000) and increase at $100,000,

$250,000, $500,000, and $1,000,000. At each higher level of investment, the discount

increases, until the sales charge is eliminated.

An investor can become entitled to a breakpoint discount to the front-end sales

charge in a number of ways. First, an investor is entitled to a breakpoint discount

if his single purchase is equal to or exceeds the specified ‘‘breakpoint’’ threshold.

Second, mutual funds generally allow investors to count future purchases toward

achieving a breakpoint if the investor executes a letter of intent that obligates him

to purchase a specified amount of fund shares in the same fund or fund family

within a defined period of time. Similarly, mutual funds generally grant investors

‘‘rights of accumulation,’’ which allow investors to aggregate their own prior purchases and the holdings of certain related parties toward achieving the breakpoint

investment thresholds (including reaching investment thresholds necessary to satisfy letters of intent).

Mutual fund families began to offer these breakpoint discounts to make their

funds more attractive to investors. Over time, funds expanded the rights of accumulation they offered by expanding the categories of accounts that could be linked or

aggregated for the purpose of obtaining breakpoint discounts. Mutual funds view

their aggregation rules as important competitive features of their products. Accordingly, these rights of accumulation can vary from fund family to fund family, and

many fund families define the related parties that can aggregate their holdings to

determine breakpoint discount eligibility differently. For instance, one fund family

may allow parents to link their accounts with a ‘‘minor child,’’ while another fund

family may allow parents to link their accounts with any child residing at home.

During routine examinations of broker-dealers by our Philadelphia District Office,

NASD discovered that broker-dealers selling front-end load mutual funds were not

properly delivering breakpoint discounts to investors. Following this discovery, in

November and December 2002, the SEC and the New York Stock Exchange joined

us for an examination sweep of 43 firms selling front-end load mutual funds. We

found that most of those firms did not give investors all the breakpoint discounts

they should. Failures to give the discounts stemmed from a variety of different operational problems, including a failure to link share classes and holdings in other

funds in the same fund family and a failure to link accounts of family members.

NASD issued a Notice to Members on December 23, 2002, reminding firms to

explain and deliver breakpoints. And we issued in January 2003, an Investor Alert

to advise customers of breakpoint opportunities.

Also in January 2003, the SEC asked NASD to lead a task force to find breakpoint solutions. The task force had 24 members, including representatives from

broker-dealers, mutual funds, transfer agents, clearing facilities, academia, the SEC

staff, other SRO’s, and trade associations.

The Task Force issued its report in July 2003, in which it recommended a number

of technological and operational changes, as well as modifications to mutual fund

prospectus and other disclosure and sales practices, to ensure that customers are

not overcharged. Working groups, consisting of knowledgeable representatives of

the mutual fund and securities industries, are currently engaged in implementation

of the Task Force recommendations. The NASD and the SEC receive periodic reports from these Working Groups and are monitoring progress as implementation

moves forward.

As for the transactions that should have received discounts, NASD supplemented

its referenced examination effort with a survey of every NASD member to learn

more about each member’s overall mutual fund activities. The survey, in turn, provided NASD with information that helped us frame a self-assessment. Specifically,

NASD directed firms to perform an assessment of their own of breakpoint discounts

delivery. These self-assessments were carried out through use of a carefully constructed sample of transactions, which permitted NASD to extrapolate each firm’s

performance to its entire universe of transactions. NASD has concluded that, during

the 2001 to 2002 period covered by the self-assessments, investors were overcharged

in about one out of every five transactions in which they were eligible for breakpoint

discounts. Those overcharges, in our view, total at least $86 million, and the average overcharge was $243. When the assessments were complete, firms were directed

to refund overcharges to investors, with interest. In addition, NASD will require

that most of the firms involved undertake further action, including contacting their

177

customers individually to alert them to possible overcharges. Disciplinary or enforcement proceedings will be brought against certain of the firms.

Late Trading and Market Timing

Investment Company Act Rule 22(c)(1) generally requires that mutual fund

shares be sold and redeemed at a price based on the net asset value (NAV) of the

fund computed after the receipt of the order. In practice this requirement means

that mutual fund shares are priced according to the value of their securities portfolio, computed at the next close of the national securities exchanges. For example,

if a mutual fund receives an order to purchase shares before the close of the securities exchanges, 4 p.m., EST, the investor should receive a price based on that 4 p.m.

close. If, however, a mutual fund receives an order to purchase shares after the 4

p.m. close, the investor should receive a price based on the next day’s 4 p.m. close.

This ‘‘forward pricing’’ requirement represents a fundamental principle of the Investment Company Act, for it prevents investors who might have access to the NAV

of the portfolio from trading on that information.

The failure to meet the forward pricing standard has become known as ‘‘late trading.’’ Late trading, however, should be distinguished from the practice, followed by

many broker-dealers and other intermediaries, of transmitting orders after 4 p.m.

because they require additional processing time. For example, some intermediaries

may net out transactions by pension plan participants in order to simplify their

order to the mutual fund company. In these instances, the participants entered their

orders before 4 p.m., but the orders of the plan were not processed and transmitted

until after 4 p.m.

The frequent trading of mutual fund shares in order to take advantage of pricing

inefficiencies or market movements has become known as ‘‘market timing.’’ Market

timing is not per se illegal. Market timing activities become illegal when they violate the fiduciary duty of the fund’s investment adviser; they also are problematic

when they violate a stated policy of the fund as disclosed in the fund’s prospectus.

Many mutual funds police market timing by their shareholders, because market

timing can increase fund expenses and can harm fund performance for the other

shareholders. When a mutual fund has disclosed a policy of protecting investors

from market timers, a broker-dealer may not knowingly or recklessly collude with

the fund in order to effect a market timing transaction. Broker-dealers must have

in place policies and procedures reasonably designed to detect and to prevent this

collusion.

In response to prevailing issues concerning mutual fund execution, in September

NASD sought information from roughly 160 firms regarding late trading and impermissible market timing.

As a preliminary matter, we have determined that numerous firms’ conduct warranted a referral to NASD’s Enforcement Department for further investigation and

possible disciplinary action. Another group of firms is being examined by our Member Regulation Department for potential late trading and impermissible market timing misconduct. Specifically, a number of firms disclosed that they had, or probably

had, received and entered mutual fund orders after U.S. markets closed for the day.

Some of these firms disclosed specifically that they had accepted and entered late

trades; other firms disclosed that they ‘‘probably’’ accepted and entered late trades.

This imprecision in the latter group indicates separate issues of poor internal controls and record keeping. These matters, too, have been referred to NASD’s Enforcement Department for action.

NASD also has identified a number of firms that were involved in market timing

and it remains to be determined whether their activities were impermissible under

our rules or applicable statutes. These firms appear to have facilitated a customer’s

market timing strategy in mutual funds or variable annuities, had employees who

agreed with a mutual fund or variable annuity to market time the issuer’s shares,

or had an affiliate involved in some form of market timing of mutual funds or variable annuities. We are investigating any broker-dealer that made any of these disclosures in our investigations. We will investigate whether these firms simply allowed market timing, which is not per se illegal, or whether they colluded with the

mutual fund companies to evade the fund’s stated policies against market timing.

Investor Education

Mutual funds have been a particular focus of NASD’s investor education efforts.

This year alone, we have issued Investor Alerts on:

• Mutual fund share classes

• Mutual fund breakpoints

• Principal-protected funds

• Class B mutual fund shares

178

Each of these Investor Alerts educates investors about the wide variety of mutual

fund fee structures that exist and urges investors to scrutinize mutual fund sales

charges, fees, and expenses.

Research has shown that many investors are unaware of how much they pay to

own mutual funds and that even small differences in fees can result in thousands

of dollars of costs over time that could have been avoided. To help investors make

better decisions when purchasing mutual funds, we have unveiled an innovative

‘‘Mutual Fund Expense Analyzer’’ on our website. Unlike other such tools, the Expense Analyzer allows investors to compare the expenses of two funds or classes of

funds at one time, tells the investor how the fees of a particular fund compare to

industry averages, and highlights when investors should look for breakpoint discounts. To make this tool more widely available to investors, we are developing a

version of the Expense Analyzer for broker-dealer websites.

Conclusion

NASD will continue its vigorous examination and enforcement focus on the suitability of the mutual fund share classes that brokers are selling, the compensation

practices between the funds and brokers, and the question of whether brokers are

delivering to their customers the benefits offered to them, such as breakpoint discounts. And as we continue our examinations and investigations into late trading

and market timing issues, we will enforce NASD rules with a full range of disciplinary options—which include stiff fines, restitution to customers, and the potential

for suspension or expulsion from the industry. While NASD cannot alone solve all

the problems revealed in recent months in the mutual fund industry, we have jurisdiction over all broker-dealers that sell these products to investors and will rigorously exercise our authority to take actions against violators as part of our overall

efforts to protect investors and to restore investor confidence.

179

(181)

UNDERSTANDING THE FUND INDUSTRY

FROM THE INVESTOR’S PERSPECTIVE

WEDNESDAY, FEBRUARY 25, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10:03 a.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD SHELBY

Chairman SHELBY. The hearing will come to order.

Today, the Banking Committee continues its examination of the

mutual fund industry. In November, this Committee held the first

two hearings in a series to consider the ongoing investigations,

enforcement proceedings, and regulatory actions concerning the

mutual fund industry. Over the coming months, we will hold additional hearings as we examine the industry and consider whether

legislative reform is needed. Although I have not yet determined

the number of hearings, I expect the process to be comprehensive,

deliberative, and informative.

A number of my Senate colleagues and fellow Committee Members have introduced legislative reform packages. Although these

proposals contain various reform measures, I expect a fully developed hearing record to guide the Committee’s consideration of any

potential legislation. With well over 95 million investors and nearly

$7 trillion in assets with that, mutual funds are the primary investment option for retail investors. Mutual funds have always

been perceived as the safe, long-term investment option, but there

is no doubt that recent revelations about self-dealing and preferential treatment have cast a shadow on the industry. Ordinary

investors were shocked to learn the extent to which fund insiders,

brokers, and privileged clients profit at the expense of the average investors.

The ongoing enforcement actions concerning late trading, market

timing, and selective portfolio disclosure suggest that too often

funds and brokers disregarded their duties to protect investor assets and act in the investors’ best interest. Many of these practices

were open secrets on Wall Street, yet they continued unabated and

undetected by the SEC. Frankly, the prevalence of these problems

must necessarily raise questions about the SEC’s compliance and

examination programs.

182

In addition to blatant malfeasance and compliance failures, this

Committee will examine the transparency of mutual fund operations and the adequacy of current disclosure practices.

Many of the questionable fund practices are not disclosed to most

investors. Furthermore, we have already learned about instances in

which firms act in direct violation of their stated disclosures.

Therefore, this Committee, the Banking Committee, must take a

comprehensive look at the industry to determine if the industry’s

practices are consistent with investors’ interests. We may have to

reemphasize the duty owed to investors to ensure that mutual

funds are operating as efficiently and fairly as investors demand.

In this regard, we will examine revenue sharing, directed brokerage and soft-dollar arrangements to determine how these practices

have evolved and are currently used in the industry.

We will also review a range of disclosure practices regarding fees

and costs, portfolio holdings, the portfolio manager’s compensation

and fund holdings, and side-by-side management of mutual funds

and hedge funds. We will also focus on fund sales practices to ensure that brokers provide adequate disclosure of any sales incentives and information about different classes of fund shares and

give clients any breakpoint discounts to which they are entitled. Although it is critical that investors receive clear, concise, and complete disclosure regarding their investments, we must be mindful

of the possibility that information overload could overwhelm the investor and impede decisionmaking. Although better transparency

and disclosure practices are key components of reform, true reform

will require changes in the boardroom. Fund shareholders rely on

the board to aggressively police potential conflicts of interest and

to vigorously protect shareholder interests.

To some, the recent scandals suggest that many boards have abdicated their responsibilities. Whether boards were unaware of recent wrongdoings or turned a blind eye to such activities, I believe

that either scenario calls for a serious review of board composition,

decisionmaking, and responsibilities. I believe we must understand

how changes to fund governance can minimize conflicts of interest

and reinvigorate the boardroom culture to better protect shareholder interests. In our own ways, the regulators, industry participants, and Congress must collectively work to reform the mutual

fund industry in order to restore investor confidence and integrity

in the fund industry. State and Federal regulators must continue

to vigorously prosecute wrongdoers in order to assure investors

that fund executives and brokers who violate their duties and profit at the average investor’s expense will be punished. Through enforcement actions, the regulators also help to define the full scope

of transgressions, conflicts, and structural problems that are at the

root of the misconduct in the fund industry.

While this Committee examines the fund industry, the SEC is

pursuing an aggressive rulemaking agenda aimed at improving the

transparency of fund operations, strengthening fund governance,

and halting abusive trading practices. Chairman Donaldson told

this Committee that the SEC has the necessary statutory authority

to reform the mutual fund industry, and he is executing his agenda

for reform. Understanding the scope, application, and consequences

of the SEC’s rulemakings will be an important element of this

183

Committee’s process. Beyond rule proposals, the SEC must also

demonstrate how it is revising its compliance and examination programs to ensure that brokers and funds comply with current law

and to detect and halt future fund abuses.

The fund industry and brokerage houses also have a vital role in

this reform process. It would be impractical, I believe, to expect the

regulators to detect every single fraud and manipulation in the industry. Therefore, fund executives and brokers must rededicate

themselves to the fundamental principles of our securities markets—the principle that securities firms and mutual funds should

not neglect investors’ interests and knowingly profit at their expense. Until firms can reassert the ideal of investor protection and

demonstrate an ability to abide by it, investors will not trust the

industry, nor should they.

Finally, Congress also has a critical role in the reform process.

As this Committee examines the issues in the regulatory landscape, we must decide whether legislation is necessary. As we have

learned in other contexts, however, additional legislation is not the

only answer. While we consider various reform measures, we must

be mindful of the cost of reform to investors and be wary of damaging the primary investment option for most Americans. We have

an obligation to ensure that through either enforcement actions,

regulation or legislation abuses are addressed and that transparency and fund governance improves. At the same time, we must

ensure that funds and their fee structures remain subject to competitive market pressures and that reform measures truly benefit

investors without having the primary effect of increasing costs and

decreasing returns. The guiding principle of the overall reform

process is investor protection—reassuring investors that mutual

funds are a vehicle in which they can safely invest their money

and not have their return on investment take a back seat to Wall

Street insiders.

Building on this principle of investor protection, I hope that this

reform process will give investors a better understanding of how

the fund industry operates. Investing in mutual funds or any other

investment vehicle is not a simple task as decisions require an understanding of risk and reward, and an awareness of potential conflicts of interest. To the extent that investors are more aware of

their investment options and their inherent risks, our markets are

better served. An educated investor is a better investor.

Our panelists this morning will share their insights on the fund

industry from an investor’s perspective and will also discuss ways

to improve investor education.

With us this morning are Tim Berry, State Treasurer of Indiana

and President of the National Association of State Treasurers; Jim

Riepe, Vice Chairman of T. Rowe Price; Don Phillips, Managing Director of Morningstar Research; Gary Gensler, former Under Secretary of the Treasury for Domestic Finance, that we all know; and

Jim Glassman, columnist for The Washington Post and Resident

Scholar at the American Enterprise Institute. We look forward to

your testimony.

Senator Sarbanes.

184

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. I join

with you in welcoming this very distinguished panel this morning.

Again, I want to express my appreciation to you for the comprehensive approach you are taking to review the many issues surrounding the mutual fund industry.

Last year, the Committee held two hearings on this subject and

heard from, among others: SEC Chairman Donaldson, SEC Enforcement Director Cutler, New York State Attorney General

Spitzer, NASD Chairman Glauber, as well as the Investment Company Institute President Matthew Fink, and Securities Industry

President Lackritz.

This is one of a series of hearings, and a number of additional

hearings, as I understand it, have been scheduled on this important subject, which clearly merits the close attention that you are

giving to it. As you mentioned, mutual funds are more than $7 trillion in assets and over 90 million Americans, half of all U.S. households, own mutual funds.

We were proceeding along without any sense of trouble. But then

we had September 2003 when New York Attorney General Spitzer

announced that a hedge fund, Canary Partners, had engaged in improper late trading and market timing. He predicted, at the time,

that more instances of mutual fund abuse would follow. Regrettably, they have, involving additional cases of market timing and

late trading, as well as misconduct involving revenue sharing, selective portfolio disclosure, failure to deliver breakpoint discounts,

and other practices.

I think it is fair to say when we began our hearings last November, few of us anticipated the full dimensions of the problem. Since

those hearings, almost every week, additional abuses have been revealed in many mutual fund families and securities broker-dealers,

revealed by the SEC and by various State Attorneys General.

For example, just last month, in January, the SEC’s Director of

Enforcement announced that the SEC had found fund abuses involving revenue sharing at 13 unnamed Wall Street brokerages. On

February 12, just a few days ago, the SEC and the NASD announced actions against 15 firms for failure to deliver mutual fund

breakpoint discounts.

The proliferation of problems reflects, as the SEC said in a recent statement, ‘‘a serious breakdown in management controls in

more than just a few mutual fund complexes.’’

In response, the SEC is actively engaging in rulemaking, and I

want to commend the SEC for the focus they have brought to this

issue and the speed to which they are moving in trying to address

it. The problem has also prompted a number of our colleagues in

Congress to introduce legislation on this subject. We have a range

of statutory proposals that have been placed before Congress.

Questions have been raised about a wide range of issues: Sales

practices, disclosure; how clearly and completely the types and

amounts of fees and other important data are disclosed to investors; incentives that funds pay brokers to sell their shares; soft dollars; fund governance and structure; the performance of directors

and their fiduciary duty to fund investors; the issues of firms that

185

run hedge funds and mutual funds together; and the effectiveness

of regulatory enforcement.

I appreciate the quality of the panel that is here before us this

morning. We are very pleased to have Tim Berry, the Treasurer of

the State of Indiana representing the State Treasurers; Jim Riepe,

Vice Chairman of the Board of Directors of T. Rowe Price Group,

I think fair to say a venerable mutual fund institution, or at least

we so think in Maryland; Don Phillips, Managing Director of

Morningstar; Gary Gensler, who served with great distinction in

the previous Administration as Treasury Under Secretary for Domestic Finance and is the co-author, along with Gregory Baer, of

a popular book on mutual funds, ‘‘The Great Mutual Fund Trap,’’

which makes for very interesting reading. You do not mind my giving a plug to your book here at the outset of the hearing.

Senator CARPER. What was the name of that book?

[Laughter.]

Senator SARBANES. And James Glassman, Resident Fellow at the

American Enterprise Institute. I look forward to hearing the panel.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Crapo.

COMMENTS OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you very much, Mr. Chairman, and I will

be brief because the two of you have both very adequately stated

my concerns as well.

I truly believe that without public trust and confidence, our markets cannot function efficiently and effectively. Recent revelations

of wrongdoing, including the late trading and market timing contrary to fund prospectuses have undermined investor confidence.

I support the approach that you have taken, Mr. Chairman, and

that is to make it very clear that investor protection is the principle which we must utilize as we proceed here to make certain

that the duty owed to the investors by the mutual funds, and

frankly, by the system that we establish is solid, and that it is understood well and that it is followed, and that the concerns that

have arisen about whether the mutual funds are being managed in

such a way that they are following the law and are being implemented according to the contracts and the principles that we expect

of them is occurring.

At the same time, I appreciate the Chairman’s comments that we

also must look at whether new legislation is the best solution. The

first principle we must follow, in my opinion, is to do no harm, and

although there are certain serious problems that have been identified, I think it is also important for us to focus in this Committee,

in our oversight role, on what the proper solutions should be. It is

very possible that if we are not careful, we or others who are trying

to address the issue, could actually raise costs and limit choices for

investors which would be contrary to the very interests of those to

whom this Committee and the entire mutual fund industry owe

their highest duty, the investors.

So, I will be looking here at this hearing and throughout the

hearings that we hold to be sure that we identify exactly what the

problem is, and to identify what the solution should be, to make

186

certain that we achieve that ultimate goal of absolutely rock solid

investor protection.

Thank you.

Chairman SHELBY. Senator Carper.

COMMENTS OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks, Mr. Chairman.

To each of our witnesses this morning, welcome. Some of you

have been before us before, and for those of you who have been before, welcome back. To our State Treasurer, I used to be a State

Treasurer, and our own State Treasurer is now a fellow named

Jack Markell, who is a very able guy, and who I think you actually

may reference in your testimony. I always say to Jack that he is

the best State Treasurer we have ever had in Delaware, and he

and others are quick to agree.

Mr. Gensler, we appreciate especially your service to our country

and welcome you here today.

I do not come into these hearing with any preconceived notion as

to what course we need to follow. I come into it with an open mind,

not an empty mind, but an open mind, and I look forward to this

team here helping to fill the mind a little bit. I think this maybe

is the ‘‘A Team.’’ Mr. Chairman, this is a good group and we look

forward to their testimony.

Thank you.

Chairman SHELBY. Senator Hagel.

COMMENTS OF SENATOR CHUCK HAGEL

Senator HAGEL. Mr. Chairman, thank you. I would just add that

I appreciate the distinguished witnesses appearing here this morning and that I look forward to their testimony.

Thank you.

Chairman SHELBY. Senator Sununu.

COMMENTS OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman. And like Senator

Carper, I do not have any preconceived notion of what we ought

to do here other than be cautious. As Senator Crapo said, we want

to make sure that any solutions that we are contemplating are

grounded in good empirical evidence that will actually address the

very problems that we say that we are concerned about.

We should not be contemplating proposals that micromanage

what is for the most part a very healthy and very vibrant industry

simply because they sound good, simply because they have a nice

rhetorical value or they make us feel like we passed legislation that

dealt with the problem, because that ultimately can be counterproductive. I have emphasized this before in earlier hearings in

this and other Committees, with regard to board structure, independent board members, independent board chairmen, if we pass

legislation mandating the structure of the board, mandating a particular role and responsibility for an individual on the board, and

then we say that that is dealing with this problem. There is no empirical evidence that boards of a particular composition are more or

less prone to the kind of scandals we have heard about, then we

are acting in a counterproductive way because we are creating in

187

the public’s mind the sense that we have dealt with a problem

when we really have not, and in the long run that will only undermine public confidence and credibility of the marketplace.

I think it is important that any proposals, ideas that we debate,

discuss, and vet have some grounding in empirical evidence that

they result in better governance, better management, and a better

product for consumers in the long run.

With that, I look forward to the testimony of our witnesses today.

Thank you, Mr. Chairman.

Chairman SHELBY. All of the witnesses’ written testimony will be

made part of the Banking Committee’s record without objection.

We welcome, all of you, to the Committee again.

Mr. Berry, we will start with you.

STATEMENT OF TIM BERRY

INDIANA STATE TREASURER AND

PRESIDENT, NATIONAL ASSOCIATION OF

STATE TREASURERS

Mr. BERRY. Thank you, Mr. Chairman and Members of the Committee. Thank you for the opportunity to testify before you here

today. As you said, I am Tim Berry, Treasurer of the State of Indiana, but also this year I am honored to serve as President of the

National Association of State Treasurers, and it is in that role as

well that I am here today.

As State treasurers we directly oversee more than $1.5 trillion in

State funds. Additionally, many of us directly oversee or sit on

boards that oversee our public pension funds, our State 401(k) and

deferred compensation plans, and most importantly and significantly, State treasurers for the most part have direct oversight of

the Section 529 College Savings Plans in our States, where citizens, families have invested more than $50 billion over the last few

years in those plans.

What is at stake here? Investor confidence, investor trust. It is

imperative that all of us, large institutional investors as we are as

State treasurers, regulators, as well as the mutual fund industry

itself, place a priority upon the investor interests. Unfortunately,

though, allegations, as you have discussed already, of wrongdoing

go beyond just a ‘‘few bad apples,’’ but it appears to involve a significant number of mutual fund complexes. The National Association of State Treasurers and many of my State treasurer colleagues

on their own have been on the forefront of calling for investor protection reforms. Much of the focus over the last year of the NAST

activities, through the creation of a Special Corporate Governance

Committee and through our own association work, has dealt with

the issues that we are discussing here today.

In recent months the Securities and Exchange Commission has

taken a number of steps to address the issues that have been

raised by State and Federal investigations into the mutual funds’

sales and trading practices. There are several principles in which

the treasurers and the Commission agree will bring about investor

confidence and trust. I will address two of those here today in

transparency of fees, and also fund board independence.

Mutual fund shareholders, in order to better understand and

gain comfort of their investments, should receive a statement of

188

charges debited from their account for management, 12b–1 and

other expenses. It is important that this billing information be both

consistent and thorough and until this system of consistency has

been developed, it is necessary that greater and clearer disclosure

take place immediately. It is also recommended that only the independent directors may vote to approve board fees. They will base

this decision on an itemization of expenditures associated with investment advisory services, marketing and advertising, operations

and administration, and general overview.

Also as it relates to the board structure, many of us believe that

75 percent of the mutual fund’s board of directors shall be independent directors, along with an independent chair. This is a necessary component of providing increased investor confidence and

trust. We also believe that it is important that these independent

directors meet at least annually with their chief compliance officer

and with the independent auditors without the presence of management to deal with the many issues that are at stake here. These

are two of the important components of the mutual fund protection principles.

We commend the Commission for their efforts and believe their

actions will go a long way toward rectifying many of the abuses

identified in recent allegations of the mutual fund industry. But in

order to succeed in our dynamic American economy, we must

ensure that through these reforms, transparency, and greater understanding by the individual investor, will be achieved through

greater financial literacy. Our citizens must be equipped with the

skills, knowledge, and experience necessary to manage their personal finances, their college savings, and their personal retirement needs.

State treasurers have long been involved and recognize the importance of financial education. Through legislative process, State

treasurers support public policy positions that promote savings and

are actively educating our citizens on savings from birth to retirement. These financial literacy programs range across the board to

a variety of target demographic groups, from school-age children, to

women, to senior citizens, to our local public finance officers.

Through these personal finance workshops citizens are learning

how to take control of their own financial situations. Over a third

of our State treasurers have implemented women and money conferences and continuing education seminars. Delaware State Treasurer Jack Markell has developed an innovative Delaware Money

School, designed to bring community-based financial education to

participants in a pressure free, no-selling environment.

A few of the States, as we do in the State of Indiana, provide

educational programs for our local public finance officials. These

workshops provide participants, our county treasurers, city clerk

treasurers, town officials, the school business officials, and tools to

deal with the fiscal and ethical issues that they face when investing public resources.

By bringing about more visibility to the corporate structure of

funds and by enhancing the availability of usefulness of financial

information disclosed by these firms, this Committee can demonstrate to the American investor that mutual funds will continue

189

to operate as the cleanest, brightest investment method for all

Americans.

Chairman SHELBY. Thank you so much.

Mr. Riepe.

STATEMENT OF JAMES S. RIEPE

VICE CHAIRMAN, T. ROWE PRICE GROUP, INC.

Mr. RIEPE. Thank you very much, Chairman Shelby, Ranking

Member Sarbanes, and all the Members of the Committee. I am

James Riepe, Vice Chairman of the T. Rowe Price Group, CEO of

the Price Funds and Chairperson of all of those Price Fund Boards.

T. Rowe Price is a Baltimore-based investment management or- ganization, close to $190 billion in assets under management,

about $120 billion of that is in mutual funds, and we have been

managing investments for nearly 70 years now, and I personally

have been in the business for about 35 years.

I very much appreciate the opportunity to talk to you about my

firm’s efforts to respond to the challenges facing us today, investor

reactions to these challenges, and to share my views on regulatory

changes that I think will help funds move investors forward.

Let me begin by saying that at T. Rowe Price we have always

lived by the principle that the interests of our fund shareholders

are paramount. As such, we have been deeply dismayed by certain

abuse of mutual fund trading practices revealed during the last 6

months. On the heels of the corporate and Wall Street scandals

and because mutual funds historically have been largely untainted

by abuses in the conduct of their business, these revelations have

attracted extensive attention from the regulators, the press, and

the legislators.

Although painful to those of us who are immersed in the task of

stewarding investor assets, I believe this additional attention and

scrutiny, excluding the hyperbole that has accompanied it, is

healthy and will benefit most fund investors and those of us who

serve them. I think your hearings, Mr. Chairman, should further

enlighten that process.

My firm, and I might add, my colleagues in this industry as well,

support appropriate and decisive action by Government authorities

to redress these abuses. We also support changes to bolster an already strong regulatory system. In my view, the SEC has responded to the recent abuses swiftly and with the most comprehensive mutual fund regulatory reform agenda in recent history, certainly in my history. I have stated many times that one of the key

factors in the success of mutual funds is the regulatory scheme

under which funds have operated for all these years.

A little more than 11 years ago I sat in front of your Securities

Subcommittee and argued that SEC’s resources had not kept up

with industry growth. I repeat again today that continued effective

oversight by the SEC, as well as the successful implementation of

any new reforms, cannot be achieved unless the SEC is adequately

and consistently funded.

Mr. Chairman, as your Committee reviews the current mutual

fund situation and regulatory responses, we all need to understand

that in the end ethical behavior cannot be regulated, no matter

how extensive the compliance regulations. Ultimately, each one of

190

us must create an environment within our organizations in which

the right decisions are made by our employees consistent with our

obligation to investors. Although we have seen very strong evidence

that investors continue to recognize the fundamental benefits of investing in mutual funds, we also have witnessed several harsh examples of what can happen if damage is done to the implied bond

of trust between investors and fund managers.

Notwithstanding the improvements represented in some of the

proposed reforms, we recognize that the challenge of maintaining

investor trust falls primarily on those in the fund industry and its

intermediaries and not on the Government. At T. Rowe Price, we

take this responsibility very, very seriously. We have in place, for

example, procedures and practices that seek to protect our fund

shareholders against late trading, abusive short-term trade in

the mutual fund shares, and the selective disclosure of fund portfolio holdings.

In light of the recent investigations and enforcement proceedings,

we have conducted thorough reviews of all of these areas. We have

confirmed that our policies and practices consider to be effective.

We considered ways we might make them even stronger. As an example, we are expanding our annual compliance review meetings

to include all of our employees instead of just our senior staff.

During this review process, we have, as always, kept the fund

boards fully informed, and they have played an active oversight

role, including their decision to extend redemption fees to a number

of additional funds.

With respect to investor communications, we have sought to educate fund investors about these particular issues. We have used

letters, newsletters, and our website to discuss the fund trading

improprieties and how we seek to protect Price Fund shareholders

from such abuses.

Our internal efforts have been supplemented by a series of very

substantive SEC regulatory initiatives. Today, I even understand

that the SEC may be proposing a new rule that would impose mandatory redemption fees on transactions and certain types of fund

shares where shares are held for 5 days or less. We strongly support most of these SEC initiatives and anticipated actions which

are discussed in much more detail in my written testimony. And

I believe that they will go a long way toward stamping out abuses

and maintaining the confidence of investors which you all have

talked about.

I would also like to say a few words about fund governance. In

my opinion, the recent disturbing revelations about mutual fund

abuses do not evidence a failure of the fund governance system, as

some industry critics have charged. These were failures of management, not fund governance. Fund directors cannot and should not

be expected to oversee day-to-day management of the fund’s activities. However, these failures have served to highlight that fund

directors could benefit from being given additional tools to assist

them in executing their oversight role more effectively. Most important of these new tools was a rule already adopted by the SEC in

December that requires mutual funds to establish comprehensive

compliance programs and to appoint a chief compliance officer who

will report regularly and directly to the independent directors on

191

all compliance matters. We strongly believe that this rule, probably

more than any of the other proposed reforms, will have the most

far-reaching effect on how fund managers conduct their day-to-day

business, and it should significantly improve the directors’ ability

to oversee fund compliance.

The Commission also has proposed certain new governance requirements, such as requiring that a fund’s independent directors

periodically meet in executive sessions, that fund boards conduct

regular self-assessments, that the independent directors have the

express authorization to retain experts and hire staff. Although

ours and many other fund boards already adhere to these practices,

formal requirements will emphasize their importance.

Unfortunately, a few of the SEC governance proposals are, in my

view, unwarranted, unrelated to the abuses that have been discovered, and in fact, could be counterproductive, as Senator Sununu

pointed out. In particular, the idea of a Government mandate that

all fund boards must have an independent chair makes no sense

to me at all. Recent events demonstrate that having an independent chair is certainly no silver bullet. Since independent directors constitute at least a majority and typically a supermajority of

fund boards, why should those directors not be allowed to determine who their chair should be? In the case of T. Rowe Price, we

have had at least a two-thirds supermajority of independent directors for many years, and they have appointed a lead director. They

do not believe they need an independent chair to enhance their influence, but would name if they wanted to. For example, they have

retained their own independent fund counsel for more than two

decades, and several years ago they requested that the fund’s advisor change its independent auditing firm because it was also the

fund’s auditor. Although changing auditors in a public company is

a very big deal, as you all know, we made the change.

Let me quickly mention two other SEC initiatives with respect

to fund distribution. We support the SEC’s recent proposal to ban

the practice of directing fund brokerage transactions to reward

broker-dealers who also sell fund shares. Further, we believe the

Commission’s decision to take a fresh look at Rule 12b–1 is both

prudent and timely. The SEC has also proposed to require brokerdealers to give mutual fund investors a new point of sale disclosure

document containing information about sales related fees and payments. This is consistent with a longstanding fund industry recommendation, I might add. If executed properly, and perhaps not

limited to just sales related costs, I believe that this document

could meaningfully enhance the investor awareness and understanding of a fund’s investment program, its risks, costs, and fees

associated with it.

In closing, I would like to emphasize that T. Rowe Price has been

and continues to be committed to acting in our fund shareholders’

interest, and we believe most other fund managers seek to do the

same. We understand very well the fiduciary relationship that exists between us and our investors. We also know that we operate

in a highly competitive marketplace and we understand that over

time, in order for us to be successful, our investors much be successful. The current challenges have presented those of us in the

fund industry with an opportunity not only to improve the reguVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00203 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
192

latory scheme under which we operate, but also to recommit ourselves to investor interests. I assure you, we will all take advantage of that opportunity.

Thank you.

Senator SARBANES [presiding]. Thank you very much. I might

note to my colleagues that there is a vote going on. The second

bells have rung. Chairman Shelby went at the outset. He hopes to

get back before we all have to depart to vote, in which case the

hearing can continue. If not, I will recess at the appropriate time

and we will flee the room in order to make the vote.

Mr. Phillips, we would be happy to hear from you. Let me just

note, though, that we very much appreciate the careful thought

and effort that obviously went into the written statements. We

have had a chance to review them, at least preliminarily, and I

must say I am struck by the care and the comprehensiveness of

many of the statements. It is enormously helpful to the Committee

that this effort has been undertaken by the people who are on the

panel today.

Mr. Phillips.

STATEMENT OF DON PHILLIPS

MANAGING DIRECTOR, MORNINGSTAR, INC.

Mr. PHILLIPS. Thank you for the opportunity to appear before

this distinguished Committee. My name is Don Phillips and I am

a Managing Director of Morningstar.

As a leading provider of mutual fund information to both individual investors and their financial advisors, Morningstar has had

a front-row seat to witness both the rapid rise and the recent

missteps of this important industry. We have seen a generation of

Americans embrace mutual funds for their compelling combination

of convenience, instant diversification, and professional management. The industry’s rise has not solely been due to these merits,

however. The mutual fund industry has also been the beneficiary

of considerable good fortune. Numerous legislative acts such as

those allowing individual retirement accounts, 401(k) plans, and

529 plans have encouraged investors to place billions of dollars into

funds, greatly enriching those companies that offer them. As a result, mutual funds now occupy a central position in the long-term

savings plans of more than 90 million Americans.

Given the privileged and highly important role that mutual

funds now play, it would behoove the industry to redouble its commitment to the effective stewardship of the public’s assets. Most

individuals who work for mutual fund companies embrace this

challenge, but the recent scandals make it abundantly clear that

too many people in this industry were willing to forsake their responsibility in exchange for short-term personal profit. Investors

are angered and confused by these scandals. While few question

the inherent benefits of mutual funds, it is clear that the industry

has foolishly jeopardized its greatest asset, the public’s trust.

Investors need reassurances that their trust will not be further

betrayed. In particular, I believe they need to know that mutual

funds operate on a fair and level playing field, that checks and balances exist to safeguard investor interest, that adequate information will be available to allow investors or their advisors to make

193

intelligent decisions about their funds, and ultimately that mutual

funds offer a reasonable value proposition.

While market forces can and will do much of the work, the industry and regulators can take steps to ensure that mutual funds meet

their obligations to the American public. Specifically, Morningstar

endorses these 10 steps:

(1) Close the door to timing and late trading abuses so that

short-term traders do not undermine the returns of long-term investors. (2) Eliminate directed brokerage and better disclose payto-play arrangements so investors know that the funds chosen for

their portfolios are done so on the basis of investment merit, not

on the willingness of the fund to pay for shelf space. (3) Eliminate

soft-dollar payments so investors can see the full cost of investment

management. (4) Eliminate or seriously reconsider the role of Rule

12b–1 fees, to make clear to the investor which costs go to pay for

fund management and which costs go to pay for distribution. (5)

Maintain vigilant and appropriately funded regulatory oversight.

(6) Make fund directors more visible and more accountable to

shareholders. While much has been made about the independence

of directors, we think a much more important issue is the visibility.

What is deeply alarming is in situations like Putnam, where there

have been whistleblowers, the whistleblowers did not even think to

go to the fund boards. If the fund boards are out of sight and out

of mind, they cannot fulfill their responsibility to investors. (7) Disclose fund manager trading and their trades as a deterrent to the

activities seen at Strong and Putnam where managers traded their

funds aggressively while encouraging investors to hold on to theirs.

(8) Disclose fund manager compensation. All investors have a right

to see that their interests are aligned with management’s. When it

comes to equities and common stocks in the United States, investors have the ability to see how management is compensated and

how they are incentivized. When it comes to mutual funds, investors do not have access to that same basic information. (9) Improve

portfolio holdings disclosure so that investors can make better use

of funds. Too often in the late 1990’s we saw investors buying what

they thought was a diversified fund, only to learn the hard way

that those funds in practice had more than half of their assets in

technology stocks. If investors do not know what is in their funds,

they cannot use them wisely. (10) State fund costs in actual dollars

like any other professional fee is stated, so that the market can

work efficiently and there can be a true debate over whether it is

good value brought for the cost that is charged.

Mutual funds have a proud history, but the recent scandals have

badly damaged the industry’s credibility. Collectively, legislators,

regulators, and industry leaders can rebuild the public’s trust in

mutual funds. Investors need assurances that the field is level, that

safeguards exist, that their manager’s interests are aligned with

theirs, and ultimately that mutual funds represent good value. By

addressing these concerns the industry can get back on track to

helping investors meet their goals and secure a safer future for

their families.

Thank you very much.

Senator SARBANES. Thank you.

194

We are going to suspend the hearing, we need to go vote. As soon

as the Chairman returns, the hearing will resume.

[Recess.]

Chairman SHELBY [presiding]. The hearing will return to order.

Mr. Gensler, we have a vote going on as you know. I tried to get

here for Senator Sarbanes. We will all be coming and going.

Again, welcome to the Committee. You have spent a lot of time

around us. Thank you.

STATEMENT OF GARY GENSLER

FORMER UNDER SECRETARY

FOR DOMESTIC FINANCE

U.S. DEPARTMENT OF THE TREASURY

Mr. GENSLER. Thank you very much Mr. Chairman and Members

of the Committee.

Chairman SHELBY. Other Committee Members are on their way.

Mr. GENSLER. Mr. Chairman, I believe that the scandals reveal

the need for substantive reform in mutual funds governance. Only

when independent directors act in the full interest of investors will

we safeguard against the inherent conflicts that will always be

there. These conflicts will not go away, lest we forget. But fund

management companies, as distinct from the funds themselves,

have their own shareholders and their own profits to consider. That

is natural. That is good. Many of them will charge high fees even

if this lowers investors’ returns.

The SEC has been very active addressing specifics of late trading, market timing, breakpoints, ethics officers, et cetera, compliance officers, and in many ways these are very good actions, but

they in some ways treat the symptoms of a greater problem. To address that problem——

Chairman SHELBY. Explain. You are going to though, explain if

treating the symptoms and not the real fundamentals.

Mr. GENSLER. I believe that the Congress will need, if they wish

to address the core problems, to mandate that independent directors truly act as gatekeepers for the benefit of investors, not in

name only, but in reality, and I believe that we simply have no

choice but to do this as we prepare for the retirement of the babyboom generation.

I see this whole debate about mutual funds around preparing

ourselves for this inevitable retirement of the baby-boom generation, and Congress will address itself to Social Security, Medicare,

and so many other things, but this is a core of that same debate.

Mutual funds operated in the best interest of investors would, in

fact, lower costs and increase investor returns, and if that were the

case, would increase retirement savings and ultimately lower the

cost of capital for the overall economy. I think that is what is at

the core of this debate.

The SEC noted, just for instance, that a 1 percent increase in

the funds’ annual expenses can reduce investors’ account balance

in the fund 18 percent after 20 years. It is just arithmetic, but it

is a critical factor. With costs totaling close to 3 percent a year for

the average investor, about half of that is the annual expense ratio,

but then there is the portfolio trading costs, the triggering of shortVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00206 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
195

term capital gains, and of course, half of funds have sales loads on

top. It is about $100 billion a year for the overall industry.

To accomplish these goals I believe that Congress should look at:

First, strengthening fund governance; second, restricting payments

under 12b–1 fees and soft dollars, and of course, third, enhancing

certain disclosures.

While the SEC has an important role to play, I do not believe

that they can do it all by themselves. In terms of governance in

particular, I think the most important thing to do is to clarify the

duties of independent directors and the standards to which they

are held. In practice, fund directors have a difficult time striking

a proper balance between working with the advisor and pursuing

investors’ interest. Why is that? First, directors are recruited by

the fund companies and serve on a multitude of fund family

boards. They serve only part time, of course. They rely solely, and

if not solely, largely on management company for all of their information. In addition, there is a landmark case that has proved

to be somewhat insurmountable. It is called the Gartenberg case.

The Second Circuit’s Court of Appeals in 1982 ruled what? That

‘‘To be found excessive, the trustee’s fee must be so disproportionately large that it bears no reasonable relationship to the services

rendered and could not have been the product of arm’s-length

bargaining.’’

The result of that? Twenty years later not one shareholder has

subsequently proved a violation of the Gartenberg standard and

not once has the SEC sued a fund director for failing to review adequately the advisory agreement. I truly believe that there are many

great firms in the mutual funds industry, but to think, with 9,000

funds and 20 years there have not been any bums that have failed

to live up to a standard, tells us something about the standard.

So in this environment, how many well-meaning directors would

really make waves? What if mutual funds directors were actually

vigorously negotiating fees and other costs? Would not retirement

savings increase in America? While I am not suggesting, as some

have, that we have mandated requests for proposals and changing

fund advisors, I do believe that the 1940 Act could be amended to

include a general fiduciary duty for directors to act with loyalty

and care in the best interest of shareholders. I believe it can mandate that the SEC promulgate rules for directors in carrying out

these duties, requiring that independent directors formally meet

without the interested parties, spell out the list, a small list of the

major contracts that they have to really review and get their minds

into. Maybe they should require true arm’s-length negotiation. It is

a tricky area. It is not without its pluses and minuses, and then,

of course, I think amend or repeal the Gartenberg standard. The

SEC cannot do that. Only the Congress can. It is another situation

where the courts, albeit 20 years ago I think, took a step maybe

too far.

I do believe that it is important that the definition to independence be tightened, and how we recruit and select directors, and I

also do support the SEC’s proposal on board chairs and 75 percent

independent directors. I would say though it is not a silver bullet.

Current law already requires that independent directors review

and make the key decisions, but legislation really should clarify

196

how they make the decisions, and this earlier comment on the

Gartenberg decision. But let me say anybody who doubts the importance of a chair, just think about all the energy, politics, and

resources that goes to putting you, sir, in that chairmanship there.

So, we all know there is some relevance to a chairmanship.

Beyond governance, I believe that Congress should give serious

consideration to restriction of 12b–1 fees and soft-dollar agreements. Most importantly on 12b–1 fees, they were promulgated in

another time, in another era, and I think their time has come.

They have not served their useful purpose.

On greater disclosure, while there is a series of things in my

written testimony, I think most relates to disclosing portfolio trading costs; eats up about a half a percent to three-quarters a percent

a year. It can be estimated. It can be disclosed. I think it is very

relevant.

In sum, again, I think this is all about retirement savings and

promoting retirement savings, and within that window I think

there is a call and a need for Congress to act beyond that which

the SEC is doing.

Thank you very much.

Chairman SHELBY. Thank you.

Mr. Glassman.

STATEMENT OF JAMES K. GLASSMAN

RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

Mr. GLASSMAN. Thank you, Mr. Chairman, and thanks for inviting me today.

In the wake of the scandals involving late trading and market

timing in mutual funds, a flood of proposals both legislative and

regulatory have been introduced to change the industry. My message to you today is that you should proceed extremely cautiously

in making changes. I say this as someone who has written a

syndicated financial column for the past 10 years, as well as two

books geared toward small investors. I fear that many of the proposals will hurt and not help small investors by adding costs and

by reducing choices. I will review them briefly and recommend different approaches.

But first let me say something as clearly as I can, the American

mutual funds has been the most successful financial vehicle of all

time. In 1970, there were 361 funds. Today, there are 8,124. In

1970, assets totaled $48 billion; today, $7 trillion. The mutual

funds is a very simple idea, a portfolio shared by thousands of

shareholders, composed of stocks, bonds, or cash managed by a professional. In the past only the rich could afford this. Now about

half of the households own mutual funds. They pay modest fees.

For no-load equity funds, an average of about $125 a year for every

$10,000 in assets, the most popular fund charges $18 a year, and

investors have vast choices.

This is a highly competitive industry, and it is getting more so.

The top five fund houses account for only one-third of assets, and

studies show that fees are falling. And I urge you, do not do damage to this success. You do so at the peril of the U.S. economy and

the well-being of small investors. I agree with what Senator Crapo

said earlier, ‘‘first, do no harm.’’

197

Investors have already spoken in response to the scandals, and

very forcefully. They have withdrawn money from the accused

firms and they have rewarded untainted firms. Just as one example, $29 billion in assets was withdrawn in 2003 from Putnam, one

of the miscreants, last year. Meanwhile, three untainted firms—

American, Vanguard, and Fidelity—gained a total of $133 billion

in assets.

Let me just move quickly to specific proposals. I oppose a hard

4 p.m. close on trading activity since it hurts small investors who

will have to get their orders in many hours before the close or suffer stale pricing. I oppose a mandatory 2 percent redemption fee

because it serves as a kind of price fixing cartel for mutual funds,

and impedes the exit of dissatisfied investors. Instead, you should

encourage the exit of investors as a way to discipline poor funds.

In that regard, I back a proposal by Bruce R. Bent to allow unlimited rollovers from one fund to another without incurring capital

gains taxes. Currently, taxes prevent exit, helping a poor fund

keep customers.

I oppose proposals to increase independent directors and have an

independent chairman. Academic research and common sense show

that this is no solution to bad governance. Enron had 11 independent directors who headed every single one of its board committees. Instead, I suggest a reexamination of the antiquated legal

structure of funds set by a law 64 years ago. This kind of reexamination has been advocated by Amy Borrus and by Paula Dwyer

of Business Week and many others. Why should 8,000 funds each

be a separate company with a separate board? Funds should be

treated in the law as what they are and what people think they

are, investment vehicles offered by investment firms.

The concern over the composition of fees is equally misguided.

Investors do not care whether this or that charge is ascribed to

12b–1 or to management fees. Let every firm simply state charges

without ascribing costs. When I buy a bicycle the company does not

say that the price comprises this much in health care costs and this

much in rubber.

On disclosure, let us be serious. My readers do not pay any attention or pay very little attention to current disclosures. Why add

a dozen more? No industry discloses more about its fees and performance. I would very much like to see competitive disclosure, absolutely, where companies brag about their best points including

their low fees, but let the companies make these decisions in response to what investors really want.

Now, my most important recommendation. Finance is rapidly becoming democratized in the United States, primarily by the mutual

funds and the 401(k) plans. But too many Americans know too

little about the basics of finance. Investor education is a job for

Government, as well as the private sector. Current efforts are diffused and underfunded, and it is investor education, not more

rules, that you should put your energy into.

Finally, I want to congratulate Eliot Spitzer, William Donaldson,

other regulators, law enforcement authorities, and the Congress,

who have moved quickly to uncover and prosecute the miscreants

in the current scandals. Illegal and fraudulent activity was found

and perpetrators were punished. This is hugely beneficial, but this

198

does not mean that major changes are necessary in the regulation

of funds. I urge you to proceed with a yellow or even a red light,

but not a green light.

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you, Mr. Glassman. I thank all of you.

Mr. Riepe, some question the sincerity of recent efforts by funds

to reach out to their investors. For many there seems to be a credibility gap between what the funds are doing now compared with

what so many were doing before the recent revelations. How do you

address this assertion and how can the investing public be sure

that funds will continue on the straight and narrow once the current attention has shifted away?

Mr. RIEPE. Obviously, I cannot speak for the thousands of fund

groups out there, Mr. Chairman, but I can tell you——

Chairman SHELBY. Speak for your own company.

Mr. RIEPE. As I said, in our particular case, we actually have had

very few inquiries from investors about this. Just to take one, I had

a review done of the hits to our website, and we have an icon up

on our website that talks about the mutual funds abuses, and less

than one-hundredth of 1 percent of the hits over the last 2 months

went to that site.

Chairman SHELBY. Is that because they have confidence in T.

Rowe Price?

Mr. RIEPE. We hope it is some of that, but obviously it is also

in terms of what people’s interests are, and what we have found

is the people who are invested with someone whose name has been

in the papers as being involved, has suffered a very big penalty and

those people are very aware of it. The rest of the industry, which

is the bulk, obviously, of the industry, that has not been tainted

by that, those investors accept that. What that says to me is that

the people are not worried about the underlying fund structure.

They are not worried about mutual funds. It is not the S&L scandal where you worried about every S&L even though yours might

not have been in the headlines. In this case it seems to me that

investors are only worried about those that they have seen in the

papers.

I do think we are trying to communicate, and I do not think people are being duplicitous in terms of how they communicate. As Mr.

Glassman pointed out, the penalty that has been exacted on those

whose names have been in the paper under these allegations has

been much, much more severe——

Chairman SHELBY. Comes in the market, does it not, sometimes?

Mr. RIEPE. Yes. The market takes care of those things, and much

more so, frankly, then the penalties that the prosecutors have had.

So anybody who is not watching that, and is not changing their

behavior if, in fact, it has to be changed, I think is making a very

big mistake.

Chairman SHELBY. Mr. Phillips, many investors are understandably concerned about the fund industry and are trying to understand the full scope of recent problems. What factors should investors monitor over the next few months as they evaluate their portfolios, and how would you advise the investing public to respond to

the wrongdoing in the industry? Are they already responding?

199

Mr. PHILLIPS. I think clearly they are responding, and I think

they are responding in an intelligent fashion. We have seen money

go into the fund industry at a near record rate, which says that

investors recognize that there is something very right about this industry at its core, and I would point out that——

Chairman SHELBY. Are the investors being a little selective on

what funds to go into?

Mr. PHILLIPS. Absolutely, they are being more selective. First,

they realize that there is a good value here. We track funds in 17

different countries, and nowhere else in the world is the value

proposition of mutual funds as strong as it is in the United States.

So there is something about the system, whether it is the corporate

structure, the directors, the entire way that the industry is policed

that is working for investors, but investors have radically been

moving their money away from those groups that have been named

and toward the others.

But I would argue that what is really happening is an acceleration of a trend that was already in place. You see the major companies that are winning in this industry, firms like T. Rowe Price,

firms like Fidelity, Vanguard, American Funds, these are firms

that not only have not been involved in the scandals, but they are

also firms that——

Chairman SHELBY. Integrity counts.

Mr. PHILLIPS. Integrity counts, and integrity shows itself in

many ways. None of these firms offered Internet funds, whereas a

lot of funds that were involved in the scandals were out offering

the hot fund at the wrong time at the market peak. All of these

funds have offered at below-market cost. Investors recognize integrity over time. The question is: Could you state costs more clearly

so that investors do not have to suffer through 10 years of bad performance in a high-cost fund before they recognize the debilitating

effect that high costs have on performance in the long-term.

Chairman SHELBY. I want to pose this next question to Mr.

Glassman and Mr. Gensler. But I want to first tell Mr. Glassman,

we are proceeding with caution because I think that if we are thorough in these hearings we learn more and we should not rush to

judgment. This industry is too big. It is too complicated, it is too

important to do otherwise, and we are pretty aware of that up

here. I appreciate your remarks.

Mr. Glassman and Mr. Gensler, some contend that the presence

of so many high-cost funds is proof that competitive market forces,

which should theoretically drive down prices, are not working in

the fund industry. How would you respond to this assertion, Mr.

Glassman? Why is it that some funds can attract billions in assets

with relative poor performance and high fees? Should regulators

mandate fees? That would be troubling to me.

Mr. GLASSMAN. That would be extremely troubling. Investors

want and need help, and they are willing to pay for it. So that it

is not simply the returns that a fund produces that should be the

factor on which people make decisions about which funds to buy.

People need hand-holding. People need the kind of advice you get

from a third party, and usually these commissions, loads are being

paid to funds that result through third parties. But they have

choices, and they have massive choices, and they can go to a fund

200

like Vanguard Index 500 for 18 basis points, and get what they

want with less hand-holding but lower returns.

The second reason—and this I bring up in my testimony at the

end—interesting new research, really is that investors are not as

educated as they ought to be, especially investors who have entered

the market recently. They really do need help. I just will give you

an analogy. I mean if I were to go look for a tie at some mall in

Washington, I would pretty much know where to find the best

value at the lowest cost. But if you plunk me down in Morocco and

tell me to find a tie, I would have a hard time doing it. Now, I

might just go to a brand that I trust if I see a brand name somehow in the souk in Morocco that I trust, and that is the position

that many investors are in, and we really need to help them.

Chairman SHELBY. Mr. Gensler.

Mr. GENSLER. I would say first, I do not think that Government,

the SEC, the Congress should mandate fees.

Chairman SHELBY. Thank you.

Mr. GENSLER. I think that is just not my upbringing. I think

markets do work well.

But I do think that this overall market breaks down in a number

of ways, and let me name five of them very quickly, and I detailed

this more in my written testimony. One is investors. We Americans

have a collective desire to rely on experts and in particular in that

reliance on experts to chase past performance. Why is it that every

January and February we see the financial magazines showing the

hot funds of last year. It is not the magazines’ fault. It is because

we Americans want to read about the hot funds of last year. Two,

I think that there is an effective advertising of the mutual funds

industry. That is good business to promote the hot funds of last

year, but every academic study shows the hot funds usually are not

that good performing next year. Three is the inherent conflicts of

brokers and financial planners. All of these things, their revenuesharing arrangements, they come back to haunt us when a broker

is pushing a fund that is not necessarily the best fund. Yet, many

funds feel they have to engage in it. T. Rowe Price, which I think

is one of the finest firms—but I have to admit a conflict here, Jim.

My identical twin brother works for Jim—but does not pay loads,

but why do half the funds——

Chairman SHELBY. It does not help much.

Mr. GENSLER. You mean the twin brother? They do want to know

why he cannot control his brother better.

Chairman SHELBY. That goes on in families.

Mr. GENSLER. That does go on in families.

My point of this though is that half of all funds feel they have

to pay loads to get access to that distribution. That pushes up

costs. Four, is the unique way the industry charges for the fees. We

are not going to change this, but it is just a reality that it is very

convenient. It is just taken out. You do not have to write a check

for it, and I am not suggesting changing it, but it is a reality.

And last, there is a practical barrier to changing fund families.

Many investors are invested through 401(k)’s, their corporation

picks the fund, many investors find they want to keep a money

market fund where they have other funds. So, they are just a pracVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00212 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
201

tical reality. I think those five reasons make it more difficult for

market forces to work as cleanly as we would like them to.

Chairman SHELBY. Senator Sununu.

Senator SUNUNU. Thank you, Mr. Chairman.

Mr. Gensler, in your testimony you state that there is no way a

chair who also works for an investment advisor can satisfactorily

serve two masters. What evidence is there to support that claim?

Mr. GENSLER. The evidence really is the history of high fees. As

I said in the testimony as well, or in my oral statement, I believe

that many of these scandals, the market timing, the late trading

and so forth, will be addressed by the SEC and in many ways adequately addressed. But they are symptomatic of something other

about governance, and it is a very difficult challenge that these

fund directors, not one that I would wish to have for myself, being

selected by the fund management company and then being put in

a position to try to serve the best interest of investors.

Senator SUNUNU. Are you suggesting evidence that funds with

chairs that work for investment advisors historically have demonstrated higher fees than those funds that do not?

Mr. GENSLER. I have not seen data on that, but to be able to

serve as a chair and both promote the highest profits for a fund

company while at the same time trying to promote the highest investor returns is a conflict of two sets of fiduciary duties. It is a

burden that really cannot be managed I believe. How do you maximize the profits of the fund company and rightly maximize the

profits of the fund company, and at the same time maximize the

returns to the investors.

Senator SUNUNU. I mean it seems to me that history has shown

that the way to maximize the returns of the fund is to ensure that

investors have confidence in that fund and thereby are willing to

invest money with that fund, and if recent history has shown us

anything, it is that investor discipline against those funds that lose

public confidence or credibility can be stunningly harsh. The folks

at Putnam, I am sure, will attest to that.

Mr Riepe, could you talk a little bit about the concept of an independent lead director? What does that mean? What is their role,

and how do they interact with an interested chairman in the case

where there is one?

Mr. RIEPE. Yes, Senator. In fact, in response to your question to

Mr. Gensler, I think there is a lot of data, and the fact is that all

of the very low-cost funds out there also have chairmen who are

members of the advisors and come from the advisor. So the evidence is quite strong that the chair has nothing to do with the fees.

Otherwise, we would have no low-cost funds because most of the

chairs are also involved with the advisor.

Senator SUNUNU. I am sorry. I just want to be clear. You are

suggesting that interested chairs that may also serve the advisory

company actually understand that low fees attract customers and

enable them to make more money?

Mr. RIEPE. I am saying that we have, for example, in T. Rowe

Price’s case, we have an interested chair who is chair of the fund

boards, and our mutual fund fees, 100 percent of our funds below

the average of all of their groups, and there are other fund groups

with fees lower than ours, and they also have interested chairs. So

202

the correlation between an interested chair and a disinterested

chair seems to me to have very little to do with the cost of the fees.

I also think that the ‘‘high fees,’’ the evidence would indicate that

fees have come down over the last 25 years in a very material way,

and so, I do not know where Mr. Gensler—what his basis is of the

high fees.

In our case with the lead director, I think it is very relevant because—and I will speak for our situation—it is a decision that the

fund directors made on their own, and that is, they felt they wanted to have one of their people be the point person in effect working

with the advisor, and in our case the lead director sees the agenda

for the meetings beforehand, reviews that agenda, has comments,

gets involved with some of our vendors, does various things that

the other directors would want them to do, and performs in that

function. He does not want to be chairman of the funds because—

as the Chairman said—this is such a complicated business. He

thinks it would be a bit of a charade to put a part-time independent director in the chair’s seat and pretend, in effect—and I

think you alluded to this in your opening comments—it gives an

impression of a lot more authority and power and independence

and knowledge than frankly exists. And that has been the reaction

to all of the suggestions from our independent directors.

Senator SUNUNU. Mr. Phillips, in your recommendations, I think

you recommend disclosing fund manager compensation. I have not

worked in the investment industry, but I am very pleased that I

have some private sector experience working for a small manufacturing firm, so in theory, I am still employable after I serve in the

U.S. Senate.

[Laughter.]

But it would seem to me that in the private sector disclosing key

compensation beyond which is required in the 10(k)’s, executive

compensation but disclosing other key employee compensation, unless it is applied in a very, very broad and uniform way, would put

funds at a tremendous competitive disadvantage relative to money

managers and private banking, at hedge funds, and investment

banking, that can just go right down the list and find those fund

managers that they think have performed well or have unique sets

of analytical or other skills, and on the basis of this information,

pick them off.

Mr. PHILLIPS. Senator, it seems to me that there is an obvious

template for this. Publicly traded companies, the key officers are—

their full compensation is disclosed. We know to the penny what

Michael Eisner is paid to——

Senator SUNUNU. Executive compensation is disclosed in a 10(k).

I do not know if it is the top five paid or the top 10 paid, but that

is for all public companies 100 percent.

Mr. PHILLIPS. That is correct. And every day we talk with fund

managers who say before they buy stock in a company they look

and see how management incentivizes. They like to see how much

is in base pay, how much is in bonus, how much is in stock compensation. In fact, I have spoken to fund managers who have commented on Mr. Riepe and said how much they like T. Rowe Price’s

bonus structure and where their senior executives have a low base

203

salary and get most of their compensation in bonuses and have significant stock options.

So, it seems to me, why shouldn’t fund investors have that same

kind of information to know whether a fund manager’s compensation is linked to sales, new sales of the fund or simply to performance, or is his or her bonus tied to short-term raw performance or

longer-term risk-adjusted performance? Is it tied to pre-tax or posttax returns? If you are an investor thinking about buying a mutual

fund, and you are thinking about putting it into a taxable or a nontaxable account, would it not be significant to know if the fund

manager’s bonus is linked to pre-tax or post-tax returns?

The notion that it would put the fund industry at a significant

disadvantage to hedge funds and other types of money management, I think to buy into that argument you would have to say that

publicly traded companies are at a significant disadvantage to privately managed ones, because all of the good managers want to go

run privately managed companies so that their compensation

would not be disclosed publicly, and I do not think anyone would

buy that. Obviously, we are able to get very talented and good people to run publicly traded companies even though that comes with

the burden of having your salary disclosed, the same way we can

get people to run for the U.S. Senate, even though it comes with

the burden of having a significant exposure to your personal income taxes.

It seems to me that all investors have a right to know if their

interests are aligned with management’s interests. We have a great

template for that with publicly traded stocks, ones that fund managers take advantage of, but then those managers turn around and

do not give the same significant and valuable insights to their

shareholders.

Senator SUNUNU. If I am buying aluminum siding for my home,

should the company be forced to publicly disclose the compensation

package for the salesman who is selling me the aluminum siding?

Mr. PHILLIPS. I do not think that mutual funds are a product.

There is not a fiduciary responsibility that goes with aluminum

siding. There is a fiduciary responsibility that goes with the management of mutual funds.

Senator SUNUNU. You talk about making directors more accountable to shareholders. Can you offer some specifics there, how that

might be accomplished?

Mr. PHILLIPS. Yes, absolutely. To me, again, the visibility is the

much more significant issue than the independence. As I mentioned in my oral testimony, one of the disturbing things that organizations like Putnam—which has a very visible board and a very

strong board—is whether whistleblowers at Putnam, none of these

whistleblowers thought to go to the board. My point is that mutual

funds’ boards have been out of sight and out of mind. In fact, you

saw that in last Friday’s Wall Street Journal, where there was a

letter to the editor in response to Ned Johnson’s editorial, looking

for—stating that independent directors are good. The woman who

wrote the letter back was clearly confused. She thought that a dependent director was one who owned shares in the mutual funds,

not one who also owned the management company.

204

What we have suggested is to have front and center the identity

of the directors. Right now the identity and the role of the directors

is in the statement of additional information. What we have asked

for is to have a statement at the beginning of the mutual funds

prospectus that says something along these lines: When you buy

shares in a mutual fund you become a shareholder in an investment company. As an owner, you have certain rights and protections, chief amongst them an independent board of directors whose

main role is to represent your interests. If you have comments or

concerns about your investment, you may direct them to the board

in the following ways.

As I share in my testimony, I have met a number of independent

directors over time, and they have very little contact with fund investors. I met one gentleman who was on the board of a number

of mutual funds and also on the board of a Fortune 500 company.

And he told me as a member of that Fortune 500 company’s board,

he received about a dozen letters a month from shareholders, and

he said he did not respond to every one, but he read every one. He

said over time they made him a better director. But he said in 10

years of being an independent director at a mutual funds complex,

he had never once received a single letter from shareholders.

My simple question is: How can these people be the voice of

shareholders if they do not hear from shareholders?

The other thing that we would ask for is that the chairperson

write back to investors in the annual report each year to simply

discuss how they reviewed the management contract, what concerns they had, what actions they took on shareholders’ behalf for

that year to create some more visibility for the board so that the

board can truly fulfill its function.

Senator SUNUNU. Given that limited shareholder contact, are

you supportive of the idea of mandating a disinterested chairman

for funds?

Mr. PHILLIPS. I think that is more of a superficial solution than

anything else, but the superficial and the symbolic things count as

well, and I think it would be a step that perhaps would give investors some assurances that at least one independent director will be

fully engaged in working on these. To me, one of the most disturbing things I have heard through the years are the extraordinarily disparaging remarks that fund industry officials will make

about the independent directors. I have been told repeatedly that

the biggest challenge is keeping the independent directors awake

at the meetings, and as long——

Senator SUNUNU. I am sure that is not true.

Mr. PHILLIPS. You hear it regularly. We have to get these people

engaged. I really believe that there is something about the corporate structure of funds that has made the mutual funds industry

in the United States a better industry than the mutual funds industry anywhere else in the world. So the boards have done something right. If we are going to keep the boards, if we are going to

have the cost of boards, let us make sure they are front and center

in the public’s mind so that they truly can fulfill that function.

Senator SUNUNU. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Carper.

205

Senator CARPER. I will yield to Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

I apologize to the panel if I ask questions which repeat testimony

that has been given or other questions that have been asked, but

since I was out of the room with the vote, I missed part of this.

The first thing I want to focus on is the—because there is a tendency to, I think, concentrate on the abuses for obvious reasons, I

mean the most manifest abuses, and late trading and things of that

sort. But I want to get some sense of the amount of monies that

are involved in the broad picture, and therefore the importance of

the mutual funds industry and its proper governance and how it

works, just in a broader social setting.

Mr. Gensler, you say that the SEC noted the potential effects on

retirement savings when they stated a 1 percent increase in a

fund’s annual expenses can reduce an investor’s ending account

balance in that fund by 18 percent after 20 years. In other words,

as I understand that, over a 20-year period, say if you were in a

fund that had a 0.5 percent fee as opposed to a fund with 1.5 percent fee structure. I know the former is pretty low, but I think

there are some that are even beneath that point. That the difference for the investor after 20 years, it would be an 18 percent

difference. Is that correct?

Mr. GENSLER. That is correct, sir.

Senator SARBANES. How much money are we talking about in the

overall? Do we have any estimate of how much goes into the fees?

Mr. GENSLER. Senator, you ask a very good question. There are

various estimates, as I outlined in the testimony. If you take the

average fees, annual expense ratios, which if you just average is

between 1 and 11⁄2 percent, and I will even use the 1 percent to

be at the low end, add in the burden of the constant trading of the

portfolios with the typical fund—I will use the median fund—turns

over their stock once every 18 months. And to that add another

half a percent if you add the commissions and trading costs and so

forth. About half of all funds have sales loads, and if you take the

average holding period that all of a sudden adds costs. Then in addition, believe it or not, we are triggering a lot of short-term capital

gains taxes, and that may be good for the U.S. Treasury, but this

hearing is about promoting savings in America, and mutual funds

do, unfortunately, trigger a lot of short-term capital gains that add

1 or 2 percent to the cost instead of the long buy and hold strategy.

So overall an investor can be looking at an additional 3 to 4 percent, not just on expenses directly to the mutual funds, but between the triggering of these additional costs and the trading costs

and the like.

Now, there are various estimates how much that means to the

mutual funds industry. I estimated approximately $100 billion a

year between the mutual fund industry and the brokers and financial planners. There have been other estimates, but these are significant dollars, and as I said in my oral statement, I think this

hearing and why I am in the reform camp if I am, is to promote

retirement savings in America. I think that is really why governance matters, is can we best promote retirement savings?

Senator SARBANES. Presumably, no one at the table is in favor

of setting up some kind of mechanism to set fees, to regulate fees.

206

Mr. GENSLER. No. Again, I am not for that.

Senator SARBANES. I understand that. So, you have to think

what structures in the industry would contribute toward lower fees

rather than higher fees. Or let me put the question another way.

Why is it that some very successful funds have low fees and other

funds have very high fees, and what is missing in terms of addressing this discrepancy? I take it one position—I think this is yours,

Mr. Glassman—is well, that is just how things are and it has to

play itself out. Would you take that view?

Mr. GLASSMAN. Well, I would not say that. I would say that

funds, especially load funds, which charge the higher fees or charge

the up-front commission, are providing something to investors, especially kind of novice investors or investors who really do not have

that much experience or who do not want to spend that much time

making choices, they provide an extra service which people are

willing to pay for. I think that is the best explanation.

I would also say, as far as how to lower fees, I think that one

thing that we have kind of lost sight of, Mr. Gensler was talking

about independent directors setting—or independent chairmen setting fees. Fees are set by supply and demand. Prices are set by

supply and demand, especially in a vigorously competitive industry

like this. If you want to lower fees, what you need to do is increase

supply. In other words, try to get more funds to participate, or you

can lower demand, in which case make all the funds do a terrible

job of providing service to people. Funds provide a good service so

that is why people pay for it.

Senator SARBANES. Is there not a basic issue, right at the outset,

of disclosure in terms of full information? How does an investor, a

prospective investor, make a wise decision if they do not have full

information? I think that was one of the points you were stressing.

Mr. GENSLER. I think there is one piece of information that is

still absent, portfolio trading cost. This industry does have exhaustive disclosure and I would not be for a lot more, but that one piece

would be critical. Just to clarify, Mr. Glassman, I do not believe

that independent chairs should set fees, nor to Senator Sununu, I

do not think it is a silver bullet. I think directionally it probably

will change the tone in the boardroom. I think more fundamental

is, we have a structure now, and do those boards weigh in to the

negotiation of fees? I do not think there should be requests for proposals and changes——

Mr. GLASSMAN. But I mean you agree——

Mr. GENSLER. —weighing in to this negotiation——

Mr. GLASSMAN. —that any business wants to charge the highest

price that it can possibly get. Let us not kid ourselves. That is

what capitalism is all about. You are constrained in the price that

you can charge basically by whether people like the product that

you are selling and whether you have lots of competition. That is

how prices occur. Information is tremendously important, Senator

Sarbanes. You are absolutely right.

Senator SARBANES. Well, what do you think the role of the directors is?

Mr. GLASSMAN. I said earlier that I think it would be a good idea

to take a look at whether the structure of the 1940 Act really

makes sense today. Senator Sununu was asking the question about

207

aluminum siding, and I think Mr. Phillips said that mutual funds

are not a product. I can tell you that my readers would be shocked

to learn that. They think mutual funds are a product. They do not

think that they are investing in a company and that there are directors and that there——

Senator SARBANES. Do you think that the directors have a fiduciary duty?

Mr. GLASSMAN. Absolutely.

Senator SARBANES. You do?

Mr. GLASSMAN. Absolutely.

Senator SARBANES. Do you think that the current fiduciary duty

standard is adequate?

Mr. GENSLER. I do not think so.

Senator SARBANES. Mr. Glassman, do you think so?

Mr. GLASSMAN. I have to say that that is not an area where I

really have any expertise, but absolutely it is——

Senator SARBANES. I mean that if you look at the standard established in the Gartenberg case, it is totally inadequate in terms of

providing some rational standard of fiduciary duty, is it not?

Mr. GLASSMAN. I do not know that case, but I really do think

that an examination of whether the current structure——

Senator SARBANES. But you do think they have a fiduciary duty?

Mr. GLASSMAN. Every director has a fiduciary duty to his shareholders.

Senator SARBANES. Then the standard of that fiduciary duty

would become a highly relevant question, would it not? You could

say, well, you have a fiduciary duty but you might have a court decision which defines that fiduciary duty at such a low level that it

does not amount to a fiduciary duty compared with other prevailing

standards for fiduciary duty. Would you concede that the standard

at which the fiduciary duty is set is, of course, a very important

and relevant question, is it not?

Mr. GLASSMAN. Absolutely, but I think the question is whether

that duty is owed to individual shareholders in one of 8,000 funds,

that is 8,000 separate companies. Let us remember this. Or whether it should be owed to the shareholders in the management company that in real life actually runs the funds. We all know that.

We are kind of pretending that something else is going on here.

This is what investors think. When they buy a fund from T. Rowe

price, they think they are buying it from T. Rowe Price.

Senator SARBANES. Therefore, you think that the fiduciary duty

that the directors of a fund owe is not to the investors in the fund,

but to the shareholders of the management company?

Mr. GLASSMAN. I think under the current structure, quite clearly

it is to the investors of the fund. All that I would encourage this

Committee to do is to look into whether that really is the best

structure, the most rational structure, in fact, the kind of structure

that investors need.

Senator SARBANES. If you are going to shift it to the shareholders

in the management company, who is going to exercise fiduciary

duty with respect to the investors in the fund?

Mr. GLASSMAN. I think that investors buy individual products, financial products, and they make the decision about the brand, the

company that is selling them that product. All I am saying, I am

208

raising this issue which others have raised about whether it makes

sense to—I would call it certainly antiquated and it may even be

kind of a fiction that these are individual companies. People do not

look at it that way.

Senator SARBANES. I know my time is up.

Mr. Phillips, Morningstar looks at all these funds. Do you have

any comment on this issue?

Mr. PHILLIPS. I would say that people do not look at this that

way because the industry has not treated them that way. The industry has lived perhaps by the letter of the 1940 Act, but not by

the spirit of the Act, and the word ‘‘product’’ does not appear in the

1940 Act.

I would say as far as fees, we have to engage investors at a level

that they are going to be capable of participating in the debate. All

other professional fees, even the taxes that you pay——

Chairman SHELBY. What is that?

Mr. PHILLIPS. To state these fees in dollars, all the other professional fees.

Chairman SHELBY. I mean what is the standard that they are

going to be able to participate?

Mr. PHILLIPS. What I mean by that, sir, is that investors do not

relate to percentages or to basis points, but they relate to dollars.

Taxes may be calculated in percentages, but if you look at your

paycheck, it is stated in dollars, the number of dollars that are deducted for Federal taxes, for State taxes, for Social Security, et

cetera. That allows an informed debate over whether these are at

a fair level.

Investors are used to looking at dollar fees that they get from

other professionals, from their accountant, from their dentist, from

their doctor, and that allows an informed debate. But when it

comes to mutual funds fees, these fees are never presented in dollars, and that keeps the investor disengaged from an active debate

over whether they are getting good value.

Chairman SHELBY. Is this by design?

Mr. PHILLIPS. I do not know if it is by intent, but it certainly is

by the way that the fees are collected, as Mr. Gensler pointed out,

and my suggestion would be simply let us level the playing field

here so you can engage investors to have an informed debate. I do

think investors over time move to lower cost funds, but not because

they have had a thorough examination of the cost, but simply because they have seen the——

Chairman SHELBY. They move to funds that may be lower cost,

but they also move to funds that perform.

Mr. PHILLIPS. That is a very good point. At the end of the day

investors do not simply want the lowest cost.

Chairman SHELBY. So the market will work if the people have

choices maybe.

Mr. PHILLIPS. That is right. They want the best returns. I mean

the way to pay the lowest taxes is to have no income. You do not

want to look at one of these things in isolation, cost alone.

Chairman SHELBY. You could have a fee, a little more expensive

fee, and you could have better managers and, gosh, if they produce,

people will pay as long as the people know that. Would they not,

Mr. Glassman?

209

Mr. GLASSMAN. Absolutely. I do not think there is a single reader

that I have who would not rather pay a much higher percentage

fee——

Chairman SHELBY. For performance.

Mr. GLASSMAN. For performance. And look at hedge funds. These

are very sophisticated investors. They are willing to pay on average

one percentage point plus 20 percent of the profits. Now that is a

great deal higher in a year in which stocks perform, as well as they

did let us say last year, than what individual investors pay. So it

is not so unusual that people are willing to pay a lot. The problem

is, obviously, that when you just look at short-term performance

and extrapolate that out, then you could be making some very bad

decisions as investors, and that is one of the great roles that

Morningstar plays in providing that information to people so they

do not make those decisions.

Mr. PHILLIPS. If I could point out one difference, investors see the

benefits. They see the returns in dollars but they do not see the

cost in dollars. If you see both in dollars, then you will have a more

informed debate.

Mr. RIEPE. Actually, to answer your question directly, they are

in percentages because returns are expressed in percentages, and

that is how people look at returns. They look at was I up 12 percent last year, did I earn 6 percent, was I up 18 percent? So putting expenses in the same mode is why expenses have historically

been expressed as an expense ratio.

One of the big successes in mutual funds has been that it is an

agency product, i.e., nothing is promised to the investor as it might

be in an insurance product or a bank. It is transparent. You are

going to get the return we earn minus X percent, and that is the

way it is.

Chairman SHELBY. Well, could you perhaps come up with some

solution that the fund would disclose a percentage and this percentage would equal so many dollars?

Mr. RIEPE. Yes, the SEC has proposed that.

Chairman SHELBY. That way you have some numbers.

Mr. RIEPE. Right. The SEC has proposed that. Certainly, we are

all in support of it. And our only argument was don’t put it in absolute dollars relative to your balance because then I as an investor

can’t compare it to anything. So, I open up my statement and it

says, you know, it cost you $742.17 last month. I don’t know what

to compare that to. What the SEC has proposed, which I think is

very reasonable, and what we have certainly supported is do it on

a $10,000 payment.

Chairman SHELBY. What do you mean you couldn’t compare it?

You can compare costs to anything if you have the model.

Mr. RIEPE. Well, but not other funds. In other words, if I own

three funds and I have $7,000 in this and $3,500 in this and

$12,500 in this, I can’t compare dollars. I can compare percentages.

Of these three funds, if one has a 1.5 percent expense ratio, another has a 1 percent, and another has an 80-basis-point expense

ratio, I can compare the cost. But if you send them to me in

dollars——

Chairman SHELBY. But if the factor is carried out into dollars

from percentages, you could figure it.

210

Mr. RIEPE. I can tell you the absolute dollars. It is a question of

you can’t compare that to anything else in terms of comparing to

other funds. And I think Don agrees with this as well.

Chairman SHELBY. But as a mutual fund owner, you would realize the cost, though, maybe in some way.

Mr. RIEPE. Yes.

Chairman SHELBY. I am just trying to learn.

Senator Carper.

Senator CARPER. I did not have the benefit of hearing Mr.

Gensler’s or Mr. Glassman’s testimony, and what I am going to ask

each of you to do is take a minute apiece just to recap briefly what

you most want us to take out of this hearing having heard.

Mr. GENSLER. Thank you, Senator. And it is good to see you, too,

Senator Corzine. My former boss. He sent me to Japan.

Senator SARBANES. We will be very mindful of that as he asks

questions and you give answers.

[Laughter.]

Mr. GENSLER. I think that this entire debate about mutual funds

really relates to retirement savings in America. We have so many

debates about Social Security and Medicare and how we provide for

the retirement of the baby boomers. Well, the good news is mutual

funds are right at the center of that. They are a product that has

served so many Americans so well. But if we can look at the policies around mutual funds to have them serve Americans even better, I think that is the challenge really moving forward. And in

that light, I think at the core is we have a governance system that

was put in place 64 years ago by Congress, recognizing inherent

conflicts that are not going to go away. Those conflicts will be there

again 65 years from now.

Can we help the balance in that boardroom? It is not a silver bullet to have independent chairs, but that is directionally, I think, a

positive step. I think more important is the fiduciary duty that

those directors are held to. Are they engaged in representing the

shareholders? As Chairman Donaldson said just 2 weeks ago, ‘‘The

fund board of directors serves as the shareholders’ representatives

in this negotiation.’’ He was referring to the negotiation with the

investment adviser. Can we really instill in them as gatekeepers to

be involved in that negotiation? Not to go out and get requests for

proposals and change fund managers, as some have said. I am not

for that. But just to be really shifting that balance a bit in that

boardroom.

I also think it is worthy to look at restricting or even repealing

12b–1 fees. I think that they have served their length of time. They

haven’t really served the purpose they were first attributed to.

Last, disclosing portfolio trading costs. Those would be my three

key takeaways.

Senator CARPER. Thank you.

Mr. Glassman.

Mr. GLASSMAN. Thank you, Senator Carper, for this opportunity.

Just briefly, my main message is that I urge you to proceed extremely cautiously, which the Chairman said that he would be

doing, you would be doing. I said that mutual——

Senator CARPER. He always says that.

Mr. GLASSMAN. He always says that.

211

Senator CARPER. You usually do.

Chairman SHELBY. Cautious but thorough.

Mr. GLASSMAN. Right. I reminded you that the mutual fund is

the most successful financial vehicle of all time. In the last 30

years, it has gone from $48 billion in assets to $7 trillion in assets.

And we really shouldn’t do damage to something that has been so

successful for individual Americans and for the economy.

I also talked about how investors have disciplined funds that

misbehaved and have been accused in these scandals, as they

should, and the discipline has been very harsh, as it should have

been. Twenty-nine billion dollars in assets were withdrawn from

Putnam. I have a table in my testimony. Meanwhile, untainted

firms—American, Vanguard, Fidelity—gained a total—some of the

untainted firms, not mentioning all of them, gained a total of $133

billion in assets.

Then I responded to specific proposals. I oppose the hard 4 p.m.

close because I think that hurts small investors. I oppose a mandatory redemption fee because I think that discourages exit, and you

want exit from funds to discipline the funds. I oppose proposals on

independent directors and instead urge an examination of the current legal structure of funds to see whether it really makes very

much sense to have 8,000 separate boards of directors. And the

same thing with the composition of fees. Why do we have to go into

such great detail about whether this is ascribed to 12b–1 or this

to management costs? Just simply make clear what the prices are

and let individuals make those decisions.

What else? And then I emphasized that really what is needed is

investor education. I see that every day. I think most of my readers

are fairly well-informed, but more and more Americans are entering the arena of investment, and that is great. Just as Mr. Gensler

is saying, this is really a retirement issue, and they need better

education. I think that is where a great deal of your emphasis

should be directed.

Thanks.

Senator CARPER. The panel before us today is a diverse panel

with diverse views. Out of that diversity, our responsibility is to try

to develop some consensus. It would be helpful to me to ask each

of you—and we will start with our State Treasurer, but just to

share with me maybe a thought or two, as it were, where you see

some emerging consensus from among the disparate testimony that

we have heard today.

Mr. BERRY. Well, I think certainly there is some consistency that

this is an issue that we all must deal with. I think there is consistency that there are more and more people entering into the mutual

fund arena. Because of tax advantages that have been provided for

investments for retirement, et cetera, more individuals are in the

mutual fund environment, and as a result, we need to make sure

that we are able to provide clear, concise, consistent reporting to

those investors of what they are seeing and what they are paying

for. There is some inconsistency here as to how that is best

achieved, but I think we all have the goals and desires to provide

that clear, consistent reporting.

Certainly, I think investor education is something that we have

heard from several individuals, that because more individuals are

212

participating in the marketplace, we need to make sure that those

individuals have access and are obtaining the education necessary

and are not more confused by the process, and that through this

whole process we do not do more harm to our investors, that we

ensure that we provide more clear, consistent disclosure.

Senator CARPER. Okay. Thanks.

Mr. Riepe.

Mr. RIEPE. Senator, I would say, number one, that I think there

is a very strong consensus that the mutual fund as an investment

vehicle for Americans has proven to be a very successful and transparent—which is one of the reasons it has been successful—product

for them. And it has given access to the markets in a very costeffective way. I don’t think you can fool 90 million Americans for

all these decades. There is no question about that.

Senator CARPER. Some of us have tried.

[Laughter.]

Mr. RIEPE. Yes, certainly.

Senator CARPER. Remember what Lincoln used to say? You can

fool all the people some of the time.

Mr. RIEPE. Right, some of the time.

Senator CARPER. Some of the people all of the time.

Mr. RIEPE. I find it kind of interesting that most of the testimony

and comments have stayed away from the abuses, which is comforting to me in the sense that I think there is a general sense that

the abuses are being dealt with by the SEC, by the prosecutors, et

cetera. This has now sort of opened up the opportunity to make

broad comments on mutual funds generally that are really off the

subject of the abuses. But I think the good news is that those

abuses are being dealt with, number one; and, number two, the

marketplace impact on those involved has been enormous, and that

is the most powerful signal that you can send to all the others in

the marketplace. Number three, I think there seems to be a general consensus that the SEC is doing what it should be doing, being

very aggressive. Whether it got a late start or not, I wouldn’t get

into any of that, but certainly as a receiver of all these reforms and

initiatives that they have put out, this is the broadest and most

comprehensive I have ever seen.

I think the disparity starts to come into a fundamental misunderstanding of funds, and I think in your future panels you will

talk about this a little bit more, and so I won’t get into it today.

But somehow people are dealing with funds as if they are these

independent entities that sit out there. But the fact is they have

to be created, and they are created by an adviser—and I think Mr.

Glassman alluded to this a little bit. They are created by an adviser. They are created by an adviser not for philanthropic purposes. They are created by an adviser as a way to package their

investment skills and put out into the marketplace. If they are successful and they deliver a good performance, they grow. If they do

not deliver good performance, they don’t grow. Then when they do

grow, somehow, because of this corporate structure the investment

companies have been placed in, they now take on a life of their

own. And that even leads to what Gary alluded to of some people

suggesting that you should go out every year for RFP’s, which I

know he opposes.

213

But I think one has to remember that you don’t go to bed at

night with a Chevy in your garage and expect six or seven or eight

or ten directors whom you don’t know to pick a Ford for you and

there is a Ford there the next morning. That is just not the way

the system works. People have hired T. Rowe Price, people have

hired Fidelity, people have hired the American funds because they

have done their homework and that is who they want to manage

those funds. The system that we have to work around that is the

system that most of the discussion has been about today, not about

the abuses.

Senator CARPER. Mr. Phillips.

Mr. PHILLIPS. Thank you. I think there is agreement that mutual

funds are a terrific investment vehicle. Even Jack Bogle, one of the

harshest critics of the industry, was quoted in The New York Times

recently as saying, ‘‘There exists in the mind of man no better vehicle for long-term investing than the mutual fund.’’

I think there is also agreement that the fund industry occupies

a privileged space, being the core vehicle for things like 401(k)

plans, 529 plans, individual retirement accounts.

I believe that there is also agreement that the industry has

misstepped. Even the most senior people in the fund, members of

the ICI, take the abuses that have happened at some fund companies extraordinarily seriously. And I have seen fund executives personally affronted by how serious some of these transgressions have

been. So there is a sense that the industry has in some cases lost

its way a bit.

I think there is also a consensus that we should be looking forward to say how do you, like the framers of the 1940 Act, think

about this industry in broader terms and put it on sound footing

that it can be protected, not just for the next 6 months but for the

next 60 years? And I think that is what has opened up the dialogue

beyond just dealing with the most recent abuses, but instead thinking mutual funds have become so central, as Gary has said, Mr.

Gensler has said, to the retirement savings that we have to be

thinking longer term. How do we protect this industry? How do we

make a good thing even better? That is what has encouraged the

debate on how to do that. I think everyone is in agreement that

this is an important issue and it is one that we need to be thinking

long-term about. There is just disagreement to some extent over

what is the right way to do that.

Some, like Mr. Glassman, are saying let’s get rid of the structure

that has protected this industry for the last 60 years. The corporate

structure, in effect, is a farce. Let’s treat these as products. To me,

it seems that there is something about the corporate structure that

has protected this industry. As I say, we track mutual funds in

other countries where they are not organized as corporations. They

are organized truly as products. They are organized contractually.

There you see real abuses, and you can see why. If someone is writing the contract, giving it to someone else to sign, they are going

to tilt that contract as much as possible in their favor.

I think there is something about the corporate structure that

works very well and has served investors well. And I think it would

be wise to consider strengthening as opposed to abandoning the

corporate structure of funds.

214

Senator CARPER. Again, Mr. Gensler and Mr. Glassman, my

question is: Where do you see the consensus?

Mr. GENSLER. Consensus that this is critical and important to retirement savings. Consensus that there is a need for reform. And

I applaud actually the industry, the ICI. Unlike some other industries, this industry actually is engaged in a constructive dialogue

of reform. The distinctions are—and even agreement that governance matters. The distinctions are does Congress need to do more

after the SEC completes its rule writing by the spring and whether

we need to enhance what goes on in that boardroom around governance. And you know where we all stand, but I think those are

the key differences.

If you say no, then maybe Congress doesn’t need to act. If you

say yes, then Congress needs to go further because the SEC doesn’t

necessarily have the authority to address itself to those fiduciary

duties in that boardroom.

Senator CARPER. Thank you.

Mr. Glassman, the last word.

Mr. GLASSMAN. Just let me make a comment on an area where

we do differ. Mr. Phillips was saying that I am in favor of throwing

out the corporate structure. I am not. I am in favor of reexamining

it. I refer the Committee to an excellent article in Business Week

on November 17, called ‘‘Funds Need a Radical New Design.’’ I

think we really need to look at that question.

I want to just go back to where I think we all agree, and the

most important thing, quite frankly, is investor education. Even in

the current scandals, Morningstar took the lead in telling its—in

elucidating this and telling its readers that perhaps they shouldn’t

be investing in some of these funds. I did the same a little bit later.

I told my readers that they ought to specifically dump several of

these funds.

We need, however, much broader investor education. The SEC

does it or is supposed to do it. The Treasury Department does it.

The Labor Department does it. There is very little coordination,

and there is very, very little money. The mutual fund industry had

done, quite frankly, a fantastic job of educating a lot of newcomers

to investing. But I really feel there is a major role for Government

here, and it ought to be played, and I think the panelists agree

with that.

Senator SARBANES. Mr. Chairman, at this very point I ought to

interject that the issue of financial literacy has been a subject in

which Members of this Committee have been extremely interested—Senator Enzi, Senator Corzine, Senator Stabenow, and myself, and, of course, the Chairman. In fact, we included in the Fair

Credit Reporting Act reform legislation a financial literacy and

education title that establishes a commission at the Federal level

of all the interested agencies and departments to develop a national strategy with respect to financial literacy. They just had

their first meeting 2 weeks ago. The chairman of that commission

is the Secretary of the Treasury, and he was there. I think there

were three or four Cabinet officials present at the initial meeting

of that commission. And the Chairman of the Federal Reserve,

Chairman Greenspan, was also there.

215

I think it is important, just as you indicate, and I wanted to get

on the record at this point, because I thought it was highly relevant, the action by this Committee and subsequent action by the

Congress and the signature by the President and this commission

is up and going.

Now there is a vast field that has to be covered on financial literacy. You have payday lending and predatory lending and so forth

and so on. But obviously we need to raise the standard of literacy

amongst the American public.

Chairman SHELBY. That is good.

Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman, and I congratulate

you and the Ranking Member for leading a most thoughtful discussion on this topic, which is at the heart of the savings function in

this country and retirement function. And I am one that believes

that the SEC is doing a terrific job in actually addressing a lot of

the issues at hand. That does not lead me to believe that there is

not room for legislation. I think capturing some of these reforms is

really about revising the 1940 Act, and it is a wise piece of legislation, but I think terms and conditions of the marketplace have

changed pretty dramatically, and we should really do a top-to-bottom review.

I apologize to the panel for being late. There are a number of

hearings going on today. But this is as important a set of issues,

I think, for savers in America that we can get to.

Part of the discussion I hear, though, is trying to put things in

either/or context. We are either going to have percentage fee disclosure or we are going to have absolute dollar disclosure. I don’t

really understand why you can’t have both. I think people are

smart enough to actually use all of that information.

I don’t fully understand why distribution fees and management

fees are fair game and transactions costs aren’t fair game, and people understanding whether their mutual fund is performing effectively. By the way, turnover in those accounts has a lot to do with

the ultimate after-tax performance, so I think we are not serving

the broadest public if there are 95 million folks. I wish I understood all of the tax implications of all the strategies that are going

on in these mutual funds, but I don’t think it is quite obvious to

most people. And I would be concerned if we didn’t address or at

least the SEC didn’t address some of these things, and I think full

fee disclosure and transaction costs are something that need to be

addressed. I haven’t heard the words ‘‘soft dollars’’ mentioned since

I have been here. Maybe they were talked about beforehand. But

there are tremendous implications, I think, for a different cost

structure and performance for individuals that should be understood, and it doesn’t mean that people won’t look at their total return over a period of time. You ought to have a right to understand

what you are paying to get the results that you are.

There is a serious issue that a lot of you have apparently pointed

out on the legislation that Senator Dodd and I introduced earlier

on the hard 4 o’clock close. I think actually we need to listen to the

industry and figure out how we can get some facilitating device to

216

have small investors be able to move through that process in a way

that doesn’t look at hard closes. I am curious whether anyone

would want to comment on some of the intermediary devices, national clearing corp or some auditable outside vehicle being able to

certify that we are not into late trading, market timing, and all the

other kinds of things. Is that a practical solution? It seems to me

that edging along those lines as opposed to either/or on the hard

4 o’clock closes is a more appropriate response.

Let’s see. Also, I continue to be troubled—and I am absolutely

not—absolute certainty about this governance issue with regard to

whether you have a board of directors that governs the management company or each of the individual funds, because you can get

a proliferation of boards that might be hard to imagine that you

will be able to staff appropriately. But from my own point of view,

I can’t imagine that the board doesn’t have a fiduciary responsibility to the investors. It strikes me that making sure we engineer

our responses along on the governance issue are pretty important,

and, again, I am not sure we want to put it in an either/or status.

Finally, I have serious concerns about mixing up hedge funds

and mutual fund managements. I understand these fee structures,

and if my brain were trying to somehow sort out without ever

verbalizing where my good trades go versus my bad trades go, no

matter how perfect a human being I might be, I think that there

is an enormous incentive that needs to be recognized in how we are

managing, which is another one of the topics that need to be put

forward here.

I would love to hear your views on some of the things that I am

talking about. I really don’t understand why we are so either/or,

particularly on fees and costs, which I think can be informative,

ties into the financial literacy and investor education. People ought

to understand what is actually transpiring, why they are paying to

get the results that they are getting, and I don’t know why more

information clearly stated isn’t a good idea.

I guess I am making more of a statement—but I would love to

hear comments about third-party verification on 401(k) investments. I would love to hear views about the debate about whether

you have an independent board of directors at a fund management

group or it has to be at each individual. I would like to hear about

the hedge fund concept. I think we are all in agreement on this financial literacy or education effort. We ought to try to structure

that in a way that is actually really practical for all of the various

individuals. And anybody that wants to talk about soft dollars, I

am always interested.

Mr. GENSLER. I will try to do it—knowing your list of seven, in

40 seconds. I think you can have dollars and percents. Some in the

industry might be hesitant because the dollars could be a bit high.

Congress already acted before you were a Senator, but unfortunately, the after-tax results are not in promotional material or on

your statements.

Soft dollars, I think there is some real problems of abuses there.

I would restrict it. There is a legitimate question about independent research and whether you would ban it completely or you

would find some way to narrow it to allow independent research,

but really only independent research.

217

I sense I am where you are. I think the hard 4 o’clock close is

too hard, and it is probably the one place Mr. Glassman and I are

in agreement.

I don’t have a problem with unitary boards, being that T. Rowe

Price have one overall board with all these investors. That is efficient. It is a little awkward, maybe if you had a problem with one

fund and not the other 80 funds. But I think governance is not

about whether there is one. You can be efficient. Governance is

about are they going to act in investors’ interests.

Then hedge funds and mutual funds, I think the real issue is allocation of shares. So if you could adequately assure that trades

aren’t going to be cherrypicked for the hedge fund, but if you can’t,

that is the real issue is the allocation of shares.

Mr. GLASSMAN. Can I comment on a few of them?

Senator CORZINE. Can I ask a follow-up question?

Mr. GLASSMAN. Sure.

Senator CORZINE. Does that mean that you think there needs to

be more transparency with regard to hedge funds? How would we

be able to assess that if we don’t know what the heck is going on?

Mr. GENSLER. Well, I think it is a question of the allocation of

shares within a mutual fund complex, and we already have that

issue, Senator Corzine, even amongst the mutual funds.

There is a benefit to allocate the hottest trades to the smaller

funds because you can goose the performance of a new fund, an incubator fund, and then advertise it later in the year as hot. So this

issue of allocation is not unique to hedge fund/mutual fund management. I think it is already in the mutual fund field, regardless

of the hedge funds. It just adds to it and makes it harder for your

hedge fund points.

Senator CORZINE. It is more complicated when you do not have

transparency, however, with hedge funds.

Mr. GENSLER. If it is in the management of the same company.

I didn’t know if you were asking about general transparency of

hedge funds that are not in the management of mutual funds.

Senator CORZINE. Multiple.

Mr. GENSLER. I don’t think there is a need to bring nonaffiliated

hedge funds into some global portfolio disclosure system. I think

the market actually benefits from a very nimble group of investors,

which we call hedge funds, and the economy benefits in a way

that—and I haven’t found a regulation that wouldn’t hurt some of

that on hedge funds.

Mr. GLASSMAN. Just three quick comments. On the hard 4 o’clock

close, I am worried about what happens to small investors who are

put at a disadvantage, and the answer is a comprehensive clearing

house with some kind of time stamping. I think that could be done,

with tremendous responsibility placed on the funds and every other

participant. People have been chastened, so that would work.

On soft dollars, I am really worried about the whole research situation in the financial world in general. I think that as a result

of previous legislation, we are getting less of it, and we ought to

have more of it. Some of these proposals would really hurt independent research, and I don’t think that is good.

Finally, on the issue of dollars versus percentages——

218

Senator CORZINE. If the research were productive in helping get

to returns, why people wouldn’t pay for it for what the cost of it

is that they think is impacting their performance. Why do we have

to do it in a system that is opaque as opposed to here is the money

I am paying to get this research that is going to help me do a better job?

Mr. GLASSMAN. I think the system could be more transparent. I

agree with that. But I don’t believe that companies should be prevented from doing transactions in soft dollars as opposed to hard

cash. I think that the firms can simply say here is the soft-dollar

amount and we will allocate it this way: This is for the trade, this

is for the research. A lot of companies are already doing that, and

I think that is fine. But whether they want to do it with soft dollars or not, I think that really should be their choice. But transparency is a good idea. It is necessary.

Finally on transparency as far as percentages versus dollars, I

agree, both is fine. But my worry is there is so much in the way

of disclosure already. I know my readers are not paying very much

attention. I agree with Mr. Riepe that to just get a specific amount

of dollars on your statement is completely meaningless. You can’t

compare it.

Morningstar does a fabulous job using both dollar amounts and

percentage amounts. They also do a very good job of showing the

tax efficiency of funds, the turnover in funds. I mean, you can get

all the information that you as an investor really need. Maybe

there are little odds and ends that you might need otherwise, but

I think that funds themselves have an incentive to provide that

information.

The problem with requiring more and more disclosures is that I

worry that people—first of all, I don’t think anybody—not that

many people read them. Second, there is this tendency to believe

that, well, we have done the disclosures, that is all we need to do,

we as policymakers. I am not against disclosure, but I really don’t

think it is any kind of panacea, quite frankly.

Mr. PHILLIPS. I would say something on soft dollars. To me it

seems like double-dipping. If you are paying a management fee,

you assume that the investment research, the trading systems, the

office furniture, all these things that a money manager needs, are

being paid through the money management, not through an artificially high trading cost. As for the independent research, Morningstar is a provider of independent research, and so my stance may

surprise you some. But it seems to me, as you say, if it has value,

people will pay for it. To me this sounds like a $400 bottle of wine

that you would happily purchase on an expense account but you

wouldn’t be willing to pay for out of your own pocket. It seems to

me that if the research truly has value, then someone paying their

own money should be willing to set the market price for that as opposed to people paying with other people’s money, which is what

is happening today.

Mr. RIEPE. Senator, on the either/or, certainly from my point of

view, I don’t think it is an either/or. I think it is both. And as I

mentioned, the SEC has already approved disclosure and shareholder reports of a dollar, it is just a question of how we do that.

219

The one complicating factor, which I think you are familiar with,

is that more than half of mutual fund accounts are held in omnibus

accounts. So the idea of moving from intention to execution in this

area gets very complicated because a broker who has an account

for somebody has all kinds of securities, plus four totally different

mutual funds. And getting all that information and getting it personalized and into that thing is a very complex administrative

task. I am not saying it cannot be done, but the devil is in the details on that one. There is no problem with either/or. I think that

both are good.

With respect to the hard close, I said in my testimony essentially

what you said. The industry backed the hard close at the time because when one thinks about that moment in time when the abuses

came out, we felt that we had to take a very strong position to

make investors feel that they were being protected. We also felt

that this was much more an intermediary problem than it was a

fund manager problem. And so the hard close is sort of the heavy

solution to that.

I think an electronic solution, like a clearing corp solution, is the

right solution. There are a lot of daily transactions in funds, but

how long would it take to be developed? I think that ultimately has

to be the solution, and that will avoid penalizing shareholders,

401(k) shareholders, and other people who come in. I think that

the NASD has one that tracks transactions from the very point it

is delivered.

Let me just say on the soft dollars, the industry has come out

and said that we ought to clarify it, we ought to end third-party

research. And the only thing I would point out to you, this is not

just a mutual fund problem. All advisers have soft dollars, and we

would not like to see just mutual funds regulated for soft dollars

and all other advisers be left out of that.

With respect to independent directors—we talked about this, and

I think the Chairman spoke to this. Independent directors are

being handed responsibilities far beyond what they are capable of

executing as part-time overseers. Everybody is directing to them

responsibilities that they are worried about, asking them to certify

things that they can’t certify. I think that has to come out of your

review here, that we have to have a clearer idea of what they are.

They are fiduciaries, but the question is: What is contained under

their fiduciary responsibilities? What responsibilities do they have?

Mr. BERRY. As relates to funds, I think it is necessary that both

be provided. Not only do investors look at their performance based

on a percentage basis, but also they look at bottom-line dollars and

what do they have in their account today. That is expressed in dollars, and as a result, fees expressed in dollars would also be meaningful to them as well.

Senator CORZINE. I thank you all. I think that personally I have

a strong sense that we also need to think about how information

is presented so that it is comprehensible. It ties together very much

with the education issue, and I don’t know whether that is a legislative approach or we need to do it in some other format. Not only

making information available, but also making it presentable in a

way that people can understand it I think is a key issue.

Thank you, Mr. Chairman.

220

Chairman SHELBY. I have a couple more questions. I want to address them to Mr. Glassman and Mr. Gensler. I am not picking on

them, though.

As we consider reforms and possible legislation to protect investors, I agree with all of you that we have to be sensitive to the

additional cost that will be borne by the investors. How do you do

a cost/benefit analysis to determine when necessary reform becomes overregulation that costs investors? Mr. Gensler? That is

something we have to weigh.

Mr. GENSLER. I think that it is a very difficult matter for policymakers and for Congress in all sectors of the economy.

Chairman SHELBY. Don’t overkill, right?

Mr. GENSLER. Don’t overkill. I mean, we do have a wonderful

capital system in America, and it is part of our great success over

the years.

I do think that in this area what some of us are suggesting in

terms of having stronger board governance, meaning that these

individuals are doing exactly what Chairman Donaldson has said,

being engaged in that negotiation or that fundamental relationship

is critical.

Might it add cost? Might these directors feel they need an adviser or something? It is possible. But when you are talking about

$100 billion of costs, if they were to negotiate even 5 percent better,

it would, I believe, cover that.

Chairman SHELBY. So when you reference in the cost/benefit

analysis, if it is a cost, somebody has to pay it. Ultimately, the investor will pay it, will he not? It will be part of the overall deal.

Mr. GENSLER. Oh, I think that there are two areas, and ultimately it would be the fund companies that would probably bear

the crux of many of my recommendations and the Wall Street that

I used to work for that would bear the crux. I mean, if the system

was more efficient and investors had higher returns, in essence if

we narrowed the gap between where corporations borrow money

and investors get a return, that narrowing in economic terms helps

the economy. But it is the intermediaries—Wall Street, mutual

funds—that would probably have lower profit margins. That is why

they would not necessarily endorse what I am saying—and rightly

so, they would not endorse. They have shareholders as well.

So, I think it is actually in narrowing that gap in the capital

markets is where I would focus my attention.

Chairman SHELBY. Mr. Glassman.

Mr. GLASSMAN. I think if you raise the costs for everyone, then

the costs to investors will rise. I think that is a pretty basic economic tenet. If you only raise it for certain companies, fine. They

will go to the other companies.

You raise a very important issue, Mr. Chairman. Even on disclosure, disclosure costs money. You have to have the accountants.

You have to do the publishing. You have to have lawyers. And it

is a very important issue——

Chairman SHELBY. You have to ask yourself, will this benefit? Is

this worth what we are doing?

Mr. GLASSMAN. Right, what is the benefit? In fact, I think we

need to define benefit here. To me, and to most of my readers, benefit is a higher return on their investment. That is what a benefit

221

is. And will they get a higher return or a lower return through

these disclosures? Well, it may be hard to say. My guess is they

will probably end up with a lower return because they already have

vast disclosures. This is just marginal disclosure that probably

won’t help.

Chairman SHELBY. Okay. Last, what do you believe is the most

critical information for an investor to consider when purchasing a

mutual fund? How can we make sure that investors get that information? Information is important.

Mr. Riepe.

Mr. RIEPE. I think there is just a few—it was interesting. Don

said something ought to be on page 1. Every time I get into disclosure discussions with people, everybody wants it on page 1. You

would have a page 1 that would fill up this room, probably. What

we need to do is to make sure investors understand some fundamental things:

Number one, the investment program that they are buying into

of that fund. What is the investment strategy? What kind of fund

is it? Number two, what are the risks that come along with that

investment program? These two things will overwhelm costs, fees,

everything else.

Chairman SHELBY. But should the risks be stated up front and

not footnoted back somewhere where nobody is going to read it?

Mr. RIEPE. Absolutely. Now, the risks get stated in words, but

they absolutely should be stated up front.

Number three, what are the costs associated with buying into

this investment? Then you get beyond that, and to me that is the

top tier sort of—I am not saying that is all someone should know,

but too many people don’t even know those three things.

Chairman SHELBY. Anybody have any other comments? Mr.

Gensler, what else should they know?

Mr. GENSLER. I would say on the risk aspect, there is a way that

sophisticated investors look at risk, and it is called risk-adjusted

return. I think that that would be the way to take those words, if

somebody wanted to get it to page 1, and actually share with investors risk-adjusted returns.

Chairman SHELBY. Is that risk versus return?

Mr. GENSLER. Without getting into the calculus, it is a way to

bring that return and adjust it for higher risk or lower risk.

Chairman SHELBY. What Mr. Glassman says, you know, we have

a capitalist economy. You are investing for profit.

Mr. GENSLER. That is correct.

Chairman SHELBY. You have growth in there, so you know there

is some risk—some risk everywhere when you put your money in.

Mr. GENSLER. Right, but there is——

Chairman SHELBY. Versus the return that they hope to make. Is

that correct?

Mr. GENSLER. Right. But just in that one small place, there is

a different risk of a Treasury bond than of an Internet stock. I

think to your question, the most important thing for investors to

do is first, on their own, without all of this information, decide how

comfortable they are in stocks versus bonds versus cash. Eighty or

90 percent of the investment decision is really right there, your

222

asset allocation. Then when you have picked stocks and bonds, how

to best invest——

Chairman SHELBY. You have funds that specialize in bonds.

Mr. GENSLER. That is right.

Chairman SHELBY. You have some in stocks.

Mr. GENSLER. That is right.

Chairman SHELBY. Everything, don’t you?

Mr. GLASSMAN. Yes, just in answer to your question, Mr. Chairman, it is kind of interesting that Mr. Berry and Mr. Gensler

should really focus on some very simple ideas, very simple metrics.

I really think those are the key. I completely agree with them. A

lot of the discussion today has been about arcana, which, quite

frankly, most investors just—I mean, they are either not interested

in it or they don’t have the time. They are doing other stuff with

their time.

What do they need to know? They need to know the past performance of the fund, the objective of the fund, the volatility, which

is basically the way we define risk, and the——

Chairman SHELBY. The integrity of the fund.

Mr. GLASSMAN. Excuse me?

Chairman SHELBY. The integrity of the people running the fund.

Mr. GLASSMAN. Absolutely. That is a very difficult thing to find

out, and that is one of the reasons that people go to third parties

to make their decisions about funds. How are they going to judge

the integrity of an individual fund manager? That is hard. The

brand is important; a brand like T. Rowe Price or like Fidelity is

important—and absolutely expenses. People need to know more

about expenses. But they have tons of information as it stands

right now about all these things, and I urge them to go to places

like Morningstar to get probably much more than they want to

know—maybe not more than they need—well, yes, I would also say

probably more than they need to know, most of them.

Chairman SHELBY. They should get involved and know probably

more than just glancing at something, because if we have mutual

funds totally with trillions of dollars in it, this is big. It is big for

the capital markets. It is big for the investor.

Mr. GLASSMAN. Yes. But I want to reemphasize something that

Gary just said. Mutual funds are a way to meet specific investment

aims. Asset allocation is much more important. That is how you

divide up your assets among stocks, bonds, and cash—much more

important than which individual mutual fund you pick. And so, we

don’t really want to lose sight of the forest for the trees here.

Chairman SHELBY. Mr. Phillips.

Mr. PHILLIPS. I think we should be careful about these arguments and say let’s dumb down the information, let’s keep it very

simple because investors are overwhelmed, and realize that there

are also a lot of forces in the market that work to help investors.

Financial advisers, the majority of investors are going through an

adviser, a professional. When a State treasurer chooses funds for

a 529 plan, the stuff that we may say is arcane information that

the investor doesn’t want to see is very important to these people

that have a fiduciary role to the investor. Academics study the

industry, and the more disclosure they have, the more they can

223

contribute to the aggregate body of knowledge that we have about

mutual funds.

So while this data may not be that important that every individual is going to read it, it will make an impact on the marketplace. Perhaps you don’t put these things front and center, but

more disclosure and more information about costs and whether

management’s interests are aligned with investors will make a difference to companies choosing funds for a 401(k) plan and other

professionals that are helping the investor with their choices.

Chairman SHELBY. Gentlemen, thank you for your patience.

Thank you for the information you have brought to the Committee,

and we will continue our hearings in a thorough way and try to

balance what is right here and without rushing to judgment.

Thank you.

[Whereupon, at 12:22 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

224

PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI

Thank you, Chairman Shelby, for the third in a series of oversight hearings on

the mutual fund industry. It has been nearly 3 months since our last hearings on

this issue were held and since that time many significant events have taken place.

Back in November, I stated that virtually every day since the revelation of market

timing and late trading abuses, the mutual fund industry appeared on the front

pages of newspapers and was featured in television news segments and radio interviews. That situation does not appear to have changed. Just over a week ago, news

surfaced of a mutual fund’s employees permitting market timing of a mutual fund

set up for young investors.

Unfortunately, the bad actors in the mutual fund industry, who put their own interests ahead of their shareholders’ and in the case I just cited ahead of children,

have put a cloud over the entire industry. I have no doubt that the individuals in

charge of preventing abuses to the system will be brought to justice. Their actions

clearly violated the current regulatory scheme, and the SEC and State regulators

already have commenced enforcement actions to rid the industry of them.

It also is clear that the SEC has been extremely busy since our last set of hearings. The Commission has been putting together a series of rule proposals to clarify

existing law and to ensure that the grey areas of a mutual funds’ activities are

clearly marked as black and white. Some of the proposals, including one on mutual

fund compliance programs, have already been adopted. While I support many of the

SEC’s actions in this area, it is clear that there are many important areas that need

to be fully and carefully examined before final action takes place.

For example, the SEC proposed a ‘‘hard 4 o’clock’’ close for orders of mutual fund

shares to reach the mutual funds. As I am a Member of the Committee on Health,

Education, Labor, and Pensions, I have heard from many pension and benefit plan

administrators, especially from the mountain and the western States that a hard

4 o’clock close would place employees with pensions and with 401(k) plans at a disadvantage with investors who place orders for mutual fund shares directly with

mutual funds.

Also, there are issues that appear ripe for a quick regulatory or legislative fix.

However, upon closer examination, these issues are far more complex and intricate

than they first appear. For example, certain industry members would institute a

complete ban on so-called ‘‘soft dollars’’ which may be a misnomer in itself. Unfortunately, other industry members state that a complete ban would place independent

research firms at a competitive disadvantage. These are the same research firms

that were described as essential for investor confidence in last year’s $1.4 billion

SEC and State global settlement with Wall Street firms. We need to fully understand why these independent research firms would be placed at a disadvantage and

what can be done so that they are not disproportionately affected by any proposed

changes to the way the industry operates.

Before us today, we have a diverse panel of mutual fund experts that will help

us to understand better the operations and corporate governance policies of mutual

funds from the perspective of investors. Their testimony is essential for us to have

a clearer comprehension of the intricacies of the operations of the mutual fund industry, an industry structured unlike any other financial or corporate industry. We

need their expertise to help us discern the true effects of proposed reforms that have

been raised to date.

For example, I have serious questions about the recent SEC proposal to require

an independent chairman for a mutual fund even if the mutual fund’s board is comprised of a super-majority of independent directors. Another proposal that the Commission is considering this morning would require a mandatory redemption fee for

investors that trade within a short period of time. I am unclear as to whether this

proposal will completely stop market timing abuses and I am concerned that the

proposal may have unintended consequences for some individual investors. The witnesses’ testimony is crucial for our understanding of issues like these.

If legislation is necessary, I would like to see Congress thoroughly evaluate the

problem to find the right solution. We should not rush to pass legislation as we may

do undue harm to the industry. I applaud the Chairman for taking a similar approach that we used in the Sarbanes-Oxley Act.

Typically, for every action, Congress has a tendency to overreact. In this situation,

we need to thoroughly review the problems to find the appropriate solution. In addition, we still have a responsibility to make sure that whatever action is taken does

not have a negative cascading effect on small entities and small investors.

Several of our witnesses in their written testimony have cited a greater need for

investor education and financial literacy. I wish to note that the Financial Literacy

and Education Commission created by the Fair and Accurate Credit Transaction Act

225

(FACT) of 2003, held its first meeting last month to coordinate the Federal Government’s financial literacy and education efforts. Financial literacy has been a very

important issue for Senator Sarbanes, our colleagues on the Committee, and I. I appreciate your efforts to have it included in the FACT Act.

Thank you, Mr. Chairman, for holding this hearing. I appreciate the effort that

you are taking to carefully analyze the problems with the mutual fund industry. I

look forward to working with you on future Committee hearings highlighting this

very important matter.

—————

PREPARED STATEMENT OF TIM BERRY

INDIANA STATE TREASURER AND

PRESIDENT, NATIONAL ASSOCIATION OF STATE TREASURERS

FEBRUARY 25, 2004

Introduction

Mr. Chairman, thank you for the opportunity to appear before this distinguished

Committee. My name is Tim Berry and I am the Treasurer of the State of Indiana.

I am honored this year to also serve as the President of the National Association

of State Treasurers. We are very pleased to offer our comments relative to current

mutual fund practices and their impact upon investors, including the States as investors. We are also pleased to provide you information on efforts to expand investor

education, and the role such efforts play in building investor confidence in the financial markets.

The National Association of State Treasurers, or NAST, is a bipartisan membership organization composed of all State treasurers, or State finance officials, from

the United States, its commonwealths, territories, and the District of Columbia. As

the elected chief financial officers of the States, the State treasurers directly oversee

more than $1.5 trillion dollars in State funds. The treasurers are important daily

participants in the domestic securities markets, investing State funds in U.S. corporations and small businesses. They have a direct stake in the health of the Nation’s economy and diligently share their expertise in fiscal and investment matters

with other Government officials and the general public. Based on this role, the State

treasurers are in the forefront of addressing concerns about corporate business practices and governance, leading efforts to ensure investor confidence in the stock markets and to increase shareholder value for the citizens of their States.

A great majority of State funds are invested in the domestic equity markets.

Earnings from investments are an important source of revenue for State governments. These earnings are used to fund vital public services, to cover public employee retirement obligations, to help families save for college, and to fund beneficial

economic development programs, among other uses. In contemporary financial markets, maximizing this source of revenue is a complex and time-consuming undertaking. To make the best use of investible public funds, investors like the State

treasurers strive to earn the best returns possible without sacrificing the safety of

their funds or subjecting their portfolios to undue risks. State treasurers and other

public investors must achieve this goal within the constraints of applicable State

and Federal laws, keeping in the forefront the overriding principles of safety, liquidity, and yield.

The nature of State investments has made the State treasurers keenly aware of

issues surrounding the mutual fund industry and its impact on investor confidence

in the capital markets. We believe that accurate and reliable financial reporting lies

at the heart of our financial market system and that investor confidence in such

information is fundamental to the health of our markets. We further believe that

expanding and strengthening the disclosure requirements of mutual fund companies

will address concerns about investor confidence and enhance efforts to raise the

level of understanding of the complexities and risks of mutual fund investing.

What is at Stake?

The recent allegations of fraud in the mutual fund industry have fundamentally

altered Americans’ perceptions of these important investment vehicles. These allegations do not involve isolated instances of individual wrongdoing by low-level employees—the proverbially ‘‘few bad apples,’’ but rather appear to involve a large number

of mutual fund complexes, and wrongdoing by a significant number of employees,

including, in some cases, executives at the highest levels of management.

Revelations regarding significant problems in mutual fund compliance have made

regulatory reform a critical issue. The alleged frauds in these cases were open and

226

1The enactment of Economic Growth and Tax Relief Reconciliation Act in 2001 has enhanced

the attractiveness of Section 529 plans by allowing greater contributions and flexibility in the

plans. The 2001 Act allows tax-free distributions from Section 529 savings plans for qualified

higher-education expenses. Previously, withdrawals from these accounts were generally taxed at

the rate of the beneficiary—usually a child or grandchild. In another change, contributors now

will be able to move their 529 plan investments from one State’s plan to another once a year

without having to change beneficiaries. As a result, assets in Section 529 savings plans have

more than quadrupled since 2001, increasing from $8.5 billion at year-end 2001 to $45.7 billion

by December 31, 2003. The number of accounts rose to over 6 million, and the average account

size was approximately $7,600.

notorious and violated express legal requirements. Fund stewards were on notice

and failed to take action. Recently, the U.S. Securities and Exchange Commission

surveyed most of the largest mutual fund complexes in the country and all of the

Nation’s registered prime brokers. Preliminary findings reveal the apparent prevalence with which mutual fund companies and brokerage firms had arrangements

that allowed favored customers, including themselves, to exercise after-hours trading privileges and market timing options—as well as the ability to participate in

other abusive practices.

Investors have placed their trust in mutual funds with the understanding that

they would be treated fairly—that fund managers would do their duty as fiduciaries.

Unfortunately, there have been instances where the mutual fund industry has failed

to live up to its fiduciary duty. The common theme running through all of the mutual fund issues that have been exposed in recent months is that certain participants in the mutual fund industry are putting their own interest ahead of mutual

fund investors.

These violations of the fiduciary duty owed to investors have caused real harm—

particularly in confidence and in lost investment value. These frauds reflect a systemic compliance failure in the sense that the current structure of fund oversight

is not resulting in fund shareholders receiving the most fundamental and obvious

forms of protection from actual and potential abuses. If shareholders are not being

protected from the most obvious frauds, they may not have any confidence that they

are being protected from frauds that we have yet to or may never discover.

The Vital Role of State Treasurers

The State treasurers have a direct stake in issues raised by mutual fund trading

and sales practices. Twenty-five States utilize money market mutual funds to invest

a portion of their general fund investments. Thirty-eight States use mutual fund

companies as intermediaries for general fund investments. Many State treasurers

also directly oversee or sit on the boards of State and local government pension

plans, including supplemental pensions, 401(k) and deferred compensation plans,

many of which are based on mutual fund investments. Most significantly, the State

treasurers are directly involved in the oversight and management of Section 529

college savings plans, the bulk of which are based on an investment model linked

to the mutual fund market.1 Additionally, numerous mutual fund firms manage institutional portfolios for State and local government pension systems and other investment programs, but these operations are generally separate from the mutual

fund’s retail business. Mutual fund investments and mutual fund companies are a

critical component of the treasurers’ investment functions.

As fiduciaries of public investment funds, the State treasurers, their investment

oversight boards, and their money managers maintain great responsibilities which

bear directly on mutual fund company issues. First, as fiduciaries, they have a duty

to act prudently and in the best interests of their plan participants and beneficiaries. Second, as investors, they have an opportunity and duty to speak out on

the strategy, direction, and governance of the mutual funds in which they and their

constituents invest. This is the essence of responsible investment management.

State and local governments are among the Nation’s most important institutional

investors. Both singly and collectively, Government fund investments are frequently

the most important shareholders a mutual fund has. Consequently, they are in a

unique position to influence corporate policies and financial markets.

Federal laws such as ERISA generally do not apply to State and local pension

funds, which are governed by State and local regulatory structures that vary from

jurisdiction to jurisdiction. In every jurisdiction, however, those who control State

and local investment funds—State treasurers, pension boards and trustees, etc.—are

considered fiduciaries. As fiduciaries, they are duty-bound to act in good faith and

for the exclusive benefit of plan participants and beneficiaries. They must discharge

their duties with the care, skill, and diligence that a prudent investor would exercise on his or her own behalf under like circumstances. To meet this high standard,

227

they must demonstrate that the investment practices and policies they adopt on

behalf of plan participants and beneficiaries are fundamentally sound.

As fiduciaries, State treasurers must factor allegations of improper mutual fund

practices into the fiduciary’s determination of the continuing appropriateness of a

fund. They must be attentive to activities that materially affect the plan’s investment in the mutual fund or expose the plan to additional risk. They must have more

active communication with mutual fund management in order to meet their obligations under State law.

As competent and effective fiduciaries, individual State treasurers are demanding

numerous changes to the manner in which corporations and mutual funds operate.

These important activities have long been recognized as a fundamental function of

our association, which last year established a standing committee on corporate governance. Currently chaired by Connecticut Treasurer Denise Nappier and Nevada

Treasurer Brian Krolicki, the Corporate Governance Committee has taken a leading

role in responding to issues raised by corporate behavior, including work on the

proxy access issue, reforms to corporate board structure, composition and functions,

and oversight of the stock exchanges. We have taken a number of strong positions

on these matters and would be pleased to share them with the Committee.

In a continuation of these efforts, North Carolina Treasurer Richard Moore, working with our Corporate Governance Committee, has implemented a series of ‘‘mutual fund investor protection principles’’ designed to provide greater transparency in

mutual fund practices. The principles aim to stop late day trading by requiring the

fund to hold all trades for 12 months. They require the fund to report how the managers are compensated and require at least two-thirds of the mutual fund board to

be independent directors.

These principles illustrate how the treasurers are acting in good faith on behalf

of the citizens of their States. They are discharging their duties with care, skill, and

due diligence. They are adopting fundamentally sound investment policies and implementing them within their States. They are attentive to fund activities that are

affecting the health of their State’s investments. And finally, they are active in their

communication with mutual fund management, working to find equitable solutions

to recent industry abuses. These actions have been taken with a fundamental goal

in mind: To restore investor confidence, mutual fund companies need to provide

timely and accurate information about costs and fees, performance and potential

risks. The mutual fund companies should be required to provide investors access to

timely and understandable information.

What Should Investors Do?

Investors must actively research and monitor their fund investments to ensure

that fund managers have their best interests in mind. At a minimum, investors

should look to see that the mutual fund charges reasonable annual expenses; and

that the fund management provides open and honest communication with investors.

The fees charged for participation in a mutual fund are a key issue for investors.

These fees can be substantial and may erode investment returns in mutual funds.

Generally, investors do not pay enough attention to mutual fund expenses. Some

funds charge investors upfront or back-end ‘‘loads,’’ or commissions, and all funds

charge investors management fees, under the term ‘‘expense ratio.’’ Investors should

be aware that even small fees may detract from growth in investments. In fact, fees

mount over time because investors’ total assets mount as well.

These recommendations, of course, are predicated on investors having adequate

access to timely and intelligible information on mutual fund fees and expenses.

Equally important, particularly for the long-term health of investors, and by extension to the whole economy, these investors need a strong education on how to

approach and manage mutual fund investments. Thus, in considering regulatory

reform, the Committee should also address the scope and adequacy of financial

literacy training in the United States.

Policy Recommendation

In recent months, the Securities and Exchange Commission has taken a number

of steps to address issues raised by State and Federal investigations into mutual

fund sales and trading practices. For example, to address late trading issues, the

Commission adopted a new rule to require that an order to purchase or to redeem

mutual fund shares be received by the mutual fund by the time that the fund establishes for calculating its net asset value in order to receive that day’s price. We believe this rule would effectively eliminate the potential for late trading through

intermediaries that sell fund shares.

The Commission also recently proposed an amendment to Rule 12b–1 under the

Investment Company Act of 1940 that would prohibit mutual funds from directing

228

commissions from their portfolio brokerage transactions to broker-dealers to compensate them for distributing fund shares. This would eliminate a large potential

conflict of interest, aligning fund companies more directly with the interests of their

shareholders.

The Commission also recently adopted a compliance rule that will require these

funds and advisers to have compliance policies and procedures, to annually review

them and to designate a chief compliance officer who, for funds, must report to the

board of directors. The designated compliance officers and written policies and procedures will have several benefits, including having a designated person charged

with fund compliance who must answer to, and be accountable to, the fund’s board

of directors, thereby enhancing compliance oversight by directors, as well as allowing the SEC’s examination staff to review the reports made to the board.

In addition, the Commission proposed enhanced disclosure requirements. These

enhancements would require funds to disclose market timing policies and procedures, practices regarding ‘‘fair valuation’’ of their portfolio securities and policies

and procedures with respect to the disclosure of their portfolio holdings. This type

of disclosure should shed light on market timing and selective disclosure of portfolio

holdings so that investors could better understand the fund’s policies and how funds

manage the risks in these areas. Mutual fund boards of directors play an important

role in protecting fund investors. They have overall responsibility for the fund, oversee the activities of the fund adviser, and negotiate the terms of the advisory contract, including the amount of the advisory fees and other fund expenses. In order

to improve such governance, the Commission recently proposed amendments to its

rules to enhance fund boards’ independence and effectiveness and to improve their

ability to protect the interests of the funds and fund shareholders they serve. First,

independent directors would be required to constitute at least 75 percent of the

fund’s board. Second, the board would be required to appoint a chairman who is an

independent director. Third, the board would be required to assess its own effectiveness at least once a year. Its assessment would have to include consideration of the

board’s committee structure and the number of funds on whose boards the directors

serve. Fourth, independent directors would be required to meet in separate sessions

at least once a quarter. Finally, the fund would be required to authorize the independent directors to hire their own staff.

We commend the Commission for its efforts in this area. The new rules governing

board composition and functions, as well as governing trading practices and expense

disclosures, will go a long way toward rectifying many of the abuses identified in

the recent investigations of the mutual fund industry.

The implementation of these new rules confirm our opinion that the mutual fund

industry is neither inherently corrupt nor in need of a major structural overhaul.

While these rules properly clarified and strengthened, it is not necessary to undertake wholesale reform of the regulation of this industry. The vast majority of people

in the fund management industry are honest and hard working. Collectively, they

provide a valuable service to the American public. Moreover, the U.S. fund industry

has a good long-term record of serving investors. This record reflects the strengths

of the industry’s structure and the emphasis placed on disclosure by its overseers

and regulators. To the extent that the industry has lost its way in recent years, we

believe that it is a function of its participants placing profit over the needs of mutual fund investors. The profitability of the fund company or its employees must

never take precedence over the interests of fund shareholders.

However, we remain concerned in particular about a practice that does great damage to investor confidence in the fairness and equity of mutual fund investments.

Specifically, what are prospective mutual fund investors being told about revenue

sharing arrangements and other incentives provided by mutual fund companies to

brokers selling their funds? Do customers understand that their broker is being paid

to sell a particular fund? And when these payments are being made from fund

assets, do customers understand that their own investment dollars are being used

to foot the bill for the mutual funds’ premium ‘‘shelf space’’ at the selling broker’s

office? Such fees may increase costs to investors, as well as create conflicts of interest between investors and the financial professionals with whom they deal.

Congress should act promptly to eliminate this gap in mutual fund fee disclosure.

Current SEC rules and positions provide investors with a misleading picture of the

incentives of brokers from whom they buy fund shares. If an investor buys shares

of a particular company, his broker must send a confirm that shows how much the

broker was paid in connection with the transaction. In contrast, if an investor buys

shares in a mutual fund, the confirm is not required to provide this information.

The Commission is considering possible solutions to this problem. But we believe

this issue is so critical to restoring confidence in mutual funds, that Congress should

require that all compensation received by brokers in connection with sales of fund

229

shares be disclosed on fund confirmations, as well as any information necessary to

direct investors’ attention to incentives that a broker may have to prefer the sale

of one fund over another. With America’s investors experiencing a crisis in confidence in the mutual funds, fee disclosure reform is more important than ever.

Financial Literacy Programs

In order to succeed in our dynamic American economy, our citizens must be

equipped with the skills, knowledge, and experience necessary to manage their personal finances and retirement needs. All members of our society should have the

financial knowledge necessary to make informed financial decisions. Despite the

critical importance of financial literacy, many citizens lack the basic skills related

to the management of personal financial affairs.

The recent allegations of fraud in the mutual fund industry underscore the tremendous need for financial education in the United States. Improved financial education will help mutual fund investors better understand the costs associated with

this form of investment, as well as the risks and rewards of mutual fund investing.

A better educated class of investors would understand the industry, which would

increase overall confidence in the capital markets.

State treasurers have long recognized the need for improved financial education

for all of our citizens. For many years, treasurers have taken a very active role in

promoting financial literacy to the residents of their State. State treasurers strive

to provide and promote financial education for the benefit of the citizens of the

States, to improve their quality of life. State treasurers draw on their substantial

expertise in the financial management of both personal and public funds to provide

opportunities to educate the citizens of the States on savings, from birth to retirement. Members emphasize there is a critical need for personal savings to the citizens of the States. Through the legislative processes, State treasurers support public

policy positions that promote savings, and seek changes of current policies which

hinder and penalize savings.

The financial literacy programs range across a variety of target demographic

groups, from school age children, to women, to public officials. For example, State

treasurers have developed an innovative personal finance workshop targeting

women interested in learning how they can take control of their financial situations.

Since that first Women and Money Conference, more than 15 treasurers have implemented this program in their States. The treasurers in Delaware, Maine, Massachusetts, Ohio, and many other States have developed strategic partnerships with local,

regional, and national organizations and they continue to provide Women and

Money Conferences for residents of their States.

Alabama Treasurer Kay Ivey, who has worked on financial education matters for

30 years, works closely with local boys and girls clubs to teach financial basics to

the young people in her State. In another example, Delaware Treasurer Jack

Markell has developed an innovative program called the Delaware Money School designed to bring community-based financial education to participants in a pressure

free learning environment. Topics covered in the Money School include basic money

management, investing, and retirement planning. Specialized classes are also offered at the request of churches, senior citizen centers, or community groups.

In the Delaware Money School, a coalition of financial professionals—from the

financial service industry, nonprofit organizations, and government—volunteer to

teach the classes. The Money School is a collaborative undertaking with various

community and public organizations, it can also be structured to fit the specific

needs of a group of people or provide educational opportunities as they arise.

Many of us take the lead in providing education programs for State and municipal

employees charged with managing public finances. These workshops present participants with tools to deal with the fiscal and ethical issues they face when investing

public resources. In some States, continuing education is mandated for public fund

managers, and the treasurers’ programs satisfy this requirement. In other States,

the treasurers initiate the workshops on their own. In California and Ohio, where

the programs are mandated, more than a dozen workshops on topics, ranging from

investment management to innovative financing techniques, are held each year. In

Illinois and Indiana, where the programs are not required by law, the treasurers

hold annual conferences for local public finance officials.

In addition to the programs administered by the States, the National Association

of State Treasurers has taken an active role in providing educational opportunities

to members and other public officials responsible for the management of public

funds. For 8 years, NAST has sponsored the National Institute for Public Finance,

a comprehensive curriculum designed to enhance participants’ understanding of

public financial management and increase their abilities to make independent financial decisions. We also recently established the NAST Foundation, a not-for-profit

230

organization, to promote and improve the educational initiatives of the organization

and individual State treasurers.

The common theme among these programs is the vital need to provide all citizens,

and the public officials who serve them, the tools and information to understand and

negotiate our complex financial markets. The issues raised by the recent developments in the mutual fund industry amplify this need. Financially literate investors,

supplied with clear and understandable information, are better able to make informed investment decisions, which is critical to their and the Nation’s financial

health and well-being.

Conclusion

Collectively, legislators, regulators, and the industry can rebuild and preserve the

public’s trust in mutual funds by implementing stronger disclosure requirements in

order to better align fund management company interests with those of fund shareholders. This will give current and prospective investors access to the type of information to enable them to make fully informed decisions about their investments.

By bringing more visibility to the corporate structure of funds and by enhancing

the availability and usefulness of financial information disclosed by the firms, this

Committee can demonstrate to American investors that mutual funds will continue

to operate as the cleanest, brightest investment method for all Americans. The industry does not need a wholly new set of operational rules or new oversight groups,

it simply needs to be held accountable to both the letter and the spirit of the rules

that have guided it well for decades. We believe the simple improvements suggested

here can help keep the industry focused on its ultimate mission—helping investors

meet their goals and secure a safer future for their families.

—————

PREPARED STATEMENT OF JAMES S. RIEPE

VICE CHAIRMAN, T. ROWE PRICE GROUP, INC.

FEBRUARY 25, 2004

Introduction

My name is James S. Riepe. I am Vice Chairman of T. Rowe Price Group, Inc.,

a Baltimore-based firm that, through its affiliates, provides investment management

services to the T. Rowe Price family of no-load mutual funds and to individual and

institutional clients. In addition, I am Chief Executive Officer of each of the Price

Funds and the Chairperson of all the Price Fund Boards. T. Rowe Price acts as

sponsor, investment adviser and distributor of 108 mutual funds and variable annuity portfolios which, as of the end of 2003, exceeded $120 billion in assets. In total,

T. Rowe Price manages approximately $190 billion in assets.

I appreciate the opportunity to appear before the Committee today to discuss the

ongoing efforts of my firm, and the mutual fund industry as a whole, to respond

to abusive mutual fund trading practices by taking concrete and far-reaching actions

to protect investors’ interests and prevent future abuses. I also note that my comments come from the perspective of having been engaged in the mutual fund business for the last thirty-five years.

Executive Summary

T. Rowe Price Group operates its mutual fund business in accordance with the

fundamental principle that the interests of our fund shareholders are paramount.

Consequently, we have been deeply dismayed by the recent revelations of abusive

mutual fund trading practices.

We support appropriate action by Government authorities to redress these abuses,

and we commend the SEC for its swift and comprehensive regulatory response. As

we have urged for a number of years, it is critically important that the SEC receive

increased funding to develop appropriate regulatory initiatives and to carry out its

mutual fund oversight and inspection duties.

We also recognize that the challenge of restoring and maintaining investor trust

falls not on the regulators but on those of us in the business of managing and distributing funds. T. Rowe Price takes this responsibility very seriously.

T. Rowe Price has policies, procedures, and practices in place that seek to protect

Price Fund shareholders against late trading, abusive short-term trading of mutual

fund shares, and selective disclosure of fund portfolio holdings. In response to the

recent investigations and enforcement proceedings, we have conducted thorough

reviews of our policies, procedures, and practices in these areas, which has allowed

us to confirm their continuing effectiveness and to implement or consider certain

enhancements.

231

We have, as always, kept the Price Fund Boards fully informed of our actions and

they have played an active oversight role. We have also sought to educate fund investors—through communications on our website, in our newsletter, and in fund

shareholder reports—about the alleged improprieties and how we protect Price Fund

shareholders from these types of abuses.

The efforts of individual firms such as T. Rowe Price to address the concerns

raised by the scandal have been significant and are being supplemented by a series

of regulatory initiatives.

Late Trading

To protect against the possibility of late trading, the SEC has proposed rule

amendments that would mandate that all purchase and redemption orders be received by a fund, its transfer agent, or a registered clearing agency before the time

the fund prices its shares (e.g., 4 p.m. Eastern time). T. Rowe Price supports the

SEC’s proposed approach, until such time as an electronic trade monitoring process

is available that would allow other entities to receive fund orders on behalf of a fund

for pricing purposes.

Excessive Short-Term Trading

T. Rowe Price also supports the various regulatory measures that the SEC has

proposed and/or adopted to address abusive market timing activities, including: (1)

requiring funds to have more formalized short-term trading policies and procedures

and to explicitly disclose those policies and procedures, (2) emphasizing the obligation funds have to fair value their securities under appropriate circumstances, and

(3) providing a more effective mechanism for board oversight of market timing policies and procedures.

With respect to personal trading activities of senior fund personnel, the SEC has

recently proposed new code of ethics requirements for registered investment advisers, which T. Rowe Price supports.

Funds and their shareholders also would benefit if funds had additional ‘‘tools’’

to combat harmful market timing activity, such as a minimum 2 percent redemption

fee on fund shares redeemed within a minimum of 5 days of their purchase. The

SEC is expected to propose requiring such minimums for certain categories of funds

and we support this approach, but note the need to provide a sufficient time period

for implementation.

Fund Governance

The recent disturbing revelations do not evidence a failure of the fund governance

system but they do indicate that fund directors would benefit from additional tools

to assist them in serving effectively in their oversight role. The mutual fund compliance program rule recently adopted by the SEC will have a significant and farreaching impact on improving the compliance environment and enable fund directors to more readily oversee this important activity. Certain proposals to ‘‘improve’’

fund governance are, however, unwarranted, unrelated to the abuses that have been

revealed and counterproductive, such as mandating that all fund boards have an

independent chair and requiring independent directors to make certifications relating to matters outside the scope of what they could reasonably be expected to know.

Other Initiatives

In addition to internal measures and regulatory changes to protect investors

against the abusive mutual fund trading practices that have been the subject of recent investigations and enforcement proceedings, it is appropriate to consider other

ways to reinforce the protection and confidence of mutual fund investors. In this

vein, the SEC recently proposed, and T. Rowe Price supports, rule amendments to

ban the practice of directing fund brokerage transactions to reward broker-dealers

who also sell fund shares. In addition, the SEC has embarked on a prudent and

timely reevaluation of Rule 12b–1. Finally, the SEC has proposed to require brokerdealers to provide a separate document to mutual fund investors at the point of sale

that will help inform them about sales-related fees and payments and alert them

to possible conflicts of interest.

T. Rowe Price is committed to protecting our fund shareholders against abusive

mutual fund trading activities. We support those Government and industry efforts

which are designed to address these issues and other initiatives that will promote

investors’ interests. We are fortunate that investor confidence in mutual funds generally remains very high, but we must take advantage of the current problems to

make improvements that will guard against future breaches of trust and allow our

fund shareholders to be confident that their interests come first.

232

1State of New York v. Canary Capital Partners, LLC, Canary Investment Management, LLC,

Canary Capital Partners, Ltd., and Edward J. Stern (NY S. Ct. filed September 3, 2003)

(undocketed complaint).

Introduction

My name is James S. Riepe. I am Vice Chairman of T. Rowe Price Group, Inc.,

a Baltimore-based firm that, through its affiliates, provides investment management

services to the T. Rowe Price family of no-load mutual funds and to individual and

institutional clients. In addition, I am Chief Executive Officer of each of the Price

Funds and the Chairperson of all the Price Fund Boards. T. Rowe Price acts as

sponsor, investment adviser, and distributor of 108 mutual funds and variable annuity portfolios which, as of the end of 2003, exceeded $120 billion in assets. In

total, T. Rowe Price manages approximately $190 billion in assets.

I appreciate the opportunity to appear before the Committee today to discuss the

ongoing efforts of my firm, and the mutual fund industry as a whole, to respond

to abusive mutual fund trading practices by taking concrete and far-reaching actions

to protect investors’ interests and prevent future abuses. I also note that my comments come from the perspective of having been engaged in the mutual fund business for the last 35 years.

T. Rowe Price operates its mutual fund business in accordance with the fundamental principle that the interests of our fund shareholders are paramount. Our

fundamental thesis is a simple one: If shareholders prosper then we, as managers,

will do likewise; if they do not see value in an investment relationship with us, then

our business will do poorly. This principle is applied through formal, documented

policies, including a comprehensive Code of Ethics, but, perhaps more importantly,

it is also deeply ingrained within the firm’s culture. In this context, it is important

to understand that one cannot regulate ethical behavior, no matter how extensive

the compliance regulations. Ultimately, each of us must create an environment in

which the right decisions are made by our employees. Given our culture, and the

industry’s previously clean record, my colleagues and I were shocked and deeply dismayed by the allegations of late trading and short-term trading in the New York

Attorney General’s complaint in the Canary case 1 and subsequent allegations of

these and other abusive mutual fund trading practices. It is difficult to fathom that

persons associated with our industry—fund managers and intermediaries—would

knowingly permit the blatantly illegal buying and selling of fund shares after 4 p.m.

It is equally troubling that some fund companies allegedly entered into arrangements that authorized short-term market timing in apparent contravention of stated

policies in exchange for promises of other benefits to the fund manager. Perhaps

most disturbing of all are the revelations that a few fund insiders may have engaged

in short-term trading for their own personal benefit, again in contravention of stated

policies and potentially at the expense of other fund shareholders.

I commend the Securities and Exchange Commission and the New York Attorney

General’s office for their investigative efforts and forceful responses to these practices. However, the marketplace impact on the fund companies involved, caused by

the disclosure of abuses, has been so severe that it far exceeds the regulatory penalties. This has been a reminder to all of us how important is the implied bond of

trust between the investor and the fund manager.

I also commend the SEC for taking swift and sweeping actions on the rulemaking

front to address the abusive practices that have been discovered, and to otherwise

strengthen mutual fund regulation. I believe the SEC’s current far-reaching and aggressive mutual fund regulatory reform agenda is unprecedented.

Of course, in order for the SEC to develop appropriate regulatory initiatives to

respond to the trading abuses that have occurred, and to successfully carry out its

oversight and inspection duties with respect to mutual funds, it is critically important that the SEC have sufficient resources. Consistent with this, I strongly support

the Bush Administration’s proposed fiscal year 2005 budget for the SEC, which

would provide a significant and necessary increase over the record amount appropriated for the current fiscal year. I note that T. Rowe Price, and the fund industry

generally, has argued for increased SEC resources for many years. Funds have

historically generated SEC registration fees far in excess of the monies spent on

regulating and examining fund companies and related entities.

In addition to the important work of the SEC and other Government authorities

in redressing mutual fund abuses, however, the challenge of restoring and maintaining investor trust falls squarely on the shoulders of the industry itself. T. Rowe

Price and other mutual fund firms take this responsibility very seriously. In this

regard, we are heartened by the fact that investors have not found fault with the

fundamental features of funds—convenience, low-cost, diversification, and professional management. This is evident in our thousands of conversations with investors

233

each day and by the continued flow of tens of billions of dollars into equity, bond,

and money market funds.

The remainder of my testimony will: (1) describe what T. Rowe Price has done

to protect its fund shareholders’ interests against late trading, abusive short-term

trading of mutual fund shares, and the practice of selectively disclosing information

about fund portfolio holdings to shareholders; and (2) discuss regulatory initiatives

in these areas. I will also comment on hedge fund oversight and fund governance

issues, as well as certain other current initiatives to reinforce the protection and

confidence of mutual fund investors.

Response to Mutual Fund Trading Abuses

Since news of the mutual fund trading abuses first broke, T. Rowe Price, like most

other firms, has conducted thorough reviews of our firm’s policies, procedures, and

practices in the principal areas that have been implicated in the various enforcement proceedings and investigations that have been announced to date. This has

allowed us both to confirm the continuing effectiveness of our existing policies,

procedures, and practices and to make or consider certain enhancements. Throughout this process, we have kept the Price Fund Boards fully informed of our actions

and they have played an active oversight role. Indeed, since the initial revelations,

we have held three meetings of the Fund Boards in addition to our regularly scheduled meetings.

In addition to keeping the Fund Boards informed and involved in this process, we

believe it is important for investors to understand these improprieties and how we

protect Price Fund shareholders from these types of abuses. To this end, we posted

a statement on our website last fall emphatically condemning the practices and additional abuses that have been revealed or alleged in these investigations. The statement, which has been continually updated, includes questions and answers about

the practices that are under investigation and T. Rowe Price’s policies in these

areas. We have also updated shareholders on these issues in our newsletter and in

the Chairman’s letter included in the funds’ most recent annual reports to shareholders. Based on what I have seen and heard, it is my impression that most industry participants have developed communications for their investors.

Late Trading

Consistent with existing legal requirements, our mutual fund trading policy, delineated in our fund prospectuses, requires that fund transaction orders received

prior to 4 p.m. Eastern time (the time as of which we price our funds) be executed

at that day’s share price. Orders received after 4 p.m. Eastern time are executed

at the following day’s price. This policy also applies to shareholders who place their

orders through intermediaries such as brokers and retirement plan recordkeepers

(i.e., orders received by intermediaries before 4 p.m. will get that day’s price). Under

current law, these intermediaries are authorized to transmit their customer orders

to T. Rowe Price after 4 p.m. for processing at that day’s closing price, provided that

the intermediary received the orders before that time. Our firm has not and will

not enter into any arrangements with investors or intermediaries that authorize

post-4 p.m. trading.

In light of recent revelations of ‘‘late trading’’ of mutual fund shares, our Internal

Audit Department conducted a review of our established policies, procedures, and

practices with respect to the timely receipt of orders to purchase or redeem fund

shares and determined that they are sound. This review and the findings were discussed with the Price Fund Boards.

In addition, given the alleged instances of late trading involving transactions conducted through intermediaries, we have taken steps to improve our oversight of

intermediaries with whom we conduct business. In particular, we formed an Intermediary Oversight Committee which is charged with:

• Overseeing the relationships with intermediaries.

• Maintaining and enforcing our policies regarding intermediaries.

• Resolving any material issues relating to intermediaries.

• Taking action to terminate intermediaries that have failed to meet our compliance

standards.

T. Rowe Price has also required each intermediary with whom we have trading

agreements (currently over 200) to sign and return a certification that it is complying with all relevant rules and regulations regarding the handling of orders for

the Price Funds on a timely basis.

The SEC, for its part, has proposed to address late trading through rule amendments that would tighten existing regulations to require that all purchase and redemption orders be received by a fund, its transfer agent, or a registered clearing

234

2See SEC Release No. IC–26288 (December 11, 2003). 3SEC Chairman Donaldson Releases Statement Regarding Initiatives to Combat Late Trading

and Market Timing of Mutual Funds, SEC Press Release No. 2003–136 (October 9, 2003). 4See SEC Release No. IC–26287 (December 11, 2003) (proposing amendments to require

mutual funds to disclose in their prospectuses both the risks to shareholders of the frequent purchase and redemption of fund shares, and fund policies and procedures with respect to such frequent purchases and redemptions) (‘‘SEC Disclosure Proposals’’) and SEC Release No. IC–26299

(December 17, 2003) (adopting Rule 38a–1 under the Investment Company Act of 1940 concerning the mutual fund compliance programs) (‘‘SEC Compliance Rule Release’’). New Rule

38a–1 requires mutual funds to adopt and implement written policies and procedures reasonably

designed to prevent violation of the Federal securities laws, including procedures reasonably deagency before the time of pricing (e.g., 4 p.m. Eastern time).2 T. Rowe Price supports

the SEC’s proposal. Although this approach could have a significant impact on many

investors who own fund shares through financial intermediaries, the recent abuses

indicate that strong measures are necessary to ensure investor protection. However,

it is our expectation that an electronic trade monitoring mechanism will be developed in the near future that will permit trades to be accepted from intermediaries

after the closing time. Such a system would create an audit trail that could verify

that trade orders were received timely by the intermediaries from customers.

My own view is that, if the SEC expands the list of entities that would be permitted to receive orders on behalf of a fund for pricing purposes under its proposal,

it should consider requiring periodic reviews of those entities’ internal controls and

reports of any material inadequacies (similar to the SAS 70 control review).

Market Timing/Excessive Trading

For many years, T. Rowe Price has taken an active role in minimizing the potential negative impacts from short-term trading by fund investors on our funds and

their long-term shareholders. Our firm has not and will not enter into any arrangements with investors or intermediaries that authorize harmful short-term trading

in any of our funds.

Frequent trades driven by short-term market timing have the potential to disrupt

the management of a fund and raise its transaction costs. For those investors for

whom we maintain individual accounts, we review daily trading activity across the

complex at a retail, retirement, and institutional level, and we analyze purchases

and sales in the funds to determine if the transactions are within the excessive

trading guidelines contained in the prospectus. If we determine that a shareholder

has violated our guidelines, action is taken to restrict future excessive trading activity. Over the years, this monitoring process has resulted in actions up to and including the suspension of purchase privileges for many individuals and a number of

intermediaries.

In addition, to discourage excessive trading, a number of Price Funds impose redemption fees ranging from 0.5 percent to 2.0 percent. The required holding periods

vary and can be as long as 2 years.

In the wake of the recent scandals, our Internal Audit Department reviewed our

established policies, procedures, and practices concerning excessive trading, including the imposition of redemption fees, and determined that they remain sound. The

review and its findings were discussed with the Price Fund Boards. As a result of

this review, we have augmented our monitoring methodologies and will be expanding the number of funds subject to redemption fees.

One issue that the recent trading abuses have highlighted is the difficulty of ensuring that fund policies regarding excessive trading, including the imposition of redemption fees, will be appropriately and consistently applied in the case of investors

who own fund shares through intermediaries. With respect to intermediaries, the

monitoring process is based on aggregate activity for each intermediary and relies

on that entity to provide us with specific sub-account information when excessive

trading is suspected. As noted above, we have formed an Intermediary Oversight

Committee to help ensure, among other things, that intermediaries meet our compliance standards on an ongoing basis. We are also seeking written certification from

intermediaries that they are collecting redemption fees in compliance with the

funds’ policies.

Last fall, SEC Chairman Donaldson outlined various regulatory measures that

the SEC staff was considering to address abusive market timing activities.3 These

measures included new rules and form amendments to: (1) require explicit disclosure in fund offering documents of market timing policies and procedures, and (2)

require funds to have procedures to comply with representations regarding market

timing policies and procedures. Chairman Donaldson also indicated that the SEC

would consider measures to reinforce board oversight of market timing policies and

procedures. The SEC has recently taken formal action in these areas.4

235

signed to ensure compliance with disclosed policies regarding market timing. In addition, it requires a fund’s chief compliance officer to provide a written report to the fund’s board, no less

frequently than annually, that addresses, among other things, the operation of the fund’s compliance policies and procedures and material compliance matters that occurred since the date

of the last report. 5Funds should retain the flexibility to impose more stringent redemption fee standards, either

in the form of higher redemption fees and/or longer minimum holding periods. Flexibility is

important because different types of funds are affected differently by short-term trading. In addition, certain types of funds (e.g., money market funds and funds that are designed specifically

for short-term trading) should not be required to assess redemption fees. 6 At the SEC’s request, the NASD formed an Omnibus Account Task Force to consider issues

raised by the implementation of mandatory redemption fees in the omnibus account context. See

NASD, Report of the Omnibus Account Task Force (January 2004), available at http://www.

nasd.com/pdf—text/omnibus—report.pdf. 7See SEC News Digest, February 18, 2004. At the meeting, the SEC also will consider any

pertinent recommendations from the NASD’s Omnibus Account Task Force.

T. Rowe Price supports these measures. While our funds and many others already

have market timing policies and procedures, requiring funds to adopt formal and detailed policies and procedures in this area and specifically providing for board oversight will ensure that all funds have systems in place to address abusive activity.

Such a requirement should also provide a more effective mechanism for boards and

regulators to police compliance because more formal policies likely will limit discretion in dealing with short-term traders. Fund shareholders also will benefit from additional prospectus disclosure about a fund’s policies on short-term trading by gaining an understanding of how the fund will protect their interests from potentially

abusive activity. Requiring that such disclosure be in a fund’s prospectus could serve

to enhance compliance with the policies. The disclosure also could have a deterrent

effect by alerting potential abusers to the fund’s policies. Of course, it will be important for any new disclosure requirements to allow funds to achieve an appropriate

balance between providing disclosure that would have these beneficial effects and

providing overly specific disclosure that inadvertently could serve as a roadmap for

potential abusers to circumvent fund policies.

Steps also clearly need to be taken to enable mutual funds to better enforce the

restrictions they establish on short-term trading when such trading takes place

through omnibus accounts held by intermediaries. One approach would be to require

intermediaries to provide information about trading activity in individual accounts

to funds upon request (a practice that some intermediaries already have in place).

And an additional approach would be to require most types of long-term funds, at

a minimum, to impose a 2 percent redemption fee on any redemption of fund shares

within 5 days of purchasing them.5 If funds had a standardized minimum redemption fee along these lines, it should be easier for intermediaries to establish and

maintain the requisite systems to enforce payment of those fees.6 It is encouraging

that the SEC appears willing to consider proposing such a requirement.7 The administrative implications for recordkeepers of such broad-based redemption fees are

significant and would have to be examined by the SEC before final approval.

Employee Trading in Fund Shares

In addition to our review of policies, procedures, and practices related to excessive

trading by fund shareholders, the firm’s Internal Audit Department, its Director of

Compliance, and our Ethics Committee (which is chaired by the firm’s Chief Legal

Counsel and oversees the administration of the firm’s Code of Ethics) have reviewed

trading by T. Rowe Price personnel in the Price Funds over the last several years.

This review did not uncover the existence of any of the abusive trading practices

described in recent enforcement actions relating to fund portfolio managers and

senior fund executives. The review and its findings were discussed with the Price

Fund Boards.

Although our review did not uncover any such abusive trading, we are exploring

how to enhance protections against such conduct at T. Rowe Price. The firm has

maintained a comprehensive Code of Ethics since 1973. Each employee must annually sign a compliance verification form attesting to his or her compliance with the

Code. We are considering the possibility of instituting additional trading controls

relating to employee transactions in Price Fund shares that may be similar to the

controls in place for many years for employee trading in stocks and bonds. In addition, each year, we conduct Code of Ethics compliance meetings with all employees

at the vice president level and above. These meetings will be expanded to include

all employees in 2004.

Consistent with the actions we have been considering on a voluntary basis, the

SEC recently proposed to require registered investment advisers to adopt codes of

ethics that, among other things, set forth conduct expected of advisory personnel

236

8See SEC Release Nos. IA–2209; and IC–26337 (January 20, 2004) (‘‘SEC Code of Ethics

Proposal’’). 9See SEC Compliance Rule Release, supra note 4. 10 Id. at 16–17. 11The SEC also has proposed revisions to clarify prospectus disclosure requirements concerning fair value pricing. The proposal is intended to make clear that all funds (other than

money market funds) are required to explain briefly in their prospectuses both the circumstances under which they will use fair value pricing and the effects of using fair value pricing.

In addition, the proposed revisions are intended to clearly reflect that funds are required to use

fair value prices any time that market quotations for their portfolio securities are not readily

available (including when they are not reliable). See SEC Disclosure Proposals, supra note 4.

The proposed revisions should serve as a useful complement to the requirements articulated in

the SEC Compliance Rule Release and the proposed disclosure of market timing policies and

procedures discussed above. As in the case of market timing, however, too much specificity about

a fund’s fair value pricing policies could prove counterproductive by tipping off arbitrageurs and

allowing them to circumvent the policies. Thus, it is equally important that new disclosure requirements concerning fair value policies call for disclosure that will be informative to investors

but is not so specific as to invite abusive practices.

and also require such personnel to report their personal securities transactions,

including transactions in any mutual funds managed by the adviser.8 We support

this proposal.

Fair Value Pricing

Short-term trading activity, it appears, is often motivated by a desire to take advantage of fund share prices that are based on closing market prices established

some time before a fund’s net asset value is set. All mutual funds are required to

have pricing procedures in place to establish a share price each business day based

on the current market values of their portfolio securities. When market prices for

portfolio securities are not readily available or are not reliable, funds must determine the fair value of those securities. In accordance with policies and procedures

approved by the Fund Boards, T. Rowe Price has utilized fair value pricing for many

years, and on many occasions to address events affecting the value of a fund’s portfolio securities.

We recently conducted a detailed review of our valuation policies and procedures,

and determined that such policies and procedures are appropriate and are being followed. We have also reviewed our policies and procedures with the Fund Boards.

The SEC has recently taken steps to minimize the possibility that long-term fund

shareholders’ interests will be harmed by the activities of arbitrageurs seeking to

take advantage of stale prices. The SEC issued a statement regarding fair value

pricing requirements in its release adopting the mutual fund compliance program

rule.9 In addition to describing the SEC’s position on when funds must use fair

value pricing, the release states that the compliance program rule requires funds

to adopt policies and procedures that require the fund to monitor for circumstances

that may necessitate the use of fair value prices; establish criteria for determining

when market quotations are no longer reliable for a particular portfolio security;

provide a methodology or methodologies by which the fund determines the current

fair value of the portfolio security; and regularly review the appropriateness and

accuracy of the method used in valuing securities, and make any necessary adjustments.10 SEC examinations of funds will provide the opportunity to further reinforce and monitor the implementation of applicable requirements in this area.11

It is important to note that, while fair valuation can reduce the impact of harmful

short-term market timing activity, it cannot by itself completely eliminate such

trading. Accordingly, funds (including Price Funds) often employ additional methods

to deter market timing activity, such as the redemption fees discussed above.

Dissemination of Portfolio Holdings Information

It appears that several fund managers may have provided information about fund

portfolio holdings to certain investors in order to enable them or their clients to

trade ahead of the fund, to the potential detriment of fund shareholders. For years,

the Price Funds have maintained a formal policy relating to providing information

about fund portfolio holdings to clients, shareholders, prospective clients, consultants, and the public. The policy is intended to ensure that all the shareholders are

treated in a fair and consistent manner and that the information is not used in inappropriate ways. The policy lists the many pieces of information that may be of

interest to shareholders and others (for example, a fund’s top 10 holdings) and then

indicates when that information will be made available (for example, 7 days after

month end). The policy has been very helpful in managing requests for portfolio

holdings information. We have reviewed important aspects of the policy with the

Price Fund Boards and are considering modest revisions to ensure that it remains

237

12See SEC Compliance Rule Release, supra note 4, at 19. The rule requires that the fund’s

board approve the policies and procedures. In addition, it provides for regular reporting to the

board on the effectiveness of the policies and procedures, any changes thereto, and material

compliance matters. 13See SEC Disclosure Proposals, supra note 4. 14See SEC Code of Ethics Proposal, supra note 8. 15Staff Report to the U.S. Securities and Exchange Commission, Implications of the Growth

of Hedge Funds (September 2003) (‘‘Staff Report’’). 16 Id. at 92–95. 17The SEC has proposed to require, among other things: That the board perform an annual

self-assessment that would include consideration of the board’s committee structure and the

number of boards on which the directors sit; that the independent directors meet in separate

sessions at least once each quarter; and that funds authorize the independent directors to hire

their own staff. See SEC Release No. IC–26323 (January 15, 2004) (‘‘SEC Fund Governance Proposals’’). T. Rowe Price supports these measures, although our fund directors view themselves

as already having authority to hire staff if appropriate. In addition, the SEC has proposed to

require that independent directors constitute at least 75 percent of each fund board. While we

support requiring a supermajority of independent directors, we question whether the marginal

benefits, if any, of a 75 percent requirement would outweigh the disruption involved in imposing

Continued

responsive to those with a genuine need for the information while also being protective of shareholders’ interests.

The SEC has taken several actions to put in place additional, more specific regulatory requirements in this area. First, the SEC Compliance Rule Release states

that a fund’s compliance policies and procedures under the rule should address potential misuses of nonpublic information, including the disclosure to third parties

of material information about the fund’s portfolio.12 Second, the SEC has proposed

to require funds to disclose their policies and procedures with respect to the disclosure of portfolio securities, and any ongoing arrangements to make available information about their portfolio securities.13 Third, as indicated above, the SEC has

proposed to require investment advisers to adopt codes of ethics that, among other

things, set forth standards of conduct expected of advisory personnel and safeguard

material nonpublic information about client transactions.14

Similar to market timing, requiring funds to adopt formal policies should ensure

that they have a system to prevent disclosure that is not in the best interests of

shareholders and to police compliance. Board oversight and public disclosure will

further enhance compliance with the policies. At the same time, the approach proposed by the SEC appropriately would preserve some flexibility in how funds release

information. T. Rowe Price supports the SEC’s initiatives.

Hedge Fund Oversight

The action brought by the New York Attorney General against Canary Capital

also underscores the need for some SEC oversight of hedge fund advisers. Last fall,

the SEC issued a Staff Report on hedge funds 15 that included a recommendation

to require hedge fund advisers to register under the Investment Advisers Act of

1940. As the Staff Report indicates, by requiring hedge fund advisers to register,

the SEC would be able to observe the trading activities of the funds managed by

such advisers and be in a better position to detect improper or illegal trading practices.16 T. Rowe Price supports the SEC recommendation to require those advisers

to hedge funds that are not otherwise already registered to register under the Investment Advisers Act.

Fund Governance

The recent disturbing revelations about mutual fund abuses have caused some to

question the effectiveness of the fund governance system. However, blaming directors, especially independent directors, for failing to uncover the wrongdoing that

has occurred is unfair. Independent directors cannot—and should not—be responsible for the day-to-day management of a fund’s, adviser’s, distributor’s, or recordkeeper’s activities. Indeed, in several cases, the problematic conduct took place at

unrelated entities.

The recent incidents do indicate that directors would benefit from additional tools

to assist them in serving effectively in their oversight role. The SEC’s mutual fund

compliance program rule, discussed above, should serve as a useful vehicle for this

purpose by requiring funds to have compliance policies and procedures reasonably

designed to prevent violation of the Federal securities laws and by improving the

flow of information about the policies and procedures, as well as significant compliance issues, to the directors. In addition, the SEC has proposed several new fund

governance requirements that should help enhance the independence and effectiveness of fund boards.17 However, certain other proposals to ‘‘improve’’ fund governVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00249 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
238

that standard rather than codifying the two-thirds supermajority that most fund boards have.

The SEC also has proposed to require fund boards to appoint an independent chair which, as

discussed in more detail below, T. Rowe Price believes should not be mandated for all fund

boards. We recently sent a letter to the SEC staff setting forth T. Rowe Price’s views on these

important matters. See Letter from Henry H. Hopkins, Chief Legal Counsel, T. Rowe Price Associates, Inc., to Mr. Paul F. Roye, Director, Division of Investment Management, Securities and

Exchange Commission, dated January 13, 2004. 18For example, some funds have found that having an interested director serve as board chair

is beneficial in that it promotes administrative efficiencies. 19For example, several years ago the T. Rowe Price funds’ audit committee expressed a desire,

for reason of the appearance of a conflict, to have different independent accountants than those

who served the funds’ adviser. The full boards supported this recommendation and, as a result,

the adviser replaced its auditors. 20For example, the Investment Company Act requires a separate vote of the independent directors on virtually all important decisions, such as approval of the fund’s investment advisory

and underwriting agreements, and the use of fund assets to support the distribution of fund

shares under a Rule 12b–1 plan. Existing practices in the fund industry—such as a supermajority of independent directors, the appointment of lead independent directors and regular

meetings of independent directors in executive session—further reinforce the independence and

authority of the independent directors. The Price Fund Boards follow all of these practices. In

addition, as noted above, the SEC recently issued a proposal that would require, among other

things, that independent directors constitute at least 75 percent of fund boards and that the

independent directors meet in separate sessions at least once each quarter. See SEC Fund Governance Proposals, supra note 17. 21See, e.g., Section 201 of H.R. 2420, the ‘‘Mutual Funds Integrity and Fee Transparency Act

of 2003,’’ as passed by the U.S. House of Representatives on November 19, 2003; Section 204

of S. 1971, the ‘‘Mutual Fund Investor Confidence Restoration Act of 2003,’’ as introduced by

Senators Corzine and Dodd on November 25, 2003.

ance in the wake of the recent scandals are unwarranted, counterproductive, and

would not improve the substantive oversight of the board.

One such proposal would require mutual fund boards to have an independent

chair. While some fund boards may choose to have an independent chair—as a number now have—not all fund boards may find that this structure works well for

them.18 It seems counterintuitive to mandate such a requirement, instead of allowing the directors to determine in their best judgment who is the most appropriate

person to serve as the board’s chair. This reasoning is reinforced by the fact that

the SEC (and applicable law) already relies heavily on the independent directors’

judgment with respect to protecting the interests of shareholders. Furthermore, the

independent directors already constitute at least a majority (and in most cases a

supermajority) of a mutual fund’s board, and therefore have full power to appoint

an independent chair if they wish to do so. In the case of T. Rowe Price, fund directors some years ago appointed a ‘‘lead independent director’’ and believe that approach has served them and the funds’ shareholders well. With a supermajority of

independents, they believe they are able to take any action needed.19

Also, it is far from clear why mutual fund boards, alone among all corporate

boards, should be deprived of the discretion to choose their chairperson. Existing

regulatory requirements and industry practices, as well as the other new fund governance requirements recently proposed by the SEC, make a requirement to have

an independent chair unnecessary.20 Finally, it bears noting that some of the funds

involved in the recent scandals have independent board chairmen. Thus, it would

be folly to suggest that requiring all fund boards to have independent chairs is in

any way an answer to the current problems.

Another misguided ‘‘solution’’ to the abusive trading practices that we have seen

would require independent directors, or an independent chair, to make a series of

certifications, many of which relate to matters that are outside the scope of what

an independent director—who serves in an oversight capacity—could reasonably be

expected to know (e.g., that the fund ‘‘is in compliance’’ with certain policies and

procedures, such as fund share pricing policies and procedures).21 Not only would

this potentially expose those certifying directors to increased liability, but also it

would not serve the best interests of fund shareholders. Independent directors (or

the independent chair) would be faced with the Hobson’s choice of either: (1) seeking

to secure and being forced to rely on a series of sub-certifications from those directly

involved in the various matters to be certified (because the directors themselves

would not be in a position to have personal knowledge of what they are certifying),

or (2) immersing themselves in the day-to-day intricacies of fund operations, thereby

inappropriately transforming their role from ‘‘oversight’’ to ‘‘management.’’ Both of

these results would place the independent directors in an awkward and/or inappropriate position and neither would improve investor protection. On the contrary, an

independent director certification requirement could give investors a false sense of

239

22Letter to The Honorable William H. Donaldson, Chairman, U.S. Securities and Exchange

Commission, from Matthew P. Fink, President, Investment Company Institute, dated December

16, 2003. The Institute urged the SEC to curtail the use of soft dollars by all investment advisers, including mutual fund managers. T. Rowe Price supports the Institute’s recommendations. 23See SEC Press Release 2004–16 (February 11, 2004), available at http://www.sec.gov/

news/press/2004–16.htm. 24See, e.g., Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Ms.

Joan Conley, Office of the Corporate Secretary, NASD Regulation, Inc., dated October 15, 1997. 25See SEC Release Nos. 33–8358; 34–49148; IC–26341 (January 29, 2004) and NASD Notice

to Members 03–54 (September 2003). Both proposals also would require disclosure concerning

differential compensation paid to salespersons that could provide an incentive to favor one fund

over another.

security. It most assuredly would also discourage many qualified persons from serving as independent directors of mutual funds.

Other Initiatives to Promote Investor Confidence

In addition to internal measures and regulatory changes to protect investors

against the abusive mutual fund trading practices that have been the subject of the

recent investigations and enforcement actions, it is appropriate to consider other

ways to reinforce the protection and confidence of mutual fund investors. Certain

current initiatives are discussed below.

Directed Brokerage

Under current law, a mutual fund manager is permitted to take sales of fund

shares into account in allocating brokerage, subject to various conditions including

that the broker must provide best execution. As a directly marketed fund complex,

T. Rowe Price has never engaged in this practice for its own mutual funds. Although

such ‘‘directed brokerage’’ is strictly regulated, prohibiting this practice may be the

most effective way to address the conflict of interest issues it raises. The industry,

through the Investment Company Institute, recently urged the SEC (and/or NASD)

to adopt new rules for this purpose.22 Consistent with the Institute’s recommendation, the SEC recently proposed amendments to Rule 12b–1 under the Investment

Company Act that would prohibit funds from using brokerage commissions to pay

broker-dealers for selling fund shares.23

Rule 12b–1

In addition to proposing amendments to Rule 12b–1 to prohibit the use of fund

brokerage commissions to pay broker-dealers for selling fund shares, the SEC is soliciting comments on whether it should make other changes to Rule 12–1. Given the

many developments in fund distribution practices since the rule was adopted in

1980, a reevaluation of the rule is appropriate and timely. Due to the significance

of the rule, its widespread use and related issues, it is important to solicit and consider the views of all interested parties before determining whether further changes

to the rule should be proposed. Intermediaries who are selected by investors to assist them in making decisions about fund investments, and monitoring those investments, deserve to be compensated. The amounts and methods of compensation, and

the disclosure of such to the investor, should all be part of this review. T. Rowe

Price looks forward to studying the SEC’s release and participating in this process.

Point-of-Sale Disclosure of Broker Incentives

Another issue that has been the focus of much attention recently involves the

so-called ‘‘revenue sharing’’ arrangements in which a fund’s investment adviser or

principal underwriter makes payments out of its own resources to compensate intermediaries who sell fund shares. The principal investor protection concern raised by

these payments is whether they have the potential for influencing the recommendations of the financial intermediary that is receiving them. Disclosure concerning

certain types of revenue sharing arrangements already is required in fund prospectuses, and the industry has long advocated additional, point-of-sale disclosure by

broker-dealers to help investors assess and evaluate recommendations to purchase

fund shares.24 Both the SEC and the NASD have recently proposed new point-ofsale disclosure requirements in this area.25

The SEC’s proposal also would encompass other sales-related fees and payments,

such as front-end and deferred sales charges and 12b–1 fees. T. Rowe Price strongly

supports requiring point-of-sale disclosure concerning such fees and payments (as

well as revenue sharing and differential compensation). Requiring broker-dealers to

provide to investors who are considering purchasing mutual funds a separate disclosure document at the point of sale (as contemplated by the SEC’s proposal) would

help educate investors about the costs they are incurring in connection with the use

240

of the broker who is assisting them, while also alerting them to any potential conflicts of interest.

Conclusion

T. Rowe Price has been and continues to be committed to acting in our fund

shareholders’ interests. We believe most fund companies seek to do the same. The

recent revelations of fund trading problems have highlighted to us and others responsible for fund investor assets the risks of doing otherwise. Many of the farreaching regulatory changes proposed by the SEC and industry will assist fund

managers, distributors, recordkeepers, and directors in fulfilling their objective of

serving investor interests. At the same time, they will help eradicate inappropriate

or illegal practices.

We are fortunate that investor confidence in mutual funds generally remains very

high. But we must take advantage of the current problems to improve our policies

and procedures so that we do not experience similar breaches of trust in the future.

Our fund shareholders need to be confident that their interests do indeed come first.

—————

PREPARED STATEMENT OF DON PHILLIPS

MANAGING DIRECTOR, MORNINGSTAR, INC.

FEBRUARY 25, 2004

Thank you for the opportunity to appear before this distinguished Committee. My

name is Don Phillips, and I am a Managing Director of Morningstar, Inc., an independent investment research firm that provides data and analysis on mutual funds

and other investments. Morningstar was founded in 1984, and today we cover more

than 100,000 investments worldwide. Over 150,000 individual investors and 80,000

financial planners subscribe to our services. In addition, there are more than 2 million registered users of our investment website, Morningstar.com.

As the leading provider of mutual fund information to both individual investors

and their financial advisors, Morningstar has had a front-row seat to witness both

the rapid rise and the recent missteps of this important industry. We have seen a

generation of American investors embrace mutual funds for their compelling combination of convenience, instant diversification, and professional management. The

industry’s rise has not solely been due to these merits, however. The mutual fund

industry has also been the beneficiary of considerable good fortune. Numerous legislative acts, such as those allowing Individual Retirement Accounts, 401(k) plans,

and 529 college savings plans, have encouraged investors to place billions of dollars

into funds, greatly enriching those companies that offer them. As a result, mutual

funds now occupy a central position in the long-term savings plans of more than

90 million Americans.

Given the privileged and highly important role that mutual funds now play, it

would behoove the industry to redouble its commitment to the effective stewardship

of the public’s assets. Most individuals who work for mutual fund companies embrace this challenge, but the recent scandals make it abundantly clear that too

many people in this industry were willing to forsake their responsibility in exchange

for short-term personal profit. Sadly, these were not the acts of a few, low-level employees, but instead were violations of trust that took place at the highest levels,

including company founders, CEO’s, portfolio managers, and several current or

former members of the Investment Company Institute’s Board of Governors.

Investors are angered and confused by these scandals. Moreover, those institutions, such as pension plans, the financial press, and even the U.S. Congress, who

steered investors toward funds have reason to feel betrayed. While few question the

inherent benefits of mutual funds, it is clear that the industry has foolishly jeopardized its greatest asset—the public’s trust. Investors need reassurances that their

trust will not be further betrayed. In particular, they need to know: (A) That mutual

funds operate on a fair and level playing field. (B) That checks and balances exist

to safeguard investor interests. (C) That adequate information will be available to

allow investors or their advisors to make intelligent decisions about their funds. (D)

That mutual funds offer a reasonable value proposition

While market forces can and will do much of the work, the industry and regulators can take steps to ensure that mutual funds meet their obligations to the

American public. Here are Morningstar’s suggestions on each of these fronts:

Mutual Funds Must Operate on a Fair and Level Playing Field

One of the most disturbing aspects of the recent scandals has been the revelation

that not all fund shareholders have been playing by the same set of rules. Too often,

241

rules imposed upon ordinary investors have been ignored by insiders or waived for

high rollers, such as hedge funds. These breaches violate the core democratic promise of funds, which, after all, are designed to be mutual. Moreover, the loosening

of these rules allowed for rapid trading of fund shares that created economic penalties for shareholders who played by the rules. It is time for the industry to define

what constitutes abusive market-timing and then take meaningful steps to eliminate it. It goes without saying that whatever standards are set must be applied

uniformly to all shareholders in a fund. It is also essential that late trading and

the possibility of time-zone arbitrage in mutual funds be curbed immediately. We

suggest a combination of redemption fees, fair-value pricing standards, and, until

a better solution can be determined, a hard 4 p.m. close that would require all fund

transactions to be at the fund company by 4 p.m. Eastern time in order to be transacted at that day’s price.

Compounding the problems of mutual fund trading abuses has been disturbing

evidence surrounding fund sales practices. When brokerage houses demand special

payments or directed brokerage arrangements in exchange for including a fund

on their preferred lists, they tilt the playing field, and they raise questions about

the objectivity of the advice their brokers give. Investors deserve to know that the

funds chosen for their portfolios are done so on the basis of their investment merit,

not on their willingness to pay for shelf space at the brokerage house. It is time

to eliminate directed brokerage deals and, at a minimum, better disclose pay-to-play

arrangements.

Another area that warps the playing field is how different fund companies account

for basic fund expenses. Investors currently pay a management fee to the fund management company to cover the cost of investment research. In addition, a host of

operational expenses, such as custodial costs or the cost of trading securities, are

charged directly to the fund. Two activities muddy the water. First, soft-dollar

arrangements allow the fund’s manager to dip into shareholder assets to pay for

research, trading systems, office furniture, or other services. While funds clearly

need these things, one would assume that these expenses would be included in the

fund’s management fee, not embedded in artificially high trading costs. Simply put,

soft dollars provide a bigger profit margin for the fund’s manager made possible by

a hidden charge to shareholders. The opportunity for such double-dipping should

be eliminated.

Rule 12b–1 fees further muddy the waters. Fund companies use these charges in

part to promote the sale of new fund shares. Investors may benefit to a small extent

from fund asset growth, but the advantages of a bigger fund are typically far greater

for the asset manager. To the extent that 12b–1 fees compensate brokers for selling

funds or for the services of fund supermarkets, we concur that these services help

investors, but feel that the charge would be more properly paid directly to those

parties, rather than through the expense ratio where all investors, not just those

receiving the benefits of an advisor or a discount brokerage house, foot the bill.

While industry advocates will praise 12b–1 fees as a means of allowing investors

greater choice in how (but not necessarily how much) they pay for advice, there is

a danger to these fees that goes unspoken. When distribution costs are bundled into

a fund’s expense ratio, they begin to affect fund manager thinking. Unlike upfront

sales charges, which are not included in the performance calculations investors see

in places like The Wall Street Journal, the costs of 12b–1 fees directly lower a fund’s

total return and its yield. Managers who are saddled with high 12b–1 fees on their

funds are at a distinct disadvantage to those who are not. If they simply buy the

same securities as their lower-cost competitors, they are guaranteed to trail their

rivals. Because fund managers are competitive people, it is not surprising that managers of higher-cost funds adjust their behavior in order to avoid this fate.

Morningstar studies have shown that managers of funds saddled with high 12b–1

fees systematically take on greater risk than do managers of funds with lower expense ratios. For bond fund investors, this often means lower-quality bonds or added

exposure to the risk of rising interest rates. For investors in equity funds, it may

mean more concentrated portfolios or more speculative stock choices. In short, Rule

12b–1 fees offer investors both insult and injury—the illusion of cost savings and

the likelihood of added risk.

At Morningstar, we think it is time to eliminate soft-dollar payments and to

eliminate or seriously reconsider the role of 12b–1 fees in funds. Investors deserve

a clear account of how their money is being spent. Allowing fund managers to dip

into shareholder assets to promote asset growth or to offset research costs distorts

the picture and makes it difficult for investors to align costs and benefits. Let’s keep

things clean and clear: Costs whose benefits flow primarily to the fund’s advisor

should be on the advisor’s tab, not passed off as an investor expense. Moreover,

distribution costs should be paid directly to distributors, not run through the fund’s

242

expense ratio where they tempt managers to take risks they otherwise would avoid.

Pricing schemes should not compromise the integrity of the investment management process.

Checks and Balances Must Be in Place to Safeguard Investors

It is not just the venality of the misdeeds in mutual funds, but the sheer number

of offenses that is so disturbing to investors. It seems that every day another fund

company is drawn into this mess. It is hard to fathom how so much wrongdoing

could go undetected for so long. Sadly, these scandals raise obvious questions about

the regulators who are supposed to safeguard investors. We support the increased

funding for the Securities and Exchange Commission and would urge the Commission to continue to prioritize mutual fund regulation among the numerous important

tasks it handles. Mutual funds are too important to the country’s savings to be a

back-burner issue with regulators.

Moves to put all fund regulation under the SEC strike us as inappropriate. The

New York Attorney General’s Office has demonstrated the significant benefits of a

fresh set of eyes looking at the industry. We support the continued ability of individual States to bring actions against mutual fund companies when they see abuses.

Mutual funds have been embedded into Government-sponsored savings plans for

both retirement and college savings. It is valuable to have multiple agencies serving

as checks and balances to safeguard investor interests, but we would ask that these

groups coordinate their efforts. The public bickering between agencies in the recent

investigations does nothing to reassure investors that their interests are paramount.

Ultimately, much of the burden of fund oversight must fall to the funds themselves, particularly to the fund directors. Much has been made of the importance

of independent directors and an independent chairman. While these moves may be

largely superficial, we think they are potentially beneficial. While in U.S. operating

companies the chairman and the CEO are often the same person, such an arrangement presents a conflict of interest in funds that does not exist in operating companies. In an operating company there is only one party to which directors, be they

independent or not, owe their loyalty—the firm’s stockholders. In a mutual fund

there are two parties to which the nonindependent directors owe their allegiance—

one is the fund shareholder, the other is the stockholder in the fund management

company. Only independent fund directors have a singular fiduciary responsibility

to fund shareholders. Accordingly, we believe that fund shareholders may be better

served when an independent chairman oversees their fund.

Of course, independence alone is no guarantee of good governance. We think a far

more important issue is the visibility of the board. The typical fund investor is

largely unaware of the corporate structure of funds. Few investors in, say, Fidelity

Magellan think of themselves as the owners (alongside their fellow shareholders) of

the fund. Instead, they think that Fidelity owns Magellan and they merely purchase

its services. It is a notion that the fund industry doesn’t discourage. Indeed, funds

do little to draw attention to their corporate structure or the role of the board of

directors, often relegating the names and biographical data of fund directors to the

seldom-read statement of additional information.

To remedy this situation, Morningstar suggests that each fund prospectus begin

with an explanation of the fund’s corporate structure, such as the following:

When you buy shares in a mutual fund, you become a shareholder in an

investment company. As an owner, you have certain rights and protections,

chief among them an independent board of directors, whose main role is to

represent your interests. If you have comments or concerns about your investment, you may direct them to the board in the following ways . . .

By bringing more visibility to the fund’s directors and by alerting shareholders to

their role in negotiating an annual contract with the fund management company,

the balance of power may begin to shift from the fund management company executives, where it now resides, to the shareholders, where it belongs.

If directors are to represent shareholders, they need to hear from them. However,

most fund directors have far more contact with the fund’s manager than they do

with fund shareholders. Several years ago I met a director who served on the board

of many funds at a large fund complex. He also served on the board of a Fortune

500 company. He told me that while he received a dozen or so letters a month from

shareholders concerning the public company, he had never in more than 10 years

received a letter from a fund shareholder. Fund boards have been out of sight and

out of mind. It is telling that the whistleblowers at groups like Putnam did not even

think to go to the fund boards. Fund boards must be more visible if they are to be

an effective check for shareholders.

243

They must also be accountable. We suggest that the independent chairman be

responsible for writing to fund shareholders in the fund’s annual report to address

the steps the board takes each year in reviewing the manager’s performance and

the contract that the fund has with the management company. By bringing to light

these important review functions, one assures that the structural safeguards of the

investment company will work in practice, as well as in theory. We would also advocate a stronger role for fund directors in reviewing all communication between the

fund management firm and fund shareholders, including marketing materials designed to attract new investors. The fund’s communications should effectively explain the fund’s investment strategy and the potential risks it may incur. By helping

to establish rational performance expectations, fund boards would do a real service

for both current and future shareholders.

Investors Must Have the Information to Make Intelligent

Decisions About Funds

Transparency is the hallmark of the American financial system and one of the

reasons that U.S. investors have put so much trust in mutual funds. Indeed, the

amount of disclosure on funds in the United States is superior to that of any other

country. Yet, at the same time, the disclosure requirements for funds fall well behind the standards set by publicly traded stocks in the United States. Given the rising importance of funds to so many Americans’ financial security, we think it would

benefit the industry to strive for the highest standards possible. While transparency

can be a burden, it is also a tremendous asset in establishing and retaining trust,

the very quality upon which mutual funds are based.

All investors deserve to know if their interests are aligned with management’s.

Every week, we speak with mutual fund portfolio managers who tell us that before

they buy stock in a company, they look to see how management is compensated.

They want managers who ‘‘eat their own cooking’’ and whose interests are aligned

with theirs. That is why institutional equity managers have long demanded and received detailed information about senior corporate executives’ compensation and

their holdings of company stock. In fact, stock investors would protest loudly if this

information were denied to them. Why, then, are fund shareholders not given the

same insights into their investments?

Consider the case of a manager’s holdings or trades in his or her fund. An equity

investor has access to detailed information on the purchases, sales, and aggregate

holdings of senior executives and other insiders at an operating company. Stunningly, fund investors are denied access to the very same data about the managers

of their funds. While it is easy to appreciate why management might not wish to

provide such data, it is hard to argue why an investor shouldn’t have the right to

see it. Indeed, such sunlight might well have been beneficial in the recent cases of

several Putnam portfolio managers or Strong Funds’ Chairman Richard Strong, who

have been accused of market-timing their own funds. Can you imagine these executives engaging in such actions if they knew their inappropriate trading activities

would become public information? Disclosure can be a powerful deterrent.

Even the aggregate investment that managers have in their funds is shielded

from fund shareholders’ view. While any equity investor can see exactly how many

shares of Microsoft Bill Gates owns, there is no way for a fund investor to see if

his or her manager has any ‘‘skin in the game.’’ In the wake of the recent fund scandals, several mutual fund portfolio managers have stated publicly that because they

invest heavily in their own funds, the kinds of trading abuses seen in other shops

would not happen at theirs. This statement is a virtue that any fund manager can

claim, but none has to prove. Why would such information that has long been disclosed about corporate insiders not be available about fund insiders?

The same principle applies to management compensation and the incentives it

creates. Disney shareholders know to the penny what Michael Eisner is paid to run

their company. Like all holders of publicly traded stocks, they receive a statement

from the compensation committee with their annual proxy materials outlining how

the committee has structured the CEO’s pay and on which metrics his or her bonus

is based. It is not uncommon for these materials to include a CEO’s entire employment agreement. Given the high level of disclosure on operating companies, it

is hard to reconcile why no disclosure whatsoever is provided on fund manager

compensation.

Fund investors do not know if their manager’s bonus is tied to short-term returns

or to rolling 5-year returns, to pretax or to aftertax profits. If the manager’s pay

is linked to pretax returns, surely a manager will be less concerned about the tax

consequences of his or her decisions. How can this not be material information to

an investor considering placing a fund in either a taxable account or an IRA? In

addition, one would hope that a fund manager’s compensation is tied to fund perVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00255 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
244

formance, rather than to the fund’s asset growth. A manager’s incentive should be

to manage, not to sell. But, with no compensation disclosure, how can a fund investor be sure? If mutual funds are indeed investment companies, let’s treat them as

companies and give fund investors the same level of disclosure that stock investors

have long enjoyed.

Finally, there is the issue of funds disclosing their portfolio holdings in a uniform

and timely fashion. Such disclosure allows investors to see how their money is being

managed and to more intelligently deploy funds within their portfolio. Many of the

funds sold to the public as ‘‘diversified’’ growth funds during the late 1990’s held

more than half their assets in technology stocks. An investor who thinks he has a

diversified portfolio, but who, in fact, has a massive sector bet, is a disaster waiting

to happen—a fate that too many fund investors learned the hard way when the tech

bubble burst in 2000.

The only way to intelligently troubleshoot a portfolio of funds is to have accurate

and timely data on the securities within the funds. While most investors won’t sort

through detailed lists of fund holdings, there are financial advisors and research

companies who will. In addition, the press and academics would be better able to

research the fund management industry if they had access to such information. We

see no need for instantaneous disclosure of fund holdings, but full portfolio disclosure at monthly intervals with an appropriate lag time to protect the manager’s

trading would greatly facilitate the research process and increase the odds that

the right investor ends up in the right fund. If funds are not deployed wisely, they

cannot possibly meet their obligations to investors. Barriers to quality research

that would help investors make better use of their funds need to be removed whereever possible.

Mutual Funds Must Show that They Offer a Compelling Value Proposition

Ultimately, mutual funds must demonstrate to investors that they offer a compelling value proposition. While the market will be the final arbitrator, fund companies

can and should disclose fund costs in a fashion comparable to other professional

fees, so that investors can make informed choices and the market can operate efficiently. Investors have moved their assets toward lower-cost funds over time, but

they have done so not because funds clearly disclose costs, but because investors

ultimately see the debilitating effect of high costs on long-term performance. Why

should we continue to subject investors to these damages when there are easy steps

that can be taken to alert investors up front to the true cost of their funds?

Funds currently state their costs in percentage terms, not dollars, and they state

them as a percentage of assets entrusted to the manager, not in terms of the percentage of the investor’s likely gain-potentially a far more relevant number. For

example, an investor with $300,000 in a bond fund is told that his fund has an expense ratio of 1.5 percent. However, if an investor expects bonds to return 5 percent

per year over the course of his investment horizon, that 1.5 percent expense ratio

in reality reflects a 30 percent annual toll on the likely returns he will receive from

his investment. While establishing expected returns for asset classes is problematic,

it is clear that the way fees are currently reported to shareholders dramatically understates their impact on returns (1.5 percent versus 30 percent).

The U.S. Government has established a fine precedent for the fund industry to

follow in how it states, in dollars, the exact amount that a worker has deducted

from his paycheck for Federal taxes, State and local taxes, Social Security, and

Medicare. Workers can decide for themselves if they think the payments they make

represent reasonable value for the services provided because they are allowed to see

the exact cost in dollars of the services. Wouldn’t the same basic level of disclosure

be helpful to investors making decisions about funds?

For many middle-class Americans, mutual fund management fees are now one of

their 10 biggest household costs, yet the same individual who routinely shuts off

every light in his house to shave a few pennies from his electric bill is apt to let

these far greater fund costs go completely unexamined. Stating these fees in a dollar

level that corresponds with an investor’s account size is an important first step.

We have truth-in-lending laws that detail to the penny the amount a homeowner

will pay in interest on his mortgage. It is time for truth-in-investing rules that

would bring the same common-sense solution to mutual funds. And of course, in

fairness to mutual funds, the same standards should be applied to all investment

services, including exchange-traded funds, variable annuities, and separately managed accounts.

Conclusions

Given the central role funds now play in the retirement savings of our country,

it makes sense to debate the rules governing this industry. At the same time, we

245

do not believe that legislative solutions alone can safeguard investors. Public scrutiny and market forces also play a crucial role. In the wake of the recent fund scandals, we have seen Larry Lasser, Putnam’s longstanding CEO, resign his position

in disgrace. We have seen Strong Funds’ Chairman Richard Strong forced to sell his

business for a price possibly less than half what he had been offered just 4 years

ago. And, finally, we have seen James Connelly of the Alger Funds sentenced to

prison for his role in covering up evidence surrounding these scandals. The message

to every fund executive is clear: If you violate the public’s trust you can lose your

reputation, your fortune, and your freedom. That is a lesson that will guide this

industry for years to come.

Still, we believe that there are additional steps that can be taken to protect the

investing public. Specifically, we endorse these 10 steps:

• Close the door to timing and late-trading abuses.

• Eliminate directed brokerage deals and better disclose pay-to-play arrangements.

• Eliminate soft-dollar payments.

• Eliminate or seriously reconsider the role of 12b–1 fees.

• Maintain vigilant and appropriately funded regulatory oversight.

• Make fund directors more visible and accountable to shareholders.

• Disclose fund manager trading in their funds.

• Disclose fund manager compensation.

• Improve portfolio holdings disclosure.

• State actual fund costs in dollars, so the market can work more efficiently.

Mutual funds have a proud history, but the recent scandals have badly damaged

the industry’s credibility. Collectively, legislators, regulators, and industry leaders

must rebuild the public’s trust in mutual funds. Investors need assurances that the

playing field is level, that safeguards exist, that their manager’s interests are

aligned with theirs, and, ultimately, that funds represent good value. By addressing

these concerns, the industry can get back on track to helping investors meet their

goals and secure a safer future for their families.

—————

PREPARED STATEMENT OF GARY GENSLER

FORMER UNDER SECRETARY FOR DOMESTIC FINANCE

U.S. DEPARTMENT OF THE TREASURY

FEBRUARY 25, 2004

Introduction

Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, thank

you for the opportunity to testify today on how to better align the mutual fund industry with the interests of investors. Since I last appeared here during my tenure

as Under Secretary of the Treasury, I co-authored a book, The Great Mutual Fund

Trap, to present common sense investing advice to middle-income Americans.

The recent mutual fund scandals have shaken the confidence of these very investors. They are now asking: What went wrong? How do they best protect their savings? What can their Government do to better protect investors in the future?

I believe that, at its core, the scandals have revealed the need for substantive reform regarding how mutual funds are governed and operated in America.

In today’s global economy, we simply have no choice but to ensure that America

has the fairest and most efficient capital markets in the world. Mutual funds are

a dominant factor for a majority of American families trying to save for retirement.

They are amongst the largest sources of capital for corporate America. If mutual

funds were to truly operate in the best interest of investors it would increase investors’ returns, increase retirement savings, and lower the cost of capital for the

overall economy. This is ever more critical as we prepare for the retirement of the

baby-boom generation.

Congress long ago recognized the inherent conflicts of interest that exist between

investors and those who mange investors’ money. Responding to an earlier era’s

financial scandals, Congress passed the Investment Company Act of 1940 (1940

Act). The 1940 Act set up a system of mutual fund governance whereby noninterested mutual fund directors (independent directors) must independently review

and approve all of the contractual relationships with the management company and

the financial community. Congress understood that these relationships presented

unavoidable conflicts and could significantly affect investors’ overall returns.

246

1 Burks v. Lasker, 441 U.S. 471, 484 (1979). 2SEC hearing (February 11, 2004).

It is largely that system—independent mutual fund directors acting as gatekeepers for the benefit of investors—which we have in place today. It is that system

that I believe deserves serious review and reconsideration.

Only Congress can adequately address these issues through reform legislation.

While the Securities and Exchange Commission (SEC) is pursuing an active agenda

of reform, it cannot act alone on all of the necessary reforms to best align the interests of mutual funds with those of the investors they are supposed to serve.

Background

The whole idea of a mutual fund is, as the name suggests, mutuality. Funds allow

investors to share the costs of professional money management, in the nature of a

cooperative. Mutual funds offer investors a chance at the superior long-term performance of equity investing, and a convenient way to buy bonds. They offer risk

reduction through diversification as most funds own a broad spectrum of the market. Finally, when compared with the full-service brokerage commissions of the

time, at first mutual funds’ costs were relatively attractive. Legally, investors actually have collective control over their mutual funds. The company managing the

assets is distinct from—and legally simply a contractor hired by—a mutual fund.

Investors are represented by a board of directors which has a fiduciary duty to oversee their investments and hire the money management company (known as an ‘‘adviser’’) to invest it. In theory, the adviser works for investors to get the best returns

for the lowest costs and risks. That is, at least in theory.

Mutual fund companies, as distinct from the funds themselves, however, have

their own shareholders and profits to consider. They have a primary responsibility

to their shareholders above any duties to the investors in the many funds they manage. They charge high management fees even though those fees come directly from

investors’ returns. They generally are willing to take added risks in an effort to

attract assets in rising markets. And they trade frequently, even if that increases

trading costs and investors’ short-term capital gains taxes.

In practice, mutual fund investors have very little power over ‘‘their’’ company.

Mutual funds are set up by advisers, not by individual investors. Funds have no

employees of their own. All of the research, trading, money management, and customer support staff actually work for the adviser.

Mutual fund directors serve part-time and rely on the adviser for information. The

adviser initially selects directors for new funds and often recruits new directors for

established funds. Approximately 80 percent of mutual fund boards are even chaired

by someone affiliated with the adviser. Furthermore, fund companies generally set

up a pooled structure, whereby fund directors serve on groups of boards for a fund

family. The Investment Company Institute (ICI) recommends use of such ‘‘unitary

boards’’ or similar ‘‘cluster boards’’ in the name of efficiency. Not surprisingly, mutual fund boards fire their advisers with about the same frequency that race horses

fire their jockeys.

The Role of Fund Directors

The 1940 Act establishes specific roles for mutual fund directors. In particular,

Section 36 of the 1940 Act imposes a fiduciary duty on directors with respect to fees

paid to advisers. Section 15 of the 1940 Act requires that the independent directors

annually review and approve the contracts with the investment adviser and the

principal underwriters. Rule 12b–1 requires a similar review of the distribution

contracts. According to the late U.S. Supreme Court Justice William Brennan, the

1940 Act was designed to place unaffiliated fund directors in the role of independent

watchdogs, to furnish an ‘‘independent check upon the management of investment

companies.’’ 1

In speaking to the inherent conflicts and potential for abuse and overreaching,

SEC Chairman Donaldson said just 2 weeks ago:

This problem is nowhere more in evidence than in the negotiations over

the advisory contract between the manager and the fund. The money manager wants to maximize its profits through the fees the fund pays. The

fund’s shareholders want to maximize their profits by paying as little as

they can for the highest level of service. The fund’s board of directors serves

as the shareholders’ representative in this negotiation.2

This duty, however, has never been interpreted very stringently. In the landmark

case on the matter, the second circuit court of appeals ruled in 1982 that:

247

3Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983). 4SEC Report of the Division of Investment Management of Mutual Fund Fees and Expenses,

(January 2001): 5. 5For example, if a worker saves just $100 per month over a 40-year career and earns 8 percent annually, they can retire with a $348,000 nest egg. Invest in actively managed funds and

the likely nest egg—$199,000—fully 43 percent less money available for retirement. 6Morningstar Principia Pro as of December 31, 2003.

7Morningstar Principia Pro as of December 31, 2003. Search was for all U.S. equity mutual

fund share classes charging a sales load, excluding index funds, exchange-traded funds, and institutional funds—3,996 funds in all. The 3.9 percent came from adding the average front-end

and back-end load.

To be found excessive, the trustee’s fee must be so disproportionately

large that it bears no reasonable relationship to the services rendered and

could not have been the product of arm’s-length bargaining.3

Over the subsequent years, the Gartenberg standard has proved to be insurmountable. No shareholder has subsequently proved a violation of the Gartenberg

standard. And while it was initially found with regard to the fiduciary duty of the

adviser (under Section 36(b)) courts have allowed its use as the standard for directors as well. The SEC also has never sued a fund director for failing to review adequately an advisory agreement.

In practice, fund directors have a difficult time striking a proper balance between

working with the adviser and vigorously pursuing investors’ interests. Directors, in

essence, are recruited by the fund companies. Directors generally serve on a multitude of the fund family’s boards. They naturally serve only part time and rely

solely on the management company for all of their information. There are not even

any direct employees of the fund or the board. The directors also have been informed of the legal standards and that until recently there has been only limited

actions by the SEC and the courts. How many well-meaning directors would wish

to make waves in this environment?

Why Governance Matters—Excess Costs Lower Retirement Savings

High mutual fund costs take a serious bite out of Americans’ retirement savings.

The SEC noted the potential effects on retirement savings when they stated: ‘‘A 1

percent increase in a fund’s annual expenses can reduce an investor’s ending

account balance in that fund by 18 percent after 20 years.’’ 4

Over a lifetime, results can be even more dramatic when compared with low-cost

passive index investing. Investing in low-cost index funds can lead to nearly twice

as much savings by retirement than with the same amount actively invested (based

upon just 2 percent more earnings per year).5

In total, investors can expect costs totaling close to 3 percent to disappear each

year in an actively managed stock fund. Those investors who invest in a fund with

sales loads (close to one half of all investors) can expect costs averaging over 4 percent per year. While fees for bond funds are modestly lower, they still overwhelm

the expected returns on bonds, particular in today’s low-interest rate environment.

Mutual fund companies impose costs on investors approaching $100 billion annually. These mutual fund costs are disclosed to investors:

• Monthly management, administrative, and distribution fees averaging well over

1 percent per year. A review of the 2,297 actively managed stock funds in the

Morningstar database shows an average expense ratio of 1.49 percent.6

• Sales loads, charged by half of all actively managed mutual funds, averaging 3.9

percent.7 With an average holding period of just over 3 years, investors can pay

an additional 1.2 percent per year.

While investors may not pay particular attention to these costs, at least they are

disclosed. Also, fund directors are legally required to pay attention to them.

There are some very important costs, though, which go undisclosed. They are hard

for investors to measure and they do not show up on any statement. Mutual fund

directors also have a more limited legal role in these costs. As investors’ representatives, however, I believe, they actually should be very engaged in these costs.

• Portfolio trading costs—the typical active equity fund manager turns over their

entire portfolio once every 18 months, incurring brokerage costs and bid/ask

spreads approximating 1⁄2 to 3⁄4 percent of assets each year.

• Excess capital gains taxes—adding costs of 1 to 2 percent of assets per year—are

incurred as portfolios are rapidly traded. While helpful to the U.S. Treasury, this

pervasive triggering of short-term capital gains tax is particularly costly for investors in the new 15 percent long-term capital gains rate environment.

248

8The Investment Company Institute, ‘‘Understanding the Role of Mutual Fund Directors’’

(1999): 16. 9Malkiel, Burton G., ‘‘Returns from Investing in Equity Mutual Funds 1971 to 1991,’’ Journal

of Finance 50 (June 1995): 549.

• The opportunity cost of holding idle cash lowers returns about 0.4 percent each

year, on average, during the last 10 years. (Though even more during the strong

market of last year.)

Why Governance Matters—Soft Dollars

Hidden within portfolio trading costs is something Wall Street calls ‘‘soft dollars.’’

This is where an adviser, with the acquiescence of the funds’ directors, benefits

itself at investors’ expense.

The mutual fund industry’s educational material on the role of directors has this

to say about ‘‘soft dollars.’’ [Emphasis added]:

Directors also review a fund’s use of ‘‘soft dollars,’’ a practice by which

some money managers, including mutual fund advisers, use brokerage commissions generated by their clients’ securities transactions to obtain research and related services from broker-dealers for the clients’ benefit. Directors review their fund adviser’s soft-dollar practices as part of their review of the advisory contract. They do this because services received from

soft-dollar arrangements might otherwise have to be paid for by the adviser.8

What is hard to figure out is how soft-dollar payments can ever be ‘‘for the clients’

benefits’’ when they ‘‘might otherwise have to be paid for by the adviser.’’ A portion

of every commission will be retained by the broker as payment for research advice

or other services normally paid for by the fund company. Basically, any expense that

the fund company can direct to the fund’s broker adds to the fund companies’ profits

at the expense of individual funds and their investors.

Why Governance Matters—The Sad Averages

All of these costs have their effect. Looking at the results over the last 10 years,

Morningstar data shows that the average actively managed diversified U.S. equity

mutual fund fell short of the market by 1.4 percent annually. Annual fund returns

of 9.2 percent compared to the overall market return of 10.6 percent annually, as

measured by the Wilshire 5000.

Furthermore, currently reported performance results include only those funds

that survived the entire period. The many funds which have been routinely merged

or liquidated are not still included in industry statistics. Looking at 10-year returns

of currently active funds in 2004 will by definition exclude all the unfit funds that

closed up shop during the last 10 years.

This phenomenon is known as survivorship bias. It is like judging the contestants

on a reality TV show simply by looking at the last few people left on the island.

If someone asked a viewer how interesting the contestants were, they would probably forget the ones who were voted off in the first few weeks. What were their

names again?

The most comprehensive look at survivorship bias was conducted by Burton

Malkiel, who concluded that such bias was considerably more significant than previous studies had suggested. For the 10-year period of 1982–1991, survivorship

bias inflated average industry returns by 1.4 percent per year.9 Furthermore, the

number of liquidating funds is rising. With 4 to 5 percent of all funds disappearing

each year, survivorship bias today is likely to be even greater than during this

earlier period.

Why Governance Matters—Distribution & Revenue Sharing Arrangements

The mutual fund industry increasingly relies on others—brokers, insurance companies, and financial planners—to sell its products. So while initially hesitant to

promote a competitor’s products, brokers later developed ‘‘revenue sharing arrangements’’ whereby they would get paid for every new sale they made. Most mutual

fund families feel that they have to pay, lest they lose access to new assets and market share.

Mutual fund companies do not eat the cost of paying these sales forces. They pass

that cost along to investors, either through a 12b–1 fee, a sales load, or in the form

of directed brokerage commissions. In certain recent cases, these arrangements have

been in direct conflict with current SEC rules. In aggregate, 12b–1 fees cost investors approximately $10 billion per year while sales loads are in excess of $20 billion

per year.

There is absolutely no reason, however, for investors to pay loads or 12b–1 fees.

They are not like brokerage commissions, which are necessary to execute a trade

249

10Morningstar Principia Pro as of December 31, 2003. 11 Carhart, Mark M., ‘‘On Persistence in Mutual Fund Performance,’’ Journal of Finance 52

(March 1997): 57.

on an exchange. Mutual funds are charging investors loads and part of 12b–1 fees

to issue them new fund shares. The other part of 12b–1 fees goes to advertising.

Brokers like both because they get to share in the action as additional compensation. Sales loads do not even help offset other costs. Expense ratios for load funds

are higher than for no-load funds, with an average of 1.89 percent per year.10 And

as a group, load funds actually earn lower average returns than no-load funds . . .

even without taking the loads into account.

Why Governance Matters—Recent Scandals

Mutual fund investors have had a series of wake up calls this past year. The

series of scandals has helped to highlight the potential for investors to take a back

seat to the inherent conflicts of interest lurking within the industry.

In a pursuit of assets, many mutual fund companies entered into questionable activities. Some sophisticated investors, such as certain hedge funds, were allowed to

invest in mutual funds based upon stale prices. These practices, known as ‘‘late

trading’’ and ‘‘market timing’’ were not readily available to the general public. With

‘‘late trading,’’ intuitional investors were allowed to invest after the legally mandated 4 p.m. close, thus getting the benefit of further market developments while

still paying the price as of 4 p.m. In ‘‘market timing’’ sophisticated investors were

allowed to trade in and out of funds on very short holding periods in an effort

to take advantage of stale prices related to international stocks. Most of these funds

had actually publicly stated to their investors that they forbade such activity.

To allow this for the privileged few was disadvantageous to the vast majority of retail investors.

Another set of problems arose around brokers incorrectly charging investors when

purchasing load funds. In many of these funds, discounts are advertised for larger

purchases. Unfortunately, many brokers were lax in recognizing these discounts or

‘‘breakpoints.’’

There also have been questionable practices which have gotten less public attention, but are no less troubling. In particular, many mutual fund companies use ‘‘incubator’’ funds and the allocation of initial public offerings (IPO’s) and other hot

stocks to boost the reported results of new funds. Other fund advisers also have

been advising hedge funds and potentially favoring those funds internally.

Market Breakdown

The mutual fund industry is certainly competitive, with significant disclosure of

its costs. So why haven’t markets worked better to protect investors?

I believe that this is due to a number of factors, including: (i) investors’ collective

willingness to put their faith in experts while chasing after recent performance; (ii)

the effective advertising of the financial industry; (iii) the unique way the industry

charges for its services; (iv) the many conflicts of brokers and financial planners;

and (v) the practical day-to-day barriers in switching mutual fund families.

There are thousands of funds and hundreds of fund companies competing in the

market. That does not mean, however, that the mutual fund industry competes on

cost. There are hundreds of casinos in Las Vegas, but that doesn’t mean that you

will find one where the odds are in your favor.

Mutual funds compete on service and the expectation of earnings performance.

Most Americans tend to pick actively managed funds in the hope of relying on the

experts to beat the market. Worse, they pick funds based upon last year’s best

performers or ‘‘hot’’ funds—expecting them to out perform the market once again

next year.

Winning funds of the past, however, are unlikely to be the winning funds of the

future. In perhaps the most important study of the factors affecting mutual fund

performance, it was found that, basically, past performance does not predict future

performance.11 If you take the top 10 percent of funds in a given year, by the next

year, 80 percent of those funds have dropped out of that top 10 percent ranking.

For the top 20 percent of funds, 73 percent drop out the next year. For the top 50

percent of funds, roughly 45 percent fall out the next year. That is not much different from what you would expect from random chance.

Regardless, mutual fund companies spend significant advertising dollars luring

investors to this loosing strategy. Advertisements are a poor guide, however, for inVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00261 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
250

12 Jaij, Prem C., and Joanna Shuang Wu, ‘‘Truth in Mutual Fund Advertising: Evidence on

Future Performance and Fund Flows,’’ Journal of Finance 15 (April 2000): 937.

vestors trying to decide on a mutual fund. Researchers examined 2 years of mutual

fund advertising in Barron’s and Money magazine.12

The study reached three conclusions:

• First, not surprisingly, the advertised funds had performed well in the year before

the advertisement was run. The pre-advertisement returns of those funds over the

past year were 1.8 percentage points better than the S&P 500 Index.

• Second, the advertisements were extremely effective in attracting new money to

the funds. Compared to a control group, advertising appeared to increase inflows

20 percent over what one would otherwise have expected.

• Third, and most significantly, the post-advertisement performance of the funds

was quite poor. The funds’ post-advertisement performance over the next year

trailed the S&P 500 by 7.9 percentage points.

Mutual fund advertising is a classic example of closing the barn door once the

horse has left. Mutual funds also have constructed a unique system whereby costs

are practically invisible—another reason why traditional market forces break down.

We all have to write a check to our utility or mortgage company, but we never pay

a bill for mutual fund management. Such costs are simply deducted from our

monthly returns, or taken off the top if we buy a load fund. Other significant costs

are not even adequately disclosed, such as portfolio trading costs. In addition, markets are volatile while trending up. This leaves most investors focused on total returns rather than how costs affect those returns.

Investors also are faced with brokers and financial planners touting suggestions

and advice which often have the added benefit of lining that broker’s or planner’s

pocket. When investors do consider changing mutual funds, they generally turn to

these same brokers and financial planners. There are some practical barriers to

switching funds, as well. A significant portion of mutual fund investors now have

some savings in 401(k) plans or 403(b) plans. These plans and the fund options

are selected by their employers. Many other investors are hesitant to make investments with a fund family other than where they might have a linked money market account.

Policy Recommendations

To promote retirement savings and the markets, I believe that Congress and the

SEC should enact significant mutual fund reforms. While the SEC and other law

enforcement agencies may be the first line of defense, I think that there is an important role for Congress to play. The SEC may go only so far under current statute.

In addition, Congress can bolster the actions the SEC might take on their own.

In this regard, I recommend that this Committee give serious consideration to: (a)

strengthening fund governance; (b) restricting payments of soft dollars and 12b–1

fees; (c) enhancing fund disclosures; and (d) adopting certain fixes directly raised by

the recent scandals.

Mutual Fund Governance

The 1940 Act sought to address inherent conflicts of interest by relying upon independent directors to promote investors’ best interests. The recent scandals and the

persistence of high fees and other costs have revealed fundamental weaknesses in

this system of governance. I believe that Congress and the SEC should now vigorously address these weaknesses by: (i) clarifying the duties of independent directors

and the standards to which they are held; (ii) tightening the definition of independence; (iii) prescribing how independent directors are selected; and (iv) increasing

their numbers and requiring the chair to be independent.

Governance—Duties & Standards

I believe that the most important thing that Congress can do in promoting reform

is to make clear—in statute—the duties which independent directors hold to investors and tighten the standards to which they will be held. In essence, I believe that

directors should act on behalf of the investors as if they were owners.

While the 1940 Act is specific as to the many duties of directors, until the recent

scandals, the mood in the boardroom has been all too accommodating. In particular,

there is significant evidence suggesting that fund directors do not actively pursue

cost reductions or vigorously negotiate major contracts related to advisers, brokers,

or portfolio trading. These are the largest controllable costs of a mutual fund.

251

13 Brown, Stewart, and John Freeman, ‘‘Mutual Fund Advisory Fees: The Cost of Conflicts of

Interest,’’ University of Iowa Journal of Corporation Law (August 2001): 609–73.

What if mutual fund directors were to vigorously negotiate fees and other costs?

Could they not confer far more significant benefits to investors than they do under

the current governance system? Would not retirement savings increase in America?

While I am not suggesting mandating ‘‘request for proposals’’ by mutual funds,

I do believe that the 1940 Act should be amended to include a general fiduciary duty

for directors to act with loyalty and care and in the best interests of the shareholders. It may be appropriate, as well, to mandate that the SEC promulgate rules

for directors in carrying out these fiduciary duties. This would provide impetus for

independent directors trying to balance their relationships with the investment

adviser and others with inherent conflicts of interest. For instance, the Act could

require that the independent directors formally meet without interested parties

while reviewing and discussing the material contracts. It could also spell out a list

of issues which must be considered when approving contracts. Most significantly,

the 1940 Act could require true arm’s-length negotiations. Imagine any other board

of directors fulfilling its fiduciary duties without requiring similar efforts related to

its principal supply contracts.

I also believe that Congress should amend or repeal the Gartenberg Standard.

This legal standard is at the very heart of the loose oversight currently evidenced

by mutual fund boards.

Finally, I believe that independent directors should be required to ask for and receive more relevant information prior to entering into major contracts, not just the

advisory contract. Section 15 of the 1940 Act could be expanded, requiring that the

SEC promulgate rules from time-to-time to best accomplish this. In particular, the

SEC should require independent directors to consider the amounts that advisers

charge pension plans and other parties for similar advisory services.

A study conducted in 2001 showed that the largest mutual funds pay twice the

amount to their advisers than public-employee pension plans do for the same services.13 In some cases, mutual fund advisory fees were 3 to 4 times higher than those

of pension funds. While challenged by the ICI, the study still raises legitimate questions for policymakers and independent fund directors. Pension funds negotiate for

lower fees, while mutual fund shareholders can only rely on their directors to do

so. Trustees of public pension plans and corporate retirement plans switch asset

managers on a regular basis, due to fee, performance or service issues. Mutual fund

directors should at least benefit from the best direct comparisons on fees. I have no

doubt that they could be made available, if required in law.

Governance—Definition of Independence & Selection Process

While the 1940 Act currently contains a definition of an independent director, I

believe that it is prudent to tighten that definition and provide for an independent

mechanism for the recruitment and selection of such directors. Sections 10 (and its

related definitions) of the 1940 Act could be amended to assure that noninterested

directors not have any material employment, business or family relationship with

the investment adviser, significant service providers, or any entity controlling, controlled by, or under common control with such companies. In addition, the recruitment and selection of such directors should be by the independent directors or by

an independent nominating committee.

Governance—Independent Chair & Percentage of Independent Directors

The 1940 Act currently mandates that at least 40 percent of mutual fund directors be independent. The SEC, in 2001, required mutual funds operating under a

series of SEC exemptions to have at least 50 percent of their directors be independent. The SEC, in response to the recent scandals has proposed rules to move

this percentage to 75 percent and require that the board chair be independent, as

well. I support these changes as they should change the dynamics in the boardroom. In particular, the chair sets the agenda and tone of board deliberations. There

is no way that a chair who also works for the investment adviser can satisfactorily

serve two masters. By way of analogy, for those who might doubt the importance of the chair, think of all the energy that goes into securing the chairs of Senate Committees.

I do believe, however, that it would be far better to incorporate these requirements directly in the 1940 Act. It is better for Congress to act on such a material

provision of law, rather than have the SEC, a regulatory agency, to mandate its

adoption particularly through indirect means. In addition, in a moment of future

confrontation between an independent board and a fund company, the fund may

avoid the SEC rule by declining the various exemptions.

252

To assure the necessary change in behavior of boards, however, more is needed

than simply changing the number of independent directors and mandating an independent chair. The great majority of funds already have a substantial majority of

independent directors. In fact, approximately 20 percent already have independent

chairs, including some of those funds caught up in the recent scandals. While it

would be a positive step, current law already requires that independent directors

review and make the key decisions of the board. That is why I believe that the most

important governance reform is to clarify the duties of independent directors and

tighten the standards to which they are held.

Restricting Soft Dollars & 12b–1 Fees

Beyond changes to encourage better mutual fund governance, I believe that Congress should give serious consideration to restrictions on soft-dollar arrangements

and 12b–1 fees. Both of these practices exist as they do as a result of specific SEC

actions. Both of these practices also have been associated with a long history of conflicts of interest, and may have outlived their purposes.

The use of soft dollars was significantly broadened under an SEC release in 1986

(interpreting Section 28(e) of the Securities Exchange Act of 1934, which allows paying more than the lowest available commission). Mutual fund companies enter into

soft-dollar arrangements with brokers at the expense of the mutual funds which

they manage. While soft-dollar arrangements can be used to support independent

research efforts, they are often used for other expenses as well. They also diminish

fund managers’ pursuit of best execution for portfolio transactions.

The SEC has put out a concept release seeking comments on soft-dollar arrangements, but the Congress may wish to significantly restrict or possibly prohibit the

current practice. Short of an outright prohibition, mutual funds should be required

to disclose the amount by which any soft-dollar arrangement are picking up costs

for the fund company and this amount should be added to expense ratios.

Rule 12b–1 was promulgated in 1980 in an effort to bring the benefits of economies of scale to investors. The theory originally was that by helping fund companies

generate cash for marketing, funds could grow faster and share economies with investors. Unfortunately, investors have seen few benefits from scale in these funds.

The evidence clearly shows that funds with 12b–1 plans simply have higher expense

ratios and poorer performance than non-12b–1 funds. The time has come to look seriously at repealing Rule 12b–1. The SEC proposed an amendment to Rule 12b–1

this month which would ban the practice by mutual funds of directing commissions

from their portfolio brokerage transactions to broker-dealers to compensate them for

distributing fund shares. I agree with these changes but would add that Congress

might want to consider the effects of other revenue sharing arrangements, as well.

These arrangements call into question the ability of investors to receive unbiased

financial advice from their financial planners or brokers. By analogy, patients do not

wish to see their doctors receive direct commissions when deciding on the appropriate medicine to prescribe.

Greater Disclosure

The mutual fund industry currently provides a considerable amount of disclosure

to the investing public. Additional disclosures, however, may assist investors and

further guard against inherent conflicts. While I think that the most important

reforms relate directly to governance, I offer the following thoughts on additional

possible disclosures to benefit investors.

First, while the direct costs of management fees and sales loads are disclosed,

many of the indirect costs are not. In particular, portfolio trading costs are generally

not disclosed. This is somewhat remarkable given their significance to investor returns. They are also one of the largest controllable costs of mutual funds. I believe

that it would be beneficial to disclose total transactions costs, commissions as well

as an estimate of the costs of bid/offer spreads. If pursued, this would be most helpful if disclosed along with management fees as a percentage of average assets.

Second, the mutual fund industry relies heavily on others—brokers, insurance

companies, and financial advisers—to sell its products. Additionally, fund companies

actively compete to win 401(k) and 403(b) plans from large corporations and institutions. Recognizing their commercial leverage, brokers have developed revenue sharing agreements whereby they get paid handsomely for new sales. Large corporations

and institutions have developed somewhat similar arrangements whereby they receive part of the mutual fund fees on plan assets. Consideration is appropriate to

greater disclosure of these revenue sharing arrangements.

Third, bringing greater transparency in the area of governance may bring greater

discipline. The SEC has this month proposed a rule to require improved disclosures

regarding the reasons for a fund board’s approval of investment advisory contracts.

253

I believe that this rule could be extended—by statute—both as it relates to the negotiations with the adviser and to include other major contracts. In addition, disclosure of portfolio manager compensation and fund ownership would be helpful.

Fourth, given the natural desire of fund companies to ignore the poor results of

liquidated or merged funds, it would be helpful to require fund companies to maintain such disclosure on their websites. Survivorship bias has a perfectly innocent explanation. When investors are trying to decide with which mutual fund family to

invest, however, they could benefit by seeing a firm’s entire track record. Many outside services and publications would also summarize the information, once it was

made publicly available.

Fifth, there is a significant relationship between risk and returns. Many observers

focus on risk adjusted returns to compare investments. Based upon modern theories

of investing, risk adjusted returns are a way of comparing investments of different

risks. There are many services that compute such statistics. It may be worthwhile

considering requiring fund companies to readily disclose such information on their

web sites or with promotional material.

Sixth, while Congress took steps several years ago to require the disclosure of

after-tax returns, the SEC does not require inclusion of this information in sales

and promotional material unless a fund is claiming to be tax efficient. Investors

wishing to know a fund’s after-tax performance currently need to review the prospectus—something they should be doing, but generally are not. It may be appropriate to mandate broader use of after-tax performance data.

Recent Scandals

The SEC has had an active agenda addressing the specifics of ‘‘late trading,’’

‘‘market timing,’’ and ‘‘breakpoint discounts.’’ In particular, the SEC proposed a rule

requiring that fund orders be received by 4 p.m. to address ‘‘late trading.’’ To address ‘‘market timing’’ problems, the SEC proposed a rule requiring enhanced disclosures including: (1) ‘‘market timing’’ policies and procedures, (2) ‘‘fair valuation’’

practices, and (3) portfolio disclosure policies and procedures. Regarding ‘‘breakpoints,’’ the SEC proposed enhanced disclosure regarding breakpoint discounts. In

addition, the SEC adopted a rule on fund compliance policies and compliance officers and has proposed a rule on fund codes of ethics.

While the SEC has been able to move forward with these rules under the current

authorities, Congress could include in any comprehensive reform package an endorsement or enhancement of these rules.

Conclusion

In conclusion, I believe that the recent mutual fund scandals have revealed the

need for substantive reform regarding how mutual funds are governed and operated.

Most importantly, it is the system of governance—whereby independent mutual

fund directors act as gatekeepers for the benefit of investors—which deserves serious review and reconsideration.

Mutual funds now play a central role in America’s capital markets. As we, as a

Nation, face increasing global competition and prepare for the retirement of the

baby-boom generation, I believe that we simply have no choice but to ensure that

America has the fairest and most efficient capital markets in the world. Even small

annual savings can lead to enormous differences upon retirement. Thus, mutual

fund reforms, with the goal to promote greater retirement savings and lower the

cost of capital, are ever more critical.

Thank you. I would be happy to answer any of your questions.

—————

PREPARED STATEMENT OF JAMES K. GLASSMAN

RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

FEBRUARY 25, 2004

Mr. Chairman and Members of the Committee, my name is James K. Glassman.

I am a Resident Fellow at the American Enterprise Institute, where my focus is economic and financial issues. I am also host of the website TechCentralStation.com,

which concentrates on matters of technology, finance, and public policy. In addition,

for the past 10 years, I have written a weekly syndicated column for The Washington Post on investing. I have also written two books geared to small investors

and have published numerous articles on investing topics in publications ranging

from The Reader’s Digest to The Wall Street Journal. Thank you for inviting me to

testify at this important hearing on mutual funds from the point of view of the inVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00265 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
254

1 ‘‘Putnam Led Industry With $28.9 Billon of Withdrawals,’’ Bloomberg, January 28, 2004.

2 Eric W. Zitzewitz, Assistant Professor of Economics, Stanford University, testimony before

the Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives, November 6, 2003. 3The Massachusetts Financial Services (MFS) is generally credited with launching the first

mutual fund in the Spring of 1924. MFS, the eleventh largest mutual fund firm, reached an

agreement on February 5, to pay $225 million and reduce fees in a settlement with regulatory

authorities after charges of permitting market timing. In addition, the CEO and President of

MFS have stepped down. (Letter to clients from Robert Manning of MFS, February 17, 2004,

at http://www.mfs.com/about/index.jhtml; $sessionid$5MJVUBMKDMDCBTXTQYUBFD4O4O

DCSESS.) 4S. 1822, S. 1958, and S. 1971. These three, along with H.R. 2420, passed by the House on November 19, 2003, are examined at length in a CRS Report (RL32157), ‘‘Mutual Fund Reform

Bills: A Side-by-Side Comparison,’’ updated December 9, 2003.

vestor, especially the small investor, who is my main concern. I testify as an individual. The views are mine, not those of any institution with which I am connected.

The Mutual Fund Scandals

In early September of last year, the Attorney General of New York, Eliot Spitzer,

announced that several mutual fund firms had allowed large investors to profit from

practices that were either illegal or actively discouraged by their own published policies. One of those investors, Canary Capital Partners, LLC, a hedge fund, agreed

to pay a fine of $40 million to settle civil charges. Since then, two dozen mutual

fund houses, including several of the largest, have been implicated in the scandal,

which, by the end of January, had led to civil or criminal complaints against at least

10 companies by attorneys general, the U.S. Securities and Exchange Commission,

and the Justice Department; the dismissal or resignation of 60 executives, including

the president of Alliance Capital and the CEO’s of Pilgrim, Baxter & Associates,

Putnam Investments, and Strong Capital; and the imposition of more than $640

million in penalties.1

Specifically, the charges concern two practices:

Late trading, by which an investor purchases shares in a mutual fund after the

4 p.m. deadline but pays the price at that day’s close, rather than the next day’s.

This practice, which typically requires the collusion of a broker or mutual fund employee, is illegal.

Market timing, by which an investor makes quick trades in a mutual fund’s

shares. Most mutual funds discourage market timing—and so officially state to investors—because it can add costs for other shareholders in the fund.

Both practices attempt to capitalize on ‘‘stale prices’’—usually in international

stocks. Trading in Europe and Japan, for example, ends many hours before the 4

p.m. deadline and, in the interim, events may occur that could lift prices the next

day. Through stale-price arbitrage, an investor can, to paraphrase Spitzer, bet on

a horse after the outcome of the race is known.

These practices dilute the holdings of the other shareholders in the fund. According to research by Eric W. Zitzewitz, ‘‘In 2001, a shareholder in the average international fund in my sample lost 1.1 percent of assets to stale-price arbitrage trading

and 0.05 percent of assets to late trading. Losses are smaller, but still economically

significant, in funds holding small-cap equities or illiquid bonds.’’ 2 Large-cap U.S.

stock funds are generally unaffected.

The scandal is by far the most extensive to afflict the mutual fund industry,

which, since its founding 80 years ago,3 has been relatively free of impropriety and

broadly respected by investors. Even before Eliot Spitzer filed his initial charges,

however, the Congress and the SEC had been examining major changes in the

structure and regulation of mutual funds, and, after the scandals, a flood of legislation was introduced, including three major bills in the Senate in the space of 20

days in November.4

But is the rush to regulate the proper response to the scandals? Judging from the

perspective of the investor, as this hearing requests, I have serious doubts.

While steps need to be taken to ensure that some investors do not exploit stale

pricing at the expense of others, the mutual fund industry is basically sound. It is

highly decentralized and competitive, and, despite the scandals and the 3-year bear

market in stocks, it continues to attract savings at a remarkable rate. The largest

firms—including Fidelity Investments, which offers more than 300 funds; Vanguard

Group, whose Index 500 Fund is the largest mutual fund with $77 billion in assets;

and American Funds, which runs four of the top biggest funds, with assets totaling

$200 billion—have not been tainted by the scandal.

A greater worry is that, by rushing to increase regulations in areas such as fees,

board composition, and disclosure, policymakers run the risk of limiting choices and

255

5 2003 Mutual Fund Factbook, 43rd edition, Investment Company Institute, May 2003; updated information from the ICI website, www.ici.org. 6 Joseph Nocera, A Piece of the Action: How the Middle Class Joined the Money Class, Simon

& Schuster, 1994, p. 369. 7 Ibid.

8 ‘‘Taking a Closer Look: The SEC’s Fund To-Do List,’’ Ian McDonald, The Wall Street Journal

Online, January 14, 2004, at http://online.wsj.com. 9 ‘‘Putnam Led Industry,’’ Bloomberg, January 28, 2004, op. cit., and ‘‘American Funds Get

Highest Inflows in United States, Report Says,’’ Bloomberg, January 29, 2004. Both articles use

the Financial Research Corporation of Boston as their main source for data in the table that

I have compiled.

raising costs for small investors. The mutual fund industry is a great American success story. It has democratized finance. It has both provided capital for businesses

and increased the net worth of families. But weighed down by dozens of new counterproductive rules, it could lose its robust character.

Popularity of Mutual Funds

The most striking characteristic of mutual funds is how popular they have become

in such a short time. In a free economy with abundant selections, people buy what

they want, and their investment of choice in the past three decades has been mutual

funds. In 1970, for example, there were 361 funds with a total of $48 billion in assets. At the end of 2003, there were 8,124 funds with $7.2 trillion in assets. Mutual

funds are owned by 91 million investors in 53 million U.S. households—roughly half

the Nation.5

Even in the wake of the scandals, Americans have continued to invest in mutual

funds. In 2003, a total of $152 billion in net new money (after redemptions) flowed

into stock mutual funds, including $30 billion in November and December, at the

height of the revelations by Spitzer and the SEC.

In his history of popular finance in America, Joseph Nocera, Editorial Director of

Fortune magazine, wrote:

Mutual funds became the investment vehicle of the middle class because

they . . . struck people as making a good deal of sense. If anything, mutual

funds made more sense than ever after the crash [of October 19, 1987,

when the Dow Jones Industrial Average lost 22 percent of its value in one

day]. For one thing, even the most aggressive mutual funds outperformed

the market on Black Monday, and in so doing provided at least a little comfort to small investors. More importantly, as the financial life of the middle

class became ever more complicated, connected irrevocably to such arcane

as the state of the Japanese market and the shape of the yield curve, Americans took increasing solace in the central notion behind mutual funds—

that by putting money in a fund, they were hiring a professional to make

market decisions they felt increasingly incapable of making themselves.6

Mutual funds created a revolution in investing by providing average Americans

with the same professional management and financial reporting enjoyed by the

rich—and at roughly the same cost. Because of private research institutions like

Morningstar Mutual Funds, investors can easily compare the performance and the

fees of thousands of funds. Nocera quotes Don Phillips of Morningstar as saying,

‘‘One of the hidden advantages of the fund industry is that by packaging investments in consumer wrapping, mutual funds tap into the consumption skills baby

boomers have spent their lifetimes refining. . . . Funds make investing very much

like shopping.’’ 7

One of the many problems with proposals for mutual fund reforms is that the

shopping will become much more difficult—with a profusion of new requirements

that will mainly serve to confuse investors and add costs that will be borne by fund

shareholders or taxpayers. The SEC alone has approved or is considering 17 separate rules changes 8 and these are in addition to those that may be enacted by other

regulators or through legislation.

A better approach is to increase incentives of investors to discipline funds through

their own choices—and to increase incentives of funds to communicate forcefully and

clearly to investors and of Government to educate.

Investor Discipline is Harsh

The discipline of investors is far more harsh than anything regulators can dream

up. Consider the new inflows and outflows of new money into major mutual funds

during 2003 9:

256

10These figures and all others regarding the individual expense ratios, loads and returns of

mutual funds come from Morningstar Mutual Funds, at www.morningstar.com. 11 ‘‘Don’t Panic, But Start Selling,’’ James K. Glassman, The Washington Post, November 9,

2003. I wrote, ‘‘It’s time to dump Putnam, Strong, and Alger funds, unless you have a very good

reason to keep them, such as avoiding a big tax bill or wanting to hold on to a fund that has

been a superb performer. . . . In my view, it is reckless to entrust your money to institutions

that have proved rotten at the top, no matter what their intentions for the future.’’ Morningstar’s more sweeping admonition to investors preceded mine and was certainly more influential. 12 ‘‘Mutual Funds Vow to Fix Their Clocks,’’ Karen Damato and Tom Lauricella, The Wall

Street Journal, October 31, 2003.

Fund Company Allegations of

Impropriety?

Net Inflow or

(Outflow)

In billions

of dollars

American ......................................................... No 66

Vanguard ........................................................ No 36

Fidelity ............................................................ No 31

Putnam ............................................................ Yes (29)

Janus Capital ................................................. Yes (15)

Amvescap (Invesco) ........................................ Yes (8)

Alliance Capital .............................................. Yes (2)

Putnam, for example, charges an annual expense ratio of between 1 percent and

1.55 percent for its equity funds, in addition to a 5.25 percent load, or up-front fee.10

Imagine that Putnam merely loses 1 percent on the foregone assets each year.

Based on an asset decline of $29 billion in 2003, that’s a loss of $290 million in revenues—with much of it dropping straight to the bottom line—in the first year alone.

Assume that a typical client who redeems her shares would have kept an account

for 5 years; the total loss (assuming no more new redemptions in subsequent years

but growth in assets of about 8 percent annually) is well over $2 billion.

The business of mutual funds is asset-gathering. Investors are willing to entrust

their money to fund companies for many reasons: High historic returns, low expenses, good service, and confidence in the fund’s integrity and safety.

When confidence is shaken—as it has been in the cases of Putnam, Janus,

Amvescap (specifically, its subsidiary Invesco Funds Group, which is accused of allowing favored clients to make short-term trades), and Alliance—investors take

appropriate action. They were encouraged in that action by analysts and commentators, including me.11

Instead of adding rules, policymakers could perform a more useful service by

using the bully pulpit to condemn executives and firms who abuse their clients’

trust and to laud those that act responsibly. That would encourage investors themselves to take action. Such statements should be part of a strategic program of investor education. There are other steps as well that would enhance competition and

give mutual funds stronger incentives to communicate vigorously with the public.

Response and Recommendations

Let me now comment on specific recommendations and offer some of my own.

Late Trading

A rule that would require a hard 4 p.m. market close on all trading activity, including reconciling trades from financial intermediaries, would hurt small investors.

It would, in practical terms, require small investors to make decisions to buy or sell

shares in a fund well before the 4 p.m. close—without knowledge of late-day market

events. The change ‘‘would require deadlines several hours earlier [than 4 p.m.] at

intermediaries such as brokerage firms and 401(k) plans. Thus participants would

have less flexibility.’’ 12 Large professional investors, which either trade securities

directly themselves or place their orders directly with fund companies, would have

an advantage over small investors. The rule should state that all orders must be

placed by buyers and sellers before 4 p.m. and time-stamped accordingly, with the

understanding that the execution of those orders may not occur until after that

257

13 Robert Reynolds, Chief Operating Officer of Fidelity, quoted in ‘‘Mutual Funds Vow to Fix

Their Clocks,’’ op. cit. 14 ‘‘An Economic Defense of Mutual Fund Timing,’’ D. Bruce Johnsen, unpublished paper presented as a draft at a conference at the American Enterprise Institute on January 28, 2004,

titled, ‘‘Mutual Fund Regulation and Litigation: Is the Cure Worse Than the Disease?’’ 15 ‘‘Mutual Funds Vow to Fix Their Clocks,’’ op. cit. 16 A Senate subcommittee found, ‘‘The Enron Board of Directors failed to safeguard Enron

shareholders and contributed to the collapse of the seventh largest public company in the United

States.’’ (‘‘The Role of the Board of Directors in Enron’s Collapse,’’ a report prepared by the

Permanent Subcommittee on Investigations of the Committee on Governmental Affairs, U.S.

Continued

time. A stronger national clearinghouse should be responsible for verifying the

orders were placed before the closing time.

Fund companies have been chastened. Further illegal late-trading activity is unlikely, considering the high costs already imposed on the miscreants. At any rate,

regulators should hold funds responsible for late trading in their funds, no matter

who participates in the practice. Fidelity Investments has properly called the shortened deadline an overly simplistic approach that ‘‘ends up hurting the shareholders,

not helping.’’ 13 A new rule is not needed. Proper compliance with the current rule

is needed.

Market Timing

If a fund states in its prospectus and other written materials that it discourages

market timing, then it must adhere to that policy for all investors, large and small.

But funds should be free to adopt policies that allow, or even encourage, short-term

trading. The choice should be that of the fund itself, but it must be clearly communicated to investors.

Why do funds allow market timing in the first place? In order to gain more assets,

which in turn can lower costs for the fund and its smaller shareholders. As D. Bruce

Johnsen, Professor of Law at George Mason University, put it:

According to the SEC’s own findings, large accounts contribute far more

than the average to scale economies in management. It is therefore no

surprise that the SEC’s perplexing rules prohibiting lower fees for larger

accounts would lead fund advisers to compete for hedge fund dollars by tolerating large-scale internal timing. It is by no means clear that this reflects

a breach of trust. Quite the contrary, fund advisers may have done nothing

worse than cut loss-minimizing deals with hedge funds. By allowing the adviser to keep hedge fund money in the complex, all investors are likely to

be better off compared to the alternative.14

Funds should be free to charge investors different fees according to the size of

their investments, and the scheme for such pricing should be left to the mutual fund

itself. Discriminatory pricing helps, rather than hurts, small investors, since it

draws more large investors into the fund to share the costs.

The SEC is also expected to propose a mandatory fee of at least 2 percent on

shares that investors sell within days or even weeks of purchase. Unfortunately,

this rule, like the hard 4 p.m. deadline, has been endorsed by the Investment Company Institute, the mutual fund trade group.15 This misguided rule will merely

penalize small investors who need to move their funds in an emergency—or some

other valid reason, such as poor performance by a fund or the revelations that the

fund has been engaged in unsavory ethical practices.

It is perfectly valid for a fund to charge a high exit fee in an effort to keep shareholders invested—thus avoiding pressure on the fund manager to sell stock at importune times in order to raise cash. But, again, the choice must be that of the fund

management itself. Investors, in turn, can choose whether they want to own a fund

with a high redemption fee (perhaps adding stability to the fund’s holdings) or a

low or nonexistent redemption fee (to give the investors themselves some flexibility).

By mandating the high redemption fee, the SEC would be dampening competition

among funds and providing all of them with serendipitous income in case of emergency withdrawals. A bad idea.

Independent Directors

The proposals have been advanced that would require each fund to have an independent chairman and for funds to increase the proportion of their independent

directors from a majority to at least 75 percent. The reasoning here is that directors

without an ownership stake or other financial interest will protect shareholders’ interests. That may or may not be true. Enron Corporation had 11 independent directors (out of 15), but they failed to stop fraud and misrepresentation.16

258

Senate, July 8, 2002.) The chairmen of Enron’s executive committee, finance committee, audit

committee, and compensation committee were all independent (and, by any conventional observation, distinguished) independent directors. 17 ‘‘Outside Directors Don’t Mean Outside Returns,’’ Mark Hulbert, The New York Times, June

15, 2003. 18For example, ‘‘Frequently Asked Questions About Mutual Fund Fees,’’ booklet, Investment

Company Institute, 2003. 19 At www.sec.gov/mfcc/mfcc-int.htm

Mark Hulbert, Editor of The Hulbert Financial Digest, the respected scorekeeper

for financial newsletters, wrote in The New York Times, ‘‘Almost all of the several

dozen academic studies on board independence have found [either] that it has no

correlation with company performance or that companies generally perform worse

when they have more outsiders on their boards.’’ 17 Why worse? Probably because

the directors with a direct personal stake in a firm put more time and effort into

governance.

Requirements like this one present a moral hazard problem for investors. Regulators are sending the signal: ‘‘We will require lots of independent directors on mutual funds, so investors won’t have to worry about good corporate governance.’’ In

fact, investors should worry, and, if they do, mutual fund companies will have an

enormous incentive to reassure them. Perhaps having lots of independent directors

provides that assurance. If it does, the funds will advertise the fact. That is the

proper dynamic to ensure integrity.

Disclosure and Fees

It is hard to be against disclosure, but the absurd amount of detail that the SEC

is now requiring—and is proposing to require—may do more harm than good. Most

disclosure involves expenses. My experience with readers is that their main interest

in choosing a mutual fund is not the expenses, but the return. Ask any investor,

and you will get the same answer: He would rather pay $100 in expenses to get

a net return of $300 then pay $2 in expenses to get a net return of $299. In this

judgment, small investors in mutual funds are no different from sophisticated investors in hedge funds. A typical hedge fund charges a 1 percent annual fee plus 20

percent of the profits. That can amount to far more than a mutual fund investor

pays. In a year when the market is up 30 percent, a hedge fund investor pays about

7 percent in expenses, compared with an average of about 1.5 percent for a mutual

fund investor.

The problem for all investors, however, is that past performance is no guarantee

(or, in most cases, even indication) of future performance. Since markets tend to be

efficient, most funds, over time, will produce returns that are close to those of the

market as a whole, reflected, for example, by the Standard & Poor’s 500 Stock

Index. If funds tend to perform alike, then the fund with the lowest expenses will

produce the highest net returns.

Life isn’t quite so simple. Last year, for example, the top quartile of diversified

stock mutual funds produced returns that averaged about 10 percentage points

higher than the average fund, and there are gifted fund managers whose long-term

records seem to show they have the ability to beat the market with some consistency. Still, expenses count, and it is difficult to get investors to believe that fact.

Despite the urging of practically every writer on the subject, despite the clear

statement of fees at the start of every mutual fund prospectus, despite the detail

on expenses in every Morningstar write-up, despite the industry’s outreach,18 despite the fact that about three-quarters of fund purchases are made through advisors whom investors can simply ask about fees, and despite the SEC’s own excellent

online fee calculator,19 many—perhaps most—investors don’t even know the fees

that their funds charge. Since expenses are netted out of returns (that is, investors

do not have to hand over a check for a fund’s services), they are largely invisible.

Will more disclosures help? I doubt it. ‘‘Mutual fund fees are subject to more

exacting regulatory standards and disclosure requirements than any comparable

financial product offered to investors,’’ says the Investment Company Institute,

which is obviously an interested party but which is speaking here with accuracy.

Beyond the basics that are required today and are explained at length in the prospectus and ‘‘Statement of Additional Information’’ and are summarized by services

like Morningstar, disclosure—in its extent and presentation—should be left to the

funds themselves. They know how to communicate best with consumers. The job of

the regulators is to ensure that the disclosure is accurate and that companies do

what they say they will do. Companies and individuals that commit fraud should

be vigorously prosecuted, as they have been—appropriately—in recent cases involving late trading and market timing.

259

20Testimony of William H. Donaldson, Chairman of the SEC, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 30, 2003, at www.sec.gov/news/testimony/ts093003whd.htm. 21 ‘‘Funds Need a Radical New Design,’’ Amy Borrus and Paula Dwyer, Business Week, November 17, 2003, p. 47. 22 Ibid. 23 Ibid. 24These figures and subsequent industry are from the 2003 Mutual Fund Factbook. 25 ‘‘ICI Economist Reports that ‘Total Shareholder Cost’ of Investing in Stock Mutual Funds

Has Declined 45 Percent Since 1980,’’ Press Release, Investment Company Institute, February

18, 2004.

Funds already have an incentive to advertise low fees, just as grocery stores have

an incentive to advertise low prices on bananas. The paucity of such advertising indicates that investors don’t care about fees as much as they care, for example, about

returns, and no amount of disclosure will change that fact. Additional disclosures

will simply cause additional confusion and may lead policymakers to think they

have done their job. One mutual fund CEO told me that only two people, out of the

many thousands that are shareholders in his fund, request the Statement of Additional Information annually, and the CEO assumes that the two are ‘‘competitors

rather than investors.’’

The SEC is also considering a requirement to disclose ‘‘incentives and conflicts

that broker-dealers have in offering mutual fund shares to investors.’’ 20 Disclosure

would come through a confirmation form. I have examined this form and find it

so complicated as to be unusable. It includes a complete page, in dense type, of

‘‘explanations and definitions,’’ and it requires ‘‘comparison ranges,’’ but it is unclear what is being compared with what: Small-cap funds, all funds, equity funds?

The SEC should drop the disclosure approach and instead adopt an education approach (following).

Structure

Much of the confusion and problems related to mutual fund governance can be

traced back to 1940, when a law established the industry’s current legal structure,

characterized recently by Business Week as an ‘‘antiquated set-up,’’ 21 and that is

putting it mildly. Under the law, each mutual fund (and there are more than 8,000

today) is a separate company, ‘‘but it’s essentially a shell, with directors but no employees. The fund board contracts out for all key services, from stockpicking to recordkeeping. In theory, the board can choose any adviser, but in reality, a fund company usually sets up a fund, appoints a board, and the board then hires the management company that founded the fund.’’ 22

It is doubtful that many investors understand this structure. They believe that

the fund adviser owns the fund. The way to rationalize and modernize the current

system is to treat mutual funds as investment products instead of companies. ‘‘It

might make sense to permit funds to structure themselves the way people actually

think of them—as services bought based on performance and cost,’’ says Steven

M.H. Wallman, a former SEC Commissioner who now runs the investment firm

FOLIOfn.23 The board that runs the funds, then, would be the board of the asset

management company that is now the funds’ adviser.

Competition Enhancement

Rather than adding rules, policymakers should seek ways to enhance competition.

Already, the mutual fund industry is fiercely competitive—and getting more so. The

five largest fund houses accounted for just 33 percent of mutual fund assets in 2002,

down from 37 percent in 1990. The 10 largest fund houses accounted for 46 percent

of assets, down from 56 percent in 1990. With 4,700 equity mutual funds, investors

have vast choices.24 Some funds charge commissions, or loads, at the time of purchase; others at the time of sale. Others impose no loads at all, instead getting all

their investor income from annual fees, charged as a percentage of total assets.

The most popular mutual fund, Vanguard Index 500, carries no load and charges

just 18 basis points in annual expenses. The second largest, Fidelity Magellan,

also imposes no load and charges only 76 basis points. There are abundant lowcost choices.

‘‘The actual costs borne by average stock mutual fund shareholders have dropped

45 percent since 1980,’’ said Brian Reid, Deputy Chief Economist for the Investment

Company Institute, reporting on a recent study by Peter Tufano of Harvard and

Erik Sirri of Babson College. The study found that 60 percent of shareholder assets

are invested in funds with total expense ratios under 1 percent.25 An extensive

study of fees found a decline in the weighted-average annual expense ratio for stock

mutual funds from 2.26 percent in 1980 to 1.28 percent in 2001; for bond funds,

260

26 ‘‘Frequently Asked Questions,’’ op. cit., p. 13. 27 ‘‘Oxley, Baker: All Mutual Fund Investors Deserve Lower Fees,’’ Press Release, House Committee on Financial Services, December 17, 2003. The Press Release is quoted in my article,

‘‘Spitzer vs. the SEC,’’ James K. Glassman, TechCentralStation.com, December 19, 2003 (http:/

/www.techcentralstation.com/121903G.html), which contains a discussion of the competitive

nature of the mutual fund industry. 28 Another way to lower expenses would be to decrease the demand for funds, which would

best be accomplished if funds did not perform a service that consumers wanted. In other words,

if funds would only do a worse job, prices would fall. 29 Bruce R. Bent, private correspondence, January 30, 2004.

from 1.53 percent in 1980 to 0.9 percent in 2001.26 Fidelity recently did away with

its 3 percent loads on sector funds. Fees don’t fall, of course, because fund company

executives are nice guys. They fall because costs drop through economies of scale

and, more important, because competition puts pressure on prices.

Investors do not, however, opt for low costs alone. Nor should they. They consider

financial returns and service as well. PIMCO Total Return, a bond fund, has accumulated $74 billion in assets despite a 4.5 percent front load plus annual expenses

of 0.9 percent. The reason is simply that the fund’s manager, Bill Gross, has compiled such a spectacular record in recent years. Similarly, Legg Mason Value Trust,

with a lofty expense ratio of 1.72 percent, has increased its assets from less than

$1 billion in 1993 to $14 billion today largely because its manager, William Miller,

has beaten the benchmark Standard & Poor’s 500 Stock Index in each of those years

(plus two more), an astounding record.

Last December, two top Republicans on the House Financial Services issued a

Press Release stating, ‘‘All mutual fund shareholders deserve lower fees. Not just

shareholders who invested in funds that engaged in questionable trading practices;

not just shareholders invested in one fund family; but all mutual fund shareholders

deserve relief from fees that continue to rise.’’ 27 First, it appears that fees are not

rising; but, second, in a competitive market, with few supply constraints, higher fees

(if they did arise) would be a reflection of higher demand. The concept that any consumer ‘‘deserves’’ a particular price is an artifact of poor economic thinking. Efforts

to push down costs by Government fiat or intimidation (an approach of Spitzer) are

misguided and misinformed. It is competition that holds down prices.

A good way to enhance competition and get the lower fees that some policymakers

seek is to increase the supply of funds—that is, the choices of investors.28 But adding new regulations—even disclosure requirements that appear innocuous—will

have the opposite effect. Some funds will simply not be able to afford the added

legal, accounting, research and publishing costs. They will either close down, merge,

or boost expenses beyond the reach of small investors.

An attraction of mutual funds is that they offer small investors much the same

professional services that well-off investors have enjoyed for years. Recently in New

Orleans, I visited the firm St. Denis J. Villere & Co., founded in 1911 to manage

the money of institutions and wealthy investors—a task it has performed exceptionally well. Villere requires a minimum starting account of $500,000 for its advisory

clients. In 1999, after requests from smaller investors, the firm launched a public

mutual fund, Villere Balanced, which requires an initial investment of just $2,000.

The fund, which combines stocks and bonds, has been an exceptional performer,

beating the S&P by an annual average of 7 percentage points over the past 3 years.

But it remains small: Just $17 million in assets.

Such a fund—and there are many—will bear a heavy burden if the regulatory

wish list goes into effect. More important, small investors could lose choices like

Villere Balanced. Calamos Growth, by some accounts the top diversified stock fund

in America, had only $12 million in assets in 1998 and now has $5 billion. It won

those assets through impressive performance (returning an annual average of 21

percent for the past 5 years), but, with heavy regulatory expenses, it might have

been killed in the cradle. By the way, Calamos charges a front load of 4.75 percent

and annual expenses of 1.4 percent. Is that too much? Evidently not for the investors who have piled into the fund to benefit from the talents of the Calamos family,

who last year produced returns of 42 percent of their shareholders.

Another way to enhance competition—and improve the governance of funds—is by

making it easier for investors to exit funds that have failed to meet financial or ethical expectations. A major obstacle to redemption of fund shares is the capital gains

tax. Investors are reluctant to leave a fund they have held for a long time if they

have to pay Federal taxes of 15 percent on their profits.

Mr. Bruce R. Bent, who invented the money-market fund in 1972, proposes that

‘‘investors be permitted to sell shares of a mutual fund for any reason . . . without

incurring tax, provided that the proceeds are reinvested in a similar fund . . . within 30 days.’’ 29 In this rollover plan, Bent would require investors who sell shares

261

30 ‘‘Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A

Case Study of S&P 500 Index Funds,’’ October 2003. 31 Ibid, pp. 2–3. 32 Ibid., p. 3. 33 Ibid., frontispiece. 34 Ibid., p. 32.

in a small-cap fund, for example, to buy shares in another small-cap fund. This

seems to me needlessly complicated; I would allow purchases of shares in any fund,

or in individual stocks and bonds, for that matter. But either way, Bent has the

right approach. Public policy should be directed at intensifying competition and increasing the anxiety of funds that, if they betray their customers, they will lose a

great deal of business.

Investor Education

As boring as it may sound, the most important step that policymakers can take

to improve governance of mutual funds and to help small investors is to focus on

investor education. Today, lip service is paid and a small amount of money is spent.

Far more effort is required, and it needs to be centralized. The SEC, the Treasury

Department, and the Labor Department all have investor education programs. Instead, there should be a single office, with sufficient funding and dynamic, marketing-oriented leadership.

Let me close on a disturbing paper by Ali Hortacsu and Chad Syverson.30 The

two University of Chicago economists looked at 85 retail index funds geared to the

S&P 500 (an index fund is constructed to mimic the performance of a popular stock

or bond index; the S&P 500 is the most popular such index, in part because it reflects about 85 percent of the total U.S. stock market capitalization in only 500

stocks). The number of S&P index funds has quintupled since 1992, so, clearly, investors have wide choices.

What is disturbing is that ‘‘the highest price S&P 500 index fund in 2000 imposed

annualized investor fees nearly 30 times as great as those of the lowest-cost fund:

268 vs. 9.5 basis points’’ (a basis point is one one-hundredth of a percentage point,

so 268 bp equals 2.68 percent). The authors continue, ‘‘This striking divergence is

not restricted to the far ends of the distribution; the seventy-fifth/twenty-fifth and

ninetieth/tenth percentile price ratios are 3.1 and 8.2, respectively.’’ 31

The authors ask, ‘‘How can so many firms, charging such diffuse prices, operate

in a sector where funds are financially homogeneous?’’ 32 In other words, why do

funds that return the same (that is, they all pretty much return, before expenses,

what the S&P 500 returns) charge fees that are so different?

The principal answer they give is that there has been an ‘‘influx of high-information-cost novice investors.’’ 33 Very simply, many investors are unsure about the investments they are purchasing. The costs—that is, the value of the time spent—in

investigating the expenses of one index fund over another are so high that these

investors just pick a name they know, or rely on the suggestions of friends or advisors. ‘‘While average search costs were declining, costs for those at the upper percentiles of the distribution actually tended to increase through our sample years.’’ 34

Again, to translate: Most investors have learned a great deal over the years about

investing, so the costs to them of picking a fund are falling, but costs (again, in

time) are still high for new investors.

This study shows, with glaring illumination, just how much education is needed,

especially for novices. Not disclosure, not new rules, not onerous requirements, but

simple education. Much of that education has been provided by mutual fund companies themselves and, of course, by journalists and research firms. But more education is urgently required, and here the Government has a significant role to play.

Thank you.

262

263

264

265

266

267

268

269

270

271

272

273

274

275

276

277

278

279

280

281

282

283

284

285

286

287

288

289

290

291

292

293

294

295

296

297

298

299

300

301

302

303

304

305

(307)

FUND OPERATIONS AND GOVERNANCE

THURSDAY, FEBRUARY 26, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 2:03 p.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

This afternoon, the Banking Committee continues its examination of the mutual fund industry. Specifically, we will focus on fund

operations and governance.

Before I get started, I want to tell the panelists, you have been

here twice for one panel, one chance to testify. We appreciate that.

We did not bring the ice and the snow earlier when we cancelled

everything in the Senate, and we did not bring trouble here either.

But we appreciate your patience and your willingness to come

again today.

Under the operating structure created by the Investment Company Act of 1940, fund boards contract with service providers for

the daily management of the fund. As a result, the typical mutual

fund maintains a variety of relationships with investment advisers,

transfer agents, and underwriters. Over the course of time, fund

operations have become increasingly complex and the need for outside expertise has grown. For instance, the expanded role of intermediaries in the sale and distribution of mutual fund shares that

has led to new fees, compensation arrangements, and conflicts of

interests.

The recent revelations concerning the fund industry raise serious

questions about the transparency of fund operations and the adequacy of current disclosure practices. It seems as if most investors

lack a basic understanding of how funds operate and are unaware

of the risks, and potential conflicts of interest, that accompany fund

operations. Currently, mutual funds are required to disclose a significant amount of information to investors. Many contend these

disclosures are confusing and omit useful information. We will consider various operational issues and compensation arrangements to

evaluate how these practices serve investors today. We will also

evaluate how the SEC’s disclosure regime might be revised to ensure that investors receive clear, concise, and meaningful disclosure

that enhances decisionmaking rather than impede it.

308

Given the complex operating structure of funds, shareholders

must rely on fund boards to police conflicts of interest and protect

shareholder interests. With such an important responsibility to

shareholders, I believe it is critical that boards exercise strong and

active leadership and sound judgment. Some contend that the recent scandals are evidence of an erosion of fund governance. We

will review the role of independent directors and examine how

changes to fund governance can better minimize conflicts of interest and reinvigorate the boardroom culture to better protect shareholder interests.

To discuss these issues with us today, we have a distinguished

panel. No stranger to the Banking Committee, Chairman Dave

Ruder. Professor Ruder was the Chairman of the SEC when we

spent a lot of time here together. He is also the Chairman of the

Independent Directors Forum; David Pottruck, President, Charles

Schwab; Mellody Hobson, President, Ariel Capital Management;

and John Bogle, founder of Vanguard Funds.

I look forward to all of your testimony here today. Your written

testimony will be made part of the hearing record in its entirety.

Chairman Ruder, we will start with you, and welcome you again

to the Banking Committee, where you have appeared many times.

STATEMENT OF DAVID S. RUDER

FORMER CHAIRMAN

U.S. SECURITIES AND EXCHANGE COMMISSION

WILLIAM W. GURLEY MEMORIAL PROFESSOR OF LAW

NORTHWESTERN UNIVERSITY SCHOOL OF LAW

CHAIRMAN, MUTUAL FUND DIRECTORS FORUM

Mr. RUDER. Thank you, Chairman Shelby. I well remember the

days of following the market crash of 1987, when I had the pleasure of appearing before this Committee.

Chairman SHELBY. That was one of yours and then Chairman

Greenspan and Mr. McDonough’s finest hours and days.

Mr. RUDER. I thank you for asking me to testify on the important

question of mutual fund reform. I am currently a Professor of Law

at Northwestern University School of Law, where I teach securities

law, and as you said, I was Chairman of the U.S. Securities and

Exchange Commission from 1987 to 1989.

Currently, I serve as the Chairman of the Mutual Fund Directors

Forum, a not-for-profit corporation, whose mission is to improve

fund governance by promoting the development of vigilant and

well-informed directors. We do so by offering continuing education

programs to independent directors, providing opportunities for

independent directors to discuss matters of common interest, and

serving as advocates on behalf of independent directors.

Although I am Chairman of the Forum, these remarks are my

own and not made on behalf of the Forum, its members, or any

other groups of persons. That is similar to an SEC disclaimer, and

I give it gladly.

My written statement contains my suggestions for improvement

in mutual fund——

Chairman SHELBY. Speaking for yourself and not for your other

members, right?

309

Mr. RUDER. That is right. My statement deals with corporate

governance and identifies several problem areas in mutual fund administration that need special attention.

The most important approach toward increasing protections of

mutual fund investors is to enhance the power of independent fund

directors and to motivate them to perform their duties responsibly.

In seeking these goals and reforms in adviser activities, I believe

Congress should rely upon the Securities and Exchange Commission and should refrain from extensive legislation.

In deciding what corporate governance structure is desirable, the

Congress and the SEC need to understand that most fund directors

are well-informed, dedicated, and active in their supervision of

mutual fund advisers. But to say that most fund directors are wellinformed, dedicated, and active does not mean that all fund directors share those qualities.

Historically, the mutual funds have been created by investment

advisers that are extremely knowledgeable about the securities industry and the intricacies of mutual fund management. Some fund

directors who are charged with supervising an adviser may at

times be unwilling to challenge the adviser who has the advantage

of superior knowledge and resources.

There are some important corporate governance improvements

that should be made, many of which have already been proposed

or adopted by the SEC.

First, regarding independence, I agree that at least three-fourths

of each fund board of directors should be independent of the adviser. I also believe that the chairman of the board of each fund

should be independent of the adviser. An independent chairman

can control the board agenda, and can control the conduct of board

meetings so that important discussions are not truncated, and can

provide important and direct liaison with the adviser between

board meetings. And both of these reforms have been suggested by

the SEC.

Second, regarding fund board operations, the fund boards in the

larger complexes should function with committees composed solely

of independent directors, including a nominating committee, an

audit committee, a compliance committee, and an investment committee. Since most funds are externally managed by the adviser, it

is also important that boards of directors have access to their own

consultants and advisers. I believe that all independent directors

should have independent legal counsel, that mutual fund boards

should be able to hire an independent staff on a permanent basis

or on an as-needed basis, and that fund boards should be able to

hire independent advisers to advise the board in areas such as fund

fees and costs, the quality of portfolio executions, and the valuation

of fund securities.

Third, regarding compliance, which I regard as all important, I

strongly endorse recent SEC actions to improve compliance. Each

investment adviser should be required to have a chief compliance

officer charged with supervising the compliance functions of the adviser and the service providers to the funds. Although paid by the

adviser, the chief compliance officer should report to the fund

board, as well as to the adviser. The fund boards should have the

310

right to set the compensation and to hire and fire the chief compliance officer.

Chairman SHELBY. Chairman Ruder, do any of the funds have a

chief compliance officer that you know of today?

Mr. RUDER. A few do.

Chairman SHELBY. A few do.

Mr. RUDER. A few do, but not many.

Chairman SHELBY. Okay.

Mr. RUDER. But there is a growing movement in that regard.

Chairman SHELBY. Absolutely.

Mr. RUDER. Advisers and funds should adopt and implement

written compliance policies and procedures. The SEC’s recently

adopted Investment Advisers Act rule will require the adviser to

adopt and to implement written policies and procedures reasonably

designed to prevent violation of the Advisers Act by the adviser. Its

Investment Company Act rule requires fund boards to adopt written policies and procedures reasonably designed to prevent violations of the securities laws.

I believe these compliance requirements will be extremely helpful

in achieving better fund governance. But I believe there are two

areas in which no action should be taken. Some have suggested

that fund directors or the board chairman should be required to

certify to shareholders regarding their oversight activities. I do not

believe that such a certification requirement is needed or advisable.

Such a requirement is not needed because fund boards are increasingly becoming more active in supervising advisers and service

providers, and they will become even more active under new SEC

rules. Such a requirement is not advisable because it could deter

qualified individuals from serving on boards.

Even under the Sarbanes-Oxley Act, the certification requirement does not reach the board level.

Some also have suggested that a mutual fund oversight board be

established for the purpose of overseeing the mutual fund industry

in a manner similar to which the Public Company Accounting

Oversight Board oversees accountants. I do not believe that such

a mutual fund oversight board is necessary. The PCAOB was established in the accounting area because of a lack of power to oversee the accounting industry. In contrast, the SEC has the authority

to oversee the mutual fund industry. It is increasing its oversight

and rulemaking activities and, thanks to the Congress, has recently been given badly needed additional resources that will help

it to perform its oversight functions.

My written statement contains some comments regarding technical areas of fund administration. I want to point to four of them.

First, in my opinion, neither the U.S. Government nor the State

governments should attempt to set mutual fund advisory fees. This

is a very complex industry and very competitive, and I think——

Chairman SHELBY. Shouldn’t the market set the fees?

Mr. RUDER. I believe the market should set the fees, but——

Chairman SHELBY. Does anybody have any disagreement with

that on the panel?

Mr. BOGLE. Yes, sir.

Chairman SHELBY. You do? Okay. I will let you continue.

311

Mr. RUDER. I think that the fees should be set by the directors

bargaining in a very vigorous way with the adviser, and there are

many subsets of that negotiation which are very important.

Second, I believe that the SEC should mandate that all directed

brokerage revenues—those are the revenues that come from portfolio transactions—including soft-dollar payments, should be used

for the benefit of the funds and not for the fund advisers.

Third, I believe Congress should enact legislation in one area. It

should repeal Section 28(e) of the Securities and Exchange Act,

which protects soft-dollar practices, and lets the SEC, by rule, deal

with those soft-dollar payment problems.

Fourth, since the SEC is addressing late trading and market timing, no legislation is needed in those areas.

The SEC may be criticized for its failure to engage in earlier action regarding the problems that have emerged in the mutual fund

industry. But I regard its recent actions and proposals to be effective in correcting the problems in this very highly complex industry. I believe Congress should rely on the SEC and fund directors

to provide effective oversight of the industry and should not seek

a legislative solution other than the repeal of Section 28(e).

If Congress should, nevertheless, decide to act, I believe it should

limit its action to structural areas, such as having an independent

chairman and three-fourths of the board being independent, and

possibly to clarifying the powers of the Commission to oversee the

industry. But the important thing is that this is such a complex

and highly difficult industry to understand that the SEC is the

right agency to take action.

Thank you.

Chairman SHELBY. Mr. Pottruck, welcome to the Committee.

STATEMENT OF DAVID S. POTTRUCK

CHIEF EXECUTIVE OFFICER

THE CHARLES SCHWAB CORPORATION

Mr. POTTRUCK. Thank you, Chairman Shelby, Ranking Member

Sarbanes—who is not here at the moment—distinguished Members

of the Committee. My name is David Pottruck, and I am the CEO

of Charles Schwab Corporation. Mutual funds are at the core of our

business, and we at Schwab share the Committee’s disappointment

over the recent events that have propelled mutual funds to the

front pages. I am delighted to be here and applaud this Committee’s efforts to identify needed reforms.

Schwab is certainly no stranger to the needs of mutual fund investors. We serve more than 8 million individual accounts and

more than 2 million 401(k) plan investors with nearly $1 trillion

in assets. And perhaps most important from the point of view of

individual investors, we pioneered the first no-load mutual fund

supermarket.

Before the launch of our no-load, no-transaction-fee mutual fund

supermarket in 1992, our clients held about $6 billion in mutual

funds at Schwab. Today, our clients have more than $278 billion

invested through our company in more than 5,000 funds. Moreover,

nearly 90 percent of mutual funds traded today, including many

401(k) plans, are executed via an intermediary, whether Schwab or

a competitor of ours.

312

I do not think I am being too bold when I say that mutual fund

supermarkets helped democratize investing for millions of Americans. Supermarkets protect investors from being held captive by a

single fund company by providing an array of investment choices.

They empower investors by facilitating comparison shopping among

funds; they increase competition by allowing investors to move easily from one fund family to another; and they simplify investing by

consolidating statements, thereby driving down costs.

In a time of growing consolidation in all of the financial services

industry, mutual funds stand out as an admirable exception. Since

our supermarket launch, competition has increased, and the number of mutual funds has nearly tripled. Many of these new funds

are managed by smaller fund companies that did not even exist a

decade ago and could not exist or blossom without the supermarket

infrastructure, such as the Ariel funds, represented on today’s

panel by Mellody Hobson.

As you consider reform, I strongly urge the Committee to remember the very qualities that make mutual fund supermarkets so valuable to investors: Choice, simplicity, disclosure, competition, and

convenience.

I would like to briefly outline a few suggestions for the Committee’s consideration to underscore these principles.

Number one, investors deserve choice without conflict. Their broker’s representative should never have a financial incentive to push

one mutual fund over another, and no one at Schwab does.

Number two, all investors need disclosure. They should know, for

example, whether a fund company has paid a fee to be on a broker’s preferred list.

Number three, having said that, it is important that we focus on

the quality, not just the quantity of disclosure. Mutual fund documents are already too complex. There is a danger that additional

disclosure will further overwhelm investors. The SEC has made

important progress in recent years in its plain-English initiatives.

It must apply those principles here as well, or we are just fooling

ourselves about helping investors.

Number four, finally, to boost competition and drive down prices,

Congress should un-fix sales loads and force broker-dealers to disclose and compete on cost. Mutual funds should be allowed to set

a maximum load, but not a minimum, as they do now. Today,

Schwab is prevented from selling load funds at reduced charges to

the consumer. Moreover, if Congress un-fixes sales loads, the SEC

should do away with the confusing proliferation of the load share

classes which leave many investors confused. At Schwab, we only

offer the same low-cost share class that fund companies offer to investors directly.

This brings us to the issues of choice, convenience, and fairness.

One of the highest profile proposals to emerge from the SEC is

known as the ‘‘Hard 4 p.m. Close.’’ We fully support the intended

result. But without further development, this proposal would unnecessarily decrease investor choice, convenience, and fairness. The

highway through mutual fund supermarkets and intermediaries,

the preferred route for nearly 90 percent of mutual fund purchases,

would have a 10-foot-tall speed bump.

313

Under the SEC’s proposal, different investors would face different cutoff times. Imagine three investors who want to buy or to

sell $5,000 worth of the same mutual fund, one through a 401(k)

plan, one through a brokerage account, and one through an account

held directly with the mutual fund. Each investor would have a different cutoff time and potentially a different price for the same

transaction. Ironically, it is this kind of disparate treatment of investors that has been the source of concern for the American people

and this Committee.

Mr. Chairman, the ‘‘Hard 4’’ needs to become the ‘‘Smart 4,’’

which takes the ‘‘Hard 4’’ and goes beyond it to embrace the services investors want. And this further evolved proposal absolutely

achieves the goal of preventing orders from being placed after the

market closes but without creating inequities among different investors. It requires that preapproved intermediaries utilize the best

technology, enhanced compliance and audit requirements, and vigorous enforcement to stamp out illegal late trading.

I provide more details about the ‘‘Smart 4’’ proposal in my written testimony, which I ask to be included in the record.

Chairman SHELBY. Without objection, your entire testimony, all

the testimony will be made part of the hearing record.

Mr. POTTRUCK. Thank you.

Finally, Mr. Chairman, let me conclude by saying that we in the

mutual fund industry bear the ultimate responsibility for acting in

the best interest of our clients. Legislation and regulation can only

do so much. Most of the failures that have been publicized were

already illegal. They were not a result of inadequate rules but,

rather, a failure to follow the letter and the spirit of the rules that

we have.

I appreciate the opportunity to share our views on this critical

issue, and I look forward to answering any questions that any of

you may have.

Chairman SHELBY. Thank you.

Ms. Hobson.

STATEMENT OF MELLODY HOBSON

PRESIDENT, ARIEL CAPITAL MANAGEMENT, LLC/

ARIEL MUTUAL FUNDS

Ms. HOBSON. Thank you, Chairman Shelby, Ranking Member

Sarbanes, and all of the Members of the Committee. I am honored

to be here.

I am President of Ariel Capital Management, the investment adviser to the Ariel Mutual Funds, a small mutual fund company

based in Chicago. Our firm’s Chairman, John Rogers, founded our

firm in 1983 when he was just 24 years old. John began investing

at the early age of 12 when his father started buying him stocks

every birthday and every Christmas instead of toys. Ultimately, his

childhood hobby evolved into a passion that led to the creation of

our firm.

At the time of our inception, Ariel was the first minority-owned

money management firm in the Nation, in my view a testament to

the American Dream. Given our pioneering status, it is part of

Ariel’s corporate mission to make the stock market the subject of

dinner-table conversation in the black community.

314

With nearly $5.5 billion in assets, Ariel’s four no-load mutual

funds invest for 280,000 investors. So, our responsibilities are indeed quite large. But in comparison to the largest mutual fund

firms in the country, with just 74 employees, we are quite small

as a company.

As a small mutual fund company, we are the norm in our industry, not the exception. More than 370 mutual fund companies manage $5 billion or less. As such, I welcome the chance to speak on

behalf of small mutual fund companies and our shareholders.

Clearly, there are important ways in which Ariel and other

small, entrepreneurial fund firms stand apart from the giants in

our industry. Yet, because of our vision and hard work, and because of regulatory innovations like the SEC’s Rule 12b–1, we are

able to compete fiercely and quite often successfully with larger

fund companies every single day.

A breach of trust involving mutual funds has raised doubts about

my industry’s commitment to integrity, a commitment that tens of

thousands of mutual fund employees have spent more than 60

years building. Recent disturbing revelations have led some to conclude that fund companies are ignoring their fiduciary obligations,

have lost their connection to shareholders, and have abandoned the

basic principles of sound investment management. Nothing could

be further from the truth. As a mutual fund company executive, I

know my future, my credibility, and my livelihood are inextricably

linked to that of our shareholders and their success.

First, I would like to address the issue of mutual fund fees. Federal regulation of prices can be appropriate when there are few

competitors and little choice that the opportunity for monopolistic

practices is a threat to the consumer. This is not the case in our

industry. Notwithstanding some heated rhetoric to the contrary,

mutual fund competition is powerful, vibrant, and growing. Capitalism is working and price regulation, as some have proposed, is

both uncalled for and potentially disastrous.

Second, mutual funds are one of the only products I know where

price increases are actually rare. To raise management fees, a majority of our fund companies’ directors must vote that an increase

is needed. Then a majority of the fund’s independent directors must

separately vote for a higher fee. After that, the ultimate decision

rests with the fund’s shareholders, a majority of whom must also

vote in favor of any increase before it can take effect.

While some critics claim mutual funds charge higher fees than

pension funds and other institutional accounts, their analysis is seriously flawed. The fact is mutual fund investors receive a litany

of services not commonly offered to institutional investors. They

include phone centers, websites, compliance, accounting, and legal

oversight, as well as prospectuses, educational brochures, and

shareholder letters.

Contrary to some claims, fund fees have declined steadily for

more than 20 years. ICI research shows since 1980, the average

cost of owning stock mutual funds has decreased 45 percent. Additionally, the SEC, GAO, and ICI have all concluded most mutual

funds reduce fees as they grow. While one of my fellow witnesses

appears to believe otherwise, it is undeniable that this is the very

definition of economies of scale. Industries generally do not produce

315

scale economies. Companies do. If any of us wanted to start manufacturing automobiles tomorrow, the huge scale enjoyed by Ford

and General Motors would be of relatively little help to us. It would

still cost us a fortune to produce new cars.

Some question if mutual fund fees are understood. Fund prospectuses are required to have an SEC-designed table showing fees in

place, English-based upon strict formulas. A key part of this table

is the standardized example illustrating the cost of a $10,000 investment. Beyond the prospectus, the SEC recently ruled reports

must illustrate the exact cost in dollars of a $1,000 investment over

a 5-year period. That is in the shareholder report now. These

guidelines enable investors to compare the total fees of 8,000 mutual funds competing for their business.

A significant mutual fund fee issue that has been frequently misunderstood relates to a portion of fund expenses called the 12b–1

fee. The issue is of great import to small mutual fund companies

like Ariel because it impacts our ability to reach investors. The

easiest way to think about mutual fund distribution is to equate it

to the film industry. You can make a great movie, but if you do not

have a distributor, no one will see it. Similarly, you can have a terrific fund with an excellent track record. But if the fund company

does not have access to effective sources of third-party distribution,

it will be a fund more in theory than in practice because it will

have so few investors.

Distribution costs money. Without the means to pay for access to

these far-reaching channels, the smaller fund companies that lack

scale, a recognizable brand name, and huge advertising budgets

will be disproportionately disadvantaged. Ultimately, mutual fund

investors will have fewer and much lesser first choices. We have

seen many instances where industries came to be dominated by a

few large firms. Does anyone believe that is good for consumers, for

competition, and for economic growth? I do not think so.

Let me now turn to fund governance. Should Congress mandate

an independent chair? In my view, an across-the-board rule is unwarranted. The Chairman’s status is far less relevant than a

strong majority of independent directors who make all the key decisions. For example, Ariel’s board has an independent chair and a

majority of independent directors advised by their own independent

counsel. Among other things, these members have the exclusive responsibility to renew our advisory contract each and every year. In

fact, our board does not even allow us to be present in the room

during their annual contract renewal discussion. So, the idea that

we as inside directors are active participants in our own contract

assignment and in some ways self-dealing is just not true.

Additionally, independent directors are solely represented on all

board nominating committees, leaving insiders like me no say in

the board’s ultimate composition. Most important of all, an independent board can at any time decide its own chair.

Another governance issue of note is the SEC requirement for the

hiring of a compliance officer reporting to independent directors. I

understand why the SEC and the ICI have advanced this rule in

response to recent abuses. But such mandates disproportionately

impact smaller fund companies, seriously affecting our cost structure, as well as our ability to compete against industry giants.

316

Finally, regarding disclosure, I agree with Federal Reserve

Chairman Greenspan who said, ‘‘In our laudable efforts to improve

public disclosure, we too often appear to be mistaking more extensive disclosure for greater transparency.’’

Former SEC Chairman Levitt appears to share the concern. He

said, ‘‘The law of unintended consequences has come into play. Our

passion for full disclosure has created fact-bloated reports, and prospectuses that are more redundant than revealing.’’

Notwithstanding these observations, the SEC reported last June

that it adopted 40 new investment company rules, including many

disclosure requirements, since 1998. That is an average of one

every 7 weeks. The impact of new proposals on small mutual fund

companies is perhaps understandably not always at the forefront

of regulators’ thinking, but I urge the Committee to think about

this. As some of you have suggested over the last few years, the

Nation would benefit substantially from finding ways to improve

our comprehension of the information already disclosed. Financial

literacy is the only real way to empower investors to make the

right choices that will secure their futures.

At Ariel, an inner-city Chicago public school bearing our name

has an innovative saving and investment curriculum. Similarly, the

ICI has developed its own financial literacy initiative. Education

programs like these will help replace both confusion and fear with

knowledge and confidence.

My colleagues at Ariel and so many others in the fund industry

are grateful for your efforts. By effectively reinforcing investor protections and supporting the integrity of our markets, we know you

are helping our business and our shareholders. That said, recent

events notwithstanding, it would be deeply regrettable if attempts

to heighten fund company oversight eroded the competitive position

of small firms that represent the dynamic, entrepreneurial spirit of

the mutual fund industry.

Again, many thanks for allowing me to testify.

Chairman SHELBY. Thank you.

Mr. Bogle.

STATEMENT OF JOHN C. BOGLE

FOUNDER AND FORMER CHIEF EXECUTIVE

VANGUARD GROUP

PRESIDENT, BOGLE FINANCIAL MARKETS

RESEARCH CENTER

Mr. BOGLE. Thank you very much, Chairman Shelby, Ranking

Member Sarbanes, and Members of the Committee. You honor me

by inviting me to be with you today.

I have a unique perspective, and it is based on a 53-year career

in the mutual fund field. I was inspired by an article in the December 1949 issue of Fortune magazine, wrote my Princeton University

thesis on mutual funds, and joined Wellington Management Company in July 1951, and served with this industry leader until 1974.

Then I took what you might call the road less traveled by, if I may

say so, and founded Vanguard as a truly mutual mutual fund complex. It is unique.

At Vanguard we broke unprecedented ground by having our

management company owned not by outside owners, but by the

317

shareholders of the mutual funds it managed. We called it the Vanguard experiment in mutual fund self-governance, and from the

outset we have operated on an at-cost basis. Shortly after we

began, we eliminated all sales charges, and we have operated as

a no-load business for almost the last 30 years.

I think it is fair to say—I hope it is not self-serving to say—that

the experiment seems to have worked. Our fund assets then were

$1.4 billion, and they now total $725 billion. Our funds are owned

by 17 million Americans. During the three decades in which the

average expense ratio of the average mutual fund has risen by 50

percent—and that is the fact—our expense ratio has fallen by 60

percent. At 0.26 of 1 percent, it is fully 1.10 percentage points

below the industry norm of 1.36 percent. That differential resulted

in a savings to our shareholders, Vanguard shareholders, of more

than $6 billion in 2003 alone. Partly and very importantly by reason of those low costs, our mutual funds have been recognized almost everywhere, if not everywhere, for earning returns that are

superior to those of their peers. And our market share of industry

assets has risen unremittingly, year after year after year, from 1

percent of industry assets in 1981 to 9 percent of industry assets

today. Delivering maximum shareholder value, it turns out, is a

winning business strategy.

Vanguard’s structure was designed to honor the basic principles

set forth in the Investment Company Act. Mutual funds must be

‘‘organized, operated, and managed’’ in the interests of their shareholders and not in the interests of their investment advisers and

distributors. The Act is completely clear on that. And it says nothing, by the way, about letting the marketplace set management

fees out there, nor does it say anything about charging fees that

traffic can bear. It says directors have the obligation to organize in

the interests of shareholders. Yet, by and large, I am sorry to say

that the conduct of this industry in general has honored that principle more in the breach than in the observance.

The recent scandals have clearly reflected the serious nature of

that breach, but these scandals are, in fact, gentlemen, the tip of

the iceberg, reflecting the conflicts that exist between the interests

of shareholders and the interests of managers. These scandals have

been terrible, but the conflicts have been far more costly to investors in two other areas: One, the setting of mutual fund fees at levels that are highly profitable to managers, even as they severely

erode the returns the funds deliver to investors; and, two, asset

gathering has overtaken prudent management in importance, exemplified by aggressive marketing practices, the asset-gathering

practices, marketing practices focused on bringing out new funds to

meet each new market fad, recent technology in the new economy,

and advertising our highest performing funds. Both of these actions

have cost investors hundreds of billions of dollars.

This is a vastly different industry than the industry I described

in that ancient Princeton thesis. Trusteeship has been superseded

by asset building. Stewardship has been superseded by salesmanship. As my prepared statement makes clear, the costs imposed on

fund shareholders have soared, and the returns earned by fund

shareholders have tumbled. And if you do not believe that, just

318

look at Chart 10b—‘‘The Stock Market, Funds, & Fund Owners’’ of

my written testimony.

Equity mutual funds today are measurably riskier than they

were then, and today picking funds is akin to picking stocks. The

six-fold increase in our portfolio turnover to 110 percent a year

reflects a strategy that has moved from the wisdom of long-term

investing to the folly of short-term speculation. Fund managers,

once almost entirely small, privately-held professional organizations—and I salute those that remain that way today—are now

overwhelmingly owned by giant United States and foreign financial

conglomerates, who are in this business, to state the obvious, to

earn not only a high return on your capital but also a high return

on their capital.

Of course, we need regulatory action to prevent a recurrence of

the ethically unconscionable conduct that we have seen in the scandals, but we need something more. We need to strengthen governance so that funds put the interests of their shareholders ahead of

the interests of their managers, just as the Act demands, at least

for the large fund complexes. I believe that we need an independent fund chairman, a board on which the manager has no

more than a single representative, an independent staff that

provides the board with objective information, and an express statutory standard of fiduciary duty to assure that the funds are, indeed, organized, operated, and managed in the sole interest of their

shareholders, just as the statute demands. These changes are not

a panacea, make no mistake about that. But they are a beginning.

We also need statutory language that encourages directors of

funds and fund complexes, once they reach a certain size, to consider moving to a mutual structure, of all things, in which shareholders, not the managers, control the funds, a structure that has

served Vanguard shareholders so very well. It is a curious irony

noted in the addendum to my remarks today that U.S. Senators,

of all people, and all other officials and employees of the Federal

Government have precisely such a program, a mutual fund group

available to all of you in the Federal Employees Thrift Savings

Plan, operating at a tiny cost, 7 basis points a year—even lower

than Vanguard’s 37 basis points for our equity funds, which has

$130 billion worth of assets. In fact, the Federal plan is the 13th

largest mutual fund complex, and they run it just the way we do.

Public fund investors deserve to have their funds operated under

those principles, too, or at least have the opportunity to. What investors deserve, gentlemen, is fund companies that are truly of the

shareholder, by the shareholder, and for the shareholder.

Thank you very much for your attention. I am looking forward

to responding to your questions.

Chairman SHELBY. I want to thank all of you on the panel.

Mr. Pottruck and Mr. Bogle, I will address this question to you.

There is no doubt that costs matter and that investors should have

access to cost information as they make investment decisions.

Many people contend that mutual fund fees are excessive and that

there are insufficient market pressures and incentives for funds to

minimize costs. How do you respond to this assertion? Shouldn’t informed investors be able to make their own investment decisions?

Mr. Pottruck, do you want to take that first?

319

Mr. POTTRUCK. Sure. Thank you, Chairman Shelby.

I think that we would say in the mutual fund industry that costs

vary all over the board.

Chairman SHELBY. But they matter, don’t they?

Mr. POTTRUCK. They certainly matter. Absolutely they matter.

But investors are most motivated by the return they get net of fees.

Many investors are willing to pay more to get something more than

the lowest-cost fund. Sometimes that is in the performance of the

fund——

Chairman SHELBY. So pay more for quality advice or for quality

investment?

Mr. POTTRUCK. Sure. It is all of the above. Sometimes they pay

more because they do not want to be put on hold when they call

a call center, or they want a superior website. Or perhaps they

want to be able to sit down and have someone explain mutual

funds to them, because they have never invested before and it is

a little frightening to put their money at risk when it is their retirement that they are talking about. And they need someone to

walk them through the difference between a bond fund and an

equity fund.

Chairman SHELBY. To most Americans, this is part of their nest

egg, or whatever you want to call it, is it not?

Mr. POTTRUCK. Absolutely. It is the primary saving vehicle for

most Americans who are trying to save for their retirement. So a

little advice and a little counsel is often a very important part of

that process.

An example is we distribute the Vanguard funds at Schwab, and we have $20 billion of our $1 trillion at Schwab has gone into the

Vanguard funds. They are a terrific fund company and very, very

competitive. But what is interesting is that everybody who buys the

Vanguard funds at Schwab pays a little extra, pays a transaction

fee, a brokerage commission, if you will, to buy the Vanguard

funds. They pay more to buy the Vanguard funds from Schwab—

and they know that at the point of purchase—than they would pay

to go to Vanguard directly. So lowest price is not always the only

thing people care about. They care about the whole range of services and things that come with the product, and you see that virtually in every industry.

Chairman SHELBY. Well, trust is an important component of all

this, too, isn’t it?

Mr. POTTRUCK. No question.

Chairman SHELBY. Integrity.

Mr. Bogle, do you want to comment?

Mr. BOGLE. Yes. Obviously price is extremely important, and investors, truth told, do not pay very much attention to it, partly

because they chase past performance. And it is wonderful for us to

say, ‘‘Wouldn’t you pay a few extra percentage points for a few

more points of performance?’’

The problem with that analogy is that cost goes on forever and

performance comes and goes. And we know by looking at the record

that the low-cost quartile of funds provides a return over a decade,

any decade you want to look at, that is something like 3 percentage

points a year—an astonishing amount—over the high-cost quartile.

And it happens in every single Morningstar style box, large cap

320

growth and small cap value, et cetera. But people do not pay much

attention to cost. Another reason they do not is because they are

much too short-term in their investment horizons. You know, a difference of 1 or 2 percentage points in return over an investment

lifetime is half of your capital. When you lose 2 or 3 percentage

points of return over 30 years, you have put up 100 percent of the

capital, you have taken 100 percent of the risk, and you have gotten 50 percent of the return. And the intermediaries put up 0 percent of the capital, took 0 percent of the risk, and got 50 percent

of the return. It is not a good deal, sir.

Chairman SHELBY. Good answer.

This next question is for all of you. Some contend that the current scandals are exposing a fundamental weakness in the structure of the fund industry. This weakness is the legal construct that

each fund is a separate company with its own board. Many contend

that in reality boards are totally reliant on the adviser who creates

and manages the fund because boards have no independent operational authority.

Some people contend that the current fund structure should be

eliminated and funds should be combined with the adviser so that

funds and advisers are under the authority of one board and are

accountable to one set of shareholders.

Chairman Ruder.

Mr. RUDER. I do not think there is any need to change the fundamental structure of the fund industry. We have had scandals in the

industrial community, as Senator Sarbanes knows, in which the

directors and officers were not doing their jobs.

The important thing is to instill into the directors the obligation

to oversee the adviser and the service providers, both in terms of

quality and in terms of fees. It is a hard thing to say that directors

have to perform their jobs better, but we need to motivate them to

do that.

Chairman SHELBY. Mr. Pottruck.

Mr. POTTRUCK. I would agree with Mr. Ruder. I do not think we

have to dismantle the governance structure of mutual funds. Effectively, the single shareholder proposal is more like some of the

other products that are already offered in the investment industry,

separate accounts and such. Mutual funds have stood the test of

time. They have made investing in equity markets and participation in the capital formation of America a possibility for millions

of Americans who otherwise could not in any way participate.

I think that while it is easy to look at the recent scandals and

think that the whole mutual fund industry does not work, I would

argue that there is so much more good than bad. We should focus

on the kinds of things that would prevent future problems. Shame

on us if we allow those things to continue to happen or happen

again. But I would urge the Committee to consider the broad range

of what mutual funds have accomplished for America. More Americans are participating in capital formation and in the power of capitalism than ever before.

Chairman SHELBY. Ms. Hobson.

Ms. HOBSON. I do not necessarily see, in thinking through how

our board meetings actually work in the structure of our firm, what

that would change. At the end of the day, this wholesale change

321

to consolidate the fund company and the adviser and the fund to

me seems, again, like it sounds good in theory, but in practice

nothing would be different. And the reason that I say that is that

when I think about who we are accountable to every single day, we

know we are accountable to those shareholders, and we know that

the board at any time can just——

Chairman SHELBY. But haven’t some people forgotten that in the

industry?

Ms. HOBSON. I think that some people, in terms of how they have

treated their shareholders, have put themselves first. But I do not

think that that is everyone in the industry.

Chairman SHELBY. I agree with you. Mr. Bogle.

Mr. BOGLE. Believe it or not, I would not require the compulsory

mutualization of the entire mutual fund industry. I do believe this:

We need a governance structure that puts funds in a position to do

that, if funds reach a size where that is a feasible option. You

know, if everyone had that kind of a structure, there would be no

entrepreneurship in the business. There may be too much of it

now, but every business needs some of it. New funds would not be

started, and the established firms would be dug in and we would

have an oligopoly situation. However, I do not think that is healthy

for anybody.

But we need to put directors in the position where they can mutualize once the funds reach a certain size and standing. It would

not apply to small funds. The example I like to use is when a fund

is born, of course it needs a parent. When the fund gets to 21 years

old and $100 billion of assets, maybe it can strike out on its own

and make its own decisions in its own best interest. And, my gosh,

the oldest fund is 80 now. It really must be time for them to think

about it. That is pretty old for not being able to make any decisions

of your own.

I do think that that structure can best be done not only by the

governance changes I have suggested, giving some heft to the

weight of the fund board and the fund operation on the decision,

but I also believe that would be substantially enhanced—and this

is exactly, by the way, the way Vanguard began; we did not begin

as a full-fledged mutual fund complex—by having the funds take

over operational control over the things that we do not usually associate with advisers, like the administration, the shareholder recordkeeping, the legal compliance. All of those would be fund functions under this structure, and the adviser would provide advice

and the distributor would provide distribution. And if you had that

structure, then the funds could say to the adviser we think we

should do a little fee negotiation here. You have gotten big. Let’s

talk about it. Or we think maybe we should use a different distributor instead of you. Or maybe the fund manager has failed, and

we say we are going to bring in another manager.

We do that at Vanguard, not frequently—but more frequently

than we would like because we hope to hire a manager forever. But

that sometimes does not work out.

We have the flexibility to deal with the funds’ managers on an

arm’s-length basis. So, I think in that little scenario lies the ingredients for a much better industry.

Chairman SHELBY. Senator Bayh.

322

COMMENTS OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Mr. Chairman.

First of all, I would like to thank all of our panelists for being

here today. We very much appreciate your time.

Mr. Bogle, you—and I apologize, Mr. Ruder, I was not able to be

present for your testimony—describe a situation in which market

imperfections keep what some of the other panelists have described

as the normal competitive forces from working in the best interests

of shareholders. Why, in your opinion, does the competitive marketplace not function as it should in this context?

Mr. BOGLE. I think that part of the answer is investors are very

unaware of the importance of independent representation, very unaware of the importance of cost, and all too aware of how the fund

did yesterday, last week, month, and year. Also do not forget that

the mutual fund industry, like the life insurance industry, spends

huge amounts of its resources on marketing and distribution. In

other words, this is a sales-driven industry and not a buyer-driven

industry. The selling power is what basically drives most of this industry, what the brokers are selling, what the advisers are selling.

So those things are an important part of it.

But the reason it should not be that way is we have a fiduciary

duty. It is established in the common law going back, I guess, thousands of years. It says that funds are different. Other people’s

money is a sacred trust that requires a fiduciary duty of those who

are overseeing it. And it is that we have moved too far away from

this idea—not entirely away from in all firms, but too far away in

too many firms.

Senator BAYH. So in your view, it is the retrospective view of

investors and focusing on that rather than costs, which, to use, I

think, your phrase, you said costs are perpetual but performance

varies. Is that in a nutshell? And I would like to give Ms. Hobson

and Mr. Pottruck——

Mr. BOGLE. Well, just let me add one thing quickly to that, and

that is what I said, but I do not want to understate the tremendous

power of a sales force. I mean, that is the way the life insurance

industry got the way it is.

Senator BAYH. Mr. Pottruck and Ms. Hobson, would you like to

respond to that? Why, in your view, do the market imperfections

that Mr. Bogle focuses on not exist?

Ms. HOBSON. One thing is that there is competition. This is very

important. It is probably the most important theme that I could

stress. There are 500 mutual fund companies, 8,000 choices. People

can select from a wide, broad range, and the market in basic capitalist terms, what we learn in economics in school, allows the customer to make their own choice, and it bears—there is supply and

demand there. Where there is demand, people go. People vote with

their feet in this business, and it is very interesting that Mr. Bogle

talked specifically about how the funds get marketed and the cost.

But at the end of the day, the investors are buying the lower-cost

mutual funds. That is one of the reasons Vanguard has been so

successful, as well as lots of other mutual fund companies around

this country.

This idea that sales and marketing become a four-letter word, a

bad thing, is something I just absolutely reject, because when you

323

are a small mutual fund company, you have to do everything you

can to think of ways to sell and market when the top 10 mutual

fund companies in this country, of the $7 trillion in assets, control

$3 trillion of them, spend lots of money in advertising, lots of

money in promotion. So sales and marketing is very important.

Senator BAYH. Forgive me for interrupting, Ms. Hobson, but in

your view, consumers have access to adequate information to make

informed decisions?

Ms. HOBSON. I certainly believe that there is a lot of information

that consumers are hit with, and the question is: Is there a way

this information can be given to them so they can understand it?

I talked about my role on TV and the types of questions that I

get there. The question is not that there is too little information.

It is that it is too much. Tell me what is important because I am

trying to sift through too much and I cannot understand.

Senator BAYH. Well, that gets to the advisory component that

Mr. Pottruck was referring to. To both of you, again, Mr. Bogle referred to the fiduciary duty component of this. Let me ask you for

your response about what appears to be a tradeoff between—with

so many members of boards serving the whole family of mutual

funds, and I gather the argument is that that in itself creates efficiencies for the shareholders. But at some point you reach a tipping

point at which you serve on so many boards, it is more efficient,

but doesn’t it also create some difficulty in adequately overseeing—

carrying out your fiduciary duty? Do you have a response to that

criticism that has been raised? I think one fund family has a director serving on as many as 277 boards. How is it possible to exert

effective oversight on that many funds?

Ms. HOBSON. In our situation, we have four mutual funds and

our directors serve on all four, and I see a lot of benefit to them

being there for the discussion of all four mutual funds and the

issues that are affected. I also see a benefit to the funds splitting

the cost of flying them to Chicago and dealing with all the expenses

that relate to them. I think that is something that is important.

Also when I think about just the logistics—if you have a mutual

fund company that has several hundred mutual funds, and you

have four to six to eight board meetings a year, and you start to

break apart the number of funds that one director can serve on,

you would be having mutual fund board meetings every single day.

That is what the company would be in the business of doing.

So, there is to me some realistic number that is right that will

allow for the efficiencies and at the same time allow people to run

a business and not spend all of their time in board meetings. I do

not know how you do that if you limit that fund company to two

or three boards. You know, when you think about how many directors they are going to need and how many mutual fund board

meetings they are going to have, it will be——

Senator BAYH. Well, four certainly is reasonable. I would say to

the layman when you get up to 277, you do kind of wonder, you

know, how is that possible?

COMMENTS OF SENATOR PAUL S. SARBANES

Senator SARBANES. Do you think 277 is too many?

324

Ms. HOBSON. I do not know how they run their structure, so it

would be impossible for me to comment.

Senator SARBANES. No matter how they run their structure, is it

too many?

Ms. HOBSON. If they have board meetings for a week, is it reasonable to think that you could cover 277 boards if you were working from 9 to 5, over 5 days, six or eight times a year——

Senator SARBANES. Is that reasonable?

Ms. HOBSON. It is possible, sure.

Senator SARBANES. Forty-five hours for 277 boards?

Ms. HOBSON. It is absolutely possible.

Senator SARBANES. Do you think that is reasonable?

Ms. HOBSON. The thing is, you would have to look at the board.

Senator SARBANES. I took your figures, 9 to 5, 5 days a week—

actually that is 40 hours, not 45 hours, for 277 funds. So is that

reasonable?

Ms. HOBSON. I think that it depends on the boards and it depends on the type of funds. If you had a hundred index funds on

that list out of 277, there is not going to be a lot of detail that you

are going to get into on performance, which is a big part of the

board meeting. So, it is impossible for me to answer that question

without having a better sense of the actual funds that are being

overseen.

Senator SARBANES. That is 14 minutes a fund.

[Laughter.]

Ms. HOBSON. But the thing is that a lot of the discussion is in

common, so you are going to have a discussion about distribution,

compliance, and legal issues that is going to happen across all of

those funds, and then there will be independent discussions about

the actual fund performance itself.

Senator BAYH. I see my time has expired. Thank you, Mr. Chairman. Again, thanks to our witnesses for your testimony today.

Chairman SHELBY. Senator Sununu.

COMMENTS OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman.

I think that was a great answer. You talked, Ms. Hobson, about

information and that there is a concern perhaps among some consumers that they have a lot of information, but maybe it is too

much, maybe it is not quite the right information, maybe they do

not know what to do with that information. Are there any specific

ideas that are out there that you have come up with, that you have

heard the SEC discussing that might help improve transparency

for investors, help clarify the information, help improve the disclosure rules that we have?

Ms. HOBSON. I think there are a number of things that I have

seen suggested, I have heard the ICI talk about, and some of your

colleagues mention. I think issues related to portfolio turnover,

prominent discussions of that will capture some of the issues that

are very hard to define around transaction costs, since there is no

agreed-upon methodology there.

Some of the discussion about the $10,000 example that the SEC

has imposed now in the shareholder letter is not a bad thing. That

shows the expense ratio and the actual cost that you will pay. I

325

think that that is very good. People, if they do not read their prospectus, maybe they would catch that information in their shareholder letter.

I think that the issue is: Can we be smarter about all of this

thick document that we are giving shareholders? We have gone to

the plain-English prospectus a few years ago that I think helps a

lot, not having the legalese. And I am sure we could be more creative about some of these other ideas that would help investors.

Certainly some of the new advertising rules are very, very good,

where the standardized periods, the performance discussion, aftertax I think is very good. So there is information there that is helping the investor get a clearer view of what they are paying.

Senator SUNUNU. So, Mr. Bogle, you talked about the predicted

performance of costs. Low-cost funds historically have performed

better than high-cost funds. That seems to me to be a strong argument for good transparency, good disclosure, along the lines just

described by Ms. Hobson, maybe some of the other proposals that

are out there. Do you also, however, advocate a capping or Government regulation of those fees?

Mr. BOGLE. No, I do not.

Senator SUNUNU. You do not. Excellent.

Mr. Ruder, you talked about the proposal for independent board

members and for a disinterested chairman. I think it was yesterday, it may have been the day before that we had a hearing—we

have had a number of important hearings in this Committee—but

we had a hearing where specific studies were referenced that

showed no correlation between having a disinterested chairman

and the quality, the overall performance of the company, or the

overall performance of a mutual fund. What is the purpose of proposing a standard mandate or requirement that every fund have a

disinterested chairman?

Mr. RUDER. In most cases, when the fund board meets, the adviser presents the agenda. The adviser, with its own chairman, will

run the meeting and will have control of the meeting. That is a situation which does not allow the independent directors to act in a

forceful manner.

We have a situation now in which, within the last 3 years, the

SEC has required that the independent directors be a majority of

the fund boards. And we are only moving into a situation where

these directors are going to have to fulfill their responsibilities, and

I think that directors are going to be much more able to fulfill their

responsibilities if they have power. If you allow an adviser to be

the chairman, he can cut off discussion, he can control the agenda,

and he can force his or her attitudes on the independent directors.

I think that is wrong.

Senator SUNUNU. If, in fact, the board structure you describe resulted in limitation on directors from being able to fulfill their responsibilities or act as they should—your words—or their ability to

make good decisions, would not an evaluation of 50 or 100 or 1,000

boards be able to identify that that board structure results in poor

performance, bad decisionmaking or, in the case of recent history,

the scandals that we have read about being correlated to the lack

of an independent chairman?

326

Mr. RUDER. I know of no studies which have reached that conclusion. On the other hand, I do not believe there have been very

many studies about this topic. What I am talking about is essentially a sea change in the way the boards work. I think that our

investors need to have the opportunity to see what will happen in

this industry if we have a responsible governance mechanism.

Senator SUNUNU. I will certainly submit for the record that the

study that was described in the hearings earlier this week was an

evaluation of approximately 1,000 different public companies, certainly not all of them financial services or mutual fund related, but

fortunately or unfortunately, there wasn’t a correlation shown. I

have no opposition to boards having independent chairmen.

Ms. Hobson has an independent chairman, correct? I am sure it

is a perfectly effective and workable structure, and there are some

independent chairs and independent board members that I think

do an outstanding job. There are others, as was also testified to at

the hearing, that have a great deal of trouble staying awake in the

meetings.

I think it is pretty clear which ones you would want to have on

your board, but it is also clear that the fact that they carry the

label ‘‘independent’’ does not necessarily mean that they are delivering a superior level of oversight, decisionmaking, or responsibility

on behalf of mutual fund investors or shareholders.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

First of all, I want to express my appreciation to the panel, not

only for their oral presentations, but also for their written statements. Obviously, a lot of work and effort have gone into them.

Mr. Chairman, I would be remiss if I did not, at the outset,

thank David Ruder for his contributions when we were working on

the corporate governance and accounting oversight issue. Mr.

Ruder was on the initial lead-off panel when we had the five

former Chairmen of the SEC. We received absolutely splendid testimony from all, extremely thoughtful, knowledgeable testimony,

from all five Chairmen. And Mr. Ruder, in subsequent weeks, was

of help in counsel to the Committee, and I want to express my

appreciation.

Mr. RUDER. Thank you, Senator.

Chairman SHELBY. If I may interject, that was unprecedented

when you were chairing the Committee, and we had five, including

you, Chairman Ruder, former Chairmen of the Securities and Exchange Commission, all of which had spent months collectively in

this Committee all in one panel. I commend you for that.

Mr. RUDER. I found them to be very opinionated, aggressive, and

wonderful.

Chairman SHELBY. Quite opinionated, but wonderful too.

Senator SARBANES. Ms. Hobson, I have been looking at your

statement, and maybe I missed it, but I am trying to find what

changes, if any, you think should be made. A quick reading of your

statement would lead me to the conclusion that you do not really

think anything should be changed. Am I right in that impression?

Ms. HOBSON. No, you are not right in that impression.

327

Senator SARBANES. Now did I miss it in your statement or is it

not here?

Ms. HOBSON. No, in my statement, I really wanted to focus on

some of the possible repercussions to the changes that are being

suggested for small mutual fund companies and ask——

Senator SARBANES. I think it would have been helpful to us if

you had also focused on what changes we might consider as being

necessary, since most people seem to think some changes are necessary. I know Mr. Pottruck has a section outlining some changes

that he thinks should be made.

Ms. HOBSON. I would be happy to comment on those changes in

writing to you that I think are appropriate. One of them that I

think is terrific that has been suggested is no longer allowing directed brokerage for the selling of mutual funds. I think that

makes a lot of sense and eliminates conflicts of interest at the brokerage level. That would be one simple one I could point to very

quickly.

I think the two-thirds majority board that the SEC adopted was

a good idea. We already had that, but again I recommended and

stated that I thought a strong independent board was the most important thing that could be done to offset some of the problems that

have existed. So those would just be two of them.

Senator SARBANES. Why don’t you submit something to us in

writing. It would be helpful——

Ms. HOBSON. Sure, I would be happy to do that. Thank you.

Senator SARBANES. It would be helpful to us in our deliberations.

Mr. Pottruck, Fortune magazine, dated December 8, 2003, contained an article, ‘‘When Bad Things Happen to Good Companies,’’

and this is what the article says: ‘‘When WorldCom blew up,

Pottruck had a fit. ‘How could this be? Where the hell are the

goddamn accountants? How could the board of directors and the

auditors let this happen? I just could not believe it.’’’ That is the

end of the quote from the article. Now, how accurate they are in

quoting you, I do not know. I am just quoting the article.

Since then, starting in September of 2003, with Attorney General

Spitzer’s case against Canary Fund, a series of scandals have

rocked the mutual fund industry. In your view, how could the

board of directors let this happen? And to use your words, I could

not believe it when I heard it, but there we are.

Mr. POTTRUCK. I think what we have learned is that there are

lots of opportunities in an industry made up of tens of thousands

of people for individual acts of failure to happen that can go undetected when they are as subtle as they sometimes are. We in the

mutual fund industry, in many cases, never even conceived of some

of the problems and practices that we have now learned were going

on. So this has been an eye-opener, an embarrassing eye-opener to

our entire industry.

In many, many cases boards rely on management to fulfill fiduciary responsibilities, and I believe that management makes every

effort to do that. But sometimes individual acts of compromised

behavior, where people are not fulfilling their legal and fiduciary

responsibilities, can go undetected if you do not have sufficient

oversight detection.

Senator SARBANES. Who should do the oversight detection?

328

Mr. POTTRUCK. Sometimes it is beyond the capability of a fund

company to do it for themselves, and they have to outsource it to

another firm who might have the technology. They might have to

rent somebody’s computer technology to do the artificial intelligence kind of work that detects patterns of behavior or other signals that indicate that more investigation needs to happen.

We are trying to look at the thousands of transactions that go

on and see if there are patterns that suggest some kind of abuse.

Then we send people in to investigate whether something real is

going on here that we should be concerned about. But ultimately

management owns the responsibility and the accountability to

make sure that those kinds of things are happening.

Senator SARBANES. Are you supportive of compliance officers and

strengthening that whole concept in order to have that watchdog

at work?

Mr. POTTRUCK. I think the idea of having a chief compliance

officer who reports to the board is not very different than public

companies having a head of audit who has a reporting responsibility to the audit committee. So, I am supportive of that idea.

Ms. HOBSON. If I could just add one thing, Senator?

Senator SARBANES. Yes, you don’t like that idea, as I understand

your statement.

Ms. HOBSON. I am concerned about the cost. So if the small fund

company has to bear the cost, does it create a scenario where they

cannot compete in the same way as the big fund companies. If you

are a Fidelity and you have a floor full of lawyers, and you are

Ariel and you have two, does that change the game for you when

you are then being told you have to bring someone in? And then,

of course, the price of those people will be very clearly set by the

demand that we will all have at the exact same time for those

individuals.

Senator SARBANES. If there are abuses going on, and if a compliance officer is adjudged would be of use in curbing those abuses,

should we forgo that change because the smaller funds present the

position that there is a cost inherent in the compliance officer?

Ms. HOBSON. I guess the answer would be, from my perspective,

that we want to do anything that will make our industry better,

and if it costs money, and it makes sense, and it can prevent

abuses and make us better, we want to do it. But this is the issue

that I think is hard.

When we were thinking about all of the scandals and how they

unfolded, I remember one day waking up, when I read the stories

about portfolio managers timing their own funds, and I said to the

chairman of our firm, not the board chairman, but the chairman

of our company: How would we have known to catch this? How

would we have figured this out? Even with the best of intentions,

trying to run our business in the best possible way, would I have

thought about looking at the transactions of our employees on the

mutual funds when that, in terms of our personal securities reporting, is an exempted category by the SEC? We report the stock

trades that our individual employees make, but we never had them

report their mutual fund trades.

Well, that was, with best of intentions, I would not have thought

of it. Now, you better believe, after the story broke, I said, ‘‘I want

329

to see everyone’s trades for the past 5 years, every single quarter,

every trade and double check and see if there was anything there.’’

And with some pleasure, I was glad to see that we did not have

any problem.

But running the company as effectively as I can think of, and

trying to put the shareholder first, I would not have had a way to

think about some junior analyst that maybe was timing our fund,

nor would there have been a policy for it.

Chairman SHELBY. Ms. Hobson, what size firm do you have? You

say you are a small mutual fund. What are you managing?

Ms. HOBSON. In mutual fund assets, we manage $5.5 billion, and

then we have——

Chairman SHELBY. What is Charles Schwab managing, Mr.

Pottruck?

Mr. POTTRUCK. We manage approximately $280 billion in mutual

fund assets.

Chairman SHELBY. So $280 billion compared to that.

Mr. POTTRUCK. Right.

Chairman SHELBY. Mr. Bogle, what is Vanguard managing now?

Mr. BOGLE. Well, $725 billion.

Chairman SHELBY. Okay, $725 billion.

So, she is making the point, although $5 billion is a lot of money

to several of us up here, it is not a lot of money compared to the

giants in the mutual fund industry; is that your point, Ms. Hobson?

Ms. HOBSON. That is my point, but also the point that I was trying to make is, if we do hire the compliance officer, we then need

to——

Chairman SHELBY. Sure, I see your point.

Ms. HOBSON. How will we know that they can check in a way

that is even more effective than what is being done, when some of

these things, you just cannot even contemplate?

Senator SARBANES. Well, I think—if I could just close, Mr. Chairman—that the industry needs to come to grips with this challenge.

In March 2003, the Chairman of the ICI, testifying before the

House Financial Services Committee said, ‘‘The strict regulation

that implements these objectives has allowed the industry to garner and maintain the confidence of investors and also has kept the

industry free of the types of problems that have surfaced in other

businesses in the recent past. An examination of several of the regulatory measures that have been adopted or under consideration to

address problems that led to the massive corporate and accounting

scandals of the past few years provides a strong endorsement for

the system under which mutual funds already operate.’’

In effect, we took that and gave credibility to it. Then, subsequently, beginning last fall, we see the unfolding of all of these

problems. Now, you know, it came I think, in effect, as something

as a surprise to a lot of people, and it seems to me at this point

we need to address what can we do to bring about changes in the

workings of the system that would make it less likely that these

abuses would occur. The SEC is working at it, of course, and they

have a prime responsibility in that area, and I recognize that, but

of course at the same time we are holding these sets of hearings

and trying to see what the lay of the landscape is. But I do not

330

think we can just let things go on as they had gone on before, before we had experienced these problems.

Chairman SHELBY. Plus, it affects about 100 million people and $7 trillion in money—$7 trillion.

Senator Allard, we thank you for your indulgence. You take what

time you want.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you, Mr. Chairman. This is a very interesting hearing. I can take all of the time I want?

Chairman SHELBY. Whatever you want.

[Laughter.]

But we think you will be judicious.

Senator ALLARD. I had better be careful here. I will try and use

discretion with the Chairman’s generosity.

Let’s suppose that I am an American that picked up $10,000, and

I am trying to decide where I want to invest this money. Why

would I invest in a mutual fund? Maybe in just 1 or 2 minutes, a

couple or three of you can give me some good reasons why I would

want to invest in a mutual fund.

Mr. BOGLE. The reason you invest in a mutual fund of any kind,

and this is a very diverse industry, as we have stock funds, bond

funds, and money market funds, but the reason you invest in a

mutual fund is, at their best—at their best—they give you broad

diversification, very consistent investment policies, and very low

costs. So it gives you a chance to capture the returns of American

industry, to own the stock market, if you will, for your lifetime.

Whatever returns American business gives, you will share in. And

if you do it at low enough cost, you will get almost 100 percent of

that return, whether it is the stock market or the bond market.

Where this industry messes it up is giving you such costs that

it, over 30 or 40 years as a long-term investor, you do not have a

fighting chance, truth told. Our average portfolio manager only

lasts for 5 years. So mutual funds, in their great diversity, give you

opportunities which are there for the taking, but we have complicated it all a lot. But it is the best way to buy stocks, it is the

best way to buy bonds, and it is the best way to buy money market

instruments.

Ms. HOBSON. If I could add, you also get low barriers to entry.

Senator ALLARD. You get what?

Ms. HOBSON. Low barriers to entry. So, you can invest at Ariel

for no minimum investment, as long as you agree to invest $50 a

month. You cannot necessarily do that and go and buy General

Motors stock in that way, and so you get that opportunity.

I do think you get low costs. You get professional money management. You are not trying to figure out what individual stock or

bond to buy on your own. And then last, but not least, you get simplicity, and simplicity meaning that you get your tax statements

prepared for you at the end of the year, you get a statement showing how your investments have done every quarter, and you get

confirmations on your investments when you make them.

Those things are all very, very helpful to the investor in managing their financial life and their account, not to mention, of course,

Mr. Bogle’s point about diversification is very important. You are

331

not putting all of your eggs in one basket, so if one stock is down

and another is up, you have averaged out a better return.

Mr. POTTRUCK. I would certainly agree with what Mr. Bogle and

Ms. Hobson have said, but let me offer a little bit broader perspective, if I may. First of all, if you have this $10,000, and you are

not a reader of financial publications and a watcher of CNBC, you

might take that $10,000 and stick it in a CD or a money market

fund because you do not fully understand how the stock market

works, and you do not have someone who is helping you. So for

many Americans, one reason to go into mutual funds is to be able

to rely upon someone who helps them understand investing and reassures them of the long-term paybacks of participating in capitalism with some of their nest egg.

Another reason to invest in mutual funds is that it really is an

easy thing to do. You could go to a firm like ours, which offers more

than 4,000 funds, use our website and scan down the array of

choices. You can screen for funds with certain levels of performance, or that have low fees, or by many other parameters. There

are many different ways to participate in this industry, which is

part of what makes it so vibrant and successful.

Senator ALLARD. Now, you have all given me a sales job. Where

do I go now to check on what you told me? You have this capability

of catering to the uninformed investor. You may be an investor who

does not want to take the time to study or maybe he says, well,

great, I do not understand all of these individual funds, and I like

to spread my risk out. That all makes sense. Where can I go to confirm what you just told me is legitimate? Where can I check on you

and confirm that they told me this. Now, can I check on performance and compare that to other companies? Where can I go for that

information.

Mr. POTTRUCK. There is considerable reporting on the mutual

fund industry. There are quarterly publications that show the performance of all mutual funds in newspapers——

Senator ALLARD. So, I have to buy quarterly magazines on the

mutual funds or——

Mr. POTTRUCK. You get monthly statements, you get quarterly

statements, which provide performance updates.

Senator ALLARD. I get that from individual mutual fund companies, but where can I go to get a comparison? Is there anywhere

I can go as a consumer and get a comparison, maybe someplace on

the Internet. Is there an agency out there that can give us the

oversight that we need and do a comparison? Where do we go?

Mr. BOGLE. You could go to the library and get Morningstar Mutual Funds. They have a full page on every mutual fund practically

in the business, every one of any serious size. It tells you more

really than you want to know or need to know. It is presented in

an attractive format. It makes recommendations. Alas, however,

Senator, I have to inform you that all of these choices we give investors basically have put us in the same position as selling stocks.

There is a big risk in buying an individual stock, and we now

have such a diversity of mutual funds in this industry, doing all

of these very odd things, that offer nowhere near the full diversification of owning the whole stock market, and so there is a preVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00343 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
332

mium on choosing the right mutual funds, the right objectives, the

right costs, the right sales charges, the right managements.

We have made what should be a nice simple game, where the

typical investor can just go on in and do what he wants to do, into

a very complicated one involving complicated choices that are made

almost always on the basis of past performance, which, alas, does

not repeat itself.

Senator ALLARD. So disclosure is important.

Mr. BOGLE. Disclosure is very important.

Senator ALLARD. And that leads to my next question. So if disclosure is very important, what are the key things in disclosure that

would be most helpful for the consumer—disclosure of the various

costs in the funds by disclosure of the dollar breakdown of costs in

the purchase of the funds; or what is the percentage of return on

their investment based on what kind of funds they are investing

in? These are all things that get discussed in regard to disclosure.

Is it appropriate to go ahead and have full disclosure? Is it appropriate for the Federal Government to insist that we have this full

disclosure or are there some areas that are proper?

I happen to be someone that feels like we need to invest, and

that we have to disclose necessary information for the consumer to

make informed decisions. I want to know what kind of disclosure

that requires.

Mr. RUDER. Sir, you should know that the Securities and Exchange Commission has over the years tried to increase the

amount of disclosure which the mutual funds are making. It has

greatly increased that amount of disclosure, and continues to do so.

My experience was that that increase in disclosure was quite frequently resisted by the industry, and I think it is not a good thing

that they did that. I think that the industry should be telling us

what kinds of disclosure should be made, and the Commission

should continue to try to increase the kinds and amounts of disclosures, and to have it be done in a very understandable way.

Senator ALLARD. Why would they want to resist disclosure?

Mr. RUDER. I have never understood exactly why. They talk

about costs, for one thing. I know that. There is a proposal out now

that each individual be given an exact dollar-for-dollar discussion

of what happened to his or her individual account. That proposal

is being resisted by the industry on the grounds that it will cost

a lot of money.

Mr. POTTRUCK. That is correct.

Senator ALLARD. So there is a cost with disclosure, but then Ms.

Hobson also said, ‘‘You know, I would never have dreamed of doing

this in my company, but I find out some other company got caught

doing this, and so I checked back with my company to make sure

we were not doing it.’’ Does disclosure not help the whole industry

so you all know what is going on? And what is the right balance?

Mr. POTTRUCK. I think that disclosure can help, and it can hurt.

I mean, there is probably not a person in this room who has not

refinanced their mortgage in the last 2 or 3 years and signed 50

documents without having the time to read any of them.

Senator ALLARD. That sounds like closing——

Mr. POTTRUCK. That is disclosure run amuck. The design of disclosure has to be done in a way that balances the importance of

333

a few things being very visible with other things being available

and somewhere findable so the press, and analysts, and others can

hold the industry accountable. That works very well.

At the point of purchase, there are only a few things the investor

needs to know. There is probably more they want to see on their

monthly or quarterly statements, more still that should be in a prospectus. There is a tremendous amount written about the mutual

fund industry, and the press plays an important role in giving bad

publicity to those funds that are doing a very bad job for consumers, and money follows that information.

Chairman SHELBY. They should play that role.

Mr. POTTRUCK. Exactly.

Senator ALLARD. Are they doing that now?

Mr. POTTRUCK. Yes, absolutely they are. Absolutely they are.

Mr. BOGLE. Information is really a tricky thing in our business

because the markets are so efficient that it is very hard to gain an

edge, and in the long run, buying individual stocks is a loser’s

game compared to the market itself, as is buying individual mutual

funds. You cannot beat the market. It is nearly impossible over

time. Look at the record.

Then you look at what is being disclosed and look at, say, Money

magazine, and what they give you here are the 100 best mutual

funds. They have been giving this list for 5 years, and I will bet

there are not 30 funds in this most recent list that were in the

first list.

So, you are supposed to be buying each year on the basis of that?

It does not make any sense. We should work much harder on simplifying and giving more diversification. This is an asset-gathering

business. The reason is that is what the asset managers do. They

want to get more assets and get more fees, and that is not illegitimate, except it does not help the shareholders. It says create this

kind of a fund when everybody wants to buy it, so that money will

come in and add to our management fees.

It has taken this nice, simple business of owning America and

holding it forever, and turned it into this complex thing where we

need these reams of disclosure, and I am not sure it is going to be

productive. We turn over our portfolios at 100 percent a year. People want information, but I don’t know what they conclude from it.

Senator ALLARD. Thank you, Mr. Chairman.

Chairman SHELBY. It sounds like I would buy the 500 index fund

from what you have just said.

Mr. BOGLE. Well, I think there are worse recommendations, sir.

Chairman SHELBY. I know it. I agree with you.

Mr. Bogle, you founded Vanguard probably with a little money,

and I do not know how much, not probably millions or billions, but

now your firm, Vanguard, has over $700 billion; is that correct?

Mr. BOGLE. Yes, sir.

Chairman SHELBY. You are the second-largest fund at this moment, is this correct?

Mr. BOGLE. Yes, sir.

Chairman SHELBY. Gosh, we would like to have that money to

close the deficit, wouldn’t we.

[Laughter.]

Mr. BOGLE. Our shareholders would be reluctant to part with it.

334

Chairman SHELBY. We would, but we do know better than that,

don’t we?

Senator ALLARD. The Government is not a good investment.

Chairman SHELBY. Yes, the shareholders would revolt.

Mr. Bogle, some contend that it is inappropriate for a portfolio

manager to simultaneously manage both institutional accounts,

like hedge funds and a mutual fund, because the manager will

favor the hedge fund at the expense of the mutual fund. What is

your perspective on this and has the side-by-side management of

hedge funds and mutual funds been at the center of any of the recent fund scandals? Further, how would a ban on side-by-side management impact, if at all, the mutual fund industry?

Mr. BOGLE. Those are very, very good questions and very, very

tough questions. It is hard to see that the financial incentives in

favor of running hedge funds are not so overpoweringly large, relative to the fees in running mutual funds, even the high fees in

running mutual funds, for that matter, that the temptation to put

the best ideas in the hedge fund would be very strong, not necessarily irresistible, but very strong.

Chairman SHELBY. There is a lot of temptation.

Mr. BOGLE. There is a lot of temptation.

In general, mutual funds, particularly the large fund complexes,

do not run hedge funds, and I think it is the kind of split that one

should think long and hard about. We need to think about what

kind of regulations might reduce that conflict, and realize that one

of the unfortunate, unintended consequences of such a law would

likely be that every hedge fund manager who ran a mutual fund

would give up the mutual fund business, and therefore his clients

would have to find other funds.

So, I do not like the idea of conflicts of interest in this business,

but I think we should be a little clearer about what we are giving

up when we eliminate them.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. I want to follow up on Chairman Shelby’s

question. When you start out on these hearings you start receiving

communications from everywhere, so to speak. We received a communication that came in that said the following. I want to quote

it to you and ask for comment.

Many asset management firms have started hedge funds in the last few years due

to the much higher fees and less stringent regulations, but run them side-by-side

with mutual funds. They are often even run by the same portfolio managers. The

main reason mutual funds firms start hedge funds is to keep star portfolio managers from leaving to set up their own fund. Some of the biggest mutual funds companies in the country are doing this. This presents incredible conflicts. Some firms

have been known to short a stock in the hedge fund, hold onto it in the mutual

funds because they are not allowed to sell short, and then sell the mutual funds

position at a later date, thus causing downward pressure on the stock price and

making the short position more valuable.

If that kind of thing is going on, as it is asserted here, do we not

need to do something about it?

Mr. BOGLE. Absolutely. That is shocking, I would say. I am not

an attorney, but I would say that is almost criminal behavior.

Senator SARBANES. We need to prosecute those people.

Mr. BOGLE. Yes. Just to make the record clear, we do not run

any hedge funds at Vanguard. I have to say, maybe editorialize it

335

a little bit, that this business about star managers is a little bit

odd. I have seen a lot of these stars come and I have seen a lot

of these stars go, and it occurs to me that there are far more comets that burn themselves out than there are stars in the mutual

fund business—think of portfolio managers that have really been

good over 25 years, and we can all name Warren Buffett, and we

can all name—well, there is somebody else out there I am sure. I

just cannot think of another top portfolio manager for 25 years.

They do not come to mind, so it is a short-term game, and that is

another thing we should try and get away from.

I think it is disgraceful if what you describe is going on, but I

have no knowledge that it goes on anywhere, however.

Chairman SHELBY. Chairman Ruder, we know you are an attorney, but would you describe the fiduciary duties that a fund board

owes to the shareholders? Would you describe the fiduciary duties

that a fund board owes to the shareholders?

Mr. RUDER. Most of the fund boards are organized either as a

corporation or as trust, and the fund board shareholders or trustees

owe obligations to be loyal, to act with care——

Chairman SHELBY. Honest.

Mr. RUDER. And to be honest. These are duties which occur in

all organizations, but to me, to call these fiduciary duties does not

nearly describe the obligations of these directors. I think in the mutual fund industry today the directors have to be alert, aggressive,

and informed, and they should assume their responsibilities in a

way that befits their special responsibilities. I think their obligations are greater than they are in a normal company when management is reporting to the board on a regular basis.

Here we have a separation of the directors from the adviser. You

can call these duties fiduciary if you want, but these are duties and

obligations that the directors need to perform in special ways.

Chairman SHELBY. Is not integrity central to the running of a

mutual funds industry or to any business, but especially one that

is so important to our capital markets involving $7 trillion?

Mr. RUDER. I could not agree with you more, Senator, that the

concept of integrity is vital. To my mind the problem with these

scandals has been at the adviser level, where the levels of integrity

have not been as great as they should have been. The SEC is trying to develop a system in which the advisers can be controlled to

make sure that they act properly.

Chairman SHELBY. It was mentioned earlier about a sales-driven

industry, but I do not know how you take marketing out of a market driven economy, whether it is mutual funds or anything else.

It is just part and parcel.

With that in mind, Mr. Pottruck and Ms. Hobson, this question

I will address to you two. Broker-dealers play a large role in the

distribution and sale of fund products. Could you describe how

12b–1 fees and revenue sharing arrangements are currently used

and how these practices benefit fund shareholders? Also, do we

need to reassess these practices in light of recent revelations?

Mr. Pottruck.

Mr. POTTRUCK. Sure. The 12b–1 fees in many cases are used to

reimburse distributors for the time and energy spent talking to

336

shareholders or potential shareholders in explaining the pluses and

minuses.

Chairman SHELBY. It is part of the marketing, is it not?

Mr. POTTRUCK. Correct, it is part of the marketing and the service. When you come to Schwab, the people who talk to clients have

no financial interest in which investment choice the client makes.

So, they are just trying to help find out what the client wants,

what their tolerance for risk looks like. There are many different

kinds of mutual funds, and this conversation can take some time.

For example, there are mutual funds that have underperformed the

stock market over the years, but have been exceptional performers

in down markets. They lose less during down markets and they

make less during up markets. Maybe over time they might underperform, but some investors want the stability during a downturn.

Chairman SHELBY. Are those bond funds?

Mr. POTTRUCK. No, equity funds. Equity funds that are managed

on a very, very conservative basis, attended by very conservative

investments. There are other funds that have much higher betas,

much higher volatility, and there are those people who love the

idea of being more aggressive. Those would be funds that would be

more heavily invested in technology, for example. People might

think, ‘‘Gee, this is a great time for that kind of investment. Companies are going to go back into technology. I want to own technology funds.’’

About 20 percent of our investors describe themselves as ‘‘selfdirected’’ investors. They come to our website every day. They scan

all the 4,000 funds and they make their choices. Fifty percent of

investors describe themselves as ‘‘validators.’’ That is a term we

use for people who do not want to turn over the management of

their money to someone else, but they want to work with an adviser who helps them navigate all these choices while they maintain an active involvement. That takes time and energy.

Chairman SHELBY. At least they are watching you.

Mr. POTTRUCK. The 12b–1 fees are one of the ways for a fund

like Ariel to help reimburse Schwab for the time and energy we

spend explaining to investors about the Ariel funds so that they

can make an informed investment choice.

Chairman SHELBY. Ms. Hobson.

Ms. HOBSON. I think that David answered it very well. The doit-yourselfers are a small group, and then there is the validators

and the designators, the people who want their decision confirmed

and those who want someone else to make it for them. And the

12b–1 fees help us to pay those people who offer that advice and

counsel.

As we have all noted, because this can be a very confusing area

for American investors and because you do not learn about investing in school in America, we need a lot of help in making these decisions and discerning what is important, and I do believe that the

payment for those services is also important. Ninety percent of our

assets right now are coming from mutual funds supermarkets,

Schwab and Fidelity, 90 percent for our company.

What is the benefit to the investor besides being able to talk to

an informed person on the phone at Schwab, being able to get all

of their investments on one statement at Schwab, having access to

337

a terrific website? Beyond that, as we grow, they get the benefits

of the scale. One simple example of that, I looked back in 1998, the

Ariel Fund, our flagship mutual fund had an expense ratio of 1.19

percent. Five years later, because the fund has grown because of

the sources like Schwab and Fidelity, our expense ratio as of today

is 1.02 percent. I am sorry. In 1998, it was 1.25 percent. It is 1.02

today, and so that is a 20 percent drop in 5 years. Because we have

grown——

Chairman SHELBY. Because you have more to manage in economy of scale, is that it?

Ms. HOBSON. We have the economies of scale through Schwab

and Fidelity.

Chairman SHELBY. Mr. Pottruck, you have testified that although the SEC’s proposal for a ‘‘Hard 4 p.m. Close’’ would deter

later trading, it will have unintended adverse consequences for

some investors and will be particularly unfair to investors that

invest through 401(k) plans which are important to all of us. We

understand the need to halt late trading, but I also appreciate the

concern about unintended consequences for investors. A number of

the proposed alternatives to the ‘‘Hard 4 p.m. Close’’ rely on technological fixes. How feasible are these alternatives, and does the

required technology exist or is that on the drawing board?

Mr. POTTRUCK. We and others are suggesting that, since 90 percent of mutual fund trades come through an intermediary on behalf

of the fund, that intermediaries be able to apply to be a designated

agent of the funds, and that when the intermediary takes the trade

by 4 o’clock, that is considered to be an adherence to the ‘‘Hard 4

p.m. Close.’’ We at Schwab take 50,000 mutual funds trades a day,

and we have to aggregate all these trades before placing them. It

takes us a little time to aggregate the trades and send the money

and the information to the various funds so that they can manage

their investing.

The technology to have hard-coded, unalterable time stamps as

to when these trades came into the system exists, but it is not all

implemented. It never occurred to us, frankly, that we had to make

the field with a time stamp something that someone could not go

in later on and override. Now, we have learned the importance of

those kinds of protections. So those technologies need to be added,

but they are not a technological challenge, it is just some time and

money for us to put those in place.

Chairman SHELBY. Mr. Bogle, do you have a comment on that?

Mr. BOGLE. Yes. I think, first of all, the idea that you should

make an investment decision based on what the market is going

to do in the last 2 hours of the day if you are investing for a lifetime, strikes me as, for the want of a better word, nuts. Second,

even a 4 p.m. close is not adequate for the proper conduct of this

industry’s affairs. It should be something like 2:30 so the money is

known to be in there when the portfolio manager can invest it by

the close of the day. In other words, the idea is to have the purchases the portfolio manager makes be made at the same price that

reflects what the net asset value is, but that is a parity there, a

linking, and at 4 o’clock it is too late to do that, so I would go for

a 2:30 close. And as absurd as that might sound to you, that is actually the way we do our index funds, because there the pressure

338

to match is so heavy that you just have to close at 2:30 so the portfolio manager can buy that future at 4 p.m. and the fund is priced

the same way.

But I think it is a good idea to have a hard close, and I am sure

no one is going to agree with me. I do not think very many people

are going to agree with me for a 2:30 close, it may be a tough medicine for everybody to swallow, but the abuses were worse, so we

have just got to do something about it.

Chairman SHELBY. How much of the mutual fund money of Vanguard roughly is in index funds?

Mr. BOGLE. Order of magnitude, probably about $280 billion

something like that, index stock and bond funds.

Chairman SHELBY. Ms. Hobson, do you have a comment on that?

Ms. HOBSON. I do not have anything to add to that.

Chairman SHELBY. Mr. Ruder, Chairman Ruder, we always addressed him as.

Mr. RUDER. Thank you, sir.

Chairman SHELBY. The SEC has not mandated a maximum

number of fund boards on which independent directors can serve,

at least not yet. What are the implications of directors serving on

over 100 boards? We talked about that a little earlier. Further,

what are the considerations for determining the appropriate number of boards on which a director serves, and who should make that

determination?

Mr. RUDER. That is a very good question. When I first learned

that directors were directors of 30, 40, 50, or 100 boards at the

same time, I was astounded. Then I learned more about the industry. As Ms. Hobson said, there are similar aspects in funds which

fund boards can examine at the same time, the governance functions, the compliance functions, and other functions. So it is quite

appropriate to have a large number of funds with the same boards.

The boards can also look at the performance characteristics of

the various funds. There must be a point, however, at which you

want to say 100 is enough or 80 is enough or 250 is enough, and

I think the SEC should look at the multiple board phenomonon

very carefully. I cannot imagine Congress making that kind of decision, but someone should.

Chairman SHELBY. Ms. Hobson had some comments on that earlier, on the time I think Senator Sarbanes asked her a question

about how much time they would spend on the board. You want to

comment on this again?

Ms. HOBSON. No.

Chairman SHELBY. No.

Ms. HOBSON. I think I said enough on that one.

[Laughter.]

Chairman SHELBY. Mr. Bogle.

Mr. BOGLE. In any abstract sense it is absolutely absurd for a

director to serve on 330 or 340 boards or even 100. I used to say

a fiduciary duty test was whether they name each fund they were

director of. Nobody could pass with 100 funds. I am absolutely

confident of that.

Chairman SHELBY. I would hate to have the responsibility if

something went wrong on one of those boards, the legal liability.

339

Mr. BOGLE. On the other hand, if I may add, sir, doing it the

other way and having—if you have 330 funds, which I believe is

a Fidelity number—having 33 boards would make Mr. Johnson,

who is the king or the emperor now, it would make him into the

Pope. I mean he would have no limits. His power would be absolutely unchecked if he had 10 different boards to deal with, all

doing different things.

So my idea for balancing those interests is to require that no director could serve on more than, say, 10 fund boards unless the

funds had an independent staff to assist the directors—an independent, objective staff on the fund’s payroll to enable the directors

to fulfill their fiduciary duty. I think that would be the best balance of interest.

Chairman SHELBY. Mr. Pottruck.

Mr. RUDER. Could I just comment once more on this?

Chairman SHELBY. Let me call on Mr. Pottruck first.

Mr. POTTRUCK. Thank you, Chairman Shelby. I think this is a

very complicated issue. We have 40 or 45 mutual funds that are

proprietary Schwab funds, where we have our own board that is in

charge of these funds. The vast majority of what the boards look

at relative to these funds is exactly the same, fund to fund to fund.

There is an enormous economy of scale. Issues having to do with

individual performances of individual funds are primarily dealt

with on an exception basis. There is an expected benchmark for

every fund. If the funds are within their benchmarks, there is not

a lot of discussion that is necessary about their performance. So it

is done on an exception basis.

But I would liken the issue of a board of funds where there are

100 or 150 funds, to the same question of whether boards of companies like Citigroup, one of the largest corporations in the world, can

effectively oversee 500 operating subsidiaries? The main issue to

me is how independent is the board? I would urge the Committee

and the SEC to focus on the issue of independence by setting rules

around, (a) what percentage of the board must be independent, and

(b) what qualifies as independent? I think if you get strong independent board management, they will set their own agenda to do

the right thing for the shareholders of the funds.

Chairman SHELBY. Mr. Ruder.

Mr. RUDER. If you have 100 boards in a complex, and you split

those boards into 10 funds each so you have 10 boards, my guess

is that the adviser would be much more powerful dealing with each

of these 10 boards one at a time than if it had to deal with, say,

two boards managing 50 funds. In the later case those boards

would be able to assert their independence with regard to the adviser. This is a very competitive situation between the adviser and

the funds, and you need to give those directors power.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. I take it you all would agree with the propositions that the directors have a fiduciary duty? To whom do they

owe the fiduciary duty?

Ms. HOBSON. Shareholders.

Mr. BOGLE. That is actually a wonderful question because of

course they owe the fiduciary duty to the shareholders of the funds.

But think about it a minute, Senator, the directors of the manageVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00351 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
340

ment company that are on that board also owe a fiduciary duty to

the shareholders of the management company. There can be no

question about that. How do they serve those two fiduciary duties?

How do they observe those two standards of loyalty to two completely different companies? I do not believe it can be done.

Chairman SHELBY. You have a bifurcated situation.

Mr. BOGLE. Well, no man can serve two masters. I read that

somewhere.

Senator SARBANES. We had Glassman in here yesterday who was

very close to arguing that they owed their fiduciary duty to the

shareholders of the management company and not the shareholders of the mutual funds.

Mr. BOGLE. He had better not get into this industry.

Ms. HOBSON. If I could just add one thing to that point, at the

end of the day when the system works—and I do not in any way

suggest that we did not have some failures—all of those interests

are in line because the management company knows very clearly

that the only way that they can be successful is to have a successful and competitive fund that has good performance for the shareholders, that will attract and retain shareholders. So in situations

where there is a sense that people are not thinking through—‘‘people’’ meaning those of us who are on the management side and sitting on a board—how these funds affect our everyday business is

not really realistic.

Senator SARBANES. That may be, but it seems to me that there

is almost an inherent conflict of interest there because if you go

one way, one side benefits, if you go the other way the other side

benefits.

Ms. HOBSON. But not over any period of time because at the end

of the day serving your shareholders well is the only way you are

going to have a successful business in our industry. The investors

vote with their feet. That is the one thing we have been able to see

very clearly, be it their 401(k) plan, be it their IRA, their children’s

college account, or whatever it might be. When they become dissatisfied with that management company, with performance which

has put them in more of a short-term performance derby, performance discussion, which I do agree with Mr. Bogle on, when they become dissatisfied, that leaves, and that hurts us as the management company.

Senator SARBANES. Would you say that there is a range in there

where you as a very smart, knowledgeable investor might march

with your feet, but most people would have to be pushed out to a

point further along the spectrum before they would march with

their feet?

Ms. HOBSON. That is not what the data is showing right now. I

have read that the typical time that an investor invests in a mutual fund now has dropped to 3.5 years, and that is down from 7

years in the late 1990’s.

Senator SARBANES. Do you think that is good or bad?

Ms. HOBSON. I think that is very bad. I am a company that has

a turtle as a logo, so our motto is slow and steady wins the race.

I think that is very bad. We call ourselves the patient investors.

Senator SARBANES. Then something is wrong with the way the

rewards and punishments——

341

Ms. HOBSON. Because we used to pay so much to get those customers and worked so hard to get them, you have no incentive to

have them leave.

Senator SARBANES. You do not want to lose them, do you?

Ms. HOBSON. Right. The customer you have is the one that you

want most of all.

Senator SARBANES. Yesterday, we had testimony on the standard

for the fiduciary duty, referencing the Gartenberg decision in the

Second Circuit, which established a very loose, in my view, standard of fiduciary duty. In fact, the court said to be found excessive,

the trustee’s fee must be so disproportionately large that it bears

no reasonable relationship to the services rendered and could not

have been the product of arm’s-length bargaining. This, since then,

has been insurmountable. No shareholder has subsequently proved

a violation of the Gartenberg standard that was initially found

with regard to the fiduciary duty of the adviser, but the courts

have now extended it to the standard for directors as well. So there

is some thinking that we need to address this question of what the

standard of duty is, of fiduciary duty that the directors have.

Would you all agree with that?

Mr. BOGLE. I would like to say, if I may, Senator Sarbanes, that

I actually have been doing a little work on that and spoke about

it this morning in a different venue, and that is the Gartenberg

standards and almost all the standards we see have a terrible flaw,

and that is they look at basis points, the number of percentage

points that you charge, and you compare one fund charging 60

basis points and one fund charging 40. They say, well, 20 basis

points doesn’t seem to be that big of a difference, so there is no

problem there.

I think what we have to do—and I will just give you a couple of

numbers—is talk about dollars and dollars as a waste of corporate

assets. It will open the eyes of the world. I have looked at the California PERS, the California Public Employees Retirement System,

and found that mutual fund shareholders typically pay their fund

managers 100 to 150 times as much as CalPERS pays for the same

manager providing the same service. The mutual funds’ fees in

basis points are only like 5 times higher, but in terms of dollars,

the fees paid to the mutual funds are 100 to 150 times higher than

what the manager charges an outside party with only a fraction of

the assets. I believe that to be a complete waste of corporate assets.

I will give you two specific examples in the mutual fund field.

There is a large money market fund which has done us a wonderful

favor by separating their fee for distribution and their fee for administration and their fee for investment management. You put all

of that together and you can therefore pull out how much is actually paid for investment management. That money market fund,

just 2 years ago, paid $257 million for the money managers who

pick A–1, P–1, and Treasury CDs. That is all there is to it, A–1

paper and P–1 paper, CDs and Treasury bills, $257 million. If the

cost of those three or four people at the desk is a million dollars,

I would eat my hat, which I am not wearing today.

Another example. There is a very large mutual fund that once

had a very good record. It got so large that it could never duplicate

that record again, and in the last 10 years it failed to do so. It beVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00353 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
342

came essentially an index fund. It correlates with the index at

about .97 or .98. But its huge size was great for its management

in that decade, and despite its loss to the stock market, the management was paid $3.6 billion for investment management, $3.6

billion for managing what is, in fact, an index fund. Sure, they are

going to tell you the rate is only 80 basis points, but $3.6 billion,

sir, is $3.6 billion, and it is not right.

Ms. HOBSON. I think the issue about the difference between the

institutional accounts and the mutual fund accounts is a very important issue. I address that in my testimony and in my written

testimony as well. I think that there are some things that are getting lost there that are very important. We manage institutional

accounts and we manage mutual funds, and I mentioned we had

$5.5 billion in mutual funds, but we have lots of large institutional

accounts around the country. There is a fundamental difference in

what we do in those two businesses.

In both situations we are the investment manager, and we are

providing our investment strategy in a very clear and disciplined

way. However, on the mutual fund side of our business we have to

have licensed professionals talking on the phone to the shareholders. When working for CalSTRS, which we do, we do not have

millions of California employees calling directly to Ariel about their

institutional account that we manage for them that is several hundred million dollars. It just does not happen. We have to have a

24-hour website that gives the individuals access to their account,

up-to-date information performance. Millions of institutional employees pension fund people do not call our firm and ask us for that

same opportunity. We have to have legal accounting compliance. A

lot of times the legal in the institutional accounts is done by the

plan sponsor. Last but not least, we have to put together shareholder letters and special brochures and things like that to keep

the customers informed. I never communicate directly with the

pensioneer with Ford Motor Company, which is one of our clients.

So there is a fundamental difference in those businesses. Investment management is just one piece of the business as it relates to

the mutual fund side.

Chairman SHELBY. Chairman Ruder.

Mr. RUDER. I have spent my life worrying about corporate governance in one way or the other, and I find it very hard to deal

with the problem of what some would call excessive fees in this industry. I do not think that the Government should be addressing

the fee question directly to say fees are too high or they should be

capped. Nor do I think the problem should be addressed by setting

fiduciary standards to say there is some level at which we are

going to penalize the directors or the managers of these funds because they have not met the standard we have set. I do not see the

fiduciary duty approach as a way to get to this problem, because

it is an indirect way of setting fees in an industry which is highly

complex, very difficult, and as Ms. Hobson has told us, in which it

is very hard to know what the right answer is.

I can only say that I think compliance and transparency, both to

the investors and to the boards, and good management are going

to give us the results that we need.

343

Senator SARBANES. Don Phillips, Managing Director of Morningstar, testified before us yesterday, and he said:

At Morningstar we think it is time to eliminate soft-dollar payments and to eliminate or seriously reconsider the role of 12b–1 fees in funds. Investors deserve a clear

account of how their money is being spent. Allowing fund managers to dip into

shareholder assets to promote asset growth or to offset research costs distorts the

picture, makes it difficult for investors to align costs and benefits. Let us keep thing

clean and clear. Costs whose benefits flow primarily to the fund’s adviser should

be on the adviser’s tab, not passed off as investor expense. Moreover, distribution

costs should be paid directly to distributors, not run through the fund’s expense

ratio where they tempt managers to take risks they otherwise would avoid.

Pricing schemes should not compromise the integrity of the investment management

process.

What is your take on that?

Mr. RUDER. Sir, if you look at my prepared statement, I have

agreed with all of those positions. I think the adviser should pay

distribution costs and management costs out of its own budget, and

those costs should be very transparent to the board. We should

eliminate soft dollars and directed brokerage for the use of the advisers, and as I have said, eliminate the protection of Section 28(e).

Those are all wonderful suggestions.

Senator SARBANES. Mr. Pottruck.

Mr. POTTRUCK. There are a lot of different things that different

mutual fund companies do on behalf of their clients. The key, to

my way of thinking, is that there is effective disclosure and that

on at least an annual if not quarterly basis, mutual funds must disclose in great detail where money goes and what money pays for

in these different fund complexes.

We are in the business of institutional brokerage so some of our

research is paid for with soft dollars. However, having said that,

I think a study of that practice is very much in order. I think that

mutual fund advisers should be able to buy research and charge

that to the fund as a separate line item and a separate expense.

It is on behalf of the funds. It helps the fund shareholders when

they have more research information. Paying for it with the brokerage commissions is probably the least good way of doing that. It

should be broken out and be more specific so we can see if it seems

to be excessive. It gives investors more information.

Effective disclosure will be the simplest tool to help investors,

rather than lots of rules and regulations on exactly how much is

a reasonable level of fees for different kinds of things. The intensity

of competition in this industry should not be underestimated. I

think many people underestimate how intense the competition is.

We worry about the problems of investors who move on, the turnover. Indeed, the time duration of people holding onto a mutual

fund has come down. All of that argues for the intense competition

in our industry. If you do not perform for the client, people vote

with their feet. They vote with their wallets every day.

Ms. HOBSON. The only thing I would add to the discussion is—

and Don Phillips’ quote I think is appropriate, that pricing schemes

should not compromise the integrity of the investment management process. No investment manager wants their performance

compromised by high fees, I can tell you that, because typically

they are very competitive people who want to win and show up as

being one of the high performers or the best performers.

344

But I do think one thing that is missing there is that the investment manager, in many cases, firms like Ariel, we are paying for

part of the distribution out of our pocket. Our 12b–1 fee on our

funds is 0.25 percent. However, Schwab and Fidelity charge us 40

basis points, 0.40 percent. So in those situations, in order to get the

access to distribution that we think is very valuable and valid, we

have to pay out of our pocket the difference.

So this idea that it is totally being passed on to the shareholder

just based upon the way the costs work is not necessarily the case.

In some of the 401(k) situations that we are in, if we are in a

401(k) plan where the provider is a Merrill Lynch or a Vanguard

or others, in order to have another fund come in, the provider, the

company that has the whole kit and caboodle to the plan, the administration, enrolling the employees, providing the investment

management options, in those situations sometimes they will make

the barrier for us to come in as high as 50 basis points just to be

on the list alongside of the other mutual funds. So, we would say,

okay, we have to pay for that right, but if that means—which did

happen for us last year—we can now be on the Wal-Mart 401(k)

plan list, which we are, and 1.4 million employees now have access

to Ariel through their relationship with Merrill Lynch that they

have at Wal-Mart. We think that that is not only good for us, as

people are working hard to grow our business, but it is also good

for the shareholders as the assets go up and the expenses on the

funds go down, as we have been able to demonstrate.

Senator SARBANES. Mr. Bogle.

Mr. BOGLE. Nothing makes it more clear that we are in a marketing business, an asset gathering business, than when we hear

phrases like ‘‘point of sale’’ and ‘‘shelf space’’ and all of that, and

that is fine as far as it goes. Every industry needs some of that.

But all those costs, which are staggering, are a dead weight on the

returns that are earned by mutual fund shareholders. There is no

way around it. And research does not bail you out. It is not at all

clear that research has any value at all. How could it have any

value when everybody is sharing it together and the stock you buy

with Merrill Lynch’s research is the stock someone else sold because of Merrill Lynch’s research? If there was ever a zero-sum

game, that is it, except for Merrill Lynch, who does very well because people buy this research with their shareholders’ money,

and, of course, everything is very cheap when you are buying it

with other people’s money.

It is all part of this idea that we just cannot simply get through

our heads that mutual funds lose to the market by the amount of

their cost year after year, and those costs are something like $125

billion. There is no way around that equation because we cannot

all be smarter than all the rest of us. We really should be thinking

much more about simplifying the business and taking some—I

would not argue all—of the marketing costs out of the business,

and certainly getting rid of soft dollars is something that is going

to have to happen. It is going to be a very difficult adjustment for

this industry and for Wall Street, but it is going to happen. I mean

if you want to get on the right side of history, do away with it

gradually. And 12b–1 the same thing. It can be held together with

bailing wire and thumbtacks for a while but not forever. We know

345

where it is all going to come out because the investor finally will

be served.

The problem with this is that time is money, and huge money

when you talk about compounding, and the longer we let these ills

go on the more we disserve the American investor, in my judgment.

Ms. HOBSON. I think it is easy to have that perspective when you have $750 billion in assets and terms like ‘‘marketing’’ and ‘‘shelf

space.’’ You just feel differently about them when you are like the

370 mutual fund companies that are like Ariel that have $5 billion

or less in assets. It is just a different discussion.

Chairman SHELBY. We appreciate all of you here today. It has

been a lively discussion, distinguished panel. We have a vote on the

floor of the Senate. Thank you for the contributions you have made

today. We will continue these hearings to see what we need to do

from a legislative standpoint. Thank you.

The hearing is adjourned.

[Whereupon, at 4:12 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

346

1 National Association of Securities Dealers, Inc. (1994).

PREPARED STATEMENT OF DAVID S. RUDER

FORMER CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

WILLIAM W. GURLEY MEMORIAL PROFESSOR OF LAW

NORTHWESTERN UNIVERSITY SCHOOL OF LAW

CHAIRMAN, MUTUAL FUND DIRECTORS FORUM

FEBRUARY 26, 2004

Introduction and Background

Thank you for asking me to testify on the important question of mutual fund reform. My views are my own and not those of any group or entity. I am currently

a Professor of Law at Northwestern University School of Law, where I teach securities law. I was Chairman of the U.S. Securities and Exchange Commission from

1987 to 1989 and was a member of the Board of Governors of the National Association of Securities Dealers, Inc. from 1990 to 1993. While a member of the NASD

Board, I was chairman of a committee that reviewed securities industry practices

in and promulgated a report on the topic ‘‘Inducements for Order Flow,’’ 1 sometimes

known as ‘‘payment for order flow.’’

Currently, I serve as Chairman of the Mutual Fund Directors Forum, a not-forprofit corporation, whose mission is to improve fund governance by promoting the

development of vigilant and well-informed directors. We do so by offering continuing

education programs to independent directors, providing opportunities for independent directors to discuss matters of common interest, and serving as advocates

on behalf of independent directors.

The Forum is a membership corporation whose members are all independent

directors of mutual funds. Their dues are paid by their funds, but their memberships are individual. The Forum is entirely independent of the mutual fund advisory

industry.

In November 2003, the Securities and Exchange Commission Chairman William

H. Donaldson asked the Forum to develop guidance and best practices in five areas

where directors oversight and decisions are critical for the protection of fund shareholders. In our view, Chairman Donaldson’s choice of the Forum to develop guidance

and best practices in critical mutual fund areas demonstrates the SEC’s confidence

in the Forum’s capability and independence.

Finally, by way of background, I am currently serving as the Independent Compliance Consultant for the Strong Financial Corporation, which manages approximately $37 billion in assets and is the adviser to more than 50 mutual funds. My

task is to recommend compliance procedures at Strong, including the areas of market timing, late trading, portfolio valuation, and disclosure of portfolio holdings.

The Role of the Mutual Fund

A mutual fund provides a vehicle through which the pooled resources of investors

can be managed by professional money managers (investment advisers or advisers).

Though mutual funds’ investors are able to achieve the benefits of diversification

and to seek above average returns by investing in funds with special characteristics,

such as growth funds, income funds, or sector funds.

In addition to offering diversification and special investment vehicles, mutual

funds provide other advantages to investors. Individual investors are unlikely to be

able to gather the information necessary to make good investment decisions, and

they do not have the experience or judgment enabling them to outperform professional managers. Mutual funds provide them with the opportunity to compete with

the professionals.

Equally important, the discipline of regular investing in mutual funds, with an

expectation of long-term investment profit, creates saving habits that are beneficial

to investors.

Directors as Monitors

When a mutual fund investor entrusts funds to an investment adviser, conflicts

inevitably arise. The adviser seeks to maximize their profits, while the fund shareholders want the adviser to charge the lowest fees possible. Conflicts also exist

because the adviser who has control over investors’ money may engage in transactions with the fund that are to the advantage of the adviser and to the detriment

of investors.

347

2Proposed Rule: Investment Company Governance, Rel. IC–26323 (January 15, 2003) p. 3.

The Investment Company Act of 1940, as administered by the SEC, recognizes

these conflicts by laws and rules designed to prevent conflicts of interest and by

placing special governance responsibilities on mutual fund boards of directors.

The most important approach to increasing the protection of mutual fund investors

is to enhance the power of independent fund directors and to motivate those directors

to perform their duties responsibly.

The Unique Form of Mutual Fund Organization

As presently constituted, the mutual fund industry has a unique form of organization. In an industrial corporation, the primary function of the board of directors is

to supervise the management of the corporation. The board has the ability to hire

and fire the corporate chief executive officer, as well as other officers, and has the

power to set corporate policy. The board has the power to tell the corporate officers

how to manage the business.

In contrast, in the typical mutual fund, the board of directors is not dealing with

a CEO or other officers charged with management of the corporation, but with an

entity—a mutual fund adviser whose obligations to the fund are determined by contract. Typically the fund board does not have a separate office or a staff. The CEO

of the fund will be an employee of the adviser, and the CEO’s allegiance typically

will lie primarily with the adviser.

Given the separation between the fund board and the adviser, the important question to be asked is: What organization and powers will best assist a fund board in

protecting the interests of the fund and its shareholders?

I will examine this question, and will also examine some specific current areas

of concern in the mutual fund area.

In deciding what corporate governance structure is desirable, the Congress and

the SEC need to understand that for the most part fund directors are well-informed,

dedicated, and active in their supervision of the adviser. Any reform in the mutual

fund governance area should be aimed toward improving the powers of fund directors to perform their supervisory functions.

To say that most fund directors are well-informed, dedicated, and active does not

mean that all fund directors share these qualities. Historically mutual funds have

been created by investment advisers that are extremely knowledgeable about the

securities industry and the intricacies of mutual fund management. In many cases,

the independent fund directors have been chosen by the adviser. Some fund directors charged with supervising the adviser may at times be unwilling to challenge

an adviser who has the advantage of superior knowledge and resources. The SEC

has stated:

Our concern is that in many fund groups the fund adviser exerts a dominant influence over the board. Because of its monopoly over information

about the fund and its frequent ability to control the board’s agenda, the

adviser is in a position to attempt to impede the directors from exercising

their oversight rule. In some cases, boards may have simply abdicated their

responsibilities, or failed to ask the tough questions of advisers; in other

cases, boards may have lacked the information or organizational structure

necessary to play their proper role.2

There are some directors who are not meeting high standards as supervisors of

fund activities, because they are new to a complex industry, because they have not

taken the time to become fully informed, or because they are friendly to the adviser.

Some directors do not meet supervisory standards because they are not sufficiently

assertive in carrying out their duties.

Our primary tasks at the Mutual Fund Directors Forum are to assist independent

directors to become better educated and to be more active in overseeing management of their funds by advisers.

In assessing director performance, it is important to recognize that the mutual

fund industry is complex. Mutual fund boards are ultimately responsible for supervising many fund functions, including:

• Advisory fees and fees of other entities providing services;

• Compliance with representations made in documents distributed to prospective

investors and fund shareholders;

• Performance of the fund portfolio;

• Quality and cost of portfolio executions;

• The manner and cost of the distribution of fund shares;

• The custody of the fund’s securities; and

• Administration of individual investor accounts.

348

3See Note 28 in SEC Releases IA–2204 and IC–26299 (December 17, 2003).

4See, e.g., SEC Proposed Rule: Confirmation Requirements and Point of Sale Disclosure Requirements for Transactions in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual

Funds. Releases 33–8358; 34–49148; IC–26341 (January 29, 2004). 5Proposed Rule: Investment Company Governance, Rel. IC–26323 (January 15, 2003).

These functions will be carried out by the adviser and by other entities, sometimes collectively called ‘‘service providers.’’ The term ‘‘service providers’’ includes

not only advisers and sub-advisers who manage fund portfolios, but also underwriters who sell fund shares, administrators of customer accounts, and transfer

agents who record transfers of shares in customer accounts. Custodians who hold

fund portfolio securities both in the United States and abroad, fund accountants,

and third-party pricing services may also be considered to be ‘‘service providers.’’ 3

In order to monitor the adviser, the fund directors need to understand the fund’s

operations, have the power to assure that the fund operations are being carried out

honestly and efficiently, and have the will to exercise these powers for the protections of shareholders. They must bargain with the adviser regarding the costs of its

services and regarding the cost of arrangements made by the adviser to have others

perform services.

An Overview of Needed Regulation

Recent events have revealed that there are serious problems in the mutual fund

industry. Advisers have facilitated late trading, market timing, and improper disclosure of mutual fund portfolio holdings. Advisers have used fund portfolio execution

revenues and their own resources to pay brokers to advocate purchase of funds

managed by the adviser, without adequate disclosure to investors.

The recent problems are being addressed by both State regulatory authorities and

the Securities and Exchange Commission. The SEC has been charged by Congress

with regulating the complicated investment company industry since 1940, and it has

performed that regulation well, given its limited resources. Nonetheless, some of the

recent scandals have caught the Commission by surprise. In reaction, the Commission has recently been vigorous in its enforcement activities, has imposed numerous

reforms through new rules governing the activities of funds and advisers, and is

preparing additional rules.4

As noted earlier, the mutual fund industry is highly complex. Detailed regulation

is best left to the discretion of the agency that has expertise regarding the mutual

fund industry and can regulate in a manner that will reflect changing industry patterns and technology in both the mutual fund industry and in the securities industry generally. I believe Congress should be very cautious in addressing mutual fund

reform by legislation. I urge Congress to recognize that for the most part needed regulatory steps are being taken by the SEC through its rulemaking and enforcement

powers under the Investment Company Act, the Investment Advisers Act, the Securities Act, and the Securities and Exchange Act.

Corporate Governance Reforms

The Mutual Fund Directors Forum recently conducted a policy conference on the

Critical Issues for Mutual Fund Directors. At that conference it was my pleasure

to listen to numerous independent directors express their desire to increase their

oversight of the advisers. My recommendations for reform are designed to increase

the oversight powers of fund directors and to help independent directors be more

assertive when they deal with fund advisers.

INDEPENDENCE

The first criteria for exercise of independent oversight is that a sufficient number

of directors be independent of the adviser.

1. At least three-fourths of each fund board of directors should be independent of

the adviser. The SEC has proposed this requirement.5

2. Director independence standards should be tightened by the SEC. The Investment Company Act’s definition of ‘‘interested person’’ does not sufficiently address

problems of indirect relationships, such as former employment with the adviser,

family relationships, and other matters.

AN INDEPENDENT CHAIRMAN OF THE FUND BOARD

The chairman of the board of each fund should be independent of the adviser. An

independent chairman can control the board agenda, can control the conduct of

board meetings so that important discussions are not truncated, and can provide imVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00360 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
349

6 Id.

7 Role of Independent Directors of Investment Companies, Rel. IC–24816 (January 2, 2001).

portant and direct liaison with the adviser between board meetings. The SEC has

proposed this requirement.6

AN INDEPENDENT COMMITTEE STRUCTURE

At the urging of the SEC, the New York Stock Exchange and the Nasdaq Stock

Market now require that the Board Nominating, Compensation, and Audit Committees be composed entirely of independent directors. Similar committees and other

committees composed entirely of independent directors are important to assuring

good fund governance. The SEC should urge or perhaps mandate that various committees exist, taking into account that funds are different in size and objectives.

Some fund boards, particularly in smaller funds, may choose to deal with some matters solely at the board level.

I recommend that fund boards in the larger complexes function with the following

committees.

A Nominating Committee

A Nominating Committee composed entirely of independent directors should have

exclusive power to nominate directors, thereby helping to assure that new independent directors of each fund will not be chosen by the adviser.

An Audit Committee

An Audit Committee composed entirely of independent directors should have responsibility to oversee the audit function and the power to hire, terminate, and set

the compensation of the auditor.

A Compliance Committee

A fund board may wish to create a Compliance Committee composed entirely of

independent directors. The Committee should have the primary responsibility for

overseeing the compliance policies and procedures of advisers and service providers,

and should be responsible for overseeing the content of their ethics codes. The Committee should monitor the fund’s compliance functions, including the activities of the

chief compliance officer.

An Investment Committee

Although practices in each fund complex may differ, some funds may choose to

create an Investment Committee composed entirely of independent directors,

charged with the review of investment performance and fund fees and costs.

Other Committees

Other committees, such as a valuation committee, should be established as

deemed desirable by the fund board.

INDEPENDENT COUNSEL AND STAFF

Since most mutual funds are ‘‘externally’’ managed by the adviser, it is important

that the board of directors have independent counsel and staff.

Independent Counsel

In 2001, the SEC required any legal counsel to the independent directors of funds

relying on certain exemptions to be independent from the adviser.7 As a result,

many independent fund directors now have legal counsel who can provide independent advice to the fund board regarding board governance matters and the entire range of fund operations. A fund board should be sure that its counsel is, in

fact, independent and is acting independently. The SEC should require that the

independent directors have an independent legal counsel. In the absence of SEC action, all independent directors should strongly consider retaining their own independent counsel.

Independent Staff

The Sarbanes-Oxley Act mandated that the Audit Committee of each company

registered with the SEC have the power to hire independent staff. The stock exchanges have recommended that the nomination and compensation committees be

empowered to hire independent staffs. Mutual fund boards should be able to hire

an independent staff on a permanent basis or on an as needed basis. They should

be able to hire independent advisers to advise the board in areas such as fund fees

and costs, the quality of portfolio executions, and the valuation of fund securities.

350

8 Investment Advisers Act Rule 206(4)–7 and Investment Company Act Rule 38a–1. Final

Rule: Compliance Programs of Investment Companies and Investment Advisers, Rel. IA–2204;

Rel. IC–26299 (December 17, 2003). 9 Rule 38a–1, Id. 10 Investment Advisers Act Rule 206(4)–7, Id. 11 Investment Company Act Rule 270.38a–1, Id.

A CHIEF COMPLIANCE OFFICER

Each investment adviser should be required to hire a chief compliance officer

(CCO), charged with supervising the compliance functions of the adviser and its service providers. The CCO should report to the fund board, as well as to the adviser.

The fund boards should have the right to hire, fire, and set the compensation for the

chief compliance officer. Mutual fund advisers typically provide investment advice

not only to mutual funds, but also to other clients, such as high net worth individuals, 401(k) retirement plan advisers, and institutions such as pension plan sponsors. The adviser’s chief compliance officer should report to the fund board regarding

adviser compliance in all aspects of the adviser’s operations that are likely to impact

the fund’s operations, including the adviser’s supervision of sub-advisers and service

providers. The chief compliance officer should be well paid, have high ranking officer

status within the adviser, and have his or her own staff.

My recommendations are not new. The SEC has adopted rules requiring chief

compliance officers at both advisers and funds.8 Rules under the Investment Advisers Act will require each adviser to have a chief compliance officer, meeting the

criteria I have set forth. Similar rules under the Investment Company Act will require mutual funds to have a chief compliance officer. The SEC’s new Investment

Company Act rule adds important additional levels of detail:

• The chief compliance officer must annually provide a written report to the fund

board regarding operation of the fund’s policies and procedures, as well as those

of the fund’s service providers.

• The chief compliance officer must meet with the fund board in executive session

as least once each year.

• The chief compliance officer must oversee the fund’s service providers, including

their compliance officers, and should keep the fund board aware of compliance

matters and needed changes at the service providers.9

POLICIES AND PROCEDURES

Advisers and funds should adopt and implement written compliance policies and

procedures. The SEC’s recently adopted Investment Advisers Act rule 10 will require

the adviser to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act by the adviser. The rule specifies a

number of areas that should be addressed, including portfolio management, trading

practices, proprietary trading, the accuracy of disclosures, the safeguarding of client

assets, and portfolio valuation procedures.

The SEC has also adopted a similar rule under the Investment Company Act 11

requiring fund boards to adopt written policies and procedures reasonably designed

to prevent the funds from violating the Federal securities laws. As with the adviser

rule, the Investment Company Act rule also specifies a number of areas that must

be addressed. In the corporate governance area, the SEC’s investment company

rules require funds to have policies and procedures designed to oversee compliance

by the adviser and the service providers, including principal underwriters, administrators of shareholder accounts and transfer agents. The rule specifies areas that

should be addressed, including the areas identified for fund advisers, as well as

pricing of portfolio securities and fund shares, processing of fund shares, and

compliance with fund governance requirements. The latter requirements include

board approval of the fund’s advisory contracts, underwriting agreements, and distribution plans.

CERTIFICATION

The Sarbanes-Oxley Act and SEC rules now require chief executive officers and

chief financial officers of industrial corporations to certify in disclosure documents

that the issuer’s financial statement fairly present the company’s financial condition

and that the company’s internal controls and procedures are effective.

Some have suggested that fund directors or the fund board chairman be required

to certify to shareholders regarding oversight activities. I do not believe that such a

certification requirement is needed or advisable. Such a requirement is not needed

because fund board’s are increasingly becoming more active in supervising advisers

and service providers and will be even more active under new SEC rules. A certifiVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00362 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
351

12See SEC Proposed Rule: Disclosure Regarding Approval of Investment Advisory Contracts

by Directors of Investment Companies. Rel. IC–26350 (February 11, 2004).

cation requirement for fund directors is not advisable because it would deter qualified individuals from serving as directors.

A MUTUAL FUND OVERSIGHT BOARD

Some have suggested a mutual fund oversight board be established for the purpose of overseeing the mutual fund industry in a manner similar to the oversight

regarding the activities of accountants now being performed by the Public Company

Accounting Oversight Board. I do not believe such a mutual fund oversight board

is necessary. The SEC has full authority to exercise such oversight, is increasing its

oversight and rulemaking activities, and has recently been given additional resources

that will help it to perform its oversight functions.

Areas Needing Attention

In evaluating possible legislation Congress should be aware of the complexity of

the issues faced by mutual fund directors in monitoring the activities of advisers

and the funds service providers. I will address several areas of particular current

concern.

ADVISORY FEES

As noted earlier, a fundamental conflict exists between the mutual fund directors,

who should be seeking the lowest fees from advisers consistent with good performance and the adviser, who will be seeking the highest profits for its services.

In reviewing advisory fees, the fund board should consider portfolio performance,

the quality of the adviser oversight of service providers, the levels of volume breakpoints that provide reduced fees to the funds based upon fund size, compensation

received by the adviser through its affiliates or from directing portfolio brokerage,

and other factors.

Criticisms of mutual fund fee levels have been made by a number of well-informed

persons. These critics contend that mutual fund boards have too readily acceded to

management’s recommendations. They also challenge fee levels in index funds and

some debt funds that do not require judgments regarding the likely future value of

particular securities.

Accepting the proposition that fund directors can be more active in attempting to

reduce advisory fees, I believe the proper way to achieve better control over advisory

fees is to improve the corporate governance environment for independent directors,

to increase director education as we are attempting to do through the Mutual Fund

Directors Forum, to encourage directors to be more assertive and energetic in challenging adviser recommendations, and to mandate increased disclosure regarding

the fee setting process.12

I strongly believe that neither the U.S. Government nor State governments should

attempt to set mutual fund advisory fees. Government price setting is inadvisable

and wrong in the exceedingly complex and competitive mutual fund industry.

BEST EXECUTION AND DIRECTED BROKERAGE

One difficult task for a fund board is to assure that the fund is receiving best execution in fund portfolio transactions. All fund boards are concerned with execution

practices and will normally insist that the adviser demonstrate that it is achieving

best execution in portfolio transactions. The adviser will present details and comparisons regarding best execution to fund boards on a regular basis. Statistical analysis by third-party consultants is sometimes provided.

Although best execution is a goal, the definition of best execution is highly subjective. The definition is frequently said to mean the achievement of the most favorable

price under the circumstances, including commissions, market conditions, and the

desire for prompt execution.

Mutual fund portfolio transactions almost always involve transactions in large

numbers of shares. In highly liquid markets, some large transactions can be accomplished without causing market price movements. However, mutual fund transactions are frequently so large in size that the execution must be accomplished

confidentially and carefully so that the transaction does not unduly affect price.

Some of the more difficult transactions are conducted by brokers who are highly

skilled at executing large size transactions without revealing the size of the order

or by electronic communications networks that have the ability to use computers to

execute orders in stages without revealing size.

Substantial competition exists among executing brokers for the right to execute

transactions. These brokers will be compensated based primarily upon a per share

352

13Securities and Exchange Act, Section 28(e). 14SEC Rel. 34–23170 (April 23, 1986). 15 In the Matter of Morgan Stanley DW, Inc. Securities and Exchange Act Rel. 48789 (November 17, 2003).

commission charge, which now is said to vary between approximately 3 and 6 cents

per share for large transactions.

The competitive environment for portfolio execution commissions has caused

many executing brokers to offer cash payments or equivalent payments in kind for

the execution privilege. These payments are sometimes called ‘‘directed brokerage’’

payments and are sometimes used to pay for the costs of adviser research, to pay

distribution costs incurred by advisers for fund shares, and to pay service providers

for costs owed to entities providing services for funds.

I believe that directed brokerage is the property of the funds, who should receive

the benefit of these payments. I believe payment to service providers on behalf of

the funds meets this objective, but that payments that benefit advisers, such as softdollar payments and payment for distribution costs do not, unless these payments

are quantified and utilized by fund boards to reduce advisory fees. I believe the SEC

should adopt a rule requiring all directed brokerage to be used for the benefit of

funds, not the benefit of fund advisers.

SOFT DOLLARS

Directed brokerage payments used to pay research or brokerage costs of fund advisers are called ‘‘soft dollars.’’ Section 28(e) of the Securities and Exchange Act protects the adviser against liability or administrative action for payment of an excess

amount of commissions for effecting a securities transaction if the adviser ‘‘determined in good faith that such amount of commission was reasonable in relation to

the value of the brokerage or research services received’’ by the adviser.13

The value of research services received for soft dollars is often difficult to measure, so that soft-dollar payments often lack transparency. Additionally, as soft-dollar

practices have developed, the SEC has by release expanded the allowable use of soft

dollars to pay for services that seem to me to be far removed from research or brokerage.14 For instance, services sometimes include costs of computers. Provision of

these and other services often creates recordkeeping problems because of the need

to separate services applicable to research and brokerage from services that are not

applicable to these functions. It is also important to monitor soft-dollar payments

to see that the funds generating commission dollars are receiving appropriate credit.

Even if allocated properly, the amount of soft-dollar payments made to the adviser

should be revealed to and approved by the fund directors.

I believe that protection given to soft-dollar payments by Section 28(e) is wrong and

creates unnecessary complications. Congress should repeal Section 28(e), and the

SEC should deal with soft-dollar payments by rule.

USE OF DIRECTED BROKERAGE FOR DISTRIBUTION

Recently the SEC brought and settled administrative proceedings with Morgan

Stanley DW, Inc.15 based upon alleged violations of SEC rules by Morgan Stanley

when it accepted payments from mutual fund advisers in return for rewarding its

sales personnel for selling shares of funds sponsored by those advisers rather than

the shares of funds sponsored by nonpaying advisers. The advisers’ motive in paying

Morgan Stanley was to increase the amount of assets under management and therefore their advisory fees. The Commission asserted that by accepting these payments

for ‘‘shelf space’’ without disclosing them to investors Morgan Stanley violated SEC

antifraud rules prohibiting misrepresentations to investors.

The Commission’s action also noted that a portion of the payments to Morgan

Stanley amounted to the use of directed brokerage by the investment advisers to

pay for distribution costs. This practice of using revenues from fund brokerage to

pay third parties for the benefit of the adviser is similar to the advisers’ receipt of

soft dollars from directed brokerage. Unless the use of directed brokerage by the adviser to pay for the distribution of fund shares is revealed to and approved by fund

directors, this practice is unacceptable. Adviser acceptance of directed brokerage to

pay for its distribution costs is not protected by Section 28(e).

I believe the Commission should adopt a rule requiring the adviser to use all directed brokerage revenues for the benefit of the funds. It may be that if the adviser

chooses to forgo all directed brokerage revenue, best execution of fund shares will

be improved.

353

16SEC Inv. Co. Act Rel. 16431 (1980). 17Proposed Rule: Amendments to Rules Governing Pricing of Mutual Fund Shares. Release

IC–26288 (December 11, 2003).

RULE 12b–1

In 1980, the Commission promulgated Investment Company Act Rule 12b–1 16

which permits mutual fund assets to be used to pay for the distribution of fund

shares. The theory underlying the rule is that the use of fund assets to pay for distribution is justified because as assets increase, advisory fees as a percentage of assets will decrease. The assertion is that when certain levels, called break points, are

reached, advisory fee levels will decrease.

Rule 12b–1 requires fund board approval for the use of fund assets to pay for fund

distribution costs. Some have suggested that at the very least the use of directed

brokerage revenues to pay for fund distribution costs should be included as a

12b–1 fee, which must be approved by the fund directors. My view is that the advisers should pay all of the costs of fund distribution and, therefore, Rule 12b–1 should

be repealed by the SEC. If that rule is not repealed, use of directed brokerage to

pay for fund distribution costs should be included as part of 12b–1 fees, subject to

approval by the fund directors.

With regard to inclusion of directed brokerage in 12b–1 fees, as with other aspects

of directed brokerage revenues, I believe Congress should refrain from legislation,

and await SEC action.

LATE TRADING AND MARKET TIMING

New York Attorney General Spitzer’s investigation involving the Canary Hedge

Fund and subsequent SEC inquires and actions have raised important concerns in

the areas of late trading and market timing.

Late Trading

Late trading is the practice by which a fund allows orders to buy or sell fund

shares to be placed after the time at which the fund determines its net asset value

(NAV), which in turn determines the per share net asset value used to price purchases and sales of fund shares. Late trading allows an investor to buy or sell

shares at prices that will differ from the next day’s prices to the advantage of the

investor. The investor may profit if it is in possession of information that will cause

the NAV to change on the following day. The practice of late trading is unlawful

under SEC Investment Company Act Rule 22c–1, which prohibits an investment

company from selling or redeeming fund securities except at a price based on the

current net asset value of the security next computed after the order is placed. Late

trading has the effect of allowing securities to be valued at a NAV computed before

the order is placed.

Late trading activities have been aided by fund transfer agent practices allowing

submission of orders by third-party fund distributors after the NAV pricing time.

The distributors are usually brokerage firms that receive customer fund orders during the day and submit so called omnibus orders aggregating smaller customer orders into large buy and sell orders. Industry practice has been to allow these orders

to be submitted as late as 7 p.m. or 9 p.m. Eastern time, or even later. Use of these

omnibus accounts raises the possibility that the orders were actually received after

the NAV pricing time in violation of the late trading prohibitions.

The SEC has attempted to meet the late submission problem by proposing a ‘‘hard

close’’ of 4 p.m. Eastern time, requiring that all purchase and redemption orders be

received by the fund no later than the time the fund prices it securities.17 Since late

trading is already illegal and since the SEC is addressing late trading practices, no

legislation is needed.

Market Timing

Market timing is the practice of engaging in short-term trading of fund shares in

order to take advantage of situations in which the fund’s net asset values will not

reflect the real value of the fund’s shares. This practice allows the market timers

to take advantage of information learned prior to the time at which the fund values

its assets at the end of the day, but which will not be reflected in the NAV. The

most frequently used illustration of this practice involves the pricing of foreign securities when foreign markets have closed many hours before NAV pricing. If events

occur during the intervening period that will be likely to cause changes in the prices

of the foreign securities, the market timer can buy or sell the fund shares on the

day the events occur, taking advantage of the fact that the fund shares will not reflect the changed values of the foreign securities. Market timing is not illegal, but

354

18 E.g., In the matter of Putnam Investment Management, LLC. Investment Advisers Act Rel.

2192 (November 13, 2003). 19Proposed Rule: Disclosure Regarding Market Timing and Selective Disclosure of Portfolio

Holdings, Release 33–8343, IC–26287 (December 11, 2003). 20Final Rule: Compliance Programs of Investment Companies and Investment Advisers. Rel.

IC–26299 (December 17, 2003). 21Proposed Rule: Disclosure Regarding Market Timing and Selective Disclosures of Portfolio

Holdings. Rel. 33–8343, IC–26287 (December 11, 2003).

a fund allowing market timing to exist may be violating representations in the

fund’s prospectus that market timing will not be allowed.

Both late trading and market timing activities injure the funds and their investors because the funds lose money to the arbitrage activities of the traders and because the funds often will have to retain additional cash in order to be able to pay

these traders when they sell their shares.

The SEC has urged funds to enhance their compliance procedures regarding market timing, and is pursuing market timing enforcement actions.18 It has proposed

amendments to the registration form used by mutual funds to register securities for

sale that would require funds to disclose risks to them of market timing and to disclose fund policies and procedures designed to prevent market timing.19 It has also

recently required funds to adopt policies and procedures dealing with market timing.20 Some funds are attempting to meet market timing problems by adopting special valuation procedures for foreign securities, and the SEC has proposed that

funds disclose their fair value procedures.21 No legislation is needed in the market

timing area at this time. The SEC should adopt its proposed disclosure rules and

should consider rules requiring third-party distributors to monitor market timing

practices.

Prospectus Disclosures

Sales of fund shares to investors are regulated by the Securities Act of 1933,

which mandates disclosures when selling securities to investors. Since sales of mutual fund shares are continually being made, the SEC allows the fund prospectuses

to be amended on a continuous basis, so that they are always current.

Prospectus disclosures must be complete and truthful. By describing the types of

portfolio securities that will be purchased by the fund, the use of leverage, the methods of distributions of fund shares, and costs to investors the funds are essentially

making a series of promises to investors regarding fund operations.

Oversight of the adviser by the fund directors includes oversight of the adviser’s

responsibility to see that its activities conform to the representations made in each

fund’s prospectus. The SEC’s recent rules requiring compliance policies and procedures and emphasizing the enhanced role of the chief compliance officer will provide

the fund boards with tools for meeting these responsibilities.

Conclusion

In conclusion, I believe that Congress should rely upon the Securities and Exchange Commission to remedy problems in the mutual fund industry, particularly

by measures designed to enhance the power of independent fund directors. Congress

should not take any legislative action, except for repealing Section 28(e) of the Securities and Exchange Act.

—————

PREPARED STATEMENT OF DAVID S. POTTRUCK

CHIEF EXECUTIVE OFFICER, THE CHARLES SCHWAB CORPORATION

FEBRUARY 26, 2004

Chairman Shelby, Ranking Member Sarbanes, distinguished Members of the

Committee: My name is David S. Pottruck, and I am the Chief Executive Officer

of The Charles Schwab Corporation, one of the Nation’s largest financial services

firms. Schwab was founded more than 30 years ago as a pioneer in discount brokerage. Today, we are a full-service firm serving more than 8 million client accounts

with nearly $1 trillion in client assets. Through Schwab Corporate Services, we

serve more than 2 million 401(k) plan investors.

I appreciate the opportunity to provide my thoughts this morning on the vitallyneeded reforms to the mutual fund industry. Let me begin by assuring you that we

stand ready to help the Committee move forward in any way we can. We at Schwab

share the Committee’s disappointment over the recent events that have propelled

mutual funds to the front pages. We fully support many of the reforms already unVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00366 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
355

dertaken by the SEC. But we also believe that more can and should be done. I applaud this Committee’s efforts to put the interests of investors—not insiders—first.

Introduction—The Importance of Mutual Fund Supermarkets

Schwab is certainly no stranger to the needs of mutual fund investors—mutual

funds have long been at the core of our business. We launched the first mutual fund

supermarket to focus on no-load funds some 20 years ago, and in 1992 we launched

the first no-load, no-transaction fee supermarket, OneSource. Today, Schwab clients can choose from among nearly 5,000 mutual funds from 430 fund families, including nearly 2,000 funds that have no loads and no transaction fees.

Our heritage is one of innovation, and I don’t think I am being too bold when I

say that mutual fund supermarkets have revolutionized investing for millions of

Americans. Supermarkets have helped provide investors with an array of investment choices unimaginable a decade or two ago, when investors were essentially

held captive by their fund company. Supermarkets empower investors by facilitating

comparison shopping among funds; they simplify investing by consolidating statements and allowing investors to move easily from one fund family to another; and

they increase competition, driving down costs for individual investors.

We made the decision early on to focus our supermarket on no-load, no-transaction fee funds because we felt that investors should not be forced to bear these

costs, and that they deserved access to funds without them. But in response to client

demand, we also make available more than 2,600 mutual funds that do carry either

transaction fees or loads, or both. The goal of our supermarket is to make available

to our clients the widest array of funds, and our customers have demanded the option of funds that carry additional costs. No two investors are the same. While the

majority of our clients prefer funds without loads or transaction fees, that is a determination for each individual investor to make on his or her own, based on his or

her own investment strategy, needs, and long-term goals. If a load fund offers superior service or performance, investors may determine that paying the load is worth

those benefits. But fewer than 1 percent of all mutual fund purchases made at

Schwab involve paying a load.

Our mutual fund supermarket is designed to make comparison shopping among

funds as easy as possible. On our website, Schwab.com, investors can compare literally thousands of mutual funds in a wide array of categories to find the one that

best meets their investment goals. They can compare the performance of a no-load

fund with that of a load fund, to determine whether loads help or hinder market

performance. They can compare funds that have transaction fees with funds that

don’t have transaction fees. They can compare multiple funds across any number

of key data points—past performance, fee structure, portfolio turnover rates, the

tenure of the fund manager, risk, amount of assets in the fund, even the percentage

of holdings that are from a particular sector of the economy. All of these tools are

designed with the idea that what is most important to one investor may be least

important to the next. At Schwab, we strive to make as much information as possible available to the investor prior to the transaction to help him or her make the

most educated decision.

It is clear to us that our supermarket strategy was the right one. Our clients love

this kind of freedom, convenience, and flexibility, and they have voted with their

wallets. Before the launch of our no-load, no-transaction fee marketplace, our clients

held about $6 billion in mutual funds. Today, our clients have more than $235

billion invested in literally thousands of mutual funds from more than 400 fund

companies. We are proud to be one of the largest mutual fund supermarkets in the

world.

And it’s not just Schwab’s supermarket that investors have responded to. The vast

majority of mutual fund trades today are executed via a supermarket, whether it

be Schwab’s, or Fidelity’s, or another competitor’s. Only about 12 percent of mutual

fund assets are purchased directly from a fund company. And, in the retirement

plan context, an estimated 80 or more percent of all 401(k) investors have access

to a fund supermarket that allows them to compare hundreds or even thousands

of funds across hundreds of fund families to find the one that best meets their individual needs, goals, and style.

Mutual fund supermarkets have also helped the industry remain extraordinarily

competitive. In a time of growing consolidation in the financial services industry

that has resulted in less consumer choice, mutual funds stand out as an admirable

exception. Since 1990, the number of mutual funds available to investors has nearly

tripled—from 3,000 to over 8,000. Many of these new funds are managed by smaller

fund companies that didn’t even exist a decade ago—and could not exist without the

infrastructure provided by mutual fund supermarkets that helps them reach large

numbers of individual investors.

356

1See Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment Management, SEC, at page 297.

In short, supermarkets are a crucial innovation that provide the link between millions of Americans and our equity markets. They are an indispensable tool that

must be preserved and strengthened—not weakened by reform proposals, no matter

how well-intentioned. As the Committee considers reform, I urge it to remember the

very qualities that make mutual fund supermarkets so valuable to investors: Choice,

simplicity, convenience, transparency, and competition.

Reforms Must Preserve the Strength of Supermarkets

Let me briefly outline a few suggestions for the Committee’s consideration that

underscore these principles.

First of all, it is clear that there is not enough transparency in the mutual fund

business. Schwab supports many of the proposals under consideration in Congress

and at the SEC to enhance disclosure to fund investors, but I think we can go further. There are three areas that I would recommend for additional disclosure:

• Investors have a right to know if their broker’s representative has a financial

incentive to push one mutual fund over another. No one at Schwab does. We voluntarily provide information on our website today to investors about how our

representatives are paid and rewarded. All investors deserve this transparency.

• Investors need to know whether a fund company has paid a fee to be on a broker’s

preferred list. At Schwab, our OneSource Select Listtm features the best performing no-load, no-transaction fee funds available through Schwab’s supermarket. No fund can pay us for inclusion on the list, and we tell investors that.

More light needs to be shed on how these lists are created.

• To bolster competition and lower prices, Congress should unfix sales loads, so that

broker-dealers are forced to compete, just like back in 1974, when commissions

were deregulated. Mutual funds should be allowed to set a maximum load, but

not a minimum. This would put the burden on the broker to determine, disclose,

and defend their commissions. Investors could then shop around for the best price.

Mutual funds already compete vigorously on the fees they charge investors; there

is no reason that broker-dealers should not do so as well.

Moreover, in 1992 the SEC’s Division of Investment Management recommended

that the Commission seek legislation to amend Section 22(d) of the Investment

Company Act, which mandates retail price maintenance on mutual fund sales

loads.1 That recommendation was never adopted, and as a result, investors are

faced today with a confusing array of load share classes that prevent too many

investors from understanding how they are paying for their sales commission—

via a front-end load, a back-end load, or level load. The proliferation of Class

A, B, and C shares leads to conflicts, as brokers could push investors into a

class that may not be appropriate for their situation. If Congress acted to unfix

sales loads, the SEC should do away with the confusing proliferation of load share

classes.

All of these steps would put investors in the driver’s seat—helping them better

understand what they are paying for and giving them better tools for making informed investment decisions.

It is critically important, though, that we focus on the quality not just the quantity of these disclosures. Mutual fund documents are already too complex. They are

littered with legalese and fine print that too few investors can understand, when

they bother to read it at all. There is a danger that additional disclosure will further

overwhelm investors. The SEC has made important progress in recent years in its

plain English initiatives—it should apply those principles here as well, ensuring

that new disclosures are presented as simply and as conspicuously as possible, and

that they facilitate comparability and clarity.

‘‘Hard 4 p.m. Close’’ Will Harm Investors

Unfortunately, Mr. Chairman, one of the highest-profile proposals to emerge from

the SEC would undermine all of these efforts. The so-called ‘‘Hard 4 p.m. Close’’

represents a step backward for investors. While well-intentioned, it does nothing to

increase transparency, minimize conflicts, or maximize convenience. Instead, it undermines the goal of competition and would deprive investors of choice.

The SEC proposal would require all fund orders to be received by fund companies

by Market Close, generally 4 p.m. Eastern time, to receive that day’s price. To

accomplish that, intermediaries, such as Schwab, would have to impose an earlier

cut-off time, perhaps at 2:30 or 3 p.m., to process, verify, and aggregate those orders

before submitting them to the fund company. Furthermore, because of the addiVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00368 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
357

tional regulatory requirements surrounding the processing of retirement plan

trades, an even earlier cut-off time would have to be imposed for retirement plan

participants. The result is a confusing array of different rules depending on how the

individual invests.

In considering the impact of the ‘‘Hard 4,’’ it is important first to understand how

mutual funds transactions currently work. At Schwab, we receive mutual fund orders throughout the day and night from individual investors, registered investment

advisers, clearing firms, and retirement plan administrators. Those orders come in

to live representatives, via our website, over the telephone, even via wireless communication devices. Close to 90 percent of our orders are received through the electronic channels with minimal or no human intervention. Whenever and however

those orders are placed, they are promptly entered into our system and electronically time-stamped. Our system automatically and in real time aggregates the order

for the appropriate day’s price. Orders received up until Market Close automatically

receive today’s price; orders received after Market Close automatically receive the

next day’s price.

Once the market closes, Schwab engages in a review process to ensure the accuracy and integrity of our aggregate omnibus orders prior to sending them to the

funds. For the majority of our mutual fund business, orders are aggregated by order

type and are transmitted as a single omnibus level order to the fund. Aggregating

the orders provides real economic value and minimizes the expenses to us and the

funds. We also use this small window of time to proactively notify fund companies

of any large purchase and redemption orders from clients. This gives fund companies the time needed to contact their portfolio managers and make an informed decision regarding the order (taking into account client trading behavior, fund flows,

and market conditions) and communicate back to Schwab. Schwab also needs time

to cancel the order(s) if the fund elects to reject the purchase. Since a rejected order

may involve multiple orders for hundreds of accounts managed by a registered investment adviser, the process of canceling a rejected order may take upwards of 30

minutes. This is important since we do not want to transmit orders that have been

rejected by the fund. This ultimately protects the funds (and Schwab) from the operational and financial risks associated with canceling orders that have been rejected

after they were transmitted to the funds.

Typically, this entire review process is completed within 60 to 90 minutes and our

omnibus orders are submitted to the various fund companies between 5 and 5:30

p.m., Eastern time. For many intermediaries, the process takes much longer, and

orders are submitted to fund companies well into the night. It is, of course, this gap

in time, between 4 p.m., when the market closes, and the time when orders are submitted to the fund company, that the SEC has identified as the period some have

taken advantage of to engage in the prohibited activity known as ‘‘late trading.’’ The

‘‘Hard 4’’ solution proposed by the SEC is an attempt to deal with this problem.

We at Schwab share the Committee’s disappointment at the illegal late trading

activity that has been uncovered in the industry, and we strongly support regulatory

and legislative steps to ensure that this kind of activity is eliminated. We have a

proposal, which we call the ‘‘Smart 4’’ solution, that I outline below. It is a solution

that cracks down on late trading without disadvantaging different groups of investors. Before I detail that proposal, which we believe is the best solution, let me take

a moment to walk the Committee through the impact of the SEC’s ‘‘Hard 4’’ proposal on various groups of investors:

• Impact on Individual Investors. As the SEC acknowledges in its rule proposal,

substantial changes would be required in the way fund intermediaries process

fund purchase and redemption orders. Today, a mutual fund may accept an order

after Market Close, provided the order was received by an intermediary prior to

Market Close. However, under the Proposed Rules, investors investing through

intermediaries would be required to submit purchase orders prior to an earlier

cut-off time, such as 2 p.m., to allow the intermediary sufficient time to process

the purchase and the redemption orders before submitting them to the fund, its

designated transfer agent, or a registered clearing agency by the 4 p.m. deadline.

Significantly, that earlier cut-off time would likely be different for different intermediaries, depending on the business model and systems capabilities of the particular firm. In other words, an investor who uses Schwab might have a deadline

of 2:30 p.m., but an investor that uses Firm ABC as an intermediary might have

a cut-off time of an hour earlier. Of course, an investor would be able to place

an order directly with a fund company right up until 4 p.m. Yet approximately

88 percent of mutual fund purchases today are executed via an intermediary. Undoubtedly, this variety of cut-off times would be confusing to investors, and it

would create different classes of investors depending on which firms they used to

execute their trades.

358

2See Remarks of Chairman Arthur Levitt, Best Execution: Promise of Integrity, Guardian of

Competition (November 4, 1999); Order Execution Obligations, Securities Exchange Act Release

No. 37619A (September 6, 1996).

Moreover, earlier cut-off times would particularly disadvantage investors on the

West Coast and in Hawaii. For example, West Coast investors might be required

to submit their mutual fund orders to the intermediary by 11 a.m. Pacific Time

(and as early as 8 a.m. in Hawaii) to receive that day’s current price (assuming

a 2 p.m. Eastern time early cut-off time).

Let me also make an observation about the nature of pricing mutual funds. Forward pricing in the fund industry has been necessary to protect existing shareholders, but the reality is that it is not a particularly consumer-friendly feature.

Where else does a consumer make a decision to buy something without knowing

the exact price he/she will pay? Mutual fund investors are promised only that

they will get the appropriate price at the next calculated time. Investors don’t like

this uncertainty, and they take steps to minimize it by placing orders later in the

day when there is less time between when their order is entered and the pricing

time. In fact, over 40 percent of mutual fund orders are received by Schwab during the last 2 hours prior to market close. Sadly, the Hard 4 p.m. Close will create

increased investor dissatisfaction by increasing the time between order placement

and pricing. We owe it to investors to do better, not worse.

• Impact on Retirement Plan Participants. More significantly, retirement plan participants, because of the increased complexity of aggregating and pricing orders

at the individual and plan levels, would have even earlier, less convenient cutoffs than ordinary retail investors. The latest order cut-off a retirement plan could

administer likely would be 12 p.m. Eastern time. In practice then, as acknowledged by the SEC in its proposal, almost all retirement plan participants would

as a result receive next-day pricing, not same-day pricing.

The proposal would have other unfortunate consequences for retirement plans.

Under the proposed rules, retirement plans will face strong pressure to offer

choices only from a single fund family, which would allow orders to be placed up

until the market closes. In this way, retirement plans will be able to take participant orders later than if the orders were first routed through an intermediary

such as a broker-dealer. However, limiting plan participants to a single fund family will be a detriment for 401(k) plan participants. It will reduce choice and the

ability to diversify retirement assets across multiple fund families. Reducing participant choice will encourage higher operating expense ratios and other costs. As

a result of reduced choice and increased costs, plan participants could face increased risk and decreased returns.

Forcing retirement plan participants to get next-day pricing would also raise

serious fiduciary issues for retirement plan sponsors as to whether they should

offer mutual funds as an investment option at all, when other pooled investment

vehicles (such as bank collective trust funds and insurance company separate accounts) with same-day pricing are available as alternatives. It would be unfortunate if the ‘‘Hard 4’’ proposal created an incentive for 401(k) plan participants,

who include less sophisticated investors, to receive investment choices with a

lower level of investor protection.

One of the issues that frustrates me most in this context is the claim that retirement plan participants are, or at least should be, long-term investors, for

whom the price of a mutual fund on a particular day is not that important. While

the effect of next-day pricing on a single investor may be small, the aggregate effect on all investors is large. SEC statements over time on best execution (in the

equities context), for example, make clear the SEC’s view that it is a serious

breach of fiduciary duty to short-change investors by a few pennies per share. In

the aggregate, especially over long periods of time, pennies matter.2 Long-term investors should be fully invested; systematically having money uninvested for a

day will increase long-term tracking error and disadvantage investors (especially

since significant market events will occur on some of the uninvested days). Furthermore, it will undermine 401(k) plan participants’ confidence in mutual funds

if they are forced to wait an extra day to sell in a falling market, or to buy in

a rising market. The Government should not be in the business of determining

what is and is not an ‘‘appropriate’’ investing strategy for a retirement plan

participant.

• Impact of an Early Order Cut-Off on Investors’ Use of Intermediaries. Another disadvantage of the ‘‘Hard 4’’ proposal is that it will create a strong disincentive to

invest in mutual funds through intermediaries, which benefit investors in many

ways. As I have already detailed, intermediaries are more convenient for investors. They allow clients to see all of types of assets, including mutual funds from

359

3See Memorandum from Paul F. Roye Re: Correspondence from Chairman Richard H. Baker,

House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises,

June 9, 2003, at 73; Investment Company Institute, 1998 SEC No-Act LEXIS 976 at *6 (publicly

available October 30, 1998).

different fund families, equities, bonds, and other investments, on a single web

page and/or a single statement; enhance clients’ ability to comparison shop among

different fund families and make more informed decisions; foster more robust

competition in the industry; and allow investors to move money more easily from

one fund family to another. The SEC staff has repeatedly noted the benefits to

investors of fund supermarkets, as recently as in a letter to the House Financial

Services Committee last summer. 3

• Impact of Early Order Cut-Off on Funds—Cost and Competition. By discouraging

the use of intermediaries and encouraging direct investment with funds, the proposed ‘‘Hard 4’’ would result in all funds having to build more infrastructure for

handling customer service and orders. Today, most fund companies receive a relatively small number of orders—the work of aggregating thousands of customer

orders (and doing all of the attendant sub-accounting) occurs at the broker-dealer,

not at the fund company. Many intermediaries, such as broker-dealers, find it

more efficient to build this infrastructure, where they can leverage the infrastructure they already have for handling orders for other types of securities.

Requiring an early order cut-off for mutual fund orders through intermediaries

will create additional competitive distortions. Newer, smaller, more entrepreneurial mutual funds primarily reach clients through intermediaries and typically

do not have the scale to reach clients directly. If the SEC adopts regulations that

discourage the use of intermediaries, the result may be higher barriers to entry

for new funds and fewer choices for investors. As a result, the mutual fund industry will move toward an oligopoly of large fund complexes with the size and scale

to be able to reach investors directly. The inevitable result of lessened competition

will be higher costs and fewer choices for investors.

Moreover, mutual funds are just one choice among many other types of investments. An earlier cut-off time that applies only to mutual funds would disadvantage these funds compared to investors in competing products that will continue

to have later cut-off times. Equities, exchange-traded funds (ETF’s), closed-end

funds, bank collective trust funds, insurance company separate accounts, and

managed accounts will continue to accept orders up until 4 p.m. A ‘‘Hard 4’’ for

mutual funds would encourage investors to prefer those products to mutual funds.

Many of these other products are less regulated and have less robust disclosure.

‘‘Smart 4’’—A Strong Alternative That Will Protect, Not Harm Investors

Mr. Chairman, the term ‘‘Hard 4’’ is accurate—it will make investing harder. We

prefer an alternative, a ‘‘Smart 4,’’ if you will. It would utilize the best technology,

enhanced compliance and audit requirements, and vigorous enforcement to stamp

out late trading. The SEC included in its recent rule proposals an alternative proposal that incorporates several of our suggestions, but we would recommend going

even further. Our ‘‘Smart 4’’ proposal would allow a fund intermediary to submit

orders after Market Close, provided that the intermediary adopts certain protections

designed to prevent late trading:

• Immediate electronic or physical time-stamping of orders in a manner that cannot

be altered or discarded once the order is entered into the trading system.

• Annual certification that the intermediary and the fund has policies and procedures in place designed to prevent late trades, and that no late trades were submitted to the fund or its designated transfer agent during the period.

• Submission of the intermediary to an annual audit of its controls conducted by

an independent public accountant who would submit their report to the fund’s

chief compliance officer.

• SEC inspection authority over any intermediary that seeks to submit orders it has

received prior to 4 p.m. to the fund company after the market closes.

• Enhanced compliance surveillance policies and procedures that would ensure that

orders were in fact received prior to 4 p.m.

We believe that any intermediary that seeks to submit orders that it received

from its customers prior to 4 p.m. to the fund company after that hour should be

required to adopt the five protections set forth above. Intermediaries should have

the option, however, to avoid adopting these protections if they elect to submit their

orders to the fund company prior to 4 p.m. This approach will be more effective in

preventing instances of late order trades, while avoiding the many hardships that

forcing an earlier cut-off time would impose on millions of mutual fund investors.

360

Schwab believes that the most effective way to stop late trading at both the fund

level and the intermediary level is to make the time that a customer submits an

order transparent to the fund, its independent auditors, and SEC examiners, and

subject the order process to strict compliance controls, certification requirements,

and independent audit and examination. This verifiable, ‘‘Smart 4 p.m. Close,’’ provides a greater level of protection because it applies to all mutual fund orders, while

avoiding the hardship on individual investors imposed by the ‘‘Hard 4 p.m. Close.’’

Let me set forth further details about each of the five elements of this plan:

• Electronic Audit Trail. The mutual fund industry should work together to establish an enhanced electronic audit trail for mutual fund orders. Ideally, this audit

trail should document the time of receipt of the order from the client, the time

of transmittal within a firm (for example, from a branch or call center to a mutual

funds operations group), the time of transmission among intermediaries (for example, from a retirement plan third-party administrator to a broker-dealer), and

the time of transmission from the intermediary to the fund or its transfer agent.

At an absolute minimum, however, the time of receipt of the order from the client

should be captured electronically with the order secured from being altered. In addition, the time stamping should be accompanied by information about the actual

individual who handled or observed that step in the process. Material modifications would require the cancellation of the original order and the entry of a new

order with a new and updated time stamp.

• Annual Certification of Procedures. Entities that handle mutual fund orders—including fund companies and their transfer agents, as well as intermediaries such

as brokerage firms and retirement plan third-party administrators—should issue

annual certifications that they have procedures reasonably designed to prevent or

detect late trading, and that those procedures have been implemented and are

working as designed. Intermediaries would make these certifications available to

any mutual fund on behalf of which it accepts orders for purchase or sale of

shares of the fund. As is typically the case for certifications under the SarbanesOxley Act of 2002, each entity would be responsible for designing a process to give

the individuals signing the certification a reasonable basis for believing it to be

correct. As with the SEC’s recent proposal for investment company and investment adviser compliance programs, the annual certification process would address

whether changes are needed to assure the continued effectiveness of the late-trading procedures.

• Enhanced Auditor Review. All entities that handle mutual fund orders should be

required to conduct an annual auditor review of their late-trade prevention and

detection procedures. For registered intermediaries such as broker-dealers or

banks, we suggest, at a minimum, a standardized SAS 70 or similar review by

independent auditors. An audit review would be based in part on the annual written compliance certification by the intermediary’s management discussed above,

which would in this context serve as the equivalent of a management representation letter for an auditor review. Both the management certification and the results of the auditor review should be provided to the funds on behalf of which the

intermediary accepts orders. Further, if the auditors discover any material control

weaknesses, and management does not promptly correct those weaknesses, the

auditor should be required to escalate that information to the SEC, similar to the

requirement for independent audit escalation under Section 10A of the Securities

Exchange Act of 1934.

• Consent to SEC Inspection Jurisdiction. The SEC should be able to inspect any

intermediary to review whether its late-trade prevention and detection procedures

are adequate and are working as designed. The SEC already has jurisdiction to

inspect broker-dealers who process mutual fund orders; but there should be consistency in oversight. The SEC should require banks and trust companies to ‘‘push

out’’ mutual fund order processing activities to an affiliated broker-dealer registered with the SEC. The Gramm-Leach-Bliley Act contemplated that these types

of securities processing activities (a core part of the definition of broker-dealer

activity in the Exchange Act) would be handled by broker-dealer affiliates; however, regulations implementing this portion of Gramm-Leach-Bliley do not exist.

Alternatively, the SEC could require that banks register as transfer agents to

engage in this type of mutual fund order aggregation and processing.

Unregistered intermediaries should consent to SEC inspection on the grounds

that they are acting as an agent of an SEC-registered mutual fund when they

accept orders for that fund. Indeed, some third-party administrators are already

subject to SEC jurisdiction as registered sub-transfer agents for fund companies.

To the extent intermediaries decline to consent to SEC jurisdiction for inspections,

361

they should be required to submit all trades to a registered intermediary (or directly to the fund or transfer agent) prior to Market Close.

• Enhanced Compliance Surveillance. Even with an electronic order audit trail,

there may be situations where the electronic version of the order is entered

shortly after the market closes (for example, when a client calls just before 4 p.m.

but the registered representative does not finish inputting the order until shortly

after 4 p.m., or when a computer systems problem delays electronic input of the

order). A robust compliance surveillance process can address the potential for

abuse of this process. Firms should require surveillance for suspicious patterns of

potential late orders by a single client, orders entered by related clients (such as

clients of a single adviser), or orders entered by a single registered representative.

Where suspicious patterns exist without adequate contemporaneous explanations,

firms should take prompt actions to investigate and respond appropriately.

In addition, each intermediary’s handling of late orders should be transparent to

the regulators. Funds and intermediaries who accept customer orders up until 4

p.m. should file annually with the SEC a report of trade activities including reporting of any ‘‘late trades’’ with explanations. This reporting would allow visibility and

oversight by the SEC without overwhelming the Agency with the need to inspect

or examine each firm: The SEC could target firms where the late trading filings indicate unusual activity. This process already exists for transfer agents in the current TA–2 filing. Finally, funds and intermediaries should be required to review late

trading policies and procedures with their employees in their annual compliance

continuing education meetings.

Mr. Chairman, this ‘‘Smart 4’’ proposal is, we believe, the most effective way to

combat the pernicious problem of late trading. It is a tough and sensible solution

that will prevent illegal activity but without disadvantaging legitimate investors

who want nothing more than to make very sound investment decisions on a level

playing field.

Other Issues

With the Committee’s indulgence, I would like to conclude by offering specific

comments on two other issues that have been under the spotlight recently.

Fees

There has been considerable discussion in the media and at the Senate Governmental Affairs hearing last month about the subject of mutual fund fees. Some believe that the Government should be mandating fee rates or capping fee rates. I

strongly disagree. This is an extraordinarily competitive industry, which puts tremendous pressure on companies to keep fees low. As an investor, if you believe the

fees a particular fund charges are too high, you have literally thousands of other

funds to choose from. Every investor is different and should be allowed to make his

or her own choices—if a particular fund has a high fee but offers tremendous performance and tremendous service, then an investor can make the decision to pay

for that. Neither Congress nor the regulators should be in the business of mandating fee levels in such a competitive environment.

The other point I want to raise is the issue of how best to disclose fees. In both

the legislative and the regulatory context over the past few months, there has been

considerable discussion of what kind of disclosure is most appropriate and useful to

investors. One idea under consideration is mandating personalized, actual-dollar

disclosure of the fees each unique investor pays. I am not convinced that this kind

of individualized disclosure is actually helpful to investors. First of all, it would be

enormously expensive, and firms would just pass that cost on to investors, increasing the fees. More importantly, I do not believe individualized disclosure facilitates

the kind of apples-to-apples comparisons that investors need. Apparently, the SEC

agrees, for Commissioners approved a rule earlier this month requiring that funds

disclosure, via a standardized example, what the fees are on an investment of

$1,000. This was a sensible decision by the Commission, as it allows for quick sideby-side comparison of different funds, would be a much better solution. We applaud

the Commission for moving so quickly on this rule.

Mutual Fund Governance

On the issue of mutual fund governance, we support the SEC’s proposal for mutual fund boards to have a 75 percent majority of independent directors. We have

concerns, however, about mandating an independent chairman. We believe the independent directors should be empowered to choose whomever they want as a chairman, and that person can be independent or interested. There does not seem to be

a correlation between behavior and having an independent chairman. Indeed, many

of the funds that have had the worst problems over the last few months had an

362

independent chairman. Finally, let me say that Charles R. Schwab is the Chairman

of our mutual fund board. We believe the expertise and experience he brings to the

table is unparalleled. Moreover, we believe his integrity cannot be questioned, and

that his long history of championing the individual investor speaks for itself.

Conclusion

As we move forward we must remember the lessons we have learned from the

evolution of mutual fund supermarkets. We must empower investors by promoting

competition and choice; requiring clear, simple disclosure; and minimizing conflicts.

Investors have given us a roadmap that should guide our reform efforts. We should

also look ahead to solutions that may be further down the road, such as examining

ways to use technology to improve pricing and, perhaps ultimately, to get to more

frequent, even real-time, pricing.

I applaud this Committee for its deliberate approach on this issue. Mutual funds

are the great democratizing force in our markets. They are the vehicle that allows

millions of Americans to participate fully in our Nation’s economic prosperity. However, any reform that confuses investors or erects new barriers for those who want

to participate in mutual funds—including well-intentioned proposals such as the

‘‘Hard 4 p.m. Close’’—will be a step backward, not forward.

Finally, Mr. Chairman, let me conclude by saying that we in the mutual fund industry bear the ultimate responsibility for acting in the best interest of our clients.

Legislation and regulation can only do so much. Most of the failures that have been

publicized were not about inadequate rules, but a failure to follow the letter and

spirit of the rules we have. At Schwab, we are committed to living by the principles

I have outlined for you today.

I appreciate the opportunity to share my views on this critical issue and I would

be happy to answer in writing any follow-up questions Members of the Committee

may have. Thank you.

—————

PREPARED STATEMENT OF MELLODY HOBSON

PRESIDENT, ARIEL CAPITAL MANAGEMENT, LLC/ARIEL MUTUAL FUNDS

FEBRUARY 26, 2004

Thank you, Chairman Shelby, Ranking Member Sarbanes, and Members of the

Committee. I am honored to be here today. The issues facing mutual fund companies demand serious and thoughtful attention from industry leaders, mutual fund

regulators, and from the Members of this Committee. An appalling breach of trust

by some in the fund industry has raised doubts about the industry’s commitment

to integrity—a commitment that hundreds of mutual fund companies and tens of

thousands of fund employees have spent more than 60 years building. As such, I

sincerely thank you for allowing me the opportunity to testify.

I particularly welcome the chance to speak on behalf of hundreds of small mutual

fund companies, and applaud the Committee for its thoughtful consideration of our

special concerns.

I am the President of Ariel Capital Management, LLC, which serves as the investment adviser to the Ariel Mutual Funds, a small mutual fund company based in

Chicago. By way of background, our firm’s Chairman, John W. Rogers, Jr., founded

Ariel over 21 years ago at the young age of 24. John’s exposure to the stock market

began when his father started buying him stocks every birthday and every Christmas instead of toys starting when he was just 12 years old. Ultimately, his childhood hobby evolved into his life’s work—a passion that led to the creation of

our firm.

It is also worth noting that at the time of our inception in 1983, Ariel was the

first minority-owned money management firm in the United States. In many ways,

you can say we are a testament to the American Dream. John and I certainly feel

that way.

In part because of our pioneering status, we work particularly hard to reach out

to those who have not experienced firsthand the wonders of long-term investing,

compound growth, and the creation of enduring wealth. To this end, I also serve as

the financial contributor for a national network news program. Besides educating

all investors, our unique mission is also to make the stock market a regular part

of dinner table conversation in the Black community. Ariel’s four no-load mutual funds hold about $5.5 billion in assets and serve approximately 280,000 investors. So clearly, our responsibilities to investors are quite

large. But it should be just as clear that as a company, in comparison to the largest

mutual fund firms, we are quite small. Ariel has a total of 74 employees.

363

I think it is important for the Committee to be aware that small mutual fund

companies are the norm in our industry, not the exception. In fact, more than 370

mutual fund companies in the United States manage $5 billion or less. Perhaps the

point is stronger if you consider it from a different perspective. If you combined all

the assets of these 370 smaller mutual fund companies that manage $5 billion or

less into a single firm, we would still be a little less than half the size of the Nation’s largest mutual fund company.

Clearly, there are important ways in which Ariel and other small, entrepreneurial

mutual fund firms stand far apart from the giants in our industry. Yet, because of

our vision and hard work—and because of regulatory innovations like the SEC’s

Rule 12b–1—we are able to compete fiercely and often quite successfully with larger

fund companies every single day. In this way too, you can say Ariel is a testament

to the American Dream.

The revelations about trading abuses involving mutual funds are extremely painful. I am, of course, profoundly disappointed about the abuses that have occurred

at mutual funds. Ariel is 100 percent committed to supporting effective reforms that

ensure these abuses will not happen again. I am greatly concerned that mutual fund

investors have had their confidence shaken and my life’s work has been threatened

by individuals motivated by their selfish, shortsighted interests.

Nevertheless, I think it is important to tell you that I still take enormous pride

in being part of a great industry. I do not believe that most mutual fund companies

ignore their fiduciary obligations, have lost their connection to their customers or

abandoned the basic principles of sound investment management. In fact, I believe

nothing could be further from the truth. As a mutual fund executive, I know my

future, my credibility, and my livelihood are inextricably linked to the success of

Ariel shareholders.

The fundamental obligation of a mutual fund company is to provide dependable,

cost-effective, long-term investment products. This is no small feat considering the

destinies of average Americans and the capitalist system itself is at stake. Each day,

my firm, Ariel, strives to do just that. I strongly believe the overwhelming majority

of the Nation’s mutual fund companies work to do the same.

Regarding the three areas I have been asked to address today, I would like to emphasize the potential affects on small mutual fund companies like Ariel.

Fees

First, I would like to address the costs and fees borne by mutual fund shareholders. In order to adequately discuss this issue, it is important for policymakers

to understand not just the sum of mutual fund fees, but also the parts.

A shareholder in a mutual fund is unique. No matter how much is invested, each

receives equal access to all of the benefits the mutual fund offers—diversification,

professional management, liquidity, and simplicity. For example, Ariel investors

who invest $50 per month are afforded the same benefits as those who have multimillion accounts.

Industry critics claim mutual fund fees are excessive when compared to management fees of pension funds and other institutional accounts. This argument is incomplete and wrong. Comparing the fee structure of an institutional account to a

mutual fund is like comparing an apple to an orange. In fact, despite some surface

similarities—mainly the offering of investment management services—the organizational, operational, legal and regulatory frameworks for mutual funds versus institutional accounts could not be more different.

More specifically, total costs for a mutual fund investor include a litany of services

that are not commonly offered to institutional investors. These services have been

developed to increase shareholder access and knowledge. They include phone centers

with licensed service representatives made available to answer any questions; websites that often provide 24-hour account access; compliance, accounting, and legal

oversight; as well as development of everything from the prospectus to the shareholder letter that keep investors informed about how their funds are performing.

In contrast, the management of an institutional account generally only calls for

portfolio management and a letter detailing performance. As opposed to the investment manager, the pension plan sponsor generally is responsible for legal, regulatory, and participant communication. The ICI recently completed an excellent

study of this question. I have attached a copy of it to my testimony as Appendix

1, and commend its key findings to you. Among the most important is the fact that,

when you adjust for the substantial differences between managing mutual funds

and pension plan portfolios, the costs of the two are essentially identical.

Fee differences aside, the total amount mutual fund shareholders are being

charged, contrary to what some claim, has decreased. The SEC, GAO, and ICI have

364

1 ‘‘The Cost of Buying and Owning Mutual Funds,’’ Investment Company Institute, Volume

13, No. 1, February 2004.

all found that substantial majorities of mutual funds lower their fee levels as they

grow, which is the very essence of economies of scale.

In addition, the ICI has found that since 1980, the average cost of owning stock

mutual funds has decreased by 45 percent; bond funds, 42 percent; and money market funds, 38 percent.1 Not to mention, because of the great deal of competition in

our industry, investors can, and do, vote with their feet. This is clear from the fact

that 87 percent of the assets shareholders have invested in stock mutual funds are

in funds whose fees are lower than the industry average. Stated differently, the typical investor’s equity mutual funds have total annual expenses of just 1 percent,

which is nearly 40 percent less than the fees charged by the average fund. The SEC

reached similar conclusions in the mutual fund fee study they completed in 2000.

When an investor buys a fund, they receive a prospectus with a fee table listed

within the first pages which details total cost. A critically important part of the fee

table is the mandatory, standardized example it includes that illustrates the costs

an investor can expect to pay over a 1-, 3-, and 5-year period given a $10,000 investment. This example enables investors to make exact apples-to-apples comparisons

of the total costs of any of the 8,000 mutual funds in the country.

It is for some reason neglected in many of the media reports I see on mutual fund

fees, but the fact is that the fee table was redesigned by the SEC in 1998 following

the most extensive testing with investors ever undertaken by the Agency. Multiple

focus groups were sponsored to determine how to make the fee table as accessible

and useful as possible. And both the SEC and GAO have since testified before Congress that the fee table is an extremely useful and accurate way to compare the

costs of competing mutual fund investments. The SEC has made the further point,

which again is frequently overlooked, that the fee table provides a form of disclosure

to investors that is superior to what is offered by all other financial services.

A significant mutual fund fee issue that has been frequently misunderstood relates to a component of the fund expense ratio called the Rule 12b–1 fee. This issue

is of great importance to small mutual fund companies like Ariel, and impacts our

ability to distribute funds to investors. The easiest way to think about mutual fund

distribution is to equate it to distribution in the film industry. You may be an inspired director and have made a great movie, but if you do not have a distributor,

no movie theaters will get copies of your film and most individuals will never have

a chance to see it.

The same is true of mutual funds. You can have a terrific, well-managed mutual

fund with an excellent track record. But if the fund company does not have access

to wide sources of third-party distribution, it will most likely be a fund without investors. Third-party firms with the scale to offer small mutual funds access to broad

distribution channels obviously must be paid for their services. Rule 12b–1 fees

have been absolutely critical to our effort to expose many small mutual fund companies like Ariel to millions of potential investors around the country.

Finally, on the subject of fees, the mutual fund industry is the only industry I

know of where price increases are rare. In order to raise its management fee, a fund

company must first get a majority of all fund directors to agree. They must then

get a majority of the independent directors to separately vote in favor of the increase. Those steps alone are insufficient: The fund company must ask its shareholders to vote on the increase, and a majority is required for the proposed increase

to take effect.

For this reason and others, price regulation of mutual funds would be directly

counter to the principles of capitalism. With over 500 mutual funds companies and

nearly 8,000 mutual funds, investors have choice. Federal regulation of prices is

often necessitated when there are few competitors and so little choice that the opportunity for monopolistic practices is a threat to the consumer. This is not the case

in our industry.

Governance

Second, the issue of board governance is worthy of some discussion given the recent push to mandate independent chairs for mutual fund boards. While we do have

an independent board chairman at Ariel Mutual Funds, I would argue the designation is irrelevant based upon the unique way in which mutual funds are governed.

More specifically, independent directors already make all of the major decisions

affecting the funds they oversee. For example, independent directors have the

exclusive ability to renew the investment manager’s advisory contract, which is

clearly one of every mutual fund’s largest annual expenses. A full review and renewal of this contract must take place each and every year. Independent directors

365

2 ‘‘Corporate Governance,’’ Remarks by The Honorable Alan Greenspan, Chairman, U.S. Federal Reserve Board, May 8, 2003. 3 Id.

4 ‘‘Taking the Mystery Out of the Marketplace: The SEC’s Consumer Education Campaign,’’

Remarks by The Honorable Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, October 13, 1994. 5 Id.

also have extensive authority with respect to hiring and retaining firms that provide

key services to the fund, such as the fund’s outside auditor. Additionally, independent directors are solely represented on board nominating committees—leaving

affiliated or inside directors little say in the board’s ultimate composition. Finally,

as both the SEC and GAO testified in June of last year, once boards are composed

of a majority or super-majority of independent directors—as most funds already

are—the independent directors are fully empowered to dictate who the chairman of

the board will be.

Another governance-related point worthy of discussion is the newly enacted requirement pertaining to fund company boards and the hiring of a compliance officer.

I certainly understand why the SEC and others—including the ICI—have looked to

such a requirement in response to the abuses revealed in recent months. ICI President Matt Fink has said that he views this particular requirement as one of the

changes most likely to have enduring benefits for funds and their shareholders.

We will defer to policy experts with respect to the likelihood that the compliance

officer requirement will produce the hoped for benefits. But we urge everyone involved to also recognize the substantial disproportionate cost that requirements like

this—and many others currently on the table or being discussed—will pose for

smaller mutual fund companies. We obviously have much more limited resources

than the small number of very large fund companies. Therefore, we hope you and

the other policymakers are aware of the serious impact such requirements will have

on our cost structure and on our competitive position within the industry. While

obviously well-intended, rules of this nature could create a barrier to entry for

future entrepreneurs—like my colleague John Rogers—interested in starting a

fund company.

Disclosure

Federal Reserve Chairman Alan Greenspan recently observed, ‘‘[I]n our laudable

efforts to improve public disclosure, we too often appear to be mistaking more extensive disclosure for greater transparency.’’ 2

Chairman Greenspan said that improved transparency is more important—but

harder to achieve—than improved disclosure. ‘‘Transparency challenges market participants not only to provide information but also to place that information in a context that makes it meaningful.’’ 3 Former SEC Chairman Levitt once expressed a

similar concern, ‘‘[t]he law of unintended results has come into play: Our passion

for full disclosure has created fact-bloated reports, and prospectuses that are more

redundant than revealing.’’ 4

In a report to the House Financial Services Committee last June, the SEC reported that it had adopted 40 new investment company rules since 1998, averaging

one every 7 weeks. The list the SEC developed is attached as Appendix 2. At the

time this represented the busiest period of the SEC’s mutual fund rulemaking in

its history.

Since the first revelation of trading abuses on September 3 last year, the SEC has

averaged one new regulatory action every 2 weeks. During this time, the SEC has

adopted two additional mutual fund rule requirements, proposed nine new regulatory initiatives, and issued a concept release about whether to require a new form

of cost disclosure.

I believe that in responding to new concerns and problems by simply calling for

more disclosure, we risk impeding rather than enhancing decisionmaking by individuals. It is worth remembering that when the SEC overhauled mutual fund prospectuses 6 years ago, the simplified plain English prospectus was hailed as the most

beneficial SEC change to disclosure requirements in the industry’s 60-year history.

At the time they adopted the new prospectus requirements, the SEC urged great

caution about succumbing to the future temptations to add new disclosure requirements, noting that they had learned that too much information ‘‘discourages investors’’ from further reading or ‘‘obscures essential information’’ about the fund.5

Earlier, I mentioned I serve as an on-air financial contributor to a television network news program. I also author a bi-monthly column to aid investors. In these

roles, I have literally received thousands of questions and requests for guidance. The

recurring theme in these appeals for help is that people feel overwhelmed. Young,

old, married, single, Black, white, working, or retired, investors want insight, timeVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00377 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
366

savers, and ways to cut through the noise to get to the most important information

that will help them make the best investment decisions. Rarely do I hear complaints

about too little information. Instead, it is nearly always the opposite—investors

drowning in data and in paper with no ability to assess what really matters. Interestingly, I have received many fairly sophisticated inquiries, but I have never received a question about some of the more esoteric fund company matters currently

under review.

For these reasons, I respectfully suggest that the Committee concentrate a considerable part of its efforts in the weeks ahead on how we could clarify and increase

understanding of the critical mutual fund information that is already disclosed to

individuals. This Committee clearly recognizes from its past work that financial literacy is fundamental to any serious effort to empower investors to make the right

choices that will secure their futures, as well as those of future generations.

At Ariel, we take financial literacy very seriously. We have partnered with

Nuveen Investments to create an investment and financial literacy program at a

Chicago Public School bearing our name. Through this effort, we award each first

grade class a $20,000 gift that follows them through their grade school career. As

the students progress through the school’s unique investment curriculum, so does

their involvement in the portfolio process and the management of their class fund.

The ICI has developed a major initiative with similar goals. Through its Education Foundation—the ICI created a program called Investing for Success Program.

The program is a partnership with the National Urban League, the Coalition of

Black Investors Investment Education Fund, and the Hispanic College Fund. Carefully designed programs have been presented in conferences and workshops across

the country, on the Internet, and at historically Black colleges and universities.

We believe educational programs like these will help diminish the confusion and

fear that shrouds the investment decisionmaking process and replace it with a culture of knowledge and confidence.

Conclusion

My colleagues at Ariel and in the fund industry are grateful for the Committee’s

efforts. When you find effective ways to reinforce investor protections and support

the integrity of our markets, you help our business and our shareholders.

Recent events notwithstanding, it would be deeply regrettable if attempts to

heighten mutual fund company oversight eroded the competitive position of small

firms, one of the most dynamic and entrepreneurial parts of the fund business. For

fund companies such as Ariel, it could seriously impair any efforts to enter and even

remain actively engaged in this marketplace.

Similarly, I urge you to bear in mind the consequences for mutual funds overall

if regulatory burdens increase so much that companies determine it is more attractive to them to market far less regulated investment products and services. I know

that groups like Fund Democracy and the Consumer Federation of America share

this concern, and I too think it merits your serious study.

Thank you again for the privilege of testifying. I look forward to your questions

and appreciate your patience.

367

368

369

370

371

372

373

374

375

376

377

378

379

380

381

382

383

384

385

386

387

388

389

390

391

392

393

*NOTE: Much of the material in this statement was included in a presentation before the Boston Society of Security Analysts on January 14, 2003.

PREPARED STATEMENT OF JOHN C. BOGLE*

FOUNDER AND FORMER CHIEF EXECUTIVE OF THE VANGUARD GROUP

PRESIDENT OF THE BOGLE FINANCIAL MARKETS RESEARCH CENTER

FEBRUARY 26, 2004

Good morning, Chairman Shelby and Members of the Committee. Thank you for

inviting me to speak today.

I hope that my experience in the mutual fund industry will be helpful in considering the issues before you. I have been both a student of, and an active participant

in, the mutual fund industry for more than half a century. My interest began with

an article in the December 1949 issue of Fortune magazine (‘‘Big Money in Boston’’)

that inspired me to write my Princeton University senior thesis (‘‘The Economic

Role of the Investment Company’’) on this subject. Upon graduation in 1951, I joined

Wellington Management Company, one of the industry pioneers, and served as its

Chief Executive from 1967 through January 1974. In September 1974, I founded the

Vanguard Group of Investment Companies, heading the organization until February

1996, and remaining as Senior Chairman and Director until January 2000. Since

then I have served as President of Vanguard’s Bogle Financial Markets Research

Center. The views I express today do not necessarily represent those of Vanguard’s

present management.

The recent market timing scandals that have thrust the mutual fund industry

into the limelight have illustrated, in a most shocking way, this industry’s profile.

But these scandals are but the tip of the iceberg. For they have also illuminated

the fact that too far, too great an extent, this industry has focused on the financial

interests of its managers at the cost of the 95 million citizens who have entrusted

their hard-earned assets to us. While the damage done to our shareholders by allowing selected investors to do market timing at the expense of their fellow fund shareholders has been estimated at some $5 billion, excessive management fees and fund

expenses can easily be siphoning off many times that amount, year after year. And

our focus on marketing speculative funds that pander to the public tastes probably

cost the investing public hundreds of billions of dollars in the recent market crash.

As discouraging as the scandals are to someone like me, who has dedicated his

life to the mutual fund industry, they also have a good side, in that they bring to

light all of the nibbling around the edges of ethical behavior that has been happening for decades. In that respect, the scandals present us a wonderful opportunity

to finally get it right, and I hope that, with the help of Congress and our regulators,

we seize that opportunity. Toward that end, it is high time that we carefully examine how the fund industry works today, and the extent to which it is serving the

national public interest and the interest of investors. The preamble to the Investment Company Act of 1940 demands that funds be ‘‘organized, operated, and managed’’ in the interests of their shareholders rather than in the interests of their

‘‘investment advisers and underwriters.’’ But that sound principle has, I fear, been

turned upside down.

Let me begin with the conclusion I reached in my thesis, all those years ago. My

extensive study of the industry led me to four conclusions: One, that mutual funds

should be managed ‘‘in the most efficient, honest, and economical way possible,’’ and

that fund sales charges and management should be reduced. Two, mutual funds

should not lead the public to the ‘‘expectation of miracles from management,’’ since

funds could ‘‘make no claim to superiority over the (unmanaged) market averages.’’

Three, that ‘‘the principal function (of funds) is the management of their investment

portfolios’’—the trusteeship of investor assets—focusing ‘‘on the performance of the

corporation . . . (not on) the short-term public appraisal of the value of a share (of

stock).’’ And four, that ‘‘the prime responsibility’’ of funds ‘‘must be to their shareholders,’’ to serve the individual investor and the institutional investor alike.

In retrospect, the industry described in my thesis is barely recognizable today.

Not just in size, for, as I predicted, an era of growth lay ahead for this industry,

although I don’t think anyone could have anticipated that mutual funds would grow

from $2 billion in assets then to over $7 trillion today. If my thesis described a tiny

industry, I’m not sure what adjective would be adequate to describe today’s giant.

But the real difference between funds past and funds present, the principal theme

of my statement, is not that dramatic change in size, but the change in the very

character of the industry. A half-century ago, the mutual fund industry was one in

which the idea was to sell what we made: Funds provided a prudently diversified

list of investments, and offered the small investor peace of mind. It was an industry

394

1Sixty-six of these original diversified funds, constituting 90 percent of equity fund assets,

were broadly diversified ‘‘blue chip’’ funds. The remaining nine funds (10 percent of assets) were

largely ‘‘single industry’’ funds that were soon to vanish.

that focused primarily on stewardship. By contrast, the industry we see today is one

focused primarily on salesmanship, an industry in which marketing calls the tune

in which we make what will sell, and in which short-term performance is the name

of the game.

This change in character is not an illusion. Since I entered this industry slightly

over a half-century ago, there are specific, quantifiable ways in which this industry

has changed. Today, I will examine nine of them, and then conclude with an appraisal their impact on the effectiveness with which mutual funds serve their shareholders, and some suggestions on returning this industry to its roots. I will be using

industry averages to measure these changes. Of course some fund firms—not nearly

enough in my view—have strived to retain their original character. But be clear

that the mutual fund industry has changed radically. Let me count the ways:

1. Funds are Far Bigger, More Varied, and More Numerous

The mutual fund industry has become a giant. From its 1949 base of $2 billion,

fund assets soared to $7.2 trillion at the outset of 2004, a compound growth rate

of 16 percent. Then, 90 percent of industry assets were represented by stock funds

and stock-oriented balanced funds. Today, such funds compose just over half of industry assets (54 percent). Bond funds now represent 17 percent of assets, and

money market funds—dating back only to 1970—constitute the remaining 29 percent. Once an equity fund industry, we now span the universe of major financial

instruments—stocks, bonds, and savings reserves—a change that has been a boon

not only to fund investors, but also to fund managers as well.

So too has the number of funds exploded. Those 137 mutual funds of yesteryear

have soared to today’s total of 8,200. More relevantly, the total number of common

stock funds has risen from just 75 to 4,600.1 The investor today has more mutual

funds to choose among than common stocks listed on the New York Stock Exchange

(2,800). It is not clear, however, that the nature of this increase has created investor

benefits, for in retrospect, ‘‘choice’’ has done more harm than good.

2. Stock Funds: From the Middle-of-the-Road to the

Four Corners of the Earth

As the number of stock funds soared, so did the variety of objectives and policies

they follow. In 1950, the stock fund sector was dominated by funds that invested

largely in highly diversified portfolios of U.S. corporations with large market capitalizations, with volatility roughly commensurate that of the Standard & Poor’s 500

Stock Index. And today such middle-of-the-road funds represent a distinct minority

of the total. While 2,524 of the 3,599 equity funds measured by Morningstar are

395

2The accepted terminology in equity funds reflects this change. We have come to accept a

nine-box matrix of funds arranged by market capitalization (large, medium, or small) on one

axis, and by investment style (growth, value, or a blend of the two) on the other. Yesteryear’s

middle-of-the-road funds would today find themselves in the ‘‘large-cap blend’’ box, constituting

just 23 percent of the funds in the diversified U.S. fund category, and 14 percent of the

Morningstar all-equity fund total.

considered diversified U.S. stock funds, only 572 funds now closely resemble their

blue-chip ancestors.2

In addition to the diversified U.S. funds, there are 381 specialized funds focused

on narrow industry segments, from technology to telecommunications (particular favorites during the late bubble), and 694 international funds, running the gamut

from diversified funds owning shares of companies all over the globe to highly specialized funds focusing on particular Nations, from China to Russia to Israel. We

offer a fund for every purpose under heaven.

Paradoxically, the major new entrant in the stock fund derby since 1950—the

stock market index fund—represents a throwback to a simpler age. The first index

fund was created in 1975. It holds the 500 stocks in the S&P 500 Index and seeks

to match its return (before costs). With its first cousin, the total stock market index

fund (owning essentially all publicly held U.S. stocks), introduced in 1987, these

consummate middle-of-the-road funds now account for 8 percent of equity fund

assets. On the other hand, there are also market segment index funds (matching,

for example, a technology stock index or an index of Austrian stocks), the antithesis

of their diversified forebears.

In substance, a half-century ago investors could have thrown a dart at a list of

stock funds and had nine chances out of ten to pick a fund whose return was apt

to closely parallel that of the market averages. Today, they have just one chance

out of eight! The 1949 Fortune article noted the allegation that Massachusetts Investors Trust (M.I.T.), the first and then-largest mutual fund, did no more than give

investors ‘‘a piece of the Dow Jones Average.’’ But the author was right when he

presciently added, ‘‘the average is not a bad thing to own.’’ In any event, selecting

mutual funds has, for better or worse, become an art form.

3. From Investment Committee to Broadway Stardom

These vast changes in fund objectives have led to equally vast changes in how

mutual funds are managed. In 1950, the major funds were managed almost entirely

by investment committees, and that original Fortune article pictured the M.I.T.

trustees and their advisory board as they made their investment decisions. There

they are—not quite as dour as the famous Grant Wood portrait of the Iowa couple

in ‘‘American Gothic,’’ but pretty close—distinguished of mien, serious of visage,

doleful of countenance. The picture almost shrieks: We are conservative!

But the demonstrated wisdom of the collective was soon overwhelmed by the perceived brilliance of the individual. The ‘‘Go-Go’’ era of the mid-1960’s introduced

both the concept of far more aggressive ‘‘performance funds’’ and the notion of a

396

‘‘portfolio manager.’’ That era had much in common with the recent bubble, as fund

sponsors introduced hot funds with supercharged returns (often based on cooked-up

numbers), aggressively marketed through stock brokerages. The new game seemed

to call for free-wheeling individual talent, and the portfolio manager gradually became the prevailing standard. Today, the term ‘‘investment committee’’ has vanished, apparently replaced by ‘‘management team.’’ But ‘‘portfolio manager’’ is the

advisory model for some 3,400 funds of the 4,094 stock funds listed in Morningstar.

The coming of the age of portfolio managers who serve as long as they produce

performance moved fund management from the stodgy old consensus-oriented investment committee to a more entrepreneurial, free-form, and far less risk-averse

approach. Before long, moreover, the managers with the hottest short-term records

had been transformed by their employers’ vigorous public relations efforts, and the

enthusiastic cooperation of the media, into ‘‘stars,’’ and a full-fledged star-system

gradually came to pass. A few portfolio managers actually were stars—Fidelity’s

Peter Lynch, Vanguard’s John Neff, Legg Mason’s Bill Miller, for example—but

most proved to be comets, illuminating the fund firmament for a moment in time

and then flaming out, their ashes floating gently down to earth. Even after the devastation of the recent bear market, and the stunning fact that the tenure of the

average portfolio manager is just 5 years, the system remains largely intact.

4. Turnover Goes Through the Roof

Together, the coming of more aggressive funds, the burgeoning emphasis on shortterm performance, and the move from investment committees to portfolio managers

had a profound impact on mutual fund investment strategies—most obviously in

soaring portfolio turnover. At M.I.T. and the other funds described in that Fortune

article, they didn’t even talk about long-term investing. They just did it, simply

because that is what trusteeship is all about. But over the next half-century that

basic tenet was turned on its head, and short-term speculation became the order

of the day.

Not that the long-term focus didn’t resist change. Indeed, between 1950 and 1965,

it was a rare year when fund portfolio turnover much exceeded 16 percent, meaning

that the average fund held its average stock for an average of about 6 years. In the

Go-Go era, that figure nearly tripled, to 48 percent (a 2-year holding period), only

to fall back to an average of 37 percent (a 3-year holding period) after the 1973–

1974 market crash. But that was just the beginning.

With the elimination of fixed commissions on stocks in 1975 and the later burgeoning of electronic trading networks, the unit costs of buying and selling plunged.

Turnover rose accordingly, averaging about 80 percent from the early 1980’s

through 1999. And it has risen even further since then, with fund managers turning

their portfolios over at an astonishing average annual rate of 110 percent(!). Result:

Compared to that earlier 6-year standard that prevailed for so long, the average

stock is now held for just 11 months.

The contrast is stunning. At 16 percent turnover, a $1 billion fund sells $160 million of stocks in a given year and then reinvests the $160 million in other stocks,

$320 million in all. At 110 percent, a $1 billion fund sells and then buys a total

of $2.2 billion of stocks each year—nearly seven times as much. Even with lower

unit transaction costs, it’s hard to imagine that such turnover levels aren’t a major

drain on shareholder assets.

When I say that this industry has moved from investment to speculation, I do not

use the word speculation lightly. Indeed, in my thesis I used Lord Keynes’ terminology, contrasting speculation (forecasting the psychology of the market) with enterprise (forecasting the prospective yield of an asset). I concluded that as funds

grew they would move away from speculation and toward enterprise (which I called

‘‘investment’’), focusing, not on the price of the share but on the value of the corporation. As a result, I concluded, fund managers would supply the stock market

‘‘with a demand for securities that is steady, sophisticated, enlightened, and analytic.’’ I was dead wrong. Mutual fund managers are no longer stock owners. They

are stock traders, as far away as we can possibly be from investing for investment

icon Warren Buffett’s favorite holding period: Forever.

397

5. High Stock Turnover Leads to Low Corporate Responsibility

Whatever the consequences of this high portfolio turnover are for the shareholders

of the funds, it has had dire consequences for the governance of our Nation’s

corporations. In 1949, Fortune wrote, ‘‘one of the pet ideas (of M.I.T.’s Chairman

Merrill Griswold) is that the mutual fund is the ideal champion of . . . the small

stockholder in conversations with corporate management, needling corporations on

dividend policies, blocking mergers, and pitching in on proxy fights.’’ And in my ancient thesis that examined the economic role of mutual funds, I devoted a full chapter to their role ‘‘as an influence on corporate management.’’ Mr. Griswold was not

alone in his activism, and I noted with approval the SEC’s 1940 call on mutual

funds to serve as ‘‘the useful role of representatives of the great number of inarticulate and ineffective individual investors in corporations in which funds are interested.’’ By appraising corporate management critically and expertly, the SEC added,

funds can ‘‘not only serve their own interests, but also the interests of other public

stockholders.’’

It was not to be. Just as my early hope that funds would continue to invest for

the long-term went aborning, so did my hope that funds would observe their responsibilities of corporate citizenship. Of course, the two are hardly unrelated: A fund

that acts as a trader, focusing on the price of a share and holding a stock for but

11 months, may not even own the shares when the time comes to vote them at the

corporation’s next annual meeting. By contrast, a fund that acts as an owner, focusing on the long-term value of the enterprise, has little choice but to regard the

governance of the corporation as of surpassing importance.

A half-century ago, funds owned but 2 percent of the shares of all U.S. corporations. Today, funds own some 23 percent of all stocks. They could wield a potent

‘‘big stick,’’ but with few exceptions, they have failed to do so. As a result of their

long passivity and lassitude on corporate governance issues, fund managers bear no

small share of the responsibility for the failures in corporate governance and

accounting oversight that were among the major forces creating the recent stock

market bubble and the bear market that followed. It is hard to see anything but

good arising when this industry at last returns to its roots and assumes its responsibilities of corporate citizenship.

6. The Fund Shareholders Get the (Wrong) Idea

The change in this industry’s character has radically affected the behavior of the

mutual fund shareholder. In the industry described in the Fortune article as having

‘‘tastes in common stocks that run to the seasoned issues of blue-chip corporations,’’

shareholders bought fund shares and held them. In the 1950’s, and for a dozen

years thereafter, fund redemptions (liquidations of fund shares) averaged 6 percent

of assets annually, suggesting that the average fund investor held his or her shares

for 16 years. Like the managers of the funds they held, fund owners were investing

for the long pull.

398

But as the industry brought out funds that were more and more performanceoriented, often speculative, specialized, and concentrated—funds that behaved increasingly like individual stocks—it attracted more and more investors for whom

the long-term didn’t seem to be relevant. Indeed, in the 1970’s the industry added

a not-so-subtle temptation to investors to trade among funds, an ‘‘exchange privilege’’ that facilitated swaps between funds in a given family. Up, up, up went the

redemption rate, actually reaching 62 percent in the year of the 1987 market crash.

Last year, the redemption rate (including exchanges out of funds) totaled 31 percent,

an average holding period of slightly more than 3 years. The time horizon for the

typical fund investors had tumbled by fully 80 percent .

This change in behavior has forced a change in the delivery mechanism for fund

shares. As ‘‘buy and hold’’ turned to ‘‘pick and choose,’’ the average fund owner who

once held a single equity fund came to hold four. Freedom of choice became the industry watchword, and ‘‘fund supermarkets,’’ with their ‘‘open architecture,’’ made

it easy to quickly move money around in no-load funds. Trading costs are hidden

in the form of access fees for the shelf-space offered by these supermarkets, paid

for by the funds themselves, so that swapping funds seemed to be ‘‘free,’’ tacitly

encouraging fund shareholders to trade from one to another. But while picking

tomorrow’s winners based on yesterday’s performance is theoretically attractive, in

practice it is a strategy that is doomed to failure.

7. The Modern Mutual Funds . . . Made to be Sold

It is easy to lay the responsibility for this astonishing telescoping of holding periods on gullible, flighty, and emotional fund investors, or on the change in the character of our financial markets. After all, the investment climate was relatively

peaceful during the 1950’s and early 1960’s, while the boom and bust in the stock

market bubble of 1997–2002 was clearly a mania driven by the madness of crowds.

But the fund industry was a major contributor to that bubble. Departing from our

time-honored tenet, ‘‘we sell what we make,’’ we jumped on the ‘‘we make what will

sell’’ bandwagon, creating new funds to match the market mania of the moment.

First, it was during the Go-Go era when ‘‘concept stocks’’ were the rage, and at least

one-half of the new funds we formed were ‘‘performance funds,’’ sold not on the

soundness of their policies and strategies, but on the glitter of their often illusory

and sometimes fraudulent records. Then, during the recent market bubble, when

technology and telecom stocks led the way, we formed 494 new technology, telecom,

and Internet funds, and aggressive growth funds favoring these sectors. It was not

just the industry opportunists who sought to capitalize on this foolishness. As the

prices of ‘‘new economy’’ stocks moved relentlessly upward, many of the most

respected firms in the industry—to their later embarrassment—abandoned their

investment discipline, formed speculative funds, and offered them to their clients.

But in the recent mania it was considerably easier to bring the investor sheep into

the new-fund fold. Why? Because funds were now permitted to advertise their returns, and advertise them they did. Consider just one issue of a single magazine:

399

In the March 2000 issue of Money, right at the market peak, 44 mutual funds advertised their performance. Their average return over the previous 12 exuberant

months came to +85.6 percent! Small wonder that this industry took in $555 billion

of new money—more than a half-trillion dollars—during 1998–2000, overwhelmingly invested in the new breed of speculative high-performance funds.

And just as those winners of yesteryear led the market upward and attracted all

that money, so they led the market on the way down and saw it vanish. In 1998–

1999, the hottest 10 funds provided a cumulative average return of 332 percent,

only to decline by 75 percent in 2000–2002. While the resultant net gain of 8 percent for the shareholder of the fund throughout the period, the overwhelming majority came in late, garnering little if any of the upside, and most, if not all, of the

downside. The industry’s cash flow, of course, traced the same up-then-down pattern. Eternally a trailing indicator in this ever-market-sensitive business, the gushing equity cash flow of the boom actually turned negative in the bust—an $18 billion outflow as the market reached its low in 2002. Today, it is not irrational exuberance but rational disenchantment that permeates the community of fund owners.

In another astonishing reversal, this flagrant formation of new funds soon began

to unwind. Fund deaths began to match, and will surely soon exceed, fund births.

But it is not the old middle-of-the-road funds that are dying; it is largely the new

breed of funds—those that sought out the exciting stocks of the new economy and

hyped their records. Most of those stodgy funds of 1950 remain survivors. M.I.T. and

the other 10 largest funds of a half-century ago ($75 million or more in assets!) remain in business today.

Those early funds were, as the saying goes, ‘‘built to last.’’ Typically, 99 percent

of the funds in business at the beginning of each year were still around at its end,

and nearly 90 percent still in business after a decade, with some 10 percent liquidating or merging with another fund. But as ‘‘built to last’’ turned to ‘‘born to die’’

during the Go-Go era, that decade-long failure rate then rose to 60 percent in the

1970’s, only to fall back to 18 percent in the 1980’s. Then, in the 1990’s, the failure

rate soared to 50 percent. The acceleration continued in 2000–2002, with nearly 900

funds giving up the ghost—an annual failure rate averaging 7 percent. If that rate

continues (and there is reason to believe it may accelerate), half of today’s funds

won’t be around a decade hence.

8. The Costs of Fund Ownership

When ‘‘Big Money in Boston’’ featured Massachusetts Investors Trust, it was not

only the oldest and largest mutual fund, but also the least costly. The Fortune article reported that its annual management and operating expenses, paid at the rate

of just 3.20 percent of its investment income, amounted to just $827,000. In 1951,

its ‘‘expense ratio’’ (expenses as a percentage of fund assets) was just 0.29 percent,

the lowest in the industry, and the average expense ratio for the 25 largest funds,

with aggregate assets of but $2.2 billion, was only 0.64 percent.

400

What a difference five decades makes! In 2002, M.I.T.’s expense ratio had risen

to 1.20 percent, and its $126 million of expenses consumed 80 percent(!) of its investment income. The average expense ratio for the equity funds managed by the

25 largest fund complexes has risen 139 percent to 1.53 percent despite the fact that

assets have soared 1,070-fold, to nearly $2.4 trillion. The dollar amount of direct

fund expenses borne by shareholders of all equity funds has risen from an estimated

$15 million in 1950 to something like $35 billion in 2003. There are staggering

economies of scale in mutual fund management, but it is obvious that fund investors

have not only not shared in these economies, but have also been victims of far

higher costs.

Of course, the expense ratio is only part of the cost of fund ownership. And in

those olden days, the industry’s no-load (no sales commission) segment represented

less than 3 percent of industry assets. The predominant form of distribution was

the independent broker-dealer, and the fund buyer typically paid a sales charge

averaging perhaps 6 percent on each purchase. Spread over a then-holding period

of perhaps 15 years, that additional cost of about 0.4 percent per year brought the

all-in direct costs of fund ownership to, say, 1.00 percent annually.

The distribution mechanism has changed. Now, no-load funds are a powerful force

in the industry, accounting for some 40 percent of equity fund assets. And for load

funds, the traditional front-end sales charge has been largely supplanted by a host

of ‘‘alphabet’’ shares, usually with no front-end commission. Rather, the sales charge

is paid in annual installments of 1 percent a year or so, usually aggregating about

6 percent. When this ‘‘distribution fee’’ is included in the fund’s expense ratio, there

are significant conceptual differences in comparing today’s fund expense ratios with

those of a half-century earlier.

The fund industry reports that the costs of fund ownership have steadily declined,

but it is difficult to take that allegation seriously when total fund operating expenses have, as stated earlier, risen more than 3,000-fold(!) since 1950. While the

ratio of fund expenses to fund assets may be lower, such a decline arises only because investors are increasingly choosing no-load funds and low-cost funds, not because of substantial management fee reductions. Stripped of statistical legerdemain,

recent industry data show that direct all-in equity fund expenses amount to 1.46

percent of assets, not far from the crude unweighted 1.66 percent expense ratio reported for the average equity fund.

The industry data on what it calls ‘‘the cost of mutual fund ownership’’ is shockingly understated. Why? Because it omits one of the largest costs of fund ownership.

Portfolio transaction costs—an inseparable part of owning most funds—are ignored,

yet they add something like 0.8 percent per year to that 1.66 percent expense ratio,

bringing the cost to 2.4 percent. Out-of-pocket costs paid by fund investors are also

ignored. Fees paid to financial advisers to select funds (partly replacing those frontend loads) are also ignored. Opportunity cost—the long-term shortfall in the returns

engendered by the cash reserves that nearly all equity funds maintain—is ignored.

Put them all together and it is fair to estimate that the all-in annual costs of mutual

fund ownership now runs in the range of 21⁄2 percent to 3 percent of assets.

What does that mean? While 21⁄2 percent may look like small potatoes compared

to the value of a typical fund investment, such a cost could cut deeply into the

so-called ‘‘equity-premium’’ by which investors expect stock returns to exceed bond

returns, giving the average equity fund investor a return little more than a bondholder, despite the extra risk. Looked at another way, 21⁄2 percent would consume

25 percent of an annual stock market return of 10 percent. Over the long-term, $1

compounded in a 10 percent stock market would grow to $17.50 over 30 years; compounded at 71⁄2 percent—a fund’s return after such costs return—would reduce that

value by exactly one-half, to $8.75. Costs matter!

The astonishing rise in equity fund costs since 1950—despite the truly flabbergasting leap in fund assets, not just on new speculative funds but on old conservative funds—is one more indication that the fund industry has veered from its roots

as an investment profession, moving ever closer to being just another consumer

products business. Further disclosure of the total costs incurred by fund investors

would be a much-needed first step in the long process of reversing this trend.

9. The March of the Entrepreneur

That the line between a business and a profession is an obscure one does not

mean that it does not exist. We think of a business as an undertaking in which the

principal purpose is to earn a profit for the owner, and a profession as an undertaking in which the provider’s purpose is to serve clients. Nonetheless, it must be

clear that every business must entertain some idea of service to others. (Without

that element, the customers would go elsewhere.) And that every profession must

401

3While Vanguard is not included in this list, it is owned by the mutual funds it manages.

also, in some sense, make a profit. (Doctors and lawyers, after all, should earn a

good living.)

But the industry that Fortune described all those years ago clearly placed the emphasis on fund management as a profession—the trusteeship of other people’s

money. The article is peppered with the words ‘‘trust’’ and ‘‘trustee,’’ and frequently

refers to the ‘‘investment-trust industry.’’ Funds were largely middle-of-the-road in

focus, diversified in investments, and built to last. Management fees were used to

pay for, of all things, management. Costs were low, and distribution costs were paid

not by the funds, but by the investors, as they purchased their shares. (M.I.T., for

example, had its own employees (28!), no management company, and no economic

or ownership interest in the company that distributed its shares.)

Today, it seems clear that marketing has superseded management as our industry’s prime focus, the exact opposite of what I called for in my thesis. The industry

spends, I would estimate, at least five times as much on selling as on supervision,

contributing heavily to those soaring expense ratios. Advertising has gone from virtually nonexistent to pervasive (or at least it was until the onset of the great bear

market). We have put aside our professional judgment and formed new funds when

the investing public demanded then, and, when they outlive their usefulness or lose

their performance luster, we give them a decent burial, happily consigning their

records to the dustbin of history.

What caused the sea change in our industry? Perhaps it is that stewardship was

essential for an industry whose birth in 1924 was quickly followed by tough times—

the Depression, and then World War II. Perhaps it is that salesmanship that became the winning strategy in the easy times thereafter, an era of almost

unremitting economic prosperity. Perhaps it is because as we became the investment of choice for American families fund shareholders, with no more efficient way

to own stocks, bonds, and saving reserves, became less discriminating. Perhaps it

was the very genetics of the capitalistic system that drives companies to compete

and win. But I believe that the most powerful force behind the change was that mutual fund management emerged as one of the most profitable businesses in our

Nation, with pretax profit margins that average 40 percent to 50 percent or more.

Entrepreneurs could make big money managing mutual funds.

The fact is that, only a few years after ‘‘Big Money in Boston’’ appeared, the whole

dynamic of entrepreneurship in the fund industry changed. In 1958, it became possible not only to make a tidy profit in managing money, but also to capitalize that

profit by selling shares of a management company to outside investors. Up until

then, the SEC had successfully defended its position that the sale of a management

company represented the payment for the sale of a fiduciary office, an illegal appropriation of fund assets. Why? Because by allocating future advisory fees to whomever the manager might wish, a sale of the trustee’s office would have taken place.

If such sales were allowed, the SEC feared it would lend to ‘‘trafficking’’ in advisory

contracts, leading to a gross abuse of the trust of fund shareholders.

But in 1954, a California management company, in effect challenging the SEC’s

position, sold its shares to an outside investor. The SEC went to court, and lost. As

1958 ended, the gates that had prevented public ownership for 34 years came tumbling down. Apr`es moi, le deluge! The rush of public offerings began. Within 2 years,

the shares of a dozen management companies, including some of the industry

pioneers, were brought to market via initial public offerings. Over subsequent

years, many others followed. Investors bought management company shares for the

same reasons that they bought Microsoft and IBM and, for that matter, Enron,

because they thought their earnings would grow and their stock prices would rise

accordingly.

But the IPO’s were just the beginning. Most of the companies that went public

were ultimately acquired by other financial companies. Giant banks and insurance

companies also acquired privately held management companies, taking the newly

found opportunity to buy into the burgeoning fund business at a healthy premium—

averaging 10 times book value or more. ‘‘Trafficking’’ wasn’t far off the mark; there

have been at least 40 such acquisitions during the past decade, and the ownership

of some firms has been transferred several times. Today, among the 50 largest fund

managers, only six(!) are privately held, largely by their executives.3 Thirty-six are

owned by giant financial conglomerates, including bank, stock brokers, insurance

companies, and foreign financial firms. (In 1982, even the executives of M.I.T. and

its associated funds sold the management company to Sun Life of Canada.) The

seven remaining firms are publicly held.

It must be clear that when a corporation buys a business—whether a fund manager or not—it expects to earn a hurdle rate of, say, 12 percent on its capital. So

402

if the acquisition cost were $1 billion, the acquirer would likely defy hell and high

water in order to earn at least $120 million per year. In a bull market, that may

be an easy goal. But when the bear market comes, we can expect some combination

of: (1) slashing management costs; (2) adding new types of fees (distribution fees,

for example); (3) maintaining, or even increasing, management fee rates; or even (4)

indeed, the overreaching by managers in the recent fund scandals was often done

to enrich fund managers at the expense of fund shareholders. (The SEC’s ‘‘trafficking’’ in advisory contracts writ large!)

It is not possible to assess with precision the impact of this shift in control of the

mutual fund industry from private to public hands, largely those of giant financial

conglomerates, and the change in the industry from profession to business. But such

a staggering aggregation of managed assets—often hundreds of billions of dollars—

under a single roof, much as it may serve to enhance the development, to whatever

avail, of fund complex’s ‘‘brand name’’ in the consumer goods market, seems unlikely

to make the money management process more effective, nor to drive investor costs

down, nor to enhance this industry’s original notion of stewardship and service.

10. A Half-Century of Change: For Better or Worse?

In short, this industry is a long, long way from the industry described in ‘‘Big

Money in Boston’’ all those years ago. While my characterization of the changes that

have taken place may be subjective, the factual situation I have described is beyond

challenge. This is an infinitely larger industry. The variety of funds has raised the

industry’s risk profile. The management mode was largely by committee but is overwhelmingly by portfolio manager. Fund turnover has taken a great upward leap.

Fund investors do hold their shares for far shorter periods. Marketing is a much

more important portion of fund activities. Fund costs, by any measure, have increased, and sharply. And those closely held private companies that were once the

industry’s sole modus operandi are an endangered species.

All this change has clearly been great for fund managers. The aggregate market

capitalization of all fund managers 50 years ago could be fairly estimated at $40

million. Today, $240 billion would be more like it. Way back in 1967, Nobel Laureate Paul Samuelson was smarter than he imagined when he said, ‘‘there was only

one place to make money in the mutual fund business—as there is only one place

for a temperate man to be in a saloon, behind the bar and not in front of it . . .

so, I invested in a management company.’’

At the start of this statement, I asked whether these nine changes have served

the interests of mutual fund investors. Clearly the answer is a resounding no. It

is a simple statistical matter to determine, using Dr. Samuelson’s formulation, how

well those on the other side of the bar in that saloon have been served, first by the

old industry, then by the new.

• During the first two decades of the period I have covered today (1950–1970), the

annual rate of return of the average equity fund was 10.5 percent, compared to

12.1 percent for Standard & Poor’s 500 Stock Corporate Index, a shortfall of 1.6

403

percentage points, doubtless largely accounted for by the then-moderate costs of

fund ownership. The average fund delivered 87 percent of the market’s annual

return.

• During the past 20 years (1983–2003), the annual rate of return of the average

equity fund was 10.3 percent, compared to 13 percent for the S&P 500 Index, a

shortfall of 2.7 percentage points—69 percent greater than the prior period’s—

largely accounted for by the now-far-higher levels of fund operating and transaction costs. The average fund delivered just 79 percent of the market’s annual

return.

It is the increase in costs, largely alone, that has led to that substantial reduction

in the share of the stock market’s return that the average fund has earned. But it

is the change in the industry’s character that has caused the average fund shareholder to earn far less than the average fund. Why? First, because shareholders

have paid a heavy timing penalty, investing too little of their savings in equity

funds when stocks represented good values during the 1980’s and early 1990’s. Then

enticed by the great bull market and the wiles of mutual fund marketers as the bull

market neared its peak, they invested too much of their savings. Second, because

they have paid a selection penalty, pouring money into ‘‘new economy’’ stocks and

withdrawing it from ‘‘old economy’’ stocks during the bubble, at what proved to be

precisely the wrong moment.

The result of these two penalties: While the stock market provided an annual return of 13 percent during the past 20 years, and the average equity fund earned

an annual return of 10.3 percent, I estimate that the average fund investor earned

just 3 percent per year. It may not surprise you to know that, compounded over two

decades, the nearly 3 percent penalty of costs is huge. But the penalty of character

is even larger—another 8 percentage points. One dollar compounded at 13 percent

grows to $11.50; at 10 percent, to $7.10; and at 3 percent, to just $1.80. A profit of

just eighty cents!

404

The point of this exercise is not precision, but direction. It is impossible to argue

that the totality of human beings who have entrusted their hard-earned dollars to

the care of mutual fund managers has been well-served by the myriad changes that

have taken place from mutual funds past to mutual funds present. What about

mutual funds yet to come? My answer will not surprise you. It is time to go back

to our roots; to put mutual fund shareholders back in the driver’s seat, to put the

interests of shareholders ahead of the interests of managers and distributions, just

as the 1940 Investment Company Act demands.

It Is Time For Change

It is time for change in the mutual fund industry. We need to rebalance the scale

on which the respective interests of fund managers and fund shareholders are

weighed. Despite the express language of the 1940 Act that arguably calls for all

of the weight to be on the side of fund shareholders, it is the managers’ side of the

scale that is virtually touching the ground. To get a preponderance of the weight

on the shareholders’ side, we need Congress to mandate: (1) an independent fund

board chairman; (2) no more than a single management company director; (3) a fund

staff or independent consultant that provides objective information to the board; (4)

a Federal standard that, using the Act’s present formulation, provides that directors

have a fiduciary duty to assure that ‘‘funds are organized, operated, and managed

in the interests of their shareholders’’ rather than in the interests of ‘‘their advisers

and distributors;’’ (The italicized language would be added to the statute.) (5) that

boards of directors consider a mutual structure once a fund complex reaches a

certain size.

In addition to legislation that will begin the process of reforming fund governance

in the interests of fund owners, we also need better information for mutual fund

shareholders, including: (1) annual statements that show the actual dollar amount

of annualized fund expenses and portfolio transaction costs paid by each investor;

(2) mandatory reporting, not only of the standard returns of an investment in a single share of the fund (‘‘time-weighted’’ returns), but also the returns actually earned

on the fund’s total assets (‘‘dollar-weighted’’ returns); (3) an economic study of the

fund industry by the Securities and Exchange Commission showing all of the costs

assumed by fund owners, and the itemized list of expenses incurred by their managers, as well as the managers’ profits; (4) complete disclosure of all compensation

paid to mutual fund executives, including total compensation paid to senior executives and portfolio managers, including their share of the management company’s

profits; and (5) an express requirement that compels advisers to provide, and fund

directors to consider, the amount and structure of fees paid to the adviser by institutional clients. The disparities in these fees are shocking.

As I wrote 5 years ago in Common Sense on Mutual Funds, changes such as these

would at long last allow independent directors ‘‘to become ferocious advocates for the

rights and interests of the mutual fund shareholders they represent . . . they would

negotiate aggressively with the fund adviser . . . they would demand performanceVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00416 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
405

related fees that enrich managers only as fund investors are themselves enriched.

. . . They would challenge the use of 12b–1 distribution fees . . . and no longer rubber-stamp gimmick funds cooked-up by marketing executives . . . becoming the

fiduciaries they are supposed to be under the law.’’

Alternatively, and perhaps even more desirably, I then argued, the industry may

require ‘‘a radical restructuring—the mutualization of at least part of the mutual

fund industry. . . . Funds—or at least large fund families—would run themselves;

and the huge profits now earned by external managers would be diverted to the

shareholders . . . they wouldn’t waste money on costly marketing companies designed to bring in new investors at the expense of existing investors. With lower

costs, they would produce higher returns and/or assume lower risks. But regardless

of the exact structure—(a new) conventional form or a truly mutual form—an arrangement in which fund shareholders and their directors are in working control of

a fund will lead . . . to an industry that will enhance economic value for fund

shareholders.’’ And it is in that direction that this industry must at last move.

***

Addendum: A Fair Shake for Federal Government Employees

It is a curious irony that the ‘‘radical restructuring’’ I called for in the final paragraph of my regular testimony is already in place for the employees of the Federal

Government. The Thrift Savings Plan (TSP), established by Congress in 1986, is a

defined contribution plan governed by their Federal Retirement Thrift Plan Board,

an independent Government agency. The members of the Board are required by law

to manage the Plan prudently and solely in the interests of the participants and their

beneficiaries.

In effect, the TSP joins Vanguard as the second mutual mutual fund organization,

operated on an ‘‘at cost’’ basis and managed for the benefit of its participants. TSP

invests in fixed-income securities, stocks of large companies, small capitalization

stocks, and international stocks, all ‘‘indexed’’ to track appropriate market benchmarks (for example, the Standard & Poor’s 500 Stock Index). TSP has negotiated

with Barclays the fees paid for those indexing services, which last year came to

$4,270,000, equal to 0.005 percent, or just one-half of one basis point. (A basis point

equals one-tenth of 1 percent.) Including administrative expenses, the Plan’s ‘‘expense ratio’’—expenses as a percentage of average assets—was 0.07 percent (seven

basis points).

As the attached table shows, TSP would have by far the lowest costs of the equity

funds managed by the 25 largest equity fund managers—roughly 95 percent lower(!)

than the average manager’s expense ratio of 1.60 percent, and even 30 basis points

below Vanguard’s industry-low 0.37 percent equity fund expense ratio. (Vanguard’s

equity funds are both indexed and actively managed.) The TSP has been a remarkable success. Were it a conventional fund complex, its $129 billion of assets at the

beginning of 2004 would mark it as the 13th largest firm in the industry.

TSP has provided enormous benefits to Federal employees, has operated in the

way that Vanguard operates, has been totally immune to scandal or to any of the

nine baneful trends described in my statement, and has served its owners well. The

TSP large cap stock fund, for example, delivered an annual return of 9.29 percent

to its investors during 1993–2002, after all administrative expenses, management

fees, and trading costs, compared to the return of 9.34 percent of the (cost-free)

Standard & Poor’s 500 Index, a shortfall of just five basis points. The average equity

fund, on the other hand, (see chart 10b) has tended to fall some 270 basis points

per year behind the Index, creating a staggering shortfall in investment returns.

General mutual fund investors deserve to be as well-served as Federal Government employees. I believe the optimal way to encourage the industry to move in

that direction is to enforce the objective of the Investment Company Act of 1940

that requires that funds be ‘‘organized, operated, and managed,’’ not in the interests

of their managers and distributors, but solely in the interests of their shareholders,

just as is the Federal Employees Thrift Savings Plan. I recommend that the Act be

amended to include: (1) imposing upon fund directors an express statutory Federal

standard of fiduciary duty to fund shareholders; (2) a requirement that no more

than a single management company executive be eligible for membership on the

fund’s board of directors; (3) a requirement that the fund’s chairman be an independent director; and (4) a provision empowering and encouraging fund directors to

employ their own staff to evaluate the costs and returns achieved by their managers

relative to other alternatives.

406

(407)

FUND OPERATIONS AND GOVERNANCE

TUESDAY, MARCH 2, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10:01 a.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

Today, this Committee holds its fifth hearing on reforming the

mutual fund industry. We have two panels this morning.

On the first panel, we have Senator William Armstrong, my

former colleague and the current Independent Director and Chairman of the Oppenheimer Funds; Marvin Mann, Chairman of the

Independent Trustees of the Fidelity Funds; and Vanessa Chang,

who is an Independent Director for the New Perspective Fund.

I expect the witnesses to further our understanding of fund governance practices and principles as we seek to ensure that mutual

fund boards are properly armed to protect shareholder interests.

We will also hear from Michael Miller, who is Managing Director

for The Vanguard Funds. Mr. Miller will discuss the issues surrounding the simultaneous management of mutual funds and other

institutional accounts, such as hedge funds, by portfolio managers.

I am sensitive to the potential for conflicts that can arise through

the side-by-side management of mutual funds and hedge funds.

Like all potential conflict situations, these side-by-side arrangements must be subjected to close scrutiny under strong and active

compliance programs.

I look forward to hearing whether, and how, fund advisers go

about ensuring that fund shareholders are treated fairly and receive equitable share allocations.

The second panel will address the SEC’s recent rule proposal

aimed at halting late trading. As we learned from the recent scandals, late trading was all too common in the industry. In an effort

to shut the window for late trading, the SEC proposed a rule that

would essentially require all mutual fund trades to be reported to

the fund or a registered clearing agency by 4 p.m. Eastern Standard Time.

This proposal is known as a ‘‘Hard 4 p.m. Close.’’ Many contend

that although the ‘‘Hard 4 p.m. Close’’ would deter late trading, it

will have the unintended adverse consequence of limiting investors’

408

access to their mutual fund investments. This unintended consequence will be particularly unfair to 401(k) investors.

The witnesses will discuss how the ‘‘Hard 4 p.m. Close’’ will impact investors and will hopefully offer alternatives that deter late

trading without unintentionally harming investors.

On the second panel, we will hear from Ms. Ann Bergin, Managing Director of the National Securities Clearing Corporation; Mr.

William Bridy, President of Financial Data Services, a subsidiary

of Merrill Lynch; Mr. Raymond McCulloch, Executive Vice President, BB&T Trust; and Mr. David Wray, President, Profit Sharing/

401(k) Council of America. I look forward to your testimony.

Now, I want to recognize Senator Allard for a special recognition.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you, Mr. Chairman. I just want to take

a moment to welcome the panel here and particularly one member

on the panel, former Senator Bill Armstrong. Bill represented my

State of Colorado—in fact, he represented the seat that I now hold

here in the Senate—from 1979 to 1991. He spent 10 years of that

time right here on the Banking Committee.

Chairman SHELBY. Some of it with me.

[Laughter.]

Senator ALLARD. He is recognized as somebody who is very

thoughtful and who was extremely effective while he was here.

I also know he has not been particularly anxious to come back.

It has been over a decade since he has testified before a committee

or even had his words put on any kind of public record around

here. He has certainly been a strong advocate of the free enterprise

system, and I know that he recommends this Committee to new

Members that come into the Senate. I had a discussion with him

when I came to the U.S. Senate, and he recommended that I get

on this Committee—that was a very good recommendation. I have

never regretted that and have thoroughly enjoyed serving with you,

Mr. Chairman, and serving on this particular Committee.

I just wanted to give him my special welcome. I am not going to

be able to stay long because I am on the Budget Committee, so I

won’t be able to hear all your words this morning.

Mr. Chairman, I also have some comments I would like to have

in the record.

Chairman SHELBY. Without objection, they will be made part of

the record.

Senator ALLARD. Thank you very much.

Chairman SHELBY. Before I recognize the panel, I do want to add

something else about Senator Armstrong. He served on this Committee. He was a senior Member of this Committee when I was a

freshman Member, and my first 2 years on the Committee were

your last 2 years in the Senate. He left by choice not by force. I

told him the other day that if he had stayed here, he would be

Chairman of the Committee and I would be one of his lieutenants.

And I would gladly be so.

We have just been joined by Senator Hagel. Do you have any

opening comments?

409

COMMENTS OF SENATOR CHUCK HAGEL

Senator HAGEL. The only comment I would make, Mr. Chairman,

is to welcome our witnesses and, as you have noted, our former colleague and dear friend, Bill Armstrong. I might add that one of the

reasons he is so smart and wise, he is a Nebraskan.

[Laughter.]

As is his wife.

Chairman SHELBY. You are all probably cousins in some way.

[Laughter.]

I could not resist.

Senator HAGEL. Mr. Chairman, thank you.

Chairman SHELBY. Senator Hagel, I think that both of you understand the business model and market forces.

Senator Armstrong, we will start with you. If you have written

testimony it will be made part of the record. You know the Committee. Proceed as you wish.

STATEMENT OF WILLIAM L. ARMSTRONG

INDEPENDENT MUTUAL FUND DIRECTOR AND

CHAIRMAN, OPPENHEIMER FUNDS

FORMER U.S. SENATOR (1979–1991)

Senator ARMSTRONG. Mr. Chairman, thanks very much. Thanks

for the opportunity to be here. Thank you for your gracious comments. The financial services industry and thoughtful people all

over the world are glad that I retired and you became the Chairman of this Committee. And I compliment you for your leadership.

Chairman SHELBY. Maybe I should retire and you would be the

Chairman, if you would show me how the market forces work.

Senator ARMSTRONG. Mr. Chairman, I do not want to take too

much time to say so, but I left because of illness and fatigue. I was

afraid if I stayed too long, my constituents would get sick and tired

of me.

[Laughter.]

I particularly want to thank my dear friend, Wayne Allard, for

his comments. It just reminds me how much I appreciate his

friendship and his service to the people of our State and country.

And to Chuck Hagel, who has been a friend for, I guess, three decades and a person whom I have admired and appreciated, I thank

Senator Hagel for his comments as well.

Mr. Chairman, I am an Independent Mutual Fund Director. I am

the Chairman of 38 Denver-based mutual funds with about 5 million shareholder accounts and $75 billion in assets.

My colleagues and I on these fund boards have learned with

mounting indignation that some people in this industry have betrayed the trust placed in them by shareholders. These people must

be called to account. It seems to me that people who have violated

their trust must be punished. And, in fact, as far as I am concerned, we should throw the book at them.

Having said that, it is important to keep in mind that all of the

wrongdoing has been discovered and can readily be punished under

existing statutes. What has happened does not, in my opinion, call

for sweeping new legislation. In fact, some of the proposals which

have been suggested—and I have reviewed 106 specific proposals

contained in various legislative initiatives and regulatory proVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00421 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
410

posals—some of these actually end up punishing the shareholders.

What an irony it would be if, as a result of the wrongdoing, we

somehow ended up punishing the victims instead of the violators.

Now this is not to say that we should do nothing. Obviously,

there is some action called for, and I take it for granted that Congress should and will act. I think the important thing, though, is

to separate out what will help the shareholders because they

should be, it seems to me, the paramount interest of this Committee and certainly the paramount interest of directors.

Mr. Chairman, broadly speaking, the things that will be good for

shareholders are governance and disclosure, and I would like to

just quickly address two or three items.

First of all, my colleagues and I in the fund industry—and I do

not speak for all of them, but I must say, I have talked to a great

many, probably the chairmen or directors of maybe 25 different

fund families over the last few months. Most of us believe that

independent directors are a good idea. We favor the concept of twothirds or 75 percent of directors being independent, though I would

urge caution in how this is implemented. In one case that I know

of, an 11 member board has 10 members who are independent

under present law, but if the definition was changed in accordance

with some suggestions, suddenly people who are now considered

independent would not be. And to get into conformity, it would require discharging a number of the present directors or actually

adding 13 new directors to the board, which would produce a board

too large to govern effectively; it would be unwieldy and not a desirable outcome.

We favor the independence requirement, but we want it either

phased in or leave the definition alone just to avoid unintended

consequences and either the loss of expertise or creating boards

that are too large.

Many people in the industry favor the concept of an independent

chairman. I am an independent chairman. I generally think that

is a good idea. In fact, I happen to think independent chairmen are

a good idea for most business corporations, not just mutual funds.

But I cannot help but wondering: Why should this be mandated by

law? Why shouldn’t this be left up to individual boards of independent directors to decide whether they want to elect someone

who is an executive or somebody who is an independent trustee?

Why can’t that just be left up to everybody?

Now, for example, if Mr. Mann’s fund finds that he wants to

have an executive chairman and our fund at Oppenheimer has an

independent chairman, if that is fully disclosed, shareholders can

make that decision. And if they decide that they do not like an executive chairman, fine, let them sell their Fidelity shares and buy

Oppenheimer shares and vice versa. In other words, if the people

know, they will work it out for themselves.

Which brings me to the whole topic of disclosure. We think truth

is our friend, and with one exception which I want to mention, we

favor disclosing everything, only to the extent that it does not

become confusing to investors, but basically we think sunshine is

great. We think that regulation is probably to the disadvantage of

shareholders.

411

The one exception, the one place where I personally and my colleagues have some concern about disclosure is when it comes to

disclosing the exact salary of a portfolio manager, which just puts

such people on a shopping list for headhunters and will end up

having people recruited out of the industry into hedge funds and

other financial institutions.

Mr. Chairman, let me just close by saying this: In my written

statement I have submitted commentary on a number of the issues

that are pending, including things that have to do with the next

panel. I will not go into them now, but I do want to say that my

colleagues and I wish the Committee much success in your deliberations. The mutual fund industry is enormously important to

America. Fifty-four million Americans have mutual fund accounts,

with $7 trillion invested. It has been perhaps the most important,

the most significant engine of wealth creation for most American

families, particularly middle-income families who do not have the

financial resources or access to hedge fund managers, separate

accounts, or all of the investment vehicles that are available to the

wealthy. They do not have that. But the mutual fund industry has

made it possible through 8,200 funds for them to have a chance to

create significant wealth, much to their advantage, but also to the

advantage of the whole country because such people do not tend to

become dependent upon the Government for help.

Mr. Chairman, we do wish you well, and needless to say, if my

colleagues or I can ever be of help, we are eager to do so.

Thanks again for the opportunity to be here.

Chairman SHELBY. Thank you.

Ms. Chang.

STATEMENT OF VANESSA C.L. CHANG

INDEPENDENT DIRECTOR

NEW PERSPECTIVE FUND

Ms. CHANG. Thank you and good morning.

Chairman SHELBY. Pull the mike up to you a little bit, please.

Ms. CHANG. Okay.

My name is Vanessa Chee Ling Chang. I serve as an Independent Director, Chair of the Audit Committee, and a member of

the Contracts Committee of New Perspective Fund, also known as

NPF, a member of the American Funds family. The fund is advised

by Capital Research and Management Company, and it has in excess of $30 billion in assets and is sold through third parties.

I appreciate the opportunity to appear before this Committee this

morning to discuss mutual fund governance and my perspective as

an independent director.

I am greatly dismayed by the abuses that have come to light in

this industry over the last couple of months. In particular, I am

distressed, like my colleague Mr. Armstrong, about the abuses that

some industry participants have chosen to benefit themselves unfortunately at the expense of fund investors, causing the current

crisis of confidence. Their behavior is so contrary to my experience

with my fellow directors at American Funds, with the associates at

Capital Research, and in particular, independent directors of other

funds whom I have gotten to know and with whom I have had industry discussions.

412

I commend Congress’ and the regulators’ interest, especially the

SEC, in restoring investor confidence and faith in our capital markets. Clearly, some regulatory response is necessary. I thank this

Committee for your thoughtful consideration to determine what

legislative response may be necessary.

My testimony this morning will focus on two areas: First, I will

discuss the operation of a fund board and my experience in carrying out my duties and responsibilities as an independent director.

Second, I will address some of the pending reform proposals that

could affect the duties of an independent director on fund boards

and provide my views on whether they could enhance or hinder our

oversight role.

A shareholder invests in a mutual fund because the investment

strategy and process of the adviser is attractive to that individual

investor. In fact, the investment adviser created the mutual fund

to offer its services on a pooled basis to the investing public who

otherwise could not possibly afford the services of a professional

money manager.

Fund directors are subject to State law duties of loyalty and care.

We are also subject to additional specific duties under the Investment Company Act of 1940 and the SEC. These responsibilities

typically include monitoring for conflicts of interest between the

fund and its adviser and other service providers. One prominent

example of the independence role in protecting against conflicts is

the annual renewal of the adviser’s contract.

A mutual fund has no employees and, therefore, contracts out for

all its services. Accordingly, the mutual fund board must continually focus on the quality of those services and determine whether

the fund has received fair value. The adviser and service providers

manage its operations and provide staff. As fund directors, we are

not charged with managing any of the fund operations. We serve,

however, the interests of fund shareholders through our oversight

of the fund’s operations and of the fund’s service providers such as

the adviser, the auditors, lawyers, and the like.

At NPF, active oversight of the fund’s investment adviser is the

heart of our work. We receive monthly briefings that address the

business, industry, and regulatory developments amongst other

items of interest, and especially in connection with the annual contract renewal. We review and discuss information provided by the

adviser over two board meetings. I have never felt inhibited in asking questions or raising issues that were either not on the agenda

or not in the book.

Only the independent directors, together with our independent

counsel, meet in executive session to discuss all of the information

in connection with this contract renewal. Only after we are all satisfied do we vote on the advisory contracts. All independent directors sit on the Contracts Committees, and only we vote on the contract matters.

My duty as a director is to feel comfortable not just at one point

in time. As a result, throughout the year, I look for or request information that satisfies me that the controls, systems, policies, and

procedures necessary to protect the fund’s investors continue to be

in place. Our board regularly takes the initiative to identify matVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00424 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
413

ters for the adviser to report on at the board meetings or in special

sessions. Management is always responsive to our requests.

Attendance at our board meetings and committee meetings is almost always 100 percent. My fellow directors diligently do their

homework, as evidenced by the tough and probing questions. Independent directors are nominated by the Nominating Committee

that consists of only independent directors. We have a separate

committee consisting of one independent director from each of

the nine clusters to oversee the shareholder operations performed

by a subsidiary of Capital Research. This committee meets biannually with at least one meeting taking place at one of the four

service centers.

Now, I would like to mention a couple of examples of the reforms

that I consider beneficial and most likely will have an impact on

how I discharge my duties as an independent director.

I support broadening the definition of ‘‘interested person,’’ requiring 75 percent of the board be independent, self-assessing the

board performance annually, separate independent director meetings at least four times a year, and requiring the chief compliance

officer to report directly to the independent directors.

On the matter of the independent chair, I do not support the proposal that every mutual fund board must have an independent

chair. In fact, I support choice. Other alternatives that would

strengthen the board equally well, for example, use of a lead director, combined with 75 percent independent directors, independent

nominating committees, and the ability to contribute to the agenda

and control the board discussion.

American funds have nine clusters ranging from 1 to 12 funds

per cluster. For example, the Fixed-Income funds consist of 12

funds, while my cluster has only one fund. I serve on only one

board, but our board meetings coincide with two other global equity

funds—EuroPacific Growth Fund and New World Fund. We meet

quarterly over consecutive days, and we oftentimes have joint

board and Audit Committee meetings.

I like the efficiency and economies of scale provided by these

joint meetings. It is my impression that directors serving on multiple boards benefit in much the same way. I do not believe the

Congress or the SEC should dictate the number of boards an independent director can sit on. There are too many subjective influences, subjective factors to influence this. Instead, I think that the

annual review of the board’s performance will oversee this matter

in an effective way.

With the matter on certification requirements, I understand that

the independent directors or an independent chair is proposed to

certify on a number of matters. I strongly believe an independent

director should not be required to certify matters about which directors have no direct knowledge.

In particular, I am troubled by proposals that will require independent directors to certify that a fund is in compliance with its

policies and procedures to calculate daily net asset values and oversee the flow of funds into and out of the fund.

I inquire and am satisfied that there are controls, procedures,

and policies in place to calculate net asset values and oversee those

fund flows. But neither I nor my fellow directors would be able to

414

certify that that fund is in compliance with those procedures on a

daily basis. It is my view that these certifications, if required,

should be directed to those persons who are responsible for managing the operations.

Putting this responsibility on directors would confuse our role as

overseers with day-to-day managers. Moreover, should these certifications come to pass, it would be difficult to retain and to attract

responsible, conscientious people to serve as board members.

I have found these people, independent board members of other

funds and my fellow directors, to be smart, conscientious, inquisitive, and outspoken.

Thank you, Mr. Chairman.

Chairman SHELBY. Mr. Mann.

STATEMENT OF MARVIN L. MANN

CHAIRMAN OF THE INDEPENDENT TRUSTEES

THE FIDELITY FUNDS

Mr. MANN. Thank you very much, Chairman Shelby, Ranking

Member Sarbanes, and Senator Hagel. I am Marvin Mann, Chairman of the Independent Trustees of the Fidelity Funds. I appreciate this opportunity to appear before you today to discuss mutual

fund governance and how the Fidelity Funds Board does its job. It

is a challenge to do this in 5 minutes.

Today, I am speaking on behalf of the Governance and Nominating Committee of the Fidelity Funds. First, I would like to touch

on recent proposals, including those of the SEC, designed to improve fund governance, and I will do that briefly.

The SEC’s proposal contains several requirements, most of which

I support. Three of the more significant would require that independent trustees constitute 75 percent of a fund’s board, undertake

an annual self-evaluation, and meet separately from management

at least quarterly.

One proposal that I do not support is a requirement that the

board chairman be an independent trustee. A fund’s independent

trustees should, however, have the authority to elect and remove

the chairman.

There are also legislative proposals that would require independent trustees to certify as to certain matters, such as the existence of certain procedures. I would not support such a requirement.

For public companies’ certifications are the responsibility of management, not directors. A certification requirement would create

uncertainty as to the trustee’s duties and potential liabilities.

I do believe that there are measures that should be taken to improve mutual fund regulation. In my written statement, I outline

three proposals that address fund expense disclosure, soft-dollar

arrangements, and arrangements for distributing fund shares.

Frankly, I think that these could be very meaningful actions if

carefully considered. And if time permits, I would be happy to discuss these proposals further.

Now, I would like to turn to how the Fidelity Funds Board exercises our fiduciary duties in our oversight of the 292 funds that we

are responsible for.

First, we accomplish this through five attributes that characterize well-functioning boards: The right people, spending the

415

amount of time that is required, the time commitment, the authority to set the agenda, access to information, and the right organizational approach.

Having the right people is critical. Ten of the 14 trustees of the

Fidelity Funds, or over 70 percent, are independent. The Governance and Nominating Committee, which is composed exclusively of

independent trustees, is responsible for all aspects of independent

trustee recruitment. We recruit people who are highly experienced

at managing large, complex organizations, who are independent in

fact and are prepared to be adversarial, who have the highest personal integrity, and who are able to meet the significant time

commitment.

Let me pause a moment on this last point. The Fidelity Funds

Board has regular meetings 11 times a year. Meetings take two

long and very full days. A significant amount of time is required

to prepare for these meetings.

Independent trustees must have a strong voice in setting the

agenda for board and committee meetings. We approve an annual

calendar that lays out the essential agenda items for the entire

year. Then each month we add additional matters to the agenda for

that month’s meeting.

Information and organization are critical. The Fidelity Funds

Board has a well-defined committee structure that is a key factor

in our ability to oversee the Fidelity Funds and obtain the information we need to carry out our duties. The structure, mission, and

membership of each board committee are decided solely by the

independent trustees. These committees are chaired by and consist

exclusively of independent trustees.

We have 10 committees that address the numerous responsibilities that require our attention. For example, we have three fund

oversight committees, each of which oversees a specific category of

funds and focuses primarily on fund performance. These fund oversight committees provide a good illustration of how our committee

structure works.

The independent trustees receive monthly reports on the performance of all funds. Now these are graphs and charts, so it is

easy to quickly identify funds that are not performing as they

should be. This includes information comparing the performance of

each Fidelity fund to a peer group of funds and to appropriate

securities indices.

Each fund oversight committee conducts regularly scheduled, indepth reviews of the funds it is responsible for. Prior to each fund

review meeting, the board receives written reports and analyses

from the portfolio manager. This material provides the independent

trustees with essentially the same information that Fidelity management uses in its periodic review of its portfolio managers.

At a typical fund review meeting, the Oversight Committee discusses this data and other aspects of fund performance in-depth

with the portfolio managers and their supervisors. Topics include

the fund’s compliance with its investment objectives and its performance, and the highlights of these meetings are reported to and

discussed by the full board.

The fund oversight committees focus on matters unique to each

fund. In contrast, there are a number of operational elements that

416

are generally common to all funds, such as processes related to brokerage allocation, fund operations, accounting, and compliance, and

so on. Several of our committees focus on these common elements.

Given the limits of time, I regret that I cannot provide a more

complete overview of how we do our job, but I have described one

process that gives you some insight into how we exercise our fiduciary duties for the benefit of shareholders.

I appreciate the opportunity to share my views, and I would be

happy to respond to your questions about these and any other

issues. And I respectfully request that my entire written statement

be included in the record.

Chairman SHELBY. Without objection, it will be made part of the

record, Mr. Mann.

Mr. Miller.

STATEMENT OF MICHAEL S. MILLER

MANAGING DIRECTOR, THE VANGUARD GROUP, INC.

Mr. MILLER. Chairman Shelby, Ranking Member Sarbanes, and

Senator Hagel, my name is Mike Miller. I am a Managing Director

at The Vanguard Group, where my responsibilities include selecting and overseeing third-party investment advisory firms that

manage assets for our funds, as well as for our corporate compliance function.

Vanguard understands that in the wake of fund trading scandals

there is some interest in imposing a direct ban on the ability of an

individual to manage both hedge funds and mutual funds, sometimes referred to as side-by-side management. Congress is properly

considering this and other issues relating to the operation and the

regulation of mutual funds. Vanguard appreciates the opportunity

to testify today.

Although Vanguard does not manage or offer hedge funds, we

are very concerned that a ban on side-by-side management will

eliminate a substantial number of investment professionals that

would ordinarily be available to our shareholders. Like Congress,

Vanguard is concerned about protecting the interests of mutual

fund shareholders. We believe that there are ways to effectively

protect the interests of mutual fund clients without taking the extraordinary and potentially damaging step of an outright ban on

managing both hedge funds and mutual funds.

Let me provide just a quick background on Vanguard. We are the

world’s second-largest mutual fund family with more than 17 million shareholder accounts and approximately $725 billion in our

126 U.S. mutual funds. Investment professionals on our own staff

manage about 70 percent of Vanguard’s assets. The remaining

$220 billion or so are in portfolios managed by third-party investment advisory firms, which are hired and overseen by the funds’

boards of trustees with substantial assistance from Vanguard’s professional staff. In all, 37 of our funds receive portfolio management

services from 21 independent advisory firms. We have been selecting and overseeing independent advisers for more than 25 years.

At many investment advisory firms, including Vanguard, other

mutual fund companies, and all the third-party advisers we use,

individual portfolio managers run multiple accounts for multiple

clients. Besides mutual funds, these may include separate acVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00428 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
417

counts, bank common trust accounts, collective trusts, and in some

cases hedge funds. Managing money for multiple clients has always

been an inherent feature of successful asset management firms.

None of the sub-advisers we have hired manages money solely for

Vanguard. Importantly, any firm that manages mutual fund assets

is a registered investment adviser and as such should have in place

policies and procedures that help ensure that the investment

professionals manage multiple accounts in the interest of all of

their clients.

Mutual fund shareholders are protected by a number of practices

today including internal controls and Federal regulation. At Vanguard, the protections for fund shareholders start, of course, with

careful selection of advisers in the first place. Once an adviser is

hired, we continually review the performance and portfolio characteristics of the funds, as well as the investment practices and compliance policies of the adviser.

All of our third-party managers are subject to periodic audits by

Vanguard. Every firm that manages mutual fund assets must be

registered under the Investment Advisers Act and is a fiduciary

under both State and Federal law. Simply stated, this means the

adviser has a duty to recognize and disclose potential investment

conflicts and to manage them appropriately. These potential conflicts are not unique to advisers who provide investment management to mutual funds and hedge funds. They exist whenever a

portfolio manager advises two accounts that differ in any way, potentially even two different mutual funds.

Investment firms typically manage potential conflicts through allocation policies and procedures, internal review processes, and

oversight by directors and independent third parties. Trade allocation systems and controls ensure that no one client is intentionally

favored at the expense of another.

In addition, the SEC has very recently enacted new rules that

will raise industry-wide standards for addressing potential conflicts

for the protection of all investors. These changes are discussed in

my written testimony.

Banning individual portfolio managers from managing mutual

funds and hedge funds would disadvantage and fail to fully protect

mutual fund shareholders.

Allowing side-by-side management of mutual funds and other accounts, including hedge funds, affords mutual fund investors access

to top investment firms and professionals. The supply of exceptional investment professionals is limited. It is important that all

investors, including mutual fund shareholders and 401(k) plan participants, who largely invest in mutual funds, have access to the

same universe of investment expertise available to large institutions or wealthy individuals.

Many mutual funds with strong long-term performance records

are managed by portfolio managers who also invest for other accounts, which may include hedge funds. These managers can

choose where to commit their time and their talent. Hedge funds

can be an attractive option because they allow the use of a broader

range of investment techniques and provide an opportunity to earn

higher fees based on performance.

418

To the extent that a ban causes investment professionals to move

on to accounts not subject to the ban, mutual fund investors would

experience higher portfolio manager turnover. Continuity and stability benefit mutual fund investors. In our experience, they are

among the key determinants of long-term investment success.

A better way, in our opinion, to address concerns about conflicts

of interest is to strengthen compliance procedures, reporting, and

oversight. For example, mutual fund directors should be required

to review and approve stringent procedures to address conflicts of

interest and to review an adviser’s performance under those procedures. Advisers should be required to demonstrate to mutual fund

boards that they have successfully followed their procedures.

Congress and regulators have responded to recent events by demanding more specific protections. The SEC recently strengthened

the position of fund directors in this regard by requiring that every

mutual fund have a chief compliance officer reporting to the directors. Each investment adviser must now have written policies and

procedures for a number of matters, including allocation of trades

among multiple clients. Fund boards must approve the policies and

procedures of their advisers. In addition, the SEC has recently proposed that mutual funds explicitly authorize their independent directors to hire employees or other experts to help them fulfill their

fiduciary duties. We support requiring this authority for directors.

We believe that the combined effect of enhanced compliance

obligations and additional support for independent directors will

protect investors. An outright ban would be a drastic solution in

our opinion, especially in light of recent efforts to impose more

stringent requirements.

Thank you, Mr. Chairman. Vanguard does very much appreciate

the opportunity to testify today, and we would ask that our written

testimony be included in the record.

Chairman SHELBY. Thank you, Mr. Miller.

My first question is for the directors. Many people contend that

an independent chairman is critical to facilitating a vigorous and

challenging boardroom culture. The chairman of any board controls

the agenda, as you well know, and information flow. Would you describe your experiences with either insider or independent fund

chairmen? What are the benefits and the negatives? Also, how do

you address the assertion that an independent chairman requirement is a justified safeguard in light of the inherent conflict of

interest between the adviser and the fund?

Senator Armstrong.

Senator ARMSTRONG. Well, Mr. Chairman, I happen to think that

in most cases an independent chairman is a good idea. The chairman does set the agenda——

Chairman SHELBY. You are an independent chairman.

Senator ARMSTRONG. I am an independent chairman, and I will

just note for the record that I was elected chairman long before

that became a battle cry because of recent developments.

Chairman SHELBY. How large a fund is Oppenheimer?

Senator ARMSTRONG. The funds that I am Chairman of are 38

funds with about $75 billion under management. We are not one

of the biggest, but we are certainly not one of the smallest either.

And there is no doubt that the Chairman has——

419

Chairman SHELBY. You have not been involved in the problems

either, have you?

Senator ARMSTRONG. No. And thank you for noting that, Mr.

Chairman.

Chairman SHELBY. Okay.

[Laughter.]

Senator ARMSTRONG. Happily, we have escaped that notoriety.

I think the issue, however, is not whether I happen to think it

is a good idea. I happen to like strawberry and vanilla, but I do

not think we should outlaw chocolate.

Chairman SHELBY. I agree.

Senator ARMSTRONG. And if there are some people who strongly

feel that an executive chairman, a member of the management

team, is a better choice for a particular fund under particular circumstances, and if that is well disclosed, then I say let the investors decide that.

Chairman SHELBY. Mr. Miller.

Mr. MILLER. Vanguard would fully support Mr. Armstrong’s position. We today have seven directors on our board—one of whom is

an interested director, our Chairman and CEO Jack Brennan; the

other six are independent directors. So about 85 percent of our directors are independent. We feel very strongly that when the rules

require that there be a supermajority of independent directors,

then one should let those directors decide and use their judgment

and their discretion to decide who is best to serve as chairman of

the board. And so we very much believe that the fund boards

should make that determination.

Chairman SHELBY. Mr. Mann.

Mr. MANN. Mr. Chairman, I would perhaps make the comment

that the independent trustees should be able to select the individual that they feel is most qualified to do the job, whether it be

an insider or an independent trustee.

The major considerations I find are whether you are able to have

control over the agenda, whether you are able to structure the

board the way it needs to be structured to get your job done,

whether you have the ability to have independent trustee meetings

so that you can resolve issues where there are conflicts with management, and whether you have an organization and a staff that

is open and willing to provide all of the information you require to

be able to make the judgments that you have to make. That information must be provided in a format that is requested and is efficient to use. And if you have those things, I do not think it really

matters whether the board has an independent chairman or not.

You see, the board meeting itself is not where the work gets

done. I suspect it is a little like the work here. The work gets done

in committees, and the committees are independent trustees.

Chairman SHELBY. But doesn’t the board set the agenda in a

sense, the broad agenda?

Mr. MANN. The board sets the agenda, and I can tell you specifically how it works at Fidelity. We have this annual calendar that

I mentioned that prescribes the required things that we must do.

Then on a monthly basis, early in the month, prior to the board

meeting, we work out specific topics that we want to include in the

next meeting. The Fidelity people put that agenda together because

420

their staff does the work. They contact me. I get input from the

chairmen of the committees. And whatever we suggest gets on the

agenda. There is no debate about it.

Chairman SHELBY. Thank you.

Mr. Miller, the dramatic compensation differences between the

mutual funds and hedge funds create an incentive for portfolio

managers to favor hedge funds, or they seemingly would. If this is

true, how do you ensure that in your case Vanguard’s shareholders

receive fair treatment? Are there processes to manage the conflict

of interest and ensure equitable share allocations here? If so, how

do you do it?

Mr. MILLER. Mr. Chairman, there are clearly conflicts, potential

conflicts of interest between hedge fund managers and mutual fund

managers when they are the same individual, as there are with

other kinds of accounts, not just hedge funds, separate accounts—

I mentioned some in my oral statement.

We work judiciously to ensure that our outside managers that

may run hedge funds, as well as money for Vanguard shareholders

adhere to compliance procedures, policies, written guidelines, and

codes of ethics. Under the law itself, there is a fiduciary duty that

requires that you manage money in a way that does not disadvantage any client over another. And so it is a combination of using

the professional staff of Vanguard—for example, at Vanguard we

have a group called the Portfolio Review Group, which is about 25

individuals, mostly MBAs, CFAs, and CFPs. They work closely

with the outside advisers. They help, you know, in the selection,

the monitoring of what those advisers do for our fund shareholders,

performance issues, things of that sort. Then we meet with our outside managers on a regular basis. They come to Vanguard and

meet with senior management. They come to Vanguard periodically

to meet with our board of directors. We go to their shops. We monitor their own procedures, their own policies, to ensure compliance,

to ensure that there is no favoritism of one client over another.

We have long-term relationships with our managers. We are confident that they understand the protocol, the rules, the procedures,

what is required by law. We go beyond our confidence to inspect,

to enforce, to audit. And they know as a manager for Vanguard

that at any time they are subject to our inspection and our audit

activities to ensure they are managing money correctly on behalf

of all investors fairly.

Chairman SHELBY. Senator Sarbanes.

COMMENTS OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you, Mr. Chairman. I want to join

with you in welcoming the panel and, in particular, our former colleague Bill Armstrong. It is very good to see him back in the Committee room, although at this time on the other side of the table.

I am interested in this issue of the independent directors and the

independent chairman and how that decision is made. The SEC

has put out a rule proposing that 75 percent of the directors be

independent. What is your reaction to that, very quickly?

Senator ARMSTRONG. Mr. Chairman, our board supports that, I

think most directors do, but with this caveat: That if the definition

is simultaneously changed, that is, the definition of interested or

421

independent directors is changed, it could have some unforeseen

consequences.

In one case I know of, it would literally—in order to meet the 75

percent requirement instantaneously, the board would have to discharge several of its existing members who are presently considered to be independent, or add 13 new members to an 11 member

board, creating a board so large that it would not be functional.

So if Congress decides, as I expect they will, to require two-thirds

or 75 percent, which we favor, we would ask that there be a long

phase-in period to accommodate the natural retirement of members

who would otherwise be lost to the process, lose their expertise.

Senator SARBANES. Ms. Chang.

Ms. CHANG. I do support the 75 percent independent director

proposal. In fact, on our fund, we exceed that.

With respect to the definition of interested director, I actually

like that proposal. I like the definition to make it clearer of what

an independent director is and their prior relationships with service providers.

Senator SARBANES. Mr. Mann.

Mr. MANN. The tightening up of the definition of independent

director we think is very good. At Fidelity, 70 percent of the directors—or 71 percent, to be precise, are independent, truly independent trustees. The additional 5 percent, the 75 percent, would

require us to either add independent directors or drop one insider

off the board, who we would not be excited to lose from the board

because they make contributions to the board. But at the next

board meeting, we would probably comply after we were told that

that was the rule, and we would be okay with that.

Senator SARBANES. Mr. Miller.

Mr. MILLER. Senator Sarbanes, we also at Vanguard would support the SEC’s proposal. As you know, the law has long required

that there be a majority of independent directors on the board. The

SEC now says let’s take that to 75 percent. We would be very much

in favor of that. As I noted, we do not favor the chairman necessarily being independent, but we do believe that the 75 percent

proposal makes sense. We do at Vanguard favor a strict definition

of independence and would not be in favor of permitting close relationships to fall within the definition.

Senator SARBANES. Let me ask all of you this question, because

I am interested in your answers, which, of course, range a bit. We

have established the Securities and Exchange Commission. It has

five Commissioners. They have to be appointed by the President

and confirmed by the Senate. We think we look for quality in picking Commissioners, and at the moment I think most of us think we

have quite a good Commission at work.

Traditionally, the SEC has had a very good reputation, although

it has had its ups and downs. It has a highly professional staff, a

lot of expertise and a lot of technical competence.

Should we make these decisions we are talking about by statute

in the Congress as opposed to the SEC making them by regulation?

The SEC has a broad grant of authority, as witnessed by the fact

that they are proposing various rules and regulations now to address some of the problems in the mutual fund industry. They have

a staff that is looking into it. We are giving them more money.

422

They are going to have an upgraded staff. Suppose the SEC were

to decide two-thirds. Should we pass a statute requiring threefourths? Why not?

Mr. MANN. I would say broadly that of all of the things that we

are discussing here, my counsel has been that all of these, perhaps

with one exception, one of the things I am recommending, could be

done by the SEC. The SEC has a very good process of putting out

a proposal and asking for comments. There is a lot of back and

forth and a lot of debate, a lot of enlightenment in the process that

assures that the implications of those rules are well understood

and that there will be a proper transition period during which it

can be implemented, et cetera. And I think it works very well.

So, I think the Senate Banking Committee should give its direction and its ideas to the SEC and then encourage the SEC to act.

Senator SARBANES. Does anyone want to add to that?

Senator ARMSTRONG. Well, Senator Sarbanes, I agree with the

implication of your question that the Senate would be wise to set

the policy but leave the detailed regulation to the SEC, for all the

reasons that you mentioned in your question. But on that same

topic, there is floating around an idea of an oversight board which

would be a separate and new regulatory body. Personally, I think

that would be the worst outcome because if you put the regulation

of the mutual fund industry in a new board and leave the regulation of the securities industry and the brokerage industry in a

board over here, we end up fragmenting the process rather than integrating it and making it strong.

I have met recently with the Chairman of the SEC and members

of his staff, and I sense a great vigor, a great enthusiasm for the

task, and I believe that in most cases, as your question suggests,

in most cases Congress can look to the SEC with confidence for the

solution. Where that cannot happen, where there is doubt about

their authority, then, of course, you would want to act or clarify

their authority in some way.

Senator SARBANES. But where they have authority, you think we

should defer to it as the expert body?

Senator ARMSTRONG. I do, and I think——

Senator SARBANES. Now would you all take that position with

respect to the independent chairman?

Mr. MILLER. I will jump in here, because I do agree with what

my colleagues have said, Senator, with respect to your question

about legislation versus regulation. The SEC has proposed an independent chairman.

Senator SARBANES. They have proposed it. But they have not

adopted it yet, and you all presumably are commenting about it.

Mr. MILLER. Yes, sir, we will be commenting.

Senator SARBANES. What is our role here? Should Congress move

in now and start legislating all these various standards, or should

the Congress say, ‘‘well, you know, this is why we set up the SEC,

this is why we have jumped their budget, just shy of doubling it

in 3 fiscal years.’’ We have this expertise and professionalism. But

there are some times, I say, ‘‘I might have not made that decision

that way myself, but there are enough pros and cons on both sides

that if the expert body makes the decision that way, I am prepared

to accede to it and to give them their role.’’ It is not only the SEC

423

we have set up this way, but we also have set up the Financial Accounting Standards Board to set accounting standards.

Then the issue becomes, is the Congress going to legislate accounting standards if the board seems to be moving in a direction

that people do not like? So there is a one-stage-removed dimension

to all of this, and I want to get from you what you see. Do you

want us in there doing all of these things? Or do you want us sort

of holding back and giving the Commission the chance to do its job?

They have, I think, by and large, a very good process worked out

for reaching the decisions, by proposing rules, taking comments,

and reviewing the comments, it has struck me as being a thoughtful process. I think the industry generally agrees with that.

Mr. Miller.

Mr. MILLER. Senator, absolutely, I believe you have summed up

quite nicely the position this Committee and Congress should take.

The SEC is there, and it has been there for a long time. It works

closely with the industry. At times, the SEC may propose a rule

that the industry or members of the industry would disagree with,

but that is the process.

I believe it is highly appropriate for the Congress, for this Committee, to weigh in with the SEC in terms of your beliefs, your

judgments, your opinions. But I would defer to the expertise of the

SEC and allow them to be the body that governs our industry, the

rulemaking body.

Mr. MANN. I agree.

Ms. CHANG. I agree, too. In addition, with respect to the independent chairman issue, just as your question was the legislative

versus the regulatory process, there needs to be a balance. On the

independent chairman issue, there are funds out there whose

shareholders may not be well-served. In our situation, we have an

interested chairman, and it is because of his or her day-to-day

knowledge, they are able to anticipate problems and to deal with

them well in advance because of their day-to-day knowledge.

Thank you, Senator Sarbanes.

Senator SARBANES. Thank you.

Chairman SHELBY. Senator Bennett.

COMMENTS OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you very much, Mr. Chairman.

I am delighted to have Senator Sarbanes go down the road he

is because we are——

Senator SARBANES. I am just asking hypothetically.

[Laughter.]

Getting the benefit of the witnesses’ wisdom here.

Senator BENNETT. Particularly in this session of Congress, the

idea that we do not have to do something is quite appealing.

But I do think we have a role to play in these hearings as we

set a record and get the combined wisdom of our witnesses. And

while I agree with Senator Sarbanes on FASB and the SEC and

so on, I do ultimately reserve the right as a Member of Congress

to yank their chain a little, pull back their authority a little. They

are, in fact, creatures of the Congress, that is the Congress created

them. And the Congress createth, the Congress can taketh away.

424

I would hope that we do not put ourselves in the position of saying

we will never, ever take a position here.

I think that the role of this Committee in this situation is to

hold hearings of this kind, get your comments on the record, and,

frankly, I think they have more impact on the record before the

Banking Committee and our comments on those comments than

they do in the dry filing being sent over to the SEC.

I am perfectly willing to leave this one to the SEC. I agree that

they are competent to do it. I do have some concerns about potential rigidity of an independent chairman and the definition of what

is an independent chairman.

So in the spirit of what I have just said, to get it on the record

with our reactions, can you describe for me the difference between

an independent chairman and an interested chairman? I do know

the difference between uninterested and disinterested.

[Laughter.]

But I do not know the difference between independent and interested in this context, and I think it would be good for the record

to have that discussed. Yes, sir?

Senator ARMSTRONG. Senator, so far as I know, the term ‘‘independent’’ does not appear in the statute. The term that appears is

‘‘interested.’’ But they mean the same thing in everyday usage, so

far as I am aware.

By the way, I agree with everything you just said.

Senator BENNETT. Well, I thought that ‘‘independent’’ meant

‘‘disinterested.’’

Senator ARMSTRONG. Pardon me?

Senator BENNETT. I have always thought that ‘‘independent’’

meant ‘‘disinterested.’’

Senator ARMSTRONG. Yes, that is correct.

Senator BENNETT. But this is interested, so by definition, it is

not the same thing as disinterested?

Senator ARMSTRONG. I apologize. I jumped to a conclusion I

should not have. ‘‘Interested’’ is what I understand to be described

in the statute, and a person who is independent is said to be ‘‘disinterested.’’

Senator BENNETT. I see.

Senator ARMSTRONG. Perhaps I am not responding to the question that you are asking.

Senator BENNETT. No, no. This is helpful. You are. So, you are

saying the current statute says you have to have an interested

chairman?

Senator ARMSTRONG. No. The current statute is silent on that.

Senator BENNETT. Is silent, so the proposed rule says you have

to have an interested chairman.

Senator ARMSTRONG. Yes.

Senator BENNETT. A disinterested chairman.

Senator ARMSTRONG. I beg your pardon.

Senator BENNETT. Okay.

Senator ARMSTRONG. The point that you made which I thought

was very significant was the idea of retaining authority in this

Committee and in the Senate, and the Congress, to supervise the

process, but deferring, as Senator Sarbanes had suggested, to their

expertise and also to the fact that they have the time to do a

425

thoughtful job. I think that is a very significant point, and forgive

me for leading you into an intellectual cul-de-sac on the distinction.

Senator BENNETT. No, you are helping to clarify.

Ms. Chang.

Ms. CHANG. Senator Bennett, ‘‘independent,’’ or ‘‘disinterested,’’

and ‘‘interested’’ is really two things. They are independent and

disinterested in fact as well as in mind. And as I said in my oral

earlier, I do not support a mandate for an independent chairman.

However, we have an interested chairman, but the individual allows us to control the agenda, to add items to that, and he allows

us to control the discussions. So although he may be interested in

fact, he is actually allowing the board the freedom to discuss what

we want to discuss and the freedom to request the information we

need in order to protect the fund’s investors.

Senator BENNETT. Well, I know how majorities are formed, and

it seems to me if independence controls 75 percent of the seats,

even if the chairman says I want this on the agenda, a quick motion and vote and the agenda gets changed. So, I am not quite sure

how essential it is that the chairman be an independent chairman.

Ms. CHANG. I agree with you.

Senator BENNETT. Okay. Any other comment?

Mr. MILLER. At Vanguard, Senator, we have as our Chairman of

the Board our CEO. He is clearly not independent under the standard that the SEC uses. He is clearly affiliated with Vanguard. He

runs our company. He is our CEO.

There are standards that govern how independent directors, disinterested directors, not-interested directors, however you want to

say it, are defined. Things that, for example, if you formerly

worked with a fund complex and retire, and then the next week go

onto the board, you would not be considered an independent director. There has to be a passage of a certain amount of time. And

there are proposals in some quarters that there be a tightening up

of that definition to make it a stricter definition so that there

would not be close relationships allowed to be independent directors. As I said earlier, Vanguard would favor those proposals and

the tightening up of the standard.

But today at many fund companies, there is an independent

chairman. At some fund companies, there is a nonindependent

chairman. I think many complexes—Vanguard would be one of

them, although we have as the chairman of our board our CEO, we

have a lead outside director, a lead independent director that

works closely with our chairman and CEO, and obviously represents the interest of the supermajority of directors that we have

on the board who are independent.

Senator BENNETT. I want to make one more comment if I could,

Mr. Chairman. There is a trend in industrial corporations, as opposed to the kinds of corporations you run, to move toward a chairman who is not the CEO. But it is not necessarily a chairman who

is ‘‘disinterested.’’ For example, Bill Gates is no longer the CEO of

Microsoft, but you could not say that Bill Gates was not very much

interested in every way in what goes on in Microsoft. The same

thing is true, Andy Grove is the Chairman of Intel, but he is no

longer the CEO of Intel. So the CEO is put in a position where he

clearly is reporting to the board, and that I think is the important

426

issue here rather than whether or not the board chairman knows

anything about the business, because there is always the fear if

you get an independent chairman, he is so independent that he

does not really understand. And in many ways my experience is

you get such an independent chairman, you run the risk of increasing the possibility that the CEO can pull the wool over his eyes

rather than decreasing it, because he is so independent he is divorced from the day-to-day operations and can be conned.

Nobody is going to con Bill Gates as to what is really going on

in Microsoft or Andy Grove as to what is really going on in Intel.

And I would think it might well be if the decision is made that it

cannot be the CEO, it nonetheless must be somebody—can be, not

must be, but nonetheless can be somebody who has a very big financial stake in the organization and a history of dealing with it.

There is a kind of separation there between the chairmanship and

the CEO that does not fit the legal definition of ‘‘disinterested,’’ but

might as a practical matter make a little more sense.

But having put that on the record, I will leave it up to the SEC

to read the record. I am not necessarily looking for a response, but

if you feel you have to, by all means.

Senator ARMSTRONG. Well, Mr. Chairman, the point you have

made, which I agree with completely, illustrates——

Senator BENNETT. This is the Chairman [pointing to Chairman

Shelby]. I am not.

Senator ARMSTRONG. I am sorry. Senator Bennett, the point you

have made——

Senator SARBANES. We are very sensitive to that sort of thing.

[Laughter.]

Senator ARMSTRONG. Yes, I understand that.

[Laughter.]

You are exactly right, but what that illustrates is precisely why

it should be left to the boards of the 8,256 funds to make that decision. They will not all make the same decision based on a different

set of circumstances. And if it is disclosed, it feels to me like that

is a great outcome. Then investors can decide what they think the

right answer is and they will have before them what the fund

boards have decided as well.

Senator BENNETT. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Carper.

COMMENTS OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks very much. I apologize for missing all

of your testimonies. We have some interesting issues on the floor

today, as you may know: Gun control legislation and assault weapons bans and gun show loopholes. I have been involved in some of

that debate, and I apologize for missing what you had to say.

I would just like to start off by asking each of you what role, if

any, do you believe that the Congress should play with respect to

the governance issues that you are discussing and that we are discussing here this morning. I would be interested in hearing what

your thoughts—not disinterested, but I would be interested in

hearing what you have to say.

I want to say, that exchange between you and Senator Bennett

a little bit earlier, Senator Armstrong, was just a classic.

427

[Laughter.]

I wish we could have videotaped that one and shown that one,

say, at orientation for new Senators. It would have been good comic

relief, and maybe instructive, too.

Mr. Miller, do you want to lead off?

Mr. MILLER. Sure. Senator, I believe that—we have discussed

this a little bit this morning, and I believe that it makes very much

sense for Congress, this Committee, to weigh in with their opinions, their judgments, express their policy concerns to the SEC or

whatever agency might be involved. In this case, it is obviously the

SEC that is more involved.

I do believe that the expertise, by and large, rests with the SEC.

I believe that they take the pulse of Congress. I think that they are

smart in that regard. But at the end of the day, probably because

they have the expertise—this is what they do on a full-time basis

and have been doing it for many years. I think because the industry tries to work in conjunction with the SEC to express our issues,

our concerns, to express whether we oppose or favor, you know,

there is a dialogue that goes on. And I think properly it is at the

SEC level that there should be the rulemaking that governs the

governance issues that we are here discussing this morning.

Senator CARPER. So if I understand what you are saying, you are

saying our role is to really have our pulse taken and to share our

sense with the regulators, at least in this instance, and to convey

those beliefs.

Mr. MILLER. I certainly would think that Congress, this Committee, could make its role whatever it wanted to make its role.

But I believe that probably from a prudent standpoint, from the

standpoint of expertise and familiarity, deferring to some extent to

the SEC, again, weighing in very much with your judgments and

your opinions and expressing your beliefs, but looking to the SEC

to set the rulemaking that governs the industry, including these

corporate governance issues, would probably make sense.

Senator CARPER. Thank you.

Mr. Mann.

Mr. MANN. Well, I would say that I think there is significant risk

for Congress to legislate details of corporate governance. That is

what a board of directors is in place to do—to figure out what

needs to be done in a given situation. I believe that most boards

do what they should do.

That does not mean to say that you should not give lots of direction, gather lots of information, and try to influence the process.

But it seems to me that legislation in this particular area would

not be something that you should rush to do.

Senator CARPER. All right. Thanks.

Ms. Chang.

Ms. CHANG. Senator Carper, I agree that Congress should have

a balance here in that having these hearings, you are hearing from

the industry. What is very important here is to make sure that we

restore investors’ confidence and that there is appropriate governance. But as to the actual implementation, it should be left to the

SEC. They have an excellent process. They listen to the industry.

They give us time to comment. But the fund board uses their judgment, their experience, to be able to ask the right questions, followVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00439 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
428

up questions, challenging questions. And if there were legislation,

I am concerned that it might take away the board’s judgment and

their use of the experience just in order to meet those laws.

So, I support leaving it up to the SEC, but with your direction

and the fact that you have shown concern. By having these hearings, I think it has gotten front and center with respect to the SEC.

Senator CARPER. Thank you.

Mr. Armstrong, did you serve in the House of Representatives?

Senator ARMSTRONG. I did, indeed.

Senator CARPER. Did you ever serve in the U.S. Senate?

Senator ARMSTRONG. I did.

Senator CARPER. Well, I have always wondered: Is there life after

politics?

[Laughter.]

Senator ARMSTRONG. Yes, sir, there is.

Senator CARPER. Is it pretty good?

Senator ARMSTRONG. It is not bad.

Senator SARBANES. That is very reassuring to all of us.

[Laughter.]

Senator CARPER. You are in an interesting position because you

have sat in our seats, and maybe even served as a chairman. I do

not know if you were independent.

Chairman SHELBY. He would be Chairman if he had stayed, but

I am glad he left.

[Laughter.]

With all due respect to my friend.

Senator CARPER. Anyway, I think that we would have turned out

okay. But you served here.

Senator ARMSTRONG. I did.

Senator CARPER. Now, you have an interesting perspective from

within the industry. And just take a minute or two and using both

of those hats, just tell me what you feel we should be doing here.

Senator ARMSTRONG. Thank you, Senator. In fact, I think the

Committee is doing exactly what it should do. In light of the disclosures of wrongdoing by a handful, relatively speaking, of the

456,000 people that work in the mutual fund industry, a handful

have stepped across the line and violated shareholder trust in an

ethical or even in a legal manner. I do not think this Committee

or the Senate would or should fail to take that seriously.

The hearings that this Committee is having, which are really a

very ambitious schedule of hearings, are completely appropriate.

And there may be some legislation needed. But it is my impression

that the Securities and Exchange Commission has undertaken a

very, very fast-track, ambitious schedule of reform proposals. I believe that this Committee will be generally well pleased with the

outcome, and I think most of us in the industry are going to be

pleased, at least with some of it. There will be some give and take

as to whether the outcome is satisfactory. I am personally convinced that unless there are areas where we really need to clarify

the authority of the SEC or where Congress wishes to give very

specific direction that it thinks that the SEC needs, then I see no

reason not to leave the responsibility with the SEC, but to make

it clear that this Committee intends to hold the Commission fully

429

accountable for the outcome. But my impression is they are moving

rapidly with a very ambitious agenda.

Senator CARPER. One last quick question, if I could. I am sure

you have said this already earlier in your testimony before, but

with respect to the proposed rules promulgated by the SEC, I think

in January, as they pertain to independent chairmen, what were

your views on that?

Senator ARMSTRONG. Senator, I am an independent chairman.

Senator CARPER. I thought so.

Senator ARMSTRONG. I am generally sympathetic to that idea,

not only for mutual funds but actually for other kinds of boards.

I am a director of several public corporations as well, at least one

of which, partly because I lobbied for it, has an independent chairman. I think there are many times when that is a great idea. But

I do not think it should be mandated by law or by regulation. I

think that is a proper decision for the directors to make, and in

turn, for shareholders to make. If a shareholder thinks that is a

significant issue, then they can, in effect, vote with their feet. They

can put their money in funds that have their preferred form of

organization, but I think a one-size-fits-all approach is probably not

a good answer.

Senator CARPER. Why does it work well for the fund for which

you are the independent chairman? Why does it work well?

Senator ARMSTRONG. To have an independent chairman? Well, I

am not sure that I was elected because I was independent. I was

elected because my predecessor, who had been in the job 30 years,

decided it was time to retire, and we could well have elected someone else who was not technically an independent director. But I am

just convinced that these decisions generally are better left to each

board to decide on a case-by-case basis.

I personally tend to favor independent directors, but I can certainly imagine situations, such as those that are represented at

this table, where that is not the best answer in the shareholders’

interests.

Senator CARPER. All right. Thanks. Thanks to all of you.

Chairman SHELBY. Senator Armstrong, just briefly, if you would,

you serve as chairman of a mutual fund board. You are a director,

of course. So how does this differ from serving on a public company

board? You have done both and there is a difference, isn’t there?

Senator ARMSTRONG. Oh, there is a tremendous difference.

Chairman SHELBY. Just briefly.

Senator ARMSTRONG. Mr. Chairman, the difference in brief is

that a mutual fund board is an oversight responsibility. We do not

run the company. A corporate board, for example, sets the salary

of the CEO——

Chairman SHELBY. You serve on corporate boards.

Senator ARMSTRONG. I do serve on several corporate boards and

have served on seven or eight public corporate boards at one time

or another, where we set the salary of the CEO, the salary of individual corporate officers at the senior level, where we establish the

budget, where we decide when to borrow money, where we decide

what products to do, whether to merge or not—none of which are

matters that properly come before a mutual fund board.

Chairman SHELBY. A mutual fund board.

430

Senator ARMSTRONG. A very different issue.

Chairman SHELBY. Mr. Miller, would you elaborate on how fund

shareholders would be impacted by a ban on side-by-side management of hedge funds and mutual funds? Also if we were to ban

side-by-side management of hedge funds and mutual funds, then

would we also have to ban the simultaneous management of mutual funds and all other institutional accounts? I think there are

unintended consequences here.

Mr. MILLER. Yes, Mr. Chairman, I would say that there are unintended consequences with that ban. I believe that if there were to

be a ban of mutual fund and hedge fund management simultaneously, then at least consistency would suggest that there should

be also a ban of ever managing multiple accounts involving multiple clients. I cannot see how that could work in the best interest

of shareholders. I believe in my statement. I talked a lot about the

fact that there is a relatively scarce commodity of really exceptional

investment talent. I do believe mutual fund shareholders should

have access to that talent, just like wealthy individuals or institutions. I believe 401(k) plan participants, who largely invest in mutual funds, should have access to that talent. And a ban, in my

opinion, would clearly lead to at least some managers choosing the

hedge fund over the mutual fund, in part because they can make

more money running hedge funds.

Chairman SHELBY. Sure. What is the scope of the SEC’s authority over portfolio managers who manage both hedge funds and mutual funds? Does the SEC have increased oversight authority over

a hedge fund in a situation where a portfolio manager manages

both of them?

Mr. MILLER. Hedge funds, Mr. Chairman, tend to be unregistered

and, therefore, not per se subject to the SEC’s jurisdiction. In the

case of side-by-side management——

Chairman SHELBY. Well, Hedge funds are basically private,

aren’t they?

Mr. MILLER. Yes, sir. But in the case of side-by-side management

involving a mutual fund, the SEC has access and jurisdiction because of that mutual fund management, and, therefore, because of

that mutual fund management, have access and enforcement and

inspection authority over the activities of the same person managing the hedge funds.

Chairman SHELBY. Would you quickly describe the fiduciary duties—I think this is important to the integrity of the mutual fund

industry—that a board owes to the fund shareholders? Do you

think that the current fiduciary standards are sufficient to protect

investors? We will start with you, Senator Armstrong?

Senator ARMSTRONG. Yes, sir, I do. I personally think that they

are extraordinarily high, properly so.

Chairman SHELBY. Ms. Chang.

Ms. CHANG. Yes, I agree. In fact, if I could come back to your

question earlier of my colleague, Mr. Armstrong, with respect to

the comparison of corporate boards, there are also a lot of similarities, and this also speaks to your question on fiduciary duties.

Board members at both corporate level and at the mutual fund

level—and I also serve on a corporate board—the quality of the

board members who serve is very important. They must hold manVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00442 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
431

agement accountable. They must look at the performance of the

business, be it a corporate board or a mutual fund, and they must

have an independent mind. They must be inquisitive.

The fiduciary duties, in terms of the standards, I believe are adequate, and I believe we have board members, both in the mutual

fund industry and in the corporate world, who take their responsibilities very seriously.

Thank you, Mr. Chairman.

Chairman SHELBY. Mr. Mann.

Mr. MANN. I think the fiduciary standards are very high, and I

think they are adequate.

Mr. MILLER. I would agree, Mr. Chairman. I think satisfying

one’s fiduciary duty requires the highest possible standard of care

and fair dealing. I think those standards are adequate. They obviously need to be enforced.

Chairman SHELBY. But that is one of the challenges in the industry, maybe not with particular funds but with some funds today.

Mr. MILLER. I would say that is a fair statement, Mr. Chairman.

Chairman SHELBY. Mr. Miller, many contend that fund investors

should receive more disclosure regarding the portfolio’s manager

compensation and fund holdings. How would this information benefit investors and how would it impact fund operations? I think this

is being discussed up here, as you know.

Mr. MILLER. Vanguard is, generally as you know, Mr. Chairman,

I believe in favor of additional disclosure. We think disclosure is

good. I believe that when it comes to—if the proposal would be to

actually disclose the dollar amount of the compensation of a portfolio manager or a senior executive of the fund complex, for that

matter, that is not something Vanguard would favor. If there are

proposals to disclose the structure of compensation, we believe that

could make sense.

There is disclosure today of the fees that are paid to firms that

manage money, and those fees should be properly disclosed, perhaps disclosed better than they are today. There is a difference, I

think, between disclosure of the advisory fees paid to the firm and

the particular compensation, dollar amount compensation of an individual. There we think that there is a common sense of privacy,

just like we treat our shareholders and their information as private. It is a very serious commitment by Vanguard. In some respects you wonder what is the relevance to the investment decision

to know what an individual is making. Someone mentioned earlier

that could open up that individual to every headhunter out there.

I think that would be a real concern. I think that basically——

Chairman SHELBY. That might not necessarily help the fund

holders at all, right?

Mr. MILLER. I think that would not help the fund shareholders

because you might then have that individual leave the management of mutual funds.

Chairman SHELBY. Senator Armstrong, you have a comment?

Senator ARMSTRONG. I think my colleague summed it up very

well. Let us not put a bull’s eye on the chest of these portfolio managers and send headhunters after them.

Chairman SHELBY. You agree, Ms. Chang?

432

Ms. CHANG. Yes, I do, and it also goes to the SEC’s proposal

where the board should determine the compensation of the compliance officer. I disagree there because the fund board hires outside

contractors. An analogy is when I hire the audit firm, I do not require, nor do I set the salary of that partner. So, I would be more

interested in the structure of the compensation.

Chairman SHELBY. Mr. Mann.

Mr. MANN. Mr. Chairman, I would like to make a comment about

disclosure. One of my recommendations is that we should significantly improve the disclosure of fees and expenses. I think, to be

very direct——

Chairman SHELBY. To the shareholders.

Mr. MANN. To the shareholders. To be very direct, I think that

a confirmation statement should be given to the investor when an

investment is made that spells out the mutual fund and brokerage

fees and expenses in dollars and cents. Also in a quarterly or semiannual statement, the same thing, for each investment, what the

expense is in dollars and cents and in percentage terms, so every

investor can see what it is costing to manage their investments.

Chairman SHELBY. It should be done in unvarnished language

too, should it not?

Mr. MANN. In just dollars and cents on their investment. The

SEC has taken a step in that direction to show what the fees are

per $1,000, but if you went through the details, what it would require an individual to really figure out how much money they are

paying in expenses, it is very complicated and very difficult.

On your point specifically, I think it would be a drastic mistake

to disclose the compensation of individual portfolio managers. I

think perhaps disclosing the general structure of compensation

could be worthwhile, and not even the details of that because that

gives out information that would be a competitive problem.

Chairman SHELBY. This question has come up before here. Many

people contend that fund directors are over committed and serve on

too many boards. What are the considerations for determining the

appropriate number of boards on which a director serves, and who

should make that determination?

Senator Armstrong, I will start with you and then move over.

Senator ARMSTRONG. Interestingly, Mr. Chairman, when I was

elected to be Chairman of the Mutual Fund Boards of which I am

Chairman, that is one of the issues which was put to me by my

colleagues before they voted to elect me, and what I told them was

that if they chose to elect me, I would commit to shuck off anything

that proved to be an impediment. I am busy. I have companies of

my own to run, and I am a director of some other public companies.

So, I think it varies with the individual, but clearly, anybody who

is the chairman or a director of a mutual fund has to be prepared

to devote the time and energy to do it. The right people to make

that decision of whether that is happening are the other directors.

Chairman SHELBY. Ms. Chang.

Ms. CHANG. I do not know what the right number is, but I think

there should be balance, and I agree with Mr. Armstrong in that

it really depends on that individual’s own time commitment as long

as that individual is responsible, and they are doing their homework. I do not think the number of boards should be legislated.

433

As I mentioned in my oral comments, I can see the efficiencies

and economies of scale of people sitting on multiple boards.

Chairman SHELBY. Mr. Mann.

Mr. MANN. I guess I would probably be able to speak to this as

well as anyone. We oversee 292 mutual funds at Fidelity.

Chairman SHELBY. How much total money roughly?

Mr. MANN. Over $900 billion.

Chairman SHELBY. Getting toward $1 trillion.

Mr. MANN. Yes.

Chairman SHELBY. Vanguard is right behind you, right?

Mr. MANN. Yes, sir, they are.

[Laughter.]

Chairman SHELBY. Not on your back, but looking at you.

Mr. MANN. We are watching them closely.

Senator SARBANES. You are looking over your shoulder there.

Chairman SHELBY. Go ahead, Mr. Mann.

Mr. MANN. I would say this, that over the 10 years that I have

been an independent trustee, the workload has increased dramatically, not just because of the number of funds that are overseen,

but also because of a lot of other issues that have arisen over the

last 2 or 3 years that have increased the amount of time that one

must spend.

I would say to you that fortunately there is a lot of commonality

of issues in overseeing mutual funds, and you focus on those one

time if you are overseeing 10 funds or 100 or 200 funds, and then

you have to review the individual funds. You review the funds, frequently on an exception basis, and then you have in-depth reviews

periodically as required to make sure that things are going well,

and that proper actions are taken.

Chairman SHELBY. Mr. Miller.

Mr. MILLER. Mr. Chairman, we have at Vanguard a common or

a single board. We think that is highly appropriate. I will give you

just briefly two reasons why: The commonality of the issues that

cut across the various funds of the fund complex, and frankly, the

consistency of the decisionmaking. It helps very much that these

directors oversee all of the complex of the funds because you do get

consistency in the way they look at the issues and they render

their opinions and judgments.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

There is a line of thought that the standard for the fiduciary duties of the directors on these boards is inadequate in light of the

Gartenberg decision in the Second Circuit in 1982. I am not going

to take the time now to press you on that, but I would like you all

to go back and look at that, and let us have the benefit of your

comments. Just to take the example of trustees’ fees, which after

all the board is supposed to actively negotiate on behalf of its

shareholders, this is what the Court said: ‘‘To be found excessive,

the trustee’s fee must be so disproportionately large that it bears

no reasonable relationship to the services rendered and could not

have been the product of arm’s-length bargaining.’’

That is a pretty low standard for a fiduciary duty in my judgment. I have some concern about that, and I know that all of you

said that you thought the standard was appropriate, but I have difVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00445 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
434

ficulty drawing that conclusion looking at this language, the Second Circuit opinion for which the Supreme Court did not give cert

20 years ago.

Mr. Miller, I want to ask you about the hedge fund and the mutual funds, and having individual investment managers managing

both. Now, I take it your position is that if you do not do that, you

are going to lose a lot of talent because people will go off and do

the hedge fund instead of the mutual fund. Is that right, that is

one of the problems?

Mr. MILLER. That is part of the issue, Senator, yes.

Senator SARBANES. As I understand it, Vanguard does not manage hedge funds; is that right?

Mr. MILLER. Vanguard does not manage or offer hedge funds, but

we do use, as I mentioned earlier, a number of outside investment

advisory firms, some of which run mutual funds—hedge funds in

addition to mutual funds.

Senator SARBANES. As I understand it, 70 percent of your assets

are managed by your own people; is that correct?

Mr. MILLER. That is correct, sir.

Senator SARBANES. So, they are excluded from the hedge funds,

is that right?

Mr. MILLER. We do not run hedge funds at Vanguard, so they do

not run hedge funds.

Senator SARBANES. Do you feel you have a talent deficiency with

respect to this 70 percent of the funds you manage, because you do

not do hedge funds, and your people cannot do them? What are you

saying about your own operation by your earlier testimony?

Mr. MILLER. Senator, I would make it very clear that we do not

believe we have a talent deficiency at Vanguard. Frankly, we do

not offer hedge funds. I am sure our people have the talent to do

it, but we——

Senator SARBANES. I take it your position is that even not doing

it, you can still get very good talent at Vanguard, right?

Mr. MILLER. We believe so, yes sir.

Senator SARBANES. Why do you then advance the general proposition that if people cannot do hedge funds and mutual funds you

are not going to be able to get talent?

Mr. MILLER. What we are saying, Senator, is that at Vanguard

we do not offer hedge funds because it does not fit our business

model. You cannot offer—I have never seen one at least—a low-cost

hedge fund. That is our business model. We have the talent in

house to do hedge funds if we chose to do that. We just do not

choose to do that.

We do believe that when you go outside to look for investment

talent, it is a limited commodity, it is a scarce commodity, and to

put people, individual managers of money in the position where

they have to choose between a mutual fund or a hedge fund, we

believe could lead to unintended consequences of those hedge fund

managers deciding to pursue the hedge funds because, frankly,

they can do different things from investment techniques and they

can earn more money.

Senator SARBANES. Do you think hedge funds should be registered and that the SEC should move in to exercise more oversight

over hedge funds?

435

Mr. MILLER. My position on that, Senator, would be to what purpose would you request to require the registration of hedge funds?

I believe the SEC today has ample jurisdiction, depending on the

circumstances of the particular money manager. For example, we

have talked to you about side-by-side management, so again, if you

have a person managing a mutual fund and a hedge fund simultaneously, the SEC has ample jurisdiction to go in to inspect and to

enforce, to ensure that all clients are being treated fairly.

Senator SARBANES. What about the separate hedge fund?

Mr. MILLER. Some believe—and I am not an expert——

Senator SARBANES. Do you think it is a good thing, where it is

side-by-side, that the SEC is able to do that with respect to the

hedge fund?

Mr. MILLER. I think it does provide an additional degree of oversight and insurance, and perhaps comfort level that the SEC does

have that ability to go in and look and enforce if there is side-byside management of these funds.

Senator SARBANES. When there is not side-by-side management,

why wouldn’t the same argument apply with respect to the hedge

fund alone?

Mr. MILLER. I think partly, Senator, it goes to the clientele of the

hedge fund manager. In that circumstance, typically the clientele

tends to be institutional money, very high net worth individual

money——

Senator SARBANES. There is some concern that arrangements are

now being set up that in effect allow what amounts to retail participation in hedge funds; is that not correct?

Mr. MILLER. There is some movement in that direction.

Senator SARBANES. What do you think about that? And if that is

the case, what does it do to the proposition you just put to me? It

makes it hollow and empty, does it not?

Mr. MILLER. I suspect, Senator, to the extent that the concern is

retail—traditionally to find retail investors moving into hedge fund

accounts because hedge fund managers are moving downstream,

there would be some more legitimacy to the registration of hedge

funds. In the typical model where hedge funds are doing the money

management for the institutional and high net worth individuals,

I think that is one of the reasons why there has not been registration required in the past.

Senator SARBANES. Thank you.

Chairman SHELBY. I want to thank the panel. It has been very

informative, we appreciate your candor. Thank you all very much.

We are going to call up the second panel although we are on the

verge of having three stacked votes on the Senate floor.

Ms. Ann Bergin, Managing Director of the National Securities

Clearing Corporation; Mr. William Bridy, President, Financial Data

Services, Inc., a subsidiary of Merrill Lynch; he will testify on behalf of the Securities Industry Association, SIA; Mr. Raymond

McCulloch, Executive Vice President, BB&T Trust, testifying on behalf of the American Bankers Association; and Mr. David Wray,

President, Profit Sharing/401(k) Council of America.

We welcome our second panel and we appreciate your patience

here this morning in waiting for the first panel, which has been

436

more than interesting. All of your written testimony will be made

part of the Banking Committee’s hearing record in its entirety.

We will start with Ms. Bergin. If you will sum up your testimony, we will go from here. Thank you, Ms. Bergin.

STATEMENT OF ANN E. BERGIN

MANAGING DIRECTOR

NATIONAL SECURITIES CLEARING CORPORATION

Ms. BERGIN. Chairman Shelby, I appreciate the opportunity to

discuss the recent SEC’s proposal to amend Rule 22(c)(1) of the Investment Company Act of 1940. With your permission, I would like

to have two documents previously provided to Committee staff, included in the record.

Chairman SHELBY. Without objection, it will be made part of the

hearing record.

Ms. BERGIN. Thank you. The February 6, comment letter to the

SEC on the proposed amendment, and a brochure that describes

how Fund/SERV, which is our fund processing system, works.

NSCC and its affiliated clearing agencies play a significant role

in supporting the U.S. financial markets. We provide post trade

clearance, settlement and information services, not only for mutual

funds, but for equities, fixed income and other securities as well.

I have been asked today to speak about one aspect of the SEC’s

proposal which provides that in order to purchase or redeem shares

in a mutual fund, it be received by the fund, its transfer agent or

a registered clearing agency prior to 4 p.m. in order to receive the

current day’s price.

NSCC is currently the only registered clearing agency providing

services to the mutual fund industry. We are registered with the

SEC and subject to comprehensive regulation and oversight by the

Commission. As such, our Fund/SERV system was directly reference in the rule proposal. NSCC is owned and governed by our

users. Our revenues are generated by the fees paid by our users

and excess revenues are refunded to them.

Our participation in the mutual fund industry began in 1986 at

the request of market participants looking for a way to address

market inefficiencies. Our Fund/SERV system provides a central

automated process for broker-dealers and other distribution intermediaries to transmit purchase, redemption and exchange orders

through a single standard process and communications link. Like

all of our fund services, participation in Fund/SERV is optional, but

it has become the industry standard for processing fund and defined contribution transactions at the wholesale level.

We estimate today that Fund/SERV processes the vast majority

of these wholesale transactions. Last year Fund/SERV handled 87

million fund transactions, roughly 350,000 on the average day.

Fund/SERV is used by——

Chairman SHELBY. How many on the average day?

Ms. BERGIN. On the average day 350,000. Fund/SERV is used by

about 650 mutual fund companies, offering 30,000 different funds

and more than 430 distribution intermediaries. Fund/SERV has

had a tremendous impact on the efficiency of the industry over the

years by greatly reducing operational errors and processing costs.

It has established broadly adopted standards and introduced order

437

into the marketplace. By acting as a central conduit, Fund/SERV

allows intermediaries to offer a much broader range of funds than

before at a much lower cost.

Under current regulation, as long as a broker-dealer is in receipt

of a mutual fund order by 4 p.m., the order is given that day’s closing price regardless of what time the trade is processed through

Fund/SERV, which today could be up until midnight or in some circumstances the following morning. Under the proposed regulation,

even if the order is received by the broker-dealer before 4 p.m., unless it is transmitted to the NSCC, the fund or its transfer agent

by 4 p.m., the purchase would not be made at that day’s price.

Although we anticipate that this would dramatically change the

current trade flow and result in a significant increase in the number of trades received at NSCC in the half hour just prior to 4 p.m.,

we believe our current system’s capacity is sufficient to handle a

concentration of orders in that time frame. However, we will need

to make some enhancements to our services. To date we have identified three.

First, we would need to create a uniform methodology to record

the time of receipt of each file and each order within that file before transmission to the fund. Second, our system would need to

recognize the elements of a complete and valid order so that the

order is final and unalterable as of 4 p.m. Those elements would

include the name of the fund, the specific number of shares or dollar amount of the trade and whether the order is a purchase, redemption, or exchange. Third, we would need to build functionality

to allow intermediaries to communicate additional information

about a valid order after 4 p.m. An example of that would be

breakpoint discounts to which a shareholder would be entitled, as

long as the information would not alter any of the essential elements of the order.

We believe we can complete these enhancements within the 1

year following adoption of the amendment as was proposed by the

SEC at an estimated cost of approximately $5 million, which as I

indicated earlier, would be funded by our users. It does not include

costs that would be incurred by our users in making conforming

changes to their own systems.

We do recognize that migrating the time-stamping function from

the intermediary to NSCC will impose some limitations on the

flexibility that fund investors currently have. We feel very strongly,

however, that applying a hard 4 o’clock close at NSCC is far better for investors than applying that close at the fund or the transfer agent.

The SEC, in their proposal, offered an alternative solution which

would leave the responsibility for time-stamping at the intermediary level with the adoption of new safeguards to prevent latetrading abuses. In our comment letter to the SEC, we advised that

implementing this alternative would preserve the flexibility of the

current system. Whatever the Commission’s final determination,

NSCC is committed to working with the industry to facilitate compliance with the new regulations.

That would complete my prepared remarks.

Chairman SHELBY. Thank you.

Mr. Bridy.

438

STATEMENT OF WILLIAM A. BRIDY

PRESIDENT, FINANCIAL DATA SERVICES, INC.

ON BEHALF OF THE

SECURITIES INDUSTRY ASSOCIATION

Mr. BRIDY. Good morning and thank you very much, Chairman

Shelby, Ranking Member Sarbanes, and Members of the Banking

Committee.

I am Bill Bridy. I am President of Financial Data Services, Inc.,

a wholly-owned subsidiary of Merrill Lynch. My business unit is responsible for the prompt and accurate processing of mutual fund

orders placed through our firm. I am honored to appear before the

Committee today on behalf of the Securities Industry Association,

and I commend the Committee for your many contributions to the

efforts to protect investors.

We agree that the practice of late trading is unequivocally illegal,

and its very existence threatens to undermine the public’s trust

and confidence in mutual funds. For this reason we applaud the

strong enforcement actions the SEC and other authorities are taking to punish wrongdoers.

My testimony today will focus on the ‘‘hard close’’ solution at the

intermediary level. The intermediary level includes broker-dealers,

banks, trust companies, insurance companies, and third-party administrators supporting the 401(k) marketplace. Such a solution

will entitle the mutual fund orders to receive current day pricing

as long as the order is received by a broker-dealer or other intermediary by the time the subject mutual fund determines its net

asset value or NAV, which is generally 4 p.m. Eastern Time.

This solution would benefit 88 percent of the 95 million investors

in mutual funds. The solution is predicated on two core principles.

The first, that a critical factor is not where an order is physically

located at the time a fund’s net asset value is determined, but

rather whether the receipt of such time can be verified with a high

degree of certainty. Second, and most importantly, the available

hard close solution must not be detrimental to or in any way disadvantage the tens of millions of honest mutual fund shareholders

who are not trying to game the system.

The Securities and Exchange Commission recently made a proposal that would essentially allow for hard close solutions only at

the fund or the registered clearing agency level. In the proposing

release, the Securities and Exchange Commission recognize that requiring a hard close at the fund level would require that intermediaries establish an earlier preclose cutoff time for investors to

submit fund orders and obtain current day pricing with respect to

401(k) plans. The SEC acknowledged that investors may not be

able to receive same-day pricing at all.

The net result of the earlier cutoff time is that the vast majority

of fund shareholders who deal through intermediaries, some 88

percent of fund share investors, would be unavailable to effect fund

purchases at current day prices for at least a portion, and possibly

the entirety, of the trading day. The hard close at the fund remedy

also fails to provide for an effective tamper-proof electronic order

capture time-stamping system. The proposed remedy merely carries over the current time-stamping requirement, which is shown

to be prone to abuse both at the fund and the intermediary levels.

439

We advocate adoption of the Securities Industry Association’s

electronic order capture time-stamping approach for funds, brokers

and 401(k) intermediaries to cure the shortcomings. The Securities

Industry Association’s hard close of the intermediary solution

would require broker-dealers to use an electronic order capture and

routing system, which assigns a verifiable order entry time aligned

with the atomic clock currently used for equity order time-stamping. Other regulated and nonregulated entities would have to use

a system certified to be functionally equivalent. It is noteworthy

that House bill H.R. 2420 and several of the bills introduced in the

Senate propose a similar approach.

Importantly, the SIA recommendation contemplates that orders

not accepted into the intermediary system by the hard close, even

where the lack of timely receipt was due to legitimate errors,

would, without exception, receive next-day pricing. Thus, corrections would have to be effected through an error account and essentially they, not the fund shareholders, would bear the economic risk

of loss with respect to any orders processed after the hard close.

So the Securities Industry Association’s proposal would impose

stringent additional requirements on the use of time-stamping

methodologies that would make it extremely difficult to game the

system. And the Securities Industry Association recommendation,

which could be implemented expeditiously, would eliminate the inadequacies of the current time-stamping system and would create

a readily auditable order trail, while avoiding the significant adverse consequences of early order cut-off times. Electronic and

auditable electronic time-stamping systems are critical components

to any effective hard close rulemaking solution. This approach

would place the vast majority of investors holding their fund investments through intermediaries on a more level playing field

with other investors.

While imposing a hard close at the fund or registered securities

clearing agency should be among the available alternatives, these

measures should not be the exclusive solution.

We are really looking forward to working with your Committee

to swiftly and effectively eliminate late trading in a way that protects all investors and does not create competitive advantages for

some. We believe such measures are essential to maintaining the

integrity of our capital markets and retaining the public trust of

the 95 million Americans for whom mutual funds are a core investment vehicle.

Thank you.

Chairman SHELBY. Thank you. We are going to recess the hearing. We have the first vote coming up immediately. We will recess

for about 30 minutes. If you will stick around, we will get on with

the rest of the panel.

[Recess from 11:49 a.m. to 12:36 p.m.]

Chairman SHELBY. The hearing will come to order.

I know that was a long 30 minutes, but that is in the tradition

of the Senate and the way it is managed. I apologize, but this is

the way we operate up here as you well know.

Mr. McCulloch, you proceed.

440

STATEMENT OF RAYMOND K. McCULLOCH

EXECUTIVE VICE PRESIDENT, BB&T TRUST

ON BEHALF OF THE

AMERICAN BANKERS ASSOCIATION

Mr. MCCULLOCH. Thank you, Mr. Chairman.

I am Ray McCulloch. I am the Executive Vice President for

BB&T Trust. I have over 26 years of banking experience with the

last 12 focused on trusts and employee benefits.

BB&T Trust administers over 2,200 employee benefit plans with total assets equaling $5.2 billion. Our parent, BB&T Corporation,

is the Nation’s 13th largest bank, and I am pleased to testify on

behalf of the American Bankers Association.

As investors and intermediaries of mutual funds, ABA members

are quite concerned about the issue of late trading. Let me be very

clear. ABA members emphatically believe that late trading has no

place in mutual funds. This practice is illegal under current law,

and we applaud the SEC for punishing those at fault.

The SEC’s proposal, however, often referred to as the 4 o’clock

hard close, is unworkable and will have a detrimental effect on investors, particularly the millions of people who have trusted their

retirement and trust accounts to banks like mine to manage. While

the SEC’s proposal seems to be a simple solution to the problem

of late trading in practice, it would result in different cut-off times

for mutual fund companies and for intermediaries that sell shares

of funds of those companies.

This occurs because the processing, particularly for 401(k) plans

is operationally complex and time consuming. Unlike the mutual

fund companies that can perform all the processing tasks after 4

o’clock, all other providers must complete the processing before 4

o’clock. Processing trade orders involves as many as five steps

using four separate systems, as discussed in my written statement.

For BB&T Trust it generally takes 3 hours to complete the processing. For other ABA member banks, it can take much longer.

This would mean that an investor making a decision at 3 p.m.

would get today’s price if he or she dealt with the mutual fund directly, but tomorrow’s price if the order was placed through us. It

makes no sense for the SEC to create a system that discriminates

against investors based upon the choice of one distribution channel

over another.

Fortunately, alternatives to the SEC’s proposal exist. The key is

a tamper proof order system where the entry time of an order can

be verified with a high degree of certainty. This would allow fund

intermediaries to receive orders up to the time of the net asset

value calculation. The time-stamping, whether done by an outside

company or internally, must be subject to audit. Annual audit of

controls and certification of policies and procedures would be appropriate. Time-stamping processes are already available, and companies are working to make the electronic signing of documents,

using digital certification, as simple as signing a piece of paper

with a pen.

And technological solutions can be expensive to implement. Thus,

it is very important that the SEC’s approach be flexible and sensitive to the cost and provide an implementation period of at least

1 year.

441

Finally, Mr. Chairman, the ABA appreciates efforts by Senators

to assure that solutions to late trading do not disadvantage investors. We are hopeful that, with your strong encouragement, the

final SEC regulations will recognize this as well. Should it not, it

may become necessary to address this through legislation.

Thank you for the opportunity to present the views of the ABA.

Chairman SHELBY. Thank you.

Mr. Wray.

STATEMENT OF DAVID L. WRAY

PRESIDENT, PROFIT SHARING/401K

COUNCIL OF AMERICA

ON BEHALF OF

ASPA, ASSOCIATION FOR FINANCIAL PROFESSIONALS,

AUTOMATIC DATA PROCESSING, INC., COMMITTEE ON

INVESTMENT OF EMPLOYEE BENEFIT ASSETS, THE ERISA

INDUSTRY COMMITTEE, FLINT INK CORPORATION, FLORIDA

POWER & LIGHT COMPANY, HEWITT ASSOCIATES, ICMA

RETIREMENT CORPORATION, INTEL CORPORATION,

PROCTER & GAMBLE, PROFIT SHARING/401K COUNCIL OF

AMERICA, SMALL BUSINESS COUNCIL OF AMERICA, AND

SUNGARD CORBEL

Mr. WRAY. Good afternoon, Mr. Chairman. I am David Wray,

President of the Profit Sharing/401K Council of America, an association of employers that provide profit sharing and 401(k) plans

for their workers.

Thank you for this opportunity to share the views of the employer-provided retirement plan system with the Committee. My

comments reflect the views of the companies and of the organizations listed on the transcript of my statement.

As we all know, mutual funds play a key role in the employerbased system. According to Investment Company Institute, 36 million U.S. households invest one-third of all mutual fund assets

through employer-provided retirement plans. Like this Committee,

we are concerned by the breaches of trust that have occurred recently, and we applaud the efforts under way in the Congress to

restore confidence in our Nation’s financial institutions.

Late trading must be eliminated. At the same time it is important that we preserve a level playing field for the ability to make

investment decisions using same-day pricing. In most employerprovided plans, investors can make trading decisions up to or very

close to a fund’s closing time, generally, 4 p.m. Eastern Time. Some

have questioned if plan participants value same-day pricing. I can

assure you that they do, as evidenced by the predominance of this

feature in 401(k) plans. Like all investors, plan participants adopt

a long-term saving strategy, and only infrequently make changes

in their investment decisions. However, when plan participants do

make investment change decisions, they highly value same-day

pricing. This is particularly true for distribution decisions upon

retirement.

Same-day pricing in employer-provided retirement plans is possible because intermediaries are permitted to process participant

trades and forward the final aggregated trades to the funds or a

clearing agency after 4 p.m. This late processing is necessary to

442

ensure that all the requirements surrounding the operation of a

qualified retirement plan are met, including satisfying plan features and the highly complex rules issued by the Departments of

Labor and Treasury. On a more basic level, fund trade processing

is always delayed to reflect the fund’s net asset value for the current day, an event that does not occur until well after 4 p.m.

Congress understands the need to preserve same-day pricing in

employer-provided plans when addressing late trading. The House

overwhelmingly passed H.R. 2420 last November. It instructs the

SEC to issue rules to address late-day trading that permit late

processing by retirement plan and other intermediaries if procedures exist to prevent late trading and such procedures are subject

to independent audit. Similar provisions are found in S. 1971, cosponsored by Senators Corzine, Dodd, and Lieberman; and S. 2059,

cosponsored by Senators Fitzgerald, Levin, and Collins. I applaud

these Members for all of their efforts, and I urge this Committee

to move forward on this important legislative provision if the final

SEC rule on late trading fails to preserve equal opportunities for

all investors.

Under the SEC’s proposed rule, to offer same-day pricing an

order must be received by the fund, its designated transfer agent

or a registered securities clearing agency by the fund’s closing time.

This means that a retirement plan participant’s ability to enjoy full

same-day pricing will be based on the employer’s selection of a plan

intermediary and investment choices. Employers will be pressured

to adopt service provider arrangements that favor same-day pricing

over an open architecture design with offerings from several fund

complexes. Participants could be influenced to invest in proprietary

funds of the intermediary when also offered funds from other fund

complexes. Intermediaries will incur significant initial and recurring systems cost that will be borne by participants.

I commend Ann Bergin and the NSSC staff for their valiant efforts to develop a viable process to meet the SEC’s clearing agency

proposal. Although the clearing agency approach will provide some

relief to retirement plan participants that do not trade in a bundled

provider environment, it will not create parity among investors. It

will not accommodate all plan transactions, and it will result in

additional costs for many plan participants.

There is a preferable way to address late trading. The SEC has

requested comments on an alternative approach. And this would

include tamperproof time-stamping, certification policies, and independent audits. This approach is very similar to that in the legislation I mentioned earlier in my comments. A large majority of SEC

commenters, including leading consumer organizations support inclusion of this approach in their final rule. Several technology companies have confirmed their ability to provide the technological

safeguards sought by the SEC.

I hope that the SEC final rule will include this alternative approach that preserves the opportunity for same-day pricing for all

retirement plan participants. I repeat my request for this Committee to intercede legislatively if that does not occur.

Thank you very much for this opportunity. I look forward to your

questions.

443

Chairman SHELBY. The goal of the ‘‘Hard 4 p.m. Close’’ is to stop

illegal late trading. Without a hard 4 p.m. on order delivery to the

funds, how do we ensure that the late trading window has been

shut? Are there solutions—you alluded to something—that can be

immediately implemented that address the problem? Ms. Bergin,

we will start with you.

Ms. BERGIN. I think, Chairman, there are probably several solutions that could be workable. The question is: At what point can

we certify or determine that a shareholder’s intent to make a trade

is determined prior to 4 p.m. Today that determination is made at

the intermediary level, and for the most part, I would say, is preserved there, even though the processing happens after 4 p.m.

I think that the SEC is certainly looking for some greater validation of that going forward and has suggested several alternatives,

though they do still preserve the opportunity for the intermediary.

Chairman SHELBY. Could you describe the technology that would

be needed to support the NSSC’s proposal? Is the technology currently available? If not, how long would it take to develop and to

implement a new system?

Ms. BERGIN. Some of that technology is available. It would require additional technology to actually stamp a file that contains

trades, and stamp each of those trades within that file, and transmit that information.

We have estimated that it would take us the better part of the

year that the SEC has proposed.

Chairman SHELBY. All that will be subject to audit, of course,

would it not?

Ms. BERGIN. Exactly, yes.

Chairman SHELBY. Are you talking about maybe software of a

year or so ahead or what?

Ms. BERGIN. It would take about a year to develop and implement that, yes.

Chairman SHELBY. Mr. Bridy, many contend that in place of the

‘‘Hard 4 p.m. Close,’’ the industry could implement an audit trail

and time-stamping system at the intermediate level. How would a

system work like that? How will you authenticate a mutual fund

transaction and prevent people from altering records? This is important to have an auditing trail that would be hard to alter.

Mr. BRIDY. Within the broker-dealer community, there is a platform today that we use for equities which is referred to as OATS.

That provides a hard and a verifiable time-stamp on every single

security.

Within our firm, being Merrill Lynch, we have a hard clock, and

you cannot enter a trade after 4 o’clock for that day’s execution. If

so, our system will automatically process that trade entered after

4 p.m. on the next day for execution. Also, not only is our retail

broker-dealer business within the broker-dealer entity, but also our

401(k) business is within the construct of the broker-dealer. Both

of our trading platforms have the capability to ensure that a hard

clock is implemented within the structure of the broker-dealer

intermediary.

I think what is critical is that there are technologies that exist

today that can ensure a hard close is implemented at the intermediary level. The need to transmit a transaction to either the

444

fund or to a clearing organization prior to 4 p.m., in effect, in our

view, will substantially disadvantage about 88 percent of the fund

investor marketplace. Eighty-eight percent of the marketplace conducts their business through an intermediary today. So how do we

sit there and say we are going to disadvantage 88 percent of the

marketplace because of the channel they use to execute a trade?

Chairman SHELBY. Sure. Mr. McCulloch, go ahead and compare

how you currently monitor late trading with how you would do it

under your proposal. Why should the regulators have confidence

that your proposal will be accurate? How do you ensure the integrity of the information which goes to the crux of it?

Mr. MCCULLOCH. Today, we cannot accept post-4 o’clock trading

on our current systems. I, like my colleague from Merrill, have systems that shut down and flip to the next day automatically.

What we do not have today that would make the audit trail

much easier for our internal auditors, external auditors, and the

FDIC and Fed to come in and check would be the electronic stamping. Knowing that this was coming, we have already had discussions with our software provider about this technology so that we

can—as the 1-year time frame has been put forward, would give us

time to put that in. Then if, in fact, my customers, being those participants out in the country and their employers, call me—as some

have already done—and ask me at BB&T, ‘‘How are you protecting

this from happening?’’ Not only can I tell them that my current

systems will stop it, but I can also turn to them and say that my

regulators and my auditors now can follow my pattern of behavior

electronically.

Chairman SHELBY. Okay.

Mr. Wray, would you elaborate on your concerns with the

NSCC’s proposal? Why doesn’t the designation of the NSCC as a

national clearinghouse work for the plan administrators?

Mr. WRAY. The regulatory compliance requirements of 401(k)

plans are much more complicated than a typical order processing.

For example, for a plan loan, you can only borrow up to 50 percent

of your account balance, and that does require a transaction if you

request a plan loan. You have to know the NAV in order to run

the test to make sure that the person has not asked to withdraw

more than 50 percent of their account balance. And so you have to

hold back that processing until you get this other information. That

is an example, and there are a lot of cases like that.

So the special compliance requirements that are imposed on the

401(k) system really make it impossible to utilize that kind of process. The people that we——

Chairman SHELBY. Is it too simple for 401(k)s?

Mr. WRAY. Pardon?

Chairman SHELBY. Is that process too simple for 401(k)s?

Mr. WRAY. Right. We have talked to the recordkeepers that we

work with, and they say that they would have to impose a cutoff

approximately 4 hours earlier in order to run all their evaluations

and things, and then they could get it over by 4 o’clock to the clearing agency. But they could not still provide equivalent treatment

compared to a 401(k) participant who is in a bundled investment

product who can still trade right up to 4 o’clock, because the direct

relationship with a mutual fund permits that in that case.

445

So what we are trying to do is have a level playing field. We do

not want to see plan sponsors and participants making plan design

decisions or investment decisions based on how processing works or

trade handling works. It should be based on other things.

Chairman SHELBY. Basically it is your concern that the proposal

to have the NSCC serve as a clearinghouse for trades does not take

into account all the trades made by the 401(k) participants. Is that

correct?

Mr. WRAY. That is correct.

Chairman SHELBY. And, of course, we have a challenge of how

to resolve the problem, right?

Mr. WRAY. Correct. We are with the other members of the panel.

Chairman SHELBY. Sure.

Mr. WRAY. If you look at the 401(k) system, nowhere in the

401(k) system is there any evidence or even allegation that there

was any wrongdoing in this area. And it is a huge system.

Chairman SHELBY. So how much money, roughly, is invested

through the 401(k) system?

Mr. WRAY. Probably, if you include all of the 401(k) products,

such as 403(b)’s, it is probably $2 trillion.

Chairman SHELBY. Two trillion dollars.

Mr. WRAY. Right.

Chairman SHELBY. That is not pocket change.

Mr. WRAY. No, it is not. And there is no allegation that there

was any wrongdoing in the system, and yet we are imposing a solution or talking about a solution that would harm this innocent

group of people.

Chairman SHELBY. But we have to protect, see what we can do,

and the SEC has to see what they can do to protect the whole shed

and everything under it.

Mr. Wray, some contend that the ‘‘Hard 4 p.m. Close’’—we keep

talking about that—is not a real hardship for 401(k) investors

because they are long-term investors. How would you respond to

the assertion that 1 day’s price really does not matter for 401(k)

investors because they are in it for the long haul?

Mr. WRAY. Well, there is no question that 401(k) participants do

not trade their accounts.

Chairman SHELBY. I know.

Mr. WRAY. I mean in the normal cases. But they do make transactions that are very important, and I will use an example.

Chairman SHELBY. Sure.

Mr. WRAY. In 1987, on Friday afternoon, there was an anticipation that the market would do certain things, and on Monday, the

market lost 25 percent of its account value. If I am in the process

of converting my assets from equity assets to fixed assets in order

to buy an annuity when I retire——

Chairman SHELBY. What if you went to cash?

Mr. WRAY. But you have to sell to go to cash.

Chairman SHELBY. I know.

Mr. WRAY. Then you convert the cash to an annuity. I mean, this

person needs to have a high degree of certainty.

Chairman SHELBY. The market was going to drop 25 percent.

You better do something, shouldn’t you?

446

Mr. WRAY. Right. And you want some degree of certainty. Kicking the trade over to the end of the next day, who knows what

might happen between that decision and the next. We need the

highest degree of precision and predictability that we can get. That

is the reason the system is moving to daily evaluation. This is how

the system should work.

So it is very important in those cases when the employee does

make changes in their account balance.

Chairman SHELBY. Ms. Bergin, do you want to comment on that?

Do you have any comment?

Ms. BERGIN. I would comment insofar as NSCC does acknowledge that the 401(k) market is significantly more complex than the

retail market.

Chairman SHELBY. Than ordinary transactions.

Ms. BERGIN. Absolutely. We have worked with many of our clients who are 401(k) recordkeepers, and we have carved out——

Chairman SHELBY. Well, how do we work it out?

Ms. BERGIN. I am sorry?

Chairman SHELBY. How do we work it out?

Ms. BERGIN. I think, Mr. Chairman, some of the transactions——

Chairman SHELBY. Or how does the SEC work it out?

Ms. BERGIN. Our system would recognize the transaction coming

through as a retail—it looks to us like a retail trade in the new

4 o’clock world. There are some certain transactions that the trade

record could not be built at the recordkeeper until after the NAV

is known at 4 p.m. So unless there is a carveout for those kinds

of transactions——

Chairman SHELBY. What is the harm here? There has to be a

downside to something here. What is the uptick and what is the

downside? Obviously, Mr. Wray is concerned about certain things.

Ms. BERGIN. I think I would share his concern for the 401(k) investor, that he is going to have less ability to move his money in

the same way a retail investor would, you know, on that same-day

time frame.

Chairman SHELBY. But how do we resolve it?

Mr. McCulloch.

Mr. MCCULLOCH. I would like to make two points.

First of all, I go back a long way in this business and remember

the days of common trust funds where you could only submit transactions quarterly. And the business has evolved really to a 24/7

environment where you can do things through Internet and voice

response. If we move backward from that, our investors not only

will be harmed, but they also will be terribly disappointed they do

not have prompt access.

We are in a very regulated business as a bank. We have multiple

regulators in our shop. To have them look at our policies, our procedures, and our audit trail and have that certified annually, I am

more than happy to do that if that solves the problem the SEC has

concern about, that we at BB&T and other banks we are not processing past 4 o’clock.

The technology exists today to do that, and to me it is common

sense that we would take that approach to ensure that when I am

selling these services and supporting these services that I, in fact,

am living within the law.

447

Chairman SHELBY. Mr. Bridy.

Mr. BRIDY. I think there is one other thing we want to mention.

Not only do we have a problem in the 401(k) arena, but we also

have problems in the retail arena, because intermediaries are going

to have to back up their closing process to calculate trades and distribute those trades. A lot of trades are linked trades where you

are selling one security and purchasing with the proceeds from another and you need pricing for execution. So, we would have challenges within that arena.

I think that the other significant disadvantage is that the whole

world does not reside on the East Coast, so if we are going to start

backing things up and we are going to close off retail at 2 o’clock,

well, then we are going to be shutting down the West Coast at 11

o’clock in the morning, and it becomes even more exaggerated as

one moves west.

Chairman SHELBY. Four o’clock Eastern Time might have worked

at one time, or seemingly so, but with the 24/7 investment syndrome, worldwide, internationally, we have challenges. Isn’t that

what your message is?

Mr. MCCULLOCH. Exactly. But, again, getting back to audit and

verification, we are more than willing to do that to ensure our investors that we are not processing past 4 o’clock. We hire external

auditors. We have the FDIC audit. We have DOL. There are

enough bodies to oversee this, but obviously not to raise the cost

dramatically. Electronically, we could provide that information, as

an intermediary.

Chairman SHELBY. Well, we have a lot of work to do. We have

a number of hearings left on the mutual fund industry, where we

will be looking at it.

We appreciate your patience today and appreciate your input for

the record. Thank you so much. It is getting late in the day. The

hearing is adjourned.

[Whereupon, at 1:02 p.m., the hearing was adjourned.]

[Prepared statements supplied for the record follow:]

448

PREPARED STATEMENT OF SENATOR WAYNE ALLARD

Thank you, Chairman Shelby, for holding this hearing to discuss the operations

and governance of mutual funds. This is the fifth hearing the Committee has convened to discuss mutual funds, and I feel that we have gained a great deal of knowledge. I appreciate your special attention to this matter as revelations of late trading

and market timing abuses have signaled the need for closer scrutiny of the mutual

fund industry. In particular, I appreciate the balanced and cautious approach you

have taken in examining such a critical part of the U.S. economy.

Mutual funds are a unique investment vehicle, allowing middle-income Americans

the ability to invest responsibly and save for the future. While many invest in mutual funds to save for college or a house, much of the saving by Americans is done

in retirement accounts and 401(k) plans. Whatever the ultimate reason for investing

in mutual funds, Americans deserve to be confident about the decisions they are

making. Congress plays a critical role in seeing that the necessary steps are taken

so that investors remain confident, and the industry remains vibrant.

The late-trading and market-timing abuses that have been brought to light are

disturbing, and those who are guilty of these wrongdoings must be punished. However, as we move forward in examining the mutual fund industry and its investors,

it is essential that we are as prudent and as deliberative as necessary. As Congress,

it is our job to ensure that existing law is vigorously enforced. Furthermore, we

must see to it that we do not overreach our authority.

Today, we will discuss how funds actually operate, and who is involved in that

process. I am pleased to welcome my good friend and colleague, Senator Armstrong,

to the Committee today. Senator Armstrong is no stranger to this room as he served

on this very Committee, as well as the Senate Finance and Budget Committees. He

is currently the Independent Chairman of Oppenheimer Funds, and serves as a Director of Helmerich & Payne—a leading oil and gas-drilling contractor, and UNUM

Provident—the world’s leading disability insurer. His extensive understanding of

the legislative process coupled with his experience in fund governance will undoubtedly provide the Committee with valuable insight and wisdom in our examination

of fund operations and governance. Welcome, Senator.

I would also like to welcome the other witnesses to the Committee today. You all

have very busy lives and we appreciate you taking the time to come and share your

experience and expertise with us. I look forward to your testimony.

—————

PREPARED STATEMENT OF WILLIAM L. ARMSTRONG

INDEPENDENT MUTUAL FUND DIRECTOR & CHAIRMAN, OPPENHEIMER FUNDS

FORMER U.S. SENATOR (1979–1991)

MARCH 2, 2004

Mr. Chairman and Members of the Committee, thank you for the opportunity to

appear before you this morning. I am an Independent Mutual Fund Director and

Chairman of the Denver-based Oppenheimer Funds. Our 38 funds manage $75 billion for 5 million shareholder accounts.

During the past few months, my colleagues and I on these fund boards have

learned with mounting indignation that some mutual fund industry executives have

violated the trust placed in them by shareholders. In my opinion, we should throw

the book at those who have done so.

But let’s keep one thing in mind—the wrongdoing has been discovered—and can

be readily punished—under the existing statutes and regulations. Nothing has happened which calls for sweeping new legislation.

The fund industry is already heavily regulated. So, I urge Senators to go slow in

considering costly and burdensome new requirements and regulations that could

end up costing shareholders more than the abuses they are intended to correct. If

that were to happen, it would be tantamount to punishing the victims instead of the

violators, punishing shareholders instead of those who betrayed them.

Does this mean Congress should do nothing?

Absolutely not. I have reviewed 106 specific proposals contained in pending legislation and regulations. All are undoubtedly well-intended. And some, particularly

recommendations for enhanced disclosure, are highly desirable. I recommend such

measures for your approval.

But other proposals do not take into account the unique nature of funds and the

role of mutual fund directors. In contrast with corporate directors, our role is one

of oversight. The adviser created the fund, and investors have chosen to invest in

449

it. Fund investors do not expect or want us to take control of the fund, nor be deeply

involved in day-to-day management, as would become inevitable under some of the

pending proposals.

Based on my experience as an independent fund Director, I believe Congress

should evaluate proposed legislation based on the following considerations:

1. More than 54 million American families own mutual funds in 95 million accounts. These shareholders are invested in eight thousand funds with assets totaling

approximately $7 trillion.

2. Mutual funds have been and continue to be a powerful engine for economic

growth and wealth creation for American families.

3. Mutual funds are the primary investment vehicle for middle- and low-income

families. Wealthy investors have access to many different kinds of investments and

a wide range of financial advice. But for most families, mutual funds provide skilled,

professional investment management that would not otherwise be readily available

to them or would be available only at a significantly higher cost.

4. Although instances of misconduct by people managing or dealing with mutual

funds have been widely publicized, recent sensational news reports should not obscure the tradition of honorable dealing and high ethical standards for which the

industry has long been recognized. Almost all of the 456 thousand men and women

who work in the mutual fund industry are decent, hard working, and honorable.

They have served shareholders with dedication and expertise.

5. The mutual fund industry is already heavily regulated.

6. Proposed reforms should be carefully vetted to weigh costs against benefits and

to avoid unintended consequences. Although I do not know the extent of investor

losses as a result of misconduct by these wrongdoers, various estimates run from

tens to hundreds of millions of dollars.

Nor do I know the exact cost to shareholders of pending legislation, but some

news articles have estimated that cost at more than $1 billion in one report, and

5 to 10 basis points (a basis point is 1⁄100th of 1 percent) of the total assets in another article. I cannot vouch for these numbers, but my experience as Chairman or

Director of several private and public companies convinces me there is a real risk

that proposed ‘‘reforms’’ will prove to be more burdensome and costly to shareholders than the abuses they were intended to correct.

7. Traditionally, U.S. regulation of investments and securities has focused on disclosure, leaving actual investment and operational decisions to investors, financial

advisers, brokers, fund boards, managers, etc. In general, Congress and the SEC

have upheld the idea that sunshine is the best investor protection, and that it is

rarely advisable to impose operational requirements on business corporations or

mutual funds. The stunning economic record of the American economy strongly

validates the wisdom of this approach.

8. The Securities & Exchange Commission is the appropriate agency to monitor

and supervise the mutual fund industry. My colleagues and I favor additional funding for the SEC so it will have adequate resources to perform this role.

9. Finally, I note that all good ideas need not be enacted into law.

Many interesting and worthwhile proposals have been advanced for improving

governance and operational reform in the mutual fund industry. Some of these are

well-suited for some funds, less so for others. Ultimately, consideration of many of

these reforms may be better left to the discretion of fund boards and management.

Along with proper disclosure, competition among funds is likely to give shareholders

a fairer and more efficient outcome than imposing additional unnecessary supervision on an industry that is already heavily regulated.

With these considerations in mind, and with concurrence of many, though not all,

of my colleagues in the industry, I offer the following comments and recommendations. I have been asked to particularly discuss issues of governance and director

independence. So let me start there.

Governance

In general, we agree with the idea that a super-majority of fund directors should

be independent. Most of us, therefore, favor the requirement that two-thirds or 75

percent of fund boards be independent. (H.R. 2420, S. 1822, S. 1971, S. 1958)

It is important to understand, however, that if such a requirement is imposed

and, at the same time, the definition of independent (or not ‘‘interested’’) director

is changed, the results could be quite drastic.

Take the example of one particular board with which I am familiar. The board

has 11 directors, 10 of whom are independent under existing law. The most extreme

proposed definition (calling for a 10 year cooling off period for former adviser employees) would create a Hobson’s Choice for the board. It could discharge several

450

directors and lose the expertise of experienced board members. Or it could reach the

new standard by adding 13 new directors and, thereby, creating an unworkably

large board. Neither of these outcomes is good for shareholders.

So, Congress should be cautious in amending the definition of an ‘‘interested’’ director. If Congress wishes to increase the cooling-off period, it should also permit

a phase-in period of sufficient length to accommodate turnover in a natural manner

as present directors retire.

We favor the proposal (S. 1822, S. 1971, S. 1958) that fund board nominating committees be composed of independent directors. This issue is already largely addressed by SEC rules adopted in 2001 that require that, for virtually all funds, the

independent directors must nominate and select the independent directors. There is

also some agreement among us that it is usually a good idea for a fund board chairman to be independent. Accordingly, some of us favor such a requirement.

But others of us wonder whether this is always the best arrangement. Are there

not some circumstances in which a chairman who is part of fund management better serves shareholders? And, in any case, why must this be mandated by law? Why

can’t this matter, if properly disclosed, be left to the discretion of investors themselves? If they think an independent chairman is a better approach, they will have

many funds from which to choose. But if they are indifferent to this issue or, for

some reason, think some other arrangement is preferable, why should they not be

permitted to invest as they choose?

Financial Expert

We oppose the requirement that each board include at least one ‘‘financial expert,’’

a provision that will impose a serious hardship on small funds.

Even for large fund groups, such as ours, this requirement will adversely affect

our ability to attract ‘‘experts’’ to serve on our boards because of the implication of

additional liability attributed to persons so designated. Frankly, when someone is

designated as such an ‘‘expert,’’ it is like painting a bull’s eye on his or her chest.

That person will automatically be subject to more scrutiny, more criticism and, potentially, more liability.

I know from firsthand experience as a corporate director, and as one who has been

responsible for corporate director searches, that this requirement will make it a lot

harder to attract and retain highly qualified board members.

We favor instead the current Sarbanes-Oxley standards, which require disclosure

of whether a fund has a financial expert on its Audit Committee.

Other Audit Committee Requirements

We believe that additional audit committee requirements, if needed, should be

provided by SEC rule. Many of the Sarbanes-Oxley requirements have already been

imposed on fund audit committees by the SEC. If there is remaining doubt about

the authority of the SEC to do so, it would be appropriate for Congress to explicitly

grant such rulemaking power to the Commission.

Chief Compliance Officer

We favor requiring the Chief Compliance Officer to report directly to the board,

as provided by H.R. 2420 and S. 1971. I note, however, SEC Rule 38a–1 already substantially requires this.

Director Review of Soft Dollar, Revenue Sharing & Directed Brokerage

Three pending bills establish a fiduciary duty for boards to review the soft dollar,

revenue sharing, and directed brokerage arrangements. We see no need for legislation on this matter since, in our view, the law currently imposes the duty on a

fund board to carefully monitor the use of fund assets. I should also note that directed brokerage and certain aspects of revenue sharing are the subject of the SEC’s

rulemaking.

Certifications by Independent Chairman and/or Independent Director

We are against proposals to require various certifications by the fund board chairman and/or independent directors. Such requirements entail too much director involvement in fund management and adversely affect the independence of directors.

We believe such certifications should be made to the board, not by the board itself.

If the most extreme proposed independent director certification requirements were

adopted, several things would quickly happen:

First, many independent directors would throw in the towel. They would just

resign. Second, the remaining directors would have to get so deeply entangled in

day-to-day operations of the company that they would no longer, as a practical matter, be independent. Third, the cost of D&O insurance would skyrocket.

451

So, we believe such certifications should be made to the board, not by the board.

If the board is going to continue its historic role as an independent watchdog, it

should receive, not prepare, such certifications.

Ethics Code

Our board has a well-established code of ethics (as required by Rule 17j–1 of the

Investment Company Act) and regularly reviews compliance by board members and

management company personnel.

But we are skeptical of requiring that ethics violations be posted on fund websites

(S. 1971). Doing so would raise questions of fairness, libel, and administrative practicality, and entails so many ‘‘due process’’ issues that the result would be to scuttle

an otherwise worthy process.

Disclosures

In general, we favor disclosure. Truth is user-friendly for our shareholders, and

we support giving the public all the facts needed to make good investment decisions.

In reviewing the numerous proposed disclosure requirements, we note that many

of the matters included in pending legislation are already required by current SEC

and NASD rules, and are likely to be enhanced by proposed rules.

Four pending bills require disclosure of the structure and method for determining

portfolio manager compensation and the ownership interest of managers. We have

no objection to making such disclosures.

We are troubled, however, by the requirement of S. 1971 to disclose the exact

amount of manager compensation. This unnecessarily intrudes on the privacy of

portfolio managers and creates a competitive disadvantage for mutual fund companies in attracting and holding managers.

We have no objection to additional disclosure of share ownership by directors, as

already contained in the Statement of Additional Information. But the proposal to

report if a director ‘‘does not’’ own shares seems to us awkward. On balance, we prefer affirmative, rather than negative, disclosure.

We also wish to point out that increasingly complex disclosure tends to make various required documents difficult to understand and, if carried too far, the purpose

of informing investors is actually undermined, rather than enhanced.

Mutual Fund Oversight Board

There has been some discussion of establishing a new Mutual Fund Oversight

Board. We are against this idea because the SEC already has invaluable regulatory

expertise that any new agency could acquire only over a long period of time.

Moreover, we believe splitting mutual fund regulation from exchange and brokerage regulation will weaken the regulatory framework and result in confusion and

fragmentation.

It is our strong view that Congress should instead provide additional funding so

that the SEC can properly enforce statutory and regulatory requirements. This

seems a more practical and direct approach.

4:00 P.M. Closing

We favor the so-called ‘‘soft close’’ concept (H.R. 2420, S. 1971), which requires

strict monitoring of intermediaries to assure that all buy/sell orders are received

either by the fund or the intermediary prior to the time funds calculate their net

asset value (usually 4 p.m.).

The ‘‘hard close’’ alternative (S. 1958) would require that all transactions be received by the fund itself (or its transfer agent or a registered clearing agency) prior

to 4 p.m. This means orders placed through brokers or other intermediaries would

have to be cut off several hours earlier to assure receipt prior to 4 p.m.

The practical result might be that Pacific Time zone brokers would be forced to

put all orders received after 9 or 10 o’clock into the following day’s business. So,

for some investors, order execution would be delayed for more than an entire business day, hardly fair to such investors.

In our funds, a majority of shareholders place their transactions through intermediaries. So the ‘‘hard close’’ concept would be to the disadvantage of millions of

our accounts.

In our opinion, the ‘‘soft close,’’ with strict monitoring of intermediaries, assures

a level playing field for all investors without implementing the more draconian

‘‘hard close.’’

Market Timing

We favor forthright disclosure by funds of how frequently investors will be permitted to trade in fund shares. And we favor disclosure of the penalty to be invoked

by the fund on those who violate the guidelines.

452

But we are against mandatory restrictions or a one-size-fits-all prohibition on

quick turnaround trading. The overwhelming majority of mutual funds are designed

for long-term investors with a time horizon of years, not months and certainly not

days or hours. Many funds also permit controlled asset allocation programs. But if

a particular fund or complex wishes to offer itself to market timers, we see no reason why this should be prohibited, if properly disclosed.

We also favor full disclosure of any trading restrictions that funds may place on

adviser personnel to limit the frequency of their trades. In general, however, we

think such personnel should be subject to the same limitations as other investors.

RICO

One pending bill, S. 1958, proposes to apply RICO to the mutual fund industry.

We are strongly opposed to this concept and feel that it is completely inappropriate

for the mutual fund industry.

Other Issues

Mr. Chairman, again let me express my appreciation to you and Members of the

Committee for the opportunity to be here today. I hope you and your staff will call

on my colleagues and me for help as you consider legislation regarding the mutual

fund industry. Thank you.

—————

PREPARED STATEMENT OF VANESSA C.L. CHANG

INDEPENDENT DIRECTOR, NEW PERSPECTIVE FUND

MARCH 2, 2004

Introduction

My name is Vanessa Chee Ling Chang. I serve as an Independent Director and

Chair of the Audit Committee and member of the Contracts Committee for the New

Perspective Fund, a member of the American Funds family. The fund, whose board

I joined in March 2000, is advised by Capital Research and Management Company,

has assets in excess of $30 billion and is sold through third parties. I also serve

as an Independent Director, Audit Committee and Governance and Nominating

Committee member for Inveresk Research Group, Inc., a Nasdaq-listed company

providing contract research services for drug development to biotechnology and

pharmaceutical companies. I am a Certified Public Accountant and worked for Peat

Marwick, now KPMG, in the Audit Department and later in Corporate Finance. I

was a partner from 1986 to 1997.

I appreciate the opportunity to appear before the Committee to discuss mutual

fund operations and governance from my perspective as an independent director.

I am greatly dismayed by the abuses that have come to light in the mutual fund

industry over the past few months. In particular, I am distressed that some industry participants apparently chose to benefit themselves at the expense of fund

investors, resulting in the current crisis of confidence. Their behavior is so contrary

to my experience with my fellow directors at the American Funds family, the associates at Capital Research and Management Company and independent directors of

other funds whom I have had the opportunity to know and with whom I have discussed industry issues. I have found these individuals to be smart, responsible,

conscientious, inquisitive, and outspoken. I commend Congress’ and the regulators’

interest, especially the Securities and Exchange Commission, in restoring investor

confidence and faith in our capital markets. Clearly, some regulatory response to

the recent events is necessary but it must be well considered and practical. I thank

this Committee for its thoughtful consideration to determine what legislative response may be necessary.

I will discuss:

• the organization of our boards and how we work;

• service on a single versus multiple boards;

• the independent chair proposal; and

• the independent director certification proposals.

Duties and Responsibilities of Fund Boards of Directors

In evaluating proposals that would reform fund governance, it is important to

understand how investment companies operate and, in particular, the role of independent directors. Today, I will share with you how I go about discharging my

duties and responsibilities in the shareholders’ best interests.

453

Before I joined the board of New Perspective Fund, my experience had been with

traditional public corporations. Therefore, I had to learn very quickly the distinctions between my role as an independent director of a mutual fund versus that of

a corporate director. A shareholder invests in a mutual fund because the investment

strategy and process of the investment adviser is attractive. In fact, the investment

adviser created the mutual fund to offer its services on a pooled basis to the investing public who could not otherwise afford the services of a professional money manager. A fund has no employees—the adviser and service providers manage its operations and provide staff. As fund directors, we are not charged with managing any

of the fund operations. We serve the interests of fund shareholders through our

oversight of the fund’s operations and of the fund’s service providers such as the

adviser, auditors, and the like.

Under the Investment Company Act and SEC rules, independent directors have

particular responsibilities to protect fund shareholders against conflicts of interest

between the fund and its adviser and other service providers. One prominent example of the independent directors’ role in protecting against conflicts of interest is

the renewal of a fund’s advisory contracts. At New Perspective Fund, we receive

substantial education from the adviser throughout the year, especially in connection

with the annual contract renewal. In advance of the first of two board meetings during which we will be discussing the contracts, we receive extensive information from

the adviser that we review carefully and compare some of the information with that

of the prior year. The first meeting is devoted to asking questions of the adviser

and/or requesting additional information. I have never felt inhibited in asking questions or raising issues that may not be on the agenda or in the book. After questioning management, the independent directors and our independent counsel meet

in executive session to discuss the information in connection with the renewal of the

contract. At the second board meeting we receive the additional information and discuss any further issues. Only after we are all satisfied do we vote on the advisory

contracts. All independent directors sit on the Contracts Committees and they vote

separately on contract matters.

My duty as a Director is to feel comfortable not just at one point in time. As a

result, throughout the year I look for or request information that satisfies me that

the controls, systems, and procedures continue to be in place. Our board regularly

takes the initiative to identify matters for the adviser to report on at board meetings

or in special sessions. Management is always responsive to our requests.

We meet in clusters. American Funds have nine clusters ranging from one to

twelve funds per cluster. For example, the Fixed-Income funds may meet in a cluster that consists of 12 funds, while my cluster has only one fund. Although I only

serve on New Perspective Fund’s Board, our meetings coincide with board meetings

of two other global equity funds, EuroPacific Growth Fund and New World Fund.

We meet quarterly over consecutive days. We often have joint board or Audit Committee meetings to discuss issues common to us all, such as discussion of a particular industry or country or the internal control review (SAS 70) performed by an

independent audit firm. After the joint meetings, each Board then meets separately,

including our executive sessions.

Independent directors are nominated by the Nominating Committees that consist

solely of independent directors. We have a separate committee consisting of one

independent director from each of the nine clusters to oversee the shareholder operations performed by a subsidiary of Capital Research and Management Company.

This committee meets bi-annually with at least one meeting taking place at one of

the four service centers.

Finally, we are encouraged to attend independent educational seminars and hold

biennial 2-day seminars for all American Fund directors at which we discuss various

topics outside the context of regular board and committee meetings.

Service on Multiple Fund Boards

The proposed reforms for fund governance include questions concerning service by

independent directors on multiple boards. Although I serve on a single board, I believe there are efficiencies and economies of scale to be achieved from service on

multiple boards. I have experienced these efficiencies as a result of the joint board

and/or Audit Committee meetings in which I have participated.

While our ‘‘cluster’’ arrangement works for us, I can appreciate that different complexes may find other structures preferable. I do not believe that Congress or the

SEC should dictate the number of boards on which an independent director can sit.

The factors affecting a director’s ability to serve on multiple boards are quite varied

and subjective. I think that the SEC’s proposal to require directors to evaluate,

annually, their ability to serve the shareholders of the funds they oversee is an

effective way to address this issue.

454

Fund Governance Reforms

As an American by choice and not by birth, I have great faith in this committee

and the legislative process that any actions will be for the benefit of the individual

investor/shareholder. Some of the reforms suggested will, in my opinion, improve

the governance system, yet others threaten to add more cost and burdens on boards

and fund shareholders without any benefit.

As I mentioned, I believe certain of the proposed reforms would be beneficial and

most likely to have an impact on how I discharge my duties as an independent director. For example, I support:

• broadening the definition of ‘‘interested person’’ to draw a clearer line between

independent directors and persons with ties to the fund’s adviser or other service

providers;

• requiring 75 percent of the board to be independent;

• self-assessing annually the board’s performance;

• meeting separately with only independent directors at least four times a year;

• implementing nominating committees consisting only of independent directors;

and

• requiring a fund’s chief compliance officer to report directly to the independent

directors.

Independent Chair

I do not support the proposal that every mutual fund board must have an independent chair. Although our Board does not have an independent chair, we have

never been prevented from adding items to the agenda or discussing issues that are

not on the agenda. I also believe that the quality of our Board meeting agendas is

a function of the input from the independent directors, as well as the interested

chair, the officers of the adviser, independent legal counsel, and the fund’s auditors.

They reflect an open and challenging dialogue between the adviser and the independent directors. While some funds may benefit from an independent chair, I do

not agree that the chair should be an independent director in every case because:

• An independent chair would not have the day-to-day exposure to the fund’s operations to understand and raise current issues or anticipate potential problems

before they become ‘‘problems.’’ In order to gain that kind of knowledge, the

independent chair may find himself/herself with a full time job, thereby negating

his/her independence from the fund’s adviser. This also would increase the cost

to shareholders.

• No two-fund families and advisers have the same culture; accordingly, one size

does not fit all.

My recommendation would be to allow boards to decide whether to have an independent chair or lead director. Independent boards should vote and appoint either

an independent chair or lead director, whichever they believe would best benefit

shareholders of their funds.

Certification Requirements

Pending legislative proposals would require that independent directors or an independent chair certify to a number of matters. These include whether there are

certain policies and procedures in place, as well as whether those policies and procedures have been followed. I strongly believe that an independent director should not

be required to certify to matters about which directors could have no direct knowledge. I am particularly troubled by proposals that would require independent directors to certify that a fund is in compliance with its policies and procedures to calculate daily net asset values and oversee the flow of funds into and out of the fund.

I inquire and am satisfied that there are controls, procedures, and policies in place

to calculate net asset values and oversee fund flows. While we receive reports on

these issues at board meetings, directors do not and should not have the obligation

to monitor compliance on a day-to-day basis. Some of these certifications also appear

to confuse the role of an independent director of a mutual fund with the role of

the distributor/financial adviser in serving the ultimate investor/shareholder. For

example, while I can be satisfied that all the fund’s share classes bear appropriate

fees and expenses, I have no way to determine whether a given share class is appropriate for a particular investor without knowing that investor’s investment

objectives, holding period, etc. That is not my role as an independent director of a

mutual fund.

I also am concerned about the implications of independent director certifications.

Do these certifications expose us to additional liability or remove our business judgment? As an independent director, do I add value if I must rely on sub-certifications

455

1The views expressed in this testimony may not represent the views of Fidelity Management

& Research Company. The views expressed in Part V of this testimony reflect my own views.

from the people who really are in a position to monitor day-to-day compliance with

these operations? Am I suggesting to fund shareholders that additional protections

are in place, protections that I could offer only if I were to immerse myself in the

day-to-day operations of the fund? If I did take it upon myself to become so immersed, am I now performing the role of management, and am I still independent?

The whole area of certifications, as proposed, crosses the line from oversight to dayto-day management, and sometimes may cross the line from investment adviser to

distributor. I also believe that the certification could cause a problem for funds attracting and retaining qualified persons as fund directors, which certainly would not

be in the best interest of shareholders.

It is my view that these kinds of certifications, if required, should be redirected

to those persons who are responsible for managing the operations of a fund or its

distribution, as appropriate. This would place the responsibility directly on the persons who are capable of conducting the types of review necessary to verify compliance. To place this responsibility on directors would badly confuse our oversight

responsibilities with the operating responsibilities of management.

Conclusion

I appreciate the opportunity to address the Committee and to share my perspective as an Independent Director with you. I trust that I have given you a better

understanding of independent directors’ roles in the fund industry. I also hope that

you take into consideration that the vast majority of independent directors take

their responsibilities seriously as you evaluate the numerous proposals relating to

fund governance.

—————

PREPARED STATEMENT OF MARVIN L. MANN

CHAIRMAN OF THE INDEPENDENT TRUSTEES, THE FIDELITY FUNDS

MARCH 2, 2004

I. Introduction

Chairman Shelby, Ranking Member Sarbanes, and distinguished Members of the

Committee, my name is Marvin Mann. I am Chairman of the independent trustees

of the Fidelity Funds. I appreciate this opportunity to appear before you today to

discuss mutual fund governance and to describe how the Fidelity Funds Board does

its job.

The Fidelity Funds are the largest mutual fund family in the United States, with

assets of over $900 billion and about 19 million shareholders as of December 31,

2003. As an Independent Trustee, it is my job to oversee the Fidelity Funds and

to help protect the interests of the many shareholders of the Fidelity Funds. In that

capacity, I have had the good fortune to work with a group of independent trustees

who are dedicated to acting independently in pursuing the best interests of the

Fidelity Funds and their shareholders. The way in which we go about our job may

be instructive.

Before I begin, I want to applaud this Committee for the leadership it demonstrated in connection with the enactment of the Sarbanes-Oxley Act of 2002. This

Act recognized that corporate governance generally could best be improved by

enhancing the role of independent directors, strengthening auditor independence,

subjecting internal controls to more rigorous scrutiny and reinforcing the process by

which information gets ‘‘reported up’’ through a corporation—ultimately, when necessary, to the board of directors. Without this type of system, corporate boards, including fund boards, cannot do their job. These types of reforms, rather than efforts

to mandate a specific ‘‘one-size-fits-all’’ board of trustees model for all mutual funds,

are the most effective means to improve mutual fund governance, compliance, and

accountability.

Today, I would like to address mutual fund governance matters. In addressing

these matters, specifically in Parts II, III, and IV of this testimony, I am expressing

not only my own views but also those of the Governance and Nominating Committee

of the Fidelity Funds, all of the members which are independent trustees.1

In addition, stepping from my role as an Independent Trustee of the Fidelity

Funds and speaking more broadly about public policy issues affecting the entire

fund industry, I would also like to address three proposals that I believe will imVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00467 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
456

prove mutual fund regulation and benefit investors in a meaningful way. I encourage Congress and the SEC to give these proposals serious consideration.

II. Characteristics of Effective Boards of Trustees

I know that you are interested in how fund boards oversee a large number of

funds in an effective manner. An engaged and well-functioning board of trustees can

undertake this responsibility and do the job well. To describe how this can be done,

I would like to identify what I believe are the five general characteristics of a wellfunctioning board. Having been an Independent Trustee for approximately 10 years

and a member of corporate boards for many more, I have had ample opportunity

to observe and think about the characteristics of a well-functioning board and to put

my thoughts into practice. The Fidelity Funds Board incorporates these characteristics. It is important to understand the role of a board of directors in the corporate

governance of mutual funds and, for that matter, of companies generally. The role

of a board of directors is primarily one of oversight. A board of directors typically

is not, and should not be, involved in the day-to-day management affairs of the company. With this in mind, I would now like to address the five characteristics of a

well-functioning board.

First, a well-functioning board recruits high quality, highly experienced people,

who are independent, to serve as trustees. In the case of the Fidelity Funds Board,

the independent trustees have established criteria that are aimed at recruiting such

people who also have the time, the commitment, the expertise, the judgment and,

most importantly, the values to serve as independent trustees. One of the most important values, in addition to integrity, is the disposition to act independently in

fact. We expect that the independent trustees, as fiduciaries, will play an active role

and, as necessary, an adversarial role in pursuing the best interests of the funds

and their shareholders.

We also focus our Trustee recruiting efforts on people who are highly experienced

in overseeing large, complex organizations. Trustees with this type of experience

have the expertise, disposition, and the instincts to guide the formulation of processes that enable them to: (i) oversee many complex issues in an effective manner,

(ii) identify areas that require detailed board attention, and (iii) establish reporting

mechanisms that provide assurance that appropriate actions are promptly taken.

We make an effort to recruit senior executives from a variety of fields, including

business operations, finance and accounting, marketing, investment management,

and Government service. Trustees with diverse backgrounds bring complementary

skills, strengths, experiences and insights that enhance our ability to provide effective oversight.

The process of recruiting independent trustees is crucial. It requires a lot of effort,

because 10 of the 14 trustees of the Fidelity Funds, or over 70 percent, are independent. Substantially more effort would be required if a limit were to be imposed

on the number of funds that a single board could oversee. As the number of boards

overseeing funds increases, there would be more board seats to be filled without any

increase in the number of suitable candidates.

Responsibility for all aspects of the Independent Trustee identification and recruitment process is vested in the Governance and Nominating Committee, which

I chair and which is composed exclusively of independent trustees. More recently,

in order to assure that we consider a broader range of qualified candidates, the Governance and Nominating Committee has retained an executive search firm to assist

us in canvassing for qualified people.

The Governance and Nominating Committee consults with the other independent

trustees throughout the selection process. The decision to select an independent

trustee for our board is made by all of the independent trustees. Of course, ultimately our selections must be approved by fund shareholders.

The second characteristic of a well-functioning board is time commitment. Trustees must make the significant time commitment necessary to prepare for and fully

participate in board meetings. The Fidelity Funds’ Board has regular meetings 11

times a year, almost always in person. Special board and committee meetings are

not infrequent. Regular meetings generally take the better part of 2 days. Board

members are expected to review an extensive amount of material prior to each

meeting. Preparation time can span several days prior to the meeting. In order to

contribute meaningfully to board discussions and meetings, trustees therefore must

be in a position to make a real commitment of their time. Often, potential candidates who would otherwise be extremely capable independent trustees have been

eliminated from consideration due to their inability to make this commitment.

The third important characteristic is the ability to exercise a strong voice in setting the agenda for board and committee meetings. The Fidelity Funds independent

trustees pay a great deal of attention to structuring the agenda. First, we establish

457

an annual calendar to schedule all of the matters that require board action and review over the course of the year, including individual fund portfolio reviews. Each

month we consider whether additional matters should be added to the agenda for

that month’s meeting. At every board meeting, we reserve a substantial amount of

time for executive sessions limited to independent trustees. At these meetings we

discuss the agenda, the agendas for future meetings and other matters relating to

our oversight of the Fidelity Funds.

This process ensures that issues important to fund shareholders are considered.

As Chairman of the independent trustees of the Fidelity Funds, I not only approve

meeting agendas, but I also make sure that they reflect my input, as well as the

input of committee chairs and the other independent trustees.

The fourth characteristic of a well-functioning board is access to information and

resources. Trustees cannot exercise oversight and fulfill their fiduciary duties in a

vacuum. The independent trustees of the Fidelity Funds have our own legal counsel.

We need and receive regular reports and detailed presentations from Fidelity on a

broad range of matters related to our oversight of the funds. Our requests for information are promptly addressed. As necessary, we schedule tutorials to address additional questions and provide additional analytical data that we may need to support

the Board’s decisionmaking process. Importantly, Fidelity has the resources and

commitment to keep the board of trustees fully informed.

The fifth and final characteristic is organization. A well-functioning board needs

to have effective and flexible structures and processes that govern the board and

its committees. These structures and processes must be designed to ensure that all

necessary work is completed, based on the right mix of information.

The Fidelity Funds Board has developed a well-defined committee structure that

is a critical factor in our ability to oversee the funds. The structure, mission, and

membership of each board committee are decided solely by the independent trustees. These committees are chaired by, and consist exclusively of, independent trustees. This assures that the committee agendas and decisions are controlled by the

independent trustees.

We have a Nominating and Governance Committee, an Audit Committee, an Operations Committee, a Fair Value Oversight Committee and a committee that focuses on brokerage, distribution and shareholder services. We also have divided the

universe of Fidelity Funds into three categories, based largely on investment focus,

and we have established a separate committee to oversee each category. We also

have committees that lead the board’s review and negotiation of the fund’s investment advisory contracts.

The committee structure, coupled with the other elements that I have described,

make it possible for the independent trustees to consider the issues faced by all of

the Fidelity Funds in an effective manner.

It may be much more difficult for a board to oversee a large number of operating

companies in diverse businesses, each with different groups of shareholders. But

there are important differences between operating companies and mutual funds.

Funds within the same fund complex share a substantial number of common elements. These common elements include distribution, fair value pricing procedures,

brokerage allocation processes, administrative and operational processes (such as

transfer agency, custody, and IT issues), audit, internal control and compliance processes, and many investment management processes. And, unlike operating companies, funds do not have separate employees or substantial physical assets and operating facilities. Rather, mutual fund boards generally oversee a relatively limited

number of service providers that furnish specified services to each of the funds in

the complex. While there may be variations in the specific services that each fund

receives, they are generally variations of the common services that each fund must

receive. Issues arising in connection with these common elements often must be resolved in a uniform way—a resolution that can most readily be achieved by a single

unified board.

The time and effort involved in overseeing a large number of funds with common

elements is, therefore, not the same as would be required to serve on separate

boards of the same number of unaffiliated operating companies. A well-functioning

unified fund board can leverage its knowledge of the common elements, address

them in an efficient manner and in the process do a superior job in exercising its

fiduciary duties and looking after the best interests of fund shareholders.

Our committee structure comes into play here and really makes it possible for the

independent trustees to oversee all of the Fidelity Funds. The common elements of

fund operation, such as fair value procedures, internal controls and audit functions,

brokerage allocation, shareholder services and distribution, are addressed by committees that have oversight responsibilities for these areas across all funds in the

complex.

458

We also have processes that allow us to identify issues that are unique to specific

funds. The Board of Trustees’ oversight of fund performance provides a good example. The independent trustees receive monthly reports on the performance of all of

the funds. This includes information comparing the performance of each Fidelity

Fund to a peer group of funds and an appropriate securities index or combination

of indices. Unusual performance that may require attention is immediately obvious

to all of us. The Fund Oversight Committees also conduct regularly scheduled indepth reviews of the funds they oversee. Prior to each fund review meeting, the

board receives written reports and analyses from the portfolio manager to assist the

oversight committee’s preparation for the meeting. This material provides the independent trustees with essentially the same information that Fidelity management

uses in its periodic reviews of portfolio performance. At the meeting, the oversight

committee discusses this data and other aspects of fund performance in depth with

the portfolio managers and their supervisors. The highlights of these meetings are

reported to and discussed by the full Board. In this manner, all of the independent

trustees are made aware of the significant issues faced by each of the Fidelity Funds

and any actions required to remedy them.

Another good example of the process that allows us to identify issues that are

unique to specific funds relates to our review of the funds’ investment management

agreements with Fidelity. I will discuss this in the next section of my testimony.

To sum up, the five characteristics of a well-functioning board are people, time

commitment, the authority to set the agenda, access to information and organization. When all five of these elements are present, a board should be able to effectively fulfill its oversight and supervisory responsibilities. This certainly is the case

with the Fidelity Funds Board.

You will note that one characteristic that I did not include is having an independent chairman.

A well-functioning board can, and in the case of the Fidelity Funds Board does,

act independently and effectively without having an independent trustee serve as

chairman. Independent trustees should have the authority to select an independent

chairman, and the independent trustees of the Fidelity Funds have that authority

now. I believe that the key structural component of assuring that independent trustees are in a position to control the board is to assure that they constitute a substantial majority of the board, as the SEC has proposed. The independent trustees of

the Fidelity Funds further reinforce their independence by setting their own compensation. The investment adviser and management trustees are not involved in

this determination.

I am sure that there are some fund boards where governance might be improved

if a particular individual, who also happened to be an independent trustee, served

as chairman. In the case of many funds, that may not be the case. In each case,

the independent trustees are the parties in the best position to make this decision.

The SEC and the Investment Company Act entrust to independent trustees a

number of important decisions with respect to various matters, including the approval of investment advisory contracts, underwriting agreements and determinations under various rules that address conflicts of interest. Removing from our discretion the election of the board chairman seems to me to be in basic conflict with

that approach, particularly when, as a practical matter, the independent trustees

must be at least a majority of the board. The Sarbanes-Oxley Act strengthened corporate governance for public operating companies. Wisely, it did not require corporate boards to have independent chairs. I do not believe that the case has been

made that an independent chairman is essential to improving mutual fund governance. I therefore feel strongly that mandating a governance structure that requires

an independent chairman is not in the best interests of all funds or all shareholders.

It may be appropriate, however, to require that a majority of the independent

trustees of a fund have the authority to elect and remove the board chairman.

III. Consideration of Investment Management Contracts

One of the most important functions of a mutual fund board of trustees is its annual consideration of the investment management contract between the mutual

fund and its investment adviser. The approval and annual renewal of the investment management contract requires the approval of a majority of the independent

trustees. The Fidelity Funds Board of Trustees receives an enormous amount of

information in connection with our review of the funds’ investment management

contracts with Fidelity and any affiliates of Fidelity that serve as sub-advisers (who,

for purposes of this testimony, I refer to collectively as ‘‘Fidelity’’).

First, however, I want to dispel any notion that all of the issues relating to investment advisory contracts are considered at a single meeting. The formal contract reviews occur over a series of meetings. Moreover, we receive data and information

459

relevant to that review throughout the year, including the fund reviews that I discussed above.

In reviewing the contracts, the Board of Trustees considers a number of factors.

We receive data and information from Fidelity to support our consideration of these

factors, including comparative data relating to peer groups of funds. I should also

emphasize that the management fees paid by a large number of the Fidelity Funds

include a performance-based adjustment, which can increase or decrease the fee.

Thus, we receive information on the impact of performance adjustments to the management fees.

The factors that we consider typically include the following:

• Benefits to Shareholders. We consider the benefit to shareholders of investing in

a fund that is part of a large family of funds offering a variety of investment disciplines and providing for a large variety of fund and shareholder services.

• Investment Compliance and Performance. We consider whether each fund has operated within its investment objective and its record of compliance with its investment restrictions. We also review each fund’s investment performance as well as

the performance of a peer group of mutual funds, and the performance of an appropriate index or combination of indices (approved by the independent trustees).

• The Investment Advisers’ Personnel and Methods. As discussed above, we have annual meetings with each fund’s portfolio manager. We review each fund’s investment objective and discipline. The independent trustees also have discussions

with senior management of Fidelity responsible for investment operations and the

investment discipline of each fund. Among other things that we consider are the

size, education, and experience of Fidelity’s investment staff, their use of technology, and Fidelity’s approach to recruiting, training, and retaining portfolio

managers and other research, advisory, and management personnel.

• Nature and Quality of Other Services. We consider the nature, quality, cost, and

extent of administrative and shareholder services performed by Fidelity and its

affiliates, under the investment management contracts and under separate agreements covering transfer agency functions and pricing, bookkeeping and securities

lending services, if any. We also consider the nature and the extent of Fidelity’s

supervision of the third-party service providers, principally custodians and subcustodians.

• Expenses. We consider each fund’s expense ratio, and expense ratios of a peer

group of funds. We also consider the amount and the nature of fees paid by the

shareholders.

• Profitability. We consider the level of Fidelity’s profits in respect of the management of the Fidelity Funds, including each fund. This consideration includes an

extensive review of Fidelity’s methodology in allocating its costs to the management of a fund. We consider the profits realized by Fidelity in connection with

the operation of a fund and whether the amount of profit is a fair entrepreneurial

profit for the management of a fund. We also consider Fidelity’s profits from nonfund businesses that may benefit from or be related to a fund’s business. We also

consider Fidelity’s profit margins in comparison with available industry data.

• Economies of Scale. We consider whether there have been economies of scale in

respect of the management of the Fidelity Funds, whether the Fidelity Funds (including each fund) have appropriately benefited from any economies of scale, and

whether there is potential for realization of any further economies of scale.

• Other Benefits to Fidelity. We consider the character and amount of fees paid by

each fund and each fund’s shareholders for services provided by Fidelity and its

affiliates, including fees for services like transfer agency, fund accounting and direct shareholder services. We also consider the allocation of fund brokerage to brokers affiliated with Fidelity, the receipt of sales loads and payments under Rule

12b–1 plans in respect of certain of the Fidelity Funds and benefits to Fidelity

from the use of soft-dollar commissions to pay for research and other similar services. We also consider the revenues and profitability of Fidelity’s businesses other

than its mutual fund business, including Fidelity’s retail brokerage, correspondent

brokerage, capital markets, trust, investment advisory, pension record keeping,

insurance, publishing, real estate, international research and investment funds,

and others. We also consider the intangible benefits that accrue to Fidelity and

its affiliates by virtue of their relationship with each fund.

I have outlined a significant number of factors and, as you can imagine, that

means we review a significant amount of information. As I have just discussed, our

committee structure makes our review of this information more efficient. The independent trustees and Fidelity also spend a great deal of time in developing formats

for the presentation of this information that facilitate our review of the data applicaVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00471 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
460

ble to each fund. As I discussed earlier, a well-functioning board of trustees can

and, in the case of the Fidelity Funds, does have the capabilities required to consider all of the factors relevant to the review of each fund’s investment management

contract.

IV. Independent Director Certifications

Certain legislative proposals would require independent trustees, or an independent board chairman, to certify as to certain matters, such as, depending on the

bill, the existence of procedures for verifying a fund’s net asset value, the oversight

of the flow of assets into and out of the fund, the adoption of codes of ethics, the

accuracy of disclosure documents and certain other matters.

The fundamental role of a mutual fund board, and particularly of the independent

trustees, is to provide oversight. It is important that the fundamental oversight role

of independent trustees not be confused with the operating responsibilities of fund

management. Certification is a proper function for entities that manage the fund on

a day-to-day basis since it is they, not the board, that must carry out the appropriate risk assessment, compliance, and internal audit responsibilities.

Proper oversight may require a board to review and approve various policies and

procedures and receive reports on their implementation. A certification requirement

is not necessary to assure that these actions are taken by the board. It would be

relatively simple for a regulator to confirm that required procedures have been

adopted from a review of the board’s minutes and to take appropriate action if the

board had failed to adopt required procedures.

Certification requirements would go beyond the requirements imposed on independent directors of other public companies and would not serve any practical purpose. They would only blur the line between the oversight function of the board and

the day-to-day management and operational responsibilities of various entities, such

as the investment adviser. This is likely to create uncertainty as to the board’s

duties and potential liabilities. It would have a chilling effect on a board’s ability

to recruit and retain independent trustees.

For these reasons, I do not support trustee certification requirements.

V. Three Proposals to Improve Regulation

The existing regulatory frame work under which mutual funds operate has served

investors well. It continues to accomplish its primary goal of investor protection.

There is always room for improvement, however. In that spirit, I would like to take

off my Fidelity Funds trustee hat, and instead speak more broadly about issues that

affect the fund industry as a whole. In particular, I would like to discuss three proposals that would improve the regulation of mutual funds and the financial markets

generally, to the benefit of all investors.

These proposals relate to fund expense disclosure, the use of fund brokerage to

acquire certain types of goods and services (sometimes referred to as ‘‘soft-dollar’’

arrangements) and fund distribution costs. I cannot take credit for these proposals

because they appear, in one form or another, in various bills that have been introduced to reform the mutual fund industry.

I want to emphasize that these proposals reflect systemic and competitive issues

that can only meaningfully be addressed on an industry-wide basis. I raise them

today in the hope that my voice will encourage their consideration.

Expense Disclosure

Mutual fund investors could benefit from being told, in dollars and cents, exactly

how much it costs for them to invest in their fund. Current rules, which require that

fee disclosures be presented in fund prospectuses as a generic percentage of fund

assets and a dollar-based hypothetical may be helpful, but they lack precision and

specificity. An investor who is interested in getting the full picture of the expenses

related to his or her investment would be required to collect data concerning commissions, fees, expenses (to the extent that the data is available) and performance

from multiple sources (such as account statements, confirmations and prospectuses).

The investor would also be required to keep track of changing account balances and

then would have to attempt to make computations of the expenses and net performance on each investment. Investors, even reasonably sophisticated investors, would

find this time consuming and difficult. Investors could receive more useful information regarding the costs associated with their investments, and that information

could be presented in a better way.

It may be useful for investors to receive information on actual expenses applied

to a hypothetical investment amount that would be the same for all funds, so that

investors could compare expenses among funds. This type of disclosure requirement

was recently adopted by the SEC. I would have liked the SEC to have gone further.

461

The regulations should require that when an investor buys shares in a fund he

or she receive from the fund or the broker a statement setting forth the expenses

that the investor will incur. This information should be set forth as a percentage

of his or her investment and in actual dollars. The statement would detail all sales

charges and itemize all of the fees and expenses that will be paid by the investor

either directly or indirectly. The disclosure would be presented so that the investor

would not need to search for it in the prospectus or other documents that the investor may receive.

Thereafter, on a quarterly basis, the investor would receive as part of his or her

account statement the amount of fees and expenses that the investor actually paid

with respect to his or her investment in each fund during the period and, on a

cumulative basis, since the beginning of the year. The gross and net returns of the

fund investment, in dollars, would also be shown. The goal would be to allow investors who are interested in expense information to receive it in a manner that is

readily accessible, easy to understand and, more importantly, in the context of a report that shows what they really earned on their investment.

I believe that this approach should be required for all investment vehicles and accounts. There will be some costs in implementing it, some of which may be borne

by investors. But I firmly believe that improved expense disclosure will result in

greater investor awareness of expenses. I believe that this increased awareness will,

over time, bring competitive pressures to bear on some funds with higher fees. I

hope that the SEC will be encouraged to continue to actively pursue the type of

expense disclosure that I suggest.

Fund Brokerage and Soft Dollars

Broker-dealers often provide investment advisers with research products and services in exchange for the direction by the adviser of mutual fund and other client

brokerage transactions to the broker-dealer. A portion of the commission paid by a

client, sometimes substantial, may, in effect be used to pay for these research products and services. In other words, the additional services are bundled with execution

and their costs are reflected in commission rates.

These arrangements, known as soft dollars, are specifically permitted under current law. Section 28(e) of the Securities Exchange Act of 1934 provides, in effect,

that an investment adviser shall not be deemed to have breached a fiduciary duty

solely by reason of having caused the client to pay more than the lowest available

commission. The adviser must determine in good faith that the amount of the commission is reasonable in relation to the value of the brokerage and research services

provided. The research need not have any relationship to the client that generated

the commission; the investment adviser can conclude that the value of the research

was reasonable when viewed in terms of its overall responsibilities with respect to

clients for whom it has investment discretion.

Brokerage commissions are not reported as fund expenses. Thus, while the use

of fund brokerage in connection with soft-dollar arrangements is disclosed in mutual

fund disclosure documents, the real costs of the services provided under soft-dollar

arrangements are not obvious to investors.

I believe that regulatory action should be taken to ‘‘unbundle’’ fund portfolio brokerage. Specifically, mutual fund brokerage commissions should reflect execution

costs and nothing else. I support the recent SEC rule proposal to prohibit the use

of fund commissions to reward brokers for sales of fund shares as a step in the right

direction. But more needs to be done.

Section 28(e) should be repealed. I acknowledge that repeal of Section 28(e) could

result in some significant changes in the way in which brokerage firms and others

conduct business. I believe that the SEC should develop a transition plan to allow

the repeal of Section 28(e) to take effect on a date certain without inordinate disruptions to market participants.

If an adviser wants to purchase research products or other services such as data

terminals, or other nonexecution services, or pay a dealer compensation for fund

sales (to the extent currently permitted by law), it would pay for those in hard dollars from its own resources, not from fund commissions. Once soft-dollar arrangements are eliminated, the receipt of research would no longer be a factor in allocating portfolio brokerage.

The end of soft-dollar arrangements may result in pressure to increase investment

advisory fees, since investment advisers will need to pay for certain research products and services out of their own pocket. If that is a result, it is a matter that

would be considered by fund boards as part of their advisory contract review process. I would expect that any increased advisory fees will in the long run be more

than offset by reduced brokerage costs. In any event, the cost of the services, if they

continued to be purchased by the fund or through increased advisory fees, would

462

be reported to investors. Investors would have a much better understanding of the

expenses of investing in a mutual fund and would be able to make better-informed

investment decisions. At the very least, the cost of research and other services to

fund investors would be transparent.

Distribution Costs

The third area where change is called for relates to the way in which the costs

of distributing fund shares are paid.

Investors who purchase fund shares through intermediaries pay for the distribution of fund shares in a number of ways. The investor may be charged a commission

or sales load at the time they purchase their shares. The investor may also have

the option to pay for the services of the intermediaries on a deferred basis through

an annual asset-based fee imposed in accordance with Rule 12b–1 under the Investment Company Act. The Rule 12b–1 fees provide for the payment over time of distribution and marketing expenses from fund assets. The investor, of course, bears

these expenses through his or her investment in the fund and, in certain circumstances, through a contingent deferred sales load.

Sales loads and Rule 12b–1 fees also have been supplemented, in some cases, by

fund brokerage commissions, which may be allocated to sellers of fund shares under

certain circumstances. In other words, a portion of the fund brokerage commissions

may actually pay for distribution costs.

In addition, the investment adviser also may supplement sales loads and Rule

12b–1 fees by paying for marketing and distribution costs from its own resources.

These payments may be for services such as advertisements in newspapers or cash

payments to dealers. The latter type of payments, have come to be characterized as

‘‘revenue sharing.’’ Revenue sharing payments may cover some of the broker’s costs

in selling the funds. They may also, in effect, be payments for ‘‘shelf-space’’ or being

placed on ‘‘preferred lists’’ at the broker-dealer.

The complexity of these different methods for paying sales charges may make it

difficult for investors to fully comprehend the cost of investing in a mutual fund.

Certain practices, such as revenue sharing, may create conflicts of interest for the

broker that, even when fully disclosed, may be difficult to understand.

I have a three-element proposal that would bring greater clarity to this area.

First, sales charges for the services of the broker-dealers or other intermediaries,

whether up front or paid in installments, should be paid directly by the investor.

A Rule 12b–1 fee should not be used as a substitute for sales loads. The compensation of intermediaries should generally be limited to their receipt of sales loads

(whether paid up front or over time) paid by the investors that choose to utilize

their services. If brokers want to give investors the option of paying their sales loads

over time, they should collect them in installments as is specifically permitted by

the rules.

There is no reason why such installment payments should be a fund expense—

they can and should be deducted from the shareholder’s account. Thus, if a dealer

charges a deferred asset-based sales fee in lieu of a front-end load for its distribution efforts, it should be collected by the broker or by the fund complex either by

imposing a direct charge on the investor or by deducting the amount from the shareholder’s account. These charges would, of course, be fully disclosed and agreed to

by the investor.

The SEC recently requested comment on whether Rule 12b–1 should be amended

to require this approach. I hope that, after reviewing the comments that it receives,

the SEC embraces this approach.

The second element would be to prohibit intermediaries from collecting any additional cash payments (including brokerage commissions) from the fund, its adviser

or the adviser’s affiliates for distribution efforts. In other words, revenue sharing

and other similar practices that involve cash payments to dealers would be prohibited. Accommodation may have to be made for the provision of training and due diligence services by the fund adviser to the dealer sales force.

The third element would recognize that fund complexes themselves have marketing and other unique costs, whether the funds are sold directly to investors or

through intermediaries. These fund expenses, which reflect the cost of gathering

and servicing assets from tens of thousands of investors, as well as the administrative and regulatory compliance costs, differ greatly from the expenses incurred by

investment advisers to pension plans and other large institutional investors. The

investment adviser should be permitted to collect a reasonable fee from fund assets

to pay for these costs. The fee could be approved by the independent trustees (subject to their fiduciary duty to approve only reasonable fees). The fee could be used

to pay for marketing, administrative and shareholder servicing expenses. This

fee could not be used to make cash payments to intermediaries (although it could

463

be used, subject to the NASD rules, to pay for marketing activities directed at

intermediaries).

This fee would be separate and unbundled from the investment advisory fee. The

investment advisory fee would only represent the charges for portfolio management

services and thus would be more directly comparable to the investment management

fees paid by pension funds and other large institutional investors.

This three-element approach would have several benefits. First, the amount that

the investor pays an intermediary for its selling efforts would be clear and obvious.

The amounts would be paid by the investor directly. There would be little need for

the complex multiclass fund structures that have been developed to accommodate

different distribution arrangements, since the payments would not pass through the

fund. The amount would be totally transparent.

Second, eliminating revenue sharing payments would reduce conflicts of interest.

Revenue sharing creates potential conflict of interest situations for broker-dealers

and other recipients, and has presented significant regulatory issues and resulted

in SEC enforcement actions. And I do not believe that the way to address these conflicts is more disclosure—the disclosure simply becomes too complicated even for the

more sophisticated investor. I believe that the conflicts created by these practices

can best be addressed through prohibition rather than disclosure.

Third, my proposal would recognize the reality that mutual fund sponsors have

marketing and other costs. The approach would provide investors with a basis for

differentiating between the expenses borne by the fund for these efforts and the

expenses borne by the fund for pure portfolio management. This may provide better

disclosure for certain investors.

Greater transparency, reduced conflicts, and better disclosure: I think that these

are worthwhile objectives.

I appreciate that implementing this approach would create complex transition

issues for mutual funds and intermediaries that have been relying on the current

system. I believe that these issues could be effectively addressed once the basic concepts are understood.

***

These proposals must be implemented on an industry-wide basis. These are not

issues that each fund family can choose to address as it sees fit; it would simply

not be feasible for a board of trustees to attempt to implement these changes on

its own. I have been advised that substantially all of these proposals could be implemented by the SEC. Therefore, in order to ensure industry-wide change, Congress

and the SEC should give these proposals serious consideration.

I am certain that you will hear lots of arguments from all sides against these

three proposals. If implemented, they will result in some dislocations. They will also

result in some up-front costs, mostly for systems development, as well as some ongoing costs, mainly in the reporting area. But we should view these costs in the context of the trillions of dollars invested in mutual funds and the billions of dollars

of trading commissions mutual funds generate. Improving market forces through

greater transparency and reducing opportunities for conflicts of interest should offset these costs many times over.

Conclusion

The series of hearings on mutual fund regulation being held by this Committee

is a great service. These hearings serve to demonstrate, above all, that the issues

facing mutual fund investors do not present simple problems or solutions. I believe

that this Committee should consider other proposals to help investors better understand their mutual fund investments and the costs associated with them.

Thank you for this opportunity to share my views.

—————

PREPARED STATEMENT OF MICHAEL S. MILLER

MANAGING DIRECTOR, THE VANGUARD GROUP, INC.

MARCH 2, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

my name is Michael Miller. I am a Managing Director at The Vanguard Group,

based in Valley Forge, Pennsylvania, where I am responsible for Planning and Development. An important part of my responsibilities is managing our Portfolio Review Group, which selects and oversees third-party investment advisory firms that

manage assets for our funds.

464

Vanguard understands that in the wake of fund trading scandals there is some

interest in imposing a direct ban on the ability of an individual to manage both

hedge funds and mutual funds. Congress is properly considering this and other

issues relating to the operation and regulation of mutual funds. Vanguard appreciates the opportunity to testify on the issue of joint management of mutual funds

and other accounts.

While Vanguard does not manage or offer hedge funds, Vanguard is very concerned that a ban on side-by-side management will eliminate a substantial number

of investment professionals and investment advisory firms that would ordinarily be

available to its mutual fund shareholders. Like Congress, Vanguard is concerned

about protecting the interests of mutual fund shareholders. We believe there are

ways to effectively protect the interests of multiple clients without taking the extraordinary, and potentially damaging, step of an outright ban on managing both

hedge funds and mutual funds.

The Vanguard Group

The Vanguard Group is the world’s second largest mutual fund family, with more

than 17 million shareholder accounts and approximately $725 billion of investments

in our U.S. mutual funds. Vanguard offers 126 funds to U.S. investors and over 35

additional funds in foreign markets. The Vanguard Group has a unique structure

within the mutual fund industry. At Vanguard, the mutual funds, and therefore indirectly the fund shareholders, own The Vanguard Group, Inc., which provides the

funds with all management services ‘‘at cost.’’ Under this structure, all ‘‘profits’’

of The Vanguard Group are returned to our fund shareholders in the form of reduced expenses.

Given Vanguard’s mutual ownership structure, all of our management policies,

practices, and personal incentives are designed to ensure the growth, safety, and

well-being of our fund shareholders’ assets. In addition, Vanguard has long maintained a philosophy of fair dealing with our shareholders, and we believe our current investment, business, and disclosure practices are designed to protect their

interests. As an industry leader, we are pleased to contribute to the discussions

about proposed fund initiatives, and we support appropriate and meaningful reforms

at the Federal level to restore investor trust in mutual funds.

Approximately 70 percent of Vanguard’s assets are managed by investment professionals employed by The Vanguard Group, Inc. These professionals manage

equity index funds, actively managed quantitative equity funds, actively managed

and indexed bond funds, and money market funds. The remaining 30 percent of

Vanguard’s assets, or roughly $220 billion, include actively managed equity and

fixed-income portfolios that are managed by third-party investment advisory firms,

which are hired and overseen by the funds’ boards of trustees with substantial assistance from Vanguard’s professional investment staff. In all, 37 of our funds receive portfolio management services from 21 independent advisory firms. We have

been selecting and overseeing independent advisory firms for more than 25 years.

There are substantial benefits for investors from our approach of using both internal

and outside managers:

• Diversity of Thought. Vanguard funds and shareholders benefit from the diversity

of thought that a variety of external advisers bring to the asset management process. We are able to engage portfolio managers with distinct investment strategies

and cultures that would not otherwise be available to mutual fund investors. Investment styles and strategies in fund offerings across the Vanguard complex are

distinct.

• Larger Pool of Investment Talent. Vanguard funds and shareholders benefit from

the additional investment talent that outside managers represent. Vanguard is

able to consider a wider range of potential managers for a specific investment

mandate and is not limited by geographic or other constraints.

• Capacity to Grow. Vanguard funds and shareholders benefit from the flexibility

to absorb new investments by engaging additional sub-advisers, without a fund’s

larger size diluting the effectiveness of existing managers. Introducing new managers can increase a fund’s capacity to grow and provide greater economies of

scale without diminishing potential investment returns.

• Diverse Investment Offerings with Consistent Compliance and Service Standards.

Vanguard funds offer diverse investment styles and strategies by using independent advisory firms. Importantly, Vanguard fund shareholders also benefit

from a consistent level of compliance oversight and service that a single management company can provide.

465

Side-by-Side Management

At many investment advisory firms, including Vanguard and all of the third-party

advisers we use, individual portfolio managers manage multiple accounts for multiple clients. In addition to mutual funds, these other accounts may include separate

accounts (assets managed on behalf of institutions such as pension funds, insurance

companies, endowments, and foundations), bank common trust accounts, collective

trusts, and other unregistered investment companies. Although, as stated earlier,

Vanguard does not manage or offer hedge funds, many asset management firms, including a number of our sub-advisory firms, do. A growing number of mutual fund

families hire independent sub-advisers to manage one or more funds. These sub-advisers have other clients, including, in some cases, hedge funds.

While the structure of asset management firms may vary widely, managing

money for multiple clients is, and has always been, an inherent feature of a successful asset management firm. Vanguard, for example, has never had a sub-adviser

that managed money solely for Vanguard. Importantly, any firm that manages mutual fund assets is a registered investment adviser and, as such, should have substantive policies and procedures that help ensure that the investment professionals

manage multiple accounts in the interest of all clients. The law and an adviser’s

role as a fiduciary demand no less.

Current Practices to Protect Mutual Fund Shareholders

VANGUARD’S APPROACH

Vanguard’s external investment advisers are subject to multiple controls and regulations to help ensure that Vanguard fund shareholders are protected. Among

these are:

• Careful Selection. In the selection of fund advisers, Vanguard carefully evaluates

the people, philosophy, process, and performance of a prospective investment management firm. In our view, the integrity and ethics of an advisory firm’s investment professionals are as critical as experience and talent.

• Close Supervision. Vanguard works closely with our advisers to ensure that they

are employing talented and experienced investment personnel, as well as devoting

the necessary research and compliance resources in the management of our funds.

In addition, the investment professionals in our Portfolio Review Group continually review the performance and portfolio characteristics of our funds. The practices and policies of our advisers are also subject to periodic audits by Vanguard.

• Federal Regulation and Fiduciary Obligation. Under the Investment Advisers Act

of 1940, all investment advisers are required to perform as fiduciaries and must

place the interests of their clients above their own at all times. Advisers also have

a fiduciary obligation to treat all clients fairly and equitably.

• Codes of Ethics. Each of our advisers has long maintained a strict code of ethics

that requires them to conduct their business in a completely ethical manner and

adhere to the highest standards of professional behavior. Accordingly, all managers representing Vanguard are expected to act for the benefit of fund shareholders. Vanguard regularly reviews each adviser’s code of ethics and its procedures and efforts to assure compliance with its code.

• Internal Compliance Policies and Procedures. In addition to the various laws and

regulations that govern investment management firms, our advisers maintain formal compliance procedures and policies that are consistent with SEC regulations

and designed to address potential conflicts of interest. These safeguards help to

assure us that Vanguard funds are not being disadvantaged by any of the firm’s

other investment activities.

FEDERAL REGULATION

All of the investment advisers who manage mutual funds are required by law to

be registered with the Securities and Exchange Commission under the Investment

Advisers Act. Therefore, all investment advisers whose business models include

side-by-side management of mutual funds and other accounts are also required to

be registered under the Advisers Act. All registered investment advisers are subject

to the SEC’s jurisdiction, inspection, and enforcement powers for all of their business, including the side-by-side management of mutual funds and hedge funds. The

SEC’s oversight of the investment adviser extends to all of its management activities, regardless of whether the investment activity is otherwise regulated. This provides the SEC with enhanced insight into unregulated investment activity, a degree

of transparency that is not present when the unregulated funds or accounts are not

managed jointly with mutual funds.

Under the Advisers Act, a registered investment adviser has a fiduciary duty to

recognize and disclose potential investment conflicts and carefully manage them

466

1 A detailed list of compliance procedures is included in the Appendix.

2SEC Rel. No. IA–2204, ‘‘Final Rule: Compliance Programs of Investment Companies and Investment Advisers’’ (December 17, 2003). 3 Investment Trusts and Investment Companies: Hearings on S. 3580 Before the Subcommittee

of the Committee on Banking and Currency, 76th Congress, 3d Sess. 202 (1940). 4 Id. at 194. See also, In re: Arleen W. Hughes, Exchange Act Release No. 4048 (February 18,

1948).

through appropriate policies and oversight. For example, a portfolio manager might

hypothetically have an incentive to allocate well-priced trades to a client paying

higher fees and more expensive trades to a client paying lower fees. As another

example, a manager might hypothetically have an incentive to benefit one client by

‘‘trading ahead’’ of the trading strategies of another client. As noted previously,

these potential conflicts are not unique to advisers who provide investment management to a mutual fund and a hedge fund. They exist whenever a portfolio manager

advises two accounts that differ in any way, potentially even when a manager runs

two different mutual funds simultaneously.

COMPLIANCE POLICIES AND PROCEDURES

Investment firms typically manage potential conflicts, whether involving hedge

funds or other types of accounts, through allocation policies and procedures, internal

review processes, and oversight by directors and independent third parties. Investment advisers develop trade allocation systems and controls to ensure that no one

client—regardless of type—is intentionally favored at the expense of another. Allocation policies are designed to address potential conflicts in situations where two or

more clients’ accounts participate in investment decisions involving the same securities, which happens frequently. In our experience, there are four core elements of

a strong compliance program.1 These elements are:

• assigning one average price per security for all trades in that security executed

for multiple clients;

• when supply of a security is insufficient to satisfy all clients, apportioning the

available supply according to equitable, predetermined rules;

• periodic reviews of the trading activity of portfolio managers for anomalous trading patterns involving multiple accounts; and

• independent review of the internal controls relating to the management of accounts, including controls on trade allocation.

These systems can also be, and typically are, examined by the SEC staff during

their inspections of registered investment advisers.

The SEC has very recently adopted new rules that will raise industry-wide standards for addressing these potential conflicts for the protection of all investors.2 The

new rules require each mutual fund, and each registered investment adviser, to

have written compliance policies and programs administered by a designated chief

compliance officer. Fund boards must approve not only the policies and programs

of the fund but also of the fund’s adviser. Fund chief compliance officers will report

directly to fund directors. These changes will enhance the transparency and accountability of fund investment advisers and also require fund directors to review

these activities very closely to determine that fair and equitable allocation policies

are in place and are being followed.

FIDUCIARY DUTIES OF INVESTMENT ADVISERS

Many investment advisers have adopted practices such as those described previously regarding joint management in order to meet the fiduciary duties that have

been required of them by Congress. All investment advisers (whether registered or

not) are subject to Section 206 of the Advisers Act, which generally makes it unlawful for an investment adviser to engage in fraudulent, deceptive, or manipulative

conduct. Congress enacted the Advisers Act upon declaring that the public interest

was adversely affected ‘‘when the business of investment advisers is so conducted

as to defraud or mislead investors, or to enable such advisers to relieve themselves

of their fiduciary obligations to their clients.’’ 3

An investment adviser has a fiduciary duty to exercise good faith and to disclose

all material facts fully and fairly, as well as an affirmative obligation ‘‘to employ

reasonable care to avoid misleading’’ its clients.4 As a fiduciary, an adviser owes its

clients more than honesty and good faith alone. Rather, an adviser has an affirmative duty to act solely in the best interests of the client and to make full and fair

disclosure of all material facts, particularly where the adviser’s interests may conflict with the client’s. Pursuant to this duty, ‘‘an investment adviser must at all

467

5Thomas P. Lemke & Gerald T. Lins, Regulation of Investment Advisers, at 2–34 (1999).

times act in its clients’ best interests, and its conduct will be measured against a

higher standard of conduct than that used for mere commercial transactions.’’ 5

Effects of Banning Side-by-Side Management

Banning individual portfolio managers from managing mutual funds and hedge

funds would disadvantage mutual fund shareholders and fail to protect them fully.

ACCESS TO INVESTMENT TALENT

Allowing side-by-side management of mutual funds and other accounts, including

hedge funds, affords mutual fund investors access to top investment firms and investment professionals. Based on our experience, there is a limited supply of exceptional investment advisory firms and investment professionals. It is important that

all investors, including mutual fund investors and 401(k) plan participants (who

largely invest through mutual funds), be afforded access to the same universe of

investment expertise as may be otherwise available to large institutions or highnet-worth individuals.

Many mutual funds with strong long-term performance records are managed by

portfolio managers who also manage other accounts, including in some cases, hedge

funds. These professionals have a range of options open to them regarding where

they commit their time and talent. Hedge funds can be an attractive option because

they allow for a broader range of investment techniques and provide an opportunity

to earn higher fees based on performance. Banning the joint management of mutual

funds and hedge funds would simply force these managers to choose between mutual funds and hedge funds. The unfortunate and undesirable result would be a

reduction in the pool of managers available to mutual fund investors.

MANAGEMENT CONTINUITY AND STABILITY

Such a ban would hurt fund investors in other ways as well. Mutual funds will

experience higher portfolio manager turnover, whether the fund is managed by an

individual manager or a team, as investment professionals move on to manage other

accounts not subject to such a ban.

Allowing management of different types of investment accounts also enhances the

ability of investment management firms to retain their best portfolio managers. By

managing a wide variety of accounts, investment firms and individual portfolio managers are able to diversify their client bases, as many businesses rationally seek to

do. Moreover, the diversity of clients can give a top-quality investment firm greater

balance and the ability to better attract and retain talented professionals. This stability benefits mutual fund investors because, in our experience, the continuity and

quality of an investment organization is one of the key determinants of long-term

investment success for the firm’s clients, including mutual fund clients.

Consistent Investor Protection

Importantly, a ban against the side-by-side management of mutual funds and

hedge funds would not address potential conflicts that may arise with the management of accounts other than hedge funds. As explained above, such a ban would not

prevent a portfolio manager from managing investments for pension funds and

hedge funds, or separate accounts and mutual funds, or, for that matter, multiple

mutual funds. In any of these instances, the fee structure could be higher for one

account than another for a variety of reasons, just as the investment objectives,

strategies, and risk characteristics will differ to meet client needs. The potential

conflicts of interest that arise in these situations are the same and should be treated

consistently to maximize investor protection. Multiple compliance regimes for similar circumstances would introduce complexity and confusion, and would likely weaken rather than strengthen industry-wide compliance around these issues. A better

way to address concerns about conflicts of interest is to demonstrably strengthen

compliance procedures, reporting, and oversight.

Oversight and Compliance Evaluation by Fund Independent Directors

A better approach than banning side-by-side management of mutual funds and

hedge funds is to require mutual fund directors to review and to approve stringent

procedures to address conflicts of interest and to review the adviser’s performance

under those procedures. As mentioned earlier, at Vanguard the funds’ independent

directors monitor the independent advisory firms that manage money on behalf of

the Vanguard funds. Our approach involves careful screening and selection, close

supervision and evaluation of each firm’s compliance policies and codes of ethics,

and continuous review of its performance under those policies. We believe that advisers should be required to demonstrate to mutual fund boards that they have sucVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00479 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
468

6SEC Rel. No. IA–2204, ‘‘Final Rule: Compliance Programs of Investment Companies and Investment Advisers’’ (December 17, 2003). 7SEC Rel. No. IC–26323, ‘‘Proposed Rule: Investment Company Governance’’ (January 15,

2004).

cessfully followed all procedures and, when appropriate, to inform the Board how

the firm’s procedures can be improved.

While mutual fund directors have long been charged with overseeing the performance and compliance of the fund’s adviser, due to recent events, the Congress and

the regulators have demanded more specific protections. As mentioned earlier, the

SEC recently strengthened the position of fund directors in this regard by requiring

that every mutual fund have a chief compliance officer reporting directly to the

directors.6 Each investment adviser must now have written policies and procedures,

administered by its own chief compliance officer. These policies and procedures

must address a number of issues, including allocation of trades among multiple clients. The fund boards must approve the policies and procedures of their advisers,

and funds must oversee the performance of their advisers under these procedures.

This new regulation makes mandatory what ‘‘best practice’’ investment firms have

long required.

In addition, to the extent that fund directors require special experts to assist with

their analysis of an adviser’s performance, the SEC has recently proposed that mutual funds be required to explicitly authorize their independent directors to hire employees or other experts to help them fulfill their fiduciary duties.7 We support this

authority for independent directors (the independent directors of Vanguard funds

have long had this authority) and hope that this aspect of the proposal is adopted

in the final rule.

We believe that the combined effect of enhanced compliance obligations and additional support for independent directors will sufficiently protect investors from potential conflicts of interest present in the side-by-side management of mutual funds

and hedge funds, as well as other investment accounts. In our view, this approach

will benefit mutual fund investors and protect their interests at the same time. Accordingly, we believe that imposing an outright ban on the management of mutual

funds and hedge funds is a drastic solution that does not appear to be necessary

at this time, particularly in light of the SEC’s recent adoption of more stringent

compliance requirements for funds and advisers. To do so could well deprive mutual

fund shareholders of the widest available universe of investment management

talent—surely an unintended but severe consequence that should be avoided.

Thank you. We appreciate the opportunity to testify before the Committee on

issues of importance to mutual fund investors.

Appendix

Management of Multiple Accounts Compliance Policies and Procedures

In Vanguard’s experience, investment advisory firms have developed very effective

policies and procedures to address the conflict of interest potentially present to an

advisory firm or its personnel managing simultaneously mutual fund and other accounts, including the accounts of hedge funds. Those policies and procedures are

typically and appropriately tailored to reflect an advisory firm’s business operations

and other specific characteristics. Vanguard believes that acknowledging ‘‘one-sizedoes-not-fit-all’’ is crucial to the development of workable and effective compliance

procedures in the area of joint management. In particular, policies may differ for

equity and fixed-income securities. Nonetheless, in Vanguard’s view, certain types

of compliance procedures and policies having core elements can be effective in dealing with the conflicts present in joint management of hedge funds and mutual

funds. The policies and the procedures adopted for this purpose by firms Vanguard

has hired fall into three categories: Procedures, both general and specific, for the

allocation of securities among different clients; specialized allocation procedures

for securities offered through public offerings and other limited offerings; and oversight mechanisms. Examples of the three categories of policies and procedures follow bellow:

Allocation Policies and Procedures

• One way in which investment advisory firms seek to address the potential that

an individual portfolio manager responsible for managing hedge fund and mutual

fund accounts could favor the hedge fund in allocating securities positions is by

adopting specific policies and procedures that require orders for the purchase or

sale of the same securities on behalf of multiple clients made on the same day

to be aggregated. The central elements of these policies and procedures include:

469

—assigning the same price per securities to all clients participating in the aggregated trade, even if multiple trades are needed to fulfill the entire aggregated

order;

—executing trades in accordance with a defined and objective rotation system in

which all clients participate on the same basis;

—distributing costs among clients participating in the aggregated trade on a proportionate basis;

—allocating trades at, or immediately after, execution, and entering trades into

client accounts promptly after execution and in accordance with the allocation

policy; and

—in cases when the supply of securities is insufficient and the full amount of an

aggregated trade cannot be filled, allocating on a proportionate basis to the

original order or in some other objective manner that is consistently applied.

• A second general way in which an investment advisory firm seeks to deal with

allocation of securities when managing mutual funds and hedge funds is by only

aggregating a purchase or sale order if the aggregated order is in the best interests of each individual client participating in the order and consistent with the

firm’s best execution policies.

• A third general way of addressing joint management conflicts by an investment

advisory firm with a trading department is by having the trading department aggregate orders in the same securities, even when the orders are originated by different portfolio managers, if aggregation provides clients with better, cheaper, and

more efficient execution.

• Other specific policies and procedures Vanguard has observed that an investment

advisory firm adopts in light of its business operations and other factors, in seeking to ensure that mutual fund clients are not disadvantaged by the firm’s joint

management activities include some of the following:

—executing at the same time all the transactions undertaken by a portfolio manager employed by the firm in the same securities during the day;

—requiring consistent trading activity among all funds having similar investment

strategies, such as mandating that transactions on behalf of 11 mutual funds

be entered by a portfolio manager when the portfolio manager has entered into

a transaction for a hedge fund that is deemed suitable for the mutual fund;

—prohibiting a portfolio manager from maintaining different positions in the

same securities on behalf of mutual funds and hedge funds that generally follow

the same principal investment strategy;

—allowing a portfolio manager to undertake a securities transaction for one client

while not contemporaneously entering into the same transaction for other clients, only if the portfolio manager determines and documents that the securities

are or the transaction is not appropriate for the other clients;

—precluding a portfolio manager from purchasing securities for a mutual fund

that have been sold recently by a hedge fund managed by the same manager,

unless the manager obtains approval for the transaction from the investment

advisory firm’s chief investment officer or a compliance officer;

—prohibiting a portfolio manager from assuming a long position in equity securities on behalf of one client while simultaneously selling short the same securities on behalf of another client;

—establishing an order of trade execution priority for short and long transactions,

giving general preference to long transactions;

—separating hedge fund short sales from mutual fund sale orders when they involve the same securities, and assigning trade execution priority on the basis

of the time each of these transaction requests was received by the investment

advisory firm’s trading desk;

—prohibiting cross trades between the accounts of hedge funds and any other

client;

—limiting cross trades between or among client accounts to liquid securities for

which market quotations are readily available;

—requiring that the price used for cross transactions be the same as the last independent trade on a recognized market, and that the transactions conform to the

investment advisory firm’s overall trading policies and regulations; and

—restricting cross trades among specific types of accounts, such as trades involving accounts of employee benefit plans subject to the requirements of the Employee Retirement Income Security Act of 1974, as amended.

470

Allocation of Initial Public Offerings Securities and Other Limited Issues

• Vanguard has observed many investment advisory firms that seek to address the

conflicts of interest presented by simultaneous management of hedge funds and

mutual assets by adopting specialized rules covering securities purchased through

initial public offerings and other limited issues. Misallocation of IPO securities

has been at the center of a number of Securities and Exchange Commission enforcement cases. In some of these cases, hedge funds, but not other clients, were

allocated IPO securities believed by an investment advisory firm to have the potential for strong returns. In seeking to preclude such inappropriate allocations,

advisory firms, in Vanguard’s experience, have adopted some or all of the following policies and procedures:

—apportioning IPO securities and other securities available through limited offerings according to equitable, predetermined rules, such as for example, by apportioning securities to all clients on a proportionate basis when the supply of a

particular securities position is insufficient to satisfy all clients;

—predetermining clients that are eligible for securities offered through specific

types of IPOs;

—dividing IPOs into categories according to size and to investment strategies

furthered by holding the securities offered through the IPOs, and allocating IPO

securities among all clients that have similar investment strategies on the basis

of market capitalization of the issuers of the securities; and

—prohibiting portfolio managers and other fund personnel from participating in

IPOs through hedge funds.

Oversight of Policies and Procedures

• Vanguard believes that crucial to effective compliance is a strong oversight of policies and procedures adopted to protect the interests of clients. Each investment

advisory firm used by Vanguard must demonstrate it has established review processes and has retained the necessary oversight personnel to supervise trading

activities and to ensure compliance with Vanguard’s and the investment advisory

firm’s policies. An investment advisory firm should, as a starting point, have a

compliance officer to review trading activity, monitor compliance with policies,

and intervene in situations in which conflicts of interest are apparent. Other specific oversight mechanisms that Vanguard has observed investment advisory firms

adopt with respect to joint management allocation policies and procedures include

some or all of the following:

—investment advisory firm personnel regularly on a periodic basis reviewing client transactions to identify potential conflicts of interest;

—an investment advisory firm’s portfolio managers, traders and/or compliance

employees bringing transactions to the attention of a supervisor and/or an executive officer of the firm for closer review;

—investment advisory firm compliance personnel reviewing representative samples of client transactions to assess overall compliance with the firm’s trade

allocation policies and procedures and to ensure fairness and equity in the operation of the firm’s trading systems;

—an investment advisory firm’s allowing for exceptions to the firm’s policies and

procedures only if the exceptions are properly documented and approved by a

compliance officer employed by the firm;

—investment advisory firm personnel preparing and retaining separate documentation for each client participating in an aggregated order;

—investment advisory firm compliance officers’ periodically reviewing past trade

allocations to determine whether any client was systematically disadvantaged

as a result of aggregated transactions;

—investment advisory firm compliance officers’ reviewing portfolio manager determinations that trade aggregation provides all clients with the opportunity to

achieve more favorable execution;

—an investment advisory firm’s identifying instances in which a portfolio manager has deviated from the firm’s allocation policy, and if so, whether the portfolio manager has identified a legitimate reason for the allocation;

—an investment advisory firm’s requiring portfolio managers to document the

reasons for entering into different or opposite positions on behalf of multiple clients, and requiring a compliance officer of the firm to review portfolio manager

explanations at least every quarter;

—investment advisory firm personnel automatically time-stamping, at multiple

stages of transactions, all records of transactions undertaken on behalf of all

clients;

471

—an investment advisory firm’s allowing short selling of securities by a hedge

fund that are held long by a mutual fund advised by the portfolio manager of

the hedge fund only if the manager receives approval for the short sale from

the firm’s compliance department and if this policy is properly disclosed to all

clients involved, including the mutual fund;

—an investment advisory firm’s permitting cross trades subject to the condition

that they be monitored by compliance officials charged with identifying trading

patterns of cross trades between or among mutual funds and hedge funds;

—investment advisory firm compliance personnel simultaneously reviewing hedge

fund trading and mutual fund trading;

—an investment advisory firm’s compliance personnel reviewing daily hedge fund

transaction reports to identify transactions executed on behalf of hedge funds

by portfolio managers who executed transactions on behalf of mutual funds

within 7 days before or after the hedge fund transactions;

—an investment advisory firm’s requiring portfolio managers to sign quarterly

trading reviews for each hedge fund and mutual fund they manage, certifying

that all trading was in compliance with each fund’s investment strategy and

that all clients were treated fairly and equally;

—an investment advisory firm’s requiring portfolio managers to explain to oversight officials the investment rationale for proposed transactions on behalf of

hedge funds that appear to be inconsistent with transactions undertaken on

behalf of mutual funds;

—an investment advisory firm’s establishing hedge fund review and oversight

groups to provide specific fiduciary oversight for hedge fund transactions and

to ensure that policies and procedures relating to hedge fund management are

followed;

—an investment advisory firm’s reviewing IPO allocation procedures and allocations at least annually;

—an investment advisory firm’s having its compliance officer or an investment

committee review prospective allocation of IPO securities prior to execution of

the transaction in the securities;

—an investment advisory firm’s requiring written explanations of the investment

rationale underlying hedge fund transactions;

—an investment advisory firm’s disclosing the potential conflicts of interest presented by simultaneous management of client accounts in the appropriate regulatory forms and offering materials; and

—an investment advisory firm’s reviewing and updating compliance policies and

procedures and related disclosures to ensure accurate representation to all

actual and prospective clients of potential conflicts of interest.

—————

PREPARED STATEMENT OF ANN E. BERGIN

MANAGING DIRECTOR, NATIONAL SECURITIES CLEARING CORPORATION

MARCH 2, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, I

appreciate the opportunity to discuss the SEC’s proposal to amend Rule 22c–1 of

the Investment Company Act of 1940. With your permission, I would like to have

two documents previously provided to Committee staff included in the record:

NSCC’s February 6 comment letter to the SEC on the proposed amendment and a

brochure that describes how our fund processing system, which is called Fund/

SERV, works.

For those of you unfamiliar with our organization, NSCC and its affiliated clearing agencies play a significant role in supporting the U.S. financial markets. We

provide post-trade clearance, settlement and information services for equities, corporate and municipal bonds, mutual funds, and other securities.

Current regulation allows a mutual fund order to be priced according to the time

it is received by an intermediary—a broker-dealer or plan administrator, for example. Therefore, an order received by an intermediary by 4 p.m. is eligible for today’s

price, even if it is transmitted to the fund at a later time.

I have been asked to speak about that aspect of the SEC’s proposal providing that

an order to purchase or redeem shares in a mutual fund would have to be received

by a fund, its transfer agent or a registered clearing agency by 4 p.m. in order to

receive the current day’s price.

472

The NSCC is a clearing agency, registered with the SEC under the Securities

Exchange Act of 1934. As such, we are subject to comprehensive regulation and

oversight by the SEC. We are currently the only registered clearing agency providing services to the mutual funds industry. In the past year we have been called

upon to take an active part in several industry and regulatory initiatives involving

mutual fund processing, including the NASD/Industry Task Force on Breakpoints

and the NASD Omnibus Account Task Force.

NSCC is owned by our users—broker-dealers, banks, mutual fund companies, and

other financial service firms, and we are governed by a user-representative board

of directors. The clearance, settlement, and information services NSCC provides are

developed at the request of our users. Our revenues are generated by the fees that

are paid by our users; and, to the extent those revenues exceed our costs, the excess

revenues are refunded to them.

NSCC’s participation in the mutual fund industry began nearly 20 years ago, in

1986, at the request of market participants.

Our Fund/SERV system provides a standardized, automated process for distribution intermediaries to transmit purchase, redemption, and exchange orders through

a single process and a single communications link. Like all of the NSCC’s fund

services, participation in Fund/SERV is optional, but it has become the industry

standard for processing fund and defined contribution transactions at the wholesale

level. We estimate that today Fund/SERV processes the vast majority of these

wholesale transactions. Last year, Fund/SERV handled 87 million fund transactions—roughly 350,000 a day—with a value of $1.54 trillion. About 650 mutual

fund companies and more than 430 intermediaries, offering 30,000 different funds,

use Fund/SERV today.

Fund/SERV has greatly reduced operational errors, lowered the cost of processing,

established standards and introduced order into the marketplace. By acting as a

central conduit, Fund/SERV allows intermediaries to offer investors a much broader

range of funds than before at a much lower cost.

Allow me to walk you through how a typical mutual fund trade is processed. In

my example, once an individual investor advises his broker-dealer that he wishes

to purchase a particular mutual fund, the broker-dealer enters the order into its

system. That system transmits order files electronically to Fund/SERV periodically

throughout the day. And through Fund/SERV the orders are directed to the appropriate fund company. The fund company either confirms or rejects the orders and

then transmits that information back to the broker-dealer through Fund/SERV.

As long as the broker-dealer is in receipt of the order by 4 p.m., under today’s

rules the order is given that day’s price, regardless of what time the trade is processed through Fund/SERV. Fund/SERV receives order files over a 22-hour period

each business day from 2 a.m. until midnight, and many of these files are received

and then redirected to the fund companies between 5 and 8 p.m.

Under the proposed regulation, even if the order is received by the broker-dealer

before 4 p.m., unless the broker-dealer is able to retransmit the order to NSCC (as

the registered clearing agency), the fund or its transfer agent by 4 p.m., the purchase will not be made at today’s price.

We anticipate that this would dramatically change the current trade flow, and

result in a significant increase in the number of trades received at NSCC in the

half-hour just prior to 4 p.m. We have done some preliminary analysis and believe

that our current systems capacity is sufficient to handle the concentration of orders

within that shortened time frame. However, we will need to make technological enhancements to some of our services. To date, we have identified three such major

enhancements.

One: We would need to create a uniform methodology to record the time of receipt

of each order file at NSCC. Subsequently, each order within that file would be coded

with that time of receipt before transmission to the fund.

Two: Our system would need to recognize the elements of a very complete and

valid order, so that the order is final and unalterable as of 4 p.m. Those elements

would include the order type, that is, a purchase, redemption, or exchange; the

name of the fund; and either the specific number of shares, or the dollar amount

of the order.

Three: We would need to build functionality to allow intermediaries to communicate additional information about a valid order after 4 p.m. This could include information not known prior to 4 p.m., as long as this information does not alter any

of the essential elements of the order—for example, the breakpoint discount to

which an investor is entitled or the purchase specifics of an exchange transaction.

We believe we can complete these enhancements within the 1 year following the

adoption of the amendment, as was proposed by the SEC, at an estimated cost of

approximately $5 million. This estimate is limited to NSCC’s costs, which, as I indiVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00484 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
473

cated earlier, would be funded by our users, and does not include costs that would

be directly incurred by our users in making corresponding changes to their own systems, as many of them would have to do. Some in the industry also believe that

additional time would be needed to ensure rigorous testing of these changes.

NSCC does recognize that migrating the time-stamping function from the intermediary to NSCC will impose some limitations on the flexibility currently afforded

to all mutual fund investors. We feel strongly, however, that applying a hard 4 p.m.

close at NSCC is far better for investors than applying a hard 4 p.m. close only at

the fund or its transfer agent.

In our comment letter to the SEC, we advised that the flexibility of the current

system could be retained through the implementation of the alternative solution

that was proposed for comment by the SEC. That solution would leave the responsibility for time-stamping at the intermediary level—with the addition of new safeguards to prevent late trading abuses.

Whatever the Commission’s final determination is, NSCC is committed to working

with the industry to facilitate compliance with the new regulations.

I will be pleased to answer any questions.

474

475

476

477

478

479

480

481

482

483

484

485

486

487

488

489

490

491

492

493

494

495

1The Securities Industry Association, established in 1972 through the merger of the Association of Stock Exchange Firms and the Investment Banker’s Association, brings together the

shared interests of nearly 600 securities firms to accomplish common goals. SIA member-firms

(including investment banks, broker-dealers, and mutual fund companies) are active in all

United States and foreign markets and in all phases of corporate and public finance. According

to the Bureau of Labor Statistics, the U.S. securities industry employs more than 800,000 individuals. Industry personnel manage the accounts of nearly 93 million investors directly and indirectly through corporate, thrift, and pension plans. In 2003, the industry generated an estimated

$142 billion in domestic revenue and $283 billion in global revenues. (More information about

SIA is available on its home page: www.sia.com.) 2 ‘‘Mutual Funds Integrity and Fee Transparency Act of 2003,’’ introduced by Congressman

Richard Baker (R–LA). 3S. 1971 introduced by Senators Corzine and Dodd, S. 1958 introduced by Senators Kerry and

Kennedy and S. 2059 introduced by Senators Fitzgerald, Collins, and Levin. Senator Akaka

has also introduced mutual fund legislation (S. 1822), but it does not contain a late trading

provision. 4SEC Release No. IC–26288 (December 11, 2003).

PREPARED STATEMENT OF WILLIAM A. BRIDY

PRESIDENT, FINANCIAL DATA SERVICES, INC.

ON BEHALF OF THE

SECURITIES INDUSTRY ASSOCIATION

MARCH 2, 2004

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, I

am William A. Bridy, President of Financial Data Services, Inc., a wholly-owned

subsidiary of Merrill Lynch & Co., Inc. My business unit has overall responsibility

for the prompt and accurate processing of all mutual fund orders placed through

our firm. I am pleased and honored to appear before the Committee on behalf of

the Securities Industry Association (SIA) 1 to discuss measures to eliminate late

trading, as this Committee has contributed so much to the effort to protect the investing public.

As a preliminary matter, we, and all members of SIA, agree that the practice of

late trading is unequivocally illegal, and its very existence threatens to undermine

the public’s trust and confidence in mutual funds. For this reason, we applaud the

strong enforcement actions the SEC and other regulators have taken to date to punish wrongdoers. We believe that these enforcement actions, and the broad attention

they have received, have already had a significant deterrent effect on potential

wrongdoers and have propelled broker-dealers, other intermediaries, and mutual

funds to focus their compliance efforts more sharply on preventing late trading.

We also applaud the expeditious manner in which legislators and regulators proposed rulemaking after evidence of late trading first surfaced in September 2003.

In that regard, a manager’s amendment relating to late trading was added to

H.R. 2420, and the bill, inclusive of the manager’s amendment passed the House of

Representatives by a vote of 418 to 2 on November 3, 2003.2 Additionally, 3 of the

4 bills introduced in the Senate contain provisions that address late trading.3 Furthermore, the SEC has issued its own late trading proposal.4

My testimony today will focus on a ‘‘hard close’’ solution at the intermediary level

whereby mutual fund orders will be entitled to receive current day pricing, as long

as the order is received by a broker-dealer or other intermediary by the time the

subject mutual fund determines its net asset value (usually 4 p.m. Eastern), provided certain other conditions are met. The testimony is predicated on two core principles. First, that a critical factor is not where an order is physically located at the

time a fund’s net asset value (NAV) is determined, but rather whether its receipt

by such time can be verified with a high degree of certainty. Second, and most importantly, the available hard close solutions must not be detrimental to, or in any

way disadvantage, the tens of millions of honest mutual fund shareholders who are

not trying to ‘‘game’’ the system.

Current Proposals

Legislative

Section 205 of the Baker bill contains a provision specifically contemplating a

hard close at the broker-dealer, plan administrator or other intermediary level, provided such intermediaries have procedures designed to prevent the acceptance of

trades after the time at which NAV is determined, and such trades are also subject

to an independent audit to verify adherence to those procedures. Sections 306 and

315 respectively of the Corzine-Dodd and Fitzgerald-Collins-Levin bills contain subVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00507 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
496

5 ICI Press Release ‘‘Mutual Fund Leaders Call for Fundamental Reforms to Address Trading

Abuses’’ (October 30, 2003). 6Testimony of Stephen M. Cutler before the Senate Subcommittee on Financial Management,

The Budget, and International Security (November 3, 2003). 7 ICI Press Release ‘‘ICI ‘Strongly Supports’ SEC Proposal to Prevent Late Trading of Mutual

Funds’’ (February 5, 2004). 8See SEC proposing release at 4.

9 Approximately one-third of all mutual fund shares are held in 401(k) plans. See SEC proposing release, note 8.

stantially similar provisions, and neither the Akaka or Kerry-Kennedy bills would

preclude an intermediary hard close solution.

Regulatory

In December 2003, the SEC proposed amendments to Rule 22c–1 of the Investment Company Act which would preclude mutual fund orders from receiving current

day pricing unless the order was received directly by a fund, its designated transfer

agent, or a registered clearing agency by the time the fund establishes its NAV for

the day. The SEC’s proposal followed a recommendation by the Investment Company Institute (ICI) requiring that all orders be received by the fund company by

the hard close in order to receive current day pricing.5 Although the SEC release

accompanying the proposal invited comment on whether the SEC should consider

an intermediary approach, contrary to the intent of the legislative proposals, the

proposal excludes an intermediary solution. The SEC’s proposal also appears to be

inconsistent with the spirit of the legislative initiatives, since with respect to a hard

close solution at the fund level it provides neither for procedures designed to detect

and prevent late trades, nor for required audits to verify adherence to such procedures. This is no small shortcoming given that in testimony before a Senate subcommittee, the SEC has indicated that it found approximately a 10 percent shortfall

in late trading compliance at the fund level.6 In a recent press release 7 issued in

conjunction with the filing of a comment letter on the SEC’s proposal, the ICI moderated its position stating that:

‘‘. . . The Institute first urged that trade reporting requirements be substantially tightened in early October in the wake of investigations by Government officials that revealed late trading abuses involving a number of

mutual funds. In renewing its support for tough new requirements today,

Institute General Counsel Craig Tyle also encouraged the Commission to

consider whether some intermediaries may already be able to ‘document

through unalterable means the precise date and time’ when orders were received. In such instances, the letter suggests, the SEC should consider the

benefits that could accrue to fund shareholders by allowing the intermediary to receive orders on the fund’s behalf before the hard 4:00 p.m.

deadline.’’

Feasibility and Implications of Various Hard Close Alternatives

Hard Close at the Fund Level

Essentially, the SEC’s proposal allows for hard close solutions only at the fund

or registered clearing agency level. In its proposing release, the SEC recognizes that

requiring a hard close at the fund level would necessitate that intermediaries establish an earlier (pre-close) cut-off time for investors to submit fund orders and obtain

current day pricing, and that with respect to 401(k) plans, investors might not be

able to receive same-day pricing at all.8

This earlier cutoff would be necessary to allow broker-dealers to perform all essential order reviews prior to the 4 p.m. close. Among other things, that would include

analysis to assure that any sales discounts (breakpoints) are properly applied. Even

though many things can be done electronically to check for account linkages, much

of this is still a manual process. Because of the numerous and varying rules that

each fund group follows, many of these orders need to be held in the firm’s system

and reviewed manually before they are sent to the Fund/SERV system maintained

by the National Securities Clearing Corporation (NSCC), and ultimately to the fund.

If they are not properly reviewed, investors may not receive the discounts to which

they are entitled. Other intermediaries, such as banks, must perform similar tasks

prior to sending orders to fund companies.

Orders processed through 401(k) plans 9 involve even more complexities than

those faced by broker-dealer recordkeeping systems. For example, 401(k) recordkeepers must place trades collectively, and perform a number of reconciliations at

the participant and plan levels when executing transactions. In addition, recordkeepers perform other services that add time to the process, such as determining

497

10See proposing release, at 5. 11See ‘‘Beyond the Numbers, The 2003 Annual 401(k) Report,’’ Principal Financial Group, p.

50. Also ‘‘Profit-Sharing/401(k) Council’s 46th Annual Survey of Profit Sharing and 401(k)

Plans,’’ p. 43 (2003). 12See ‘‘Building Futures: How American Companies Are Helping Their Employees Retire. A

Report on Corporate defined Contribution Plans,’’ Fidelity Investments p. 32–33. (1998). 13Source: Standard & Poor’s Index 1999–2003. Data provided by Reuters. 14 Assumes $3,000 annual contributions over a 30-year period with an average annual rate

of return of 10 percent. The actual annual average return of the S&P 500 for the 30-year period

ending December 2003 was 12.2 percent. 15The proposing release, note 42, cites a study by Professor Eric Zitzewitz which estimates

that fund shareholders collectively lose as much as $400 million annually as the result of late

trading. This figure would translate to approximately 1⁄2 of a basis point (.00005) of fund assets,

based on total fund assets of $7.4 trillion, or about $25 per annum for each $500,000 of fund

assets owned.

eligibility for loans, since Federal law regulates the amount of a loan based on a

participant’s account balance, and there are other complexities that I will leave to

my co-panelists to address.

The net results of the earlier cut-off time is that the vast majority of fund shareholders who either prefer, or have no alternative but, to deal through intermediaries

(as is the case with 401(k) accounts) would be denied the ability to effect fund purchases at current day prices for at least a portion of, and possibly an entire trading

day. Correspondingly, with redemptions, shareholders would be exposed to an additional day of market risk. The SEC proposing release suggests that these earlier

cutoff times would not impose a significant burden on most mutual fund investors

who are making longer term investments, frequently through 401(k) plan payroll deductions, and who treat the time and date of investment as something of a random

event.10 In essence, the SEC is speaking of those investors who are solely investing

periodically in a static manner. This fails to consider a whole range of other activities in which 401(k) plan investors engage, which impose risks that cannot be managed through dollar-cost averaging.

For example, various studies have shown that in 2002 between 14 and 23.1 percent of 401(k) plan participants had outstanding loans, and 21 percent of participants with account balances took a plan distribution.11 Additionally, a major plan

administrator reported that in 1998, 24 percent of their plan participants made

exchanges. Furthermore, exchanges increase with age, with a concentration in investors in their 50’s and 60’s, who have the largest amount of retirement funds.

Such participants made an average of 3 exchanges annually.12 Furthermore, a growing number of 401(k) participants are employing mutual fund portfolio rebalancing

services that enable such participants to establish and maintain a targeted asset allocation in accordance with their investment objectives and risk tolerance. Rebalancing usually occurs several times a year. Our firm alone has 800,000 participants

enrolled in such a program.

Therefore, the SEC’s analysis fails to address what we believe to be the most substantial risks to 401(k) participants—the inability to promptly liquidate or exchange

a large mutual fund portfolio in a rapidly declining market. In that regard, it should

be noted that during the 5-year period ending December 2003, the Standard &

Poor’s 500 Index declined by 1 percent or more on 257 days.13 Thus, a 401(k) participant approaching retirement seeking to liquidate a $500,000 equity mutual fund

portfolio,14 to purchase an annuity in a declining market, could easily lose thousands of dollars by being ‘‘locked-in’’ to his or her investment for an additional trading day. This type of result would potentially cause significantly greater harm to

the participant.15

In addition to the disproportionate impact on market risk exposure the fund hard

close remedy would have on fund investors, it also fails to provide for an effective,

tamper-proof, electronic order capture time-stamping system. The proposed remedy

merely carries over the same time-stamping requirement already included in Rule

22c–1, which recent history has shown to be prone to abuse both at the fund and

broker-dealer levels. We believe adopting the SIA’s electronic order capture timestamping approach for funds, brokers, and 401(k) intermediaries can cure this shortcoming. The problems associated with early order cut-offs cannot be readily resolved, and mutual fund investors should not be faced with the choice of having to

either be denied market access during all or a portion of the trading day, or foregoing effecting their transactions through intermediaries—the preferred choice of

more than 88 percent of fund investors. Nor should any solution be adopted which

creates a competitive disadvantage between financial institutions. Therefore, the

fund hard close proposal should not be adopted as an exclusive remedy.

498

16 NASD Rules 6950–6957, approved by the Commission on March 6, 1998, and as amended

on July 31, 1998.

Hard Close at a Registered Clearing Agency

SIA members and representatives have attended exploratory meetings at NSCC,

the only current registered clearing agency, regarding the possibility of developing

a systems modification whereby intermediaries could submit mutual fund orders to

the NSCC Fund/SERV system at or prior to 4 p.m. NSCC Fund/SERV, through its

various linkages, would then transmit the orders to the applicable funds. Therefore,

while SIA supports further efforts to determine the feasibility of an NSCC hard

close solution, and looks forward to continuing to work cooperatively with the NSCC

as the process moves forward, given its current status and the considerable amount

of time it will take to develop, it should not serve as an exclusive solution. Under

the proposal it would be necessary for intermediaries to transmit ‘‘unenriched’’ orders, which do not include all the data to execute, to NSCC by 4 p.m. in order to

obtain current day pricing, and then forward enrichment data (such as information

relating to sales breakpoints), after the close. This would essentially turn a one-step

process into two steps, and to our understanding it has not yet been determined

with certainty what impact that will have on operating efficiencies. Also the NSCC

solution is likely to cause intermediaries to batch more fund orders near the close

in an effort to reduce the number that will require subsequent transmission of enrichment data. The impact of such batching will need to be addressed. It is, of

course, of utmost importance to assure that any systems or procedural changes implemented by NSCC to address late trading do not inadvertently compromise the

efficiencies achieved by its mutual fund clearance and settlement process, which has

served its participants and investors so well. It is also uncertain whether this would

provide sufficient relief to 401(k) plan participants with respect to early cutoff times.

Hard Close at the Intermediary Level

With regard to intermediaries, SIA recommends a three-pronged solution whereby

the place of order acceptance to which the hard close would apply, would include:

• For Broker-Dealers. The broker-dealer’s electronic order capture and routing system which assigns a verifiable order entry time aligned with the atomic clock currently used for equity order time-stamping, provided the other conditions set forth

in the Baker, Corzine-Dodd, and Fitzgerald bills are met.

• For Other Regulated Entities. The electronic order capture system of regulated

entities not currently under the SEC’s jurisdiction, but regulated by the OCC or

other regulator, which would impose a companion rule to require a hard close on

order acceptance by 4 p.m.

• For Non-Regulated Entities. Such entities would have to employ an electronic

order capture time-stamping system which is functionally equivalent to that utilized by broker-dealers and other regulated entities. Such ‘‘functional equivalency’’

would need to be certified to by an independent third-party and such certification

provided to the fund complexes for whom the fund transactions are processed, and

the system would be subject to the same independent audit requirements set forth

in the pending legislation.

The SIA recommendation contemplates that orders not accepted into the

intermediary’s system by the hard close, even where the lack of timely receipt was

due to legitimate errors, would, without exception, receive next day pricing. Thus,

corrections would have to be effected through their error account, and they, not

fund shareholders, would bear the economic risk of loss with respect to any orders

processed after the hard close. It is most important to note that, unlike the current time-stamping procedure contained in Rule 22c–1, and which would merely

be perpetuated in the SEC’s proposal, the SIA proposal would impose stringent

additional requirements on the use of time-stamping methodology that would

make it extremely difficult to ‘‘game’’ the system. The SIA recommendation as it

relates to broker-dealers, reflects an approach similar to the NASD’s Order Audit

Trail System (OATS), which is an integrated audit trail of order, quote, and trade

information for Nasdaq securities. The applicable NASD rules 16 required member

firms to develop a means for electronically capturing and reporting specific data

elements relating to the handling or execution of orders, including recording all

times of these events in hours, minutes, and seconds, and to synchronize their

business clocks.

Broker-dealers already subject to OATS requirements should be able to readily

transfer the OATS technology to mutual fund order processing without incurring

significant additional costs. We understand there are a number of service proVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00510 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
499

viders who may be able to offer similar capabilities to other intermediaries, and

that certain other intermediaries may be able to develop this capability internally.

It is our understanding that OATS has significantly enhanced the NASD’s ability to track and audits Nasdaq equity orders and detects violations of NASD’s

rules. Utilizing that same technology for tracking mutual fund orders should bring

similar benefits to the SEC’s examination staff. Additionally, internal compliance

reviews and outside audits of broker-dealers and/or other intermediaries could include some or all of the following:

—written policies and procedures and other controls designed to detect late trading;

—periodic review of such policies, procedures, and controls;

—periodic audits including random testing of orders (conducted both internally

and by outside auditors) to validate the integrity of the system; and

—reviews of error accounts to detect patterns that might be indicative of late

trading.

In summary, we believe that the SIA recommendation would eliminate the inadequacies of the current time-stamping system and create a readily auditable

order trail, while avoiding the significant adverse consequences of an earlier order

cutoff time. Furthermore, the SIA recommendation could be implemented expeditiously, whereas the NSCC solution would require a lengthy developmental process, and the funds themselves may not be equipped to handle the large increase

in direct transactions that could occur if the SEC’s proposal is adopted, without

modification.

Conclusion

In summary, SIA believes that electronic and auditable electronic time-stamping

systems, which intermediaries and funds would be required to utilize, is a critical

component of any effective hard close rulemaking solution. While imposing a hard

close at the fund or registered securities clearing agency should be among the available alternatives, these measures should not be the exclusive solutions, given that

they either have negative consequences for innocent investors, or remain untested.

On the other hand, significant positive experience with electronic stamping system

through OATS strongly supports a technological solution. Importantly, this type of

approach would place the vast majority of investors holding their fund investments

through intermediaries on a more level playing field with other investors.

We commend the Committee for its efforts to swiftly and effectively address abusive practices such as late trading, and believe that such measures are essential to

maintaining the integrity of our capital markets, and retaining the public trust of

the 95 million Americans for whom mutual funds are a core investment vehicle.

Thank you.

—————

PREPARED STATEMENT OF RAYMOND K. McCULLOCH

EXECUTIVE VICE PRESIDENT, BB&T TRUST

ON BEHALF OF THE

AMERICAN BANKERS ASSOCIATION

MARCH 2, 2004

Mr. Chairman, I am Raymond McCulloch, Executive Vice President for BB&T

Trust, based in Raleigh, North Carolina. I have over 26 years of banking experience,

the last 12 of which have been focused on BB&T’s institutional trust and employee

benefit lines of business. I have previously served as Chairman of the American

Bankers Association’s National Senior Employee Benefit Services Committee and

hold the professional designation of Certified Retirement Services Professional.

BB&T Trust administers over 2,200 employee benefit plans, with an average of 250

participants and total assets of $5.2 billion. BB&T Trust’s parent, BB&T Corporation, Winston-Salem, North Carolina, is the Nation’s 13th largest bank with over

$90 billion in assets.

I am pleased to testify on behalf of the American Bankers Association (ABA). ABA

brings together all elements of the banking community to best represent the interests of this rapidly changing industry. Its membership—which includes community,

regional, and money center banks and holding companies, as well as savings institutions, trust companies, and savings banks—makes ABA the largest banking trade

association in the country. The views in my testimony today are also endorsed by

the ABA Securities Association (ABASA). ABASA is a separately chartered trade

association and nonprofit affiliate of the ABA whose mission is to represent before

500

the Congress, the Federal Government, and the courts the interests of banking organizations engaged in underwriting and dealing in securities, proprietary mutual

funds, and derivatives.

The ABA is pleased to testify on the issue of late trading for mutual funds. As

investors in mutual funds, either for our own portfolio or for that of our fiduciary

and brokerage clients, as well as transfer agents and investment advisers to mutual

funds, our members are quite concerned about this issue.

Let me be very clear: ABA members emphatically believe that late trading has no

place in mutual funds. This practice is illegal under current law and we applaud

the enforcement actions of the Securities and Exchange Commission (SEC) and

other regulators to punish those at fault. More can be done to prevent late trading.

We would submit, however, that any additional legislative or regulatory solutions

to combat late trading should: (1) protect mutual fund investors; (2) restore investor

confidence in mutual funds; (3) preserve choice of distribution channels; and (4) not

limit investment options for mutual fund investors.

The SEC has put forth a proposal, often referred to as a ‘‘Hard 4 p.m. Close.’’ This

rule, which amends Rule 22c–1 under the Investment Company Act, provides that

an order to purchase or redeem fund shares would receive the current day’s price

only if the fund, its designated transfer agent, or a registered securities clearing

agency, for example, the National Securities Clearing Corporation (NSCC), receives

the order by the time that the fund establishes for calculating its net asset value

(NAV). While at first blush this seems to be a simple solution to the problem, it

would in fact result in different cutoff times in practice for mutual fund companies

and intermediaries that sell shares of funds of those companies. This would create

unnecessary confusion for investors and disruptions in the mutual fund market. The

ABA and ABASA strongly oppose the mandatory Hard 4 p.m. Close as it would have

detrimental effects on investors. Fortunately, technologies exist today that can

accomplish the intended goals without risking investor confusion and market disruptions. Thus, in my statement today, I would like to emphasize two key points:

• A ‘‘hard close’’ discriminates against investors based solely upon their choice of

distribution channel and denies investors choice by limiting their investment

options.

• Alternatives to a hard close exist that can accomplish the goal of preventing late

trading without disadvantaging mutual fund shareholders.

I will address each of these in turn.

A ‘‘Hard Close’’ Discriminates Against Investors Based Solely Upon

Their Distribution Channel and Limits Investment Options

As mentioned above, the proposed amendment would provide that a mutual fund

order receive the current day’s price only if received before the deadline for determining the fund’s NAV by the fund, its designated transfer agent, or a registered

securities clearing agency. Typically, most funds calculate NAV when the major U.S.

stock exchanges close at 4 p.m. Eastern Time. Importantly, fund intermediaries, including broker-dealers and retirement plan administrators, would not be able to receive orders up to that same time. They would be required to establish earlier trading

cut-off times—as much as six or more hours earlier—in order to transmit mutual

fund orders to the fund, transfer agent or clearinghouse in time for the 4 p.m. hard

close. Thus, it creates in practice different cut-off times for mutual fund companies

than for intermediaries that sell shares of funds of those companies.

Thus, while the 4 p.m. hard cut-off would eliminate the potential for late trading

through intermediaries that sell fund shares, the unintended consequences are severe. We see no reason to fix a problem caused by a few, yet discriminate against

the vast majority of mutual fund investors who use intermediaries, including the

millions currently saving for retirement through their company’s 401(k) or individual retirement accounts. Over $2.11 trillion in assets were invested in defined

contribution plans as of year-end 2001, the vast majority of which are in 401(k)

plans, according to Employee Benefit Research Institute. As discussed below, there

are better, less problematic methods to address late trading.

To understand the problems created by the SEC’s proposal, it is important to understand the operational complexities of these transactions. For example, processing

401(k) plan participant orders is an operationally complex and time-consuming task,

no matter which type of financial intermediary is servicing the plan. There are multiple processes and systems involved for correlating and transferring data between

receipt of the participant’s order and delivery of that order to the fund company.

Processing trade orders for a typical participant-directed plan involves as many as

five steps and four systems between the participant trade request and fund company receipt. Specifically, once the participant communicates a trade request (before

501

the 4 p.m. Eastern Time market close), it is moved to the primary participant recordkeeping system, where it is given a value and reconciled with that participant’s

account. The participant’s transaction is then combined and netted with others from

that same plan, each one having been previously reconciled and valued. Next, the

plan’s trade orders are combined with other transactions from other plan accounts

held by that recordkeeper, which are again valued, netted, and reconciled. The

penultimate step requires the recordkeeper’s net trade order to be turned over to

the intermediary where it is valued and combined with trades of other recordkeepers for a single transmission on each fund. These processing steps are taken

after the 4 p.m. close to give plan participants the same consideration for trade orders as a direct investor and to allow both sides (sale and purchase) of an investment option or rebalance of portfolio to occur as of the same trade date.

At BB&T, this process generally takes about 3 hours. Other banks have estimated

that this may take 6 hours or more, which means that trade orders would have to

be placed before 10 a.m. Eastern Time in order to have any chance to get today’s

NAV. For plan participants located on the West Coast, the chance of receiving that

day’s NAV is even slimmer.

The discriminatory impact of the proposed 4 p.m. hard close is most clearly illustrated when an individual investor invests in the same mutual fund through three

different distribution channels: A retail brokerage account, a 401(k) plan trusteed

by a bank, and an account held directly by the mutual fund. Today, if that investor

makes an investment decision at 3 p.m. on day one that he or she wants to redeem

the mutual fund shares held in all three accounts and communicates that decision

simultaneously to all three financial service providers, the investor’s trade orders for

all three accounts will be effected at today’s NAV. Under the proposed 4 p.m. hard

close, the investor’s trade order will be effected at two, and possibly three, different

NAV prices despite the fact that the decision to redeem was communicated at the

exact same time.

Specifically, the account held at the mutual fund will definitely receive today’s

NAV. The account held at the brokerage account may or may not receive today’s

NAV depending on the amount of processing required. The degree of processing required for plan participant orders guarantees that the mutual fund shares held

through the 401(k) plan will be priced at the next day’s NAV, or possibly the NAV

for additional days later. Different NAV prices for simultaneous orders will initially

lead to investor confusion and, most likely, create a strong investor bias toward

dealing directly with the mutual fund for all types of investment accounts.

The transaction discussed above involves a simple redeem or purchase order.

Even more complexity is involved when a participant’s order involves a transfer

from one fund to another, for example, a simultaneous redemption and purchase.

Today, if a participant places an order to sell 1,000 shares of Fund X and uses the

proceeds to purchase shares in Fund Y, a bank trustee can process both legs of the

transaction, because, some time after the 4 p.m. market close, they have electronically been provided with NAV’s for both funds. With a 4 p.m. hard close to the mutual fund, the bank trustee would have to place the order to redeem 1,000 shares

of Fund X before 4 p.m. Without a NAV for Fund X, the bank trustee could not

place the purchase order for Fund Y before 4 p.m. Instead, the plan participant will

purchase Fund Y shares at the next day’s NAV. Here, again, a 4 p.m. hard close

favors the mutual fund distribution channel over that provided by banks, brokerdealers, and others. Under the proposed 4 p.m. hard close, the participant’s redemption and purchase orders will both be effectuated at today’s NAV if both Fund X

and Fund Y are members of the same fund family.

The differing cutoff times would encourage investors to deal directly with mutual

funds or their agents, rather than through intermediaries. Investors who invest directly with the mutual fund will get the benefit of today’s NAV, while investors who

invest through intermediaries will get the next-day’s NAV, at best. The ABA is

strongly opposed to a system that discriminates against investors based solely upon

their choice of distribution channel.

Creating incentives to deal directly with mutual funds rather than intermediaries

would also mean that investors would gravitate to only one family of funds, regardless of whether those funds were ‘‘best in class’’ among all funds of a similar type

and investment strategy. Thus, the ability of investors to choose the best combination of funds across all funds that are offered would be limited, denying investors

both diversification and potential returns. For example, many employee benefit

plans today offer participants fifteen or more investment options from a variety of

mutual fund providers. For example, at BB&T, we offer over 200 funds from a wide

variety of sponsors, including SEI, Managers, Vanguard, Oppenheimer, American,

Dodge & Cox, T. Rowe Price, Fidelity, Goldman Sachs, Ariel, Royce, and AIM in addition to BB&T Funds. We trade over 100 funds each day. If a 4 p.m. hard close

502

is in place, investors may be forced to choose only one mutual fund provider to be

able to receive daily valuation and trading. If an investor is invested entirely in one

fund family, there is far greater potential for loss if that fund family encounters

difficulties. History has shown time and again that lack of diversification hurts

investors.

Simply put, a 4 p.m. hard close favors the mutual fund distribution channel over

that provided by banks, broker-dealers, and other intermediaries because it allows

the mutual fund complex to perform the processing tasks after 4 p.m. while all other

providers must perform the requisite processing before 4 p.m. ABA strongly believes

that the SEC should avoid adopting a solution to prevent illegal late trading that

discriminates against investors based solely upon their choice of one distribution

channel over another. The consumers should not be sacrificing choice to be able to

receive daily valuation.

An Alternative to Hard Close Exists That Will Not

Disadvantage Investors

Fortunately, alternatives to the 4 p.m. hard close do exist that would eliminate

the potential of illegal late trading without disadvantaging mutual fund shareholders. The key to this solution is to require a tamper-proof order capture system

where the entry time of an order can be verified with a high degree of certainty.

An independent company would do the time-stamping. This would allow fund intermediaries to receive orders up to the time of the NAV calculation.

We believe that the technology exists today to permit the creation of a tamperproof system for ensuring that trades are, in fact, received at the time the trade

is stamped and cannot be altered after the time-stamped without detection. The

large volume of daily mutual fund trades requires an electronic network solution.

Applications using cryptography, particularly one referred to as public key infrastructure (PKI), are increasingly being used in banks, corporations, and the Federal

Government. Digital signatures are one example of how PKI technology identifies

the signer and ensures the integrity of the signed data. Digital signatures on every

transmission would authenticate the parties involved and also encrypt the content

of every message, thereby permitting any alteration to a message content to be detected. Companies are already working to make the ‘‘signing’’ of documents electronically using digital certificates as simple as signing a piece of paper with a pen.

Similarly, algorithms are already being used to create a unique identifier or a fingerprint of any file that would work for time-stamping. If the file’s contents change

at all—even if only an extra space is put in one line—then a different fingerprint

is created, making it clear that an alteration has taken place.

Most companies that use digital time-stamping use encryption hardware that is

certified by the National Institute of Science and Technology. We believe that the

time-stamping of the file should be done by an independent company storing the

certified encryption hardware. The company that time-stamps the order would

digitally sign the data using digital certificates, thus creating a verifiable and

auditable method for assuring the time of the transaction and integrity of the original data. This solution can accommodate trade orders placed by intermediaries

either individually or in batch form.

There would, of course, be other associated requirements consistent with this approach that would have to be employed by the intermediary. For example, operating

business standards and technical interoperability requirements that ensure consistency and legal reliability will likely be needed. Audit programs and compliance review programs could then examine and validate that the institution’s policies and

procedures contain the necessary controls to ensure integrity in the trading process.

Thus, the elements of such a system could include:

• Electronic time-stamping of orders in a manner that orders cannot be altered or

discarded once entered into the trading system.

• Annual certification that the intermediary has policies and procedures in place designed to prevent late trades, and that no late trades were submitted to the fund

or its designated transfer agent during the period.

• Submission of the intermediary to an annual audit of its controls conducted by

an independent public accountant who would submit his report to the fund’s chief

compliance officer.

The ABA recognizes that not all mutual fund companies, transfer agents, or intermediaries have the capability or desire to input a technology solution such as we

have suggested. For example, we understand that some mutual fund companies only

accept trade orders with original signatures and accompanying medallion stamps

through the mail. Moreover, PKI technology can be expensive to implement, although programs that are just now coming to market will make PKI technology

503

more accessible to smaller financial institutions and intermediaries. Thus, it is

important that the approach be flexible, be sensitive to the attendant costs, and

provide a considerable implementation period of at least 1 year.

The point is this: Technology exists today—and is rapidly improving—that can be

used to create a solution that meets the goal of assuring no late trading is occurring

and does not create adverse consequences for investors.

Conclusion

As investors in mutual funds, either for our own portfolio or for that of our fiduciary and brokerage clients, as well as transfer agents and investment advisers to

mutual funds, ABA member banks applaud the SEC’s goal of protecting mutual

fund investors and restoring investor confidence in mutual funds by taking steps to

eliminate the potential for illegal late trading. We are encouraged that the SEC is

attacking the current market scandals by bringing swift enforcement actions when

wrongdoing is uncovered and believe that those who violate the current prohibition

on late trading should be brought to justice. We also believe that further regulation

designed to prevent or to minimize the possibility of these abuses occurring in the

future is warranted.

The ABA appreciates efforts by Senators and Congressmen to assure that solutions to late trading do not disadvantage investors. We are hopeful that with your

strong encouragement, the final SEC regulation will recognize this as well; should

it not, addressing this through legislation will become necessary.

Thank you for the opportunity to present the views of the American Bankers

Association.

—————

PREPARED STATEMENT OF DAVID L. WRAY

PRESIDENT, PROFIT SHARING/401K COUNCIL OF AMERICA

ON BEHALF OF THE

ASPA, ASSOCIATION FOR FINANCIAL PROFESSIONALS, AUTOMATIC DATA PROCESSING,

INC., COMMITTEE ON INVESTMENT OF EMPLOYEE BENEFIT ASSETS, THE ERISA

INDUSTRY COMMITTEE, FLINT INK CORPORATION, FLORIDA POWER & LIGHT

COMPANY, HEWITT ASSOCIATES, ICMA RETIREMENT CORPORATION, INTEL

CORPORATION, PROCTER & GAMBLE, PROFIT SHARING/401K COUNCIL OF

AMERICA, SMALL BUSINESS COUNCIL OF AMERICA, AND SUNGARD CORBEL

MARCH 2, 2004

Thank you for this opportunity to share the views of the employer-provided retirement plan system with the Committee. My comments reflect the views of the companies and organizations listed on the transcript of my statement. As we all know,

mutual funds play a key role in the employer-based system. According to the Investment Company Institute, 36 million U.S. households invest one-third of all mutual

fund assets through employer provided retirement plans. Like this Committee, we

are concerned by the breaches of trust that have occurred recently and we applaud

the efforts underway in Congress to restore confidence in our Nation’s financial

institutions.

Late trading must be eliminated. At the same time, it is important that we preserve a level playing field for the ability to make investment decisions using sameday pricing. In most employer provided plans, investors can make trading decisions

up to, or very close to, a fund’s closing time, generally 4 p.m. Eastern Time. Some

have questioned if plan participants value same-day pricing. I can assure you that

they do as evidenced by the predominance of this feature in 401(k) plans. Like all

investors, plan participants adopt a long-term savings strategy and only infrequently make changes in their investment decisions. However, when plan participants do make investment change decisions they highly value same-day pricing.

This is particularly true for distribution decisions upon retirement.

Same day pricing in employer provided retirement plans is possible because intermediaries are permitted to process participant trades and forward the final aggregated trades to the funds or a clearing agency after 4 p.m. This late processing is

necessary to ensure that all of the requirements surrounding the operation of a

qualified retirement plan are met, including satisfying plan features and the highly

complex rules issued by the Departments of Labor and Treasury. On a more basic

level, fund trade processing is always delayed to reflect the fund’s Net Asset Value

for the current day—an event that does not occur until well after 4 p.m.

504

Congress understands the need to preserve same-day pricing in employer provided

plans when addressing late trading. The House overwhelmingly passed H.R. 2420

last November. It instructs the SEC to issue rules to address late trading that permit late processing by retirement plan and other intermediaries if procedures exist

to prevent late trading and such procedures are subject to independent audit. Similar provisions are found in S. 1971, cosponsored by Senators Corzine, Dodd, and

Lieberman; and S. 2059, cosponsored by Senators Fitzgerald, Levin, and Collins. I

applaud these Members for their efforts and I urge this Committee to move forward

on this important legislative provision if the final SEC rule on late trading fails to

preserve equal opportunities for all investors.

Under the SEC’s proposed rule, to offer same-day pricing an order must be received by the fund, its designated transfer agent, or a registered securities clearing

agency by the fund’s closing time. This means that a retirement plan participant’s

ability to enjoy full same-day pricing will be based on the employer’s selection of

a plan’s intermediary and investment choices. Employers will be pressured to adopt

service provider arrangements that favor same-day pricing over an open architecture design with offerings from several fund complexes. Participants could be influenced to invest in the proprietary funds of the intermediary when also offered funds

from other fund complexes. Intermediaries will incur significant initial and recurring systems costs that will be borne by participants.

I commend Ann Bergin and the NSSC staff for their valiant efforts to develop a

viable process to meet the SEC’s clearing agency proposal. Although the clearing

agency approach will provide some relief to retirement plan participants that do not

trade in a bundled provider arrangement, it will not create parity among investors.

It will not accommodate all plan transactions. And it will result in additional costs

for many plan participants.

There is a preferable way to address late trading. The SEC has requested comments on an alternative approach that would allow fund intermediaries to submit

properly received orders after closing time if verifiable procedures are implemented

to prevent late trading. These procedures include tamper proof time-stamping, certification policies, and independent audits. This approach is very similar to that in

the legislation I mentioned earlier in my comments. A large majority of SEC commenters, including leading consumer organizations, support inclusion of this approach in the final rule. Several technology companies have confirmed their ability

to provide the technological safeguards sought by the SEC.

I hope the SEC’s final rule will include this alternative approach that preserves

the opportunity for same-day pricing for all retirement plan participants. I repeat

my request for this Committee to intercede legislatively if that does not occur.

Thank you for your time. I look forward to answering your questions.

(505)

THE REGULATORY LANDSCAPE

WEDNESDAY, MARCH 10, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10 a.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

This morning, the Banking Committee continues its examination

of the mutual fund industry. As this Committee conducts its hearing process, the regulators have simultaneously worked to reform

the fund industry. Both State and Federal regulators continue to

bring enforcement actions against wrongdoers, assuring investors

that fund executives and brokers who violate their duties will be

punished.

These enforcement actions have also helped to define the full

scope of transgressions, conflicts, and structural problems that are

at the root of the misconduct in the fund industry. In addition to

enforcement actions, the regulators have also launched numerous

rulemaking initiatives. The SEC is pursuing an aggressive rulemaking agenda aimed at improving the transparency of fund operations, strengthening fund governance, and halting abusive trading

practices. The NASD has also proposed rules intended to improve

disclosure by broker-dealers to investors at the point-of-sale, alerting investors to potential conflicts of interest affecting an investment decision. Understanding the scope, the application, and the

consequences of these rulemakings are a critical component of the

Banking Committee’s hearing process.

Although enforcement actions and rulemakings are vital elements of the regulatory landscape, we must also consider what regulators can do to prevent future abuses by funds and brokers. I believe that the regulators must demonstrate how they are revising

compliance and examination programs to ensure that brokers and

funds comply with the current law.

This morning, I would first like to welcome Mr. David Walker,

Comptroller General of the General Accounting Office, again to the

Banking Committee. Comptroller Walker recently testified before

this Committee regarding GSE reform, and we appreciate his willingness to return here so quickly. The GAO has examined the fund

industry, and we look forward to its analysis and its insights.

506

I would also like to welcome Lori Richards, Director of the Office

of Compliance Inspections and Examinations at the Securities and

Exchange Commission; Paul Roye, Director of the Investment Management Division at the SEC; and Mary Schapiro, Vice Chairman

of NASD and President of NASD Regulatory Policy and Oversight,

and no stranger to the Banking Committee because, while at the

SEC, she used to appear here quite often.

We welcome all of you to the Committee. Your written testimony

will be made part of the record in its entirety.

Comptroller Walker, we will start with you. Proceed as you wish.

STATEMENT OF DAVID M. WALKER

COMPTROLLER GENERAL

U.S. GENERAL ACCOUNTING OFFICE

Comptroller WALKER. Thank you, Mr. Chairman. It is a pleasure

to be back before the Senate Banking Committee today for the purpose of discussing the GAO’s work assessing the transparency of

mutual fund fees and other fund practices and to discuss various

proposed and anticipated regulatory reforms.

As you know, Mr. Chairman, in the last 20 years mutual funds have grown from under $400 billion to just over $7.5 trillion.

Chairman SHELBY. In how many years?

Comptroller WALKER. The last 20 years.

Chairman SHELBY. Twenty years.

Comptroller WALKER. As you know, mutual funds are not only

important from the standpoint of institutional investors, but also

for many individuals who invest in mutual funds as part of their

retirement security, either through 401(k) plans or savings plans.

I think it is important to note, because of various illegal and abusive practices that have come to light in the last several years, that

the SEC is to be commended for placing additional time, attention,

and resources in this area. They have taken a number of enforcement actions. They are proposing a number of regulatory actions.

And as you know, Mr. Chairman, the NASD is also taking certain

actions. I would like to highlight our comments on the SEC’s proposals, and I appreciate your putting my entire written statement

in the record.

With regard to corporate governance and fund oversight, we believe the SEC is clearly moving in the right direction in order to

assure that a supermajority of mutual fund boards are comprised

of independent directors and that there be an independent chairman to head these boards. They also are proposing certain other

recordkeeping requirements, that there be compliance officers and

a code of ethics, et cetera. These are all clearly steps in the right

direction.

In addition, we believe that the Congress needs to consider providing the SEC with the legislative authority to better define director independence, because it is one thing to have a supermajority

of independent directors, but it is also important to define what

‘‘independent’’ is in terms that will assure in substance as well as

form that this requirement is met.

With regard to late trading, the SEC is proposing in the shortterm to impose a hard 4 p.m. close on all orders in order to ensure

that everybody gets the same price. At the same point in time, we

507

believe—and I believe the SEC has now acknowledged—that it

would be prudent to also explore over a period of time other possible options that might achieve the same result, but without having potential adverse affects on certain investors, namely, employee

benefit plan and savings plan investors.

With regard to market timing and distribution practices, we believe that what the SEC is proposing here are also steps in the

right direction: Additional disclosure, as well as in the case of market timing, a 2 percent redemption fee on shares that are held less

than 5 days that would go into the fund. We think that is clearly

a step in the right direction. At the same time, we believe that

additional investor education will be necessary with regard to both

of these proposed actions.

On 12b–1 fees, the SEC is seeking comments on proposed revisions, which is an appropriate step. We think it is important to also

consider as part of that whether or not there should be disclosure

of the specific deductions from individual investor accounts with

regard to these fees.

On management fees, the SEC is proposing additional fee disclosures in shareholder reports. In our view, we think it is important

to figure out how this type of information could be disclosed in the

quarterly statements that participants receive. Mr. Chairman, you

and I and probably many others have investments in mutual funds,

and, quite frankly, the statement that I look at most closely is the

quarterly statement. We get all kinds of prospectuses and other

types of information, and, frankly, it does not stay in my hand very

long. I don’t know about yours.

Soft-dollar practices, the SEC is not proposing any specific action

at this time, but they are studying the issue. Mr. Chairman, when

I was Assistant Secretary of Labor for Pensions and Health, this

was an area of concern to us because of pension plan fiduciaries,

and we were put in the position of basically having to allow certain

types of soft-dollar practices, even though we had concerns from an

ERISA fiduciary responsibility perspective because the SEC had already acted in this area.

I think it is very important that the SEC consider narrowing or

even repealing the legislative safe harbor and that more disclosure

of soft-dollar usage with investor education is potentially called for.

This is an area that has been in existence for a long time. In many

ways you can call it frequent trading credits, similar to airline frequent flyer miles. And I think that it is something that needs further study.

Thank you, Mr. Chairman. I would be happy to answer any questions after my colleagues have had a chance to testify.

Chairman SHELBY. Ms. Richards, if you will suspend a moment,

Senator Schumer has joined us, and he has another hearing that

he has to attend, and I want to give him a chance to make an opening statement here this morning.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman. And I thank you

for and appreciate that opportunity. I want to thank every one of

our witnesses for being here and I am sorry that I cannot stay. We

have a whole bunch of things going on this morning, but I did want

508

to be here and welcome all of you and just make a couple of brief

comments.

The bottom line here, of course, is not just that stock prices are

down, but the more we hear of these problems, the average person’s trust in the markets goes down. And that is the great worry.

The mutual fund industry, of course, has always been a bastion of

trust, and so it came as a shock to everybody that so many things

were going on. You scratch your head and wonder at some of them,

and you say, what has been going on when a multimillionaire

breaks the law to make a small extra amount of money? It is a little like Martha Stewart. I care about this industry, as I care about

our financial markets, and usually this happens after the fact, but

I am sure there are going to be all kinds of things done to deal

with all of the illegal and gray-area practices.

I would just like to make one other point here on where I think

we have to go—and I use my experience in the credit card industry.

Credit card interest rates were at 19.8 percent, and everyone had

them at 19.8 percent, and there was not much competition in terms

of price until we required good disclosure. And then there was far

better competition, and people were far more aware.

And that is the direction I would like to see us all go in, Mr.

Chairman. I think we need real simple disclosure. We need to show

if you invest $1,000 how much the fund gets, and, of course, it is

easier said than done because for some of the funds they will get

a set fee and for others it will depend on how well they do. I think

we can put in very simple and comparative terms how well each

fund has done over the last year, 2 years, 5 years. And that to me

will be a prophylactic.

There are some who are proposing far more stringent regimens,

but I believe that the free market works, and a really good disclosure system is where we have to go. I am working on that now and

hope that I can avail all of you for your comments on it, and you,

Mr. Chairman, because that is the direction I think we have to go

in. And good disclosure ends up being a real prophylactic for future

abuses, as well as creating greater competition. That is the point

that I wanted to make here, Mr. Chairman. I do not think there

is good enough disclosure now, but I think that is the answer before we try anything that goes further than that—in addition to

wiping out all these abuses, some of which are already illegal.

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you, Senator. I think that Comptroller

Walker alluded to that a few minutes ago, lack of disclosure when

you get a prospectus. I wonder how many people are going to read

that or halfway understand it.

Ms. Richards, you may proceed. Thank you for your indulgence.

STATEMENT OF LORI A. RICHARDS

DIRECTOR, OFFICE OF COMPLIANCE INSPECTIONS

AND EXAMINATIONS

U.S. SECURITIES AND EXCHANGE COMMISSION

Ms. RICHARDS. Chairman Shelby and Senator Schumer, thank

you for inviting me to testify here today on behalf of the SEC concerning our examinations of mutual funds.

509

The Commission has undertaken aggressive steps to detect and

prevent abusive market timing and late trading. As Chairman

Donaldson said when he testified before this Committee in November, mutual fund investors have a right to an investment industry

that is committed to the highest ethical standards and that places

investors’ interests first.

The SEC oversees some 8,000 funds and over 8,000 investment

advisers. Because the size of the mutual fund industry precludes

a comprehensive audit of every area of a fund’s operations, our

routine examinations focus on those areas that pose the greatest

risk to investors. Examinations identify compliance problems at the

individual firms and also help us to identify area of emerging compliance risk. The examiners have identified a number of practices

that may harm investors, including, for example, abusive softdollar arrangements, favoritism in the allocation of investments,

misrepresentations in the sales of mutual fund shares to investors,

the inaccurate pricing of mutual fund shares, the failure to obtain

best execution, sales practice abuses, and most recently, the failure

to give customers the discounts on large-volume purchases of mutual funds.

SEC examiners, along with our enforcement staff, are conducting

numerous examinations and investigations to ferret out abusive

market timing and late trading arrangements. Prior to September

2003, however, examination staff did not detect the abusive market

timing or late trading arrangements that fund executives had with

select traders and that came to light as a result of the New York

Attorney General’s action.

We have been reviewing our examinations to identify lessons

learned from those cases and evaluating ways that our examination

oversight can be improved, both to detect abusive market timing

arrangements and, more broadly, to identify in a timely way other

types of misconduct by fund firms.

My testimony today focuses on the changes we are making to our

examination oversight, specifically with respect to detecting market

timing arrangements and, as I said, more broadly with respect to

examination oversight generally. Today, examiners are increasing

the frequency and the depth of examination reviews for high-risk

firms, increasing the use of technology and data, developing new

methods to identify new or emerging areas of compliance risk, conducting more targeted mini-sweep examinations to identify risk

areas sooner and more timely, working more closely with other

staff at the SEC to highlight the problems that examiners detect,

and to identify possible solutions to those problems sooner.

We have identified new examination steps that will help us better detect abusive market timing arrangements. In the past, prior

to the discovery of market timing and late trading abuses, examiners reviewed trading by a mutual fund but did not review trading

in the fund’s own shares. The risk that examiners were concerned

about was that funds were trying to inflate their performance returns or take on undisclosed risk that could harm investors.

Our concern was that in attempting to produce strong investment returns that would attract new investors, fund portfolio managers had an incentive to engage in misconduct in the management

of the fund. As a result, examiners focused on how the fund was

510

managed, but because examiners’ focus was on the fund itself and

not in trading in the fund’s shares, examiners did not detect the

aberrant trading patterns that could be indicative of abusive market timing.

In addition, although market timing is in itself not illegal, many

mutual funds said that they discouraged the practice, and fund

firms told us and showed us that they had appointed anti-market

timing police who were responsible for detecting market timing

trades and preventing market timers from continued trading in

their funds. Not detected by examiners was the secret complicity

of fund executives in allowing some select market timers to continue to time.

Based on our recent examinations, we have identified ways to

better detect market timing. We are obtaining now daily sales and

redemption data that can better illustrate to our examiners patterns of trading in the mutual fund shares that could be indicative

of market timing, as well as obtaining internal e-mails that may

reflect the discussions and arrangements that the firm would not

otherwise have shown to our examiners.

Additional new examination steps include a review of personal

trading records of fund executives that would show trading in the

fund’s shares, even in advance of new Commission rules that would

require that those records be made available, and a review of procedures to ensure that orders are processed to receive the appropriate day’s net asset value.

In addition, we are also implementing other changes to SEC examinations to enhance our ability to detect problems more broadly,

as well as to anticipate problems before they become widespread.

Once emerging trends and problems are identified, we must share

this information with other divisions and offices so that the Commission can bring all of its resources to bear to protect investors.

Let me highlight those changes that I believe are the most important, and they are all described in my written testimony.

First, as Chairman Donaldson announced on March 5th, he has

formed an SEC task force that will be drafting the outlines of a

new surveillance program for mutual funds. This task force will examine the existing information that is reported by mutual funds,

looking at both the frequency of reporting, as well as the type of

information that is reported. The goal of such a surveillance program would be to identify indications of problems and then allow

examiners to better target their oversight to further reviewing and

investigating the problem that has been identified.

Second, examiners have been making increased use of computer

technology to review large volumes of data.

Third, examiners have been making increased use of interviews

while on site which help examiners better understand the firm and

obtain information that may not be available in the firm’s books

and records.

Fourth, with the additional resources added to the examination

program in 2003, we will be examining the largest and highest risk

fund firms more frequently.

Fifth, we are conducting more targeted mini-sweep examinations

in order to quickly identify emerging compliance problems sooner.

We have a number of these mini-sweeps ongoing now.

511

Sixth, we have added new policies to enhance the speedy resolution of compliance problems that we do detect, including by holding

exit interviews with senior fund personnel and by providing copies

of our deficiency letters directly to the fund board.

Seventh, we are increasingly requesting written reports from

fund firms in order to allow us to review compliance by the fund

in between examinations.

Finally, as I said, it is critical that when examiners identify an

emerging compliance problem in the industry that we act upon it

promptly. To facilitate such actions, examination staff must share

exam findings and trends with the Commission and with other

Commission staff members.

In sum, Mr. Chairman, we are moving aggressively to implement

the lessons that we learned from recent market timing abuses and,

more broadly, to enhance our ability to detect other compliance

problems in the fund industry.

I would be happy to answer any questions that you may have.

Chairman SHELBY. Thank you.

Mr. Roye.

STATEMENT OF PAUL F. ROYE

DIRECTOR, DIVISION OF INVESTMENT MANAGEMENT

U.S. SECURITIES AND EXCHANGE COMMISSION

Mr. ROYE. Thank you, Chairman Shelby. On behalf of the Securities and Exchange Commission, I am pleased and honored to testify

before you today regarding the Commission’s recent regulatory actions to protect mutual fund investors. To address the various

abuses that have come to light in recent months, and to help prevent abuses in the future, the Commission has embarked on a dramatic overhaul of the regulatory framework in which mutual funds

operate. Equally important, the Commission’s rulemaking initiatives are aimed at restoring the trust and confidence of investors

that are crucial to the continued success of the mutual fund industry and preserving its key role in our economy.

Under Chairman Donaldson’s leadership, the Commission is pursuing an aggressive mutual fund regulatory agenda that is focused

on four main goals: First, addressing late trading, market timing,

and related abuses; second, improving the oversight of funds by enhancing fund governance, ethical standards, and compliance and

internal controls; third, addressing or eliminating certain conflicts

of interest in the industry that are potentially harmful to fund investors; and, finally, improving disclosure to fund investors, especially fee-related disclosures. I would like to briefly provide you an

overview of these actions.

First, late trading. The price that hundreds of thousands of mutual fund investors pay or receive on a daily basis turns on when

the order is submitted and to whom. Typically, funds price their

shares at 4 p.m. In what is known as ‘‘forward pricing,’’ investors

submitting orders before 4 p.m. receive that day’s price; and investors submitting orders after 4 p.m. get the next day’s price. An

investor that can place an order to buy or sell fund shares after

4 p.m. and still receive the price set at 4 p.m. can profit from

new information in the marketplace at the expense of other fund

shareholders.

512

The current rules permit a large number of intermediaries that

accept or transmit trades in fund shares to determine whether the

order will receive that day’s 4 p.m. price. We know today that this

system has failed. In order to help favorite customers, certain

intermediaries have ‘‘blended’’ legitimate—pre-4 p.m. orders—with

late trades, or post-4 p.m. orders. In some cases, fund managers

participated in the scheme; but in many cases they were the victims of dishonesty along with fund shareholders. The problem is

that fund companies have no way of identifying a late trade when

it is bundled with legitimate trades and submitted to the fund company in the evening hours. There are potentially enormous profits

to be gained by late trading, and all of those profits come out of

the pockets of mutual fund investors.

To address this abuse, the Commission proposed the so-called

hard 4 p.m. rule. This proposal would require that a fund or a certified clearing agency, rather than the intermediaries, receive a

purchase or redemption order prior to the time the fund prices its

shares for an investor to receive that day’s price. Now, we believe

that this rule amendment will provide for a secure pricing system

that would be highly immune to manipulation by late traders.

We are currently analyzing the comment letters we received on

this proposal, and we received over 800 comment letters so far.

Now while we believe that the proposed rule amendment would virtually eliminate the potential for late trading through intermediaries that sell fund shares, it is clear from the comments that

some believe that the hard 4 p.m. rule should not be the preferred

approach. They argue that it will require the intermediaries to

have cut-offs for trades well before 4 p.m. and limit investor opportunities to place orders for fund transactions, particularly in the

401(k) context. So, consequently, we are studying other approaches

to addressing this issue. We do not want to adversely impact fund

investors if there are alternatives that effectively—truly effectively—address late trading abuses.

The Commission has taken a number of steps to address abusive

market timing of mutual funds. Short-term trades in mutual fund

shares impose costs on funds and their long-term investors. Some

market timers attempt to purchase and redeem shares to take advantage of market actions they believe will occur in the future.

Other types of market timers attempt to more directly take advantage of the fund’s long-term shareholders by exploiting how funds

calculate their net asset values. These ‘‘arbitrage market timers’’

buy and sell shares of funds if they believe that the fund’s calculation of net asset value significantly lags behind the current value

of a fund’s portfolio securities, and this is typically in international

funds or other funds that invest in thinly traded securities. Over

time, the long-term shareholders in a fund will, in effect, pay the

costs of the short-term shareholders’ transactions and have the

value of their fund shares diluted through this activity of arbitrage

market timers.

To help prevent this type of activity, the Commission has

stressed that ‘‘fair value pricing’’ is a critical tool in effectively reducing or eliminating the profit that many market timers seek. The

Investment Company Act requires funds to calculate their net asset

values using the market value of portfolio securities when market

513

quotations are readily available. If the market quotation for a portfolio security is not readily available or is unreliable, the fund must

establish a ‘‘fair value’’ for that security, as determined in good

faith by the fund’s board of directors. The fair value pricing can

minimize market timing and eliminate dilution of shareholders’ interests. The Commission recently reiterated the obligation of funds

to fair value their securities to reduce market timing arbitrage opportunities.

Additionally, the Commission has proposed improved disclosure

of a fund’s policies and procedures regarding fair value pricing. Our

staff is currently gathering information regarding funds’ fair value

pricing practices and evaluating whether to recommend additional

measures to improve funds’ fair value pricing. We have sought public comment on the need for additional guidance or rulemaking in

this area.

In a further effort to reduce the profitability of abusive market

timing, the Commission late last month put forth a proposal that

would require funds to impose a mandatory 2 percent redemption

fee when investors redeem their shares within 5 business days.

Again, this fee would be payable to the fund, for the direct benefit

of fund shareholders, rather than to the management company or

any other service provider.

Now this 2 percent fee is designed to strike a balance between

two competing policy goals of the Commission—that is, preserving

the redeemability of mutual fund shares and reducing or eliminating the ability of shareholders who frequently trade their shares

to profit at the expense of their fellow shareholders. The Commission felt that the rule combined with fair value pricing would make

market timing less profitable, and therefore reduce the incentive to

engage in market timing. The Commission is considering whether

this mandatory redemption fee is an appropriate approach to addressing short-term trading, including abusive market timing.

The proposed rule would also require the intermediaries who sell

fund shares to provide the fund at least weekly shareholder identification information that would allow the fund to identify market

timers and impose their own market timing restrictions on these

investors.

The Commission has proposed enhanced disclosure requirements

in order to combat abuses in the areas of market timing and the

related issue of selective disclosure of portfolio holdings. These enhancements are intended to deter abusive practices and to enable

investors to better understand a fund’s policies in these areas.

The Commission has proposed amendments intended to provide

greater transparency of fund practices with respect to the disclosure of a fund’s portfolio holdings. A fund would be required to describe its policies and procedures with respect to the disclosure of

its portfolio securities, including any arrangements to make available information about the fund’s portfolio securities, the identity

of any person who receives such information, and any compensation or other consideration that would be received by the fund’s adviser in connection with these arrangements. These amendments

do not alter the requirement that a mutual fund or investment adviser may disclose its portfolio only if the disclosure of such inforVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00525 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
514

mation is consistent with the antifraud provisions of the Federal

securities laws and the fiduciary duties owed to fund shareholders.

As you mentioned, Mr. Chairman, recent events in the fund area

have highlighted the need to improve oversight of the industry, and

the Commission has undertaken several initiatives on this front.

They are designed to strengthen the hand of the fund’s board and

to provide the directors, particularly the independent directors, additional tools with which to protect fund investors and reinforce

ethical standards.

In January, the Commission proposed a comprehensive rulemaking package to bolster the effectiveness of independent directors

and enhance the role of the fund board as the primary advocate for

fund shareholders. The proposals included a requirement for an

independent board chairman; 75 percent of the board being independent directors; independent director authority to hire, evaluate,

and fire staff; quarterly executive sessions of independent directors

outside the presence of management; an annual board self-evaluation; and preservation of documents used by boards in the contract

review process.

This significant overhaul of the composition and workings of fund

boards is intended to establish, without ambiguity, the dominant

role of independent directors on a fund’s board. With an independent board chairman and with independent directors representing at least 75 percent of a fund’s board, independent directors

will set the board agenda, as well as have the power to control the

outcome of board votes.

Boards would be required to perform a thorough self-evaluation

in order to identify structural changes and processes that might enable the board to be a more potent advocate for shareholder interests. Boards would be required to assess periodically whether they

are organized to maximize their effectiveness. As part of this evaluation, boards would consider the number of fund boards on which

each individual board member sits, as well as consider the nature

and effectiveness of their board committee structures.

The Commission recently proposed that all registered advisers

adopt codes of ethics. Advisers are fiduciaries, and owe their clients

a series of duties enforceable under the antifraud provisions of the

Investment Advisers Act. This bedrock principle, which historically

has been a core value of the money management business, appears

to have been lost on a number of advisers and their personnel.

The code of ethics would set forth standards of conduct for advisory personnel that reflect the adviser’s fiduciary duties, as well as

codify requirements to ensure that an adviser’s supervised persons

comply with the Federal securities laws, and require that these

persons acknowledge receipt of a copy of the code of ethics.

The code of ethics is designed to address conflicts that arise from

the personal trading of advisers’ employees. A principal focus of

this code is a requirement that certain advisory personnel report

their personal securities holdings and transactions, including transactions in any mutual fund managed by the adviser or an affiliate.

This would close a loophole in the Investment Company Act under

which investment company personnel have not been required to report trading in the shares of the funds that they manage.

515

Now in an action that we expect to have a far-reaching positive

impact on mutual fund operations and compliance programs, the

Commission in December adopted rules that required that funds

and their advisers have comprehensive compliance policies and procedure that are reasonably designed to ensure compliance with the

Federal securities laws and that they designate a chief compliance

officer. In the case of a fund, this chief compliance officer would be

answerable to the fund’s board and fired only with the board’s consent. The fund directors would be required to review the adequacy

of these procedures at least annually.

We think an active and independent board of directors, supplied

with reliable information as to the effectiveness of compliance programs and procedures, can serve as an important check against

abuse and fraud on the part of fund management.

The Commission is undertaking a series of initiatives aimed at

certain conflicts of interest involving mutual funds and those who

distribute fund shares.

Last month the Commission voted to propose an amendment to

Rule 12b–1 to prohibit the use of brokerage commissions to compensate broker-dealers for distribution of a fund’s shares. In recent

years, it has become clear that the practice of directing a fund’s

brokerage to a broker or dealer as compensation for distribution of

a fund’s shares presents opportunities for abuse. Advisers to funds

are allocating brokerage commissions to pay for distribution when

they could seek lower commission rates or rebates to the fund, or

they could reduce custody or transfer agency or other costs of the

fund. But the use of directed brokerage to pay for distribution benefits the adviser by increasing advisory fees and lowering the

amounts that they would have to spend on distribution out of their

own assets.

Now the conflicts of interest that surround the use of brokerage

commissions to finance distribution can harm funds and their

shareholders and have led the Commission to propose a ban on

these types of arrangements.

Over time, Rule 12b–1 has come to be used in ways that exceed

its original purpose. Consequently, the Commission in seeking comment on Rule 12b–1, asked for comment as to whether or not the

rule should be repealed or modified. To address concerns that Rule

12b–1 has replaced sales loads in many cases, the Commission also

requested comment on an alternative approach to Rule 12b–1 that

would require distribution-related costs to be directly deducted

from shareholder accounts.

Chairman Donaldson has made the issue of soft dollars a priority

and has directed the Commission to explore the problem and conflicts inherent in soft-dollar arrangements and the scope of the safe

harbor in Section 28(e), and we are working with the Division of

Market Regulation to conduct a review of this area. A primary

focus is whether or not the current definition of qualifying ‘‘research’’ under the safe harbor is too broad and should be narrowed

by rulemaking.

Finally, the Commission is quickly progressing on its continued

efforts to improve fund disclosures and highlight for investors feerelated information.

516

The level of a fund’s expenses, over time, can have a significant

impact on a fund shareholder’s investment experience. So last

month, the Commission voted to significantly revise mutual fund

shareholder report disclosures to assist investors in understanding

these expenses. The shareholder reports will now be required to include dollar-based expense information so that investors can better

understand these expenses.

This initiative also includes significantly improved disclosure to

investors about a fund’s investments. The recent amendments will

make more information available and permit investors to tailor the

amount of information they receive to meet their particular needs.

This additional quarterly disclosure of fund portfolio holdings will

enable investors, through more frequent access to portfolio information, to better monitor whether, and how, a fund is complying with

its stated investment objectives.

The Commission also proposed revisions to shareholder reports

that will require fund directors to explain how they came to renew

the advisory contract and make a determination that the fees that

they pay the management company are reasonable.

In a major proposal issued in January, the Commission proposed

significant revisions to mutual fund confirmation forms and also

proposed the first-ever point-of-sale disclosure document for brokers selling mutual fund shares. Together, these two proposals will

greatly enhance the information that broker-dealers provide to

their customers in connection with mutual fund transactions.

We have seen wide-scale failures to provide appropriate breakpoint discounts on mutual fund sales charges to front-end load

funds. We are proposing enhanced disclosure in this area so that

investors understand the breakpoint opportunities for these types

of funds. We have also issued a concept release to elicit views on

how we could require better disclosure of quantification of transaction costs, which can be significant for investors.

Finally, tomorrow, the Commission will consider new proposals

to improve disclosure to fund shareholders about their portfolio

managers’ relationships with the fund. These proposals include disclosure regarding the structure of a portfolio manager’s compensation, ownership of shares of the funds that a manager advises, and

comprehensive disclosure of specific investment vehicles, including

hedge funds and pension funds, that are also managed by the

mutual fund’s portfolio manager.

As is hopefully evident, the Commission has been extremely busy

in crafting rules that are designed to protect our Nation’s mutual

fund investors. Our focus has been directed not only on addressing

the harms of late trading, abusive market timing, and related

abuses, but also on strengthening the mutual fund oversight and

regulatory framework to minimize the possibility that these and

other potential abuses don’t arise in the future. Also, we have been

focused on the goal of providing meaningful and useful disclosure

to facilitate informed decisionmaking on the part of mutual fund

investors.

Again, I thank you for the opportunity to be here, and I would

be pleased to answer any questions you may have.

Chairman SHELBY. Thank you.

Ms. Schapiro.

517

STATEMENT OF MARY L. SCHAPIRO, VICE CHAIRMAN

PRESIDENT, REGULATORY POLICY AND OVERSIGHT

NATIONAL ASSOCIATION OF SECURITIES DEALERS

Ms. SCHAPIRO. Thank you very much, Mr. Chairman. It is an

honor to be here and testify before the Committee. I really want

to commend you and the Committee for your dedicated oversight

in this area. It has been a real catalyst for aggressive and sustained action by the regulators.

The NASD is the world’s largest self-regulatory organization. We

regulate every broker-dealer in the United States that conducts a

securities business with the public. Last year, we brought more

than 1,400 enforcement actions and barred or suspended more than

825 individuals from the securities industry, both of which are unfortunately record numbers.

While the NASD does not regulate mutual funds, we do regulate

broker-dealers who are a key distribution channel for mutual

funds. Thus, we view broker-dealer participation in illegal or unethical practices in this area as a very direct concern.

The disturbing revelations of abuses in the sale of mutual fund

shares have brought a redoubling of our enforcement efforts as well

as new rules requiring both better disclosure and higher standards

for firm conduct. We have also increased our investor education

focus dramatically.

The NASD has brought more than 80 enforcement actions

against securities firms dealing with mutual funds and variable annuities in 2003 and 2004, and well over 200 cases since the beginning of 2000. We have concentrated our enforcement efforts in four

main areas.

First, are compensation arrangements. Last year, NASD and the SEC fined Morgan Stanley $50 million for giving preferential sales

treatment to some mutual funds in return for millions of dollars in

brokerage commissions and other payments. NASD is currently

conducting an examination sweep to look at more than 30 additional broker-dealers and fund distributors for similar violations.

The NASD also prohibits the award of trips, entertainment, or

other non-cash incentives to brokers for the sale of the firm’s own

mutual funds. Last fall, you may recall that we announced a $2

million fine against Morgan Stanley and a censure and a fine

against the head of the firm’s retail sales division for conducting

sales contests featuring trips and Britney Spears and Rolling

Stones concert tickets as prizes for the sale of Morgan Stanley’s

own proprietary funds.

Our second area of focus is the suitability of mutual fund sales,

in particular Class B shares. We are very concerned that brokers

are making unsuitable recommendations to investors to buy more

expensive Class B shares when they frequently are not the best investment choice for the customer. We have recently brought more

than a dozen major B share cases involving millions of dollars of

unsuitable sales, and we currently have more than 50 open and active investigations in this area.

The third focus is on breakpoints and net asset value waivers. As

we reported to you last year, NASD discovered that broker-dealers

selling front-end-load mutual funds were not delivering breakpoint

discounts to investors, resulting in an overcharge to investors that

518

is conservatively estimated at $86 million for 2001 and 2002 alone.

We have directed all firms to make refunds with interest to investors and, in conjunction with the SEC, jointly sanctioned seven

firms. NASD alone sanctioned eight additional firms with fines totaling over $21 million.

In February, NASD brought the first case of its kind in announcing the censure and fine of AXA Advisors and a senior employee

for failing to obtain sales charge waivers through NAV transfer

programs, thereby causing investors to overpay for certain mutual

funds. We have also initiated a broad-based review of other firms

to determine if they are meeting their obligations in this area.

The fourth area is late trading and market timing. Last month,

NASD announced the first of our market timing enforcement actions. We fined State Street Research Investment Services $1 million for failing to prevent market timing of their mutual funds as

a result of inadequate supervisory systems. State Street was also

ordered to pay $500,000 in restitution to the funds.

As we continue our examinations and investigations into these

areas, we have more than 200 mutual fund-related investigations

under way. We will continue to impose fines, order restitution to

customers, and suspend or expel bad actors from the industry,

charging supervisors and even CEO’s. In the appropriate case, we

will limit a firm’s ability to engage in entire lines of business.

The NASD believes that investors deserve clear and easy to compare information about all the costs associated with the purchase

and ownership of every mutual fund, as well as all of the financial

incentives that may impact the recommendations of a broker.

Therefore, we support the recent SEC proposals on point-of-sale

and confirmation disclosure, and we have also proposed disclosure

requirements on revenue sharing and differential cash compensation arrangements. By requiring broker-dealers to disclose and

update these arrangements, NASD will help investors be alert to

financial incentives that a firm may have in recommending a particular fund.

The NASD also filed a new rule yesterday with the SEC requiring that every advertisement that promotes a mutual fund’s performance also contains a prominent box with the fund’s fees and

expenses. This disclosure works a little bit like the Surgeon General’s warning: To better inform investors about the cost of purchasing and owning a mutual fund, and it will also enable easy

comparison across funds.

From our perspective, success in this realm will require more

than rules and enforcement cases. It will require a robust investor

education program. NASD recently announced the establishment of

a $10 million investor education foundation to further our already

significant efforts in this area. Looking ahead, we are expanding

our enforcement and rulemaking activities with respect to a product closely related to mutual funds, that is, variable annuity sales.

While already active in this area, our focus will be expanded in the

following four areas: The market timing in variable annuity subaccounts; switching campaigns by firms and groups of migrating

representatives; procedures surrounding sales of variable annuities

into tax-deferred accounts; and anti-money-laundering procedures

tailored specifically to the annuity business.

519

In conclusion, NASD will continue to work tirelessly with other

Federal and State authorities to solve the problems revealed in recent months in the mutual fund industry. We are committed to

building and maintaining the integrity of our financial markets.

Thank you, and I am happy to answer any questions.

Chairman SHELBY. Thank you.

As this Committee examines the fund industry and the recent

rulemakings, we are seeking to determine, among other things, if

legislation is necessary. In your view, do the regulators currently

have the necessary statutory authorities to punish wrongdoers and

also to reform the industry? And if not, what additional authorities

would you recommend that Congress grant?

We will start with you, Comptroller Walker.

Comptroller WALKER. Chairman Shelby, the two areas that we

mentioned in our statement at this point in time is to consider providing SEC with legislative authority to better define director independence and, second, to consider narrowing or repealing the legislative safe harbor dealing with soft dollars. Those are the two

issues that we would put on the table at this time.

Chairman SHELBY. Ms. Richards.

Ms. RICHARDS. I would defer to my colleague. I guess I would say

that the rules that the Commission has proposed or put in place

will help examiners better detect problems.

Chairman SHELBY. It will help a lot, but it is a question of are

they comprehensive enough under the statute.

Mr. Roye.

Mr. ROYE. I think from the Commission’s perspective, if you look

at the various rulemakings that the Commission has pursued and

the goals that the Chairman has laid out, we have been able to address each of the problem areas by addressing the specific abuses,

trying to enhance the oversight of the industry, and putting in

place the building blocks that will hopefully prevent the types of

abuses that we have seen from occurring in the future. So, I think

our existing authority is generally sufficient to deal with the problems and enhance the oversight of the industry.

I think Mr. Walker does point out specific areas where we do not

have the ability on our own to proceed.

Chairman SHELBY. Short of statutory authority.

Mr. ROYE. Yes, sir.

Chairman SHELBY. Ms. Schapiro, you came from the SEC at one

time, so you have a great background.

Ms. SCHAPIRO. That is right. I spent 6 years at the SEC, and I

think I would agree that there is sufficient authority currently.

Certainly for us, our jurisdiction extends only to broker-dealers and

not to mutual funds, and we have really quite complete authority

in that regard. We will have to rely on the SEC’s authority with

respect to the issues that need to be resolved that revolve around

the mutual funds themselves.

I agree with Mr. Walker that 28(e) is something that Congress

should examine carefully with a view toward whether the safe harbor is sufficiently circumscribed—is it too broad and is it allowing

conduct to take place that really was never intended by the Congress in creating that statutory safe harbor? There ought to be a

careful examination of whether 28(e) should at least be narrowed.

520

Chairman SHELBY. Okay. Ms. Richards, there are those who say

that much of the misconduct that has come to light in recent

months was an open secret on Wall Street. Please elaborate on why

these practices were apparently undetected by the SEC and how

you are modifying examination practices to ensure compliance and

better detect future misconduct in the fund industry. Also, do you

have the resources you need to address these problems? I think you

have to have both the will and the resources. Go ahead.

Ms. RICHARDS. Thank you. Certainly we have the will. I will say

to you very clearly that we have since September 2003 spent a good

deal of time reviewing our past examinations, our past examination

protocols, and identifying what steps we can take going forward to

make sure that we better detect not only market timing and late

trading but also other abuses of this type.

Certainly we were aware that market timing was a phenomenon

in the securities industry. We were also aware that mutual funds

were complaining about the existence of market timers and that

they were adopting market timing police and other procedures to

prevent market timing from occurring in their funds.

As I said at the outset, our examination protocols at the time did

not require that examiners receive daily sales and redemptions

data which can indicate aberrant trading patterns indicative of

market timing. We are now requesting that data as part of routine

examinations and, more broadly, as part of the Chairman’s initiation of a mutual fund surveillance program, we think that is the

type of data that the Commission should receive routinely.

It appears to us in conducting examinations and investigations

that, in many of the market timing arrangements, secret and covert market timing arrangements were negotiated via e-mail communications. And in light of that, we believe that all of our examinations must now include a fairly thorough review of e-mails of

selected fund executives, and examinations must now include a

review of fund executives’ trading in the shares of their own funds.

And those are steps that we have implemented.

More broadly, I described the changes that we are making to our

examinations. We want to make sure that we are tackling and uncovering areas of emerging abuse in a more timely way, making

sure that our colleagues on the Commission are aware of problems

that we have identified, and that we are taking appropriate steps

to bring enforcement actions where appropriate, and to undertake

rulemaking, investor education, or other steps.

As to your question about the resources, certainly if we had additional staff, we could conduct additional examinations. We are,

however, undertaking a fairly radical change to our examinations.

Each examination is likely to take longer than it had in the past

because of the review of e-mail and because of the additional examination steps that we are implementing.

The Chairman’s initiative to create a mutual fund surveillance

program may provide examiners with more efficiencies in the process. That is, if we are able to identify in a more streamlined and

systematic way compliance problems in the industry and then use

our limited examination staff to target those firms and those areas

within firms for follow-up, we may be able to use our existing

resources in a more efficient way.

521

So what I would ask is if I could reserve responding to that question for just a short period of time until we can better assess the

effect of the new changes and of the new surveillance program.

Chairman SHELBY. You will get back to us for the record on that?

Ms. RICHARDS. I would like to.

Chairman SHELBY. We want to make sure that you have the resources. You say you have the will, but the will without resources

is not good enough. Resources without will is futile, too, is it not?

Ms. RICHARDS. Yes, it is. I would also like to thank this Committee for its support in giving us additional resources in 2003 because that has been enormously helpful.

Chairman SHELBY. Senator Sarbanes.

COMMENTS OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. I want

to join with you in welcoming the panel.

I actually want to go back to the Chairman’s first question to the

panel about in what areas is legislation necessary, as opposed to

rulemaking and regulation by the SEC. I am not quite clear with

what I am hearing.

Mr. Roye, do you agree with Comptroller Walker in the two areas

that he mentioned, where he thought legislative action was necessary?

Mr. ROYE. The two areas that he mentioned, first was the definition of independent director in the fund context, the statute sets

forth a precise definition. It doesn’t give the Commission the ability

to expand that definition or to encompass situations where we

think that the director really is compromised and shouldn’t be

deemed to be independent. We have limited ability to deal with

that problem. The other area that he mentioned was soft dollars,

and, of course, there is a statutory safe harbor that protects softdollar arrangements.

The Chairman has created a task force to look at soft dollars. We

do have the ability to look at what is research, the scope of that

definition. We have the ability to do other things to make the softdollar arrangements more transparent and to address other issues.

But we don’t have the ability on our own to abolish the safe harbor.

Senator SARBANES. Ms. Schapiro, on the 28(e) safe harbor, you

said restrict it. What about repealing it? We had testimony here by

Marvin Mann before the Committee at the table, the lead independent trustee of the Fidelity Funds, advocating unbundling of

portfolio brokerage costs, the elimination of soft dollars through the

repeal of Section 28(e), and he said, and I am quoting now from his

testimony, ‘‘If an adviser wants to purchase research products or

other services such as data terminals or other non-execution services or pay a dealer compensation for fund sales to the extent currently permitted by law, it would pay for those in hard dollars from

its own resources, not from fund commissions. Investors would

have a much better understanding of the expenses of investing in

a mutual fund and would be able to make better informed investment decisions.’’

Ms. SCHAPIRO. Senator, my view is that any practice that is as

complicated, as lacking in transparency, and fundamentally conflicted as soft dollars is deserves intense scrutiny by the regulators

522

and by the Congress. And whether that leads to a narrowing of the

28(e) safe harbor, greater transparency in the disclosure to investors about what portfolio transaction costs are going to execution

versus to generate soft-dollar credits, or an abolition of the safe

harbor entirely I think is a question for Congress. But I think it

is one that is critical to address.

From my perspective, transparency is the absolute minimum.

This is an inquiry that could certainly take you to repealing of the

safe harbor.

Senator SARBANES. Comptroller Walker.

Comptroller WALKER. Senator Sarbanes, sometimes disclosure is

not enough. Disclosure is generally better in addressing competitive issues than it is equity issues. Disclosure can help to promote

alternatives, but it by itself does not do enough to prevent abuse.

I mentioned before, when I was Assistant Secretary of Labor for

Pensions and Health and oversaw all the fiduciary responsibility

provisions for the many pension employee benefit plans and trillions of dollars invested relating to those plans, we had serious concerns about soft-dollar arrangements, and we had serious questions

about whether they should be allowed under ERISA’s fiduciary responsibility provisions.

At the same point in time, we were really constrained with being

able to do too much because of Rule 28(e). So, I think that you need

to consider the pros and cons of both narrowing and repealing the

current safety harbor. I think the time has come to do that.

Senator SARBANES. Does anyone else want to add anything on

this issue?

[No response.]

Ms. Richards, at the ‘‘SEC Speaks’’ seminar held just this past

Saturday, your staff talked about the top five fund deficiencies in

2003. The staff said that the number one top deficiency was internal controls. We like to keep abreast of these SEC’s seminars.

Other deficiencies involved filings, board of directors conflicts of interests, and books and records.

Could you just describe a bit about this top deficiency and what

is and can be done to improve internal controls? Once again, do you

need legislation in order to do it?

Ms. RICHARDS. Certainly. Broadly, the category of internal controls encompasses lack of policies and procedures in a given area,

as well as lack of good quality policies and procedures and a failure

to implement those policies and procedures. It is a most common

finding that we make in our examinations of investment advisers

and investment companies, and really incorporates our review of

all aspects of a mutual fund or an investment adviser’s business—

that is, the internal controls weakness could relate to any one of

a number of different areas.

I think that what will help improve the quality of mutual funds

and advisers’ internal controls is the new compliance rule that the

Commission adopted in December that will require funds and advisers for the first time to have written compliance policies and

procedures in key areas of their operations, and will ensure that

there is a compliance officer on staff at the mutual fund to make

sure those compliance policies are being administered and enforced.

We believe as examiners that the new rule will be extremely beneVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00534 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
523

ficial in creating an environment where the internal controls are

strong and robust; that is, there are written compliance policies

and procedures, and that there is someone inside the fund making

sure that those policies and procedures are being enforced.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Thank you. We will keep going, swap rounds.

This is to Ms. Richards and Mr. Roye. Some contend that the

recent scandals continued without apparent detection by the SEC

because the SEC’s organizational structure did not facilitate information flow across divisions. Would you address that assertion and

discuss any internal reforms that the SEC has initiated to enhance

internal communication and coordination? Mr. Roye.

Mr. ROYE. The Commission is organized into divisions and offices. My division has responsibility for the rulemaking and the policy in the fund area. Lori’s organization has responsibility for going

out and doing examinations. We have an Enforcement Division

that is out there enforcing the provisions. We try to work together

and communicate.

Chairman SHELBY. It is essential that you communicate well, is

it not?

Mr. ROYE. It is critical. I guess I would dispute the assertion that

the organizational structure is what led to the SEC not picking up

on the abuses. What we try to do is learn from our colleagues in

doing examinations. When they go out, they spot problems and

issues that implicate rulemaking and our policy judgments. We get

input from them. When we do rulemaking we use our examination

staff as our eyes and ears to understand what is going on in the

industry. When we see issues and problems in our review of registration statements of mutual funds, we pick up the phone and

call our colleagues in OCIE, or if it is more severe, our colleagues

in the Division of Enforcement, to have them go and actually pursue an issue.

But all that being said, the Chairman has set forth a number of

initiatives designed to improve internal communication. One is a

risk management analysis function. In each of our divisions we

have individuals whose function is to think about risk and think

about ways that investors can be disadvantaged in each of our respective areas. We serve collectively on a committee that surfaces

up these risk management issues. The Chairman is looking for an

individual to head up this risk management function. We think

that is going to be extremely valuable. We meet periodically to go

over the examination findings that OCIE has, not only the Investment Management group, but also the Enforcement group, to look

at the types of deficiencies that are being surfaced.

Ranking Member Sarbanes mentioned the five areas where we

see deficiencies. From our perspective, does that mean our rules

are deficient? Do we need to improve our rules? From an enforcement perspective, are these issues that merit further review and

scrutiny on their part from an enforcement perspective? So, we are

doing things to enhance our communication, our ability to understand what is going on in the industry.

Chairman SHELBY. Comptroller Walker.

Comptroller WALKER. Mr. Chairman, I would suggest three possible primary reasons why the SEC may not have discovered this

524

earlier. First, one has to do with resources, staffing levels. Second,

it is my understanding the SEC did not dedicate a tremendous

amount of time and attention on trading activities dealing with the

mutual fund’s own shares, and a lot of the abuses have related

thereto. Third, some of these practices have involved fraud and

collusion, and the degree of difficulty in being able to ascertain that

is much greater than the normal type of audit and evaluation type

of activities. So, I think those are three of the primary contributing

factors.

Chairman SHELBY. Ms. Schapiro, many of the recent revelations

regarding the fund industry involve not only wrongdoing by the

funds, but also by the brokers. Describe how the NASD has modified your examination practices to account for the large role that

broker-dealers play in the distribution of funds.

Ms. SCHAPIRO. I would be happy to do that, and you make a very

important point, that broker-dealers were complicit in some of the

activity that we have been all dealing with over the last number

of months.

We have incorporated new examination protocols, much as the

SEC has, into our examination program, and I would be happy to

talk about those. We will have to always work closely, as I said before, with the SEC because we can only see a part of the activity

that may be problematic. We can only see what has happened in,

and is captured on the books and records of, broker-dealers.

I would also agree that when we have a situation where an individual or a firm has either created false documents or destroyed

documents, it will always be very difficult for us to detect violations. Nonetheless, we have rolled out to our examination staff

across the country new exam protocols for identifying late trading

and market timing red flags. Our traditional focus has always been

very much in the sales practice area, revolving around suitability

primarily. We will not ever take our focus off of those issues as

well, because they impact individual investors in a very, very real

way every day. Nonetheless, our examiners are now looking for red

flags, large trades in and out in a short period of time in a particular account. They review order tickets and other books and

records to look for manipulative practices that were intended to circumvent the prohibitions on late trading: For example, they identify whether the firm has access to any system that allows them

directly to input an order to the mutual funds after the market

close, and they look at all the supervisory procedures, policies and

practices that are in place.

With respect to market timing, again, they look at large transfers

in and out. They look for whether the broker-dealer might have received a block letter from the mutual fund, and then circumvented

that block letter by shutting down one account and opening another account for that customer, who is then unknown again to the

mutual fund until the rapid trading begins again. And then we are

also reviewing correspondence and e-mails, and working closely

with the SEC to share the results of those exams, so we can learn

from each other as we develop new techniques for examining for

these practices.

Chairman SHELBY. Senator Sarbanes.

525

Senator SARBANES. Comptroller Walker, your GAO people, in a

report, this was testimony over on the House side last June, say

‘‘Mutual fund boards follow many sound corporate governance practices, but such practices are not mandatory for all funds.’’ And in

the course of the discussion under that heading, they pointed out

that you have some reforms advocated by the ICI’s best practices

and others that have been recommended by blue ribbon groups

that are not currently actually required for mutual funds. They

were testifying about legislation in order that the legislature would

make these and other practices mandatory for all funds, which

would ensure consistent implementation of the practices across the

industry. Could the SEC do that of its own authority?

Comptroller WALKER. Senator Sarbanes, my understanding is

that is exactly what the SEC is proposing to do right now. They

are proposing to require that a supermajority of directors of these

funds be independent. I think specifically they are proposing 75

percent. They are also proposing that the chairmen of these boards

of directors overseeing the funds should be independent. The one

thing that we have suggested is you may want to think about providing them with legislative authority to define what is deemed to

be independent beyond what the statute says right now. I think

they have the authority, but I would ask the SEC to comment.

Mr. ROYE. Yes. If you look at our governance proposal, we do, in

connection with a number of exemptive rules that are under the Investment Company Act that involve conflicts of interests, we expect

boards of directors to manage and oversee those conflicts. We are

proposing to attach to those rules about five different governance

principles. And as Mr. Walker mentioned, requiring a 75 percent

independent board, and an independent chairman, confirming the

authority of the directors to retain staff, particularly the independent directors, to go out and hire experts to assist them in carrying out their responsibilities, requiring them to meet in executive

session as a group of independent directors to confer on issues, as

well as requiring the directors to go through a self-evaluation as

to whether or not they are effective, and what they can do to improve that effectiveness.

Senator SARBANES. Has the SEC gone through the exercise of

ascertaining what additional statutory authority they think they

need or what current provision in the statutes ought to be changed

with respect to the mutual funds? Have we had the benefit of your

recommendations in that regard?

Mr. ROYE. We have not done that, per se. The Commission has

taken a position, for example, on earlier versions of the Baker bill

on the House side, where there were various provisions that were

in that legislation, and testified in support of a number of those

provisions, and then——

Senator SARBANES. Were you testifying in support of provisions

that you are now seeking to put in place by rule or regulation?

Mr. ROYE. Much of what was in the Baker bill you see the Commission, through its rule proposals, actually proceeding on.

Senator SARBANES. I am beyond that. One of the questions we

have to face is if you are doing it by rule and regulation and it can

be accomplished, should we just leave it there or should we come

along and also by statute require that. Of course, if you require it

526

by statute and then subsequently you need to adjust it, you have

to adjust it by statute. So, you have to be mindful of that.

But I want to go beyond that. I want to get at difficulties or problems you see in which you think your authority under the statutes

is not sufficient or adequate, and therefore, you would come to us

and say: We can do A, B, C, D, and E, but we do not think we can

do F, G, H, and I unless we get some change in the law. Have you

done that exercise?

Mr. ROYE. I can tell you this: As we work with Chairman Donaldson on his action plan, everything that he has wanted to do we

figured out a way to do it with our existing authority.

Senator SARBANES. But you just admitted at the table today, as

I understood you, that in at least the two instances that Comptroller General Walker indicated, where he thought legislative

action was necessary, you agree with that.

Mr. ROYE. That is correct, and the Commission is on record on

the House side as supporting additional authority to be able to deal

with the independent director definition. And as I indicated, Chairman Donaldson has formed a task force to look at the soft-dollar

issue, and the Commission, as yet, has not formulated a position

on that, but if you want to go so far as to repeal that, we do not

have the authority to do it on our own.

Senator SARBANES. Is that task force at work?

Mr. ROYE. Yes.

Senator SARBANES. When does it intend to report?

Mr. ROYE. We have only about 15 things we have been trying to

do all at the same time, but Chairman Donaldson has definitely

made this a priority, and I cannot give you a firm time frame, but

if you look at the speed with which we are moving in all these

other areas, he is going to demand a report from us probably in

short order, but I cannot give you a specific time frame.

Senator SARBANES. Did you want to add something, Comptroller

Walker?

Comptroller WALKER. Senator Sarbanes, I would just say one of

the things that I hope that the SEC is looking at, as well as part

of its review is whether it believes it has adequate sanctions,

whether it has an ability to impose high enough and targeted

enough civil penalties, and whether or not in certain circumstances

criminal sanctions might be appropriate for certain extreme abusive practices.

I do not know what if anything they are doing on that, but I do

know that in order for any system to work, you have to have incentives for people to do the right thing, adequate transparency to provide reasonable assurance they will because somebody is looking,

and appropriate sanctions via accountability mechanisms if they do

the wrong thing, if you do not have all three of those, the system

will not work over time, and it does not make any difference

whether it is a corporate governance system or the mutual fund industry or the health care system or the tax system, you have to

have all those.

Senator SARBANES. Thank you.

Chairman SHELBY. As I understand it, the SEC is talking about

75 percent of the directors be independent, right?

Mr. ROYE. Yes, sir.

527

Chairman SHELBY. Why should the chairman be independent?

Why should that not be left up to the directors to elect a chairman

that would be deemed by them the leader and the most competent

and so forth, as opposed to just mandating that the chairman be

independent? This was brought out last week up here.

Let me start with Ms. Schapiro.

Ms. SCHAPIRO. We have not taken an institutional view on this,

as you can understand, because we do not regulate the funds themselves. I will say I think there is a tremendous amount of learning

that has gone on over the last couple of years, given the corporate

scandals that we have all witnessed, and I think that lead directors

or independent chairmen and a number of the other things the

SEC has already proposed, are very important for the fund industry to catch up in terms of the quality of governance that is taking

place there, but I am going to defer to the SEC on the issue of

whether this should be an independent chairman or a lead director.

I do think a supermajority of independent directors is critically

important.

Senator SARBANES. Seventy-five percent?

Chairman SHELBY. Of the directors?

Ms. SCHAPIRO. Yes.

Chairman SHELBY. Comptroller Walker, do you have a comment?

Comptroller WALKER. Mr. Chairman, I think it is important to

have an independent chairman. Now whether that is a lead director or whatever, because to me boards have to do three things.

They have to maximize value to shareholders. They have to manage risk to stakeholders and they have to hold management accountable for results. The lead director or the chairperson sets the

agenda and has a tremendous amount of influence over the board’s

activities, and I think it is an important issue.

Chairman SHELBY. Comptroller Walker, would you elaborate on

the GAO’s assertion that investors should receive individualized

cost disclosure? Has the GAO evaluated the cost and feasibility of

computing such a figure?

Comptroller WALKER. I think it is important that we keep in

mind that it is not just what is disclosed but how it is disclosed

and where it is disclosed. Our experience has been, and frankly, my

personal experience has been——

Chairman SHELBY. How it is disclosed to where the shareholder

can understand it.

Comptroller WALKER. Correct. I know myself, having investments in a number of mutual fund shares, most of which, frankly,

are through a 401(k) plan, the thing I look at on a recurring basis

is my quarterly statement. There are annual reports that come out.

There are prospectuses that come out, and they have a lot of information, but at least from a personal standpoint, I do not spend a

whole lot of time on them.

I think we need to figure out how we can get important information provided in a simple, straightforward manner in a statement

that we believe that people will read.

Chairman SHELBY. People will understand.

Comptroller WALKER. And understand.

Chairman SHELBY. And understand too.

Mr. Roye.

528

Mr. ROYE. I would agree with what Mr. Walker has indicated.

The Commission has taken a number of steps to try to improve and

simplify mutual fund disclosures. We made a major effort to try to

improve the prospectus presentation. You alluded to the fact that

the prospectus is something that many investors do not spend a lot

of time focusing on. We want that document to be something that

investors do focus on and can understand. Up front in that document is a fee table that lays out the fees and expenses. We recently

went through an effort to improve the shareholder report presentation, and it does have the new dollars and cents disclosure Senator Schumer referred to in terms of $1,000, what does it cost me

per $1,000 to be invested in the fund? Also formulations that allow

you to compare one fund to another. Is my fund a high-cost fund

or a low-cost fund?

I will add that, as we worked through these disclosures recently

with the Commission, a number of the Commissioners, and the

Chairman have directed the staff to think about how we can go further in looking at issues like account statement fee information.

Chairman SHELBY. For example, why could investors not receive

both an individualized number and a comparative number?

Mr. ROYE. That is certainly possible. I think that when you get

to the account statement, one of the things that we have to work

through is that there are a number of complications in doing that.

Most fund shares today are sold through financial intermediaries,

broker-dealers, banks, other intermediaries, and they are the ones

who generate the account statement. So the funds are going to

have to get the expense information, transmit it to a variety of—

thousands of—intermediaries. Let us say you have 10 different

funds that you are holding through that intermediary, they are

going to have to bring all that information down to an account

statement and get it out 5 days after the end of the quarter, which

creates some processing issues that we would have to work

through, but it is something that we are focusing on.

Chairman SHELBY. Mr. Roye, could you please just briefly elaborate on how the SEC intends to address the potential conflicts of

interest inherent in the side-by-side management of hedge funds

and mutual funds? Maybe Ms. Richards would have something to

say there to.

Mr. ROYE. I think in the first instance we have the compliance

policies and procedures requirement that the Commission recently

adopted. Funds are going to have to have procedures and policies

in place to deal with exactly these kinds of issues. If you look at

the release you will see a discussion of just this kind of issue, sideby-side management, of a mutual fund, hedge fund, other accounts.

How do you manage those conflicts? What are your procedures?

The rules also require a compliance officer in every fund, and every

adviser who is responsible for overseeing those procedures, to report to the board of directors as to whether or not those procedures

are working.

Tomorrow, we are recommending to the Commission enhanced

disclosure about fund portfolio managers. How is your portfolio

manager compensated? How is that compensation structured? Does

the portfolio manager own shares of the fund? Maybe more significantly, what other accounts is your mutual fund manager running

529

at the same time that he or she is running a mutual fund? Is the

manager running a hedge fund, as well as a registered mutual

fund? Again, disclosing to investors what the fund’s policies and

procedures are and how you manage that conflict?

Chairman SHELBY. Ms. Richards, do you have any comment?

Ms. RICHARDS. This is an area, I think, with significant conflicts

of interest. Whenever a portfolio manager manages more than one

account and may be paid in different ways for the success or failure

of any one of those accounts, the manager may have an incentive

to mismanage one account or to favor one account over another. As

a result, this is an area where we try to look closely at the allocation decision the portfolio manager makes during examinations. It

is also an area where the Commission has found abuse—where a

portfolio manager has allocated a hot IPO, for example, to an account where he will receive more money for the favorable outcome.

Just in the last year or so, the Commission brought a case

against Zion Management, and a case against Nevis Capital, and

in prior years against Dreyfus and Van Kampen, so it is clearly an

area where there is conflict of interest and the potential for abuse.

Chairman SHELBY. Senator Dodd.

COMMENTS OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you, Mr. Chairman. My apologies to you

and Senator Sarbanes and the witnesses. We had a hearing in the

Rules Committee of 527’s. I know there is a great deal of interest

in that subject matter, so I apologize for not being over to hear

some of the earlier statements and the comments of my colleagues.

If I am raising a question here, Mr. Chairman, that has already

been covered, then interrupt me and we will wrap this up. I just

want to raise one question.

In a bill that Senator Corzine and I put together some months

ago, we did not include a hard 4 o’clock close. I know this is not

the first time you have been asked about this question, but the obvious concerns that have been raised about a hard 4 o’clock close

are the two classes of investors, East Coast investors and West

Coast investors, and making it difficult for them to get in and out

of trades in the same day if you have a 1 p.m. cut-off. That is the

argument that is being raised.

I gather in—I should know which one—the opening statements,

there was some reference to the SEC’s examination of alternatives

to the hard 4 o’clock close, and I wonder if you might comment on

some of those alternatives and explain the benefits and problems

of the clearinghouse for orders and electronic time-stamping of orders to ensure their veracity. Any of you want to jump at this?

Mr. ROYE. I would be glad to respond to that since it was our

rule proposal. We did propose a hard 4 o’clock, and as I indicated

in my statement, we are looking at a situation of widespread abuse

in this area, abuse by intermediaries that the Commission regulates and the NASD oversees, but in some cases intermediaries

that are not within the jurisdiction of the Commission. These include banks and third-party pension plan recordkeepers who are

accepting orders, and who are blending late trades with legitimate

trades so the funds cannot see those orders. So, we are faced with

the questions of how do we attack that problem?

530

If you think about the thousands of intermediaries taking orders,

the solution the Commission proposed was to shrink that universe

down to entities that we regulate and oversee. We regulate the

funds, we regulate the clearing agencies that take the fund orders,

but you are right, in doing that, you require the intermediaries to

have earlier cut-offs in terms of accepting orders. But we are trying

to deal with a situation where there are folks that we do not regulate, and to come up with a solution that we thought would solve

the problems. We recognized in the release that the rule proposal

was going to have the kinds of potential impacts that you mentioned in terms of 401(k) issues, with West Coast investors having

to get their orders in.

At the same time the Commission recognized and asked for comment on an alternative to a hard 4 o’clock. Is there a way, through

procedures, time-stamping, electronic time-stamping, where orders

cannot be altered through certification processes or third-party audits? Is there a solution that would give us reasonable confidence

that we are not going to have a late-trading problem in the future?

We received about 800 comments on this particular rulemaking.

Senator DODD. Is that particularly high?

Mr. ROYE. That is very high for an SEC rule proposal. I think

the only one that I can recall that exceeded that was the Commission’s proxy voting proposals, requiring mutual funds to disclose

how their proxies are voted.

Senator SARBANES. That was in the thousands, was it not?

Mr. ROYE. Oh, yes.

[Laughter.]

Consequently, when we started looking at this problem, we did

not want to do anything that adversely impacts the ability of investors to get their orders in. We wanted them to have the widest window of opportunity to get the orders in. At the same time we do

not want to be up here 2 years from now talking about late trading

problems. Therefore, we are trying to understand alternatives, understand technological solutions to this. We have been working

with Fund/SERV, the clearing agency. We want to hear from everybody in terms of solutions and alternatives. I can tell you that

some of the alternatives we have seen and some of the intermediaries that have some of those procedures in place already, we

found late trading.

We are looking at it very carefully. We are going to be very careful in this area, and explore all the alternatives.

Senator DODD. Comptroller Walker or anybody else want to comment on this?

Comptroller WALKER. Senator Dodd, we at GAO have recommended that the 4 o’clock hard close might be the option that

the SEC does right now, but they need to be looking for possible

alternatives. The fact of the matter is, is that there is going to be

a difference between people who live on the East Coast and the

West Coast, no matter what the time is. That just exists. I think

one of the issues that we have to think about is, is that what are

we trying to accomplish?

Part of this is there are differences here between short-term

traders and long-term investors, and in the case of pension funds

and 401(k) plans, I hope that we are promoting people to be longVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00542 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
531

term investors, not short-term traders. I think if we look at the

date with regard to pension and savings plans like 401(k) plans,

you will find that a vast majority of participants do not trade on

a frequent basis, and they are making asset allocation decisions

and sticking with it over a longer term, and so this issue may or

may not be as big a problem as some would lead you and others

to believe.

Senator DODD. Anybody else?

Ms. SCHAPIRO. Senator Dodd, I would add I think you have highlighted important issues with respect to a dramatically shortened

trading day for West Coast investors and difficulties for pension

plan administrators who have a need to net positions before they

transmit them to the fund, and I think the SEC has done the very

logical thing to do in the first instance. But there are systems I

think that can give you an unalterable electronic audit trail that

are worth looking at.

We administer an equity order audit trail for Nasdaq securities

that captures 100 million reportable events electronically every day

in the life of an order, so that there is an electronic time-stamp

when an order is received at a branch office—this is for an equity

security—when it is transmitted to a trading desk, if it is modified

or canceled or altered in any way, and that data is then batch

transmitted overnight to NASD for analysis through our surveillance system. That is a kind of system with tremendous capacity

that may be a prototype or an analogy to look at for the mutual

fund industry so that we can get the balance right. We do not want

to disadvantage investors, particularly retail investors, by shortening the trading day, but we most certainly want to close the loop

that permitted late trading to go on.

Senator DODD. Ms. Richards, you want to comment?

Ms. RICHARDS. I would just say that the current system is extremely vulnerable to late trading because of the way that orders

are processed after 4 p.m. and batched, and also because of the fact

there are so many intermediaries that process fund shares that are

not regulated by securities regulators. So any alternative solution

that would encapsulate these other nonregulated intermediaries

would have to somehow incorporate an oversight mechanism, as

well as some requirement that would bring them into the fold.

Senator DODD. But you would agree that there are some inherent

disadvantages in a hard close rule at 4 p.m.?

Ms. RICHARDS. Yes, but as an examiner I am looking for the permanent fix to the problem. So, I come at this from a little bit different point of view.

Senator DODD. How do you feel about the PATRIOT Act? I will

not ask that.

[Laughter.]

Thank you very much, Mr. Chairman.

Chairman SHELBY. Ms. Schapiro, it is important, I believe, that

investors receive full disclosure concerning any incentives that may

influence a settling broker. Would you discuss and compare your

respective rules regarding point-of-sale disclosure?

Ms. SCHAPIRO. I agree with you completely, Mr. Chairman. The

ability for a broker-dealer in terms of the funds it includes on its

preferred list, and the ability of a broker to recommend a particular

532

fund to a particular investor can be influenced by payments that

are made either to the brokerage firm or to the registered rep, and

investors absolutely should know what those incentives are that

may have skewed the recommendation they are receiving.

We have proposed two rules, one with respect to revenue sharing

and buying that shelf space at the broker-dealer by the fund——

Chairman SHELBY. Would this be in confirmation statements?

Ms. SCHAPIRO. This will be at account opening time, then updated and posted continuously on the website of the broker-dealer,

so that when you opened your account, you would be told, ‘‘We offer

the following 30 mutual funds. These are the ones that pay us for

shelf space so that we will offer them to you and give them a preferred spot in our supermarket.’’ You would be able to see all

of that information on the website, and also be told it at account

opening time.

The other piece would be that an investor would get, again, account opening or point-of-sale disclosure with respect to the fact

that the registered rep of that broker-dealer may get a higher payout from his firm for offering or recommending to you and having

you purchase a particular mutual fund. I think this information is

absolutely critical to an investor making an informed decision and

understanding that brokers can sometimes be motivated by more

than just what is in the best interest of the investor.

Chairman SHELBY. Mr. Roye, could you discuss the role of the

12b–1 fees and how these fees have evolved since their inception?

Do they still serve their intended purpose?

Mr. ROYE. 12b–1 is a rule that the Commission adopted in 1980.

It is a rule that allows funds to use fund assets to facilitate the

distribution of fund shares. It was put in place in 1980 in a time

when the fund industry was in net redemptions, and funds were

shrinking, and it was a method believed at that time to be sort of

a temporary measure to bring in assets to the fund, and maybe

lower overall expenses. Investors would benefit from the use of assets to bring in additional monies which would then bring down

fees and expenses.

It has evolved over time that 12b–1 fees are effectively an alternative to a sales load. As you have seen, mutual fund sales loads

dropped over the years since 1980. I think the maximum was 81⁄2

percent. Now the average fund and sales load is somewhere around

41⁄2, 51⁄2 percent. So, you have seen the sales loads drop. But then

you see 12b–1 fees being introduced and used as a substitute for

sales loads. Indeed, the NASD’s maximum sales load rule now

treats these asset-based fees as the equivalent of a sales load. You

have funds that can charge 12b–1 fees up to 100 basis points in

their expenses to pay for distribution-related expenses.

The Commission, as I indicated, has proposed to amend 12b–1 to

prohibit directed brokerage arrangements, whereby commissions,

which we view as fund assets, are being used to facilitate distribution, perhaps being used to circumvent the NASD’s maximum sales

load rule. The Commission has asked for comment as to whether

or not we should move further and modify that rule. Should the

rule continue to exist, be repealed? The Commission also asked for

comment on a different approach to paying for distribution expenses. Should the investor who is generating the distribution

533

costs, a new investor coming in, rather than paying the sales load

up front, pay that distribution expense over time, as opposed to

coming out of fund assets. There you have the investor actually

paying their own freight, if you will.

Chairman SHELBY. Comptroller Walker.

Comptroller WALKER. A lot has changed since 12b–1 was put into

place, and I do think it is appropriate that the SEC review and reconsider whether and to what extent these arrangements should

continue to be allowed, and to the extent that they decided that

they should be, then additional disclosures might be necessary to

allow investors to understand exactly how much we are dealing

with here.

Chairman SHELBY. Ms. Richards, to the extent that you are permitted, could you discuss any new examination sweeps or targeted

inspections that OCIE is conducting? For example, recent press

accounts report that you are investigating potential wrongdoing

among pension consultants and are examining index funds that

have high expense ratios are paying soft dollars.

Ms. RICHARDS. Yes, sir, both of those press statements are accurate. We are increasing the number of mini examination sweeps

that we conduct, targeted to particular areas where we believe

there is a risk of violations or problems. In our review of investment consultants, the concern is that these consultants are providing advice to pension plans and other investors about which

money managers to retain. These consultants may also provide

other services and have other products that they provide to money

managers. We are interested in the intersection between those two

things, that is, whether the consultant in any way influenced in

recommending particular money managers to a pension plan by the

receipt of monies that it is receiving from money managers. We are

interested in the conflicts of interest that may exist in this area,

and the extent to which these consultants are disclosing the conflicts of interest to their customers, the pension plans. So, we initiated a fact-finding review of this area in December.

The other area that we are very interested in is the use of softdollar commissions by index funds. Are index funds using their customers’ brokerage commissions, an asset that belongs to the fund,

to purchase research? We question why an index fund would need

to acquire research inasmuch as it is invested in the index. We are

again conducting a fact-finding review.

Other areas that we are exploring are payments by mutual funds

for shelf space, as Ms. Schapiro mentioned, valuation and pricing

of bond funds in light of the enforcement action the Commission

brought against Heartland Investment Advisors for mispricing two

of its bond funds; fair value pricing by foreign funds; U.S. funds

that are invested in foreign securities appropriately fair valuing

the stocks in their portfolios; and the use of affiliated service providers by a mutual fund that may retain an affiliate to provide key

services and how are those negotiations for services negotiated, for

example. Are they negotiated at arm’s length? What price does the

fund pay for affiliated service? Performance claims by investment

advisers is an area where there has been significant abuse in the

past with investment advisers misrepresenting or overstating their

performance. We are also looking at small fund complexes that

534

may not have enough assets or enough financial ability to adequately manage their compliance programs, as well as a number of

other areas.

Those are examples of areas where conducting targeted minisweeps are likely to indicate problems, and lead to solutions in a

rapid fashion.

Chairman SHELBY. Ms. Schapiro, would you comment, if you can,

on any pending or anticipating examination sweeps by NASD concerning the fund industry?

Ms. SCHAPIRO. Sure. We are still engaged in sweeps with respect

to late trading and market timing, about 58 different firms under

scrutiny in that area.

Chairman SHELBY. Fifty-eight?

Ms. SCHAPIRO. Yes, 58 firms. We are doing an intense review of

the B-share sales, where we are looking at eight very large brokerdealers to understand the extent to which they engaged in large

transactions, either single transactions or transactions accumulated over a period of time, in B shares that would have been far

cheaper for the individual investor, had they been done in A

shares. As I said in my opening statement, we continue to have a

great concern that the most expensive products are not necessarily

the best products being offered to investors.

We have 10 firms that we are currently looking at for these net

asset value transfers, where investors should not have been

charged a new front-end load, but were, and so were overcharged.

Chairman SHELBY. Does this involve a lot of money?

Ms. SCHAPIRO. Yes. It involves a significant amount of money.

And we are looking at directed brokerage in about 50 instances,

and sales contests, much like the Morgan Stanley case, although

perhaps not quite as flamboyant.

Chairman SHELBY. In directed brokerage, you are talking about

a lot of money here too, are you not?

Ms. SCHAPIRO. Yes. And bad disclosure.

Chairman SHELBY. Billions of dollars maybe?

Ms. SCHAPIRO. We are looking at very, very large payments, yes.

Chairman SHELBY. Unusual payments?

Ms. SCHAPIRO. Large payments, yes. Then finally, with respect to

breakpoints, an area where we have had really intimate involvement, 625 firms that failed to give breakpoint discounts to their investors will have to be reexamined since we have ordered them to

give those discounts with interest to investors, and over the next

period of time, and maybe it is a year, we will have to go back into

each of those 625 firms and determine that they did, in fact, fulfill

their obligations to refund that money to investors.

Chairman SHELBY. Comptroller Walker.

Comptroller WALKER. Mr. Chairman, the only thing I would say

is I would hope that both the SEC and the NASD are coordinating

their related activities with the Employee Benefit Security Administration at the Labor Department, who has responsibility for enforcing the fiduciary responsibility provision and has a significant

amount of sanctions available to them, both civil and criminal in

dealing with illegal and abusive practices.

Chairman SHELBY. Ms. Richards, do you want to comment on

that? If not, why not?

535

Ms. RICHARDS. Yes, sir, we will do so. We will communicate with

the Department of Labor.

Ms. SCHAPIRO. Absolutely.

Chairman SHELBY. I thank the panel for your informative statements today, and we will continue our examination of the mutual

fund industry with more hearings to come. Thank you very much.

The hearing is adjourned.

[Whereupon, at 11:40 a.m., the hearing was adjourned.]

[Prepared statements and response to written questions follow:]

536

537

538

539

540

541

542

543

544

545

546

547

548

549

550

551

552

553

554

555

556

557

558

559

560

561

562

563

564

565

566

PREPARED STATEMENT OF LORI A. RICHARDS

DIRECTOR, OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS

U.S. SECURITIES AND EXCHANGE COMMISSION

MARCH 10, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

thank you for inviting me to testify today on behalf of the Securities and Exchange

Commission concerning our examinations of mutual funds. With more than 95 million Americans invested in mutual funds, representing tens of millions of households, and approximately $7 trillion in assets, mutual funds are a vital part of this

Nation’s economy. Millions of investors depend on mutual funds for their financial

security. As Chairman Donaldson said when he testified before this Committee in

November, mutual fund investors have a right to an investment industry that is

committed to the highest ethical standards and that places investors’ interests first.

The Commission’s regulatory and enforcement actions, as well as actions by State

securities regulators, are intended to prevent and deter market timing and late

trading abuses.

The Commission is responsible for examining mutual funds and their investment

advisers. There are now some 8,000 funds, managed in over 900 fund complexes,

and over 8,000 investment advisers. Until recently, the SEC had approximately 360

staff persons for these examinations. In 2003, budget increases allowed us to increase our staff for fund examinations by a third, to approximately 500 staff. The

size of the mutual fund industry precludes a comprehensive audit of each registrant’s operations by examination staff. Our routine examinations, therefore, focus

on those areas that, in our view, pose the greatest risk to investors.

Examinations identify compliance problems at individual firms, and also help to

identify areas of emerging compliance risk. In recent years, for example, examiners

have identified and Commission staff have addressed a number of practices that

may harm investors, including, for example, abusive soft-dollar arrangements, favoritism in the allocation of investments, misrepresentations and omissions in the sales

of fund shares, inaccurate pricing of fund shares, the failure to obtain best execution

in portfolio transactions, sales practice abuses in the distribution of different classes

of mutual fund shares, and the failure to give customers the discounts generally

available on the large purchases of fund shares—these discounts are known as

‘‘breakpoints.’’

The Commission examiners, along with enforcement staff, are actively conducting

examinations and investigations of a large number of market participants to determine whether they engaged in abusive and undisclosed market timing and late trading in fund shares. The preliminary results from those examinations and investigations were reported by Stephen Cutler, Director of the SEC’s Division of Enforcement, in his testimony before this Committee in November, and the Commission has

brought numerous enforcement actions and engaged in an aggressive rulemaking

agenda as a result of the misconduct.

Prior to September 2004, however, examination staff did not detect the abusive

market timing or late trading arrangements that fund executives had with select

traders. We have been reviewing examination protocols to identify lessons learned

from these cases and evaluating ways that our examination oversight can be improved, both to detect abusive market timing specifically, and more generally to

timely detect other types of misconduct by fund firms.

My testimony today focuses on the changes we are making to our examination

oversight, specifically with respect to market timing, and more broadly with respect

to overall examination oversight generally. Our goal is to improve examiners’ ability

to identify and scrutinize transactions and arrangements that place the interests of

fund shareholders at risk. Today, examiners are increasing the frequency and depth

of examination reviews for high-risk firms; increasing the use of technology and

data; developing new methods to identify new or emerging areas of compliance risk;

conducting more targeted ‘‘mini-sweep’’ examinations to identify risk areas sooner;

and working more closely with other staff at the Commission to highlight problems

detected, and identify possible solutions sooner. Attached to this testimony is a comprehensive report on the Commission’s examinations of investment companies and

investment advisers prepared in response to the request made by Chairman Shelby

to Chairman Donaldson on November 18, 2003. This report describes the examination program and these initiatives in greater detail, as well as recent enforcement

actions brought by the Commission involving mutual funds.

567

Examination Steps to Better Detect Market Timing

Prior to the recent revelation of market timing and late trading abuses, examiners

reviewed trading by a fund (for example, the fund’s purchases and sales of securities

on behalf of investors), but did not review trading in the fund’s own shares. Examiners focused on whether funds were trying to inflate the returns of the fund, or

take on undisclosed risk. The concern was that, in attempting to produce strong

investment returns to attract and maintain shareholders, fund portfolio managers

had an incentive to engage in misconduct in the management of the fund. As a result, examination protocols required that significant attention be focused on portfolio management, order execution, allocation of investment opportunities, pricing

and calculation of net asset value, advertising returns, and safeguarding fund assets

from theft. Examinations in these areas revealed problems and deficiencies. Because

examiners’ focus was on the fund itself, and not on trading in the fund’s shares,

however, examiners did not detect aberrant trading patterns that could be indicative of abusive market timing.

Although market timing in itself is not illegal, many mutual funds said that they

discouraged the practice, and fund firms told examiners that the firms had appointed antimarket timing ‘‘police’’ who were responsible for detecting market timing trades and preventing timers from continued trading in their funds. The shocking development, not detected by examiners, was the secret complicity of some fund

personnel in allowing select timers to continue to time.

Based on our recent examinations, we have identified ways to better detect market timing. These examinations have shown that daily sales and redemptions data

can reveal patterns of trading in a fund’s shares that may indicate market timing,

and we now have made a review of this data a part of every routine examination.

Additionally, our review of funds’ books and records did not reveal the covert arrangements that fund executives had with select shareholders, allowing them to

trade frequently in fund shares. These arrangements appear to have been evidenced

often only in e-mail communications and not in written agreements, contracts, or

other documents. In the past, routine examinations did not include a random review

of employees’ internal e-mail communications (unless there was cause to believe

that particular communications were relevant to the examination). Now to aid in

detecting any misconduct that might not otherwise be reflected in the books and

records kept by the firm and shown to examiners, routine examinations include a

review of a sample of fund executives’ internal e-mail communications. We are now

deploying software that will enable us to review large volumes of e-mail traffic, and

we have made this a key element of our regular oversight.

Additional new examination steps include a review of personal trading records

showing trading in the fund shares by select fund executives (even in advance of

new Commission rules that would require that this information be made available),

and a review of procedures to ensure that orders are processed to receive the appropriate day’s net asset value, including firms’ procedures governing order receipt time

and order time-stamping.

Recent Commission rule proposals that would require better and more specific disclosure of funds’ antimarket timing policies and a possible ‘‘Hard 4 p.m. Close’’ for

receiving fund orders would aid examiners in detecting abuses of this type in the

future. More broadly, the Commission has recently adopted rules to improve compliance by funds and advisers by requiring that they strengthen their own internal

compliance programs. The new rules require that advisers and funds implement and

maintain compliance policies and procedures designed to prevent, detect, and correct

compliance problems in key areas of their operations. The new rules also require

that funds and advisers designate a chief compliance officer to implement those

compliance policies and procedures, and, in order to assist the fund board in exercising compliance oversight, to report on compliance matters to the fund’s board of

directors.

In sum, we are taking aggressive steps to address abusive timing, and to improve

our ability to detect this type of misconduct.

Other Changes to Fund Examinations

We are implementing other changes to SEC examinations to enhance our ability

to detect problems, as well as to anticipate problems before they become widespread.

This is the central goal of the Commission’s risk assessment initiative.

The challenge for any examination oversight program is to determine how best

to use limited resources to oversee a large and diverse industry. More specifically,

the challenge is to identify the areas of highest risk to investors, and to probe these

areas effectively, while still providing examinations of each industry participant

with appropriate frequency. In addition, once emerging trends and problems are

identified, we must share our knowledge with other Divisions and Offices so that

568

the Commission can bring all of its resources to bear on efforts to protect investors.

We have implemented or are implementing changes that we believe will better allow

us to meet these challenges. These changes are summarized below.

New Fund Surveillance Program

As Chairman Donaldson announced on March 5, he has formed an SEC staff task

force that will be drafting the outlines of a new surveillance program for mutual

funds. This task force will examine the mutual fund reporting regime—looking at

both the frequency of reporting to the Commission and the categories of information

to be reported, as well as how new technologies can be used to enhance our oversight responsibilities. The goal of such a surveillance program would be to identify

indications of problems, and then target the particular fund or adviser for follow up

inquiry by telephone, letter, or on-site visit. Staff will also be able to examine the

relevant data—industry-wide—to determine if a systemic problem is emerging.

Increased Use of Data Analysis

Examiners have been making increased use of computer technology to facilitate

review of large volumes of data. This has significantly enhanced the level of oversight possible in critical areas such as portfolio trading and best execution.

Interviews

Examiners have been making increased use of interviews. More recently, these

interviews have played a critical role when assessing a firm’s control or risk environment.

More Frequent Examinations

With the additional resources added to the examination program in 2003, we are

able to increase examination frequency of the largest fund firms, and those fund

firms posing the greatest compliance risk (from once every 5 years, to once every

2 years). Prior to 1998, examination cycles had been as infrequent as once every

12–24 years.

More Targeted ‘‘Mini-Sweeps’’

To quickly identify and investigate a particular industry practice, and to help the

Commission and staff expeditiously solve or mitigate the compliance risk, we have

been conducting more examination sweeps focused on particular issues. Examples

of some of the ongoing or recent sweeps or mini-sweeps include: Payments by mutual funds for ‘‘shelf-space;’’ use of soft dollars by index funds, valuation and pricing

of bond funds; fair value pricing; and practices of investment consultants.

Facilitating Immediate Corrective Action

Recently, we have adopted new policies to enhance the speedy resolution of any

problems found, including holding exit interviews with senior management of firms

and providing deficiency letters directly to fund boards of directors.

Requests for Reports

Examiners have increased their requests for written reporting by funds and advisers. This allows the staff to monitor compliance in between on-site examinations,

obtain information on an expedited basis, and gather information on particular

issues across a large number of firms. It also enables examiners to better manage

and prioritize a large number of sweep examinations and focus examinations before

the on-site portion of the review.

Collaboration with Other Commission Staff

As noted above, we must act promptly on emerging areas of compliance risk. To

facilitate such action, examination staff must share exam findings and trends with

other Commission staff. Now a committee composed of examination, enforcement,

and regulatory staff reviews all examinations indicating serious problems to ensure

that appropriate findings are investigated promptly. In addition, so that any emerging trends are identified and made known promptly, examination findings and

trends are shared with other Commission staff on a routine basis. Examiners also

seek input from other Commission staff on possible areas of examination scrutiny.

‘‘Benchmarking’’ Examinations

We are adopting a program to test the assumptions we use in our routine, riskbased examinations. Each year, we will conduct comprehensive ‘‘wall-to-wall’’ examinations of a select number of firms to test the assumptions used in our risk-based

exams and to benchmark our procedures. These comprehensive reviews should identify weaknesses in our risk-based models and allow us to expand, as needed, our

review of risky activities.

569

Other Areas of Examination Scrutiny

As noted above, in addition to market timing, SEC’s examiners are conducting

sweep examinations and mini-sweep examinations designed to identify areas of

emerging compliance risk. In routine examinations, examiners are also focusing on

compliance risk areas. Examples of recent and current areas of scrutiny include: Allocations of securities among accounts; valuations of portfolio securities; use of soft

dollars to pay for fund distribution; whether customers are provided with breakpoint

and other discounts on purchases of funds; use of affiliated service providers; performance claims by advisers; antimoney laundering protections; Regulation S–P;

and best execution, among other areas.

Conclusion

As outlined in this statement, and described in greater detail in the attached report, we are moving aggressively to implement the lessons learned from recent market timing abuses, and more broadly, to enhance our ability to detect abuses in the

fund industry.

I would be happy to answer any questions you may have.

Thank you.

570

571

572

573

574

575

576

577

578

579

580

581

582

583

584

585

586

587

588

589

590

591

592

593

594

595

596

597

598

599

600

601

602

603

604

605

606

607

608

609

610

611

612

613

614

615

616

617

618

619

620

621

622

623

624

625

626

627

628

PREPARED STATEMENT OF PAUL F. ROYE

DIRECTOR, DIVISION OF INVESTMENT MANAGEMENT

U.S. SECURITIES AND EXCHANGE COMMISSION

MARCH 10, 2004

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, it

is both a pleasure and an honor to testify before you today. On behalf of the Securities and Exchange Commission (the ‘‘Commission’’), I am pleased to discuss the

Commission’s recent regulatory actions to protect mutual fund investors. To address

the various abuses that have come to light in recent months, the Commission has

embarked on a dramatic overhaul of the regulatory framework in which mutual

funds operate. The Commission’s regulatory actions, taken together with its recent

enforcement proceedings and actions by State securities regulators, are intended to

prevent and deter the types of market timing, late trading and sales practice abuses

that have dominated the headlines in recent months. Equally important, the Commission’s rulemaking initiatives are aimed at restoring the trust and confidence of

investors that are crucial to the continued success of the mutual fund industry and

preserving their key role in our country’s economy. Approximately 95 million investors have entrusted over $7 trillion dollars to mutual funds. As mutual fund investments increasingly fund the most important personal goals in Americans’ lives, from retirement and education savings to charitable

giving, our Nation’s investors rightfully look to fund managers and fund directors

to act in their interests. Sadly, these investors have been let down, as some of those

charged with protecting investors have willfully disregarded their responsibilities to

act for the benefit of their investors.

The Commission has committed its unceasing effort to holding accountable those

who violate the Federal securities laws to abuse fund investors. The Commission is

equally devoted to enhancing the mutual fund regulatory framework so that it best

serves fund investors.

Commission’s Regulatory Agenda

Under Chairman Donaldson’s leadership, the Commission is pursuing an aggressive mutual fund regulatory agenda that is focused on four main goals: (1) addressing late trading, market timing and related abuses; (2) improving the oversight of

funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) addressing or eliminating certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) improving disclosure to

fund investors, especially fee-related disclosure. Outlined below is an overview of the

Commission’s recent regulatory actions in each of these areas.

INITIATIVES TO ADDRESS LATE TRADING, ABUSIVE MARKET TIMING,

AND RELATED ABUSES

Late Trading

Every day hundreds of thousands of investors purchase or redeem shares of mutual funds. The price they pay (or receive) turns on when the order is submitted

and to whom. Typically, funds price their shares at 4 p.m. Investors submitting orders before 4 p.m. receive that day’s price; investors submitting orders after 4 p.m.

get the next day’s price. This is a simple, but very important concept known as ‘‘forward pricing.’’ If you can place an order to buy or sell fund shares after 4 p.m., and

still receive the price set at 4 p.m., you can profit from new information in the marketplace at the expense of other fund shareholders. The Commission’s recent review

of the largest brokers that sell fund shares identified numerous instances of late

trading of fund shares. It is just plain cheating, and something that clearly violates

existing Commission rules.

The current rules permit a large number of intermediaries that accept or transmit

trades in fund shares to determine whether the order will receive that day’s 4 p.m.

price. Typically, investor trades are accepted throughout the business day by fund

transfer agents, as well as brokers, banks, and retirement plan administrators—socalled fund intermediaries. These intermediaries pass on orders to fund companies

in batches at the end of the day after 4 p.m. They are only supposed to pass on

orders they receive before 4 p.m. This system, which was first created 35 years ago,

relies heavily on the honesty of fund intermediaries to segregate orders based on

the time they are received and then playing by the rules.

We know today that this system failed. In order to help favored customers, certain

intermediaries have ‘‘blended’’ legitimate (pre-4 p.m. orders) with late trades (post4 p.m. orders). In some cases, fund managers participated in the scheme; but in

629

many cases they were the victims of dishonesty along with fund investors. The problem is that fund companies have no way of identifying a late trade when it is

bundled with legitimate trades and submitted to the fund company in the evening

hours. There are potentially enormous profits to be gained by late trading, and all

of those profits come out of the pockets of mutual fund investors.

To address this abuse, the Commission proposed the so-called ‘‘Hard 4 p.m. Close’’

rule. This proposal would require that a fund or a certified clearing agency, such

as NSCC—rather than an intermediary such as a broker-dealer or other unregulated party—receive a purchase or redemption order prior to the time the fund

prices its shares (which, as previously stated, is typically 4 p.m.) for an investor to

receive that day’s price. We believe that this rule amendment will provide for a secure pricing system that would be highly immune to manipulation by late traders.

We are currently analyzing the comment letters we received during the comment

period on this proposal, which closed on February 6th. While we believe the proposed rule amendment would virtually eliminate the potential for late trading

through intermediaries that sell fund shares, it is clear from the comments that

some believe that the hard 4 p.m. rule is not the preferred approach. They argue

that it will require the intermediaries to have cut-offs for orders well before 4 p.m.

and limit investor opportunities to place orders for fund transactions, particularly

in the 401(k) context. Consequently, we are studying other approaches to addressing

this issue. We do not want to adversely impact fund investors if there are alternatives that effectively—truly effectively—address late trading abuses.

Market Timing

The Commission has taken a number of steps to address abusive market timing

of mutual funds. Short-term trades in mutual fund shares impose costs on funds

and their long-term investors. Some market timers attempt to purchase and redeem

fund shares to take advantage of market actions they believe will occur in the

future. Other types of market timers attempt to more directly take advantage of the

fund’s long-term shareholders by exploiting how funds calculate their net asset

value. These ‘‘arbitrage market timers’’ buy and sell shares of funds if they believe

that the fund’s calculation of net asset value significantly lags behind the current

value of a fund’s portfolio securities, typically in international funds or other funds

that invest in thinly traded securities. Over time, the long-term shareholders in a

fund will, in effect, pay the costs of the short-term shareholders’ transactions and

have the value of their fund shares diluted through the activity of arbitrage market

timers.

Fair Value Pricing

To help prevent ‘‘arbitrage market timing,’’ the Commission has stressed that

‘‘fair value pricing’’ is a critical tool in effectively reducing or eliminating the profit

that many market timers seek. The Investment Company Act requires funds to calculate their net asset values using the market value of portfolio securities when

market quotations are readily available. If a market quotation for a portfolio security is not readily available (or is unreliable), the fund must establish a ‘‘fair value’’

for that security, as determined in good faith by the fund’s board of directors. Fair

value pricing can minimize market timing, and eliminate dilution of shareholders’

interests. In a recent release adopting the new compliance procedures rule, the

Commission reiterated the obligation of funds to fair value their securities to reduce

market timing arbitrage opportunities. Additionally, the Commission has proposed

improved disclosure of a fund’s policies and procedures regarding fair value pricing.

SEC staff are currently gathering information regarding funds’ fair value pricing

practices and evaluating whether to recommend additional measures to improve

funds’ fair value pricing. The Commission has also sought public comment on the

need for additional guidance or rulemaking in this area.

Mandatory Redemption Fee

In a further effort to reduce the profitability of abusive market timing, the Commission just late last month put forth a proposal that would require funds to impose

a mandatory 2 percent redemption fee when investors redeem their shares within

5 business days. This fee would be payable to the fund, for the direct benefit of fund

shareholders, rather than to the management company or any other service provider.

The 2 percent fee is designed to strike a balance between two competing policy

goals of the Commission—preserving the redeemability of mutual fund shares and

reducing or eliminating the ability of shareholders who frequently trade their shares

to profit at the expense of their fellow shareholders. Combined with fair value pricing, the Commission felt that the rule would make market timing less profitable,

and therefore reduce the incentive to engage in market timing. The Commission is

630

considering whether a 2 percent redemption fee is an appropriate approach to addressing short-term trading, including abusive market timing.

Enhanced Disclosure Related to Abusive Activities

The Commission also has proposed enhanced disclosure requirements in order to

combat abuses in the areas of market timing and the related issue of selective disclosure of portfolio holdings. These enhancements are intended to deter abusive

practices and to enable investors to better understand a fund’s policies in these

areas. The Commission proposed amendments to require more open and unambiguous disclosure with respect to the methods that mutual funds use to combat market timing activity. Among other changes, the Commission’s proposed reforms

would:

• Require a mutual fund to describe in its prospectus the risks that frequent purchases and redemptions of fund shares may present for other fund shareholders.

• Require that a mutual fund state in its prospectus whether the fund’s board of

directors has adopted policies and procedures with respect to frequent purchases

and redemptions of fund shares. If the board has not adopted any such policies

and procedures, the fund’s prospectus would be required to state the specific basis

for the view of the board that it is appropriate for the fund not to have such policies and procedures.

• Mandate that a fund describe with specificity any policies and procedures for deterring frequent purchases and redemptions of fund shares, and any arrangements that exist to permit frequent purchases and redemptions of fund shares.

This description must include any restrictions on the volume or number of purchases, redemptions, or exchanges that a shareholder may make, any exchange

fee or redemption fee, and any minimum holding period that is imposed before

an investor may make exchanges into another fund. Moreover, a fund would be

required to indicate whether each restriction applies uniformly in all cases, or

whether the restriction will not be imposed under certain circumstances, and to

describe any such circumstances with specificity.

Selective Disclosure of Portfolio Holdings

The Commission also proposed amendments intended to provide greater transparency of fund practices with respect to the disclosure of a fund’s portfolio holdings.

Specifically, a fund would be required to describe its policies and procedures with

respect to the disclosure of its portfolio securities, including any arrangements to

make available information about the fund’s portfolio securities, the identity of any

persons who receive such information, and any compensation or other consideration

received by a fund or its investment adviser in connection with such arrangements.

These amendments do not alter the requirement that a mutual fund or investment

adviser may disclose a fund’s portfolio of investment securities only if the disclosure

of such information is consistent with the antifraud provisions of the Federal securities laws and the fiduciary duties owed to fund shareholders.

This new disclosure requirement should have the effect of requiring fund management to carefully assess the propriety and circumstances under which portfolio holding information is divulged, as well as inform fund investors of the fund’s policies

in this area.

INITIATIVES TO ENHANCE FUND OVERSIGHT

The recent mutual fund scandals have highlighted the need to improve oversight

of the industry, and the Commission has undertaken several initiatives on this

front. These initiatives are designed to strengthen the hand of the fund’s board and

to provide the directors, particularly the independent directors, additional tools with

which to protect fund investors, as well as reinforce ethical standards.

Fund Governance

In January, the Commission proposed a comprehensive rulemaking package to

bolster the effectiveness of independent directors and to enhance the role of the fund

board as the primary advocate for fund shareholders. The proposals included a requirement for: (i) an independent board chairman; (ii) 75 percent independent directors; (iii) independent director authority to hire, evaluate, and fire staff; (iv) quarterly executive sessions of independent directors outside the presence of management; (v) an annual board self-evaluation; and (vi) preservation of documents used

by boards in the contract review process.

This significant overhaul of the composition and the workings of fund boards is

intended to establish, without ambiguity, the dominant role of independent directors

on a fund’s board. With an independent board chairman and with independent directors representing at least 75 percent of a fund’s board, the independent directors

631

1 At the open meeting at which the Commission proposed the rule, Commissioners Glassman

and Atkins questioned whether an independent chairman would in fact provide a more effective

check on management and thus be more effective in promoting shareholder interests.

will set the board agenda, as well as have the power to control the outcome of board

votes.

The very nature of external management that characterizes the U.S. fund industry creates conflicts of interest, particularly when personnel of fund advisers may

be tempted by opportunities to benefit the adviser over fund shareholders. While not

a guarantee that all conflicts of interest will be resolved in the best interests of

shareholders, a board composed of an independent chairman and a super-majority

of independent directors is more likely to be an effective check on management, particularly when so much of the board’s responsibility involves policing the management company’s conflicts of interest.1 As Chairman Donaldson recently commented,

‘‘a fund board can be more effective when negotiating with the fund adviser over

matters such as the management fee, if it were not at the same time led by an executive of the adviser with whom the board is negotiating.’’

By empowering independent fund directors to retain staff, in conjunction with the

role envisioned for the newly-required chief compliance officer, the Commission’s

proposals emphasize the importance of boards relying on experts other than advisory personnel to provide information in appropriate circumstances. In addition, reinforcing the ability of the board to hire staff recognizes that directors often must

make decisions on issues about which they may need to seek out expertise, such as

the fair value pricing of portfolio securities.

Boards would also be required to perform a thorough self-evaluation in order to

identify structural changes and processes that might enable the board to be a more

potent advocate for shareholder interests. Boards would be required to assess periodically whether they are organized to maximize their effectiveness. As part of this

evaluation, boards would consider the number of fund boards on which individual

board members sit, as well as consider the nature and effectiveness of their board

committee structures.

As part of its effort to enhance fund governance, the Commission has proposed

to mandate that funds keep copies of the materials directors considered when reviewing the fund’s advisory contract each year. This amendment is designed to give

the Commission’s examinations staff access to the information on which directors

rely when performing this crucial function. This requirement also could have the effect of focusing directors on this key information, since they would be aware that

it will be subject to Commission scrutiny.

Adviser Codes of Ethics and Fund Transactions Reporting

The Commission recently proposed that all registered investment advisers adopt

codes of ethics. Investment advisers are fiduciaries, and owe their clients a series

of duties enforceable under the Investment Advisers Act’s antifraud provisions. This

bedrock principle, which historically has been a core value of the money management business, appears to have been lost on a number of advisers and advisory

personnel.

The Commission believes that prevention of unethical conduct by advisory personnel is part of the answer to avoiding the problems we have encountered recently.

Consequently, the code of ethics would set forth standards of conduct for advisory

personnel that reflect the adviser’s fiduciary duties, as well as codify requirements

to ensure that an adviser’s supervised persons comply with the Federal securities

laws, and require that supervised persons receive and acknowledge receipt of a copy

of the code of ethics. In addition, the code of ethics must include provisions that address the safeguarding of material nonpublic information about client transactions,

reporting promptly any violations of the code of ethics, and mandating preclearance

of personal investments in initial public offerings and private offerings.

Finally, the ethics code is designed to address conflicts that arise from the personal trading of advisers’ employees. A principal feature of the code of ethics rule

is a requirement that certain advisory personnel, referred to as access persons, must

report their personal securities holdings and transactions, including transactions in

any mutual fund managed by the adviser or an affiliate. The rule would close a

loophole in the Investment Company Act under which investment company personnel have not been required to report trading in shares of funds they manage.

This loophole became apparent when, unfortunately, fund personnel were discovered

market timing their own funds.

632

Compliance Policies and Compliance Officer

In an action we expect to have a far-reaching positive impact on mutual fund operations and compliance programs, the Commission in December adopted rules that

require funds and their investment advisers to have comprehensive compliance policies and procedures in place, and to designate a chief compliance officer. In the case

of a fund, the chief compliance officer would be answerable to the fund’s board and

fired only with the board’s consent.

The compliance officer has dual roles: First, as the primary architect and enforcer

of compliance policies and procedures for the fund; second, and perhaps more importantly, as the eyes and ears of the board on all compliance matters. The chief compliance officer, at the behest of the board, is expected to strengthen the board’s hand

of compliance oversight into the details of the operations of funds and advisers,

where compliance lapses and abuses often germinate and remain hidden from even

the most watchful board. In order to support the ‘‘watchdog’’ role of the compliance

officer, the rules require the chief compliance officer to meet in executive session

with the independent directors at least once each year, outside the presence of fund

management and the interested directors. This executive session will create an opportunity for open dialogue between the chief compliance officer and the independent directors and encourage the compliance officer to speak freely about any

sensitive compliance issues, such as any reservations about the cooperativeness or

compliance practices of fund management. To insulate a chief compliance officer

from the pressures, real or perceived, brought to bear by fund management, a fund’s

board, including a majority of the independent directors, must approve the chief

compliance officer’s compensation, as well as any changes in compensation.

To further encourage a culture of compliance among fund officers and personnel

of fund advisers, the compliance rule calls for funds and advisers to adopt policies

and procedures designed to lessen the likelihood of securities law violations. The

adequacy of these policies and procedures must be reviewed at least annually in

order to ensure that fund directors assess whether internal controls and procedures

are working well and whether certain areas can be improved.

An active and independent board of directors, supplied with reliable information

as to the effectiveness of compliance programs and procedures, can serve as an

important check against abuse and fraud on the part of fund management.

INITIATIVES AIMED AT CONFLICTS OF INTEREST

In addition to the matters outlined above, the Commission is undertaking a series

of initiatives aimed at certain conflicts of interest involving mutual funds and those

who distribute fund shares.

Directed Brokerage

Last month, the Commission voted to propose an amendment to Rule 12b–1 to

prohibit the use of brokerage commissions to compensate broker-dealers for distribution of a fund’s shares. Effectively, this proposal would ban so-called directed brokerage practices by mutual funds. When Rule 12b–1 was adopted by the Commission in 1980, the Commission thought that it would be relatively benign to permit

funds to consider distribution when making brokerage allocation decisions. However,

in recent years, it has become clear that the practice of directing a fund’s brokerage

to a broker or dealer as compensation for distribution of a fund’s shares presents

opportunities for abuse. Advisers to funds are allocating brokerage commissions to

pay for distribution when they could seek lower commission rates, rebates to the

fund, or reduce custody, transfer agency or other fund costs. The use of directed brokerage to pay for distribution benefits fund advisers by increasing their advisory

fees, which generally are based on the size of fund assets, and lowering the amount

they have to spend on distribution out of their own assets. The conflicts of interest

that surround the use of brokerage commissions (which, of course, are fund assets)

to finance distribution can harm funds and their shareholders. Directed brokerage

practices potentially could compromise best execution of portfolio trades, increase

portfolio turnover, conceal actual distribution costs, and corrupt broker-dealers’ recommendations to their customers. Therefore, the Commission has proposed to ban

these types of arrangements.

Rule 12b–1

At the same time, the Commission voted to request comment on the need for additional changes to Rule 12b–1. Over time, Rule 12b–1 has come to be used in ways

that exceed its original purpose. Consequently, the Commission is seeking comment

on whether Rule 12b–1 continues to serve the purpose for which it was intended

and whether it should be repealed. To address concerns that Rule 12b–1 fees have

replaced sales loads in many cases, the Commission also requested comment on an

633

alternative approach to Rule 12b–1 that would require distribution-related costs to

be deducted directly from shareholder accounts rather than from fund assets. Under

this approach, a shareholder would pay the same sales load regardless of when the

load is paid. An investor could pay the load at the time of purchase or over the period of the investment, with any remaining load paid upon redemption. This approach may have a number of advantages: First, actual sales charges would be clear

to investors; second, existing shareholders would not pay for sales to new investors;

and third, long-term shareholders would not pay 12b–1 fees that may exceed their

fair share of distribution costs.

Soft Dollars

Chairman Donaldson has made the issue of soft dollars a priority and has directed the staff to explore the problems and conflicts inherent in soft-dollar arrangements and the scope of the safe harbor contained in Section 28(e) of the Securities

Exchange Act. The Divisions of Market Regulation and Investment Management are

working together to conduct this review. A primary area of focus is whether the current definition of qualifying ‘‘research’’ under the safe harbor is too broad and

should be narrowed by rulemaking. The Commission has also sought public comment on whether it would be possible to require mutual fund managers to identify

the portion of Commission costs that purchase research services from brokers so as

to enhance the transparency of these arrangements.

INITIATIVES TO IMPROVE FUND DISCLOSURE, INCLUDING FEE-RELATED INFORMATION

The Commission is quickly progressing on its continued effort to improve fund disclosures and highlight for investors fee-related information. This effort began long

before mutual fund scandals hit the headlines, and Chairman Donaldson has identified improved disclosure as a priority for the Commission’s mutual fund program.

Shareholder Reports Disclosure

The level of a fund’s expenses, over time, has a significant impact on a fund

shareholders’ investment experience. The Commission has wrestled for years with

the problem of how to convey expense information to investors in a cost-effective

way that permits investors to compare funds and to understand and appreciate the

effect that expenses have on their investment. Last month, the Commission voted

to significantly revise mutual fund shareholder report disclosures to assist investors

in understanding these expenses. Shareholder reports will now be required to include dollar-based expense information for a hypothetical $1,000 investment. Using

that information, investors can then estimate the dollar amount of expenses paid

on their investment in a fund. Shareholder reports also will contain the dollar

amount of expenses an investor would have paid on a $1,000 investment in the

fund, using an assumed rate of return of 5 percent. Using this second dollar-based

number, investors can compare the level of expenses across various potential fund

investments. Increased transparency of fees should enhance fee-based competition

in the fund industry.

This initiative also includes significantly improved disclosure to investors about

a fund’s investments. The recent amendments will replace a one-size-fits-all approach to portfolio holdings disclosure, where all funds deliver their full portfolio

schedules to all their shareholders twice a year, with a layered approach that will

make more information available, while permitting investors to tailor the amount

of information they receive to meet their particular needs. The additional quarterly

disclosure of fund portfolio holdings will enable interested investors, through more

frequent access to portfolio information, to better monitor whether, and how, a fund

is complying with its stated investment objective. The amendments also require

shareholder reports to include tables, graphs, or charts that concisely, and in a userfriendly format, effectively convey key information about a fund’s portfolio. Finally,

management’s discussion of fund performance is now required to appear in annual

shareholders reports, and should assist investors in assessing the fund’s performance over the prior year. This package of initiatives will provide better information

to investors regarding fund costs, investments, and fund performance.

At the same time as it adopted these revisions, the Commission proposed to require disclosure in fund shareholder reports about how fund boards evaluate investment advisory contracts. A fund’s board of directors plays a key role in negotiating

and approving the terms of the advisory contract between the fund and the investment adviser who is charged with its management. The Commission is proposing

to make this process more transparent to fund shareholders. The disclosure would

include discussion of the material factors considered by the board and the conclusions with respect to those factors that formed the basis for the board’s approval

or renewal of the advisory contract. In making this proposal, the Commission is

seeking to promote insightful disclosure of the board review process, rather than

634

meaningless boilerplate that is not helpful to investors. Transparency of fees, informed investors and independent, vigorous boards of directors will allow the market to determine appropriate fee levels. This proposal should encourage fund boards

to consider investment advisory contracts more carefully and encourage investors to

consider more closely the costs and value of the services rendered by the fund’s investment advisers.

Fund Advertising

In September, the Commission adopted amendments to raise the standards for

mutual fund performance advertising. The amended rules require that fund advertisements state that investors should consider fees, as well as investment objective

and risks, before investing and that advertisements direct investors to a fund’s prospectus to obtain additional information about fees, investment objectives and risks.

The rules also require more balanced information when mutual funds advertise performance, as well as provide ready access to more timely performance information.

Mutual Fund Confirmation Form and Point-of-Sale Document

In a major proposal issued in January, the Commission proposed significant revisions to mutual fund confirmation forms and also proposed the first-ever point-ofsale disclosure document for brokers selling mutual fund shares. Together, these

two proposals would greatly enhance the information that broker-dealers provide to

their customers in connection with mutual fund transactions.

The proposals call for disclosure of targeted information, at the point-of-sale and

in transaction confirmations, regarding the costs and the conflicts of interest that

arise from the distribution of mutual fund shares. The point-of-sale document would

provide information to investors prior to transactions in mutual fund shares regarding the distribution-related costs that the customers would be expected to incur in

connection with the transaction, including information regarding the sales loads,

asset-based sales charges and services fees paid out of fund assets, whether the

broker-dealer receives revenue sharing payments or portfolio brokerage commissions

from the fund complex, as well as whether it pays differential compensation in connection with different classes of shares or proprietary products. The new mutual

fund confirmation form incorporates and quantifies these same disclosures. In an effort to ensure that these disclosure documents will be as meaningful as possible to

investors, the Commission has directed the staff to gather information from investors—through educational summits, focus groups and other means—so that the

Commission has meaningful input from the actual investors who will benefit from

these disclosures.

Breakpoints Disclosure

In light of the wide-scale failure to provide appropriate breakpoint discounts on

front-end load mutual fund purchases, the Commission in December proposed improved prospectus disclosure about fund breakpoints. This disclosure is designed to

highlight for investors the availability of breakpoint discounts and implements recommendations made by a Joint NASD/Industry Taskforce that convened to study

and make recommendations to improve the identification and processing of breakpoint opportunities for fund investors.

Transaction Costs Concept Release

Also in December, the Commission issued a concept release requesting comment

on methods to calculate and improve the disclosure of funds’ portfolio transaction

costs. Transaction costs can represent a significant portion of the overall expenses

incurred by a mutual fund. Although transaction costs are taken into account in

computing a fund’s total return, there is a concern that investors do not fully understand the impact of transaction costs on their fund investments because those transaction costs are not separately disclosed in a fund’s expense table. However, there

is no agreed-upon, uniform method for the calculation of fund transaction costs.

Thus, the Commission issued its concept release to elicit helpful commentary to

guide us as we pursue this issue.

Portfolio Managers

Finally, on March 11, the Commission is considering new proposals to improve

disclosure to fund shareholders about their portfolio manager’s relationship with the

fund. These proposals include disclosure regarding the structure of portfolio manager compensation, ownership of shares of the funds that a manager advises, and

comprehensive disclosure of specific investment vehicles, including hedge funds and

pension funds, that are also managed by the mutual fund’s portfolio manager. This

proposal will also require clear disclosure as to who is managing a fund, addressing

635

the current requirement that allows advisers to use a portfolio management team

to avoid identifying the principal managers of the fund.

Conclusion

As should be evident, the Commission has been extremely busy in proposing and

adopting rules that are designed to protect our Nation’s mutual fund investors. Our

focus has been directed not only on addressing the harms of late trading, abusive

market-timing and related abuses, but also on strengthening the mutual fund oversight and regulatory framework to minimize the possibility that these and other

potential abuses arise in the future and on taking steps to provide meaningful and

useful disclosure to facilitate informed decisionmaking on the part of mutual fund

investors. Again, I would like to thank you for the opportunity to be here today to

discuss the Commission’s recent regulatory actions to protect mutual fund investors.

I would be pleased to answer any questions you may have.

—————

PREPARED STATEMENT OF MARY L. SCHAPIRO

VICE CHAIRMAN AND PRESIDENT, REGULATORY POLICY AND OVERSIGHT

NATIONAL ASSOCIATION OF SECURITIES DEALERS (NASD)

MARCH 10, 2004

Mr. Chairman and Members of the Committee, NASD would like to thank the

Committee for the invitation to submit this written statement for the record.

NASD

NASD is the world’s preeminent private sector securities regulator, established in

1939 under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934. We regulate every broker-dealer in the United States

that conducts a securities business with the public—nearly 5,200 securities firms

that operate more than 92,000 branch offices and employ more than 663,000 registered representatives.

Our rules comprehensively regulate every aspect of the brokerage business, and

NASD examines broker-dealers for compliance with NASD rules, MSRB rules, and

the Federal securities laws—and we discipline those who fail to comply. Last year,

2003, NASD filed a record number of new enforcement actions (1,410) and barred

or suspended more individuals (827) from the securities industry than ever before.

Our market integrity and investor protection responsibilities include examination,

rule writing, professional training, licensing and registration, dispute resolution,

and investor education. NASD monitors all trading on the Nasdaq Stock Market—

more than 70 million orders, quotes, and trades per day. NASD has a Nationwide

staff of more than 2,000 and is governed by a Board of Governors, more than half

of whom are unaffiliated with the securities industry.

NASD Oversight of Mutual Fund Sales

Millions of Americans invest in mutual funds each year. The NASD is deeply

disturbed by recent revelations of a wide range of abuses that undermine the confidence of mutual fund investors and the integrity of the industry. Portfolio managers have traded ahead of mutual fund investors, released portfolio information differentially and selectively, and made deals with preferred customers to permit market timing and late trading. NASD does not have jurisdiction or authority over mutual funds or their advisers. Nevertheless, we do regulate broker-dealers who sell

mutual funds, including mutual fund underwriters. Broker-dealer participation in illegal or unethical sales practices in the sale of mutual fund shares is a matter of

immediate concern to NASD.

NASD reviews mutual fund advertisements, whether they appear in a magazine

or newspaper, radio or television commercial. We vigorously enforce our suitability

rule and our prohibition against compensation arrangements that create unacceptable conflicts of interest in the sale of mutual fund shares.

During 2003 and 2004, NASD brought more than 80 enforcement actions for violations concerning the sale of mutual funds and pooled investment products. The violations in these cases included suitability of the mutual fund share classes that brokers recommended, sales practices, improper disclosures, and compensation arrangements between the funds and brokers. These actions bring to more than 200 the

number of cases NASD has taken in the investment company area since 2000. In

addition, and most recently, NASD has brought enforcement actions dealing with

market timing and the improper failure of a broker-dealer to waive certain sales

636

charges, and 15 cases involving the failure to deliver breakpoint discounts on shares

with front-end load sales charges.

NASD Oversight of Mutual Fund Advertising

The NASD requires that all advertisements and other sales material issued by

broker-dealers be fair, balanced, and not misleading. Every mutual fund advertisement distributed through the media and every mutual fund sales brochure issued

by a broker-dealer must be filed with NASD. We review these advertisements and

sales pieces to ensure that they comply with the highest standards of fair and balanced disclosure. This undertaking is significant: In 2003, NASD reviewed over

80,000 investment company sales pieces.

When a broker-dealer’s mutual fund sales material fails to meet applicable standards, NASD staff directs the firm either to revise the material to meet applicable

standards or to stop using the material entirely. NASD also brings enforcement actions against broker-dealers that violate our advertising rules.

One of the most important issues that NASD has addressed in our administration

of the advertising rules concerns the manner in which mutual funds advertise their

past performance. Too often, mutual fund advertisements stress their impressive

past performance by the advertised fund, without providing balanced disclosure concerning the fees and the expenses that investors incur when they purchase and own

shares of the fund. Yet these fees and expenses can have a significant impact on

the long-term future performance of a mutual fund investment an investor makes

today.

In December, NASD proposed to amend our advertising rules to require that

every advertisement that promotes a mutual fund’s performance also presents the

fund’s fees and expenses in a prominent text box, not in a footnote. This would include the fund’s maximum front-end and back-end sales load, if any, and the fund’s

ongoing expense ratio, including any 12b–1 fees. The proposal also would require

that the text box contain the standardized 1-, 5-, and 10-year total return performance required by the SEC.

This proposal, which NASD filed with the SEC earlier this week, would help investors compare mutual funds and would make the costs of purchasing and owning

mutual funds more apparent. NASD looks forward to working with the SEC staff

on this proposal and to its prompt adoption and implementation.

Compensation Arrangements between Brokers and Funds

NASD recognizes that compensation arrangements between mutual funds and

brokers can inappropriately influence the investment recommendations that brokers

make to their retail customers. Accordingly, NASD has taken a number of steps,

both in terms of rulemaking and enforcement of existing rules, to help ensure that

investors are protected from misleading practices.

NONCASH COMPENSATION

NASD prohibits most forms of noncash compensation, such as luxury cruises,

trips and lavish entertainment, for the sale of mutual fund shares. These compensation arrangements present a conflict of interest for sales personnel and interfere

with the ability of regulated firms to supervise their sales forces. In September

2003, NASD sanctioned Morgan Stanley DW, Inc. and fined the firm $2 million for

sponsoring sales contests that awarded meals, trips, concert tickets, and other prizes

to sales representatives that met certain sales targets and favored Morgan Stanley

proprietary funds. NASD also charged Morgan Stanley and the head of its retail

sales division with supervisory violations, because Morgan Stanley failed to have

any supervisory systems or procedures in place to detect and prevent this widespread misconduct.

DIRECTED BROKERAGE COMPENSATION

NASD rules have long addressed the possibility that a mutual fund may direct

its portfolio brokerage to a broker-dealer in exchange for the broker-dealer’s commitment to feature or promote the sale of the fund’s shares. Such an arrangement presents a potential conflict of interest for the investment adviser to the mutual fund,

who must execute the fund’s portfolio transactions; it also presents a conflict for the

broker-dealer, who may recommend fund shares to its customers in order to reap

brokerage commissions from the fund. NASD prohibits any broker-dealer from accepting brokerage commissions from a mutual fund as a condition to favoring the

sale of the fund’s shares. Exchanging prominent placement of a fund or family of

funds on a firm’s website or in the firm’s marketing material or placing a fund on

a ‘‘featured’’ or ‘‘preferred’’ list of funds in exchange for brokerage commissions from

the fund may be misleading to investors and is a violation of NASD rules.

637

In November 2003, NASD and the SEC sanctioned and fined Morgan Stanley $50

million for violations of this rule due to its use of directed brokerage arrangements

to promote sales of its proprietary funds. In return for brokerage commissions and

other payments, Morgan Stanley gave 16 of 115 mutual fund families it sold preferential treatment, including placement on a ‘‘preferred list’’ of funds that financial

advisers were to look to first in making recommendations of fund products; higher

visibility on Morgan Stanley’s sales systems and workstations; eligibility to participate in the firm’s 401(k) programs and to offer offshore fund products to Morgan

Stanley customers; better access to its sales force and branch managers; and payment of special sales incentives to Morgan Stanley financial advisers.

NASD recently proposed to expand these directed brokerage prohibitions. Under

our proposal, a broker-dealer would be prohibited from selling shares of any mutual

fund that even considers its fund sales as a factor in selecting a broker-dealer to

execute its trades. The SEC has proposed a similar amendment to its Rule 12b–1.

REVENUE SHARING AND DIFFERENTIAL COMPENSATION

In September 2003, NASD proposed new rules to address ‘‘revenue sharing’’ and

‘‘differential compensation’’ arrangements. Frequently, mutual funds seek to improve the sales of their shares by paying for ‘‘shelf space’’ at a broker-dealer. This

practice, commonly known as ‘‘revenue sharing,’’ can take a variety of forms, including sharing of advisory fees, direct cash payments, and reimbursing brokers for

their sales and training-related expenses. Our rule proposal would require every

broker-dealer to disclose to its customers whether the firm accepts revenue sharing

payments from funds. The broker-dealer would have to list the funds in order based

on the amount of revenue sharing received. Broker-dealers also would have to periodically update the list of funds that pay revenue sharing to the firm and make the

list available through a website, toll-free telephone number, or customer mailings.

In addition, some broker-dealers may pay ‘‘differential compensation’’ to their

sales force. Under these arrangements, a broker-dealer may pay its sales representatives higher compensation for the sale of certain funds, such as a firm’s proprietary

fund family or funds that pay revenue sharing to be included on a preferred list.

Our proposal would require broker-dealers to disclose these differential compensation arrangements to their customers and to name the funds that benefit from these

arrangements.

The SEC recently issued its own proposal that would require brokers to make

similar disclosures regarding revenue sharing and differential cash compensation at

the point-of-sale and as part of a customer’s sales confirmation statement. We are

reviewing this proposal and we will work with the SEC both on its proposal and

on how best to proceed with our own rule proposal.

Suitability of the Fund Sales

Many mutual funds offer different classes of the same investment portfolio. Each

class provides broker-dealers and their customers with a choice of distribution fee

structure. For example, Class A shares charge a ‘‘front-end’’ sales load when the customer purchases shares and they may impose an ongoing distribution fee, called a

Rule 12b–1 fee. Class B shares do not impose a ‘‘front-end’’ sales load, but they do

impose higher annual Rule 12b–1 fees which are assessed over the first 6 to 8 years

of their investment or until they convert into Class A shares. Class B shares normally impose a ‘‘contingent deferred sales charge’’ (CDSC) which a customer pays

if the customer sells the shares within first six or eight years. This CDSC declines

over time during that 6- or 8-year period. Class C shares usually do not impose a

front-end sales load, but often impose a load if a customer sells shares within a

short time of purchase, usually 1 year. Class C shares typically impose higher Rule

12b–1 fees than Class A shares, and, unlike Class B shares, do not convert into a

lower expense class following a specified holding period.

While Class A shares impose a front-end sales load, most mutual funds offer a

reduced load, or ‘‘breakpoint,’’ for large purchases. NASD has found that some

broker-dealers have recommended Class B shares in such large amounts that the

customer would have qualified for significant breakpoint discounts had the brokerdealer recommended Class A shares instead. Some broker-dealers also have recommended transactions in Class B shares that are so frequent as to cause the customer to incur CDSC charges. In both cases, the broker may receive higher compensation for the Class B recommendations. NASD has vigorously prosecuted these

violations of our rules, and we are continuing our comprehensive monitoring of

Class B share sales practices. Over the last 2 years, NASD has brought more than

a dozen enforcement actions against firms and individual brokers for these types of

violations. Currently, NASD has more than 50 active investigations in this area.

638

Discounts for Customers

One area that has been a focus for NASD in recent months is reviewing whether

brokers are giving their customers all the discounts and waiver of sales charge benefits to which they are entitled when buying certain funds.

NAV TRANSFER PROGRAMS

Some mutual fund families offer programs that essentially permit a customer to

exchange shares from another fund family at the new fund’s net asset value (NAV),

without paying the front-end sales load. These programs permit customers to purchase Class A shares without paying a front-end sales load, if in purchasing those

shares the customer used proceeds from a recent redemption of shares of another

load fund. Investors who qualify for NAV transfer programs have no reasonable

basis to purchase any class of shares other than Class A shares.

Last month, the NASD brought the first enforcement action involving a brokerdealer’s failure to obtain sales load waivers for mutual fund customers through

these NAV transfer programs. NASD fined AXA Advisors, LLC $250,000 for these

failures. We also jointly fined a senior vice president of the firm $50,000.

NASD found that the firm failed to have an adequate supervisory system in place

to identify and provide customers with sales charge waivers to which they were entitled. We determined that, from February 2000 through July 2003, AXA earned

more than $700,000 in revenue on more than $18 million invested by the customers

of the firm in these two mutual fund families offering NAV transfer programs. As

part of the settlement, the firm was ordered to provide full restitution to all customers who paid sales charges on purchases that were subject to these programs

over a 4-year time period.

NASD is initiating a broad-based review to determine whether other firms are

meeting their obligations to provide sales charge waivers to their customers under

similar types of programs. Examinations and investigations are underway and

NASD will bring additional enforcement actions when they are warranted.

BREAKPOINTS

As previously discussed, most mutual funds offer discounts on their front-end

sales charge at certain predetermined levels of investment. These discounts are

called ‘‘breakpoints.’’ Front-end loads and breakpoints vary across fund complexes

and also may vary among funds within a single fund complex. An investor usually

is entitled to discounts on sales charges at investment levels of $50,000, $100,000,

$250,000, and $500,000, and, typically, sales charges are eliminated at the

$1,000,000 level.

Significantly, an investor usually may aggregate purchases in one or more of his

own accounts and the accounts of related parties to reach a breakpoint threshold.

These rights of accumulation vary from fund family to fund family. In addition, fund

families typically permit investors to sign a letter of intent, which allows them to

aggregate future sales over a set time period (usually 13 months) to meet breakpoint thresholds.

During routine examinations of broker-dealers by our Philadelphia District Office,

NASD discovered that several broker-dealers were selling front-end load mutual

funds without properly delivering breakpoint discounts to investors. We expanded

our inquiry by conducting a sweep of a large number of broker-dealers of varying

sizes and business models and found the same problem. Following this NASD effort,

in late 2002 the SEC and New York Stock Exchange joined us for an examination

sweep of 43 firms selling front-end load mutual funds. We found that most of those

firms did not give investors all the breakpoint discounts they should. Failures to

give the discounts did not appear to be intentional but stemmed from a variety of

operational problems, including a failure to link share classes and holdings in other

funds in the same fund family and a failure to link accounts of family members.

As was the case in the earlier NASD-only sweep, the problem was not confined to

firms of a particular type; therefore, the problem required industry-wide analysis.

Assessing and Correcting Past Performance

NASD required all broker-dealers that conducted more than a minimal amount

of automated front-end load, Class A share business in 2001 or 2002 to complete

an assessment of their breakpoint compliance. The assessment used a statistical

sampling technique, developed in conjunction with an outside expert, to enable us

to assess the universe of transactions in that time period. Approximately 625 firms

completed the assessment. The assessments showed that most firms did not uniformly deliver appropriate breakpoint discounts to customers. Overall, discounts

were not delivered in about one of five eligible transactions. The average amount

639

overcharged per transaction was $243, and ranged up to $10,000. We estimated that

at least $86 million was owed to investors for 2001 and 2002 alone.

In August 2003, NASD notified broker-dealers that they were required to make

appropriate refunds, plus interest, owed to their customers. In November, NASD directed almost 450 broker-dealers to notify customers who purchased Class A mutual

fund shares since January 1, 1999, that they may be due refunds as a result of the

firms’ failure to provide breakpoint discounts. NASD directed firms to contact investors, through an NASD-drafted letter and claim form, to assure uniform treatment

of investors. In addition, we supplemented that system of notification with an unprecedented NASD national advertising campaign to assure that investors were informed of their rights. We also directed about 175 of the securities firms with poor

records of providing breakpoint discounts to complete a comprehensive review of

transactions since the beginning of 2001 for possible missed discount opportunities.

In February 2004, the SEC and NASD announced enforcement actions against a

number of firms for failure to deliver mutual fund breakpoint discounts during 2001

and 2002. The SEC and NASD each brought cases against a group of seven firms,

and NASD separately brought actions against an additional eight firms. The 15

firms agreed to compensate customers for the overcharges, pay fines in an amount

equal to their projected overcharges that total over $21.5 million, and undertake

other corrective measures.

Correcting the Problem

At the request of the SEC, NASD, working with the Securities Industry Association and the Investment Company Institute, also led a task force on breakpoints,

which included representatives from the broker-dealer and mutual fund industries,

as well as academia and regulators. The Joint NASD/Industry Task Force on

breakpoints was charged with recommending industry-wide changes to address errors and missed opportunities to provide discounts in the calculation of sales loads

charged on the purchase of mutual fund shares that carry a front-end sales load.

The Task Force issued its report in July 2003, making recommendations that affect virtually every level of the mutual fund distribution chain, including brokerdealers that sell mutual funds, the mutual funds, and the transfer agents that administer mutual fund accounts. The Task Force made a series of recommendations

for modification of the systems used by broker-dealers and mutual funds to process

mutual fund transactions; additional steps by mutual funds to ensure that investors

are aware of breakpoint discounts; enhancement of broker-dealer procedures to

gather the necessary information from investors; and enhanced industry and investor education. The industry immediately began to implement the report’s recommendations. Many of the recommendations are fully implemented and others are nearing completion. In addition, NASD, the NYSE, and the SEC will rigorously examine

firms to ensure that they are meeting their responsibility to deliver breakpoint discounts.

Late Trading and Market Timing

NASD is extremely concerned about the recent revelations of illegal late trading

and market timing arrangements. On September 5, 2003, we reminded the brokerdealers that they would violate NASD rules if they knowingly or recklessly effect

mutual fund transactions that constitute impermissible ‘‘late trading’’ or facilitate

market-timing or other transactions in collusion with a mutual fund that is contrary

to a representation in the fund’s prospectus.

INVESTIGATIONS

In September 2003, NASD sought information regarding these practices from 160

broker-dealers. Our review indicates that a number of those examined clearly received and entered mutual fund orders after U.S. markets had closed for the day.

Other broker-dealers were not always able to tell with clarity whether or not they

had entered late trades. This imprecision indicates poor internal controls and record

keeping—issues that NASD is also pursuing.

NASD has identified a number of broker-dealers that were involved in market

timing. These cases have been referred to our Enforcement Department for full

investigation. A number of firms have been told that the staff believes that their

market timing activities were impermissible under NASD rules or applicable Federal statutes. These firms appear to have facilitated customers’ market timing strategies in mutual funds or variable annuities, employed staff who agreed with a mutual fund or variable annuity to market time the issuer’s shares, or had an affiliate

involved in some form of market timing of mutual funds or variable annuities. We

expect to conclude these cases in the coming months and bring enforcement actions

where warranted.

640

In February 2004, NASD announced the first of its market timing enforcement

actions. NASD fined State Street Research Investment Services, Inc. (SSR) $1 million for failing to prevent market timing of State Street Research mutual funds as

a result of its inadequate supervisory systems. SSR also agreed to pay more than

$500,000 in restitution to the individual State Street Research mutual funds to compensate for the losses attributed to market timing activity.

NASD found that, from 2001 thorough August 2003, SSR’s inadequate supervisory

system improperly permitted the customers of at least one other securities firm to

buy and sell shares of SSR funds alternatively, beyond the annual limits set forth

in the prospectuses. SSR’s supervisory procedures and systems were not adequate

to prevent and detect customers circumventing restrictions designed to limit the

number of exchanges made in excess of the prospectus limits.

The SSR action highlights the need for firms to follow up on red flags. While the

SSR did make some efforts to prevent market timing, it did not follow through to

ensure proper compliance with the measures it had put in place. Firms must respond quickly and effectively to market timing issues once they are placed on notice

that such activities are occurring.

Omnibus Task Force

In November 2003, SEC Chairman Donaldson requested that NASD convene a

task force to determine how omnibus processing would affect SEC efforts to curb

abusive market timing trading activity in mutual funds, and in particular imposition of mandatory redemption fees for short-term trading. The mechanics of regulating market timing, and imposing redemption fees, are complicated by the fact

that various broker-dealers, banks, and pension plan administrators and insurance

companies use omnibus processing of mutual fund transactions, which generally

does not disclose the identity of the mutual fund shareholder to the mutual fund.

Although the NASD’s jurisdiction extends only to the broker-dealers involved in

mutual fund sales, the SEC requested our assistance in analyzing the issue and offering suggestions as to how to achieve the SEC’s objectives in an omnibus environment before it moved forward with rulemaking. The Task Force consisted of 16 professionals, who represent a broad range of participants in the omnibus trading process—broker-dealers, mutual fund sponsors, third-part administrators, banks, transfer agents, and clearing corporations. We also had discussions with a number of

other interested parties who, although not members of the Task Force, were identified as having expertise, including members of the insurance and actuarial communities.

In January 2004, NASD presented the SEC with a report from the Omnibus Task

Force. The Omnibus Task Force report does not reach definitive conclusions regarding omnibus processing and market timing practices; rather, it provides the Commission with an analysis of the advantages and disadvantages of various avenues

for removing the economic incentives for mutual fund market timing and policies

when such timing occurs. The options considered and discussed range from the disclosure of information about the underlying shareholders or their accounts to delegating compliance obligations in this area on the omnibus processor. Since the

issuance of the report, the SEC has proposed a mandatory redemption fee rule,

which reflects the operational pragmatics and other views offered by the Task Force.

Investor Education

Mutual funds have also been an ongoing focus of NASD’s investor education efforts. In 2003 and 2004, NASD issued the following Investor Alerts on share classes,

principal-protected funds, and breakpoint discounts: Net Asset Value Transfers: Look

Before You Leap Into Another Mutual Fund (2/26/2004). Mutual Fund Breakpoints:

Are You Owed a Refund? (11/03/2003). Class B Mutual Fund Shares: Do They Make

the Grade? (06/25/2003). Principal-Protected Funds—Security Has a Price (03/27/

2003). Mutual Fund Breakpoints: A Break Worth Taking (01/14/2003). Understanding Mutual Fund Classes (updated; 01/14/2003).

Each of these Investor Alerts educates investors about the wide variety of mutual

fund fee structures that exist and urges investors to scrutinize mutual fund sales

charges, fees, and expenses.

The NASD’s research has shown that many investors are unaware of how much

they pay to own mutual funds and that even small differences in fees can result

in thousands of dollars of costs over time that could have been avoided. For example, nearly 80 percent of those responding to NASD’s investor survey did not understand fully the meaning of ‘‘no load’’ funds.

To help investors make better decisions when purchasing mutual funds, we have

unveiled an innovative mutual fund and exchange-traded fund expense analyzer on

our website. Unlike other such tools, the expense analyzer allows investors to comVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00652 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
641

pare the expenses of two funds or classes of funds at one time, tells the investor

how the fees of a particular fund compare to industry averages, and highlights when

investors should look for breakpoint discounts. To make this tool more widely available to investors, we developed a version of the expense analyzer for broker-dealer

intranet and websites.

NASD also recently announced the creation of an Investor Education Foundation

to focus our efforts on the critical area of investor education. The Foundation has

been initially funded with $10 million.

Conclusion

NASD will continue its vigorous examination and enforcement focus on mutual

fund advertising, the suitability of the mutual fund share classes that the brokerdealers are selling, the compensation practices between the funds and the brokerdealers, and the question of whether brokers are delivering to their customers the

sales charge and pricing discounts to which they are entitled. And as we continue

our examinations and investigations into late trading and market timing issues, we

will enforce NASD rules with a full range of disciplinary options—which include

stiff fines, restitution to customers, and the potential for suspension or expulsion

from the industry. NASD will continue to work with other regulators to protect investors and restore investor confidence in this very important area of the securities

markets.

642

RESPONSE TO WRITTEN QUESTION OF SENATOR JOHNSON

FROM MARY L. SCHAPIRO

Q.1. In your oral statement, you referenced an ongoing NASD investigation of the variable annuity marketplace, and outlined several suspected abuses. Would you please describe in greater detail

what abuse you suspect may be taking place, estimate the degree

to which this is a problem and tell the Committee whether you believe the NASD has the authority to address the problem?

A.1. In 2003, the NASD convened a Variable Annuities Task Force

(Task Force) to identify potential abusive practices and other areas

of concern in the marketing and sales of variable annuities. The

Task Force is chaired by the NASD Enforcement Department and

includes representatives of the NASD Advertising Regulation and

Investment Companies Regulation teams, the NASD Office of the

General Counsel, and the Member Regulation Department.

The Task Force is charged with identifying areas of concern and

approaches to addressing these concerns. Our approaches may include a wide range of initiatives, such as recommended enforcement action, investor and industry education initiatives, expanded

examination content, notifications to NASD member firms and

rulemaking. Set forth below is a summary of the areas of concern:

1. Market timing in sub-accounts. As in the case of mutual fund

market timing, NASD has found instances where broker-dealers

are facilitating timing in variable annuity sub-accounts (similar to

mutual funds) in contravention of the funds’ prospectuses or the

terms of the annuity contract. Timing in sub-accounts raises the

same issues as timing in mutual funds. NASD has ongoing investigations in this area. Our examiners also look for red flags that

may be indicative of market timing during the course of routine

examinations.

2. Third-party or affiliated advisers used for sub-account allocation. This involves firms selling variable products with high fees,

then recommending that either third-party or affiliated investment

advisers make sub-account allocations, and charging an additional

layer of fees for such advice. While legal if properly disclosed, it

appears that the aggregate fees could be so high as to make such

recommendations unsuitable.

3. Sale of ‘‘C share’’ variables. As is sometimes the case with the

sales of mutual fund ‘‘C shares,’’ investors in these products pay

substantial on-going expenses that may not be accurately disclosed.

4. Replacement campaigns. Registered representatives (RR’s) frequently recommend that their clients switch from one variable

product to another when the RR’s switch firms. We believe that in

many instances, these recommendations are based solely on the

RR’s desire to generate income with the new firm. Moreover, it appears that the firms employing these RR’s may be looking the other

way in the face of such activity, failing to supervise with a view

to preventing unsuitable recommendations.

5. Tax advice. NASD is concerned that some broker-dealers are

giving poor tax advice in connection with the sale of complex products. In particular, firms continue to recommend placing variable

products into tax-advantaged accounts (IRA’s, 401(k)’s) where the

tax benefit is redundant.

643

6. Marketing. Some firms use illustrations in their marketing

materials designed to highlight the advantages of the tax deferral

feature of variable annuities. We are concerned that firms are

using incorrect or otherwise unreasonable or unrealistic tax rate

and tax bracket assumptions that distort the true difference between a tax deferred and taxable investment account. We will soon

release a Member Alert to NASD member firms reminding them of

the importance of using accurate tax rates in these illustrations

that reasonably reflect the tax brackets of the intended recipients.

In addition to the areas of concern noted above, we are looking

at other variable annuity-related issues. The first is in the antimoney laundering context. Annuity distributors face unique issues

in establishing adequate antimoney laundering (AML) procedures

tailored to a variable products business. For example, firms that

sell variable annuities should have procedures designed to offer

‘‘free looks’’ and other quick surrenders of variable products (some

already do, do not they?). The ‘‘free look’’ period is designed to give

customers a very short window (often a week to 10 days) in which

to change their minds before getting locked into a long-term annuity product. There is a danger that a customer could buy an annuity, surrender the product and get their money returned to them—

in effect laundering money by exploiting the free look period. While

this is being addressed specifically in the Task Force sweep for the

firms being reviewed, it is also routinely reviewed by the NASD’s

examiners during all examinations of firms over which NASD has

AML exam responsibility. In cases where a firm is a dual NASD

and NYSE member, the NYSE may review for compliance with

AML requirements.

Another issue is whether firms are complying with a rule that

applies to sales in New York, called New York State Insurance Department Regulation 60. This regulation requires two meetings

with customers prior to a switch. The purpose of having two meetings is to give the client a chance to rethink the transaction.

NASD’s New York District Offices have been investigating variable

annuity replacements that violated Reg. 60. In one instance involving Prudential Securities’ successor, the firm reported the problem

to us and our investigation uncovered backdated and altered documents. We believe transactions in violation of Reg. 60 may be occurring at other broker-dealers as well and, as a result, NASD is

investigating about a dozen firms. At this time, NASD cannot state

for certain the degree to which each of the issues enumerated

above is a problem. Rather, we are continuing to look at each of

the issues surrounding the sales of variable annuities through the

Task Force and during examinations and investigations into the

targeted areas.

The issues presented by these problematic practices are serious

and worthy of regulatory scrutiny. Variable products are complex

securities and require a high degree of product knowledge by the

firms and the RR’s selling them, the supervisors at the firm who

review the suitability of recommendations, and investors who consider purchasing variable products.

In April of this year, in an effort to address continuing concerns

surrounding sales and exchanges of deferred variable annuities,

NASD’s Board of Governors proposed a rule that would impose a

644

wide range of requirements tailored specifically to transactions in

deferred variable annuities—from new sales practice standards and

supervisory requirements to increased disclosure and sales force

training. In general, the rule would codify and make mandatory

best-practice guidelines that NASD has previously issued. NASD

intends to request public comment on the proposed rule.

Among the key requirements of the proposed rule is that RR’s

who recommend a deferred variable annuity transaction ensure

that the customer has been informed of the annuity’s unique features; the customer has a long-term investment objective; and the

deferred variable annuity as a whole, and also its underlying subaccounts, are suitable for the customer, particularly with regard to

risk and liquidity. The RR would be required to document these

determinations.

The firm or its representative would be required to provide the

customer with a current prospectus and a separate, brief, ‘‘plain

English’’ risk disclosure document highlighting the main features of

the particular variable annuity transaction. Those features would

include: Liquidity issues, such as potential surrender charges and

IRS’ penalties; sales charges; fees (including mortality and administrative fees, investment advisory fees and charges for riders or

special features); Federal tax treatment for variable annuities; any

applicable State and local government premium taxes, and market

risk. The risk disclosure document also would be required to inform

the customer whether the variable annuity contract offers a ‘‘free

look’’ period, during which the customer could terminate the contract without paying any surrender charges and receive a refund

of his or her purchase payments.

Before an RR could effect any transaction in a deferred variable

annuity, a registered principal would be required to review and approve the transaction. The registered principal would be required

to consider specific factors, such as whether the customer’s age or

liquidity needs made a long-term investment inappropriate. Before

an RR could complete a recommended transaction, the registered

principal would be required to review and approve, in writing, the

suitability analysis document and a separate exchange or replacement document, if the transaction involved an exchange or replacement of an existing variable annuity.

The proposed rule would require registered firms to establish and

to maintain specific, written supervisory procedures reasonably designed to achieve compliance with the rule’s standards.

Registered firms would be required to develop and document specific training policies or programs designed to ensure that RR’s and

registered principals comply with the rule’s requirements and that

they understand the unique features of deferred variable annuities.

Through a combination of investor education, education of sales

persons recommending variable products, guidance to regulated

firms about suitability of recommendations, supervision, and other

areas, effective and fair rules, and thorough examination and enforcement programs, we believe that NASD, working in concert

with the SEC and other regulators, have the tools necessary to address those issues and the authority to take appropriate action.

(645)

FUND OPERATIONS AND GOVERNANCE

TUESDAY, MARCH 23, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10 a.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

This morning, the Banking Committee holds its seventh hearing

on reforming the mutual fund industry. As we continue our wideranging examination of the fund industry, this morning we will

hear from various experts on fund operations and disclosure practices. We have assembled a diverse panel, and I look forward to

hearing their recommendations and insights.

Professor Mercer Bullard is an Assistant Professor of Law at the

University of Mississippi School of Law, and the President and

Founder of Fund Democracy, a nonprofit membership organization

that serves as an advocate and information source for mutual fund

shareholders and their advisers.

Professor William Lutz is a Professor of English at Rutgers University. Professor Lutz is an expert in information design, and

served as a consultant to the SEC during the compilation of the

SEC’s ‘‘Plain English Handbook: How to Create Clear SEC Disclosure Documents.’’ Given Professor Lutz’ expertise, I look forward to

hearing his recommendations for improving investors’ comprehension of disclosure documents through clear and concise disclosure.

Mr. Robert Pozen is the Non-Executive Chairman of the Massachusetts Financial Services Company and is a Visiting Professor at

Harvard Law School. Mr. Pozen is also the former Vice Chairman

of Fidelity Investments and President of Fidelity Management and

Research Company.

Finally, the Committee will hear from Ms. Barbara Roper, who

is the Director of Investor Protection for the Consumer Federation

of America. Ms. Roper has served on the board of Fund Democracy

and the SEC’s Consumer Affairs Advisory Committee.

I thank each of you for appearing this morning and I look forward to your testimony as we proceed down this road.

All of your written testimony will be made part of the hearing

record in its entirety. Professor Bullard, we will start with you.

Proceed as you wish this morning.

646

STATEMENT OF MERCER E. BULLARD

PRESIDENT AND FOUNDER, FUND DEMOCRACY, INC.

ASSISTANT PROFESSOR OF LAW

UNIVERSITY OF MISSISSIPPI SCHOOL OF LAW

Mr. BULLARD. Thank you, Chairman Shelby and Members of the

Committee for the invitation to appear here today. It is a privilege

and an honor to be before the Committee, and I particularly compliment the Committee on its very careful and thorough analysis

of the issues with a number of hearings in the past and perhaps

a number of more to come.

The reason we are here today, of course, is that mutual funds command $7 trillion of America’s retirement assets, and therefore

mutual funds are at the center of retirement security for Americans. I would like to start with what my philosophy is on mutual

fund regulation just so you know where I am coming from, and

that is generally that whereas some investors are going to do better

than others in the market as a necessary by-product of our capitalist system, as a whole what we would like investors to do is to

get as much of the performance of the market as possible. That is,

as a group, ideally they would achieve the entire gains of the market, but once you take away the transaction cost, the cost of investing, the cost of servicing their accounts, they are going to be left

with a little bit less. What we hope to do is to leave as much of

the return of the market in their pockets as possible.

The problem is that what seems to be happening is quite the opposite. A recent study by DALBAR, and I would like to make this

part of the record if I may?

Chairman SHELBY. Sure, go ahead. You want that to be made

part of the record?

Mr. BULLARD. Part of the record, please.

Chairman SHELBY. Yes, it will be included in the record without

objection.

Mr. BULLARD. Thank you, Chairman.

In that study, DALBAR, which is an independent quantitative

analysis firm, looked at the question of how much of this market

have investors really achieved by investing in equity funds? From

1984 to 2003, they analyzed the S&P 500 and calculated the return

on an annual basis. It was 12.22 percent. They found that the return of equity fund investors was 2.57 percent. That is 12.2——

Chairman SHELBY. Say that again. I want you to go over that.

That is very important.

Mr. BULLARD. Let me make sure I have the numbers exactly

right here. From 1984 to 2002 the return on the S&P 500 Index

was 12.22 percent annually. The return of the average equity fund

investor was 2.57 percent. That is a difference of almost 10 percentage points.

My general view is that most of that is the responsibility of those

shareholders. They make bad decisions. They time the market.

They invest in funds at their peak, they sell the funds at their bottom, and that is not only a problem of investor education that we

also need to deal with, but it is also a problem of the way that the

industry is structured and regulated. Investors are leaving too

much of the market’s return on the table that for the future of our

retirement security we need to be in their pockets when they are

647

retiring. In a number of respects—and this will be the focus of my

statement—this requires action by Congress. There are a number

of areas, in fact the most important areas where reform is needed,

where the SEC either does not have the authority to accomplish

the reform or is unwilling to do so.

The first category is fund governance. In my testimony I described a mutual fund oversight board. I think we need such a

board in order to do two things. One is to establish clear guidance

for fund directors, that they have as a group generally complained

they are lacking for decades, and also to follow up on that guidance

with enforcement. It is an area where the SEC has been weakened

from the standard-setting point of view. The SEC simply is not in

a good position to set those kinds of detailed standards and keep

them current. We need a focused, expert body that would work

very closely with the industry to establish minimum standards. In

addition, the SEC has not done a good job in bringing enforcement

action against independent directors when they engage in misconduct. Throughout this scandal where we have had dozens of actions brought, not one has been brought against the independent

directors with the possible exception of Bank of America, although

it is unclear to me how the SEC could have entered into a settlement as it claims it has regarding the Bank of America directors

when the settlement did not involve the fund or the directors, and

involved only the fund manager, my understanding being that fund

directors are supposed to be independent of the fund manager and

that the fund manager does not have the authority to reach that

settlement.

Another area where reform is needed to establish a fiduciary

duty for directors that goes not just to the fees received by the

manager, which is where it resides now, but with respect to the

fund as a whole as a reasonable investment vehicle for investors.

The problem with the current standard is, while it addresses the

most important conflict of interest—that is between the fund manager and the fund—it does not go to the issue of whether this fund

is conceivably a reasonable investment. When you have a number

of funds out there with expense ratios that exceed 5 percent—there

are even some that exceed 10 percent of assets—there is a crying

need for some fiduciary standard to which directors will be held so

that they have to ensure not necessarily that the fees received by

the custodian service provider are reasonable, but the fund itself

could be a reasonable investment option.

Another area is generally the independence of the board, where

we need to ensure that independent directors, for example, are not

former directors, officers, or employees of the adviser. It would

seem obvious that those persons should be excluded from being

independent directors.

That is not currently what the law states, and the SEC does not

have the authority to change that view. The SEC has stated, and

even proposed, that the fund chairman be independent and that

the board be 75 percent independent, but that is an exaggeration

of the SEC’s authority for this reason. The SEC is going to, if it

adopts these rules—against which there is significant opposition in

the Commission itself, so it is not clear that it will even happen—

the SEC is doing this by a form of bootstrapping. What it does is

648

it adds an independent chairman requirement and a 75 percent

independent board requirement to about a dozen different exemptive rules. These are rules that the SEC has developed over the

last 65 years of regulation under the Investment Company Act, and

which most funds rely on and rely on importantly, in that they

need to rely on those rules in order to function.

The SEC figures that since they need these rules to function,

they will always have to rely on the rules, and therefore always

have to have an independent chairman and 75 percent independent

board. In fact, when those provisions are most needed, and that is

when there is a confrontation, a difference of opinion between the

fund’s directors and the investment manager, the investment manager can decide at that moment to stop relying on those rules. So

for example, if you have a 12b–1 plan, you are relying on Rule

12b–1. The SEC proposes to require that if you rely on that Rule,

you have a 12b–1 plan, you have to have an independent chairman,

75 percent independent board, but the moment the fund manager

wants to get rid of that independent chairman or has a problem

with that board, it will stop relying on Rule 12b–1, cancel the

12b–1 plan, and get rid of the board. If you have any doubt as to

whether that might happen, that is precisely what happened when

there was a conflict between Don Yacktman, the Fund Manager, of

the Yacktman Funds. He was in a conflict with the board. He engineered a proxy vote in which the board was replaced. He replaced

the board with hand-picked successors, and because it no longer

qualified under Rule 12b–1’s independent governance provisions,

he had to cancel the 12b–1 plan.

What we have now is an SEC proposal that will work in most

cases but will never work where it is needed most, where there is

actually a confrontation between the fund manager and the board,

because the board will know that if the fund manager simply is

willing to give up reliance on those rules, the requirements disappear, and in that case we do not even have a majority requirement to fall back on. All we have is that the board has to be 40

percent independent, and that is the only requirement that would

apply. It can be hand-picked by the fund manager and 60 percent

of the board can be fund manager executives.

The second category where legislation is needed is in the area of

fee disclosure, again, where the SEC usually has the authority but

has either not supported or expressly opposed——

Chairman SHELBY. Let me stop you a minute. You say fee disclosure, but you are not saying you want us to set fees, are you?

Mr. BULLARD. No. I am with the SEC on our Government really

having no role to play in regulating fees.

Chairman SHELBY. It should not set fees.

Mr. BULLARD. Absolutely not.

Chairman SHELBY. But we are talking about disclosure.

Mr. BULLARD. Absolutely. And in my mind, the essence of disclosure is that, like the SEC has stated, the marketplace should regulate fees. Investors should make decisions. That marketplace is

working fairly well. We have a fair amount of competition in the

industry. But what we have is, and that the SEC has failed to recognize, is fee disclosure that simply is not telling the market how

much it really costs to own funds. The most glaring example of that

649

is portfolio transaction costs. A recent study that was sponsored by

the Zero Alpha Group, by a number of academics—and if I might

add this as part of the record as well?

Chairman SHELBY. It will be made part of the record.

Mr. BULLARD. Thank you, Chairman.

In this study a couple of academics looked at the question of how

much are these portfolio transaction costs. Let us just start by looking at the commissions, the dollar amount paid, and to see whether

it really has an impact, and then we will do a reasonable estimate

of spread cost. Spread cost is the difference between if there is a

buy price and a sell price, it is the difference that you would pay.

I find the best way to imagine it is to imagine that you were buying and selling the same amount of stock at the same time. You

would think that you would break even, but you will not. The difference is that you are going to buy at the high price and you are

going to sell at the low price in that spread. Just including those

two components of portfolio transaction costs, they found that the

average equity funds portfolio transaction costs equaled 43 percent

of their expense ratio, which I call the partial expense ratio because any time you have an expense ratio that leaves out 43 percent of the cost, that is not something that is representative of

what it costs to own the funds. Rather, I consider that to be a misleading number.

If you look at the last page of my written testimony, I included

a chart from their study in which they show—and this is only for

funds that have more than $100 million in assets. These are not

outliers. A couple of funds, for example, the PBHG Large Cap Fund

expense ratio—and this is what the SEC is telling us this fund

costs—is 1.16 percent. What the study shows us is there are an additional 4.27 percent of assets spent on commissions, another 3.16

percent spent on spread, so that the total actual expenses, just including those two components of portfolio transaction costs, is more

than seven times what the SEC is telling us this fund costs. This

is misleading because it does not punish fund managers for behavior that the market may consider important.

I am not saying anything about whether they should be allowed

to do the frequent trading that causes these costs. The market

should make that decision. But what the SEC has done is said, we

are going to make the decision for the market. We are going to give

the market a partial expense ratio. That is the only standardized

figure we are going to give the market, and we are not going to let

the market have another standardized figure so it can choose. I say

let the market choose which is the number that they think is the

best reflection of costs, and leave it at that. Thus far the SEC has

been flatly opposed to that approach.

The second area that the SEC has opposed disclosure is the actual disclosure of individual shareholder costs in their statements.

This was a proposal they specifically rejected in a recent rulemaking. Ironically, just last week, MFS—and I am sure Chairman

Pozen can talk about that—has proposed to provide precisely the

disclosure the SEC rejected in quarterly statements to its shareholders. This is a shocking development.

Chairman SHELBY. Explain how that would work if the SEC had

adopted it.

650

Mr. BULLARD. What I would have had the SEC do is two things.

One is you have to tell the shareholder either exactly what they

paid or a pretty good estimate of what they paid so it is an individualized number, and the second thing is it has to be on their statement. That is exactly what MFS is doing.

Chairman SHELBY. And should be in plain English. We will get

into that in a few minutes.

Mr. BULLARD. Absolutely. And of course, what Professor Lutz has

worked up is an excellent analysis of the issue of what your broker

got paid, and it is the confirm disclosure. This would be on the

statement, and the reason that it is important that it be on the

statement is that what we are trying to do is reach investors who

are currently not price sensitive. We are trying to affect a part of

the market by putting a number in front of them—and again, let

the market decide—but put it in a place where they are actually

going to read it. The average investor, including probably most of

the people in this room, take their shareholder report, and it goes

right from the mailbox into the trash. What everybody in this room

does, however, is you open your statements, look at them, see the

value of your account, and you feel great if it went up that quarter

and you feel bad it went down that quarter. But what you would

also be informed by would be the dollar amount what it cost you

to pay that manager to be in that fund, right on that statement.

You cannot overload it with a lot of things. I do not think you

should do much more if anything than tell the person what the

value of their account is and what it costs to be in that account.

What the SEC has decided instead is to give you a hypothetical

number, which is not the number that you paid, and to put it in

the shareholder’s statement.

Chairman SHELBY. Why would they want to do that?

Mr. BULLARD. For two reasons. One is the cost which the industry said was prohibitive. I imagine Mr. Pozen would have some

comments about how MFS is going to be able to afford this prohibitive cost since they have now decided to do precisely the same

thing. The other reason was they thought it might be misleading.

Apparently Mr. Pozen also believes that it is not misleading. Now

that those two arguments seem to have been washed away by——

Chairman SHELBY. If it is misleading, although it might cost

more, truth should trump that, should it not?

Mr. BULLARD. I take a very economic view of this business. Truth

should trump that, and the net cost should be exceeded by the benefits. If you could show me that this disclosure in the statements

would not mean that investors will save more money because of

increased competition, I would be opposed to that disclosure. The

test has to be that the benefit has to exceed the cost because ultimately the mutual fund industry is about creating wealth for

Americans across the board and keeping as much of the market return as possible.

The other areas where the SEC has opposed disclosure would be

putting those fees in context, having disclosure like they have for

performance in the prospectus, that shows you that your expense

ratio for this fund is 1.2 percent and the average of your peers is,

let us say, 1.4 percent, and what you would pay to be an index

fund, that is, what you are paying to choose to have your money

651

managed rather than have it simply by the market is let us say

0.2 percent. So, people can really see the decision they are making,

and again, you let the market decide by forcing standardization,

which is really where the Government can intrude and can promote

efficiency and competition without having any decisionmaking authority as to what people should pay.

An area regarding fee disclosure is the distribution expenses.

Currently, the SEC requires that the fee table have a line item

that says ‘‘Distribution.’’ That is the 12b–1 fee. In fact, there are

distribution costs that are being paid out of the management fee.

So what you have is a group of shareholders who use 12b–1 fees

as a cut-off, as a screen, thinking that if I do not want to buy a

fund that is spending money on distribution, I will simply ignore

the ones that charge a 12b–1 fee. And, nothing could be further

from the truth. In fact, you could have two funds, one charges a

12b–1 fee and one does not, and the amount that that shareholder

is effectively spending on distribution is the same in both cases.

The area where the SEC does not have authority in this case is

soft dollars, and I have reached the point where I would support

a ban on soft dollars. The problems with soft dollars have been

well-studied. They are essentially twofold. One is that you have

fund managers spending other people’s money on something that

they would otherwise pay for out of their own pockets, and that

was well-illustrated in a couple of Wall Street Journal articles last

week in which both MFS’s plans and Fidelity’s requests of the SEC

include a discussion of how much of their commissions they estimate are actually being spent on things they would otherwise pay

for out of their own pockets. MFS has proposed to ban soft dollars.

Vanguard has always shunned soft dollars. American Century has

always severely restricted soft dollars. Putnam is now severely restricting soft dollars and is considering banning soft dollars.

The problem with each of these positions is that Mr. Pozen’s

shareholders are going to be asking him, why is it you are still paying 5 cents a share and the price has not gone down, yet you are

spending more of the fund manager’s money on these reports because you are not willing to buy them with that 5 cents a share?

I believe—Mr. Pozen may disagree for business reasons—but I believe he is going to be under some pressure competitively because

it is going to put him at a disadvantage because other fund managers are going to be spending the fund’s money on those reports

that are coming out of MFS’s pocket. I am saying you have to have

a level playing field for this to work, and we begin with a ban.

But if we do not have a ban, the least we could do is either

severely restrict soft dollars so that they pay only for reports that

represent an opinion about an issuer’s value, or we restrict them

in the sense that Fidelity has proposed, in that we should completely unbundle the transaction and require that there be an objective value assigned to all the nonexecution components, or at an

absolute minimum, let the market know what soft dollars is costing

us. The reason the market does not know goes back to the portfolio

transaction cost problem. It is not in the expense ratio. So at a

minimum, let the market decide if it wants to allow this practice

to continue, then let people know what the cost of it is and let them

decide for themselves, and I would say that would be at the top of

652

my list as to how to deal with soft dollars, but there are a lot of

different approaches, none of which the SEC seems to support.

Another area where Congress needs to act is in the reform of distribution costs. Congress, in 1940, wisely enacted Section 12b of the

Investment Company Act. The effect of that provision was essentially to prevent funds from underwriting their own securities, that

is, being in the business of distributing their own shares. The reason for that was that Congress was concerned that fund managers

would simply spend the fund’s money to sell more shares in order

to increase the fund manager’s advisory fee.

The SEC opposed for years any exception to that standard. They

finally relented, as we all know, with Rule 12b–1 in 1980. Initially

that was intended to allow simply marketing expenditures, and it

was designed to deal with periods of net redemptions when the

industry was actually losing assets and it needed a competitive

temporary boost. The SEC never anticipated what has happened

today, which is now those costs represent, based on ICI statistics,

only 5 percent of what 12b–1 fees go to. Sixty-three percent of 12b–

1 fees go for a purpose that was never intended by the SEC and

is flatly contrary to Section 12b, and that is to compensation for

brokers. The problem with that structure is essentially you have

brokers being paid by the product to sell the product, so that instead of selling the best product and being compensated on the

basis of a successful relationship with their clients, the broker is

getting compensated based on which fund complex he can pressure

the most payments out of, and you have a system where the brokers’ interests are not aligned with shareholders’ interests because

the broker is pushing the fund manager which pays the highest

fees to the broker. So what 12b–1 has done is essentially it has tied

the compensation of the fund manager with the compensation of

the broker, whereas the broker’s compensation should be tied to

the relationship to the customer.

What Congress needs to do is to set things back the way they

were in Section 12b in 1940 and prohibit fund managers and prohibit funds from paying brokers in connection with selling fund

shares. That is an important distinction. I do not think there is a

problem with funds or fund managers paying to market the funds.

A classic example would be running ads in Money Magazine. That

is generally where you have a reasonable alignment of interest between the fund manager and the fund. It is something that the directors could oversee and they should be expressly required to do

so. But the fund should not be paying for the relationship between

the customer and the broker, and neither should the fund manager.

That requires outlawing revenue sharing, also known as shelfspace payments, and that would require repealing 12b–1, since for

24 years the SEC has been unwilling to take any action on this,

even though it has repeatedly promised to reform 12b–1 fees.

I note that it recently proposed some changes to 12b–1 to ban

directed brokerage, and once again it has missed the opportunity

to accomplish real reform and return 12b–1 to what everyone on

the Commission and on the staff admits is a purpose for which it

was originally intended.

Finally, the last area where we really need Congressional action

is in fund names, and I think this is an issue that will strike home

653

for this Committee especially, in that the SEC has stated that

funds can use the term ‘‘U.S. Government’’ in their names, that

they can invest fully 100 percent of their assets in Government

Sponsored Enterprises. That means that a fund can say, I am a

U.S. Government fund, and I am going to address 100 percent of

my assets in Fannie Maes. My view is that your average American

expects a U.S. Government fund to invest in creditworthy instruments, and what we are learning every day, more and more, is that

Fannie Maes are not as creditworthy as we thought. They are not

guaranteed by the Government. It is inherently misleading that

any U.S. Government funds invest more than the legal limit normally required by your name, and the SEC has expressly refused

to take that position.

I applaud the SEC for the steps that it has taken. The Division

of Investment Management has accomplished more good rulemaking in the last 6 months than it has probably in its history, but

again, even though they are dealing with important aspects of the

ongoing scandal, they do not go to the most significant problem facing the industry, and that is with the market over 19 years returning 12.22 percent and investors receiving only 2.57 percent, there

is something wrong with the system, and the primary problem with

the system is that fees are not being disclosed in a way where people are making rationale decisions. To a large extent, that is their

own fault. We need to educate people to make better informed decisions, but we also have a responsibility for putting out an expense

ratio that we say is the total cost of the funds but is not actually

representing those costs.

My number one priority would be each of the fee disclosure

issues that I have laid out for the Committee before any other, because my view is we should look to the market and look to the

market first, and we have to give the market the tools to make efficient decisions.

Thank you again for the opportunity to appear here today. I will

be happy to take any questions.

Chairman SHELBY. Thank you.

Professor Lutz.

STATEMENT OF WILLIAM D. LUTZ, PH.D., J.D.

PROFESSOR OF ENGLISH, RUTGERS UNIVERSITY

Mr. LUTZ. Thank you for the invitation, Chairman Shelby.

I have rewritten about 58 mutual fund prospectuses into plain

language, at least as far as I was allowed to write them into plain

language. I can remember the first time I ran into the turnover

rate, which was always buried in the back of the prospectus, and

asking what that was.

Chairman SHELBY. When you were rewriting them—excuse me—

were you getting all the ambiguity out of them, much as you could?

Mr. LUTZ. As far as I was allowed to. There was a strict adherence to the SEC regulations, no more, no less. What I wanted to

do more to explain more, for example, the churn rate or the turnover rate, or in that wonderful phrase ‘‘portfolio transactions cost,’’

which I have absolutely no idea what that means to any normal

human being who does not have a CPA.

Chairman SHELBY. Say that again?

654

Mr. LUTZ. Portfolio transaction cost. It makes one’s eyes tend to

glaze over.

Chairman SHELBY. Portfolio transaction cost. What does that

really mean in plain English?

Mr. LUTZ. In plain English, it means when you are buying and

selling the assets in the fund you have to pay for that, and that

is what you are paying for, all the costs that are associated with

that. But you have collapsed a lot of costs into that phrase and you

have made a wonderful abstraction, the kind of abstraction that

people do not question because they do not want to appear to be

stupid or uninformed.

Chairman SHELBY. Do they bundle these costs together for the

reasons not to disclose in a sense?

Mr. LUTZ. Oh, of course. George Orwell said, ‘‘the great enemy

of clear language is insincerity.’’

Chairman SHELBY. Funneling, is it not, funneling too? You put

them all together and you do not know what is what.

Mr. LUTZ. One big ball of wax and one big ball of twine that you

have to try and unwind.

I was always impressed by the mutual fund industry—and there

are a lot of people who can do this—but I was particularly impressed by the number of synonyms they found for the word ‘‘fee.’’

[Laughter.]

Chairman SHELBY. Take your time. Go ahead.

Mr. LUTZ. My apologies to Gertrude Stein, but a fee is a fee is

a fee. It is money out of my pocket. When I bought my house and

I went through all those lists of settlement fees, and all I knew was

there was a bottom line and I had to write that check.

Chairman SHELBY. But they were broken down.

Mr. LUTZ. But they were broken down. I knew exactly how much

I was paying for the residual fuel oil in that heating tank of the

house I was buying and the sewage bill and the water. It was all

broken out so that I could question things if I had any questions.

There is no comparable effort in a mutual fund prospectus. There

could be, no trouble at all, easily done if you want to do it. I think

there is an important word here and it goes with an important

phrase. The first word is transparency. The strength of the American financial markets is transparency because nobody gives money

to somebody if they do not know what is going on. And second, disclosure is not disclosure if it does not communicate. To simply give

data is not to communicate. To say the portfolio transactions costs

are $150 tells me nothing, absolutely nothing. There is no information there, and it is the job of the people putting this prospectus

together to give information, to explain things, to create a context.

What does this cost? Why is it going to affect my investment?

I agree with Professor Bullard. The idea of doing this hypo- thetical $10,000 investment, and we would draw the charts, means

absolutely nothing to anybody. It certainly did not mean anything

to us. In fact, I do not think anybody knew, at least any investor

knew where those numbers came from or what they meant. The

question always is, what does that mean to me and my investment?

In an age of computers—and I am not a computer expert, but I

have seen enough that can be done with them—to say we cannot

do individualized reports I find mystifying at best. My investment

655

through the University is with TIAA–CREF, and each quarter I get

a detailed breakdown of all my investments.

Chairman SHELBY. Banks give you a monthly statement.

Mr. LUTZ. My checking account, my savings account, and in fact,

if anything, we are flooded with data. Computers can grind out

more data than any human being could ever assimilate, but we are

not talking about information. To simply give numbers to investors

does not say anything. We have to tell them what the numbers

mean and how the numbers affect them.

In the appendix to my statement that I submitted in the redesigned form of the confirmation of sale, we tried to take that data

and make sense out of it to the person who is buying these shares.

We wanted to say, okay, what is this going to cost me, bottom line?

How much is it going to cost me while I hold these mutual fund

shares? Is it going to cost me anything when I sell them? Just give

me these numbers. So if I am investing $1,000, but I find out that

over $300 of this $1,000 is going to various sales fees, I might want

to think about that. I might want to look for another fund that

says, hey, we only charge $150. I am a terrific believer in competition, but you cannot have competition when all the guys are hiding

the information from you. Then it does not work.

Chairman SHELBY. But it would enable the consumer, the fund

holder, the people that buy $7 trillion, have invested everything, to

make an informed decision, is that correct, for the market?

Mr. LUTZ. Exactly. I drive down the street and I can choose

which gasoline station I am going to because they post their prices.

There is nothing hidden there, and I know what those numbers

mean. But when I go to look for a mutual fund in which I might

want to invest, I am swamped with meaningless data, and if anybody in this room suffers from insomnia, let me suggest simply

picking up a statement of additional information, and by page 8,

I guarantee you will cure your insomnia, even though that statement may run over 100 pages long of 8-point type, single-spaced,

no indentations. It is designed to put you to sleep.

I am mystified—I guess I am not, I am not that innocent. This

is done deliberately. Because one of the things we discovered on the

Plain Language Project at the SEC is that the sales materials for

mutual funds, the pamphlets, the brochures that they put out,

were magnificent in design, communication, clarity, graphics information, and you would turn around and look at the other information in the prospectus and it was exactly the opposite. There was

not anything there to explain things to you, and in all of the investor information given to you once you were a shareholder.

Chairman SHELBY. You might be going to get into this. Maybe

I am getting ahead of you. What is the average financial literacy?

In other words, rate of the average American, the average investor.

It seems to me that a lot of stuff that we get in the mail you would

either have to be an investment banker, an analyst, a securities

lawyer, or somebody that was dealing with this to understand what

was coming to you.

Mr. LUTZ. You have two issues. The first is readability, that is

the reading level. You should be at a seventh grade reading level

to have a reasonable chance of having a significant amount of the

population to understand your materials, and in fact, if you want

656

to guarantee wide readability you would have to aim for the fifth

grade level. On the SEC proposed forms on one readability study

I did, the lowest grade level I got was 12.5. The highest I got was

15, which means that all you needed was a high school diploma

and 3 years of college and you would have a 50-percent chance of

understanding this document.

The second is financial literacy, and numerous studies have been

done to show that that is extremely low. The Department of Education also does a literacy study, which it updates regularly, and

it is a detailed and magnificence study. They found that less than

10 percent of the people in that study—and this is a representative

sample—could not read and interpret a bar chart. Only about 30

percent—I think it was around 28 percent—could read and interpret a simply age and weight chart for determining the amount of

medication to give to a child. You had to find the age on one side

and on the top the weight, draw the two lines together. When it

comes to literacy, financial literacy, it is much, much lower being

able to interpret this kind of technical data. It is really incumbent

on us who provide information to do our best to use information designed plain language to communicate as clearly and as simply as

possible. It can be done. It has been done, and it is done regularly

if you want to do it.

One of the main points in my statement is that the Securities

and Exchange Commission has to incorporate this into all of their

procedures. Document design, information design, should just be

automatic and standard. It is in a number of Federal agencies already. The Social Security Administration has done extensive work.

The Veterans Benefits Administration has found that they saved a

huge amount of money by redesigning their forms to make them

understandable to the recipients. So, we are not talking about anything new. We are talking about not just money. We are talking

about retirement, your future life, your children’s college education.

You are talking about the quality of how people will live. Will they

be able to retire? This is more than money. It goes to the very

heart of the quality of our lives.

Transparency is important because it leaves to confidence that

we have the information we need, and when we have confidence we

trust, and if we trust, we invest. If we do not trust, we draw back,

as we have seen recently. My theory is that there will be a great

distrust of mutual funds, and once trust is lost it is very difficult

to get back, no matter how hard you try.

Chairman SHELBY. Thank you.

Mr. Pozen.

STATEMENT OF ROBERT C. POZEN

CHAIRMAN, MFS INVESTMENT MANAGEMENT

VISITING PROFESSOR, HARVARD LAW SCHOOL

Mr. POZEN. Thank you, Chairman Shelby and Ranking Member

Sarbanes.

I know that you have been holding these important hearings on

the broad subject of mutual fund reform, but today I would like to

concentrate on three areas, one having to do with brokerage commissions, which the professors already started to address; another

individualized reporting which has also been discussed; and finally,

657

fund governance. Then I would like to add just a few comments on

12b–1 fees.

Beginning with brokerage commissions, we at MFS want to reduce the brokerage commissions that are paid by the fund shareholders, but it is now very difficult to negotiate for a lower price

on commissions because the system is not transparent. If a mutual

fund has a large trade, for example, a 500,000 share order in a

stock like Genzyme, you will need to go to a full service broker to

get a good execution. A trade this big would not be easily executable through electronic networks because they do not handle that

sort of volume. You might need capital on the desk, you need a

much higher level of skill. Such a trade cannot easily be done

through a passive facility. If you go to any full service broker on

the street, it will charge you 5 cents a share and it is very hard

to get a lower price. But full-service firms are very willing to give

all types of what I call in-kind discounts. If you want to, they will

forward some of the commission to pay for third-party research. If

you want to, they will forward some of the commission to Bloomberg and provide you with a Bloomberg terminal. If you want to,

they may even pay your rent. So there clearly is a system by which

there are noncash items that are being paid for by soft dollars, and

these items are not very easy to separate from the overall price of

the commission.

MFS announced last week that we will be paying cash out of our

own pocket for third-party research and certain types of market

data, and we hope to get a lower price on the commission, but we

need help. MFS alone is not going to change the pricing structure

on Wall Street.

As mentioned before, there are some firms like 20th Century

that are moving in this direction or already have moved, but we

need many mutual fund companies to move in this direction. We

also need the help of the SEC.

In 1975, Congress passed a safe harbor for soft dollars in Section

28(e) of the 1934 Act. Early on the SEC had a rather strict and

narrow interpretation of that safe harbor, saying you could only

use soft dollars when the good or service was not readily available

for cash. But then in 1986, the Commission vastly expanded the

safe harbor by saying essentially that you could use soft dollars for

any ‘‘legitimate use,’’ and this has led to a widespread proliferation

of soft dollars.

What I am proposing is fairly simple. I think we should go back

to the stricter definition that the SEC originally had, and that will

constrain soft dollars.

Chairman SHELBY. What was that? What was the stricter——

Mr. POZEN. The stricter definition was you can only use soft dollars if the good or service is not readily available for cash. In that

case you could not have somebody paying for your Bloombergs, you

could not have somebody paying your rent, you could not have a

lot of things that go on.

Chairman SHELBY. Senator Sarbanes has a question.

Senator SARBANES. What is the rationale for having it at all?

Mr. POZEN. I would say we do not know how the system would

work without any safe harbor, and I would like to see from an evolutionary point of view how it would work out with a narrow safe

658

harbor, so the rationale is both a preference for an experiential approach, and second of all, that in all industries there is some bundling, there are things that are put together, and I think the key

is to understand what the bundles are composed of. We are very

much supportive of the value of research. I was misquoted in The

New York Times about a week ago on that. But the question is,

what research is exactly being provided as part of that commission?

The SEC has proposed an itemization or a better accounting of the

components of the commission. I have no problem if I am buying

a 3-cent execution and I am paying one penny more for access to

a very well-trained and very good set of researchers. I just want

to know what I am paying for. If research and execution are bundled together, you could argue this is no different than the fact

that when you buy a computer, you also get software.

Chairman SHELBY. Sir, how can you know what you are paying

for if it is all intertwined?

Mr. POZEN. Now, it is intertwined. That is why I support the

SEC’s concept release where they would itemize the elements and

so we would know what they are. But that is very different than

saying if you know what the elements are, then you cannot buy a

bundle. In order to allow the industry to continue buying bundles

of products, you probably do need the safe harbor in Section 28(e).

I am just explaining that there are two very different questions.

One is, should there be an itemized breakdown of the commissions?

And I strongly agree. I also feel that the SEC should have a much

stricter definition of 28(e). But I would not answer yes to the second question—should we push for the repeal of 28(e)? If we knew

the prices of all the items included in the commission and the SEC

adopted a stricter interpretation of 28(e), I believe we could have

a transparent negotiation, and some of the services might be bundled with others, as long as we know what we are getting, which

we do not now.

Chairman SHELBY. But any market works more efficiently when

people know what the cost of this is and where it is out there, as

Professor Lutz says, ‘‘in plain English.’’ Otherwise you are guessing. It is ambiguous.

Mr. POZEN. Here we are talking about the disclosure by the Wall

Street firms as to what are the components of the full-service commission. As I said, I strongly support the proposal to have an accounting of those items so that we can see what the items are. But

I am just trying to say that is a very different question than if you

understand all the items, can you buy two services together?

Chairman SHELBY. But you will never understand them if they

are not itemized, will you?

Mr. POZEN. I agree with that.

Chairman SHELBY. You will never know, just like Professor

Bullard referenced. Go ahead.

Mr. POZEN. I would also advocate in the semi-annual and annual

reports that there be an average commission per share that is disclosed, but I would be against putting brokerage commissions into

the expense ratio for two reasons. One is, brokerage commissions

are treated for both accounting and tax purposes as a capitalized

expense, and all the other expenses in the ratio are ordinary expenses. By capitalized expense, I mean that it goes to the basis, the

659

tax basis of the security. So if you buy a security for $10 and you

pay 5 cents a share, then its basis is $10.05, and when you go to

sell it, you subtract the $10.05. So, you are really mixing apples

and oranges.

Chairman SHELBY. But it is still an expense.

Mr. POZEN. I believe it should be disclosed as a separate average

commission per share. But I am saying if we put brokerage commissions in the expense table, we create the sense that it is the

same expense as management fees and transfer agency fees; it is

not the same expense.

Chairman SHELBY. It might be apples as opposed to oranges, but

it is still fruit, is it not?

Mr. POZEN. It is fruit, and we definitely need to have disclosures

about brokerage commissions. All I am saying is that it should

probably be right below the expense table, but should not be in the

expense table.

The other thing is that commission prices are only one element

of brokerage costs. You also have spreads, and spreads are extremely difficult to compute. I do not know how anyone would be

able to say the exact amount of spread that had been paid. So, I

am all for the disclosure of the average commission per share that

the fund pays, but I think that we should be careful to understand

that it is a very different expense than the other expenses in the

expense table and should be broken out separately.

On the question of expense reporting, I think we should understand that there has been an effort over the past decade to have

expense reporting in the prospectus. There is a fee table with the

advisory fee, the transfer agency fee, the 12b–1 fee, and other fees.

I think the problem is that these are expressed in basis points

which most people have a hard time understanding.

Chairman SHELBY. Excuse me. But they could change that. You

could have a little formula there, saying 10 basis points equals soand-so, or 5 basis points, rather than just basis points.

Mr. POZEN. I agree, and the hypothetical, the $10,000 hypothetical is there to try to give you an actual dollar amount, but

still, it is a hypothetical. What we are doing at MFS is to provide

for every shareholder in the quarterly report the estimated dollar

expense of their expenses in each of their funds.

There has been a large debate about whether or not this is too

expensive for the industry, and if you really tried to get the actual

expenses of every single shareholder and every single fund, it

would be in fact a very large computer programming project and

would cost a lot of money. But what we have done is made two simplifying assumptions which are quite reasonable and give you a

very good estimate. The first assumption is that at the end of the

quarter we look and see what funds you hold, and then we assume

that you have held them for the full quarter. We do not assume

that, for instance, you came in on January 21 and came out on

March 21. That assumption makes it a lot easier. In fact, by making that assumption, we might be overstating a little your fund

expenses because if you came in on January 21, we are actually

giving you what you would have paid during the full quarter.

We are also making a second simplifying assumption that you

are reinvesting your dividends, which most shareholders do. So

660

with those two simplifying assumptions, which are applicable to

over 90 percent of our shareholder base, we are able to provide

later this year an estimated dollar amount of the expenses for each

shareholder for each of the funds that he or she holds at the end

of the quarter. I think this is a case in which the best is the enemy

of the good. We can give a good estimate. It is not perfect. We can

do it at a reasonable cost. If we try to have the perfect number,

the exact number per shareholder, then we are imposing these

large computer programming costs, which I think are unnecessary

because I think we can get a very good estimate that is applicable

to most shareholders through such assumptions.

I also wanted to talk about fund governance, and here again

MFS is leading the way. We already have over 75 percent independent directors and we have independent co-chairmen of the

funds drawn from the independent directors. But I have to say in

this debate about whether you should have an independent chairman or an independent lead director, I think it has become a little

symbolic. The question from my point of view is, do you have a senior independent director who is playing the functional roles that

you need? Among these functional roles, the most important are

first to have an executive session of the independent directors in

which management is not there, where they can have a discussion

about issues. And you need a senior independent director to lead

that. Second, you need a senior independent director to work with

management to help set the agenda for the board meetings. If you

have such a senior independent director playing those two functions, in my view it is not so important whether that person is

called a chairman or a senior lead director. The key is to have the

functions played, and if those functions are played, it seems to me

it is okay to have them called in some complexes ‘‘chairman’’ and

in other complexes ‘‘senior lead directors.’’ The key point is to have

the functions played.

Another aspect of fund governance is to have outside advice for

the independent directors that is really their own advice. Most

complexes, as MFS, have outside counsel to the independent directors, and that outside counsel is an independent firm. At MFS, we

have gone one step further and we will have an outside compliance

monitor who works for the independent directors and who will

monitor the compliance activity of management.

Of course, we on the management side have our own compliance

director, but this will serve as an additional check and balance.

On the management side of MFS we have my position, which is

a new position, the Non-Executive Chairman of the management

company who reports directly to the fund directors. We also have

a second new position, an Executive VP for Regulatory Affairs,

which shows how important we think those issues are, and that

person is now a member of the management committee, the executive committee of the management company.

However, I have heard various proposals on governance that I

would respectfully disagree with. Some of these proposals involve

establishing an SRO for mutual funds. Some of them involve having a special board to provide guidelines to directors. I personally

am in favor of a flat organizational structure. I think it is best

when people are getting the word from the real authority. I believe

661

that the key is to have an effective Investment Management Division at the SEC, to strengthen it, and to give it more personnel if

necessary. SEC officials are the ones who should be dealing directly

with the regulation of the industry, and they are the ones who

should also be giving guidelines to directors if guidelines are appropriate. So, I would urge the Committee to take the approach of giving the SEC more resources, which I know has been done, rather

than to create these intermediate boards or bodies which I believe

would not be particularly helpful.

The last question, on which I had not intended to testify, but

since it was brought up, I will mention it involves 12b–1 fees. Here

I would strongly agree with the people who say we need better disclosure at the point of sale. When the broker or representative is

presenting these issues to the customer, the customer needs to understand if there are 12b–1 fees and how much they are paying in

addition to the other fees. The SEC has a proposal now for better

point-of-sale disclosure. I think it is a step in the right direction.

And it is quite a good proposal. Obviously there are aspects of it

that people will debate.

But I am strongly against the elimination of 12b–1 fees, because

12b–1 fees are essentially an installment payment plan for a sales

load. It used to be the case that we had sales loads of 8 percent

up front. Then 12b–1 fees were allowed by the SEC. The historical

origins of 12b–1 are quite complex, and people can debate historically what its original intent was. But now it serves as an installment sale plan, so instead of paying 8 percent up front or 6 percent

up front, you pay a certain amount each year for a certain number

of years. In my view, people should have the choice. They should

have the choice between an up front payment and an installment

sale over a number of years. But the key point is that they understand the difference and they understand what they are signing up

for. If they know that they are signing up in one instance for a

front-end load and in another instance for an installment plan with

a certain amount of payments each year, then that is a reasonable

choice. If we do not have good point-of-sale disclosure, then we are

not building a good system.

I think it would be a big mistake to eliminate 12b–1 fees and

eliminate the choice of an installment sale plan for many people

who want that plan.

I think I am going to end there and leave the floor for Ms. Roper.

Chairman SHELBY. Thank you.

Ms. Roper.

STATEMENT OF BARBARA ROPER

DIRECTOR, INVESTOR PROTECTION

CONSUMER FEDERATION OF AMERICA

Ms. ROPER. Thank you very much. Thank you, Chairman Shelby

and Senator Sarbanes for holding this hearing today and for inviting me to testify.

When I prepared for my testimony today, I thought it was a good

opportunity to look back at what has been done at the SEC since

the mutual fund scandals first hit. I would like to say at the outset

that we at CFA think that the SEC has done a very good job in

recent months of developing a strong and credible mutual fund reVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00673 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
662

form program. Although the Agency may have been caught off

guard initially by the mutual fund scandals, it seems now to be acting aggressively in all three areas of its responsibility—enforcement, oversight, and regulatory policy.

It is on that issue of regulatory policy that CFA has primarily

focused its attention. Last November we, along with Fund Democracy and several other national consumer groups, released a blueprint for mutual fund reform, outlining the steps we believed were

necessary to restore badly shaken investor confidence and the integrity of the mutual fund industry. When I prepared my testimony

today, I went back to that blueprint to see what we had recommended, what the SEC has since done, and what we believe

remains to be done by Congress or by the SEC to achieve that

agenda. My written statement goes point by point through the

blueprint and analyzes those issues.

Chairman SHELBY. Could you touch on those just a minute?

Ms. ROPER. There are probably 30 recommendations in the blueprint, but, yes, I will look at that. When you look at what the SEC

has done, it is a preliminary assessment at this point. Most of what

they have proposed is either in the rule proposal or concept release

stage on the key issues, and we do not know for sure what the final

rules will look like. In some cases, particularly like the point of sale

and confirmation disclosure, we are very supportive of the thrust

of what the SEC is trying to do, but believe significant amendments are needed to realize the potential of those reforms. We believe Professor Lutz has some very helpful suggestions. We do not

know whether those changes will be adopted, so we do not know

what this program will look like 6 months from now. What is really

rather remarkable, when you go back and perform this exercise, is

how much of the policy that we suggested in the blueprint in November has since been taken up by the SEC. So in areas that have

to do with how you specifically address the trading scandals or how

you deal with broker-dealer sales abuses or how you deal with

oversight of mutual funds, most of what we have suggested has

since been either proposed or adopted by the SEC.

Despite that important progress, we see some areas where we

think there is still a need for legislation. Some of those are the result of the SEC’s lack of authority to act, or lack of authority to

adopt reforms that we believe are needed. Some of them are areas

where the SEC would appear to have the authority but simply has

not taken the actions that we think are necessary to adopt important investor protections. So while we do not necessarily see the

need for sweeping legislation, the mutual fund equivalent of the

Sarbanes–Oxley Act, we do still believe that there is a need for a

narrower bill targeted at some specific issues.

At the top of our list of those issues is one that we have discussed a lot this morning, and that is mutual fund cost disclosure.

It has for us been the one big disappointment in the SEC’s response that they have not proposed the innovative presale cost disclosure for mutual funds that we believe is necessary to provide

real effective market discipline of mutual fund costs. I am going to

leave aside the point on portfolio transaction costs. I agree with the

statements that Mercer has made, that if we are going to provide

cost disclosure information, it needs to be complete cost disclosure.

663

We need to be covering the costs in a way that does not create a

misleading impression about the affordability of that fund.

That said, I think that the current system works reasonably well

for a portion of the investing public—those people who either have

the sophistication themselves to find the relevant information and

use it to make cost conscious decisions and buy high-quality, lowcost funds, and those people who have objective advisers who are

helping to steer them into those high-quality, low-cost funds. But

we also know that there are a lot of low-quality, high-cost funds

that are able to survive and even thrive in this marketplace. And

the question is why? I think ineffective boards is part of the answer. I think reverse competition in the broker sold market is part

of the answer. But I think a major part of the answer is that we

are not giving unsophisticated average investors the type of cost information they need to make good purchase decisions.

The way we assess disclosure is, does it provide the information

you need at a time when it is useful to you in making your purchase decision and in a form you can understand and that encourages you to act on that information? I would say that the current

cost disclosure on mutual funds fails all three of those tests.

The SEC’s recently adopted rule on cost disclosures, putting this

information in the shareholder report, in my view, simply fine

tunes the system for the people for whom it is already working reasonably well. It does not do much to help ensure that the investors

who are not well-served by the current system are now going to get

the information they need in a form they can understand at a time

when it is useful to them.

So, we would certainly like to see this Committee take up the

issue of improved mutual fund cost disclosure. Because you can

bring down costs a fairly modest amount, and add billions of dollars to the retirement and other savings of working Americans.

The goal should be to look at how we are going to make the system work for the people for whom it does not work now—for the

people who are buying high-cost, low-quality funds, and the average unsophisticated investors who are most in need of controlling

their costs and least likely to do so now.

To do that, in very general terms, we would like to see you adopt

legislation that requires presale disclosure of comparative cost information for mutual funds in plain English, in a document that

is accessible to average investors, that is tested in advance for its

readability and usability by average investors. And we would also

like to see mandatory disclosure along the lines that MFS is now

providing on account statements of estimated actual costs for

shareholders.

We know investors look at their account statements. It is a document that we believe is an effective place to provide cost information. It is not as good as presale disclosure, because it comes after

the purchase has been made. But at least it provides an opportunity to make investors much more aware of the impact of costs

and to maybe encourage them to make more informed decisions in

the future.

We believe that approach combined with the fund governance reforms proposed by the SEC—and we would like to see those enhanced in certain ways, creating a broader fiduciary duty along the

664

lines that Professor Bullard has recommended—we believe that

those steps could go a long way toward wringing out excess costs

from the mutual fund industry, enhancing the retirement savings

of average Americans, and doing that without any need to set costs

or impose costs. Let the market discipline costs. But for the market

to discipline costs, we have to have an effective system of disclosure, which we do not have now.

And then quickly looking beyond the cost issue, there are several

areas where we believe the SEC needs enhanced authority to act—

where we believe they may have the will to adopt reforms, but not

the ability. One of those that we think is very important is in the

issue of the independent governance requirements. We believe that

the SEC needs to be able to apply those reforms directly, not rely

on the exemptive rule process. We believe they need the ability to

strengthen the definition of what constitutes an independent director so that your uncle or someone who retired 2 years ago from the

fund manager cannot serve as an independent director. And, as I

said, we would like to see the fiduciary duty of directors expanded

to cover the entire range of costs of the mutual fund.

We also believe that Congress either needs to ban soft dollars directly or the SEC needs to be given the authority to do that. You

cannot allow funds to shift the costs for certain operating expenses

on to shareholders in a form that they cannot see or understand—

to take costs that are operating costs that they should have to be

paying for directly, and that should be reflected in the expense

ratio, and allow them to shift it into the portfolio transaction costs,

where they are paid by shareholders and hidden from view. When

you have a system that discloses costs in one area and hides them

in another, the incentive to move expenses into the hidden arena

is too strong. We think a ban on soft dollars is the cleanest approach to solving that problem.

I was here when you held a hearing recently with the officials

from the SEC, and one of the issues that they raised is the hard

4 p.m. close to deal with late trading. That has been a controversial

proposal because of certain inequities it creates for those of who do

not live on the East Coast or who invest through retirement plans.

They suggested that the reason they had been forced to take that

approach is that they do not have regulatory oversight authority

over a number of the intermediaries who handle mutual fund

transactions. So, they could not be confident that, if they relied on

a system that was based on end-to-end tracking of mutual fund

transactions, they would have the authority to ensure that that

system was functioning properly.

Chairman SHELBY. They would have to have statutory authority.

Ms. ROPER. Presumably. They seem to think that they need statutory authority to do that. I am not certain whether there is not

an alternative without that. But if that is the case, I think that

they need at least some limited oversight authority of those intermediaries so we can get to an alternative to the hard 4 p.m. close

that does not have its same drawbacks.

These are the issues that we see on a short-term agenda. There

is a longer-term issue that I think has been raised in the mutual

fund scandals, and that has to do with the abusive sales practices

by brokers. The SEC has put forward a number of helpful proVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00676 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
665

posals, fairly bold proposals in some cases, to deal with those problems targeted at mutual funds. But I think the issue of abusive

broker-dealer sales practices is a broader, more complex issue that

needs a lot more study. The goal should be to narrow or eliminate

this gaping divide between the professional advisory image that

brokers portray of themselves to the public, the way they market

themselves to the public, and the conflict-laden, sales-driven reality

of their conduct.

Thank you.

Chairman SHELBY. Thank you.

Professor Pozen, could you elaborate on the conflicts surrounding

soft dollars and how a ban would benefit investors, if it would. In

other words, how would a ban on soft dollars impact both smaller

and full-service broker-dealers and independent research providers?

Mr. POZEN. I think that that is a complex question because we

have never had a ban. But I believe there is an issue involving research and then there is an issue involving market data, and then

there is an issue involving other services, and I think it is important to distinguish among them.

There are certain products which are now paid for with soft dollars, which are clearly readily available for cash. Those include

things like terminals. They include items like computer software,

these types of things. In that case, the broker-dealer to whom you

are paying the 5 cents a share is only acting as a paying agent.

They are acting as a conduit. So, I do not think there would be

much disruption if those types of soft-dollar payments were cut out.

But research is a much more complex matter. We have independent research firms, and some of them are excellent and, not

surprisingly, we have some independent research firms that are

not so good. We have some good research departments on Wall

Street or some particular analysts that are good and some that are

not so good. We want to encourage securities research. We want to

encourage good research.

Any management company like MFS that is really excellent has

a large stable of its own analysts, but we need to be able to get

research from other places, so I think we need to be very careful

about what we do with soft dollars with regard to research, as opposed to other goods and services.

Chairman SHELBY. I think you have answered this, but a number of broker-dealers and independent research providers have

advocated that a ban on soft dollars would drive fund advisers to

integrated firms that provide in-house execution and research at

the expense of independent broker-dealers and third-party researchers.

Mr. POZEN. I think this is an issue and that there are two ways

to solve it. One is going back to the old test of readily available for

cash, since that eliminates a lot of goods and services other than

research, and maybe it should be limited to nonresearch services;

and, second of all, as you point out, requiring more of a specific accounting for the elements of the full-service commission because

then people would know whether they are paying for research and

what type of research they are paying for.

666

Chairman SHELBY. Professor Bullard, some contend that instead

of prohibiting soft-dollar arrangements, the SEC should require

broker-dealers and the funds to unbundle commissions and disclose

the values assigned to execution and research. In addition, others

contend that the SEC should tighten the definition of research,

narrowing the scope of products and services that qualify.

How would unbundling commissions and redefining research

help to reform soft-dollar practices? In other words, would

unbundling create greater transparency for soft dollars and allow

competitive market forces to work? If commissions are unbundled,

should the underlying cost of the research be disclosed in the expense ratio?

Mr. BULLARD. It is a good question. As Mr. Pozen has already

suggested, under the current environment, it is very difficult, even

for a huge money manager such as Fidelity and MFS, to negotiate

down that 5-cents-a-share commission. Unbundling permits competition between the fund manager and the broker by giving the

fund manager a much stronger leverage in order to negotiate a

lower price because now the amount of that 5 cents that is paying

for research has been separated out.

This proposal was actually made by the SEC a number of years

ago when I was at the Commission. It was shot down mainly by

the independent researchers on the view that at that time what

would get quantified was what they provided and what the Goldman Sachs and the Merrills of the world provided would not because they would argue, that is just overhead. It does not really

cost us anything, and they would hurt the independent researchers.

What I am hearing from the independent researchers is they

think it can be done. If it can be done, that would be a very good

step to promoting competition in that context. It does not do anything, however, to promote price competition between funds and

let shareholders see the real impact of different approaches, and

that is why putting it in the expense ratio or at least allowing the

SEC to provide a number that adds up all of those figures, and let

Morningstar and Don Phillips decide whether that is a number

that really reflects expenses as your exchange with Mr. Pozen

suggested.

Chairman SHELBY. Ms. Roper and Mr. Pozen, could you comment

on the effectiveness of unbundling commissions and tightening the

definition of research as means to reform soft-dollar practice.

Ms. Roper, we will start with you.

Ms. ROPER. First of all, when we talk about banning soft dollars,

we think it is essential that you require the full service firms to

unbundle, that you cannot discriminate against independent research and let Wall Street continue to include the cost of its research in the portfolio transaction costs. So, for us, unbundling is

part of a ban, as well as a possibility for another approach that

stops short of a ban and yet provides significant benefits.

With unbundling, if there is at least disclosure, clear disclosure

of what you are paying for when you are paying those commission—it helps to provide transparency. But it still allows those

costs that are operating costs to be shifted onto shareholders. If

they are legitimate operating costs, they need to be reflected in the

operating expense ratio.

667

Chairman SHELBY. And disclosed?

Ms. ROPER. And disclosed. I think it is Jack Bogel, who said, ‘‘It

is amazing what you are willing to pay when you are paying with

other people’s money.’’ You need to exert some market discipline on

research costs. We need to make sure that when funds are buying

research, they are buying research that adds real value to shareholder and does not simply satisfy certain trading agreements that

they have made with brokers.

I think there is progress that can be made short of a ban, in

terms of making those costs transparent, making it easier for fund

managers to negotiate down their transaction costs. I think the

best solution is to make, I mean, you can, if you get portfolio transaction costs into the expense ratio, then you have solved the problem of the cost shifting onto shareholders.

There are different ways to approach this, but the goal of that

should be one, that operating costs are reflected in the expense

ratio and, two, that costs that should be borne by the fund manager are not shifted onto shareholders.

Chairman SHELBY. Mr. Pozen.

Mr. POZEN. Again, I think that we have to distinguish research

from all of the other goods and services. I think that most of the

other goods and services are readily available for cash, and management companies should pay cash for them, so then we can

eliminate all these issues. The SEC has the authority to do it now.

All they have to change is their interpretation of 28(e).

As to research, I think it is much more complicated. We do not

want to put independent research at a disadvantage to the fullservice firms. And the only way I know to do that is to require an

accounting of the items that compose the full-service commission.

But then I think you should disclose the average commission per

share in the semi-annual reports, and then that would reflect, to

the extent there was any bundling, a higher or lower cost so that

the shareholders could see. If somebody was reporting an average

commission share of 5 cents a share, then they obviously were paying in part for research versus someone who was reporting an average of 3 cents a share. I think from the shareholders’ point of view,

they should understand what is being paid for commission per

share.

Again, what is the real expense of a brokerage transaction? You

have to combine the commission with the spread. And if you start

to try to compute the spread, I really do not know how you would

compute it, and therefore I am very reluctant to say that this is

the total brokerage expense for a fund. I think it is more accurate

to say this is the average commission per share, recognizing that

there are other elements to brokerage cost—the market making

spread, a whole series of other things—and that would be a more

accurate approach.

Chairman SHELBY. Thank you.

Senator Sarbanes, thanks for your indulgence.

COMMENTS OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you, Mr. Chairman.

First of all, I want to thank the members of the panel not only

for their statements here today, but also the careful work that has

668

gone into the written statements which are very helpful to the

Committee.

I want to try to get a little more focus. I want to ask each of you

what you think are the one or two or, if you feel compelled, the

three priorities the Congress should address and whether the SEC

has the authority now to do these items. There are different categories. There are some priorities that you could say this should be

done, and the SEC cannot do it because they need authorities that

they are now lacking statutorily. Therefore, we call on the Congress to give them those authorities. Or, indeed, you can go a step

further and say that is not enough, either with respect to those authorities or authorities they already have; they do not seem to be

moving to apply a standard that we think is appropriate, and

therefore we ask the Congress to apply or impose that standard.

Could we very quickly just get what your top priorities would be

in response to that framework of analysis?

Mr. BULLARD. Sure. My top priorities would be all fee disclosure

proposals.

First, portfolio transaction costs. And I think it is important to

emphasize this is not about the SEC forcing the market to take the

commission, plus the spread, which is routinely measured by fund

boards at virtually every major complex and forcing that on the

market. This is offering the market, this is offering Morningstar a

decision about whether it thinks the best number to use for its clients is a number that includes portfolio transaction costs.

I do not see why either MFS or the SEC should make that decision for the market by refusing to let that portfolio transaction cost

number be added to the expense ratio that the SEC apparently believes is more truthful, notwithstanding that the most recent study

showed it is 43 percent of cost.

In addition to that, dollar disclosure, which Mr. Pozen has just

explained, is not too costly, as argued by the Investment Company

Institute for the last 9 months, and the consumer groups have consistently supported the best possible, most practical approach that

you just described. The SEC, to answer the question of where they

are on that issue, has flatly rejected that approach.

Finally, with respect to 12b–1 fees, I think that that is an area

where we can have real cost savings if we start making investors

see more precisely what they are paying.

I totally agree with Mr. Pozen that I would not repeal 12b–1 unless you still allowed installment loads to be one way that investors

paid, but there is nothing inconsistent about the two. The SEC can

allow installment loads to be used, as well as front-end loads and

back-end loads and any combination thereof, and that is a good

thing for investors. It is just that in each case it should come out

of the investor’s pocket. It should be clearly paid as a result of the

investor’s relationship with the broker so that you do not have this

harmful incentive to buy shares that have an installment load that

the fund is paying, so you do not see the cost, as opposed to a frontend load that comes right out of your pocket.

So it would be fee disclosure, fee disclosure, fee disclosure.

Chairman SHELBY. Professor Lutz.

669

Mr. LUTZ. I would agree that number one, would be to reveal all

fees, but to explain them clearly and understandably and in a format that makes them comparable from fund to fund to fund.

Number two, I would design all disclosure documents, forms, et

cetera, from a user’s point of view. The current proposed forms are

designed from a broker’s point of view, that is, to ensure that the

broker is complying with the regulations. It seems to me that that

is backward. We should design all of the documents from the user’s

point of view.

Number three, I would require all the principals of information

design, and any such forms or documents delivered to people before

and after the sale. That would include usability testing, document

design, plain language, et cetera, so that these are fully understandable as stand-alone documents. You do not need a lawyer and

an accountant to explain these things to you.

I think that, for that third one, perhaps the SEC might need

some small additional funding for that, but once in place, it would

not be a significant expense, but the benefits would be tremendous

from the investors’ point of view.

Chairman SHELBY. Mr. Pozen.

Mr. POZEN. It will not be surprising to know that the first item

I think we should rework is 28(e) for nonresearch items; we need

a better accounting and itemization disclosure system for research

payments done through soft dollars.

The second item, as we are doing at MFS, I would advocate individualized expense reporting based on these two simplifying assumptions—that the person holds all his or her funds through the

whole quarter and that they reinvest their dividends.

The third item, which I think Barbara raised, is an interesting

point about the hard close. My concern is that this is not an authority issue so much as a practicality issue. I have been involved

with the development of a lot of computer systems, and let us put

it this way, it is very rare that you see a big system brought in

on time and on budget, and that these macro systems are very expensive and take a long time.

I would actually be in favor of a much simpler system in which

any pension fund or any brokerage firm that sends bundled orders

to a mutual fund be required to certify that all of the orders were

submitted to them before 4 o’clock, and we should have some random audit that should be done by their auditors to make sure that

that is really true.

All of the cases of late trading that I know of involve instances

of collusion, where people were actively colluding with firms. What

we need is both a certification and an outside person, an external

auditor and perhaps an occasional SEC random check, to make

sure that when these firms put a time stamp on an order and when

they certify that it was submitted before 4 o’clock, it actually was.

MFS was never involved with any of these collusive activities, so

I am not an expert on them. But it seems logical to me that before

developing a hugely expensive computer system, we should again

look at what is a good system rather than the best, go to timestamping, with an external audit and an occasional random check.

This might be the most practical way to deal with this very difVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00681 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
670

ficult set of issues for pension funds and brokers that send bunched

groups of orders rather than individual orders.

Senator SARBANES. Ms. Roper.

Ms. ROPER. Our top priority, as I said before, is that we develop

a system of mutual fund disclosure that is designed with average,

unsophisticated investors in mind to give them presale comparative

cost disclosure and other key information—about the fund, such as

risks or investment style, strategy, who it is appropriate for—at

the point that that fund is recommended so that we enable investors—average, unsophisticated investors—to make better mutual

fund purchase decisions.

The SEC in our view has the authority to do that, but has not

taken that approach. And what is interesting is they have now created the opportunity with their proposed disclosure, at point of

sale, which we would like to see as a point of recommendation. But

with their proposed disclosure on broker-dealer costs and conflicts,

they have introduced a point in the transaction where you can provide that disclosure, but have not taken the next step of saying

that we are going to disclose not just these distribution-related

issues, but this mutual fund information as well.

Beyond the specific issues, I already outlined where we believe

the SEC needs added authority, there is another longer-term issue

that I think is extraordinarily important, and that has to do with

brokers; sales practices. Anyone who has looked at a broker’s ad

sees that they portray themselves to the public as if their investment advice were the primary service they had to offer, as if they

were objective professional advisers. Yet the law says that they are

salespeople and that they are exempt from the Investment Advisers Act to the degree that they give advice that is solely incidental,

or merely secondary, to product sales.

I think this disconnect between how brokers market themselves

to the public and how they then behave in reality has a lot to do

with the lack of effective cost competition in the mutual fund industry. They have an impression that they create with the investor

that they are operating in their best interests, but no legal obligation to do so. They have an obligation to make generally suitable

recommendations, which, as enforced, falls far short of any obligation to act in their clients’ best interests, or to put their clients’ interests ahead of their own.

Even where we have for advisers an obligation to put their clients’ interests ahead of their own, we have never seen that enforced in a way that makes them take costs and quality of the

product into account in their recommendations.

And so I think there is a longer-term agenda of looking at the

way that we sell products to the investing public that looks at this

disconnect between the image that is planted in the public’s mind

about what to expect and the reality of practices. That would go a

long way toward helping average investors. Because we can do

great disclosure. I mean, we could design a system that provided

great disclosure. But you have to take into account the reality that

the average person who goes in and consults a broker does not expect to second-guess their recommendations. So what are we going

to do to make sure that they get the services that they expect when

they enter that relationship?

671

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Professor Lutz, you are a lawyer and an

English professor. You have a Ph.D. and a J.D. You state that mutual fund disclosure is confusing because investors are presented

with a lot of data that is located in several documents. It seems

that fund disclosure documents are written by lawyers for lawyers.

I appreciate that there can often be a balance between insuring

sufficient disclosure to protect against legal liability and presenting

information in an easy-to-understand manner. For example, some

would contend that technical language is necessary in order to protect the funds against subsequent allegations that they did not provide full disclosure. How do you balance these interests and give

investors the information that they need to make informed investment decisions, as well as comply with the necessary language to

protect the——

Mr. LUTZ. There is no conflict.

Chairman SHELBY. No conflict. I am glad to hear that.

Mr. LUTZ. Well, stop and think for a second. We are talking

about using plain language to explain things. How can we be distorting or hiding?

Chairman SHELBY. The people that contend otherwise, it is not

a good argument, in other words.

Mr. LUTZ. But I have done it. The State of New Jersey has a

plain language law which it passed over 20 years ago. I was in law

school at the time that the New Jersey legislature passed it. I remember the instructor in one of my courses saying, he called it the

Employers’ Full Employment Act because we would be litigating all

of these plain language documents. Since that time there has not

been one lawsuit in the State of New Jersey over the plain language documents that are used.

The Michigan State Bar Association a few years ago conducted

a search as far as they could find any lawsuits, whether Federal

or State level, brought because of plain language, and they found

none. Since I have translated technical language into plain language, stop and think for a second. What you are saying is that

only these words can communicate this reality. It is linguistically

impossible. This is why we have synonyms.

Chairman SHELBY. Ms. Roper, you know the SEC has recently

proposed rules requiring brokers to make certain disclosures to investors at the point of sale. Would you discuss how investors might

benefit from point of sale disclosure regarding the cost, the expenses, and performance of the fund that they are purchasing.

Ms. ROPER. Right. First of all, I want to move the timing back.

I want it at point of recommendation, not at point of sale. I think

if you get a document when you are ready to write the check or

transfer the money, you have made your decision. You are not

going to then carefully review that information. So the information

needs to come at the time when you are still considering your purchase so that you can factor it into your purchase.

It seems to me to be simple common sense, that if we want people to make cost-conscious purchase decisions, that we should give

them information about costs before they make their purchase.

Right now, if you buy through a broker, you do not have to get

that prospectus until 3 days after the sale. The likelihood that you

672

will then take that information and act on it and try to rescind that

transaction or bear the costs of changing into a lower-cost fund is

just remote, at best. If you want people to have information they

are going to act on, common sense dictates it has to be presale.

I think if you then present the information in a way that is compelling—not just data, as Professor Lutz said, but information in

a way that is compelling. You could, for example, say, when we

talk about comparative information—and I do not have all of the

answers about the best way to do this—but say you said this is

how the costs of your fund compare to the category average costs,

this is how it compares to an index fund that invests in the same

type of securities, and this is the dollar cost implications of that

difference over 1-, 5-, and 10-year periods. Assuming the same rate

of return, this is what you are going to pay more or this is what

you are going to save, by virtue of the costs of your fund, how it

compares. If you give that information to people in advance of the

sale and say, look, you are going to pay $900 extra over the next

10 years because you chose this fund rather than one that has just

average costs or you are going to pay more than that extra because

you chose this actively managed fund rather than a comparable

index, you might get people to factor costs into their decisions.

What that means is that 30 years down the line when they are

retired, it is tens of thousands of dollars that they have in their retirement savings account that they would not have had, had they

invested in a high-cost fund. That, to me, is why we have to care

about this issue. We know that people are not making adequate

preparations for retirement. We have a way that we can help address that situation by giving them information that they can use.

I think we should be doing it. We should reflect, in our approach

to disclosure, the fact that the markets have changed.

Chairman SHELBY. Information they can use before they make

their decisions.

Ms. ROPER. Before they make their decision, and information

that is designed with the idea in mind that the nature of investors

has changed in the last 20 years, that we have a lot of people in

the markets today who are not financially sophisticated. We need

to design a system with them in mind.

Chairman SHELBY. Professor Bullard, do you have any comments?

Mr. BULLARD. Sure. I would like just to add to your question

about liability versus plain English. I think there are situations

when they can be in conflict. To give you an example, there was

a District Court decision recently in which a plaintiff alleged that

there was a fund that had A, B, and C shares and that there was

no rational investor for whom B shares could possibly be the best

investment. The question was do you have to tell them that in your

prospectus? Do you have to say in your prospectus, look, we are offering you A, B and C, none of you could conceivably be better off

with B?

The Court said, okay, I will assume that that is the case, and I

will find there is absolutely no obligation to disclose that no one

would be better off buying B shares. This was the holding of the

Court.

673

The SEC has specifically decided not to require that you explain

to people the pros and cons of different classes and that you do not

have to tell people when one of those classes would never be the

best investment.

Now imagine that you are counsel for that fund, and they come

to you and they say, well, clear language would require that we tell

them do not buy B shares, even though we are offering them, and

the lawyer has to tell them you would be out of your mind to say

anything about those B shares because, first of all, you will not sell

any and second, you will get sued, and the District Court has just

told you, you are completely insulated if you keep your mouth shut.

There are other instances like that when they are in conflict.

That is why we need the type of disclosure that we have been talking about today.

Chairman SHELBY. Mr. Pozen, do you have any comments?

Mr. POZEN. We had an effort maybe 5 or 6 years ago, and I actually designed what was called a short-form prospectus, and at that

point people were trying to come to grips with the fact that most

investors will not read a long prospectus. And with all respect to

Professor Lutz, if it is a 20-page prospectus, even with his great

English, I am not sure they are going to read it.

Chairman SHELBY. But they have a better chance to read it.

Mr. POZEN. They would have a better chance, but——

Chairman SHELBY. And a better chance to comprehend.

Mr. POZEN. I agree, but they would have a much better chance

if we could have a 3- or 4-page prospectus in Q&A form, and that

is what was developed, plus a backup longer form.

I guess I am just wondering out loud whether or not, regardless

of how well you write the prospectus, if it is 20 or 25 pages long.

I have a feeling that a lot of people I know who are not investment

experts would still go to sleep on the prospectus. I urge the Committee to look at these short-form prospectuses that were done.

They were done especially for 401(k) plans. They were all done in

similar question and answer order. They gave you the gist of the

prospectus so you could get most of what you want quickly.

The real dilemma here is the investor will read something that

is short and gets at the major points, but there are a lot of other

points that the investor probably should take into account. Once

you start putting all of those in, even though you do a good job,

like Professor Lutz says, it gets to be a 20- or 25-page document.

So, I am still trying to figure out how you resolve that tension.

But I know one thing, when we did a number of focus groups,

more people will read a 3-page prospectus than will read a 20-page

prospectus, no matter how well that 20-page prospectus is written.

Chairman SHELBY. But the bottom line is what is in that information and how well-disclosed it is.

Mr. POZEN. I agree with that. But still, if you are going to do a

3-page prospectus with a backup, you inevitably have to focus those

3 pages on the main points, and there are other points which can

be important in individual circumstances which you are not going

to be able to get into those 3 pages.

Chairman SHELBY. But what we are trying to do, at least this

would be my perspective, is to have a well-informed mutual fund

purchaser.

674

Mr. POZEN. Sure.

Chairman SHELBY. You know, a purchaser of mutual funds

would know what the costs were. Nothing hidden, no hidden

agenda——

Mr. POZEN. I agree with that.

Chairman SHELBY. —nothing hidden by words or deeds and so

forth. In other words, we have all been taught, I think, that an informed purchaser is the best purchaser because then they can

trade or not trade in the marketplace.

Mr. POZEN. My experience has been that if we really want to accomplish that goal in practice, we need what I call ‘‘tiered’’ disclosure. We need a short-form prospectus in 3 or 4 pages that you can

look at quickly, and then we need that to be backed up with a 20-

or 25-page prospectus that Professor Lutz would write in plain

English.

Chairman SHELBY. All of this reflecting the truth, though.

Mr. POZEN. Of course. All I am trying to say is that there is a

tradeoff—the more information you give people, the longer the prospectus is, the less likely people are going to read it. What I mean

by a tiered disclosure system, what I would like to see, is a good

Q&A, short-form prospectus which would be attached to the longform prospectus, so that people would have the benefit of getting

the main points in those 3 or 4 pages. Then if they wanted more,

we would encourage them to read the full prospectus.

As a practical matter, from my experience with focus groups,

many investors are not prepared to read the full 20 to 25 pages no

matter how good the English is, no matter how good the disclosure

is. So that is why I am in favor of two documents—a short-form

prospectus and then a full prospectus written in plain English, as

Professor Lutz suggests.

Chairman SHELBY. Professor Lutz, throughout this reform process, we have tried to remain mindful as to the increased costs that

might accompany the proposed regulatory reforms because ultimately the shareholder is going to pay the cost. Could you estimate

how much it would cost mutual funds and broker-dealers to revise

their disclosure practices to incorporate the information design and

usability reforms that you have suggested. If you want to do that

for the record or you can do it now.

Mr. LUTZ. I could not give you a dollar amount. Based on my experience, I can tell you that it is capital intensive, but it is something that, once done, lives for the life of the investment.

Chairman SHELBY. What is done is there, is it not?

Mr. LUTZ. So the costs are spread out over the life of the form.

But the forms that we are looking at would come from the SEC and

would be model forms.

They could be easily customizable through desktop publishing, so

it really does not become that much of an expense once it is installed, as a continuing expense.

Let me say one thing about the short form, if I may.

Chairman SHELBY. Okay.

Mr. LUTZ. I helped design short forms at the SEC. When we did

the plain language project, we did a number of them. I think there

is a misperception here about a 20-page document and people not

wanting to read it. It is not a matter of plain language. It is a matVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00686 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
675

ter of document design, making the information attractive, enticing, making you want to read it.

Chairman SHELBY. Understandable.

Mr. LUTZ. Drawing you into it. What do we do with magazines?

The magazines make you want to read them. That is the whole

purpose of their design. We should do the same thing. There is no

reason why we cannot.

Chairman SHELBY. You could usher in a new era in the average

American’s financial literacy, could you not?

Mr. LUTZ. Absolutely, and there is something else that nobody

has mentioned here. We are all talking about writing these documents of what we want them to know. One of the things that I

have learned as a teacher is that I never know what they do not

know, and I am always amazed to find out what they do not know.

Chairman SHELBY. Should it not be what they should know?

Mr. LUTZ. Well, you start with what they want to know first. Let

me give you one simple example. I have done work with some of

the health disclosure issues currently in the medical profession,

and the hospital had designed a very good document on a procedure to get the permission of the patients, but none of the patients

were paying any attention to it. And when they sat down and

talked to them about it, the first question that the patients had

was, how much does this cost? Because if I cannot afford it, I am

not going to read this pamphlet. And the hospital never thought to

even mention cost in the document. It was not in their minds.

We do not know what is in the minds of investors. That is why

we do usability testing, to sit down and find out what it is they

want to know, and that becomes our starting point for disclosure,

and I agree, you are absolutely correct. We have to also educate

them at the same time, but if we are going to get them to read

those 20 pages, we are going to lure them in by giving them what

they want to know.

Chairman SHELBY. After all, it is their money, is it not?

Mr. LUTZ. All of it is their money.

Chairman SHELBY. It is their investors’ money, the $7 trillion,

the 100 million people, more or less, that invest, and they should

have the knowledge of what is happening to their money.

Mr. LUTZ. They should have some say in it someplace along the

line. Every penny of every expense and every salary is their money.

Chairman SHELBY. Mr. Pozen, in addition to the governance reforms proposed by the SEC, some people contend that additional

reforms are necessary.

First, some contend that Congress should amend the Investment

Company Act to give fund boards authority to hire and fire the investment adviser without having to get a shareholder vote. Many

believe that this authority would shift the balance of power from

the adviser to the board.

Second, others contend that Congress should redefine the fiduciary standards for fund boards and advisers.

What is your perspective on these two proposals, the issues?

Mr. POZEN. On the first one, in terms of the management contract, I think that there is a lot of power now in the independent

directors to terminate management contracts and to change management contracts. Also to the extent that the shareholders have

676

bought into a fund because they have been attracted by the management company, I think they have a right to have some say in

whether or not the management company that they chose, would

continue to be there.

Chairman SHELBY. But does the board not run companies?

Mr. POZEN. The independent directors of the management

company——

Chairman SHELBY. The shareholders elect members of the board.

That is true of anything. So if the board runs things, should they

not have the ability to hire and fire?

Mr. POZEN. They have the ability to fire a management company

now.

Chairman SHELBY. The board now has the ability, in corporate

America, to fire a chairman or to fire a president.

Mr. POZEN. So I have heard.

[Laughter.]

Chairman SHELBY. Is this not right, though?

Mr. POZEN. I believe that the independent directors of a mutual

fund board now have the power to terminate the advisory contract

of a director, and they have the power also to change the terms,

to negotiate new terms of the contract.

Chairman SHELBY. But without getting a shareholder vote.

Mr. POZEN. Yes, without getting a shareholder vote. I think they

have the power now. They have the ability to terminate an advisory contract now.

May I ask Professor Bullard for a little help on this one? Do the

independent directors have this legal authority?

Mr. BULLARD. The directors at any time can terminate the adviser, as long as they are willing to be sued for the next 5 years

by the fund manager. If you are going to do something, you might

provide them that protection, something that certainly would be

appreciated by the Navellier directors, who I think 7 years after

the battle they had with the fund manager are still in litigation.

Mr. POZEN. I have terminated subadvisers without a lawsuit.

Chairman SHELBY. But you cannot be intimidated by the adviser.

What if he is a sorry adviser, and you say, ‘‘Gosh, what you are

giving me is wrecking the fund. You have to——’’

Mr. POZEN. There are two different issues—a legal issue and a

factual issue. Legally, I believe that the independent directors now

have the authority to terminate the adviser if they do not think the

adviser is doing a good job and that that power is there and is already in the statute in Section 15 of the Investment Company Act.

As to the second question of fiduciary duties, I think that there

already are fiduciary duties under State law, the duty of care and

duty of loyalty that are incorporated through Section 36(a) of the

Investment Company Act. And Section 36(b), which is on fees, has

been heavily litigated, and I think the case law is pretty good.

The last thing I would like to do is to change the fiduciary standard so that we then have another 10 years of litigation to try to

figure out what exactly that standard means.

So, I believe that on these two issues, the statute and the case

law are already in a reasonable position.

Mr. BULLARD. Mr. Chairman, if I could add something to that.

The record under the fiduciary standard in the case law is pretty

677

good because no fund manager has ever lost a decided case under

Section 36(b) in a private action.

Mr. POZEN. But there have been a lot of settled cases.

Mr. BULLARD. There have been a lot of settled cases.

Mr. POZEN. That is true of most class action lawsuits. Very few

of them go to actual judgment.

Mr. BULLARD. Right, that is true. And frankly, I am not that big

a fan of private class actions as a way of inducing competition, but

even more noteworthy is the fact that in 34 years, this provision

the SEC specifically asked for has never exercised its authority

under 36(b) to bring a true excessive fees case against a board that

signed off on an excessive management fee.

There have been two 36(b) cases, and neither is really an excessive fee case. They are essentially churning cases where fees being

charged that should not have been charged in the first place, not

that the advisory agreement fee was too high.

Mr. POZEN. I think you would agree, Professor Bullard, it is not

for lack of legal authority that the SEC has not brought a case.

Mr. BULLARD. That is correct. The SEC has made a conscious

decision not to bring those cases, and it is a real gap in their enforcement program, and there are cases out there they can bring.

Chairman SHELBY. Why, though? What is behind the conscious

decision?

Mr. BULLARD. The investment management directors have said

that they tried to find cases and have not been able to find them.

I think that they need to be more aggressive. I think that this is

not the Fidelitys that they should be suing, as are typically the defendants in the civil cases. These are the outliers, where the expense ratio is 5 or 10 percent of assets, and the performance has,

for 5 or 10 straight years, lagged the S&P 500, where there is no

rational basis for the fund directors to approve those contracts.

I think Mr. Pozen would agree, if you can give me those set of

facts, that is a case where the SEC should sue that fund board

under 36(b).

Chairman SHELBY. Mr. Bullard, you state that 12b–1 fees have

evolved beyond their intended purpose and are now used as substitutes for sales loads. In a sense, fund advertising cost and distribution costs are blended.

Comment, if you would, on the SEC’s concept release regarding

changes to Rule 12b–1 and how advertising and distribution fees

might be separated, also how would such a separation impact mutual funds and broker-dealers.

Mr. BULLARD. Well, the first step the SEC has taken and has

said that you simply cannot use a fund asset in the form of the

fund’s brokerage to pay brokers for sales. I think the SEC will finalize that position and that issue will be taken care of.

As to the separation of the two, I do not believe the SEC can

really do what is necessary because of the current lack of statutory

authority to expressly allow, if 12b–1 fees are not used, some other

source of fund assets to pay for, let us say, Money magazine advertisements, what I would call classic distribution services. You need

Congressional action, you need an amendment to Section 12b to expressly allow the management fee to be used for that purpose, and

678

thereby give the fund manager incentive to keep those costs low,

albeit allowed to spend that money.

As far as the sales charges go, I agree, as I said before, I agree

with Mr. Pozen. You should not repeal 12b–1, if you are then going

to be depriving shareholders of the ability to, instead of paying a

front-end load or a back-end load, spread that load out over time.

But that is already possible under SEC rulemaking authority. They

can allow, under whatever set of standardized arrangements they

choose, brokers to collect a front-end load on an installment basis,

be it 25 basis points a quarter, 100 basis points at the end of each

year, either paid by through a check written by the investor or paid

by automatic redemptions from fund shares.

So there are a lot of different ways to do it. The key is not to

change any of the payments that are currently made, and not in

any way to force any reduction or increase. It is simply to rationalize the way in which they are paid. When you pay your broker,

it is coming out of your pocket, whether it is an installment load

or not, and you can see what that cost or that relationship is and

understand that this is not a fund cost. This is a cost that you are

incurring because you need the services of that broker, and that is

what will make you think twice about whether you are paying too

much and whether you need to get smarter about making more investment decisions perhaps with a little less help.

Chairman SHELBY. Do you agree with Professor Bullard?

Ms. ROPER. I do. When you look at the evolution of 12b–1 fees,

I think you need to keep in mind that there is a reason we have

gone to compensating brokers this way. And it is because when we

first created no-load funds and investors were presented with a

clear choice between paying a load and not paying a load, they

said, ‘‘Well, I do not want to pay a load. Why would I want to pay

this sales charge?’’ And so there was an effort made to shift the

way that we pay brokers so that it is less evident to investors.

Chairman SHELBY. But should the investors not know?

Ms. ROPER. Yes. As you look at how you reform 12b–1 fees, the

goal should be that investors understand what they are paying for

the services from their brokers and what they are paying for the

operations of the funds and how those two things are separate.

Right now the disclosures I do not think effectively do that. I do

not think there is a single one approach that solves the 12b–1

problem, but I agree you should have an ability to pay an installment load. You should recognize that that is what you are paying

for the services of the broker and, frankly, I think it should be

something that is negotiated between the investor and the broker

and not set by the mutual fund.

When I buy a share of stock, the company that issues that stock

does not tell me how much I have to pay my broker to buy that

stock, but the mutual fund does. And so what you do is you take

that element of broker compensation out of the competitive marketplace. It is not negotiated between the investor and the broker in

the same way, and you create a system in which mutual funds

compete to be sold instead of competing to be bought, and they

compete to be sold by offering financial incentives to the broker.

And so you have a system of reverse competition that drives

costs to investors up, not down, and makes it possible for mediocre

679

funds to continue to survive by virtue of offering generous compensation to the broker. I think the SEC concept on 12b–1 fees is

a very helpful start, but there is a broader look that needs to be

taken on how we design this system so that it better aligns investor interests with the funds. It better protects investor interests,

better ensures that there is an incentive on the part of the broker

to sell them a good fund instead of one that pays the broker well.

Chairman SHELBY. Mr. Pozen, how, if at all, should 12b–1 practices be reformed, from your perspective?

Mr. POZEN. I, again, think that the key is for investors to know

what they are getting. I think it is perfectly reasonable for some

people to want to pay up front, for other people to want to pay on

an installment basis. The question is: Do they know exactly what

they are paying on an installment basis?

You do have in the prospectuses now a separate line for 12b–1

fees, but it is expressed in basis points. Maybe we should express

this in dollars so people would have a better sense of what it actually is. As long as they know, at the point of sale, what the various

fees are, including the 12b–1 fees, then we should give them whatever choice they want.

Mr. BULLARD. Chairman Shelby, if I could just clarify one point

Ms. Roper made.

Chairman SHELBY. Go ahead.

Mr. BULLARD. When she said that an ultimate goal would be to

try to ‘‘unfix’’ these payments, just so we understand, that under

the Investment Company Act, prices for mutual funds are fixed,

not just with respect to the shares themselves, but what you pay

to the broker. And ultimately it would truly be a courageous step

for the Committee to look at the question of whether we need to

repeal fixed pricing, which the Division has supported repealing for

almost 15 years, the Division of Investment Management.

Mr. POZEN. I am sorry. I do not understand what you mean by

‘‘fixed pricing.’’

Mr. BULLARD. Well, under the Investment Company Act, Section

22(d), a broker is only allowed to sell shares at the price in the prospectus, and that price in the prospectus includes not only the NAV

or the way the NAV is calculated, but also the percentage that the

broker gets paid.

A broker cannot give you a discount on the front-end load, for example, it cannot give you a rebate of the 12b–1 fee, for example,

if you happen to be an investor who requires a lot less services

than some other investor, and that is because, under 22(d), those

prices are required to be fixed.

In a SEC Division of Investment Management study in 1992, the

Division came out in opposition to 22(d) and in favor of its repeal,

and I think that that ultimately should be the direction that we are

going to be going in, whether it is now or later. Just as commissions were unfixed in the 1970’s for a retail brokerage, it is inevitable that they will become unfixed in the fund industry. It is just

going to be very hard to do that as long as we force the tying of

the product price and the distribution price. You have to separate

the distribution costs from the product costs in order then to allow

the freeing up of the distribution costs and competition between

brokers, as far as their charges go.

680

Mr. POZEN. Chairman Shelby, with all due respect, I believe

Professor Bullard is technically right, but as a practical matter, the

results are quite different.

You are allowed, under Section 22(d), to create any waiver you

want, and the SEC is extremely flexible in allowing you to create

many types of pricing waivers. Therefore, you will see differential

sales loads based on how much you invest, based on whether you

are a trust, based on whether you are a retirement plan. There is

a broad range of flexibility in pricing.

However, if you decide that you are going to treat, say, all charitable trusts one way, and you put it in your prospectus, then you

have to follow the language. But you can even say for a charitable

trust, if the charitable trust invests more than $25,000, we will

charge them 2 percent load, rather than 4 percent load.

So, in practice, Section 22(d) is a weak constraint; I am impressed by how much flexibility that Section provides load waivers.

And I think, in the scheme of things, increasing that flexibility is

a minor point, rather than a major point.

Mr. BULLARD. Just to clarify, all of those variations are done by

the fund, not by the brokers. Once Fidelity or MFS sets all of those

variations, the brokers have no leeway to change them based on

their actual relationships with their clients, based on the services

their clients provide to them and how much those clients value

those services.

Mr. POZEN. I can assure you, if the brokerage community says

we need a certain set of waivers, then those waivers will definitely

be provided.

Mr. BULLARD. Yes, but brokers like fixed commissions. Consistently, if you have regulators come in and fix prices, it is more profitable for the industry.

Chairman SHELBY. Let us give Ms. Roper the last word.

Ms. ROPER. I would just say the last thing the brokers want is

for customers to be able to negotiate those costs and to have them

subject to actual price competition. It is not in their interests.

Chairman SHELBY. What we really want is the market to work,

do we not?

Ms. ROPER. Right. What I think Professor Bullard and I are saying is this is an area where the market does not work. It is not

allowed to work. It is not allowed to discipline those costs.

Chairman SHELBY. I want to thank all of you for appearing

today. We are continuing to learn a lot as we look into these abuses

in the mutual fund industry. I want to thank all of you.

Mr. BULLARD. Thank you, Chairman.

Ms. ROPER. Thank you.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 12:02 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

681

PREPARED STATEMENT OF MERCER E. BULLARD

PRESIDENT AND FOUNDER, FUND DEMOCRACY, INC.

ASSISTANT PROFESSOR OF LAW, UNIVERSITY OF MISSISSIPPI SCHOOL OF LAW

MARCH 23, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

thank you for the opportunity to appear before you to discuss enforcement and regulatory developments in the mutual fund industry. It is an honor and a privilege to

be before the Committee today.1

Introduction

The Committee’s topic today is current investigations and regulatory actions regarding mutual funds, and this is precisely where the Committee’s focus should be.

With more than $7 trillion in assets, mutual funds are this country’s most important investment vehicle. The ongoing scandal in the mutual fund industry has demonstrated the need for significant reform in mutual fund regulation. I applaud this

Committee’s deliberate, thorough, and careful review of the full range of issues facing fund regulators and the fund industry today.

I commend the efforts of the Commission, Attorney General of the State of New

York, Secretary of the Commonwealth of Massachusetts, National Association of Securities Dealers (NASD), other regulators, and the Justice Department for their

forceful and diligent investigation and prosecution of persons and firms who have

violated the law and investors’ trust.

I applaud the efforts of the Commission and NASD to identify gaps in regulation

and propose practical, effective solutions. As a former member of the staff of the Division of Investment Management, I am especially impressed with the Division’s extraordinary accomplishments of the last 4 months. During this time, the Division

has made more progress in reforming mutual fund regulation than in any period

in its history.

As the Commission has itself noted, however, there are many important gaps in

regulation that it does not have the authority to address. There are also instances

in which the Commission has the authority to effectuate important reforms, but it

has chosen not to do so.

Where the Commission cannot or will not implement reform, legislation provides

the only hope for promoting competition and adequately protecting investors. Part

I of this testimony discusses the following areas where Congressional action is necessary: mutual fund governance, disclosure of fund fees, soft-dollar and distribution

arrangements, and misleading fund names.

Part II briefly describes other areas where reform is needed and the Commission

has taken reasonable steps in the right direction. This Committee should note, however, that the Commission is divided on a number of these matters. The Committee

should continue to be vigilant that a minority of the Commission does not succeed

in derailing these efforts.

I. Areas Where Legislation is Necessary

MUTUAL FUND GOVERNANCE

The problems with mutual fund boards fall into two categories: (1) oversight and

accountability, and (2) independence and authority. Fund directors will not actively

negotiate fees to keep fund costs low or assiduously fund managers’ conflicts of interest without guidance as to the minimum standards to which they will be held

and accountability for living up those standards. No amount of board oversight and

accountability will help shareholders if directors do not have the independence and

authority to effectively carry out their mandate.

Mutual Fund Oversight Board

As I discussed in prior testimony,2 the mutual fund scandal reflects pervasive,

systemic compliance failures that require structural changes in the way that fund

boards are regulated. These failures can be partly traced to a lack of guidance regarding the minimum standards to which boards will be held in the fulfillment of

their duties. To address this problem, Congress should create a Mutual Fund Oversight Board that would provide such guidance.

This Board would promulgate informal, minimum standards for fund boards regarding a range of issues, including fee negotiations, fair value pricing, market timing policies, redemption policies, and distribution practices. The Board’s focused

mandate would give it the flexibility to respond quickly to changing circumstances

and to develop an unparalleled depth of expertise regarding the role of fund directors. The model for the Board, the Public Company Accounting Oversight Board, is

682

widely considered one of the most effective creations of the Sarbanes-Oxley Act of

2002.3

The Commission does not have the authority to create a Mutual Fund Oversight

Board or the capacity to provide effective guidance itself. For example, the Commission issued guidelines for the approval of 12b–1 plans in 1980 that have never been

updated,4 despite repeated promises do so.5 The requirements of the formal rulemaking process, among other things, make it difficult for the Commission to maintain current guidelines for fund directors. The breadth of the Commission’s mandate

also makes it difficult to stay continually focused on the evolving responsibilities of

fund boards. The Oversight Board would effectively supplement the Commission by

providing the kind of current, continuous guidance necessary for boards to function

effectively.6

The Board also would have examination and enforcement authority over mutual

fund boards. It would be charged with identifying potential problems in the fund

industry and ensuring that fund boards are actively addressing these problems

before they spread. For example, the Board would promulgate guidance regarding

current regulatory issues and best practices regarding how to deal with them, and

examine boards to ensure that they are taking necessary steps to protect shareholders.

One reason that an oversight board is needed is that the Commission has not held

fund boards accountable for misconduct. The Commission’s enforcement actions in

the wake of the mutual fund scandal have suffered from a major flaw. To date, not

one case has been brought against an independent fund director, despite settlements

involving dozens of different complexes and individuals.7 A settlement was recently

announced regarding fund directors who exempted a market timer from a fund’s redemption fee, yet the only punishment for such misconduct was that the directors

would have to retire by the end of 2005.8

In 2003, the Commission agreed to settle charges with the directors of the Heartland funds with the sole penalty being a cease and desist order.9 These directors

were responsible for overseeing the worst mispricing incident in the history of the

fund industry, in which shareholders in two Heartland funds lost 70 percent and

44 percent of the savings in a single day in 2000. Nonetheless, they were permitted

to retain their directors’ fees—even those earned during the 3 years that the case

was pending. In dissent, Commissioner Campos stated:

The investigation in this case presents significant evidence, if proven at

trial, of directors, having unambiguous information that funds’ NAV is significantly overstated and that the funds were illiquid, failing to act in any

meaningful way to protect shareholder interests.10

In view of the extraordinary level of misconduct involved in the Heartland matter,

and the impotence of the penalty imposed, it is difficult to imagine the Commission

justifying any sanction on any fund director in connection with current mutual fund

scandal.

For 34 years, the Commission has abdicated its statutory duty to prosecute funds

and directors for excessive fees. Section 36(b) of the Investment Company Act, which

was passed in 1970, provides that a fund director and fund manager shall have a

fiduciary duty with respect to the fees charged by the fund, and tasks the Commission with bringing actions against directors and fund managers who violate this

duty. The Commission has never brought a case for excessive fees.11

The Mutual Fund Oversight Board would remedy the Commission’s failure to hold

independent directors accountable by promulgating and enforcing minimum standards of conduct for fund boards.

The Board would be financed from assessments on mutual fund assets to provide

an adequate and reliable source of funding. Board members would be persons with

specific expertise in the fund industry and would be appointed for 5-year terms by

the Commission to ensure their independence. This model, which ideally combines

the strengths of independent, expert oversight with the advantages of a reliable and

adequate funding source, would do more to restore confidence in the fund industry

and protect fund shareholders than any changes in the makeup, qualifications, or

authority of fund boards.

Board’s Fiduciary Duty

Creating a Mutual Fund Oversight Board alone will not be sufficient to ensure

that fund directors are held accountable for failing to protect the interests of shareholders. Under current Federal law, the only express fiduciary duty that applies to

directors is limited to fees paid to the fund manager.12 When a fund’s high fees are

attributable not to fees paid to the fund manager, but to fees paid on account of

the administrative expense of operating a small fund, this fiduciary duty is not trigVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00694 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
683

gered. Thus, a fund director’s decision to offer a fund with an 8 percent or 10 percent expense may be reviewable only under a toothless State law standard.13 Congress should enact legislation that creates a fiduciary duty for fund directors that

would require, for example, that directors affirmatively find that the fund could be

a reasonable investment in light of its investment objective, performance history,

and expenses. The Commission does not have the authority to establish such a fiduciary duty.

Directors’ Independence and Authority

As discussed above, recent frauds demonstrate systemic weaknesses in mutual

fund compliance. These systemic weaknesses necessitate the creation of a regulatory

structure, such as a Mutual Fund Oversight Board, that is designed to ensure that

fund boards of directors fulfill their responsibility to protect shareholders. A fund

board cannot protect shareholders unless its independent members have the independence and authority necessary to counter the influence of the fund manager.

In order for independent directors to provide oversight that is truly free of the

fund manager’s control, the board’s chairman must be independent, the board must

be at least 75 percent independent, and the definition of independent director must

be amended to exclude former directors, officers, and employees of the fund manager. In addition, independent directors should have to stand for election at least

every 5 years. Independent fund directors often are appointed by the fund manager

or nominated as the result of a relationship with the fund manager and never stand

for election because funds—unlike publicly traded companies—are not required to

elect directors periodically. Finally, as suggested by the Commission, Congress

should require that independent fund directors perform a self-evaluation at least annually and meet at least quarterly in a separate session, and expressly authorize

independent directors to hire their own staff.

The necessity of these reforms has been well-documented over the last year—in

a wide range of contexts including statements by Members of Congress, Commission

releases, and Congressional testimony—that does not need repeating here.14 What

needs to be emphasized here is that, contrary to popular perception, the Commission

does not have the authority to enact these reforms. The Commission does not have

the authority to require a fund to have an independent chairman or a 75 percent

independent board, to hold separate meetings of independent directors, or to require

annual self-evaluations. These reforms can only be accomplished through legislation.

Although the Commission has proposed certain fund governance rules,15 these

will not be remotely as effective as legislation for two reasons. First, the Commission

has excluded critical reforms from its proposal. The Commission’s proposal includes

no provisions that would prevent a former director, officer, or employee of the adviser from being considered to be an independent director. Nor does the Commission’s proposal include any provision regarding the election of independent directors,

thereby effectively leaving their election in the hands of fund management. Only if

Congress passes legislation will independent directors have to be truly independent

and at least periodically meet with the approval of fund shareholders.

Second, the Commission’s proposal does not effectively require fund boards to be

75 percent independent and have an independent chairman. In fact, as the Commission concedes, the proposed rules ‘‘would apply only to funds that rely on one or

more of the Exemptive Rules.’’ 16 The Exemptive Rules to which the Commission refers are rules that many funds may, but are not required to, rely on in the operation

of their funds. For example, a fund can charge a 12b–1 fee only in compliance with

Rule 12b–1. The Commission proposes to amend Rule 12b–1, among other Exemptive Rules, to require that funds relying on Rule 12b–1 comply with certain fund

governance provisions.17 If a fund cancels its 12b–1 plan, however, it will be able

to replace its independent chairman with an officer of the fund manager and reduce

the percentage of independent directors from 75 percent to 40 percent (the statutory

minimum), thereby returning control of the board and fund in the hands of the fund

manager.

The Commission claims that, ‘‘[b]ecause almost all funds either rely or anticipate

someday relying on at least one of the Exemptive Rules, we expect [the governance

conditions] would apply to most funds.’’ 18 This is no doubt true, but it is not ‘‘most

funds’’ at which these provisions are targeted. These governance measures are targeted at funds where the likelihood of fund manager overreaching is greatest. The

Commission’s proposal has a fatal Achilles’ heel. When the independence of the

board is most critical, that is, when there is a conflict between the board and the

fund manager, the board will know that the manager need only cease relying on

the Exemptive Rules to dismiss the independent chairman and eviscerate the independent majority. The question is not whether, at any given time, ‘‘most funds’’ have

truly independent boards, but whether fund directors have the requisite independVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00695 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
684

ence and authority when they most need it—when they are challenged by the fund

manager.

This is precisely the scenario that unfolded when the independent directors of the

Yacktman Funds confronted Don Yacktman, the fund manager. At the time, the

Funds charged a 12b–1 fee under Rule 12b–1, which required that the board be ‘‘selected and nominated’’ by the independent directors. Mr. Yacktman engineered a

proxy battle that led to the ouster of the independent directors and the installation

of an ‘‘independent’’ slate of directors that he selected and nominated. No longer

able to rely on Rule 12b–1, Mr. Yacktman cancelled the fund’s 12b–1 plan. The ‘‘selected and nominated’’ provision that was intended to ensure the independence of

the board was swept aside at the very moment when it was most needed. The lesson

from the Yacktman experience is that the Commission’s proposal will only guarantee an independent chairman and a 75 percent board as long as the fund manager

does not object. The independent chairman and independent director majority will

know that they serve at the whim of the fund manager. Only legislation can guarantee that a board must be 75 percent independent and that its chairman is not

under the control of the fund manager.

FEE DISCLOSURE

As the Commission has recognized, fund fees ‘‘can have a dramatic effect on an

investor’s return. A 1 percent annual fee, for example, will reduce an ending account

balance by 18 percent on an investment held for 20 years.’’ 19 Notwithstanding the

importance of fees, ‘‘the degree to which investors understand mutual fund fees and

expenses remains a significant source of concern.’’ 20

In many respects, investors’ lack of understanding is directly attributable to the

way in which fees are disclosed. The current expense ratio is misleading because

it excludes what can be a fund’s single largest expense: Portfolio transaction costs.

The 12b–1 fees are misleading because they create the impression that funds that

do not charge 12b–1 fees therefore do not incur distribution expenses. Fund fees are

disclosed in dollars based on hypothetical amounts, rather than a shareholder’s actual costs, and the location of this disclosure makes it unlikely that investors will

pay attention to this information. Nowhere are funds required to put their fees in

context by comparing them to fees charged by index funds and comparable managed

funds. The Commission has failed to support or actively opposed reforms designed

to address each of these problems.

Portfolio Transaction Costs

The current expense ratio, which to be accurate should be referred to as the ‘‘partial expense ratio,’’ excludes portfolio transaction costs. Portfolio transaction costs

are the costs incurred by a fund when it trades its portfolio securities. Some portfolio transaction costs are easy to measure. For example, commissions paid by funds

are disclosed as a dollar amount in the Statement of Additional Information, which

is provided to shareholders only upon request. Other portfolio transaction costs

must be measured indirectly, such as spread costs, but their existence and their

substantial impact on fund expenses is no less certain.

The Commission concedes that portfolio transaction costs constitute a significant

expense for fund shareholders. ‘‘[F]or many funds, the amount of transaction costs

incurred during a typical year is substantial. One study estimates that commissions

and spreads alone cost the average equity fund as much as 75 basis points.’’ 21 A

recent study commissioned by the Zero Alpha Group, a nationwide network of feeonly investment advisory firms, found that commissions and spread costs for large

equity funds, the expenses and turnover of which are well below average, exceeded

43 percent of the funds’ expense ratios.22 A recent survey by Lipper identified at

least 86 equity funds for which the total amount paid in commissions alone exceeded the fund’s total expense ratio, in some cases by more than 500 percent.23

Notwithstanding the significance of portfolio transaction costs, the Commission has

opposed including these costs in the mutual fund expense ratio. In a June 9, 2003,

memorandum, the Commission demonstrated that it had already prejudged the

issue of the disclosure of portfolio transaction costs.24 It concluded that ‘‘it would

be inappropriate to account for commissions as a fund expense’’ and unequivocally

answered the question of ‘‘whether it is currently feasible to quantify and record

spreads, market impacts, and opportunity costs as a fund expense. We believe the

answer is ‘no.’’’ 25 Only after reaching this decision has the Commission proceeded

with the formality of issuing a concept release asking for comment on disclosure of

portfolio transaction costs, apparently for the purpose of considering any alternative

other than full inclusion in the expense ratio.26 Thus, without Congressional action,

there is little doubt that the Commission will continue to require funds to use the

685

current, partial expense ratio. Congress should require that funds include portfolio

transaction costs in a total expense ratio.

The Commission’s position is inconsistent with its responsibility to provide the information that the marketplace needs to promote price competition. By requiring

funds to use the partial expense ratio, the Commission is effectively forcing the public to choose funds based on the Commission’s view of the proper measure of fund

costs. The Commission’s decision to second-guess the market by deciding for investors which kinds of information they are capable of understanding, contradicts basic

market principles and is inconsistent with our capitalist system of free enterprise.

Investors logically look to the Commission to provide standardized reporting of expenses, and it is appropriate for the Commission to provide this service. But once

the Commission has provided the important service of providing standardized information, it should remove itself from the market-driven determination of which information provides the best measure of a fund’s true costs.

The Commission has argued that including portfolio transaction costs might distort fund managers’ behavior.27 As noted above, this is not for the Commission to

judge. The marketplace should decide which expense ratio—the partial expense

ratio or a total expense that includes portfolio transaction costs—is the best measure of a fund’s costs.

Furthermore, it is the partial expense ratio that distorts fund managers’ and investors’ behavior alike. The partial expense ratio distorts fund managers’ behavior

by not holding them accountable for their decisions to spend a substantial amount

of fund assets on trading securities.

As illustrated in Exhibit A, for example, the Commission believes that investors

should only be told that the expense ratio for the PBHG Large Cap Fund is 1.16

percent, and that they should not be told that when commissions and spread costs

are included, the Fund’s expense ratio is 8.59 percent.28 The true cost of that Fund

is more than seven times the amount shown in the Commission’s expense ratio!

How can it be in the best interests of investors or consistent with free market

economics to require, much less permit, the Fund to show its total costs of 1.16 percent? The partial expense ratio is misleading because it impliedly represents, in conjunction with other shareholder expenses listed in the fee table, the total cost of

fund ownership.

The data in Exhibit A does not reflect outliers, but randomly selected examples

from funds with more than $100 million in assets. If smaller funds with high turnover were considered, the differentials would be so large as to render the Commission’s partial expense ratio fraudulent. For example, Lipper reports that the Rydex

Telecom Fund’s commissions for the fiscal year ending March 31, 2003, equaled 8.04

percent of assets. By applying the Zero Alpha Group study’s methodology of estimating spread costs, we can estimate that total spread costs during that period

equaled 8.75 percent of assets. Thus, whereas the Commission tells us that the

Rydex Telecom Funds are only 1.37 percent, its true costs are 18.16 percent, or 13

times higher.29 The Commission’s partial expense ratio distorts investors’ behavior

because investors obviously would make different investment decisions if they knew

the true costs of owning certain funds.

The Commission’s partial expense ratio also distorts managers’ behavior because

it creates an incentive for them to pay for nonexecution expenses with fund commissions. Under current law, fund managers can pay higher commissions—that is, more

than it would cost merely to execute the fund’s trades—in return for nonexecution

services. By paying for these nonexecution services with commissions, or what are

known as soft dollars, fund managers effectively move these costs out of the expense

ratio where they belong. This enables the fund that uses soft dollars to show a lower

partial expense ratio than a fund that does not—even if the fund managers use

identical services and have identical operating expenses. The Commission itself has

conceded that ‘‘[t]he limited transparency of soft-dollar commissions may provide incentives for managers to misuse soft-dollar services.’’ 30

Furthermore, the nondisclosure of portfolio transaction costs exacerbates the conflict of interest that is inherent in the payment of soft dollars. As the Commission

has recognized,

[s]oft dollar arrangements create incentives for fund advisers to (i) direct

fund brokerage based on the research provided to the adviser rather than

the quality of execution provided to the fund, (ii) forego opportunities to recapture brokerage costs for the benefit of the fund, and (iii) cause the fund

to overtrade its portfolio to fulfill the adviser’s soft-dollar commitments to

brokers.31

The continued concealment of portfolio transaction costs permits the soft-dollar

conflict to operate virtually unchecked by market forces, whereas including portfolio

686

transaction costs in a total expense ratio would, at least, permit the marketplace

to judge the efficacy of soft-dollar arrangements. If Congress does not take steps to

eradicate soft dollars, at least it can require that these costs be disclosed so that

the market can reach its own judgments regarding their efficacy.

Dollar Disclosure of Fees

Under current disclosure rules, funds are not required to disclose to investors how

much they pay in fees. Many other financial services documents show investors exactly how much they are paying the service provider, including bank statements, insurance bills, credit card statements, mortgage loans, and a host of other documents. But mutual funds provide only an expense ratio (and a partial one, at that,

see supra) and the dollar amount of a hypothetical account.

Congress should require that funds provide individualized dollar disclosure of

fund expenses in shareholder statements, as proposed by the Government Accounting

Office.32 This requirement is necessary for two reasons. First, although the expense

ratio is appropriate for providing comparability across different funds, it does not

pack the same import as a dollar amount. Providing investors with the amount in

dollars that they actually spent will give concrete form to an indefinite concept and

make investors consider more fully the costs of different investment options.

Second, placing the dollar amount of expenses in the shareholder statement will

direct shareholders’ attention to the actual costs of fund ownership. No document

is more likely to be read than a shareholder statement that shows the value of the

shareholder’s account and transaction activity during the period. Whereas the prospectus and shareholder report typically go directly from the mailbox to the trash

can, even the most uninformed investors normally open their statements to check

on the status of their accounts. There is no better way to draw shareholders’ attention to the costs of investing than to require that the dollar amount of fees for the

period be disclosed next to the value of the investor’s account.

Some members of the fund industry have opposed informing investors about the

actual costs of their fund investments on the grounds that doing so would be too

costly and might mislead investors.33 It appears that MFS Investment Management,

the 12th largest mutual fund manager in America, disagrees. Earlier this month,

MFS announced that it would begin providing fund shareholders with a quarterly

statement of their actual fees.34

The Commission opposes disclosure of shareholders’ actual costs and opposes including dollar disclosure in shareholder statements. The Commission recently concluded its consideration of a proposal to require funds to disclose individualized

costs in shareholder statements by expressly rejecting both concepts. Instead, the

Commission decided to require disclosure of the hypothetical fees paid on a $1,000

account in the shareholder report, despite the facts that the hypothetical fees paid

on a $10,000 account are already disclosed in the prospectus, and shareholders who

most need to have their attention directed to the fees that they pay are least likely

to read the shareholder report. In view of the Commission’s, express opposition to

effective disclosure of actual fees paid by shareholders, shareholders will receive disclosure of their actual fees in shareholder statements only if Congress requires funds

to provide that information.

Fee Comparisons

Congress should take additional steps to promote price competition in the mutual

fund industry by requiring that funds disclose fees charged by comparable funds

and, for managed funds, the fees charged by index funds. Without any context, current fee disclosure provides no information about whether a fund’s fees are higher

or lower than its peers. Current disclosure rules also do not show the premium paid

to invest in a managed funds as opposed to an index fund. Requiring comparative

information in the fee table would enable investors to consider a fund’s fees in context and evaluate how they compare to fees across the industry.

Distribution Fees

The Commission currently requires that 12b–1 fees be disclosed on a separate line

that describes those fees as ‘‘distribution fees.’’ It does not require that the fee table

show the amount spent on distribution by the fund manager out of its management

fee. This is inherently misleading, as investors often use the presence of 12b–1 fees

as a negative screen that they use to avoid paying any distribution fees. In fact, investors in non-12b–1 fee funds may actually pay as much or more in distribution

expenses than some investors in 12b–1 fee funds.35

Congress should overrule the Commission’s position and require that, if distribution fees are stated separately in the fee table, they must reflect all distribution expenses paid by a fund, directly or indirectly. Alternatively, Congress should require

that fund expenses be displayed in a pie chart that shows how much of a fund’s

687

fees were spent on each type of service. The Commission’s current fee table is misleading and understates the amount of fund assets spent on distribution.

SOFT DOLLARS

Congress should ban soft dollars. The term ‘‘soft dollars’’ generally refers to brokerage commissions that pay for both execution and research services. The use of

soft dollars is widespread among investment advisers. For example, total third-party

research purchased with soft dollars alone is estimated to have exceeded $1 billion

in 1998.36 An executive with American Century Investment Management has testified that the research component of soft-dollar commissions costs six times the value

of the execution component.37

Soft-dollar arrangements raise multiple policy concerns. The payment of soft dollars by mutual funds creates a significant conflict of interest for fund advisers. Soft

dollars pay for research that fund advisers would otherwise have to pay for themselves. Advisers therefore have an incentive to cause their fund to engage in trades

solely to increase soft-dollar benefits.38

Soft-dollar arrangements normally would be prohibited by the Investment Company Act because they involve a prohibited transaction between the fund and its

adviser.39 Section 28(e) of the Securities Exchange Act, however, provides a safe

harbor from the Investment Company Act for soft-dollar arrangements as long as

the brokerage and research services received are reasonable in relation to the

amount of the commissions paid.

The conflicts of interest inherent in soft-dollar arrangements are exacerbated by

current disclosure rules. The amount of fund assets spent on soft dollars is not publicly disclosed to shareholders, so they are unable to evaluate the extent, and potential cost, of the adviser’s conflict.

Current disclosure rules reward advisers for using soft dollars because this practice creates the appearance that a fund is less expensive. The expense ratio does

not include commissions, which gives advisers an incentive to pay for services with

soft dollars, thereby enabling them to lower their management fees and the fund’s

expense ratio. Advisers can effectively reduce their expense ratios by spending more

on soft dollars, while the fund’s actual net expenses remain unchanged.

Finally, current disclosure rules may encourage excessive spending on soft dollars.

Advisers would tend to spend less on soft dollars if they knew that they would be

held publicly accountable for their expenditures.

The Commission has frequently recognized but declined to address the problem

of soft dollars. As discussed above, the Commission is opposed to including portfolio

transaction costs in funds’ expense ratios, which would have the benefit of enabling

the market to determine for itself the efficacy of soft-dollar arrangements. The Commission previously proposed a rule that would require that soft-dollars costs be

quantified, but decided against adopting it.40 When the Commission staff last evaluated soft-dollar arrangements in 1998, it concluded that additional guidance was

needed in a number of areas.41 For example, the staff found that many advisers

were treating basic computer hardware—and even the electrical power needed to

run it—as research services qualifying under the Section 28(e) safe harbor.42 The

staff recommended that the Commission issue interpretive guidance on these and

other questionable uses of soft dollars, but it has failed to do so.

In fact, the only formal action that the Commission has taken in recent years is

to expand the use of soft dollars. In December 2001, the Commission took the position that the safe harbor should apply to markups and markdowns in principal

transactions, although Section 28(e) expressly applies only to ‘‘commissions.’’ 43 This

position directly contradicts not only the plain text of the statute, but also the

position taken by the Commission in 1995 that Section 28(e) ‘‘does not encompass

soft-dollar arrangements under which research services are acquired as a result of

principal transactions.’’ 44 Although the Commission has, once again, suggested that

it intends to narrow the scope of soft dollars, its recent history suggests that Congressional action is necessary. In any case, the Commission lacks the authority to

ban soft dollars.

There is no better evidence that the time has come to ban soft dollars than the

recent recognition of the insidious nature of this practice by members of the fund

industry. Earlier this month, MFS Investment Management announced that it has

ceased the payment of soft dollars.45 The chairman of the board of the Putnam

Funds, America’s 6th largest fund complex, recently announced that the Funds intended to severely restrict the use of soft dollars and to consider a complete ban.46

Vanguard, the Nation’s second largest fund complex, has traditionally shunned soft

dollars.47 American Century, the Nation’s third largest fund complex, uses soft dollars only for research, and not for other nonexecution services.48

688

The explanations provided by fund directors and executives reflect the insidious

nature of soft dollars. In addressing the fact that soft dollars enable fund managers

to use the fund’s money to pay for research used by the manager, the independent

chairman of the Putnam Funds stated that ‘‘[t]he best decisions get made when you

buy services with your own money.’’ 49 Similarly, MFS’ Chairman, Robert Pozen,

Sees the soft-dollar funnel as a lucrative one for brokers, but one that

hides the true cost of such services to shareholders. ‘‘It is all camouflaged,’’

said Mr. Pozen, a former Associate General Counsel of the SEC. Now, he

added, ‘‘If we want something, if we think it is valuable, we will pay

cash.’’ 50

A Fidelity executive acknowledged the procompetitive advantage of a ban on soft

dollars, stating: ‘‘[w]e do not rule out a competitive environment through which all

research is acquired through cash rather than commissions.’’ 51

The difficulty for fund firms, however, is that without a statutory ban on soft dollars they may suffer a competitive disadvantage MFS estimates that paying for its

own research will reduce its advisory fees.52 Fidelity estimates that of the $1.1 bil- lion in commission it paid in 2003, $275 million paid for soft-dollar research.53 It

is unrealistic to expect these fund managers to maintain the high road at the expense of reduced advisory fees, while other fund managers continue to pay their own

research expenses through soft dollars rather than out of their own pockets.

DISTRIBUTION

12b–1 Fees and Revenue Sharing

When Congress enacted the Investment Company Act of 1940, it expressly prohibited fund managers from using fund assets to finance the distribution of the fund’s

shares. Section 12(b) of the Act recognized the inherent conflict of interest between

the manager’s desire to increase fund assets in order to increase its fees on the one

hand, and the fund’s desire to hold down costs on the other hand. Unfortunately,

the policy underlying Section 12(b) has long been abandoned, as fund assets are

used for a wide range of distribution expenses that benefit fund managers at the

expense of fund shareholders.

The policy of separating the product from its distribution was first abandoned by

the Commission when, after a prolonged review, it adopted Rule 12b–1 in 1980.54

In the 1970’s, mutual funds experienced periods of net redemptions that prompted

fund managers to lobby the Commission to permit the use of fund assets to finance

the distribution of the funds’ shares.55 Fund managers argued that net redemptions

resulted in increased costs and that the financing of distribution by the fund would

help reduce or eliminate net redemptions.56

The Commission initially rejected these arguments,57 but ultimately relented, provided that certain conditions were observed. For example, the Commission required

that the fund’s independent directors approve the 12b–1 plan.58 Among the factors

the Commission said a fund’s directors should consider when evaluating whether to

adopt or renew a 12b–1 plan was the plan’s effectiveness in remedying the problem

that it was designed to address, for example, increased costs resulting from net redemptions.59

The Commission’s most significant concern regarding 12b–1 fees was the conflict

of interest that they created between the fund and its adviser.60 The Commission

feared that 12b–1 fees would result in higher advisory fees and the fund’s adviser

would not share the benefits of asset growth.61 Some would argue that this is precisely what has happened, with any growth-based economies of scale realized from

12b–1 fees being pocketed by fund managers and not shared with fund shareholders.62

Of course, this analysis goes primarily to the use of 12b–1 fees for marketing the

fund, which is what Rule 12b–1 was intended to permit. It does not address the

ways in which 12b–1 are actually used today and that were wholly unanticipated

by the Commission when Rule 12b–1 was adopted. According to the Investment

Company Institute, only 5 percent of 12b–1 fees are spent on advertising and sales

promotion, whereas 63 percent of 12b–1 fees are spent on broker compensation.63

The use of fund assets to compensate brokers is precisely what Section 12(b) was

intended to prohibit. This practice puts the fund squarely in the position of underwriting its own securities. The fund’s assets are used to incentivize brokers to recommend the fund over competing funds. The lesser the quality of the fund, the

greater the pressure on the fund and its manager to pay brokers more to sell the

fund.

This irreconcilable conflict is mirrored on the distribution side of the business.

When brokers are paid by the funds, rather than their customers, they have an incentive to recommend the fund that offers the biggest payout, rather than the fund

689

that will provide the best investment for their customers.64 There is another incentive for brokers to favor arrangements whereby they are compensated by funds, and

that is the fact that the compensation from the fund is not transparent. Whereas

the payment of a front-end load is relatively evident to the investor, the payment

of a 12b–1 fee is not. It is even less clear that the already opaque 12b–1 fee is ending up in the broker’s pocket. For this reason, brokers and investors have begun to

favor classes of fund shares where the broker is compensated by the fund, regardless of whether that class is in the best interests of shareholders.65

Thus, the Commission has created a distribution compensation structure that is

directly at odds with the interests of investors and the Investment Company Act.

Rather than tying brokers’ compensation to their relationships with their customers,

where the Investment Company Act requires that it be placed, the Commission has

tied brokers’ compensation to their relationships with the funds, where the Investment Company Act expressly forbade its placement.

Congress should reaffirm the supremacy of Section 12(b) and prohibit funds from

compensating brokers for selling fund shares. Although this will necessarily entail

the repeal of Rule 12b–1, it will in no way limit the ways in which investors can

choose to pay their brokers. It will simply require that however brokers are compensated—through a front-end load, back-end load, level-load, or any combination

thereof—they are compensated by their customers, not by the funds. Thus, if a customer chooses to pay his broker on an installment basis, at 0.50 percent each year,

for example, that amount would be paid by the customer directly or deducted from

his fund account.

In addition, Congress should prohibit fund managers from compensating brokers

in connection with the purchase or sale of fund shares. For decades, the Commission

has permitted fund managers to circumvent the prohibition against fund assets

being used for distribution by endorsing the fantasy that managers’ payments to

brokers are made out of the managers’ ‘‘profits,’’ and not out of the fees they receive

from the funds.66

One might argue that, to maintain perfect legislative coherence, Congress should

also prohibit fund managers from paying for distribution that is not connected to

sales and purchases, that is, distribution that does not compensate the broker for

distribution services provided to its customer. I disagree. The conflict is substantially reduced in this situation because the fund manager’s and the fund’s interests

are generally aligned. General marketing payments do not create a direct incentive

for brokers to favor one fund group over another. General marketing does what advertising for decades has been shown to do: Promote competition. Indeed, by locating

these payments in the management fee, the manager will be spending its own

money and accordingly will have an incentive to minimize costs. With an express

requirement that independent fund directors evaluate the efficacy of fund manager

expenditures on marketing and determine that resulting economies have been

shared with fund shareholders, expressly permitting fund managers to use the management fee to pay for marketing would be appropriate.

Misleading Fund Share Classes

Mutual funds often offer several classes of shares that reflect different ways of

paying for distribution services. Typically, Class A shares carry a front-end load,

Class B shares a back-end load, and Class C shares carry a level load. An investor

is usually better off buying Class A shares if he intends to hold his shares for the

long-term, and Class C shares if he may sell in the short-term. When Class B shares

are best option, it is for the shareholder who holds for the mid-term. In some cases

there is virtually no shareholder for whom Class B shares are the best option.67

The Commission does not prohibit funds from offering Class B shares, even when

there is no shareholder for whom Class B shares could be the best investment option. The Commission even rejected a rule amendment that would have required

that funds illustrate in the prospectus the relative costs of each class of shares. Following the Commission’s lead, a court held in January 2004 that, even assuming

that there was no rational investor for whom Class B shares would be the best investment, the fund had no duty to disclose this fact in the prospectus.68

It is unconscionable that under current Commission positions a fund can offer a

class of shares that would not be the best investment for any rational investor. Congress should require that multiclass funds illustrate, in a graphic format, the costs

of investing in different classes over a 15-year period. In addition, Congress should

require that the fund’s independent directors find, subject to a fiduciary duty as

described above, that each class of shares offered could be a reasonable investment

alternative.

690

FUND ADVERTISING

Throughout the late 1990’s, the Commission frequently berated the fund industry

for misleading investors by advertising short-term performance.69 Funds with short

life-spans routinely advertised 1 year, sometimes even 2- and 3-year annualized investment returns in excess of 100 percent. With the crash of the stock bubble in

2000, the Commission’s concerns were validated, as many of these funds experienced huge losses, in some cases in excess of 70 percent of their value.

The Commission’s actions have not reflected its words, however. In September

2003, the Commission adopted advertising rules that utterly failed to address the

very problems that it had identified in the late 1990’s.70 The rules require funds to

provide a telephone number or web address where current performance information

is available, as if the problem with short-term performance was that it wasn’t current enough. The Commission also required that the text in fund ads include the

statement that ‘‘current performance may be higher or lower than the performance

data quoted.’’

Recent fund advertisements have demonstrated the inadequacy of the Commission’s new rules. After 3 years of negative returns, stock funds had a banner year

in 2003. Many of those funds are now advertising their stellar 1-year performance

without any disclosure of their poor returns in 2000, 2001, and 2002. Because they

are required only to show their 1-, 5- and 10-year returns, the negative returns of

2000 to 2002 are hidden from view. The ads create a misleading impression by

showing the outsized returns of 2003 without any mitigating disclosure of the down

years that preceded them and the performance volatility that those years’ returns

illustrate.

For example, one ad shows SEC-mandated performance for four funds, each of

which experienced superior returns in 2003, but experienced losses or substantially

lower performance in each year from 2000 to 2002. As illustrated in the table below,

the disclosure of each fund’s annual performance in the years preceding 2003 would

have presented a very different, far more accurate picture. The Commission’s rulemaking has done nothing to prevent such misleading ads, which have appeared routinely in business and personal finance magazines in the first few months of this

year.

Funds

Disclosed* Not Disclosed**

2003 2002 2001 2000

Fund No. 1 .......... 51.68 percent (21.27 percent) ( 7.56 percent) (18.10 percent)

Fund No. 2 .......... 42.38 percent ( 9.37 percent) (12.99 percent) ( 8.96 percent)

Fund No. 3 .......... 23.36 percent (20.44 percent) ( 3.74 percent) 12.25 percent

Fund No. 4 .......... 29.96 percent (17.16 percent) ( 5.02 percent) 8.54 percent

*Source: Business 2.0 (March 2004).

**Source: Fund Prospectuses.

The Commission’s rulemaking also did nothing to address the problem of the disconnect between the advertised performance of funds and the actual returns experienced by shareholders. As confirmed by a recent DALBAR study, ‘‘[i]nvestment

return is far more dependent on investment behavior than on fund performance.’’ 71

DALBAR found that the average equity fund investor earned 2.57 percent annually

over the last 19 years, in comparison with the S&P 500’s 12.22 percent annual return during the same period. This translates into a cumulative return for the S&P

500 of 793.34 percent from 1984 to 2002, compared with equity fund investors’ actual cumulative return of 62.11 percent during the same period.

These stunning and disheartening data illustrate, in part, a failure of investor

education and individual choice. Investors have consistently chased the best performing funds just before they crashed, and dumped the worst performing funds just

before they recovered. This sell-high, buy-low mentality is only encouraged by the

Commission’s current approach to fund performance advertising, which permits

funds to present outsized returns with no meaningful caveats regarding their volatility and the likelihood that performance will soon revert to the mean.72

Not only do current rules fail to require meaningful disclosure about the volatility

of fund returns, but they also fail to place outsized, 1-year returns in the context

of the market as a whole. To illustrate, the performance of the S&P 500 for 2003

was 28.68 percent, which puts the 51.68 percent return of the fund cited above in

a light very different (albeit still positive) from one in which the performance data

stands alone. The fund’s advertised 10-year return of 10.58 percent would tell a difVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00702 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
691

ferent story if it were required to be juxtaposed against the S&P 500’s 11.07 percent

10-year return.

The Commission also has recognized the need for investment returns to be considered in the context of fees, yet its rules do virtually nothing to benefit investors in

this respect. In its proposing release, the Commission promised that its new rule

would ‘‘ensure that fund advertisements remind fund shareholders about the availability of information about fund charges and expenses.’’ 73 Yet the final rule

required only that fund advertisements refer investors to the prospectus for consideration of fund expenses, among other things.74 In contrast, the NASD has proposed

that fund advertisements include a box that shows both the fund’s maximum sales

charge and its expense ratio.75

Congress should require that fund advertisements include all information necessary to make the information presented not misleading. This must include, at a

minimum, investment returns for each individual year where such returns differ

materially from fund’s 1-year performance, disclosure of the fund’s total expense

ratio (for example, including the fund’s portfolio transaction costs) and sales

charges, and the performance and expenses of a comparable index fund.

MISLEADING FUND NAMES

Funds are prohibited from using misleading names, yet the Commission has taken

the position that a fund with ‘‘U.S. Government’’ in its name can invest 100 percent

of its assets in Fannie Mae or Freddie Mac securities.76 These securities are not

guaranteed by the U.S. Government, which is the guarantee investors reasonably

believe they are getting when they invest in Government securities. Congress should

prohibit funds from using names that imply that they invest in U.S. Government securities unless at least 80 percent of the funds’ assets are actually invested in securities that are backed by the full faith and credit of the U.S. Government.

Commission Initiatives

As discussed above, there many areas where Congressional action is needed either

because the Commission lacks the necessary authority or opposes mutual fund reforms. In other areas, however, the Commission has taken strong steps to address

problems in the mutual fund industry, in some cases over the objections of certain

Commissioners. None of these initiatives has taken the form of final rules, and the

Committee accordingly should continue to encourage the Commission to proceed

with these rulemaking proposals to ensure they do, in fact, become law. Fund Democracy strongly supports the Commission’s efforts in each of these areas.

DIRECTED BROKERAGE

Many fund managers compensate brokers for selling fund shares with fund brokerage. Under these arrangements, the fund manager pays the broker through commissions received in connection with a fund’s portfolio transactions.77 This practice

increases funds’ portfolio transaction costs while reducing the amount the fund manager might otherwise spend on distribution, thus creating a significant conflict of

interest. The Commission has proposed to prohibit fund managers from considering

sales of fund shares when selecting brokers to effect fund transactions.78 Fund Democracy expects to file detail comments generally supporting this proposal.

DISCLOSURE OF BROKERS’ COMPENSATION

For virtually all securities transactions other than purchases of mutual fund

shares, investors receive a transaction confirmation that shows how much the

broker was paid in connection with the transaction. Permitting brokers to hide their

compensation on the sale of mutual funds has spawned a Byzantine and harmful

array of selling arrangements, including revenue sharing (also known as payments

for shelf space), directed brokerage, and noncash compensation.

Mutual fund shareholders should be entitled to receive the same information as

other investors in securities in the form of full disclosure of their brokers’ compensation on fund transaction confirmations. Such disclosure also should show how

breakpoints applied to the transaction, as well as any special compensation received

by brokers for selling particular funds.

Brokers also should be required to provide, at or before the time the investor

places the order, an estimate of compensation to be received by the broker in connection with the transaction and the total costs of investing in the fund. When buying a house, purchasers are provided with an estimate of their total closing costs

before making a final decision. As discussed immediately above, however, fund

shareholders do not even receive a final statement of their actual costs, much less

an up-front estimate of such costs.

The Commission has proposed to require brokers to provide, both at the point-ofsale and in the transaction confirmation, disclosure of the costs and conflicts of inVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00703 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
692

terest that arise from the distribution of mutual fund shares.79 Fund Democracy expects to file comments with the Commission generally supporting its proposal.

MANDATORY REDEMPTION FEE

The most substantial losses resulting from the current mutual fund scandal were

caused by funds’ selling their shares at inaccurate or stale prices and allowing certain investors to trade rapidly in and out of the fund to take advantage of those

pricing discrepancies. Some academics who have studied the issue have estimated

that this practice costs long-term fund shareholders billions of dollars each year.

Funds are already required to price their shares accurately, and this requirement

should be more strictly enforced. To the extent that pricing is not a perfect science,

however, some funds still may use slightly inaccurate prices that sophisticated traders can identify and exploit.

These opportunities would be eliminated by the imposition of a small redemption

fee on all sales of fund shares occurring within a short time period after the purchase. The Commission has proposed to require ‘‘funds (with certain limited exceptions) to impose a 2 percent redemption fee on the redemption of shares purchased

within the previous 5 days.’’ 80 In all cases, the redemption fee would be payable

to the fund, so that shareholders would receive the benefits. Fund Democracy expects to file comments with the Commission generally supporting its proposal.

HARD 4 P.M. CLOSE

In connection with the current mutual fund scandal, some mutual fund companies

apparently conspired to allow late trading in their funds. Others were the victims

of brokerage firms and other trade processing intermediaries who assisted their clients in evading those restrictions. Steps must be taken to better prevent evasion

of the late trading restrictions, including tough sanctions against those who knowingly violate or aid their clients to violate those restrictions. In addition, the quality

of compliance systems at both the funds and the trade processing intermediaries

must be upgraded to ensure detection of these and other abuses and to allow an

effective regulatory inspection of those procedures.

The Commission has proposed to require that orders to purchase fund shares be

received by the fund, its designated transfer agent, or a registered securities clearing agency no later than the time at which the fund is priced.81 This is known as

a ‘‘Hard 4 p.m. Close’’ because most funds price their shares at 4 p.m. Eastern Time.

Fund Democracy and the Consumer Federation of America have submitted joint

comments to the Commission generally in support of its efforts to prevent late trading of mutual fund shares.

PORTFOLIO MANAGER COMPENSATION

In some cases, a portfolio manager’s compensation or fund investments may not

align his or her interests with the interests of fund shareholders. For example, a

fund portfolio manager who also manages a hedge fund or other private accounts

may have an incentive to favor those accounts over the mutual funds.82 The highestpaid executives of operating companies are required to disclose their compensation

and their trades in company stock, yet there is no comparable requirement for mutual funds.

Recent revelations have included investments by portfolio managers that are

harmful to shareholders’ interests. The Commission has proposed that fund managers be required to disclose the structure of their compensation and their investments in the funds they manage.83 Fund Democracy expects to file comments with

the Commission generally supporting this proposal.

693

694

ENDNOTES

1 I wish to thank the assistance of Thomas Walker and Milo Mitchel in the preparation of this testimony. 2Testimony before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives (November 6, 2003) and Testimony before the Subcommittee on Financial Management, the Budget, and International Security, Committee on Governmental Affairs, U.S. Senate (November 3, 2003). 3T3See Marcy Gordon, Accounting Oversight Official pledges ‘‘tough love’’ Kansas

City Star (November 21, 2003) (William McDonough, Chairman of the Public Company Accounting Oversight Board, suggesting that a similar agency may be needed

for the mutual fund industry). 4See Bearing of Distribution Expenses by Mutual Funds, Investment Company

Act Rel. No. 11414 (October 28, 1980) (adopting Rule 12b–1). 5See, e.g., Report on Mutual Fund Fees and Expenses, Division of Investment

Management, Securities and Exchange Commission, Part IV.B.2 (December 2000)

(recommending that the Commission issue new guidance to fund directors regarding

the review and approval of 12b–1 plans). 6The Board would supplement, and not in any way supplant, the SEC’s authority

over mutual funds. In the event of any disagreement between the SEC and the

Board, the SEC would have final decision making authority. 7See, e.g., SEC v. Columbia Management Advisors, Inc. and Columbia Funds Distributor, Inc., Civil Action No. 04 CV 10367–GAO (D. Mass., February 24, 2004);

SEC v. Mutuals.Com, Inc., Connely Dowd Management, Inc., Mtt Fundcorp, Inc.,

Richard Sapio, Eric McDonald, and Michele Leftwich, Civil Action No. 303 CV

2912D (N.D. Tex., December 4, 2003); SEC v. Invesco Funds Group, Inc., and Raymond R. Cunningham, Civil Action No. 03–N–2421 (PAC) (D. Col., December 2,

2003); SEC v. Millennium Capital Hedge Fund, L.P., Millennium Capital Group,

LLC, and Andreas F. Zybell, Civil Action No. CV–03–1862–PHX–FJM (D. Ariz., December 2, 2003); SEC v. Security Trust Company, N.A., Grant D. Seeger, William

A. Kenyon and Nicole McDermott, Civil Action No. CV 03–2323 PHX JWS (D. Ariz.,

November 25, 2003); SEC v. Gary L. Pilgrim, Harold Baxter and Pilgrim Baxter &

Associates, Ltd., Civil Action No. 03–CV–6341 (E.D. Penn., November 20, 2003);

SEC v. Justin M. Scott and Omid Kamshad, Civil Action No. 03–12082–EFH (D.

Mass., October 28, 2003); In the Matter of Massachusetts Financial Services Co.,

John W. Ballen and Kevin R. Parke, Investment Company Act Rel. No. 26347 (February 5, 2004); In the Matter of Paul A. Flynn, Investment Company Act Rel. No.

26345 (February 3, 2004); In the Matter of Alliance Capital Management, L.P., Investment Company Act Rel. No. 26312 (December 18, 2003); In the Matter of James

Patrick Connelly, Jr., Investment Company Act Rel. No. 26209 (October 16, 2003);

In the Matter of Theodore Charles Sihpol, III, Administrative Proceeding File No.

3–11621 (September 16, 2003). None of the individuals named in these complaints

was an independent fund director. 8The Commission and Attorney General for the State of New York reported that

they had reached a settlement with Bank of America in which ‘‘Bank of America

has also agreed to implement certain election and retirement procedures for the Nations Funds trustees that will result in the replacement of the Nations Funds trustees within 1 year.’’ SEC Press Release 2004–33 (March 15, 2004); see Press Release,

New York Attorney General (March 15, 2004) (‘‘Under a specific provision of the

agreement, eight members of the Board of Directors of Nations Funds, BOA’s mutual fund complex, will resign or otherwise leave the board in the course of the next

year’’); see also Beth Healy, Pressure to Quit Riles Trustees, Boston Globe (March

17, 2004) (‘‘Under the deal, Bank of America promised the regulators it would ‘use

its best efforts’ to persuade 8 of the 10 Nations Funds directors to leave the board

by May 1, 2005, . . .’’). Bank of America does not have the legal authority to set

procedures for the board of the Nations Funds, however, and suggesting that Bank

of America has such authority effectively undermines the principle that a fund’s

board is independent of the fund manager. See Yuka Hayashi, Directors’ Treatment

In Bk Of Amer Settlement Causes Stir, Wall Street Journal (March 19, 2004)

(quoting Allan Mostoff, President of the Mutual Fund Directors Forum: ‘‘I think a

lot of people are confused.’’) The Nations Funds trustees reportedly have denied that

they plan to give up their positions, thereby suggesting that not even this de minimis ‘‘penalty’’ will stand. See Healy, supra (directors may fight agreement to by

Bank of America); Christopher Oster & Tom Lauricella, Bank of America Likely

Will Face Trustees’ Review, Wall Street Journal (March 19, 2004) (same); see generally Mark Boslet, Spitzer Reiterates Vow To Watch Mutual Fund Board Members,

Wall Street Journal (March 19, 2004).

695

9 In the Matter of Jon D. Hammes, Albert Gary Shilling, Allan H. Stefl, and Linda

F. Stephenson, Investment Company Act Rel. No. 26290 (December 11, 2003). 10 Id. (dissent of Commissioner Roel C. Campos). 11 I am aware of two cases that the Commission has brought under Section 36(b),

neither of which involved an excessive fees claim. See In the Matter of American

Birthright Trust Management Company, Inc., Litigation Rel. No. 9266, 1980 SEC

LEXIS 26 (December 30, 1980); SEC v. Fundpack, Inc., No. 79–859, 1979 WL 1238

(D.D.C., August 10, 1979). 12 Investment Company Act Section 36. 13For example, my research assistant was able to identify 18 funds in

Morningstar’s database with expense ratios in excess of 5 percent, yet the average

management fee for these funds was only 1.06 percent, and only one fund’s expense

ratio exceeded 1.29 percent. 14See, e.g., Letter from Senator Daniel Akaka, Representative Richard Baker,

Senator Peter Fitzgerald, Senator Carl Levin, and Representative Michael Oxley to

William Donaldson, Chairman, Securities and Exchange Commission (March 11,

2004); Letter from Representative Richard Baker and Representative Michael Oxley

to William Donaldson, Chairman, Securities and Exchange Commission (July 30,

2003); Investment Company Governance, Investment Company Act Release No.

26323 (January 15, 2004); Testimony, supra note 2; Letter from Mercer Bullard to

Richard Baker, Chairman, and Paul Kanjorski, Ranking Member, Subcommittee on

Capital Markets, Insurance, and Government Sponsored Enterprises, Financial

Services Committee (July 9, 2003). 15See Investment Company Governance, id. 16 Id. 17 If the Commission could really impose ‘‘requirements’’ in this way, then it could

effectively rewrite the entire Investment Company Act simply by amending the Exemptive Rules and enact every reform discussed in this testimony, but the Commission has expressly conceded that its authority is not so broad. See, e.g., Ian McDonald, SEC’s Roye Wades Through New Rules for Mutual Funds, Wall Street Journal

Online (March 19, 2004) (interview with Paul Roye, Director, SEC Division of Investment Management, in which he acknowledges that the Commission does not

have the authority to ban soft dollars). 18 Investment Company Governance, supra note 14. 19Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies, Investment Company Act Release No. 25870, Part I.B

(December 18, 2002). 20 Id. (citing a joint report of the Commission and the Office of the Comptroller

of the Currency that ‘‘found that fewer than one in five fund investors could give

any estimate of expenses for their largest mutual fund and fewer than one in six

fund investors understood that higher expenses can lead to lower returns’’). 21 Concept Release at Part I (citing John M.R. Chalmers, Roger M. Edelen, Gregory B. Kadlec, Fund Returns and Trading Expenses: Evidence on the Value of Active

Fund Management, at 10 (August 30, 2001) (available at http://finance.wharton

.upenn.edu/edelen/PDFs/MFltradexpenses.pdf). ‘‘These estimates omit the effect of

market impact and opportunity costs, the magnitude of which may exceed commissions and spreads.’’ Id. [Emphasis added]. 22See Jason Karceski, Miles Livingston & Edward O’Neal, Mutual Fund Brokerage Commissions at 9 (January 2004) (available at http://www.zeroalpha

group.com/headlines/ZAGlmutuallfundltruelcostlstudy.pdf). Exhibit A to

this testimony shows the expense ratios, brokerage commissions, and spread costs

for total costs for eight of the funds studied. 23See Sara Hansard, Lipper Data Miffs Some Firms, Investment News at 3 (February 23, 2004) (173 funds paid commissions in excess of 0.99 percent of net assets,

which is the dollar-weighted average expense ratio for equity funds). 24Memorandum from Paul F. Roye, Director, Division of Investment Management,

Securities and Exchange Commission to William H. Donaldson, Chairman, Securities and Exchange Commission, (June 3, 2003) (available at http://financial services.house.gov/media/pdf/02-14-70%20memo.pdf) (Donaldson Memorandum). 25 Id. at 28 & 30. 26See Request for Comments on Measures to Improve Disclosure of Mutual Fund

Transaction Costs, Investment Company Act Rel. No. 26313 (December 19, 2003)

(Concept Release). 27See, e.g., Donaldson Memorandum at 30–31, supra note 24. 28 Exhibit A also shows that, when commissions and spread are included, the expenses of the Strong Discovery Fund rise from 1.50 percent to 4.50 percent, the

CGM Focus Fund from 1.20 percent to 4.48 percent, and the RS Mid Cap Opportunities Fund from 1.47 percent to 7.52 percent.

696

29The Lipper data show that at least 31 funds’ expense ratios would exceed 10

percent if they include commissions and spread costs. 30 Concept Release at Part III.A, supra note 26. 31Donaldson Memorandum at 36, supra note 24. Regarding directed brokerage,

the Commission recently stated: ‘‘We believe that the way brokerage has been used

to pay for distribution involves unmanageable conflicts of interest that may harm

funds and fund shareholders.’’ Prohibition on the Use of Brokerage Commissions to

Finance Distribution, Investment Company Act Rel. No. 26356 at Part II (February

24, 2004). 32Government Accounting Office, Mutual Funds: Information On Trends In Fees

And Their Related Disclosure (March 12, 2003). 33See, e.g., Testimony of Paul G. Haaga, Jr., Executive Vice President, Capital Research and Management Co. and Chairman, Investment Company Institute, before

the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives, at 16–

17 (June 18, 2003). 34MFS to Make Sweeping Reforms to Tell Investors About Fees, Wall Street Journal Online (March 16, 2004) (‘‘ ‘We want people to know that although we have had

a difficult time lately, we will do whatever’s necessary to put shareholders first,’

[MFS Chairman Robert] Pozen said.’’). 35 In 1999, Paul Haaga, Chairman of the Investment Company Institute and Executive Vice President of the Capital Research and Management Company, stated at

an SEC roundtable: ‘‘The idea that investors should prefer the funds that do not

tell what they are spending on distribution over the ones that do is nonsense. You

know, if you are spending money on distribution, say it. If you are not spending

money on distribution do not say it; but do not pretend that there are no expenses

there for a fund that doesn’t have a 12b–1 plan.’’ Conference on the Role of Investment Company Directors, Washington, DC. (February 23 & 24, 1999) (Haaga was

not ICI Chairman at this time). 36 Inspection Report on the Soft-Dollar Practices of Broker-Dealers, Investment

Advisers and Mutual Funds, Securities and Exchange Commission, at text accompanying note 1 (September 22, 1998). 37Testimony of Harold Bradley, Senior Vice President, American Century Investment Management, before the Subcommittee on Capital Markets, Insurance, and

Government Sponsored Enterprises, Committee on Financial Services, U.S. House

of Representatives, at 5 (March 12, 2003). 38 Id. at 2 (the statutory safe harbor permitting soft-dollars arrangements ‘‘encourages investment managers to use commissions paid by investors as a source of unreported income to pay unreported expenses of the manager’’). 39See Investment Company Act Section 17(e); Inspection Report at 38, supra note

36.40Donaldson Memorandum at 13–17, supra note 24. Fidelity recently recommended that the Commission reconsider its decision not to require the quantification of soft-dollar costs. Ann Davis, Fidelity Wants Trading Costs to Be Broken

Down, Wall Street Journal (March 15, 2004). 41 Inspection Report on the Soft-Dollar Practices of Broker-Dealers, Investment

Advisers and Mutual Funds, Securities and Exchange Commission, at text accompanying note 1 (September 22, 1998) (‘‘Section 28(e) Report’’). 42 Id. at Section V.C.4. 43 Commission Guidance on the Scope of Section 28(e) of the Exchange Act, Exchange Act Rel. No. 45194 (December 27, 2001). 44 Investment Advisers Act Release No. 1469 (February 14, 1995). 45 John Hechinger, MFS Ends Soft Dollar System on Concerns over Ethics, Wall

Street Journal (March 16, 2004). 46 Id. 47 Id. 48 Id. 49 Id. (quoting John Hill). 50 Id. 51Landon Thomas, Jr., Mutual Fund Tells Wall Street It Wants a` la Carte Commissions, New York Times (March 16, 2004). 52MFS Ends ‘‘Soft Dollar’’ System, supra note 35. 53Fidelity Wants Trading Costs to Be Broken Down, supra note 40. 54 Bearing of Distribution Expenses by Mutual Funds, Investment Company Act

Rel. No. 11414 (October 28, 1980) (adopting Rule 12b–1); Bearing of Distribution

697

Expenses by Mutual Funds, Investment Company Act Rel. No. 10862 (September

7, 1979) (proposing Rule 12b–1) (‘‘12b–1 Release 10862’’); Bearing of Distribution

Expenses by Mutual Funds, Investment Company Act Rel. No. 10252 (May 23,

1978) (advance notice of rulemaking) (‘‘12b–1 Release 10252’’); Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Rel. No. 9915 (August

31, 1977) (rejecting requests to permit funds to finance their distribution expenses)

(‘‘12b–1 Release 9915’’). The Commission held public hearings on the bearing of

distribution expenses by mutual funds on November 17, 18, 22 & 23, 1976. See Investment Company Act Rel. No. 9470 (October 4, 1976) (announcing hearings on appropriateness of funds’ bearing their distribution expenses); see also Vanguard

Group, Inc., et al., Investment Company Act Rel. No. 9927 (September 13, 1977)

(order of temporary exemption and notice and hearing on application for exemption

to permit funds to bear their distribution expenses). 55 12b–1 Release 10252, supra n.3. 56 12b–1 Release 10252, supra at 1. 57See 12b–1 Release 9915. 58See Rule 12b–1(b)(2). 59See 12b–1 Release 10862, supra at 11–13 (when renewing a 12b–1 plan, the directors should consider ‘‘whether or not the plan was working as anticipated’’). 60See 12b–1 Release 10252, supra at 3; 12b–1 Release 10862, supra at 9. Indeed,

the Dreyfus Corporation, a major fund complex, argued against Rule 12b–1 on the

ground that that no amount of protections ‘‘could ameliorate the adviser’s conflict

of interest.’’ 12b–1 Release 10862, supra at 6. 61See 12b–1 Release 10252, supra at 3 (proposing that the advisory fee be a fixed

amount to prevent the adviser from confiscating benefits derived from 12b–1 fees);

Donaldson Memorandum, supra at 70–71 (‘‘When a fund bears its own distribution

expenses, the fund’s investment adviser is spared the cost of bearing those expenses

itself, and the adviser benefits further if the fund’s distribution expenditures result

in an increase in the fund’s assets and a concomitant increase in the advisory fees

received by the adviser.’’). 62 Report on Mutual Fund Fees and Expenses, at Part F, supra note 5 (noting

funds whose assets exceed their highest breakpoint). 63 Use of Rule 12b–1 Fees by Mutual Funds in 1999, Investment Company Institute, 9 Fundamentals 2 (April 2000). Funds spend the other 32 percent of 12b–1

fees on administrative services. Id. 64See Laura Johannes and John Hechinger, Conflicting Interests: Why a Brokerage Giant Pushes Some Mediocre Mutual Funds, Wall Street Journal (January 9,

2004); see also In the Matter of Morgan Stanley DW Inc., Exchange Act Rel. No.

48789 (November 17, 2003). 65See Complaint, Benzon v. Morgan Stanley, No. 03–03–0159 (M.D. Tenn.). 66This has created the ludicrous situation, embodied in Commission positions, in

which fund directors technically are prevented from reviewing the manager’s payments to brokers. Under Section 36(b) of the Act, fund directors are supposed to consider the manager’s profitability, which means that they must ignore distribution

payments or risk being accused of reducing the manager’s profitability to make the

management fee seem more palatable. See Remarks of Robert Pozen, President and

Chief Executive Officer, Fidelity Management & Research, at the Roundtable on the

Role of Independent Investment Company Directors, Washington, DC (February 23,

1999) (‘‘The second deficiency is one that the SEC has chosen to take a position on

that I have always believed doesn’t make any sense. The SEC’s position is that independent directors are not allowed to see sales and promotional expenses. They are

not allowed to consider them, unless there is a 12b–1 plan in place.’’) [Emphasis

added]. 67See Complaint, Benzon v. Morgan Stanley, No. 03–03–0159 (M.D. Tenn.). 68See Benzon v. Morgan Stanley, Morgan Stanley, 2004 WL 62747 (M.D. Tenn.). 69See, e.g., Statement by Arthur Levitt at the Investment Company Institute

(May 15, 1998) (‘‘I want you to look beyond your prospectuses when you think about

how you communicate with investors. I do, and I worry that the fund industry is

building unrealistic expectations through performance hype. I read the ads. I see

nothing but performance, performance, performance. Why not outline clearly the impact of expenses or the nature of risks?’’). 70 Amendments to Investment Company Advertising Rules, Investment Company

Rel. No. 26195 (September 29, 2003). 71DALBAR, Quantitative Analysis of Investor Behavior at 2 (2003). 72 Notably, the Commission requires that the prospectus include a bar chart that

shows a fund’s return for each of the preceding 10 years. If such a disclosure is necVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00709 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
698

essary to make the prospectus not misleading, it is unclear why the same reasoning

is not applicable in the context of a fund advertisement. 73Proposed Amendments to Investment Company Advertising Rules, Investment

Company Rel. No. 25575, Part II.C (May 17, 2002). 74 Amendments to Investment Company Advertising Rules, supra note 60. 75See Disclosure of Mutual Fund Expense Ratios in Performance Advertising, National Association of Securities Dealers (January 23, 2004). 76Letter from Paul F. Roye, Director, SEC Division of Investment Management,

to Craig Tyle, General Counsel, Investment Company Institute (October 17, 2003). 77See supra note 64. 78Prohibition on the Use of Brokerage Commissions, supra note 31. 79 Confirmation Requirements and Point of Sale Disclosure Requirements for

Transactions in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, Investment Company Act Rel. No. 26341 (January 29, 2004). 80Mandatory Redemption Fees for Redeemable Fund Securities, Investment Company Act Rel. No. 26375A (March 5, 2004). 81 Amendments to Rules Governing Pricing of Mutual Fund Shares, Investment

Company Act Rel. No. 26288 (December 11, 2003). 82See Ian McDonald, A Look at What Drives Money Managers’ Pay, Wall Street

Journal Online (March 16, 2004) (describing survey that found that ‘‘most portfolio

managers say their firms’ sales and profits are often greater drivers of their bonuses

than the investment returns they earn for clients’’). 83Disclosure Regarding Portfolio Managers of Registered Management Investment

Companies, Investment Company Act Rel. No. 26383 (March 11, 2004).

—————

PREPARED STATEMENT OF WILLIAM D. LUTZ, Ph.D., J.D.

PROFESSOR OF ENGLISH, RUTGERS UNIVERSITY

MARCH 23, 2004

I would like to thank Chairman Richard Shelby for this opportunity to comment

on the Security and Exchange Commission’s proposed requirement that investors be

provided with both cost and conflict of interest information before they invest in mutual fund shares and certain other investments.

I have served as a consultant in plain language to the Securities and Exchange

Commission, and I have worked with a number of corporations and mutual fund

companies to revise their documents into plain language. I have also written extensively on plain language and clear communication.

I believe the SEC’s proposal is an important step in the right direction. As the

SEC notes in its proposed rules, providing this information will help investors determine the full cost of an investment. Both point of sale and confirmation of sale disclosure will certainly go far in revealing to investors just what they are paying in

fees for a particular investment. However, I think the proposal, as good as it is, does

not go far enough, and what it does propose doesn’t help investors as much as it

could or should.

Right now investors face many problems in trying to figure out how much it will

cost them to buy, hold, and sell shares in a mutual fund. First, they are overwhelmed with data, all kinds of data. Please note that I say ‘‘data’’ and not ‘‘information.’’ ‘‘Data’’ consists of all the numbers, facts, and statements that fill the

prospectus and the statement of additional information (SAI). Not only is there a

flood of data, but it is located in two places. So assuming intrepid investors have

carefully read the prospectus, and have even managed the Herculean task of reading the statement of additional information, just what have the investors learned?

Who knows, because both documents offer ‘‘data’’ not ‘‘information.’’

Data is not information. Information is that which leads to understanding. In

other words, data must be transformed into information. And who has the responsibility of performing that transformation? I would argue that the responsibility lies

not with investors but with those who would sell investments such as mutual fund

shares to investors. It is the responsibility of the seller to provide investors with information, not data.

Transforming data into information is the function of information design. Professionals in information design deal with designing everything from websites to the

instrument panels in civilian and military airplanes. They also design documents

that communicate information. Indeed, in 1984, one entire issue of Information DeVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00710 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
699

sign Journal, the international publication of professional information designers,

was devoted to ‘‘The Design of Forms and Official Information.’’ The editors of the

journal said that this issue focused on the one question that concerned all citizens:

How can complex organizations communicate with the public. Information designers

have been working for over 20 years on the problems of designing documents that

communicate complex information clearly. It would seem prudent, therefore, to use

the skills of information designers when confronted with the challenge the SEC

faces in designing their proposed set of disclosure forms.

Document design uses a variety of tools—from plain language to the best type

face—to create a document that gives readers the information they need, and gives

it to them simply, quickly, clearly, efficiently. Information design transforms data

into information that readers can use. With information design, sellers can design

disclosure documents that give investors not data but information.

To ensure that the forms they create do indeed communicate clearly and effectively, document designers evaluate their designs not theoretically but practically.

They see how well the forms work when people use them. The procedure they use

is called usability testing, and it is a well-established methodology that produces

documents that meet the needs of those who use them. When joined with information design, usability testing produces documents that communicate, in every sense

of that word. Data not only becomes information, but it also becomes information

that people can use quickly, easily, and with a minimum of errors or misunderstanding.

Through usability testing, document designers discover what people want to

know, and what they need to know in order to accomplish a specified task. Usability

testing can help the SEC learn what information, if any, to leave out of the document because investors find it unnecessary, as well as learning what information

investors want included. And I would like to stress that usability testing is a professional field, with proper procedures, standards, and protocols. (See, for example,

Carol M. Barnum, Usability Testing and Research, Longman, 2002; Joseph Dumas

and Janice Redish, A Practical Guide to Usability Testing, Ablex, 1993; Jeffrey

Rubin, Handbook of Usability Testing, Wiley, 1994.) Investors should not have to

root about the endless pages of dense, jargon filled prose of the statement of additional information. Nor should they have to piece together the information they need

from the data scattered throughout the prospectus.

I am sure that usability testing would quickly reveal a fundamental problem with

the SEC’s proposed disclosure forms: All the forms present disclosure from the point

of view of the seller, not the buyer. The proposed forms are designed to ensure that

the broker conforms to the new rules about disclosure. They are not designed to

communicate the information investors want and need to make informed decisions.

Indeed, at this point no one, neither the SEC, I, nor anyone else, knows what investors want to know because as far as I know no one has asked them in a systematic,

controlled way designed to elicit accurate, reliable information.

Right now investors have to assemble data from the prospectus and the statement

of additional information. While the new forms proposed by the SEC will ideally

present the most important cost data gathered from these two documents, we must

remember that we are adding another document to the hierarchy of data for investors. These new forms should not replace the prospectus or the statement of additional information but should be designed to function as part of this hierarchy. The

new forms should present in summary format the essential information about costs

based on the statement of additional information and the prospectus, both of which

should continue to be available to those investors who want to consult them. But

the addition of these summary forms does not address the question of what information should be communicated to investors that is not now available.

To be sure, the SEC’s call for comments on its proposed rules has elicited many

comments, but these are from those people who just happened to learn about the

proposed rules. These comments will certainly be helpful, but this procedure does

not systematically engage investors in seeking to discover what they want to know.

Document design and usability testing is a more effective, accurate, and reliable

way to find out if these rules and the proposed disclosure forms will provide the

information that investors need, what information investors want, what kind of

forms will best communicate that information, and the best way to present the information so investors can use it.

Generally speaking, I think investors want to know what I, as an investor, want

to know: What will it cost me to make this investment; What will it cost me while

I own it; What will it cost me to sell it; and are there alternatives that are better

and cheaper for me?

These are the money issues, and it should not be difficult to provide this information to investors. However, as The Wall Street Journal recently (March 17, 2004)

700

pointed out, mutual fund investors may be paying significant transaction costs while

they hold their shares, and they probably do not know they are paying them. These

costs are difficult to locate because, in the words of the Journal, they are ‘‘buried.’’

The SEC has discussed these hidden costs in its concept release number 33–4389

(December 19, 2003) ‘‘Request for Comments on Measures to Improve Disclosure of

Mutual fund Transaction Costs.’’ In this release, the SEC identifies the transaction

costs of commissions, spread, market impact, and opportunity. While estimates of

the magnitude of these costs vary, it is very clear from the studies cited by the SEC

that these transaction costs can add up to a significant expense, an expense which

occurs yearly. These costs can substantially affect the rate of return for long term

investors, as the Journal article dramatically illustrates in its hypothetical examples. Yet most of these costs are not revealed in any currently available documents

for investors.

And this leads to another problem with the SEC’s proposed disclosure forms. As

presented, these forms imply that investors are being told of all the costs they are

paying. Since the present proposal makes no provision for revealing these hidden

costs in any disclosure form, investors are not informed of all the costs they are paying over the term of the investment. If these transaction costs are not included in

the disclosure form, investors should be told that the expenses as listed on the form

do not include transactions costs over the life of the investment, and these costs

may significantly affect the return on their investment.

I am submitting with my statement a sample revision of the SEC’s proposed disclosure form for a confirmation of a hypothetical purchase of a class A share (Attachment 1 to SEC Release No. 33–8358, January 29, 2004). This redesigned form

is the result of a term effort that included me, Nancy Smith (who previously served

as Director of the SEC Office of Investor Education and Assistance) and Dan Koh,

of The Corporate Agenda, a design firm in New York. I must stress that this is not

a final copy because we did not have time to conduct usability testing to refine the

form. We addressed what we saw as the design deficiencies in the proposed SEC

form, and we have tried to produce a document where investors can see in one place

all the information that is currently available. And we have tried to design a form

that communicates quickly, clearly, efficiently using both plain language and good

document design.

In our form we tried to include all the data we thought important for investors,

and we tried to turn it into information that the investor can use. Since we did not

have the opportunity to conduct usability testing on the form, we do not know what

information is not included in our form that investors would want included, nor do

we know if investors would find unnecessary any of the information we have included. We did try to make the information clear, simple, and accessible. Among

other techniques, we use serif typeface, a readable type size, lots of white space,

plain language and no jargon, and we defined in context any terms we thought

needed to be defined. We simply eliminated the full page of definitions included with

the proposed form because it is been our experience that no one will read these definitions, let alone understand any of them. If a technical term is necessary in the

disclosure form then it should be defined in the context in which it is used, but we

found we could avoid technical language and still be clear and accurate. In short,

we followed many of the principles of information design and plain language, principles that are listed and explained in the SEC’s own publication, A Plain English

Handbook: How to Create Clear SEC Disclosure Documents, which the SEC published in 1998 under the aegis of Nancy Smith and which I helped write. (You can

download a copy of the handbook at www.sec.gov/pdf/handbook.pdf.)

Let me repeat that I think the SEC’s proposed disclosure rules are extremely important in improving disclosure to investors. But let me also repeat and emphasize

that as proposed the disclosure forms simply aren’t up to what should be the SEC’s

standards for clear and effective financial disclosure documents. I have suggested

here what can and should be done to make these forms really disclose information

in a way that investors can use. I have also included a sample to suggest ways in

which the SEC can improve its proposed forms.

Finally, I would like to urge that given the importance of clear, effective communication in financial disclosure documents the SEC should incorporate document

design and usability testing into its regular procedures for producing all such documents. Many Federal agencies have already made extensive use of usability testing

and document design to produce forms and documents, among them the Food and

Drug Administration, Federal Trade Commission, National Institutes of Health, Internal Revenue Service, Veterans Benefits Administration, Federal Aviation Administration, and the Department of Housing and Urban Development.

The SEC must do more than just give investors new and better information. It

must give investors this information in a form and format that really communicates

701

and doesn’t simply present numbers. Document design is just as important as any

other consideration when creating a financial disclosure document. I believe the

SEC has done and continues to do an excellent job in providing American investors

with access to more financial data than investors in just about any country in the

world. Now, the SEC needs to take the next step to ensure that this data is transformed into information that investors can use. We must always remember that disclosure is not disclosure if it doesn’t communicate.

702

703

704

1We are not stopping the use of ‘‘soft dollars’’ for proprietary research and other services. Only

recently has the SEC issued a concept release on accounting for all the elements of a bundled

commission. SEC Release IC–26313 (December 19, 2003).

PREPARED STATEMENT OF ROBERT C. POZEN

CHAIRMAN, MFS INVESTMENT MANAGEMENT

VISITING PROFESSOR, HARVARD LAW SCHOOL

MARCH 23, 2004

Thank you, Chairman Shelby, Ranking Member Sarbanes, and other Members of

the Committee for this opportunity to present my views on appropriate reforms for

the mutual fund industry.

My name is Robert C. Pozen and I am from Boston, Massachusetts. I am currently Chairman of MFS Investment Management, which manages approximately

$140 billion for approximately 370 accounts including over 100 mutual funds serving approximately six million investors. I am also a Visiting Professor at Harvard

Law School and author of the textbook The Mutual Fund Business (2 ed. Houghton

Mifflin 2001).

I commend the Committee for engaging in a deliberative and broad-ranging review of the operations and regulation of the mutual fund industry. While I welcome

questions about any aspect of the fund industry, I will limit my testimony today to

three areas where I believe that MFS is helping to set important new standards for

the fund industry: (1) maximized shareholder value through fund brokerage; (2) individualized reporting of shareholder expenses; and (3) structural enhancements for

fund governance. We are making changes in these three areas to benefit MFS shareholders and, if followed by the rest of the industry, to benefit all fund shareholders.

Reducing Reliance on Soft Dollars

The current system of paying for goods and services with ‘‘soft dollars,’’ taken out

of brokerage commissions, is detrimental to mutual fund shareholders. The use of

‘‘soft-dollar’’ payments makes it virtually impossible for a fund manager to ascertain

the true costs of executing trades because execution costs are bundled together with

the costs of other goods and services such as research reports and Bloomberg terminals. If these costs were unbundled, then fund managers could pay cash out of their

own pockets for independent research or market data, and could negotiate for lower

execution prices for fund shareholders.

Currently, if a trader from a mutual fund executes fund trades through a fullservice broker on Wall Street, the trader pays 5 cents a share for execution plus

a broad range of goods or services from the executing broker or third parties: For

example, securities research, market data, and brokerage allocations to promote

fund sales. These goods and services are paid in ‘‘soft dollars’’: That is, they are bundled into the 5-cents-per-share charge in a nontransparent manner. If MFS does not

accept these ancillary goods or services through ‘‘soft dollars,’’ it will still be required to pay 5 cents per share by the full-service broker.

In other words, it is almost impossible to obtain a price discount from a full-service Wall Street firm for executing a large fund trade. However, that firm is willing

to provide an in-kind discount in the form of soft dollars that can be used to purchase various goods or services. This is more than a technical pricing oddity. The

key point is this: A price discount on the trade (for example, from 5 cents to 3 cents

per share) would go directly to the mutual fund and its shareholders. In-kind services like market data services go directly to the fund management company and

only indirectly to the mutual fund and its shareholders.

MFS has already eliminated the use of ‘‘soft dollars’’ to promote sales of mutual

fund shares. Since January 1, 2004, MFS has been paying cash out of its own pocket

to broker-dealers to promote fund sales. While the SEC has proposed a rule to this

effect, MFS has switched from soft dollars to cash to promote fund sales regardless

of whether and when the SEC adopts its rule.

More dramatically, earlier this month MFS decided to stop using soft dollars to

pay for third-party research 1 and market data. Again MFS will pay cash out of its

own pocket for these items. MFS estimates that this decision will cost the management company $10 to $15 million per year. Yet MFS has agreed not to raise its advisory fees for its funds over the next 5 years.

Why is MFS willing to take the lead on getting off the addiction to soft dollars

and moving to the healthy environment of price discounts? The simple answer is:

MFS puts the fund shareholder first. We recognize the need to employ a full-service

broker to execute a large block trade (for example, 500,000 shares in Genzyme); we

need their skills and capital to actively work the trade and take up a portion of the

705

2These individualized expenses will not include brokerage costs because they are capitalized

in the cost of the portfolio security.

trade themselves if necessary. But we want to pay a price in the range of 3 cents

per share for an agency-only trade, though we are willing to pay more for a trade

requiring capital to be put at risk by the broker-dealer.

The broader answer is that MFS wants to lead the industry to lower and more

transparent execution costs. To accomplish this objective, MFS will need support

from other asset managers as well as the SEC. Section 28(e) of the Securities

Exchange Act provides a safe harbor for asset managers using ‘‘soft dollars’’ for research and brokerage services. Initially, the SEC interpreted this safe harbor narrowly—allowing payment in ‘‘soft dollars’’ only if a good or service or product were

not readily available for cash. Several years later, however, the SEC broadened the

safe harbor to include any ‘‘legitimate’’ purpose for soft dollars (SEC Exchange Act

Release 23170, April 23, 1986). The SEC should move back to its initial narrow interpretation of 28(e) to reduce the reliance on the use of ‘‘soft dollars.’’

Individualized Expense Reporting

MFS will issue an individualized quarterly statement, rather than a general listing of fund expenses in basis points, which will show each fund shareholder a reasonable estimate of his or her actual fund expenses in dollar terms. The MFS design

for this individualized quarterly statement is cost effective as a result of one key

assumption: That shareholders hold their funds for the whole prior quarter. This assumption is reasonable because over 90 percent of MFS shareholders fall into this

category.

At present, the prospectus of every mutual fund contains an expense table listing

the various categories of fund expenses in basis points. The table might say, for

instance:

Fund Expenses Basis Points

Advisory Fee ................................................................................... 53

Transfer Agency Fee ...................................................................... 10

Other Fees ...................................................................................... 2

12b–1 Fee ........................................................................................ 25

Total Expenses ................................................................. 90

In addition, the prospectus of every fund includes a hypothetical example of a $10,000 investment in the fund to show the dollar amount of actual fund expenses

paid by such a fund shareholder during the relevant period. The hypothetical example for the mutual fund with the expenses described above, for instance, would show

$90 in total fund expenses over the last year.

Nevertheless, some critics have argued that mutual fund investors need customized expense statements. By that, these critics mean the actual expenses paid

by a shareholder in several funds based on his or her precise holding period as well

as the fund dividends during that period. For example, we would have to compute

the exact expenses of a shareholder who held Fund A from January 15 until March

31 without reinvesting fund dividends; another shareholder who held Fund B for the

whole year and reinvested all fund dividends; and yet another shareholder who held

Fund C from February 1 until June 15, as well as from August 22 until December

11 (during both periods, assuming no record date for fund dividends occurred).

This type of customized expense statement would, in my opinion, involve enormous computer programming costs. The program would have to track the holdings

of every fund shareholder on a daily basis, take into account whether a fund dividend was reinvested or paid out to the shareholder, and apply monthly basis point

charges to fund balances reflecting monthly appreciation or depreciation of fund assets. Of course, these large computer costs would ultimately be passed on to fund

shareholders.

At MFS, we will provide every fund shareholder with an estimate of his or her

actual expenses on their quarterly statements.2 We can do this at an affordable cost

by making one reasonable assumption—that the fund holdings of the shareholder

at the end of the quarter were the same throughout the quarter. Although this is

a simplifying assumption, it produces a good estimate of actual fund expenses since

most shareholders do not switch funds during a quarter. Indeed, this assumption

will often lead to a slightly higher estimate of individualized expenses than the acVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00717 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
706

tual amount because some shareholders will buy the fund during the quarter and

other shareholders will reinvest fund dividends during the quarter.

In addition, MFS will send its shareholders in every fund’s semi-annual report the

total amount of brokerage commissions paid by the fund during the relevant period

as well as the fund’s average commission rate per share (for example, 4.83 cents

per share on average). But this information on brokerage commissions should be

separated from the fund expense table because all the other items in the table are

ordinary expenses expressed in basis points. By contrast, brokerage commissions are

a capital expense added to the tax basis of the securities held by the fund, and brokerage commissions are expressed in cents per share.

Enhanced Governance Structure

The mutual fund industry has a unique governance structure: The fund is a separate entity from its external manager. The independent directors of the fund must

annually approve the terms and conditions of the fund’s contract with its external

manager. Of course, the independent directors usually reappoint the management

company. In an industrial company, how often do the directors throw out the whole

management team? But the independent directors of most mutual funds, in my experience, do represent fund shareholders by negotiating for contract terms and monitoring potential conflicts of interest.

At MFS, we believe we have the most advanced form of corporate governance in

the industry. To begin with, over 75 percent of the board is comprised of independent directors, who elect their own independent chairman. The chairman leads

the executive sessions of independent directors, which occur before or after every

board meeting. The independent chairman also helps set the board’s agenda for each

meeting. A lead independent director could definitely take charge of the executive

sessions and a lead director could also help set the board’s agenda. Thus, it does

not matter which title is employed; the key is to ensure that a senior independent

director plays these two functions.

In many boards, the independent directors have their own independent counsel,

as the MFS boards do. But the independent directors of the MFS funds are going

one step further by appointing their own compliance officer. This officer will monitor

all compliance activities by MFS as well as supervise the fund’s own activities, and

will report regularly to the Compliance Committee of the Board (which itself is composed solely of independent directors).

On the management company side, MFS is the only company I know of that has

a nonexecutive chairman reporting to the independent directors of the MFS funds.

This is a new position designed to assure that the management company is fully

accountable to the funds’ independent directors.

Finally, MFS as a management company has established the new position of

Executive Vice President for Regulatory Affairs, and filled the position with a distinguished industry veteran. In addition, MFS has hired a distinguished law firm partner as its new general counsel. Both will serve on the executive committee of MFS.

The new Executive Vice President will be in charge of several regulatory functions—

compliance, internal audit, and fund treasury. This high profile position within MFS

is more than symbolic; it represents the great significance given by MFS to these

regulatory functions. While these functions are performed in most fund management

companies, it is rare to see the person in charge of these functions having the title

of executive vice president and serving on the executive committee of the firm.

Conclusions

In summary, MFS is trying to establish standards of best practices in three

important areas to fund shareholders: (1) reduced reliance on ‘‘soft dollars,’’ (2) individualized expense reporting, and (3) enhanced governance structure. Other management firms are trying to take the lead in setting industry standards in other

areas. At the same time, the SEC is in the process of proposing and adopting a myriad of rules on disclosure requirements and substantive prohibitions for the fund industry—which overlap to a degree with the efforts of the fund management firms.

Because the SEC and the management firms are making such serious efforts to

develop higher behavioral norms for the mutual fund industry, it might be useful

for Congress to monitor these efforts before finalizing a bill on mutual fund reforms.

These are complex issues that may be better suited to an evolutionary process, led

by an expert public agency with the flexibility to address the changing legal and

factual environment.

Thank you again for this opportunity to testify on mutual fund reform. I would

be pleased to answer any questions the Chairman or Committee Members might

have.

707

1 A Pro-Investor Blueprint for Mutual Fund Reform, prepared by Mercer Bullard, Founder and

President of Fund Democracy and Barbara Roper, Director of Investor Protection for the Consumer Federation of America, November 25, 2003.

PREPARED STATEMENT OF BARBARA ROPER

DIRECTOR, INVESTOR PROTECTION, CONSUMER FEDERATION OF AMERICA

MARCH 23, 2004

Good morning. I am Barbara Roper, Director of Investor Protection for the Consumer Federation of America. CFA is a nonprofit association of 300 consumer

groups, which in turn represent more than 50 million Americans. It was established

in 1968 to advance the consumer interest through research, education, and advocacy. Ensuring adequate protections for the growing number of Americans who rely

on financial markets to save for retirement and other life goals is among our top

legislative and regulatory priorities.

Introduction

I want to congratulate Chairman Shelby, Ranking Member Sarbanes, and the

Members of this Committee for the thorough and careful attention you have given

to a wide range of issues arising out of the recent mutual fund trading and sales

abuse scandals. In the best tradition of the Congressional oversight process, your

hearings have helped to inform the debate, guide the SEC regulatory response, and

lay the groundwork for additional reforms.

Let me make clear at the outset, CFA believes the SEC has done a very good job

since the trading scandals first broke of developing a strong and credible mutual

fund reform agenda. While the SEC may have initially been caught unaware, it has

since responded aggressively on all three fronts of Agency responsibility enforcement, oversight, and regulation. The settlements of enforcement actions announced

by the SEC in recent months have included an appropriate combination of shareholder restitution, stiff penalties, and governance reforms. The Agency is reportedly

at work on a number of positive steps designed to promote quicker identification of

potential problems within the industry and to improve the quality of its oversight

program. On the regulatory front, the Commission has proposed a host of new rules

to end trading abuses, strengthen fund governance, and address a range of abuses

in the sale of mutual funds.

It is in this area of the regulatory response that CFA has primarily focused its

attention. Last November, CFA and Fund Democracy developed a ‘‘blueprint’’ for

mutual fund reform, which we released together with Consumer Action, Consumers

Union, and the U.S. Public Interest Research Group.1 The document provided a

brief review of the broad range of reforms we believed were needed to restore badly

shaken investor confidence in the mutual fund industry. Our proposals fell into five

basic categories: Reforms specifically designed to address trading abuses; reforms to

improve regulatory oversight of mutual funds; reforms to enhance the independence

and effectiveness of mutual fund boards of directors; reforms to improve mutual

fund sales practices; and reforms to improve mutual fund fee disclosures. (A copy

of the blueprint is included as an appendix to my testimony.)

The purpose of the blueprint was to provide a benchmark against which our organizations would measure legislative and regulatory proposals put forward in the

wake of the trading and sales abuse scandals. In preparing for my testimony today,

I have used that document as a starting point for assessing the adequacy of the

SEC’s regulatory response to date. My conclusions are necessarily preliminary, as

the SEC is still in either the rule proposal or concept release stage on a number

of key issues. We won’t know for some time what the Commission’s final actions will

be. In some instances, we support the general thrust of an SEC proposal but have

suggestions for significant amendments that may or may not be adopted. Despite

those caveats, what is really quite remarkable is how many of the suggestions laid

out in our blueprint have since been taken up by the SEC.

Despite that fact, we believe legislation is absolutely essential this year to fill certain significant gaps in the SEC’s regulatory response. Several of these gaps result

from the SEC’s lack of authority to act. For example, legislation is needed to enhance the SEC’s independent governance reforms by giving the Agency authority to

impose its requirements directly, to strengthen the definition of independent directors, and to expand the fiduciary duty of fund directors. We also believe investors

would benefit from a repeal of the soft-dollar safe harbor, which cannot be accomplished without legislation. In addition, we believe legislation is needed to give the

SEC limited oversight authority over intermediaries that handle mutual fund transactions. This would allow the Agency to develop an effective alternative to the hard

708

4 p.m. close that provides a strong degree of certainty that late trading will be prevented without the inequities associated with the hard 4 p.m. close.

When we look beyond the areas where the Agency is prevented from acting, the

one area where we see major shortcomings is in the SEC’s completely inadequate

efforts to promote vigorous cost competition among mutual funds. This is a serious

deficiency, since evidence strongly suggests market discipline is not currently serving as a reliable and effective check on excessive fees. Because bringing down costs

even a modest amount would add billions each year to the retirement and other savings of mutual fund shareholders, we believe it is essential that Congress step in

and adopt major improvements to mutual fund cost disclosure. The goal should be

to enable and encourage investors to make better mutual fund purchase decisions

and to enhance the ability of market forces to discipline costs.

These are the proposals we believe should be included in legislation this year. In

addition, although the SEC has put forward a number of very useful proposals to

reform mutual fund sales, we believe that the issue of abusive broker-dealer sales

practices deserves much further scrutiny and a more comprehensive legislative and

regulatory response. We recognize, however, that this as a task that cannot be accomplished in the time remaining in this legislative session. We, therefore, urge the

Committee to make this a top priority for comprehensive review in the next

Congress.

My testimony will briefly review the reforms we have advocated in each of the

categories mentioned above, what actions the SEC has taken, where the SEC lacks

authority to complete its reform agenda, and what additional actions Congress

should take for the benefit of mutual fund investors. I will then lay out in greater

detail what steps we believe are needed to promote effective cost competition in the

mutual fund industry and to further reform broker-dealer sales practices.

Reforms to Address Trading Abuses

Our blueprint outlined several steps to ensure that abusive trading practices are

ended, that perpetrators are punished, and that investors receive full and fair restitution for their losses.

Fair Value Pricing

Our Recommendation: As a starting point, our organizations advocated stricter

enforcement of the existing requirement that funds price their shares accurately.

Such an approach is key to reducing the opportunity for investors to trade rapidly

in and out of a fund to take advantage of pricing discrepancies.

Commission Action: In December, the Commission issued a release clarifying its

position that funds are required to calculate their net asset value based on the ‘‘fair

value’’ of a portfolio security if the market quotes are either unavailable or unreliable. In addition, the Commission staff is reportedly currently gathering additional

information about funds’ fair value pricing practices to determine whether additional steps are needed. CFA strongly supports this approach. However, because fair

value pricing introduces an element of subjectivity into the pricing of fund shares,

it also creates an opportunity for abuse. We, therefore, believe it is essential that

the SEC continue to carefully monitor funds’ use of fair value pricing to ensure that

a reform adopted to address one set of abuses doesn’t itself become an avenue of

abuse.

Congressional Oversight Needed: We urge this Committee to provide on-going

oversight to ensure that mutual funds are not abusing fair value pricing or that this

approach to pricing does not create unanticipated flaws in the pricing of mutual

fund shares. Should it find problems with the use of fair value pricing, we urge the

Committee to work with the SEC to identify steps that could be taken to eliminate

those problems.

Mandatory Redemption Fees

Our Recommendation: Because pricing is not a perfect science, we also recommended requiring at least those funds that claim to restrict short-term trading

to impose a small redemption fee on sales occurring within a short-time period after

the purchase. We specified that the fee should be payable to the fund, so that shareholders and not management would receive the benefit. And we indicated that redemptions should be permitted without triggering a redemption fee in financial

emergencies.

Commission Action: The Commission issued a proposed rule in March that would

require all funds except those that disclose that they allow rapid trading to impose

a mandatory, uniform 2 percent redemption fee on trades within 5 days of purVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00720 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
709

2File No. S7–11–04.

3File No. S7–03–03.

4File No. S7–27–03.

chase.2 Although we have not yet had an opportunity to review this proposal in detail, it appears to meet the basic criteria that we laid out for helping to take the

profits out of rapid trading. It contains provisions to allow partial, small, and emergency redemptions without triggering the fee, which should limit any potentially

harmful effects on average retail investors. It also requires that fees be paid to the

fund, not the fund managers. The rule also includes a requirement that intermediaries send funds, on at least a weekly basis, taxpayer identification numbers,

and specific trading information for those shareholders who trade through omnibus

accounts. This is an essential and welcome step to allow funds to identify those

shareholders who engage in rapid trades and ensure that they pay appropriate redemption fees.

Prevent Late Trading

Our Recommendation: In addition to advocating tough sanctions for those who

knowingly help their clients to evade late trading restrictions, we recommended that

the Commission adopt an approach to ending late trading that relies on compliance

systems to provide reliable tracking of fund trades. With that in mind, we suggested

that the quality of compliance systems at funds and trade processing intermediaries

needs to be upgraded to ensure detection of these and other abuses. We also noted

that the system must allow an effective regulatory inspection of those procedures.

Under our suggested approach, intermediaries who could not provide adequate assurances of the integrity of their order processing systems, including fool-proof timestamping of trades, would be prohibited from submitting orders to the fund after

4 p.m.

Commission Action: The Commission has finalized a rule requiring that funds

have policies and procedures in place that are designed to prevent late trading and

requiring that these policies and procedures be administered by a chief compliance

officer who reports to the fund board.3 In addition, the Commission has proposed

a rule requiring that all orders for the purchase or sale of mutual fund shares be

received by the fund, its designated transfer agent, or a registered clearing agency

before the time the fund is priced in order to receive that day’s price.4 Because of

concerns expressed over inequities in this approach, the Commission is reportedly

currently considering whether alternative approaches exist that would prove equally

effective without posing the same drawbacks of a hard 4 p.m. close.

Congressional Oversight Needed: While we do not oppose the hard 4 p.m. close as

a short-term solution to late trading abuses, we believe an alternative long-term solution must be found. With that in mind, we urge this Committee to monitor developments to ensure that the final, long-term approach adopted by the Commission

meets basic standards of fairness to all investors.

Legislation Needed: In addition, the Commission has suggested that one reason

it adopted the hard 4 p.m. close approach is that it lacks oversight authority over

certain intermediaries who handle mutual fund transactions and therefore cannot

assure their compliance with appropriate standards under an alternative system

that relies on creating an end-to-end audit trail for mutual fund transactions. To

the degree the Commission needs additional oversight authority to provide end-toend tracking of mutual fund transactions, Congress should provide the Commission

with that authority. The goal would be to provide the Commission with narrowly

targeted oversight authority, for example to inspect systems to determine whether

they are adequate to prevent late trading and other trading abuses. This would enable the SEC to identify those intermediaries that lack adequate systems to prevent

trading abuses and deny them the privilege of forwarding transactions after the 4

p.m. close.

Reforms to Improve Regulatory Oversight of Mutual Funds

Because we believe the mutual fund scandals provided evidence of a structural

breakdown of mutual fund oversight, our blueprint identified several steps necessary to strengthen regulatory oversight of the fund industry.

SEC Efforts to Enhance its Regulatory Operations

Our Recommendation: Acknowledging that the SEC had begun to take steps to

improve its regulatory oversight, we urged Congress to support and expand on those

efforts to ensure that the Agency gets at the root cause of its oversight failure in

this and other areas.

710

Commission Action: Responding to criticism that it should have detected trading

abuses earlier, the Commission announced late last year that it was creating a new

risk assessment office whose purpose is to identify emerging problems and better

coordinate the Agency’s response. In addition, in recent testimony before this Committee, Lori Richards, Director of the Office of Compliance Inspections and Examinations, outlined a number of steps being taken to improve the SEC’s oversight of

the mutual fund industry. These include creating a new surveillance program for

mutual funds, improving examination procedures, by including more interviews and

reviewing more e-mail for example, conducting more targeted mini-sweep examinations, and reviewing the largest and highest risk funds more frequently.

Congressional Action Needed: We believe these efforts both deserve Congressional

support, in the form of adequate agency funding, and merit Congressional scrutiny,

to ensure that they deliver the desired results, a more aggressive and effective oversight program for the mutual fund industry, and for the securities industry as a

whole.

Independent Regulatory Board to Oversee Mutual Funds

Our Recommendation: We recommended that Congress consider creating an independent board, modeled after the Public Company Accounting Oversight Board, with

examination and enforcement authority to supplement SEC oversight and enforcement efforts.

Commission Actions: SEC Chairman, William Donaldson, said in his November

testimony before the House Financial Services Committee that the Commission was

considering whether there were ways in which funds could ‘‘assume greater responsibilities for compliance with the Federal securities laws, including whether funds

and advisers should periodically undergo an independent third-party compliance

audit. These compliance audits could be a useful supplement to our own examination program and could ensure more frequent examination of funds and advisers.’’

Ms. Richards indicated in her March testimony before this Committee that the size

of mutual funds precluded a comprehensive audit of every area of fund operations.

Given the poor record of private audits in uncovering wrongdoing, if the SEC needs

a supplement to its own examination program, we believe a far better approach

would be to create an independent board, subject to SEC oversight, to conduct such

audits.

Legislation and Oversight Needed: As a first step, we believe Congress needs to

assess the adequacy of SEC resources for oversight of mutual funds. If it is not possible to provide the Agency with adequate funding directly, Congress should determine whether an independent board would provide the best supplement to agency

efforts. With this in mind, we support the requirement in legislation introduced by

Senators Dodd and Corzine (S. 1971) to require a General Accounting Office study

of the issue. We also urge this Committee, which has taken the lead in the past

in improving SEC funding, to provide on-going oversight on this issue.

Settlements Without an Admission of Wrongdoing

Our Recommendation: Although the SEC settlements of trading abuse cases have

included a number of proinvestor provisions, the Agency continues to rely almost

exclusively in this and other areas on settlements without any admission of wrongdoing by the perpetrators. While we believe this is in most cases an appropriate approach for the agency to take, we also believe there are some instances when the

Commission should not allow those guilty of egregious violations to get off without

an admission of culpability. We therefore recommended that Congress look into this

practice, not just with regard to the mutual fund scandals, but also with regard to

the SEC’s enforcement program more generally.

Congressional Action Needed: Either through its own oversight process or by commissioning a GAO report, we urge this Committee to examine the SEC policy of

settling even cases involving egregious ethical and legal violations without an admission of wrongdoing.

Reforms to Enhance the Independence and

Effectiveness of Mutual Fund Boards

The mutual fund scandals helped to shine new light on the failure of all too many

mutual fund boards to provide effective oversight of fund managers on behalf of

fund shareholders. To address this systemic breakdown in fund governance, we advocated a number of steps to improve the independence and effectiveness of fund

boards.

Independence of Fund Boards

Our Recommendation: To clarify that fund boards are responsible for representing

shareholders, not management, our organizations recommended that three-quarters

711

5File No. S7–03–04.

6File No. S7–08–04.

of fund boards be required to be independent and that funds be required to have

an independent chairman. Such an approach should help to ensure that fund boards

are firmly under the control of those individuals whose sole obligation is to shareholders. Given the primary role of the board in policing conflicts of interest and negotiating the management contract, we believe it is essential that funds be chaired

and dominated by individuals whose loyalty is exclusively to shareholders.

Commission Action: The Commission proposed a rule that would require all funds

that rely on one of the Commission’s exemptive rules to have an independent chairman and three-quarters of board members who are independent.5 The rule, portions

of which face strong industry opposition, has not been finalized, so it is not clear

whether this strong proposal will actually be adopted. The Commission also requested comment on a much weaker alternative approach that would require funds

to have a lead independent director. This approach would continue to allow executives of the fund management firm to chair the board, putting them in the position,

among other things, of negotiating with themselves when it comes time to negotiate

the advisory contract.

Legislation Needed: Because the SEC lacks authority to strengthen the definition

of independent director, individuals with close family and business ties to the fund

manager could still serve in this capacity, undermining the intent of this reform.

Congress should adopt legislation that, at a minimum, gives the SEC authority to

strengthen the definition of independent director. The definition included in the bill

introduced by Senators Fitzgerald, Collins, and Levin (S. 2059) provides both a good

statutory definition and authorization for the SEC to further refine the definition

as needed. The Dodd-Corzine bill (S. 1971) gives the SEC authority to add new categories of individuals who would be precluded from serving as independent directors

because family or business ties to the fund manager. Either approach would provide

much needed enhancements to the SEC’s proposed independent governance reforms.

In addition, because the SEC lacks authority to impose its governance reforms directly, it is forced to rely on the indirect means of imposing them as a condition

of relying on the Commission’s exemptive rules. Past experience suggests that this

approach may be most likely to fail just when it is needed most—when there is a

bona fide confrontation between the independent directors and the fund manager.

The risk is that, in the event of such a confrontation, the fund manager will simply

cease relying in the exemptive rules, in which case the independence requirements

will no longer apply. We therefore strongly urge Congress to amend the Investment

Company Act to give the SEC authority to impose its fund governance requirements

directly.

Congressional Oversight Needed: We also urge this Committee to monitor agency

action on this issue to ensure that the final rule does not back away from the Commission’s initial very strong reform proposal.

Election of Independent Directors

Our Recommendation: Fund directors rarely stand for election by shareholders,

leaving shareholders with little ability to hold directors accountable for protecting

their interests. We therefore recommended that independent directors be required

to stand for election every 5 years.

Legislation Needed: The Committee should seriously consider adopting provisions

from the Dodd-Corzine bill (S. 1971) which would require that all directors be approved by shareholders every 5 years and would establish a nominating committee

composed entirely of independent members to nominate new board members.

Fiduciary Duty of Board Members

Our Recommendations: Current law imposes a fiduciary duty on a fund’s manager

and directors only with respect to fees received by the manager. We recommended

that the fiduciary duty of fund directors be expanded to cover the totality of a fund’s

fees in relation to the services offered.

Commission Actions: As part of its rule on independent governance, the SEC

would require fund boards to maintain records of documents used in the review of

the fund manager’s contract. It has proposed a separate rule that would require

funds to disclose more detailed information regarding its approval of the advisory

contract, including such factors as the actual cost of services provided and the degree to which economies of scale are being realized by shareholders.6 We believe the

Commission requirements are a good step toward making fund directors more aware

of their responsibilities to keep fund costs reasonable and more accountable for how

712

7File No. S7–06–04.

8File No. S7–06–04.

they arrive at those decisions. However, we believe more can and should be done

to increase board accountability on this central area of board responsibility.

Legislation Needed: The Fitzgerald-Collins-Levin bill (S. 2059) contains excellent

provisions spelling out an expanded fiduciary duty for fund directors. We strongly

support its adoption.

Reforms to Improve Mutual Fund Sales Practices

The mutual fund scandals helped to shine a light on a number of unsavory sales

practices that stand in sharp contrast to the image brokers promote of themselves

as objective, professional financial advisers. We recommended a number of steps to

improve the quality of mutual fund sales practices and to give investors information

they need to better protect themselves.

Presale Delivery of Mutual Fund Profile

Our Recommendation: When investors purchase mutual funds from brokers, they

are not required to receive the fund prospectus until 3 days after the sale. The idea

is that the broker’s obligation to make suitable recommendations substitutes for full

presale disclosure. Because this clearly provides inadequate protections to investors,

we recommended that investors who purchase funds through a broker or other sales

person be provided with at least a copy of the fund profile at the point when the

broker makes his or her recommendation.

Commission Actions: The Commission has proposed a rule that would require

point-of-sale disclosure of broker-dealer costs and conflicts, but it would not require

comparable disclosure about the operating costs of the mutual fund or about other

important fund characteristics, such as investment strategy and risk.7

Legislation Needed: We urge the Committee to adopt legislation that would require mutual fund investors to be provided with a copy of either the fund profile

or the full prospectus at the time when a mutual fund purchase is recommended.

Disclosure of Broker Compensation

Our Recommendation: We recommended that mutual fund investors get the same

disclosure on the transaction confirmation that is provided for virtually all other securities transactions showing how much the broker was paid in connection with the

transaction. We also recommended that mutual fund investors get an up-front estimate of both broker compensation and the total cost of investing in the fund.

Commission Actions: The Commission has proposed a rule that would require

point-of-sale disclosure of the dollar amount of any front-end or deferred sales load,

if applicable, including the amount of the sales fee that is to be paid to the broker.8

It would also require disclosure of the estimated first-year asset-based distribution

fees or service fees to be received by the broker from the fund (12b–1 fees). In addition, the point-of-sale document would disclose whether the broker engages in certain practices that create potential conflicts of interest, including directed brokerage

arrangements, revenue sharing payments, increased compensation for sale of proprietary products, and increased compensation for sale of back-end sales load products.

The same rule would require disclosure on the confirmation statement of the actual

amount paid in the sales load and how it compares with industry norms and the

amounts paid to the broker by the fund and its affiliates.

The rule proposal offers significant progress in getting investors important information about costs and conflicts in advance of the sale. While we have not yet completed our review of the rule proposal, our initial review has led us to conclude that

it needs significant amendments to improve the timing, format, and content of the

proposed disclosures. Among other things, we believe it is essential that the proposed disclosures also include mutual fund operating costs, in addition to sales

costs. Creating a document that purports to offer apparently comprehensive information on mutual fund costs but leaves out this key cost may make investors even

less likely to consider operating costs when selecting a mutual fund than they already are. To the degree possible, information provided should be specific to the

fund being recommended.

For example, instead of using boilerplate language referring investors to the prospectus for more information on breakpoints, it could identify the next available

breakpoint opportunity. We also believe the disclosures should be reworded and reformatted to improve their readability for average, unsophisticated investors and

should be tested for effectiveness on investors. Finally, we believe the information

must be provided at the point of recommendation, rather than at the point of sale,

so that the investor has an opportunity to consider the information in making their

713

9File No. S7–09–04.

10File No. S7–09–04.

purchase decision. Leaving these disclosures to the last minute when the investor

is preparing to write a check or transfer funds for the purchase greatly diminishes

the likelihood that they will be carefully read and incorporated into the purchase

decision.

Congressional Oversight Needed: We urge this Committee to monitor development

of this proposal to ensure that it fulfills its potential. We also believe investors

would greatly benefit from a long-term comprehensive review of securities industry

disclosure practices generally. The goal of such a review should be to determine,

comprehensively, whether these disclosures are effective in giving investors the information they need about the professionals they hire and the products that they

purchase, at a time when it is useful to them, and in a form they can understand.

Ultimately, we believe investors would benefit from major reforms in the disclosure

system. Obviously, that is not a goal that can be accomplished in the time remaining in this Congress. We therefore urge the Committee to make this a top legislative

priority in the next Congress.

Directed Brokerage

Our Recommendation: Many fund managers compensate brokers for selling fund

shares by directing their portfolio transactions to that broker, often paying commissions on those transactions that are higher than those available elsewhere. Because

this drives up portfolio transaction costs and creates significant conflicts of interest

for both fund managers and brokers, we recommended that this practice be banned.

Commission Actions: The Commission has proposed a rule that would prohibit

funds from compensating brokers for distribution by allocating portfolio transactions

to that broker.9 It would require that funds have procedures in place to prevent allocation of portfolio transactions based on distribution considerations. We strongly

support this rule.

12b–1 Fees

Our Recommendation: At the time we developed our blueprint, our organizations

recommended only that disclosure of 12b–1 fees be reformed to eliminate the currently misleading impression that these are the only distribution payments being

made by fund managers out of shareholder assets. Our thinking on this issue has

since evolved, and we have subsequently recommended that all payments for distribution using shareholder assets be banned. We do not object to a system that

allows periodic (annual, quarterly, or monthly) payments for distribution as an alternative to paying a front-end or deferred load, but we believe the current system

creates unacceptable conflicts of interest. Furthermore, we believe the growing use

of 12b–1 fees to compensate brokers is a direct result of funds’ and brokers’ desire

to hide the distribution costs from investors who might otherwise prefer a genuine

no-load fund.

Commission Actions: As part of its rule proposal to ban directed brokerage the

Commission has solicited suggestions on how to reform 12b–1 fees.10 Although it is

too soon to say what approach the Commission will ultimately recommend, it appears to be leaning toward an approach that would require funds to deduct 12b–

1 fees directly from shareholder accounts, rather than from fund assets. Under such

an approach, the account-based fee would be subject to NASD caps on sales charges.

This approach would make the charges more transparent, particularly if they are

accompanied by good disclosures making clear that these are charges for the services provided by the broker rather than charges associated with operations of the

fund. As an important added benefit, long-term shareholders wouldn’t be forced to

go on paying the fees after their own distribution costs had been paid, and existing

shareholders would not be forced to bear the cost of distribution to other shareholders. While we have not yet had an opportunity to study the proposal in detail,

we strongly approve of the Commission decision to study the issue and believe the

approach they have outlined offers a number of significant benefits over the current

system.

Congressional Oversight Needed: We encourage this Committee to conduct a comprehensive review of distribution practices in the securities industry to determine

whether they create unacceptable conflicts of interest. Although the Commission has

made a good start in examining mutual fund sales practices, we believe a more thorough, long-term review of this issue is warranted, as we will discuss in more detail

below.

714

11File No. S7–12–03.

Reforms to Improve Mutual Fund Fee Disclosures

Regulators, financial advisers, and investor advocates all agree that minimizing

costs is one of the most effective steps investors can take to improve the long-term

performance of their investments. Unfortunately, most also agree that investors do

not currently give adequate consideration to costs in selecting mutual funds and

other investment products. This is a particularly troubling situation with regard to

mutual funds, given the central role they play in the long-term savings of average,

middle-class Americans. Our blueprint contained several recommendations to improve mutual fund fee disclosures to make them much more complete and to make

it more likely that investors will incorporate that information into their investment

decisions.

Portfolio Transaction Costs

Our Recommendation: Investors in mutual funds receive information on fund expenses that purports to provide an accurate assessment of the costs of operating

that fund. In reality, however, the fund expense ratio omits what for many actively

managed stock funds is the largest expense—the trading costs for portfolio transactions. Because this failure to include portfolio transactions costs results in fee disclosures that may dramatically understate actual costs, eliminates market discipline

to keep these costs as low as possible, and creates a strong incentive for funds to

pay for other operating costs through portfolio commissions, our organizations recommended that portfolio transaction costs be incorporated in the fund operating expense ratio.

Commission Actions: The Commission issued a concept release at the end of last

year seeking suggestions on whether and how disclosure of portfolio transaction

costs could be improved.11 The industry opposes incorporating transaction costs in

the expense ratio, and the Commission has long resisted this approach. It is therefore not at all clear that this concept release will result in meaningful improvements

to portfolio transaction cost disclosure.

Legislation Needed: Congress should require that all portfolio transaction costs be

included in the expense ratio that can feasibly be included. The Fitzgerald-CollinsLevin bill (S. 2059) takes a reasonable approach to this issue, requiring that at least

the commission and spread costs be incorporated in the expense ratio and requiring

that the information be provided both as part of a total expense ratio and separately. Such an approach allows the market to decide which number is most useful

to investors. We urge this Committee to include this provision in any legislation it

adopts on mutual fund issues.

Soft Dollars

Our Recommendation: Failure to incorporate portfolio transaction costs in the expense ratio creates a strong incentive for funds to find a way to pay for other items,

beyond trading services, through their portfolio transaction payments. This allows

fund managers both to create the impression that the funds are cheaper than they

actually are and to shift costs the manager would otherwise have to absorb onto the

fund shareholders. For these reasons, we have advocated a ban on use of soft dollars

for all purposes. Such a ban should include a requirement that Wall Street firms

unbundle their commissions and charge funds separately for research and other

services currently being paid for through trading commissions.

Commission Actions: The Commission is reportedly studying soft-dollar practices,

but it lacks authority to ban soft dollars. It could, however, take steps to improve

the current situation, by limiting use of soft dollars to genuine research and requiring full disclosure of soft-dollar payments, including total unbundling of commissions by full-service brokerage firms who conduct portfolio transactions for mutual

funds. Absent Congressional action, this is the approach we believe the Commission

should take.

Legislation Needed: Because we believe a soft-dollar ban is the cleanest solution

that offers the greatest benefits to investors, however, we urge this Committee to

repeal Section 28(e) of the Investment Company Act.

Comparative Fee Disclosures

Our Recommendation: If the goal is to get investors to make more cost-conscious

mutual fund purchase decisions, they need to receive cost information presale and

in a format that is likely to help them understand the differences in mutual fund

costs. To accomplish that goal, we recommended requiring that fee tables show both

the average fees charged by a peer group of funds and the average fees for index

funds that invest in the same types of securities. Ideally, the table should show the

715

12File No. S7–51–02.

dollar amount impact of those costs over 1-, 5-, and 10-year periods, assuming a uniform rate of return. Such an approach would help investors to better understand

the significant differences in fund costs and the major impact that paying higher

costs can have on long-term returns.

Commission Actions: The Commission adopted a rule requiring mutual funds to

disclose their costs in dollar amounts in annual and semi-annual shareholder reports.12 While requiring the information to be reported in dollar amounts, and in

a form that allows comparison among funds, is a step forward, putting the information in the shareholder reports greatly minimizes its benefits. Because few investors

read these reports in advance of a fund purchase, the new disclosures will do little

if anything to change investor behavior or introduce meaningful cost competition to

the mutual fund industry.

Legislation Needed: In order to promote cost-conscious purchase decisions by mutual fund investors, the Committee should adopt legislation that requires presale

disclosure of fund costs and presents those costs in comparative terms, as described

above. These changes could be incorporated into the fund profile document, as well

as the prospectus, in keeping with our earlier recommendation that investors be

provided with one or the other of these documents at the time a fund purchase is

recommended.

Actual Dollar Cost Disclosure

Our Recommendation: As another way to get investors to focus more on costs, we

recommended requiring funds to present individualized information on actual dollar

amount costs on the shareholder account statement. Putting this information on the

account statement would greatly increase the likelihood that it would get read. In

addition, putting the information in close proximity to information on fund returns

would help investors to understand how high costs can eat into fund returns. While

not as desirable as presale disclosure, since it would come too late to influence the

purchase decision, this approach could at least make investors more cost-conscious

when it comes to future mutual fund purchases.

Commission Action: The Commission has opposed requiring individualized cost

disclosure on account statements and adopted its far weaker shareholder report disclosure requirement instead.

Legislation Needed: The Committee should adopt legislation requiring mutual

funds to provide dollar amount cost information on account statements in close proximity to information on fund returns.

Why High Mutual Fund Costs Persist

Three forces are supposed to work together to discipline mutual fund costs. Mutual fund boards of directors are supposed to ensure that fees are reasonable, and

the SEC has authority to take action against fund boards and managers that charge

excessive fees. But the main check on excess costs is supposed to be supplied by

market discipline. Many within the industry argue that these forces, and market

discipline in particular, are working effectively to keep costs reasonable. There is

compelling evidence, however, that this is not the case.

To approach this issue from the simplest, most straightforward angle, CFA examined costs at S&P 500 index funds, using a list of such funds complied for us and

Fund Democracy in July of last year by Morningstar. We chose this type of fund

because no one can credibly argue that higher costs bring added benefits to shareholders in these passive investments, which seek only to match the returns of the

underlying index. Yet, when we examined the data last fall, we turned up 16 fund

families that offer S&P 500 index funds with annual expenses of more than 1 percent. This compares with expenses of 0.18 percent and 0.19 percent respectively for

the Vanguard and Fidelity funds.

Most of the funds on the list were B and C shares, for which a significant portion

of the annual expenses came in the form of 12b–1 fees set at or near the maximum

permissible level. The most expensive of these was the AAL Large Company Index

II B fund, with an annual expense ratio at that time of 2.18 percent. However, two

of the funds on the list, the AAL Large Company Index A and Mainstay Equity

Index A, charged front loads of 5.75 percent and 3 percent respectively for their very

high-cost funds.

While distribution costs were a significant factor contributing to the high costs of

most of the funds, virtually all of the funds on the list had underlying management

and administrative costs (with 12b–1 fees subtracted) that were two, three, and

even four times as high as those of the Vanguard and Fidelity funds. While we recognize that not every fund company can match the rock-bottom prices charged by

716

13The search was conducted by Fund Democracy President Mercer Bullard in response to a

request from Senator Fitzgerald. The highest cost fund turned up in that search was the Frontier Equity Fund, which according to its registration statement, has annual expenses of 43.24

percent and a front load of 8 percent. Because the adviser waives certain fund expenses, however, the annual fee charged to investors is reduced to 42.26 percent. 14 Investment Company Institute, 2003 Mutual Fund Fact Book, 43rd Edition. 15 Ibid. 16 ‘‘Misdirected Brokerage,’’ by Rich Blake, Institutional Investor Magazine, June 17, 2003.

Vanguard, when such large discrepancies exist for a passive investment like an S&P

500 index fund, we believe it is reasonable to conclude that the costs at the higher

end of that scale are excessive. If funds that charge clearly excessive costs exist

among S&P 500 index funds, there is every reason to believe they exist among all

other types of funds as well. A separate search for very high cost funds confirmed

this view, when it turned up a handful of funds with annual expenses at or around

10 percent.13

The question is why, given the several protections that exist, high fund costs persist. One reason is that the SEC has never used its authority to attack excessive

fees. Some progress is apparently being made on that front, with the enforcement

division reportedly looking into high costs for index funds. Another reason is that

mutual fund boards have too often taken the approach of approving fees as reasonable, without regard to the underlying cost of services provided, as long as they are

not too far out of line with industry norms. The recently proposed rules on independent governance and disclosure regarding approval of the advisory contract offer

the prospect of progress on this front as well. Supplemented by legislation as outlined above, this approach could provide real progress toward getting boards to take

seriously their obligation to keep costs reasonable.

Despite this progress, market discipline will continue to be the primary factor

keeping costs reasonable. In a market in which investors are free to choose from

among hundreds of fund companies offering thousands of funds using several

different distribution and pricing models, one would expect to find vigorous price

competition. In reality, however, only a relatively small portion of the mutual fund

marketplace could currently be said to be truly cost competitive. That is the roughly

13 percent of mutual fund transactions that occur directly between the fund company and the retail investor and outside of any employer-sponsored retirement

plan.14 While performance-based advertising may distort this market somewhat, the

prevalence of relatively low-cost funds in the direct-marketed segment of the industry strongly suggests that minimizing costs is viewed as critical to success for funds

that rely on their ability to sell themselves to investors directly.

As we all know, a growing percentage of mutual fund transactions today occur

through employer-sponsored retirement plans.15 In these plans, investors generally

have very limited options and therefore very little ability to consider costs in choosing among funds. These investors must instead rely on their employers to consider

cost when selecting the plan. But plans often compete for employers’ business by

keeping administrative costs low, which they are able to do by shifting those costs

onto employees in the form of higher 12b–1 fees. While the recent trading scandals

may have made employers somewhat more sensitive to their fiduciary duties in selecting a plan, it is by no means certain that this is that case or, if it is, that this

new sensitivity will extend to issues of cost.

That leaves the approximately 50 percent of mutual fund transactions that occur

through broker-dealers and other salespeople outside a company-sponsored retirement plan.16 Funds that rely on this market compete to be sold, not bought. While

funds that compete to be bought can be expected to do so by offering a high-quality

product and good service at a reasonable price, funds that compete to be sold do

so by offering generous financial incentives to the selling firm and to the individual

salesperson. They do this through a variety of means sales loads, 12b–1 fees, payments for shelf space, and directed brokerage that drive costs to investors up, not

down. This sales-driven model offers mediocre, high-cost funds a means to compete

for sales despite the fact that better alternatives for investors are widely available.

As such, it allows funds to survive, and even thrive, that simply could not do so

in a truly competitive market.

How to Encourage Vigorous Cost Competition in the Mutual Fund

Marketplace

To turn this situation around, it will require both truly innovative and effective

cost disclosure and a new approach to sales practices.

717

Improved Cost Disclosure

We have described above some of the changes needed to improve cost disclosure.

The goal is to ensure that these disclosures provide the information that investors

need to accurately assess costs, at a time when it is useful to them in making their

purchase decision, and in a format that catches their attention and conveys the information clearly and compellingly.

Content: At its most basic, the cost information provided must be accurate. That

means it must incorporate as many of the operating costs of the fund as possible.

Ideally, this means including all portfolio transaction costs in the annual expense

ratio. As we explained in more detail in our joint CFA-Fund Democracy comment

letter on the SEC’s concept release, we believe this is an achievable goal. Many

funds already get an analysis of their total transaction costs for their internal use.

Setting standards for computing these costs and then requiring that they be included in a total expense ratio, while complex, should therefore not pose insurmountable challenges.

Should Congress and SEC decide for some reason against incorporating portfolio

transaction costs in the expense ratio, it becomes even more important to ban soft

dollars, something the SEC cannot do on its own. Soft-dollar payments are used to

shift operating costs out of the sunlight of disclosed costs and into the undisclosed

arena of portfolio transaction costs. If portfolio transaction costs remain undisclosed,

then it is imperative that they be used only to cover trading costs and not to cover

other products and services. Failure to adopt these reforms makes a mockery of the

expense ratio as an accurate reflection of mutual fund operating costs.

In addition, if cost disclosure is to promote cost-conscious purchase decisions, the

information must be presented in a context that helps investors to understand the

long-term implication of paying higher costs. We believe the best way to accomplish

this is by requiring comparative information to be included when costs are disclosed.

One such approach would be to require the fee table to include an average cost figure for funds in the category and an average cost for index funds that invest in

similar securities. To make the information even more compelling, the 1-, 5-, and

10-year dollar amount added costs or savings, relative to the category average and

the index fund cost should be presented. Showing an investor that, performance

being equal, they will pay an additional $900 over 5 years in fees because of a fund’s

above-average costs might cause them to carefully consider what they are getting

in return for those high costs. Showing that they could save thousands over 10 years

by investing in a low-cost index fund could provide an even greater incentive to take

costs into account when purchasing a fund.

Timing: It is simple common sense to suggest that cost competition will only

thrive if investors receive cost information in advance of the sale. Yet the current

disclosure system does not require that this information be disclosed until several

days after the sale has been completed. The SEC has taken an enormous step forward by suggesting that distribution-related costs should be provided presale, but

it has not suggested providing similar presale disclosure of operating costs. This

makes no sense from an agency that has emphasized the importance of allowing

market competition to discipline costs. Once you have taken the step of requiring

presale disclosure, there is every reason to use that opportunity to ensure that investors receive all the appropriate information that should inform their purchase decision. We believe the best approach would be to amend the fee table along the lines

that we have suggested above and require that investors receive a copy of either

the fund prospectus or fund profile including that fee table in advance of the sale.

It is not enough to provide the information at the actual point of sale, when the

check is being written or the funds are being transferred. At that point, the purchase decision has already been made. Far better is to provide the information at

the point of recommendation, so that the investor has a reasonable opportunity to

include cost considerations (and other factors, such as investment strategies and

risks) as they decide whether to accept the recommendation or seek out a better

alternative.

Format: Almost as important as getting investors the right information at the

right time is getting it to them in a format that catches their attention. The best

disclosure in the world can be fatally undermined if it is presented in a way that

encourages investors to ignore it. If the Commission can be convinced, or compelled

by Congress, to develop more effective cost disclosures, they should consult experts

such as my fellow panelist Professor Lutz on the best way to convey the appropriate

information. They should also be required to test prototype disclosures with investors to determine whether they are effective.

718

17SEC Proposed Rule, ‘‘Certain Broker-Dealers Deemed Not To Be Investment Advisers,’’ File

No. S7–25–99. The rule was proposed in 1999, at which time the Commission adopted a ‘‘no

action’’ position that assured brokers that they would not be subject to enforcement actions

based on a violation of the rule pending adoption of a final rule. No final rule has been adopted,

and the no action position is apparently still in place.

A New Approach to Product Sales

While improved disclosure can help to alert investors to conflicts of interest and

to make them more aware of the importance of costs, disclosure alone is unlikely

to promote vigorous cost competition in the broker-sold market. A broader solution

to this problem must take into account the fundamental reality of how investors relate to brokers and other financial professionals and, specifically, the degree to

which they rely on them for advice.

Brokers are legally salespeople, without an adviser’s obligation to place client interests ahead of their own. In fact, their exemption from the Investment Advisers

Act is conditioned on their limiting themselves to giving advice that is ‘‘solely incidental’’ or ‘‘merely secondary’’ to product sales. However, this is not how they

present themselves to clients. Instead, they adopt titles, such as financial adviser

or investment consultant, that are designed to convey to their customers that advice

is the primary service they have to offer. They spend millions on advertising campaigns that relentlessly send the same message.

Even sophisticated personal finance writers often fail to make this distinction between brokers, whose role is to effect transactions in securities, and investment advisers, whose role is to offer advice. If those who make their living covering personal

finance issues make this mistake, it should not come as a big surprise that unsophisticated investors tend to approach their relationship with their broker with an

attitude of trust. Lacking confidence in their own financial acumen, they seek out

the advice of a financial professional, and they expect to rely without question on

that professional’s recommendations.

Improved disclosure of conflicts of interest, as the SEC has proposed, should help

encourage investors to see their financial professionals in a more realistic light. We

doubt, however, that even the best disclosures will be able to overcome multimilliondollar advertising campaigns that send exactly the opposite message. Instead, we

believe it is long past time to require brokers either to live up to the advisory image

they project—and accept the attendant responsibility to make recommendations that

are in their customers’ best interests—or to cease misrepresenting themselves to

customers and prospective customers as advisers. To the degree that the Commission has taken a position on this issue, however, it has been to propose to expand

the loophole that allows brokers to portray themselves as advisers, earn fees they

identify as fees for advice, and still rely on the ‘‘solely incidental’’ exclusion from

the Advisers Act.17

Even where advisers have an obligation to put their clients’ interests ahead of

their own, the SEC has not, to our knowledge, ever enforced this obligation with

respect to price or challenged advisers based on their recommendation of high-cost,

inferior products. We believe it is high time for the Agency to start. However, given

its history on this issue, we doubt the Commission will take this position without

prodding from Congress. As a first step, Congress should conduct a thorough investigation of the role and operations of brokers and advisers as the basis for legislation to ensure that their conduct matches their representations about the services

they offer.

The focus on mutual fund sales practices has raised some issues that should be

included in such a review. One question it has raised for us is why distribution costs

should be set by and paid through the mutual fund. When an investor buys shares

in Microsoft, Microsoft does not determine what the broker is paid for that transaction. As a result, we have vigorous cost competition among brokers when it comes

to trading costs for stocks. Yet, when an investor purchases shares in a mutual

fund, the mutual fund’s underwriter sets the level of the broker’s compensation, either through loads or asset-based distribution fees. This results in the kind of competition to be sold that we described above, a competition that drives costs up and

allows mediocre, high-cost funds to survive that could not do so absent their ability

to buy distribution. If funds got out of the business of competing to be sold, and brokers’ compensation came directly from the investor and did not depend on which

fund they sold, then brokers might begin to compete on the basis of the quality of

their recommendations, and broker-sold funds might have to compete by offering a

quality product and good service at a reasonable price, just as direct-marketed funds

must do.

Obviously, this is not an approach that can be adopted without more thorough

study of all of its implications. We believe, however, that similarly dramatic changes

719

in the sales practices of brokers and other financial professionals will be necessary

to truly change the dynamics of this marketplace in ways that benefit investors. We

urge this Committee to include these issues on its agenda, if not this Congress,

which is quickly drawing to a close, then in the next Congress.

Conclusion

Mutual funds have long offered the best way for investors who have only modest

amounts of money to invest to obtain broad diversification and professional management. The trading scandals have sullied the fund industry’s reputation, but they

have also opened up an opportunity to reexamine some industry practices that have

too long gone unchallenged. The SEC has so far done an excellent job of addressing

many of these issues, particularly fund governance, sales abuses, and improved regulatory oversight.

There are, nonetheless, significant gaps in its efforts. Some result from the SEC’s

lack of authority to act. Others result from the SEC’s apparent lack of a vision for

how the market could be transformed. The most serious gap in this regard is the

Agency’s total failure to adopt reforms that would introduce vigorous cost competition in the mutual fund marketplace. It is a failure that is responsible for allowing

billions of dollars to be transferred each year from the retirement savings of working Americans into the pockets of highly profitable mutual fund companies and financial services firms.

Because of the SEC’s aggressive response to the mutual fund scandals, there is

not a pressing need for sweeping legislation to address the abuses that have been

uncovered. Legislation is clearly needed, however, to fill specific gaps in the SEC’s

regulatory agenda. Such a bill should do the following things:

• Strengthen the definition of independent director, authorize the SEC to impose its

governance requirements directly (rather than as a condition of relying on exemptive rules), and clarify and expand the fiduciary duty of fund directors.

• Give the SEC the oversight authority it needs over intermediaries who handle

mutual fund transactions in order to enable the Agency to adopt an alternative

late trading solution that does not rely on a hard 4 p.m. close.

• Ban soft dollars.

• Direct the SEC to adopt rules to require that portfolio transaction costs be included in the operating expense ratio, to amend the fee disclosure table to provide

comparative operating cost information; to require that mutual fund investors receive a copy of either the prospectus or the fund profile at the time when a fund

purchase is recommended; to require dollar amount cost disclosure on shareholder

account statements; and to pretest those disclosures for effectiveness in conveying

the key information to investors.

It is also imperative that Congress continue to ensure that the Agency has adequate funding to fulfill its responsibilities, as this Committee has taken the lead in

doing in the past. As part of that effort, we would encourage you to include in legislation a provision requiring a GAO study of whether investors would also benefit

from creation of an independent oversight board for mutual funds. Another area

that deserves further study, in our view, is the SEC’s reliance on settlements without an admission of wrongdoing.

Beyond the issues that can and should be addressed in legislation this year, we

believe there is a compelling longer-term need to reexamine broker sales practices.

The goal should be to eliminate the gaping divide that separates the professional,

advisory image brokers promote to the public and the reality of their conflict-laden,

sales-driven conduct. Forcing brokers to live up to the advisory standards they promote, and raising the bar for advisors as well, would go a long way toward improving the long-term financial well-being of American investors.

We congratulate you, Chairman Shelby, and Members of the Committee for the

thorough and careful consideration you have given to a wide range of mutual fund

issues. That attention has already helped to support and promote proinvestor reforms at the SEC. It has also helped to identify additional areas where legislation

is needed. We look forward to working with you to create a more equitable and honest mutual fund marketplace.

720

721

722

723

724

725

726

727

728

729

730

731

732

733

734

735

736

737

738

739

740

741

742

743

744

745

746

747

748

749

750

751

752

753

754

755

756

757

758

759

760

761

762

763

764

765

766

767

768

769

770

771

772

773

774

775

(777)

EXAMINING SOFT-DOLLAR PRACTICES

WEDNESDAY, MARCH 31, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10:00 a.m., in room SD–538, Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

This morning, the Committee will examine soft-dollar practices

in the mutual fund industry. Following the SEC’s elimination of

fixed brokerage commission rates in 1976, Congress enacted Section 28(e) of the Exchange Act, creating a safe harbor for soft-dollar

arrangements. As generally understood, soft-dollar practices consist

of arrangements in which investment advisers pay commission to

a broker-dealer and receive bundled services such as executions

and research products. Section 28(e) allows a fund adviser to pay

more than the lowest available commission rate on the basis of the

brokerage or research services provided, so long as the payment is

reasonable in terms of a value of these services. Since enactment

of Section 28(e), soft dollars have become the primary currency by

which fund managers obtain research and other services from

broker-dealers.

Soft-dollar arrangements can benefit investors by increasing the

availability of research for a fund adviser. Many contend, however,

that these practices are inherently conflicted, nontransparent, and

lead to higher commission costs. Some argue that soft dollars harm

investors by creating incentives for fund advisers to overtrade accounts and generate soft-dollar credits that can be used to pay for

conferences and other business expenses. Many believe that because soft dollars are paid from brokerage commissions and not

from the fund manager’s pocket, there is little incentive for managers to be price sensitive. Many also state that the cost of soft dollars are hidden from investors and that bundled commissions, for

both execution and research, lead to higher costs for investors. This

hearing will be an opportunity today for the Committee to examine

these arguments and to gain greater understanding of how soft dollars are currently used by funds, broker-dealers, and third-party

researchers.

During the course of our hearings, witnesses have offered a

range of reform alternatives concerning soft dollars. The SEC has

convened a task force to examine soft dollars, and I anticipate that

778

it will soon offer reform recommendations to better protect shareholders’ interests. Some contend that Congress should not wait for

the SEC’s proposals, but should instead repeal Section 28(e) and

ban soft dollars. Others contend that Congressional action is unnecessary because the SEC already has the necessary authority to

implement reforms. For example, the SEC could tighten the definition of ‘‘research’’ and require broker-dealers and funds to

unbundle commissions, assigning specific values to execution and

research. As this Committee evaluates possible legislative reforms,

it is critical that we understand the merits and implications of various reform alternatives and proposals.

This morning, we will hear from various experts on soft-dollar

practices. With us we have Harold Bradley, Chief Investment Officer of Growth Equities for American Century Investments; Geoffrey

Edelstein, Managing Director and Co-Founder of Westcap Investors, LLC; Howard Schilit, Founder and CEO of Center for Financial Research and Analysis; Benn Steil, Andre ́ Meyer Senior Fellow

in International Economics at the Council on Foreign Relations;

Grady Thomas, President of The Interstate Group; and Joseph

Velli, Senior Executive Vice President of the Bank of New York.

I thank all of you for appearing here today.

Senator Allard.

STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, I have a statement, and in order

to expedite the hearing, I will just submit my comments for the

record.

Chairman SHELBY. That will be made part of the record in its entirety.

Senator ALLARD. I would like to welcome the panel and look forward to hearing their comments this morning.

Chairman SHELBY. Senator Enzi.

STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Thank you, Mr. Chairman. I appreciate your holding this session, and I would ask that my complete statement be

a part of the record.

Chairman SHELBY. Without objection, it will be made part of the

record in its entirety.

Senator ENZI. Some have called for a complete ban on the softdollar arrangements and for 12b–1 fees. Previously, we have heard

from witnesses before this Committee that there may be unintended consequences if a complete ban were implemented. One of

the unintended consequences may be that mutual funds may be

disinclined to use the independent third-party research if the mutual funds are required to pay for the research as an outright expense rather than being able to use the soft-dollar fees.

It is extremely troubling to me, as the global settlement between

certain Wall Street firms and the SEC and State security regulators made independent research a key element of the agreement.

I do think that we need to fully understand why these independent

research firms would be placed at a disadvantage and what can be

done so that they are not disproportionately affected by any proposed changes to the way the industry operates. I am very interVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00790 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
779

ested in hearing from the witnesses today on their views on how

we can maintain the vital source of independent research.

In addition, I would like to know if investors would benefit from

greater transparency on the payment and use of these funds and

whether there should be greater accountability by mutual funds

and the broker-dealer community on these monies.

Thank you, again, Mr. Chairman, for holding these two hearings

today.

Chairman SHELBY. Mr. Bradley, we will start with you. All of

your written testimony which we have will be made part of the

Banking Committee’s hearing record without objection. And if you

would sum up your comments briefly. We are interested in finding

out how the mutual fund business works, all aspects, and that is

why we have had so many of these hearings because this is too important to rush to judgment on.

Thank you, Mr. Bradley. We will start with you.

STATEMENT OF HAROLD BRADLEY

CHIEF INVESTMENT OFFICER, GROWTH EQUITIES

AMERICAN CENTURY INVESTMENTS

Mr. BRADLEY. Thank you, Chairman Shelby.

Members of the Committee, thanks for the invitation for coming

here. This is complicated stuff. I brought along some pictures because I think it is sometimes easier to tell a story with pictures,

and I will walk you through these ideas.

We think this is a major problem for our industry—soft dollars

or the 28(e) safe harbor—and a problem that we have been trying

to illuminate for more than 10 years. I do a lot of public speaking

on this and presentations and writing. We believe investors are

paying undisclosed fees through soft-dollar practices with a negative impact on investors that vastly exceeds any sum associated

with the already identified trading scandals. American Century manages $90 billion for 1.5 million investors

and mutual funds in separate accounts. My views reflect 16 years

as the head of trading, and as a portfolio manager and chief investment officer for several mutual funds owned by our retail fund investors. I understand the role of Wall Street research, including

independent research, and investment banking research and how

each affects investors.

Section 28(e) provides a safe harbor, as you have already summarized, Chairman Shelby. We pay for ancillary services with those

extra commissions; and the average institutional commission rate

today is synonymous with inflated brokerage commissions.

These excess commissions often go from the investor’s pocket,

through the fund adviser, to the broker and back into the adviser’s

pocket. In the construction business, this arrangement is called a

kickback. In our business, curiously, it is called a safe harbor.

Chairman SHELBY. Explain how it makes these rounds.

Mr. BRADLEY. Well, I have a bill. For instance, last year a computer company came in to pitch some computer technology to us,

a $2-million bill. If I paid them $3.2 million in commissions, I had

no bill, but I got the technology installed. I send my commissions

to the broker. Under 28(e), the broker then says, ‘‘Oh, you have a

relationship here. You have paid me commissions for research. I

780

will pay your computer vendor for you.’’ And so that money goes

in that circuitous fashion. I will try and develop a theme a little

bit. It has an awful nice impact on the profit margins of an investment adviser.

There have been repeated reform attempts, and I notice the GAO

testimony said that the SEC has studied this. The regulators and

Congress have studied this issue to death for at least 25 years.

Ever since the safe harbor was created, people have worried what

would happen, and we are now at the day of reckoning, where it

is a major force in our business and, again, a growing problem.

If I could let you look at some of these charts, maybe it will lay

out for you a little bit, too, how this food chain works.

Exhibit 1 is, ‘‘What Does ‘Paying Up’ Mean.’’ I just have a simple

bar graph. Last year, American Century did 55 percent of its business on execution-only venues. In other words, we paid for no research at all on these execution venues.

Mr. Chairman, do you see where I am here?

Chairman SHELBY. I understand you.

Mr. BRADLEY. That bar at the bottom is our effective executiononly rate, about .88 cents a share.

The other bar represents all of the other goodies, including valuable ideas in research, which are in that bar, that are paid with

the extra. The bar goes up to what Greenwich reported last year

as the average all-in commission rate, the bundled rate, in our

business. In that are IPO allocations, normal and customary business expenses, fund expenses and then bundled research.

If you go to the next page—well, and actually I think where we

need help is section 28(e), we do need to amend 28(e), at a minimum. And what we should do is preclude, from any broad definition of research the following: Computer hardware and software,

publications including books, periodicals and newspapers, professional development seminar fees, exchange data for quotes and

services.

For goodness sakes, if you pay a management fee, should the

manager not be able to afford paying for his quotes from the New

York Stock Exchange? How else can you manage money?

And then investors should not be able to use commissioners to

pay for any service from third-party providers otherwise available

for cash to the general public—the so-called pre-1986 standard.

The next graph gives you a little bit more perspective. In 1976,

Congress acted on commissions because they were fixed, and there

were lots of goodies changing hands under the table. What they did

is said let us deregulate commissions. Well, what happened is commissions went to 5 cents a share and stayed there for 15 years. Because the goodies were under the table, volumes went up by 6

times. That is the solid bar. It shows the increase in trading volume in the New York Stock Exchange over that time. Effectively,

you had a sixfold increase in trading volume, with commissions

going down 15 percent. It seems kind of sticky to me, and I think

there are significant economic benefits that have led to the dramatic increase in this business activity.

So we think that, to start: Remove the incentives. Prohibit fund

advisers from taking into account sales of fund shares in the allocation of brokerage commissions. Direct the SEC to regulate investVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00792 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
781

* Held in Banking Committee files.

ment bank activity, where excess commissions—and this gets back

to some of the Spitzer findings—are used by the industry’s largest

and most dominant players to secure access to the hottest deals.

This pay-to-play practice must be transparent. Require the SEC to

gather and publish an industry-wide average execution-only rate

from all registered broker-dealers. This would become a benchmark

for the industry where fund advisers would then have to justify

anything above that rate, in terms of value of research and services

to fund directors and investors. Frankly, there should be a companion hard-dollar disclosure of the costs for such services as well.

The Financial Services Authority is working on this in London

right now, and I have some stuff off their website I would like to

enter.

Chairman SHELBY. We will make that part of the record.

Mr. BRADLEY. Thank you.

Exhibit 3, I have a very simplistic illustration of the impact of

soft dollars on fund company profitability, but it is real. I took the

numbers that are averages we have on how costs are attributed

within the mutual fund business to an adviser. And what we see

is that high cents per share commission rates can really positively

influence operating profitability.

According to Greenwich Research, soft-dollar usage increased significantly during the bear market. This outcome should have been

anticipated. Income for fund advisers is driven by assets under

management. As assets fell, revenue for the asset managers fell.

Faced with the choice to cut costs to preserve profit margins or use

more trading commissions to pay the bills, many chose the latter.

It is a staggering fee that is levied on investors without their

knowledge, and we need more complete soft-dollar recordkeeping

and periodic review, at a minimum, by fund boards and the SEC.

Chairman SHELBY. Where has the SEC been on all of this?

Mr. BRADLEY. The SEC, frankly, has studied this a lot, and they

had recommendations after their sweep in 1998. The GAO has told

you the same thing, and they have not acted on their own recommendations. Now, they have been a little busy lately, but I think

that is why they need the help. Many people blame the broad language in 28(e) for the reason they cannot act. And the interpretative release that they put out, without rulemaking, in 1985 is what

opened this floodgate.

Are we a lone voice in the wilderness on this? For about 10

years, we felt that way. Right now, the industry is running fast

and hard from this problem, and I have not met anybody who is

willing to stand up and defend what has been going on here.

The GAO and large and small practitioners have appeared in

front of you. Thirty-seven percent of leading traders—these were

head traders from major organizations gathered at a broker conference last year—reported that directed orders and soft-dollar obligations represented the biggest impediment to best execution.* The

professionals know this is a big problem. Most of them do not have

the courage to solve it. There is too much profit in it.

How about unbundling? I know there has been some talk here

and in the media about unbundling. Is it desirable? Nobody in our

782

* Held in Banking Committee files.

business can agree on a majority of anything. According to Benn

Steil’s work, 51 percent think that unbundling is desirable.* Most

do not think it is feasible. Again, they do not have the courage because of the distribution practices and the extra profit incentive advisers enjoy in the way the business is currently structured.

At Exhibit 4, I have attached a little bit more information to

quantify the extent of this problem. I called a broker and said, ‘‘If

I was going to pay soft, what can I pay for?’’ He sent me a list, in

1988—I have been doing this for a long time you can see now—in

1988, when I first wrote in my Market 2000 piece, 264 vendors

were on that list; in 1994, 573 vendors. Today, more than 1,200

companies meet the definition of research as advisers have defined

it. I will tell you what I can pay for—not I. My counsel has told

me not to say ‘‘I.’’ What those in the business might pay for. We

chose not to do this.

Ernst & Young is on the list; Buck Consulting, a compensation

consultant; New York Stock Exchange Quote Fees; Nasdaq; the

Wharton School for Executive Education; The Wall Street Journal;

Oracle and Dell. Stuff people have in their homes are getting paid

in the business with commissions.

Finally, when I am really tired at the end of the day, this is one

I found really interesting on this soft-dollar list, the Standard Club

of Chicago. Apparently, tired portfolio managers go into the trading

room and say, ‘‘Hey, can I ship a little dollars here because they

are on the soft-dollar list,’’ probably for seminars. But, again, I

think this speaks to the problem we have here that demands definition and constriction. And I think that this problem, in some of

the data I have seen, can represent as much as a $6-billion-fee levy

on investors that needs to be fixed.

I thank you for the opportunity to comment on these issues.

Chairman SHELBY. Mr. Edelstein.

STATEMENT OF GEOFFREY I. EDELSTEIN, CFA, CIC

MANAGING DIRECTOR AND CO-FOUNDER

WESTCAP INVESTORS, LLC, ON BEHALF OF

THE INVESTMENT COUNCIL ASSOCIATION OF AMERICA

Mr. EDELSTEIN. Chairman Shelby and Members of the Committee, thank you for the opportunity to appear here today.

I am a Managing Director and Co-Founder of Westcap Investors

in Los Angeles. Westcap is registered as an investment adviser

with the SEC. Our firm was founded in 1992 with four employees

and no assets under management, and today we employ 43 people

and manage about $2.8 billion in growth stocks and fixed income.

I am pleased to bring to this panel the unique perspective of a

smaller money manager. The Investment Council Association of

America represents Westcap and SEC-registered investment advisory firms. I am offering my testimony today on behalf of the ICAA.

Westcap is a research-intensive firm. Our team of 13 investment

professionals conducts extensive research on the investment environment and individual companies. This internal research is augmented by external research provided by brokerage firms, comVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00794 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
783

monly referred to proprietary research. In addition, we use external

research from other third-party providers.

Examples of proprietary research services that we use include

not only written research reports, but also, more importantly, to

our firm access to economists, strategists, analysts, and company

management. The research received from third parties includes the

same range of services provided by those full-service brokers, as

well as access to information sources and analytical systems. All of

this information is considered, along with our internal research, in

making investment decisions on behalf of our clients.

The research services that we purchase, whether proprietary or

third party, are essential to our research process. The ability to use

soft dollars to pay for research was crucial in the start-up phase

of our firm, and it continues to give us access to information that

otherwise would be unattainable. This allows us to provide services

on par with firms of far greater size than ours.

Small- and medium-size firms are important participants in the

capital markets. They fill a wide variety of market needs in terms

of asset classes, level of service, size of clients, and regional coverage. Smaller managers can be more nimble in their management

and very successful. For example, a study of the rate of return over

the past 5 years for large-cap growth separate account managers

shows that 7 of the top 10 performing managers have less than $2

billion under management. Clearly, smaller firms can provide investors an attractive alternative to larger firms.

Following are the three major points described in greater detail

in my written statement:

First, investment advisers are fiduciaries who have an obligation

to seek best execution in connection with client transactions and to

disclose potential conflicts of interest to clients. Client brokerage is

an asset of the client, not of the adviser, and thus there is a potential conflict where an adviser uses commissions to pay for research.

Accordingly, we support full and appropriate disclosure of soft-dollar practices by all investment advisers. Consistent with the basic

approach of U.S. securities laws and market principles, we strongly

believe the SEC should ensure that there is adequate disclosure regarding soft-dollar practices, combined with appropriate inspection

and enforcement of regulations governing these practices.

Second, we support the SEC’s current initiative to examine softdollar practices. Specifically, we urge the SEC to propose rules ensuring that required disclosures related to soft-dollar arrangements

are adequate and appropriate, requiring enhanced recordkeeping to

demonstrate compliance, and clarifying the current definition of research. The consequences of abolishing soft dollars, an outcome

that would require Congressional action, will adversely affect

smaller investment advisory firms, reducing the services they provide, and encroaching on their ability to compete with larger firms.

It will create barriers to entry for new investment advisory firms,

further reducing competition, and it will diminish the availability

of third-party research.

Finally, we strongly oppose the recommendation that the SEC

should eliminate the use of soft dollars for third-party research. We

believe this approach would harm investors and diminish the availability of quality research. It would result in an unjustifiable,

784

unlevel playing field, providing a regulatory-driven advantage for

full-service brokerage firms, and a disadvantage to third-party research providers. Eliminating soft dollars for third-party research

would also result in less transparency to investors, regulators, and

market participants.

Thank you again for the opportunity to testify today. I commend

the Committee for its deliberate and thorough approach in considering these and other important issues, and I look forward to your

questions.

Chairman SHELBY. Mr. Schilit, go ahead, sir.

STATEMENT OF HOWARD M. SCHILIT, PHD, CPA

CHAIRMAN AND CHIEF EXECUTIVE OFFICER

CENTER FOR FINANCIAL RESEARCH & ANALYSIS (CFRA)

Mr. SCHILIT. Thank you, Chairman Shelby and the rest of this

distinguished panel.

I am Howard Schilit, the Founder of a large independent research organization called the Center for Financial Research and

Analysis and also author of the book called, ‘‘Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial

Reports.’’ Our organization serves as an independent watch dog organization for investors, warning them about unusual accounting

practices. Two years ago, I testified before the Governmental Affairs Committee at the height of the Enron hearings, and we witnessed some very sad events during that period, and I hope and

pray we do not have a repeat of that.

Independent research organizations, in general, perform an important watch dog role for investors. As we all know, our Founding

Fathers had the wisdom to devise a system of checks and balances

to not allow a single branch of Government to exert undue power.

In much the same way, the independent research industry provides

checks over potentially biased and misleading information distributed by public companies and their sponsors at investment banking

brokerage firms.

Independent research organizations typically are paid by thirdparty brokers that use soft-dollar commissions. A ban on soft-dollar

commissions would have a devastating impact on independent research firms and indirectly hurt investors. I urge this Committee

to search for other solutions and leave soft-dollar payments intact.

Historically, when investment managers trade stock, they have

had to purchase a bundled package of services from one source—

full-service brokerage firms. All research, trading, and other brokerage services came from this one source. Within the last generation, competition has emerged as small boutique brokerage firms

enter the market, driving down commission rates. In order to truly

compete with full-service brokerage firms, the boutiques needed to

bundle some value-added services. Since customers wanted research, the boutiques outsourced these products by partnering with

value-added independent research organizations.

Investment managers loved having new trading partners and

new research sources. In contrast, traditional, proprietary fullservice brokerage firms were not pleased at all with competition

emerging on two fronts: brokerage and research. In the old days,

proprietary brokerage firms were the only game in town. They had

785

a monopoly on trading and research, and investors paid exorbitant

commissions for research of questionable value.

Fortunately, for investors, the proprietary brokerage monopoly

has been threatened. Today, competition is fierce for trading commissions driving trading costs lower for investors, and fierce competition exists on the research front as well, with over 300 entrepreneurial independent research firms pushed to produce the most

value-added research at the best price. Investors never had it so

good, with commission costs dropping and high-quality, independent research widely available.

Unfortunately, for investors, the proprietary brokerage firms are

fighting hard to regain their monopoly in trading and research.

They are pushing for a ban on soft-dollar trading, the commissions

typically paid to smaller brokerage firms and later directed to independent research organizations. The single act of banning soft dollars would irreparably hurt competition from boutique brokers and

independent research organizations.

My first recommendation is to retain the current soft-dollar

mechanism to provide flexible payment options for purchasing

independent research. Now, make no mistake, there are serious

issues and problems that need to be addressed so that brokerage

commissions charged are fair and reported in a transparent fashion

and that investment managers always act in the best interest of

the investing public.

I have a few fundamental questions before I give my specific recommendations:

What is the appropriate currency, brokerage commissions, or

cash to be used for investment research? Is it inherently wrong for

investment managers to use commissions as the currency to pay for

research or consulting services? I think not since, for over 200

years, most investors have used trading commissions as the sole

currency for such services.

If, however, you disagree and believe that a new currency should

be used, that is, cash only for research, that would be agreeable,

provided all research purchased by investment managers is paid

for with cash. Thus, if commissions were banned as a currency to

pay for third-party independent research, then I would urge you to

establish a total ban on using commissions for any research from

any source.

Specifically, if an investment manager purchased research from

my investment organization and must pay cash, then, in all fairness, research that is acquired from Merrill Lynch, Goldman Sachs,

Morgan Stanley should also require a cash payment as well. I

would have no objection to creating a meritocracy that allows all

research providers to compete on the same playing field.

So, Recommendation No. 2, assuming there is little interest in a

cash-only approach, commissions should be in the currency of or

the currency for paying for research should remain commissions,

and no distinction should be made between research that is provided from proprietary brokerage firms and from third-party firms.

Some specific recommendations and issues are: Bundling execution costs, where there is no differentiation between the execution

and the other services; failure of mutual fund companies to include

the nonexecution portion of the commission in their expense ratio;

786

and inflated brokerage commissions and inadequate disclosure of

that portion of the brokerage commission directed to third parties.

I have a recommendation to solve each one of these.

Recommendation No. 3, all brokerage organizations must unbundle execution from nonexecution costs and disclose this information

to investment companies. Since nonexecution brokerage commissions are identical at all firms, regulations should treat them as

such. Requiring the unbundling of brokerage commissions and

showing the trade execution costs and other services separately can

easily solve most problems that this Committee is addressing.

Full-service brokerage firms typically charge 5 cents per share to

trade, down from about 8 cents a number of years ago. Included is

approximately 2 cents for execution, and the remaining 3 cents for

nonexecution costs, including such things as research. Brokerage

firms have not been required to disclose to investors and other

stakeholders how the 3-cents-per-share is spent and consequently

fail to report this information. In many cases, the 3 cents supports

in-house research and operations at proprietary brokerage firms. In

contrast at soft-dollar brokerage firms, the 3 cents is paid out to

third-party research organizations. In essence, the commissions

that are paid, whether at a proprietary brokerage firm or a thirdparty brokerage firm, is essentially the same. Whereas, the proprietary brokerage firm keeps all 5 cents for their in-house execution

and other services, and the boutique brokerage firm outsources and

pays a part of that 5 cents to research organizations, such as myself. In essence, the customer is not being ripped off or not paying

more by going to a third-party firm.

Recommendation No. 4, nonexecution costs should be included in

the expense ratio that mutual fund companies disclose. I think research is a part of the cost of the mutual fund. A big mutual fund,

as American Century, has an army of in-house analysts. That is included in their expense, and if they decide to outsource some of the

research to third parties, whether it is a Merrill Lynch or whether

it is a CFRA, those are the same type of research expenses that

should be included in the expense ratio by requiring brokerage

firms to unbundle the total commission. And we know how much

is execution and how much is research. That problem is solved. We

simply need regulation that requires mutual fund companies to include research from whatever source in the ratio.

Recommendation No. 5, regulators and accountants should audit

the records of both brokerage organizations and investment managers to ascertain proper accounting and disclosure of nonexecution

costs and the expense ratio. So, once we have an a` la carte menu

of how much is the nonexecution cost, how much is research, then

regulators could require including that information in the expense

ratio and it is auditable.

And my last recommendation, No. 6, is severe penalties should

be meted out to organizations that fail to properly account for nonexecution costs.

So, in summation, I believe that the world we are looking for,

lower brokerage commissions, giving investment managers the

flexibility to purchase on an a` la carte menu where they trade,

where they are going to purchase research, will drive down the

commission costs and will allow the investment manager to purVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00798 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
787

chase research from wherever they believe the greatest value is

going to be, and with the unbundling of the total brokerage commission, then we are in a position to know whether people are

cheating. And we are able to say to investment managers, you

must include the total research costs in your expense ratios to

shareholders.

I thank you all for this opportunity.

Chairman SHELBY. Mr. Steil.

STATEMENT OF BENN STEIL, PHD

ANDRE ́ MEYER SENIOR FELLOW

IN INTERNATIONAL ECONOMICS

COUNCIL ON FOREIGN RELATIONS

Mr. STEIL. Thank you, Mr. Chairman, and thank you, Members

of the Committee, for the opportunity to testify before you this

morning.

The central question before us this morning is why fund managers should choose to buy research, computer systems, and other

support services as a bundle, indirectly through trading commissions, rather than directly by agreeing a price for each product

with the research purveyors, with the computer system purveyors,

et cetera, and writing checks to each of them. After all, that is how

normal businesses pay for their consulting, their computers, et

cetera. That is how you and I pay for such services. We do not, for

example, pay for a computer by agreeing to buy $3,000 worth of

telephone calls from a telephone company.

The answer to this question, Mr. Chairman, is very simple. The

fund managers are trying to finance as much of their operating

costs as possible using their client’s assets rather than their own.

And the only way that they can do this legally, other than through

the management fee, is through trading commissions. It would, for

example, be illegal for them to buy computers through bills paid to

a telephone company out of their clients’ assets, but it is legal for

them to do so through brokerage commissions. This is the significance of the Section 28(e) loophole in the Securities Exchange Act

which, in my view, has given rise to a vast industry-wide kickback

scheme through which fund managers use institutional brokers to

transfer fundholder assets to themselves in a manner totally invisible to the fundholders.

The mutual funds will tell you, Mr. Chairman—indeed, legally,

they must tell you—that they use soft dollars to buy research. This

is true, but also very misleading. As Mark Twain observed, Mr.

Chairman, almost all lies are acts and speech has no part in them.

Let me illustrate. As you will see from the attached Figure 1, attached to my testimony, mutual funds actually pay trading commissions to brokerage firms using their clients’ money to buy such

diverse items as newspapers, magazines, online services, conference registrations, accounting services, proxy services, office

administration, computers, monitors, printers, modems, cables,

software, network support, and maintenance agreements. And in

one of the ultimate ironies, Mr. Chairman, fund managers even pay

inflated trading commissions to brokers in return for third-party

trading cost measurement services, which invariably tell them that

their brokers cost too much.

788

Now, how significant is this problem? Let me provide just a few

examples for you.

As you will see in the attached Figure 2, the average institutional broker kicks back $1 in products and services to the fund

manager for every $1.60 it receives in trading commissions. That

is, most of the standard institutional trading commission represents payment for items that have nothing to do with trading. As

you will see in Figure 3, the percentage of institutional trading

commissions allocated specifically to pay for ‘‘research,’’ broadly defined, rather than good trade executions, actually rose from 29 percent in 2001 to 39 percent in 2003. That is, the problem is getting

worse.

Figure 4 will show you that the average fund manager cannot

possibly be seeking best execution for the client, as the trading

desks, according to the funds themselves, only control between 21

and 29 percent of the commission payments. The bulk of these payments are determined in advance by others who never actually initiate trades themselves.

Now, how much does this practice of soft-dollar trading actually

cost investors? I would remind the Committee that in the recent

fund timing investigations, it was widely suggested that the cost to

investors of this practice was about 5 basis points. In my attached

paper on ‘‘The Economics of Soft-Dollar Trading,’’ I estimate that

the true effective management fee that a fundholder pays is about

70—seven-zero—basis points higher than the headline fee which

the fundholder sees in the prospectus. This 70-basis-point premium

is accounted for by bad trading: commissions which are about 2.5

times higher than they would be if the fund manager were seeking

best execution, even after stripping out the value of the kickback

services—that is, I am assuming that the kickback services directly

assist the investor—and implicit—or market impact—costs about 3

times higher.

Now, if the Committee accepts that soft-dollar trading is indeed

a problem, how then should this problem be addressed? There are

three basic approaches:

The first approach is to require increased disclosure of trading

costs to fundholders. More information is always preferable to less,

in my view, but this is not——

Chairman SHELBY. How would you do that?

Mr. STEIL. A very good question. Most people who support this

support doing it through the expense ratio. Mr. Pozen, and others,

have presented you the complications in doing that. My feeling is

that it also would leave out the most significant portion of trading

costs, which is totally invisible. This is the market impact or implicit cost. This measures the cost of bad trading, above and beyond

the trading commission.

For example, a lot of so-called research firms have brokerage

arms attached to them not because they are particularly good at

executing trades, but because that is the only way that they can

get paid, using the fund manager’s clients’ assets, rather than

using the fund manager’s assets. So these firms are not set up specifically because they trade well, but because they want to receive

these soft-commission payments.

789

In my view, it should be through the management fee, and I will

explain in my last point how I think that could be done.

Since the largest component of trading costs—so-called implicit

costs—is not actually captured in the visible commission fees at all,

we must ultimately look for a solution that encourages fund managers to trade as efficiently as possible, not just in the interests of

their client, but in their own self-interest.

More fundamentally, if the practice does truly represent an

abuse of fundholder assets, surely, the remedy must be more robust

than just disclosure. After all, we do not merely regulate fiduciary

abuses by obliging fiduciaries to publish a costed inventory of client

property improperly used.

Now, a second approach is to eliminate the 28(e) loophole entirely. In other words, fund managers would only be allowed to use

trading commissions to pay for trading. This would be a big step

forward, although I do suspect that funds will try to continue to

pay inflated trading commissions in return for kickback services

that will simply be less visible to regulators. There is no doubt, for

example, that the industry pushed a lot of practice underground

after the SEC sweep in 1997.

Now, a third approach would be to oblige fund managers to pay

trading commissions out of their own assets—as recommended in

the March 2001 Myners Report prepared for the Treasury of the

United Kingdom. This would dramatically realign fund managers’

interests with those of their clients. They would immediately

unbundle commissions and seek best execution because it would be

in their self-interest, as well as the interest of their clients. It

would, in fact, lead to a dramatic improvement in U.S. market

structure, with an expansion of low-cost direct electronic trading at

the expense of brokers whose only value added is in facilitating the

soft-dollar kickback system.

As I show in my paper on ‘‘The Economics of Soft-Dollar Trading,’’ a typical fund management firm could cover the cost of bearing trading commissions by raising its management fee by about 18

basis points, and this would still leave the fundholder better off by

about 50—five-zero—basis points.

Chairman SHELBY. How would that translate into real savings

dollars—55 basis points is——

Mr. STEIL. Sure. Well, take a fund manager who is charging a

1 percent management fee.

Chairman SHELBY. So half of it.

Mr. STEIL. Right now, that fund manager is really charging the

client 1.7 percent.

Chairman SHELBY. Okay.

Mr. STEIL. The client just does not know it. Now, if this fund

manager were to move to hard-dollar trading, that fund manager

would suddenly become terribly concerned with the cost of trading

and would redirect his trading from soft-dollar brokers to the

cheapest possible trading vehicles available. Now, that would be a

cost to the fund management firm if they had to pay those trading

commissions themselves. So, I calculate, if they wanted to recoup

the entire cost, they could raise their fee by 18 basis points. So,

now, the management fee would be 1.18 percent. But that would

still leave the client better off by 52 basis points. Because, if you

790

remember, the effective management fee was 1.7. Both the

fundholder and the fund manager would be better off.

The only losers in this unbundling process, over the long run, are

the brokers who earn their living facilitating soft-dollar kickbacks.

American investors, in my view, would be far better off if these brokers found another way to employ their capital.

I thank you again for the opportunity to testify this morning, and

I look forward to assisting your deliberations.

Chairman SHELBY. Thank you.

Mr. Thomas.

STATEMENT OF GRADY G. THOMAS, JR.

PRESIDENT, THE INTERSTATE GROUP

DIVISION OF MORGAN KEEGAN & COMPANY, INC.

Mr. THOMAS. Thank you, Chairman Shelby, and Members of the

Committee.

My name is Grady Thomas. I have been in the securities business for 40 years, and in 1986 became the President of the Interstate Group, today a Division of Morgan Keegan & Co., Inc. I have

been active in the securities industry. I was on the board of directors of the Boston Stock Exchange for 8 years, served as Chairman

and President of the NOIP, the National Organization of Investment Professionals, was Chairman of the NASD District 7. I am

currently Chairman of the SIA Institutional Brokerage Committee.

Interstate Group has provided independent research for commission dollars to investment advisers and mutual funds since 1975.

During the past 30 years, I have seen innovative research flourish

and institutional commission rates fall from a high of 82 cents a

100 to approximately 5 cents a share today. For example, in 1975,

if a manager put an order in to buy a thousand shares of $100

stock, the commission was $750. Today, that commission would be

roughly $50. In 1975, there were 400 mutual funds, 4,000 investment advisers, and hedge funds were practically unheard of, only

around 200.

So where are we today? Today, there is 8,000-plus mutual funds,

7,000 investment advisers and 6,000 hedge funds. Mutual funds

alone manage $7.5 trillion in assets. The result is a wide selection

of fund opportunities for an individual investor and the need for informative, readily available research for the investment manager

who must excel in a highly competitive marketplace.

Over the years, I have seen the transparency of independent research arrangements improved to the point where investment managers involved in these transactions receive monthly statements

detailing the type of research provided, its cash value, and the total

commissions used to pay for that research. This has all been to the

advantage of security markets and investors.

The driving force behind these beneficial developments has been

Section 28(e) safe harbor adopted by Congress in 1975. I was there

in 1975 when 28(e) was approved, and I believe that Congress and

the SEC got it right. Research and execution of services provided

by broker-dealers to investment managers add value to investment

managers’ accounts.

In its consideration of 28(e), Congress recognized that without access to research through portfolio commissions, small investment

791

managers would have to charge higher advisory fees. The adoption

of 28(e) has allowed start-up and smaller investment managers to

compete with large advisory firms on a more level playing field.

In 1986, the SEC revisited 28(e). Up to that point, research was

delivered basically by the U.S. Post Office in the form of written

reports, ink on paper. Managers had to shuffle through tall stacks

of research reports to make their investment decisions. Locating

that information was a tedious task at best. Then, the method of

delivery changed. The fax machine and FedEx came along speeding

delivery of reports. Meanwhile, technology was making huge advances, moving into the computer era in the 1980’s.

In 1986, the SEC broadened the scope of 28(e) to accept electronic research capabilities. In my opinion, we would not have the

incredible pool of research we have available today without the

door that was opened in the 1986 release. Systems have developed

which can take the balance sheets of 17,000 companies, and using

hundreds of different parameters, can crunch those numbers in literally seconds—seconds. That would have been an impossible research task just a few years ago. Today, with the electronic boom,

almost all research is provided through e-mail, through the Internet, T–1 lines, so delivery is instantaneous. Portfolio managers

have a wealth of creative research, sophisticated systems available

to assist them in the investment decisionmaking process.

The safe harbor has allowed broker-dealers, specializing not only

in execution, but also the provision of independent research, to

compete more equally with large Wall Street firms. The result has

been lower execution costs and more competition.

In closing, I heard testimony last week in this room, which is

often repeated in the press, that commission dollars are used to

pay for such items as rent. In my 30 years providing independent

research, I have never been asked to provide an item such as rent

in a 28(e) arrangement. This is not research, and it is not covered

by Section 28(e) safe harbor. I think that the SEC studies and examinations bear this out.

The SEC did an extensive sweep in 1997 of 75 broker-dealers,

280 investment advisers, and investment companies. We were part

of that sweep, and we received a clean letter from the SEC.

Quoting from the SEC Inspection Report, issued September 22,

1998, ‘‘We did not observe any instances in which fund commissions were used to purchase non-research items which did not directly benefit the funds themselves.’’

In Section VIII of the Inspection Report, the SEC staff made a

number of recommendations pertaining to the provision of independent research for portfolio commissions. I encourage the SEC to

give further consideration to these recommendations.

Congress and the SEC showed foresight when they adopted Section 28(e) in 1975 and broadened the scope in 1986. The results

have been an increase in competition and in the availability of excellent research, both of which, bottom line, benefit all investors.

In a nutshell, 28(e) is the gas that drives the research engine.

Thank you for allowing me to appear before you today, and I

would be glad to answer all of your questions.

Chairman SHELBY. Mr. Velli.

792

STATEMENT OF JOSEPH M. VELLI

SENIOR EXECUTIVE VICE PRESIDENT

THE BANK OF NEW YORK

Mr. VELLI. Chairman Shelby and Members of the Committee, I

am Joseph Velli of The Bank of New York. Thank you for allowing

me to testify today.

We appreciate the Committee’s efforts to examine issues concerning mutual fund practices. We would also like to applaud the

SEC for proposing new rules to ensure that investors are given a

fair shake. The Bank of New York is the oldest bank in the United

States, founded by Alexander Hamilton. Today, The Bank of New

York is a global leader in securities services. In fact, today, we

safe-keep over $8 trillion in investor assets. BNY Securities Group

houses the bank’s agency brokerage and clearing businesses. We

believe BNY Securities Group is the largest agency brokerage firm

in the world.

Securities-related research is, and always has been, an integrated part of the brokerage business. Soft-dollar commissions are

the method of paying for research, whether the research is produced by a full-service investment banking firm or by an independent research firm. Even though the same term is used, the

level of disclosure is very different. Full-service firms bundle numerous services, including research, into one commission rate.

Agency brokers fully disclose the cost of independent research and

of execution.

It is important to note that not one of the recent scandals has

involved soft dollars under either the full-service or agency models.

Yet, these practices are under fire. Part of the perceived problem

is in the name ‘‘soft dollars.’’ I cannot think of a more misleading

name. In describing what we do as an agency broker, we prefer to

use the term ‘‘independent research commissions.’’ All of the noise

around whether soft dollars are good or bad has had a chilling effect on the market. This has resulted in independent research

being scaled back, which is unhealthy.

Without dynamic research, advisers cannot meet their obligations to investors. We believe that the appropriate action would be

for the SEC to reassure the markets and enhance access to independent research by clarifying its guidelines under Section 28(e).

As mentioned earlier, SEC Chairman Donaldson has created a task

force to review this subject and additional guidance is likely.

Broker-dealers that offer independent research have made a

business of disclosure and commission management. Our clients expect us to account for every penny of their clients’ commissions,

and we do. Like many other firms, and as Mr. Thomas mentioned,

we give our clients detailed statements reporting their trading activity, the independent research provided, and their separate costs.

We see four intrinsic values in independent research: One, it is

free of conflicts, which is very important; two, it stands on its own

merits. It either performs well or it is no longer selected; three, it

is serious, innovative, and often very different from Wall Street research; and four, it serves the public interest. Long before regulators reacted, various independent researchers uncovered the

frauds of Enron and WorldCom. In settling the case of tainted research last year, the regulators further validated the importance of

793

independent research. We do not need less independent research.

We need more.

It is important that Congress not place an unfair burden on independent research as compared to proprietary research, a result

that is at odds with the principles of the global settlement.

Research has always been paid for with commissions and is a

natural alignment of the ideas generated and compensation paid

for those ideas. Increased disclosure will better allow the asset

manager to judge the value of the research and make the asset

manager and broker more accountable to the underlying investor.

Some assert that mutual fund managers engage in this practice

for their own benefit, without the investor or the fund board’s

knowledge. The way to solve this problem is through disclosure and

responsible fund governance.

Many have asked, ‘‘Why not cash?’’ There would be considerable

negative consequences to banning the use of commissions to pay for

research. Among the losers would be investors, independent research firms, small mutual funds, agency brokers, and funds reliant on sophisticated analytics. Such a radical change would strike

a hard blow to independent research just as it is coming into full

bloom, and would also lead to further reduction of proprietary research. This cannot be good for investors.

Agency brokers and independent researchers, whose fees are

transparent, already compete on an uneven playing field. Allowing

advisers to use commissions to pay for research from full-service

firms, but not for independent research, would simply be unfair

and create a competitive disadvantage, the worst-possible outcome.

Most mutual funds have limited internal research staffs. They

rely on independent and proprietary research. Some of the larger

funds employ hundreds of their own researchers, yet some of the

highest returns are generated by smaller funds.

According to a 1998 SEC report, the smallest advisory firms used

over half of their commissions for independent research, while the

largest advisory firms used, on average, 8.3 percent. In other

words, independent research provides essential support to smaller

funds. Abolishing research commissions would extend the dominance of the large mutual fund complexes, limiting competition, reducing choice, and hurting small mutual funds. Since the costs of

independent research are disclosed, they are, and can be, audited.

Lastly, we believe that commissions used to pay for research

should be accounted for. However, we do not support full

unbundling of commissions by the full-service firms, even though

we as, an agency broker, might benefit. Full unbundling would be

highly disruptive to the markets, difficult to account for and accomplish, and would lead to a drastic reduction in research.

In conclusion, soft-dollar practices benefit investors. So what is

the problem? Investors should have more information about how

investment advisers are using their commission dollars. Better disclosure will help restore investor trust and will make all market

participants more accountable.

We agree with the SIA, which supports the safe harbor for research created by Section 28(e), that the SEC mandate reasonable

additional disclosure. We are confident that the SEC can manage

this responsibility. If we are to ban anything, let us ban the term

794

‘‘soft dollars.’’ Let us call them what they are—research commissions—and encourage the greater use of independent research.

Thank you for this opportunity.

Chairman SHELBY. Thank you.

Senator Allard.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. First question, I have been particularly interested in the role that disclosure plays as a it relates to appropriateness to the investor both—in the amount of disclosure provided and

the location in which that information is provided.

I understand that current law requires that investment advisers

disclose the mutual fund soft-dollar policies and procedures ‘‘in

law,’’ as necessary or appropriate in the public interest or for the

protection of the investors.

I would be interested to hear from any of the witnesses regarding, first, what information on soft dollars is specifically required

to be disclosed by law and, second, where that information is located or provided to the investor.

Mr. Bailey.

Mr. BRADLEY. May I, Senator Allard?

Senator ALLARD. Yes.

Mr. BRADLEY. Currently, there is broad and generic disclosure in

Form ADV which investors must ask to receive as an additional or

supplemental piece of information.

My problem with that particular disclosure, it is a very broad, as

is 28(e), it says, ‘‘Would you categorize who provides research and

services,’’ not what they are, not what the hard-dollar equivalent

amount might be, and very, very little else. So it just becomes kind

of a line-by-line summary, and that is really the only disclosure

there is.

When we talked to our accountants about this a year ago, I

asked why this is not treated as either an income or expense item

on a fund’s income statement. And according to our accountants—

fund accountants and auditors—they disclosed to us that because

these are not written agreements, in fact, 28(e) is an agreement between the broker and Oracle or the broker and Dell, not between

me and Dell or Oracle. So that, while I get a record back, there is

no requirement that I provide that recordkeeping to anybody else.

Without a specific record of the cost of the service, accountants say

it falls outside of GAAP rules—if such costs were captured and reported, funds may be required to report the use of commissions as

income and subject to taxation.

In fact, the SEC, in that same study that was quoted, also said

that the recordkeeping and ability to get at the records was a key

problem, and that was some of the recommendations they had

asked for.

Senator ALLARD. How do they deal with multiple transactions?

How were those charges allocated out? If you had a number of clients invest, and you use that research data, I would not expect, if

you are making the same investments, that you keep ordering new

research. Is that allocated out to the various accounts or is that ignored? How is that handled?

795

Mr. BRADLEY. Well, right now my understanding is—I am not a

lawyer and I am not in the business. I am on the buy side. We are

called the buy side because we buy these services—what typically

happens is they are not broken out by fund, but in a broad aggregate in the SAI, I think which is fund specific. But, again, I am

not in the lawyer’s office. I am a practitioner. There is an attempt,

but they are not broken out on an allocated cost-to-fund basis.

Mr. VELLI. Senator, I think you hit the button right on the head

as far as a weakness as we see it. We believe that more disclosure

should be given to the investor, and we have been very strong advocates of creating various buckets for commissions as to how an

asset manager would record and disclose these, how they are using

their commissions: Basically, execution-only, bundled commissions

for proprietary research, and also how much of the commission dollars are going to independent research.

We believe that if you take that type of approach, over time,

asset managers will increase their use of independent research and

investors will also demand it and be able to monitor the different

funds and how they are spending their commission dollars.

Mr. EDELSTEIN. Currently, our disclosure is Form ADV. We manage money for institutions, individuals, and also sub-advise to mutual funds. And all of those types of clients ask us for additional

disclosure of what we buy in detail, what their commission levels

were, a description of not only what we are buying, but also how

it is used in the decisionmaking process.

I think that process would enhance more conservative practices

in this area. It certainly, you know, bears upon our decisionmaking

when we utilize commissions.

Additionally, we do not have the ability to buy anything we

want. As a smaller firm, our budget is quite limited, so we are rationing what we are buying. There are a lot of things that we buy

with hard dollars that other firms are able to buy with soft dollars.

Mr. THOMAS. Senator, all our clients receive detailed monthly

statements, including the breakdown of every trade, every invoice,

every service we provide. That information is then checked, I am

sure, by the manager’s internal auditors. And to my knowledge, it

is referred to their fund board of directors, so they see that information also.

Senator ALLARD. Mr. Steil.

Mr. STEIL. Two very brief points. First, with regard to the track

record on disclosure, the SEC in its 1997 sweep, found a number

of interesting items. I will just give you a few of them.

Half of all investment advisers failed to disclose to clients the nature of nontrading services being financed through commissions

charged against a client’s assets—half.

Over one-third of U.S. institutional brokers have illegal—that is,

not research related, even by the SEC’s generous definition—arrangements with investment advisers, none of which, zero, were revealed to clients. And almost two-thirds of soft-dollar arrangements

are entirely undocumented.

Now, if you ask me to guess which of these statistics has changed

since the SEC published this, the last one. Now the industry has

learned not to publish anything with regard to soft dollars because

it is just going to hurt you if the SEC does another sweep.

796

The second important point to make is that bad trading is very,

very difficult to quantify and put in the expense ratio because it

goes well beyond commission payments. So-called market impact

costs of bad trading can often swamp the commissions. And in this

case, it is exceptionally difficult to reveal the damage to fund performance to the fundholder. Therefore, what I would like to see us

do over the long term is realign the interests of the fund manager

with the investor by giving the fund manager the maximum incentive to get efficient trading. And we can do that by obliging the

fund manager to cover the cost of commissions itself.

Now, of course, some are going to argue that is going to damage

industry profitability, but I am not suggesting here that we should

regulate management fees. What I am suggesting is that the problem would be very simple in a hard-dollar world. The investor

would have two primary quantitative indicators that he or she

would use in selecting a fund. One is that fund’s record over time.

Does that fund produce good performance? And, two, the management fee, which finally would be something meaningful. Right now

it is not meaningful because the funds have a maximum incentive

to shift costs out of the fund management fee and to hide them in

soft dollars.

Mr. THOMAS. Senator, let me add one point. The gentleman just

referred to the SEC 1997 sweep and alluded to ‘‘the inspection report,’’ which I have a copy of here, and I referred to it in my verbal

testimony. The SEC staff did not find one mutual fund that misused their client’s commission dollars. In the executive summary of

this report, the SEC says—and this is how they lead off this inspection report: ‘‘Research is the foundation of the money management industry. Providing research is one important, longstanding

service of the brokerage business. Soft-dollar arrangements have

developed as a link between the brokerage industry’s supply of research and the money management industry’s demand for research.’’ This is quoted from the SEC.

Senator ALLARD. Mr. Chairman, my time has expired, but I

would like to follow up just a little bit.

Chairman SHELBY. You go ahead. Take your time.

Senator ALLARD. If research is so valuable, Mr. Thomas, what

difference does it make who pays for it? Will it survive? It is going

to survive no matter who pays for it if it is so valuable, is it not?

Mr. THOMAS. Well, I think it will survive to a certain extent,

Senator, but what will happen to the start-ups the people that we

have seen over the 30 years that have, for the most part, come out

of traditional brokerage firms? They have had better ideas, and a

lot of times those ideas did not fly where they were. They started

a service, and some needed help. We have loaned money through

the years to help them get started, and they are extremely successful.

Now, what happens for the next wave? They may not have the

opportunity to start up if you hamper just independent research.

They will never have a chance to sell their product, because in a

sense we are the sales organization of these products and services.

They start up their firms, but they do not have marketing or sales

staff. We use our sales people to help sell those products for them.

Senator ALLARD. So you end up subsidizing——

797

Mr. THOMAS. Subsidizing—no I said loan. My contention is that

if the investment manager pays for the same independent research

product with cash instead of commission dollars there will not be

a savings. Without our support in the sales and marketing area,

the independent research provider will incur more expense to provide the product. We are unbundled versus full serice brokerage

firms. We show our clients the cost of the service. We provide an

easier and less expensive way to obtain independent research.

Mr. BRADLEY. Senator, may I address that?

Senator ALLARD. Go ahead.

Mr. BRADLEY. I have a couple of concerns with the framing on

some of these ideas. One is I have heard that we have an infinite

amount of research available today that we did not formerly have

and how valuable it is. But if soft dollars go away in any way, it

will hurt the availability of research.

To your question, if it is really valuable, I do not know how we

can assign that. Right now, we have fixed commissions. And so we

have an infinite availability of ‘‘stuff’’ because the margins for everybody in this game are so high. In competition, the reason you

want freedom of entry is so that it forces costs down and

rationalizes the best players. And right now, in my opinion as a

fund manager and one who purchases some of these services, the

intellectual research, I do not know what the rationing mechanism

is to make sure we have quality versus abundance. And I think

that is a key question.

Senator ALLARD. I have had the opportunity to start my own

business, and nobody subsidized me when I started out. The next

question is: How do you decide who you are going to subsidize and

who you are not? You know, I had to start small and struggled, but

finally you break through. Go ahead.

Mr. EDELSTEIN. Speaking from the standpoint of one who started

a firm, we started our firm about 12 years ago, and we had no assets under our management. So we had no commissions to use. We

invested a substantial amount of our own money in this company,

but over time we were able to build up clients and utilize the client

brokerage to augment our internal research. We have also over the

years added from our research staff of the original three professionals or four professionals to 13. We have continued to augment

not only building up our usage of external research but also internal research. And I think it has been essential to our start-up.

I also want to correct one misnomer that commissions are fixed.

In our company, at least, our experience is that commissions, since

we started, have come down by over 50 percent, the commissions

that we pay. And as we get larger, I think that will come down

more. And I think also introducing the concept of scale into this,

our firm at $2.8 billion, we are now being able to leverage our

costs, both the internal fixed costs that we have invested in, as well

as the external research. So, I applaud the large mutual fund firms

who have, you know, $50 million——

Mr. BRADLEY. We were not large 15 years ago.

Mr. EDELSTEIN. You were large compared to other firms 15 years

ago. The whole industry has grown terrifically. But they have been

able to leverage these costs and now start to reduce the amount of

services provided to them—or commissions that they have used to

798

buy services. I always think about these larger firms in terms of

the aggregate amount of dollars that they use to spend on research.

At some point when you are working with Merrill Lynch or Goldman Sachs, you have reached the highest level of commissions that

they need to pay you the services—to provide you the services. Beyond that, it seems like it is excess. And as they get to that level,

they should be able to reduce the commissions paid.

Mr. VELLI. Senator, if I could just emphasize one point, commission rates are clearly not fixed. As an agency broker, over 70 percent of our customers trade with us on an execution-only basis, not

related to any soft dollars, and not related to any proprietary research. Also, we do not subsidize any of these independent research

firms. They are viable businesses. They are growing. Some of them

are very large. But they do rely on commissions as a fuel that generates their growth.

Mr. SCHILIT. Could I jump in?

Senator ALLARD. Yes.

Mr. SCHILIT. The question I think was most specifically directed

to the independent research industry, and on this panel I am the

only member of that, and the question was: What impact would it

have on the viability of my company and my competitors if we went

from a commission payment mechanism to a cash-only payment

mechanism?

There is a very simple answer and with a very high degree of

confidence: It would have a devastating impact, and more so on the

smaller firms. My organization is one of the oldest and largest. It

would affect me less than the newer players. But you do not want

to create a system where only the big and the strong—for example,

an American Century, which has an enormous wherewithal to put

additional dollars in their budget, would be able to purchase research from a longstanding research firm, which they do, where a

smaller firm, both a smaller and newer research provider and a

smaller investment manager would not be able to participate at all.

You do not want to have a system in place where only the big and

the powerful can play.

I wrote down a few notes, and I want to just share the thoughts.

One is research is research and commissions are commissions.

Now, let me elaborate. If we agree that the appropriate currency

to be used to pay for research is cash—and I have not heard any

strong argument in that direction. But the only thing that should

be used in the commission is the lowest execution price, a penny

a share, 2 cents a share, and anything over that, whatever it is,

for a big brokerage firm that is doing conferences or they are doing

research, if the policy is that the only thing that can be used to pay

for commission is the best execution on the trade. And everything

over and above that must be paid for in cash. And Merrill Lynch

put out a price sign for their research and said if you want to have

our research, this is the cash price. I would in a moment sign off

on that type of approach.

But that is not what we have. The proprietary brokerage firms

today have over 90 percent of the business. One of my clients sent

a year-end statement showing how much he pays in commissions

and how much went to the soft dollar for independent research. Six

percent—six percent—went to independent research, and he would

799

love to buy more and more independent research. And what is the

right number? Should it be 99 percent that goes to the big brokerage firms? Should it be 100 percent?

The point is everybody should compete. So if a brokerage firm

wants business, they have to be able to show they have the best

price and the best execution. If a research provider wants to compete—and I want to compete—if you say you have—I have the cash

price for my business. Fifty percent of my clients would write out

a check. Fifty percent of them use the other currency. I do not really care. But I would care if you say the rules are different for my

firm and for Merrill Lynch and for those firms. That, I think, is

really the gut of where we need to focus. If we believe commissions

are an appropriate currency to pay for research, then it is appropriate whether the research comes from a proprietary brokerage

firm or an independent research boutique. I am not in the brokerage business at all. I put out a cash price for my business, and I

sell it to investment firms.

Mr. BRADLEY. Including ours.

Mr. SCHILIT. Such as American Century, and I sell it to other

people. But if you are going to ban the use of soft dollars, there are

smaller firms. So American Century has the ability to put X millions of dollars in their budget as a line item for research. Smaller

firms who do not have that type of ability will not be able to have

access to our research. That is not good for the investor. We do not

want to protect the big, longstanding firms at the expense of the

newer ones.

Mr. BRADLEY. May I respond?

Chairman SHELBY. Go ahead.

Mr. BRADLEY. My company was started in the late 1950’s as a

small company. We didn’t manage more than $1 billion until the

1980’s. We were little. We have never done the third-party structure, always adhering to what we call the pre-1985 standard.

But as you walk down this path of decisionmaking, at many

firms, , it becomes apparent that portfolio managers have a veracious appetite for ‘‘free’’ services. We recruit from other investment

management firms. If a portfolio manager says, ‘‘I have to have

this to do my job,’’ many advisers tell the trading desk, okay, we

need this service.

At our shop we annually have a big fight over what we really

need in terms of services, because there are 50 guys pounding on

our door every week wanting us to give them commissions. And

when we pay cash for these services that are not part of our execution function, it is a fight because it is coming out of real cash that

you have got in your investment company profits. It comes out of

the profits.

The rationalization function is really important to having quality

and investor benefit. Right now, I do not know how to attribute any

value to what we purchase. And I think that would really be

helped if this was more explicit.

Chairman SHELBY. Mr. Steil.

Mr. STEIL. Two very, very brief points.

First, research is just another form of consulting. An industrial

firm that wants advice on how to service its clients better could do

that internally, or it could go to a McKinsey.

800

I, for example, in addition to my work at the Council on Foreign

Relations, do my own consulting. I consult for securities exchanges,

securities firms, mutual funds, and SRO’s, both in the United

States and in Europe. Recently, for example, I consulted for a mutual fund that wanted advice on soft commission regulation in the

United Kingdom. All of those firms have chosen to come to me and

pay me with their own assets for my advice because they found it

worthwhile in servicing their clients. They could have, for example,

just gone to my website and downloaded every piece of research

that I have ever published for free, but they chose often to contract

me to do proprietary research for them because they found it of

value to them in their business. I do not understand why the mutual fund business should be any different.

Second, the reason that this problem is getting worse and worse

year after year is that the implicit cost of research is rising very

rapidly. What do I mean by that? Mutual funds now can trade directly on electronic trading systems. They are proliferating, like Archipelago and Instinet. Many European exchanges allow mutual

funds to be members. The only reason the brokers are there, still

there in the first place, despite this proliferation of direct electronic

trading, is because they facilitate this soft-dollar business.

So as Harold mentioned at the outset, the cost of full-service brokerage has hardly gone down at all over the past decade, from

about 6 cents a share now down to—what?—about 41⁄2 cents a

share. Meanwhile, we have got direct access execution costs down

to as low as half a cent a share. That gap is growing year after

year, the gap between full-service commissions and direct access

electronic commissions. That is the implicit cost that the investor

is paying for these consulting services.

Senator ALLARD. Thank you, Mr. Chairman. I did not realize

that last question was going to stimulate that amount of discussion.

[Laughter.]

But I do think that it has been helpful for us to hear that.

Chairman SHELBY. As an alternative to repealing Section 28(e),

some have suggested that the SEC should require broker-dealers

and mutual funds to unbundle the cost of research and execution

and assign values to each service. Some claim that this unbundling

would create more transparency and eventually lead to lower commission costs for investors.

Would you comment on the impact of unbundling on soft-dollar

practices? Also, if commissions are unbundled, should the soft-dollar costs of research be included in the expense ratio?

We will start with you, Mr. Bradley.

Mr. BRADLEY. Thank you, Chairman Shelby. I talked specifically

about this within my written remarks to some extent.

The unbundling function is difficult because it has so many definitions. My recommendation would be for the SEC to gather and

publish information similar to Rule 11Ac1–5 that the Commission

established for exchanges. Exchanges are required to report certain

metrics every quarter or every month on their quality of execution

and trade. In the commission field, it might be done in a similar

fashion. I would like to see the SEC require broker-dealers to report quarterly their execution-only rate as negotiated with all their

801

clients, and then see the SEC aggregate that number into an industry-wide, execution-only average commission rate.

The reason I would want the SEC to do that is to provide an opportunity for those who are negotiating to do so in a way that they

can get lower cost or pay for higher value and justify that to preserve the possibility of competitive rate-making.

Chairman SHELBY. Would that be added cost to the industry,

though?

Mr. BRADLEY. I assume what you are going to have to do is get

the brokers to disclose what they identify as an execution-only rate,

and I am not sure most of the major firms have identified that yet.

However, firms like Archipelago, Bloomberg, and other execution-only broker-dealers, will easily be able to report the cost of

doing the trade, usually 1 cent a share or less. It would require

some definition, I am sure, and interpretation.

Chairman SHELBY. Mr. Edelstein.

Mr. EDELSTEIN. First of all, I would like to just comment that

there is no one execution-only rate because trades require varying

degrees of attention by brokers. We have a lot of smaller trades in

companies that are smaller-cap that require a lot more attention.

And in order to have the broker work this trade over several days,

they want to be paid for it. So there is no minimum commission

out there that I think is definable.

In terms of the unbundling proposal, I think that that would create more transparency, and I think that would be very interesting.

However, I think that should be the burden of the broker, not the

adviser, to break out that cost.

The concern I would have with it, though, is that it could end

up reducing the overall coverage level of stocks in the universe because the brokers may find that it is not profitable to cover a lot

of smaller companies. This could result in less liquidity in the markets and less information.

Chairman SHELBY. Mr. Schilit.

Mr. SCHILIT. Yes, I think your question really gets at the heart

of what the solution is. By requiring the brokerage firms to present

an a` la carte menu—it has always been bundled together with the

execution and conferences and institutional sales. It is all bundled

into that one number. By requiring all brokerage firms to unbundle

and disclose what the a` la carte cost is for every one of them, then

an American Century and a Westcap can have the flexibility to

pick and choose. Do they want to get research from Morgan Stanley? Well, if it is not part of the package price, they may decide

that they want to get research from other sources. So, I think the

cost of the trades will invariably go down, which is good for the

consumer.

Chairman SHELBY. The shareholder.

Mr. SCHILIT. The shareholders. The access to the best research

and only the research you want to buy, and if you want to pay

cash, you could pay cash. If you want to, you know, bundle it

through some third party—but everybody knows what they are

buying.

So once we do the unbundling, then the second part of your question with the expense ratio, that is the easy part, because once we

know what is included, then if the regulators say research from

802

whatever source should be included in the expense ratio, that is

what I would propose. Again, whether it is an expense ratio or

management fee, but, you know, it cannot be hidden.

So as the gentleman next to me was saying, he does consulting,

he gets paid cash for it. I do seminars and consulting; I have a cash

price for it. So the expense ratio I would like to see including research from any source.

Chairman SHELBY. Mr. Steil.

Mr. STEIL. There are two basic types of unbundling. One is the

unbundling that takes place before the trade when the fund manager has the right incentives. In other words, the only reason that

the fund manager bundles now is because he can use his client’s

assets to fund his operating costs.

Chairman SHELBY. The client doesn’t really know, does he?

Mr. STEIL. The client doesn’t really know that, and it is not well

disclosed at all, and that was well documented by the SEC back in

1998. The unbundling that you are describing is an ex-post

unbundling. It is an accounting unbundling after the fact. That will

naturally lead to a huge debate in the industry as to what an execution actually costs. The full-service brokers are going to have

maximum incentive to say that the execution component is as expensive as possible, probably in the range of 3 cents a share. Personally I think that would be untenable to maintain when you have

already got direct access electronic brokerage fees down to around

half a cent a share.

But if it is just going to be an accounting exercise, Senator, I see

a problem there because the basic conflict of interest in the industry is going to remain. In other words, the fund managers and the

brokers together will have maximum incentive to disguise what

fund managers are really paying for services above and beyond

what they actually need to execute a trade efficiently.

Chairman SHELBY. Mr. Thomas.

Mr. THOMAS. Senator, the expense ratio is not my expertise, but

let me touch on the bundling. At present, the investor can select

a manager that pays cash for all the research—that is independent

research. The manager cannot pay cash for research from full-service brokerage firms.

As far as an execution-only rate, there are many different rates.

There are ECN rates that were referred to in Mr. Bradley’s chart

of Archipelago. There are rates that full-service firms might charge

for execution-only. There are direct access rates where you call directly to, say, the floor of the New York Stock Exchange. The rates

all vary, and they could be anywhere from a penny to 3 pennies.

Then there is expertise. You really cannot give an ECN—such as

Archipelago so that we were referring to earlier—an order to sell

5 million shares of Coca-Cola, market not held, use your discretion.

It does not really work that way.

I want a trader that can take the order, walk away from it, and

when the stock gets out of the range, come back to it, trade when

they want to trade and execute the order by using their expertise.

So, I think we have the ability now for many types of execution

rates if you want to go that way you can, except for the full-service

firms. Their rate is usually combined with brokerage, their research.

803

Chairman SHELBY. Mr. Velli.

Mr. VELLI. I think we are overcomplicating this. I look at it in

a very simple way. As an agency broker, we fully disclose how

much a trade costs from an execution standpoint and how much of

the commission is going——

Chairman SHELBY. Who do you disclose that to?

Mr. VELLI. We disclose it to the asset manager.

Chairman SHELBY. Okay, but not to the fundholder.

Mr. VELLI. No. And as I said before, we do advocate that the

asset manager disclose how they are using their commissions. But

as an agency broker, as I was saying, we do fully disclose how

much of the commission we are receiving is going to purchase independent research and how much is going to execute the trade. And

the portion that is going toward executing the trade is fully negotiable.

I am not in the business of defending the full-service firms. I

compete with them. But I think that you would find it very difficult—or they would claim that it is very difficult—to unbundle

their commissions from the other services contained in their rate.

But I would also advocate that an asset manager has a choice. He

does not have to deal with a particular broker if he does not want

to on a bundled basis. He could go to an agency firm, he could go

to many other full-service firms and negotiate an execution-only

price. The only reason why he wants to trade with that full-service

firm who may be unwilling to unbundle is because he highly values

the research being supplied. And so that is the cost of purchasing

that research.

Chairman SHELBY. Senator Sarbanes.

Mr. BRADLEY. Mr. Chairman, may I just add one additional point

that I neglected to include?

Chairman SHELBY. Proceed.

Mr. BRADLEY. One of the biggest problems we have here is the

United States, just as we were the last market in the world to go

to decimals, is that we are the last market in the world—except for

Canada—to charge cents per share on trades, which makes no

sense to me at all. If a stock is trading at $100 a share today and

splits 3 for 1, I pay 3 times the commissions tomorrow for the same

dollar value of the company. Across the world, all of us who trade

globally have systems set up to do that as a percent of principal.

Chairman SHELBY. What does that do for you?

Mr. BRADLEY. Let me explain the positive impact for investors.

In 2000, if I was paying a nickel on a $25 stock and it dropped during the bear market to $10, I am now paying a much higher value

for the same percent of that company than I was at a higher stock

price. And so there is a negative incentive in that the percent of

commissions paid to trade a stock by investors goes up as stock

prices come down. I think that is not aligned very well with investors’ interests. And I would argue we should begin to require

reporting in percent of principal terms, both trading costs and commissions.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you, Mr. Chairman.

804

I apologize to the panel I was not able to be here at the outset,

and so if the question I asked has been put before and you have

responded, maybe you could summarize your answers. I just have

a very basic question. What do you see as the consequences of just

repealing 28(e), just not having that safe harbor at all available?

This, I take it, would put people back to having to judge what their

fiduciary duty was as they proceeded.

Mr. BRADLEY. Senator, I would like to try and address the idea

of repealing 28(e). It may surprise some that we would not support

repeal. We have been a very vocal critic of many of the uses and

safe harbors created by interpretation within 28(e). I am concerned

about the use of research in one specific application. Most of what

we are talking about is focused on the investor and returns used

to fund his retirement and his children’s education, really important topics to be sure. But the capital markets were created as a

place where people can go with ideas to start a business and build

jobs because they cannot borrow money on favorable terms at the

bank for the risk the bank would have to take.

Now, I believe that research does provide a valuable service for

those new companies that come public that is really, really important. So while I think that repealing 28(e) could have some very

positive impacts, I do think there could be some unintended consequences on the capital formation part of the market. I am a small

company investor, and I may be overstating that because obviously

things fill the void, and if you pay cash you are going to maybe get

better research. But it will not help those small companies get advertised as fast when they have a good business and they might

have to build those businesses more slowly.

Mr. EDELSTEIN. I think repealing 28(e) would have a disproportionate impact on smaller advisers and give a significant advantage

to larger advisers. Smaller advisers do not have the large in-house

research staffs, and we tend to rely somewhat more on external research from both proprietary sources and third parties. And as

such, you know, if we did not have the ability to pay for these services in soft dollars or with commissions, we would have to make

some decisions about which services we did pay in hard dollars because we probably could not afford all of it. Ultimately, that could

hurt investors.

The other choice, I guess, would be to raise fees, but I think in

this environment that would be very difficult to see how that would

happen.

Mr. SCHILIT. Senator, when I gave my introduction, I described

that I run an independent research firm, and so I talked specifically how it might affect my organization and some of the small

competitors. Ten years ago when I began our research center—an

integral introducer of clients—a marketer for a firm were the agency brokerage firms, and that certainly saved a lot of cost in terms

of not having to hire a marketing staff. I think the repeal of 28(e)

would have a very adverse impact on the viability of many independent research firms, particularly the smaller new ones, so the

firms are emerging.

I spoke at the first Independent Research Conference in New

York about 2 weeks ago, with about 300 fledgling organizations,

more than half of them did not exist a year ago. And many of those

805

organizations will not have a chance to blossom and to be able to

show their services to investment managers if 28(e) is repealed,

and smaller investment management firms will also suffer because

they will not have the opportunity of benefiting from that research.

Mr. STEIL. Repealing 28(e), Senator, in my view, would be a significant step forward because it would establish the principle that

trading commissions are to be used specifically for trading. In Figure 1 of my testimony, I document services that fund managers are

currently legally paying for with trading commissions, and many of

these services, Senator, have absolutely nothing to do with trading

whatsoever. My fear is that even with repeal of 28(e) fund managers and brokers will still have an incentive to push the invisible

services that brokers are kicking back to the fund managers, underground, push them underground, make them invisible to regulators entirely.

The point has been made on this panel before that the fund manager currently has free choice whether to bundle trading commissions or whether to unbundle them. The problem with this choice

is that we know that they prefer to bundle because every time they

bundle they outsource using the clients’ assets. When they

unbundle they are funding things like computers and conference

registrations and research—they fund that with their own assets.

That is why they do not want to do it. You have much too much

of these services being outsourced right now, specifically so that the

fund manager can use the clients’ assets. A more radical solution

to this problem that I support was outlined in the 2001 Myners Report to the Treasury of the United Kingdom, which recommended

that fund managers bear the cost of their own trading commissions.

In my testimony, I explain that an average fund manager could

recoup the cost of bearing those trading commissions by raising its

management fee about 18 basis points, but this would still leave

the fund holder better off by about 50 basis points because the

trading would be so much better and so much more efficient. So,

I think the best way to unbundle is to give the fund manager the

incentive to bargain the cost of all the services he is using, whether

they be trading, research, or otherwise.

Mr. THOMAS. Senator, this is probably the first time I have been

in agreement with Mr. Bradley, but I am, with these comments. I

think it would have a real disadvantage to start-up money managers and also the new research providers. Then if you look at the

goal of Mr. Spitzer’s global research settlement, which was to have

more research, that is, more independent research, I think we definitely need to go along those lines.

Mr. VELLI. Again, I have a habit of simplifying things, but when

I look at this, research drives the investment process without the

idea generated from research whether I am an individual buying

a single stock or if I am investing in a mutual fund, I am appointing that mutual fund to act as my agent, and research drives the

process. By eliminating 28(e), there is no question in my mind it

would have a devastating effect on the independent research community as well as the full service firms, cutting down on the

amount of research available in the marketplace.

806

Senator SARBANES. In a 1998 SEC staff study of soft dollars, 35

percent of investment managers examined had used soft dollars to

pay for nonresearch items, including employee salaries, rent, association fees, travel expenses and dinner, parking fees, limousine

service, and concert tickets. Is there anyone at the table who contends these practices or feels that these are legitimate purchases

for soft dollars?

Mr. VELLI. Not at all.

Mr. THOMAS. No.

Mr. BRADLEY. Senator Sarbanes, I do not think they are defensible but if you look at the language——

Senator SARBANES. How would you eliminate the practices? Very

quickly, because I am running over my time.

Mr. BRADLEY. If you look at the language in 28(e), it would suggest that this should not even be allowable. It was the interpretive

release by the SEC in 1985 that opened the door to all these other

things, and in my testimony and some of the questions I have already responded to, what we would do is preclude many of those

things by amending 28(e).

Senator SARBANES. By statute.

Mr. BRADLEY. By statute.

Mr. EDELSTEIN. I think that all of those, to me, are currently outside of the safe harbor, and I believe that the approaches I would

take to encourage more conservative practices by managers, and

adherence to the safe harbor would be better disclosure, enhanced

disclosure, better recordkeeping required of the managers and a

narrowing of the definition of research, particularly to exclude,

clearly exclude things that are available on the street corner like

The Wall Street Journal, Business Week, or perhaps computers,

things that you can buy at the store.

Senator SARBANES. Who should know the definition?

Mr. BRADLEY. I think the SEC should know the definition.

Senator SARBANES. Who expanded the definition?

Mr. THOMAS. It was reinterpreted in 1986. And, Senator, those

items are not allowable.

Senator SARBANES. By whom?

Mr. THOMAS. By the SEC.

Senator SARBANES. And, Mr. Edelstein, you think that the SEC

should——

Mr. EDELSTEIN. I think the practices that you spoke of that they

discussed in their report were outside of the safe harbor.

Mr. VELLI. We do not believe they are currently allowable.

Mr. THOMAS. They are not allowable under 28(e).

Senator SARBANES. A lot of people are doing it apparently.

Mr. VELLI. And that should be stopped.

Senator SARBANES. Mr. Steil.

Mr. STEIL. You pointed out services that are outside the safe harbor, but I think the more important point is services that are within the safe harbor that are perfectly legal. Just to give you a few

of them: Newspapers, magazines, online services, conference registrations, accounting services, proxy services, computers, monitors,

printers, modems, cables, software, network support, and maintenance agreements. All those things are 100 percent legal according

807

to our Securities and Exchange Commission. Those abuses, in my

view, should be eliminated.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Schumer.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. I am getting a little perturbed here. You

mean if you have to buy a newspaper in a small town to learn

about a business, that is an abuse? A newspaper, per se, is not an

abuse. That is what research is all about. So are certain online

services what research is all about. I mean going to a concert is a

lot further away than online services, is a lot further away than

buying a newspaper. Now, it is The New York Times and you are

getting it anyway, and it is your subscription, that is one thing.

Buying some—you know, the Journal of Commerce, which you

might only read to do research, you are not reading it to become

a better informed citizen, that seems to me to be perfectly legitimate. Do you disagree, Mr. Steil?

Mr. STEIL. I strongly disagree with that, Senator.

Senator SCHUMER. Why is it illegitimate to buy a newspaper to

do research?

Mr. STEIL. As I said earlier, in addition to my work at the Council on Foreign Relations, I also do consulting. I do consulting for securities firms, securities exchanges, mutual funds, and SRO’s. In

order to do that consulting, I read The New York Times, The Wall

Street Journal, and the Financial Times every day. I use specialist

journals. I use all types of research tools. I do not pass on the cost

of my educating myself to my client. That is part of the service I

am offering my client, being an educated adviser.

Mr. BRADLEY. Senator Schumer, may I respond as a large money

manager? I have almost all of my money in our funds, and as an

investor in those funds I pay a management fee of 1 percent, and

I expect that my manager can turn on his lights, can turn on the

computer, can use whatever systems he can to deliver results, and

that is why I pay a management fee. My concern about this is that

it is not part of the management fee, it is not disclosed, it is hidden

and it is a subsidy, and that we should eliminate that. If it is legitimate, I agree, we need those things, but what are people paying

the fund management fee for?

Senator SCHUMER. Right, Okay. I am not sure I agree with you,

Mr. Bradley, but that is a different point than saying any newspaper, any online service is not part of research. You can decide

how to disclose it and who should pay for it, et cetera, but it is research, and the idea of making yourself a well-informed person

should all not be part of research, well, making yourself a well-informed person one way or the other.

Let me tell you, I think this hearing is very important, but I

think we really, again, run the risk of throwing out the baby with

the bath water. As many of you have underscored, research is key

to our capital markets and it is key for the small investor in particular, because if you are a big investor you can do your own research any way you want, and a small investor cannot. The idea,

especially after Eliot Spitzer’s settlement which said we need indeVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00819 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
808

pendent research, to now go ahead and say, well, let us be so

counting angels on the head of a pin.

Well, my father, a small stock investor, cares more about getting

good research as a package then going out and finding his own research firm before he buys 50 shares of AT&T or whatever he is

buying. And the logical free market response here is disclosure,

and if people want it, fine, and if they do not want it, fine. Mr.

Steil, you are imposing your own views on every investor and saying they should do it your way, and that is not right, and that is

not fair. I have to tell you something else, it will, academic theories

notwithstanding, lead to a great decline in research and particularly a decline in research for the little guy. One of the things I

am terribly worried out, there are all these rules.

There is a book called, The Logic of Collective Action by Mancur

Olson, . It is a brilliant theory, where he said, there are certain

things that are societal goods that require a thousand or a million

of us each saying we will be part of a little bit, but if each individual were making a totally rational decision for himself or herself, they would say, I do not want to pay for it. So you add up

those one thousand each rational decisions, and society declines because you do not get the overall good. That is a book which I would

commend to you, The Logic of Collective Action. I have to tell you,

I think your views are rarified, are very academic, and do not make

any sense in the real world, in all due respect.

To say that we have to go beyond disclosure, which is a fundamental free market tenet, and we should always make disclosure

better and better and clearer and clearer, and you want to break

it down so people know exactly what each thing is. I mean you get

to a point where people cannot understand it too, so there is balance there. But let us be practical here. The real worry we have

is not that people might be paying one-tenth of a cent more. I mean

I understand free market theory would say that is the goal, but

there are certain externalities that are good for the market and

have proven to be good for the market and research is one of those.

Your view, if somebody wants to pay for research, let them, and do

not even allow it, once fully disclosed, I believe will lead again to

a dramatic decline in research and particularly a decline in research for the small guy.

To tell that person he cannot have the research once it is disclosed, and he has to go out and buy all these services separately,

is like saying, if you buy a General Motors car, you cannot have

General Motors put its engine in there, but you have to have General Motors provide a brochure and you can decide a Ford engine,

a Chrysler engine, whatever.

I mean we are getting to the point of absurdity here, Mr. Chairman. Anyway, since I was my usual mild-mannered self.

[Laughter.]

Please, Mr. Steil, respond.

Mr. STEIL. Senator, my father is one of those small investors you

are talking about. My father had a very modest upbringing. My father has never had a defined benefit company pension in his lifetime. So the way his fund managers, like Harold Bradley, spend

his money is very important to him. He asked me why I was coming before this Committee to testify, and I explained to him what

809

soft dollars were about. He was very surprised. He thought that

when he paid a management fee to an investment management

company, about 1 percent of his assets, that the rest of his assets

were being invested and that the fund manager knew how to pick

stock, did not have to use the rest of his assets to pay somebody

else behind his back to decide what stocks to pick. He thought he

was buying——

Senator SCHUMER. Disclosure will deal with the ‘‘behind his

back’’ aspect of this, and then your father will know and make the

choice. Why are you saying the way your father wants to do it

should be the way my father has to do it?

Mr. STEIL. Disclosure will not work because of the fact that the

commissions are bundled today. They are all bundled together in

one package which gives the fund manager a massive incentive to

fund as much of his operating cost as possible through trading

commissions——

Senator SCHUMER. Does everyone agree with that?

Mr. BRADLEY. Senator Schumer, I will tell you that what has not

been said today, one of the reasons at American Century we have

been so—and I tried to avoid it, but I am not going to now. We

have tried for years to get Wall Street to go lower on bundled rates

with us because we do not value their services to us as high as

they do, and they will not break certain levels. They go to a certain

set level, they will not break it. If they do for one, they do for all.

The way we have put pressure on and gotten some is by moving

more and more of our business to electronic trading venues, which

is an execution-only function.

Senator SCHUMER. There you go.

Mr. BRADLEY. But that again, most people——

Senator SCHUMER. You have made my point.

Mr. BRADLEY. No. We choose not to do this and we forego tens

of millions of dollars of profit every year by trying to do what is

right. We think it is wrong for investors to be paying fees that are

not disclosed.

Mr. STEIL. Senator.

Senator SCHUMER. Can I just have Mr. Thomas and Mr. Velli respond.

Mr. VELLI. First, I would like to say, Mr. Bradley, I will be happy

to talk to you after this meeting because we will negotiate our execution rates. You know, there is a choice that an asset manager

has as to how they deal.

Senator SCHUMER. Maybe the big boys will not, but there are a

lot of people in the market who will negotiate as I understand it.

Mr. BRADLEY. The big boys are the guys with the investment

banking books, and if we do not deal with them, we cannot buy the

new companies.

Senator SCHUMER. That is a different issue. That is a totally different issue.

Mr. BRADLEY. That is a completely related issue.

Senator SCHUMER. Then you do not want to have any—you want

to break every——

Mr. BRADLEY. I want competition. I want competition.

Senator SCHUMER. —in the Financial Services Act, which we just

passed——

810

Mr. THOMAS. I think we have plenty of competition today. I know

just in the area that Mr. Velli and I are in, we probably compete

with 250 firms every day. There is plenty of competition. And our

clients can pick up and leave us any day if we do not inform them

properly.

Senator SCHUMER. Could Mr. Bradley call you up and negotiate

a lower rate?

Mr. THOMAS. He absolutely can.

Senator SCHUMER. Do other of your clients do that?

Mr. THOMAS. Absolutely they do, Senator.

And I would add I think our execution is as good as any full-service firm. In fact, in many cases we have a larger amount of volume

going through an agency desk than a full-service firm. So there is

plenty of choice out in the marketplace.

Chairman SHELBY. Let me ask a question briefly. Disclosure is

important, I agree with Senator Schumer on that. Then the question is, should we statutorily repeal 28(e) or should we push the

SEC for more disclosure?

Senator SCHUMER. Exactly that is the question.

Mr. THOMAS. SEC, more disclosure. I think it is in their study

they did in 1997 and their 1998 recommendations. As I said in my

verbal statement, we totally endorse those recommendations.

Chairman SHELBY. Go ahead, Mr. Steil.

Mr. STEIL. My solution, Senator, goes beyond repeal of 28(e). I

would like to challenge your assertion that it is academic. You can

find everything that I am advocating online in the Myners Report

prepared for the Treasury of the United Kingdom by Paul Myners,

who was the Chairman of Gartmore Asset Management, one of the

largest asset management firms in all of Europe. This is not academic, Senator.

I should also point out that my solution that I am advocating,

if you look at the appendix to my testimony, you will see that it

will help fund holders because even if fund management companies

raise their fees by 18 basis points to cover the cost of all the hard

dollars they are going to have to lay out for research, fund holders

will still be better off by about 50 basis points because their money

is going to be used——

Senator SCHUMER. But, Mr. Steil, the externality of lower research, less research, might be worth a heck of a lot more than 50

basis points. That is the forest and you are talking about trees.

Mr. VELLI. Senator, can I just make one comment, please? I have

been hearing a lot about Paul Myners. Paul Myners is on our board

of directors, and I think it is important that you read some of his

editorials that have come out on this subject since his original

statement. And he is a supporter, in a lot of ways, of research, and

especially independent research.

Senator SCHUMER. What does he say? Where does that lead him,

given his report?

Mr. BRADLEY. The FSA just yesterday came out with recommendations they are going to release. We have put it into the

record today, that is heading toward unbundling in the United

Kingdom.

Mr. SCHILIT. Senator, I just wanted to underscore, when you

used the expression, throwing out the baby with the bath water,

811

you could not be more on target. If there is one resounding message, the investor will be heard more not because the commission

goes up 20 basis points or 11 basis points or 50 basis points. The

title of my presentation is ‘‘Unintended and Undesirable Consequences of Banning Soft Dollars.’’ And I know, because I sell

independent research, I know for a fact what has happened in the

United Kingdom with the Myners Report. Fund managers are no

longer buying independent research. I know what is happening in

the United States, as fund managers are moving from soft-dollar

arrangements to hard dollars. They are not buying independent research or they are buying from fewer sources, and they are buying

perhaps only from the well-established ones. Again, the big boys,

the big investment management firms like MFS and like American

Century have the wherewithal to buy it. Those firms can put an

additional $15 million in their budget. A small firm like Westcap

does not have that kind of flexibility.

So before we repeal 28(e) we should look so carefully at what are

the alternatives short of that that if there are abuses and people

are buying things that are inappropriate, you and Mr. Steil can

argue all day long in terms of what should be included and what

should not—and that is appropriate to argue about that. But if we

have the unintended consequence of eliminating independent

research——

Two years ago, as I mentioned early in my testimony, I was sitting on another Congressional panel on the Enron hearings, and

sitting side-by-side with me were four proprietary research analysts who all had strong buy recommendations. None of them had

the ability or the gumption of the backing of the firm to come out

and say, there is something very wrong here. All of the warnings

that the investors received during the horrible accounting frauds,

came from independent research firms. So if you think what happened a few years ago—Senator Sarbanes walked out—but if you

think what happened a few years ago was bad for the investors,

stay tuned how bad it is going to be the next round.

Senator SCHUMER. These are the external benefits of independent research that far exceed a 25 or 37 basis point to the small

investor and to the markets, and we are getting to again here—

that is why I think this is truly academic, as opposed to practical

and real.

I worry about, as capitalism becomes more pure and everybody

pays for each little thing, another argument in economic theory,

which is externalities, get lost. And a lot of externalities have

helped this country, Adam Smith economics work, and the markets, and we are getting away from that and I worry about it. So,

I will be—I have to leave—I agree with you, Mr. Schilit.

Chairman SHELBY. Senator Schumer before you leave, I have a

couple comments, and then we will let the panel continue. I have

a couple comments.

I agree with Senator Schumer in that central to all investing is

research. It is central. The question is how do we deal with it? I

believe research should be research. You know, apples should be

apples, they should not be oranges or grapefruit or broccoli or anything else. So how do we deal with this?

812

Could not the SEC, if they wanted to, if they had the will, deal

with this under their authority short of us getting into this statutory area? This is why we hold these hearings.

Senator SCHUMER. Right. It is my belief they could not, Mr.

Chairman.

Mr. BRADLEY. Senator Shelby, in 1993 and 1994 Congress held

hearings on this. There were meetings and regulatory roundtables

in 1987 and 1988. This has come around every 3 or 4 years depending on the tone and tenor of the market, and there has been no further resolution of this problem.

Chairman SHELBY. Mr. Edelstein.

Mr. EDELSTEIN. I just wanted to make one other point about the

United Kingdom. Their structure, their market is much different.

They are dominated by large institutions. In the United States, we

have over 8,000 SEC registered investment advisers.

Chairman SHELBY. And we benefit from small, emerging firms.

Mr. EDELSTEIN. And 70 percent of them are less than 10 employees, so it is much different.

Chairman SHELBY. Mr. Steil.

Mr. STEIL. Two very brief comments, one as a starry-eyed academic. I happen to be a Ph.D. economist, and one thing that annoys Ph.D. economists is abuse of the term ‘‘externalities.’’

Chairman SHELBY. I do not think this is an academic question.

I think this is an argument.

Mr. STEIL. I could not agree with you more, sir. I want to refer

to the economics term that Senator Schumer used which is

‘‘externalities.’’ There are two types of externalities in economics.

One is technological, one is pecuniary. A technological externality

is one for which there is not a market solution. That is, for example, I produce pollution which affects your backyard and I am not

absorbing the cost. Those are the types of externalities that economists say regulation is necessary for.

The other type is a pecuniary externality, which is entirely intermediated by the price system. In other words, we can pay for research. It is available out there at a market price. I do it, Mr.

Chairman. I provide clients with research at a market price. It is

not unavailable.

Also, with regard to the nonstarry-eyed academic, Paul Myners,

former Chairman of Gartmore, I will just read you very briefly

what he said in his report to the United Kingdom Chancellor of the

Exchequer. ‘‘Clients’ interests would be better-served if they required fund managers to absorb the cost of any commissions paid,

treating these commissions as a cost of the business of fund management, as they surely are. Fund managers would of course seek

to offset this additional cost through higher fees. This would be a

matter for them to agree with their clients. Under this system the

incentives would be different. Institutional clients would see more

clearly what they were actually paying to have their funds invested.’’

That is all I want, Mr. Chairman. This is not starry-eyed academics.

Chairman SHELBY. Mr. Thomas.

Mr. THOMAS. Mr. Chairman, we would welcome some direction

from the SEC, more clarification.

813

Chairman SHELBY. Mr. Velli.

Mr. VELLI. We agree. My biggest concern right now is that many

asset managers have stopped using independent research and I

think some action has to take place sooner rather than later to encourage them, once again, to start to use independent research for

the benefit of investors.

Chairman SHELBY. Will the market not really work sooner or

later? If they do not have the proper research, the fund is generally

not going to do as well. People work for their fee, do they not? If

I were investing in any of your funds and I got burned, I am probably not going to stay there. I would say, what is going on? As opposed to somebody who invested in research. You have to invest in

research. It is a question of what do you call it and what constitutes research? I do not think opera tickets constitute research,

although that would be nice. I do not think football tickets constitute research. But what are the parameters? Is that not what we

are getting at?

Mr. BRADLEY. Exactly right, sir.

Chairman SHELBY. And could not the SEC deal with this?

Mr. BRADLEY. Yes, with a little nudge.

Chairman SHELBY. They will get more than a nudge.

[Laughter.]

Gentlemen, we have had a full and frank exchange and that is

what hearings are about. Thank you very much.

The hearing is adjourned.

[Whereupon, at 11:58 a.m., the hearing was adjourned.]

[Prepared statements and response to written questions supplied

for the record follow:]

814

815

816

817

818

819

820

821

822

823

824

825

826

827

828

829

830

831

832

833

834

835

836

837

838

839

840

841

842

843

844

845

846

847

848

849

850

851

852

853

854

855

856

857

858

859

860

861

862

863

864

865

866

867

868

869

870

871

872

873

874

875

876

877

878

879

1Section 202(11) of the Investment Advisers Act of 1940 defines an investment adviser as

‘‘any person, who, for compensation, engages in the business of advising others . . . as to the

value of securities or as to the advisability of investing in, purchasing, or selling securities. . .’’

This section also sets forth several exceptions to the definition. 2 As with all other SEC-registered investment advisers, Westcap’s Form ADV Part 1 is publicly available on the Investment Adviser Public Disclosure website: www.adviserinfo.gov. This

required registration and disclosure form provides information about an investment advisory

firm, its principals, its clientele, any disciplinary history, and various activities. 3The ICAA’s membership consists of more than 300 SEC-registered investment advisory firms

that collectively manage in excess of $4 trillion for a wide variety of individual and institutional

clients. For more information, please visit: www.icaa.org.

PREPARED STATEMENT OF GEOFFREY I. EDELSTEIN, CFA, CIC

MANAGING DIRECTOR, WESTCAP INVESTORS

ON BEHALF OF THE

INVESTEMENT COUNCIL ASSOCIATION OF AMERICA

MARCH 31, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, I

greatly appreciate the opportunity to appear before you today to address issues related to soft dollars. On behalf of the Investment Counsel Association of America

(ICAA), I wish to commend the Committee for convening this and other hearings

on issues related to current investigations and regulatory actions regarding the mutual fund industry.

I am a Managing Director and Co-Founder of Westcap Investors, LLC, an investment advisory firm located in Los Angeles, California. Westcap was founded in 1992

and is registered as an investment advisory firm with the Securities and Exchange

Commission.1 Our firm provides investment advisory services to both individuals

and institutions. Our clients include a wide variety of individual investors as well

as pension and profit sharing plans, charitable organizations, corporations, State

and municipal government entities, and pooled investment vehicles, such as limited

liability companies and mutual funds (as a subadviser). Today, our firm employs 43

people and is majority-owned by its employees. Westcap’s current assets under management total about $2.8 billion.2

The Investment Counsel Association of America 3 is a nonprofit organization based

in Washington, DC that represents the interests of SEC-registered investment advisory firms. Westcap has been a member of this organization for many years and I

am pleased to offer my testimony today on behalf of the ICAA. A statement on soft

dollars that was released by the ICAA earlier this month is included as part of my

statement.

Summary of Positions

• Investment advisers are fiduciaries and, as such, have an obligation to seek best

execution in connection with client transactions and to disclose potential conflicts

of interests to both existing and prospective clients. Client brokerage is an asset

of the client—not of the adviser, and thus there is a potential conflict where an

adviser uses client brokerage for research. Accordingly, the ICAA supports full

and appropriate disclosure of soft-dollar practices by all investment advisers. Consistent with the basic approach of U.S. securities laws and market principles, we

strongly believe that the SEC should ensure that there is adequate disclosure

about soft-dollar practices, combined with appropriate inspection and enforcement

of regulations governing these practices.

• The ICAA fully supports the SEC’s current initiative to examine soft-dollar practices. Specifically, the ICAA believes the SEC should conduct a rulemaking aimed

at ensuring that required disclosures related to soft-dollar arrangements are adequate and appropriate and to clarify the current definition of ‘‘research.’’ The consequences of abolishing soft dollars—an outcome that would require Congressional

action—likely will adversely affect smaller investment advisory firms, create entry

barriers for new investment advisory firms, and diminish the quality and availability of proprietary and third-party research. Consequently, the ICAA strongly

believes that a rulemaking is the best option for considering and implementing

changes in this important area.

• The ICAA supports appropriate recordkeeping requirements for investment advisers regarding soft-dollar transactions. Investment advisers should maintain appropriate documentation of soft-dollar transactions, the services received, their uses,

and allocation methodologies for mixed-use items (a service or product that provides both research and other uses). In addition, the ICAA believes that investment advisers should develop and implement appropriate internal controls and

880

4 In general, any investment adviser that manages in excess of $25 million must file Form

ADV, Part 1 via the IARD system. 5 Evolution/Revolution: A Profile of the U.S. Investment Advisory Profession, Investment Counsel Association of America and National Regulatory Services (May 2003). The report is posted

on the ICAA’s web site: www.icaa.org. 6 Inspection Report on the Soft-Dollar Practices of Broker-Dealers, Investment Advisers and

Mutual Funds, The Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission (September 22, 1998).

procedures that are designed to ensure that soft-dollar arrangements are supervised, controlled, and monitored. • As set forth in the ICAA’s March 3 statement, however, we oppose the suggestion

that the SEC should eliminate the use of soft dollars for third-party research. We

believe this approach would harm investors and diminish the availability of quality research. It would result in an unjustifiable, unlevel playing field for many

market participants. It would provide a regulatory-driven advantage for full-service brokerage firms and disadvantage third-party research providers. Ironically,

eliminating soft dollars for third-party research also would result in less transparency to investors, regulators, and market participants.

Profile of the Investment Advisory Profession

The profile of the investment advisory profession is often mischaracterized and

misunderstood. Investment companies (mutual funds) and the investment management companies that provide investment advice to mutual funds constitute a significant and important part of the investment advisory profession. However, mutual

fund companies and their advisers comprise only a portion of the entire investment

advisory profession. In fact, statistics indicate that the vast majority of SEC-registered investment advisory firms are small companies and that most of them do

not manage mutual funds.

Beginning in 2001, investment advisers have been required to use an electronic

filing system—the Investment Adviser Registration Depository (IARD)—when submitting Form ADV, Part 1, the basic registration and disclosure document required

by the SEC.4 Since then, the ICAA and National Regulatory Services have issued

annual reports profiling the investment advisory profession based on these required

filings. In 2003, we reported that there were a total of 7,852 entities registered with

the SEC as investment advisers. Of this total, 5,299 (67.5 percent) reported having

10 or fewer employees. On the other end of the spectrum, only 260 (3.3 percent) of

all SEC-registered investment advisory firms reported that they employ more than

250 persons. And only 1,478 (less than 20 percent) of all SEC-registered investment

advisers reported that they provide portfolio management for mutual funds (investment companies).5

While a relatively few large firms dominate the investment advisory profession in

terms of their collective assets under management, the fact remains that most investment advisory firms are small businesses that are extremely diverse, both in

terms of the investment services they provide and the extremely wide range of investors they serve. We submit that this fact should be considered carefully in making any significant regulatory or policy decisions that affect investment advisers.

Definition of Soft Dollars/Proprietary vs. Third-Party Research

The subject of today’s hearing is often misunderstood and controversial, in part

due to the unfortunate term, ‘‘soft dollars.’’ Soft dollars simply refers to the provision by broker-dealers of research in addition to execution of securities transactions

in exchange for commission dollars. The SEC staff has described soft-dollar arrangements as follows:

Research is the foundation of the money management industry. Providing research is one important, long-standing service of the brokerage business. Softdollar arrangements have developed as a link between the brokerage industry’s

supply of research and the money management industry’s demand for research.

Broker-dealers typically provide a bundle of services including research and execution of transactions. The research provided can be either proprietary (created

and provided by the broker-dealer, including tangible research products as well

as access to analysts and traders) or third-party (created by a third party but

provided by the broker-dealer). Because commission dollars pay for the entire

bundle of services, the practice of allocating certain of these dollars to pay for

the research component has come to be called ‘‘softing’’ or ‘‘soft dollars.’’ 6

As noted in the SEC’s report, soft-dollar arrangements generally can be categorized as either ‘‘proprietary’’ or ‘‘third party.’’ When the broker-dealer that

executes a trade also provides internally generated research in exchange for one

881

7SEC v. Capital Gains Research Bureau, 375 U.S. 180, 186 (1963). 8See, for example, In re: Arleen W. Hughes, Exchange Act Release No. 4048 (February 18,

1948). ‘‘The record discloses that registrant’s clients have implicit trust and confidence in her.

They rely on her for investment advice and consistently follow her recommendations as to the

purchase and sale of securities. Registrant herself testified that her clients follow her advice ‘in

almost every instance.’ This reliance and repose of trust and confidence, of course, stem from

the relationship created by registrant’s position as an investment adviser. The very function of

furnishing investment counsel on a fee basis—learning the personal and intimate details of the

financial affairs of clients and making recommendations as to purchases and sales of securities—cultivates a confidential and intimate relationship and imposes a duty upon the registrant

to act in the best interests of her clients and to make only recommendations as will best serve

such interests. In brief, it is her duty to act in behalf of her clients. Under these circumstances,

as registrant concedes, she is a fiduciary; she has asked for and received the highest degree of

trust and confidence on the representation that she will act in the best interests of her clients.’’

9Lemke & Lins, Regulation of Investment Advisers, at p. 174 (2003). 10 Id., at p. 175. 11 ‘‘An investment adviser is a fiduciary and has the responsibility to render professional, continuous, and unbiased investment advice oriented to the investment goal of each client.’’ ICAA

Standards of Practice.

bundled commission price, that arrangement is referred to as ‘‘proprietary.’’ This is

often also referred to as ‘‘Wall Street research.’’ Wall Street, or full-service brokerage firms, will not break out the costs to purchase these proprietary services ‘‘a` la

carte’’ to the vast majority of its clients. Instead of proprietary research, however,

the executing broker can provide independent research generated by third parties

in exchange for commission dollars. In these instances, the executing broker must

be obligated to pay for the third-party research provided to the investment adviser

in order for the arrangement to fall within the 28(e) safe harbor. These ‘‘third-party’’

arrangements are an important mechanism for the distribution of independent research and analytic services.

Several issues are raised by soft-dollar arrangements. First, the commissions used

for execution and research services are paid by the investment advisers’ clients. As

such, an investment adviser has the obligation to use these commissions in the best

interests of its clients and consistent with its fiduciary duties. Second, because

proprietary research is bundled with execution services, the costs of research, execution, and other services are not as transparent as they would be if charged separately. Third, the definition of what is allowable research has been blurred as new

products and services are created, particularly those using various technological innovations. Ultimately, we believe these issues are best addressed by ensuring that

investors receive full and accurate disclosure of soft-dollar arrangements; by clearly

delineating the types of research services that are eligible in such arrangements;

and by giving the SEC appropriate tools and resources for inspection and enforcement activities.

Fiduciary Duty

Investment advisers are subject to a fundamental fiduciary duty. This duty has

been upheld by the U.S. Supreme Court 7 and reiterated by the SEC in various pronouncements over the years.8 As described in the following excerpt, an investment

adviser’s fiduciary duty is one of the primary distinctions between investment advisers and others in the financial services industry:

As a fiduciary, an adviser owes its clients more than honesty and good faith

alone. Rather, an adviser has an affirmative duty of utmost good faith to act

solely in the best interests of the client and to make full and fair disclosure of

all material facts, particularly where the adviser’s interests may conflict with

the client’s. Pursuant to this duty, an investment adviser must at all times act

in its clients’ best interests, and its conduct will be measured against a higher

standard of conduct than that used for mere commercial transactions.9

Among obligations that flow from an adviser’s fiduciary duty are: (1) The duty to

have a reasonable, independent basis for its investment advice; (2) the duty to seek

best execution for clients’ securities transactions where the adviser is in a position

to direct brokerage transactions; (3) the duty to ensure that its investment advice

is suitable to the client’s objectives, needs, and circumstances; (4) the duty to refrain

from effecting personal securities transactions inconsistent with client interests; and

(5) the duty to be loyal to clients.10

Since it was founded in 1937, the ICAA has emphasized an adviser’s fiduciary

duty as a cornerstone of an investment adviser’s obligations.11 In the soft-dollar context, we believe that fiduciary principles require an investment adviser to make

appropriate disclosure to their clients about soft-dollar practices. Appropriate disclosure will allow investors to make informed judgments about such practices based

882

12 Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of

1934 and Related Matters, Exchange Act Release No. 23170 (April 23, 1986). 13 Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV, Advisers Act

Release No. 1862 (April 5, 2000).

on all relevant facts. In addition, fiduciary principles require investment advisers

to make trade execution decisions in the best interests of their clients in light of

relevant facts and circumstances.12

Disclosure and Transparency

Disclosure is a bedrock principle of the U.S. securities laws. As a general matter,

in fulfilling its fiduciary obligations to clients, an investment adviser is required to

make full and fair disclosure of all material facts necessary for informed decisionmaking by clients, particularly where a potential conflict of interest is involved.

One of the primary disclosure tools required of investment advisers is Form ADV,

Part II, or the so-called ‘‘brochure.’’ The brochure is the key disclosure document

that all investment advisers must deliver to existing and prospective clients (and

offer to clients each year).

In the soft-dollar context, Form ADV, Part II requires investment advisers to disclose information related to brokerage and commissions. Specifically, Item 12 requires disclosure regarding whether: (a) The adviser or a related party has authority

to determine, without specific client consent, the broker-dealer to be used in any securities transaction or the commission rate to be paid, and (b) the adviser or a related party suggests broker-dealers to clients. If the adviser engages in either of

these practices, it is required to describe the factors considered in selecting brokerdealers and in determining the reasonableness of commissions charged. If the value

of research products or services given to the adviser or a related party is a factor

in these decisions, the adviser must describe the following:

• The research products and services;

• Whether clients may pay commissions higher than those obtainable from other

broker-dealers in return for these products and services;

• Whether research is used to service all of the adviser’s clients or just those accounts whose commission dollars are used to acquire research products or services; and

• Any procedures the adviser has used during the past fiscal year to direct client

transactions to a particular broker-dealer in return for research products or services.

The SEC has proposed enhancements to these soft-dollar disclosures by investment advisers. While the proposal has not yet been finalized, the ICAA anticipates

final action later this year. Following is an excerpt from the SEC’s regulatory proposal that describes these enhancements (all footnotes omitted): 13

Soft-Dollar Practices. Advisers often receive ‘‘soft-dollar’’ benefits from using

particular brokers for client trades. Client brokerage, however, is an asset of the

client—not of the adviser. When, in connection with client brokerage, an adviser

receives products or services that it would otherwise have to produce itself (or

pay for), the adviser’s interest may conflict with those of its clients. For example, soft-dollar arrangements may cause an adviser to violate its best execution

obligation by directing client transactions to brokers who are not able to adequately execute the transactions, or may give the adviser incentive to trade client securities more often than it would absent the benefits the adviser receives.

Because of these conflicts, we have required advisers to disclose their policies

and practices on use of client brokerage to obtain soft-dollar benefits.

During 1997–1998, our staff conducted a wide-ranging examination of advisers’

soft-dollar practices and disclosure. Our Office of Compliance Inspections and

Examinations found widespread use of soft dollars by investment advisers that

manage client portfolios. The Office concluded that advisers’ disclosure often

failed to provide sufficient information for clients or potential clients to understand the adviser’s soft-dollar practices and the conflicts those practices present.

In its report, the Office noted that most advisers’ descriptions were simply

boilerplate, and urged that we consider amending Form ADV to require better

disclosure. Today we are acting on those recommendations.

Item 11 would require an adviser that receives research or other products or

services in connection with client securities transactions (soft-dollar benefits) to

disclose the adviser’s practices and discuss conflicts of interest that result. The

brochure’s description of soft-dollar practices must be specific enough for clients

to understand the types of products or services the adviser is acquiring and perVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00894 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
883

mit them to evaluate conflicts. Disclosure must be more detailed for products

or services not used in the adviser’s investment decisionmaking process.

Item 11 would describe the types of conflicts the adviser must disclose when it

accepts soft-dollar benefits, and require the adviser to disclose its procedures for

directing client transactions to brokers in return for soft-dollar benefits. The

item would require the adviser to explain whether it uses soft dollars to benefit

all clients or just those accounts whose brokerage ‘‘pays’’ for the benefits, and

whether the adviser seeks to allocate the benefits to client accounts proportionately to the brokerage credits those accounts generate. The item would also require the adviser to explain whether it ‘‘pays up’’ for soft-dollar benefits.

These enhanced disclosures will put more detailed information in the hands of clients, permitting clients to decide whether they approve of their advisers’ use of their

commissions.

In addition to disclosure and other regulatory requirements, there are a number

of market factors that play a significant role in soft-dollar arrangements. For example, many investment advisory clients (or their consultants) request and receive extensive information relating to soft-dollar practices. These requests often extend to

information that go beyond disclosures required by regulations, including specific

client information. The fact of the matter is that investment advisers often supply

a great deal of information regarding soft-dollar practices in response to requests

from clients or their consultants.

Similarly, it should be recognized that excessive trading or paying excessive commissions to ‘‘earn’’ soft-dollar credits for research takes an adverse toll on an investment adviser’s investment performance (by creating additional trading costs that

must be deducted from any appreciation in value of a client’s account). This fact

alone serves as an important ‘‘market’’ deterrent from abusing soft-dollar arrangements. Investment performance is clearly the single most significant factor that

investors (and their consultants) use to hire or fire an investment adviser. Accordingly, investment advisers whose clients are able to monitor their portfolios and investment performance will be sensitive to potential negative effects that may follow

from trading activities associated with soft-dollar arrangements. In addition, clients

(including mutual fund directors) receive independent custodial reports and can

judge for themselves the appropriateness of commissions paid and the turnover of

securities in their portfolios.

The ICAA supports full and appropriate disclosure of soft-dollar practices by all

investment advisers. Consistent with the basic approach of U.S. securities laws and

market principles, we believe that the SEC should ensure that there is adequate

disclosure about soft-dollar practices, combined with appropriate inspection and enforcement of such regulations.

Definition of ‘‘Research’’

Section 28(e) of the Securities Exchange Act of 1934 was enacted by the Congress

in 1975 following the abolition of fixed commission rates. The section provides that:

‘‘no person . . . in the exercise of investment discretion with respect to an account

shall be deemed to have acted unlawfully or to have breached a fiduciary duty

under State or Federal law . . . solely by reason of his having caused the account

to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of the commission another

member of an exchange, broker, or dealer would have charged for effecting that

transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services

provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to

which he exercise investment discretion.’’

In order to rely on the safe harbor under Section 28(e), an investment adviser

must satisfy the following conditions:

• The adviser must be supplied with ‘‘brokerage and research’’ services; • The services must be ‘‘provided’’ by a broker-dealer; • A ‘‘broker-dealer’’ must be the provider of the service; • The investment adviser must have ‘‘investment discretion’’ in placing the brokerage; • The commissions paid must be ‘‘reasonable’’ in relation to the services provided;

• ‘‘Commissions’’ must be used to purchase the services; and

• The brokerage commissions paid must relate to ‘‘securities transactions.’’

One of the most important aspects of the safe harbor is the definition of ‘‘research’’ services. The leading pronouncement on this issue is the SEC’s 1986 interpretive release. According to the 1986 release, the test for determining ‘‘whether

884

14Supra, fn.10. 15 In re Kingsley, Jennison, McNulty & Morse, Inc., Advisers Act Release No. 1396 (December

23, 1993); In re Goodrich Securities Inc., Exchange Act Release No. 28141 (June 25, 1990); In

re Patterson Corp., Advisers Act Release No. 1235 (June 25, 1990). 16Supra, fn.4.

something is research is whether it provides lawful and appropriate assistance to

the money manager in the performance of his decisionmaking responsibilities.’’ 14

The SEC noted that what constitutes lawful and appropriate assistance ‘‘in any particular case will depend on the nature of the relationships between the various parties involved and is not susceptible to hard and fast rules.’’ In later decisions, the

SEC has noted that ‘‘research’’ does not cover a wide variety of expenses, including

overhead (such as office rent, utilities, and salaries), administrative expenses, exam

review courses, association membership dues, electronic proxy voting services, consulting services designed to assist an investment adviser in client marketing, legal

expenses, accounting and tax software, as well as items such as travel, meals, hotel,

and entertainment expenses associated with attending a research seminar or conference.15

The 1986 interpretive release specifically identified so-called ‘‘mixed-use’’ products

and services that may have both research and nonresearch purposes. Among such

mixed-use products are: Computer equipment used for research undertaken on behalf of clients and for nonresearch functions, such as bookkeeping or administrative

operations; quotation systems that provide information pertinent to the valuation of

securities while facilitating the adviser’s reports to clients; and information management systems that integrate trading, execution, accounting, recordkeeping, and

other administrative functions. The SEC requires investment advisers that receive

a mixed-use product or service to make a reasonable allocation of the cost of the

product or service according to its use.

Since the enactment of Section 28(e) in 1975, investment advisers have begun to

use investment styles that require quantitative analytic tools that are in some ways

quite different from the traditional research tools used by investment advisers. In

addition, the way that research is delivered has significantly changed since 1986,

when the SEC last defined ‘‘research.’’ The predominant form of research in 1975—

paper documents covering one issuer—have now developed into a myriad of research

services, including electronic delivery and software that provides consolidations of

research covering entire sectors, industries, and other categories into searchable, analytical databases. These changes have presented many challenges for advisers attempting to interpret the SEC’s guidance from 1986.

The ICAA supports the SEC’s efforts to ensure that soft dollars are used only for

legitimate research purposes. We also recognize the difficult challenges associated

with this task. Particularly given advances in technology, including communications

and electronics, the line between research and nonresearch products and services

is more difficult to discern and to delineate. We support a rulemaking by the SEC

to clarify the definition of research to preclude the use of soft dollars for nonresearch products and services while retaining enough flexibility so as not to preclude the development of innovative and valuable research services.

1998 SEC Report on Soft-Dollar Practices

The best starting point for evaluating actual practices related to soft dollars is the

report issued by the SEC’s Office of Compliance Inspections and Examinations

(OCIE) in 1998.16 From November 1996 through April 1997, OCIE conducted an extensive inspection sweep to gather information about the current uses of soft dollars,

based on on-site examinations of 75 broker-dealers and 280 investment advisers and

investment companies. In September 1998, OCIE issued a written report detailing

the results of their sweep and setting forth recommendations for consideration by

the SEC. Among the key findings set forth in the report are the following:

• ‘‘Almost all’’ investment advisers obtain products and services (both proprietary

and third-party) other than pure execution from broker-dealers and use client

commissions to pay for those products and services.

• Most products and services obtained by investment advisers with soft dollars fall

within the definition of research, that is, they provide lawful and appropriate assistance to the adviser in the performance of its investment decisionmaking responsibilities.

• While most of the products acquired with soft dollars are research, OCIE found

that a significant number of broker-dealers (35 percent) and investment advisers

(28 percent) provided and received nonresearch products and services in soft-dollar arrangements. In such cases, OCIE found that investment advisers failed to

provide meaningful disclosure to their clients.

885

17 Id., at p. 3. 18 Id., at pp. 4–5. 19Supra, fn.11. 20 Compliance Programs of Investment Companies and Investment Advisers, Advisers Act Release No. 2204 (December 17, 2003).

• OCIE also reported shortcomings by investment advisers with respect to ‘‘mixed

use’’ items, for example, products that have both research and nonresearch uses.17

The staff report set forth the following recommendations for the SEC to consider:

‘‘1. We noted many examples of advisers claiming the protection of the safe harbor

without meeting its requirements. We also found that industry participants were

not uniformly following prior Commission guidance with respect to soft dollars. As

a result, we recommend that the Commission publish this report to reiterate guidance with respect to the scope of the safe harbor and to emphasize the obligations

of broker-dealers, investment advisers and investment companies that participate in

soft-dollar arrangements. We also recommend that the Commission reiterate and

provide further guidance with respect to the scope of the safe harbor, particularly

concerning (a) the uses of electronically provided research and the various items

used to send, receive, and process research electronically, and (b) the uses of items

that may facilitate trade execution.

‘‘2. Many broker-dealers and advisers did not keep adequate records documenting

their soft-dollar activities. We believe the lack of adequate recordkeeping contributed to incomplete disclosure, using soft dollars for nonresearch purposes without

disclosure, and inadequate mixed-use analysis. We recommend that the Commission

adopt recordkeeping requirements that would provide greater accountability for softdollar transactions and allocations. Better recordkeeping would enable advisers to

more easily assure compliance and Commission examiners to more readily ascertain

the existence and nature of soft-dollar arrangements when conducting inspections.

‘‘3. We noted many instances where advisers’ soft-dollar disclosures were inadequate or wholly lacking—especially with respect to nonresearch items. We

recommend that the Commission modify Form ADV to require more meaningful disclosure by advisers and more detailed disclosure about the products received that

are not used in the investment decisionmaking process. In addition, the Commission

should require advisers to provide more detailed information to clients upon request.

‘‘4. In light of the weak controls and compliance failures that we found, we recommend that the Commission publish this report in order to encourage advisers and

broker-dealers to strengthen their internal control procedures regarding soft-dollar

activities. We suggest that advisers and broker-dealers review and consider the controls described in this report, many of which were observed as effective during examinations.’’ 18

At the time it was issued, the OCIE report clearly represented the best available

information on soft-dollar practices. In light of the fact that the report was published more than 5 years ago, one of the key questions today is whether any of the

practices described in the report have changed. Some of the key issues that may

warrant reexamination include whether documentation, disclosure, and control procedures relating to soft-dollar arrangements have improved.

Current SEC Initiatives

Following the recommendations set forth in the 1998 OCIE Report, the SEC

issued an extensive proposal in April 2000 to revise the so-called ‘‘brochure’’ (Form

ADV, Part 2), the disclosure document that all investment advisers must offer to

provide to clients and prospective clients each year.19 As discussed above, the proposed rule would amend the brochure requirements to mandate more specific disclosure regarding soft-dollar practices and any resulting conflicts. The ICAA expects

the SEC to finalize this important rule later this year.

In addition, the SEC recently finalized a major new rule that requires all investment advisers to adopt written compliance policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act of 1940, to

review such policies and procedures at least annually, and to designate a chief compliance officer who is responsible for administering the policies and procedures.20

The written release accompanying the SEC’s new regulation lists a number of areas

that investment advisers should consider in developing written policies and procedures, including best execution and soft-dollar practices. Clearly, the new rule will

encourage investment advisers to enhance—and review on a continuing basis—their

written policies and procedures relating to soft-dollar practices and will provide the

SEC with an additional tool in identifying potential problems in this area.

886

21Testimony Concerning the Securities and Exchange Commission’s Recent Regulatory Actions

to Protect Mutual Fund Investors, Paul F. Roye, Director, SEC’s Division of Investment Management, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs (March 10,

2004). 22See March 2, 2004 Comment Letter from Fidelity Management and Research Company to

SEC re: Concept Release on Measures to Improve Disclosure of Mutual Fund Transaction Costs,

Release No. 33–8349; 34–48952: IC–26313; File No. S7–29–03. 23 Id. 24See December 2, 2003 Comment Letter from the Investment Company Institute to the SEC

re: soft dollars.

Early this year, Chairman Donaldson announced that he has directed SEC staff

to explore various issues relating to soft dollars. SEC staff have been meeting with

a number of interested parties to discuss issues related to soft-dollar practices, including contracts for soft-dollar arrangements, recordkeeping practices, and disclosure practices. At the March 10 hearing before this Committee, the Director of the

SEC’s Division of Investment Management noted in his prepared testimony that:

Chairman Donaldson has made the issue of soft dollars a priority and has directed the staff to explore the problems and conflicts inherent in soft-dollar arrangements and the scope of the safe harbor contained in Section 28(e) of the

Securities Exchange Act. The Divisions of Market Regulation and Investment

Management, along with the Office of Compliance Inspections and Examinations, are working together to conduct this review. A primary area of focus is

whether the current definition of qualifying ‘‘research’’ under the safe harbor is

too broad and should be narrowed by rulemaking. The Commission has also

sought public comment on whether it would be possible to require mutual fund

managers to identify the portion of commission costs that purchase research

services from brokers so as to enhance the transparency of these arrangements.21

We understand that as part of this review, the SEC is considering certain public

comments that have been filed with the SEC that set forth a number of suggestions

for improving disclosure of soft-dollar arrangements and for narrowing the scope of

allowable research.22 Among these comments is a suggestion that proprietary research costs be ‘‘unbundled’’ from execution costs.23 Although we have not had an

opportunity to fully consider this proposal, we strongly believe that any such reform

should place full responsibility to calculate the cost or price of nonexecution services

on the broker-dealer providing the services, rather than requiring investment advisers to make a subjective estimate regarding such services.

The ICAA fully supports the SEC’s current initiative to examine soft-dollar practices and issues. Specifically, the ICAA would support an SEC rulemaking aimed

at improving disclosure of soft-dollar practices and arrangements to investors and

to clarify the current definition of ‘‘research.’’

Conclusions and Summary

In summary, the ICAA supports a rulemaking by the SEC that would:

• Enhance soft-dollar disclosure requirements, as envisioned by the SEC’s proposal

to revise Form ADV; • Strengthen books and records requirements related to soft dollars; and • Clarify the scope of allowable ‘‘research’’ within the Section 28(e) safe harbor.

We believe that these rule changes, combined with appropriate inspection and enforcement of these regulations will strengthen the transparency of soft-dollar arrangements and deter abuses in this area.

However, we believe that the SEC should reject suggestions to eliminate the use

of soft dollars for third-party research.24 As described in the ICAA’s March 3, 2004

statement, we believe such a suggestion is fundamentally flawed:

It would result in a diminution of quality research and thus is contrary to our

strong support for independent research that benefits investors. If adopted, the

proposal would unfairly advantage full-service brokerage firms and disadvantage third-party research providers, as well as clients of investment advisers

who benefit from third-party research.

Finally, the ICAA believes that an SEC rulemaking is a better approach than repealing Section 28(e). While the consequences of eliminating soft dollars cannot be

predicted with certainty, we believe the SEC is in the best position to consider the

complex issues related to this important question. Abolishing soft dollars may well

diminish the amount of quality research that is made available to investment advisers and thus may hurt investors. In addition, repealing section 28(e) may disproportionately disadvantage thousands of smaller investment advisory firms and their

887

clients while favoring the relatively few larger firms that have greater resources to

produce and acquire research.

In closing, the ICAA wishes to commend the Committee for conducting this hearing on these important issues. We would be pleased to provide any additional information that may be helpful to you in your continuing deliberations.

*****

FOR IMMEDIATE RELEASE

March 3, 2004

CONTACT: DAVID TITTSWORTH

202.293.4222

ICAA STATEMENT RE: SOFT DOLLARS

(Washington, DC) The Investment Counsel Association of America today issued the

following statement regarding soft dollars:

The ICAA fully supports SEC Chairman Donaldson’s announced initiative to analyze issues related to soft dollars and we stand ready to assist the Commission in

this important effort. Specifically, we encourage the SEC to require enhanced disclosure of soft-dollar practices to clients and to focus on whether the SEC’s interpretation of allowable research requires clarification. However, the ICAA believes the

SEC should reject the Investment Company Institute’s proposal to eliminate all

third-party research from soft-dollar practices. We believe this aspect of ICI’s proposal is fundamentally flawed. It would result in a diminution of quality research

and thus is contrary to our strong support for independent research that benefits

investors. If adopted, the proposal would unfairly advantage full-service brokerage

firms and disadvantage third-party research providers, as well as clients of investment advisers who benefit from third-party research.

The ICAA has been a consistent advocate for high ethical standards and strong

and effective compliance practices. The ICAA Standards of Practice, first adopted

in 1937, continue to emphasize that an investment adviser is a fiduciary that has

the responsibility to render professional, continuous, and unbiased investment advice to its clients. As such, basic fiduciary principles prohibit an investment adviser

from taking an interest that is potentially adverse to its clients without the client’s

informed consent and from using client assets for its own benefit. Client brokerage

is an asset that should be used in the best interests of the client. Accordingly,

investment advisers that choose to enter into soft-dollar arrangements must be

mindful of their fiduciary obligations, including their duty to make full and complete

disclosure to investors about such practices.

In 1975, the Securities and Exchange Commission acted to make the U.S. securities markets more competitive by abolishing fixed commission rates. Shortly thereafter, Congress enacted Section 28(e) of the Securities Exchange Act of 1934, the

safe harbor that allows investment advisers to ‘‘pay up’’ for research. Section 28(e)

provides that a person who exercises investment discretion with respect to an account will not be deemed to have breached a fiduciary duty solely by reason of having caused the account to pay more than the lowest available commission, if such

person determines in good faith that the amount of the commission is reasonable

in relation to the value of the brokerage and research services provided. Soft-dollar

practices, as defined by the SEC, consist of arrangements in which products or services other than execution of securities transactions are obtained by an investment

adviser by or through a broker-dealer as a result of the adviser’s using the brokerdealer for execution of client securities transactions. The SEC’s current definition

of soft dollars makes no distinction between proprietary and third-party research

and services.

The Investment Company Institute, a trade association that represents the mutual fund industry, wrote to SEC Chairman Donaldson in December proposing,

among other things, that the SEC issue rules to exclude certain research products

and services from the scope of Section 28(e), including computer hardware and software, publications that are available to the general public, and all third-party research services. In January, Chairman Donaldson stated that he had directed the

SEC staff to explore a number of complex issues, including ‘‘the use of soft-dollar

arrangements by investment managers and the scope of the safe harbor contained

in Section 28(e) of the Exchange Act.’’

The ICAA fully supports Chairman Donaldson’s initiative and stands ready to assist the Commission in analyzing current practices and identifying appropriate ways

888

to improve soft-dollar disclosure and to clarify current law. However, we believe the

SEC should not eliminate all third-party research from the scope of the safe harbor.

As an initial matter, it is worth noting that the vast majority of investment advisory firms are small businesses that do not manage mutual funds. There are approximately 8,000 entities registered as investment advisers with the SEC. Of this

total, more than 5,000 have 10 or fewer employees. More than 6,000 investment advisers report that they have no mutual fund clients. In fact, investment advisory

firms have a wide variety of business models and investment styles and an extremely varied clientele, from individuals, families, and trusts, to a diverse range

of institutional clients, including public and private pension plans, endowments,

foundations, and pooled investment vehicles such as mutual funds and hedge funds.

The ICAA’s membership represents a cross-section of the broader universe of registered investment advisory firms.

Given the enormous diversity among the investment advisory profession and our

membership, it should come as no surprise that there is not unanimous agreement

on issues related to soft dollars. Some firms have expressed support for the concept

of severely restricting—or even eliminating—soft-dollar usage. In fact, some firms

have voluntarily taken the position that they will not engage in soft-dollar transactions, other than receiving research from full-service brokers. On the other hand,

many firms have expressed a variety of serious concerns about the ICI’s proposal.

They particularly object to the proposal to eliminate the use of soft dollars for all

third-party research, on the grounds that this will hurt clients and all investors because it will result in less innovative and independent research. Even among the

minority of firms that view soft dollars as objectionable, most agree that the proposal to eliminate soft dollars for third-party research may have significant and unpredictable consequences.

We are persuaded that any proposal to eliminate soft dollars for third-party research, if adopted, would have unfortunate and untenable results. If adopted, it

would have a number of profoundly negative consequences. It would result in an unjustifiable, unlevel playing field for many market participants. It would provide a

regulatory-driven advantage for full-service brokerage firms and disadvantage thirdparty research providers. As such, it would increase costs for existing investment

advisers and third-party research firms and would create an additional barrier to

entry for new advisory and research firms. Most important, it would have adverse

consequences for clients of investment advisory firms that benefit from third-party

research. Instead of helping investors by giving investment advisers access to superior, independent research, the proposal in fact would reduce the overall research

available, to the detriment of investors. Such a result would be particularly ironic

in view of the problems that have been uncovered during the past few years relating

to conflicted research provided by various brokerage firms. Indeed, many advisers

believe that third-party research provided by independent firms is of higher quality

than propriety research provided by large Wall Street brokerage firms. Further,

using soft-dollar credits for third-party research is undeniably more transparent

than ‘‘paying up’’ for proprietary research from full-service brokers bundled with

execution services. Third-party research is separately identified, invoiced, and quantifiable. Proprietary research is not. In this respect, the mutual fund industry’s proposal would result in less transparency to market participants, regulators, clients,

and investors.

In addition, we believe that eliminating third-party research will drive up costs

for many investment advisory firms and may have undesirable economic consequences, particularly for smaller firms. Accordingly, the ICAA strongly urges the

SEC to evaluate carefully the impact of such a proposal on investment advisers, including the thousands of smaller investment advisory firms. We also urge the SEC

to study the potential impact of such a proposal on the quality and availability of

research, a review that has never, to our knowledge, been undertaken. Due to the

widespread use of soft dollars, we believe that any major change in their usage may

have significant and unpredictable consequences—for investors, investment advisers, third-party research providers, and full-service brokerage firms. Given these

potentially far-reaching implications, the SEC should take time to investigate the

likely effects of any major changes in soft-dollar regulations.

Several years ago, the SEC’s Office of Compliance Inspections and Examinations

conducted an intensive fact-finding effort regarding current practices. OCIE’s targeted examinations involved a large number of brokerage firms and investment advisers. In September 1998, OCIE issued an extensive written report detailing its

findings. Among the most prominent findings were the following: (1) Nearly all investment advisers obtain products and services (both proprietary and third-party)

other than pure execution from broker-dealers and use client commissions to pay

for those products and services; (2) by far, most of the products and services obVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00900 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
889

tained by investment advisers with soft dollars fall within the definition of research,

for example, they provide lawful and appropriate assistance to the adviser in the

performance of its investment decisionmaking responsibilities; and (3) in cases

where investment advisers received nonresearch products and services using softdollar arrangements, virtually all investment advisers failed to provide meaningful

disclosure of such practices to their clients (a practice that already violates current

laws and regulations). A sound starting point for further SEC action would be to

assess whether the conclusions from the prior report are still valid.

The ICAA believes that policy makers should ensure that there is adequate disclosure about soft-dollar practices and then allow market forces to work in determining

how and when such practices make sense. Investors deserve to have accurate and

complete disclosure about soft-dollar practices of brokerage firms and investment

advisers so they can make a competent decision as to whether such practices are

consistent with their interests. Ensuring appropriate disclosure in a competitive

market will allow investors—rather than regulators—to make choices about soft-dollar practices that work for them. As noted above, some investment advisory firms

already have made the voluntary decision not to engage in soft-dollar transactions

involving third-party research providers. We believe that allowing market-driven decisions by investors, combined with full and complete disclosure, is certainly a better

solution than abolishing soft-dollar arrangements for third-party research services.

The ICAA also supports efforts by the SEC to clarify the types of products and

services that constitute permissible research under current law. We recognize that

research products and services are evolving, with innovative developments continuing on an ongoing basis. However, the SEC’s clear guidance in this area, to the

extent feasible, will have a salutary effect on both investment advisers’ compliance

programs, and the SEC staff’s inspection of such programs.

The ICAA supports full and complete disclosure of potential conflicts of interest

that confront investment advisers, including soft-dollar arrangements. We look forward to working with the Congress, the SEC, and other policymakers to ensure that

investors have full and complete disclosure of soft-dollar practices and that uniform

and consistent laws and regulations are in place governing these and related issues.

*****

The ICAA is a not-for-profit association that represents the interests of investment adviser firms. Founded in 1937, the ICAA’s membership today is comprised

of more than 300 firms that are registered as investment advisers with the SEC

that collectively manage in excess of $4 trillion for a wide variety of individual and

institutional investors. For more information, please visit www.icaa.org.

——————

PREPARED STATEMENT OF HOWARD M. SCHILIT, PHD, CPA

CHAIRMAN AND CEO

CENTER FOR FINANCIAL RESEARCH & ANALYSIS (CFRA)

MARCH 31, 2004

Thank you for the opportunity to share my views on the role of independent research, soft-dollar commissions, and their interdependence.

My name is Howard Schilit. I am author of the book Financial Shenanigans and

founder and CEO of the Center for Financial Research & Analysis (widely known

as CFRA), a forensic accounting organization serving the investment management

community. Our center serves as a ‘‘watchdog’’ organization for investors, warning

about unusual accounting practices. For example, over the last decade, we warned

investors about problems at Worldcom, Enron, Parmalat, Cendant, and Sunbeam.

Independent research organizations perform a vital watchdog role that greatly

benefits investors. As we all know, our founding fathers had the wisdom to devise

a system of checks and balances to not allow a single branch of Government to exert

undue power. In much the same way, the independent research industry provides

checks over potentially biased and misleading information distributed by public

companies and their sponsors at investment banking brokerage firms.

Independent research organizations typically are paid by third-party brokers that

use soft-dollar commissions. A ban on soft-dollar commissions would have a devastating impact on independent research firms and, indirectly, hurt investors. I urge

this Committee to search for other solutions and leave soft-dollar payments intact.

890

Historical Perspective

Historically, when investment managers trade stock they have had to purchase

a bundled package of services from one source—full-service brokerage firms. All research, trading, and other brokerage services came from this one source.

Within the last generation, competition has emerged as smaller boutique brokerage firms entered the market, driving down commission rates. In order to truly compete with the full-service brokerage firms, the boutiques needed to bundle some

value-added services. Since customers wanted research, the boutiques outsourced

these products by partnering with value-added independent research organizations.

Investment managers loved having new trading partners and new research

sources. In contrast, traditional proprietary full-service brokerage firms were not at

all pleased with competition emerging on two fronts—brokerage and research. In

the ‘‘old days,’’ proprietary brokerage firms were the only game in town; they had

a monopoly on trading and research. And investors paid exorbitant commissions for

research of questionable value.

Fortunately for investors, the proprietary brokerage monopoly has been threatened. Today, competition is fierce for trading commissions, driving trading costs

lower for investors. And fierce competition exists on the research front, as well, with

over 300 entrepreneurial independent research firms pushed to produce the most

value-added research at the best price. Investors never had it so good, with commission costs dropping and high quality independent research widely available.

Unfortunately for investors, however, the proprietary brokerage firms are fighting

hard to regain their monopoly in trading and research. They are pushing for a ban

on soft-dollar trading—the commissions typically paid to smaller brokerage firms

and later directed to independent research firms. The single act of banning soft dollars would irreparably hurt the competition from boutique brokers and independent

research providers. And proprietary brokers would again emerge with the monopoly

they enjoyed for many years.

I urge this Committee and your colleagues in Congress to create laws and policies

to nurture competition. Then investors win. Banning soft-dollar payments would

have unintended and undesirable effects of eliminating competition for proprietary

brokerage firms on both the research and trading fronts.

Recommendation No. 1: Soft dollars should be retained to provide a flexible payment option for purchasing independent research.

Make no mistake, there are serious issues that need to be addressed to ensure

that brokerage commissions charged are fair and reported in a transparent fashion

and investment managers always act in the best interest of the investing public.

Before offering certain much-needed reforms, please consider the following fundamental questions:

What is the appropriate currency (brokerage commissions or cash) to be used to

pay for investment research? Is it inherently wrong for investment managers to use

commissions as the currency to pay for research or consulting services? I would

think not, since for over 200 years most investors have used trading commissions

as the sole currency for such services.

If, however, you disagree and believe that a new currency should be used—that

is, cash only for research—that would be agreeable to me, provided all research purchased by investment managers is paid for with cash. Thus, if commissions were

banned as the currency to pay for third-party independent research, then I urge you

to establish a total ban on using commissions for any research from any source. Specifically, if an investment manager purchased research from my independent research organization and must pay cash then, in all fairness, research acquired from

Merrill Lynch, Goldman Sachs, or Morgan Stanley should require a cash payment,

as well. I would have absolutely no objection to creating a meritocracy that allows

all research providers to compete on the same playing field. Indeed, I would advocate such an approach.

Recommendation No. 2: Assuming little interest exists in a ‘‘cash-only’’ approach,

commissions should be the currency to pay for any investment research. No distinction should be made between proprietary and third-party research.

Assuming the commission-for-research model is retained, several important problems must be addressed:

• Bundling execution costs and nonexecution trading costs;

• Failure of mutual fund companies to include the nonexecution portion of the commission in their reported expense ratio;

• Inflated brokerage commissions; and

• Inadequate disclosure of portion of brokerage commissions directed to third-parties.

891

Recommendation No. 3: All brokerage organizations must unbundle execution and

nonexecution costs and disclose this information to investment companies. Since nonexecution brokerage commissions are identical at all firms, regulations should treat

them as such.

Requiring the unbundling of brokerage costs and showing the trade execution

costs and the other service costs separately can easily solve many problems that this

Committee is addressing. Full-service brokerage firms typically charge 5 cents per

share to trade (down in recent years from 8 cents). Included is approximately 2

cents for execution and the remaining 3 cents for nonexecution costs, such as research. Brokerage firms have not been required to disclose to investors and other

stakeholders how the 3 cents per share is spent, and consequently, fail to report this

information. In many cases, the 3 cents supports in-house research and operations

at a proprietary brokerage firm. In contrast, at a ‘‘soft-dollar’’ brokerage firm, the

3 cents is paid to third-party research firms. The money generally is spent for research—indeed the reason for the trade—and it clearly benefits the investor. And,

if the investment manager believes the most value-added researcher works at an

independent research firm, proceeds from trades should be directed to the research

enterprise. That is the essence of a ‘‘soft-dollar’’ arrangement.

With an unbundled menu, investment managers can now shop ‘‘a` la carte.’’ That

is, they can trade with a broker with best execution and the lowest pricing. And

they could purchase research and other investment tools from an organization (Wall

Street proprietary or independent) based on the value-added quotient of those services. The logical result would be that:

• Commission costs would be lowered with more disclosure and competition;

• Trading volume would be reduced with less pressure to trade; and

• Research quality would improve, since only the strongest research products would

be purchased.

Recommendation No. 4: Non-execution costs should be included in the expense

ratio the mutual fund companies disclose.

If all brokers must disclose the nonexecution costs that pertain to research, then

mutual fund companies would have the necessary data to include such costs in their

expense ratio. And, I would recommend that mutual funds should be required to include such nonexecution costs in the expense ratio reported to investors.

Recommendation No. 5: Regulators and accountants should audit the records of

both brokerage organizations and investment managers to ascertain proper accounting and disclosure of nonexecution costs and expense ratios.

Recommendation No. 6: Severe penalties should be meted out to organizations that

fail to properly account for nonexecution costs or expense ratios.

Recommendation No. 7: Whatever changes are made, there must be one consistent

set of rules concerning brokerage commissions and research services.

No distinction should be made between proprietary and third-party research. Full

disclosure of an investment manager’s research expenses should be required regardless of the source. Excluding costs by proprietary brokers would discriminate against

third-party independent research enterprises.

Concluding Thoughts

A ban on allowing soft-dollar payments for third-party research would be a big

mistake. It would not directly solve the real problems and instead, would have the

undesirable effect of eliminating an important resource for investors—value-added

independent research.

I believe that my recommendations would have a number of desirable results that:

• Allow the emerging industry of independent research to solidify and provide the

checks and balances that Wall Street needs;

• Give investment managers choices in trading and research that would result from

unbundling and disclosure of brokers commission;

• Drive trading costs down and quality of research up with healthy competition; and

• Drive out unethical commission kick-back arrangements with new mandated disclosures.

892

893

894

895

896

897

898

899

900

901

902

903

904

905

906

907

908

909

910

PREPARED STATEMENT OF GRADY G. THOMAS, JR.

PRESIDENT, THE INTERSTATE GROUP

DIVISION OF MORGAN KEEGAN & COMPANY, INC.

MARCH 31, 2004

Introduction and Background

Thank you for the opportunity to appear before this distinguished Committee to

discuss research-commission arrangements under Section 28(e) of the Securities Exchange Act of 1934. My name is Grady Thomas. I have been in the securities business for 40 years, and in 1986 became the President of the Interstate Group, today

a Division of Morgan Keegan & Co., Inc., a subsidiary of Regions Financial Corporation. I have been active in the securities industry throughout my career. I was on

the Board of Directors of the Boston Stock Exchange for 8 years; served as Chairman and President of the National Organization of Investment Professionals; was

a District Chairman of the NASD; two-term Governor of STA; Founding President

and Chairman Emeritus of the North Carolina Security Traders Association; and

am currently Chairman of the SIA Institutional Brokerage Committee.

I have been involved in providing independent research to investment managers,

including mutual fund portfolio managers, for 30 years, and in that period of time

I have seen innovative research flourish and commission rates fall, to the benefit

of all investors. I have also seen the transparency of independent research arrangements improve to the point where investment mangers involved in independent

research arrangements receive monthly statements detailing the type of research

provided, its cash value, and the aggregate commissions used to pay for that research. The driving force behind these beneficial developments has been the Section

28(e) safe harbor adopted by Congress in 1975. My experience has been that Section

28(e), and various interpretations of the safe harbor by the Securities and Exchange

Commission, have done an excellent job of assuring that research and execution

services provided by broker-dealers to investment managers provide value to the investment managers’ accounts.

You will notice that throughout my testimony I use the terms ‘‘research-commission’’ or ‘‘independent research’’ arrangement rather than ‘‘soft dollars.’’ This is

intentional. In the first place, the term soft dollars has come to have negative connotations that do not reflect the reality of independent research arrangements. Second, the term soft dollars is not defined in the securities laws, and is often used

as shorthand to describe many uses of commissions by investment managers, including uses that do not involve the provision of investment research or execution services. In contrast, Section 28(e) provides protection only to arrangements where

broker-dealers provide brokerage and research services that benefit an investment

manager’s managed accounts.

History of Research-Commission Arrangements and Section 28(e)

Because broker-dealers are deeply involved in the investment decisionmaking

process through their execution and trading activities, it follows that they would

also provide research and other advisory services to investors. Indeed, the practice

of providing both trade execution and investment research in exchange for commissions may go back to the opening of the New York Stock Exchange in 1792. Some

large full-service broker-dealers budget hundreds of millions of dollars to providing

in-house research to their brokerage clients. Other firms, such as The Interstate

Group, service their institutional clients by providing research services and analytical tools developed or authored by independent organizations. Arrangements for the

provision of independent research are estimated to involve approximately $1 billion

of institutional commissions on an annual basis. Commissions committed to proprietary research and execution-only trades are estimated at about $9 billion annually.

Definition of a Research-Commission Arrangement

A research-commission arrangement under Section 28(e) of the Securities Exchange Act of 1934 is one in which a broker-dealer provides research services to a

fiduciary, such as an investment adviser or bank, who manages other people’s

money. In such an arrangement, the fiduciary must use the research to assist in

the investment decisionmaking process on behalf of account beneficiaries. The beneficiaries pay for the research indirectly with commissions on portfolio transactions

that the broker-dealer effects for their accounts.

Under a lawful Section 28(e) arrangement, a fiduciary may use commissions only

to acquire services that are useful in the investment decisionmaking process. A fiduciary may not, for example, use commissions for administrative expenses such as

carpeting, telephones, or other items which benefit the fiduciary but not the acVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00922 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
911

1Securities Act Amendments of 1975, Report of Committee On Banking, Housing, and Urban

Affairs, S. Rep. No. 75, 94th Cong., 1st Session 71 (1975). 2 Report of the Committee On Banking, Housing, and Urban Affairs, S. Rep. 94–75 (1975).

count. If a research service has the potential to provide administrative or nonresearch assistance to the money manager, Section 28(e) guidelines require the

money manager to allocate the cost of the service according to its use. Where a research service has a ‘‘mixed-use,’’ only that percentage of the service attributable to

the investment decisionmaking process may be paid for with commission dollars.

The fiduciary must use its own resources to pay for that portion of the service that

provides nonresearch assistance to the fiduciary.

History of Section 28(e)

Commission rates on exchanges have been competitive only since 1975. Before

that time, commission rates on portfolio transactions generally were fixed by law

and had been throughout the history of the New York Stock Exchange. Under the

old fixed rate system, money managers were able to obtain research through expenditure of their accounts’ commissions without incurring additional costs to the

accounts, since commission rates were the same regardless of whether the brokerdealer provided research. Because commission rates were fixed by law, the practice

of providing research services to fiduciary accounts eventually was prevalent, as

much as brokers recognized the need to compete for orders on the basis of services

rendered. In this way, brokers came to provide necessary support for the professional fiduciaries’ internally developed advisory functions. These business relationships and expectations that evolved between fiduciaries and their accounts continue

today in the era of competitive commission rates.

When commission rates on exchanges were made competitive in 1975, the investment community was concerned that the flow of research would be restricted.

Money managers feared that fiduciary principles would or could require fiduciaries

to operate under the principle that ‘‘cheapest is best’’ and that only the lowest cost

execution would avert a lawsuit for failure to obtain best execution. In response to

these concerns, Congress passed Section 28(e) of the Securities Exchange Act of

1934, a safe harbor for fiduciaries who receive research services in consideration of

portfolio commissions, to ensure the continued availability and quality of research

in the competitive commission rate environment. The Congressional hearings on

this provision reflect the notion that without Section 28(e) protection, the flow of research previously furnished to institutions under a fixed commission rate structure

could be cut off, and investors would be harmed.1

Both Congress and the SEC have taken steps to ensure that the legal standards

that apply to Section 28(e) arrangements protect the interests of investors. Section

28(e) itself limits the definition of research that can be obtained for commissions,

and requires the fiduciary to determine that the commissions paid are reasonable

in relation to the research and brokerage services provided. Based on the legislative

history of Section 28(e), the SEC has interpreted that research services received by

investment managers under these arrangements must assist the manager in the investment decisionmaking process.

Benefits to Investors of Research Commission Arrangements

Investors reap a number of benefits from the research-commission arrangements

described above:

• Flow of Research Services to Money Managers

One of Congress’ principal objectives in adopting Section 28(e) was to ensure ‘‘the

future availability and quality of research and other services’’ to the investment

community.2 It was adopted to address the concern that investors would suffer if

the flow of research services to money managers were impeded. Events over the

past 29 years demonstrate that Section 28(e) has indeed facilitated the flow of research to investment managers.

Broker-dealers now provide literally hundreds of independent research services to

money managers to assist in the investment decisionmaking process. The vast majority of these research services have only become available to money managers

since Congress adopted Section 28(e) in 1975. These services include not only investment information but fundamental databases, portfolio modeling, and strategy software. Equally significant, the technology for the delivery, formatting, and use of

information has made research more accessible to the investor and has added greatly to market efficiencies. Technology decisions relating to the investment process

have become extremely important as money managers today face growing market

complexities and information needs.

912

3 Report of the Committee On Banking, Housing, and Urban Affairs, S. Rep. 94–75 (1975).

4See Part II of Form ADV, Item 12(b); Form N–1A Item 16.

The Section 28(e) safe harbor has been particularly useful in assisting in the development of the independent research community. Independent research providers

are often small operations using innovative and unique methodologies and targeting

research at a specific segment of the market which is not given sufficient coverage

by full service firms. It is extremely difficult for a small independent research provider with a limited marketing budget to gain a foothold in the market for investment research. Section 28(e) arrangements allow independent research providers to

rely upon and obtain assistance from broker-dealers to gain market acceptance. In

turn these broker-dealers provide independent research and execution services to

many investors.

• Competition Among Broker-Dealers Providing Research Has Reduced Execution

Costs

By becoming major competitors for institutional order flow, research brokers such

as The Interstate Group have exerted downward pressure on commission rates.

Since commission rates became unfixed in 1975, execution costs have declined significantly. Prior to 1975, commission rates on institutional trades were on a sliding

scale based on volume with a high of $0.82 per share. In 1998, a SEC report found

commission rates of about $0.06 per share for those institutional accounts examined

by the SEC Staff. My experience is that commission rates today average $0.05–

$0.06 per share for institutional trades.

• Smaller Asset Managers Have Benefited from the Favorable Regulatory Environment for Providing Research in Conjunction with Execution

In its deliberations on Section 28(e), Congress recognized that without highly developed internal research resources, smaller money management firms might be required to rely entirely on Wall Street research. Congress feared that without access

to research that broker-dealers provide, small investment managers would be pressured to charge higher fees than large money managers would charge.3

What was true in 1975 is true today. Many startup investment advisers cannot

establish their businesses and compete against larger money managers (who command large fee bases from which they can sustain in-house research) without access

to the research services that broker-dealers provide. Section 28(e) has thus facilitated small firms’ entry into the investment advisory business.

Common Misconceptions Regarding Section 28(e) Arrangements

Over the years, I have noted that many people within and without the financial

industry harbor misconceptions regarding Section 28(e) arrangements. Following are

a few I encounter most frequently.

• Misconception 1: Section 28(e) arrangements are used by investment managers to

pay for administrative expenses such as carpeting and rent.

As discussed above, the definition of ‘‘research’’ under Section 28(e) extends only

to items that provide assistance to fiduciaries in the investment decisionmaking

process. Administrative expenses such as rent are not, and have never been, covered

by the Section 28(e) safe harbor. Furthermore, in the last industry-wide examination sweep conducted by the SEC staff in 1997, the staff found no instances ‘‘ . . .

in which [mutual] fund commissions were used to purchase nonresearch items,

which did not benefit the funds themselves.’’ While it is true that some privately

managed investment vehicles, such as hedge funds, engage in directed brokerage activity to pay for nonresearch services, this type of activity is not covered under the

Section 28(e) safe harbor. Accordingly, changes to the Section 28(e) safe harbor

would not effect these types of arrangements.

• Misconception 2: Section 28(e) arrangements lack transparency and are not disclosed to investors.

Independent or ‘‘third-party’’ research arrangements are among the most transparent arrangements in use in the investment industry today. Investment managers

involved in such arrangements receive monthly statements detailing the dollar

value of research provided, the aggregate commissions used to pay for the research

and an identification of the research provided. While it is true that some proprietary

research arrangements lack this level of transparency, all Section 28(e) arrangements, both proprietary and independent, must be disclosed by investment advisers

in their Form ADV, and by mutual funds in their Form N–1A.4

• Misconception 3: Investment managers who execute trades with Wall Street firms,

and receive proprietary research services, do not engage in ‘‘soft dollars.’’

913

5Statement made by the SEC Office of Compliance Inspections and Examinations in the ‘‘Inspection Report on The Soft-Dollar Practices of Broker-Dealers, Investment Advisers and Mutual

Funds,’’ (September 22, 1998, Section I.)

Every so often I will encounter an investment manager who will declare that his

firm does not use ‘‘soft dollars.’’ When I probe the issue, I usually discover that the

manager does indeed execute portfolio trades with large Wall Street firms, and receives services such as research reports, access to research analysts, etc., from these

firms. Proprietary research arrangements require the protection of the Section 28(e)

safe harbor to the same extent as do independent research arrangements. However,

because investment managers involved in proprietary research arrangements do not

typically receive statements detailing the value and type of research they receive,

they do not understand that they are indeed involved in a ‘‘soft-dollar’’ arrangement.

• Misconception 4: Requiring investment managers to pay cash for research would

benefit investors.

Denying investment managers the use of portfolio commissions to purchase research would have a devastating effect on the securities markets and investors.

Smaller investment managers would lack the resources to compete with larger

peers, driving them out of business. Independent research firms, which have flourished in recent years, would lose the invaluable marketing mechanism provided by

broker-dealers seeking to provide research to their institutional customers. Small

independent research firms would fail, and the now vibrant market of new types

of research would dry up.

If required to finance research expenses from their own resources, investment

managers would be forced to raise management fees, or to reduce their use of investment research. Neither of these outcomes would be helpful to investors or the

markets. If investor managers merely passed research costs along to investors

through higher management fees, investors would end up paying more for research

and commissions than they do now, as studies have shown that combining research

and execution services leads to economic efficiencies that would be lost if they were

provided separately. Furthermore, research costs would be less, not more, transparent than under the current structure, as they would be lumped in with all of

the managers’ other overhead costs.

If managers were to reduce their use of research, investors would also suffer.

Studies have shown the use of research has a positive correlation with investment

return. A reduction in research used by managers would result in inferior performance for investor’s accounts. Many managed funds would resort to a form of indexing, trying to mimic, rather than beat, the overall market. While index-type investing certainly has a place in the investment management field, investors and the

markets as a whole have greatly benefited from growth, value, and other more research-centric investment strategies in the past. The diminution of the amount of

research available to managers would disproportionately affect managers who rely

on these types of strategies, to the detriment of investors and the price discovery

mechanism of our securities markets.

Finally, I believe this argument ignores the fact that there is nothing stopping

investment management firms from determining on their own to pay for research

with cash, and for competing for clients on that basis. In fact, some firms do so

today. As discussed above, investment advisers and mutual funds must disclose to

investors whether or not they receive research in exchange for portfolio commissions. If investors truly believe that they would benefit from using an investment

manager who pays only cash for research, they can easily find such a manager. On

the other hand, if managers were required to pay only cash for research, investors

would lose the opportunity to select a manager or investment vehicle that benefits

from the practice of combining research and execution services.

Conclusion

Research is the foundation of the money management industry. Providing research is one important, long-standing service of the brokerage business. Softdollar arrangements have developed as a link between the brokerage industry’s

supply of research and the money management industry’s demand for research.5

Congress’ adoption of Section 28(e) in 1975 has fostered the development of innovative and useful research products by both independent and proprietary research

providers. Section 28(e), and SEC interpretations thereof, have done an excellent job

of assuring that research services are readily available to investment managers and

provide value to investors by supporting managers in the investment decisionmaking process.

914

1 BNY Securities Group does not engage in investment banking business or principal underwriting business. One of the Group’s members, Pershing Trading Company, L.P., acts as a market maker and specialist to facilitate the Group’s broker-dealer clearing business. The Group’s

other broker-dealers, however, act solely as agent or ‘‘riskless’’ principal (that is, the economic

equivalent of agent).

The last major study of Section 28(e) arrangements conducted by the SEC staff

did not observe any instances in which mutual fund commissions were used to purchase nonresearch items, which did not directly benefit the funds themselves. The

SEC staff did, in Section VIII of its 1998 Inspection Report, make a number of

recommendations pertaining to the provision of investment research for portfolio

commissions. I encourage the SEC to give further consideration to these recommendations, and note that many of them have already been adopted by The

Interstate Group and other broker-dealers involved in the provision of independent

research.

Thank you for the opportunity to appear before you and express my views on behalf of The Interstate Group.

—————

PREPARED STATEMENT OF JOSEPH M. VELLI

SENIOR EXECUTIVE VICE PRESIDENT, THE BANK OF NEW YORK

MARCH 31, 2004

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, I

am Joseph Velli, Senior Executive Vice President of The Bank of New York. Thank

you for inviting me to testify about research commissions, commonly called ‘‘soft dollars,’’ an issue important to investors, investment managers, independent research

firms and broker-dealers. We appreciate the Committee’s efforts to examine issues

concerning mutual fund fees, expenses, and governance. We also applaud the efforts

of the Securities and Exchange Commission (SEC) in proposing rules changes designed to curb abusive behavior, address conflicts of interest and ensure that investors are given a fair shake. We think The Bank of New York can add to the dialog

in a meaningful way.

The Bank of New York and BNY Securities Group

The Bank of New York is the oldest bank in the United States. It was founded

in 1784 by Alexander Hamilton and was the first corporate stock to be traded on

the New York Stock Exchange in 1792. Together with its parent company, The Bank

of New York Company, Inc., The Bank of New York has a distinguished history of

serving clients around the world through its five primary businesses: Securities

Servicing and Global Payment Services, Private Client Services and Asset Management, Corporate Banking, Global Market Services, and Retail Banking. The Bank

of New York Company, Inc. is a global leader in securities management services operating in more than 100 markets and servicing issuers, institutional investors, and

broker-dealers. The Company plays an integral role in the infrastructure of the capital markets safekeeping over $8 trillion in investors assets. Through its nearly

23,000 employees, the Company provides quality solutions for global corporations,

financial institutions, asset managers, governments, nonprofit organizations, and individuals.

I am a Senior Executive Vice President of The Bank of New York and head of

BNY Securities Group. Over the past several years, The Bank of New York has

greatly enhanced its brokerage and clearing capabilities through both targeted

acquisitions and internal growth. This focused strategy is part of The Bank’s continued efforts to provide clients with the resources and highly personalized service

required to succeed in the investment marketplace. BNY Securities Group’s core

business lines include institutional agency brokerage, clearing and financial services

outsourcing businesses.

Agency Brokerage

BNY Securities Group’s execution businesses focus on agency brokerage.1 We act

as our clients’ agent in the marketplace, representing their interests in seeking best

execution of their orders. An agency broker receives orders from its clients—in our

case, investment managers, pension plans, and corporations—and executes the

transactions with the ‘‘Street,’’ other broker-dealers in the marketplace who may be

915

2 Implicit transaction costs, such as market impact and opportunity cost are borne by a

broker-dealer’s customer regardless of the mode of execution. Although such implicit costs indeed are costs to the customer, the customer’s broker-dealer is not the beneficiary; such costs

flow to market participants other than the executing broker-dealer. 3 A Research Commission is one in which an investment adviser receives securities brokerage

and research services from a broker-dealer in exchange for the investment adviser directing

some portion of its clients’ brokerage transactions to the broker-dealer.

acting on their own behalf (that is, principal) or their customers (that is, agent). We

earn a commission for this service, which is fully disclosed to our clients.

In contrast to an agency broker’s role, a broker-dealer acting as principal buys

from its customer (in the case of a sell order) or sells to its customer (in the case

of a buy order) using the firm’s capital. The broker-dealer makes money in such

transactions by charging a mark-up or markdown, that is, adding to or subtracting

from the price to the customer. In most cases, the broker-dealer’s charge and the

customer’s cost are not disclosed to the customer.

Agency brokerage provides investors two primary benefits they do not receive

when transacting with a principal: (1) transparency of the explicit cost of execution; 2 and (2) absence of a conflict between the interests of the broker and those

of the client. In an agency transaction, the client receives a confirmation setting

forth, among other things, the amount of commission charged by the broker.

This information enables the client to take a methodical approach in assessing

execution quality: First, to review the execution quality against appropriate benchmarks (for example, volume weighted average price, market opening price, market

closing price, or some other relevant measure), and second, to review whether the

explicit cost of execution—the commission—was reasonable in relation to the value

of the services provided.

Agency brokerage also gives clients the comfort of knowing their broker is working on their behalf. An agency broker has no incentive other than to obtain the best

execution reasonably available on behalf of the client. Moreover, agency brokerage

significantly reduces the risk of economic incentives that adversely affecting the client. The institutional investment community recognizes the value of agency brokerage—we believe the agency brokerage business as a percent of the total institutional

brokerage business has increased significantly in the past few years.

Research Commissions and Section 28(e)

The provision of securities-related research is an integral part of the brokerage

business. This is perfectly natural, for a broker’s business is to assist clients in the

purchase and sale of securities. Brokers are expected to know the ‘‘market,’’ to understand and provide valuable information about securities trading activity and the

factors affecting the prices of the market generally as well as individual securities.

Indeed, customers demand it. As a result, brokers long have distinguished their

services from competitors’ by highlighting the quality of their research.

What has been true for decades is true today: Investors want their brokers to provide them with high-quality research. One need only turn on the television to see

major retail financial services firms publicizing the quality of the research they provide customers to enable them to make well-informed investment decisions. Research Commissions3 (soft dollars) are no different. Institutional brokers distinguish

their services, among other ways, by providing their clients—asset managers—with

research that helps the asset managers make better investment decisions on behalf

of their clients (for example, mutual fund investors).

Background of Section 28(e)

It would be helpful to provide some background on the history and scope of Section 28(e) of the Securities Exchange Act of 1934. In 1975, when Congress abolished

fixed commission rates, investment managers were concerned that they would be

deemed to have violated their fiduciary duty to act in the best interests of their

clients if they caused their clients to pay a commission higher than the lowest commission available. The concern was driven by the existing practice of an adviser obtaining from its brokers research as well as brokerage services. In some cases, the

research would be directly related to transaction and the account generating the

commission, while in other cases the adviser would use the research to benefit its

advised accounts generally. Congress responded by enacting Section 28(e), a ‘‘safe

harbor’’ that shields an investment adviser from breach of fiduciary duty claims for

causing its clients to pay a higher commission to a broker-dealer that provides ‘‘brokerage and research services’’ within the meaning of the statute.

To rely on the safe harbor, an adviser must determine in good faith that the commissions paid are reasonable in relation to the value of the brokerage and research

services provided. Section 28(e) permits an adviser to obtain services, particularly

916

4See S. Rep. No. 75, 94th Cong. 1st Sess. 248 (1975); Securities Exchange Act Release No.

23170 (April 23, 1986). 5 U.S. Equity Investors: Soft-Dollar Market Trends, Greenwich Associates, 2003.

research services, with client commission dollars so long as the adviser determines

that the services provide ‘‘lawful and appropriate assistance’’ to the asset manager

in the investment decisionmaking process.4 Section 28(e) is a tacit recognition that

securities brokers legitimately have always been in the business of providing research to their clients—the person who is making the investment decisions. In retail

brokerage, the investment decisionmaker usually is the individual owner of the account. In institutional brokerage, the investment decisionmaker often is an investment adviser acting on behalf of its clients. In both cases, brokers are assisting the

decisionmaker—the client—by providing research that the client deems valuable.

Scope of Section 28(e)

Many misunderstand the scope of ‘‘soft dollars’’ and Section 28(e). The safe harbor

applies to any transaction pursuant to which an adviser causes a client to pay a

higher commission than the lowest available in exchange for brokerage and research

services. Specifically, it applies to commissions where the adviser receives proprietary research (proprietary research transactions) as well as commissions for thirdparty research services (independent research commissions). Advisers executing

transactions with integrated investment banks at full service rates are engaging in

soft-dollar transactions primarily with respect to the provision of proprietary research and, to a far lesser extent, with respect to the provision of third-party research. Integrated investment banks dominate the institutional commission market.

In fact, independent research transactions account for only about 12 percent of the

institutional commission market, $1 billion out of a total of $8.4 billion in 2003, with

the vast majority of the remaining 88 percent going to investment banks.5

Despite the very clear application of Section 28(e) to both proprietary research

commissions and independent research commissions, critics of these commissions

sometimes focus on the latter. We believe the criticisms of independent research

commissions are unfounded. In particular, we believe the vast majority of market

participants—investment advisers, broker-dealers, and independent research providers—conduct their business in compliance with the SEC’s guidance pursuant to

Section 28(e).

The SEC’s 1998 Sweep Report

In 1996 and 1997, the SEC’s Office of Compliance Inspections and Examinations

(OCIE) conducted a sweep examination of the soft-dollar industry. OCIE issued a

report in 1998 detailing its findings (the Sweep Report). OCIE found that approximately 2 percent of commissions paid in purported reliance on Section 28(e) was in

fact for ‘‘nonresearch products and services.’’ OCIE’s finding merits comment.

• First, OCIE’s finding of only 2 percent of commissions being used for services outside the safe harbor is remarkably low, particularly considering that, prior to

issuance of the Sweep Report, the legislative history, and other guidance on the

definition of research for purposes of Section 28(e) was sparse. Indeed, the Sweep

Report is the most extensive guidance on the topic to date.

• Second, among the items to which OCIE objected as being outside the safe harbor

are proxy services, membership and licensing fees related to investment management certification programs, and services related to regulatory compliance. In

most cases, the industry was acting in the good faith belief that many of these

products and services were within the safe harbor.

• Third, a corollary to the first two points is that the industry’s practices have improved a great deal since the Sweep Report was issued. Once guidance was issued

and standards were set, even informally, the industry responded. Independent

agency brokers generally, and BNY Securities Group’s brokers in particular, have

adopted policies and procedures designed to ensure that their practices are consistent with the requirements of Section 28(e) for those clients required or desiring to stay within the safe harbor.

The Sweep Report made a series of recommendations to the SEC regarding potential soft-dollar reforms. The primary recommendations were: (1) publication of the

Sweep Report to provide guidance to investment advisers and broker-dealers; (2) enhanced recordkeeping by investment advisers and broker-dealers with respect to

soft-dollar arrangements; (3) enhanced disclosure by investment advisers of research

products and services; and (4) enhanced internal controls.

Advisers and agency brokers responded to the Sweep Report’s guidance by adopting procedures and controls designed to ensure compliance with the requirements

917

6See Investment Advisers Act Release No. 2204 (December 17, 2003).

of the safe harbor. Agency brokers, such as those within BNY Securities Group, provide detailed information to investment adviser clients regarding their brokerage

commissions and the services they receive; we also retain detailed records of the

products and services provided and information about the research providers. Exhibit A is a sample monthly report, which shows in great detail the commissions

generated by the client and each research service, with the associated cost, provided

to the client.

The Securities Industry Association has issued a Best Practices guide on soft dollars that many brokers have adopted wholesale. The Association of Investment

Management and Research also issued soft-dollar standards shortly after the

issuance of the Sweep Report, which have been adopted by some in the investment

adviser community. In addition, the SEC recently adopted rules requiring investment advisers to adopt formal compliance programs.6 Investment advisers are required to comply by October 5, 2004. Accordingly, we believe the current system

works as intended. We believe, however, that enhanced disclosure about transaction

costs would benefit investors (see below).

Independent Research Commissions Should be Encouraged

At BNY Securities Group, we believe Independent Research Commissions benefit

investors and play a valuable role in the marketplace. Such commissions combine

best execution and choice of independent research in an unbundled, transparent

fashion. Accordingly, Congress and the SEC should encourage their use.

Best Execution

Research commissions can only exist in an environment where investment advisers are required to obtain, and broker-dealers are required to provide, best execution

of the underlying securities transactions. In the case of independent research arrangements, agency brokers must compete on the basis of best execution. Advisers

can obtain third-party research services from any number of sources, including other

broker-dealers. Therefore, execution quality has a central role in differentiating

market participants.

Agency brokers involved in independent research commissions—sometimes called

‘‘soft-dollar’’ brokers—provide best execution by using people and technology to find

liquidity in a fragmented marketplace. BNY Securities Group’s broker-dealers operate business models designed to provide choice to investment advisers. BNY Securities Group allows advisers to execute through a fully integrated agency broker with

direct access to the NYSE floor, through a network of over 30 third-party executing

brokers pursuant to correspondent clearing arrangements, or through an electronic

communications network. Investment advisers are able to choose the model best designed to obtain the best prices reasonably available for their clients, depending on

such factors as the size of the transaction, the liquidity of trading in the security,

and the speed at which the adviser must execute.

Independent Research Commissions Provide Transparency

Most independent research commissions are negotiated by the investment adviser

and broker-dealer based on a ratio of commission dollars to value of research services provided (for example, 1.5:1). The ratio, which represents the value of execution

and research services provided, is explicit. Moreover, investment advisers engaged

in such commissions receive extensive information from the providing brokers regarding the commissions they generate, the products and services they receive, and

the cost of those services. This information typically is provided in detailed monthly

account statements. Proprietary research commissions with integrated investment

banks, by contrast, are opaque. Integrated investment banks generally do not

charge a separate fee for research. Rather, trade execution and research are ‘‘bundled.’’ The investment adviser is left to its own devices to determine what it is being

charged for each service and whether the amount charged is reasonable. Accordingly, independent research commission arrangements facilitate the adviser’s determination, required by Section 28(e), that the cost of the brokerage and research

services is reasonable in relation to the value of such services.

The Global Research Analyst Settlement

In settling the case of tainted research with 10 major investment banks earlier

this year, the SEC, the New York Attorney General, and other regulators insisted

that the settling firms spend $432.5 million for their client on independent research

over the next 5 years. The Global Research Analyst Settlement evinces the value

of independent research product versus the value of in-house research product of

918

7 Amendments to NYSE Rule 472 and NASD Rule 2711, and SEC Regulation AC.

investment banks. I discuss below the value inherent in independent investment research. It is important that Congress not place an additional unfair burden on independent research that could discourage the growth of the market for independent

research, a result for example at odds with the fundamental principles of the Global

Research Analyst Settlement. I believe that independent, conflict-free research is an

essential element in restoring investor confidence in the markets. We should encourage, not discourage, its use.

Access to Independent Research

Independent agency brokers offer access to hundreds of sources of independent research, including fundamental and technical research on individual issuers, industry

and sector analyses and broad-based economic research. We believe that access to

such a wide variety of ideas encourages better decisionmaking on the part of the

adviser. Many of the sources of independent research are small businesses with little or no research distribution capability. Such boutiques might not survive but for

the business provided by independent agency brokers. Independent agency brokers

can assist advisers in sourcing independent research and, where available, achieve

volume discounts. Independent research commissions provide critical access to research and remain the most viable distribution vehicle for the independent research

providers.

Small Investment Advisers Benefit the Most

Small investment advisers typically have small research departments. Many do

not have the resources to create an elaborate in-house research infrastructure.

Small advisers benefit the most from having continued access to a wide variety of

independent research. Independent research commissions allow small advisers to

compete with the bigger players.

Powerful Combination for Investors

BNY Securities Group combines best execution brokerage with an opportunity for

institutional customers to select from the highest performing sources of independent

research in an environment where all costs are completely transparent. If the expression ‘‘soft dollars’’ was created on Wall Street as jargon for those services whose

costs or values are undefined, then it does not exist at the Bank of New York. Indeed, we prefer to use the term ‘‘research commissions,’’ because it more accurately

describes the practice of providing clients with research that complements our execution services, and disclosing the costs of each.

BNY Securities Group, other leading agency brokers and full service firms that

offer independent research have made a business out of disclosure and commission

management. Our clients expect us to account for every penny of their client’s commissions, and we do. Like many other brokerage firms, we give our clients detailed

monthly statements—reporting all of their trading activity, the independent research providing the cost of each. A sample client statement is attached hereto as

Exhibit A.

The Intrinsic Values of Independent Research

BNY Securities Group has grown to be one of the largest aggregators of independent research in the world. We see four intrinsic values in this kind of research:

First, it is free of conflicts. While we believe the global settlement and recently

adopted SEC and SRO rules 7 provide a framework for reform of research on Wall

Street, the possibility of conflicts arising again is as enduring as human nature.

Second, independent research must stand on its own merits—it performs well or

is no longer selected. Our clients are not required to purchase one product or service

as a condition to receiving another. One of the products we offer our clients is access

to a proprietary rating system, which allows the client to sort and analyze research

on approximately 6,000 issuers covered by over 150 research providers according to

factors they select. Utilizing this rating system, our clients can measure performance of independent research and choose only those who are providing real value.

Third, independent research is serious, innovative, and often completely different

from Wall Street research. Due to its independence—and because of the system of

commission payments—market data providers were able to grow from ideas into a

revolutionary and highly successful research services business.

Fourth, independent research serves the public interest. Independent research

firms pioneered the concept of ‘‘forensic research,’’ hunting through complex financial documents searching for mismanagement or worse. Long before the public or

regulators reacted, various independent research firms uncovered the frauds of

919

Enron, Worldcom, Tyco, HealthSouth, and many more. We do not need less independent research we need more.

Research Should Be Paid for with Commissions

We believe permitting fiduciaries to use client commissions to obtain independent

research provides proper incentives to the asset management and brokerage communities to promote the development and distribution of products and services that

benefit investors.

The first reason research should be paid for with commission dollars is that the

value of research is included in the cost of the commission. Research has just as

much ‘‘right’’ to be paid out of the proceeds of the trade, as does the cost of executing the trade. In fact, with recent increases in trading efficiencies and declines

in overall commission rates, research is often the primary value received for the

commission. Disclosure will better allow the investor to judge the value of the research and will make the asset manager and broker more accountable. Some assert

that mutual fund managers engage in this practice for their own benefit or without

knowledge of the investor or the mutual fund’s board. The correct answer to these

concerns is disclosure plus stricter fund governance.

There will be considerable negative consequences to banning the use of commissions to pay for research. Among the losers will be: Investors, independent research,

smaller mutual funds, agency brokers, and funds reliant on sophisticated market

analytics.

We believe such a radical change will severely impair a growing and important

independent research industry. We have heard from prominent independent researchers who believe that the damage will be even greater, possibly even fatal.

Agency brokers and independent researchers are used to competing on an uneven

playing field. The integrated investment banks dominate the market for many reasons but partially because they offer a number of highly valuable services which we

do not. Allowing advisors to use commissions to pay for the research from integrated

firms, but not for independent research, would simply be unfair and create a complete disadvantage.

It is not in the interests of investors in a mutual fund to require a mutual fund

manager to add to the expenses of the fund when commission dollars can be, and

always have been, used to defray the costs of research. Some propose a requirement

that any and all research be paid for in cash and that it be included in the expense

line of the fund. They assert that such requirements will push down commission

rates. We believe it is far more likely that the net return to the investor will go

down. We believe this will strike a hard blow to independent research just as it is

coming into full bloom and will lead to the full service firms further reducing the

amount of research they produce. This cannot be good for investors.

Most mutual funds often have limited internal research staffs. They rely almost

exclusively on independent research. Some of the larger mutual fund complexes

employ hundreds of their own researchers. Yet some of the highest returns in the

industry are generated by the smaller funds. Reducing choice and hurting smaller

mutual funds are not good ideas.

According to a 1998 SEC report, the smallest advisory firms use over half of their

commissions for independent research, while the largest advisory firms use on average, just 8.3 percent. In other words, independent research provides essential

support to smaller asset management firms; abolishing independent research commissions would extend the dominance of the largest mutual fund complexes, reducing choice, and hurting smaller mutual funds are not good ideas.

Finally, but certainly not least important, is that since the costs of independent

research are disclosed, they can be, and are, audited.

Comment on Unbundling

The Bank of New York believes that commissions used to pay for research should

be accounted for. We do not support full unbundling of commissions by integrated

investment banks. Even though we, as agency-brokers, might benefit, we believe

that full unbundling would be highly disruptive to the capital markets, difficult to

accomplish, and would likely lead to a drastic reduction in research.

Conclusion

Soft-dollar practices should continue to be regulated, but let us establish the problem first. The problem is that commission dollars used to acquire research are only

disclosed in 10 percent of the cases—when independent or third-party research is

involved.

The Bank of New York agrees with the Securities Industries Association, which

supports the current safe harbor for research created by Section 8(e) and proposes

that the SEC mandate reasonable additional disclosure. We are confident that the

920

SEC can manage this responsibility well and we look forward to working with the

Commission on this.

If we are to ban anything, let us ban the term ‘‘soft dollars.’’ Let’s call them what

they are—independent research commissions—and let us encourage their greater

use.

Mr. Chairman, Senator Sarbanes, Members of the Committee, thank you. I would

be delighted to answer any of your questions.

921

922

923

924

925

926

927

928

929

930

931

932

933

934

935

936

937

938

939

940

941

942

943

944

945

946

947

948

1Throughout this paper, we refer to brokerage arrangements that include provision of thirdparty research services as ‘‘independent research arrangements,’’ and brokerage arrangements

that include provision of proprietary research services as ‘‘soft-dollar’’ arrangements. We also

use the term ‘‘soft dollars’’ to identify generally the practice whereby an investment adviser

causes its clients to pay a commission higher than the lowest commission available in consideration for the value of brokerage and research services provided. 2Greenwich Associates Survey, 2001.

3Greenwich Associates Survey, 2001.

EXHIBIT C

Independent Research Commissions

We appreciate the opportunity to express our views concerning the recent Congressional and regulatory scrutiny focused on mutual fund fees and expenses. In

this paper, we address issues regarding soft-dollar arrangements, particularly those

soft-dollar arrangements whereby broker-dealers provide third-party services, which

we call independent research arrangements.1 As discussed in detail below, we believe the current system works well, although we support enhanced disclosure of

quantitative information regarding investment advisers’ use of client commissions

and advisers’ brokerage allocation practices. We also emphasize that any changes

contemplated must be applied fairly.

The Bank of New York, through a number of entities in the BNY Securities Group

sector, is committed to providing institutional clients, such as investment advisers,

institutional investors, and broker-dealers, with a broad range of agency brokerage,

clearing and financial outsourcing services. Critical components of the Group’s offerings include trade execution, commission management, and independent research.

Investment advisers can maximize the value of their clients’ commission dollars by

choosing a broker capable of providing best execution and a host of independent

third-party research services unencumbered by investment banking conflicts. We believe we are uniquely qualified to comment on the current legislative and regulatory

focus on soft-dollar arrangements.

Regulatory Status of Soft-Dollar Arrangements

‘‘Soft dollars’’ are arrangements under which an investment adviser receives securities brokerage and research services from a broker-dealer in exchange for the investment adviser directing some portion of its clients’ brokerage transactions to the

broker-dealer. It has been estimated that 90 percent of investment advisers engage

in soft-dollar arrangements.2

An investment adviser has a fiduciary duty to act in the best interests of the client. In 1975, when Congress abolished fixed commission rates, there was a concern

that advisers would be deemed to have violated their fiduciary duty if they caused

their clients to pay a commission higher than the lowest commission available. The

concern was driven by the existing practice of an adviser obtaining research services

that might not directly benefit the account generating the commissions. Congress

responded by enacting Section 28(e) of the Securities Exchange Act of 1934, a ‘‘safe

harbor’’ that shields an investment adviser from breach of fiduciary duty claims for

causing its clients to pay a higher commission to a broker-dealer that provides ‘‘brokerage and research services’’ within the meaning of the statute. To rely on the safe

harbor, an adviser must determine in good faith that the commissions paid are reasonable in relation to the value of the brokerage and research services provided.

Thus, Section 28(e) permits an adviser to obtain services, particularly research services, with client commission dollars even though the services do not directly benefit

any particular client.

Many misunderstand the scope of ‘‘soft dollars’’ and Section 28(e). The safe harbor

applies to any transaction or arrangement pursuant to which an adviser causes a

client to pay a higher commission than the lowest available in exchange for brokerage and research services. Specifically, it applies to arrangements where the adviser

receives proprietary research, as well as arrangements for third-party research services. Advisers doing business with integrated investment banks (for example, Morgan Stanley or Goldman Sachs) at full service rates are engaging in soft-dollar

transactions primarily with respect to the provision of proprietary research and, to

a far lesser extent, with respect to the provision of third-party research. Integrated

investment banks dominate the institutional commission market. In fact, independent research arrangements account for only about 10 percent of the institutional commission market, less than $800 million out of a total of $8.6 billion in

2001, with the vast majority of the remaining 90 percent going to investment

banks.3 In other words, investment banking firms dominate the soft-dollar market.

We believe that permitting an adviser to obtain execution services and independent research that the adviser determines provides lawful and appropriate asVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00960 Fmt 6621 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
949

sistance in its investment decisionmaking process serves the best interests of the

adviser’s clients. Independent agency brokers and independent research arrangements provide the combination of best execution and independent research.

Independent Agency Brokers Provide Best Execution

Independent agency brokers—sometimes called ‘‘soft-dollar’’ brokers—provide best

execution by using people and technology to find liquidity in a fragmented marketplace. BNY Securities Group’s broker-dealers operate business models designed to

provide choice to investment advisers. BNY Securities Group allows advisers to execute through a fully integrated agency broker with direct access to the NYSE floor,

through a network of over 30 third-party executing brokers pursuant to correspondent clearing arrangements, or through an electronic communications network.

Indeed, independent agency brokers must compete on the basis of best execution.

Advisers can obtain third-party research services from any number of sources, including other broker-dealers. Therefore, execution quality has a central role in differentiating market participants. Integrated investment banks offering proprietary

research, by contrast, do not necessarily have to compete on the same basis. For example, an adviser may be forced to trade through Investment Bank XYZ to gain

access to XYZ’s ‘‘star’’ analyst or to receive higher-end proprietary quantitative research or modeling products. Such arrangements create conflicts, which could compromise an adviser’s duty to obtain best execution.

Independent Research Arrangements Provide Greater Transparency

Most independent research arrangements are negotiated by the investment adviser and broker-dealer based on a ratio of commission dollars to value of research

services provided (for example, 1.5:1). The ratio, which represents the value of execution and research services provided, is explicit. Moreover, investment advisers

engaged in such arrangements receive extensive information from the providing brokers regarding the commissions they generate, the products and services they receive, and the cost of those services. This information typically is provided in detailed monthly account statements. Proprietary research soft-dollar arrangements

with integrated investment banks, by contrast, are opaque. Integrated investment

banks generally do not charge a separate fee for research. Rather, trade execution

and research are ‘‘bundled.’’ The investment adviser is left to its own devices to determine what it is being charged for each service and whether the amount charged

is reasonable. Accordingly, independent research arrangements facilitate the adviser’s determination, required by Section 28(e), that the cost of the brokerage and research services is reasonable in relation to the value of such services.

The Market for Independent Research Must Remain Vibrant

It has been evident for many years, but most pointedly as a result of the bursting

of the late-1990’s market bubble, that research created by integrated investment

banks is tainted by conflicts created by association with the corporate finance business. In settling the case of tainted research with 10 major investment banks earlier

this year, the Commission and other regulators insisted that the settling firms

spend $432.5 million on independent research over the next 5 years. The Global Research Analyst Settlement evinces the value of independent research product versus

the value of in-house research product of investment banks. Placing unfair burdens

on independent research could discourage the growth of the market for independent

research, a result that is at odds with the fundamental principles of the Global Research Analyst Settlement. We agree that independent, conflict-free research is an

essential element in restoring investor confidence in the markets.

Access to Independent Research

Independent agency brokers offer access to hundreds of sources of independent research, including fundamental and technical research on individual issuers, industry

and sector analyses and broad-based economic research. We believe that access to

such a wide variety of ideas encourages better decisionmaking on the part of the

adviser. Many of the sources of independent research are small businesses with

little or no distribution capability. Such boutiques might not survive but for the

business provided by independent agency brokers. Independent agency brokers can

assist advisers in sourcing independent research and, where available, achieve volume discounts. Independent Research Arrangements provide critical access to research and remain the most viable distribution vehicle for the independent research

providers.

Small Investment Advisers Benefit the Most

Small investment advisers typically have small research departments. Many do

not have the resources to create an elaborate in-house research infrastructure.

950

4See Investment Advisers Act Release No. 2107 (February 5, 2003). 5Securities Exchange Act Release No. 23170 (April 23, 1986).

6 Id.

Small advisers benefit the most from having continued access to a wide variety of

independent research. Independent research arrangements allow small advisers to

compete with the bigger players.

The Current System Works Well

Abuses Are Rare

In 1996 and 1997, the Commission’s Office of Compliance Inspections and Examinations (OCIE) conducted a sweep examination of the soft-dollar industry. OCIE

issued a report in 1998 detailing its findings (the Sweep Report). OCIE found that

approximately 2 percent of commissions paid in purported reliance on Section 28(e)

was in fact for ‘‘nonresearch products and services.’’ OCIE’s finding merits comment.

• First, OCIE’s finding of only 2 percent of commissions being used for services outside the safe harbor is remarkably low, particularly considering that, prior to

issuance of the Sweep Report, the legislative history, and other guidance on the

definition of research for purposes of Section 28(e) was sparse. Indeed, the Sweep

Report is the most extensive guidance on the topic to date.

• Second, among the items to which OCIE objected as being outside the safe harbor

are proxy services, membership and licensing fees related to investment management certification programs, and services related to regulatory compliance. In

most cases, the industry was acting in the good faith belief that many of these

products and services were within the safe harbor.

• Third, a corollary to the first two points is that the industry’s practices have improved a great deal since the Sweep Report was issued. Once guidance was issued

and standards were set, even informally, the industry responded. Independent

agency brokers generally, and BNY Securities Group’s brokers in particular, have

adopted policies and procedures designed to ensure that their practices are consistent with the requirements of Section 28(e) for those clients required or desiring to stay within the safe harbor.

The Sweep Report’s Recommendations Largely Have Been Adopted by the

Independent Agency Brokerage Industry

The Sweep Report made a series of recommendations to the Commission regarding potential soft-dollar reforms. The primary recommendations were: (1) publication of the Sweep Report to provide guidance to investment advisers and brokerdealers; (2) enhanced recordkeeping by investment advisers and broker-dealers with

respect to soft-dollar arrangements; (3) enhanced disclosure by investment advisers

of research products and services; and (4) enhanced internal controls.

As noted above, advisers and agency brokers responded to the Sweep Report’s

guidance by adopting procedures and controls designed to ensure compliance with

the requirements of the safe harbor. Independent agency brokers, such as those

within BNY Securities Group, provide detailed information to investment adviser

clients regarding their brokerage commissions and the services they receive; we also

retain detailed records of the products and services provided and information about

the research providers. The Securities Industry Association has issued a Best Practices guide on soft dollars that many brokers have adopted wholesale. The Association of Investment Management and Research also issued soft-dollar standards

shortly after the issuance of the Sweep Report, which have been adopted widely by

the investment adviser community. In addition, the Commission recently proposed

rules that would require investment advisers to adopt formal compliance programs.4

Accordingly, we believe the current system works as intended. We believe, however,

that enhanced disclosure about transaction costs would benefit investors (see below).

The Scope of the Section 28(e) Safe Harbor Is Appropriate

As stated by the Commission, ‘‘the controlling principle to be used to determine

whether something is research is whether it provides lawful and appropriate assistance to the money manager in the performance of his investment decisionmaking

responsibilities.’’ 5 What constitutes lawful and appropriate assistance depends on

the facts and circumstances and is ‘‘not susceptible to hard and fast rules’’ 6 or

‘‘laundry lists’’ of specified items. This is because the definition of ‘‘research’’ necessarily will evolve along with changes in market practices, investment strategies,

and technology. It’s up to the investment adviser to determine in good faith whether

951

7Section 28(e) defines ‘‘research services’’ to include, among other things, advice, either direct

or through publications or writings, ‘‘as to the value of securities, the advisability of investing

in, purchasing, or selling securities, and the availability of securities or purchasers or sellers

of securities,’’ and ‘‘analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts.’’ 8Staff memorandum at 40.

9See Investment Advisers Act Release No. 1469 (February 14, 1995).

a particular product or service is ‘‘research’’ based on the beneficial effect it has on

the adviser’s investment decisionmaking process.

Market data and the services that typically accompany market data are properly

within the scope of Section 28(e).7 Providers such as Reuters, Baseline, Thomson,

and Bloomberg offer highly sophisticated products that include data feeds, quotes,

news, analyses, analytics, and customizable functions. These products permit investment advisers to conduct in-depth research of issuers, industries, economic and market factors and trends. Many advisers use these tools to support momentum and

quantitative investment and trading strategies. In other words, these products provide just the ‘‘research’’ that should be available to investment advisers under the

safe harbor, because they provide lawful and appropriate assistance to advisers’ investment decisionmaking process. We believe that singling out such products, as is

currently being discussed in the United Kingdom, reflects a bias in favor of ‘‘fundamental’’ over ‘‘technical’’ or other research that is inconsistent with Section 28(e)

and marketplace practices. We recommend that the Commission does not narrow

the Section 28(e) safe harbor to preclude an adviser from paying for such products.

Hedge Funds and Other Investment Advisers Can and Do Operate Outside

the Safe Harbor

Investment advisers to clients other than mutual funds or ERISA plans may use

client commissions to obtain services outside the safe harbor, provided the adviser

receives client consent. The adviser to a hedge fund is a common example of the

type of adviser that receives such services. We believe the perception that soft dollars are abused may relate to the fact that advisers to hedge funds commonly receive services outside the safe harbor (for example, office rent). In most cases, such

advisers have received client consent to do so. As such, this is neither an abuse of

the Section 28(e) safe harbor nor a matter that requires regulatory intervention.

Enhanced Disclosure

As stated above, we believe the current system works well. Nevertheless, we feel

that investors could benefit from enhanced disclosure by investment advisers regarding their soft-dollar practices. As noted in the staff memorandum, the Commission ‘‘twice has proposed requiring increased disclosure of quantitative information

about the use of client brokerage and the research and services advisers obtain from

brokers. Both times the rules were not adopted because of intractable problems in

valuing the research and services that advisers receive for soft dollars, tracing the

allocation of those benefits to clients’ accounts, and quantifying the effect of the benefits on the accounts’ performance.’’ 8

The Commission last proposed such rules in 1995.9 The rules would have required

disclosure on an annual basis of the twenty brokers other than ‘‘execution-only’’ brokers (research brokers) to which the adviser directed the most commissions, and the

three execution-only brokers to which the adviser directed the most commissions.

For each broker, the adviser would have disclosed the aggregate amount of commissions directed by the adviser to the broker, the percentage of the adviser’s discretionary brokerage commission that this represents, the average commission rate

paid to the broker, and a description of soft-dollar services provided by the broker.

Goldman Sachs and Morgan Stanley offered an alternative proposal. The Goldman/Morgan proposal would have required explicit disclosure of independent research arrangements, but would have exempted soft dollars used to pay integrated

firms, such as themselves. One of the arguments put forth in support of the Goldman/Morgan proposal was that it was too difficult to separate the costs of execution,

research, and other services provided as a bundle. The Commission correctly refused

to move forward with its rule proposal unless it applied equally to integrated investment banks. Last December, the Investment Company Institute (ICI) issued a letter

to the Commission essentially parroting the failed Goldman/Morgan proposal. We

find it ironic that during a time when it is more apparent than ever that more disclosure encourages better practices and decisionmaking, the ICI would propose a

framework, rejected almost 10 years ago, that would increase the opacity of brokerage commissions.

We offer a different approach. We support enhanced disclosure by broker-dealers

to their investment adviser clients regarding the costs of execution, clearance, and

952

settlement (brokerage), research and other services provided by the broker-dealer,

so long as any requirements are applied equitably to all market participants.

We recognize that average investors would have difficulty understanding detailed

transaction cost disclosures. We agree with the Commission that fund independent

directors are in the best position to monitor brokerage allocation practices and to

protect fund investors’ interests. Nevertheless, we believe that investors can benefit

from enhanced disclosure of summary information that would provide them with a

clearer picture of their advisers’ brokerage allocation practices. We favor requiring

disclosure of commissions and mark-ups/mark-downs (to the extent they are required to be disclosed in a Rule 10b–10 confirmation) in the aggregate, and broken

out into three categories: Execution-only, proprietary research commissions, and

independent research commissions. We believe this information will be easily understood by investors and will help them assess their advisers’ use of their commission

dollars.

Changes Must be Applied Equitably

Any changes to soft-dollar practices, whether in limiting the scope of ‘‘research’’

under Section 28(e) or enhanced disclosure about soft-dollar arrangements, must be

made in a way that does not discriminate against market participants. As demonstrated above, the direction of commissions to an integrated investment bank in

exchange for access to its analyst is every bit as much a soft-dollar transaction as

the direction of commissions in exchange for a Reuters terminal. Moreover, the

amount of commissions directed to the integrated investment banks dwarfs the

amount directed to independent agency brokers. No reform effort could be meaningful unless it addresses the practice of providing proprietary research.

Conclusion

Independent research arrangements provide a combination of best execution and

independent research. Independent research is vital to our financial markets, because it provides advisers access to a wide variety of thoughts and investment ideas,

and the absence of conflicts will help restore investor confidence in our markets.

Compliance practices with respect to independent research arrangements are

state of the art. Indeed, investment advisers and broker-dealers largely have adopted the Sweep Report’s recommendations. Firms have enhanced policies and procedures, training, and recordkeeping in response to the Sweep Report’s guidance.

Independent research arrangements are transparent and actively managed by investment advisers. Accordingly, we believe the Commission should not enact broad

change that could have unintended adverse repercussions.

Although we believe the system currently works well, we believe investors can

benefit from enhanced disclosure about how their investment advisers direct brokerage. We support requiring disclosure by investment advisers of the amounts and

percentages of commission dollars directed to execution-only firms, independent

agency brokerage firms and proprietary research firms (for example, integrated investment banking firms). Most importantly, any contemplated changes must be applied fairly.

953

RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI

FROM GRADY G. THOMAS, JR.

Q.1. Last week, a Federal judge approved monies from the $1.4 billion that would go toward financial literacy. How should this

money be used to educate investors?

A.1. Interstate Group Division of Morgan Keegan & Company, Inc.

was not a party to the referenced civil action, and I am not privy

to the terms of the settlement. I do believe that improving the financial literacy of retail investors is a worthwhile cause. One suggestion I have is for investors to be educated as to the importance

of consulting several sources of information before making an investment decision, and the differences between various investment

research tools, such as independent versus proprietary research.

Q.2. Can we truly improve market transparency or enhance investment governance in the best interest of shareholders, or implement

enduring reform, without a widespread expansion of investor comprehension?

A.2. I believe that over the past two decades, the SEC and the securities industry have greatly improved market transparency by

way of rapid and broad dissemination of market data (last sale information, quotations, etc.) and improved disclosure of investment

practices through the evolution of confirmations, prospectuses, and

investment adviser registration documents. In that regard, I support the goal of continuing to improve the dissemination of financial information to investors. I also support actions such as the

SEC’s ‘‘plain English’’ initiative to provide information to retail investors in a clear, easy to understand format. I do, however, believe

that we must take care not to overload investors with information.

The danger here is twofold. First, information overload tends to obscure the truly important disclosure from the eyes of investors. Second, the costs of producing and distributing such information are

ultimately passed down to investors, lowering investment returns.

Q.3. As a representative from an independent research company,

you strongly oppose a ban on soft-dollar commissions for thirdparty market research. How does your company, and other companies like yours, improve the mutual fund industry from an investor’s perspective?

A.3. The Interstate Group Division of Morgan Keegan & Company,

Inc. is a registered broker-dealer who provides independent research to our institutional clients, some of whom are advisers to

mutual funds. Mutual fund investors reap a number of benefits

from arrangements through which broker-dealers like The Interstate Group provide research to mutual fund portfolio managers.

Independent Research Arrangements Improve The Flow Of

Investment Research To Investment Managers

When Congress adopted Section 28(e) it was concerned that investors would suffer if the flow of research services to their money

managers were impeded. Investment research is the lifeblood of the

investment management industry and allows portfolio managers to

maximize the performance of their managed accounts. At least one

study has suggested that the use of research commission arrangeVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00965 Fmt 6621 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
954

ments by money managers is positively correlated with investment

returns. Under the rubric of Section 28(e), broker-dealers such as

the Interstate Group now provide literally hundreds of independent

research services to money managers to assist in the investment

decisionmaking process. These services include not only investment

information but also fundamental databases, portfolio modeling,

and strategy software. The Interstate Group and other broker-dealers have been particularly successful in assisting the development

of the independent research community as a viable alternative to

proprietary research produced by Wall Street firms. Independent

research firms are often small operations who use innovative and

unique methodologies and/or who target research at a specific segment of the market not given sufficient coverage by Wall Street. It

is difficult for small independent research providers with limited

marketing budgets to gain a foothold in the market for investment

research. Firms like The Interstate Group provide assistance to

independent research firms in gaining market acceptance through

the use of research commission arrangements.

Competition Between Broker-Dealers Providing Independent

Research Has Reduced Execution Costs To Investors

By becoming major competitors for institutional order flow, brokers such as The Interstate Group have exerted downward pressure on commission rates, thus lowering costs to investors. Since

commission rates were unfixed in 1975, execution costs have declined significantly. Prior to 1975, commission rates on institutional trades were on a sliding scale based on volume with a high

of $0.82 per share. In 1998, an SEC report found commission rates

of about $0.06 per share for those institutional accounts examined

by the SEC staff. My experience is that commission rates have further been reduced and today average $0.05–$0.06 per share for institutional trades.

Independent Research Arrangements Allow For Enhanced

Competition Between Investment Managers

In its deliberations on Section 28(e), Congress expressed the fear

that without access to the research that broker-dealers provide,

small investment managers would be pressured to charge higher

fees than those charged by large money managers. What was true

in 1975 is true today. Many start-up investment advisers cannot

establish their businesses and compete with larger money managers without access to research provided by broker-dealers such as

The Interstate Group under Section 28(e) arrangements. Enhanced

competition between money managers provides more choice to investors while keeping management costs down.

Q.4. Do you think that other proposals, including enhanced disclosure of soft dollars and stiffer penalties for violations, will be

strong enough to prevent future abuses of soft-dollar commissions?

A.4. I believe that abuses of soft-dollar arrangements are rare and

can be easily dealt with by the SEC using its existing enforcement

tools. Indeed, in the last industry-wide examination sweep conducted by the SEC staff in 1997, the staff found no instances ‘‘. . .

in which [mutual fund] commissions were used to purchase nonVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00966 Fmt 6621 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
955

research items, which did not benefit the funds themselves.’’ This

being said, I note that the SEC staff did, in Section VIII of the

1998 inspection report that discussed its 1997 examination sweep,

make a number of recommendations pertaining to the provision of

research for portfolio commissions. I encourage the SEC to give further consideration to these recommendations, and note that many

of them have already been adopted by The Interstate Group and

other broker-dealers.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI

FROM JOSEPH M. VELLI

Q.1. Last week, a Federal judge approved monies from the $1.4 billion that would go toward financial literacy. How should this

money be used to educate investors?

A.1. There are a number of private foundations, such as the Foundation for Investor Education founded by the Securities Industry

Association, that are dedicated to raising the level of investor literacy in the United States. These foundations have a variety of

programs and web-based tutorials that are available to investors.

The track records and reach of these programs should be reviewed

so that the settlement monies can go to objective education programs that will have the greatest impact. In addition, the SEC,

NASD, and the NYSE all have substantial websites that include investor information sections that could be further supported and enhanced.

Q.2. Can we truly improve market transparency or enhance investment governance in the best interest of shareholders, or implement

enduring reform, without a widespread expansion of investor comprehension?

A.2. I agree with you that improved transparency, enhanced investment governance and other reforms, while positive developments

for and beneficial to investors, may not be fully understood by

them. A better-educated investor would better comprehend these

reforms and utilize the improved information and protections

afforded to make more informed investment decisions. Investor

education is critical to such reforms. However, such reforms, nevertheless, benefit investors.

Q.3. How would the proposed changes to the regulation of soft dollars, especially enhancing disclosure and ‘‘unbundling’’ commission

payments, affect your firm?

A.3. Fund boards and individual investors should have more information about how their commissions are being used. The Bank of

New York supports enhanced disclosure requirements regarding

the use of commissions to acquire research. We believe a policy of

greater disclosure will serve investors well, restore their confidence, increase merit-based competition among sources of research, increase competition between execution-only brokers and

full-service brokers and, ultimately, benefit the securities industry.

As an agency broker, we already disclose to our asset manager

customers the amount of commissions used to pay for research

products and services selected by the asset managers—including an

itemized list of the research we provided and the cost of each product or service. We believe that all broker-dealers can, and should,

956

disclose these costs, to the extent they are quantifiable, and make

narrative disclosure about what is not quantifiable. We have

shared with the staff of the Securities and Exchange Commission

a suggested approach to disclosure, a copy of which was included

in our submitted materials.

We draw a distinction between the disclosure of research commissions and complete unbundling. The Bank of New York believes

that commissions used to pay for research should be accounted for

and disclosed. We do not support the full unbundling of commissions by integrated investment banks because such investment

banks provide other services, such as capital commitment, as part

of their commission. However, to the extent that disclosure drives

the market, resulting in a component-priced research product for

proprietary research, much like the way third-party independent

research currently is priced, we continue to believe that it is appropriate to use commissions to pay for research because the research

benefits the investor.

Q.4. If commission unbundling was mandated, how would it affect

your relationships with independent and third-party research companies?

A.4. Presently, independent third-party research commissions are

effectively unbundled, because each research product component is

individually priced. Investment managers know exactly what is

paid for execution and each research product component. Accordingly, mandated disclosure of the bundled services would have no

impact on third-party independent research companies, assuming

that commissions could continue to pay for research.

However, if such unbundling also prohibited the use of commissions to pay for research, this would have a significant adverse

impact on independent third-party research companies because

smaller investment managers would not be able to afford their

products and large money managers would rely more heavily on internal

research because of cost. This further would result in smaller investment managers becoming less competitive in terms of their expenses and would negatively impact the quality of their investment

advice and judgment.

(957)

AFTERNOON SESSION

The Committee met at 2:35 p.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

We have already had a hearing most of the day on mutual funds.

We are continuing that, so we may have worn out some of the

Members.

This afternoon, the Committee continues its examination of the

mutual fund industry. Since the mutual fund scandals broke last

November, a number of my Senate colleagues have offered remedial legislation. This afternoon, we are fortunate to have with us

several of our colleagues who have advocated such reform. I would

like to welcome Chairman Susan Collins, from the Governmental

Affairs Committee, and Senators Fitzgerald, Levin, and Akaka. I

look forward to hearing their comments on their proposed reform

package and the fund industry generally.

On the second panel this afternoon, we will hear from representatives of several mutual funds and broker-dealers. At the beginning

of this hearing process, I challenged these two industries to recommit themselves to the ideal of investor protection and demonstrate

an ability to abide by it. I believe that an industry so dependent

on integrity and investor trust must identify and address potential

conflicts of interest and nontransparent practices. Although a few

months time is certainly insufficient for final judgment of the industry’s response, I do believe that we have a preliminary record

to begin to evaluate its commitment to reform. As we near the conclusion of our scheduled hearings, it is important to understand the

industry’s response to the SEC’s slate of proposed rules and to examine whether additional reforms are necessary.

During the course of our hearings, we have learned how the

growing role of broker-dealers in fund sales and distribution has

significantly changed fund operations. Funds rely on broker-dealers

not only to provide brokerage and research services, but also to

widely market and distribute their investment products. As the

role of the intermediaries has evolved, so too, have the payment

and cost structures. Funds employ a number of payment methods

such as 12b–1 fees, revenue sharing, and directed brokerage arrangements to enhance the distribution of their products. This

hearing will be an opportunity to better understand these practices

and their impact on investors.

On the second panel this afternoon, we will hear from Mr. Paul

Haaga, Executive Vice President and Director of Capital Research

and Management Company and the Chairman of the Investment

Company Institute; Mr. Chet Helck, President and Chief Operating

958

Office, Raymond James Financial; Mr. Thomas Putnam, Founder

and CEO of Fenimore Asset Management; Mr. Edward Siedle,

Founder and President of The Benchmark Companies; and Mr.

Mark Treanor, General Counsel and Head of the Legal Division of

Wachovia Corporation.

I thank each of you for appearing this afternoon. Your written

testimony will be made part of the record in its entirety. Chairman

Collins, I will start with you. Welcome to the Committee.

Senator COLLINS. Thank you, Mr. Chairman. I think Senator

Fitzgerald would like to proceed first.

Chairman SHELBY. If you will yield to him. You are the Chairman.

Senator COLLINS. I will. Thank you.

Chairman SHELBY. I will recognize Senator Fitzgerald.

STATEMENT OF PETER G. FITZGERALD

A U.S. SENATOR FROM THE STATE OF ILLINOIS

Senator FITZGERALD. Thank you, Mr. Chairman, and I want to

at the outset compliment you on the very comprehensive series of

hearings you have held in the Banking Committee, and I compliment your reform-mindedness and your independence. You are

taking on a lot of important issues, like GSE reform, stock options

accounting, and the like. Thank you very much for allowing us the

opportunity to appear here.

I want to thank my cosponsors, Senator Collins and Senator

Levin, who are also appearing on the panel, and I want to compliment my good friend, Senator Akaka, who is here to talk about

a serious reform bill that he has introduced. We also have a very

serious bill that has been introduced by Senators Dodd and

Corzine, too, who have also come up with some very good ideas.

In our Governmental Affairs Committee, we did two hearings on

this issue, and actually a third hearing on the Government Thrift

Savings Plan. We spent about 6 months analyzing the issues, and

mainly what we concluded is that consumers could be much better

protected if there were enhanced disclosure of the types of fees that

mutual fund shareholders are charged.

The first thing I want to point out, Mr. Chairman, is that most

Americans now are investing in mutual funds. This is a graph that

shows by State and percentage of the population. In your State,

you have 1.1 million mutual fund shareholders; 24 percent of your

State is invested in mutual funds. Overall in the country, 95 million Americans are invested in mutual funds.

Chairman SHELBY. What is the average percentage State by

State of the population investing?

Senator FITZGERALD. It is 39 percent, almost 40 percent. In my

State, there are 5 million mutual fund investors.

Chairman SHELBY. That is high.

Senator FITZGERALD. And it is not clear to me—in households, if

you say 95 million Americans are invested in the markets, then

that is a majority of the households, certainly, in America.

Chairman SHELBY. I agree.

Senator FITZGERALD. If you could flip the——

Chairman SHELBY. Involving $7 trillion I believe, is it not?

Senator FITZGERALD. Exactly. Exactly.

959

Now, if you go back to 1980, the mutual fund industry was very

small. There was only $115 billion in assets total in the industry.

The growth has been explosive in the last 20 years. It has grown

from $135 billion in 1980 to $7.5 trillion that are invested in mutual funds.

When you hear the average fees on mutual funds, they are expressed as a percentage. In fact, the average mutual fund percentage expense ratio is 1.56, 1.5 percent. Now, that sounds diminutive,

it sounds trifling, 1.5 percent fees. But if you add that up in dollars, 1.5 percent of $7.5 trillion, you are talking tens of billions of

dollars. In fact, probably in total there are close to $200 billion a

year being earned on America’s savings in mutual funds.

Our main concern that our bill addresses is that a lot of the fees

are not disclosed. You would think that as mutual funds’ assets

have grown, you would think the fees would have shrunk as a percentage of the assets because there are enormous economies of

scales in money management. But, in fact, mutual funds’ assets

have risen. That is the red axis. It has risen. As it has climbed to

$7 trillion, it has risen 60 times over in the last 20 years. But fees

have risen more. They have risen 90 times over. So what happened

to the economy of scale?

What has happened is that, for some reason, there are a lot of

mutual funds out there. In fact, there are 8,800 mutual funds.

There are only 6,600 publicly traded corporations, but there are

8,800 mutual funds. It tells you it is a pretty good business to start

a mutual fund. Most Americans do not understand—are trapped in

high-cost funds because I do not think they understand the significance of fees, and it turns out 88 percent of mutual funds underperform the market over time.

Chairman SHELBY. By ‘‘the market,’’ is that the S&P, for example?

Senator FITZGERALD. Just the overall market, yes. The overall

market funds underperform the overall market.

Chairman SHELBY. Okay.

Senator FITZGERALD. And there is a big difference whether you

are in a low-cost fund—if you are in a low-cost fund, imagine a

fund with only a 0.15-percent fee. That is 15 cents for every $100

invested. If you invested $10,000 in the low-cost fund and kept it

there for 40 years, you would wind up with $205,000 at the end

of the 40 years. If you go in a high-cost fund, however, with a percentage point more in fees, you will have substantially less. You

will wind up with only $141,000 at the end of 40 years.

It turns out a 1-percentage-point increase in the fees you are

paying will cut your retirement nest egg by something close to 45

percent over a lifetime of investing.

Mr. Chairman, what we have sought to do is very clear. The evidence is clear that the lowest-cost quartile of funds dramatically

outperform the highest-cost quartile. This is over 10-years returns

on equity funds, much higher returns for the lower-cost funds.

Nonetheless, many investors are going into high-cost funds, and

I think it is because the fees are ill-disclosed and people do not understand the importance of fees. About half the fees aren’t disclosed

at all. Those are the transaction costs.

960

We seek in our bill a very free market solution to this dilemma

and, that is, enhanced disclosure. We do not want to regulate fees.

We totally believe in a free market, but we want to liberate those

free market forces so that you can go look and compare one fund

with the other on a cost basis, on an apples-to-apples basis.

I am going to turn this over to Senator Collins and Senator

Levin. The other thing I want to mention that our bill does,

though, is we do bolster the fiduciary duty that fund directors

would owe to fund shareholders. My legal staff has surveyed all the

cases and found that it is very rare for a court to find a breach of

fiduciary duty on behalf of a fund director or on behalf of a fund

adviser. And it turns out that the fiduciary duty that is now in the

Federal law is very weak and without content. In fact, no case in

the country has ever found a breach of fiduciary duty by an investment adviser, no matter how high their fees were, because the fiduciary duty in our Investment Company Act is very weak. We seek

to boost that.

We also go in the same direction as the SEC does in terms of

mandating an independent chairman of the board. In my closing,

I would just like to rebut a point that was made by Mr. Ned Johnson, the Chairman of Fidelity Advisers, in his op-ed piece in The

Wall Street Journal on February 17. He argued that it is a bad

idea to have an independent chairman of a mutual fund who is different than the chairman of the fund’s adviser. And he said it

would be akin to having two captains to a ship.

The point I would make is that Mr. Johnson’s analogy is wrong

because there are two separate ships here: one ship is the mutual

fund, in which the consumers are investing; the other ship is the

adviser firm, the asset manager firm that Mr. Johnson’s family

owns. He can be chairman of his asset manager firm, and he owes

a fiduciary duty to that. But, in my judgment, I agree with Justice

Harlan Fiske Stone, who said that one man cannot serve two masters. How can he both fulfill his fiduciary duties to his adviser, his

asset management firm, and the mutual fund?

That is why we do go in the same direction as the SEC, and I

would like to point out that I do think Fidelity is a very good fund.

They have one of the lowest-cost funds, and obviously they have

been successful, in part for that. But I did want to rebut that point

of Mr. Johnson’s.

Thank you.

Chairman SHELBY. Senator Collins.

STATEMENT OF SUSAN M. COLLINS

A U.S. SENATOR FROM THE STATE OF MAINE

Senator COLLINS. Thank you very much, Mr. Chairman. I want

to thank you for inviting me and other Members of the Governmental Affairs Committee. Under the leadership of Senator Fitzgerald, the Committee has spent a great deal of time investigating

mutual fund issues, and we hope to be able to share our findings

with you today. I want to commend you for your leadership on this

issue. I know your Committee has held several hearings, and this

issue really matters. As you pointed out, it affects some 95 million

American investors who hold assets exceeding $7 trillion that are

961

invested in mutual funds—funds that are often touted as a safe

haven for the small investor.

As the Governmental Affairs Committee pursued its investigation, I thought about a fundamental question: Why is it that in a

society built on competition, market forces do not drive down mutual fund fees? Why is it that the legendary American consumer,

who will search far and wide for the cheapest gas, clip newspaper

coupons, and take advantage of early bird specials, appears to be

oblivious to fees that can, over time, affect his or her net worth by

thousands of dollars, as Senator Fitzgerald’s charts amply demonstrate? Why is it that mutual fund fees seem more impervious

to competitive forces than almost any other cost in our society? In

fact, the only thing I can think of that is more impervious is college

tuition, which seems to not be affected at all by competition among

schools.

I start with the basic notion that competition can only work

when market participants have adequate information. If mutual

fund investors do not fully understand either the level of their fees

or the fees’ impact on fund performance, then competition lacks one

of its essential ingredients. Furthermore, if this is true for many

mutual fund investors, then we cannot expect the informed choices

and decisions of a majority to protect the uninformed decisions of

the minority as occurs in markets that are efficient. This theory

would suggest that the Government should act to improve either

the amount of fee information provided to investors or the clarity

with which it is provided, or both. And I believe that this is the

most important reform included in our bill.

What we need to do is to help investors focus attention on the

costs of owning mutual funds. For most investors, high mutual

fund expenses will cost them far more than such abusive practices

as late trading or market timing, which have grabbed the headlines. As Senator Fitzgerald indicated, even a 1-percent difference

in fees over a lifetime of investment can result in a 35- to 40-percent difference in the ultimate retirement savings for a worker.

We cannot enjoy the benefits of competition among these 8,000

funds unless we have an efficient marketplace. And an efficient

marketplace requires that prices be both transparent and easily accessible to investors. Currently, however, mutual fund expenses

and fees are often opaque and obscure. In contrast, historical performance of funds, the rate of return, is well known because successful funds tout their past performance data through large advertising campaigns.

I recognize the impediments to calculating and providing to consumers the true costs of mutual funds. For example, as Senator

Fitzgerald noted, mutual fund trading costs, which funds pay to

brokers when the funds buy or sell securities for their portfolios,

are not included in the expense ratio.

Compounding this problem, there are many expenses that are

bundled in with these transactions, which means that even more

mutual fund expenses never make it into the expense ratio. They

include, for example, research and related costs that are purchased

with so-called soft dollars. Another example is the practice of directed brokerage, by which trades are executed with certain brokers that sell the fund’s shares and are understood by both parties

962

to be a form of compensation. This practice, in essence, combines

distribution costs with brokerage costs and becomes a hidden 12b–

1 fee.

Now, the SEC has made a good start in improving cost disclosure

with its recent proposal that mutual funds disclose in shareholder

reports, their costs per $1,000 invested. However, I believe that

Congress should go further. In our legislation, S. 2059, we would

require that such data be published on a shareholder’s account

statement at least annually. In addition, such data should be personalized for each investor to the extent practical.

It is not enough to tell an investor how much his costs would

have been had he owned x amount of shares that he does not actually own. Like a bank checking account statement that tells a bank

customer how much he or she was charged for individual banking

services, a mutual fund statement should tell an investor how

much his or her actual share of the fund’s fees were.

I recognize, Mr. Chairman, that there would be costs to generating and reporting this personalized data. But, still, having reviewed the analysis done by the General Accounting Office, I have

concluded that this disclosure is warranted, it is needed, and would

be welcomed by consumers. It is not that expensive.

GAO estimates it would cost about 65 cents each year for the individual accountholder. And GAO has recommended that the SEC

seriously consider requiring that types of disclosure. As I have said,

the SEC has not gone that far. I hope this Committee will.

In view of the number of witnesses you have today, I would ask

that the balance of my statement be put in the record. And, again,

I commend you for your leadership in this area.

Chairman SHELBY. Without objection, your statement will be

made part of the record.

Chairman SHELBY. Senator Levin.

STATEMENT OF CARL LEVIN

A U.S. SENATOR FROM THE STATE OF MICHIGAN

Senator LEVIN. Mr. Chairman, thank you for holding this important hearing, for listening to those of us who are just part of the

numbers of Senators who are deeply concerned about these mutual

fund problems that were disclosed about 7 or 8 months ago. In particular, I also want to thank this Committee for the very prompt

response to the corporate scandals of 2002, the Enrons, the

WorldComs and the Tycos. This Committee led the way with a bipartisan effort. We adopted in Sarbanes-Oxley, a real reform that

has made a difference, and we hope this Committee will also act

promptly relative to the need for mutual fund reforms indicated by

recent events in that area as well.

Late trading, market timing, hedge fund favoritism, hidden fees,

and other abuses have undermined public confidence in this industry. Senator Fitzgerald has been a tremendous leader in this bill.

I am proud to join with him. Our Chairman, Senator Collins, as always, has been very supportive and helpful in the efforts of her

Committee and in the oversight role of that Committee, in this case

relative to mutual funds, and I am proud to join them and other

supporters of this legislation.

963

The Mutual Fund Reform Act was introduced in February. It addresses a number of the issues which you have already heard about

in the last few minutes, but I want to just focus on the conflictsof-interest component of this bill.

It troubles me greatly that people who are selling me mutual

fund shares or advising me on investments are, on the one hand,

being paid a fee by me at the same time they are receiving financial rewards from the mutual funds that they are promoting. And

the issue is: What do we do about that?

There is an inherent conflict of interest when someone who is

saying to me ‘‘buy this mutual fund’’ is receiving from that mutual

fund a benefit.

I think most people say that is wrong. There is a conflict in

there. ‘‘You can only serve one master,’’ as Senator Fitzgerald

quoted properly. We have to really make a decision here as to

whether, it is going to be tolerated in the future that we can have

a situation where a broker or a financial adviser is receiving the

fee from the investor to advice on a mutual fund at the same time

that adviser is receiving an incentive to promote that mutual fund

from the mutual fund itself.

And there are two alternatives here. One is to ban it because it

is an inherent conflict of interest. The other one is to disclose it.

And these alternatives are really what, it seems to me, the tug of

war is about. It is clear we have to do something. To me, banning

it is right because it is an inherent conflict of interest. Disclosing

this conflict of interest does not address the conflict. All it does is

say to an investor, if he or she can understand it—because these

are complicated issues—there is a conflict of interest. But that frequently gets buried in verbiage. We have seen these disclosures, for

instance, on other things, on telephone bills and on long distance,

on pharmaceutical purchases, and a whole lot of areas. These disclosures do not do the job, number one. But, number two, they do

not address the fundamental problem here, which is that you have

a conflict of interest. Disclosure does not correct and cleanse the

conflict.

Chairman SHELBY. You are saying basically that if you disclose

a wrongdoing, that does not cure the wrongdoing.

Senator LEVIN. It does not, and there are two forms that I want

to just to spend 30 seconds or a minute on: the so-called revenue

sharing and the directed brokerage. And what it amounts to is this.

If a mutual fund has an agreement with a broker or financial adviser that they will purchase from that broker stock for their own

inventory, for their own portfolio, if that broker will promote its

mutual fund to those investors, those 95 million investors out

there, you have got an inherent conflict.

The other form, which is called revenue sharing, is when a mutual fund tells the broker, if you will promote my fund to those 95

million people out there, I will give you a share of the profits of

my fund. There is an inherent conflict because the broker or the

financial adviser there is not only being paid, on the one hand, by

the person who is benefiting from the sale on the sale end, but also

getting a fee from the person who is purchasing that share in the

mutual fund.

Those are two, it seems to me, inherently conflicting situations.

964

Chairman SHELBY. Could the SEC ban that?

Senator LEVIN. We hope they can. We hope they have got the legislative authority, but you can strengthen their hand. In the one

case, they are proposing to ban it. In the other case, they are proposing to disclose it. In the case of the revenue sharing, the SEC

is proposing disclosure. In the case of directed brokerage, they are

proposing a ban. But it is important that the Congress strengthen

their hand, give them the clear authority, hopefully, to ban both

since there is an inherent conflict and disclosure does not solve the

conflict but, in any event, to support their efforts. The SEC has

taken important steps, and legislatively we can give them a greater

legal hand, it seems to me, if we give them the clear statutory authority.

There are other conflicts which we address in this bill, but I just

wanted to focus on two of them because they really need the attention of the Congress, and we hope that this Committee will again

lead the way in the Senate toward bringing a strong bill to the

floor so that we can get on with restoring the credibility which this

industry needs and deserves, for the reasons given. The Chairman

has already indicated it is a $7 trillion industry. This is a big

chunk of our economy. There are 95 million people relying on this

industry for their retirement, buying a house, or educating their

kids. So this is a big chunk of the economy, and we look forward

to this Committee’s continuing leadership in this reform effort.

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

Senator Akaka.

STATEMENT OF DANIEL K. AKAKA

A U.S. SENATOR FROM THE STATE OF HAWAII

Senator AKAKA. Mr. Chairman, I thank you very much for holding this hearing and for giving me the opportunity of participating

in it. And I want to thank you for what you have done in addressing this problem.

The mutual fund industry, Mr. Chairman, and its reform is important to our country because 95 million people have placed their

trust and significant portions of their future financial security into

mutual funds. And I must tell you that Hawaii has approximately

371,000 investors in mutual funds. Mutual funds provide middleincome Americans with an investment vehicle that offers diversification and professional money management. Mutual funds are

what average investors rely on for retirement, savings for children’s college educations, or other financial goals, and even for

their dreams.

Last fall, I was appalled by the flagrant abuses of trust among

mutual fund companies. So, I introduced S. 1822, the Mutual Fund

Transparency Act of 2003, to bring about structural reform in the

mutual fund industry, increase disclosures in order to provide useful and relevant information to mutual fund investors, and restore

trust among investors.

I want to commend the SEC for its proposals to improve the corporate governance of mutual funds and to increase the transparency of mutual fund fees that investors pay. The proposed requirement for an independent chairman for mutual fund boards,

965

increased percentage of independent directors to 75 percent, and

development of a confirmation notice so that investors will be able

to know how their broker gets paid in mutual fund transactions are

a solid and measured response to the litany of transgressions

which have undermined public confidence in the mutual fund industry. These provisions mirror those in my legislation. In addition, I have been impressed with the SEC’s attempts to address

point-of-sale disclosure.

However, I continue to believe that legislation is necessary to

codify some of the proposed regulations so that the reforms will not

be rolled back in the future. It is also important to legislatively address areas where the SEC needs additional statutory authority to

address problems and abuses in the mutual fund industry. Legislation is necessary to ensure corporate governance improvements

apply these rules universally among mutual funds. Finally, additional legislation may be necessary if disclosures of revenue sharing agreements and portfolio transaction costs are not adequately

addressed by the Commission.

S. 1822 includes a number of provisions that are important for

Congress to enact. Boards must be strengthened and more independent to be more effective. Investment company boards should be

required to have an independent chairman, and independent directors must have a dominant presence on the board. My bill strengthens the definition of who is considered to be an independent director. It also requires that mutual fund company boards have 75 percent of their members considered to be independent. To be considered independent, shareholders would have to approve them. In addition, a committee of independent members would be responsible

for nominating members and adopting qualification standards for

board membership. These steps are necessary to add much needed

protections to strengthen the ability of mutual fund boards to detect and prevent abuses of the trust of shareholders.

To increase the transparency of the actual costs of the fund, brokerage commissions must be counted on as an expense in filings

with the SEC and included in the calculation of the expense ratio,

so that investors will have a more realistic view of the expenses of

their fund. Consumers often compare the expense ratios of funds

when making investment decisions. However, the expense ratios

fail to take into account the cost of commissions in the purchase

or the sale of the securities. Therefore, investors are not provided

with an accurate idea of the expenses involved. Currently, brokerage commissions have to be disclosed to the SEC, but not to individual investors. Brokerage commissions are only disclosed to the

investor upon request. My bill puts teeth into brokerage commission disclosure provisions and ensures that commissions will be included in a document that investors actually have access to and

utilize.

I know soft-dollar practices, Mr. Chairman, were discussed during hearing this morning. The inclusion of brokerage commissions

in the expense ratio creates a powerful incentive to reduce the use

of soft dollars. Soft dollars can be used to lower expenses since

most purchases using soft dollars do not count as expenses and are

not calculated into the expense ratio.

966

There have been calls for the prohibition of soft dollars. However,

my bill provides an immediate alternative, which is an incentive

for funds to limit their use of soft dollars by calculating them as

expenses. If commissions are disclosed in this manner, the use of

soft dollars would be reflected in the higher commission fees and

overall expenses. This makes it easier for investors to see the true

costs of the fund and compare the expense ratio of funds.

Some may argue that this gives an incomplete picture and fails

to account for spreads, market impact, and opportunity costs. My

bill merely uses what is already reported and presents this information in a manner meaningful to investors.

One of the provisions in my bill requires the SEC to conduct a

study to assess financial literacy among fund investors. This study

is necessary because any additional disclosure requirements for

mutual funds will not truly work unless investors are given the

tools they need to make smart investment decisions, and we must

first know what education exists.

Mr. Chairman, I look forward to working with you, my colleagues, and the SEC to address problems identified in the mutual

fund industry. Thank you very much, Mr. Chairman.

Chairman SHELBY. I want to thank all of you. I have a few questions. It is not every day we have a bipartisan effort here, two Republicans, two Democrats, on a very important issue.

Senator Levin, on the conflict, I think you touched on something

just a few minutes ago. If you just disclose a conflict and do nothing about it, there is still a conflict, isn’t there?

Senator LEVIN. I am afraid so.

Chairman SHELBY. And a lot of the people might not even recognize it as a conflict. Isn’t that one of your concerns?

Senator LEVIN. The fear is that if it is just simple disclosure, the

verbiage which surrounds it may not be easily understood by that

average investor who does not have a lot of time to pore over that

verbiage and words. So particularly where the inherent conflict is

not resolved, it is still there, as you just pointed out. There are

some things where disclosure is fine. If you are disclosing side effects of a drug, well, if you read about that, you still may want to

take the drug even though it may give you headaches or stomachaches. But here the question is whether or not that conflict is

something which should be corrected or whether we should tolerate

and accept that conflict.

I do not think we should accept these fundamental conflicts as

to who is the beneficiary of a sale of a share in a mutual fund. Do

we want the person who is selling that mutual fund to be paid by

the mutual fund at the same time they are getting a fee from the

person they are selling to?

Now, it is worse when that person does not know about it. The

question is if somehow or another this conflict is surrounded by

verbiage, will that be enough knowledge for that investor to say,

well, I understand there is a conflict here, but I will take a chance

that you are really giving me advice in my interest rather than lining your own pocket with that money that you are getting from the

mutual fund. I do not think we can assume that most investors are

going to take the time to understand the language which surrounds

that disclosure.

967

Chairman SHELBY. Does the SEC in your judgment have the

power to ban this conflict if it had the will to do it?

Senator LEVIN. I am not sure it does. I hope it does. In one case,

it bans it; in the other case, the conflict I mentioned, there is simple disclosure. But I do not know for sure that it does.

Chairman SHELBY. It would be an inconsistent message, would

it not?

Senator LEVIN. Very inconsistent. But even if it has the legal

power to do it——

Chairman SHELBY. It has to have the will, too.

Senator LEVIN. Exactly, it has to have the will. But as Senator

Akaka points out, too, when you put something in legislation, it is

stronger because it cannot readily be changed, as a regulation can.

But I would say that there is always the possibility of a legal challenge. I do not know of any power that a regulatory body has that

cannot be subject to some legal challenge or another. Very few of

them have that clarity, and I think we should reinforce their case

in case it is challenged.

Senator FITZGERALD. May I interject on this point? The one thing

the SEC definitely cannot ban is soft-dollar transactions because

that is——

Chairman SHELBY. It is statutory, is it not?

Senator FITZGERALD. —in Section 28(e), I guess it is, of the Securities Exchange Act. It is a safe harbor. And so we have to act, and

that is something even, as I understand it, the ICI has come out

for banning those soft-dollar arrangements.

Chairman SHELBY. Should they be banned or disclosed?

Senator FITZGERALD. Well, the reason we say they should be

banned is because if you get into trying to disclose all these shadow

transactions, you will create a document dump on the consumer

that will only succeed in confusing him. And we believe you have

to keep the disclosure as simple as possible.

On soft dollar, for example, funds will still be able to go out and

buy some research or buy Bloomberg terminals for every desk. But

what they cannot do is permit a brokerage firm to charge the fund

shareholders an exorbitant brokerage fee in return for having the

brokerage firm provide those Bloomberg terminals on everybody’s

desk. They are running up costs for shareholders in an underhanded way that troubles me greatly. And your statement that you

do not cure wrongdoing by disclosing it hits the nail on the head.

Chairman SHELBY. That was Senator Levin’s statement, and I

just picked up on it.

Senator FITZGERALD. It is great. But I think some of these other

things the SEC probably can ban. SEC cannot redefine ‘‘independence’’ of the directors.

Chairman SHELBY. The reason we are asking these questions, we

are going to have the SEC up here. It will be our last hearing. We

want to be prepared for what the SEC can do, has the will to do,

and so forth, what they cannot do or what is murky, because I

think those are relevant to our hearings.

Senator FITZGERALD. We have a list of things they cannot do, and

we will share that with your staff.

Chairman SHELBY. We will share that with our Committee.

968

Senator Collins, what about the 4 p.m. closing? Have you spent

some time on that?

Senator COLLINS. I support the SEC’s proposal for a hard 4 p.m.

closing. I think that makes a lot of sense and would deal with the

late trading problem.

Chairman SHELBY. What do you say to people in Hawaii, Senator

Akaka’s people, or California, if you have a 4 p.m. Eastern time

closing? We have got all these time zones. This question has been

asked right here at the table, we will ask the Chairman of the SEC

on it, too, because you have the time zone issue, as Senator Akaka

knows very well.

Senator COLLINS. You do.

Chairman SHELBY. You have to weigh it.

Senator COLLINS. Exactly.

Chairman SHELBY. Senator Akaka, do you have any concerns

since your constituents are from Hawaii and they would have a 4

p.m. closing?

Senator AKAKA. Mr. Chairman, you have put your finger on one

of the concerns. I am glad to hear from the industry that they are

aware of this problem and they are working to address it.

Chairman SHELBY. Okay. Senator Fitzgerald, let us start with

you. What about the proposed independent chairman? If you are

going to mandate that you have 75 percent of the directors be independent—I am just posing the question—why should you say that

the chairman has to be independent, too, when the other directors

elect the chairman? In other words, you have got three-fourths of

the boards members that will be independent. They could elect a

chairman or not elect one. Why should we do that? This question

has been asked.

Senator FITZGERALD. The mutual fund industry just has a bizarre setup because if you and I are shareholders in a mutual fund,

let us say ABC mutual fund, we are the owners of the fund. But

the way it is set up in America is an outside firm, which is the

principal supplier or adviser to the fund, winds up dominating the

fund.

So the ABC adviser firm, which is owned by somebody else, the

officers of which owe a duty of loyalty and fidelity to ABC adviser

firm, they wind up controlling ABC mutual fund that is really

owned by you and me. And they also owe a duty of loyalty and fidelity to us. But sometimes the interests of—when they are trying

to serve two masters, the interests diverge with the scandals——

Chairman SHELBY. Do all mutual funds do it the same way?

Senator FITZGERALD. All except Vanguard. Vanguard is the only

one that is set up where the fund shareholders actually own

the——

Chairman SHELBY. They do it all inside.

Senator FITZGERALD. —Vanguard Group, and they did explicitly

to eliminate the conflicts and, interestingly, they are by far the

lowest-cost mutual fund in America because they competitively bid

out the management services and they get much lower costs.

With the scandals you saw breaking, you saw directors engaging

in behavior that harmed the fund shareholders but benefited the

management companies that they also work for. I believe we have

to recognize that the mutual fund and the outside adviser are two

969

separate ships, and you need somebody looking out on the fund

shareholder side.

You know, in politics, when somebody tells us they are neutral

and we have a hard time deciding whose side they are on? Pretty

good bet if you do not know whose side they are on, they are not

on your side. I think when I look at the mutual funds, I see a lot

of instances in which the boards have been engaging in behavior

that suggests they are not fully on the fund shareholder side.

Chairman SHELBY. Senator Collins, how would you define the fiduciary relationship that the management of the mutual fund owes

to the shareholders?

Senator COLLINS. Well, I think that is one of the problems. I

think we need an explicit statement in the law that the management of the mutual fund owes the fiduciary duty to the shareholders of the fund. And that is not clear right now.

But there was another point that I just wanted to touch on if you

will allow me, and that is, in addition to the issue of how many

independent directors and whether the chairman should or should

not be required to be independent, we have found that directors

tend to serve on many, many different fund boards within a family

of funds.

Chairman SHELBY. I have heard 80. Somebody served on 80.

I do not know how much time they spend on that board.

Senator COLLINS. That is my issue. What we have found were

several cases where the director was serving on over 100 boards.

And I wonder if the real question here is not whether or not the

person is an independent director, but whether you can serve on

113 mutual fund boards and really devote the attention and oversight that you need.

I realize that a lot of these funds are very similar and they may

be in the same family. But, nevertheless, I do not know how anyone could be an aggressive board member fulfilling that oversight

responsibility if you are stretched that thin.

Chairman SHELBY. I do not know about you Senators, but I am

on enough committees and subcommittees, and if you do due diligence to any of them, you are still strained, aren’t you?

Senator COLLINS. Absolutely.

Chairman SHELBY. Senator Levin, what about the fiduciary

duty? Shouldn’t it be of the highest order?

Senator LEVIN. I think so, and it should be defined and clear so

there is no ambiguity about it to whom you owe your loyalty. And

I think the clearer, frankly, the better. When you come to fiduciary

duty, there should not be ambiguity as to where you owe your allegiance.

Chairman SHELBY. Senator Akaka, do you agree with that?

Senator AKAKA. Yes. Mr. Chairman, I ask to be excused at this

point in time.

Chairman SHELBY. Certainly, and thank you.

Senator FITZGERALD. You know, that is one of the areas the SEC

cannot do. Only Congress can amend that. Right now the Act recites a fiduciary duty, but there is no content to it and no case has

ever found a breach of fiduciary duty.

Chairman SHELBY. I think one of the purposes of all these hearings is, one, to get to the bottom of the scandals, what caused it,

970

how you can avoid it in the future; what is the role of the SEC,

their proper role, according to statute what they can do and what

they cannot do; what do we need to do, if anything. And we start

with these hearings.

I appreciate your appearance and your leadership on these

issues. We look forward to your participating in some kind of solution to this. Thank you very much.

Senator FITZGERALD. Thank you, Mr. Chairman.

Senator COLLINS. Thank you, Mr. Chairman.

Senator FITZGERALD. And may I have leave to introduce my full

statement as well as——

Chairman SHELBY. Without objection, all of your statements will

be made part of the record.

Senator FITZGERALD. —a letter from John Bogle endorsing our

bill.

Chairman SHELBY. Absolutely.

Chairman SHELBY. Our second panel, if you will come up while

the other one is making an exit.

We welcome all of you on the second panel to the Committee.

Your written testimony will be made part of the hearing record in

its entirety. We hope you will sum up your remarks because we do

have a few questions.

STATEMENT OF PAUL G. HAAGA, JR.

EXECUTIVE VICE PRESIDENT

CAPITAL RESEARCH AND MANAGEMENT COMPANY

CHAIRMAN, INVESTMENT COMPANY INSTITUTE

Mr. HAAGA. Thank you very much. Good afternoon, Chairman

Shelby, Members of the Committee staff. My name is Paul Haaga,

Executive Vice President and Chairman of the Executive Committee of Capital Research and Management Company. Capital Research is the investment adviser to The American Funds Group,

the third largest U.S. mutual fund group, with more than $500 billion in assets under management. I also serve as Chairman of the

Board of Governors of the Investment Company Institute, and I appear here today on behalf of the Institute and its members.

Chairman SHELBY. That is the trade association of mutual funds.

Mr. HAAGA. It is the association of mutual funds, yes. This afternoon, I will discuss how the industry and regulators have been responding over the past several months to the unfortunate and very

disappointing revelations of abusive trading practices in the mutual fund industry. But I want to begin by recognizing the key role

that this Committee and Chairman Shelby, in particular, have

played in responding to the problems that have occurred.

It is very important for the Committee to engage, as it has been

doing, in a thorough and deliberate process of gathering information from all interested parties to help determine what actions may

be needed to ensure that the interests of fund shareholders are

served. I thank you, most sincerely, for your efforts and especially

for giving me an opportunity to participate in today’s hearing.

Having worked with mutual funds for over 30 years, beginning

as an attorney on the SEC staff, I am outraged and personally offended that some mutual fund officials and others appear to have

temporarily ignored the guiding principle by which we all must

971

live: Our fund shareholders always come first. I look forward to a

time in the future when the wounds have healed and we can look

back on these events from a broader perspective and once again

speak proudly of mutual funds’ record of integrity. I have several

thoughts on what we need to do to reach that point.

First, Government officials must continue investigating and taking forceful actions against wrongdoers.

Second, regulatory reform is necessary to address late trading,

abusive short-term trading, and selective disclosure of portfolio

holdings.

Third, as painful as this process has been, it has also presented

all of us with a golden opportunity to make improvements that go

beyond the specific problems that have been revealed, but that will

further reinforce protection and enhance the confidence of fund investors. The institute, the SEC, and the Congress have seized upon

this opportunity, and I look forward in the questions to elaborating

on some of those efforts.

Finally, as we take advantage of the opportunity to improve what

is already a strong regulatory system, we must reject changes that,

while well-informed and well-intentioned, would have harmful consequences. It would be most unfortunate if the late trading and

market timing problems were used as a predicate for making

changes that are not cost-effective and fostering the interests of

fund shareholders. These problems are serious, and they must be

readdressed. But we should not lose sight of the fact that mutual

funds still offer the best and least expensive way for millions of

Americans to invest in the securities markets and reach important

financial goals.

To serve investors’ best interests, reforms should preserve the industry’s defining characteristics rather than making changes that

would render the industry less entrepreneurial, less competitive,

less creative, and less responsive to investors’ changing needs.

On behalf of the Investment Company Institute and the entire

mutual fund industry, I pledge our continued commitment to take

necessary steps to make sure that fund shareholders are fully protected.

I thank you again for the opportunity to testify and I would be

happy to respond to any questions.

Let me ask the Chairman, if I can take one more minute.

Chairman SHELBY. Go ahead.

Mr. HAAGA. I would like to respond to something in the charts.

You hear a lot of numbers thrown out about expenses and fees in

the funds and have they gone up and have they gone down. And

I want to give one word of advice to everybody, is just be careful

of simple unweighted averages. They can be misleading.

Let me use a simple example. Let us say that our funds are the

only ones in the industry, American funds are the entire industry.

Among our largest funds, our average fees are 65 basis points, so

that is also the industry average. Now, if my friend, Tom Putnam,

starts up the FAM Group of—Fenimore Group of that mutual

funds, his average fees on his large funds are 1.25 percent. If you

are looking at average fees in the industry, they have now jumped

to 0.95 percent, nearly a 50 percent increase. That is a lot of what

has been happening in the 1990’s. Average fees have gone up beVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00983 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
972

cause small new fund groups have started and they tend to be of

the more expensive types of funds to manage, international funds,

growth funds, et cetera. Nobody raised their fees. Our fees stayed

at 65. His fees are 11⁄4, and yet the industry average just jumped

50 percent. Be careful if you read that.

I might also point out that the 1.5-percent number is a simple

unweighted average. If you look at the weighted average, which is

actually what is happening to shareholders, that is about 1 percent.

Total costs, that is all in, the costs of buying shares and owning

them, have declined by about 40 percent since 1980. You need to

look at the total cost, not just the fund expenses.

Finally, I would point out that 77 percent of shareholders own

funds with lower than average cost. That tells us that shareholders

are not paying the average costs. I think it also tells us that they

understand very well what the costs are and they are voting with

their feet for the less expensive funds.

Thank you very much for letting me add that.

Chairman SHELBY. Thank you very much, Mr. Haaga.

Mr. Helck.

STATEMENT OF CHET HELCK

PRESIDENT, RAYMOND JAMES FINANCIAL, INC.

Mr. HELCK. Thank you, Chairman Shelby.

I am Chet Helck, President and Chief Operating Officer of Raymond James Financial and a member of the board of directors of

the Securities Industry Association. I am honored to be here today

and present our views on this important subject.

I have three points I would like to make to you today, and these

points are set out in greater length in my written submission, but

I think I can summarize them as follows.

First, mutual funds have been and should continue to be the

basic investment vehicle for most Americans and partly small investors. Second, many investors need financial advice from trained

professionals to make mutual funds an effective part of their financial plans. The present mutual fund compensation structure makes

that possible. Third, the mutual fund distribution system works for

the benefit of investors. We support improved disclosure, but we do

not believe that the current distribution system is fundamentally

flawed. Let me make each of these points in turn.

First, mutual funds allow investors, and particularly small investors, to obtain professional management of their investment dollars. Investors can diversify a relatively small investment which is

essential for both growth and safety. Half the households in America trust mutual funds with their hard-earned dollars and for good

reason. Mutual funds have helped turn Americans from a country

of savers to a country of investors. Mutual funds help investors pay

to support their standard of living, educate their children, and provide for their retirement.

Second, more than ever, investors need sound investment advice.

I represent some 5,000 financial advisers at Raymond James, and

thousands of others around the country whose firms are members

of the Securities Industry Association. We are proud of the work

we do and the services we provide to our customers. Most Americans know that they must save during their working days and inVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00984 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
973

vest wisely for their retirement years. Many investors want assistance when making their financial choices. To be sure, there are

those investors who believe they can do it themselves, select the

proper mix of fixed income and equity investments, adjust those

portfolios on a regular basis and select from the enormous panoply

of financial products to meet their needs. But for most of us that

is a daunting task and not one that can be safely done in our spare

time. This Committee is addressing issues that go directly to the

compensations structure that supports the financial advisers who

help their clients.

Broker/dealers receive compensation from the funds for evaluating thousands of mutual fund choices, for educating its financial

advisers, providing costs associated with comprehensive investor

reporting, and for advisory services provided to clients such as financial planning, portfolio review, and performance reporting for

the investors. The compensation streams from fund complexes to

broker/dealers support these services that investors want and need.

At Raymond James, we sell over 11,000 mutual fund share classes. That includes load and no-load funds. To support those sales efforts and provide investor reports to clients, provide them with

comprehensive tax information, and combined critical information

on one consolidated statement, it costs us roughly $30 million a

year. In addition we spend well over $7 million a year to educate

our financial advisers. We do that to help our advisers make sound

recommendation to their customers.

My third and final point is that we agree that we must improve

the investing public’s awareness of the compensation systems and

how they affect the costs of mutual fund ownership. The current

system for distributing mutual funds benefits investors, there is

certainly room for improvement, but that improvement should be

undertaken from a perspective that recognizes that mutual funds

have been a significant component in making financial security for

generations of Americans possible.

We have all read about abuses in the mutual fund and securities

fund industries. We agree that abusers should be rooted out and

punished. We condemn abuses of fiduciary duties and urge where

appropriate, swift, and sure penalties for the wrongdoers. We

should make improvements to restore public confidence in this critical vehicle, but if this Committee or the regulatory community

leaves American investors with the impression that they cannot

trust mutual funds and should regard the product and all those

who distribute it with hostility, that will ill serve the very investors

you are dedicated to protecting.

At Raymond James, we have always believed in good disclosure,

and that is a fundamental part of our client service philosophy.

There needs to be improvement overall in disclosure of these different ways of compensating broker/dealers. The SEC has proposed

a disclosure format for confirmations of point of sale disclosure that

addresses many of these issues. We and others in the industry will

be commenting on these proposals in an effort to make them useful

and meaningful to investors. While we agree that disclosure should

be improved, we believe it should be disclosure that is meaningful,

concise, and understandable, and above all, relevant to investor

needs.

974

We think the SEC does have the authority it needs to provide for

that disclosure, and we in the industry propose to help them do it.

We want to join in making the system better, and we do not want

to make the mistake of thinking we have to create a new one in

its place.

Thank you for inviting me to testify.

Chairman SHELBY. Thank you.

Mr. Putnam.

STATEMENT OF THOMAS O. PUTNAM

FOUNDER AND CHAIRMAN

FENIMORE ASSET MANAGEMENT, INC./FAM FUNDS

Mr. PUTNAM. Chairman Shelby, Members of the Committee, it is

an honor to appear before you today. My name is Tom Putnam,

and I am Founder and Chairman of Fenimore Asset Management,

a small investment advisory firm with 30 employees in rural upstate New York.

We manage investment portfolios for about 400 individuals and

institutions and we offer two mutual funds. I serve as co-portfolio

manager for each of the FAM Funds, which have combined assets

of about $700 million and approximately 25,000 shareholders. In

addition to my varied duties at the firm, I also serve as Chair of

the Small Funds Committee of the Investment Company Institute.

First let me express my deep disappointment about the events

that have brought us here today. Investors’ trust in the entire mutual fund industry has been shaken, and rightfully so, by the current revelations of wrongdoing. In an industry based on fiduciary

principles, there is simply no place for this kind of behavior.

I am pleased that the SEC and State officials have moved very

quickly to investigate and punish those responsible. I also applaud

the SEC’s swift action in developing regulatory reforms aimed not

only at remedying immediate problems such as late trading, but

also addressing potential conflicts of interest, strengthening fund

governance, and enhancing standardized fund disclosures. These

are sweeping reforms that will benefit investors for years to come.

This Committee also has played a critical role by thoroughly examining the recent scandals and thoughtfully considering what

steps are necessary in response. I hope that my perspective, as a

founder of a small mutual fund group, will assist you in this important effort.

Specifically, I would like to share with you my thoughts about

the impact of regulatory changes on small fund groups. My written

statement explores this issue more fully and also provides my

views on some of the specific reform proposals that have been advanced. I hope my testimony today clearly conveys my strong support for the tough reforms undertaken by the SEC to date.

Let me also say this: If other proposals are shown to clearly benefit long-term mutual fund investors, I am very likely to support

them, and my firm would find a way to bear the associated costs.

At the same time, however, I have serious concerns about the enormous number of changes proposed for our industry.

Former Senator William Armstrong testified before this Committee and said he counted 106 pending reforms. My fear is that

some of the proposals might be approved in the name of reform

975

without any real basis of whether they are likely to achieve benefits for shareholders that begin to justify their costs. For small fund

groups, with our smaller asset bases and thinner profit margins,

the cost could be prohibitive.

Small mutual funds can be easy to overlook, in part, because we

do not have the immediate name recognition that many of our larger fund groups enjoy. In fact, if you look at the number of fund

groups in the industry, small groups constitute a substantial majority. Of the approximately 500 fund groups in the United States,

more than 370 of them have assets under $5 billion or less. By

comparison, a large fund group may have hundreds of billions of

dollars under management.

Small fund groups like FAM Funds provide a greater choice for

investors and help foster competition. Small mutual funds typically

find a niche and stick with it, achieving success by staying within

their circle of competency, rather than trying to be all things to all

investors. In addition, a small mutual fund group typically can provide its shareholders a level of individual service and attention,

such as providing access to fund portfolio managers that simply is

beyond the reach of a large fund group with millions of shareholders.

Finally, it is important to note that many of the most innovative

fund products and services, such as money market funds, were introduced by entrepreneurs new to the industry. As this Committee

considers whether additional steps are necessary to respond to the

recent scandals, I respectfully request that you bear in mind the

law of unintended consequences.

No proponent of mutual fund reforms wants to damage the longterm competitiveness and creativity of this industry which is so vitally important to millions of lower and middle-income investors.

Yet, if the scales are tipped so that the regulatory restrictions and

costs of managing mutual funds outweigh the possible rewards,

there could be a brain drain. At the very least, the brightest portfolio managers might be drawn away from the mutual fund industry to more creative and lucrative forms of money management.

New firms simply might not enter our industry at all, choosing

instead to limit their investment offerings to less-regulated products. The creativity to provide new investment funds that would be

advantageous to lower- and middle-income investors might be stifled, if not lost. If one proposal creates a barrier to entry for a mutual fund entrepreneur, that would be tragic.

I hope these observations about the potential threat of overregulation are taken by the Committee in the spirit in which I offer

them—as constructive commentary based on my 30 years of serving individual investors and my strong belief that a vibrant, competitive mutual fund industry serves our Nation’s interests.

Please allow me to share with you one final observation. It is

clear to me that the problems that have been found in the mutual

fund industry cannot be fixed solely by changing rules and regulations. Rather, the industry itself, fund group-by-fund group, must

renew its commitment to act in accordance with the highest standards of ethics, morality, and integrity. This has always been an integral part of our philosophy at Fenimore, and I firmly believe that

these values have served our shareholders well.

976

I thank you for the opportunity to participate today.

Chairman SHELBY. Thank you for your statement.

Mr. Siedle.

STATEMENT OF EDWARD A.H. SIEDLE

PRESIDENT, BENCHMARK FINANCIAL SERVICES, INC.

Mr. SIEDLE. Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, thank you for the opportunity to appear before you today to discuss the crisis of confidence in the mutual fund

industry.

I am the Founder and President of Benchmark Financial Services, Inc., a firm that investigates money management abuses primarily on behalf of public pension funds. The matters we examine

typically involve esoteric breaches of fiduciary duty by brokers,

money managers—many of whom manage mutual funds—and pension consultants.<k>

I have worked in financial services for over 20 years. I originally

started as an attorney with the Division of Investment Management of the SEC in 1983. Subsequently, I served as Associate

Counsel and Director of Compliance of the Putnam Companies.

From 1990 through 1997, I owned a soft-dollar brokerage firm,

so I have a great deal of familiarity with the soft-dollar industry.

Years ago, unfortunately, I was referred to in an article as the

‘‘Sam Spade of money management,’’ and I am sorry to say the

name has stuck with me. I have also been called ‘‘the Nation’s most

vocal critic of money management abuses.’’ Over the past 10 years,

I have written about, and spoken about, illegal and unethical activity in the mutual fund industry. In the course of the investigations

my firm has undertaken, I have collaborated with the FBI, law enforcement, and the SEC to actively pursue those involved in wrongdoing involving the mutual fund industry and the money management industry, in general. It is a real pleasure, after so many years

in the industry, to witness the dawn of an era of heightened public

scrutiny of mutual fund practices.

The harm to investors related to the mutual fund industry’s betray of the public trust is tremendous. How big is the price tag?

It is clear to me that over the years a significant portion of mutual

fund investment advisory fees that investors have paid is excessive.

Our firm, in 2003, conducted a survey of 100 pension funds and

the investment advisory fees they actually pay. The findings from

our survey indicated that the pricing of institutional investment

advisory services is somewhat irrational; that is, even institutions

sometimes pay excessive money management fees. We found that

some pensions are actually paying as much as four times the fees

as others for the exact same services. Our conclusion was that pensions need to be more informed regarding fees, negotiate more vigorously and carefully draft ‘‘Most Favored Nation’s’’ provisions for

inclusion in their contracts with managers. These clauses are designed to assure that the funds receive the lowest fees that the

money managers have to offer.

As bad as the news is about the pension investment advisory

fees, it is my perception that for mutual fund investors, it is far

worse. We have actually seen mutual funds that pay up to 10 times

the advisory fees that pensions pay for the same services from the

977

same managers. There are no good reasons for mutual funds to pay

these excessive fees.

I have concluded that mutual funds pay excessive management

fees simply because the fund’s boards of directors fail to fulfill their

fiduciary duties and do not vigorously negotiate fees with managers. And it is the Nation’s mutual fund investors who are paying

the price.

I recommend that the fiduciary duty of mutual fund trustees be

strengthened. And in discharging their duties, I believe that fund

trustees should negotiate ‘‘Most Favored Nation’s’’ clauses in their

contracts with every fund manager.

Chairman SHELBY. What do you mean by ‘‘Most Favored Nation’’

clauses?

Mr. SIEDLE. Most Favored Nation clause is where you, the money

manager, represent to the client you are giving him your best rate

for an account that size. It is your best price. Eliot Spitzer has also

endorsed this proposal and called for it recently in a Forbes article.

Members of the fund’s boards of directors who are affiliated with

fund managers face conflicts of interest that may make them resist

vigorous negotiations with fund managers. These conflicts would be

eliminated by requiring a supermajority of independent directors

on fund boards and an independent fund chairman.

The mutual fund managers will resist such negotiations to reduce fees. Excessive investment advisory fees enable fund managers to comfortably enter into revenue-sharing arrangements with

brokers. Revenue sharing results in tremendous amounts of money

being paid to brokers that agree to push the funds.

Mutual fund brokerage commission rates related to portfolio

trading are also in excess of what they should be and are intentionally kept high by managers who want to use the excess to compensate brokers for selling fund shares.

Another practice that I wanted to discuss was that of using soft

dollars to purchase goods and services. I believe that Congress

should repeal the safe harbor for soft dollars. However, if soft dollars continue to be allowed, the amount of soft dollars should be

disclosed and included in computing management fees, since softdollar amounts are, in reality, another form of manager compensation. Many pensions actually do this. They will add into a money

manager’s fee the cost of soft dollars.

As a result of using client commissions for marketing and research, fund investors are essentially giving huge amounts of

money in commissions for the business expenses and interests of

the mutual fund money managers.

Fund directors should ensure that the client funds are used to

benefit the investors. I believe it is inappropriate to use fund assets

to pay the ICI, the industry lobby group, because I have not seen

that it has historically advocated in the best interest of mutual

fund investors and, thus, investors do not benefit from the ICI receiving their money. I bring to your attention an article from

Forbes, dated September 15, 2003, entitled, ‘‘Your Money at Work

Against You,’’ in which Neil Weinberg and Emily Lambert have

stated similar views. In short, the ICI ‘‘uses the money to oppose

virtually every proinvestor initiative to come out of the SEC or

Congress.’’

978

Mutual fund investors are treated as second-class citizens by

many money managers. Mutual fund investors are typically far less

fee- and performance-sensitive than institutional accounts, and are

less profitable to money managers than hedge funds.

In the mutual fund industry, ‘‘assets under management’’ has

unfortunately come to mean ‘‘assets used by management.’’ So, in

the face of the ethical shortcomings that have surfaced, there is a

stronger need for Congress to protect mutual fund investors.

The serious problems that I have mentioned have been longstanding. While some believe that the transgressions surfacing at

this time were desperate measures adopted by the mutual fund industry as assets under management plummeted around 2000, I can

assure you, from personal experience, that improper and unethical

activity has been pervasive for over 20 years.

The effect that the problems with mutual funds have had on the

Nation’s retirement savers is tragic. The entire investment return

attributable to an individual’s retirement account over a lifetime

may be eaten away by excessive fees and other malfeasance.

I believe that skimming by the mutual fund industry is a significant factor in explaining why the Nation’s retirement savers will

enter into retirement with lesser assets than they envisioned.

While we cannot eliminate the potential for poor investment decisionmaking, we must seek to ensure that investors have clear disclosure of the information necessary to make good investment decisions and, most importantly, are treated fairly. When the industry

fails to do this itself, we must have statutes and regulations that

promote this.

We want mutual fund investors to succeed. And we want as

many of these investors to succeed as possible. Every success

strengthens our society, and every time an investor is robbed of his

hard-earned savings, our society suffers. It is time to put an end

to self-dealing by the mutual fund industry and provide mutual

fund investors with the protections they always thought they had.

Thank you very much.

Chairman SHELBY. Thank you, sir.

Mr. Treanor.

STATEMENT OF MARK TREANOR

GENERAL COUNSEL, WACHOVIA CORPORATION

ON BEHALF OF THE FINANCIAL SERVICES ROUNDTABLE

Mr. TREANOR. Thank you, Mr. Chairman.

Mr. Chairman, I am Mark Treanor of Wachovia Corporation. I

am the general counsel there. Wachovia is one of the largest

providers of financial services to retail, brokerage, and corporate

customers in the country. We serve 12 million households and businesses primarily in the 11 East Coast States and here in Washington. Our full-service brokerage, Wachovia Securities, serves

clients in 49 States, and Evergreen Investments is our asset management business, serving more than 4 million investors with a

broad range of financial products.

I am a member of The Financial Services Roundtable, and I am

very pleased to be here to testify on the Roundtable’s behalf today.

The Roundtable would like to start off by commending you,

Chairman Shelby, and this Committee for the thorough and delibVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00990 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
979

erate examination of mutual fund issues which has been conducted

to date. The Securities and Exchange Commission is also conducting a comprehensive review of mutual fund regulation. Not

only is the SEC moving aggressively to consider proposals to prevent recurrences of such things as abusive late-trading and market

timing, but the Agency has also proposed or already adopted rules

across virtually the entire spectrum of mutual fund operations. The

Roundtable believes the regulatory process should be allowed to

work to a conclusion before legislative changes are enacted.

The comment periods for many of the proposals are still open,

and the Roundtable expects to file comments with the SEC and has

not yet taken final positions on many of these SEC proposals, and

the Roundtable would be very pleased, of course, to provide the

Chairman and the Committee with copies of those comment letters

when they are filed.

I would like to take a few minutes on behalf of the Roundtable.

I have submitted a more detailed statement, but to comment on

some of the issues and the SEC positions on some of these as well.

I will start off by pointing out, as has been noted a little bit earlier, that some investors, have the time, sophistication, and inclination to investigate and evaluate mutual fund options on their own.

Other investors prefer to have an intermediary help them identify

their investment goals and the funds that may be appropriate to

help them meet those goals. In fact, 88 percent of mutual fund

shares are purchased through intermediaries.

In addition to distributing mutual funds, intermediaries may

have an important role to play in servicing customers’ accounts on

an ongoing basis. Many investors prefer the convenience of receiving a single statement that presents all of their investments, including their investments in various mutual fund families, rather

than receiving multiple statements from different financial institutions. Intermediaries may also help investors understand those

statements and the performance returns of all of their mutual fund

investments.

It is proper to compensate intermediaries for those services. They

are done for the benefit of the investors who choose to avail themselves of them. Historically, that compensation has taken the form

of an up-front charge paid by the investor, known as a front-end

sales load. Today, compensation can take various forms, including

12b–1 fees, which are deducted from fund assets to pay for distribution. The SEC has the authority to regulate a fund’s distribution of securities, including how the 12b–1 fees are used. Rule 12b–

1 permits funds to adopt written plans for using fund assets to pay

for distribution and it, in essence, allows investors to pay for distribution and related costs over time, rather than all at once up

front.

Some fund advisers may also make payments to intermediaries

for distribution, sometimes known as revenue-sharing payments. It

is important to note that these payments are made from the assets

of the adviser, as opposed to the assets of the fund. Futhermore,

a broker-dealer’s registered representatives always remains subject

to rules that require that the funds they recommend to investors

be suitable for those investors.

980

Payments by fund advisers to their affiliates may also compensate broker-dealers for performing routine shareholder servicing. These functions can include processing transactions, maintaining accounts, mailing prospectuses and the like. Payment of

those administrative services have helped investors have the convenience of accessing multiple fund families in a single place and

receiving a single statement covering their mutual fund investments.

The term ‘‘directed brokerage’’ refers to the use of fund brokerage

commissions to facilitate the distribution of fund shares. The NASD

regulates this. The rule allows a fund to consider sales of shares

and the selection of brokers to execute portfolio transactions for the

fund subject to best execution and provided the policy is disclosed.

The SEC expects that fund boards will consider the potential

conflict of interest inherent in using fund assets to pay for distribution. The SEC has proposed alternative amendments to the rule to

prohibit mutual funds from directing brokerage transactions to

compensate a broker-dealer for promoting fund shares or, alternatively, seeking comment on requiring greater disclosure.

There are a number of other items like that that the SEC is looking at. For example, requiring brokers to provide customers with

information about distribution-related costs at the time of the purchase of shares. Brokers would have to estimate and disclose total

annual dollar amounts of asset-based sales charges, including 12b–

1 fees. Additionally, the SEC is seeking comment on whether to

prohibit funds from deducting certain distribution-related costs, including some 12b–1 fees from fund assets and, instead, deducting

them directly from shareholder accounts.

All of this causes the Roundtable, on each of these issues, to believe that disclosure is a very crucial tool to ensure that funds

serve their shareholders and that shareholders can evaluate fund

performance effectively. The Roundtable supports improvements to

make certain that fund disclosures are periodic, timely, robust, efficient, uniform, and easy to administer.

As I said, the Roundtable is studying the SEC’s proposals carefully and will comment on them. In general, the Roundtable feels

that improvement to disclosure is a better response to these issues

than is a prohibition of specific business practices. We believe the

SEC is moving aggressively in its rulemaking and commend them

for doing so, and we commend this Committee for its thorough examination of these issues and look forward to working with the

Agency and the Committee so that investors can continue to have

confidence in mutual funds as an important investment vehicle.

Thank you, Mr. Chairman.

Chairman SHELBY. Would you all agree with a premise that financial integrity in the mutual fund or any financial integrity

should not put a burden on anyone? In other words, if you had integrity in your system, it should not put a burden on you if you

have the basic integrity in the fund.

Do you want to comment on that, sir?

Mr. SIEDLE. Yes, I would absolutely agree with that; the people

who should be entrusted with the Nation’s savings to manage

should be people who have integrity in their blood.

Chairman SHELBY. Especially mutual funds.

981

Mr. SIEDLE. Yes, this is the common man’s savings vehicle really.

Chairman SHELBY. Trust. Trust.

Mr. SIEDLE. Trust is critical.

Chairman SHELBY. Do any of you have problems with that?

Mr. HAAGA. Not at all. We have spent the last several months

trying to restore trust.

Chairman SHELBY. But it should not have a price. Without financial integrity, you are going to destroy the industry, are you not?

Mr. HELCK. Absolutely.

Chairman SHELBY. Is that right, Mr. Treanor?

Mr. TREANOR. Yes, sir, I agree. I was going to say I do not believe that one can either regulate or legislate integrity.

Chairman SHELBY. You cannot legislate morality. You cannot do

that, absolutely right. But you can regulate and put rules and laws

out there that if you do violate it, you pay a price, could you not?

Mr. TREANOR. That is correct, Mr. Chairman.

Chairman SHELBY. And that does not keep people from doing it.

That is like having a statute against murder, but people are going

to murder some people. We hate that, but there are. And we also

have a statute against robbery, but people are going to break the

statutes—that does not keep us from doing it, I mean, to legislate

in the field, does it?

Let me ask you all a question because I do not know. I will start

with you, Mr. Treanor. Let us say I had several accounts at

Wachovia, mutual funds—whatever you sell. What would I get at

the end of the month or quarterly or whatever you send out? Would

I get a statement showing, let us say I invested $100,000—that is

a lot of money. I do not know where I would get it—but $100,000.

Would I get a statement back showing what that $100,000 has

done a year later? In other words, the value of the portfolio now

as opposed to what and the costs associated with this? Do you see

what I am getting at?

Mr. TREANOR. You get a monthly and an annual statement.

Chairman SHELBY. Would I be able to understand it?

Mr. TREANOR. I think that you will.

Chairman SHELBY. I do not know.

Mr. TREANOR. I think if you go back to actually purchasing the

funds, also, Mr. Chairman, that you will find that the broker or the

intermediary from whom you purchased those funds explains at the

front end what is going to go into——

Chairman SHELBY. Is this explained—we had a hearing the other

day on unambiguous language that the average person is not used

to—the 100 million Americans or 95 million Americans, could they

understand, if they spent 10, 15 minutes on it, what their $100,000

did or did not do and the costs associated with it? We are talking

about disclosure. Everybody is advocating disclosure, and I like disclosure too. Would they be able to understand what you are disclosing, I guess is the question.

Mr. TREANOR. That is certainly the goal of adequate disclosure

all along in the process and starting at the front end of that.

Mr. HAAGA. Mr. Chairman, the $100,000, actually, they do not

have to wait a whole year. They can get it every day.

Chairman SHELBY. See, I did not know.

982

Mr. HAAGA. Just go up on the website, and it is there every day, and it is what the $100,000 worth now because all of our results

are given net of all fees.

Chairman SHELBY. Let us say it went up because the market went up and so forth, and let us say it went up from $100,000 to

$122,000—22 percent. Now, in addition to that, would it show what

it cost when that person sent $100,000 to you; in other words, what

are the costs to maintain it, to invest it and all of this?

Mr. HAAGA. Any up-front charges——

Chairman SHELBY. Do you understand what I am getting at?

Mr. HAAGA. Yes, sir.

Chairman SHELBY. See, I do not.

Mr. HAAGA. Any up-front charges are deducted from the amount

they send us, so they would get a confirmation saying it is $98,000

or whatever the number was.

They would also get a prospectus, and on the front cover page,

in clear language, in a single percentage number, they would see

the annual effect of all fees, so they would know what was deducted from the outcome.

And, of course, any statement they get is going to be net of the

fees, so they know what the fees are, but what they see is their

actual account value throughout the life of the investment.

Chairman SHELBY. Mr. Helck.

Mr. HELCK. In addition to showing what you put in and any deductions that came out for front-end sales charges, so therefore the

net amount your account was worth, the statement may also tell

you what it was worth last month, at the end of last year, and give

you a rate of return on how you are doing in your investment. And

maybe, depending on the account services that you enlist in your

account, how that might compare to other comparable indexes.

Chairman SHELBY. Explain this to me about brokerage fees. If I

were a broker, I would expect to be paid for my services, otherwise

I would not do them. The market does work, let us be honest with

you. Why would I sell mutual funds if I were not going to get paid

for it? I would not. No one would.

Mr. HELCK. Absolutely not.

Chairman SHELBY. Are those fees disclosed? And if they are not

disclosed, why are they not disclosed?

Mr. HELCK. The fees are disclosed.

Chairman SHELBY. I know, but we have been hearing for sometime that they need more disclosure on brokerage fees.

Mr. HELCK. The fees that are disclosed are the sales charges that

paid the person who is selling you the funds, and they have several

different models that they can offer you, and they are obligated, by

regulation, to explain those choices to you, to include also a feebased account which may not have any commissions at all, but

have an advisory fee.

Chairman SHELBY. Well, I certainly do not believe we should legislate or regulate what fees are, that the market should set fees,

but it seems to me that it would behoove the mutual fund industry

that you had an informed purchaser or shareholder, that it would

be in your long-term interest, especially if you were a well-managed fund. If you were not, you might not want to disclose anything. You might want to get out of town.

983

Mr. HELCK. And to a good point. If you do not disclose it, your

competition clearly will disclose to your client what you paid or

should have paid or could have paid, and if they feel like you have

abused their trust, then they are very quick to move to another

source of their services.

Chairman SHELBY. This morning—a lot of you heard or aware of

the hearing this morning—we held a hearing that examined softdollar practices. The witnesses, among other things, discussed the

merits of various reform alternatives. We will start with you, Mr.

Haaga. Would you comment specifically on should Congress repeal

Section 28(e)? And if not, why not? And should the SEC require

firms to unbundle commissions? And what should be done to revise

the definition of ‘‘research’’ as a broad term?

Mr. HAAGA. We strongly recommended the SEC tighten the definition of ‘‘research’’ so it includes only intellectual content and does

not include the Bloomberg machines that Senator Fitzgerald described. So we are clearly in line with his recommendation on that.

We have also suggested that third-party research, where there

was actually a portion of the commission that is paid to someone

else, and therefore it is identifiable, and it is clear that these products are commercially obtainable for a cash price, that those be

eliminated from the 28(e).

Chairman SHELBY. Personally, if I was investing in a mutual

fund, and if you were well managing and you made my fund grow,

I would not mind paying a little research or whatever it was. That

is just common sense.

Mr. HAAGA. I think the question is not whether they should pay

it, it is how they should pay it, and we think the advisory fees——

Chairman SHELBY. And how it should be disclosed——

Mr. HAAGA. Exactly, sir.

Chairman SHELBY. —with a definition.

Mr. HAAGA. We think the advisory pays for that.

As far as repealing 28(e), you would have to take an initial step,

and it is one that the United Kingdom regulator is struggling with

now, and that is, in order to repeal the safe harbor for proprietary

research—that is the research that is given to you by——

Chairman SHELBY. Can the Commission deal with it without

statutory——

Mr. HAAGA. The SEC can do the things we have recommended

without statutory approval.

Chairman SHELBY. If they have the will.

Mr. HAAGA. Correct.

Chairman SHELBY. For many years, you have worked at this. So

you know.

Mr. HAAGA. Yes. The SEC can do everything that we have recommended that they do, tightening the definition and eliminating

third party on their own.

Chairman SHELBY. We are going to find out what they are going

to do.

Mr. PUTNAM. Mr. Chairman, could I add, also——

Chairman SHELBY. Yes, sir.

Mr. PUTNAM. —from a small fund’s perspective, the total elimination of 28(e) would be very harmful I think to many small funds

who do not have access to——

984

Chairman SHELBY. Yes, that was made this morning.

Mr. PUTNAM. —to research, to intellectual property, and they depend on soft dollars to access intellectual property, and I think that

is appropriate because that is in the best interests of long-term

shareholders.

Chairman SHELBY. Would it bring about unfair competition, in a

sense?

Mr. PUTNAM. Pardon me?

Chairman SHELBY. Would it bring unfair competition for the big

versus the small in the mutual funds?

Mr. PUTNAM. Well, that is one of the ways actually to bring more

competition and enable smaller funds to participate in that arena.

Mr. HELCK. No matter how large the organization, nobody has

the resources to cover every company as thoroughly as they need

to be covered. So having outside research resources is in all of our

interests, and the more competition there is, the better it serves

our industry.

Chairman SHELBY. Yes, sir. Go ahead.

Mr. SIEDLE. The remarkable thing about money managers is

when you ask them do they do their own research or do they rely

on the information of others, uniformly, money managers say they

do their own research.

The Nelson’s Guide to money managers asked managers to indicate how much they rely on Street research and how much do they

use their own research. We asked Nelson’s to do an analysis to indicate how much managers claim to do their own research.

Managers claim to do 80 percent of their own research. A good

money manager does his own research and does not rely heavily on

research done by others, and that is one of the selling points of

their services.

Mr. HAAGA. Can I respond to that?

Chairman SHELBY. Yes, sir. Go ahead.

Mr. HAAGA. We do our own research at Capital. We are famous

for it. We have several hundred research analysts all over the

globe, but we also read the Street research to see what other people

are saying. So he is positing it as an either/or. It is not an either/

or. We look at every resource possible.

Mr. PUTNAM. Mr. Chairman, could I also add to that?

Chairman SHELBY. Yes, sir, go ahead, and then I am going to call

on Mr. Treanor.

Mr. PUTNAM. We are an internal research house. And while I

talked to the issue of soft dollars, we do not use any soft dollars.

There are several small-fund groups that are very good groups

who do their own internal research. One of the small-fund groups

was before this Committee February 26—Mellody Hobson, from

Ariel Group, and they do a great job too. We know several of those

groups that do internal research. But I do think soft dollars provide

some flexibility for smaller fund groups who do not have access to

the full range of research that we perhaps look at.

Chairman SHELBY. Mr. Treanor, go ahead.

Mr. TREANOR. Mr. Chairman, what I was going to say is just

three brief points.

985

First, I think this discussion points out that, in many respects,

one size does not fit all. There is a great deal of variety in the industry.

Second, there has been an SEC study that looked at the use of

soft dollars over the last several years, and it concluded that there

were very few instances of abuse of soft dollars, that they were actually well-used to help investors themselves.

Third, I think that the Chairman hit the nail on the head with

the idea that this is again a disclosure issue, when you do not have

something that is uniform across the industry, and it will be something that will differentiate funds.

Chairman SHELBY. Mr. Haaga, many people contend that your

proposal to eliminate soft-dollar payments for third-party research

provides a regulatory advantage for full-service brokerage firms.

Why did you not also propose to ban the use of soft dollars for proprietary research that is produced by full-service broker-dealers?

Mr. HAAGA. Let me say, if there were proprietary research that

had a cash price on it, then it would follow logically that it should

be banned as well because that should be paid for by the adviser.

The challenge here is that there really is, if you look at 28(e), it

defines the term ‘‘brokerage and research services.’’ It does not separate out the two. And in the United Kingdom, they have been

working for the past several years trying to unscramble that egg

and say when brokerage ends and research begins, and they are

having a terrible time of it.

I think if you wanted to do that, if you wanted to eliminate proprietary research, you would have to first define where the brokerage ends and the research begins, and then make them unbundle

it and pay for it, and that is the challenge. That may be a later

step, but we certainly did not want to hold up the very good step

and the very straightforward and easy step of eliminating the

third-party research payments. Of course, the important part of

that is also the directed brokerage for sales.

Chairman SHELBY. I am going to direct this question to Mr.

Treanor and Mr. Helck.

How would a requirement that broker-dealers must unbundle

commissions and assign specific values for research and execution

impact commission cost? Would commissions decrease? Would it

impact the availability of independent research?

Do you want to try that, anybody? Do you want me to ask that

again?

Mr. HELCK. I think that I understand the thrust of your question.

Chairman SHELBY. You understand the question.

Mr. HELCK. I believe that it would result in less research being

available.

Chairman SHELBY. Why?

Mr. HELCK. Because it would seek to allocate artificially the costs

or the value of research and execution.

Chairman SHELBY. Why do you use the term ‘‘artificially’’ here?

Mr. HELCK. As I thought Mr. Haaga said so artfully, it is

unscrambling an egg, and nobody knows how to do it. And so you

have to make an arbitrary decision and make some assignments.

The problem with that is that execution is so nonuniform. Different

986

trades, different liquidity, different days of the week, and different

requirements of the portfolio put different values on the trade. And

so if we artificially say x percent goes to this and that, it is not

real. Therefore, in some cases it will be over, in some cases undervalued, and I am not sure that improves anything unless we figure

out a way to do it that is just and appropriate.

Chairman SHELBY. It is not exactly in the math, is it, not totally?

Mr. HELCK. If it results in firms saying, I cannot be in this business because I cannot execute appropriately, and therefore they

withdraw coverage on companies, therefore there is less coverage

and less research available, that would be bad for investors.

Chairman SHELBY. Mr. Treanor.

Mr. TREANOR. I think the only thing that I would add to that is,

again, this is one of the issues I think that the Roundtable is taking a look at across the industry because it would have a different

impact on different firms and the way that they would be able to

handle that going forward.

Chairman SHELBY. You all are very familiar with what has been

going on in the Banking Committee, and you are probably familiar

with Bob Posen’s testimony here. He proposed a method for providing investors individualized cost disclosure in their quarterly

statements. Mr. Posen indicated that an individualize estimate

could be done without great cost or administrative burdens to the

funds.

Would each of you address his comment on the utility of providing investors an individual cost figure. Also, should investors receive both an individual cost figure and an expense number that

they can use to compare funds? In other words, they are in the

marketplace.

Mr. Haaga, do you want to start.

Mr. HAAGA. Yes, I think the important word in Mr. Posen’s

phrase was ‘‘estimate.’’ It is an estimated phrase, and of course

since they can do their own estimate when we give them the percentage, when we give them the amount per thousand dollars, they

just multiply by the thousand they have, so they can come up with

that estimate.

I think that the most relevant aspect of expenses is how they

look comparatively. There is no relevance to them unless you can

compare them to what you would use for another fund.

Chairman SHELBY. But if they have something to compare with,

they could compare, could they not?

Mr. HAAGA. That is why we support the SEC’s proposal versus

the GAO proposal, which would give a standardized fee disclosure.

And I think one disclosure is enough. Adding something else that

says, and here is what the math would be if you applied it to your

own fund, I do not think is necessary. I think it is better to stick

with the one number—this is the per thousand—because that is

the one they can compare.

Chairman SHELBY. Mr. Helck.

Mr. HELCK. Keeping in mind that your condition on that question was that it was cost-effective, we, as I said earlier, have over

11,000 CUSIP’s, that means different mutual fund classes, that we

propose. It is hard enough, we need only consult the break-point

issue to see how complex it is for broker-dealers to be informed by

987

the funds of all of the various discount criteria for administering

that program, which is overwhelming, and those are relatively stable. Once stated in the prospectus, they tend to stay the same for

a long period of time, but these expense numbers change daily,

quarterly, annually.

And so it is a process of having to have good sources of information on a flowing, dynamic basis that can recalculate against every

fund, and every shareholder, and every account value and get recalculated, and how you can do that in a cost-effective way eludes

any of us who have given it consideration, which is why we say let

us come up with something that is cost-effective, that will not unduly burden the cost of the funds and the shareholders and does

represent to them what their experience would be on a reflective

basis.

Chairman SHELBY. Mr. Putnam.

Mr. PUTNAM. I might anecdotally add we have our own shareholder services firm and also transfer agency, and I talked to the

person that heads that up and said, ‘‘Could we be able to do this?’’

And he looked at me and he said, ‘‘Well, you know, I do not know

how we are going to be able to do it at this point. I do not know

of any software that is available to do that, especially for small

funds.’’ And the 60-cent-per-statement cost I heard earlier was

shocking to me.

But, at any rate, I think fee disclosure is important when it is

in the best long-term interests of shareholders. And the only way

that I think that is possible is to make it in a form that they could

compare it to other funds. And I think the expense ratio does this

pretty adequately. I mean, if you think about gasoline, when you

compare gasoline, you do not compare the total costs that you are

putting in your tank. You compare the price per gallon. And I think

expense ratios do that.

But I also would like to add that I think the emphasis on looking

at fees only as being part of the solution to how investors think

about buying a fund is one that only looks at a very small minority

piece of that decision.

If I may, for just a minute, I would like to just read this from

my—this happens to be our shareholder letter that is going out

with our statements at the end of March.

Chairman SHELBY. Yes, sir. Take your time.

Mr. PUTNAM. This is a paragraph from that shareholder letter

that I wrote:

We agree with several new proposals designed to ensure that shareholders fully

understand the expenses of mutual fund ownership. In fact, we are taking an extra

step to prepare an owner’s manual, which we hope will help our shareholders understand all fees and expenses associated with an investment in FAM Funds.

However, we believe that a shareholder’s decision to invest in a mutual fund

should not be based solely on numbers, whether they are related to expenses or performance, but also on a system of shared beliefs about investing. The alignment of

fund managers and shareholders should be forged in terms of shared interests, similar beliefs in terms of investment objectives, risk tolerance, and service levels.

While performance and expenses can be quantified, the inclusion of these other

components combine both the art and science of investing and create an understanding that goes beyond mere numbers.

So I think there is more to the discussion as to what is in the

best interests of long-term shareholders than just looking at fees as

being part of the equation.

988

Chairman SHELBY. Putting in information that they can understand as to cost, long-term and short-term interest to them.

Mr. PUTNAM. That is correct.

Chairman SHELBY. Mr. Siedle.

Mr. SIEDLE. I do not think most investors have a system of

shared beliefs about investing. I do not know if you do. I do not

know that I do. Most investors, their belief about investing is that

they are going to put their money away somewhere and hope that

it grows, and that is about it. And the fact is that one of the most

objective criteria an investor can look at is cost and fees. And as

we heard earlier, the lowest cost funds, in fact, generally outperform the higher cost funds.

So fee information is terribly important, and the only other information investors typically rely on is past performance, and we all

know how fallible that is. So, I think enhancing fee information is

critical and giving information about the cost of index funds versus

actively managed funds is also critical.

One last point I want to make is I have owned brokerage firms

for 14 years, and I can tell you to a penny what it costs to execute

a trade. I do not know what this difficulty in calculating it is. In

fact, firms like mine that clear through Merrill Lynch, we are given

a statement on every trade of what the cost of execution is. It is

15 percent of the commission. The rest is fluff. It is commission.

It goes in my pocket.

Chairman SHELBY. Mr. Treanor.

Mr. TREANOR. I think the key on that issue is that disclosure of

the fees to investors is extremely important and that it needs to

be done in a fashion which will allow them to compare fund-to-fund

so that they can make the appropriate investment decisions, and

that is probably done in the best fashion by using the SEC proposal

on that instead of the individualized account that otherwise would

be proposed.

Chairman SHELBY. Should funds be required to deliver to investors a summary prospectus with material cost and expense information at or before the time of their purchase?

Mr. HAAGA. Well, summary prospectus. We supported very much

the Arthur Levitt effort back in the late 1980’s, early 1990’s, to develop the summary prospectus.

We also support the proposal to have point-of-sale disclosure of

fees. The actual proposal now is not a full summary prospectus, but

it is a statement of fees, and we think that both those proposals

are a good idea.

Chairman SHELBY. Do you have any comments, Mr. Helck?

Mr. HELCK. We are all in favor of full disclosure. It is the method

of how we do it that we want to talk about it.

Chairman SHELBY. But the method is important, is it not, the

method of disclosure?

Mr. SIEDLE. I think a summary prospectus would be a fine idea.

Chairman SHELBY. The SEC is considering, as you all know, a

rule change that would clarify the use of 12b–1 fees by stating that

the fees can only be used for advertising and distribution payments

and must be deducted directly from the shareholder’s account rather than fund assets.

989

What is your view on the use of 12b–1 fees and the merits of the

SEC’s potential proposal?

We will start over here on the left.

Mr. HAAGA. I think it would be a mistake to repeal 12b–1, which

is I think the proposal as you summarized it, and to require that

all ongoing payments be made by the shareholder.

I would go back to 1988, when we adopted our 12b–1 plans, and

we decided that 25 basis points—we, American Funds—was the

right amount of ongoing service fees to pay brokers, and set that,

and that has been the rate, and it has never changed since.

And I have a hard time believing that if we quit dictating it—

we, the provider of the fund or manager of the funds—quit dictating what that 12b–1 fee is going to be and turn it over to the

brokers, I cannot imagine it is going to go down. I would suggest

that it may even go up.

In addition, we have an incentive to keep the fees low and that

is that all of our investment results are reported net of that fee.

If the fee is shifted over to the shareholder, we will report investment results that are not net of that fee, and we will have less of

an incentive to keep it low. So, I think we should keep the fee in

the fund in the form of the 12b–1.

Chairman SHELBY. Should funds be permitted to charge 12b–1

fees after a fund has already closed?

Mr. HAAGA. Well, I deal with a lot of people who are retired. We

have a lot of friends who are retired, and they are never going to

buy another fund share in their life. Their goal now is not to outlive their savings. And every time the market moves, and every

quarter, whether it does not, they go visit their broker, and they

talk to them about how much money they can take out, get them

to do the recalculations, talk about, assure them that they are not

going to outlive their money.

If one of their funds that they are invested in stops selling fund

shares, they do not stop owning them. They still go visit their

broker, and somebody needs to pay that broker. So the idea that

for some reason the service fees should be stopped on all of those

retirees that are going and seeing their brokers just perplexes me.

It is the wrong view of what a 12b–1 fee is for.

Chairman SHELBY. Does anybody have any different—yes, sir,

Mr. Siedle.

Mr. SIEDLE. But there are a lot of other fees that mutual fund

companies pay brokers to keep clients in their funds—their commissions, directed commissions, which are substantial, their revenue-sharing arrangements. And so 12b–1 fees are not the sole

source of compensation to brokers.

Chairman SHELBY. How about after the fund is closed?

Mr. SIEDLE. After the funds close, it still trades. Commissions

are being directed to brokers out there.

Mr. HAAGA. We propose to eliminate directed brokerage commissions.

Mr. SIEDLE. I think that would be an excellent idea.

Mr. HELCK. The assumption of that proposal is that the basic

value provided by the financial adviser is the transaction when

they buy it. And what we are trying to point out is it is the ongoing

990

service, advice, due diligence, and counsel that is provided that is

being compensated for, and it is appropriate that it should be.

Chairman SHELBY. Getting into a little different area now. I appreciate your patience. These are important questions for the

record here we think.

The Committee is considering reforms that would help ensure

that funds are subject to competitive market forces. We all agree

with that. People make choices in the market.

In light of this objective—and I hope it is yours—would each of

you discuss Section 22(d) of the Investment Company Act in this

regard, which essentially requires funds to fix sales load in the prospectus. In other words, why should sales loads be fixed in the prospectus rather than allowing funds and broker-dealers to compete

with one another on price?

Mr. SIEDLE. Section 22(d) I think is, in order to establish

fairness——

Chairman SHELBY. That is right.

Mr. SIEDLE. —that brokers are not cutting deals with everybody

under the sun, and therefore you will never know that you are paying the same price as someone else. I think the statutory provision

makes sense, and I think it should stay.

Mr. HELCK. Actually, that has served well, if you look back over

the history of funds. But there is an emerging alternative to that,

that the marketplace has created in fee-based accounts, where essentially there is no sales charge added to the fund share price, but

a fee is paid directly by the client for advisory services, and that

choice exists as well. So the marketplace can choose how it wants

to be served.

Chairman SHELBY. And what is generally that advisory fee?

Mr. HELCK. That is negotiated based on the level of service that

is expected from the client.

Chairman SHELBY. It depends on the quality of the advice, I

would hope.

Mr. HELCK. Exactly right, and the amount of service that the client expects.

Chairman SHELBY. In a recent press report in The Washington

Post, it was said that some fund managers ‘‘have engaged in the

practice of window dressing, a practice through which funds seek

to improve their portfolios by selling more speculative investments

and buying more conservative ones right before they disclose their

holdings to investors twice a year.’’

Is window dressing another widespread industry practice that investors do not know about? What other practices are out there that

we should know about as we near the conclusion here?

Mr. HAAGA. I am certainly not aware of any window dressing

practices, widespread or otherwise. It would be pretty easy for the

SEC to finally go in and do an inspection and say, ‘‘Give me all of

your trades for the last 3 days of the period.’’

I also would point out that the investment results do not stop at

the end of every quarter. We have to disclose those over 1-, 5-, and

10-year periods, and you cannot——

Chairman SHELBY. Most people in mutual funds are in it for the

long haul.

991

Mr. HAAGA. Right. You can dress up your portfolio, but you cannot dress up your results. I wonder what the incentives are,

but——

Chairman SHELBY. If you are playing games with your fund, you

are playing games on yourself, too, are you not?

Mr. HELCK. And the cost of doing those transactions comes out

of your results, so it is counterproductive unless it does you some

good.

Chairman SHELBY. Mr. Putnam, do you have any comment on

window dressing?

Mr. PUTNAM. No, I agree with everything that was just said.

Chairman SHELBY. Mr. Siedle.

Mr. SIEDLE. I think there are a lot of abuses that have still not

surfaced that will surface in time. Front-running by portfolio

managers——

Chairman SHELBY. Tell us what you mean by ‘‘front-running.’’

Mr. SIEDLE. Front-running is, if I am running a portfolio, and I

know I am going to buy a million shares of Dell stock today or tomorrow, I will buy it for myself today, knowing that when I buy

it tomorrow, it will go up in price, and I will have made an immediate profit.

Front-running is something I have investigated, and it does happen at mutual fund companies.

Chairman SHELBY. Does it happen everywhere there is a lot of

money being traded?

Mr. SIEDLE. As long as there are human beings involved, yes. As

long as there is temptation, there is always going to be somebody

who succumbs to it. There are other practices like parking. Funds

that have affiliated investment banking arms will park client stock

in the mutual fund portfolios. Another thing is what is called

pump-priming, which is where you start a fund out with like

$100,000 and trade a bunch of stock and show a great performance

record, and then you advertise it, and then of course it goes down

immediately as money starts rolling in.

Mr. HAAGA. Each of the things that Mr. Siedle just described is

illegal. So do not worry that we need any more rules.

Mr. SIEDLE. No, we need enforcement.

Chairman SHELBY. Enforcement. If it is illegal, we do need enforcement.

Mr. Treanor, you have a comment?

Mr. TREANOR. That is exactly the point I was going to make is

that I do not know that any of those are major problems in the industry, and they are all covered by laws and regulations today.

Chairman SHELBY. But you are not suggesting there is not trouble in the industry or has not been.

Mr. TREANOR. No, I am not suggesting that at all. There certainly has been. I do believe firmly, though, Senator, that the overwhelming majority of people in the industry get up every morning

and try to do the right thing.

Chairman SHELBY. I do not doubt that.

I appreciate the panel being here today. It is going to be interesting when we have the SEC at our final hearing. I know you will

be watching that. We will probably have a big attendance that day.

Thank you very much.

992

The hearing is adjourned.

[Whereupon, at 4:32 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

993

PREPARED STATEMENT OF PETER G. FITZGERALD

A U.S. SENATOR FROM THE STATE OF ILLINOIS

MARCH 31, 2004

Good afternoon, Chairman Shelby, Ranking Member Sarbanes, and Members of

this distinguished Committee. Thank you for including me as a witness today during your hearing on mutual fund fees. I would like to commend you and the Banking Committee for the series of in-depth hearings you are holding on the mutual

fund industry.

Today, I would like to discuss S. 2059, the Mutual Fund Reform Act of 2004, that

I introduced on February 10, 2004. I was pleased to be joined in introducing this

legislation by my distinguished colleagues on the Committee on Governmental Affairs, Senator Carl Levin and Senator Susan Collins, the Committee’s Chairman,

from whom you also will hear today. I am grateful for the extensive and important

input both Senators provided in the drafting of this bill, and appreciate the invaluable perspective Senator Collins provided based on her first-hand experience as

Maine’s Commissioner of Professional and Financial Regulation.

Since we introduced MFRA, we have been joined by a solidly, bipartisan group

of Senators who are cosponsors. We welcome the support of Senators Lugar,

Voinovoich, Hollings, Lautenberg, Durbin, and Kennedy.

The Mutual Fund Reform Act, referred to as MFRA, would make fund governance

truly accountable, require genuinely transparent total fund costs, enhance comprehension and comparison of fund fees, confront trading abuses, create a culture

of compliance, eliminate hidden transactions that mislead investors and drive up

costs, and save billions of dollars for the 91 million Americans who invest in mutual

funds. Above all, MFRA strives to preserve the attraction of mutual funds as a flexible and investor-friendly vehicle for long-term, diversified investment.

I would like to take this opportunity to recognize the work of a number of our

colleagues in this area. Last year, I was pleased to cosponsor S. 1822, introduced by

Senator Daniel Akaka, the Ranking Member of the Senate Governmental Affairs

Subcommittee on Financial Management, the Budget, and International Security,

which I chair, to address mutual fund trading abuses. Senators Corzine, Dodd, and

Kerry also have sponsored mutual fund bills from which I drew, as well as legislation introduced by Congressman Richard Baker last summer and overwhelmingly

passed by the House of Representatives at the end of the last session.

Mr. Chairman, MFRA reflects extensive testimony that was presented during

oversight hearings of the Financial Management Subcommittee that I chaired on

November 3, 2003 and January 27, 2004. The general consensus of the panelists at

the November hearing was that illegal late trading and illicit market timing were

indeed very serious threats to investors but that excessive fees and inadequate disclosure of those fees posed a much more serious threat to American investors. Witnesses at our hearing in January testified regarding the propriety and the adequacy

of the disclosure of mutual fund fees, specifically hidden costs such as revenue sharing, directed brokerage, soft-money arrangements, and hidden loads such as 12b–

1 fees. The Subcommittee also heard from two whistleblowers who were responsible

for the initial revelations regarding Putnam Investments and Canary Capital Partners, LLC.

MFRA also reflects the constructive input from a number of key organizations and

leaders of mutual fund reform. I especially appreciate the extensive contributions

of John Bogle, the Founder and former CEO of the Vanguard Group, who has been

a champion of reforms in the mutual fund industry for many years. In his letter

of endorsement of February 6, 2004, Mr. Bogle indicated that he viewed MFRA ‘‘as

the gold standard in putting mutual fund shareholders back in the driver’s seat.’’

In addition to Mr. Bogle, the following individuals and organizations have endorsed MFRA: Massachusetts Secretary of State William Galvin, the Coalition of

Mutual Fund Investors, Fund Democracy, Consumer Federation of America, U.S.

Public Interest Group, Consumer Action, Consumers Union, and the Government

Accountability Project.

I ask consent from the Committee that letters of endorsement from these leading

individuals and organizations be made a part of the record following my statement.

As Members of this Committee know well, in 1980 only a small percentage of

Americans invested in mutual funds and the assets of the industry were only $115

billion. Today, roughly 91 million Americans own shares in mutual funds and the

assets of all the funds combined are now more than $7 trillion. Mutual funds have

grown in popularity in part because Congress has sanctioned or expanded a variety

of tax-sheltered savings vehicles such as 401(k)’s, Keoghs, traditional IRA’s, Roth

IRA’s, Rollover IRA’s, and college savings plans. Given that mutual funds are now

994

the repository of such a large share of so many Americans’ savings, few issues we

confront are as important as protecting the money invested in mutual funds.

Overview of the Mutual Fund Reform Act of 2004

The Mutual Fund Reform Act of 2004 puts the interests of investors first by:

• Ensuring independent and empowered boards of directors; • Clarifying and making specific fund directors’ foremost fiduciary duty to shareholders; • Strengthening the fund advisers’ fiduciary duty regarding negotiating fees and

providing fund information; and • Instituting Sarbanes-Oxley-style provisions for independent accounting and auditing, codes of ethics, chief compliance officers, compliance certifications, and whistleblower protections.

The Mutual Fund Reform Act of 2004 empowers both investors and free markets

with clear, comprehensible fund transaction information by:

• Standardizing the computation and disclosure of (i) fund expenses and (ii) transaction costs, which yield a total investment cost ratio, and tell investors actual

dollar costs; • Providing disclosure and definitions of all types of costs and requiring that the

SEC approve imposition of any new types of costs; • Disclosing portfolio managers’ compensation and stake in the fund; • Disclosing broker compensation at the point of sale;

• Disclosing and explaining portfolio turnover ratios to investors; and

• Disclosing proxy voting policies and records.

The Mutual Fund Reform Act of 2004 vastly simplifies the disclosure regime by:

• Eliminating asset-based distribution fees (Rule 12b–1 fees), the original purpose

of which has been lost and the current use of which is confusing and misleading—

and amending the Investment Company Act of 1940 to permit the use of the

adviser’s fee for distribution expenses, which locates the incentive to keep distribution expenses reasonable exactly where it belongs—with the fund adviser;

• Prohibiting shadow transactions—such as revenue sharing, directed brokerage,

and soft-dollar arrangements—that are riddled with conflicts of interest, serve no

reasonable business purpose, and drive up costs;

• ‘‘Unbundling’’ commissions, such that research and other services, heretofore covered by hidden soft-dollar arrangements, will be the subject of separate negotiation and a freer and fairer market;

• Requiring enforceable market timing policies and mandatory redemption fees—as

well as provision by omnibus account intermediaries of basic customer information to funds to enable the funds to enforce their market timing, redemption fee,

and breakpoint discount policies; and

• Requiring fair value pricing and strengthening late trading rules.

The Mutual Fund Reform Act also would perpetuate the dialogue and preserve

the wisdom gathered from hard experience. MFRA directs the SEC and the General

Accounting Office to conduct several studies, including a study of ways to minimize

conflicts of interest and incentivize internal management of mutual funds; a study

on coordination of enforcement efforts between SEC headquarters, SEC regional offices, and State regulatory and law enforcement entities; and a study to enhance

the role of the Internet in educating investors and providing timely information

about laws, regulations, enforcement proceedings, and individual funds, possibly by

mandating disclosures on websites.

The Essential Role for Congress in Putting America’s Investors First

Mr. Chairman, some people now inquire whether this institution has any role to

play in cleaning up an industry that controls so much of America’s savings. I believe

it would be a serious mistake if we fail to enact meaningful reform legislation. This

is an historic opportunity to do right by 91 million Americans who trusted too well.

I certainly commend the many recent regulatory initiatives from the Securities

and Exchange Commission. They are collectively a step in the right direction and

a demonstration of our seriousness in Washington about putting the interests of

America’s mutual investors first. But the SEC does not have the statutory authority

to take all of the needed steps to restore integrity and health to the mutual fund

industry. The current scandals demand that Congress take a comprehensive look at

an industry still governed by a 64-year-old law.

For example, the SEC cannot tighten the definition of what constitutes an ‘‘independent director.’’ The definition of ‘‘interested’’—in contrast to ‘‘independent’’—appears in the 1940 Act, and the SEC is normally not empowered to make law around

995

acts of Congress. (I say ‘‘normally’’ because the SEC has in fact done precisely that

in several areas, through its so-called ‘‘exemptive rules,’’ which I will discuss in a

moment.)

As we aim to empower a truly independent board of directors to act as the ‘‘watchdogs’’ for investor interests that they were intended to be, it is critical we tighten

the statutory definition of what constitutes ‘‘independence.’’ The SEC itself has

made this point persuasively in testimony before the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises.

Mr. Paul Roye, Director of Investment Management at the SEC, testified before that

Subcommittee on June 18, 2003 about H.R. 2420, the bill that ultimately overwhelmingly passed the House, as follows:

Finally, Section 4 of the bill would amend Section 2(a)(19) of the Investment

Company Act to give the Commission rulemaking authority to deem certain persons to be interested persons as a result of certain material business or close

familial relationships. We strongly support this amendment, which would

permit us to close ‘‘gaps’’ in the Investment Company Act that have permitted

persons to serve as independent directors who do not appear to be sufficiently

independent of fund management. For example, currently a fund manager’s

uncle is permitted to serve on the fund’s board as an independent director. In

other cases, former executives of fund management companies have served as

independent directors. Best practices guidelines of the Advisory Group provided

that former fund management executives should not serve as independent directors because their prior service may affect their independence, both in fact and

in appearance.

I could not have said it better than the SEC itself has testified about the need

for Congress to step up to the plate—even if the SEC remains absolutely committed

to doing what it can to clean up the industry.

Mr. Chairman, I will give you a few more examples of what the SEC cannot do.

Of the various nefarious transactions that have become commonplace in the industry, few match soft-dollar arrangements for sheer anticompetitive and anti-investor

brazenness. With soft-dollar arrangements, investment advisers essentially get to finance their office overhead with investors’ money—and that is on top of the substantial adviser’s fee they collect, also from investors’ money. Investment advisers

cause investors to pay an artificially inflated commission on every transaction in the

fund’s portfolio—and investment advisers thereby obtain ‘‘soft-dollar credits,’’ which

they can use for research, computer terminals, and other office overhead. In Section

28(e) of the Securities Exchange Act, Congress permits soft-dollar arrangements.

MFRA prohibits soft-dollar arrangements—and only Congress can do that. Through

rulemaking, the SEC can interpret the ‘‘safe harbor’’ in Section 28(e) narrowly or

broadly—and it has done both—but it cannot eliminate the safe harbor. It is time

for Congress to correct the error of that safe harbor.

As for the SEC view, I am pleased to quote again from Mr. Roye’s testimony on

June 18, 2003:

Our current regulatory regime primarily relies on disclosure by advisers of their

soft-dollar policies and practices. The staff responses submitted last week suggested that disclosure alone might not be adequate and suggested the need for

Congressional reconsideration of Section 28(e).

Congress should act to eliminate this indefensible and anticompetitive confiscation of shareholder money.

Further, Congress must act to strengthen and clarify what it truly means to be

a fiduciary in the mutual fund industry. A ‘‘fiduciary duty’’ is supposed to entail

much more than mere honesty and good faith, but it has too often meant much less.

The Investment Company Act of 1940 refers to the fiduciary duty of both fund directors and fund advisers—but in both cases, the duty has been relatively empty and

virtually unenforced. Indeed, the investment adviser’s fiduciary duty with respect to

fees is so weak—as interpreted by Federal courts—that I am advised that not a

single plaintiff has ever prevailed in an excessive fees case. MFRA amends the Investment Company Act to strengthen these twin fiduciary duties of directors and

advisers to make abundantly clear that the interests of investors are always paramount. In the case of advisers, MFRA makes clear that their fiduciary duty extends

not only to fair fees, but to providing all material information to directors in the

directors’ exercise of their fiduciary duties—a statutory and regulatory lapse that

has made it very difficult for good-faith directors to wrangle essential information

out of advisers.

A level playing field is critical to the proper resolution of market forces. Arm’slength negotiations over fees are supposed to be the key market dynamic that keeps

996

1Other examples include Rule 10f–3 (permitting the purchase of securities in a primary offering where a fund affiliate is a member of the underwriting syndicate); Rule 15a–4 (permitting

the approval of interim advisory contracts without shareholder approval); Rule 17a–7 (permitting securities transactions between a fund and certain affiliated persons of the fund); Rule 17a–

8 (permitting mergers of certain affiliated funds); Rule 17d–1(d)(7) (permitting funds to purchase

joint liability insurance policies with affiliates); Rule 17e–1 (addressing when funds may pay

commissions to affiliated brokers); Rule 17g–1(j) (permitting joint insured bonds); Rule 18f–3

(permitting funds to issue multiple classes of shares); and Rule 23c–3 (permitting closed-end

funds to repurchase shares periodically from investors and thereby operate as interval funds).

State and Federal regulators out of the board rooms. But both directors and advisers need a clearer and more specific statement of their fiduciary duties, and MFRA

provides it.

For a final example, MFRA shifts the fund distribution dynamic from its current

anti-investor and anticompetitive posture to a fairer and more rational marketbased dynamic—a change that only Congress can make. MFRA directs the SEC to

repeal its Rule 12b–1—but simultaneously makes it clear that distribution expenses

may be incurred by fund advisers, and thereby (1) gets funds out of the distribution

business; and (2) imposes the incentive to keep distribution expenses reasonable exactly where it belongs—with the investment adviser.

The SEC cannot amend the 1940 Act to prohibit asset-based fees for distribution

of fund shares. The SEC cannot amend the 1940 Act to make it clear that distribution expenses may be incurred out of the management fee paid to investment advisers. These fundamental changes embodied in MFRA would rationalize a system that

has become a mockery of the 1940 Act’s preamble declaration that the interests of

investors are always paramount. Consider carefully what happens as a consequence

of the SEC’s Rule 12b–1. While funds themselves have some incentive to ‘‘grow’’

(primarily, for example, to ensure sufficient liquidity to meet redemptions), the overwhelmingly more powerful incentive to swell net assets is with the fund adviser,

whose fee is a percentage of those assets. The current incentive and fee structure

is accordingly troublesome: Individual investors typically gain nothing from growth,

except in the very unusual circumstance of sustained net redemptions, in which

portfolio holdings must be sold disadvantageously to meet redemptions. Yet, the industry forces these very investors to pay for promotion and growth. And it gets

worse. Investors pay for promotion and growth that do not directly benefit them

(and may often actually hurt them if the fund grows so large as to make strategic

portfolio transactions unwieldy or impossible)—and they pay a fixed percentage for

the ‘‘privilege’’ of doing so, regardless of fund size (that is, Rule 12b–1—in conspicuous contrast to its founding theoretical framework—has been almost entirely

impervious to economies of scale).

Free market principles would typically discipline excessive distribution costs as a

direct bite out of profits—but fund advisers are (1) collecting their substantial fees

as a percentage of fund assets; and (b) financing the sustained swelling of those

same assets with investors’ money. Put another way, the King compels the cook to

buy the food that fattens the King. Does the King worry about his food budget? Unlikely. MFRA rearranges this incentive structure—without dictating any specific

diet. Fund advisers will now bear distribution expenses—and if, as appears virtually

self-evident, some of these expenses are excessive, we can be certain that fund advisers, spending their own money, will discover the cost discipline that has been elusive to date.

Only Congress can rationalize the fund distribution system that its own Act of 64

years ago created—and that the SEC complicated with its well-intended but injuriously perpetuated Rule 12b–1.

Finally, Mr. Chairman, I would like to say a word about the SEC’s so-called ‘‘exemptive rules.’’ I am struck, given our system of separation of powers, that the SEC

has managed, for example, to require a majority of independent directors on mutual

fund boards, when Congress said quite clearly in the 1940 Act that only 40 percent

of the directors need be independent. You won’t learn about that kind of power in

any basic civics textbook, because it seems to run directly counter to what the framers established. I happen to believe the SEC is right on the merits about independent directors—but I am concerned that Congress appears to have abdicated its

essential legislative power to an unelected agency of the executive branch.

The SEC accomplishes this legislative function through ‘‘exemptive rules’’—rules

that essentially create carrots for funds, and then oblige the funds to abide by certain additional rules of they wish to take advantage of the carrots. Perhaps the best

known example of an exemptive rule is Rule 12b–1—which allows funds to pay for

distribution expenses if they comply with certain fund governance rules. 1 Apart

from the separation of powers concerns triggered by reliance on such exemptive

rules, I believe the system has spiraled into unacceptable complexity. Congress

997

should make the essential policy determinations that have driven the SEC’s exemptive rules. And Congress should make those policy directives independently binding—not dependent upon use of an agency-conferred benefit. It is one obvious weakness of reliance on exemptive rules that funds may—though it is rare for obvious

reasons—opt out of the agency-conferred benefit, and thus decline to be bound by

the requirements in the exemptive rules.

These are a few of my concerns with abdication of our Congressional role to the

SEC. There are more. I believe, however, the foregoing examples well illustrate the

essential role of Congress in giving the mutual fund industry back to its owners—

the 91 million American investors who will rely on mutual fund investment for their

college and retirement security. They would be big winners under this legislation—

and the big losers would be high-cost funds that cannot compete in a fair market.

Thank you again, Mr. Chairman, for the opportunity to testify today. I look forward to continuing to work with this Committee as it considers reporting the Mutual Fund Reform Act to the full Senate for consideration.

—————

PREPARED STATEMENT OF SUSAN M. COLLINS

A U.S. SENATOR FROM THE STATE OF MAINE

MARCH 31, 2004

Chairman Shelby, Senator Sarbanes, and Members of the Committee, thank you

for inviting me to testify on legislation that I have introduced with Senators Fitzgerald and Levin, who have spent an enormous amount of time examining the complex issues involving mutual funds. Our bill, The Mutual Fund Reform Act, is a

comprehensive approach that contains many different proposals for strengthening

our system of mutual fund regulation. I commend the Committee for your work on

these issues that affect approximately 95 million investors who have invested more

than $7 trillion into mutual funds.

As the Committee on Governmental Affairs pursued its investigation of mutual

funds, I thought about a fundamental question. Why is it that in a society built on

competition, market forces do not drive down mutual fund fees? Why is it that the

legendary American consumer, who will search for the cheapest gas, clip newspaper

coupons, and take advantage of early bird specials, is oblivious to fees that can, over

time, affect his or her net worth by thousands of dollars? Why is it that mutual fund

fees seem more impervious to competitive forces than almost any other cost in our

society, surpassed, in this regard, perhaps only by college tuition?

I start with the basic notion that competition can only work when market participants have adequate information. If mutual fund investors do not fully understand

either the level of their fees or their impact on fund performance, competition lacks

one of its essential ingredients. Furthermore, if this is true of many mutual fund

investors, then we cannot expect the informed decisions of the majority to protect

the uninformed choices of the minority, as occurs in markets that are efficient. This

theory would suggest that the Government should act to improve either the amount

of fee information provided to investors or the clarity with which it is presented,

or both.

The most important reform that can be made, in my view, is to focus investors’

attention on the costs of owning mutual funds. For most investors, high mutual

fund expenses will cost them more than such abusive practices as ‘‘market timing’’

or ‘‘late trading.’’ For example, assume a worker chooses a mutual fund at the beginning of her career. Should she choose one with high returns in recent years and expenses of 1.5 percent? Or should she choose another with steadier, less spectacular

recent returns with only a 0.5 percent expense ratio? Unfortunately, there is a very

good chance that she will choose the former when choosing the latter would, by the

end of her career, have returned 35 to 40 percent more money in this particular

case.

We cannot enjoy the benefits of competition unless we have an efficient marketplace. And, an efficient marketplace requires that prices be both transparent and

easily accessible to investors. Currently, however, mutual fund expenses and fees

are often opaque and obscure. In contrast, historical performance is well known as

successful funds tout the past performance data that puts them in the best light

through large advertising campaigns.

The American Enterprise Institute’s Shadow Financial Regulatory Committee,

which is comprised of some of the top economists and financial experts in the country, recently stated:

998

Mutual fund expenses are an important determinant of investors’ actual returns. Though market fluctuations may swamp the impact of fund expenses on

short-run returns, such expenses become much more significant in determining

differential returns among funds over a number of years. Therefore, expense ratios are particularly important to long-term investors.

I recognize the impediments to calculating the true costs of mutual funds. Most

important, mutual fund trading costs, which funds pay to brokers when the fund

buys or sells securities for its portfolio, are not included in the expense ratio, which

is the most commonly used mutual fund cost metric.

Compounding this problem, there are many expenses that are bundled in with

these transactions, which means that even more mutual fund expenses never make

it into the expense ratio. They include research and related costs, which are purchased with so-called ‘‘soft dollars.’’ Another example is the practice of ‘‘directed brokerage,’’ by which trades are executed with certain brokers that sell the fund’s

shares, and are understood by both parties to be a form of compensation for such

sales. This practice, in essence, combines distribution costs with brokerage costs and

becomes a hidden 12b–1 fee.

The SEC made a good start in improving cost disclosure with its recent proposal

that mutual funds disclose their costs per thousand dollars invested in the funds’

shareholder reports. I believe, however, that Congress should go further. S. 2059, for

example, would require that personalized data be published on a shareholder’s account statement at least annually.

It is not enough to tell an investor how much his costs would have been had he

owned an amount of shares he does not actually own. Like a bank checking statement that tells a bank customer how much he or she was charged for individual

banking services, a mutual fund statement should tell an investor how much his or

her actual share of the fund’s fees were.

I realize, Mr. Chairman, that there would be costs to generating and reporting

personalized cost data to each mutual fund investor. Still, having reviewed work

done by the General Accounting Office (GAO), I have concluded that this disclosure

is warranted, just as it is in other types of financial records, such as checking account statements.

Specifically, using industry data, GAO calculated that, spread out over the vast

number of accounts, such disclosure would cost each fund account holder about 65

cents every year after a one dollar initial cost.

Also, I would urge the Committee to report mutual fund reform legislation as soon

as possible, so that it can be enacted prior to adjournment.

The Investment Company Act, which is the principal statute governing mutual

funds, was originally passed in 1940. As originally enacted, the Investment Company Act of 1940 was considered to be a weak law. It has not been significantly

amended since 1970. At 64 years of age, the law governing mutual funds is therefore approaching what we typically consider to be retirement age. Although I do not

think we need to retire the 1940 Act, leaving matters to the SEC alone would be,

in my view, an insufficient response to the recent revelations about wrongdoing in

the mutual fund industry.

This is not to slight the SEC’s recent activities. The SEC has taken many steps

to improve the oversight and regulation of the mutual fund industry. They include

new proposals regarding fund governance, broker compensation disclosure, and

many other facets of mutual fund regulation. The end result of all of this activity

will be a better-regulated and safer environment for Americans to invest in mutual

funds. Still, I want to urge the Committee to report mutual fund reform legislation

so that we can ensure that reforms endure regardless of who becomes future members of the SEC.

Since their earliest conception as 19th century English investment trusts, mutual

funds have been touted as allowing small investors access to the same advantages

enjoyed by larger and wealthier investors. What we have learned from practices

such as ‘‘late trading’’ and ‘‘market timing,’’ however, is that there has all too often

been two sets of rules—one for favored investors, and another for everyone else. Although American families continue to invest in mutual funds, their continuing trust

in them and our capital markets in general is not something that we can take for

granted. We must not only address abusive practices but also, arguably even more

important, excessive fees, and we must do so in a manner that maximizes investor

faith in the mutual fund industry.

Striking the right balance, Mr. Chairman, is the job of you and your colleagues

on this Committee. I wish you well in your efforts, as I believe that protecting our

Nation’s mutual fund investors is one of the most important tasks that your Committee could undertake this Congress.

999

PREPARED STATEMENT OF CARL LEVIN

A U.S. SENATOR FROM THE STATE OF MICHIGAN

MARCH 31, 2004

Chairman Shelby, Ranking Member Sarbanes, other Members of the Banking

Committee, thank you for inviting us here today to testify about what needs to be

done to tackle the abuses associated with the recent mutual fund scandals. Your series of hearings shows the same thoughtfulness and thoroughness that this Committee displayed in response to the corporate scandals of 2002, and, I hope, will also

result in sensible and meaningful reforms this year.

When Enron, WorldCom, Global Crossing, and other scandals exploded onto the

scene in late 2001 and early 2002, this Committee acted with deliberation, but it

also did not let these scandals fester. Within a year, you produced a bipartisan bill,

and moved it through the Senate. Enactment of the Sarbanes-Oxley Act of 2002 was

a proud moment for this Committee, for the Senate, and for the country.

With respect to mutual funds, 7 months have now passed since abusive practices

and allegations of wrongdoing came to light. Late trading, market timing, hedge

fund favoritism, hidden fees, and other abuses have sullied an industry. These mutual fund abuses should not be allowed to infect investor confidence. With your leadership, Congress will again act decisively to restore investor confidence in what has

been a powerful source of investment capital for the markets and a critical source

of savings for millions of average American families.

I want to recognize and acknowledge the important enforcement and regulatory

actions already taken by the SEC. These actions have sent a message to wrongdoers

seeking to take advantage of mutual fund investors. But as much as the SEC has

done, it doesn’t have the authority to undertake certain key mutual fund reforms.

Congress should strengthen the hand of the SEC by taking a stand on these issues

and placing mutual fund reforms in statutory law. Over 95 million Americans now invest more than $7 trillion in mutual funds.

These investors deserve complete and accurate information about mutual fund costs

so they can make informed decisions and comparison shop to find well-run, efficient

mutual fund products. They need to have confidence that the fees they pay are legitimate. They also deserve to know that the persons advising them relative to their

investments are exercising independent and objective judgments.

Unfortunately, significant conflicts of interests in the industry today have undermined confidence in some of the investment advice being offered on the market. It

is essential that we act to eliminate these conflicts. The Mutual Fund Reform Act,

which was introduced in February by Senators Fitzgerald, Collins and me, zeroes

in on, among other things, the conflicts of interest problem. And it takes the approach of banning rather than simply disclosing unacceptable conflicts of interest

that undermine public confidence in the mutual fund market.

Disclosure is not enough to address the conflicts problems in the mutual fund

field. Complicated disclosures of such practices as revenue sharing and directed brokerage would, I am afraid, confuse and overwhelm average investors. Just look at

what disclosure has done to our telephone bills — there are pages of information,

but the sheer length and amount of unfamiliar data make it virtually impossible

to decipher.

Mutual fund data is even more complex than long distance and local call data,

and it unlikely that meaningful disclosures can be designed to educate investors and

stamp out conflict of interest abuses.

The conclusion our bill reaches is that a disclosure-only regime is not enough.

Mere disclosure also blurs a key point: The conflicts are not acceptable—period. Instead, we prohibit those practices that embody conflicts of interest and undermine

confidence in the market. I would like to briefly touch on a few of the conflicts of

interest that our bill has determined need to be ended, not continued under a cloak

of disclosure, if we are to act forcefully to restore confidence in the mutual fund industry.

Revenue Sharing

A key conflict of interest targeted by our bill is a practice known as revenue sharing. Revenue sharing occurs when a mutual fund manager pays a broker to promote

the mutual fund to the broker’s clients. This payment creates a clear conflict of interest by throwing in a new factor for an investment advisor to consider—his or her

company’s own financial profit—when deciding which mutual funds to recommend

to an investor. The SEC recently conducted a review of the 15 largest Wall Street

brokerage firms to determine the extent of revenue sharing between those firms and

various mutual funds. It found that 14 of the 15 brokerage firms received payments

from mutual funds in exchange for steering their clients toward those funds.

1000

The SEC and the National Association of Securities Dealers (NASD) have proposed addressing this issue by requiring brokers to disclose revenue sharing payments to their clients at the time of purchase. But disclosure is not enough. Even

if an investor is clearly told that his or her broker is getting paid to promote a mutual fund, the investor is left wondering whether the broker’s recommendation is

based on the mutual fund’s merits or the broker’s financial benefit. Disclosure does

not resolve the conflict; it allows revenue sharing payments to continue to undermine objective investment advice. The better course of action is to ban revenue sharing from the mutual fund marketplace.

Directed Brokerage

A second conflict of interest targeted by our bill is directed brokerage. In directed

brokerage, a mutual fund typically promises to buy a certain amount of brokerage

services from a broker-dealer who agrees to promote that mutual fund to investors.

Like revenue sharing, this practice undermines objective investment advice, to the

detriment of average investors. To its credit, the SEC has already proposed prohibiting, rather than just disclosing, directed brokerage. Our bill would provide the

SEC’s proposed ban with a statutory basis, helping the SEC to remove another

cloud over the objectivity of investment advice.

Independent Directors

A third conflict of interest I want to mention today involves mutual fund directors. Recent scandals have disclosed a number of problems with mutual fund boards

of directors. In some cases, the same person is the chairman of the board of both

the mutual fund and the fund manager, meaning that when fees are negotiated, the

same person is on both sides of the table. In other cases, close relations between

a mutual fund’s board members and its management company leads to lax oversight

and a misplaced reliance on the managers to protect shareholder interests. Shareholders are best represented when board members engage in active oversight and

arms-length negotiations with management over expenses and investment decisions.

The SEC has already proposed requiring that 75 percent of each mutual fund board

members be independent from the fund’s management, for example the people who

set up the fund, and that an independent chairman sit at the helm. Our bill would,

again, strengthen the SEC’s position.

Mutual Fund Expense Disclosures

I want to mention one other topic, the importance of enacting legislation establishing a standard for calculating and disclosing mutual fund expenses that includes

all material costs. The current ‘‘expense ratio’’ calculation allows funds to leave out

key transactional expenses like brokerage commissions, which means that investors

cannot accurately comparison shop to find well-run, low-cost mutual fund products.

Just like grocery shelf price tags give a ‘‘price per ounce’’ so shoppers can assess

the price savings between different brands and sizes, investors should have access

to a cost ratio that includes all expenses and allows easy and accurate comparisons

between mutual funds. Expense disclosures that are comprehensive, easy to understand, and easy to compare are critical to creating a vibrant and fair mutual fund

market and guaranteeing investors access to the information they need to make informed choices.

Mutual funds are a $7 trillion engine of growth for our economy and investment

of choice for many average Americans. I urge this Committee to act decisively and

to act this year so the Senate can consider meaningful investor protections and help

restore the confidence needed to keep this mutual fund engine humming.

—————

PREPARED STATEMENT OF DANIEL K. AKAKA

A U.S. SENATOR FROM THE STATE OF HAWAII

MARCH 31, 2004

Thank you, Chairman Shelby and Ranking Member Sarbanes, for the opportunity

to participate in today’s hearing.

Mutual fund reform is important because 95 million people have placed a significant portion of their future financial security into mutual funds. Mutual funds provide middle-income Americans with an investment vehicle that offers diversification

and professional money management. Mutual funds are what average investors rely

on for retirement, savings for children’s college education, or other financial goals

and dreams.

1001

On November 5, I introduced S. 1822, the Mutual Fund Transparency Act of 2003.

I believed that legislation was necessary to bring about structural reform in the

mutual fund industry, increase disclosures in order to provide useful and relevant

information to mutual fund investors, and restore trust among investors. I was appalled by the flagrant abuses of trust among mutual fund companies.

I commend the SEC for its proposals to improve the corporate governance of mutual funds and to increase the transparency of mutual fund fees that investors pay.

The proposed requirements for an independent chairman for mutual fund boards,

increased percentage of independent directors to 75 percent, and development of a

confirmation notice so that investors will be able to know how their broker gets paid

in mutual fund transactions are a solid and measured response to the litany of

transgressions which have undermined public confidence in the mutual fund industry. These provisions mirror those in my legislation. In addition, I have been impressed with the SEC’s attempts to address point-of-sale disclosure.

However, I continue to believe that legislation is necessary to codify some of the

proposed regulations so that the reforms will not be rolled back in the future. It is

also important to legislatively address areas where the SEC needs additional statutory authority to address problems and abuse in the mutual fund industry. Mr. Mercer Bullard, in his testimony before this Committee, indicated that the ‘‘Commission’s proposal does not effectively require fund boards to be 75 percent and have

an independent chairman’’ because the rules would only apply to funds that rely on

one or more of the exemptive rules. This means that these rules would not apply

to all funds. Legislation is necessary to ensure corporate governance improvements

apply these rules universally among mutual funds. Finally, additional legislation

may be necessary if disclosures of revenue sharing agreements and portfolio transaction costs are not adequately addressed by the Commission.

S. 1822 includes a number of provisions that are important for Congress to enact.

Boards must be strengthened and more independent to be more effective. Investment company boards should be required to have an independent chairman, and

independent directors must have a dominant presence on the board. My bill

strengthens the definition of who is considered to be an independent director. It also

requires that mutual fund company boards have 75 percent of their members considered to be independent. To be considered independent, shareholders would have

to approve them. In addition, a committee of independent members would be responsible for nominating members and adopting qualification standards for board

membership. These steps are necessary to add much needed protections to strengthen the ability of mutual fund boards to detect and prevent abuses of the trust of

shareholders.

My bill will also increase the transparency of often complex financial relationships

between brokers and mutual funds in ways that are meaningful and easy to understand for investors. Shelf-space payments and revenue-sharing agreements between

mutual fund companies and brokers present conflicts of interest that must be addressed. Shelf-space and revenue sharing agreements present risks to investors.

Brokers have conflicts of interest, some of which are unavoidable, but these need

to be disclosed to investors. Without such disclosure, investors cannot make informed financial decisions. Investors may believe that brokers are recommending

funds based on the expectation for solid returns or low volatility, when the broker’s

recommendation may be influenced by hidden payments. S. 1822 will require brokers to disclose in writing, to those who purchase mutual fund company shares, the

amount of compensation the broker will receive due to the transaction, instead of

simply providing a prospectus. The prospectus fails to include the detailed relevant

information that investors need to make informed decisions. Prior to their recent

rulemaking, the SEC exempted mutual funds from Rule 10b–10, which requires that

confirmation notices of securities transactions be sent to customers to indicate how

the broker was compensated in the trade. My legislation would prevent the exemption of mutual funds from confirmation notice requirements.

To increase the transparency of the actual costs of the fund, brokerage commissions must be counted as an expense in filings with the SEC and included in the

calculation of the expense ratio, so that investors will have a more realistic view

of the expenses of their fund. Consumers often compare the expense ratios of funds

when making investment decisions. However, the expense ratios fail to take into account the costs of commissions in the purchase and sale of securities. Therefore, investors are not provided with an accurate idea of the expenses involved. Currently,

brokerage commissions have to be disclosed to the SEC, but not to individual investors. Brokerage commissions are only disclosed to the investor upon request. My bill

puts teeth into brokerage commission disclosure provisions and ensures commissions will be included in a document investors actually have access to and utilize.

1002

The inclusion of brokerage commissions in the expense ratio creates a powerful

incentive to reduce the use of soft dollars. Soft dollars can be used to lower expenses

since most purchases using soft dollars do not count as expenses and are not calculated into the expense ratio.

There have been calls for the prohibition of soft dollars. This is a recommendation

that needs to be examined. However, my bill provides an immediate alternative,

which is an incentive for funds to limit their use of soft dollars by calculating them

as expenses. If commissions are disclosed in this manner, the use of soft dollars will

be reflected in the higher commission fees and overall expenses. This makes it easier for investors to see the true cost of the fund and compare the expense ratios of

funds.

Some may argue that this gives an incomplete picture and fails to account for

spreads, market impact, and opportunity costs. However, the SEC has the authority

to address the issue further if it can determine an effective way to quantify these

additional factors. My bill does not impose an additional reporting requirement that

would be burdensome to brokers. It merely uses what is already reported and presents this information in a manner meaningful to investors.

One of the provisions in my bill requires the SEC to conduct a study to assess

financial literacy among mutual fund investors. This study would identify the most

useful and relevant information that investors need prior to purchasing shares,

methods to increase transparency of expenses and potential conflicts of interest in

mutual fund transactions, existing efforts to educate investors, and a strategy to increase the financial literacy of investors that results in positive change in investor

behavior. This study is necessary because any additional disclosure requirements for

mutual funds will not truly work unless investors are given the tools they need to

make smart investment decisions, and we must first know what education exists.

I look forward to working with my colleagues and the SEC to address problems

identified in the mutual fund industry.

1003

1004

1005

1006

1007

1008

1009

1010

1011

1012

1013

1014

1015

1016

1017

1018

1019

1020

1021

1022

1023

1024

1025

1026

1027

1028

1029

1030

1031

1032

1033

1034

1035

1036

1037

1038

1039

1The Securities Industry Association, established in 1972 through the merger of the Association of Stock Exchange Firms and the Investment Bankers Association, brings together the

shared interests of nearly 600 securities firms to accomplish common goals. SIA member-firms

(including investment banks, broker-dealers, and mutual fund companies) are active in all U.S.

and foreign markets and in all phases of corporate and public finance. According to the Bureau

of Labor Statistics, the U.S. securities industry employs more than 800,000 individuals. Industry

personnel manage the accounts of nearly 93 million investors directly and indirectly through

corporate, thrift, and pension plans. In 2002, the industry generated $222 billion in domestic

revenue and $304 billion in global revenues.

PREPARED STATEMENT OF CHET HELCK

PRESIDENT, RAYMOND JAMES FINANCIAL, INC.

MARCH 31, 2004

Introduction

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee. I

am honored to address the Senate Banking Committee concerning a subject that I

believe is crucial to the welfare of American investors and our Nation’s securities

markets, as well as the industry and regulators who support these markets.

I am Chet Helck, the President and Chief Operating Officer of Raymond James

Financial. Raymond James provides financial services to individuals, corporations,

and municipalities through its 5,000 financial advisors throughout the United

States and internationally. I am also privileged to represent my firm on the Board

of Directors of the Securities Industry Association (SIA) and to testify today on behalf of Raymond James and on behalf of SIA.1

While I represent a securities firm that serves hundreds of thousands of investors,

I am also speaking to you as an experienced financial advisor who has spent more

than 20 years providing counsel and services to help individuals take care of their

families and realize their financial objectives. Through these experiences, I have

witnessed the dramatic impact that knowledgeable advisors who are supported by

effective resources can make on their clients’ lives. My experience has taught me

full-well that investors’ trust and confidence is a hard-earned, precious, and essential asset, on which our business is built. Abuses that undermine investor trust and

confidence must be met with tough and firm regulatory action. At the same time,

my perspective makes me concerned that proposed mutual fund reforms not have

unintended consequences that could ultimately degrade the infrastructure that

makes it possible for these relationships to thrive—to the detriment of the investing

public, and particularly the small investor.

Importance of Professional Advice to the Investing Public

Most Americans realize that they can no longer depend on one lifelong job or an

employer’s pension to provide them with a secure retirement. They know that they

must develop meaningful savings during their working days and then establish an

investment plan to create a revenue stream to sustain them over retirement. Planning for education and health care costs represents similarly daunting financial

challenges. For most of us, even if there were no other mitigating factors complicating these planning processes, creating these types of investment plans would be

overwhelming.

It is against this backdrop that I suggest that most Americans need financial advice more than ever before. Indeed, many investors have learned to truly value professional financial advice during these difficult times. Even some securities firms

that traditionally served only self-directed investors have recently recognized this

need and established lines of business to provide advice.

I believe that our current system, which provides investors with the ability to engage professional advisors for financial guidance, works well for millions of Americans and I also believe that mutual funds play a critical role in the financial plans

of millions. For that reason, we should all be concerned about instances of illegal

conduct occurring in some funds. For the same reason, it is important that proposals

for fundamental changes to this system avoid unintended consequences that could

harm individual investors and also weaken the financial markets that help make

our free enterprise economy so strong.

In my capacity as a member of SIA’s Board of Directors, I appreciate that many

SIA member firms follow a different business model, encouraging investors to make

investment choices on their own. I respect that alternative and certainly believe in

competition—that is the American way. But my own career and my firm are dedicated to the idea that financial consultants can add great value by helping investors

make intelligent choices when confronted with so many investment alternatives.

1040

2http://www.sia.com/research/pdf/equitylowners02.pdf. 3 Id.

4http://www.federalreserve.gov/releases/Z1/Current.

5For equity market capitalization (combined New York Stock Exchange and Nasdaq) see

http://www.nyse.com/pdfs/mmv1204.pdf; http://www.marketdata.nasdaq.com/daily/daily

2004.xls; For mutual fund data see http://www.ici.org/stats/latest/trendsl01l04.html#TopOf

Page.

Mutual Funds and the American Investing Public

The focus of your deliberations is the compensation structure for the services associated with selling mutual funds, and the advisory and administration services required to support investors in the purchase of mutual funds. We believe that mutual

funds are, and will continue to be, a basic investment vehicle for most Americans.

In spite of the barrage of recent bad press concerning these investments, mutual

funds are the vehicle by which an overwhelming majority of investors participate

in our markets. Mutual funds offer investors an inexpensive way to share in the

benefits of owning stocks and bonds and a method for diversifying a relatively small

investment, thereby managing their risk exposures. And they allow investors to

benefit from professional management of their invested dollars. For these reasons,

mutual funds are extremely popular products for small investors, as well as for retirement plans such as 401(k) plans.

Overall, 49.6 percent of all households in the United States own mutual funds directly or through a retirement account.2 As of January 2002, 89 percent of U.S. equity investors owned stock mutual funds, and 51.5 percent of equity investors held

stock only mutual funds.3 Twenty-six percent of all household liquid financial assets

were in mutual funds as of the end of 2003.4

The health of our capital markets depends to a great extent on the public’s continued robust participation in mutual funds. As of January 2004, equity mutual funds

had a market capitalization of $3.8 trillion dollars, roughly 25 percent of the total

capitalization of our equity markets.5

Retail investors put their trust in the integrity of mutual fund managers and advisers, as well as in the financial advisors who assist in their investment decisions

and the broker-dealers that implement their trade orders. It is certainly troubling

that recent events have severely damaged the reputation of mutual funds and their

management companies, as well as those who participate in their distribution. I

know that all of us in the industry firmly believe that abuses such as insider trading should be rooted out and punished wherever it occurs—whether at high profile

public companies, at broker-dealers, or at mutual funds. Abuse of fiduciary responsibilities should be condemned and, where appropriate, punished. And we also recognize that, as I shall discuss in a few moments, better disclosure of mutual fund

compensation practices can be helpful to investors and should be required.

In order to restore public trust and confidence in mutual funds and their distributors, the interests of investors must come first. Investors must be assured that

fraud, self-dealing, and dishonesty will not be tolerated. Investors should be treated

fairly, and should be given clear and useful information about the funds they buy.

Fund fee structures, financial support offered to intermediaries, fund investment,

and redemption policies—all should be as transparent and meaningful as possible.

When an investor seeks investment advice, the financial advisor should recommend

mutual funds that are suitable in light of an investor’s objectives. And all investors

should be assured of prompt execution and fair pricing of their mutual fund transactions.

But public trust is a fragile thing. This Committee, and the regulatory community, can either work to restore it—or can diminish that public confidence even further by actions that ultimately detract from that trust. We are confident that this

Committee, along with other policymakers, will choose wisely and strengthen the viability of these products and the vital distribution systems that bring them to investors’ doorsteps. The recent scandals have presented a serious challenge to all of us

who believe that funds serve investors well. We must face these challenges forthrightly and seek thoughtful and workable solutions that will protect investors’ interests. This Committee and the regulatory community must help restore public

confidence by rooting out instances of wrongdoing, without diminishing the basic

value of mutual funds or of the advisory structure that has grown up around it. Because mutual funds are good investment planning solutions for most Americans—

particularly those who are of modest means—anything that unfairly undermines

their confidence in funds or makes it more difficult to provide meaningful advice

concerning them would be a disservice to the investing public.

1041

6SEC Division of Investment Management, Protecting Investors: A Half Century of Investment

Company Regulation, at 322 (1992) (Protecting Investors Study), citing SEC Division of Investment Management, Regulation, Mutual Fund Distribution, and Section 22(D) of the Investment

Company Act of 1940, at 19, 20–22 (1974) (1974 Distribution Report).

Compensation for Mutual Fund Sales

As with any product, there are costs associated with distributing and servicing

mutual funds. As mutual funds types have proliferated—a result of vigorous competition and innovation—selling arrangements for funds have expanded as well.

Because selling arrangements have raised particular concerns, we address several

aspects of these arrangements.

Forms of Compensation

Broker-dealers receive payments in connection with sales of mutual funds, unit

investment trusts, municipal fund securities, variable annuity contracts, and variable life insurance policies (collectively, funds) from a variety of sources. Some payments are made by the funds themselves or by investors when they buy or sell fund

shares. Other payments may be made by investment advisers, fund distributors, or

other fund affiliates; and some broker-dealers charge investors directly for their

services through the medium of fee-based accounts.

In addition to these various sources, broker-dealers may receive payments in several different ways. Some payments may represent hard-dollar payments from funds

and investors (encompassing sales loads and 12b–1 fees). Other payments may represent hard-dollar payments from fund affiliates (commonly known as revenue sharing). Still other payments may be made in the form of commission payments on fund

portfolio brokerage transactions (often referred to as directed brokerage).

Some observers believe that fund payments, directed brokerage, and revenue

sharing are simply ‘‘taxes’’ that broker-dealers impose upon funds and their affiliates, and that all such payments go straight to the broker-dealers’ bottom lines.

However, these arrangements are necessary to enable broker-dealers to support the

administrative costs associated with fund sales and investor reporting, and provide

more comprehensive investor services such as financial planning, total portfolio review, and performance reporting that investors have come to expect.

In recent years, broker-dealers have been handling functions that mutual fund organizations previously might have performed exclusively. This shift in function has

provided many operating efficiencies and benefits to investors, including consolidation of investments within a single financial services organization, and easier access

to investment services. Revenue-sharing payments often help reimburse broker-dealers for some of the following expenses associated with processing fund transactions

and maintaining customer accounts:

• Customer sub-accounting.

• Mailing trade confirmations, prospectuses, and other disclosure documents.

• Comprehensive tax reporting.

• Maintaining information websites.

• Implementing changes initiated by funds, including revising systems and procedures and communicating changes to financial advisors and customers.

• Overseeing and coordinating fund wholesaler activities at the firm.

To the extent that the services are performed by the broker-dealer, instead of the

fund, investors are not paying more. For example, there is a cost to maintaining an

accurate shareholder record—whether the fund’s transfer agent performs that function or the fund delegates that responsibility to the broker-dealer.

In addition, broker-dealers use revenue-sharing payments to fund other activities,

such as educational seminars for their financial advisors and their clients about the

different funds they consider. These activities make the financial advisors more

knowledgeable about the funds and can help them tailor their recommendations

more effectively. SIA members offer a broad spectrum of fund choices—ranging from

offering perhaps a few families of funds to thousands of different share classes. But

regardless of how many mutual funds a broker-dealer sells, it is in investors’ best

interest if the broker-dealer’s financial advisors are well acquainted with those

funds and can help their customers choose wisely. Revenue sharing contributes significantly to that goal.

12b–1 Fees

The SEC adopted Rule 12b–1, which permitted mutual funds to use their assets

to pay for distribution, as long as the fees were disclosed and regulated.6 Since Rule

12b–1 was adopted, more than half of all mutual funds have enacted Rule 12b–1

plans, using these charges, alone or with sales loads, as the primary means of fiVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01053 Fmt 6601 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
1042

7Protecting Investors Study, at 320.

8 Id.

9See Id., at 330. 10 Id., at 331. 11 A CDSC is a sales load paid by investors upon redemption that declines over the period

of a shareholder’s investment. So-called B shares typically feature a combination of Rule 12b–

1 fees ranging from 0.50 percent to 1.00 percent of the average daily net assets of a mutual

fund attributable to the B shares (annualized), and CDSC’s in lieu of front-end sales loads, while

so-called A shares typically feature front-end sales loads and Rule 12b–1 fees of no more than

0.25 percent of the average daily net assets of the mutual fund attributable to the A shares

(annualized). However, the NASD has taken enforcement actions against broker-dealers who

have sold B shares to individuals in instances in which A shares would have been an economically superior investment. See, for example, McLaughlin, Piven, Vogel Securities, Inc. (MPV)

(press release available at http://www.nasdr.com/news/pr2003/releasel03l027.html).

nancing distribution.7 Other mutual funds have added a relatively modest Rule

12b–1 fee to pay for some sales commissions, printing prospectuses and sales literature, advertising, and similar expenses.8 It is important to note that while Rule

12b–1 was intended to assist no-load mutual funds to finance their distribution expenses, the vast majority of load mutual funds have adopted Rule 12b–1 plans as

a complement to, or a substitute for, a front-end sales load.

The impact of these fees has been positive. They have allowed funds to reduce

front-end sales charges. They have contributed to development of longer holding periods and a more stable investment profile for clients. And, because they are paid

over an extended period of time, they promote a continuing relationship, encouraging the financial advisors to offer continued service over a period of time.

Mutual Fund Share Classes

Sometimes lost in the discussion of mutual fund fees is the fact that the fund industry also created a number of share classes. The wide variety of share classes

available today affords investors a variety of options for compensating advisors for

their services. Advisors and clients can select fund classes to establish a compensation arrangement that is consistent with clients’ objectives, time horizons, and

personal preferences. Each class of a multiple class fund must have a different arrangement for shareholder services or distribution or both, and must pay all of the

expenses of that arrangement. Some multiple class funds enter into arrangements

whereby particular classes of fund shares are sold to specific institutional investors,

such as banks acting in a fiduciary, advisory, agency, custodial, or similar capacity

on behalf of customer accounts, insurance companies, investment counselors, brokers, or other financial institutions.9

Multiple class funds also permit investors to select the method of financing distribution best suited to their investment horizon and the size of their investment.10

Some investors may wish to pay a front-end sales load, whereas others may wish

to avoid paying a front-end sales load, and are willing to pay a Rule 12b–1 fee and

contingent deferred sales charge (CDSC) instead.11

As the type and level of mutual fund charges began to change, the NASD revised

its rules governing the level of mutual fund sales loads and distribution fees to provide consistency of approach and fairness to investors (NASD Conduct Rule

2830(d)).

Brokerage and ‘‘Soft-Dollar Payments’’

When Congress enacted Section 28(e) of the Securities Exchange Act of 1934, it

recognized the need for money managers to obtain research from a wide range of

sources. Section 28(e) permits money managers to pay for research and related services through commission (soft) dollars rather than paying for them in cash. Such research helps money managers, including fund managers, do a better job of serving

their customers.

Eliminating this source of research dollars would be contrary to investors’ interests. Research improves the quality of markets by helping money managers channel

capital to the most promising companies. Research analysts challenge companies to

explain their business models and their record of results. Reducing research dollars

would mean the elimination of research on certain types of companies. Reducing research dollars could therefore adversely affect the ability of smaller, newer companies to obtain financing for their activities. We all know that new businesses create

the most jobs in America; raising their cost of capital hurts everyone.

Some have urged that research is not a legitimate expense for investors to bear

through ‘‘soft-dollar’’ payments made in the form of trades placed by broker-dealers

on behalf of the fund company. Over the years, the SEC has monitored the use of

soft dollars by the industry. We believe that few abuses have been found and, in

general, soft dollars have proved to be proinvestor and procompetitive, because they

1043

12We note that one objective of last year’s global research settlement was to require investment banks to fund independent research. 13Market forces also may affect how investment advisers buy execution and research services

from broker-dealers and third-party providers. 14 Confirmation Requirements and Point-of-Sale Disclosure Requirements for Transactions in

Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments,

and Amendments to the Registration Form for Mutual Funds, Release Nos. 33–8358; 34–49148;

IC–26341; http://www.sec.gov/rules/proposed/33–8358.htm. 15Prohibition on the Use of Brokerage Commissions to Finance Distribution, Release No. IC–

26356; http://www.sec.gov/rules/proposed/ic–26356.htm. 16SIA notes that many firms take different approaches to disclosure and we do not mean to

suggest that other approaches are inadequate.

increase competition among money managers, encourage independent research, and

give investors more choices.

We believe that research, whether from the broker-dealer, or a third party, contributes to the effort to identify better investments. Third-party research is a valuable resource to money managers because it provides managers with ideas and

insights that otherwise might be overlooked; and any ban on soft dollars is likely

to diminish independent research.12 Consequently, we believe that any movement

to abolish soft dollars or to prohibit the use of soft dollars to obtain independent

research would adversely affect the quality of the research available to money managers, which would ultimately harm investors.13

Raymond James and its Mutual Fund Expenses

Let me give you some examples of what costs are supported at Raymond James.

At Raymond James, we sell over 11,000 mutual fund share classes, offered by over

200 fund companies. During fiscal year 2003, the total cost to our firm for providing

the administrative support for mutual fund sales was approximately $30 million.

These payments also help fund our Mutual Fund Research Department, which analyzes the universe of mutual fund offerings to generate a recommended list of mutual funds that we consider to have superior prospects. And that list has nothing

to do with our receipt of ‘‘revenue sharing’’ payments; there are mutual funds on

that list from whom we receive no payments, and there are funds from which we

receive payments that are not on that list.

In addition to administrative support and research, we are required to provide

educational programs for our financial advisors to help them deal with the complexities and regulatory requirements involved in making effective use of mutual funds

in client financial planning. During the past 12 months, on major regional and national educational conferences we spent well over $7 million. Many of the sessions

in these conferences qualified for continuing education credit by regulators, CFP and

CPA societies and others. These are serious substantive courses that improve the

effectiveness of our financial advisors and better equip them to help clients face the

issues that they must face.

All of these costs and programs are supported by the payments that we receive

from mutual fund companies and their managers in all the forms that we have discussed: Sales loads, revenue sharing, and directed brokerage. In our view, it is entirely reasonable that the fund complexes sponsoring these mutual fund families

should help defray the expense of educating our financial advisors about their particular products. The net result of this effort is that our financial advisors have a

much deeper understanding about the products that they sell and can be of much

greater help to their clients in making investment choices. Why would anyone want

to dismantle a system that provides such advantages to investors?

Full Disclosure—But Meaningful and Cost-Effective Disclosure

The Securities and Exchange Commission has proposed new confirmation rules

that would require brokers, dealers, and municipal securities dealers to provide customers with information about distribution-related costs that investors incur when

they purchase those types of securities, as well as disclosure of other distributionrelated arrangements. Furthermore, it has proposed new point-of-sale disclosure

rules that would require brokers, dealers and municipal securities dealers to provide

point-of-sale disclosure to customers about costs and conflicts of interest.14 (The

SEC has also proposed rule amendments that would prohibit funds from using portfolio brokerage commissions to pay for the cost of distributing their shares.15)

Raymond James has been an industry leader with respect to client disclosure of

mutual fund sales and compensation.16 Our long-form confirmation discloses a comprehensive range of relevant information, including many items currently being proposed by the SEC. These include:

• How the sales charge was computed.

1044

• Information regarding possible discounts to which the customer may be entitled. • Information regarding other available sales classes. • The fact that Raymond James may be receiving compensation in the form of revenue sharing from the fund or its management company.

In addition, ever since 1994, Raymond James has produced a pioneering document

entitled ‘‘Your Rights and Responsibilities as a Raymond James Client.’’ Each client

receives one, and it is available on our website. There, we provide additional comprehensive information regarding how mutual funds are distributed, the different

options for purchase, and the existence of revenue sharing arrangements that result

in payments to Raymond James.

It is from this perspective that we are comfortable in supporting clear, concise,

and meaningful disclosure of compensation practices, including those we have discussed in this paper. The SEC has proposed such disclosure and we, along with others in the industry, will be submitting our thoughts as to how these disclosures can

be made meaningful and useful, without at the same time imposing excessive costs

on the industry, costs which are ultimately borne by the investing public.

Briefly, we believe that additional disclosure to investors about revenue sharing

is useful; but we believe that there are better ways to provide relevant information

without imposing excessive costs that investors ultimately have to bear—and without distracting them from other important information. Raymond James, along with

other firms and SIA, are busy working on our suggestions for improvement, so I

cannot give you all our comments right now—the proposal runs to over 120 pages

with over 200 footnotes. But from Raymond James’s perspective, we would like to

make two suggestions regarding this proposal:

1. It is time for the SEC to move away from paper disclosure—the proposal

itself indicates the annual printing costs will add more than a billion dollars

a year to the cost of mutual fund sales, ultimately to be borne by the investors.

Let us enter the 21st century and put as much as possible of the important disclosures on our websites, where investors can access them readily—and have

our confirmations refer the investors to our websites. For those clients who do

not have computer access, our confirmation forms can give them the phone

number to request a copy of the information on the website.

2. Don’t require transaction-by-transaction breakdown of revenue sharing payments—it would require extraordinary programming costs that again would be

borne by investors. Instead, let us use hypothetical examples of the costs that

would be borne by investors at different purchase levels: say $10,000, $50,000,

and $100,000. That should be enough to give every purchaser a sense of the impact on his investment of these costs.

I am sure that we will have other comments, but I think that should give you

a sense of the direction we are trying to move: Provide relevant information, but

do it in a cost-effective and concise way.

We believe that the SEC has all the power and authority necessary to provide for

this kind of disclosure and we would urge that they exercise that authority responsibly. Their active rulemaking agenda and enforcement docket indicates that they

are not shy about using the authority that Congress granted to them.

However, we believe that full and clear disclosure, rather than complex over-regulation of payment structures or levels, is the best way to approach fund payments

to broker-dealers. We further believe that, with better disclosure, many of these

issues can be resolved through the working of the competitive marketplace. So long

as fund investors and their financial advisors receive clear information regarding

compensation practices, they will be able to choose from the universe of products

those that are consistent with their objectives and suitable for their investment

goals at a reasonable cost. We hope to work with the Commission to develop disclosure that is meaningful, relevant, and cost effective.

Conclusion

America has changed from a Nation of savers to a Nation of investors. At Raymond James, we believe very strongly that a large number of Americans need access

to professional investment advice. A majority of our citizens can now be counted

among the investing population, and we know that many of these investors place

a significant value on consulting with a financial advisor in planning for their futures. If compensation and payments to broker-dealers are fully disclosed in a manner that is meaningful to the investor, investors can determine whether or not that

compensation is fair and acceptable. This decisionmaking process is greatly facilitated by the fact that we operate in a competitive industry that currently presents

investors with a range of choice concerning not only products, but also varying models of service that allow investors to choose the level of advice they prefer.

1045

Because we believe that investor protection is paramount to the future of the financial markets and our country’s economic well-being, we recommend that disclosure and structural reform efforts should aim to ensure that:

• Fund shareholders are able to readily access meaningful information about the

costs they incur, the various types of payments received by the distributors of

funds, including broker-dealers and the nature of the services being provided; • Competitive forces, not Government fiat, set appropriate levels of compensation,

whether through fund payments, directed brokerage, revenue sharing, or other

structures; and • Investors are presented with the broadest possible array of fund choices.

Above all, we believe that it is critically important for Congress, regulators, selfregulators, State officials, the mutual fund industry, and the securities industry to

work together to restore the trust and confidence of investors in mutual funds as

a product, and in those who are committed to providing advice and service to those

investors in how to make the best use of that product.

Thank you for your attention.

—————

PREPARED STATEMENT OF THOMAS O. PUTNAM

FOUNDER AND CHAIRMAN

FENIMORE ASSET MANAGEMENT, INC./FAM FUNDS

MARCH 31, 2004

Introduction

My name is Thomas O. Putnam. I am the Founder and Chairman of Fenimore

Asset Management, a small investment advisory firm in rural upstate New York.

Fenimore has been in business for 30 years and currently has 30 employees and

more than $1 billion in total assets under management. At Fenimore, we manage

structured portfolios for about 400 individual and institutional clients throughout

the United States.

Fenimore also serves as investment adviser to the FAM Funds, a registered mutual fund company offering two investment portfolios with combined assets of approximately $700 million. Each fund has two classes of shares: The investor class,

which is no load and is sold directly by Fenimore, and the advisor class—new as

of July 2003—which is sold through intermediaries. I serve as co-portfolio manager

for each of the mutual funds and also as Fenimore’s Director of Research. In addition to my varied duties at the firm, I also serve as Chair of the Small Funds Committee of the Investment Company Institute (ICI).

I am honored to participate in today’s hearing on regulatory actions regarding the

mutual fund industry and, in particular, fund costs and distribution practices. My

testimony will focus on the role of small fund groups in the mutual fund industry

and the impact of regulatory reforms on small fund groups. I will also offer the

Committee my thoughts on some of the specific reform proposals that have been advanced.

Let me begin, however, by expressing my deep disappointment about the events

that have brought us together today. Investors’ trust in the entire mutual fund industry has been shaken—and rightly so—by the revelations of wrongdoing that have

unfolded over the past several months. That some industry participants would so

blatantly disregard their fiduciary duties is both shocking and abhorrent to me.

Clearly, there is no place in our industry for this kind of behavior, and I am pleased

that the SEC and State regulators have moved quickly to investigate and punish

those responsible.

Enforcement actions are just part of what is needed to ensure that the interests

of mutual fund investors are fully protected going forward. I applaud the SEC’s

swift action on regulatory reforms to address the abuses we have seen with respect

to late trading and market timing and to place much greater emphasis on fund compliance efforts, which will help to detect and prevent future wrongdoing. I am particularly pleased that certain of the SEC’s proposals build in flexibility that may be

useful to small funds, rather than taking a one-size-fits-all approach (for example,

ensuring that independent directors have the authority, but are not required, to hire

staff).

This Committee also has played an important role by thoroughly examining the

recent scandals and thoughtfully considering what steps are necessary in response.

Finally, mutual fund firms themselves must continue to embrace reforms that will

protect investors, who have placed their savings and their trust in the industry.

1046

1See Statement of Mellody Hobson, President, Ariel Capital Management, LLC and Ariel Mutual Funds, Review of Current Investigations and Regulatory Actions Regarding the Mutual

Fund Industry: Fund Operations and Governance, Before the Committee on Banking, Housing,

and Urban Affairs, U.S. Senate, 108th Cong., 2nd Sess. (February 26, 2004), at 1–2.

With all that said, however, I must tell you that I have some serious concerns

about the possible scope of this reform effort. Several of the pending legislative proposals, for example, contain provisions that go well beyond the abuses that have

been uncovered and, if enacted, could substantially change the face of the industry.

Even reforms that are more squarely focused on the abuses could, if drafted too

broadly, impose considerable costs on individual fund groups and, ultimately, on

fund shareholders. Such reforms also could prove to be cost prohibitive for smaller

fund groups, especially those who allow access at a lower minimum (for example,

at FAM Funds, the minimum initial investment is $500).

As this Committee considers what steps are necessary to respond to the recent

scandals, I respectfully request that you bear in mind the law of unintended consequences. No proponent of mutual fund reform wants to damage the long-term

competitiveness and creativity of this industry, the health of which is so vitally important to millions of lower- and middle-income investors. Yet if the scales are

tipped too far, so that the regulatory restrictions and costs of managing mutual

funds outweigh the possible rewards, there could be a ‘‘brain drain’’ as the best and

brightest portfolio managers are drawn away from the mutual fund industry to

more creative and lucrative forms of money management. New firms—which historically have developed many of the most innovative fund products and services, such

as money market funds—simply might not enter our industry at all, choosing instead to limit their investment offerings to less regulated products. Any departure

of top talent could well be followed by an adverse effect on long-term shareholders,

including diminished returns and a departure of investors, which would leave fewer

investors to shoulder an increased share of their funds’ expenses. Finally, the creativity to provide new investment funds that would be advantageous to lower- and

middle-income investors might be stifled, if not lost, if a proposal creates a barrier

to entry for a mutual fund entrepreneur. That would be tragic.

I hope that these observations about the potential threat of overregulation are

taken by the Committee in the spirit in which I offer them—as constructive commentary, based upon my 30 years of experience in this industry and my strong belief that a vibrant, competitive mutual fund industry serves our Nation’s interests

and the interests of all mutual fund investors, which represent more than half of

all U.S. households.

The Role of Small Funds in the Mutual Fund Industry

To appreciate concerns about the impact that some of the reform proposals could

have on small funds, I believe that it is important for the Committee to understand

this segment of the mutual fund industry.

Many, if not most, investors are familiar with the larger mutual fund groups, such

as Fidelity and Vanguard. It is no surprise that people often think of these fund

groups first—they enjoy immediate name recognition because of their size and their

ability to advertise widely. It would be a mistake, however, to think that these

groups are representative of the entire mutual fund industry.

In fact, a large part of our industry is comprised of small fund groups. This point

was very well articulated in recent testimony to this Committee by a fellow small

fund executive, Mellody Hobson of Ariel Capital Management and the Ariel Mutual

Funds.1 Ms. Hobson noted that more than 370 U.S. mutual fund companies have

assets under management of $5 billion or less. This is out of a total of approximately 500 fund companies. To put this fact further into perspective, Ms. Hobson

explained that if you were to combine the assets managed by all of these firms into

a single firm, the amount under management would be less than half that managed

by the single largest mutual fund company.

If you were to ask 10 small advisory firms how they got into the business of managing mutual funds, you would probably get 10 different answers. Here is mine. I

was working with my father in the family manufacturing business in the early

1970’s. At the same time, my father and I began managing some family money, and

we did not suffer losses on our investments despite the bear market of 1973–1974.

Word got around, as it usually does in a small town, and we learned that people

were interested in what we were doing. We started Fenimore Asset Management

and slowly built a client base, largely through referrals by existing clients. Over

time, we had many clients who wanted us to manage small sums for them—an account for the benefit of a child or grandchild, for instance. The most cost-effective

way to manage small sums is through a pooled investment vehicle, so in 1987, the

1047

firm launched its first mutual fund. Almost a decade later, Fenimore launched its

second mutual fund, an equity income fund, in order to meet the needs of clients

who wanted an income stream from their investments.

Small fund groups such as FAM Funds play an important role in the mutual fund

industry. They provide greater choice for investors and help to foster competition.

In addition, a small fund group can typically provide its shareholders a level of individual service and attention that is simply beyond the reach of a large fund group

with its millions of shareholders. At FAM Funds, for example, we do not contract

any shareholder service activities to outside vendors. Instead, we provide these services through our own team of registered representatives. We also make our portfolio

managers available to address shareholder questions and concerns, and we hold

shareholder meetings annually at the local high school. In ways such as these, we

seek to facilitate dialogue, educate, and create understanding between our shareholders and those of us at FAM Funds to whom they have entrusted their savings.

Many small fund groups specialize in one or more investment styles. At FAM

Funds, our specialty is long-term, value-oriented investing. In other words, we are

old-fashioned stock pickers. Our investment philosophy is based on the teachings of

Benjamin Graham from his classic 1934 book, Security Analysis, which outlines the

key elements to value investing. Using Graham’s methodology, we have developed

our own proprietary investment criteria to identify undervalued securities with good

long-term growth potential. We consistently apply a thoughtful and disciplined approach to investing that will grow and preserve capital over the long term. In this

way, we are able to achieve our overall purpose of providing financial peace of mind

to our shareholders.

Unlike a large fund group, which typically offers funds covering a wide spectrum

of investment objectives, small fund groups such as FAM Funds find a niche and

stick with it. We are not trying to be all things to all investors or to change our

investment offerings to capitalize on hot trends in investing, like the technology

stock craze of a few years back. Rather, small funds tend to succeed by staying within their circle of competency.

A corollary to this is that a small fund group has to be able to communicate effectively with investors, so that they understand both the benefits and the limitations

of what the fund group has to offer. A growth-oriented investor, for example, is simply not going to be happy with an investment in my firm’s value-oriented mutual

funds. Nor would that benefit my firm, since we depend upon the referrals of satisfied clients in order to grow. For this reason, we put a great deal of energy into

helping our investors understand our process for selecting stocks and our long-range

investment horizon.

The Impact of Regulatory Reforms on Small Funds

In my 30 years as a money manager, I cannot recall another time in which the

SEC has proposed so many sweeping changes to the regulatory scheme for mutual

funds in such a short period of time. I fully support the SEC’s efforts, and I commend the Agency for proposing reforms that are aimed not only at remedying the

immediate problems that have been found in the industry, but also addressing potential conflicts of interest, strengthening fund governance, and enhancing standardized fund disclosures. These reforms will benefit investors for years to come. As

I stated at the outset of my testimony, however, these reforms—if enacted—would

come with a hefty price tag.

It should not be surprising that the aggregate cost of these regulatory changes

will have a proportionately larger impact on small fund groups. Small funds have

smaller asset bases to absorb these costs, so their shareholders are hit harder than

those in large fund groups, where the costs can be more spread out.

In addition, profit margins tend to be much thinner at smaller fund groups, which

do not have the economies of scale enjoyed by large fund groups. Consequently, we

must be extremely vigilant about controlling costs and keeping our fees at a reasonable level. If we do not, our shareholders can always move their money elsewhere.

While this is true for all mutual funds, the costs associated with shareholder defections are more difficult for small funds to absorb. Put another way, small funds

must be competitive not only to attract investors in the first instance, but also to

retain their business.

An example might be helpful. My firm is working to come into compliance with

the SEC’s newly adopted rule that requires each mutual fund to have in place a

comprehensive compliance program and to designate a chief compliance officer to

oversee that program. We are just able to think about bringing on board an in-house

counsel at Fenimore who will also serve as the chief compliance officer for each of

the FAM Funds. And that is because the costs associated with hiring this new employee would be partially subsidized by our private client business. For fund groups

1048

2See, for example, Investment Company Governance, SEC Release No. IC–26323 (January 15,

2004) (Fund Governance Release). Other reforms proposed by the SEC include requiring that:

Independent directors constitute at least 75 percent of a fund’s board; fund boards perform annual self-assessments; independent directors meet in separate sessions at least once each quarter; and funds authorize their independent directors to hire staff. 3See Enhancing a Culture of Independence and Effectiveness, Report of the Advisory Group

on Best Practices for Fund Directors (June 24, 1999) (Best Practices Report), at 25. 4The SEC requested comment on whether it should require the annual election of the board

chair. See Fund Governance Release, supra note 2. The ICI also supports this approach. See Letter from Craig S. Tyle, General Counsel, Investment Company Institute to Jonathan G. Katz,

Secretary, Securities and Exchange Commission, dated March 10, 2004 (ICI Fund Governance

Letter).

smaller than ours, or whose investment adviser does not manage other accounts,

that approach will simply be too expensive. I expect that such fund groups will have

to designate an existing employee to take on the additional—and not insignificant—

responsibilities that are required of a chief compliance officer. I offer this example

not as a criticism of the new requirement, but merely as an illustration that even

worthwhile reforms can stretch the limited resources of small fund groups.

Comment on Select Reform Proposals

Our differences aside, small fund groups and large fund groups agree that the

merits of any reform proposal should be measured against a single standard, one

that has been the hallmark of our industry throughout its history. That standard

is this: Will the proposed reform benefit the interests of long-term mutual fund investors? While well intentioned, some reforms that have been proposed fall short of

this mark. Such proposals include, among others, requiring each fund board to have

an independent chair and barring a portfolio manager from jointly managing a mutual fund and a hedge fund. In addition, I will offer my observations with respect

to certain other areas in which reform proposals have been advanced: Mutual fund

fees, Rule 12b–1 under the Investment Company Act of 1940, directed brokerage,

soft dollars, and revenue sharing arrangements.

Independent Chair

Several legislative proposals and the SEC’s proposed package of fund governance

reforms would require that each fund board of directors have an independent chair.2

While this requirement may sound good in theory, I do not think that a one-sizefits-all approach is necessary. A requirement like this one would cause many fund

groups—including my own—to choose a new board chair even though their current

structure works well for them.

At FAM Funds, I serve as Chairman of the Board of Trustees, and the remaining

trustees are independent. As a practical matter, they already have the power to replace me at any time with a new board chair if they feel that such a change would

benefit the Funds and our shareholders. The independent trustees also have appointed a lead independent trustee, who serves as a point of contact with Fenimore

and plays a major role in preparing the agendas for our Board meetings. This independent trustee also chairs the separate meetings held by the independent trustees

before each board meeting.

I would favor an approach that gives fund boards the ability to choose between

having an independent chair and a lead independent director. It is important to

note that the appointment of a lead independent director also is consistent with recommended industry best practices.3 As an alternative to giving fund boards the

choice between an independent chair and a lead independent director—or perhaps

even in addition to such a choice—the SEC could consider requiring a fund board

to elect its chair annually, by a majority vote of both the independent directors and

the entire board.4

By focusing so much attention on whether fund boards should have an interested

or an independent chair, we may well be missing the forest for the trees. What I

think persons on both sides of this debate really want are board chairs who are

knowledgeable about business, investment, finance, and the fund industry, and who

are both capable and willing leaders. Obviously, who fits the bill will depend upon

the composition of a particular fund board. For this reason, I feel strongly that

board members themselves are in the best position to select their chair.

I also want to share the following observation. Contrary to their portrayal in some

recent news stories, fund directors are not lemmings that blindly follow the lead of

management. It has been my experience, both at FAM Funds and in the industry,

that fund directors take their responsibilities seriously. They recognize their fiduciary obligations and they try to use their best judgment in fulfilling the many duties assigned to them by the Congress and the SEC. If fund directors are charged

1049

5See Best Practices Report, supra note 3, at 10–12. 6The negative effects of a joint management ban were well articulated in recent testimony

before this Committee. See Statement of Michael S. Miller, Managing Director, The Vanguard

Group, Inc., Review of Current Investigations and Regulatory Actions Regarding the Mutual

Fund Industry: Fund Operations and Governance, Before the Committee on Banking, Housing,

and Urban Affairs, U.S. Senate, 108th Cong., 2nd Sess. (March 2, 2004). 7 Contrary to the assertions of some industry critics, mutual fund boards are not charged with

negotiating the lowest possible management fee. But rather, fund directors, acting in an oversight capacity, must ensure that fees are within a reasonable range. They also must evaluate

the continuing propriety of fees in light of any material change in circumstances. See ICI Fund

Governance Letter, supra note 4.

with such important responsibilities, they certainly should be treated as responsible

enough to choose their own chair.

I support other measures to enhance the role of independent directors, because

I know from experience that a strong board is an important partner in protecting

the interests of fund shareholders. In particular, I believe that each fund board

should be required to have a supermajority of independent directors, as we do at

FAM Funds. I do not believe, however, that requiring a three-fourths supermajority

for all fund boards—rather than the two-thirds supermajority recommended by industry best practices 5—would provide any additional benefits to shareholders. On

the other hand, such a change would cause significant disruption for many fund

boards, most of which already comply with the recommended two-thirds standard.

I also support strengthening fund boards by requiring independent directors to meet

in executive session at least quarterly, authorizing independent directors to retain

their own staff members (although we at FAM Funds believe that our independent

trustees already have this authority), and having fund boards annually assess their

performance.

Joint Management of Mutual Funds and Hedge Funds

Pending legislative proposals would prevent an individual from managing both a

mutual fund and any other type of unregistered investment company, most notably

a hedge fund. Although they purport to give the SEC the authority to make exceptions, the authority would be so narrow in scope that the proposals effectively would

ban the practice. Fenimore itself does not manage hedge funds, but some of my colleagues on the ICI’s Small Funds Committee are very concerned about the possible

impact on their firms of such a ban.

My colleagues fear that a ban on joint management would result in reduced access for mutual fund investors to skilled investment professionals who, if forced to

choose, likely would opt to manage less regulated and more lucrative types of investment accounts such as hedge funds. In addition, the prohibition could eliminate important operating efficiencies for investment management firms. My colleagues also

believe that it could have harsh, disruptive, and anticompetitive effects for smaller

investment management firms, which have fewer employees and might not have the

resources to maintain separate staff for different types of accounts.6

The potential conflicts of interest associated with joint management of mutual

funds and hedge funds do not seem to call for such a drastic all-or-nothing approach.

Rather, it should be possible to address these potential conflicts and protect the interests of fund investors by requiring advisers who manage both types of products

to adopt appropriate policies and procedures. It is important to note that, under the

SEC’s new compliance rule, such policies and procedures would be subject to continuing oversight by the fund’s chief compliance officer and the fund board.

Mutual Fund Fees

Notwithstanding statements by Members of Congress and Federal regulators that

they are not interested in rate setting for mutual funds, some proposals have been

floated that would seem to move in that direction (for example, requiring specific

SEC approval before a fund may charge its shareholders for any new service). Such

Government intervention with respect to fees has no place in an industry that is

as dynamic and competitive as ours.

I firmly believe that discipline with respect to mutual fund fees and costs comes

from two things, and two things alone: Competition in the marketplace, which is

fostered in part by the creation and success of smaller fund groups, and transparency, which is fostered by clear and meaningful disclosure to investors about the

costs associated with investing in a particular mutual fund.7 I am pleased that the

SEC has taken steps to provide more meaningful fee disclosure to fund investors,

in particular by its recent adoption of a rule that will require shareholder reports

1050

8See Prohibition on the Use of Brokerage Commissions to Finance Distribution, SEC Release

No. IC–26356 (February 24, 2004) (Rule 12b–1 Release). 9See Letter from Matthew P. Fink, President, Investment Company Institute, to the Honorable William H. Donaldson, Chairman, U.S. Securities and Exchange Commission, dated December 16, 2003 (ICI Letter to Donaldson). 10See Rule 12b–1 Release, supra note 8. The NASD also has filed with the SEC a proposal

to amend its rules to prohibit broker-dealers from selling the shares of any mutual fund that

considers fund sales in making its brokerage allocation decisions. See Proposed Amendment to

Rule Relating to Execution of Investment Company Portfolio Transactions, File No. SR–NASD–

2004–027 (February 10, 2004). 11See Confirmation Requirements and Point-of-Sale Disclosure Requirements for Transactions

in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, SEC Release Nos. 33–8358,

34–49148, IC–26341 (January 29, 2004).

to include more detailed information about fund expenses and to present such information in a standardized way, thus facilitating comparisons across funds.

Rule 12b–1

Adopted more than 20 years ago by the SEC, Rule 12b–1 under the Investment

Company Act permits payments for distribution from fund assets, subject to several

safeguards, which include ongoing board oversight of Rule 12b–1 plans. There is

widespread agreement that fund distribution practices have evolved significantly

since 1980 and that a thorough review of such practices, and the role of Rule 12b–

1, is overdue. I am pleased that the SEC has initiated such a review and has solicited comments from the public on possible reforms to the rule.8

One of the pending legislative proposals calls for the outright repeal of Rule 12b–

1, and the SEC also specifically requested comment on whether it should repeal the

Rule. The Rule should be updated to reflect today’s realities but should not be repealed. Rule 12b–1 continues to serve an important function by giving investors

choice on how to compensate the intermediaries whose assistance they sought in

making their investment decisions. Moreover, many small fund groups have been

able to remain competitive because they were able to gain access to a wider array

of distribution channels than they otherwise would have through traditional sales

load structures.

Directed Brokerage

In keeping with its commitment to acting in the best interests of fund shareholders, the mutual fund industry must be willing to reexamine practices that give

even the appearance that a fund’s adviser may be putting its own interests before

those of the fund’s shareholders. One such practice is ‘‘directed brokerage,’’ in which

an adviser may take sales of fund shares into account when selecting brokers to execute portfolio transactions for the fund. Although the NASD strictly regulates this

practice, and prohibits any type of quid pro quo between the adviser and broker,

directed brokerage involves potential conflicts of interest that could easily be avoided by simply banning the practice altogether.

In December, the industry called on the SEC to put an end to directed brokerage

arrangements.9 Consistent with the industry’s recommendation, the SEC has issued

a proposal that would prohibit any consideration of broker sales efforts in allocating

fund brokerage.10 I would urge the SEC to modify its proposal, however, so that

funds executing portfolio transactions through selling brokers would have the protection of a safe harbor if they put procedures in place to ensure that the direction

of brokerage in each instance is based solely on the broker’s execution capabilities

and is not intended as a reward for its sale of fund shares.

Revenue Sharing Arrangements

Several reform proposals, both in Congress and at the SEC, seek to address the

criticism that revenue sharing payments by a fund adviser to a broker selling the

fund’s shares are not sufficiently transparent to investors. This criticism is a valid

one, and I do think reform is needed in this area. An investor buying fund shares

through a broker needs to be made aware of any incentives the broker may have

to sell those shares. Armed with that information, the investor would be able to

evaluate the broker’s recommendation in light of those incentives. Knowledge is

power, and providing this type of information to investors at the point of sale—as

the SEC has proposed 11—would empower investors to make more informed decisions about how to invest their hard-earned savings.

At the same time, I do not agree that revenue sharing arrangements should be

eliminated or that fund boards should be required to make value judgments about

whether such arrangements are in the best interests of fund shareholders, as some

legislators have proposed. The revenue that is being shared under such arrangeVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01062 Fmt 6601 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
1051

12See ICI Letter to Donaldson, supra note 9.

ments belongs to the adviser, not the fund, and there are already protections in existing law to ensure that an adviser is not indirectly using fund assets to finance

distribution. The fact that revenue sharing arrangements exist simply reflects a

basic economic principle that transcends the mutual fund industry—that is, competition for access to available distribution channels.

Soft-Dollar Arrangements

The use of soft dollars by investment advisers is another area worthy of reform.

Current law contains a safe harbor that in effect permits a fund’s adviser, in certain

circumstances, to pay for brokerage and research services using commissions generated by the fund’s portfolio trades. The potential conflicts of interest are clear: An

adviser may be tempted to (1) select a broker based on such services rather than

on the broker’s ability to deliver best execution or (2) pay too much in commissions

or engage in unnecessary trading to generate soft-dollar credits. In my view, these

potential conflicts have been exacerbated by the SEC’s broad interpretation of the

safe harbor, which allows soft-dollar ‘‘credits’’ to be ‘‘redeemed’’ for products and

services that have attributes of traditional overhead expenses and lack intellectual

content.

The SEC could easily stem the potential for abuse in this area by narrowing its

interpretation of the safe harbor. I support a recommendation made by the ICI in

December that would significantly narrow the safe harbor—and thus the use of softdollar credits.12 Requiring advisers generally to pay for research services directly

would also promote transparency, making it easier for investors to compare the fees

charged by different investment advisers. It is important to note that any reforms

relating to the use of soft dollars should apply to all investment advisers, not just

those managing mutual funds. Otherwise, not all investors would benefit from the

additional protections that would flow from curbing the use of soft dollars.

Conclusion

In closing, I would like to reiterate my support for the SEC’s regulatory actions

to address the problems that have been uncovered in the mutual fund industry.

Going forward, however, I would urge policymakers to be mindful of the potential

impact of further changes on small fund groups. As I hope I have demonstrated,

small fund groups play a vital role in spurring competition and innovation in the

mutual fund industry. In the same way that mutual fund investors benefit from the

competitiveness and creativity of our industry, they also bear the costs associated

with legislative and regulatory changes affecting the industry. For this reason, it is

imperative that any such changes be guided by this single standard: What is best

for our Nation’s mutual fund investors.

I thank the Committee for the opportunity to present my views, and I offer my

continuing assistance as you continue your thoughtful consideration of these important issues.

—————

PREPARED STATEMENT OF MARK TREANOR

GENERAL COUNSEL, WACHOVIA CORPORATION

ON BEHALF OF THE FINANCIAL SERVICES ROUNDTABLE

MARCH 31, 2004

Introduction to Financial Services Roundtable

The Financial Services Roundtable unifies the leadership of large integrated financial services companies. The Roundtable’s membership includes 100 of the largest firms from the banking, securities, investment, and insurance sectors. This

broad membership, including investment advisers, broker-dealers, and administrators of retirement plans, makes the Roundtable uniquely qualified to comment on

mutual fund distribution issues.

Summary of Position on Mutual Fund Distribution

The Roundtable would like to commend Chairman Richard Shelby and the entire

Senate Banking Committee for conducting a thorough, deliberate examination of

mutual fund issues. The Securities and Exchange Commission (SEC) is also conducting a comprehensive review of mutual fund regulation. Not only is the SEC

moving aggressively to consider proposals to prevent recurrences of abusive late

trading and market timing, but also the Agency has proposed or adopted rules

1052

1Proposed Rule: Confirmation Requirements and Point-of-Sale Disclosure Requirements for

Transactions in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, SEC Rel. No.

33–8358 (January 29, 2004); Proposed Rule: Prohibition on the Use of Brokerage Commissions

to Finance Distribution, SEC Rel. No. IC–26356 (February 24, 2004). 2The Roundtable would be pleased to provide any comment letters it files for the Committee’s

hearing record. 3 ‘‘Class A’’ mutual fund shares may have a front-end sales load, with breakpoints for larger

investments. ‘‘Class B’’ shares may have no front-end sales charge, but may have ‘‘12b–1 fees’’

and a sales charge deducted if the shares are redeemed within a certain period of time. ‘‘Class

C’’ shares may have no sales charges but have 12b–1 fees. 4 17 CFR 270.12b–1.

across the entire spectrum of mutual fund operations. The Roundtable believes the

regulatory process should be allowed to work before any legislative changes are enacted.

The SEC has put forward for public comment a number of proposals addressing

distribution issues.1 These proposals are discussed in greater detail below. In summary, the Agency is seeking to improve disclosure to investors and possible prohibitions on particular business practices. The comment periods for many of these proposals are still open and the Roundtable expects to file comments with the SEC.2

As a result, the Roundtable has not yet taken positions on each specific proposal

put forward by the SEC. In general, the Roundtable favors disclosure over prohibitions, including prohibitions on specific types of distribution arrangements. Our goal

should be the greatest possible choice for investors. Armed with the appropriate information, investors can choose how they want to compensate the intermediaries

who service them. The Roundtable also expresses its views below on improving mutual fund disclosure; strengthening fund ethics and governance; and protecting fund

shareholders.

Introduction to Wachovia

Wachovia Corporation is one of the largest providers of financial services to retail,

brokerage, and corporate customers throughout the East Coast and the Nation, with

assets of $401 billion, market capitalization of $61 billion and stockholders’ equity

of $32 billion at December 31, 2003. Its four core businesses, the General Bank,

Capital Management, Wealth Management, and the Corporate and Investment

Bank, serve 12 million households and businesses, primarily in 11 East Coast States

and Washington, DC. Wachovia’s full-service brokerage, Wachovia Securities, LLC,

serves clients in 49 States. Global services are provided through 32 international

offices.

Distribution of Mutual Funds

Mutual funds have become the investment vehicle of choice for Americans seeking

to reach long-term financial goals. Whether directly or through retirement plans and

other investment channels, American investors have turned to mutual funds in

order to save and build wealth. Mutual funds offer a convenient and affordable way

to make diversified investments in stocks and bonds. Roughly half of all American

households own mutual funds; nearly three-quarters of all mutual fund shares are

owned by individual investors.

Some investors have the time, sophistication and inclination to investigate and

evaluate mutual fund options on their own. Other investors prefer to have an intermediary help them identify their investment goals and funds that may be appropriate to help them meet those goals. In fact, 88 percent of mutual fund shares are

purchased through intermediaries. Brokers, financial planners, insurance company

separate accounts, retirement plan administrators—all serve as important channels

for distribution of mutual funds to the public. They provide investors a convenient

means of comparing and accessing a variety of competing mutual fund families.

In addition to distributing mutual funds, intermediaries may have an important

role to play in servicing customers’ mutual fund accounts on an ongoing basis. Many

investors prefer the convenience of receiving a single statement that presents all of

their investments, including their investments in various mutual fund families,

rather than receiving multiple statements from different financial institutions.

Intermediaries may also help investors understand their statements and the performance returns on their mutual fund investments.

It is proper to compensate intermediaries for these services performed at the request and for the benefit of investors. Historically, that compensation took the form

of an upfront charge paid by the investor—known as a ‘‘front-end sales load.’’ Sales

loads typically ranged in amount up to 8.5 percent. Today, compensation may take

various forms.3 ‘‘12b–1 fees,’’ so-called after SEC Rule 12b–1,4 are fees deducted

1053

5 15 U.S.C. 80a–12(b).

6 NASD Conduct Rule 2830(k) (Execution of Investment Company Portfolio Transactions).

7 Id.

8SEC Investment Company Act Rel. No. 11662 (March 4, 1981). The SEC has proposed to

prohibit mutual funds from directing brokerage transactions to compensate broker-dealers for

promoting fund shares. See text accompanying footnote 7 below. 9 NASD Conduct Rule 2830 (Investment Company Securities).

from fund assets to pay for distribution. Section 12(b) of the Investment Company

Act gives the SEC authority to regulate a fund’s distribution of its securities, in

order to protect fund shareholders from excessive distribution costs.5 Rule 12b–1

permits funds to adopt written plans for using fund assets to pay for distribution.

In effect, 12b–1 fees allow investors to pay for distribution and related costs over

time rather than all at once.

Fund advisers make payments to intermediaries for distribution, sometimes

known as ‘‘revenue sharing’’ payments. It is important to note these payments are

made from the assets of the adviser, as opposed to the assets of the fund. Furthermore, a broker-dealer’s registered representatives always remain subject to rules of

self-regulatory organizations that require that any funds they recommend to investors be ‘‘suitable’’ for those investors.

Payments by fund advisers or their affiliates may also compensate broker-dealers

for performing routine shareholder servicing. These functions may include processing fund transactions; maintaining customer accounts; mailing prospectuses and

confirmation statements; and other tasks that mutual funds otherwise perform

themselves. Payments for these administrative services have helped foster the development by broker-dealers of mutual fund ‘‘supermarkets.’’ These allow investors

the convenience of accessing multiple mutual fund families in a single place and receiving a single statement covering their mutual fund investments.

The term ‘‘directed brokerage’’ refers to the use of fund brokerage commissions to

facilitate the distribution of fund shares. In general, pursuant to rule of the National Association of Securities Dealers (NASD), a broker may not condition its efforts in distributing a fund’s shares on receipt of brokerage commissions from the

fund.6 The rule allows a fund to consider sales of its shares in the selection of brokers to execute portfolio transactions for the fund, subject to best execution and provided the policy is disclosed.7 In approving this rule, the SEC added that this should

not generate additional expense to the fund and fund boards should consider the

potential conflict of interest inherent in using fund assets to pay for distribution.8

Disclosure of the Costs of Distribution

Mutual fund management fees are paid to investment advisors to select portfolio

securities and to manage funds. They do not include all costs and expenses that

have an impact on a fund’s net performance. Mutual fund investors deserve to know

how their assets are being spent on items such as fund distribution. When these

costs and expenses are disclosed, investors can make informed decisions as to

whether shareholders interests are being served.

Safeguards already apply to the imposition of 12b–1 fees and they are currently

disclosed to investors. Under Rule 12b–1, a fund may not use fund assets to pay

distribution-related costs except pursuant to a written plan approved by fund directors and shareholders. A majority of fund independent directors must approve the

fees each year. Any increase in 12b–1 fees must be approved by both a majority of

fund independent directors and the fund shareholders. A fund that charges 12b–1

fees must disclose that fact in its prospectus. A fund is required to disclose how

12b–1 fees increase costs over time and identify them as a separate item in the

fund’s fee table in the prospectus and as part of the fund’s annual operating expenses.

While Rule 12b–1 itself does not limit the level of 12b–1 fees, rules adopted by

the National Association of Securities Dealers (NASD) act to do so. NASD rules

limit the amount of aggregate mutual fund charges, including sales loads, 12b–1

and service fees.9 Pursuant to NASD rule, a broker may not sell shares of a mutual

fund with a sales load in excess of 8.5 percent of the purchase price, whether assessed at the time of purchase or the time of redemption, and so long as the fund

does not charge a 12b–1 fee or a service fee. The sales load of a fund with a 12b–

1 fee and a service fee may not exceed 6.25 percent of the amount invested; the 12b–

1 fee and service fee of a fund with a sales load may not exceed 0.75 percent per

year of the fund’s average annual net assets plus a 0.25 percent service fee. A fund

also may not advertise itself as a ‘‘no load’’ fund if it imposes 12b–1 fees and/or service fees greater than 0.25 percent.

As described above, as part of its comprehensive review of mutual fund regulation

the SEC is seeking comment on potential changes to the distribution of mutual

1054

10See footnote 1 above. 11Proposed Rule 12b–1(h)(1). 12Proposed Rule 12b–1(i). 13SEC Proposed Rule: Prohibition on the Use of Brokerage Commissions to Finance Distribution, Rel. No. IC–26536 (February 24, 2004), at 9. 14 Id. 15See Proposed Rule: Disclosure Regarding Portfolio Managers of Registered Management Investment Companies, SEC Rel. No. 33–8396 (March 11, 2004).

funds, including under Rule 12b–1.10 The public comment periods with respect to

the following proposals remain open and the Roundtable anticipates that it will respond to the SEC’s proposals in detail. In general, the Roundtable prefers improved

disclosure of distribution and other business arrangements to attempts to prohibit

specified types of arrangements.

First, the SEC has proposed amendments to the Rule to prohibit mutual funds

from directing brokerage transactions to compensate a broker-dealer for promoting

fund shares.11 A fund that directs any portfolio securities transactions to a broker

that sells its shares must have policies and procedures in place that are designed

to ensure that its selection of brokers is not influenced by fund distribution issues.12

Alternatively, the SEC is seeking comment on requiring greater disclosure of directed brokerage.

The SEC has also proposed requiring brokers to provide customers with information about distribution-related costs at the time of purchase of mutual fund shares.

Brokers would have to estimate the total annual dollar amount of asset-based sales

charges, including 12b–1 fees, that would be associated with the share purchased,

assuming their value remains unchanged. Brokers also would be required to disclose

the existence of differential compensation—broadly speaking, whether brokers have

a greater financial incentive to sell certain mutual funds over others.

Separately, the SEC is also seeking comment on whether to prohibit funds from

deducting distribution-related costs, including 12b–1 fees, from fund assets; the proposal would provide instead that they be deducted directly from shareholder accounts with the deduction appearing on account statements.

Under this approach, a shareholder purchasing $10,000 of fund shares with a

5-percent sales load could pay a $500 sales load at the time of purchase, or

could pay an amount equal to some percentage of the value of his or her account

each month until the $500 amount is fully paid (plus carrying interest).13

Among the potential benefits of this change identified by the SEC are increased

transparency to shareholders; reduced payments by long-term fund shareholders;

and reduced payments by existing shareholders.14 The SEC is also seeking comment

on whether to rescind the rule.

Other Mutual Fund Issues

The Roundtable would like to share its views on improving mutual fund disclosure; strengthening fund ethics and governance; and protecting fund shareholders.

Improving Mutual Fund Disclosure

A mutual fund’s management fee (the fee paid to the investment advisor to select

portfolio securities for and manage the fund) does not include all costs and expenses

that have an impact on a fund’s net performance. The Roundtable believes that mutual fund investors deserve to know how their assets are being spent on items other

than distribution, such as brokerage. When costs and expenses are disclosed, investors can make informed decisions as to whether shareholder interests are being

served. The Roundtable’s member companies agree that aggregate fund brokerage

commissions, average commission rate per share, and turnover information are useful types of disclosure. More information could also be disclosed about any services

received by a fund in addition to trade execution, such as investment research. But,

the Roundtable believes that efforts to require funds or brokers to assign precise

dollar values or artificial prices to proprietary services that are not commercially

available on an independent basis (such as an in-house research product) are likely

to be unworkable and unreliable.

The Roundtable does not support disclosure of actual dollar amounts of compensation paid to individual portfolio managers. Instead, the Roundtable does support disclosure to fund investors of the structure and methodology of portfolio manager compensation.15 This would help investors understand portfolio managers’ incentives

and whether the fund will meet their investment objectives.

1055

16Final Rule: Compliance Programs of Investment Companies and Investment Advisers, SEC

Rel. No. IA–2204 (December 17, 2003). 17Proposed Rule: Amendments to Rules Governing Pricing of Mutual Fund Shares, SEC Rel.

No. IC–26288 (December 11, 2003). 18Proposed Rule: Disclosure Regarding Market Timing and Selective Disclosure of Portfolio

Holdings, SEC Rel. No. 33–8343 (December 11, 2003).

Strengthening Fund Ethics and Governance

In addition to robust disclosure obligations, the Roundtable believes mutual funds

must have vigorous ethics and governance requirements. At the same time, it is important to understand that mutual funds differ from operating companies. Mutual

funds typically do not have employees. Instead, the fund’s investment advisor carries out its day-to-day operations.

The Roundtable supports requiring that a supermajority of a fund’s board of directors be independent of the fund adviser. Independent fund directors play a critical

role in the protection of fund shareholders. Directors approve an advisory contract

and oversee the advisor’s performance. Oversight by fund boards is the most effective method of managing potential conflicts of interest that could harm fund shareholders. Requiring that a supermajority of directors be independent is an important

step toward ensuring that the board carries out this role.

The Roundtable believes that a board with a supermajority of independent directors can determine the individual best suited to serve as chairman and would not

support a requirement that the chairman be an independent director. If a nonindependent director serves as fund chairman, certain governance safeguards could be

in place to promote the independence of the board as a whole. These include requiring the independent directors to choose a lead director and hire their own counsel;

requiring the board nominating committee to be composed entirely of independent

directors; and requiring that the independent directors set their own compensation.

These measures would ensure that a nonindependent chairman cannot control a

board and that independent directors will be able to carry out their responsibilities

to fund shareholders.

The SEC has recently taken a step that should enhance the ability of fund directors to safeguard shareholders’ interests. The SEC has adopted rules requiring fund

directors to approve written compliance policies and programs for both the fund and

the fund’s advisor. The fund’s compliance program will be administered by a chief

compliance officer, reporting directly to the board. This will increase accountability

and provide fund directors a centralized assessment of fund compliance that is not

influenced by the management of the fund’s investment adviser.16

Protecting Mutual Fund Shareholders

Recent instances of late trading and market timing in mutual funds have undermined investor confidence. Roundtable members care very deeply about restoring investor trust and preventing future abuses. The Roundtable supports a number of

additional protections for mutual fund shareholders.

First, the Roundtable supports vigorous additional efforts by the SEC to protect

mutual fund shareholders from late trading. From intermediaries to funds, more can

and should be done to ensure that all investors are treated fairly in terms of the

price they receive when buying and selling fund shares. Roundtable member firms

support requiring participants in the process of transmitting investor orders in

mutual funds to adopt forceful safeguards against late trading. The Roundtable advocates requiring funds and fund intermediaries, as a condition to be eligible to receive mutual fund orders up to the 4:00 p.m. closing time, to have electronic time

stamping systems and abide by associated compliance, certification and independent

audit requirements. The Roundtable believes these requirements would better serve

investors than the ‘‘hard close’’ at the fund only proposed by the SEC.17 Roundtable

members believe the ‘‘hard close’’ would be disruptive and confusing to investors. Investors buying or selling fund shares through brokerage or retirement accounts

could face cut-off times of 2:30 p.m. or even earlier. The Roundtable suggests that

it has put forward a more investor-friendly means of preventing late trading.

Roundtable members support vigorous additional efforts by the SEC to guard

against market timing. The Roundtable supports the enhanced disclosure by funds

of their market timing policies and practices proposed by the SEC.18 In general, the

Roundtable believes it is better to present investors with greater information regarding funds’ market timing policies than to enforce new ‘‘one size fits all’’ rules

on this issue. The Roundtable also supports the SEC’s proposals on the wider use

of fair value pricing and on disclosure of that issue and of disclosure to selected parties of fund portfolio holdings.

1056

19See Proposed Rule: Disclosure Regarding Portfolio Managers of Registered Management Investment Companies, SEC Rel. No. 33–8396 (March 11, 2004).

Finally, the Roundtable supports requiring mutual funds to disclose to investors

the potential conflicts arising out of the joint management of mutual funds and

other accounts.19 At the same time, fund directors must ensure that advisers do not

disadvantage fund shareholders in favor of other advisory clients. Investors can then

evaluate the risks in deciding where to invest. A blanket ban on joint management

of mutual funds and hedge funds would actually harm mutual fund investors, as

many portfolio managers would likely choose hedge funds because they typically

offer higher compensation than do mutual funds.

Conclusion

Roundtable members believe disclosure is a crucial tool to ensure that funds serve

their shareholders and that shareholders can evaluate fund performance effectively.

The Roundtable supports improvements to make certain that fund disclosures are

periodic, timely, robust, efficient, uniform, and easy to administer. However, proposals that would increase compliance costs without commensurate increases in investor protection would only reduce returns for mutual fund shareholders. The

Roundtable is concerned that mutual funds not be undermined as an attractive

product for investors.

The Roundtable is studying the SEC’s proposals carefully and expects to file comments with the Agency before the comment periods expire in April and May. As

noted, the Roundtable in general feels that improvement to disclosure is a better

response to these issues than is prohibition of specific business practices. The

Roundtable commends the SEC for its vigorous efforts to ensure that mutual fund

shareholders receive the information and protection they need and deserve.

We look forward to continuing our dialogue with the Agency, and the Committee,

so investors continue to have confidence in mutual funds as an investment vehicle.

(1057)

U.S. SECURITIES

AND EXCHANGE COMMISSION

THURSDAY, APRIL 8, 2004

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10:06 a.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

This morning, the Committee concludes its series of hearings examining the mutual fund industry. Since November, the Committee has held a total of 10 hearings devoted to the fund industry.

This extended hearing process reflects the complex nature of the

issues under consideration. During these hearings, we have benefited from expert testimony on the full scope of issues confronting

the fund industry. These hearings have educated the Committee

and have created a substantial record of reform.

At the beginning of this process, I stated that the guiding principle of reform would be investor protection. I further stated that

the regulators, industry, and Congress must work collectively to restore integrity to our markets and reassure investors that mutual

funds are a vehicle in which they can safely invest their money. It

is against this principle that we must evaluate reform efforts. Although a few months’ time is certainly insufficient for final judgment, I do believe that we have a preliminary record to measure

the SEC’s commitment to reform.

Last November, Chairman Donaldson testified before this Committee that the SEC would reform the mutual fund industry, and

he is fulfilling that promise. Under Chairman Donaldson’s leadership, the SEC has swiftly executed an aggressive reform agenda

comprised of strong enforcement actions, revised compliance and

inspection programs, and comprehensive rulemakings. The SEC

has promulgated more than 10 rules addressing fund compliance,

governance and ethics, conflicts of interest, and disclosure practices. This slate of rules is one of the most comprehensive rulemaking initiatives in the SEC’s history. Through these

rulemakings, the SEC continues to thoroughly analyze these complex issues and carefully evaluate the benefits and consequences of

various reform alternatives. This Committee has spent a great deal

of time reviewing the scope, application, and consequences of these

rules. Given the revelations of wrongdoing in the fund industry, I

1058

believe that such an expansive rulemaking effort was required.

And, Mr. Chairman, I support your aggressive leadership. We commend you for the road you are going down.

As we conclude these hearings, Congress must determine, Mr.

Chairman, whether legislation is necessary in light of the SEC’s

vigorous response. Clearly, Chairman Donaldson and his staff have

answered the charge for reform. Nevertheless, I believe it is incumbent upon Congress to determine how we can complement Chairman Donaldson’s initiatives and bolster his reform efforts. We, in

Congress, have an obligation to the investing public to ensure that

the SEC is armed with the full array of powers necessary to fulfill

its mission of investor protection. If necessary, I believe that Congress stands ready to enhance the SEC’s authority through the

grant of new authority. Hopefully, Mr. Chairman, today’s hearing

will shed more light on what Congress should do to complement

SEC’s efforts.

And while evaluating the scope of the SEC’s authority, this Committee must also measure the SEC’s resolve to continue reform.

Some issues, such as soft dollars, have not yet been addressed

through rulemakings, and the difficult tasks of rule implementation and compliance remain ahead. I believe that true fund industry reform will result from sustained regulatory and enforcement

efforts that change the culture inside mutual funds and brokerdealers. This slate of recent rulemakings is just the beginning, Mr.

Chairman. Successful implementation and compliance may be the

true measure of reform.

I must acknowledge—and I will—the hard work of Chairman

Donaldson and his staff during the preceding months. Their timely,

thorough, and diligent responses helped to restore investor confidence. Chairman Donaldson, I look forward to your testimony

today and perhaps where we might need to go.

Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Chairman Shelby. I

want to underscore the thorough and comprehensive manner in

which you have been examining the problems that have arisen in

the mutual fund industry. SEC Chairman Donaldson testified at

the Committee’s first hearing, as I recall, on this subject, and it is

appropriate, that he returns today to testify at the concluding hearing. Chairman Donaldson, I join Chairman Shelby in welcoming

you back before the Committee. It is always a pleasure to have you

here.

How these mutual fund problems are resolved has important implications for more than half of all U.S. households. About 100 million Americans today own mutual funds. And they count on these

investments to provide retirement security, to cover children’s education expenses, or to meet other significant financial obligations.

Clearly, they must be able to rely on the integrity and honesty of

the funds to which they entrust their savings.

As Chairman Shelby has said, we place the interests of the investor paramount. My recollection is there is an engraving at the

SEC headquaters from Chairman William O. Douglas that makes

1059

this very point—this is what the SEC is there for, to protect the

investor.

The SEC has noted that a 1-percent increase in a fund’s annual

expense can reduce an investor’s account balance in the fund 18

percent after 20 years. This is an arena in which small amounts,

which in and of themselves may not look significant, really amount

to substantial amounts over a period of time, and we need to be

aware of that.

The crisis of investor confidence in our markets was precipitated

by the collapse of Enron Corporation and other major public companies, beginning in late 2001. The mutual fund industry continued to assure the public and the Congress that it had no major

problems. Those assurances, regrettably, took on a hollow ring in

September 2003, first, when the New York Attorney General Eliot

Spitzer disclosed that a large hedge fund had engaged in improper

late trading and market timing with several major mutual fund

families.

Since then, regrettably, numerous instances of misconduct have

come to light. As Don Phillips, Managing Director of Morningstar,

observed in testimony before this Committee, ‘‘Sadly, these were

not the acts of a few low-level employees, but instead were violations of trust that took place at the highest levels, including company founders, CEO’s, and portfolio managers.’’

The Director of Enforcement at the SEC, Stephen Cutler, said in

November, ‘‘More than 25 percent of firms responding to an SEC

mutual fund inquiry reported that customers have received 4 p.m.

prices for orders placed or confirmed after 4 p.m., 50 percent of responding fund groups appear to have had at least one arrangement

allowing for market timing by an investor. And almost 70 percent

of responding brokerage firms reported being aware of timing activities by their customers.’’

In the wake of public disclosure of these improprieties, the SEC,

under the effective chairmanship of Chairman Donaldson, the

NASD, the State Attorneys General, and the State regulators have

responded forcefully. The regulators have brought enforcement actions, enhanced their examination functions, and are engaging in

extensive rulemaking.

Chairman Donaldson has said, ‘‘The Commission is deeply committed, to try to restore investor confidence in fund investments.’’

And his actions and those of his fellow Commissioners have demonstrated their determination in seeking that goal. Business Week

recognized recently, and, ‘‘The SEC chief has accomplished more

than many expected.’’

From the testimony at our hearings, the Committee has learned

much about the regulators’ and the industry’s response to the concerns about such issues as: Late trading, market timing, selective

portfolio disclosure, fee disclosures, fund governance, soft dollars,

side-by-side management of mutual funds and hedge funds, and

disclosure of adviser compensation. This has helped us to gauge the

extent of the problems, their impact on investors, and what is

being done to prevent future abuses.

The SEC has brought several enforcement actions and engaged

in a dozen rulemakings affecting mutual funds, which include

many appropriately strong proposals. The SEC actually is reviewVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01071 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1060

ing public comments on many of these, so a number have not yet

been finalized. And we are awaiting the final rules, and, of course,

the Commission carries a heavy responsibility in that regard.

Our witnesses have brought to our attention matters involving

transparency, accountability, and conflicts of interest. We have had

a number of proposals made to the Committee on how we might

proceed in those areas. There are other areas where the SEC has

not yet had the opportunity to formally address the issue or is

studying or soliciting comment on the matter.

I look forward to hearing the Chairman Donaldson’s assessment

of the current situation, whether the full dimensions of the problems in the fund industry have surfaced, how the SEC is addressing the problems, and what is planned for the future, and how the

Congress can work with the Commission to promote the integrity

of the fund industry and to protect the fund investors.

It is obviously of very great importance that we all work together

in order to assure a framework with respect to industry practices

that enables the investor to be confident that he or she will be

dealt with in a fair, straight-forward, and honest manner.

Thank you very much, Mr. Chairman.

Chairman SHELBY. Senator Bunning, you may have arrived just

in time. We will move back and forth.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman.

First of all, I want to thank you for holding the hearing, and I

want to thank our witness, Chairman Donaldson, for testifying.

As my colleagues know, I was in the securities business for 25

years. I actually sold mutual funds, so I am very familiar with the

subject.

There has been a lot of talk about the mutual fund bill. A lot of

talk. The House has passed a bill. Some of my colleagues on this

Committee have introduced a bill. And Senators not on this Committee have introduced a bill. Chairman Shelby recently indicated

that he would lean toward passing a bill this year. I am not in the

habit of disagreeing with my Chairman, but it will be a high hill

to climb to convince this Senator that we must pass a bill this year.

Chairman Donaldson came in at a very difficult time. I have disagreed with a lot of his actions, but he has been active. He has

moved to curb abuses and has moved to establish the SEC as the

regulator for securities once again. I believe the SEC has reestablished its authority. If you do not believe me, I ask the securities

industry people who are filling the audience today. We have greatly

increased the SEC resources over the past few years. This Committee has taken the lead on making sure the SEC does have the

resources it needs. I believe—and I think Chairman Donaldson

agrees with me—that the SEC currently has the resources to enforce the authority and enforce the law. I think they can effectively

regulate the mutual fund industry under existing statutes. I am

sure the securities industry will agree with me on that, also. We

have given the SEC a lot of resources. I believe it is time to let

them use them. If they go too far or not far enough, then I am sure

this Committee will be getting involved.

1061

One area where I think the Commission has already gone too far

is the independent chairman issue. I completely disagree with the

Chairman on this issue. If we have independent boards and the

SEC required boards to be 75 percent independent, we should let

them pick whoever they want as chairman. Let it be their choice.

If they believe it is in the best interest of the investor to have a

management chair, they should be able to have a management

chair. There have been studies showing that funds with independent chairs have a much worse return.

I also favor the idea of having someone who will be accountable.

Funds with a management chair do have someone who will be accountable if there is a problem with the fund rather than saying,

‘‘I was independent. How could I know of any of these problems?’’

Let the independent boards pick who they believe is the best chair

for a particular fund.

Thank you, Mr. Chairman, for holding these hearings, and I am

anxious to hear from Chairman Donaldson.

Chairman SHELBY. Before I call on Senator Reed, I just want to

set the record straight as of today. I do not deny that I said I was

leaning toward legislation. That was days ago or weeks ago. Today

I am leaning straight up. I am not leaning toward legislation.

[Laughter.]

Because I think that as we reviewed the testimony that has come

before the previous nine hearings and we have put together what

the SEC has been doing, I think at the end of this hearing we will

see from Chairman Donaldson’s testimony and what they are going

to do, and maybe, Senator Bunning, we should let the SEC do its

work, continue our oversight, not rule out any legislation in the future but not be rushing to judgment on legislation.

Senator BUNNING. I think that is a great idea, Mr. Chairman.

Chairman SHELBY. Thank you.

Senator Reed.

COMMENTS OF SENATOR JACK REED

Senator REED. Thank you, Mr. Chairman. Thank you also for

holding these many hearings on this very important topic. Welcome, Chairman Donaldson.

The Securities and Exchange Commission has put forward a

comprehensive package of proposals that would fundamentally

change how this industry operates, and I look forward to hearing

from you, Mr. Chairman, about these proposals and encourage you

to let us know what we can do to assist you, particularly if you believe you need additional Congressional authority.

We must continue to keep in mind that mutual funds represent

one the best ways for individual investors to participate in the market. Millions of Americans rely on these funds to have easy access

to diversification and the management skills of an experienced investor adviser. With so many Americans investing and benefiting

from mutual funds, Congress has an important responsibility to ensure that all investors are treated fairly and equally.

Thank you, Mr. Chairman. I look forward to your comments.

Chairman SHELBY. Senator Corzine.

1062

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman. And let me congratulate you on running a terrific set of hearings with respect to

this overall topic.

Chairman SHELBY. Thank you.

Senator CORZINE. Those nine hearings that you talked about are

really quite a tutorial on the industry, the issues, and the problems. And I must say I have learned a lot, and as you know, along

with Senator Dodd, we introduced an original piece of legislation,

S. 1971, which we intend on using the extensive testimony as a

basis to upgrade and update many elements of it.

That said, I want to identify with what both Senator Bunning

and Senator Reed said with regard to the SEC, which does mean

maybe leaning into the wind or standing straight up, may be is an

appropriate point. I think it is one of those issues we should have

some discussion about today. But I think the SEC has done a great

job as it relates to the mutual fund industry and taking a comprehensive response. Everybody can disagree on elements of all

kinds of policies, but I think it has been quite effective in a very

troubled time. And I think the reestablishment of the credibility of

the SEC has been really quite extensive, and I think that comes

in part from the leadership. And I welcome Chairman Donaldson

here and I congratulate him for those efforts.

But there still is a lot to debate about whether making permanent some of the very thoughtful ideas and elements of the proposals that the SEC has come across, particularly in the context of

we are where we are today, but if we have difficulties down the

road, do we end up then not thinking through this in as thoughtful

and as precise a way and then end up having what I think are less

effective long-run formulations for it. And so there is a case to be

made for having some of this put into statutory format. So I would

like to hear the arguments back and forth on why, but I think we

have all experienced situations where we react to a crisis in a

much different format than what we do when we have the ability

to actually think objectively in periods that may be a little bit off

the front burner. And that is certainly what I would like to see us

at least examine.

I thank you, Mr. Chairman, for a very, very effective dialogue

with regard to this whole effort.

Chairman SHELBY. Thank you.

Senator Stabenow.

STATEMENT OF SENATOR DEBBIE STABENOW

Senator STABENOW. Thank you, Mr. Chairman. I also would like

to thank you for a very thorough set of hearings, and it has been

very enlightening for all of us. There is no doubt that there has

been some troubling findings over the last year which have indicated that some funds are not looking out for the best interests of

their investors. And, in addition, it is clear we need more transparency in the industry as we have talked about.

But I am very encouraged by the leadership that we have seen

both by regulators at the State and the Federal level, and I am

particularly glad that Chairman Donaldson is before us today to

update us on the actions that the Commission has, in fact, taken.

1063

There is so much that can be done through the regulatory policy

process, and I am confident that the actions of the SEC and other

regulators are beginning to have a corrective impact on the problems that we have been uncovering.

I know that, Mr. Chairman, you have indicated that you want to

look at the issue comprehensively and then determine if there is

more that needs to be done legislatively. I appreciate that. I appreciate your careful and methodical approach to this. We want to

make sure that we solve the problems at hand, but do so in a way

that is measured and appropriate. The need to resolve investor confidence in the market for mutual funds and in the markets at large

remains a paramount concern of mine, as I know it does of yours.

In addition to looking at the mutual fund industry, though, I

might add that we also need to remain vigilant in looking at the

implementation of the Sarbanes-Oxley Act, and with the Chairman

here, I do want to take the opportunity again to say that I am particularly concerned about provisions in the Act that relate to the

anonymous corporate whistle-blower provisions. We have talked,

you and I, about this, and I am concerned that we have not yet

seen the aggressive implementation or monitoring by both the

stock exchanges and by the SEC as it relates to those provisions.

And I continue to urge you to do so.

And as we look at our provisions there, the whistle-blowers, who

serve as our first line of defense in combating corporate fraud and

misleading accounting, need to know that there is a confidential

process and that it is a specific process. And I will continue to look

forward to working with you on that very important piece of the

legislation.

And, again, thank you, Mr. Chairman, for this hearing.

Chairman SHELBY. Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. I will be very brief.

Chairman Donaldson, thank you for joining us today, and thank

you for the good work that you and the SEC are doing. I have

learned in the 3 years I have been in the Senate that sometimes

you have to pass legislation to accomplish certain objectives. Sometimes you can do so by circulating a letter and getting a lot of your

colleagues to sign on and send that letter to a key decisionmaker.

Sometimes you can accomplish a whole lot by having a hearing,

other times by having an extended series of hearings. And I think

what has happened over this series of hearings is you and those

who work with you at the SEC have had an opportunity to make

some decisions, study the field, and to step forward and say these

are the changes that we would like to see made. And I think for

the most part, what you are doing are things that I agree with—

not all, but for the most part, I agree with you and appreciate the

diligence and the determination that you have brought to the task.

If you need to do more, maybe we can have more hearings, give you

more time to finish those things.

I look forward to asking you some questions. I will just telegraph

one of them, and that is the question of the need for an independent chairman, the same issue raised by Senator Bunning. If

1064

that is something that is truly going to be of value or not. So having telegraphed that pitch, I look forward to hearing from you.

Thank you.

Chairman SHELBY. Chairman Donaldson, before you start, I just

want to say what others are saying. We believe that your leadership at the SEC has been exemplary. You have been facing the

tough issues, and you will continue to do this. We want to work

with you. We are going to continue to work with you, as we have

in the past, as the Banking Committee, with legislative and oversight jurisdiction of the SEC.

In your remarks today, I hope you will tell us where we need to

work with you specifically, on oversight or in legislation, or defer

legislation, or what, because I believe we need to see how your regulations are going to work before we rush to judgment legislatively.

You proceed as you wish. Your written testimony will be made

part of the record in its entirety.

STATEMENT OF WILLIAM H. DONALDSON

CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

Mr. DONALDSON. Good morning, everyone. Chairman Shelby,

Ranking Member Sarbanes, and other Members of the Committee,

I am delighted to be here. I thank you for inviting me to testify

today.

Senator BUNNING. Could you move the mike a little closer?

Mr. DONALDSON. Yes.

Senator BUNNING. Thank you.

Mr. DONALDSON. The breadth of your hearings have clearly and

effectively illustrated the complexity of the issues the Commission

is facing in addressing the problems in the mutual fund industry.

The hours upon hours that you and the Committee have spent performing critical oversight, and the testimony from witnesses representing all sectors and aspects of the problem have been

immensely valuable as the Commission works to tackle these

issues. I thank and commend you for the thorough and thoughtful

approach that this Committee has brought to the problems.

Like you, as I said many months ago, I am outraged by the conduct that has come to light in the recent mutual fund scandals. In

large part, I believe that the industry lost sight of certain principles, in particular, its responsibility to the millions of investors

who entrusted their life’s savings to this industry for safekeeping.

As I said last fall when I testified—and I believe it bears repeating—these mutual fund investors are entitled to honest and industrious fiduciaries who sensibly put their money to work for them

in our capital markets. Investors deserve a brokerage and a mutual

fund industry built on fundamentally fair and ethical legal principles. This has been the Commission’s urgent and guiding mission

as it pursues a very aggressive mutual fund reform program to

identify and address a range of problems in the industry.

Our regulatory efforts include strengthening the governance

structure of mutual funds, addressing conflicts of interest, enhancing disclosure to mutual fund shareholders, and fostering an

atmosphere of high ethical standards and compliance within the industry.

1065

The Commission has made significant progress and will continue

to move aggressively to track down and pursue wrongdoers while

expeditiously considering all of the outstanding mutual fund rulemaking proposals: market timing disclosure, breakpoint disclosure,

the fund governance package, the investment adviser’s code of ethics rule, disclosure regarding the factors considered by the fund’s

board in approving an advisory contract, the proposed amendments

to Rule 12b–1, the hard 4 p.m. close, portfolio manager disclosure,

the mandatory 2-percent redemption fee, and new confirmation

form and point-of-sale disclosure, to mention a few.

While it is important that we act on these rules in an expeditious

manner, it is, in my view, equally important that we get it right.

Interested parties must have the opportunity to comment, our staff

must have sufficient time to fully consider possible unintended consequences, and we need appropriate time to vet alternative approaches to our proposals so that when we adopt final rules we will

adopt rules that best address the problems we are seeking to solve.

The complexity associated with some of our proposals, such as

our proposal on late trading, may take some additional time to ensure our solution appropriately addresses the underlying problem.

As you have no doubt seen in your hearings, there are divergent

views among knowledgeable experts over how best to address mutual fund oversight. Because these views often conflict with one another, particularly among competitors, the Commission’s notice and

comment process, which Congress so wisely required in all Commission rulemakings, is of infinite value to our final product. We

benefit from a wide spectrum of views and opinions put forth in a

formal, structured format on how to strengthen our proposed rules

and regulations, the practicalities of implementing these rules and

regulations, and, most importantly, alternative approaches to address the underlying goals.

My written testimony provides significant detail about the agenda the Commission has undertaken. Today, I would like to just

briefly describe some of these key reforms and then answer any

specific questions that you have.y

First of all, on the 4 p.m. rule proposal, to put an absolute halt

on abusive late trading practices, the Commission proposed the socalled hard 4 p.m. rule. This rule amendment would provide for a

secure pricing system that would be largely immune to manipulation by late traders by requiring that orders be placed with the

fund or its primary transfer agent or clearing firm by the time set

by the funds.

To date, the Commission has received more than 1,000 comment

letters on this proposal, many raising concerns about how the proposal might adversely impact certain fund investors, such as 401(k)

plan participants and investors in earlier time zones. As an alternative to the proposal, some have advocated a system of controls

that would better prevent and detect late trading. Others have recommended the use of more sophisticated technology to create tamper-proof timestamping of trade tickets that would help eliminate,

or at least better detect, late trading. The staff is analyzing this information to determine whether there is an effective alternative to

the hard 4 p.m. proposal that would not disadvantage certain investors and does not distort competition in the marketplace. It may

1066

very well turn out that we adopt a combination of some of the alternatives that have been presented to us during the notice and

comment process. Again, the hard 4 p.m. rule proposal illustrates

the effectiveness of the Commission’s rulemaking process, whereby

we, and indeed the investing public, are the beneficiaries of a wide

range of views and perspectives and possible solutions.

It is a complicated situation, and, of all the things we are working on, it may be the one that is going to take the most time for

us to come up with a compromise solution.

As far as disclosures to fund investors, improved disclosure—particularly disclosure about fund fees, conflicts, and sales incentives—has been a stated priority for the Commission’s mutual fund

program in the months before the trading abuses came to light.

The Commission adopted a requirement that shareholder reports

include dollar-based expense information so that investors can easily compute the dollar amount of expenses paid on their investment

in a fund. Some have questioned whether we should have required

more information, that is, individual account information to each

shareholder. While the staff and the Commission considered this

alternative, we were convinced that the dollar-based expense information that the Commission ultimately adopted was a better

course, as it allowed for comparability. We have ongoing efforts to

examine the entire mutual fund disclosure regime to see if it is as

good as it can be. However, I firmly believe we need to give this

particular rule—which will go into effect in July—a good chance to

operate before we begin to contemplate changing it.

Internal reforms within the Commission. Last year, following a

thorough internal review of how the Agency deals with risk, we initiated a new risk management program and laid the groundwork

for an Office of Risk Assessment and Strategic Planning, the first

of its kind at the Commission. The first phase has been to organize

internal risk teams for each major program area. This framework

has already been put into place and allows for what I like to think

of as a bottom up approach to assessing risk in each of our divisions. A good example of this is through our Office of Compliance,

Inspections, and Examinations, OCIE. We have empowered our examiners, through OCIE’s internal risk management team, to look

at potential problems in the mutual fund industry and broker-dealer industry and to formally examine these for potential problem

areas.

The new Office of Risk Assessment will work in coordination

with these internal risk teams throughout the entire agency and

push the Agency to proactively identify potential problem areas

within the mutual fund and broker-dealer industries, focusing on

early identification of new or resurgent forms of fraudulent, illegal,

or questionable activities. In addition to fostering better communication and coordination between the divisions and offices within

the Commission, the risk assessment initiative will help to ensure

a process whereby senior managers at the Commission have the information necessary to make better, more informed decisions, and

to proactively adjust operations and resources and methods of oversight to address these new challenges.

We have also greatly enhanced our examination program. Budget

increases in 2003 allowed us to increase our staff for fund examinaVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01078 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1067

tions by a third, to approximately 500 people. These new resources,

coupled with the Office’s new risk-based examinations approach,

should greatly improve our ability to detect abusive behavior and

possible violations of law.

Another critical aspect of our risk assessment effort has been the

creation of special multidivisional task forces that were designed to

bring together staff from various divisions and offices to brainstorm, evaluate, and create strategies to proactively undertake

issues of potential concern in protecting our securities markets.

Four of these task forces, which are under way now, will tackle

issues that will help us better protect mutual fund investors. They

are called the Chairman’s Task Forces on Soft-Dollar Arrangements, College Savings Plans—or the so-called 529 plans—Enhanced Mutual Fund Surveillance, and Disclosure Regime. The

task forces will meet with the relevant interested parties, such as

individual investors, industry representatives, and fellow regulators, to gather critical intelligence and data and ultimately work

toward addressing problems over the long haul. All of these task

forces are discussed in detail in my written testimony.

Because I know that the issue of soft dollars is of particular concern to the Committee, just as it is to the Commission, I want to

draw attention to the Task Force on Soft Dollars and our efforts

to address this issue.

The Task Force on Soft Dollars, comprised of SEC staff from five

divisions and offices, has already met with a number of industry

representatives as it tackles this very complicated issue. Its goal is

to fully understand all aspects of how soft dollars are used and the

pros and cons of various alternative reform approaches, including

the possible unintended consequences. While the task force is working expeditiously to provide recommendations, I want to ensure

that the staff has adequate time to fully consider the issue and

meet with interested persons so that it can come in with what we

hope are the best and most informed recommendations possible.

Like so many of the issues that we are facing, the area of soft

dollars is very complex, and we have to be cautious, in my view,

as we move forward with reforms. At the very least, the Commission, through the rulemaking process, should consider narrowing

the definition of qualifying ‘‘research’’ under the safe harbor so that

only ‘‘real’’ research that has valid, intellectual content, qualifies.

I also expect the Task Force to consider whether the costs of research and execution should be quantified and separated and other

ways that make the costs of research and the costs of execution

more transparent. Some have advocated a distinction between

third-party research and proprietary research. My view is that we

should not draw such distinctions, but the Task Force will also consider this issue and provide recommendations.

I would like to say a few words about hedge funds. The issues

surrounding hedge funds are an excellent example of how the Commission can be proactive and work to enhance enforcement in problem areas before they spread. Indeed, this is why I believe our risk

assessment and internal reforms are so important. While my written testimony describes my concerns in detail, I would like to summarize just a few points now with the caveat that these are my

1068

own views and do not necessarily reflect the views of the entire

Commission.

One of the views I often hear in the context of this issue is that

hedge fund investors are wealthy and sophisticated individuals

who do not need protecting. This, in my view, is not the point.

Hedge fund managers are, directly and indirectly, providing advisory services for many U.S. investors, with significant impact not

only on those investors but also on the operation of the U.S. securities markets. The Commission is the only Government agency that

is charged with protecting those investors and policing those markets. Hedge funds are being purchased by intermediaries on behalf

of millions of ultimate small investor beneficiaries—retirees, pensioners, and others not generally thought of as the traditional

hedge fund investor. The increased employment of hedge funds by

pension plans or funds of hedge funds makes it critical for investors that the Commission have basic information and a resulting

insight as to how many hedge fund managers are deploying assets

under management, how they handle their conflicts of interest, how

they account for results and value their investments, and, most importantly, in my view, what impact their market activities have on

the other participants in our equity markets.

The SEC is responsible for enforcing the Federal securities laws,

policing the securities markets, and ensuring fraud prevention and

detection. This is the Commission’s responsibility, regardless of

whether we are talking about mutual funds, self-regulatory organizations, public companies, hedge funds, or other market participants. Hedge funds have become one of the fastest growing

segments of the investment management business, with assets fast

approaching $1 trillion, at a time when returns on other investments have not kept pace.

Other Government entities, particularly the Federal Reserve

Board and the Treasury, are responsible for monitoring potential

systemic risks and the safety and soundness issues raised by the

structure of these vehicles. While their oversight priorities are of

great importance to our banking system, these agencies are not responsible for enforcing the Federal securities laws and protecting

investors. The data they collect is aimed at the discharge of their

prudential oversight responsibility.

It troubles me that the Commission, under the current rules, is

limited in its ability to gather information that could help protect

millions of investors. What we have found in the mutual fund scandal supports this concern. We have seen hedge fund managers engaged in illegal behavior that results in taking advantage of the

long-term retail investors and these funds. Critics, in my view, cannot have it both ways—on the one hand, to demand that the Commission be proactive and prevent and detect emerging but as of yet

unforeseen, harms and abuses, but, on the other hand, to handicap

our ability to obtain simple, fundamental information that facilitates our identification of such abuses.

Building on the risk assessment capability we are developing in

the Agency, we could consider a form of registration and an oversight regime for hedge fund managers different from that which we

use for other, more heavily regulated entities, like mutual funds.

They could be specifically tailored to the unique dynamics of these

1069

funds and managers. We could thus better target our inquiries on

those hedge fund managers where there is some reasonable concern

that they may be violating Federal securities laws.

I intend to ensure that the Commission’s consideration of the

hedge fund issue, which in many ways is an extension of pooled vehicles, be thoughtful and thorough, and that any proposal that we

put forth will be fully and appropriately vetted.

Let me just touch for a moment on the enforcement efforts. Let

me note now our four key enforcement areas related to mutual

funds: one, late trading and abusive market timing; two, mutual

fund sales practices, including fee disclosure issues in connection

with the sale of mutual funds; three, the sale of different classes

of mutual funds; and finally addressing the failure of firms to give

their customers the discounts available on front-end loads for large

purchases of Class A shares.

For the enforcement program’s current area of focus in the mutual fund arena, the staff is continually on the lookout for additional mutual fund practices that may be vulnerable or ripe for

abuse. Accordingly, the staff is closely examining, among other

things, the status of funds closed to new investors that, nevertheless, continue to charge Rule 12b–1 fees, the portfolio pricing practices of high-yield bond funds, the role of pension consultants and

pension plan selection of particular mutual funds as their preferred

investment vehicle, and the reasonableness of management fees

charged by certain index funds. In all of the foregoing areas, the

Commission is intently focusing on the roles and conduct of mutual

fund directors. Have they adequately discharged their responsibility? Have they properly overseen the mutual fund management

company on behalf of mutual fund shareholders?

As my testimony illustrates, the Commission has embarked on

an aggressive regulatory and enforcement agenda. I believe our efforts will help to ensure that there are strong safeguards in place

to minimize the possibility of future illegal, fraudulent, or harmful

activity. We have had ample regulatory authority with which to

carry out this agenda and, due in large part to your support and

your constructive approach, we have been able to pursue this agenda in an expedited manner.

Let me once again compliment the Committee, Mr. Chairman, for

its thoughtful and thorough approach to the oversight of this issue.

The significant number of hours that you and the staff have spent

conducting these oversight hearings and questioning witnesses

from all segments of the industry have been immensely helpful to

the Commission and represent a constructive approach to analyzing the complexity of the problems that have plagued the mutual fund industry for quite some time. The Commission and indeed the mutual fund investor have benefited from your approach.

If, as the Commission moves ahead with its mutual fund reforms,

there are critical issues that we do not have the ability to address,

the Commission will immediately seek your assistance to do so;

however, I do not believe that at this time legislation is necessary,

and, in fact, that legislation could impede the speed with which we

move forward on some of the rules that we have put forward.

Thank you again for inviting me, and I would be delighted to answer any questions.

1070

Chairman SHELBY. Chairman Donaldson, just to follow up on

what you just said, do you believe that the Securities and Exchange Commission has the authority and the power it needs to

adopt the full complement of rules necessary to reform the mutual

fund industry? At this point in time, do you believe that?

Mr. DONALDSON. Let me just say that I think the Commission

has the tools it needs to address the critical areas. Our rulemaking

authority under both the Investment Company Act and the Investment Advisers Act gives us ample authority to act in virtually

every area, not only to address the late trading and market timing

abuses, but also strengthen fund governance, enhance ethical conduct, increase compliance, et cetera. The notice and comment process provides the great benefit of allowing us to receive these great

thoughts.

We have some 10 proposed rules on the docket. We have approved an additional two rules. We have a concept release out. Our

comment period has closed and is closing through all the way to

the end of May. I believe that by summertime we will be in a position to make final rule determinations, with the exception of one

or two, the hard 4 p.m. close being the most appropriate one.

But to answer your question, I believe we do have the authority

that we need at this juncture, and I also assure you that if we find,

as we move ahead, particularly on a longer-term basis with some

of the task forces, that we do not have the proper authority, we will

come back to you and ask for it.

Senator SARBANES. Mr. Chairman, I think if you would pull that

microphone closer to you, it would be——

Mr. DONALDSON. I am sorry.

Chairman SHELBY. Thank you, Senator Sarbanes.

Many of the legislative proposals that have been floating around

in the House and the Senate would essentially either codify or ratify areas contemplated by the SEC in your rulemaking. Is there a

need at all to codify or reaffirm the SEC’s rulemakings in any respect? Or should we give you that time to see how these rules are,

first, proposed, adopted, and implemented?

Mr. DONALDSON. As I said, we are moving aggressively to adopt

the rulemakings. I believe we have the necessary authority. I believe that there is no need at this juncture to codify by new laws

what we are doing. As I intimated, I think, to stop in this process

now and to start a whole new process would be counterproductive

to what we are doing.

It is not just me. It was the microphone.

[Laughter.]

And as I say, I think that, if we need further help, we will come

back to you.

Chairman SHELBY. This is digressing a little, but you brought up

the subject of hedge funds. Right here, in this Committee, the

Chairman of the Federal Reserve, Alan Greenspan, I asked the

question about regulating private hedge funds, and he said he was

not for that. Have you ever discussed this proposal with him? Or

do you all just have a difference of philosophy here?

Mr. DONALDSON. Again, let me, if I might, digress on that a bit,

because I have spoken with Chairman Greenspan on a number of

1071

occasions. I also have had our staff meet with the Federal Reserve

people to discuss the whole issue.

I referred briefly to this in my testimony. I read Chairman

Greenspan’s testimony, and I think he started out by saying, ‘‘I am

against it,’’ and then he said, ‘‘I am not really against the rule. I

am worried about what you are going to do with it.’’

Chairman SHELBY. That is right.

Mr. DONALDSON. I think that was his statement, and I think we

have to draw a distinction between the Federal Reserve and the

Treasury Department’s responsibility here in terms of the prudential oversight of the financial system and the banking system and

the information that they gather for that. That is their role.

We have a different role. Our role is investor protection and the

policing of securities laws, and we have a very different mission.

And I believe that the Federal Reserve and Chairman Greenspan—

looking back to the Long-Term Capital days—believes, and I think

rightly so, that the liquidity provided by hedge funds is an important risk-offsetting capability they have, and worried at that time

that any attempt to legislate that hedge fund could be counterproductive. But we are talking about something totally different.

Chairman SHELBY. We are talking about oranges instead of apples.

Mr. DONALDSON. Exactly. And I believe that—not to beat a dead

horse here, but I believe that we must have the simple capability

to look inside hedge funds and find out what is going on, not to

protect the wealthy investors, although do that, too, but to make

sure that the market impact on other investors—I call it ‘‘the other

side of the trade’’—be examined.

Chairman SHELBY. Thank you.

Senator Sarbanes.

Senator SARBANES. Thank you very much, Chairman Shelby.

Chairman Donaldson, we always pay attention to what Chairman Greenspan recommends because he has been around a long

time and has provided some important leadership to the country.

On the other hand, just 3 years ago, he appeared before us and

told us that we were paying down the national debt too quickly and

that we needed to change the trajectory of paying off the national

debt and, therefore, we could enact a large tax cut without worrying about deficits and without impeding continuing to pay down

the national debt. We would just slow it up a bit because it was

being paid off too quickly. That was 3 years ago, and, of course, we

know where we are now, you know you are working within your

own area of expertise, and I simply commend you to carry forward

in that regard.

Now, having made that diversionary statement, let me——

Mr. DONALDSON. If I might just interrupt and say I have the

highest regard for Chairman Greenspan.

Senator SARBANES. Oh, yes. We ought not——

Mr. DONALDSON. I guess it is just a matter of who is responsible

for doing what.

Senator SARBANES. Well, yes, but we ought not to get to the point

where, if people have very good reasons for disagreeing with a position of his, they ought not to take it or should feel uncomfortable

about putting it forward. And I just mention this 3-year-ago recVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01083 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1072

ommendation and his view that the debt was being paid off too

quickly.

Now, let me ask a diversionary question as well. A week ago yesterday, you appeared before the House Appropriations Subcommittee to discuss your budget. In that testimony, you indicated

that you had yet to fill hundreds of new staff positions made available to you by the substantial budget boost that the Commission

has received and which Members here have, I think almost without

exception—I think without exception, have been supportive of. In

fact, you currently have, according to this article in the National

Journal, 525 vacant staff slots, although you expect to fill 100 of

them by the end of May.

Subcommittee Chairman Frank Wolfe, our colleague on the

House side from Virginia, said he was shocked the SEC has not yet

found enough high-quality, capable people to fill these jobs. ‘‘I am

surprised that you are having trouble,’’ Wolfe said. ‘‘What you are

doing is really exciting, it is important, it is public service, and that

is a good salary.’’ And, of course, the starting salaries now are running at about, I guess, $75,000, which, of course, for a Government

starting position is pretty good money. And a senior-level SEC

accountant with 20 to 25 years’ experience could earn an annual

salary of more than $186,000. I am just putting this out there so

people know there are some career possibilities down at the SEC.

[Laughter.]

But how are you coming? This is important. Last year, you

turned back about $100 million, as I recall, to the Government and

I think that generally met with approval because, you know, there

is no sense in you going out and spending the money if you cannot

spend it wisely.

But we are now into another budget year. We want to get the

Commission staffed up. I know you have done pay parity on the

salaries. I do not think you have done it yet on the benefits, as I

understand it. I do not think that has been brought to a conclusion.

So how are we doing on this whole issue of staffing the Commission and getting you up to full strength?

Mr. DONALDSON. If I do not bore you, let me try and bore in a

little bit on these figures because they are confusing.

We received 842 new position authorizations back at the end of

2002, the beginning of 2003. But those are not all the positions

that we have to fill. In total, we have worked to fill 1,265 position

because we have people leaving the Agency, and that has been one

of the problems of the Agency over the last few years.

Senator SARBANES. Well, I gather you have cut that down considerably, and I commend you for that. I understand the turnover rate

has gone down——

Mr. DONALDSON. The turnover rate has gone——

Senator SARBANES. Is that correct?

Mr. DONALDSON. It has gone down markedly, and that has been

the result of the supplemental payments, salary payments, and it

has been the result of the other benefits that we are bringing out.

Our comparability with other Government financial institutions

has been very helpful, as well as, I believe, the challenge of the

work that is being done.

1073

But we always will have, even though that departure rate has

been way down, we always will have a certain number of positions

that we have to fill. So, you know, we are putting water in the

tank, but it is leaking out at the bottom.

We will have filled all of the new authorizations that we have by

the end of this fiscal year, and I might just comment that the relative speed with which we have done that was impeded to begin

with by the fact that we did not have fast hiring capabilities. In

other words, we could hire lawyers quickly, but we could not hire

accountants. You all and the Congress helped us get accelerated

hiring capabilities. We did not get that until July of last year.

We also are very conscious of the quality of people, you know, not

just going out and hiring anybody. We are having problems in the

accounting area, and we are working to address those problems.

We are working to address some virtual accounting approaches

that would allow people to operate outside of Washington and so

forth. We are getting great competition from PCAOB and so forth.

The availability of accountants in the Washington area is low. So

we are behind there, but we are on track for our hiring, and we

will have completed our hiring by the end of this fiscal year.

Senator SARBANES. I will save my other questions for the next

round. I think you should send a signal across the country to accountants that there are good opportunities here in Washington at

the SEC, and in that regard, I also should note that many of the

people in the private sector that come before us as witnesses or

come to talk with us who are doing exceedingly well now in the private sector spent time earlier in their careers working at the SEC,

and gaining the training and the knowledge that came with that

experience.

I agree with you. I know you said to Wolfe that, ‘‘We have refused to hire employees simply to fill chairs but, rather, are focused

on hiring the best and most appropriate people to fill these important positions.’’ And I think that is a very important framework to

be working within. But I do think it is important that we try to

get staffed up to full level and that you not come to the end of this

fiscal year and again not be able to utilize the resources which the

Congress is providing.

Mr. DONALDSON. I totally agree with you, and I just want to reassure you that we are attending job fairs, we are advertising, we

are across the country trying to recruit accountants as aggressively

as we can. It is our number one priority.

Senator SARBANES. Okay. Thank you.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

I would like to go back to the board, the proposed changes that

you have suggested. If a board is truly independent having 75 percent of its members to be independent board members, why cannot

an independent board choose who they think would serve investors

the best, be it an independent chairman or an interested chairman?

Mr. DONALDSON. Let me try and address that issue. I obviously

heard your earlier comment on this, and I think it is an area where

the structure of a mutual fund and the management company has

an embedded conflict of interest. That embedded conflict of interest

is that what is good for the management company is not always

1074

good for the mutual fund shareholders. That is particularly true in

deciding fees. Mutual fund shareholder directors are charged with

a responsibility for fee setting. The chairman of a management

company, when he is also chairman of a mutual fund, has a direct

conflict of interest.

Senator BUNNING. Mr. Chairman, we are talking about threequarters of the board being independent.

Mr. DONALDSON. I understand that, and let me go one step further. Some argue that an interested chairman; for example, the

chairman coming from the management company, has all of the

knowledge and so forth that an independent chairman would not

have. My answer to that is that that chairman sits at the meeting,

he sits and brings all of that expertise, 40 years of running a management company, knowing more about the business than anybody

else, he is able to give his advice to that board.

But when it comes to conflict of interest and negotiating with

yourself, I believe that you need an independent person who basically is in control of the agenda and basically has an

independence—

Senator BUNNING. But that does not answer my question, sir.

Mr. DONALDSON. Pardon?

Senator BUNNING. My question is if it has three-quarters of independent board members, they have the option of hiring whoever

they want to run the board. Are you telling me that three-quarters

would always choose an interested party? Are you telling me that

they are not independent?

Mr. DONALDSON. I am telling you that I believe that the dynamics of the way boards, and particularly the dynamics of the way

mutual fund boards work, there is, in my view, a necessity for the

independence of the chairman, and not defined by the board itself

picking it.

Senator BUNNING. I have some other questions, and you are not

answering my question. So, I am going to move on.

Do you know about the study, Bobroff’s Mac study, that found

that funds with interested chairs have performed better than those

with independent chairs? In fact, I believe Putnam had an independent chair when they had all of their problems. Do you have

evidence to the contrary showing that independent chairs perform

and board chairs on mutuals perform better?

Mr. DONALDSON. Senator, I am aware of lots of studies that come

to all a lot of different conclusions. I spent a number of years myself in an academic environment where studies were done. I believe

we are in a totally new environment. I believe that the appraisal

of independence or lack of independence back before we were making these changes is a totally different environment.

Senator BUNNING. We had this discussion the last time you appeared here about the independence of the SEC making the rules.

Do you realize that Vanguard, T. Rowe Price, Fidelity would all

have many people that would have to resign because of the rules

that you make? How many investors have put their savings to

these funds because of the reputation of these companies and their

managers? I think that what you have proposed does more harm

to the investor than good.

1075

Mr. DONALDSON. I think that the expertise that the management

company chairman, can still be available to the fund. If you bought

the expertise of Mr. Johnson at Fidelity, 40 years in the business,

50 years in the business or whatever, he can still sit at the table.

You are not taking him out of the room. He sits at the table, gives

all his expertise, all of the reasons, if you bought his funds because

of him, he is there.

When it comes to the power of independence, and the power of

control and asking the tough questions, and controlling the agenda,

that I believe there has to be an independent chairman.

Senator BUNNING. We have a difference of opinion.

Thank you.

Chairman SHELBY. Senator Reed.

Senator REED. I thank you very much, Mr. Chairman, and let me

commend you, Chairman Donaldson, for the energy and insights

you have brought to this task, and the results are obvious. Thank

you for that.

Let me follow this independent chair inquiry. Just for the record,

I think Senator Bunning asked the question about empirical studies and facts that you would use to make this recommendation. Are

there studies that you can refer to or any empirical evidence that

suggests that an independent head of the fund is better than a

company head?

Mr. DONALDSON. What immediately comes to mind is the Mutual

Fund Directors Forum, formed and led by former SEC Chairman

Ruder, which has very strong views on this issue, very strong views

from people who are practicing as independent directors about the

necessity for independent chairmen. I admit that there is a difference of opinion on this, and it is not a silver bullet. Nothing that

we do is a silver bullet.

What I am saying, at this time in our history of the mutual fund

business, is that there should be a very clear separation. This relationship between a mutual fund and its management company is

a very conflicted relationship, and it is different than a board of directors of a corporation with all different independent directors,

lead directors, separation of chairman and so forth——

Chairman SHELBY. Mr. Chairman, how is it different?

Mr. DONALDSON. Excuse me?

Chairman SHELBY. How is it different?

Chairman DONALDSON. For several reasons. First of all is the

profitability for the management company, in many instances, of

things that are of no benefit to the shareholders. The use of commissions for research and so forth, a very ticklish area. The conflict

relative to the fees charged and the obligations of the independent

director to negotiate; you cannot negotiate with yourself. If I am

chairman of the management company and I am chairman of a mutual fund, I cannot—no matter how honest I am—I cannot negotiate with myself on this issue, and I believe that we need an independent person doing that.

That does not directly address your comment, Senator, but it is

a matter of personal feelings, it is a matter of judgment, having sat

on a number of boards and having seen how they operate. I think

you should have an independent chair.

1076

Senator REED. Chairman Donaldson, under the current law, as

I understand it, management contracts, underwriting agreements,

12b–1 plans, other decisions that may involve conflicts are voted on

separately by the independent directors. Why is that not an appropriate response to this problem, particularly if you can identify

those specific issues where, as you point out, an individual cannot

negotiate with himself, even the fairest, most scrupulous ones.

Is that a possible alternative to this situation?

Mr. DONALDSON. All of those issues are ones that we have under

examination right now, and we are trying to reach meaningful conclusions on them. I think that having an independent person who

is not a shareholder of the management company, who does not

have his personal livelihood in the management company, dependent upon the management company is very important. We need to

have somebody who is not in that position, and I think we particularly need it at this time in history. I believe that shareholders will

benefit from this, and I think they will welcome it. The additional

expense of bringing an independent person into that role would be

money well spent.

Senator REED. Mr. Chairman, I think you can recognize that

there is an interest in this topic.

Mr. DONALDSON. I know.

Senator REED. And I think it is interest driven by both sides trying to find the best solution without harming the operation of these

funds and then ultimately protecting the investors. But I think

you, again, recognize that this is a topic that probably requires

even further scrutiny, and I am sure you will do it.

Mr. DONALDSON. I obviously know that this is a controversial

issue. The ICI is opposed. The ICI has been very active, and, I believe in many ways they have opposed this. I wish we had the time

for you to sit down, and maybe we can do this before we make any

final rules and you can talk to some of the independent directors

who have been faced with this, who have sat in board meetings and

get their views on it. I think they are almost unanimously of the

view that it should be an independent chairman.

Senator REED. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sununu.

STATEMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Let me follow up on that point. I apologize. I

did not hear all of the answer that you provided, Mr. Chairman.

I certainly heard the final part of the response which is you asserted your belief that an independent chairman would benefit

shareholders.

My question is has the Commission begun the process of assembling the data and empirical evidence necessary to assert that

claim that an independent chairman would directly benefit shareholders through either lower fees or better performance of funds?

Mr. DONALDSON. Well, we are always looking for more data, and

we are always looking for empirical justification for what we are

doing. I think that there are arguments on both sides of the equation in terms of data and data presentation. I do not think one

study does it.

1077

The judgment that I am putting forth here has to do with just

that—judgment—and the sense of timing here in terms of the ills

that the mutual fund industry has had. It is not a silver bullet. I

just think it is one of many actions that will address the fundamental conflict that is there.

Senator SUNUNU. I genuinely believe you have done a fine job as

chairman, and I do not want this to be taken the wrong way. But

I think it is an important point in the Committee, and people who

have come to these hearings are probably tired of me making this

point. But judgment without data is a guess, and in fact all of the

empirical studies that I have seen—and there have been several,

and we have submitted them for the record already—have shown

no relationship between having an independent chairman and fund

performance or fees.

I believe if we are going to assert that it is a good thing, it will

help, it will benefit shareholders, I think it is very important to assemble empirical evidence or data that will at least indicate the

kind of benefits that we are trying to provide.

I think that is even more important, given that at least the political reason, the emotional reason, one of the emotional reasons that

we have had so many hearings on this at this particular time is

because of the so-called mutual fund scandals, the problems that

we have seen that upset us all of fraud or a violation of existing

law in mutual funds. In point of fact, many, if not most, of those

scandals have occurred at funds with independent chairmen.

I just think we really need to provide some objective assessment

that would indicate the benefits that we are trying to achieve.

Another question, a different topic. I am sure you are pleased

about that.

[Laughter.]

I did not hear it explicitly stated in your testimony whether or

not you thought that soft-dollar arrangements should or should not

be banned.

Mr. DONALDSON. I did mention that we have a—

Senator SUNUNU. Task force, and that they are working hard—

yes, I appreciate that.

Do you have a position on whether or not these soft-dollar arrangements should be banned?

Mr. DONALDSON. I think you have to refer to specific soft dollars

and what they are being used for. We have proposed a rule that

would not allow soft dollars to be used to promote the sale of mutual funds, and that is one of our rule proposals that is out for comment right now.

Senator SUNUNU. That relates to the distinction between qualified and nonqualified?

Mr. DONALDSON. No, it relates to the use of brokerage commissions to induce or compensate for the sale of mutual fund shares

without the mutual fund shareholder knowing that those dollars

are a hidden inducement to a supposedly impartial salesman.

The other part of soft dollars is the issue of what is in a commission rate. The typical rate now for execution and research is 5

cents a share, and typically 2 cents of that is for execution services,

and 3 cents is for something else. And I believe that the disclosure,

by the broker, of how much of that commission is for execution and

1078

how much is for research is a very important thing that needs to

be done and needs to be displayed by the mutual fund—how much

they are paying for executions and then how much they are using

soft dollars for research and where that money is going.

This gets into something we did not delve into, which is that

money, in my view, should be available for third-party research

people, not just the research coming from a large institutional firm.

I think it would be a real mistake to eliminate the ability to pay

for research from third-party people. Now, we need to define, under

28(e), what research is. I think that under that rule there is too

loose a definition of research.

So it is not a simple ‘‘yea’’ or ‘‘nay’’ on soft dollars; it is what they

are being used for.

Senator SUNUNU. I appreciate that point. I think what I hear you

saying is that you want to make sure that, one, the rules are applied evenly, that we are not discriminating against independent

research vis-a`-vis proprietary research at full-service firms, and I

think that is extremely important, especially given everything that

the SEC has already done to encourage independent research. I appreciate your response, and thank you, Mr. Chairman.

Chairman SHELBY. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman.

Mr. Chairman, I do not want to dwell on this independence of

the chairman, but I suppose that definition of what independence

means is also something that needs to be examined and fleshed

out. Now, I think when you look at these studies, you have to ask

yourself whether somebody is not necessarily an immediate family,

but a family member, whether somebody is 2 years past retirement

that had worked their whole career with an organization.

There are lots of ways to define independence, and I hope that

being one that supports either an independent chairman or at least

a lead shareholder in the board, that we do more to refine what

the definition of what an independent shareholder is, in this context, so that we could get what I think is practical independence,

as opposed to pro forma independence, which may be allowable

under the current rules.

Do you, moving to another question, believe you have the authority to deal with the hedge fund issue in the context of how you described it in your testimony and presentation? Do you have the

statutory authority to deal with that issue?

Mr. DONALDSON. I believe we do. Of course, this would be subject

to a rule proposal to be viewed or vetted by the Commission itself,

and that proposal being put out for comment and so forth, but I

think we do have the authority to do that.

Senator CORZINE. Not here at this moment, but if I could have

your legal people give us a statement on how you think that flows

from the Investment Company Act and other places where you actually think you have that authority, I would like to understand

that.

Chairman SHELBY. Senator Corzine, would you request for the

whole record.

Senator CORZINE. Yes, please.

Mr. DONALDSON. Yes, we would be glad to provide that.

1079

Senator CORZINE. Would you comment—particularly since I

thought you were particularly articulate about saying it is very

hard to negotiate with yourself if you are in a mutual fund company, and you are the chairman of the board, and you are negotiating the fees—we had a similar issue when we have mutual funds

that have hedge funds, and you have a similar manager between

the two, and one gets 1-percent management fee and the other gets

an override or some performance-based fee, could you comment on

the side-by-side elements of application of hedge funds inside a mutual fund.

Mr. DONALDSON. I think that this is an issue that is comparable

to issues that were around the industry through the years that had

to do with potential conflicts of interest by fund managers as to

how they buy securities for their own account or whether there is

front-running of the fund by insiders, et cetera. The side-by-side

hedge fund issue is an extension of this. Shareholders are entitled,

in my view, to the knowledge that a fund manager may also be

running, or a fund management group may also be running, a

hedge fund, where the compensation is much greater, the personal

compensation is much greater.

I believe that there are several ways of getting at that. Number

one is to disclose the compensation structure for managers, not

their salaries and so forth, but how they are evaluated within the

fund complex. And that, I believe, should be part of it, and we have

work going on on that, I think that should be part of the disclosure

process.

Second, I think there needs to be oversight, internal oversight,

by the new officers that we are recommending be part of the mutual fund complex, to sit on that potential conflict in terms of the

way shares are allocated when funds or investments are being

made, who gets what first, the order of priority in that. Again, that

is part of the whole process.

I think that, if where you are heading is to ask if mutual fund

management companies should be prevented from running both

hedge funds and mutual funds out of the same shop, I think that

could cause a serious ‘‘brain drain,’’ if you will, out of mutual fund

management companies into the more lucrative independent hedge

fund management positions.

Senator CORZINE. I would love to hear your comments—and I

know my time has run out—the definition of research, as it relates

to the whole soft-dollar question——

Mr. DONALDSON. Right.

Senator CORZINE. —I think at least looks to me like the nub of

the question as opposed to—if you actually were able to deal with

that, at some point, I would love to hear your views on that.

And turnover rate, which Senator Sarbanes talked about, what

is the turnover rate now? What was it and what is it now?

Mr. DONALDSON. Turnover?

Senator CORZINE. The turnover rate of personnel. You said it

slowed down.

Mr. DONALDSON. I think it is, right now, at 1.5 percent of——

Senator CORZINE. Annually?

1080

Mr. DONALDSON. And it was as high, as little as 4 years ago, as

8 percent, and it has come steadily down, and it has come down

in the last 2 years precipitously.

Senator CORZINE. Yes, 1.5 percent is pretty good for any organization I have ever heard of. If that is what it is, that is pretty terrific.

Chairman SHELBY. Thank you, Senator Corzine.

Senator Santorum.

STATEMENT OF SENATOR RICK SANTORUM

Senator SANTORUM. Thank you. First, I would like to agree with

Senator Sununu. I think you are doing a fine job, and I agree with

your testimony that we should not be rushing in here in the Congress to legislate in this area, that you are proceeding along—I do

not agree with everything that you are proposing—but I think that

the fact that you are moving forward and dealing with this in a

forum which allows for experts in the industry and for the industry

to participate, I think is a proper setting, before Congress rushes

in with, at least from my perspective, this is really the best-informed approach on this issue. At least the actions that I have seen

in the other body would indicate that to be the case.

I do want to add my voice in disagreeing with the issue on the

independent chairman. I understand what you are trying to accomplish. I think Senator Bunning’s point, which I think he made well,

but I will remake it in a little different context, and that is if you

have three-quarters of the board that are independent, if they are

truly independent, then it should not be a concern that someone is

trying to pull one over on this board.

If you do not believe they are independent or you do not believe

independent directors are, in a mutual fund context, somehow or

another strong enough to represent the interests of the shareholders, that is a different issue, and maybe we need to look at the

qualifications of independent directors, I do not know, maybe the

definitions of independent directors to make sure that they do have

what is necessary to stand up and do what is in the best interests

of shareholders.

If what you are saying is, traditionally—and I am intimating

what you are saying—independent directors have really been

pawns or puppets of the mutual fund company, well, then maybe

we need to look at what independent directors really should be, as

opposed to trying to, in my opinion, give independent—your proposal is to try to give independent directors more power and then,

in a sense, take it away from them by limiting the choice of who

they can put as chairman. That is a limitation on your power.

You are trying to give them power to be able to run this organization as they see best, and then you are limiting their power as

to who they can select as chairman. I do not necessarily see how

that comports.

I think the fundamental issue that you are trying to get at is are

these people really independent, and that is what I think you

should focus your attention on, not on who the chairman is. You

can comment on that, but only if I get my other questions in.

The second point I want to make is on the issue of disclosure.

Senator Corzine left, and I am going to ask his question because

1081

that was the question that I had in mind. I agree with you on the

issue of disclosure, as far as fees, and you went on to describe fees

would be execution and research. Then you said the definition of

‘‘research’’ is loose. Can you suggest to me how you would tighten

that definition.

Mr. DONALDSON. Yes. I think that the safe harbor that came in

with 28(e) a number of years ago has gradually been expanded, if

you will, and there are all sorts of things that are currently being

paid for that are not really research. I do not want to get into anecdotal evidence, but whether it is newspaper subscriptions or whatever, there are a lot of things that are being paid for now that are

not fundamentally investment research oriented, and it gets particularly confusing because of the rise of electronic research. Is it

the software that delivers the research or is it the machine itself?

I mean, there are a whole series of issues.

What I am saying is that I believe we can tighten up, and should

tighten up, the definition of what is research. I think we can do

that under 28(e) without changing 28(e).

Back on your question, and Senator Bunning’s issue, on the independent chairman. I want to assure you that my view is just that—

my view. I am one of five commissioners. I know that the commissioners are going to read this testimony. I know there are a lot of

people on the other side of this issue. I just want to assure you that

we will be as open as we can be, in terms of getting data, examining the issue and so forth.

I have taken a position on this. It is a personal, deeply held position, but again it will be an issue that will be brought up in a full

Commission meeting, and I do not know where the other commissioners are on this issue.

It finally comes down to, as far as I personally am concerned, the

issue of how the board agenda and how the dynamics and so forth

of a board meeting work. A concept that is just hard for me to believe is that somebody who has an ownership position, and a salary

and so forth, can sit in judgment on some of these issues. I believe

that you must have an independent person there who is not the

management company executive.

I am repeating myself now, but I will say it again. A management company executive who has all of that expertise can sit at the

table and give all of that expertise to the board. It is just who controls the agenda that is of concern to me.

Senator SANTORUM. My time is up. Thank you.

Chairman SHELBY. Senator Carper.

Senator CARPER. Chairman Donaldson, let me just follow up on

what Senator Santorum was saying, at least at the beginning of his

question, with respect to independent chairmen or independent directors.

You mentioned that you are one of its five commissioners?

Mr. DONALDSON. Correct.

Senator CARPER. In the end, if you end up being in the minority

of the decision on whether or not an independent chairman is to

be required, and then the focus should return, rightly, to then what

comprises independent directors.

1082

Just talk with us a little bit about what kind of concerns that

we should be mindful of, and you should be mindful of, in terms

of what constitutes independent and what does not.

Mr. DONALDSON. A very good question. It is one that we are

wrestling with right now. The definition of independence is somewhat limited. While it does not exclude uncles and aunts, and so

forth, from being classified as independent, we are nevertheless

concerned about those individuals.

We have found that we can get at that in certain instances by

requiring disclosure; in other words, maybe uncle Joe, twice removed, is not technically precluded from being considered an independent directors by law. But we can get the mutual fund company

to disclose uncle Joe’s relationship to management in their prospectus, and I think that would be reason enough for them not to

want uncle Joe, twice removed, to be an independent director but

with the disclosure of the realtionship in a prospectus.

Senator CARPER. I once had an uncle Joe.

Mr. DONALDSON. Pardon me?

Senator CARPER. And he was a pretty independent cuss.

[Laughter.]

Mr. DONALDSON. But in terms of the issue at hand, I believe that

it is, no matter how honest and full of integrity a person is, if he

or she has spent their lifetime in a management company as an

owner of stock, is paid by the management company, et cetera, I

think it is very difficult for them to negotiate with themselves, to

have the power of being a chairman. That is what I am talking

about.

Senator CARPER. Do you have a similar view when it comes to

a person being the chairman of the board, let us say, for General

Motors or Dupont or some company like that, being CEO of a company, the person who is running the company and also being chairman of the board?

Mr. DONALDSON. This will seem to be an inconsistent position,

but I think it is a different situation.

Senator CARPER. Just explain why.

Mr. DONALDSON. I am not one who believes that one suit fits all

in the corporate world. I am not one that believes—I think there

are certain great benefits from separating the chairmanship from

the chief executive officership. I think there are certain times when

you want to have a lead director fill that role. I think there are certain times when you want to have one person be both chairman

and CEO. In that world, I would not be for one formula. I would

be for giving flexibility to have a system that is pertinent at a particular time in history.

I think the relationship between a mutual fund and a mutual

fund management company is a very different situation.

Senator CARPER. One of the violations that has been disclosed,

in terms of abuses, I think, of customers of mutual funds is the violation of the hard 4 p.m. close.

[Laughter.]

I understand that in 1968 a requirement was established for, I

guess, a time stamp. So we have had a requirement that was put

in place maybe 36 years ago for a time stamp, the idea of which

1083

was to try to make sure that people did not make purchases to the

disadvantage of others. That obviously has not worked too well.

We are a lot better with technology today than we were in 1968.

Is there some way to use that technology—whether it is with a

time stamp or some other device—to be able to, you talked about

the problems with 401(k)’s and how they might be disadvantaged,

is there some way to use technology, whether it is a 21st century

time stamp or not? What are your thoughts on that?

Mr. DONALDSON. Very definitely there are ways. Let me go back.

There have been ways of abusing the old time-stamp method of

doing things. Time stamps have been altered, tickets have been

time stamped and then held back and then put in on a late trade.

So there are ways of—modern ways—of changing that, making inalterable kinds of time stamps and so forth, high-technology ways

of doing that. We are examining that right now.

There is the other issue of the unfairness, if you will, of people

in different time zones and all of those issues, and I think the hard

4 p.m. suggestion by the SEC is under extensive examination.

There are costs to some of these electronic ways of doing things,

and we are going to try and come up with the best combination.

I am not sure you were here when I was commenting on this before, but this is one of the most difficult problems for us to meet

with the right solution, a cost-effective solution, but we are working

on it.

Senator CARPER. Good.

Mr. Chairman, has my time expired?

Chairman SHELBY. If you want to do another question, do it.

Senator CARPER. Thanks very much.

You have talked a little bit about soft dollars, and I was not

originally aware of the practice where, as a mutual fund, I can contract with a brokerage house to execute trades and also give them

some extra money that they would use to pay for independent research.

I am troubled by that practice. I do not think we are going to

legislate on it, but tell me again what would you would have the

SEC do with respect to that practice? I think I heard you say that

you would establish a soft-dollar task force, one of the things that

they are looking at was this.

Mr. DONALDSON. We are looking at the whole——

Senator CARPER. And the other half of my question, are there

other soft-dollar practices that you are focusing on?

Mr. DONALDSON. Let me try and answer that in two ways.

First of all, under the safe harbor of 28(e), the definition of what

can be paid for with brokerage dollars is too loose. Over a period

of time, there are things that are being supplied to investment

managers that are really not research. We could fill you in on that

in detail.

The second part of this is the execution commissions that funds

pay to the broker. That clearly can be broken down. There is an

average now of 5 cents a share—the common average. What part

of that is for execution, and what part of that is for research?

And what I am saying is that we need to get to a stage where

the executing broker tells the institution that 2 cents of that 5

cents is for the execution, and maybe it is 3 cents if we position

1084

some stock and gave an additional service. Therefore, you have, let

us say, 3 extra cents. The institution should be able to direct perhaps a penny of that 3 cents to the executing broker for research

in the big institutional brokerage firm and should be able to direct

2 cents to an independent research person, who is again providing

real research and not Wall Street Journal subscriptions and so

forth.

So, I guess what I am saying is that the funds—to get back to

the mutual funds—in my view, should disclose to their customers

how these brokerage dollars are being spent, that we are spending

2 cents times x million shares for executions, and we are spending

3 cents for research. And I believe that is the way to get at it.

Senator CARPER. Thanks very much.

Mr. Chairman, thanks for your indulgence.

Chairman SHELBY. Chairman Donaldson, it is troubling to a lot

of us up here, you can tell, if you and the SEC were to mandate

that a director be independent, although you are mandating or

plan to mandate that 75 percent of all of the directors be independent. It looks to me like the directors should make that decision, who they want to be the chairman of their board, and that

they should—and if they are independent, and if you define that

properly, and I hope you would—make that decision because you

are taking a lot of their power away from them to begin with, if

you say you have got to have an independent director.

Let us say the most knowledgeable, the most worthy, the strongest person there was not independent, and everybody that was an

independent—75 percent of the directors—would recognize that—

they know they could fire the director or elect him or take him

down—what would be wrong with the directors making that decision?

You see what we are asking, do you not?

Mr. DONALDSON. Yes.

Chairman SHELBY. I know you say that he has got an inherent

conflict, but ultimately the directors should be looking after the

mutual fund shareholders, should they not?

Mr. DONALDSON. This gets down to the definition of independence.

Chairman SHELBY. Absolutely.

Mr. DONALDSON. And it gets down to the attempt to define something by law. I think you can define away a lot of things that make

somebody clearly not independent. I think it is very hard to define,

by law, what true independence means, and I think that the nature

of human relationships is such that independence is an ephemeral

thing in the final analysis of what true independence is. And I

think it is quite possible that you can have someone who qualifies

as independent because of laws that have been written, but who

really is not independent because of the relationships. That is what

is in my head, based on the experiences that I have had.

Chairman SHELBY. We have these hearings, though, to discuss

things like this.

Mr. DONALDSON. Obviously, it is a question that you all have.

Chairman SHELBY. For the Committee.

Mr. DONALDSON. It is a question that the Commission will look

at very, very closely. Again, empirical evidence that you have or

1085

that anybody has, we would like to have it. We are going to try and

make the right decision, and a decision may be made that disagrees with my personal views. That is why we have five people

on the Commission.

Chairman SHELBY. I want to touch on one more thing that I

think we are in total agreement on this. We have talked about it,

personally, and that is we should not legislate or regulate fees and

that the fees should be set by the market, should they not?

Mr. DONALDSON. I can say that that is not only my opinion, but

that is the unanimous opinion of the five commissioners, and this

is where we differed in terms of the remedies brought against the

mutual fund industry. We did not think that we should be legislating commissions. We thought the free market should.

Chairman SHELBY. You touched on the idea of disclosure, which

is very important. But the information that the shareholders get in

the mail regarding their fund, it has to be readable, it has to be

understandable and so forth. What are you contemplating in this

area? We had one hearing on that alone.

Mr. DONALDSON. We have a staff group, one of the study groups

that we have put together, that is working on just that subject. If

we are going down a plank of more, and more, and more disclosure,

the question is does more disclosure disclose less because it is so

complicated and so hard to understand, et cetera?

We have panels going now in three cities in the next couple of

weeks, where we are bringing people together to examine some of

our proposed actual physical ways of displaying some of this information and to see how useful it is to people.

We have a group going with the AARP, in which they are looking

at alternative ways of displaying some of this information and

helping us get it in a way that people can understand. And I think

that is absolutely the other side of this equation. Disclosure can go

just so far, and overdisclosure obfuscates, as opposed to disclosing.

We are trying to get at that.

Chairman SHELBY. Thank you.

Senator SARBANES.

Senator SARBANES. Does Senator Bunning want to go?

Chairman SHELBY. If you want to go, go ahead.

Senator SARBANES. And then I will go.

Senator BUNNING. Chairman Donaldson, I quoted a study, and I

have been informed by your staff that you do have that study—the

Bobroff Mac Study on Mutual Funds and Independency.

Before you take a step that we may have to react to in the wrong

direction, I would appreciate any data that indicates to the contrary that the SEC might have in regard to independency, independent directors and an independent head of the board. I would

like to see what you are basing your opinions on, as the Securities

and Exchange Commission, rather than what we are basing our

own feelings on, and that is data.

I would like to see the data come from the SEC to the Committee, and I am requesting that you do that.

Mr. DONALDSON. We would be delighted to do that.

Senator BUNNING. Rather than a gut feeling that it just does not

feel right, I would like to see the data that you base your facts on.

1086

Mr. DONALDSON. I totally agree with that sentiment. I disagree

with your characterization of my views on this as being an uninformed gut feeling.

Senator BUNNING. No, no. You obviously have studied the issue.

Mr. DONALDSON. What we try to do, before something is brought

to the Commission, is analyze the pluses and minuses, and bring

whatever data we have, whatever data we have on the other side,

testimony by independent directors about the dynamics of the

board room, all of this brought together, plus and minus, and then

make a decision.

Senator BUNNING. Well, I hope your Commission, the Securities

and Exchange Commission, is not like a lot of other commissions,

that is chairman-dominated; in other words, that the four other

people—

[Laughter.]

Mr. DONALDSON. You do not have any worry about that, Senator.

Senator BUNNING. Well, I worry about it because I have dealt

with the Federal Reserve for the last 18 years, and I assure you

that, in my opinion, the FOMC Committee has been chairmandominated no matter who the chair was, and I have lived through

three Chairs on the Federal Reserve.

So, please, because this is a very, very important issue, because

the information that I have, in regards to mutual funds, and my

experience over 25 years of selling and owning mutual funds, indicate to me that the owner-director or the person who is closest to

the fund not only outperforms those that are independent chairmen, but also has a deeper commitment to make sure that that

fund performs at the best number it can for its stockholders.

So, I cannot be more positive than I am in requesting your information and your data before you do something that there is going

to be an unbelievable uproar on. So please do that for me.

Mr. DONALDSON. Sure. We absolutely will do that. The expertise,

and the devotion and all that you imply for the management company officer who is also the chairman of the fund itself would be

there sitting there giving that. The only difference would be that

he would not be running the board meeting.

Senator BUNNING. Maybe he will be there.

Mr. DONALDSON. Absolutely. He is part of the 25 percent that

can be there.

Senator BUNNING. The misfortune or the unfortunate part of this

is that we may have a chairman who has been the number one producer and number one seller because of his performance as chairman, and I can go back and do some specific funds, but I am not

going to do that. And the reason that investors really went into

this fund is because of the performance that this man has had as

chairman of this certain fund.

We have seen them advertised on television many times how well

they have performed, although performance is not necessarily guaranteed for the future.

[Laughter.]

I know the disclosure. So, please, let us not have to fire somebody who is doing one great job as chairman of the board of some

mutual fund just because the SEC feels and has data that they feel

makes a change necessary.

1087

Thank you.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

Chairman Donaldson, first of all, we did a little research in the

interim. The quote that I was referring to, which is at the entrance

to the SEC’s public meeting room from Chairman William O. Douglas, subsequent Supreme Court Justice, says, ‘‘We are the investors’ advocate.’’ ‘‘We are the investors’ advocate,’’ is really the

charge for the SEC.

I want to again commend you. I am just looking at your mutual

fund initiatives, and some have been finalized, but most are in the

process of being considered. Amendments to rules governing pricing

of mutual fund shares, late trading, disclosure regarding market

timing and selected disclosure of portfolio holdings, compliance programs of investment companies and investment advisers, enhanced

disclosure of break-point discounts by mutual funds. Also, concept

release on mutual fund transaction costs, new investment company

governance requirements, investment adviser codes of ethics and

insider reporting of fund trades, confirmation requirements and

point-of-sale disclosure requirements for mutual fund transactions,

enhanced mutual fund expense and portfolio disclosure, and improved disclosure of board approval of investment advisory contracts.

I do not know, there may have been additional ones that have

been added recently, but that I think is a very active and vigorous

agenda on the part of the SEC, and I want to commend you for it.

Once you put these things out for comment, everything comes in

upon you, and I understand that. We, on occasion, have a similar

experience here, and obviously you have to work through these

things and end up doing what you think is right, and there is a

lot to be done.

On March 12, 2003, Mr. Haaga, representing the ICI, testified

before the House Financial Services Committee, March 12, 2003—

just over a year ago. This is what he said, in part:

‘‘The strict regulation that implements these objectives has allowed the industry to garner and maintain the confidence of investors and also has kept the industry free of the types of problems

that have surfaced in other businesses in the recent past. An examination of several of the regulatory measures that have been adopted or are under consideration to address problems that led to the

massive corporate and accounting scandals of the past few years

provides a strong endorsement for the system under which mutual

funds already operate.’’

Now, obviously, either people did not know what was going on,

there was a complacency because all of these practices now that

are coming out, most of which are the subject of your proposed

rulemaking, obviously have raised questions about what confidence

investors can have, and they need to be corrected or they need to

be cleaned up, and my perception is that is what the Commission

is working to do, and I am supportive of your efforts to do that.

I think you need to carry through on it. You put out the proposed

rules. You get the benefits of the comments in order to work

through to an even better substantive decision, but I do not think

the Commission, I do not expect the Commission would back off

1088

simply because there is a lot of pressure if they perceive that what

they are trying to accomplish is the appropriate thing to do.

Now, Chairman Shelby and I received a letter, which I think we

have sent down to you, and you have had a chance to look at, from

the consumer groups—Consumer Union, Consumer Federation of

America, Consumer Action, and Fund Democracy—raising a number of questions. They say the SEC has responded effectively to the

majority of issues raised by the recent mutual fund scandals. They

say, ‘‘Because of that, Congress finds itself in the enviably position

of not needing to pass sweeping mutual fund reform legislation.’’

They do then address some issues, though, that they think remain outstanding, which the Congress out to take a look at.

I do not know if you have had a chance to examine that letter.

Mr. DONALDSON. I saw that letter yesterday.

Senator SARBANES. I would be interested in your reaction, if you

had a chance to formulate one. Then they go on and also say, ‘‘Almost as important, we urge the Committee to continue to monitor

SEC implementation of its proposed mutual fund rules to ensure

that it does not waiver in its commitment to strong pro-investor reforms.’’

And I, Mr. Chairman, Chairman Shelby, I think we obviously

need to do that monitoring.

Chairman SHELBY. We will do it.

Senator SARBANES. Not that I have reason to believe that the

Commission will waiver in its commitment to strong pro-investor

reforms, but simply as carrying out our responsibilities. In fact, I

hope the Chairman will come away from this hearing refortified in

his determination to carry through on strong pro-investor reforms.

Do you have, as yet, any view on these suggestions within the

letter?

Mr. DONALDSON. That letter came across my desk yesterday, and

I jotted down a few reactions to it that I had. These are my reactions to it. We are going to take a good hard look at what they said.

Senator SARBANES. I thought it was, I mean, these are responsible organizations, and I thought it was a thoughtful responsible

letter.

Mr. DONALDSON. I have no doubt of that. The title of the letter

is, ‘‘Cost Competition,’’ and they say that they advocate that ‘‘Congress mandate better mutual fund cost competition.’’ Many of the

ideas that were exposed in that letter are thoroughly addressed in

the SEC’s concept release on transaction costs, and I would suggest

this consumer group read that release.

It also says, ‘‘although transaction costs are not taken into account in computing a fund’s total return, there is concern that investors would not fully understand the impact of transaction costs

because those transaction costs are not separately disclosed in a

fund’s expense table.’’ We are working on that. We are working on

the correct disclosure of that.

The letter also advocates better disclosure at the point of sale.

Again, the SEC has a rulemaking proposal right now pending that

will provide, for the first time, point-of-sale disclosure about certain

costs and conflicts.

I could go through that letter point-by-point. Basically, it was a

letter that seemed to not have been informed by a reading of our

1089

agenda that is out there and what we are doing right now. We will

answer that letter and provide copies of our answer to you, but our

bigger point is that we are not going to back off in any way.

And we do not view the 10 proposals that we have out there—

we do not view that as the end of what we are doing. We have

these teams working now that are going to go into the next step

here—things we do not catch now, the next step, year after year,

after year. I want to assure you that that is what we are working

on, and that is what we are going to do.

Senator SARBANES. Are these teams that you keep referring to,

internal teams at the SEC made up of SEC staff; is that correct?

Mr. DONALDSON. They are representatives of the different divisions who bring different dimensions to bear. Studying this, they

have the right to talk to people outside and to gather any information and to come up with some recommendations for us.

Senator SARBANES. When would you expect that the SEC will

have finished its work, at least on the rules that have been put out,

leaving aside further rules that you might propose as a consequence of further examination or as a consequence of the reports

of these task forces.

Mr. DONALDSON. We have two rules that were put out that have

now been adopted by the SEC. They were adopted in December and

February. That had to do with investment adviser compliance programs and shareholder reports and portfolio disclosure. We have 10

proposed rules out there now, and the beginning of the proposal of

those rules started in December, and it ended on March 11. We

have scheduled times, if you will, for bringing these rules up for

final approval. That schedule may change, depending upon the

state of our deliberations.

I anticipate that by hopefully the end of the summer or the beginning of the fall we will have acted on most of these proposals.

I cannot guarantee that on all of them. And, if we are delayed, it

will be because we are trying to get a better fix, if you will. But

I would say that certainly by year end, hopefully, by the fall, and

possibly by the end of the summer.

Senator SARBANES. Does the industry perceive the necessity of

making significant changes in order to restore investor confidence

or do you perceive them as resisting this and taking an attitude:

Well, nothing is really wrong—there were a few outliers, but aside

from that, we just want to go on doing things as we always did

things?

Mr. DONALDSON. No, I do not think that is true. I think if you

can talk about the industry, I think the industry is cooperating. I

think the trade associations are cooperating. We do disagree on a

few things. A couple of their recommendations we do not think are

correct, but, by and large, I think there is a new attitude out there,

and I think that it has been a very cooperative attitude.

Now, that is not to say that there are not intensive lobbying efforts mounted against some of the things that we want to do. We

recognize that as part of the way the process works. But I think,

generally speaking, there has been great cooperation.

I might also say, because it is said too little, that, although there

were some shocking things that happened in terms of this late

trading, market timing, and selective disclosure, and although

1090

there was the front office of the funds telling us they were trying

to cure this stuff when the back office was making deals, and that

is shocking, there are other funds that have not been doing this at

all, that are very well run, that have controls, et cetera, and I

think they deserve a pat on the back.

Senator SARBANES. Yes, I think that is a very apt observation because there are a number of funds that their practices have not

been brought into question.

Mr. DONALDSON. Exactly.

Senator SARBANES. And that is, of course, highly commendable.

Mr. DONALDSON. I just want to say that publicly. But I think

overall, in terms of your observation or your question, I think that

a new day is afoot here, and I think there is new attention being

brought to these issues. I think there are people in the industry

who are as upset as we are and you are by what has happened in

the industry, and they are doing everything they can to not only

change their own organization, but also working through other organizations to bring about change in the whole industry.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Chairman Donaldson, you certainly realize,

and we do, too, that your chairmanship of the Securities and Exchange Commission is at a critical time. I want to say again that

we appreciate your appearance here again. You have spent a lot of

time with us, and I am sure in the future we will be spending a

lot of quality time together as we continue our oversight of what

your regulations will bring forth, how they work.

We are certainly not ruling out legislation in the future, but we

are not ruling it in today either because we want to see what the

SEC does, how it works, and then we will work with you and see

if there is something in the months to come. This is a short year,

legislatively, as we all know, but we appreciate what you are doing,

the start you are doing, the challenge you have, and you are always

welcome here, and we will get together again.

Mr. DONALDSON. Thank you, Mr. Chairman.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 12:13 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

1091

PREPARED STATEMENT OF SENATOR JON S. CORZINE

Thank you, Mr. Chairman. Mutual funds are the primary means for investors to

participate in the market. Approximately 95 million Americans invest in mutual

funds, and investments total near $7 trillion dollars. The industry, one of our oldest

and most revered, is entrusted by Americans with their dreams of retiring comfortably or of paying their children’s college tuition or of buying a first home. In addition to being a force for economic growth and wealth creation, the mutual fund

industry has been, for decades, a standard-bearer for ethical behavior, investor protection, and strong oversight and governance in our capital markets.

But as we have witnessed over the past year, this industry has found itself at

the center of scandal after scandal. To be sure, a great deal of confidence has been

lost due to the litany of allegations of fraud and mismanagement, corporate governance failing, financial conflicts of interest, and other abusive practices. Last fall,

Senator Dodd, the Ranking Member of the Securities Subcommittee, and I introduced S. 1971, The Mutual Fund Investor Confidence Restoration Act of 2003. This

legislation aims to protect the millions who invest in these funds by seeking to:

• improve mutual fund governance, internal controls, and ethical compliance; • enhance cost, fee and other disclosures to shareholders; • eliminate financial conflicts of interest where possible, and make shareholders

aware of where potential others may exist; • prevent abusive mutual fund practices, such as late trading and market timing

and; • strengthen the oversight of the industry.

The measures included in the legislation were a response to the scandals that

arose from investigations by the SEC and the office of State attorney generals. To

their credit, the SEC has been aggressively pursuing changes in the culture of the

mutual fund industry through an aggressive approach at proposing regulatory initiatives.

But while their actions are important, we must consider what more—if anything—can and should be done. And we should give consideration to whether codifying these rules will prevent an overreaction during future shocks or scandal.

In short, Mr. Chairman, it is legitimate to consider what role—if any—Congress

should play in this effort. I personally believe there is a role. As a result, shortly

after we return from recess, Senator Dodd and I will be introducing a new version

of our mutual fund legislation. The bill will include some of the fund governance,

transparency and disclosure, and other provisions included in S. 1971. But it will

also address some of the complex issues that lead to conflicts of interests. Some of

those can be found in the financial arrangements between fund complexes, investment advisers, broker-dealers, and other intermediaries to promote the sale and distribution of the funds.

We will be addressing the issue of directed brokerage, soft-dollar arrangements,

and revenue sharing, just to name a few. Additionally, we will address the SEC’s

‘‘hard 4 p.m.’’ proposal, and consider an alternative that will not disadvantage certain investors, particularly 401(k) and west coast investors, but will provide the

SEC with the assurance that these intermediaries have controls, compliance systems, and audit trails in place to prevent abusive market timing and late trading.

Mr. Chairman, there is no doubt that real reforms are needed. Thankfully, they

are already on the way. I commend the efforts of the SEC, Chairman Donaldson,

and his staff for their aggressive approach toward promoting these much-needed reforms. But while the reforms they have initiated are important, I am not sure that

they vitiate the need for statutory action, especially since in some areas, like soft

dollars, the necessary changes will require ultimately statutory fixes.

Mr. Chairman, I look forward to working with you, and the other Members of this

Committee, in the effort to fashion these reforms. And, I again thank you for your

thoughtful and deliberate approach to these important matters.

—————

PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI

Thank you Chairman Shelby for holding this series of oversight hearings on the

mutual fund industry. It is a very similar approach to the one the Committee took

with the Sarbanes-Oxley Act. The mutual fund industry operates unlike any other

financial service industry. The series of hearings has helped us to understand the

industry as well as being able to understand how the scandals were able to happen.

Under the direction of Chairman Donaldson and the rest of the Securities and Exchange Commission, I believe that we are on the proper course to reforming the muVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01103 Fmt 6601 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
1092

tual fund industry. I cannot recall a time when the Commission has acted in a more

timely and comprehensive way to restore investor confidence. The Commission has

undertaken a variety of regulatory, enforcement, and examination initiatives to correct the significant problems and lax oversight of an industry that millions of investors rely upon for their future retirement and investment needs.

Chairman Donaldson, in your capacity as Chairman of the SEC during the past

14 months it is very likely that you have been more active and productive than perhaps the last couple decades of SEC Chairmen. The extremely hard work that you,

the Commissioners, and the staff have undertaken to put the SEC back on track

should be recognized. I also realize that your work on the many issues pending before the Commission is not yet done.

While I applaud the Commission with moving forward quickly on the regulatory

reforms, the many hearings before us have given me a greater insight as to how

the mutual fund industry has developed over the years. What may be considered

unique or unusual practices to typical corporation or Wall Street firms, may in fact

be practices that are an integral part of the operations of the mutual fund industry.

Accordingly, I urge the Commission to carefully consider proposals that would impose a ‘‘hard 4 p.m. close’’ for the placement of mutual fund orders and the mandatory requirement of an independent chairman. I strongly believe that alternatives

are available that be in the best interests of investors and would not change the

dynamic nature of the mutual fund industry.

Being from a western State, I have heard from constituents that the hard 4 p.m.

close proposal would place western State investors at a great disadvantage to their

eastern State neighbors. The proposal also would pit investors that place mutual

fund orders through third parties, such as employer-sponsored retirement plans,

against those who place orders directly with mutual funds. I know that the Commission can find a solution that will not place certain investor groups over others.

In addition, I understand that the Commission has established a task force to

study the soft-dollar issue. I urge the task force to commence its review of this area

in the very near future. We have heard a great deal of testimony before the Committee that there are inappropriate uses of soft dollars, however, a complete ban on

soft dollars would disproportionately effect small, independent research firms. The

findings of the Task Force are essential in order to determine whether legislation

is necessary in this very important area.

Recently, you have given speeches and testified before Congress on the Commission’s upcoming proposal to regulate hedge funds. I am very concerned that the

Commission will expend resources on regulating hedge funds when it has not yet

finished Phase 2 of the Investment Adviser Registration Depository for the oversight

of investment advisers. In addition, I would hope that the Commission is fully confident that it can oversee and examine the mutual fund industry prior to expanding

its oversight into other areas.

As we know, the oversight of the mutual fund industry by the Commission has

not been as stringent or as thorough as it should have been in the past few years.

I do not want to give false hope to investors that the Commission can further tax

and stretch its resources without doing a sufficient job on its primary oversight of

the mutual fund and investment adviser industries. Millions of retail investors are

counting on you to do the right thing to safeguard their retirement and investment

savings.

Thank you again Chairman Donaldson for appearing before us today.

Mr. Chairman, thank you again for taking a careful, thoughtful, and thorough

oversight review of the mutual fund industry. I have greatly benefitted from all of

the witness’ testimony.

—————

PREAPRED STATEMENT OF WILLIAM H. DONALDSON

CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

APRIL 8, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

thank you for inviting me to testify today at your tenth hearing on mutual fund

issues since late trading and market timing abuses came to light last fall. The

breadth of your hearings have clearly and effectively illustrated the complexity of

the issues the Commission is facing in addressing problems in the mutual fund industry. The hours upon hours that you and the Committee have spent performing

critical oversight, and the testimony from witnesses representing all sectors and aspects of the problem, have been immensely valuable as the Commission works to

1093

tackle these issues. I thank you and I commend you for your thorough and thoughtful approach.

Like you, I am outraged by the conduct that has come to light in the recent mutual fund scandals. In large part, I believe that the industry lost sight of certain

principles—in particular, its responsibility to millions of investors who entrusted

their life’s savings in this industry for safekeeping. As I said last fall when I testified before you, and I believe it bears repeating, these mutual fund investors are

entitled to honest and industrious fiduciaries who sensibly put their money to work

for them in our capital markets. Investors deserve a brokerage and mutual fund industry built on fundamentally fair and ethical legal principles. This has been the

Commission’s urgent and guiding mission as it pursues an aggressive mutual fund

reform program to identify and address a range of problems in the industry. The

Commission has made significant progress, and will continue to move aggressively

to track down and pursue wrongdoers, while expeditiously considering and adopting

the outstanding mutual fund rule proposals.

As you have seen through your hearings, and we have witnessed through our

rulemaking process, there is a wide variety of views among knowledgeable experts

as how best to address mutual fund oversight—views that very often conflict with

one another, particularly among competitors. That is why our notice and comment

process, which Congress so wisely required in Commission rulemakings, is of infinite value to us and to the final product. In a deliberate, structured format, we benefit from a wide spectrum of views and opinions as to how to strengthen our

proposed rules and regulations, the practicalities of implementing those rules and

regulations, and alternative approaches to address the underlying goals of our proposals.

As you requested, I will address the Commission’s recent initiatives to respond

to the specific problems of late trading, market timing, and selective disclosure

abuses. I will also address what the Commission has done and is continuing to do

to strengthen the mutual fund regulatory framework overall, as we work to prevent

any future breakdowns in the industry.

With more than 91 million Americans invested in mutual funds, representing almost half of all U.S. households, and a combined $7.5 trillion in assets, mutual

funds are unquestionably one of the most important elements of our financial system. Investor protection is a top priority at the Commission. We are focusing our

attention on pursuing an aggressive program to identify and address a range of

problems and challenges in the mutual fund industry—challenges such as strengthening the governance structure of mutual funds, addressing conflicts of interests,

enhancing disclosure to mutual fund shareholders, and fostering an atmosphere of

high ethical standards and compliance within the industry.

Appropriately, the Commission and its staff have been extraordinarily busy addressing challenges with particular focus on addressing the specific problems of late

trading, market timing, and selective disclosure abuses. In my testimony, I will outline: (1) our aggressive rulemaking agenda—which has immediately tackled late

trading and market timing abuses; and our extended efforts to address broader

structural problems in the mutual fund regulatory framework; (2) our vigorous inspection and enforcement efforts; and (3) the restructuring of the Commission’s

overall internal functions and operations to better assess and anticipate risk, particularly vis-a`-vis the mutual fund industry.

The Commission’s Rulemaking Initiatives

Last month, as part of your hearing series, Paul Roye, the Director of the Commission’s Division of Investment Management, testified regarding the aggressive

regulatory agenda the Commission has undertaken to combat late trading, market

timing, and related abuses. In addition, he outlined the aggressive overall regulatory agenda to: (1) improve the oversight of funds by enhancing fund governance,

ethical standards, and compliance and internal controls; (2) address or eliminate

certain conflicts of interest in the industry that are potentially harmful to fund investors; and (3) improve disclosure to fund investors, especially fee-related disclosure. In each of these areas the Commission has moved swiftly to propose rules and

to vet them through our notice and comment process and, in many instances,

through meetings with relevant interested parties. We also are moving promptly to

craft final rules but, because of the complexity associated with some of our proposals—such as our proposal on late trading—we may take additional time before

finalizing our proposed rules. More important than acting quickly is making sure

we get it right. Let me briefly describe our proposals in each of these areas.

1094

Late Trading & Market Timing

Investors rightfully assume that mutual fund managers and fund directors put

the investors’ interest first. When the late trading and market timing abuses came

to light, it was clear that many of these investors had been let down, as some of

those charged with protecting investors had willfully disregarded their responsibilities to act for the benefit of their investors. To put an absolute halt on late trading,

the Commission proposed the ‘‘hard 4:00’’ rule. This rule amendment would provide

for a secure pricing system that would be largely immune to manipulation by late

traders by requiring that orders be placed with the fund or its primary transfer

agent or clearing firm by the time set by the funds.

Typically, funds price their shares at 4 p.m. eastern standard time. Investors submitting orders before 4 p.m. receive that day’s price; investors submitting orders

after 4 p.m. get the next day’s price. If an investor can place an order to buy or

sell fund shares after 4 p.m., but still receive the price set at 4 p.m., that investor

can profit from new information in the marketplace at the expense of other fund

shareholders. Under the current system, various intermediaries, including some

pension plan recordkeepers—some of whom are not registered with the Commission—can receive the orders by 4 p.m. We know that the current system has failed

because intermediaries allowed certain, select shareholders to receive the 4 p.m.

price, even though their orders were placed after 4 p.m.; consequently, we needed

to devise a new system to minimize the possibility of this abuse in the future.

To date, the Commission has received more than 1,000 comment letters on this

proposal, many raising concerns about how the proposal might adversely impact certain fund investors such as 401(k) plan participants and investors in earlier time

zones across the country. As an alternative to the proposal, some have advocated

a system of controls that would better prevent and detect late trading; others have

recommended the use of more sophisticated technology to create tamper-proof time

stamping of trade tickets that would help eliminate, or at least better detect, late

trading. The staff is analyzing this information to determine whether there is an

effective alternative to the hard 4:00 rule proposal that would not disadvantage certain investors and would not distort competition in the marketplace. It may very

well turn out that we adopt a combination of some of the alternatives that have

been presented to us during the notice and comment process. Again, the hard 4:00

rule proposal illustrates the effectiveness of the Commission’s rulemaking process,

whereby we, and indeed the investing public, are the beneficiaries of a wide range

of views and perspectives, and possible solutions.

To address market timing, especially so-called ‘‘arbitrage market timing,’’ the

Commission has stressed that ‘‘fair value pricing’’ is critical to reducing effectively

or eliminating the profit that many market timers seek and the dilution of shareholder interests. However, because fair value pricing can be subjective, the Commission also intends to continue to monitor funds’ fair value pricing practices and has

proposed improved fair value pricing disclosure; enhanced disclosure regarding a

fund’s antimarket timing policies and practices; and, to reduce the possibility of abusive market timing, that funds impose a mandatory 2 percent redemption fee when

investors redeem their shares within 5 days of purchase. If the Commission moves

forward with adopting the mandatory redemption fee proposal, I feel that it must

contain exceptions—for example, exceptions for individual investors who have

suffered an unforeseen hardship and for money market funds and funds that specifically cater to market timers. Along with the mandatory redemption fee, the Commission also proposed a process that, for the first time, would give mutual funds

a weekly pass-through of buyer and seller information from intermediaries. That

process, which is often lost in discussion, is a critical piece of the proposal that

would allow funds to identify market timers and apply the funds’ antimarket timing

procedures.

Fund Governance, Ethical Standards, and Compliance

In an effort to enhance oversight of the industry, the Commission proposed a comprehensive rulemaking package to bolster the effectiveness of independent directors

and solidify the role of the fund board as the primary advocate for fund shareholders. The proposal would enhance the independence of fund boards by including

a requirement for an independent board chairman and a board comprised of 75 percent independent directors. Board and chairman independence is just part of what

we are considering to restore overall accountability to the fund board.

In an effort to reinforce the fundamental importance of integrity in the investment management industry, the Commission recently proposed that all registered

investment advisers adopt codes of ethics. The code of ethics would set forth standards of conduct for advisory personnel that reflect the adviser’s fiduciary duties, as

1095

well as codify requirements to ensure that an adviser’s personnel comply with Federal securities laws and report their securities transactions.

In the area of improving compliance and the oversight of fund boards, the Commission, in December, adopted a rule requiring that funds and their investment advisers have comprehensive compliance policies and procedures in place, including

appointing a designated chief compliance officer. In the case of a fund, the chief

compliance officer would be answerable to the fund’s board and could be terminated

only with the board’s consent. This rule will have a far-reaching, positive impact on

mutual fund operations and compliance programs by ensuring that funds have a primary architect and enforcer of compliance policies and procedures for the fund and,

perhaps more importantly, a compliance officer who can be the eyes and ears of the

board of directors. This requirement will provide fund boards with a powerful tool

to identify and prevent misconduct that could potentially harm funds and their

shareholders. Funds must begin compliance with this final rule by October 2004.

Conflicts of Interest

In addition to taking steps to enhance mutual fund oversight and ethical standards, the Commission has also undertaken a series of initiatives aimed at certain

conflicts of interest that exist now between mutual funds and those who distribute

fund shares. For example, the Commission voted to propose an amendment to Rule

12b–1 to prohibit the use of brokerage commissions to compensate broker-dealers for

distribution of a fund’s shares. This would eliminate a practice that potentially compromises best execution of a fund’s portfolio trades, increases portfolio turnover, and

corrupts broker-dealers’ recommendations to their customers.

At the same time, the Commission sought comments as to whether other changes

should be made to Rule 12b–1 or even if it should propose to abolish the rule altogether. For instance, should we continue to permit 12b–1 fees to be used in lieu of

a front-end sales load? Should distribution costs be taken directly out of a shareholder’s account rather than out of fund assets, so that each shareholder pays his

or her own distribution related costs? Should long-term shareholders even be bearing distribution costs? We are anxious to review the comments we receive on these

questions as we move forward in our reconsideration of Rule 12b–1.

The Commission also has proposed improved disclosure regarding a portfolio manager’s relationship with the fund. The proposals include disclosure regarding the

persons managing the fund, the structure of portfolio manager compensation, ownership of shares of the funds that a manager advises, and comprehensive disclosure

of specific investment vehicles, including hedge funds and pension funds that are

also managed by a fund’s portfolio manager.

Disclosure to Fund Investors

Improved disclosure—particularly disclosure about fund fees, conflicts, and sales

incentives—had been a stated priority for the Commission’s mutual fund program

in the months before the trading abuses came to light. Consequently, the Commission took steps to significantly improve the information required for individual

shareholders. First, the Commission adopted a requirement that shareholder reports

include dollar-based expense information so that investors can easily compute the

dollar amount of expenses paid on their investment in a fund. This is an important

step in providing shareholders with critical information about their mutual fund investments. Some have questioned whether we should have required more information—that is individualized account information to each shareholder. While the staff

and the Commission considered this alternative, we were convinced that the dollarbased expense information that the Commission ultimately adopted was the better

course, as it allowed for comparability. We have ongoing efforts to continue examining the entire mutual fund disclosure regime to see if it is as good as it can be;

however, with respect to this particular rule—which will go into effect in July—I

firmly believe we must give the rule a good chance to operate before we contemplate

changing it.

In other efforts to improve disclosure for investors, the Commission has:

• issued a concept release on methods to calculate and improve the disclosure of

funds’ portfolio transaction costs;

• proposed to make more transparent in shareholder reports how fund boards

evaluate investment advisory contracts;

• proposed new fund confirmation forms and new point-of-sale disclosure that would

greatly enhance the information that broker-dealers provide their customers in

connection with mutual fund transactions, and highlight the conflicts that brokerdealers face in recommending mutual fund investments; and

1096

• proposed improved prospectus disclosure to address the wide-scale failure on the

part of broker-dealers to provide appropriate breakpoint discounts on front-end

load mutual fund purchases.

While neither I nor my fellow Commissioners have finalized our positions regarding each of these rule proposals, we all agree that the areas they address are of critical importance to the protection of mutual fund investors. The staff is reviewing

and analyzing the comments received on these various rule proposals in order to finalize its recommendations for the Commission’s consideration in adopting the

rules. We have received comment letters from fund shareholders, Senators, Congressmen, fund complexes, directors, officers, and broker-dealers to name just a few.

While not all commenters have agreed with the staff’s proposals, just as the Commissioners do not always agree with one another, a healthy, intellectual, reasoned

debate will better inform the staff and improve the final product as we move toward

final adoption of these rules.

And, just as we embarked on an aggressive agenda to propose these rules, we will

be just as aggressive in our agenda for considering the final rules. This spring and

summer, the Commission will be considering all of these outstanding mutual fund

rulemaking proposals: market timing disclosure, breakpoint disclosure, the fund

governance package, the investment advisers code of ethics rule, disclosure regarding the factors considered by the fund’s board in approving the advisory contract,

the proposed amendments to Rule 12b–1, the hard 4:00 close, portfolio manager disclosure, the mandatory 2 percent redemption fee and flow through of information

between funds and intermediaries, and new confirmation form and point-of-sale disclosure. However, while it is important that we consider adoption of these rules in

an expeditious manner, it is equally important that we give interested parties an

opportunity to comment and our staff sufficient time to consider fully possible unintended consequences and vet alternative approaches to our proposals so that we

adopt the final rules that best address the problems we seek to solve.

Inspections and Enforcement Efforts

Complementing our regulatory reforms are vigorous inspection and enforcement

programs for detecting wrongdoing and enforcing the Federal securities laws. As I

have mentioned before, the mutual fund abuses that we have witnessed represent

a fundamental betrayal of American investors, and the Commission has punished,

and will continue to punish, the malefactors swiftly and with every tool available

to us. The detection and enforcement piece of the Commission’s agenda relating to

mutual funds currently is focused primarily on four types of misconduct, each of

which may show that the interests of financial services firms or their employees

were being placed above the interests of investors.

The first area of priority is late trading and abusive timing of mutual fund shares.

Since the disclosure of these practices last September, the Commission has conducted a broad investigation and has brought numerous enforcement actions charging hedge fund managers, broker-dealers, investment advisers, and their associated

persons with engaging in such abuses to the detriment of fund investors. While our

examinations and investigations are ongoing, the enforcement actions we have

brought thus far have involved some of the most well-known names in the mutual

fund industry, including Putnam Investments, Invesco Funds Group, Alliance Capital Management, Massachusetts Financial Services, FleetBoston Financial, and

Bank of America. The settlements obtained by the Commission in several of these

cases have resulted in significant corporate governance and compliance improvements, as well as substantial payments that will be used to compensate harmed investors.

Among these recent settlements was the Commission’s order against Massachusetts Financial Services, Inc. (MFS). On February 5, 2004, the Commission filed a

settled enforcement action against MFS, its chief executive officer, and its president

and chief equity officer, for violating the Federal securities laws by allowing widespread market timing trading in certain MFS mutual funds in contravention of

those funds’ public disclosures. The Commission censured MFS and ordered it to

pay $225 million, consisting of $175 million in disgorgement and $50 million in penalties. The Commission’s Order further requires MFS to undertake certain compliance and mutual fund governance reforms designed to enhance the independence of

mutual fund boards of trustees and strengthen oversight of MFS’s compliance with

the Federal securities laws.

For their roles in the misconduct, the Commission prohibited MFS’s CEO and

president from serving as an officer or director of any investment adviser and from

serving as an employee, officer, or trustee of any registered investment company for

3 years. In addition, the Commission’s order places certain restrictions on the duties

the CEO and president can perform during that period. The Commission also susVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01108 Fmt 6601 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
1097

pended both the CEO and president from association with any investment adviser

or registered investment company for 9 months and 6 months, respectively, and ordered each to pay a penalty of $250,000 and disgorge over $50,000 in ill-gotten gains

derived from MFS’s market timing practices. All of the money paid by MFS, its CEO

and its president will be distributed to harmed shareholders.

Our second area of examination and enforcement priority focuses on mutual fund

sales practices, including fee disclosure issues in connection with the sale of mutual

funds. In particular, we are looking at what prospective mutual fund investors are—

or are not—being told about revenue sharing arrangements and other incentives

provided by mutual fund companies to broker-dealers selling their funds. Customers

have a right to know how their broker-dealer is being paid to sell a particular fund.

And when these payments are being made from fund assets, customers should understand that their own investment dollars are being used to foot the bill for the

mutual funds’ premium ‘‘shelf space’’ at the selling broker’s office. Such fees may

increase costs to investors as well as create conflicts of interest between investors

and the financial professionals with whom they deal. The Commission brought the

first case targeting these undisclosed payments in November 2003 against Morgan

Stanley. In settling the matter, Morgan Stanley agreed to pay $50 million in

disgorgement and penalties. We are continuing to examine and investigate industry

participants for similar practices. The potential disclosure failures and breaches of

trust spotlighted in the Morgan Stanley case are not necessarily limited to Morgan

Stanley, or even to broker-dealers.

The Enforcement staff is also looking very closely at the role and responsibilities

of mutual fund companies themselves in these arrangements. In fact, last week, the

Commission filed a settled action against MFS related to the company’s use of mutual fund assets—namely, brokerage commissions on mutual fund transactions to

pay for the marketing and distribution of mutual funds in the MFS Fund Complex

(MFS Funds). The Commission issued an order that found MFS failed to adequately

disclose to the Boards of Trustees and to shareholders of the MFS Funds the specifics of its ‘‘shelf-space’’ arrangements with brokerage firms and the conflicts created by those arrangements. As part of the settlement, MFS agreed to a series of

compliance reforms and to pay a penalty of $50 million, which will be distributed

to the MFS Funds. In addition, as I previously stated, the Commission has proposed

to ban the use of brokerage commissions to compensate broker-dealers for the distribution of fund shares.

Our third area of priority in the mutual fund examination and enforcement arena

is the sale of different classes of mutual fund shares. Many mutual funds offer multiple classes of shares in a single portfolio. For each class of shares, a mutual fund

uses a different method to calculate and collect distribution costs from investors.

Class A fund shares are subject to an initial sales charge (front-end load); discounts

on front-end loads are available for large purchases of Class A shares. Since the

sales fee is paid up front, Class A shares incur lower (or no) ‘‘Rule 12b–1 fees,’’ fees

the mutual fund pays for distribution costs, including payments to the broker-dealers and their registered representatives selling fund shares.

Last July, the Commission brought an action against Prudential Securities for

abuses in this area. In that case, the Commission found that Prudential’s supervisory system for overseeing practices in this area was inadequate. Prudential had

in place policies and procedures requiring registered representatives to advise their

clients of the availability of different classes of mutual funds and fully explain the

terms of each. Prudential branch managers were also expected to approve all purchases greater than $100,000 and confirm the suitability of the choice of fund class.

The Commission found, however, that Prudential failed to adopt a sufficient supervisory system to enable those above the branch manager to determine whether these

policies and procedures were being followed. In resolving the Commission’s action,

Prudential was censured and agreed to pay disgorgement and a civil penalty. The

Commission’s action against the registered representative and branch manager,

which charges them with fraud, is pending.

The fourth examination and enforcement priority area with respect to mutual

funds is to address the failure of firms to give their customers the discounts available on front-end loads for large purchases of Class A shares. Last year, examiners

at the SEC, NASD, and NYSE completed an examination sweep and outlined the

results in a public report. This sweep culminated in the filing, on February 12, 2004,

of enforcement and disciplinary actions against a total of 15 firms for failure to deliver mutual fund breakpoint discounts during 2001 and 2002. The 15 firms agreed

to compensate customers for the overcharges, pay fines in an amount equal to their

projected overcharges that total over $21.5 million, and undertake other corrective

measures. The NASD has ordered all firms to repay their customers any amounts

overcharged.

1098

While these are areas of focus in the mutual fund arena, the Examination staff,

in coordination with the Enforcement staff, are continually on the look out for additional mutual fund practices that may be vulnerable to or ripe for abuse. Accordingly, the staff is closely examining, among other things, the status of funds closed

to new investors that nevertheless continue to charge Rule 12b–1 fees, the portfolio

pricing practices of high yield bond funds, the role of pension consultants in pension

plans’ selection of particular money managers, the use of ‘‘fair value’’ pricing, the

use of affiliated service providers, and the fees charged by certain index funds. And

in all of the foregoing areas, the Commission is intently focused on the roles and

conduct of mutual fund directors. Have they adequately discharged their responsibilities? Have they properly overseen the mutual fund management company on

behalf of mutual fund shareholders?

Internal Restructuring

The third key element in enhancing the protection of our Nation’s mutual fund

investors—indeed of enhancing the protection of all of our Nation’s investors—is the

internal restructuring of the Commission’s management and functions. One of my

primary goals since coming to the Commission has been to help restore the Commission’s credibility as the investors’ watchdog. This, of course, means reforming how

the Commission operates. I will briefly summarize these reforms for you.

Last year, following a thorough internal review of how the Agency deals with risk,

we initiated a new risk management program and laid the groundwork for the

Office of Risk Assessment and Strategic Planning, the first of its kind at the Commission. The first phase has been to organize internal risk teams for each major

program area. This framework has already been put into place and allows for a bottom up approach to assessing risk. A good example of this is through our Office of

Compliance Inspections and Examinations. We have empowered our examiners,

through OCIE’s internal risk management team, to look at potential problems in the

mutual fund and broker dealer industries and to examine formally for these potential problem areas.

The new Office of Risk Assessment will work in coordination with the internal

risk teams and will push the Agency to identify proactively potential problem areas

within the mutual fund and broker-dealer industries, focusing on early identification

of new or resurgent forms of fraudulent, illegal, or questionable activities. In addition to fostering better communication and coordination between Divisions and Offices within the Commission, the risk assessment initiative will help to ensure a

process whereby senior managers at the Commission have the information necessary to make better, more informed decisions and to adjust operations and resources to address these new challenges.

We also have greatly enhanced our examination program, as our Director of the

Office of Compliance Inspections and Examinations, Lori Richards, shared with you

a few weeks ago. In 2003, budget increases allowed us to increase our staff for fund

examinations by a third, to approximately 500 staff. These new resources, coupled

with the Office’s new risk-based examinations approach, should greatly improve our

ability to detect abusive behavior and possible violations of the law.

In addition to the overarching risk assessment effort has been the creation of a

number of multidivisional task forces designed to bring together staff from various

divisions and offices to brainstorm, evaluate and create strategies to proactively undertake issues of potential concern in protecting the Nation’s securities markets.

Four of these task forces will tackle issues that will help us better protect mutual

fund investors and monitor the mutual fund industry. They are the Chairman’s

Task Forces on: Soft-Dollar Arrangements; College Savings Plans (or 529 plans); Enhanced Mutual Fund Surveillance; and Disclosure Regime. The Task Forces will

meet with the relevant interested parties—such as individual investors, industry

representatives, fellow regulators, and others—to gather critical intelligence and

data, and ultimately work toward addressing problem areas.

Let me start with the Task Force on Soft Dollars, because I know this issue is

of particular concern to some of you on the Committee, and I want to assure you

that it is also a very high priority for the Commission in the context of our mutual

fund reforms.

The Task Force on Soft Dollars, comprised of SEC staff from five divisions and

offices, has already met with a number of industry representatives as it tackles this

complicated issue. Its goal is to fully understand all aspects of how soft dollars are

used, and the pros and cons of various alternative reform approaches, including possible unintended consequences. While I would like to have those recommendations

as soon as possible, I also want to ensure that the Task Force has adequate time

to fully consider the issue and the benefit of meeting with interested persons so that

it can come to us with the best and most informed recommendations possible.

1099

Like so many of the issues we are facing, the area of soft dollars is complex, and

we must be cautious as we move forward with reforms in this area. I believe that

at the very least, the Commission, through the rulemaking process, should consider

narrowing the definition of qualifying ‘‘research’’ under the safe harbor so that only

‘‘real’’ research that has valid, intellectual content, qualifies. I would also expect the

Task Force to consider whether the costs of research and execution should be quantified and other ways in which the costs of research could be made more transparent. Some have advocated a distinction between third-party research and proprietary research. My view is that we should not draw such distinctions, but the Task

Force will also consider this issue and provide recommendations. As you are aware,

the Securities Exchange Act contains a statutory safe harbor, Section 28(e) of the

Exchange Act, which protects use of soft dollars. So, the Task Force will also consider whether Section 28(e) of the Exchange Act should be repealed. While I have

not yet reached that conclusion, if the Task Force and the Commission ultimately

arrive at that conclusion, I will not hesitate to seek Congress’ assistance in that endeavor.

Because there are growing concerns with disclosure and transparency with respect to 529 tuition savings plans, or college savings plans, we have established a

task force on college savings plans. This task force is charged with examining the

issue of college savings plans, including a focus on the structure and sale of college

savings plans and disclosures to plan participants, particularly with respect to fees

and expenses. More specifically, I have asked the Task Force to review disclosure

and transparency for investors in these plans, the extent of the Commission’s oversight of these plans and whether the costs and fees associated with these plans

outweigh the tax advantages of these plans for families saving for their children’s

educations.

Another critical area where the Commission will be more proactive is mutual fund

surveillance. In this vein, we have formed a Task Force on Self-Reporting Regimes

for Mutual Funds to look at both the frequency of reports made by mutual funds

to the Commission and the categories of information to be reported. Further, this

Task Force will examine how new technologies can best be used to enhance our

oversight responsibilities. The Task Force will draw on the expertise of our fellow

regulators at the NYSE, NASD, and NASAA, as well as others knowledgeable in the

area of surveillance and reporting.

Another critical area for Commission review is our disclosure regime. Because the

Federal securities laws are largely disclosure based, investors receive a large volume

of disclosure documents, especially when they invest in a mutual fund. The Task

Force on Disclosure will examine the value of the various disclosures provided by

mutual funds, brokers and issuers to investors as required by our rules and regulations. The Task Force will also explore what types of disclosures best serve investors, the timing of the disclosures, delivery versus access to the disclosures, and how

best to harness technological advances in assisting investors. In addition, the Task

Force will analyze whether there is data that the Commission should collect and

publish on a periodic basis that would be useful to investors in making comparisons

among the various investment options available to them. This Task Force will reach

out to investors to help guide it through the important task of ensuring that investors are receiving the proper mix of disclosure in a format meaningful to them.

Hedge Funds

Before closing, I would note that hedge funds have played significant roles in

some of the most notorious mutual fund scandals that have come to light recently—

the Bank of America/Canary Hedge Fund case is one example. So, I would like to

summarize my personal concerns related to hedge funds, with the caveat that my

views on hedge funds are my own and do not reflect the views of the entire Commission.

The issues surrounding hedge funds are an excellent example of how the Commission can be proactive and work to enhance enforcement in problem areas before they

spread. The Commission is responsible for enforcing the Federal securities laws, policing the securities markets, and ensuring fraud prevention and detection. This is

the Commission’s responsibility regardless of whether we are talking about mutual

funds, self regulatory organizations, public companies, hedge funds, or other market

participants. Hedge funds have become one of the fastest growing segments of the

investment management business—with assets fast approaching $1 trillion—at a

time when returns on other investments have not kept the same pace.

Other Government entities—primarily the Federal Reserve Board and the Treasury—are responsible for monitoring potential systemic risks, and the safety and

soundness issues raised by the structure of these vehicles. While their oversight priorities are of great import to our banking system, these agencies are not responsible

1100

for enforcing the Federal securities laws and protecting investors. The data they

collect is aimed at the discharge of their prudential responsibilities. Any regulatory

action the Commission ultimately takes will focus on the protection of investors,

rather than safety and soundness issues.

I would also like to address the need for protecting investors in the hedge fund

context. One of the points I often hear about not regulating hedge funds is that

hedge fund investors are wealthy and sophisticated individuals who do not need protecting. This is not the point. Hedge fund managers are, directly and indirectly, providing advisory services for many U.S. investors—with a significant impact not only

on those investors, but also on the operation of the U.S. securities markets. The

Commission is the only Government agency that is charged with protecting those

investors and policing those markets. Further, hedge funds are being purchased by

intermediaries on behalf of millions of ultimate smaller investor beneficiaries—retirees, pensioners, and others not generally thought of as the traditional hedge fund

investor—through their pension plans or funds of hedge funds, again making it critical for investors that the Commission have basic information and a resulting insight as to how many hedge fund managers are deploying assets under management; how they handle conflicts of interest, how they account for results and value

their investments, and most importantly, what impact their market activities have

on the other participants in our equity markets.

Moreover, hedge funds often promise performance in all types of market conditions, and typically include hefty performance fees for their managers. This combination can motivate unscrupulous hedge fund managers to attempt behavior or

conduct that circumvents or crosses the legal boundaries of the securities laws.

As we move forward to debate this issue, there are a few questions that I think

we need to consider: How are hedge fund managers pricing the securities in their

portfolios? What practices are in place regarding hedge funds’ use of and access to

inside information? How do hedge fund managers conduct their securities trading?

What prevents hedge funds from front-running mutual funds or other large investors? What are hedge funds’ activities regarding initial public offerings? How hedge

funds answer these questions not only has an impact on the investors in the hedge

funds, but also more importantly has a significant impact on all investors in our

markets, including those investors that have exposure to hedge funds indirectly,

whether through their retirement and pension plans or through funds of hedge

funds.

It troubles me that the Commission, under the current rules, is limited in its ability to gather information that could provide answers to these questions, and could

help protect millions of investors. I fundamentally believe that the Commission has

a legitimate interest in obtaining the information, and imposing appropriate recordkeeping and other regulatory requirements, if needed, to protect investors receiving

advisory services from hedge fund managers. Further, what we have found in the

mutual fund scandals supports this concern. We have seen hedge fund managers

engaged in illegal behavior that results in taking advantage of the long-term retail

investors in these funds. Critics cannot have it both ways—on the one hand, to demand that the Commission be proactive and prevent and detect emerging, but as

of yet unforeseen, harms and abuses, but on the other hand, to handicap our ability

to obtain information that facilitates our identification of such abuses.

Let me be clear: I believe hedge funds play a vital role in our financial markets,

and I would reject any regulatory proposal that would in any way impede the ability

of hedge funds to function as they currently do, so long as we have the ability to

ensure that their managers are not taking advantage of millions of investors. This

is a point the Commission staff made clear in its report on hedge funds last fall.

Mindful of the balance between fulfilling our responsibility to protect investors

and protecting hedge funds’ vital role in our financial markets, I have asked the

staff to move forward with a rulemaking proposal that would enhance the Commission’s ability to prevent, detect and deter abusive, fraudulent conduct in the hedge

fund segment of the investment management industry. As part of this rulemaking,

and building on the risk assessment capability we are developing in the Agency—

including our new risk identification and mapping programs, we could consider both

a form of registration for hedge fund managers and an oversight regime different

from that which we use for other, more heavily regulated industries, like mutual

funds. They could be specifically tailored to the unique dynamics of these types of

managers. We could thus better target our inquiries on those hedge fund managers

where there is some reasonable concern that they may be violating the securities

laws.

As with all rulemaking proposals, this one will have to be voted upon by the Commission and would go through the notice and comment process so as to consider the

views of all interested persons on this subject. I intend to ensure that the CommisVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01112 Fmt 6601 Sfmt 6621 97186.TXT SBANK4 PsN: SBANK4
1101

sion’s consideration of the hedge fund issue is thoughtful and thorough, and that

any proposal will be fully and appropriately vetted.

Conclusion

As my testimony—taken together with previous testimony from the Commission

staff—demonstrates, the Commission has embarked on an aggressive regulatory and

enforcement agenda to combat the current ills plaguing the mutual fund industry.

I believe our efforts will help ensure that there are strong safeguards in place to

minimize the possibility of future illegal, fraudulent, or harmful activity. We have

ample regulatory authority with which to carry out this agenda, and—due in large

part to your support and your constructive approach—we have been able to pursue

this agenda in an expedited manner.

Please allow me to once again complement the Committee, Mr. Chairman, for its

thoughtful and thorough approach to the oversight of these issues. The significant

number of hours that you and the staff have spent conducting oversight hearings,

and questioning witnesses from all segments of the industry, has been immensely

helpful to the Commission, and represents a constructive approach to analyzing the

complexity of the problems that have plagued the mutual fund industry. The Commission—and indeed the mutual fund investor—has benefited from your approach

and your efforts, and I thank you.

If, as the Commission moves ahead with its mutual fund reforms, there are critical issues that we do not have the ability to address, the Commission will immediately seek your assistance to do so; however, I do not believe that legislation is

necessary at this time.

Thank you again for inviting me to speak on behalf of the Commission to discuss

our efforts to protect the investing public. I would be happy to answer any questions

that you may have.

1102

1Section 36(b) specifically authorizes the Commission, and any fund shareholder, to bring an

action in Federal district court against the fund’s investment adviser for a breach of fiduciary

duty ‘‘with respect to the receipt of compensation for services, or of payments of a material nature’’ made by the fund to the investment adviser (or to an affiliated person of the investment

adviser). 2See SEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH,

H.R. REP. NO. 2337, 89th Cong., 2d Sess. 10–12, 126–27, 130–32 (1966). See also, DIVISION OF

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED

FROM WILLIAM H. DONALDSON

Q.1. Does the SEC have a standard format in which electronic evidence from mutual fund operators is collected and reviewed? Is

there a need for such a standard?

A.1. Electronic data, such as electronic mail, is an important component of many enforcement investigations, including those involving mutual funds. To facilitate efficient review of two common

forms of electronic data, the Division of Enforcement has established ‘‘preferred formats’’ for the production of electronic mail and

imaged documents. Parties producing electronic mail or imaged

documents are requested, but not required, to utilize these preferred formats. These two categories of electronic data account for

the large majority of electronic productions made to the Enforcement staff. In addition, under Exchange Act Rule 17a–25, when the

Commission requests transaction data from a registered brokerdealer, the firm must submit the information electronically in an

industry standard format known as the Electronic Blue Sheet format. ‘‘Blue Sheeting’’ is the primary means of transmitting trading

data to the SEC and self-regulatory organizations.

The Enforcement Division does not require production of electronic data in a particular format in order to accommodate parties

producing the data and, where feasible, limit the associated burden. In addition, because conversion of electronic data to a format

other than the one in which it is maintained may cause a loss of

information, it is often beneficial to accept production of electronic

data in its native format. This is one of the reasons that the Enforcement Division uses preferred formats rather than required formats. In the staff’s view, because maintaining flexibility concerning

the format in which electronic data is produced can yield more

complete information, a mandatory format for production of electronic data is unnecessary.

Q.2. In his testimony before this Committee on February 25, Gary

Gensler argued that Congress should amend or repeal the

Gartenberg Standard. This legal standard essentially says that to

be found excessive, an adviser’s fee must be so large that it has no

relationship to the services rendered and could not have come from

‘arm’s-length’ bargaining. Do you believe that Congress needs to

pass legislation that would statutorily create a new, stronger

standard for reasonableness of adviser fees?

A.2. Section 36(b) of the Investment Company Act of 1940 imposes

on fund investment advisers a fiduciary duty with respect to their

receipt of compensation from funds.1 Congress adopted Section

36(b) in response to concerns that fund advisory fees were not subject to the usual competitive pressures because funds typically are

organized and operated by their investment advisers.2 As interVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01114 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1103

INVESTMENT MANAGEMENT, PROTECTING INVESTORS: A HALF CENTURY OF INVESTMENT COMPANY

REGULATION 317–19 (May 1992). 3Gartenberg v. Merrill Lynch Asset Management, Inc. 694 F.2d 923, 928 (2d Cir. 1982). See

also, Gartenberg v. Merrill Lynch Asset Management, Inc., 740 F.2d 190 (2d Cir. 1984). 4Like fund directors, fund investment advisers are subject to fiduciary duties under State and

Federal law in connection with the approval and renewal of investment advisory contracts. See,

e.g. Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979). Fund investment

advisers are subject to duties of care and loyalty and must affirmatively disclose to a fund’s

board of directors all facts that are material to the board’s approval and renewal of the investment advisory contract. See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,

191–92 (1963); In the Matter of Kemper Financial Services, Inc. et al., Investment Advisers Act

Release No. 1476 (March 2, 1995); In the Matter of Joan Conan, Investment Advisers Act Release No. 1446 (September 30, 1994). In particular, a fund’s investment adviser is required by

the Investment Company Act to furnish ‘‘such information as may reasonably be necessary’’ for

the fund’s directors to evaluate the fund’s investment advisory contract. See Section 15(c) of the

Investment Company Act of 1940. 5See, e.g., Schuyt v. Rowe Price Prime Reserve Fund, Inc., 663 F.Supp. 962, 971 (S.D. N.Y.

1987) aff’d., 835 F.2d 45 (2d Cir. 1987). ‘‘The legislative history of the [Investment Company]

Act clearly indicates that it is not the role of the Court to ‘substitute its business judgment for

that of the mutual fund’s board of directors in the area of management fees.’ ’’ Id. (quoting S.

Rep. No. 194, 91st Cong., 1st Sess., reprinted in 1970 U.S. Code Cong. & Ad. News 4902).

preted by the courts, directors’ responsibilities under Section 36(b)

involve the evaluation of whether the compensation that is paid to

a fund’s investment adviser is ‘‘so disproportionately large that it

bears no reasonable relationship to the services rendered and could

not have been the product of arm’s length bargaining,’’ otherwise

known as the Gartenberg standard—a reference to one of the leading court cases interpreting section 36(b).3 Based on the Gartenberg

standard, when approving and renewing investment advisory

agreements, particularly the compensation to be paid to the investment advisers, fund directors typically consider the following relevant factors:

• The nature and quality of all of the services provided by the adviser (either directly or through affiliates), including the performance of the fund;

• The adviser’s cost in providing the services and the profitability

of the fund to the adviser;

• The extent to which the adviser realizes economies of scale as

the fund grows larger;

• The ‘‘fall-out’’ benefits that accrue to the adviser and its affiliates

as a result of the adviser’s relationship with the fund (for example, soft-dollar benefits);

• The performance and expenses of comparable funds; and

• The volume of transaction orders that must be processed by the

adviser.

While the Gartenberg standard establishes a test for when advisory fees become excessive, the court cases provide that the decisions of independent directors regarding advisory fees will not be

second-guessed if the directors are fully informed 4 and considered

all appropriate factors in determining the reasonableness of fees.5

I agree that the amount of mutual fund fees generally should not

be set by courts or by the Commission. Fees should be determined

by the marketplace, and investor consideration of mutual fund

costs can be facilitated by transparent disclosure of fund fees and

expenses and the effective and diligent oversight of independent

fund directors. That is why the Commission is focused on improving fund disclosure—particularly disclosure about fund fees, conVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01115 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1104

6See Shareholder Reports And Quarterly Portfolio Disclosure of Registered Management Investment Companies, Investment Company Act Release 26372 (February 27, 2004) [69 FR 11244

(March 9, 2004)]. 7See Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction

Costs, Investment Company Act Release 26313 (December 18, 2003) [68 FR 74820 (December

24, 2003)]. 8See Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Investment Company Act Release 26350 (February 11, 2004) [69 FR 7852

(February 19, 2004)]. 9See Confirmation Requirements and Point-of-Sale Disclosure Requirements for Transactions

in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, Investment Company Act

Release 26341 (January 29, 2004) [69 FR 6438 (February 10, 2004)]. 10See Disclosure of Breakpoint Discounts by Mutual Funds, Investment Company Act Release

26298 (December 17, 2003) [68 FR 74732 (December 24, 2003)]. 11See Investment Company Governance, Investment Company Act Release 26323 (January

15, 2004) [69 FR 3472 (January 23, 2004)].

flicts, and sales incentives—and enhancing the mutual fund governance structure.

The Commission has taken several recent steps to significantly

improve the information required for individual shareholders. For

example, the Commission adopted a requirement that shareholder

reports include dollar-based expense information so that investors

can easily compute the dollar amount of expenses paid on their

investment in a fund.6 This is an important step in providing

shareholders with critical information about their mutual fund investments. In other efforts to improve disclosure for investors, the

Commission has:

• issued a concept release on methods to calculate and improve the

disclosure of funds’ portfolio transaction costs; 7

• proposed to make more transparent in shareholder reports how

fund boards evaluate investment advisory contracts; 8

• proposed new fund confirmation forms and new point-of-sale disclosure that would greatly enhance the information that brokerdealers provide their customers in connection with mutual fund

transactions, and highlight the conflicts that broker-dealers face

in recommending mutual fund investments; 9 and

• proposed improved prospectus disclosure to address the widescale failure on the part of broker-dealers to provide appropriate

breakpoint discounts on front-end load mutual fund purchases.10

With respect to fund governance, the Commission recently proposed a comprehensive rulemaking package to bolster the effectiveness of independent directors and enhance the role of the fund

board as the primary advocate for fund shareholders. The proposals

included a requirement for (i) an independent board chairman; (ii)

75 percent independent directors; (iii) independent director authority to hire, evaluate, and fire staff; (iv) quarterly executive sessions

of independent directors outside the presence of management; (v)

an annual board self-evaluation; and (vi) preservation of documents

used by boards in the contract review process.11 This significant

overhaul of the composition and workings of fund boards is intended to establish, without ambiguity, the dominant role of independent directors on a fund’s board.

As a result of the Commission’s initiatives to improve fund disclosure and fund governance, I do not believe that it is necessary

at this time for Congress to revise the statutory standards regarding fund fees. I believe that the best way to ensure that funds

1105

charge fair and reasonable fees is through a marketplace of vigorous, independent, and diligent mutual fund boards, coupled with

fully informed investors who are armed with complete, easy-to-digest disclosure about the fees paid and the services rendered.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CORZINE

FROM WILLIAM H. DONALDSON

Q.1. The last time you appeared before this Committee, Senator

Miller submitted questions to you on the National Securities Clearing Corporation’s (NSCC) proposed rule. And then subsequent to

that he submitted a comment letter on December 22, 2003, on the

proposed rule. We understand the rule is still pending before the

SEC. In Senator Miller’s questions and letter he expressed reservations about a rule that would allow the NSCC to open up shop in

an entirely new industry (Separately Managed Accounts) from

what its been doing since its creation. As he said in his letter, we

question a rule that would allow a quasi-government SRO to take

business away from private companies that have invested millions

to work out their SMA business and eventually make a profit in

it, especially when, if this rule is approved, the NSCC would carry

a kind of SEC ‘‘stamp of approval’’ that will inevitably give them

a competitive advantage over the private companies.

We have since learned that SEC procedures would allow this rule

to go into effect without a single Commissioner ever having reviewed, much less voted, on it. We find that very troubling, Mr.

Chairman, on a matter as important as this one is, and we would

like your assurance today that you and your colleagues on the

Commission will personally review any decision/recommendations

the Commission staff puts forward on the NSCC rule.

A.1. NSCC is a subsidiary of Depository Trust and Clearing Corporation (DTCC), which is owned by its bank and broker-dealer

members. NSCC provides coordinated comparison and clearance

services to the financial markets. It currently is the sole clearance

system for equities, as a result of consolidation of many competitors

that has taken place over the past two decades. NSCC has developed many new services upon request of its members, in order to

reduce processing costs by providing standardized interchanges of

information inexpensively, on a widely available basis. Some of

these new services involve regulated clearing agency activities; others do not. Where possible, NSCC has engaged in these activities

internally rather than through an affiliate, to use existing systems

to reduce costs. The SMA Service is only one of such services offered by NSCC.

The SMA Service is an information messaging system for separately managed accounts, which is similar to the information messaging system NSCC currently provides for mutual funds in its

Mutual Fund Profile Service. The Mutual Fund Profile Service

automates the flow of information between users through a centralized system using standardized formats. It allows users to, among

other things, exchange accurate and timely information of daily

prices and dividend rates, firm and fund member profiles, individual security data, and projected and actual distribution declarations.

1106

NSCC is a private, member-owned entity that is organized as a

not-for-profit corporation under the laws of the State of New York.

It is registered with the Commission as a clearing agency (pursuant to Sections 17A and 19 of the Securities and Exchange Act of

1934) and as such is a self-regulatory organization subject to extensive Commission oversight. It was not created by any U.S. governmental action.

As a registered clearing agency, NSCC is required under Section

19(b) of the 1934 Act to file any proposed rule change, which

includes the offering of new service, with the Commission. Commission approval of a proposed rule change means only that the Commission has found that the proposed rule change is consistent with

the requirements of the 1934 Act and rules and regulations thereunder applicable to the clearing agency. It is not a determination

as to the relative market value of any service proposed to be offered by the clearing agency nor is it an endorsement of the service. If users of a service value the fact that the service is offered

by a registered clearing agency, it is most likely because the clearing agency is subject to extensive Commission oversight and review

and not because the Commission has given a stamp of approval to

the service.

With regard to the Commission’s review of the proposed rule

change, the Commission has authority pursuant to Section 4A of

the 1934 Act to delegate any of its functions to a division of the

Commission. Section 200.30–3(a)(12) of the Commission’s regulations delegates to the Director of the Division of Market Regulation

the authority to approve proposed rule changes filed by self-regulatory organizations. However, because of the interest expressed by

you, and by other Members of Congress, and because of the comments the Commission has received regarding the proposed rule

change, I can assure you that I and the other Commissioners will

be kept apprised of any recommendations made by Division staff

regarding the proposed rule change.

Q.2. We understand that the rule is silent on the fees that will be

charged when and if this rule is approved. As Senator Miller said

in his letter, we are curious about where the funding is coming

from to subsidize the high priced legal and lobbying talent, among

other expenses, that the NSCC has expended in the course of this

effort. Apparently, the NSCC’s own comment letter sought to answer my question, and said that the money to fund this effort is

coming from ‘‘the general funds’’ of the Corporation (p.29), as

though that is some other source other than mutual fund-related

fees. In your response to us, we would like to know, precisely, what

the source for the NSCC’s funding for this effort is, and whether

any of it comes, directly or even indirectly, from mutual fund fees?

A.2. Regarding further clarification for the funding of the SMA

Service and whether any of the money used to fund the service is

coming from fees NSCC collects for its mutual fund services, NSCC

has funded the start-up costs for the SMA Service out of its general

corporate funds as it generally does with new services. NSCC’s general funds are comprised of revenues NSCC receives from all its

services, including mutual fund services. NSCC retains only the

revenues that are required in order to maintain an adequate revVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01118 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1107

enue base for current operation costs, product and service enhancements and developments, and earnings as directed by the board. In

accordance with this policy, NSCC’s Board, comprised of representatives of its owner-users, determines when to reserve revenues as

general corporate funds and which new product development efforts shall be funded from reserved revenues. To the extent that

revenues in excess of NSCC’s costs to provide its services are not

so reserved, the Board has followed the practice of refunding these

excess revenues to its members in proportion to the fees paid by

them. Mutual fund revenues represent less than 25 percent of

NSCC’s total revenues.

It is important to note that NSCC designs its services to be selfsupporting and so there is an expectation that any start-up costs

of the SMA Service will be paid back to the general fund from SMA

Service fees. As a result, the fees NSCC will charge for the SMA

Service will initially be higher than they would be if the SMA Service were an existing service of NSCC. Additionally, the start-up

costs for the SMA Service are not very high. NSCC will use its existing connectivity for the service and has only had to incur costs

for the systems development of the service.

With regard to NSCC funding its lobbying and legal expenses related to the SMA Service, NSCC has informed the Commission that

it has not invested a significant amount of money in lobbying or

legal expenses. It has not lobbied for the SMA Service, and it has

hired legal counsel only to respond to questions from Congress and

to the comments submitted to the Commission as part of the public

process on the rule filing.

RESOPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI

FROM WILLIAM H. DONALDSON

Q.1. In response to questions asked by Senator Sarbanes, you stated that the SEC was having difficulty hiring accountants. How

many SEC staff have been hired away by the PCAOB? In addition,

how has the PCAOB’s ability to compensate staff more than the

SEC hurt the SEC’s ability to recruit accountants and staff?

A.1. The PCAOB has hired approximately 7 SEC staff since its inception. Most of these employees were instrumental in starting the

Board and ensuring that it was able to meet the statutory commencement deadlines of the Sarbanes-Oxley Act.

Hiring accountants with the experience and skills we need continues to be a challenge. This is because there is high demand for

seasoned accountants in the private sector—not just from the

PCAOB. While we did lose some staff to the PCAOB early on, we

do not believe the salary differences between us and the PCAOB

have proven to be a significant factor in our hiring difficulties. This

is primarily because we have not been seeking the same types of

accountants as the PCAOB. We have been seeking journeymen

level accountants with at least 5 years of experience to review SEC

filings and more senior accountants with experience in dealing with

complex accounting issues to fill positions in the Division of Enforcement and the Office of the Chief Accountant; whereas we understand that the PCAOB is seeking very senior accountants with

10 or more years of auditing experience. This difference means that

we are drawing from different pools of available candidates.

1108

1See, e.g., Hanson Trust PLC v. ML SCM Acquisition Inc., 781 F.2d 264, 273 (2d Cir. 1986)

and Norlin Corp v. Rooney, Pace Inc., 744 F.2d 255, 264 (2d Cir. 1984).

We currently hope to complete hiring for all of the accountant positions we have received by the end of this year.

Q.2. The intent of Congress in enacting the Investment Company

Amendments Act of 1970 was to relieve independent directors of

personal liability other than for ‘‘personal misconduct.’’ Do you

think Congress should change this concept and impose a personal

liability on independent directors for violations by the investment

adviser?

A.2. Section 36(a) of the Investment Company Act, as amended in

1970, states

The Commission is authorized to bring an action in the proper

district court of the United States, or in the United States

court of any territory or other place subject to the jurisdiction

of the United States, alleging that a person serving or acting

in one or more of the following capacities has engaged within

5 years of the commencement of the action or is about to engage in any act or practice constituting a breach of fiduciary

duty involving personal misconduct in respect of any registered

investment company for which such person so serves or acts—

1. as officer, director, member of any advisory board, investment adviser, or depositor; or

2. as principal underwriter, if such registered company is an

open-end company, unit investment trust, or face-amount certificate company.

If such allegations are established, the court may enjoin such

persons from acting in any or all such capacities either permanently or temporarily and award such injunctive or other relief

against such person as may be reasonable and appropriate in

the circumstances, having due regard to the protection of investors and to the effectuation of the policies declared in Section I (b) of this title.

Section 36(a) permits the Commission to bring an action against

a director for a breach of fiduciary duty involving ‘‘personal misconduct,’’ which generally is a higher standard than required for a

civil action under State law. However, as originally enacted, the Investment Company Act only permitted the Commission to sue directors whose breaches involved ‘‘gross misconduct.’’ Thus, the 1970

Amendments to the Investment Company Act expanded the Commission’s ability to bring cases against directors. The term ‘‘personal misconduct’’ is not defined in the statute or explained in the

legislative history.

Mutual fund directors’ fiduciary duties arise primarily from the

law of the state in which they are organized. Fund directors are

subject to fiduciary duties of care and loyalty. The duty of care generally requires that directors act with that degree of diligence, care,

and skill that a person of ordinary prudence would exercise under

similar circumstances in a like position.1 The duty of loyalty generally requires fund directors to exercise their powers in the interests of the fund and not in the directors’ own interests or in the

interests of another person or organization (for example, the investVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01120 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1109

2See the policy directives contained in Sections 1(b)(2), (4), and (6) of the Investment Company Act of 1940 Act. See also, Norlin Corp v. Rooney, Pace Inc., 744 F.2d 255, 264 (2d Cir.

1984), citing Pepper v. Litton, 308 U.S. 295, 306–07 (1939). 3See, e.g., Salomon v. Armstrong, 1999 Del. Ch. LEXIS 62, 23 (Del. Ch. March 25, 1999). See

generally Dennis J. Block et al., THE BUSINESS JUDGMENT RULE—FIDUCIARY DUTIES OF COR- PORATE DIRECTORS (5th ed. 1998). 4See Section 2(a)(41) of the Investment Company Act of 1940. 5See Section 15(c) of the Investment Company Act of 1940. 6See Section 32(a) of the Investment Company Act of 1940. 7See Section 9(b)(2) of the Investment Company Act of 1940. 8See Section 9(b)(3) of the Investment Company Act of 1940. 9See Section 9(f) of the Investment Company Act of 1940; Section 203(k) of the Investment

Advisers Act of 1940.

ment adviser).2 Under State law, the business judgment rule can

protect fund directors from liability for their decisions, so long as

the directors acted in good faith, were reasonably informed, and rationally believed that the action taken was in the best interests of

the fund.3

In addition to these fiduciary duty standards, the Investment

Company Act imposes direct obligations on fund directors. For example, the Act requires fund directors to assign fair valuations as

determined in good faith to certain portfolio securities,4 to request

and evaluate such information as may reasonably be necessary to

evaluate the fund’s advisory contract; 5 and to select a fund’s independent auditor.6 The Commission could sue fund directors if they

fail to appropriately perform these assigned duties, regardless of

whether the violation involved ‘‘personal misconduct.’’ 7 Additionally, as raised in your question, the Commission has authority to

sue fund directors for aiding and abetting a violation by the fund’s

adviser.8 The Commission also can obtain a cease and desist order

against fund directors if they are, were, or would be a ‘‘cause’’ of

a violation under the Investment Company or Investment Advisers

Acts, or their rules, due to an act or omission a director knew or

should have known would contribute to such violation.9 I do not

believe, however, that it would be appropriate to impose a direct

personal liability on independent directors for violations by the investment adviser.

Q.3. In your testimony today, you stated that you are requesting

the staff to move ahead with a proposal to oversee the hedge fund

industry. To date, the SEC has not finalized Phase 2 of the Investment Advisor Registration Depository. In addition, the SEC has not

fully hired all of the staff necessary to oversee the mutual fund industry. Based upon your testimony, it appears that the SEC would

have to expend significant monies to make changes to the registration depositories for hedge funds and to hire the appropriate staff

to oversee and examine hedge funds.

How can the SEC move forward on hedge funds when it has not

finished its job in those areas and exactly how much money will

the SEC need to regulate hedge funds?

A.3. Portions of the IARD system necessary to register hedge fund

advisers have been fully operational since 2001. Part 2 of the system, which is currently under development, will add additional system functionality that will permit investment adviser disclosure

statements to be filed.

The SEC has moved forward with hiring additional examiners to

oversee mutual funds and investment advisers, and we are tarVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01121 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1110

geting more examinations of funds and advisers posing the greatest

compliance risks. Hedge fund advisers face several conflicts of interest that raise compliance risks, including side-by-side management and soft dollars, and our ability to examine these firms is

critical if we are to detect and deter frauds. We now have 495 staff

allocated to examining funds and advisers nearly a 30 percent increase from fiscal 2002. We are focused on hiring the best, most appropriate people to meet staffing needs, and have refused to hire

employees simply to fill chairs. By the end of the year, we fully expect that we will achieve current targeted staffing levels. As a preliminary matter, our staff has estimated the pool of SEC-registered

advisers would increase by approximately 10 percent if we impose

our current adviser registration requirements on hedge fund managers, though the number could be higher. Our 2005 budget request incorporates $18.7 million for additional staffing positions

necessary to implement recent Commission initiatives as well as

possible regulation in the hedge fund adviser area.

Q.4. Recently, the SEC proposed a set of minimum standards for

market linkages in its NMS rule proposal. With respect to the proposed rule to establish a hard 4 p.m. close, is one of the alternatives that the SEC is considering the establishment of minimum

standards for electronic timestamping to allow the market to establish the best way to accurately timestamp mutual funds orders? If

not, what are the obstacles to establishing minimum standards.

A.4. The Commission is considering a number of alternatives to the

amendments it proposed last fall to respond to late trading in mutual fund shares. As you know, that proposal would permit a purchase or redemption order for mutual fund shares to be priced as

of the day it is received, if the fund, its designated transfer agent,

or a registered clearing agency receives the order by the fund’s designated pricing time (typically 4 p.m. eastern time). The Commission received more than 1,000 comment letters on the proposal.

Many commenters recommended that the rule provide an exception

for fund intermediaries, such as retirement plan administrators

and fund service providers, that implement certain controls such as

an unalterable, automatic timestamp on each order received. Other

commenters have suggested the Commission require an order to

purchase or redeem fund shares be submitted to a central clearinghouse by the fund’s pricing time in order to receive same-day pricing. The Commission and its staff are meeting with representatives

of broker-dealers, retirement plan sponsors and administrators,

fund companies, and fund service providers about the alternatives

that they recommended, and they have explained their approaches

in more detail, including requirements for a timestamp. We are

considering these and other comments in order to substantially

eliminate the potential for late trading while minimizing the costs

of the regulations on funds and their investors.

Q.5. Mr. Chairman, your establishment of the Office Risk Assessment and Strategic Planning and the four task forces are a very

good move forward for the Commission to be proactive on many

issues rather than being reactive. I am particularly interested in

how the Task Force on Disclosure Regime would operate. Often it

seems that the investors are overwhelmed with the many discloVerDate 11-MAY-2000 09:44 Dec 10, 2004 Jkt 000000 PO 00000 Frm 01122 Fmt 6601 Sfmt 6601 97186.TXT SBANK4 PsN: SBANK4
1111

sures they receive and I am afraid many of the disclosures end up

in the trash can. What is the timetable for the Task Force and how

comprehensive will it be? For example, will it also cover disclosures

required by the self-regulatory organizations?

A.5. The Commission has a long-term mission of improving the

quality of disclosure to investors and other market participants, including financial intermediaries. The Commission seeks to ensure

that its disclosure regime will be an effective one, and has charged

the disclosure task force with evaluating that regime and recommending improvements.

To be effective, a disclosure regime must contemplate the manner in which information is communicated to the users of the information and the impact of the disclosure obligation on the provider

of the information. The Task Force on Disclosure will therefore examine the value of the various disclosures provided by mutual

funds, brokers, and issuers to investors as required by our rules

and regulations. It will also explore what types of disclosures best

serve investors, the timing of the disclosures, delivery versus access

to disclosures, and how best to harness technological advances in

assisting investors. In addition, the Task Force will analyze whether there is data that the Commission should collect and publish on

a periodic basis that would be useful to investors in making comparisons among the various investment options available to them.

The Task Force will report periodically to the Commission and will

provide recommended courses of action.

RESONSE TO A WRITTEN QUESTION OF SENATOR MILLER

FROM WILLIAM H. DONALDSON

Q.1. On February 5, 2004, The Wall Street Journal reported that

the SEC is planning a formal review of the role of SRO’s in the

marketplace. The article was focused on the New York Stock Exchange, but we wonder if any final consideration of the NSCC’s

proposal, to compete with private sector companies already active

in the Separately Managed Account (SMA) arena, should at least

wait until your ‘‘concept release’’ exploring the relative benefits and

drawbacks of various SRO models, including, we would hope, the

NSCC example, as well as any public comments that might ensue.

Do you agree?

A.1. SRO issues the Commission will consider first likely will primarily relate to the recent problems of transparency and self-policing in the securities markets, which would not have a significant

impact on the structure or operations of clearing agencies.

Pursuant to Section 19 of the 1934 Act, the Commission is not

empowered to put final consideration of a proposed rule change on

hold. Under Section 19(b)(2), once a proposed rule change has been

published for notice and comment the Commission is required either to approve a proposed rule change if it finds that such proposed rule change is consistent with the requirements of the Act

and the rules and regulations thereunder or to disapprove the proposed rule change if it cannot make such a finding unless the SRO

extends the time period. The Commission’s action regarding SRO’s

does not appear to give a clear basis for the Commission to put on

hold the approval/disapproval process of an SRO proposed rule

change.

1112

1113

1114

1115

1116

1117

1118