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92–686 PDF 2004

S. Hrg. 108–461

OVERSIGHT HEARING ON MUTUAL FUNDS:

HIDDEN FEES, MISGOVERNANCE AND OTHER

PRACTICES THAT HARM INVESTORS

HEARING

BEFORE THE

FINANCIAL MANAGEMENT, THE BUDGET, AND 

INTERNATIONAL SECURITY SUBCOMMITTEE

OF THE

COMMITTEE ON 

GOVERNMENTAL AFFAIRS 

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

JANUARY 27, 2004

Printed for the use of the Committee on Governmental Affairs

(

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS 

SUSAN M. COLLINS, Maine, Chairman 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

NORM COLEMAN, Minnesota 

ARLEN SPECTER, Pennsylvania 

ROBERT F. BENNETT, Utah 

PETER G. FITZGERALD, Illinois 

JOHN E. SUNUNU, New Hampshire 

RICHARD C. SHELBY, Alabama 

JOSEPH I. LIEBERMAN, Connecticut 

CARL LEVIN, Michigan 

DANIEL K. AKAKA, Hawaii 

RICHARD J. DURBIN, Illinois 

THOMAS R. CARPER, Delaware 

MARK DAYTON, Minnesota 

FRANK LAUTENBERG, New Jersey 

MARK PRYOR, Arkansas

MICHAEL D. BOPP, Staff Director and Chief Counsel 

JOYCE A. RECHTSCHAFFEN, Minority Staff Director and Counsel 

AMY B. NEWHOUSE, Chief Clerk

FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL 

SECURITY SUBCOMMITTEE 

PETER G. FITZGERALD, Illinois, Chairman 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

ARLEN SPECTER, Pennsylvania 

ROBERT F. BENNETT, Utah 

JOHN E. SUNUNU, New Hampshire 

RICHARD C. SHELBY, Alabama 

DANIEL K. AKAKA, Hawaii 

CARL LEVIN, Michigan 

THOMAS R. CARPER, Delaware 

MARK DAYTON, Minnesota 

FRANK LAUTENBERG, New Jersey 

MARK PRYOR, Arkansas

MICHAEL J. RUSSELL, Staff Director 

RICHARD J. KESSLER, Minority Staff Director 

TARA E. BAIRD, Chief Clerk 

(III)

C O N T E N T S 

Opening statements: Page 

Senator Fitzgerald ............................................................................................ 1

Senator Akaka .................................................................................................. 4

Senator Collins ................................................................................................. 5

Senator Levin .................................................................................................... 7

Senator Sununu ................................................................................................ 9

Senator Lautenberg .......................................................................................... 11

WITNESSES 

TUESDAY, JANUARY 27, 2004

Richard J. Hillman, Director, Financial Markets and Community Investment, 

General Accounting Office ................................................................................... 13

Hon. Eliot L. Spitzer, Attorney General, Office of the New York State Attorney General .......................................................................................................... 15

John C. Bogle, founder and former Chief Executive Officer of The Vanguard 

Group, and President, Bogle Financial Markets Research Center .................. 33

Peter T. Scannell, Weymouth Landing, Massachusetts ....................................... 43

James Nesfield, Nesfield Capital ............................................................................ 45

Jeffrey C. Keil, Vice President, Global Fiduciary Review, Lipper Inc. ............... 61

Travis B. Plunkett, Legislative Director, Consumer Federation of America ...... 63

Paul Schott Stevens, Partner, Dechert LLP, on behalf of the Investment 

Company Institute ............................................................................................... 65

Marc E. Lackritz, President, Securities Industry Association ............................. 68

John P. Freeman, Professor of Law, University of South Carolina Law School 70

ALPHABETICAL LIST OF WITNESSES

Bogle, John C.: 

Testimony .......................................................................................................... 33

Prepared statement .......................................................................................... 106

Freeman, John P.: 

Testimony .......................................................................................................... 70

Prepared statement .......................................................................................... 266

Hillman, Richard J.: 

Testimony .......................................................................................................... 13

Prepared statement .......................................................................................... 81

Keil, Jeffrey C.: 

Testimony .......................................................................................................... 61

Prepared statement .......................................................................................... 179

Lackritz, Marc E.: 

Testimony .......................................................................................................... 68

Prepared statement .......................................................................................... 250

Nesfield, James: 

Testimony .......................................................................................................... 45

Prepared statement by James Nesfield and Ian Grigg ................................. 150

Plunkett, Travis B.: 

Testimony .......................................................................................................... 63

Prepared statement .......................................................................................... 205

Scannell, Peter T.: 

Testimony .......................................................................................................... 43

Prepared statement .......................................................................................... 131

Spitzer, Hon. Eliot L.: 

Testimony .......................................................................................................... 15

Prepared statement .......................................................................................... 102

Page

IV

Stevens, Paul Schott: 

Testimony .......................................................................................................... 65

Prepared statement .......................................................................................... 224

APPENDIX

Prepared statements from: 

Peter J. Kugi, Grafton, Wisconsin ................................................................... 276

Niels C. Holch, Executive Diretor, Coalition of Mutual Fund Investors ..... 278

Roy Weitz, Publisher of Fundalarm.Com ....................................................... 295

Questions and responses for the Record from: 

Paul Schott Stevens, with an attachment ...................................................... 301

Marc E. Lackritz ............................................................................................... 333

John P. Freeman .............................................................................................. 334

(1)

OVERSIGHT HEARING ON MUTUAL FUNDS: 

HIDDEN FEES, MISGOVERNANCE AND 

OTHER PRACTICES THAT HARM INVESTORS 

TUESDAY, JANUARY 27, 2004

U.S. SENATE,

SUBCOMMITTEE ON FINANCIAL MANAGEMENT,

THE BUDGET AND INTERNATIONAL SECURITY,

OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, 

Washington, DC. 

The Subcommittee met, pursuant to notice, at 10:07 a.m., in 

room SD–342, Dirksen Senate Office Building, Hon. Peter G. Fitzgerald, Chairman of the Subcommittee, presiding. 

Present: Senators Fitzgerald, Akaka, Collins, Levin, Lautenberg, 

and Sununu. 

OPENING STATEMENT OF SENATOR FITZGERALD 

Senator FITZGERALD. This meeting will come to order. Today we 

are conducting our second oversight hearing on the mutual fund industry. At our first hearing in November we examined the breadth 

and the depth of the illicit trading practices that have come to light 

in the past year. We also examined mutual fund management and 

governance and sought to identify statutory and/or regulatory reforms that should be enacted to better protect mutual fund shareholders. 

I would like to begin by welcoming all of our witnesses who are 

present today, and to thank each of them for taking time out of 

their schedules to share their insights with us. I see that some of 

them flew in last night, which turned out to be a good move given 

the weather conditions in Washington today. 

I also want to acknowledge the dedication and hard work of my 

colleagues with us today, Governmental Affairs Committee Chairman Susan Collins, whose experience as Maine’s Commissioner of 

Professional and Financial Regulation has contributed an invaluable perspective to our reform dialogue; and the Subcommittee’s 

Ranking Member, Senator Akaka, whose bill, S. 1822, introduced 

the U.S. Senate to serious legislative treatment of these issues. 

Also with us is Senator Levin from Michigan, whom I know to having a keen interest in the welfare of America’s mutual fund investors. 

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 were an even more serious threat 

2

to American investors. We heard extensive testimony from industry 

experts who forcefully noted that small differences in mutual fund 

fees can add up to enormous differences in investment returns over 

time, but that poor disclosure of those fees, and in fact no disclosure of transaction cost, makes it very difficult for investors to compare funds. 

In general the experts agreed that regulators could readily stop 

illegal or illicit practices such as market timing and late trading, 

but that it would be far more difficult and complex to address the 

problem of excessive fees and the inadequate disclosure, in part because most mutual funds are organized in a manner that makes 

the interest of fund managers largely adverse to the interest of 

fund shareholders. 

The purpose of this hearing is to take the bull by the horns and 

to pick up where the last hearing left off. We will examine mutual 

fund fees, the whole menu, the whole panoply of mutual fund fees, 

their propriety and the adequacy of their disclosure under the current regime. We will attempt to lift the veil off hidden fees such 

as revenue sharing, directed brokerage and soft money arrangements. We will also attempt to unmask and deconstruct hidden 

loads such as 12b–1 fees. We will discuss how statutory or regulatory changes might improve disclosure and allow for more informed comparisons between funds. 

This Subcommittee has specific jurisdiction over Federal retirement benefits. Later this year we will hold a hearing on the unique 

mutual fund system that is available only to employees of the Federal Government. It is called the Thrift Savings Plan, or the TSP 

for short. I have a brochure right here from the Federal Thrift Savings Plan. The TSP is essentially a public sector version of the private sector 401(k) plan. All Members of Congress, all of us up here, 

the Administration and their agency staffs, can invest their retirement savings in any or all of five TSP funds, each of which is either an equity or a debt security index fund. 

While I may be jumping ahead somewhat to a future hearing, it 

is worth mentioning here that the expense ratio of the average government TSP fund last year was only 11 basis points, or 11 cents 

per $100 invested, and that in previous years it has been as low 

as 7 or 8 basis points. In fact, one of the funds, the Government 

G Fund, in 1999 and 2000, had a net expense ratio of only 5 basis 

points. 

In contrast, according to the most recent data available from the 

Lipper Services, the average expense ratio for private sector S&P 

500 Index Funds is 63 basis points. That is 63 cents per $100 invested. Many private sector S&P Index Funds have total expense 

ratios substantially lower than that, maybe as low as 17 or 18 

basis points, but none even comes close to the Government Thrift 

Savings Plan. The difference between expenses of 11 cents per $100 

invested and 63 cents per $100 invested may not sound like much, 

but keep in mind what all the experts emphasize, that small differences in fees add up to large differences in returns as the principal invested is compounded over long periods such as 10, 20 or 

30 years. 

I point these facts out now because I think it ironic that Members of the House and Senate have managed to protect themselves 

3

from the sort of abusive practices and excessive fees which eat 

away at the savings of many Americans. If you are lucky enough 

to be a Senator or a Member of Congress, you simply do not have 

to worry about excessive fees, directed brokerage, revenue-sharing 

arrangements or soft dollar payments eating away and siphoning 

away your retirement savings like most Americans do. Nor do you 

have to worry about an incestuous board of directors that is beset 

with conflicts of interest because board members are completely 

independent and required by law to act solely in the interests of 

plan participants and beneficiaries. The TSP competitively bids out 

the management contract for the TSP Fund, and not surprisingly, 

the management fee charged to TSP shareholders is only a negligible percentage of the overall TSP expense ratio. I said that the 

expense ratio averaged 11 basis points last year for TSP participants. A large portion of that was for a computer system that they 

had to charge off. They entered a contract to change their computers. Chairman Collins is investigating that. In previous years 

the expense ratios for the TSP Fund have been much lower than 

that, and it is projected that next year it will go back down into 

the single digits, 7 or 8 basis points. 

The mutual fund industry is indeed the world’s largest skimming operation, a $7 trillion trough from which fund managers, brokers 

and other insiders are steadily siphoning off an excessive slice of 

the Nation’s household, college and retirement savings. Is it not 

special that Members of Congress and Senators have set up a special separate mutual fund deal for themselves in which no skimming is allowed? Sad to say, retirement investing appears to be yet 

another instance in which Federal employees get a great deal, but 

everyone else gets the shaft. A Senator or a Congressman or a 

member of the SEC staff, for that matter, who participates in the 

Thrift Savings Plan will have more money at retirement than a 

member of the general public who invests the same amount for the 

same number of years in a comparable private sector index fund. 

That is not right. In fact, it is outrageous. 

This Committee and this Senate should not rest until Congress 

has given every American the same retirement savings opportunity 

that it has given itself. 

As we commence this oversight hearing, I would like to note that 

the Senate Committee on Banking, Housing and Urban Affairs, the 

authorizing committee which will ultimately decide questions of 

mutual fund industry reform, has scheduled a series of legislative 

hearings to examine the mutual fund scandal and the merits of 

various proposals. I commend the leadership of Chairman Shelby 

and Ranking Member Senator Sarbanes, and look forward to continuing to work with them on this issue in the coming months. 

Today we will hear a broad spectrum of informed opinion on the 

problems confronting the mutual fund industry. We will hear the 

State and Federal Government perspective in our first panel, the 

illuminating, in-the-trenches whistle-blower perspective in our second panel, and a truly diverse and academic perspective in our 

third panel. 

At this point I would like to also acknowledge Senator Lautenberg from New Jersey, who has joined us. Senator, we thank you 

for your participation. The Senator had a distinguished business 

4

career before coming into the Senate, and before retiring and then 

coming back into the Senate. Welcome back. It is good that you are 

here for this issue. 

Senator LAUTENBERG. Pleased to be here. 

Senator LEVIN. Mr. Chairman, if you could just yield on that. 

There was another event in Senator Lautenberg’s life on Sunday 

which we all ought to take note off, which I just found out about. 

His beloved Bonnie is now his wife. 

Senator FITZGERALD. Congratulations. You did not go on a honeymoon. 

Senator LAUTENBERG. Thank you for the mention, everybody. It 

is about time. 

Senator FITZGERALD. There we go. No honeymoon? Maybe later. 

Senator LEVIN. That is a sore point already probably. [Laughter.] 

Senator LAUTENBERG. In a safe, secure relationship, it is all right 

to take the precise week that you want for your honeymoon. 

Senator FITZGERALD. Maybe wait until congressional recess to do 

that. 

Senator LAUTENBERG. Thank you very much. 

Senator FITZGERALD. At this time, before I introduce our witnesses, I would like to recognize our Ranking Member, Senator 

Akaka, who may have an opening statement, and then I will proceed to the Chairman of the full Committee, Senator Collins, and 

then to Senator Levin and Senator Lautenberg. 

Senator Akaka, thank you. 

OPENING STATEMENT OF SENATOR AKAKA 

Senator AKAKA. Thank you very much, Mr. Chairman. I really 

appreciate your conducting this hearing today, and thank you for 

your leadership on the issue of mutual fund reform. I look forward 

to continuing to work with you, Mr. Chairman, along with our colleagues on the Senate Banking Committee in enacting meaningful 

legislation intended to protect investors. 

Mr. Chairman, I have found the betrayal of trust of mutual fund 

investors by fund companies and brokers appalling, because mutual funds are investment vehicles that the average investor relies 

on for retirement, savings for children’s college education, or other 

financial goals and dreams. In one example directly related to 

worker retirees in the State of Hawaii, Putnam Investments had 

been responsible for managing $440 million for the State of Hawaii’s Employees Retirement System, which administers retirement and survivor benefits for over 96,000 State and county employees in Hawaii before the company was fired due to the late 

trading abuses that one of our witnesses, Mr. Scannell, helped to 

bring to the attention of regulators. 

Today’s hearing will provide an opportunity to closely examine 

the hidden financial relationships between mutual fund companies 

and brokers. For example, shelf-space payment and revenue-sharing agreements between mutual fund companies and brokers 

present conflicts of interest that must be addressed. Brokers also 

compile preferred lists which highlight certain funds which typically generate more investment than those left off the list. It is not 

clear to investors that the mutual fund company also may pay a 

percentage of sales and/or an annual fee on the fund assets held 

5

by the broker to obtain a place on the preferred list or to have their 

shares sold by the broker. 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 of solid returns or low volatility, but the broker’s recommendation may be influenced by hidden payments. Mutual fund investors need to know the amount of 

compensation the broker will receive due to the transaction instead 

of simply providing a prospectus. The bottom line is that the prospectus fails to include that detailed relevant information that investors need to make informed decisions. Mutual fund investors deserve to know how their broker is being paid. 

I am also concerned that although consumers often compare the 

expense ratios of funds when making investment decisions, they 

are not getting a realistic view of the true expenses of mutual 

funds. The expense ratios fail to take into account the costs of commissions in the purchase and sale of securities. Brokerage commissions are only disclosed to the investors upon request in the Statement of Additional Information. Brokerage commissions must be 

disclosed in a document and in a format that investors actually 

have access to and utilize. 

Mr. Chairman, I want to take a moment to commend the Securities and Exchange Commission for its proposals intended to improve the corporate governance of mutual funds and to increase the 

transparency of mutual fund fees that investors pay. The SEC has 

recently proposed rules to require an independent chairman for 

mutual fund boards, an increased percentage of independent directors to 75 percent, and a confirmation notice so that investors will 

be able to know how their broker gets paid in mutual fund transactions. These provisions mirror those in the Mutual Fund Transparency Act of 2003, which I introduced along with Senator Fitzgerald and Senator Lieberman in November in order to restore 

public trust in the mutual fund industry. 

I am pleased that the Commission has taken these and other actions to protect the 95 million American investors who have invested a significant portion of their financial security in mutual 

funds. I am encouraged by the steps taken by the SEC and I look 

forward to the implementation of many of the proposed reforms. 

However, legislation is still needed to codify several of these proposals and to bring about additional changes so that comprehensive 

reform of the mutual fund industry is achieved. For working Americans, mutual funds are an important investment vehicle that offers diversification and professional money management. 

We must restore the trust of investors in mutual funds, and I 

look forward to today’s discussion and what needs to be done to accomplish that essential goal. 

Thank you very much, Mr. Chairman. 

Senator FITZGERALD. Senator Akaka, Thank you very much. 

Chairman Collins. 

OPENING STATEMENT OF CHAIRMAN COLLINS 

Chairman COLLINS. Thank you very much, Mr. Chairman. I want 

to thank you for holding a second hearing to examine the mutual 

6

fund industry, and particularly to recognize your leadership in 

focusing on a very important topic this morning, the fees paid and 

expenses borne by mutual fund shareholders. 

For many investors, as the Chairman has pointed out, high fees 

and excessive expenses are even more of a problem than market 

timing, late trading and other abuses previously examined by this 

Subcommittee. Mutual funds have long been promoted as a haven 

for the small investor who may not have the time nor the expertise 

to pick stocks. Many investors like to leave the difficult and worrisome decisions regarding which companies to buy and sell to a mutual funds professional manager. To achieve their saving goals, 

whether it’s for a new home, a college education, or a secure retirement, many American families put their hard-earned savings into 

mutual funds. Savings for the future often mean sacrifices for the 

present. A secure retirement may mean a shorter vacation. A college education for children can equate to buying a used car rather 

than a new one. Saving for a first home means fewer dinners out 

and foregoing other luxuries. 

These sacrifices, Mr. Chairman, are why I am so concerned that 

we maximize investors’ mutual fund returns, and even more important, that investors understand precisely the fees and the expenses 

they are charged. Maximum returns for investors cannot occur if 

fees are excessive or opaque, or if any other questionable practices 

that reduce investment returns are permitted. 

By now we are all too familiar with the allegations regarding late 

trading, market timing, and other practices. What they revealed is 

that far too often there are two sets of rules, one for favored insiders and another set for the average investor. Perhaps most disturbing, however, was that these practices were carried out not by 

shady dealers in boiler rooms, but rather by senior executives at 

some of the most respected names in the mutual fund industry. In 

the most egregious cases these practices were not only tolerated by 

senior management but actually exploited by them as well. These 

executives seem to have forgotten the fundamental principle of 

money management, that the money given to them to invest is not 

their money but rather the shareholders’ money. That is why Federal law imposes upon investment advisers who run mutual funds 

a fiduciary duty to the fund and its shareholders. At the very least 

this should mean, as one former regulator put it, that mutual fund 

executives are not spending their days trying to invent new ways 

to skim their shareholders’ assets. 

Although mutual funds have been around for some 80 years, they 

have only become popular investment choices in the past 25 years. 

The American public’s investment in mutual funds has exploded 

during that time. In 1980, total assets amounted to about $135 billion, and only 10 percent of Americans owned mutual funds. Today 

approximately 50 percent of Americans own a mutual fund, and 

total assets are at least $6.4 trillion. It can be very difficult for consumers to choose among the 8,200 mutual funds. Consumers often 

focus primarily on the historic rate of return, rather than on fees 

and expenses. Yet according to the former chief economist of the 

Securities and Exchange Commission, small differences in investor 

costs can make a huge difference in the ultimate return over the 

long run. 

7

For example, assume a worker chooses a mutual fund at the beginning of her working 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, but 

only a 0.5 percent expense ratio? Sadly, there is a very good chance 

that most average investors will choose the former, but choosing 

the latter would, by the end of this woman’s career, probably have 

returned 35 to 40 percent more money. That is the difference that 

the amount of fees and expenses charged can make. 

The government does not place limits on how much mutual funds 

can charge, nor should it, in my opinion. We know that U.S. mutual funds generally have lower costs than those in many other 

countries. But research by the General Accounting Office and the 

SEC suggest that we can do much better in lowering mutual fund 

investors’ costs. 

It is my hope that today’s hearing will shed more light on why 

the mutual fund market is simply not more cost competitive. It 

may be that consumers simply do not understand, or have not been 

given enough information to understand the impact of fees. But one 

problem clearly is that it is often very difficult for the average investor to discern the level of fees. We do not have a simple system 

such as we do with our checking accounts, where every month we 

can clearly see what fees were assessed. I think we need to look 

at the disclosure of fees and the location of that disclosure to bring 

increased transparency and disclosure to the process. 

Again, Mr. Chairman, I want to thank you very much for your 

leadership, and I look forward to hearing the testimony today. 

Senator FITZGERALD. Thank you very much, Chairman Collins. 

That is an incredible statistic, 8,200 mutual funds in the country. 

I believe there are only about 6,000 publicly traded corporations, 

so that statistic would seem to suggest it is a very good business 

to own or run a mutual fund. 

Senator Levin. 

OPENING STATEMENT OF SENATOR LEVIN 

Senator LEVIN. Thank you, Mr. Chairman. With 95 million 

Americans invested in mutual funds, hoping and planning to use 

their investment dollars for college expenses, mortgages, retirement, and to help their kids, the recently-exposed mutual fund 

scandals have brought home the need to look at potential reforms 

to stop late trading and market timing abuses, as previously examined by this Subcommittee. We are going to examine this morning 

to prevent hidden fees and to end ongoing conflicts of interests and 

other harmful practices that hurt mutual fund investors. 

Investors pay $75 billion each year in fees that support the mutual fund industry. The immense size of this dollar amount reflects 

the importance of the subjects of this hearing: Clear fee disclosure 

and the elimination of conflicts of interest. Investors deserve complete and accurate information about mutual fund costs so that 

they can make informed investment decisions and comparison shop 

to find well-run, low-cost mutual fund products. They also need to 

have confidence that the fees that they incur are legitimate. They 

deserve to know that the persons in charge of their investments are 

exercising independent and careful judgments on their behalf and 

8

that their investment advisers are providing them with objective 

investment advice. 

As we consider appropriate mutual fund reforms, it is critical to 

recognize and address conflicts of interests and lax oversight practices. We can start at the top. Like a typical corporation, every mutual fund is governed by a board of directors that has a duty to act 

in the best interest of the funds’ shareholders, but as we can see 

from recent scandals many of these boards, as currently constituted, have failed to provide needed oversight of their funds. 

One way to address director conflict of interest concerns is to 

make sure that the requirement for so-called independent directors 

is met with directors who are truly independent of the funds they 

oversee. For instance, right now a current officer or director of a 

service provider to a fund can be counted as an ‘‘independent director.’’ We must change that. 

Other troubling conflicts of interest arise when mutual funds 

make undisclosed arrangements with brokerage houses which now 

sell about half of all mutual fund shares. For instance, recent press 

reports indicate that some brokers receive undisclosed incentives 

from mutual funds, without telling their customers about the compensation they get to push that fund’s products. These types of secret commissions and arrangements mean that investors are not 

getting objective investment advice. 

We need to throw a spotlight on hidden, difficult-to-understand 

arrangements between mutual funds and brokerage houses involving so-called directed brokerage, revenue sharing and soft dollars 

arrangements. Directed brokerage occurs when a mutual fund buys 

stock from a brokerage firm for its holdings if that brokerage firm 

promotes the mutual fund’s shares to their other customers. In socalled revenue sharing, the mutual fund gives the brokerage firm 

a share of its revenues if the brokers sell the mutual fund shares 

to their customers. With soft-dollar arrangements, a mutual fund 

pays a brokerage firm for research and other services, in the expectation that the brokers will promote the mutual fund’s products. 

These hidden practices raise troubling conflicts of interest that 

need to be ended. As SEC Chairman Donaldson has said, ‘‘Investors have the right to know everything that is inducing a broker 

to recommend a particular fund.’’

Another key reform would be to standardize the method for calculating and disclosing mutual funds’ ‘‘expense ratios’’ and ensure 

that they include all material costs. That ratio is designed to show 

the total annual operating expenses of a fund is a percentage of its 

total assets. The figure is already compiled by every fund and theoretically should be one of the most helpful numbers to investors 

comparing fees. If designed well, it should function in a way similar to the per-unit price listed on a grocery shelf price tag, giving 

a ‘‘price per ounce’’ so that comparison shoppers can assess the 

price savings between different brands and sizes. But right now, 

many funds leave out key expenses when calculating that ratio. For 

example, while the ratio now includes the management fee charged 

by the fund management, distribution fees and other administrative expenses, it excludes what can be one of the fund’s largest expenses, portfolio transaction costs such as broker commissions. 

9

According to consumer groups, these portfolio transaction costs 

sometimes exceed all the costs combined that are currently included in the expense ratio. These transaction costs ought to be disclosed in a standard and easily-understood format. 

Other fee reforms are also needed. Many investors find the various fee options for mutual funds bewildering and rely on their broker’s advice about which to choose. However, a broker’s interest is 

often at odds with the investor’s. The fee option with the greatest 

payoff for the broker may result in the highest charge to the investor. That conflict of interest could be addressed by requiring a clear 

fee disclosure prior to the purchase that presents a clear comparison of the dollar costs of investing in each class of shares over a 

certain period of time. 

Mutual funds are the investment of choice for a large percentage 

of Americans. It is their money that provides much of the fuel for 

economic growth. All of us have a duty to protect the average investor and in turn the American economy. It is sad but true that 

the mutual fund industry has shown that it cannot be relied upon 

to protect its customers. Strong reforms must be put in place in law 

and in regulation. 

I salute our Chairman, Senator Fitzgerald, Senator Akaka, Senator Collins, all of those who are involved in the leadership of advocating needed reforms for the mutual fund industry on behalf of 

the average investor. 

Thank you, Mr. Chairman. 

Senator FITZGERALD. Thank you, Senator. We have been joined 

by Senator Sununu from New Hampshire, and if I go in the order 

that Senators arrived, I would go first to Senator Lautenberg and 

then we will come back to Senator Sununu. 

Senator Lautenberg. 

OPENING STATEMENT OF SENATOR LAUTENBERG 

Senator LAUTENBERG. Thanks, Mr. Chairman. Senator Sununu 

has got all kinds of excitement going on in his State, so he has to 

get back to the TV screen and we will permit him to do so very 

shortly. 

Mr. Chairman and Chairman Collins, we thank you both for having this hearing at this opportune moment. We have been looking 

at hidden fees and misgovernance and self-dealing and other practices that have harmed investors in the mutual fund industry, and 

it seems that there is no end to corporate scandals shaking Wall 

Street and Main Street. 

I am a former chief executive and a founder of a company called 

ADP, Automatic Data Processing, and I always felt that my responsibility to the investor was a paramount part of my obligation, that 

if I could face them regularly, and even if we had an occasional dip 

in earnings because of the general economy, there was very good 

acceptance of our stock, and the PE, which I assume most people 

here are familiar with, was always at a very high level, and that 

is because they had faith and it is because that was the only way 

we knew how to run a company. 

Now what we see is instead of working to enhance shareholder 

value, it seems that many directors and fund investment advisers 

have used their trusted positions to line their own pockets and the 

10

pockets of their industry cronies. I am on the board of the Columbia University Business School—it is my alma mater—and recently 

established a chair in corporate governance. And having served on 

the public corporation for 25 years, I learned a lot from my trusted 

directors, including Alan Greenspan, who came to the Fed directly 

from the ADP Board, and recently departed Larry Tisch, who we 

all knew and who was a terrific example of credibility and care 

about how you treat public funds. 

So to see that the mutual fund principles have been so lax that 

their mission appears to be not to serve the shareholders, not the 

95 million Americans who invest in mutual funds because they believe that the funds are diversified, well-regulated and managed by 

honest professionals, but it turns out that some investment fund 

managers are more concerned about creating arrangements that 

are profitable for them, leaving the leftovers for the investors, 

many of whom are counting on the safety and growth of what 

might be their only reserve. 

Today’s witnesses—and I am pleased to see the list of witnesses, 

Mr. Chairman, are credible people, and we are pleased to have 

them. I am particularly familiar with Attorney General Spitzer’s 

record and zeal in rooting out corruption wherever it can be found, 

and I salute that effort and urge you to continue it. 

Today’s witnesses will testify—and this may be slightly repetitive 

but I think worth mentioning—that while the total assets of all 

mutual funds increased from $56 billion in 1978 to $6.4 trillion in 

2002, the expense ratio of the average mutual fund, which actually 

represents less than one half of all the costs incurred by fund investors, increased from 0.91 percent in 1978 to 1.36 percent during 

the same period. It sounds like good business to me. That is an increase of 49 percent in the expense ratio. Mutual fund investors 

have not realized any of the benefits of the economies of scale, and 

to make matters worse, industry experts have concluded that the 

return earned by the average mutual fund in the past 20 years, 

from 1982 to 2002, has lagged behind the return of the S&P 500 

by more than 3 percent. That is more than double the lag from the 

previous 20 years of 1950 to 1970. In other words, mutual funds 

have gotten more expensive, thus, their performance has realistically gone down. 

I am searching for a good reason why this has happened. It is 

hard to think of one. We do know that there has been a rash of 

corporate malfeasance that has extended into the mutual fund industry. It is clear that the fund managers and investment advisers 

seem to have become less interested in how their funds perform to 

the benefit of all shareholders, and more interested in creating 

schemes that line their own pockets regardless of performance. The 

New York Times reported last week that corporate executives at 

the World Economic Forum in Davos, Switzerland complained that 

the Sarbanes-Oxley Bill passed in the wake of the accounting scandals at Enron, WorldCom, Tyco, is hampering their ability to do 

business. They brought it on themselves. I think the simplest 

axiom for Sarbanes-Oxley is ‘‘tell the truth’’ and then you do not 

have to worry about those kinds of imposing laws. They brought it 

on themselves. Someone has to look out for shareholder interests 

for the public interest, and there is too much at stake. 

11

Just think, this comes at a time when it is suggested that some 

part of Social Security ought to be permitted to be invested in the 

public marketplace. Well, I think that if that does happen, it is 

going to have serious scrutiny in the Senate and House, and we are 

going to make sure—if I can do anything about it; my colleagues 

here I think would agree—that we highlight the performance of the 

funds including the expenses both hidden and real and make them 

part of the reporting system. It comes up frequently and regularly. 

That is where this timing, Mr. Chairman, is so important. I congratulate you. I look forward to hearing the testimony of our distinguished witnesses. I think that we have heard much about Attorney General Eliot Spitzer, almost all of it very positive and very 

exciting. I urge him to continue. It is a difficult and painful review, 

but it is essential that we get the markets functioning properly 

again and restore the American people’s faith in the fundamental 

way that this country conducts its business affairs, and I thank 

you. 

Senator FITZGERALD. Senator Lautenberg, thank you very much 

for that excellent opening statement. 

Senator Sununu, last but not least. 

OPENING STATEMENT OF SENATOR SUNUNU 

Senator SUNUNU. Thank you, Mr. Chairman, and thank you for 

putting together this hearing. I am also a member of the Banking 

Committee and I look forward to the series of hearings that Chairman Shelby will also be holding on these issues. 

Let me begin picking up on a point that Senator Lautenberg 

made, and that is the importance of the board structures and the 

responsibility of the board structures. It is easy to be a little bit 

disdainful of wealthy board members that might be meeting overseas for a big economic forum and that they are lamenting some 

of the regulatory complexities of Sarbanes-Oxley. But at the same 

time these are board members that are supposed to be representing 

shareholders’ interests and if we pass regulations, whether it is 

Sarbanes-Oxley or any other piece of regulation, one that limits 

their ability or creates disincentives for them to make creative decisions and good investment decisions on behalf of shareholders, or 

two, if we pass legislation against Sarbanes-Oxley or any regulations having to do with the mutual fund industry that makes it difficult to encourage good people, independent minds, creative individuals to sit on boards, we will have done a disservice to shareholders. So while it is important that we have regulations in place 

that set a clear path, set clear standards for behavior, a bright-line 

for legal and illegal behavior, conflicts of interest and disclosure, 

we do not want to create an environment, whether they are volunteer or compensated, where good, qualified people no longer want 

to participate in the process or serve the interests of shareholders 

on boards because our financial systems and our markets will have 

been hurt significantly by it. 

We all have concerns about some of the issues that have been 

uncovered and revealed in part by the work of Eliot Spitzer and 

others. Late trading, market timing, these are practices in some 

cases that were discouraged if not outright illegal, that need to be 

clarified and dealt with either by the SEC or by legislation passed 

12

by Congress. Investors need to be protected by the impact of any 

illegal or inappropriate trading schemes. They can place undue 

burdens on the funds themselves, and they can also undermine the 

confidence that investors have in our financial system, and that is 

what we saw with some of the concerns that were addressed by 

Sarbanes-Oxley. 

First and foremost we are concerned about confidence in the 

marketplace because without confidence we cannot have efficient 

trading and investing activities. Disclosure is also extremely important and highlighted here in a number of cases. We want to have 

consistent standards for the fees reported by these mutual funds or 

any other investment vehicle. What are the costs, what are the fees 

as a percentage? 

But at the same time, the absolute level of the fee is not the 

most critical piece of information that consumers can have, and if 

we suggest otherwise as policy-makers or witnesses or anyone else, 

then we are doing the public a disservice. The most important 

number is the returns of the fund net of all the fees. That is how 

you compare one fund to another, and if I say this fund has expenses of 20 basis points and this one has expenses of 50 basis 

points, but one has a return that outstrips another, then we are 

not going to be giving the consumers all the information that they 

have, so it is important that we are able to discern that different 

funds are going to have different risk profiles, or different returns. 

We want to look at those returns net of all the fees. 

Given good information, I think consumers will make good decisions, and I think it is a mistake to suggest that the entire mutual 

fund industry is a giant skimming operation. There are some bad 

funds out there, of course, 8,000 funds, Senator Collins pointed out. 

There are funds that have individuals, managers, brokers that 

might have broken the law and they should pay. They should certainly be prosecuted under current or future securities laws. There 

are funds that have done a very poor job in delivering returns to 

their investors, and they should certainly pay in the court of public 

opinion that we call the marketplace. Eight thousand mutual funds 

suggest to me at least an extremely competitive marketplace that 

is good for investors, that is good for the country. 

By doing a good job here with our oversight to deal with disclosure issues, we can make that marketplace even stronger and 

healthier, but the oversight needs to be geared toward not just 

good disclosure but fairness in disclosure. Some of the proposals 

that I have seen seem to be weighted against independent research 

firms. The very firms that as a result of the settlement by the Attorney General of New York and the SEC has been encouraged and 

I think strengthened. Independent research is a good thing. We 

should not do anything now in our oversight or new regulations 

that put independent researchers at a disadvantage. I do not believe that we should undertake regulations that try to micro manage the selection of boards on behalf of shareholders. If anything, 

we should be looking at ways to give the shareholders themselves, 

whether it is a mutual fund or a public company, the power that 

they need to exercise a choice in selection over board members and 

even hold board members accountable, and it is not the topic for 

this hearing, but questions of proxy and how shares are voted and 

13

1The prepared statement of Mr. Hillman appears in the Appendix on page 81. 

the disclosure of those votes are all very important, I think, to giving power to shareholders and the decisions that they make. 

I appreciate the opportunity to make an opening statement and 

appreciate the work of the Chairman that he has done on this 

issue. Thank you, Mr. Chairman. 

Senator FITZGERALD. Senator Sununu, thank you very much. We 

are glad to have you here. 

I would like to now introduce our first panel of witnesses. Our 

first witness is Richard J. Hillman, who is the Director of Financial 

Markets and Community Investment at the General Accounting Office (GAO). Mr. Hillman has served at the GAO for the past 27 

years and has worked on a series of reports regarding the mutual 

fund industry including an assessment of the industry’s transparency, the quality of listing standards within securities exchanges and other corporate governance and oversight matters. 

The GAO conducted a review of the mutual fund industry and published an extensive report in June 2003 stating the need for greater 

transparency. Of course, that was before the market timing and 

late trading scandals broke, and now that report is getting needed 

attention, as are many other reports you wrote in previous years, 

going at least as far back as 2000 that I have seen. 

Our second witness is the Hon. Eliot L. Spitzer, Attorney General for the State of New York. Attorney General Spitzer’s inquiry 

into the trading activities of Canary Capital Partners was the first 

of many subsequent announcements and actions against players in 

the mutual fund industry. Additionally, his investigations of conflicts of interest on Wall Street have been a major catalyst for reform in the Nation’s financial services industry. Prior to being 

elected Attorney General, Mr. Spitzer served as an Assistant District Attorney in Manhattan from 1986 to 1992. 

I would like to thank both of you for appearing before us. In the 

interest of time your full statements will be included in the record, 

so we would ask that you limit your summary statement to 5 minutes. Thank you very much. 

Mr. Hillman, you may proceed. 

TESTIMONY OF RICHARD J. HILLMAN,1 DIRECTOR, FINANCIAL 

MARKETS AND COMMUNITY INVESTMENT, GENERAL ACCOUNTING OFFICE 

Mr. HILLMAN. Thank you, Mr. Chairman. Thank you, Chairman 

Collins and Members of the Subcommittee. 

I am pleased to be here today to discuss GAO’s work on the disclosure of mutual fund fees and the need for other disclosures of 

mutual fund practices. Concerns have been raised over whether the 

disclosures of mutual fund fees and other fund practices are sufficiently fair and transparent to investors. 

Our June 2003 report, entitled ‘‘Greater Transparency Needed in 

Disclosures to Investors’’ reviewed (1) how mutual funds disclose 

their fees and related trading costs and options for improving disclosure of those costs; (2) changes in how mutual funds pay for the 

sale of fund shares and how the changes in those practices are affecting investors; and (3) the benefits of and the concerns over muVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
14

tual funds’ use of soft dollars. This testimony summarizes the results of our report and discusses certain events that have occurred 

since the report was issued. 

In summary, we recommend that SEC consider the benefits of requiring additional disclosure relating to mutual fund fees and 

evaluate ways to provide more information that directors and investors could use to evaluate the conflicts of interest arising from 

payments funds make to broker-dealers and fund advisers’ use of 

soft dollars. 

Specifically regarding mutual fund disclosures, we learned that 

although mutual funds disclosed considerable information about 

their cost to investors, the amount of fees and expenses that each 

investor specifically pays on their mutual fund shares are currently 

disclosed as a percentage of fund assets, whereas most other financial services disclose the actual cost to the purchaser in dollar 

terms. The SEC has proposed that the mutual funds make additional disclosures to investors that would provide more information 

that investors could use to compare fees across funds. However, 

SEC is not proposing that the funds disclose the specific dollars 

amount of fees paid by each investor, nor is it proposing to require 

that any fee disclosure be made in the account statements that inform investors of the number and value of mutual fund shares they 

own. Our reports recommend that SEC consider requiring mutual 

funds to make additional disclosures to investors including considering requiring funds to specifically disclose fees in dollars to each 

investor in quarterly account statements. Our report also discusses 

less costly alternatives that could also prove beneficial to investors 

and spur increased competition amongst mutual funds on the basis 

of fees. 

The work that we conducted for our report also found that 12b–

1 fees, which allow fund companies to deduct certain distribution 

expenses such as sales commissions from fund assets can raise cost 

to investors, but also provide additional ways for investors to pay 

for investment advice. Our work also found that mutual fund advisers have been increasingly engaging in a practice known as revenue sharing under which they make additional payments to the 

broker-dealers that sell their fund shares. Although we found that 

the impact of these payments on the expenses of the fund investors 

was uncertain, these payments can create conflicts between the interests of broker-dealers and their customers that could limit the 

choices of funds that these broker-dealers offer investors. However, 

under current disclosure requirements, investors may not always 

be explicitly informed that their broker-dealer, who is obligated to 

recommend only suitable investments based upon the investor’s financial conditions, is also receiving payments to sell particular 

funds. Our report recommends that more disclosure be made to investors about any revenue-sharing payments that their brokerdealers are receiving, and on January 14, SEC proposed new rules 

in this area. 

We are also reviewing a practice known as soft dollars in which 

a mutual fund adviser uses fund assets to pay commissions to 

broker-dealers for executing trades and securities for the mutual 

fund portfolio, but at the same time also receives research or other 

brokerage services as part of that transaction. These soft-dollar arVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
15

1The prepared statement of Mr. Spitzer appears in the Appendix on page 102. 

rangements can result in mutual fund advisers obtaining research 

or other services, including research from third-party independent 

research firms that can benefit the investors in their funds. However, these arrangements also create a conflict of interest that 

could result in increased expenses to fund shareholders if a fund 

adviser trades excessively to obtain additional soft-dollar research 

or chooses broker-dealers more on their ability to provide soft-dollar offerings, rather than their ability to execute trades efficiently. 

SEC has addressed soft-dollar practices in the past, and recommended a number of actions, but has yet to act upon them. Our 

report recommends that more disclosure be made to the mutual 

fund directors and investors to allow them to better evaluate the 

benefits and the potential disadvantages of the fund adviser’s use 

of soft dollars. 

In conclusion, GAO believes that various changes to the current 

disclosure and other practices would benefit fund directors and investors. Additional disclosures and mutual fund fees could help increase the awareness of investors of the fees they pay and encourage greater competition amongst funds on the basis of those fees. 

Likewise, better disclosure of the costs funds incur to distribute 

their shares and the costs and benefits of funds’ use of soft-dollar 

research activities could provide investors with more complete information to consider when making their investment decision. 

Mr. Chairman, this concludes my prepared statement. I would be 

pleased to respond to questions at the appropriate time. 

Senator FITZGERALD. Thank you, Mr. Hillman. Mr. Spitzer. 

TESTIMONY OF HON. ELIOT L. SPITZER,1 ATTORNEY GENERAL, 

OFFICE OF THE NEW YORK STATE ATTORNEY GENERAL 

Mr. SPITZER. Thank you, Mr. Chairman, Madam Chairman, 

Members of the Subcommittee. 

This Subcommittee’s hearing last November played an important 

role in focusing attention on the conflicts inherent in an industry 

where directors were beholden to management. That hearing also 

started the process of crafting solutions to protect the $7 trillion 

Americans have invested in mutual funds. Several of the proposals 

that seemed radical when we discussed them in November have already become conventional wisdom. Requiring mutual funds to 

have truly independent directors and an independent board chairman are now the centerpiece of every reform proposal. There is 

now also widespread recognition that mutual fund directors must 

be given the staff and resources needed to allow them to effectively 

oversee the management companies that run the funds’ day-to-day 

operations. Many reformers also recognize that mutual fund compliance officers should report to the funds’ independent directors 

and not to the managers, whose activities are being monitored and 

reviewed. Perhaps most significantly, there is universal agreement 

that the disclosures provided to mutual fund customers are inadequate, and several competing proposals address this problem. 

I continue to believe that the proper approach would be to provide each investor with an itemized statement of the actual costs 

charged to his or her account. This would provide mutual fund cusVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
16

tomers with the information necessary to engage in true comparison shopping. That is the good news. The bad news is that the industry and many of its apologists are still opposing true reform in 

the area that most directly impacts investors, advisory fees. 

As I indicated when I was here last November, in 2002 mutual 

fund investors paid advisory fees of more than $50 billion and 

other management fees of nearly $20 billion. That is in addition to 

the tens of billions of dollars in marketing fees and trading costs 

imposed by the fund industry. The advisory fees that mutual funds 

charge their shareholders greatly exceed those charged to institutional customers. If mutual fund customers were charged the lower 

rate for advisory fees paid by institutional investors they would 

save more than $10 billion every year. 

The industry has asked whether there is a link between the advisory fees charged to investors and the late trading and market timing practices that were the initial focus of investigation. The answer is yes. Improper trading and exorbitant advisory fees are both 

a consequence of a desire by managers to enrich themselves at the 

expense of investors and an inability or unwillingness on the part 

of directors to protect investors. This can be 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. As one mutual fund manager 

frankly admitted in an E-mail uncovered during the investigation, 

‘‘I have no interest in building a business around market timers, 

but at the same time I do not want to turn away 10 to 20 million 

dollars.’’

Mutual fund directors and managers breached their duties to investors in many ways, and we must pursue every manifestation of 

that breach. This includes breaches of duty that allowed managers 

to overcharge investors. 

When I was last before this Subcommittee I spoke in generalized 

terms about the advisory fee overcharges imposed on investors. 

Now that our investigation has progressed, I’d like to talk more 

specifically about the advisory fees charged by two fund complexes, 

Putnam and Alliance. 

In 2002 Putnam managed approximately $279 billion from mutual fund and institutional investors. Our investigation revealed 

that Putnam charged mutual fund investors significantly higher 

advisory fees than those charged to institutional investors. Here 

are the numbers. Putnam’s mutual fund investors were charged 40 

percent more for advisory services than Putnam’s institutional investors. In dollar terms what this fee disparity means is that in 

2002 Putnam mutual fund investors paid $290 million more in advisory fees than they would have paid had they been charged the 

rate given to Putnam’s institutional clients, and these are for identical services. 

There was a similar disparity in the advisory fees charged by Alliance. Once again mutual fund investors were charged significantly higher advisory fees than institutional investors. Specifically, Alliance’s mutual fund investors paid advisory fees that were 

twice those paid by institutional investors. In dollars terms this 

means that Alliance investors paid more than $200 million in adviVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
17

sory fees than they would have paid had they been charged the 

rate given to Alliance’s institutional clients. 

Because of these findings I refused to join in a settlement with 

Putnam that did not provide investors with some form of compensation for the advisory fee overcharges they incurred. Similarly, 

my office’s settlement with Alliance requires them to return $350 

million to investors by way of a 5-year 20 percent reduction in their 

advisory fees. These actions have led some to accuse me of engaging in rate setting. That is simply wrong. Requiring mutual funds 

to return to investors money that should never have been taken 

from them is not rate setting. It is what regulators across the country do every day when they uncover evidence that consumers have 

been ripped off, and it is what I will continue to do as I uncover 

more evidence that mutual fund investors have been overcharged. 

When the charge of rate setting fell flat, the industry turned to 

a more audacious argument in defense of their advisory fees. Earlier this month the Investment Company Institute issued a report 

that attempted to rebut the evidence showing that mutual fund investors pay more than institutional investors for advisory services. 

The ICI report tries to rebut the important conclusions of an academic article published in the Journal of Corporation Law by Professors Freeman and Brown. Professor Freeman is testifying in a 

later panel and does not need my assistance to articulate the foundation of his analysis, but he is due our thanks for shedding light 

on an abusive practice that takes billions of dollars each year from 

the pockets of average family savings of families who are saving for 

a new home of their children’s education. 

The ICI’s conclusion that mutual fund investors do not pay more 

than institutional investors for advisory fees was unfortunately 

misleading and wrong. It was not based on data showing what mutual funds charge for advisory services. Instead, the ICI relied exclusively on data concerning the fees that sub-advisors, the outside 

advisors occasionally hired by mutual fund managers to give investment advice, charge management companies. There are three 

reasons it is inappropriate to rely on data concerning sub-advisors. 

First, fewer than 20 percent of all mutual funds employ sub-advisors. Indeed, after the ICI released its report, Business Week noted 

that as few as 7 percent of mutual funds employ sub-advisors. Second, unlike most mutual fund fees where directors rubber stamp 

their affiliated management companies request, the fees charged by 

sub-advisors are the product of an arm’s length negotiation between disinterested parties. Third, even the small percentage of 

mutual funds that employ sub-advisors often impose their own 

costs on top of those of the sub-advisor. For example, if the subadvisor charges the fund 30 basis points, the fund will tack on its 

own premium of 20 or 30 basis points and charge investors the 

combined amount. The ICI report used the amount charged by the 

sub-advisors without accounting for the premiums tacked on by the 

mutual funds and passed on to shareholders. The result is that 

even in mutual funds that are sub-advised, shareholders pay more 

for advisory services than the actual cost for that service incurred 

by the management company. Thus, the ICI report takes a number 

that reflects a narrow slice of the industry and is the only part of 

the industry where fees are a product of arm’s length negotiation, 

18

ignores the markup imposed by mutual fund and then attempts to 

pass that number off as representative of the entire industry. The 

real data that reflected the overcharge throughout the overwhelming majority of the industry are those such as what I gave 

you from Putnam and Alliance, data, by the way, that the companies themselves provided to us. 

I know that the ICI has a representative testifying in a later 

panel. I hope the Subcommittee will explore the issue of sub-advised fees, especially the premiums that the funds impose on top 

of sub-advisory fees. My sense is that these premiums are often as 

much or more than the fees charged by the sub-advisor itself. This 

raises the question of what service is being provided to justify these 

premiums. In the coming weeks my office will take a closer look at 

that question. 

When discussing advisory fees the challenge is not in determining the scope of the problem but in crafting an appropriate solution. I would like to ask this Subcommittee to consider a proposal 

endorsed a few weeks ago by the treasurers of California and North 

Carolina and by the New York State Controller. This proposal 

would require all mutual fund fee contracts to control break points 

providing economies of scale savings to shareholders, and would require mutual fund boards to justify fees in an analysis published 

in the fund’s annual report. The analysis must include a comparison of the fees charged to institutional investors, a review of the 

management company’s pretax profit and a detailed itemization of 

the costs of the various services including investment advice, marketing and advertising, operations and administration. I believe 

that this proposal, if enacted, would lead to savings of billions of 

dollars or more every year. I hope the Subcommittee will give it serious consideration. 

Thank you very much. 

Senator FITZGERALD. Thank you, Attorney General Spitzer. I 

wondered if you had any kind of response to Senator Sununu’s 

opening statement where he argued that the investment returns of 

the funds are equally if not more important than the fees charged 

by the funds. I know that last time he was here, John Bogle, who 

will be on our final panel today, noted that 88 percent of mutual 

funds underperformed the market, and that while some funds do 

outperform the market sometimes for a number of years, ultimately 

they all tend to revert to the mean, and they are at or a little bit 

less than the market return. So that in Mr. Bogle’s view the fees 

are indeed very important over time, and I think that was reflected 

in Chairman Collins’ opening statement. Do you have a response 

to Senator Sununu’s argument? 

Mr. SPITZER. Yes, sir, I do. I think that certainly I am not going 

to dispute that the net return is a critical number that one should 

look at, but I think that as you just pointed out, Senator Collins 

and Senator Lautenberg and my great friend John Bogle, have 

pointed out that the fee component of the overall return is so critically important that the failure to explain adequately what fees are 

being built into that overall return really is what has been leading 

to substantial misinformation out in the marketplace. If we do not 

understand what fees are, why they keep increasing over time and 

how the compound impact of that fee will affect overall return, 

19

then investors are making a decision that is not based upon a full 

litany of the facts they should have. 

Clearly, return is a critical determinant to where we invest. 

Clearly as well, the fee structure, which is a constant number, is 

important, and I think it was Senator Collins who so well articulated if you have a momentary above-market return but high fees, 

that above-market return may be volatile and it may be that 2 

years from now that return has returned back to the market mean, 

in which case the high fees that you are paying for will overwhelm 

that 1 year of high returns. And consequently, all these numbers 

are critical, must be disclosed, and the sort of disclosures that I 

laid out for you, that so many others have laid out for you I think 

is the way we should go. 

Senator FITZGERALD. The ICI and its allies, and even some perhaps at the SEC, seem to have been critical of you for negotiating 

settlements with mutual fund companies where you have required 

them to reduce their fees. What is your justification for bringing 

fees into the mix in your settlements? Is it your thought that telling them to end market timing and late trading and pay some kind 

of a fine really is just a slap on the wrist, that where they are getting rich really quickly is with these exorbitant fees. In my judgment we do not have a total free market here because disclosures 

are inadequate. Some funds are captive; they are in accounts that 

are tax sheltered that cannot just be moved into any other funds. 

To some extent these mutual funds have a lot of money, lazy 

money that cannot be moved. They have a guaranteed clientele. 

What is your public policy justification for tying fees in to your 

settlements? 

Mr. SPITZER. Let me articulate it this way, Senator. I agree with 

everything you just said with respect to the market reason that 

fees are as high as they are. The assets in the mutual fund industry are sticky, by which we mean they do not move as rapidly as 

they should if investors were making a market determination every 

day or every quarter based upon returns and costs, and consequently there is a complacency in the board room. There is an 

improper relationship between boards and management companies. 

There has been inadequate disclosure. 

Having said all that, none of that would give me an appropriate 

rationale for seeking a fee reduction in a settlement absent a belief 

on my part, a provable belief on my part that the boards had 

breached their fiduciary obligation in a way that led directly to the 

increased fees. I believe that we need disclosure. I have laid out in 

my testimony—and others who have studied this much longer and 

in greater depth than I will speak more wisely than I to the types 

of disclosures that will lead to better market behavior. But I do believe that where a regulator finds a board that has permitted behavior to continue, behavior that is a breach of its fiduciary obligation, then you seek a remedy that addresses that breach. In this 

case the breach was permitting and acquiescing, and indeed sometimes soliciting overcharges that injured those to whom they owed 

a fiduciary duty, the investor. 

Senator FITZGERALD. In saying they breached a fiduciary duty 

are you describing that fiduciary duty in the traditional sense of 

20

corporate law, that the directors owe a fiduciary duty to their 

shareholders? 

My legal staff tells me they have canvassed all the reported cases 

out there and have never found an instance in which a mutual 

fund board was held to violate or breach a fiduciary duty, and my 

staff tells me that is because the fiduciary duty in the Federal 

laws, in the Investment Company Act, is a weaker fiduciary duty 

than the one we are accustomed to in State corporate laws, and the 

State courts have found a weaker fiduciary duty apply in State 

laws. Most mutual funds are organized either as a Delaware trust, 

I believe, or a lot of them are organized under the laws of the State 

of Massachusetts. 

Have you had an opportunity to examine the nature of the fiduciary duty that is imposed by law on mutual fund directors? 

Mr. SPITZER. We have looked at it and I would say this, that it 

is an area where these unique facts have really not been presented 

to the courts, and it is my belief that if we were ever to be forced 

to litigate a case where we could show that a board had knowledge 

and was aware that there were two different fee structures that 

had been imposed, one that permitted institutional investors to be 

getting a fee structure that was significantly lower than that was 

being charged to the other mutual fund investors, we would be able 

to demonstrate that was a breach of the duty and we would succeed in that litigation. 

Senator FITZGERALD. One final question before I turn it over to 

my colleagues. It has come to my attention that some of the funds 

charge fees to their mutual fund shareholders in order to remit 

their dues to the ICI which has been fighting you so aggressively. 

I find it kind of incredible that fund boards debit everybody’s account to get dues to pay for the ICI to go lobby in Washington 

against the interests of the shareholders that are paying for their 

lobbying. Do you have any thoughts on that issue, and what do we 

do about that, because does not the ICI really represent the insiders? They encourage the perception that they represent mutual 

fund shareholders, ma’s and pa’s here in Washington, but is it not 

really the case that they represent the insiders? 

Mr. SPITZER. I agree with your conclusion because I agree with 

your premise which is that the ICI does, in fact—and with all deference to my friends who are here from the ICI—the ICI has not 

been a voice for reform or protection of the shareholder, but really 

has been a voice for the status quo and a voice for the very internecine set of relationships that have led to the enormous breaches 

of fiduciary duty——

Senator FITZGERALD. Do you think they have acted in the interest of mutual fund shareholders? 

Mr. SPITZER. No, I do not, and needless to say, I have disagreed, 

as my testimony makes clear, fundamentally with not only the conclusions but the very way that the ICI has addressed this issue. I 

will say that the way that the ICI addressed and thought about the 

issue of timing and other clear problems that existed, structural 

problems that existed within the industry has been deeply disconcerting to me because I think it was a voice for the status quo, 

a voice in opposition to meaningful and reasoned reform. 

21

Senator FITZGERALD. Thank you very much, Mr. Spitzer. It is 

wonderful testimony and we appreciate you coming to Washington 

in this adverse weather. 

Senator Akaka. 

Senator AKAKA. Thank you very much, Mr. Chairman. 

Mr. Spitzer, I would like to ask you two things. First, a study 

conducted by John Freeman and Stewart Brown showed that the 

average actively managed mutual fund company investing in large 

cap stock paid 0.52 percent of fund assets for investment advice, 

as opposed to the 0.21 percent paid by pension funds for large cap 

portfolio management. My request is that you please explain to the 

Subcommittee why this difference exists, and would like the benefit 

of your experience and your insights. What should be done so that 

mutual fund companies act more like pension funds and reduce 

their expenses? 

Mr. SPITZER. Those numbers are perhaps the most important 

numbers that we should focus on because it is that net, that enormous margin between the 52 basis points and the 21 basis points 

that compounds every year to those enormous return differentials 

that investors are suffering from as a result of the disparity between what institutional investors pay and mutual funds by and 

large pay. What should be done falls into several categories, but 

first disclosure, and disclosure we all believe transparency. Disclosure ultimately will leave the marketplace and investors to make 

the appropriate determinations. But we also, given how broken the 

fund board structure is right now, we need to go beyond that to actually mandate—and this is what I wove into the final passages of 

my testimony—we need to mandate a particular methodology by 

which mutual fund boards would then begin to undertake this 

analysis. They can reach whatever conclusions they want of course. 

They are the board. But they must consider the factors that are 

enumerated, which are what fees are being paid by institutional investors, what are the margins that are being derived by those who 

are rendering this advice, what are the costs that are being incurred. Given the failure of the boards to properly weigh these factors—and we know that that is the case because of the 52 versus 

21 basis point differential we just highlighted—we I think can fairly say to them: Do this analysis, reveal your conclusion. You are 

free to reach any decision you wish, but you must go through this 

analysis and give us the tools to evaluate the wisdom of your conclusion by giving us the data that you relied upon. 

Senator AKAKA. Mr. Hillman, I am concerned that it is not clear 

to investors that the mutual fund company also may pay a percentage of sales or an annual fee on the fund assets held by the broker 

or both to obtain a place on the preferred list, or to have their 

shares sold by the broker. Investors may think that their broker is 

recommending funds based on the expectation of solid returns, low 

volatility or the needs of the investor, but the broker’s recommendation may be influenced by hidden payments. Mr. Hillman, please 

describe for the Subcommittee what you have learned about the 

typical revenue-sharing arrangements found at the large fund supermarkets, and also what the typical investor knows about these 

financial relationships. 

22

Mr. HILLMAN. Thank you very much. What you are referring to, 

revenue sharing, is payment that is made by the fund’s investment 

advisor from its own resources to finance the distribution of fund 

shares. SEC, in 1977, through Rule 10b–10 of the Securities and 

Exchange Act, required that the nature of revenue-sharing arrangements be described in general terms which they are in mutual funds prospectus. However, a fairly simple statement amounting to the acknowledgement that payments are made to brokerdealers has historically met SEC’s requirements. Therefore, no 

publicly available information that would allow one to quantify the 

nature or extent of revenue sharing at the fund or industry level 

exists. There is simply no transparency of these expenses. It is also 

a legal issue. 

As to whether payments are an indirect use of fund assets to finance the distribution, you would think therefore that they ought 

to be included within a 12b–1 plan that funds’ boards of directors 

are supposed to be evaluating. Because, though they are taking out 

of the investment advisor’s profits, there is limited disclosure to the 

board of directors of these payments, and therefore limited information being provided to them for their review. 

SEC has recently, January 14, proposed new rules to enhance 

the information that broker-dealers provide to customers at both 

the point of sale, which is critically important, as you mentioned 

in your opening statement, and during the confirmation process 

once a trade is executed, and we applaud the SEC for their initiative in this area. 

Senator AKAKA. Thank you, Mr. Chairman. 

Senator FITZGERALD. Thank you, Senator Akaka. Chairman Collins. 

Chairman COLLINS. Thank you, Mr. Chairman. 

Mr. Hillman, I want to explore with you the issue that the Attorney General brought up in his statement about the huge disparity 

in the fees charged institutional investors versus the every-day retain investor, at least in the two cases that he cited. For example, 

in the Putnam case I believe the Attorney General said there was 

a 40-percent difference, which is certainly substantial. In addition, 

one of our witnesses who will appear later this morning has also 

looked very closely at this issue and authored an article in the 

Journal on Corporate Law that also concluded that institutional investors were charged considerably less than the small investor. 

The mutual fund industry, as the Attorney General cited, has 

done a study that says that such differences can be accounted for 

by a different level of service or more work being done to serve institutional investors. I also wonder if perhaps the industry looks at 

the institutional investor as deserving of volume discount, if you 

will. 

What are your views on this issue? Is there a justification for 

having a very different fee structure, a much more favorable fee 

structure for institutional investors than for the average American 

who is investing in a mutual fund? 

Mr. HILLMAN. That is a very good question, something that we 

have not looked at as part of our study in June 2003, but let me 

offer these viewpoints. It is clear that institutional investors bring 

to the table greater assets, and therefore a reduced fee will allow 

23

mutual fund companies to retain large amounts of funds from those 

individual institutional investors that is drastically different from 

what might be coming available from an individual investor who 

may have a smaller portfolio, a smaller amount invested. Additional costs on the part of that fund to maintain information could 

cause for a difference to be there between institutional cost expenses and those of individuals. But the numbers that the Attorney 

General surfaced are quite astounding. The difference between 

those fees are enormous over the long term, and something that is 

deserving of additional attention. 

Chairman COLLINS. Mr. Spitzer. 

Mr. SPITZER. Senator Collins, could I just add one thought to 

that? Obviously, it is not only framed properly, but really cuts to 

the core of the issue. I would point out that the differentials we 

talked about are for essentially equivalent pools of capital even 

though the individual institutional investor may be larger, obviously, than the individual mutual fund investor. We are aggregating those pools and we are saying: What did you charge to provide advisory services for equivalent pools of capital? $100 million, 

$200 million; not $100 million to the $10,000 mutual fund investor. 

The incremental costs that clearly are borne, in terms of redemption fees, in terms of communication, in terms of statement 

issuance that attached to the small investor are not part of the advisory fee costs. Those are shown elsewhere. Those are other fees. 

This is an apples to apples comparison. 

When we generated these numbers, we went to Putnam and we 

said: Give us your best apples to apples comparison for identical 

services. The numbers were from them for that identical set of 

services. 

Chairman COLLINS. That is a very important clarification, and I 

appreciate you adding that to your testimony. 

I want to explore with both of you the best way that we can ensure that consumers have the information they need on the fees 

that they are paying. As, Mr. Hillman, you pointed out the amount 

of fees and expenses that each investor specifically pays now are 

currently disclosed only as a percentage of the fund’s assets. Most 

other financial services disclose the actual cost to the purchaser in 

dollar terms, and again I go back to my checking account analogy, 

where you can see very clearly what fees you are being assessed 

every month. It is my understanding that the SEC has proposed 

additional disclosures, but still is not proposing that funds disclose 

the specific dollar amount of fees paid by each investor, nor is the 

SEC requiring that the fee disclosures be listed on the account 

statements. And yet the account statement is what most of us rely 

on. We do not go back and read the prospectus to determine our 

investment expenses are. So really that means we are not getting 

any timely, regular disclosure at all of the fees if you are the average investor. 

Starting with you, Mr. Attorney General, and I see my time is 

up, could you tell me if you think the SEC’s proposal is adequate 

or whether you would like to see on the quarterly account statement a clear disclosure in dollar terms as well as percentages of 

the fees? 

24

And then, Mr. Hillman, I would like you to answer the same 

question. 

Mr. SPITZER. Thank you for that question, Senator. I vowed I was 

going to come to Washington and leave without being critical of the 

SEC, and so I am going to answer your question a little differently. 

Rather than saying whether the SEC is good or bad, I would merely say that I think the format of disclosure that you described 

would be enormously helpful for investors and perhaps would be 

the most important way for them to understand what fees they 

have actually been charged. I think that there is certainly a desire—there should be a desire to give each consumer an actual dollar cost that he or she is paying. There also should be a desire to 

provide an easy comparative basis, which means a per-unit comparison akin to what we all see at the supermarket, where as either Senator Levin or Senator Lautenberg referred to it, as either 

a per ounce, what am I paying per ounce? So there should be both 

a per dollar disclosure and what your portfolio is being charged per 

quarter. 

Chairman COLLINS. Thank you. Mr. Hillman. 

Mr. HILLMAN. This is an area that we have done considerable 

work on, and the concern here really is over investor awareness of 

fees. Despite existing disclosures and educational efforts, the degree to which investors understand mutual fund fees and expenses 

remains a significant source of concern. 

There were studies conducted by the SEC and the OCC back in 

1996 which found that one in five fund investors could not give an 

estimate of the expenses for their largest mutual funds, and fewer 

than one in six understand that higher expenses lead to lower returns. A Vanguard money investor literacy test back in September 

2002 found that 75 percent of respondents could not accurately define a fund expense ratio, and 64 percent did not understand the 

impact of expenses on funds’ returns. Clearly, more needs to be 

done to make sure investors are aware of the impact of fees on the 

returns for their mutual fund investors. Special dollar disclosure 

could be the incentive that some investors need to take action to 

compare their fund’s expenses to those of other funds and to make 

more informed investment decisions. 

Chairman COLLINS. Thank you, Mr. Chairman. 

Senator FITZGERALD. Thank you. Senator Levin. 

Senator LEVIN. Thank you, Mr. Chairman. 

I would like to get into the area of revenue sharing and directed 

brokerage. This is a way that the mutual funds get money to brokers for selling their shares. I want to ask you just a very simple 

question about a public company that wants to have a broker sell 

its shares on the stock exchange and pays the broker a hidden fee 

of a dollar for every share of stock that it sells to that broker’s customers. Is that legal? 

Mr. SPITZER. I think not. 

Mr. HILLMAN. It is not. Not a practice you would want to do, no. 

Senator LEVIN. How is it any different when a mutual fund pays 

a broker a hidden fee, and one of the two ways that are involved 

in either revenue sharing or directed brokerage, to sell its shares 

to the broker’s customers; how is that any different from a publicly 

25

traded company saying: For every share you will sell of my company on the stock exchange, I am going to pay you a buck? 

Mr. SPITZER. I do not believe it is different. I think it is a hidden 

subversive interest that without full and complete disclosure runs 

contrary to the fiduciary duty that is owed to that customer to 

whom you are marketing the product. 

Senator LEVIN. You would agree with that, Mr. Hillman? 

Mr. HILLMAN. Yes. Hidden cost. 

Senator LEVIN. The fiduciary duty that we are talking about here 

actually, I believe, or from what I know is the broker’s fiduciary 

duty. 

Mr. SPITZER. That is correct. 

Senator LEVIN. It seems to me that is what we have to really 

clarify. We have to focus on what conflicts of interest we are talking about here. With directed brokerage what we are talking about 

is that a mutual fund is going to agree that it will buy stock from 

a broker if that broker sells that mutual fund’s shares. So it will 

give business in effect to that broker if that broker sells its shares. 

It is a hidden deal. 

Mr. SPITZER. For the mutual fund it is a disclosure violation, that 

it is not disclosed that it is providing this incentive to the broker, 

and that is a material fact that obviously should be disclosed in 

their hidden fee issues. For the broker, who has not disclosed to his 

or her client that there is a hidden benefit that he or she derives 

from that sale, it is a breach of the fiduciary duty. 

Senator LEVIN. Is it an illegal act for a broker to receive that hidden fee from somebody to sell a share to that broker’s customer? 

Mr. SPITZER. Let me state it this way because I do not want to 

suggest that necessarily it would be a criminal act. We would have 

to look at all sorts of surrounding factors, but it is something that 

we would consider to be a violation of the Martin Act. 

Senator LEVIN. Of the what? 

Mr. SPITZER. Of the Martin Act, the New York State securities 

law. 

Senator LEVIN. If it is a violation of law for a broker to sell me 

a share of stock when unbeknownst to me he was paid by that company to sell me that share of stock, it seems to me that is obviously, it is more than a conflict of interest. It seems to me it is a 

violation of law. If it is not, it should be. 

Mr. SPITZER. It is. 

Senator LEVIN. Now looking at the mutual fund that is paying 

the broker to do that, are they not aiding and abetting an illegal 

act? 

Mr. SPITZER. You could certainly try to bring them in as aiders 

and abettors, absolutely. 

Senator LEVIN. Should we try to bring them in as aiders and 

abettors either by regulation or by law? Are they not contributing 

to an illegal act by making a payment to somebody to sell me something that is not known to me? Is there not an inherent conflict 

there which either is or should be illegal on the part of the broker 

and should it not be illegal to do that because you are aiding and 

abetting that just the way—if I give you a bribe and you accept the 

bribe, you have violated the law by accepting a bribe. But have I 

26

not violated the law by offering the bribe? How is this different except that it is in a market setting? 

Mr. SPITZER. It is not different. I would come at it from a slightly 

different perspective. I would reach the same conclusion, but I 

think it is the behavior that we want to eliminate, and whether we 

eliminate the behavior by saying the mutual fund is aiding and 

abetting or whether we simply ban the behavior without full and 

fair disclosure to all participants and make everybody equally culpable, I suppose I could say I am indifferent to how you address 

it. The behavior we wish to eliminate is the hidden fee shifting. 

Senator LEVIN. I agree with that, but when we come to eliminating behavior we do it in two ways. One is disclosure, but the 

other one is a prohibition with a fine at least, an administrative 

fine and maybe sometimes a criminal fine, but nonetheless there 

are a number of ways to address the conduct. I agree with you, we 

want to stop the conduct, but disclosure is one way. It may or may 

not succeed by the way, just like these fee disclosure may or may 

not succeed depending on how complicated they are. You get a fee 

disclosure on your telephone bill, most people do not have the vaguest idea, looking at a complicated telephone bill, what the heck 

is in that bill. That is disclosure, but it does not do the job. 

I guess this is my final question because my time is up. It seems 

to me that is a critical question which we face. We have got to act 

against the conduct. It is clearly a violation of a fiduciary duty on 

the part of a broker, it seems to me, to be selling something to me 

without disclosing to me that he is getting paid by the guy whose 

share he is selling to me or whose stock he is selling to me, to sell 

it to me. If that is not a violation of law, it surely ought to be. But, 

what we need to do is decide do we want to get at the conduct from 

the mutual fund side by either forcing disclosure, but if it is improper, it should not just be disclosed. We do not just want to disclose impropriety. We want to stop impropriety it seems to me. And 

if it is a conflict or aiding and abetting in a conflict, why should 

we not just ban that action rather than simply say disclosure is 

good enough? That is my final question. It sounded like a speech 

but it is really a question. [Laughter.] 

Mr. SPITZER. With all due respect, if I were in the courtroom I 

might have objected to the question as being compound, but that 

is all right. 

Senator LEVIN. I think it was a leading question. 

Mr. SPITZER. I am going to hedge right now on whether there 

should be a ban because I can imagine situations where smaller 

mutual fund companies would want to announce to the world: We 

have many representatives out there, who when they sell your 

products, we give them some degree of compensation. There are 

salesmen who have relationships with us and many other mutual 

funds as well. As long as the investor is fully aware—and I do not 

mean the sorts of disclosures that are on the third page of an 18-

page contract. I mean they are really being informed why the salesman, the broker as it were, has an interest in pushing particular 

funds over others. Then I can imagine that that is a conflict. 

Senator LEVIN. A financial interest? 

Mr. SPITZER. Correct. 

Senator LEVIN. Has a financial interest. 

27

Mr. SPITZER. That is correct, because that is a way to disseminate and market the product. 

Senator LEVIN. I would end with a request then, that you would 

give us advice for the record on that issue because I think that is 

one of the really fundamental questions we face as to whether disclosure is going to be adequate or whether there ought to be some 

kind of a prohibition that we ought to urge on the regulators. 

Thank you, Mr. Chairman. 

Senator FITZGERALD. Senator Levin, those were excellent questions, and I hope to have the opportunity to share with you a bill 

I am working on, because I tend to agree with you that a lot of 

these practices, these shadowy practices which people are only 

vaguely aware of, should simply be banned as opposed to disclosed 

in a better fashion. I think your analogy with what if a publicly 

traded corporation, not a mutual fund, went to brokerage houses 

and said: We will give you a dollar for every share of our stock that 

you sell. That would be an outrageous fraud on the public. Right 

now you have brokerage firms steering their clients into certain 

mutual funds, not because it is necessarily in the best interest of 

their client, but because they are going to get revenue sharing or 

some other fee from the mutual fund. In Chicago they call that a 

kickback, as I said at the last hearing. I do not think it is right. 

Senator Sununu. 

Senator SUNUNU. Thank you, Mr. Chairman. 

I did not understand all of the details of the previous question, 

but I assume in the public equities market to a certain extent, provided it is disclosed the right way and you comply with the laws, 

it is also called a commission. The brokers make commission all the 

time for selling stocks. You want it to be disclosed, and depending 

on who else they are doing business with there could be some conflicts of interest, and that is obviously what the line of questioning 

gets to, but simply being a broker is making money by selling mutual funds or stocks does not necessarily mean they are doing anything wrong. 

I want to pick up on a point that you made, Mr. Spitzer, and I 

think it is a very important one, which is in this discussion about 

the financial arrangement, you emphasize that there could be a situation where a small mutual fund in particular, your example, was 

disadvantaged. In other words, you focused on the disclosure but 

you could imagine, I think you said, a situation where a small mutual fund was trying to get out information about the new fund. 

Without getting into the particulars of the example, I think that is 

an important point because there are other areas of regulation here 

where we might see practices we would enjoy better disclosure of. 

We want to make sure we are not disadvantaging new mutual 

funds, smaller funds, at the expense of the larger funds or to the 

benefit of the larger funds. I was not very clear there, but we want 

to make sure we have a level playing field, which gets to my first 

question. 

Would you be concerned about regulations that treat independent 

research in a discriminatory manner with respect to the large full 

service brokerage houses? 

Mr. SPITZER. Let me restate your question. I have seen the articles that I gather you have seen as well that suggest that if there 

28

were a straight ban on soft money as a means of compensating certain entities, that could have a disparate impact and a very negative impact on some of these smaller independent research boutiques that are there. 

Senator SUNUNU. That qualify either a straight ban or a discriminatory reporting report, that one set of fees has to be reported 

in a particular way, and another set of fees for the full service does 

not have to be reported. 

Mr. SPITZER. The answer to your question is yes, I am worried 

that we not act in a way—and as you pointed out in your opening 

statement, one of the efforts 2 years ago now really was to resuscitate the role of independent research and to make sure that there 

was somehow a business model that would work. I think we need 

to think carefully as we address the issue of soft money and the 

issues relating to these regulatory schemes, what collateral impact 

there may be in the context of research. 

Now, I do not say any of that to justify what I think is at best 

a very murky area, which is the enormous sum of money that flows 

through these soft dollar commissions which is untracked and hard 

to understand, and I think is an area that significantly cries out 

for some very careful thought. 

Senator SUNUNU. Are you for banning all soft dollar transactions, 

or are you for uniform disclosure of those transactions? 

Mr. SPITZER. I have said in prior testimony, and my position has 

not changed since then, I simply have not looked at the issue to 

have an informed judgment on the matter. I have seen obviously 

enough to know that there is, as I said, significant area for inquiry, 

but there are also significant subtleties in how we deal with it. 

Senator SUNUNU. A hypothetical. Two funds, they are mid-cap 

funds. They are the size——

Mr. SPITZER. Mid-cap, I am sorry, you said? 

Senator SUNUNU. Mid-cap funds. They advertise themselves in 

the same way, have generally the same requirements for investment, about the same size in total assets. One has a 5-year return 

of 11 percent and an expense ratio of 40 basis points. 

Mr. SPITZER. Five years, 11 percent, OK. I want to make sure I 

get my numbers. I do not have an HP 12. 

Senator SUNUNU. One has a 5-year annualized return of 8 percent and expenses of 20 basis points. Which one was the better investment? 

Mr. SPITZER. I will have to ask Mr. Bogle. He is the master of 

these numbers. 

Senator SUNUNU. I think both the esteemed Mr. Bogle and you 

could come to the same conclusion. The 11 percent with the 20 

more basis points in the expense is going to be the better return 

over the 5 years. I mean 300 basis points and at least the gross 

returns really does make a difference in the long run. A simple example, I know, but it just comes back to this point that we want 

to make sure we are emphasizing the important statistics for investors, and I will consistently come back to the issue of returns net 

of all expenses I think is the best barometer because it takes into 

consideration different levels of investment, different levels of assets. I could have expenses of $387 for my mutual fund investment, 

29

but it obviously makes a difference whether my total assets are 

$350 million invested in that or $1,000 in the expense ratio. 

So the dollar value could be important. I could imagine circumstances where I would want to be able to compare that, but I 

think the return net of all expenses is the one that consumers will 

use most often to compare mutual fund performance across their 

own portfolio or to other funds that are out there. 

With regard to the board structure, you support the idea of an 

independent board chair, correct? 

Mr. SPITZER. That is correct. 

Senator SUNUNU. Did any of the firms against whom you brought 

charges have independent board chairs? 

Mr. SPITZER. Yes. In fact, let me just clarify. I support the notion 

of an independent chair and the 75 percent threshold, but have always made it clear these are not panaceas. To go back to a slightly 

different context, if you were to look at the Enron board and look 

at the constituency of that board on paper you would say: What a 

spectacular board. So clearly when you define board membership, 

and we try to promote good board behavior by defining constituency, that does not guarantee any result. It is sort of like a prospectus. But it perhaps permits us to be in a situation where we 

can raise expectations and get divergent views. 

Senator SUNUNU. Unless there is an academic study out there 

that I am unaware of, and I would be very interested in seeing it, 

why support a ‘‘reform’’ if there is no empirical evidence that it has 

ever resulted in better behavior or better results for shareholders 

or investors? 

Mr. SPITZER. I think you are drawing the wrong logical conclusion. To say that it does not inevitably guarantee an appropriate 

result does not mean that it is not logically superior as a matter 

of principle to have an independent board chair who would then be 

in a position to negotiate at arm’s length with a management company to which he or she does not owe a parallel duty. 

Senator SUNUNU. Do the independent board members not participate in those negotiations with fund managers now? 

Mr. SPITZER. They might participate but I think the record suggests that the participation has not been adequately vigorous, and 

that is why as a theoretical matter, what we are trying to do—as 

I think we all, even you, I dare say, would agree with the notion 

that we want to resuscitate the vigor with which the mutual fund 

board enters these negotiations. As a matter of principle it seems 

quite clear that having a board which does not have a significant 

overlap with the management company is more likely to give you 

an arm’s length negotiation. 

Senator SUNUNU. But I come back to my belief, which could be 

wrong, that there is no empirical evidence that shows that those 

boards led by independent chairmen have had their boards engage 

in these negotiations ‘‘more vigorously’’ than boards that do not 

have independent chairmen. You can feel free to respond, but I 

think it would be wrong to suggest that we know there would be 

a better result if there were an independent chairman, even though 

we cannot show that in all the cases where there were independent 

chairmen there was a better result. That seems to me to be a non 

sequitur. 

30

Mr. SPITZER. I am happy——

Senator SUNUNU. No, you do not have to respond. 

Mr. SPITZER. I think we have stated our positions with some clarify, but I think the premise of independence is one that most people 

feel would move us in the right direction. 

Senator SUNUNU. Do you support—one final question, it is a yes 

or no; can I just ask one more? I am sorry. 

Senator LAUTENBERG. Time is flying, and we are trying to parcel 

it out. 

Senator SUNUNU. Do you support the same proposal for every 

public in America, that they have to have an independent disinterested chairman? 

Mr. SPITZER. I do not, but I will tell you some of the most staid 

and conservative corporate lawyers in America have come to that 

conclusion. I would point to Ira Millstein at Weil Gotshal, who has 

for years been calling for independent chairs as one of the critical 

ways to resuscitate board behavior. 

Senator SUNUNU. Thank you. 

Thank you, Senator Lautenberg. I apologize for running over. 

Senator LAUTENBERG. That is all right. 

Senator FITZGERALD. Senator Lautenberg. 

Senator LAUTENBERG. Thank you, Mr. Chairman. 

I want to say to Senator Sununu I think that he is on a good 

track, and the hearing thus far has been excellent, and I thank 

both of the witnesses here for their testimony. 

I look at this a little bit differently. First of all, I think that in 

the case of an underwriting, which I think was Senator Levin’s 

kind of focus, compare it to the difference between—may I call it—

wholesale and retail, because everyone knows that if you want to 

buy a car, Mr. Levin’s example perhaps ought to be—that what you 

pay does not give you all of the details about what the dealer you 

bought it from paid. You make your decisions based on a net, but 

it is a lot easier to compare Chevrolet to Ford, etc., than it is for 

the arcane business of details about mutual fund purchases, etc. 

For most of the public it is foggy. For most of the people in our 

business it is foggy because it is very complicated, hard to understand. 

One of the things I think we might have to do is—I think Senator Sununu was on the right track with one exception, and that 

is that simply measuring the net performance of a mutual fund to 

its shareholders is not quite sufficient because you do not know 

what these hidden costs are, and maybe the shareholder ought to 

get more. Just because they got 11 percent compared to an 8 percent, maybe they should have gotten 15 percent, and had they been 

aware of where it was going, that they would have required that. 

Someplace along the way we have to make this knowledge comprehensible about what people ought to look for. I do not know 

whether it is an index, a mutual fund index that says here are the 

costs, here is the net result, the difference between the two is thus, 

and give people an easy way of forming opinions about whether or 

not they go ahead and purchase these shares. 

The thing that is scandalous is the amount of—some call it baksheesh; it is a common term in the Middle East, and we paid plenty for that in Iraq—but it is distributed around. I think that if they 

31

are giving away your money, even if you got a pretty good return 

for it, that is not appropriate. 

Mr. Spitzer, I would like to know if anything has happened since 

you broke the mutual fund scandal in September? Have you seen 

anything that says: Uh-huh, they are making changes that would 

correct some of the conditions that brought on these problems? 

Mr. SPITZER. Yes, sir. I think the answer is that it is—I do not 

know if it was Justice Holmes, I may be wrong—light is the best 

disinfectant, which is not only the premise to disclosure but the 

enormous spotlight that has been beamed and been focused upon 

the industry over the last number of months that has revealed not 

only the warts and improprieties but also those who are good, has 

led every board to reconsider and rethink its behavior, and therefore we are seeing embers, that hopefully will burst into flames, of 

changed behavior. So, yes, there is change that results from first 

the sheer embarrassment of having the names of companies in the 

headlines, the fact that people have been taken away in handcuffs 

and sentenced to jail, and so, yes, there are changes. 

Senator LAUTENBERG. There are still people being taken away in 

handcuffs. 

Mr. SPITZER. And there will be more. 

Senator LAUTENBERG. This is kind of a pet subject of mine, and 

that is directorships and how they function, and I think one day 

that in America we will see a class of executive called director. I 

know this, that when I was running ADP and we started with 

nothing, we had nothing to invest except our hard work, and the 

company that we started many years ago, today has over 40,000 

employees and had the longest growth record of any company in 

America, over 10 percent gain each and every year for 41 years 

straight in a row. It was a good investment. I should not have sold 

my stock. [Laughter.] 

But I do believe that to obtain the interest of a director away 

from a company, I never took another company’s board seat. I did 

for a while and decided that was not for me. If I was going to run 

my company, I wanted to focus exclusively on my company. If I 

wanted to do something that was a not-for-profit or something like 

that, I enjoyed it, but I did not believe that I had the right to take 

time away from my company, no matter how comfortable they offered to get me there or whether it was an overnight conference in 

Las Vegas, that that was enough to divert me from my appointed 

rounds, as I say. I think we are going to see a class some day of 

directors exclusively, people who will have attained a degree of experience and reputation and so forth that can qualify as directors, 

and they will sit on several boards. This is where I think we are 

going, and I think it is essential. Otherwise, it is too tough. People 

become friends. There are relationships, serious relationships that 

develop. 

But to respond to Senator Sununu’s question about have you see 

any different result as a consequence of an independent board, I 

think it is fair to say that what you have seen is just the reverse 

of that, which is a corollary, and it says, hey, when you look at 

Enron and you look at the people and you look at some of the people who were directors, they closed their eyes. They did not have 

the time, they did not have the interest. 

32

You made a very important statement, directors should be furnished with a staff person, resources, and information expanded 

that the public can understand. No matter what happens, I do not 

think the CEO of a company—this is a personal thing—ought to be 

able to walk away with the profits of the store unless he owns the 

store. I think that he has a job like everybody else, and when a 

chief executive walks away from a job that paid millions and millions and millions of dollars, and then there is still a reach out, 

there are grasps out there to see that the favorite wines or the favorite airplanes or the favorite massages are still included. I think 

it is a travesty. 

One thing we have to make sure of is that we have people taking 

their assignments seriously. Maybe they begin to understand that 

when they too are punished for either lack of interest of lack of action on their part when they see these abuses. 

I commend you, Mr. Chairman, for holding this hearing. We are 

going to go much further before these subjects are fully aired. 

Senator FITZGERALD. Thank you. 

As I wrap up, I just would like to make my own comments on 

Senator Sununu’s suggestion. I think, again bringing up the analogy of the Government Thrift Savings Plan that we are all members of, our directors have to be independent by law, and they competitively bid out the management contract. The management contract was won on a competitive bidding basis by Barclays Global 

Investors in London. They charge an exceedingly low fee to manage 

the TSP fund for Federal employees. I wonder how we would feel 

if all of a sudden we changed the law and the directors of our TSP 

board did not have to be independent and they could instead be insiders at the outside manager. What if the chairman of the TSP 

board were an officer of Barclays Global Investors and owed a fiduciary duty to shareholders of Barclays? We might not sleep as well 

at night knowing that. 

Yes, there are independent directors who do not have conflict 

who are not very bright or are not very diligent or do not work very 

hard or whatever. So having an independent director is no guarantee that you are going to have a good director, but certainly it 

helps to eliminate conflicts that could otherwise arise. We do not 

have to worry about that for our retirement funds because Congress has created a separate investing regime for Members of Congress. We get one special deal, and the whole rest of the world is 

stuck in this rotten world where conflicts are all over the place, 

where fees are exorbitant, where there is revenue sharing, directed 

brokerage. We do not have to worry about that, but my goal is that 

hopefully we can give the rest of America as good a mutual fund 

deal as Congress has given itself. 

With that, I want to thank these two witnesses. They have been 

excellent. We have gone on for 2 hours. You have been very patient. We are going to give you leave to go back to New York or 

go back to your offices. Thank you very much for being here. 

Mr. SPITZER. Thank you, sir. 

Mr. HILLMAN. Thank you. 

Senator FITZGERALD. Our next panel is the whistleblower panel, 

and before I introduce them I am going to take a 2-minute break 

33

1The prepared statement of Mr. Bogle appears in the Appendix on page 106. 

so that we can all stretch. We have been here for 2 hours. So why 

don’t we take a 2-minute break and then we will return. 

[Recess.] 

Senator FITZGERALD. During the break there was a request made 

to take one of our panelists out of order because he has a plane 

to catch, and we are happy to honor his request. 

John Bogle probably needs no introduction. In the mutual fund 

world I think he is probably the best known investor in the country. He is the founder of Vanguard. It is something he had wanted 

to do since he was in college and wrote his thesis at Princeton I 

believe on the Massachusetts Investment Fund at the time. He had 

this dream of creating a truly mutual mutual fund, and he had the 

opportunity to fulfill that dream in founding Vanguard and watching it grow in a short period of time to be one of the two largest 

mutual funds in America. He is the author of several books on mutual funds. He is an industry expert without equal, as far as I am 

aware, and we are honored and delighted to have him back for the 

second time before this panel. 

So without further ado, Mr. Bogle, thank you very much for 

being here. 

TESTIMONY OF JOHN C. BOGLE,1 FOUNDER AND FORMER 

CHIEF EXECUTIVE OFFICER, THE VANGUARD GROUP, AND 

PRESIDENT, BOGLE FINANCIAL MARKETS RESEARCH CENTER 

Mr. BOGLE. Thank you, Chairman Fitzgerald, and thank you particularly for the courtesy in accommodating my schedule. Sometimes we get a little bit over scheduled and that is the position in 

which I find myself today. 

I am very happy to be here because when you think about it, if 

you do for a moment, out of all the persons you have heard from, 

I am the only one who has actually been in the mutual fund business. I have been the Chairman of the Investment Company Institute back in 1970–71, I think, and I have actually been in this 

business for more than half a century. So I hope the perspective 

that I can bring to you is helpful. My entire career has been in this 

business, and I have observed in that period that this industry has 

changed greatly in that half century and it has not changed for the 

better. It has been a business that originally focused on prudent 

stewardship. It focused on long-term investing. It focused on putting the shareholder first. It had very low costs and attracted people who were attracted to the wisdom of long-term investing. 

Since then the industry has changed in almost every measurable 

way. Portfolio turnover is higher. Costs have doubled for equity 

funds. Funds hold their shares for a much shorter period of time, 

meaning we are selling the public speculative funds that basically 

are capitalizing on the folly of speculation rather than the wisdom 

of long-term investing. Instead of running this industry in the interest of fund shareholders, we are running this industry, I am 

sorry to say, to too great an extent in the interest of fund managers. We have become too much of a business and not enough of 

34

a profession. So this industry has to rethink, has to stand back and 

look at itself. 

I think the steps that are necessary to bring this change 

around—I will not deal with the technical steps too much—requires 

us to figure out how to give the mutual fund investors the fair 

shake they deserve. Part of that is to give the weight of the mutual 

fund structure more heft, if you will, on the mutual fund shareholder side and less left on the mutual fund manager side. To that 

end I believe deeply that we need a more independent board, a 

completely independent board chairman, and I believe we badly 

need an express Federal standard of fiduciary duty which requires 

directors to act with loyalty and care in the best interest of fund 

shareholders. 

I think we need to help fund investors better understand their 

costs, and what would do that is the full disclosure of the total 

costs you bear as a shareholder in your fund, including transaction 

costs and others, the actual dollar cost each investor pays. I think 

it would be unarguably a great advantage for investors. 

We also need something that has not been brought up today. We 

need mutual funds to report not just their per share results, which 

are the time-weighted, returns you read in the paper—we got a return of, say, 11 percent per share—but the returns their shareholders actually earn, what are called dollar-weighted returns. So 

many mutual fund purchases are done at the wrong prices at the 

wrong time and the wrong funds that those dollar-weighted returns 

are often as many as 6 or 7 percentage points behind the returns 

that the funds actually report. That should be reported. It is a 

known number. It should be reported in fund reports. I think those 

will help. 

I also think that we should direct the Securities and Exchange 

Commission to undertake a comprehensive economic study of the 

mutual fund industry. With $7 trillion in assets, in mutual funds, 

the national public interest and the interest of investors would be 

well served by shining the simple spotlight of disclosure on the revenues and expenditures of mutual funds and their managers, taking into account the fees, the sales charges, the transaction cost, 

where they are spent, where they come from, where are they spent, 

and how much is left for manager profits. Mutual fund investors 

incur not only the $70 billion of costs that were referred to earlier. 

That $70 billion is the direct cost that the mutual funds pay, but 

they pay another $40 or $50 billion in transaction costs, sales 

charges and other expenses like that. We need to follow that money 

because those costs of $120 billion are the amount by which mutual 

fund returns are apt to fall short of the financed markets’ returns 

year after year. 

I also think, strongly agreeing with Attorney General Spitzer, 

that we need a requirement for fund advisors to provide, and fund 

directors to consider, the amount and structure of fees paid by institutional clients. One brief example to show how shocking this 

disparity can be. One advisor charged its mutual fund 97 basis 

points on a $4.5 billion fund, $41 million. But it charged a fee of 

98 basis points, less than one-tenth as much, for a $900 million 

fund for California retirement system, or one-sixtieth as many dollars, just $700,000. California also pays investment incentive fees 

35

for investment success, but such fees, so-called performance fees, 

are conspicuous by their absence in the mutual fund industry. 

Finally, as I say in my formal statement, there are two firms in 

this business—actually three now that you mention the Federal 

Thrift Savings Plan—that have in fact been truly mutual in their 

struture. One is Massachusetts Investors Trust, which started the 

first mutual fund 80 years ago, had an excellent record, was the 

largest fund in this industry for 45 years with the lowest cost. It 

abandoned that structure in 1969. Five years later Vanguard 

adopted a similar mutual structure, albeit very different in concept 

and development. And we are unique in many other ways. 

So over 75 of this industry’s 80-year history, we can observe how 

mutuality worked. Our costs are the lowest in the industry, 100 

basis points below the industry norm. We operate at a quarter of 

1 percent compared to 1.4 percent for the industry. Our market 

share has gone up 20 years in a row from 1 percent of assets to 

9 percent of industry assets. So mutually has been a successful 

business strategy. It has provided above-peer returns to our shareholders and the lowest cost in the industry. I think we have to 

have some language in the new legislation that requires mutual 

funds to consider, once they reach a certain size, the option of 

mutualization. It works for investors. 

Directors also need an independent staff, I believe, when they get 

to a certain size or when directors oversee a certain number of 

funds, a staff that will be independent of the manager, giving them 

the objective information they need. 

Who would pay for that? Let me tell you how we did that at the 

inception of Vanguard. We said to the manager, ‘‘We are going to 

have our own independent staff to evaluate you, and we will not 

only reduce your fees by the cost of that staff, we will reduce them 

by a 50 percent fee markup because that is the profit you are making in those services.’’ I think it would be a wonderful example for 

other firms to follow. 

Thank you, and sorry to be a couple of minutes long, Mr. Chairman. 

Senator FITZGERALD. Mr. Bogle, we are so honored to have you 

here. I appreciate your coming down a second time, and as always, 

your comments were directly on point. You and I talked the last 

time you were here about the fact that Vanguard was the only private sector mutual fund. We have now identified the Government 

Thrift Savings Plan as being in essence a truly mutual mutual 

fund in that it is not directed by somebody else who is profiting off 

it. 

I was troubled by the fact that mutual funds in America are allowed to call themselves mutual funds because that implies they 

are mutuals, like Mutual of Omaha, or a mutually-owned insurance company like State Farm in my State, in which the owners 

are actually the policy holders. We have a system in this country 

for chartering mutual savings banks. There are lots of mutual savings banks in which there are no stockholders. The depositors in 

the banks are the actual owners of the savings bank. 

Do you think it is appropriate that we allow mutual funds, when 

they are in fact not mutual and they are not owned by their fund 

shareholders? They are in effect used by an outside private comVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
36

pany that is stock held to make money. I mean, do you think it is 

appropriate that mutual funds be allowed to call themselves mutual funds, or does the name ‘‘mutual’’ not mean much to younger 

people today so it is no longer a misleading term? Do you have any 

thoughts on that? 

Mr. BOGLE. We have somehow tried to get around that by calling 

ourselves mutual mutual funds, which is a little bit repetitious but 

gets the point across. I think we would have a hard time changing 

the name that everybody has come to give this industry, and of 

course, I would be enough of a rebel to say that maybe what we 

ought to do is do the opposite, require mutual funds to be mutual, 

and I think we can do that without going to a full mutualization, 

by the way, simply by giving that board the heft, the weight that 

I talked about in my testimony. 

Senator FITZGERALD. I know you want to comment on Senator 

Sununu’s suggestion in his opening remarks that one of the most 

important things for investors to focus on is investment returns, 

and that if investment returns in a given fund are very high, then 

a higher fee will not really matter over time. What is your response 

to that? That line of reasoning suggests that the Senate, this panel, 

should not be so concerned about mutual fund fees. What do you 

think about that? 

Mr. BOGLE. With all due respect to Senator Sununu, I hope he 

does not invest the way that little syllogism of his would suggest. 

That would be very unwise indeed. Because what we have here is 

a—of course, he is mathematically correct. If a fund earns twice as 

much as another, let us say 20 percent compared to 10, and they 

charge you 9 percentage points a year, you would have been better 

off in that 20 percent minus 9, rather than the 10 percent fund 

minus 1. I mean that is just mathematics. 

However, the reality of the matter is that we know that over 

time the lowest cost funds win. A simple statistic, and that is if you 

take the lowest-cost quartile of funds—and this is not in any selected 10-year period; this is every 10-year period we have looked 

at—the lowest-cost quartile of funds outperforms the highest-cost 

quartile of funds by 21⁄2 to 3 percent per year in all of the 

Morningstar boxes. So you know from looking back, cost matters. 

It has been said that the mutual fund industry is the only industry 

in the world where you get what you do not pay for. Think about 

that. You get what you do not pay for, and that is a truism. 

What happens in our business, however, is the broker or the 

salesman that wants to sell a high-cost fund, he picks a high-cost 

fund because there are plenty of them, and he picks one with a 

high return in the past, and he makes the exact argument that 

Senator Sununu was putting forth. But the reality is that the past 

has nothing to do with the future. We did a study about a year ago, 

and we looked at the 10 highest-performing—I am sorry—the 20 

highest-performing mutual funds of the 3 year period, 1997, 1998 

and 1999, and compared those returns of those funds with the 3-

year period 2000, 2001, and 2002. It was literally biblically true 

that the first shall be last. The first mutual fund, number 1, in the 

first performance derby was last in return, 841st, I think the number was, among those groups of funds that had been in business 

all that time over a certain minimum size level, 841st. And the 

37

other 20 funds—I believe this was the number—there was one that 

was not ranked below 700 out of those 800 funds. So much for past 

performance. It tells you nothing except probably the manager is 

speculating, exactly the opposite of what that Federal Thrift manager is doing. 

Senator FITZGERALD. Senator Collins. 

Chairman COLLINS. Thank you, Mr. Chairman. 

Mr. Bogle, thank you so much for testifying before us today. I am 

a great admirer of yours and I think we have a lot to learn from 

your experience, because as you pointed out, you have actually 

done this for much of your life. 

One of the challenges that we face is making sure as we attempt 

to bring about reforms that we do so in a way that does not cause 

unintended problems down the road, and therefore it is difficult to 

decide what should be legislative, what should be left up to SEC, 

and what should we look to the industry to do for itself to self reform. 

My inclination is to believe that we need a combination of all 

three. We are dealing with a law that I think in the mutual fund 

area has not been significantly revised in approximately 65 years. 

I suspect that it does need to be brought up to date. But can you 

give us any guidance of the areas that you think should be codified 

versus the reforms that you think the SEC ought to pursue via regulation, versus the areas that we should just stay out of and expect 

industry to pursue? 

Mr. BOGLE. Yes, thank you. I would say on the regulatory side 

things like a redemption fee on short-term transactions, things like 

disclosure about soft-dollar brokerage, things like perhaps banning 

the shelf space sort of payments that are made that are such a cost 

for investors and so misshape the distribution process. Those kind 

of things I believe should be left to the regulators. I believe that 

the Congress, speaking for the people of the United States, should 

do its best to have a governance structure that improves on the 

governance structure that was given to us in the 1940 Act. That 

Act, as you know, says that mutual funds must be organized, operated and managed in the interest of shareholders, rather then the 

interest of investment advisers, and that is clearly not what is happening. That is why I feel we need to chairman of the board to be 

independent. That is why I feel we need a heavy majority—indeed, 

sometimes I wonder why any management representative should 

be on the board—and that is why we deeply need this Federal 

standard of fiduciary duty for fund directors. These are things that 

will require legislation. 

As to the industry, I do not know how many of you have had a 

chance to read my paper on the development of mutualization that 

was my formal statement before the Committee, but it talks about 

how mutualization work, how it came, the struggle it was to get 

it done. An SEC report that was delivered in 1966 called Public 

Policy Implications of Investment Company Growth, that suggested 

many of the problems that we came to face later on. In that report, 

the SEC recommended very good solutions, but they were never 

implemented in law because the lobbying power of the Investment 

Company Institute was just too great. They wanted a requirement 

38

that the fees be reasonable. Well, nobody in the industry wanted 

that. So we got to where we are today I think through that route. 

But at the end of my formal testimony is a very important point, 

and that is you can legislate a structure, let us say more power for 

the board of directors of the funds or the requirement that a mutual structure be made available or be considered at certain levels 

at fund size, but a structure will only take you so far. 

I also mentioned next you have to have the right strategy in that 

structure. The Federal Thrift Savings Plan has that structure, and 

they have followed with the right strategy. The structure gives the 

power to get cost out of the equation and give the participants, 

Federal Government employees, basically the total return the stock 

market delivers, a magnificent return over the long run. 

But the third thing you need—and this is the hardest part, we 

can’t legislate it—is the spirit. How do you get that spirit into the 

mutual fund industry once you have the structure and once you 

have the strategy? I think we have to rely on the individual investor, the man on the street, and I have talked to thousands and 

thousands of mutual fund shareholders individually, and I do not 

know how many hundreds of thousands in groups, and the people 

that come out to the meetings or the people that I meet with sense 

that spirit. How do you get it out to the public? That has a lot to 

do with the kind of cost disclosure. Investers will learn. They will 

learn in the long run, but they will be hurt as they. I would like 

to make the experience of mutual fund investors a very positive 

one for them, but it takes all of those fronts, as you say, Chairman 

Collins. 

Chairman COLLINS. Thank you. My second question that I want 

to ask you has to do with soft dollars. We have heard comments 

about that today. I think of soft dollars in terms of campaign finance reform, but here we are learning of another kind of soft dollars, but one that once again creates possible conflicts of interest. 

Is the answer a ban on soft dollars? 

Mr. BOGLE. I think ultimately the answer is yes, there should be 

a ban on soft dollars, and it seems to me it comes down to a very 

simple principle, and that is, it is amazing how cheap everything 

you buy is if you buy it with other people’s money, and that is true 

of distribution services and it is true of research, which of course 

as we all know, has as soon as it is out in the public eye, a value 

of zero. Because everybody has it, it cannot be capitalized on any 

longer. It would be very disruptive to the brokerage system and the 

market system, but I think that should be the direction. 

In the meanwhile, I am somewhat concerned about banning soft 

dollars for the smaller research firms when the large firms, the big 

brokerage firms, will just collect more and more hard dollars in the 

guise of payments for research. As enlightened as that solution 

may appear at first glance, it is not the right solution. So I think 

we need a more global solution for soft dollars than that. 

Chairman COLLINS. Thank you. 

Senator FITZGERALD. I have a follow-up on that. Soft dollars are 

expenses that, if a mutual fund paid for its research, would show 

up in its expense ratio. So what they do is in order to get research 

or other services, such as when some mutual funds want to get a 

new set of computers, they cut a deal with the brokerage firm. The 

39

brokerage firm will buy them new computers for their office. One 

mutual fund had a brokerage firm buy new carpeting for their office, and the way the brokerage firm was able to do that is the mutual fund permitted the brokerage firm to charge an excessive brokerage commission, which was passed along to their mutual fund 

shareholders. 

There seems to be an impulse on the part of mutual funds to convert operating costs into brokerage expenses or transaction costs 

because then they do not show up in the expense ratio. Am I not 

right about that? And that is a problem with our disclosure law, 

we do not require transaction costs to be disclosed so mutual funds 

keep trying to convert their ordinary overhead, like buying computers and carpeting, into a transaction cost which does not have 

to be disclosed. 

Mr. BOGLE. You are quite right, Chairman Fitzgerald and I have 

even heard an anecdotal story that goes beyond the computers for 

these traders who are working so hard. This may be apocryphal, 

but I was told with a straight face that the person offering the soft 

dollars said: Well, these traders are working so hard we not only 

get them good computer systems, but we ought to get them golf 

club memberships so they can relax on the weekend. Both arguments are equally valid. Once you start going down that long trail, 

you are going to be wasting the shareholders’ money. 

But the reality is that it is in the manager’s economic interest. 

And one thing we should always be confronted with is that these 

directors who are directors of both the manager and the mutual 

fund, have a fiduciary duty to the manager’s shareholders as well, 

and that is something that we cannot get away from. They have 

two sets of loyalties and are trying to be, as the biblical quote says, 

‘‘men who can serve two masters.’’ I do not think it can be done. 

When they are buying research with soft dollars they ae maximizing the profitability of the manager. If they took that, say, $25 

million of soft dollars and expensed it through the manager’s books, 

the manager would earn $25 million of lower profits. So of course 

they want to get their own expenses as low as they can. 

So it is a very tough system to beat, but it is going on, and that 

is certainly where very strong action, both disclosure and I think 

ultimately regulatory will have to be required. 

Senator FITZGERALD. Senator Lautenberg. 

Senator LAUTENBERG. Thanks very much, Mr. Chairman. 

It is interesting to see how you can play it straight and make so 

much money, Mr. Bogle. It can be done in this great country of 

ours. Obey the rules and do it the way you should do it. 

These situations, a lot of these funds are regarded as if they are 

a gold mine, and if you mine it hurriedly, you know that you have 

yours all taken care of before it goes to the marketplace, and frankly, I think that the problem is an informational problem. How do 

we get a message to the mutual fund investor that makes them 

clear, informs of the risk, informs them of the cost, other than perhaps hiring Howard Dean to go out and put out the message. 

[Laughter.] 

The fact of the matter is, that does not get him elected President, 

but it does show that your message can be delivered. 

40

How do we tell the public that they are getting gypped in part, 

that this idea of, well, simply say 11 versus 8 or what-have-you, 

but as I said earlier, that 11 maybe ought to be 20. I ask you this 

with a degree of innocence because I am not as familiar with the 

mutual fund industry as you might be. I know that you do a pretty 

good job. Is yours the lowest cost? 

Mr. BOGLE. By far. Our second lowest-cost competitor, lowest 

cost next to us, has costs that are approximately 200 percent higher than ours. We run for about 26 basis points, and the second lowest cost is up there around 75 basis points. 

Senator LAUTENBERG. You have managed to grow with that modest cost, have you not? 

Mr. BOGLE. Our market share has grown from 1 percent of industry assets to 9 percent, and has not declined in any one of the 

last 20 years. 

Senator LAUTENBERG. How much is invested now, and are you—

how much are the funds that you are managing these days? 

Mr. BOGLE. We started in 1974 with one billion dollars under 

management. We used to celebrate each billion additional, and our 

most recent number was $700 billion, so we gave up the one billion 

celebrations quite a while ago. 

Senator LAUTENBERG. That is a nice celebration to give up, on to 

the larger increments. Is there a way, when we see a prospectus 

or proxy or a mutual fund that parallels that for industry generally——

Mr. BOGLE. Mutual fund prospectuses are singularly unhelpful. 

There are pages after pages of type. There is no highlighting of 

things like costs, or even for that matter returns or returns compared to the market, or the total dollar amount of costs. I think we 

need a uniform disclosure document in which certain things are 

highlighted in large type, the dollar amount of the fee, the fund’s 

record compared to the stock market over long periods of time, the 

impact of cost on returns, things of that nature, in a very simplified 

way, and then throw in the rest of the prospectus afterward. 

Senator LAUTENBERG. Does a typical mutual fund annual statement include salaries or profits made by the senior executive team? 

Mr. BOGLE. No, sir, it does not, and it does not because we have 

never been able to pierce the corporate veil. The mutual fund itself 

reveals its directors’ compensation, but all we know about the manager’s compensation is the total fee paid. I believe we absolutely 

need disclosure of the officers and the management company’s salaries, disclosure of portfolio manager’s salaries, disclosure of the 

transactions and ownership they have in the funds, none of which 

is out there now, and disclose of each individual’s share of the profits the management company has earned. I would also add that we 

need disclosure of how the manager spends that money—and that 

is why I want this economic study of the industry done. If the manager is getting paid $100 million, is it spending $10 million on investment management and $50 million on marketing, and has a 

profit of $40 million or whatever the case may be? We have been 

unable to get to that because the management company is a separate and often privately-held company. 

I should add to that there is another extremely unhealthy trend 

that has taken place in the years over the last half century, and 

41

that is, 36 of the largest 50 mutual fund management companies 

are subsidiaries of giant financial conglomerates. Believe me, sir, 

you know enough about corporate America to know that those conglomerates are in this business to earn a return on their capital, 

not a return on the capital of the mutual fund investors. When 

those two conflicting goals butt up against each other, as we have 

now seen in some of these scandals, it is the return on capital to 

the manager that has taken precedence. While I do not think we 

can ban that conglomerate ownership, we ought to think long and 

hard about whether the American public is served by 

conglomerating this once professional business. 

Senator LAUTENBERG. Is there any kind of an index out there 

that identifies the efficiency of the operation of a fund and shares 

its cost basis in a way that the public can understand it, or would 

it be a good idea? I think in terms of indices because we used to, 

at ADP, we delivered the Alan Greenspan econometric space. They 

sold it, but we would deliver it through our network. It seems to 

me that there is a heck of a value out there if we can put this information in a simple enough form that it tells the investor, hey, 

these people have this kind of a cost ratio, they have that kind of 

a result, and really understand what it is. There is a comfort derived from thinking that you are going into a mutual fund that everybody—you said it, Mr. Chairman—is like an insurance company, that here we are all in this together so everybody is going 

to take care of everybody and we need not worry about it. Meanwhile, we have seen some of the most outrageous scandals that 

have come across the financial marketplace in this hidden array of 

things that are there. 

Mr. BOGLE. The array of costs and revenues and ways money 

gets spent, and profitability of managers, is so vast that I have to 

confess to you that I am not sure, other than dealing with the most 

basic information I think would be understandable and palatable 

to the public. When you get to the real information to see how this 

industry works, I think it is more complex than that, and therefore, 

I think what we need very urgently is to have a staff responsible 

to the board of directors that can provide that information to directors on an independent basis. The present consultants to boards 

are always paid by the mutual fund managers, so they shape that 

information—for example, they often leave Vanguard out of the 

comparisons I am told—but I think it is up to the fund directors 

to be responsible in this industry, where unlike corporate America 

there are no large owners; in corporate America, we have 100 large 

financial institutions that own 50 percent of all stock, and if they 

just asked for information, they would receive it. There is no such 

dominant body in the fund industry, so I think we need the fund 

directors to assume their responsibility. 

I agree with you, by the way, on the potential emergence of a 

kind what we will call a director class. I think it is an excellent 

idea, because the responsibility in this business largely owned by 

small investors is to have a board that puts those small investors 

first. The board will be able to digest any information that we can 

think of, particularly if it is provided by independent sources. 

Senator LAUTENBERG. Just this closing question. Is there a point 

in time when size becomes a determinant as to whether or not anVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00045 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
42

other fund under the same management company must be created 

so that there is not such a mass in one place, it can destroy a company’s value if there is a decision to sell? 

Mr. BOGLE. Yes. You bring up a very good point, Senator Lautenberg. In this business, when you are in the business of asset gathering and fee maximizing, which is what a management company 

does—you can argue it is fine, for that is their business—you tend 

to let funds grow to awesome size. One of the funds in the industry 

grew actually to $100 billion. They had a 1 percent management 

fee. They were paid $1 billion for investment management. And of 

course, by the time they were that large, they turned into an index 

fund. They did not want to be an index fund, but they had no other 

choice. They could not buy small-cap stocks or mid-cap stocks in 

any appreciable way. So you can observe them now kind of going 

along the index route, which is fine for me—I mean I love it—except at a cost that means they are destined to fall short of the 

index return. So, yes, we let funds get to too large a size, and no, 

we do not cut funds off at a reasonable level, and it is very difficult 

to replace one large fund with another fund doing the same thing. 

In other words, they say, we are going to close Fund A and start 

Fund B. But if you use the same advisor, clearly the problems do 

not go away, unless, as we did at Vanguard in the case of Windsor 

Fund and Windsor II, you use a totally different advisor. So it is 

another area that I believe the SEC should be looking at very carefully. I do not think that is a legislative issue on fund size because 

I do not think any of us can articulate it very well. 

But, yes, there is a size beyond which you cannot differentiate 

yourself because the cost of portfolio transactions simply overpowers your ability to move the money. 

Senator LAUTENBERG. I appreciate your candor. Thank you very 

much. 

Mr. BOGLE. Thank you, sir. 

Senator LAUTENBERG. Thanks, Mr. Chairman. 

Senator FITZGERALD. Thank you, Senator. 

Mr. Bogle, we want to thank you once again for making the journey down to Washington in the inclement weather, and as promised, we will have you out of here in time to make your plane. But 

thank you very much for coming here. We really appreciate it. 

Mr. BOGLE. Thank you all for your courtesy. It has been a privilege to be here. 

Senator FITZGERALD. Thank you. Now I would like to go to the 

whistleblower panel. 

Mr. BOGLE. I am not one. [Laughter.] 

Senator FITZGERALD. You are not one of the whistleblowers. Well, 

I guess you are, yes. 

I would like to ask Peter Scannell and James Nesfield to please 

come up to the witness table. Thank you very much for being with 

us today, and we appreciate your patience waiting through the first 

panel and giving a special dispensation to John Bogle so we could 

accommodate his schedule. 

Mr. Scannell began working for Putnam Investments in March 

2000. As a preferred services specialist in Putnam’s call center, Mr. 

Scannell noticed a pattern of high-volume trades by a group of investors. In March 2003—that is nearly a year ago—Mr. Scannell 

43

1The prepared statement of Mr. Kugi appears in the Appendix on page 276. 

2The prepared statement of Mr. Scannell appears in the Appendix on page 131. 

disclosed this repeated trading to the Boston office of the Securities 

and Exchange Commission, then subsequently presented his information to the Massachusetts Securities Division within the Office 

of the Secretary of State. Shortly thereafter, William Galvin, the 

Massachusetts Secretary of State, issued subpoenas seeking further 

information that later led to disclosures about Putnam’s mutual 

funds. 

Our second witness on this panel is James Nesfield, a former 

contractor with Canary Capital Partners. Mr. Nesfield cooperated 

with authorities in their investigation of market trading abuses. 

When Mr. Nesfield was hired by Canary as a consultant, he was 

asked to help find companies willing to allow Canary to actively 

trade their funds and find points of access to enter orders for market timing purposes. Mr. Nesfield has extensive knowledge of trade 

processing systems on Wall Street that enabled him to communicate directly with many mutual funds. 

I would like to note for the record at this time that Peter J. 

Kugi 1 of Grafton, Wisconsin, has submitted a statement for the 

record. Mr. Kugi was recently profiled in Newsweek Magazine as an 

aggrieved investor who saw the savings he invested in mutual 

funds for his son’s college education dwindle by more than half. Mr. 

Kugi considers himself to be an above-average investor. As reflected in his statement, however, even he found that he could not 

understand the fee structure of the mutual fund in which he invested, leading him to believe that the vast majority of average investors are likely to share his frustration. 

Thank you both for appearing today. Mr. Scannell, you may proceed. As with the earlier witnesses, we will ask you to submit your 

written statement for the record. It will become part of the permanent record of this hearing, and if you are able, we would appreciate it if you could summarize your testimony in 5 minutes. Thank 

you. 

Mr. Scannell. 

TESTIMONY OF PETER T. SCANNELL,2 WEYMOUTH LANDING, 

MASSACHUSETTS 

Mr. SCANNELL. Thank you, Mr. Chairman, Subcommittee Members and Senators. I have submitted my written testimony. It is 

fairly lengthy, so I will do an overview. Again, I would like to 

thank you for this extraordinary opportunity to come forward before you to share my experiences and profound concerns. 

If I was told a year ago that I would be present at a Senate Subcommittee hearing addressing the very issues I was trying to expose, I would not have believed it possible. Every step of this fight 

was met with obstacles designed to keep someone like myself, without a corporate title, from being heard. 

I became aware of the market timing abuses taking place at Putnam Investments in April 2000, and tried to expose those abuses 

to the Boston office of the Securities and Exchange Commission in 

March 2003. 

44

I was working at the fifth largest mutual fund company in the 

world, and although most prospectuses state that market timing is 

either prohibited or discouraged, known to be a detriment to the 

unwitting long-term investor, it was my experience it was occurring 

daily. My fear was that market timing abuse and exploitation of 

the mutual funds were not only an accepted practice at Putnam, 

but that my understanding of the darker side of human nature and 

the research I had done told me it may be an accepted practice for 

those with influence and money throughout the mutual fund industry. For years no news was good news for both the mutual fund industry and the regulators who had oversight responsibilities. 

A tangled web has been woven, and from my perspective in the 

mutual fund scandal, it is an imperative that we fully understand 

the scope and the depth of those abuses. of fiduciary malfeasance 

and the lack of proactive regulating. These abuses should have 

been brought to light years ago. 

Senators, the important part of my testimony is not about my 

family and I, but it is more importantly about what happened to 

me on this road not traveled by others. Every step in this fight has 

been met with an imposing force. That is, until I met with Massachusetts Deputy Secretary of State Matthew Nestor. Mr. Nestor 

immediately understood the magnitude of what I was presenting to 

him, and also understood the immensity of the burden that I carried. I put my welfare and the welfare of my family aside because 

of the importance of bringing to light this behavior. 

I must emphasize that there were thousands of decent, honest, 

hard-working Putnam employees who live in the area I call my 

home, and most if not all, had no knowledge of the abuses I speak 

of, yet their lives could be greatly impacted as well. In my neighborhood there is outrage. We have read that the American public 

does not seem to have great concern because of the inflows of monies to the funds. The American family, who is being responsible for 

their future retirement needs and their children’s higher education 

have no other choice. For them, mutual funds are the only game 

in town, and they realize that however lopsided that game may be, 

they have to participate. They know it is time in the market, not 

timing the market that will help them reach their goals. Families 

are working two jobs, taking care of their children, and deeply concerned for the world they live in. They have no time and energy 

left to protest in the streets over the mutual fund scandal. 

Senators, let me commend you for your deep concern and understanding of the issues that face the American worker, who is the 

taxpayer and who ultimately is the long-term investor. Every single day they are getting nickeled and dimed to death, and through 

no fault of their own they are being scammed on such a daily basis 

their heads are spinning. Here we are, the very lifeblood of our 

economy, and to think that there are some of the many who manage the mutual fund industry think the contributions entrusted to 

them are theirs to divvy up amongst themselves is outrageous. The 

longer it takes mutual fund companies that are under scrutiny to 

address their past, the longer it is going to take them to move 

ahead, if they can move ahead at all. For a CEO to leave Putnam 

Investments in such a horrendous state, risking the livelihoods of 

all the innocent rank and file has to be a crime. 

45

1The prepared statement of Mr. Nesfield and Mr. Grigg appears in the Appendix on page 150. 

Individuals in these corporations need to be held accountable. 

Consequences need to be imposed and licenses need to be yanked. 

If you do not care about your neighbor, you need to get out of the 

mutual fund business. And for those who do not think market timing is not a real problem, I believe we should think again. After 

I read Stanford University Professor Eric Zitzewitz’ study on market timing, I was not surprised. I was validated. But there was one 

question that was not addressed that I thought was critically important, so I gave Eric a call and asked him quite simply, ‘‘Did 

market timing in the last 5 years contribute to the historic volatility we have experienced affecting all markets?’’ His answer was, 

‘‘Sure it did, but it would be unquantifiable.’’

So that means we permitted a select group, not just market timers but those who allow market timing, to affect our markets in a 

way we will never fully understand, and that is a very troubling 

thought. 

Mutual fund trading abuses and hidden fees can be curtailed 

with the appropriate regulation, but there is one form of uncovering abuse that has yet to be suggested. As the Federal Government 

has in place a very effective Whistleblower Statute for the monies 

we entrust the government to spend, so too should there be a replicated statute for the securities industry. 

The Sarbanes-Oxley Act of 2002 will not inspire those who may 

want to come forward but are not willing to risk their careers and 

maybe more. Every regulator that I have spoken to has said: Peter, 

it is going to take an insider like you to make a difference. It is 

the proverbial needle in a haystack, and with the technologies 

available today, as well as future technologies, which will magnify 

thousands of times, we can make the difference. Maybe the next 

person to step up to the plate may have even more to offer than 

a former waiter from Boston’s North End, 

Senator, as I have read to you and submitted my previous testimony, I have been dismissed by a CPA, a CEO and the SEC, and 

all of them more than likely regret it. I was bashed in the head 

for the American investor. 

It is our once in an investor’s lifetime opportunity now to level 

the playing field. I remember Matt Nestor saying that he worked 

on the side of the angels, and to do effectively you must think like 

the devil. Let us not close the back door to have offenders slip in 

the side window. There will always be those who will try to take 

what is not rightfully theirs. 

I would like to thank you once again for allowing me to present 

these issues for your consideration, and it is truly a privilege and 

an honor for me to do so. 

Senator FITZGERALD. Thank you for being here, Mr. Scannell. 

Mr. Nesfield. 

TESTIMONY OF JAMES NESFIELD,1 NESFIELD CAPITAL 

Mr. NESFIELD. My name is James Nesfield. I have worked in the 

securities industry at various levels since 1978. In 1999, I was approached by Hartz Trading, later to be named Canary Capital, to 

find brokerage firms, trust companies and mutual fund managers 

46

that would be willing to accept large orders at frequencies generally not available to the average shareholder. This activity is 

known as market timing. A critical feature is permission by funds 

managers or a way to hide the volume of frequency of the transactions from the fund managers, thereby avoiding being blocked. 

In 5 minutes of testimony I will not be able to relay the intricacies and techniques developed by timers, mutual fund managers, 

administrators, and other agencies to thwart detection. It has 

taken hours and days of multiple communications to convey my 

knowledge to the AG’s Office. My job was to find those that would 

bend the rules for Canary because they were richer and could provide a quid pro quo of investing in other funds or private equities 

or separate accounts operated by the fund managers. 

I found these people simply by reading the news, public directories and searching for their E-mails. Most people within the fund 

industry hated timers, as that was the official doctrine. I found as 

I got closer to the upper levels of management, the morality was 

gray and easily shaded by immediate need or greed. The same is 

true of brokerage firms and trust companies. It is the golden rule 

that he who has the gold rules, and if you want a friend get a dog. 

No support staff member sets out to originally break a law or 

help the boss break a law. There is a slow process of inclusion, indoctrination, that pulls the helpers into the complex web. It was 

that naive perspective that would convince me that the founders 

and former managers of Hartz Mountain Pet Food were pursuing 

legitimate investments. Lawyers had vetted them with opinions on 

the strategy, and it was shocking to learn these pillars of society 

were violating laws. 

Because I worked from my home in North Carolina I learned 

from the newspapers that Mr. Stern, the Chief Executive at Canary 

Capital, had computers in his office connecting directly to the mutual funds, and he was purloining portfolio inside information from 

them and making investments with every edge imaginable. While 

it was a secret shared by many mutual funds that the Sterns were 

late timing and receiving portfolio inside information, the pawns 

were not enlightened. Each knew their part. None could fathom the 

entire picture. Although any one could see if they examined the 

NSCC FundServ system, that late trading was possible and easily 

transacted. 

I was never once at a meeting with Mr. Stern or a mutual fund 

manager or had any other significant business contact through Mr. 

Stern. I was never given information about the trades except after 

they were complete and mismarked in execution to hide the true 

time of execution so that no one would know. A good conspiracy rotates on its ability to keep the critical elements apart. Canary Capital kept staff separated from both trading parties and from senior 

management. Even Noreen Harrington, who is another mutual 

fund whistleblower, only reported suspicions by overhearing some 

mutual fund lingo on the trading form. I filled in technical detail 

and produced the errant confirms, but the AG still had to find the 

extent of the trading through subpoena. 

Even today it is unclear if the $40 million penalty was commensurate with the profits on and offshore. 

47

I may not have originally understood all the parts of Hartz 

Mountain’s operations, as we had come to know them, because I 

was not the accountant or the trader with direct responsibility for 

transactions. But once I understood the severity of these allegations without legal representation, as I still am here today, I came 

forward to inform completely. I like to think that if I knew earlier, 

I would have come forward voluntarily. Indeed, in December 2002, 

I filed a form CA–1, a Form 1 with the SEC outlining potential industry abuses, a way to stop them through automation. 

The lesson here is that if there is a legislative solution, it is that 

mutual funds needs to be regulated on par with broker-dealers as 

they occupy a strange place of issues, investment advisor, and in 

many cases points of distribution. A coordinated regulatory regime 

and checks and balances must be established for mutual funds that 

can be verified in a robust manner. The lack of expenditures by 

mutual funds for compliance and critical self assessment warrants 

concern and suggests an almost intentional neglect of public trust. 

I also hope that the Securities and Exchange Commission will review its duty to the public in the strictest terms as well. If legislation is passed in this Congress, the SEC should take care to consider the best interest of the investor first and foremost in implementing any legislation. 

Too many times I have seen legislative mandates watered down 

by interpretations of agencies implementing them. The mutual 

fund industry should have a higher level of disclosure and inspection since the shareholders are not protected by the Security Investor Protection Act. Mutual funds are exempted. 

Thank you. 

Senator FITZGERALD. Mr. Nesfield, you have come forward and 

given your story to the New York Attorney General’s Office, as I 

understand it. You cooperated with Attorney General Spitzer’s office, and ultimately your cooperation, as well as that of a couple of 

others led to the charges that were announced in early September 

of this past year against Canary and others. 

Did the Attorney General grant you immunity? 

Mr. NESFIELD. No. 

Senator FITZGERALD. Apparently because of your cooperation, 

they have not pursued any criminal charges against you for your 

participation? 

Mr. NESFIELD. No, there has been none. 

Senator FITZGERALD. What were you doing before 1999? You 

were a consultant of some sort? 

Mr. NESFIELD. Before I went to work for Canary I worked at 

SIPC liquidation in Longview, Texas. 

Senator FITZGERALD. What did they do? 

Mr. NESFIELD. SIPC is the Security Investors Protection Corp. A 

brokerage firm had gone under, and I was working for the trustee. 

Senator FITZGERALD. OK. You were hired as a consultant by the 

trustee? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. When you were hired by Canary, were you 

hired as an outside contractor or as an employee? 

Mr. NESFIELD. Outside contractor. 

48

Senator FITZGERALD. Outside contractor. Who at Canary hired 

you? 

Mr. NESFIELD. I was contacted by Andrew Goodwin. 

Senator FITZGERALD. Andrew Goodwin. 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. What is his position or was his position? 

Mr. NESFIELD. He was one of the traders there. 

Senator FITZGERALD. He was one of the traders. 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. What did he say to you? Did he call you up 

on the phone? How did he find your name? 

Mr. NESFIELD. He basically saw my resume on the Web and it 

lists a number of skill sets I have in regards to some of the technical aspects of the business. 

Senator FITZGERALD. He called you up. What did he say? 

Mr. NESFIELD. ‘‘I would like to meet with you. I will pay you,’’ 

basically, if you want to——

Senator FITZGERALD. Did he tell you what he was interested in 

over the phone? 

Mr. NESFIELD. No. 

Senator FITZGERALD. So he met with you in his office at Canary? 

Mr. NESFIELD. I went up to Secaucus, New Jersey and met with 

him, Eddie Stern and Noah Lerner. 

Senator FITZGERALD. And Mr. Stern——

Mr. NESFIELD. Yes. 

Senator FITZGERALD [continuing]. Was in the room. And Mr. 

Stern and Mr. Goodwin? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. And a lawyer? 

Mr. NESFIELD. No. Noah Lerner. He is another gentleman that 

worked with Mr. Stern. 

Senator FITZGERALD. Noel Lerner? 

Mr. NESFIELD. Noah, as in the boat. 

Senator FITZGERALD. Noah, OK. Noah Lerner, Mr. Stern and Mr. 

Goodwin, they met with you? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. What did they say to you in that meeting? 

Mr. NESFIELD. They basically said, ‘‘We do market timing.’’ I 

knew what it was. I had talked to somebody else. This might have 

been 5 years before that I knew about market timing. And somebody had approached me to—mutual fund companies had started 

implementing automated means of detecting market timing activity 

so they would be able to block those orders or stop timers. If you 

look at the design of the system that is used to put orders in for 

mutual funds, there is a way to subvert that, and essentially that 

is what they hired me to do. 

Senator FITZGERALD. Did you advertise your ability to help them 

engage in market timing? 

Mr. NESFIELD. No. 

Senator FITZGERALD. They called you in. You did not know exactly what they wanted to hire you for, and then they explained to 

you, ‘‘We do market timing. Can you help us?’’

Mr. NESFIELD. You have to understand market timing is not illegal, correct? 

49

Senator FITZGERALD. Maybe illicit. Could be illegal in certain circumstances. 

Mr. NESFIELD. It is what you call gray, is that correct? 

Senator FITZGERALD. Well, it could be illegal in certain circumstances. If Mr. Stern, as you said in your opening remarks, was 

receiving insider portfolio information——

Mr. NESFIELD. I did not know that directly. I learned that in the 

paper. 

Senator FITZGERALD. You did not know that by working there? 

Mr. NESFIELD. No. I never put an order in for Mr. Stern. I was 

never—as I said, I never had direct knowledge. 

Senator FITZGERALD. OK. 

Mr. NESFIELD. I knew all the technical aspects of it, but that is 

why Mr. Spitzer’s office had to go and get Mr. Goodwin because 

Mr. Goodwin had the direct knowledge. 

Senator FITZGERALD. So when they were hiring you, you did not 

view this as them asking you to help them with any illegal activity? 

Mr. NESFIELD. Basically, just find people, find the people that 

had access to this. 

Senator FITZGERALD. What did you tell them? Did you tell them 

you thought you could help them with that? 

Mr. NESFIELD. I knew I could. 

Senator FITZGERALD. You knew you could. 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. That you knew the processes at mutual 

funds and you would be able to sift out the ones that would——

Mr. NESFIELD. Well, it is not just mutual funds, OK? 

Senator FITZGERALD. OK. 

Mr. NESFIELD. Anybody that is an NSCC FundServ participant——

Senator FITZGERALD. NSCC? 

Mr. NESFIELD. Right. National Security Clearing Corp. 

Senator FITZGERALD. OK. 

Mr. NESFIELD. Anybody that is an NSCC FundServ participant 

can time mutual funds with or without the permission. 

Senator FITZGERALD. OK. 

Mr. NESFIELD. So Mr. Bogle’s fund was timed. 

Senator FITZGERALD. Did they tell you at that meeting how much 

they would pay you? Did you settle on an arrangement? 

Mr. NESFIELD. Yes. $50 an hour to start. 

Senator FITZGERALD. So you were paid by the hour? 

Mr. NESFIELD. Initially, yes. 

Senator FITZGERALD. Initially. 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. Did that fee later go up? 

Mr. NESFIELD. About 2 weeks later. 

Senator FITZGERALD. What did it go up to? 

Mr. NESFIELD. It went on a percentage of assets they put into 

timing capacity channels I had found. 

Senator FITZGERALD. What was that percentage? 

Mr. NESFIELD. A tenth of 1 percent or 10 basis points. 

Senator FITZGERALD. You got 10 basis points. That is the total 

expense ratio for the Government Thrift Savings Plan. 

50

Mr. NESFIELD. Well, I worked harder. No. 

Senator FITZGERALD. How much money did you make doing this? 

Mr. NESFIELD. Over 4 years, maybe between $250,000 and $300,000. 

Senator FITZGERALD. Over 4 years? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. How much in total assets did you find market timing capabilities for them? 

Mr. NESFIELD. I do not know. A great deal. I was not paid on 

some of it. 

Senator FITZGERALD. You were not? 

Mr. NESFIELD. No. 

Senator FITZGERALD. Did they owe you money at the end? 

Mr. NESFIELD. Well, Mr. Stern has a funny way of accounting for 

things. He owes me money and he owes Mr. Goodwin money as 

well. 

Senator FITZGERALD. How much money do you think you are 

owed? 

Mr. NESFIELD. I do not know. I do not have full disclosure, but 

I mean if I take a guesstimate, not concerned about how it appears, 

he might owe me $3 million. 

Senator FITZGERALD. Do you have other clients that you have 

helped market time? 

Mr. NESFIELD. No. Mr. Stern nailed me to an exclusivity contract. 

Senator FITZGERALD. Had you ever helped any other entities engage in market timing? 

Mr. NESFIELD. Someone proposed the question to me years ago 

before Mr. Stern. I gave them my best answer and they would not 

take my advice. 

Senator FITZGERALD. So you have not done this, provided this 

service to anyone else? 

Mr. NESFIELD. No. 

Senator FITZGERALD. Just for Canary Capital. 

Mr. NESFIELD. Right. 

Senator FITZGERALD. It is quite a story. It is really an interesting story. You said that you wondered whether the fine, the $40 million penalty that the Attorney General’s Office assessed on Canary, 

you wondered whether that was enough. How much do you think 

they made? 

Mr. NESFIELD. I think the Attorney General’s Office probably—

this is my assumption, but they probably did not go and turn over 

every rock inside the Stern organization. I mean they probably 

trusted what was given to them for——

Senator FITZGERALD. How big is the Stern Hedge Fund? 

Mr. NESFIELD. It was $4 billion. 

Senator FITZGERALD. It was $4 billion. How big was it when you 

started in 1999? 

Mr. NESFIELD. It was $300 million. 

Senator FITZGERALD. So it grew really fast? 

Mr. NESFIELD. Yes, but it’s not just——

Senator FITZGERALD. With this market timing it was having abnormally high returns? 

Mr. NESFIELD. They made 110 percent the first year. 

51

Senator FITZGERALD. One hundred seven percent? 

Mr. NESFIELD. One hundred ten percent. 

Senator FITZGERALD. One hundred ten percent? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. How about the second and third years? 

Mr. NESFIELD. Diminished returns, 25 or 26 percent. 

Senator FITZGERALD. Is that because the fund was getting bigger 

and bigger? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. Were they making most of their money 

from market timing or did they have some real good investments? 

And a lot of this—the market crashed in 2000, right? 

Mr. NESFIELD. You have to understand, if you—the mutual funds 

need market timing. I mean nobody really understands. There is 

this organization called Reflow.com that has been funded by—what 

is his name—Getty, the oil guy, Gordon Getty? He started this investment advisory firm. What it does is it helps mutual funds deal 

with negative redemptions, and in some sense it was the prudent—

I mean it sounds obtuse to say this at this point, but it was the 

prudent manager of the mutual fund who actually required cash, 

additional cash coming in from market timers to handle the impact 

of negative redemptions. So it is really a money management technique, even though when Stern does late timing, or anybody does 

late timing, it is illegal. 

The fund manager, when—some fund managers like MFS ran a 

trading program or a timing program. When they were doing it, it 

was basically a means for them to borrow money short term in 

order to handle a falling market or negative redemptions. So while 

they might not ordinarily accept that, during a falling market, 

which we have experienced, which we are still in more or less, they 

are going to have to take some rather weird type of money management things. They have to get their money where they can get it. 

The other thing that happened is since 1999 the investment advisory companies collateralized their fees. There is actually bonds 

that are issued on the fee income derived from mutual fund managers. One of the reasons they are so adverse to having the assets 

under management go down is because it will affect their debt 

service on those bonds that they have written. You know, you can 

put your finger in the water, but it is a pretty mixed pond. There 

are a lot of things going on there. That is why when I hear people 

talk about legislative solutions, it is not so clear cut. It is not as 

easy to perceive—I mean it is not as easy as everybody would like 

to make it. It is very complex and it has got to be done carefully. 

Senator FITZGERALD. Let me ask you this. You started trying to 

search out mutual funds that would give market timing capacity to 

the Stern Hedge Fund. 

Mr. NESFIELD. Right. 

Senator FITZGERALD. How many mutual funds did you find over 

the course of your 4 years there? 

Mr. NESFIELD. Hundreds. 

Senator FITZGERALD. Hundreds? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. What were the five biggest funds? 

Mr. NESFIELD. Janus. 

52

Senator FITZGERALD. Janus. 

Mr. NESFIELD. Invesco. 

Senator FITZGERALD. Invesco. 

Mr. NESFIELD. AIM, A–I–M. That’s part of Invesco. 

Senator FITZGERALD. A–I–M. 

Mr. NESFIELD. Putnam. 

Senator FITZGERALD. Putnam? 

Mr. NESFIELD. Yes. And that’s all I can recall off the top of my 

head. 

Senator FITZGERALD. OK. But it was hundreds of them, so many 

that——

Mr. NESFIELD. Yes, everybody had a deal. 

Senator FITZGERALD. OK. But typically——

Mr. NESFIELD. Kinetic is another one, yes. 

Senator FITZGERALD. Who? 

Mr. NESFIELD. Kinetic Funds. They’re a small group of funds. Kinetic had one. 

Senator FITZGERALD. Kinetic. 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. So on your first go-round with these people, 

how would you—a lot of times you are turned down. Were there 

some that accepted you right away? 

Mr. NESFIELD. Well, my motto—and it held true—is if you heard 

no, you didn’t ask the right person, or you didn’t ask at the right 

time. 

Senator FITZGERALD. Were there any that turned you down? 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. Who turned you down? 

Mr. NESFIELD. Scudder. But I have recently found out in the 

newspaper that they had a timing program, so obviously it was the 

wrong time and the wrong person. 

Senator FITZGERALD. Scudder turned you down. Who else turned 

you down? 

Mr. NESFIELD. Well, I was turned down by most of them. It is 

just I had to reapproach it—see who do you ask. 

Senator FITZGERALD. Who kept turning you down and never 

changed their mind? 

Mr. NESFIELD. Nobody. 

Senator FITZGERALD. Oh, once you told them that you are huge, 

you are big, you are a multi-billion-dollar——

Mr. NESFIELD. Kind of like the same pick-up lines you use at a 

bar, yes. I am kidding around; it is a joke. I’m sorry. 

Senator FITZGERALD. So they all were agreeing ultimately. Were 

they putting any limits on you at Janus? 

Mr. NESFIELD. They would have limits, but I didn’t discuss them. 

They would—once the contact became like affirmed, if you will, 

then I turned it over to Mr. Stern, and he would negotiate with 

them. 

Senator FITZGERALD. And then Stern would negotiate with them 

personally? 

Mr. NESFIELD. Yes. I didn’t have the latitude to actually negotiate the deal. 

Senator FITZGERALD. Now, you probably made them, if they had 

102-percent return the first year you came on board, you probably 

53

just made millions and millions of dollars for them, and all you got 

paid was $250,000 over 4 years. 

Mr. NESFIELD. Just my luck, right? 

Senator FITZGERALD. Just your luck. 

Mr. NESFIELD. Yes. 

Senator FITZGERALD. Mr. Scannell, turning to your experience 

with Putnam, you noticed large, repeated timing trades happening 

at Putnam, apparently in accounts of some union members? 

Mr. SCANNELL. Yes. Those are the ones that would stand out, 

Senator, only because of——

Senator FITZGERALD. What union was it? 

Mr. SCANNELL. The initial union was the Joint Industry Board 

of Electricians. This was a 27,000-member union. That was in 

2000, and probably almost 3 weeks into my employment after 

training, again, for a complete career change, this was very unique. 

I believe one of the things that made it stand out to me is because 

I didn’t have a background in the financial services industry. They 

were marketing timing two tech funds, and they were being hurt 

significantly. They were losing literally thousands and thousands of 

dollars in individual accounts. These gentlemen had two, three, 

four hundred thousand dollars in their accounts. I’ve given examples in my testimony to you. And they just went away in 2000, September 2000, a little later. The NASDAQ just wouldn’t provide 

enough recovery for the systems or the techniques that they’re 

using to market time. 

It was my belief that it was almost like scuttlebutt or what have 

you. They’d call up—I mean, these are hardworking guys. They’d 

call up between three and four, Hey, people, what’s the NASDAQ 

doing? And, put me in, put me out. 

Senator FITZGERALD. They would call into your call center where 

you worked? 

Mr. SCANNELL. Exactly. 

Senator FITZGERALD. And initially you were probably helping 

some of them, not knowing what they were doing. 

Mr. SCANNELL. I was executing transfers at the request of participants and/or members, of which they were. This was something 

that many representatives brought up to our supervisors, and this 

was a——

Senator FITZGERALD. Had you been trained to look out for this? 

Mr. SCANNELL. Absolutely not. There was no training. 

Senator FITZGERALD. You had no training. 

Mr. SCANNELL. No. As a matter of fact, one of our concerns was, 

as the market was plunging in 2000, the mantra in the industry 

was diversity, suitability, really trying to get people to do it. And 

I’d address supervisors with that and would talk with preferred 

services specialists like myself who were becoming licensed and 

more educated in regards to the mutual fund industry and what 

detriment this was doing. 

Senator FITZGERALD. So did you understand the detriment to the 

other funds? 

Mr. SCANNELL. Absolutely. Before I even received my first license. 

Senator FITZGERALD. At what point did you go—you went to supervisors at Putnam? 

54

Mr. SCANNELL. Yes. 

Senator FITZGERALD. Who was your supervisor? 

Mr. SCANNELL. I had many supervisors. 

Senator FITZGERALD. You had many supervisors. 

Mr. SCANNELL. Yes. It’s a very high-turnover call center, and 

what happened was we actually became very adept at what we 

were doing. Putnam increased our ability to form multi-task and do 

the——

Senator FITZGERALD. What did the supervisors tell you? 

Mr. SCANNELL. Just discouraging the discussion. Yes, stating we 

cannot give advice. We were always constantly being—it was trying 

to be told to us that there was a bill before the legislature that 

would allow us to give advice over the phone. I mean, it was fairly——

Senator FITZGERALD. Just they would give you the roundabout. 

Mr. SCANNELL. Exactly. 

Senator FITZGERALD. Did you take it beyond your supervisors in 

the call center? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. Where did you go to? 

Mr. SCANNELL. Well, later on, discussing, again, after I received 

my Series 63, and Series 7 license, we became this preferred services unit where we encountered a different market timing strategy, 

and that was an international fund market timing. Now, this was 

a fund that the—it happened to be just another union. We had a 

lot of market timers at Putnam Investments throughout the 2,000 

plans. But, again, because they had a technique and as a group 

they had the fund within their plan, they had the ability to market 

time. 

Senator FITZGERALD. And what union was this? 

Mr. SCANNELL. This was the Boilermakers Local 5. 

Senator FITZGERALD. In Boston? 

Mr. SCANNELL. No, it was not in Boston. I believe it was New 

York or New Jersey. 

Senator FITZGERALD. In New York or New Jersey? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. And you start getting boilermakers calling 

you. 

Mr. SCANNELL. Right. And, unfortunately for myself, the connotation unions, market timing, and what it’s conjuring isn’t the case. 

I mean, they had a technique that we allowed them to do. It was 

the International Voyager Fund, and any fund family that has 

their participants or members, as we describe union members, had 

a particular group of funds that they could invest in. 

Now, they had the ability to transfer those funds daily from an 

International Voyager Fund into a guaranteed investment contract 

fund. That was the technique. It was done 100 percent, as Mr. 

Nesfield was discussing. That was very common. The market going 

down was insignificant for transfers of Internal Voyager Fund and 

their ability to turn a profit. 

Senator FITZGERALD. So you began to wonder why your firm permitted this because you knew it was harming the other fund shareholders. 

55

Mr. SCANNELL. It was not only harming the other fund shareholders, but, again, I’m going back to the initial, Joint Industry 

Board for the Electrical Industry (JIB), that it was actually—we 

were allowing—I compared it to a pharmacist—and, again, not the 

boilermakers—refilling a prescription over and over again knowing 

that it’s doing great harm to somebody. 

Senator FITZGERALD. Was anybody else in your call center as 

concerned as you? 

Mr. SCANNELL. Absolutely. 

Senator FITZGERALD. And did anybody else do anything? 

Mr. SCANNELL. Absolutely. We brought it up to the attention—

of senior management. It was discussed in front of one senior manager that said it wasn’t criminal in a preferred services specialist 

meeting where one of my peers brought it to their attention. We 

had a great buffer between senior management for obvious reasons. 

Senator FITZGERALD. But you did get in to see the senior——

Mr. SCANNELL. Well, we were at a meeting, and it was brought 

up. 

Senator FITZGERALD. With the senior manager there. 

Mr. SCANNELL. Exactly, and his reply was it’s not criminal. 

Senator FITZGERALD. Who was that senior manager? 

Mr. SCANNELL. His name was Robert Capone. 

Senator FITZGERALD. Like Al Capone. 

Mr. SCANNELL. Exactly. 

Senator FITZGERALD. OK. And you brought it up to Mr. Capone, 

and what did Mr. Capone say? 

Mr. SCANNELL. It was brought up to Mr. Capone by another representative in front of another senior vice president, and a human 

resources representative——

Senator FITZGERALD. Is Mr. Capone still there? 

Mr. SCANNELL. I believe so. 

Senator FITZGERALD. He is? 

Mr. SCANNELL. I believe so. I’m not sure. 

Senator FITZGERALD. OK. It was brought up at one of those meetings. You weren’t the one who brought it up. Someone else brought 

it up. 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. And his response was? Mr. Capone’s——

Mr. SCANNELL. It’s not criminal. 

Senator FITZGERALD. It’s not criminal so don’t worry about it. 

Mr. SCANNELL. It was very shocking to hear him say that. 

Senator FITZGERALD. OK. 

Mr. SCANNELL. But that he would say that in front of us—for 

myself, understand as well that——

Senator FITZGERALD. Was this after-hours trading or market timing? 

Mr. SCANNELL. This is market timing. 

Senator FITZGERALD. OK. 

Mr. SCANNELL. And it could be just as successful as after-hours 

trading with an international fund. Again, it’s well known now, we 

all seemingly have a good idea of market timing. It does not take 

a positive movement in the market. It just takes taking advantage. 

It’s the arbitrage that’s available. 

56

Senator FITZGERALD. OK. So after it was brought up to Mr. 

Capone and he just said it’s not illegal and dismissed it, then 

what? Did you or your——

Mr. SCANNELL. One of the representatives, again, who—and because he’s still working there actively, I’d rather not mention his 

name. He confronted a supervisor with a spread sheet. I already 

had a spread sheet active in my—an Excel spread sheet. I was 

tracking them. I knew that they knew I was tracking them. Everything that I did was monitored, whether it was on my computer or 

on my phone—everything. 

So I was putting myself in a position that, well that’s——

Senator FITZGERALD. Did anybody tell you, warn you off, to quit 

pursuing this line? 

Mr. SCANNELL. Well, what happened—no, they wouldn’t. But, 

again, it wasn’t applauded. And the efforts—one of the interesting 

things was that we were constantly told that there is not a system 

to do this. And that was for a number of years. 

And back to your point about another supervisor, I put this 

spreadsheet together, and I actually gave them the account numbers of market timers, and nothing was ever done. That’s when I 

decided that I need to take my time and make sure I provided all 

the documents I could not only to protect myself but to expose Putnam. And I found internal documents that suggested Putnam was 

aware of this in 2000. 

Senator FITZGERALD. You then went to the SEC? 

Mr. SCANNELL. Exactly. 

Senator FITZGERALD. Was that the first place you went? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. OK. And when did you go to the SEC? 

Mr. SCANNELL. I went to the SEC at the end of March. First I 

went to—I have a brother who is an attorney, and he said, ‘‘You 

need a securities attorney.’’ And I was fortunate enough to find a 

firm in town, and she happened to be an employment specialist. It 

was through a family friend. So it was decided in March that I 

would go to the SEC and provide them the documents. 

Senator FITZGERALD. Did the lawyer go with you? 

Mr. SCANNELL. Well, there was some discussion first. Evidently 

this wasn’t incredibly welcome news, and it was described what I 

did have, a very compelling and succinct anthology of what I believed was something disturbing at Putnam Investments. 

It took a number of communications, as I provided in my testimony, before they would even meet with my attorney. I wanted to 

remain—my identity to remain confidential. Unfortunately——

Senator FITZGERALD. OK. So they didn’t meet—you didn’t go initially to the SEC? 

Mr. SCANNELL. We had a number of communications through my 

attorney. 

Senator FITZGERALD. Through your attorney. 

Mr. SCANNELL. There was about seven. 

Senator FITZGERALD. Seven, before they met with her? 

Mr. SCANNELL. Before they met with her, three attorneys on 76 

Tremont Street. 

Senator FITZGERALD. And how long did that take? 

Mr. SCANNELL. That was in April. 

57

Senator FITZGERALD. So you started this process at the end of 

March, and by April——

Mr. SCANNELL. April 24, I believe it was. 

Senator FITZGERALD. April 24, your attorney——

Mr. SCANNELL. I finally was able to meet with them. This was 

happening——

Senator FITZGERALD. Did they meet with your attorney first? 

Mr. SCANNELL. They met with my attorney first. I believe it was 

on April 14. 

Senator FITZGERALD. OK. And they were interested? 

Mr. SCANNELL. Again, they came back to me—I mean, my attorney came back to me, and there was some more discussion. They 

did not agree to meet with me yet. 

Once I met with them, I needed to provide them with the 

prospectuses of the funds that I was concerned about, and in doing 

so, obviously identify myself. There was a number of websites out 

there and there was a number of people at Putnam Investments 

that knew that it was me that was——

Senator FITZGERALD. Now, it wasn’t necessarily illegal activity 

you were bringing to their attention, but perhaps activity that——

Mr. SCANNELL. It wasn’t mine to judge that it was illegal. I was 

just seeing—I was seeing something that I didn’t believe was in the 

best interest of initially the actual members doing it and losing 

hundreds of thousands of dollars. 

Senator FITZGERALD. Did it contradict the promises in the prospectus? 

Mr. SCANNELL. That was interesting. When I met with three attorneys from the SEC, they handed me back the prospectus that 

I gave them and asked me what my opinion was of it. I found that, 

as not an attorney, I read very clearly that it stated that shortterm trading—this was not a vehicle for short-term trading. It 

would be prohibited. Putnam would do anything within its management ability to curtail or to stop or to refuse transactions, whether 

it was from one fund to another. 

Senator FITZGERALD. So there is the violation, they advertise in 

their prospectus that they discourage this market timing, but then 

you see them allowing it every day. 

Mr. SCANNELL. And there was also a disclaimer in it that said—

there was a 1-percent redemption fee, which we now know that 

that would not stop market timing, a 1-percent redemption fee. 

Senator FITZGERALD. Were they imposing that redemption fee or 

they were——

Mr. SCANNELL. That 1-percent redemption fee would not be imposed to anybody in a 401(k) Putnam-managed fund, omnibus plan, 

or variable annuity. 

Senator FITZGERALD. OK. 

Mr. SCANNELL. So that was kind of where it started to point me. 

Well, let’s get into a Putnam plan, and if you don’t have to worry 

about tax consequences, if you don’t have to worry about redemption fees, you are all set. 

Senator FITZGERALD. OK. So you meet April 24 with the SEC? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. You personally meet. Then what happens? 

58

Mr. SCANNELL. With my attorney. We had a meeting for an hour 

and a half. They thanked me for my courage. And I went on my 

way. 

Senator FITZGERALD. Did you hear from them again? 

Mr. SCANNELL. My attorney contacted them in about 2 weeks. 

There was nothing to report. Then it went on for about 3 weeks, 

another 3 weeks. I asked her to contact them, and previously they 

asked me if I was going to be going anywhere else, to let them 

know first. And then for whatever reason, it was communicated 

through my attorney that they’re not interested in updating me or 

keeping me abreast. All the while I knew that market timing was 

continuing at Putnam Investments. 

Senator FITZGERALD. And at what point did you then go to somebody else, the Secretary of State’s office? 

Mr. SCANNELL. September 11, 2003. I met with Matt Nestor in 

the Federal Reserve Building where my attorney’s offices are. 

Senator FITZGERALD. And that was after the charges had been 

brought in New York against Canary, which Mr. Nesfield has 

worked for? 

Mr. SCANNELL. Yes, right about that time. 

Senator FITZGERALD. OK. And then you got the idea, you saw a 

State attorney general was pursing this in New York. 

Mr. SCANNELL. Yes, and I had a lot of admiration for what Attorney General Spitzer was doing. At the same token, our Secretary 

of State William Galvin was investigating Prudential Securities before that for brokers—I believe it was trading after hours. 

Senator FITZGERALD. OK. 

Mr. SCANNELL. So obviously I went to my——

Senator FITZGERALD. And the Secretary of State, Mr. Galvin’s office, got on it right away in September. 

Mr. SCANNELL. Well, in about 4 hours after having met with 

Matthew Nestor, who I informed, that the SEC never got back to 

me and seemingly was not interested. From what I believed and 

from the market timing I knew was continuing, he assured me that 

William Galvin’s office wouldn’t behave like that, they would be 

acting on this. He was very impressed with the information. 

Senator FITZGERALD. Are you still working at Putnam? 

Mr. SCANNELL. No, I’m not. Excuse me. I am on disability from 

Putnam Investments. I was assaulted over what I believe this——

Senator FITZGERALD. When did you go on disability? 

Mr. SCANNELL. February 2. 

Senator FITZGERALD. OK. So you were bringing these concerns to 

the SEC after you had gone on disability? 

Mr. SCANNELL. What happened to me right before February 2, I 

compiled my information and left, knowing—and telling a supervisor, an assistant vice president there, that I’d no longer be accepting transactions for known market timers. I was told to be 

careful and I had to do what I had to. It was the following Sunday 

at a meeting that I regularly attended that I was assaulted by 

somebody that I believed was trying to make me—the person who 

assaulted me looked like they were a Boilermaker Local 5 member. 

Senator FITZGERALD. When were you assaulted? 

Mr. SCANNELL. The following Sunday, February 2. 

Senator FITZGERALD. On February 2. 

59

Mr. SCANNELL. My disability is from my assault. 

Senator FITZGERALD. Your disability is from your assault? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. And you had been raising concerns within 

Putnam? 

Mr. SCANNELL. And downloaded documents and, again, that 

they’re well aware that I did, once I left. People were aware that 

I was—I wasn’t going to——

Senator FITZGERALD. Where did the assault occur? 

Mr. SCANNELL. In Quincy, Massachusetts. 

Senator FITZGERALD. OK, and you believe it related to your whistle-blowing activities within Putnam? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. Who do you think were——

Mr. SCANNELL. Actually, I feel kind of uncomfortable talking 

about this in detail, Senator. I’ve included that in my testimony to 

you very——

Senator FITZGERALD. OK. 

Mr. SCANNELL. In descriptive form. It’s another incredible coincidence, and that’s something that a lot of people have wanted me 

to believe that all these coincidences are just that—coincidences. 

And I’m concerned that there’s more to it than that. 

Senator FITZGERALD. Did you tell the SEC when you met with 

them that you had been assaulted? 

Mr. SCANNELL. Yes. 

Senator FITZGERALD. And that you thought it related to your——

Mr. SCANNELL. Yes. 

Senator FITZGERALD [continuing]. Complaints. OK. Well, I compliment you on your courage. I compliment both of you for coming 

forward. I think you have done a great public service by helping 

shed a spotlight on the experiences that you two had within the industry. A lot of this is difficult for people outside the mutual fund 

industry to understand technically how some of these activities, the 

market timing and late trading, actually occur. And both of you 

show a lot of courage by coming forward, testifying before Congress, and we certainly appreciate it. 

Mr. Scannell, we do have your full statement for the record, and 

we can read the details there. And if you have more ideas, please 

feel free to be in touch with my office as all of this progresses. 

Is there anything else either of you would like to add before we 

close up? Well, if not, we will allow you to get on your way, and 

thank you very much. 

Mr. NESFIELD. Thank you, Senator. 

Mr. SCANNELL. Thank you for the opportunity, Senator. 

Senator FITZGERALD. OK. We are set to begin the third panel, 

and I want to begin by thanking all of you for your patience. You 

have probably been waiting here since the first panel, and I know 

it has been a long day. And I am sure many of you traveled a long 

way as well in the inclement weather, so we appreciate all that you 

have done to be here. 

Our first witness on the third panel is Jeffrey C. Keil, who is vice 

president of Global Fiduciary Revier at Lipper, Incorporated, 

headquartered in Denver, Colorado. Mr. Keil has been analyzing 

the mutual fund industry for the past 12 years and has specialized 

60

in mutual fund fees and expenses as well as regulatory and disclosure issues. 

Last week, Lipper released a study on the feasibility of eliminating the 12b–1 fees that mutual fund companies charge to cover 

costs such as marketing and advertising and reimbursements to 

brokers for distributing their funds. We look forward to hearing 

from Mr. Keil on Lipper’s findings in their report. 

Our second witness is Travis B. Plunkett, who is the legislative 

director at the Consumer Federation of America. The Consumer 

Federation of America is an association of 300 organizations that 

work to promote and protect the consumer interests by engaging in 

advocacy, education, and network building. Mr. Plunkett’s focus at 

the CFA is on financial services, including credit reporting, credit 

counseling, and consumer privacy and insurance. 

Our third witness is Paul S. Stevens, who is a partner at Dechert 

LLP, in the firm’s financial services group. Mr. Stevens is with us 

today on behalf of the Investment Company Institute, known as 

ICI, where he served as senior vice president and general counsel 

from 1993 to 1997. While serving in this capacity, Mr. Stevens is 

credited for leading the ICI in its efforts to support passage of the 

National Securities Markets Improvement Act of 1996, as well as 

in the adoption of mutual fund disclosure reforms by the SEC and 

the formation of new industry standards on personal investing. In 

his position at Dechert, Mr. Stevens leads the firm’s practice in the 

areas of mutual fund governance and bank/broker-dealer activities. 

Our fourth witness on this panel is Marc E. Lackritz, who is the 

President of the Securities Industry Association. The Securities Industry Association represents the shared interests of over 600 securities firms, including mutual fund companies, investment banks, 

and broker-dealers. Mr. Lackritz has a great deal of experience in 

the securities industry, having served not only as SIA president 

since 1992, but also as executive vice president to the organization 

and as executive vice president at the Public Securities Association, 

which is now known as the Bond Market Association. 

And, finally, with us today is Professor John Freeman of the University of South Carolina School of Law. Professor Freeman was referred to in remarks by Attorney General Spitzer. Professor Freeman holds the John Campbell Chair in Business and Professional 

Ethics and has taught courses in legal ethics and securities laws 

for the past 30 years. Professor Freeman has an extensive background analyzing mutual fund and other investment issues, and he 

recently co-authored an extensive study entitled ‘‘Mutual Fund Advisory Fees: The Cost of Conflicts of Interest.’’ That was the report 

Attorney General Spitzer was referring to. 

Again, I would like to thank each of the witnesses for being here, 

and in the interest of time, if you could all be kind enough to submit your written remarks for the record and we will include those 

remarks as part of the permanent record of this Subcommittee 

hearing, and if you could summarize those remarks in no more 

than a 5-minute opening statement, we would greatly appreciate it. 

So, Mr. Keil, we will begin with you. Thank you for being here. 

61

1The prepared statement of Mr. Keil appears in the Appendix on page 179. 

TESTIMONY OF JEFFREY C. KEIL,1 VICE PRESIDENT, GLOBAL 

FIDUCIARY REVIEW, LIPPER, INC 

Mr. KEIL. My pleasure. Thank you, Chairman Fitzgerald. Lipper 

appreciates the opportunity to be here and address the Subcommittee today. 

I wish to address four issues vital to the business today in the 

next few minutes: Lipper’s recent study on 12b–1 fees; generally on 

fees and expenses of mutual funds; costs opaque to investors; and 

fund governance. My aim is to clear up some misperceptions about 

these particular topics and outline some recommendations for reform. 

First, with regard to 12b–1 fees, several misperceptions will require a bright light at this time. Rule 12b–1 fees frequently are referred to as an advertising and marketing fee borne by investors. 

Frankly, 95 percent of the fees pay for sales charges, investor service fees, and administration, while only 5 percent actually pay for 

advertising and promotion. 

Second, given this particular reality, saying the 12b–1 sheets 

should create commensurate economies of scale through asset 

growth is effectively outdated since advertising and promotion is 

only 5 percent. 

Finally, funds closed to new investors must continue to provide 

certain service to investors covered by the 12b–1 plan. Hence, some 

plans should be—are justified for closed funds. 

Briefly, the highlights of our study on Rule 12b–1 recommendations update the factors that boards should consider when reviewing and continuing 12b–1 plans, issue more definitive guidelines as 

to acceptable 12b–1 expenditures, provide more investor transparency on the specific uses of 12b–1 fees, and commission a study 

that considers whether sales charges, meaning commissions to brokers actually under the rules, should be removed from underneath 

Rule 12b–1, and generally recraft Rule 12b–1 to account for today’s 

market realities, as it is woefully outdated at this point. It hasn’t 

been updated for about 23 years, if I’m correct. I believe I’m correct. 

Copies of our 12b–1 study have been provided in its entirety to 

the Subcommittee for your review. 

With regard to funds’ management fees and expense ratios, 

based on Lipper expense data, most shareholders are not paying 

more in both management fees and total expenses than they were 

10 years ago. Using funds’ size-weighted ratios, fees for most investors have not risen. When simple average ratios are cited to the investing public and through the press, they are highly skewed by a 

larger proportion of very small funds not held by the vast majority 

of investors. 

To the point about pension funds and mutual funds, we would 

maintain that funds do not necessarily pay substantially more in 

advisory fees than pension funds do. We have maintained that a 

more definitive study still needs to be authored that uncovers all 

reasonable benchmarks to the extent that the data actually is 

available, which is one of the limitations that the data are not 

62

available to a large extent; hence, the ICI study using sub-advisory 

comparisons. 

A full 1.5-percent difference between the industry-wide median 

total expense ratio and a much lower ratio weighted for fund size 

indicates that size economies are being passed to investors. That 

obviously doesn’t address the actual amount of the fee, but there 

are economies of scale that do exist in this business. I see it on a 

daily basis. 

Finally, to extend the economies-of-scale argument to an entire 

fund business based on aggregate assets of the business is illogical. 

Scale is realized on the fund and the complex level only, not the 

entire business. This business has quite a few hundred variable 

very small fund complexes which have not reached any serious 

asset threshold, and there are very few economies to be had. Simple as that. 

As far as Lipper’s recommendations, we support initiatives to report hypothetical expense levels in dollars in shareholder reports. 

We suggest an aggressive investor education initiative on cost impacts on returns be launched. That comes from comments earlier. 

Last, we feel enhanced disclosure should be provided in the prospectus on expense benchmarks. This comes from earlier discussion 

as well so that investors know, in relation to some type of average 

or index, what are they paying. 

With regard to costs opaque to investors, I would certainly echo 

the sentiment today that most of the lack of transparency centers 

around brokerage fees. There are very few misperceptions about 

brokerage fees because, frankly, there isn’t a lot of disclosure about 

brokerage fees. We recommend transparency of all brokerage arrangements. That includes soft dollars, directed brokerage, etc. 

Boards should review all brokerage arrangements and ensure 

shareholder interests are protected. Regulation considering requiring the quantification of brokerage costs based on consistent algorithms across all complexes. And to the benchmarking comment, 

require brokerage costs be reported as a ratio in the prospectus 

alongside the total expense ratio, again, for comparative purposes. 

And, finally, with regard to fund governance, we recommend the 

following: We support the appointment of chief compliance officers 

reporting directly to independent trustees or directors. We also support calls for board administrative support and a 75-percent independent majority. We urge formal independent certification of 

board members’ financial and fiduciary knowledge. Election of 

board chairpersons by independent board members would allow 

outside directors to determine whether they function more effectively with inside assistance or are hindered. 

We feel, in line with several comments today, we think that the 

general level of fiduciary duty of boards needs to be elevated. We 

do not feel, however, that advisory contracts should be put out for 

bid. We feel market forces and investor demand should set prices. 

We feel we can strengthen the current board structure through 

clear oversight guidelines. And probably the punch line, perhaps, 

of my oral testimony, we do not endorse or support punitive damages levied through indiscriminate advisory fee reductions unrelated to trading charges. Damages do not replace board activism. 

Rather, we feel if fees are reviewed by regulators as unreasonable, 

63

1The prepared statement of Mr. Plunkett appears in the Appendix on page 205. 

we feel a structured and equitable solution be designed to provide 

boards with a road map for ensuring reasonable costs are borne by 

investors and market forces are left to their own devices. 

In closing, we wish to caution legislators and regulators to proceed with care. Quickly assembled reforms may have unintended 

consequences and costs unforeseen during this period of improprieties and investor outcry. We fully support reform of the mutual 

fund business to the extent it bolsters competition, protects investors, and strengthens the business long term. 

Thank you. 

Senator FITZGERALD. Mr. Plunkett. 

TESTIMONY OF TRAVIS B. PLUNKETT,1 LEGISLATIVE 

DIRECTOR, CONSUMER FEDERATION OF AMERICA 

Mr. PLUNKETT. Good afternoon. I am Travis Plunkett, legislative 

director of the Consumer Federation of America. I want to congratulate you, Mr. Chairman, and Ranking Member Senator 

Akaka, for holding hearings on a mutual fund scandal that does far 

more harm to its victims than the recently revealed trading abuses, 

as shocking as those are. That is the scandal of how mutual funds 

are sold to unsuspecting investors and the high costs that result. 

My concern today is primarily with the nearly 50 percent of mutual fund transactions that are conducted between broker-dealers 

and retail investors. What sets these transactions apart is the veneer of impartial advice that attaches to them. Despite their fancy 

titles and polished advertising campaigns, however, broker-dealers 

are not advisors. They are salespeople. And the overwhelming evidence now suggests that all too many brokers select mutual funds 

and other products they recommend not based on which offer the 

highest quality at the lowest price, but on which funds offer lucrative financial incentives to the brokerage firm and the individual 

sales representative. This is a phenomenon sometimes called ‘‘reverse competition.’’

This is allowed to occur because only a relative small portion of 

the mutual fund marketplace could be said to be truly cost competitive right now, and that is the 13 percent of mutual fund transactions that occur directly between the fund company and the retail investor outside of any employer-sponsored retirement plan. 

In the growing number of fund transactions that occur through 

retirement plans, however, investors generally have very limited 

options and, therefore, cannot effectively make cost-conscious purchase decisions. And in the rest of the market, funds that rely on 

broker-dealers and other salespeople outside of company-sponsored 

retirement plans, as I mentioned, this portion of the market competes in ways that drive costs to investors up, not down, through 

a number of mechanisms we have heard about today: Sales loads, 

12b–1 fees, payments for shelf space, and directed brokerage. This 

allows mediocre, high-cost funds to survive and even thrive that 

could not do so in a truly competitive market. 

Another major factor undermining effective competition is the 

lack of good disclosure, either of mutual fund costs or of the conflicts of interest that can bias sales recommendations. For discloVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00067 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
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sures to be effective, they must provide the information investors 

need, in a form they can understand, at a time when it is useful 

to them in making their purchasing decisions. Mutual fund costs 

and conflict disclosures fail all three tests. In particular, they leave 

out key information, such as expense portfolio transaction costs. 

Now, let’s talk a little bit about the SEC’s regulatory response. 

Initially, the SEC was slow to acknowledge the need for fundamental cost disclosure and governance reforms. Although the Commission now appears to be making important progress on these and 

other issues, there are still serious gaps in their regulatory agenda. 

For example, the SEC does not have the authority to strengthen 

the definition of independent director, as legislation introduced by 

Senator Akaka and Chairman Fitzgerald would. 

Even if the Commission’s promising disclosure proposals on 

broker conflicts of interest are offered—and we are waiting for the 

actual details there—they appear to have serious holes. We will not 

know for sure until the rule is proposed, but it does not appear 

that the Commission intends to include information about the nondistribution-related expenses of the fund, the annual expense ratio, 

in either the point-of-sale document or the confirmation statement. 

If the Commission is going to take the unprecedented step of requiring point-of-sale disclosure, it should do more to ensure that it 

covers all the information investors should have prior to sale, including information on investment risks, for example, and comparative information on fund costs, not just sales incentives. Congress should build on what the Commission has begun and ensure 

that all the key information investors need pre-sale is included in 

these reports. 

Chairman Donaldson has indicated the agency will study use of 

soft dollars, but the SEC does not have the authority to repeal the 

safe harbor for this unacceptable conflict of interest. Congress 

should. 

A major shortcoming of the SEC approach is that it relies exclusively on better disclosure of broker-dealer conflicts of interest 

rather than on bans of conflict-inducing practices. Such an approach ignores the fundamental reality of how investors relate to 

brokers and the degree to which they rely on them for advice. We 

doubt that even the best disclosures will be able to overcome multimillion-dollar advertising campaigns that encourage investors to 

view financial professionals as objective advisors. It is long past 

time to require brokers to either live up to the advisory image they 

project and accept the attendant responsibility to make recommendations that are in their client’s best interest or to cease 

misrepresenting themselves to clients as advisors. 

One timely idea is to get mutual funds out of the business of determining distribution prices entirely, not just by eliminating 12b–

1 fees, directed brokerage, and payments for shelf space, but also 

by getting funds out of the position of determining commission levels altogether. 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 funds might have to compete accordingly by offering a quality 

product and good service at a reasonable price. 

65

1The prepared statement of Mr. Stevens appears in the Appendix on page 224. 

I want to thank the Subcommittee again for exploring these important issues, and we look forward to working with you as you 

move forward. 

Senator FITZGERALD. Thank you, Mr. Plunkett. Mr. Stevens. 

TESTIMONY OF PAUL SCHOTT STEVENS,1 PARTNER, DECHERT 

LLP, ON BEHALF OF THE INVESTMENT COMPANY INSTITUTE 

Mr. STEVENS. Chairman Fitzgerald and Ranking Member Senator Akaka, thank you very much. 

I think it is appropriate to begin by underscoring on behalf of the 

Institute its strong support for the ongoing efforts of Federal and 

State Government authorities to root out abusive trading practices 

affecting mutual funds. The Institute is committed to taking whatever steps are necessary to prevent such abuses in the future and 

to fulfill the industry’s fiduciary obligations to its tens of millions 

of fund shareholders. The SEC has moved swiftly across a broad 

front to bolster regulatory protections, and the Institute pledges its 

cooperation as Congress, the SEC, and other interested parties 

work to restore and maintain the confidence of fund investors. 

I welcome the opportunity to present the Institute’s views on mutual fund fees and expenses. My written testimony goes through a 

whole variety of issues. There are three in particular that I would 

like to emphasize here. 

First, although you might not know it from this morning’s discussion, we all should recognize that this is at least a glass that is 

half-full. Indeed, fully informing investors about mutual fund fees 

and expenses has been a long-time objective of SEC regulations. 

Current regulations, including the very prominent standardized fee 

table that appears in every mutual fund prospectus, assure a high 

degree of transparency about the costs of mutual fund investing. Is 

there more that might be done? This is the question that, Mr. 

Chairman, your hearing poses. Yes. And the SEC is developing a 

variety of new additional disclosure requirements. Maybe there are 

things that the SEC has not yet considered or proposed that should 

be added to that. Fair enough. But building on existing regulations, 

these and other reforms, it seems to me, will provide a level of information to fund investors that is unrivaled by any other financial 

product. I am more than prepared to discuss the details, but I want 

you to know that the Institute strongly supports precisely that objective. 

Second, with respect to recent research on trends in mutual fund 

costs, I believe the consensus of all serious recent research is that 

the costs of mutual fund investing have trended downward significantly over the past 20 years. The Institute’s own extensive published research supports this view. So, too, does the independent 

analysis that has been conducted by the SEC and the GAO. And 

it is fair for us to ask, why is that? Well, I believe there are a variety of market forces at work in producing this result, including, 

among others, the healthy level of competition that exists among 

fund providers, and the very widespread availability to investors of 

information about mutual fund costs, performance, and services. 

66

In fact, if you look at trends over that 20-year period, the fact 

that mutual fund shareholders are now heavily invested in the lowest-cost funds suggests that they and their financial advisors understand and recognize the importance of fund fees. 

Finally, Mr. Chairman, in light of the interest in this topic that 

has emerged during this hearing, I want to address how mutual 

fund fees compare with those of pension managers, other institutional investment managers, as well as—and this is a subject to 

which you have returned a couple of times—those that are associated with the Federal Thrift Savings Plan. 

My colleague, Professor Freeman, on this panel and others have 

contended that differences between the ‘‘investment advisory fees’’ 

paid by a pension plan and the ‘‘management fees’’ paid by a mutual fund indicate that mutual funds are overpriced. The analysis 

is provocative. It is one that Attorney General Spitzer has cited numerous times. But, unfortunately, the analysis is seriously flawed. 

The two types of fees that Professor Freeman and his colleagues 

compare are fundamentally different. A pension plan’s ‘‘advisory 

fee’’ primarily covers portfolio management services. I have been a 

mutual fund lawyer for 25 years, and I know that, by contrast, a 

mutual fund’s ‘‘management fee’’—that is, the number that is reported in a fee table, the number available through Morningstar—

covers a host of additional costs that are spelled out in the fund’s 

contract with its manager. These can include a whole variety of 

things: Pricing the fund, providing it office space and equipment, 

providing a clerical staff and bookkeeping support, defraying the 

salaries of fund officers and directors, and paying for legal and regulatory compliance, which in the case of a fund is no small undertaking. And these are to name just a few. 

The comparison drawn in Professor Freeman’s study is for this 

reason incorrect and misleading. The ICI study that Attorney General Spitzer referred to earlier—and invited you, Mr. Chairman, to 

ask me about—is a study that makes precisely the point I just 

made: That this is an apples-to-oranges comparison, and the data 

is not normalized, if you will, in order to draw any inferences. 

Now, the ICI study also suggests that if you compare the pure 

investment advisory fees of a pension plan with some equivalent in 

the mutual fund arena, the two would appear to pay comparable 

amounts for similar portfolio management services. Attorney General Spitzer and, I suspect, probably Professor Freeman, don’t accept that comparison, but even if they don’t, it doesn’t make the 

comparison drawn in Professor Freeman’s article accurate. The fact 

of the matter is the comparison he was drawing is just simply misleading. 

Now, what about institutional versus retail money management? 

This is important and it is a subject that Attorney General Spitzer 

addressed this morning. 

Institutional investment managers and retail investment managers occupy a very different space, and I think it is a truism in 

the business that it is much more difficult and expensive to deal 

at a retail than it is an institutional level. And if you think about 

it for a moment, it is intuitively obvious why that is the case. 

First of all, retail assets are much harder to attract. They are out 

there in a much more disparate universe, belonging to households 

67

and individuals. Institutional assets come from institutions, of 

which there are fewer, and they are more readily identifiable and 

approachable. 

Retail assets are also harder to manage. In a mutual fund form, 

for example, a high percentage of the assets has to be maintained 

in a liquid form. That is under SEC rules. But it is also to provide 

the daily transaction capabilities and redemption capabilities that 

a mutual fund promises to its investors, which institutional managers don’t have to deal with. 

They are also more difficult to administer, again, because of legal 

and regulatory issues, and they are harder to retain. Individual 

mutual fund investors make decisions every day about redeeming, 

exchanging from one fund to another, or moving to another manager, and the open-end form of their funds assures them the ability 

to do that. Institutional money, however sticky it may seem retail 

mutual fund money is, is far stickier. 

Now, if it were, in fact, the case that institutional money managers’ fee schedules are so much more reasonable by comparison to 

retail managers, you would think institutional money managers 

would be making a lot—retail money managers, rather, would be 

making a lot more money. That is simply not the case. We can provide for the Subcommittee’s consideration after these hearings information concerning this point. Capital Resource Advisors conducts an annual survey called ‘‘Competitive Challenges,’’ where it 

addresses these issues, among others. 

In 2001, on average, as a percentage, retail investment managers’ total operating profit margin was 22.3 percent. Institutional 

managers’ profit margin you would think would be less if their fees 

were so much more reasonable. Well, it was not. It is 29.5 percent. 

In 2002, the comparison was 16.5 to 28.5. The truism is, I think, 

demonstrated in the profitability of the businesses. The retail part 

of investment management is simply a much more expensive and 

difficult exercise. 

And then, finally, Mr. Chairman, I know my time is up, but let 

me say just a few things about the Federal Thrift Savings Plan. 

When I was at the Reagan White House for 3 years, I participated in the Federal Thrift Savings Plan, so I know it from the 

point of view of an investor as well. 

Senator FITZGERALD. Do you still have it, or did you get rid of 

it? 

Mr. STEVENS. Well, as you know, President Reagan has been out 

of office a long time, and since I hadn’t been back in Federal Government any longer, I did cash out my interest in the plan. 

Senator FITZGERALD. OK. 

Mr. STEVENS. Maybe that was a mistake, but it is a decision I 

made. 

Senator FITZGERALD. It almost assuredly was a mistake. 

Mr. STEVENS. Well, perhaps. 

But I think one of the things that it reinforces to me, at least, 

my familiarity with both the Thrift Savings Plan and the retail 

mutual fund business, is that they are very different animals. For 

example, all of the Thrift Savings Plan’s portfolios are indexed, and 

all of them are very large. That is not true with retail mutual 

funds. 

68

1The prepared statement of Mr. Lackritz appears in the Appendix on page 250. 

Many of the costs that we think of in a mutual fund arena as 

administrative and distribution costs are actually subsidized by the 

Federal Government. They are borne by the agencies whose employees participate in the Thrift Savings Plan and are never taxed 

back to the expense ratios of the portfolios themselves. So there is 

a governmental subsidy. I am not saying it is inappropriate. It just 

does not appear in the performance figures. 

And then, finally—and this is significant as well—there are no 

regulatory or related costs in running the Thrift Savings Plan. And 

I want to tell you, 25 years of being a mutual fund lawyer underscore to me those costs are not insignificant. 

So at least some observations, Mr. Chairman, that may be of use. 

Thank you. 

Senator FITZGERALD. I will hold my rebuttal until all the witnesses have finished, but thank you very much for that very good 

presentation. 

Mr. Lackritz, thank you very much for being here. 

TESTIMONY OF MARC E. LACKRITZ,1 PRESIDENT, SECURITIES 

INDUSTRY ASSOCIATION 

Mr. LACKRITZ. Thank you, Mr. Chairman and Ranking Member 

Senator Akaka. Thank you very much for the opportunity to testify 

today on behalf of the Securities Industry Association. 

First of all, let me begin by commending you and your Subcommittee for your long tradition of protecting the public, and I 

would add we look forward to working with you and your colleagues and the other committees in the Senate and the Commission to restore the public’s trust and confidence in the Nation’s securities markets and in mutual funds. 

Our members, Mr. Chairman, underwrite securities—stocks and 

bonds—to raise funds—capital—for private companies and public 

bodies. These entities use the funds we raise to expand and grow—

hiring new workers, investing in new equipment, and building public works. Our industry has raised more than $21 trillion over the 

last 10 years to finance innovation and growth in the form of new 

enterprises, new processes, new products, and new bridges, roads, 

hospitals, and schools. 

We also help individual investors achieve their financial goals, 

such as planning for a child’s education or for a comfortable retirement. Thus, as intermediaries between those who have capital on 

the one hand and those who need it on the other, we serve the very 

essential function of channeling capital to its most productive uses. 

The securities industry is based on two bedrock principles: Disclosure and competition. The format of securities regulation was articulated by Justice Louis Brandeis back in the early part of the 

20th Century, and the architecture of the securities laws reflect, 

that you need both full disclosure and vigorous competition. Justice 

Brandeis was also credited with the notion that sunshine is the 

best disinfectant, electric light is the best revealer. I think in this 

discussion that we are having about what to do in this area, Justice Brandeis’ teachings are actually very relevant here, that, in 

fact, what we need is more transparency and what we need is betVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00072 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
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ter disclosure, because public trust and confidence are really the 

bedrock principles on which our market participants succeed, and 

as long as the same rules are vigorously and fairly applied. 

Mutual funds are the vehicle by which an overwhelming majority 

of investors participate in our markets. Nine out of ten investors 

have at least some money in stock mutual funds, and just over half 

invest exclusively in funds. As a result, the health of our securities 

markets depends to a great extent on the public’s continued robust 

participation in mutual funds. Yet, as we know from these hearings 

and other disclosures, not all is well with mutual funds. Revelations of wrongdoing, including late trading and market timing, contrary to fund prospectuses, as well as other practices, have shaken 

investors’ confidence in many fund organizations and in the intermediaries distributing the funds. 

To restore public trust and confidence in funds and their distributors, the interest of investors must come first. Investors must 

be assured, Mr. Chairman, that fraud, self-dealing, and dishonesty 

will not be tolerated and will be vigorously enforced and punished. 

Investors should be treated fairly and should be given complete, 

clear, and useful information about the funds that they buy. All aspects of the mutual fund business, including fund fee structures, financial incentives offered to intermediaries, fund investment and 

redemption policies, and fund governance must be as transparent 

as possible. And all investors should be assured of prompt execution in fair pricing of their fund transactions. 

We think a two-pronged approach is necessary to restore the 

public’s trust in mutual funds. First, swift, sure, and tough enforcement actions are the proper remedy to address clear violations of 

the law. I might add that, in addition to tough enforcement and 

swift enforcement, the time has come to implement some necessary 

reforms as well. 

We support efforts to improve disclosure and sales and trading 

practices to ensure that investors’ interests come first. Specifically, 

investors should have clear, direct, timely information in a useful 

format that allows them to comparison shop and that promotes 

consumer choice and competition. Disclosure must be easily accessible and investor friendly rather than a ‘‘Where’s Waldo?’’ search 

through fragments of disclosures and long prospectuses and long 

legalese for relevant information. 

In that vein, we strongly support efforts to enhance the transparency of revenue sharing agreements, including the nature of 

services received and differential compensation arrangements. 

Such disclosures should be uniform across regulatory agencies and 

should focus on arrangements that are likely to influence recommendations made to investors. Disclosures should provide investors with material information that they need. Finally, investors 

should have full, clear, and useful information on mutual fund fees, 

since they will have a significant effect on the investor’s return. 

With respect to both soft dollars and directed brokerage, the key 

investor protection here is to maintain best execution for the customers. We believe that soft dollars are both pro-investor and procompetitive, particularly for third-party research, as we heard earlier. But advisors, fund trustees, and broker-dealers must always 

70

1The prepared statement of Mr. Freeman appears in the Appendix on page 266. 

put investors first. Thus, we support improved disclosure of softdollar arrangements to both investors and to fund trustees. 

We have been appalled by reports of late trading of mutual fund 

shares. As Attorney General Spitzer noted earlier, such activity is 

the equivalent of betting on a horse race after it is over. Reforms 

should make late trading virtually impossible to achieve. At the 

same time, we believe strongly that any reforms here should not 

penalize innocent investors, particularly those in 401(k) plans or 

529 plans or those who buy their mutual funds from broker-dealers 

rather than directly from funds. 

We look forward to working with the SEC and your Committee 

to eliminate late trading in a way that protects all investors and 

does not create competitive disadvantages for some. Late trading 

has had a terribly corrosive effect on investor confidence, and we 

must find and implement an effective remedy now. 

Mr. Chairman, we are very proud of the capital our industry has 

raised, the jobs we have helped create, the innovation and growth 

we have helped foster, the new products and services we have 

made available, and the dreams we have helped our consumers 

achieve. Yet, we abhor the abusive activities involving mutual 

funds that you have shone a spotlight on. We urge the SEC, the 

NASD, and State authorities to continue to bring wrongdoers to 

justice swiftly and surely. And we are eager to do our part to improve mutual funds so that they can continue to be an effective investment vehicle for all Americans. 

Thank you very much. 

Senator FITZGERALD. Thank you, Mr. Lackritz. Professor Freeman, thank you for being here. 

TESTIMONY OF JOHN P. FREEMAN,1 PROFESSOR OF LAW, 

UNIVERSITY OF SOUTH CAROLINA LAW SCHOOL 

Mr. FREEMAN. Thank you for inviting me, Mr. Chairman and 

Ranking Member Senator Akaka. I am delighted to be here with 

you. 

The issue isn’t whether or not we should thoroughly regulate mutual funds. As my formal statement points out, there isn’t an issuer 

of securities in the United States that is subject to more detailed 

regulation than mutual funds. They are the most heavily regulated 

financial product in our economy, and all this regulation and all 

this attention has gotten us a train wreck and a scandal that is beyond belief for somebody like me who has been watching and writing about the fund industry for about 35 years. 

Where to start? Basically, it is conflict of interest. Conflict of interest, conflict of interest, conflict of interest. Fiduciary duty, fiduciary duty, fiduciary duty breaches. The bigger the fund, the more 

money under management, the more the advisor makes. Raising 

that money, bringing that money in, means getting dollars in the 

hands of people who sell the funds. When I was working at the 

SEC on mutual fund distribution in the summer of 1977, this quote 

came in, which I have never forgotten and have often repeated: ‘‘To 

close one’s eyes to the reality’’—this is from the industry—‘‘that 

salesmen in the mutual fund industry have traditionally sold prodVerDate 0ct 09 2002 10:12 May 26, 2004 Jkt 092686 PO 00000 Frm 00074 Fmt 6633 Sfmt 6633 C:\DOCS\92686.TXT SAFFAIRS PsN: PHOGAN
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ucts which pay the most money is to regulate without a sense of 

what the industry is about.’’

Now, there has been talk about overcharging and fees, and let’s 

talk about that. I have been criticized and called irresponsible by 

the ICI. And speaking of conflict of interest—you alluded to this 

earlier, Mr. Chairman—here is an entity that takes money from 

fund shareholders and uses that money unceasingly to protect the 

interests of sponsors who are exploiting those fund shareholders. I 

say the ICI epitomizes problems of conflict of interest in the mutual fund industry, and anything they say should be taken in light 

of that. 

But let’s talk about their criticisms. They say: ‘‘Oh, Freeman’s 

got it wrong, he’s too stupid, maybe, he’s irresponsible. He’s been 

dealing with this topic for 35 years. He’s been teaching securities 

regulation in law school for 30 years. He’s been writing about this 

for a long, long time. He’s working with a guy who’s a Ph.D. and 

a chartered financial analyst. But they just can’t get to the bottom 

of it. They just can’t figure it out.’’

Well, let’s assume that is true. If we can’t figure it out, who on 

Earth can? Your average investor? No. Your average State regulator? No. The SEC itself, where I used to work, have they figured 

it out? I question that. 

Now, let’s talk about the irresponsible statements in our report. 

We had a statement in our report that was to the effect that mutual fund shareholders—and this is the direct quote—‘‘pay nearly 

twice as much as institutional investors for money management. 

And that calculation doesn’t even include any front- or back-end 

sales charges you may also pony up.’’ And that was about our finding, and it is about double. And you say, well, Freeman and Brown, 

they don’t know any better. That quote came from Ruth Simon. It 

was published in Money Magazine and is in Footnote 10 of our article. That was published in Money Magazine in 1995. It is so well 

known that the funds have been gouging their shareholders that 

when the Wall Street Journal wrote a story about our article—

which is unusual for national press to write about a law review article—they did it in 2001, and the headline was, ‘‘This is news? 

Study finds mutual fund shareholders being overcharged on fees.’’ 

In other words, I mean, come on, guys, come up with something 

original. 

What we cited in our article, besides Ruth Simon and a lot of 

data talking about profitability, in the article is some evidence that 

when fund management companies are sold out, they command 

double the multiple for other institutional management companies. 

The marketplace values the lucrativeness of mutual fund management when the marketplace buys out these people. But we also 

quoted and referred to the Wharton Report, going back 30 years—

and you have heard references today—the Public Policy Implications Study. And what did those things find? What they found was 

the same thing we found: Fund shareholders being gouged, paying 

prices far in excess of other institutions. 

Now, the question is—it has been raised. Mutual funds are all 

these little people and you get these big institutions, they should 

be paying less. Well, let’s take a look very quickly at that one. 

72

In the case of Alliance Fund, Alliance was charging the Alliance 

Fund shareholders 93 basis points, and Alliance was managing 

something like $16 billion. What was the fee? It was around $160 

million a year for the Alliance Fund. The same management company using the same processes and the same theories and everything was managing a portfolio of about $900 million for the Wyoming Retirement Plan for 10 basis points. So the fund shareholders 

at Alliance are paying $160 million or so a year, and the people at 

the Wyoming Retirement Plan are paying around $900,000 for the 

same services. 

Now, wouldn’t you think some fund director might say to Alliance, ‘‘Why don’t you give us a 10-basis-point price?’’ But that apparently hasn’t happened. 

One thing that has been alluded to, but not said expressly—it is 

in our article; Mr. Spitzer has referred to it previously. Most-favored-nation treatment. Every mutual fund director should require 

the advisor, if the advisor is selling similar services in the free 

market, should require the advisor to give the board those prices 

and to justify the price differential between the prices that are 

being charged in the open market to the Wyoming Retirement Plan 

and the prices that are being charged or would be charged to the 

fund’s shareholders. In other words, you want 93 basis points from 

us to manage $16 billion, but you are only charging them 10 basis 

point to manage $900 million. You are going to make a lot more 

money. Would you explain to us why this makes any sense? 

I could say a lot more. I will reserve my comments for answering 

questions. 

Senator FITZGERALD. Well, I can tell this is going to be a lively 

question and answer session. I appreciate that, Professor Freeman. 

It was very good. 

I would like to start with Mr. Stevens. Let’s go back to the point 

that Professor Stevens raised, picking up on something that I said 

earlier. 

Mr. STEVENS. Professor Freeman. 

Senator FITZGERALD. I am sorry. 

Mr. STEVENS. I am Stevens. 

Senator FITZGERALD. I am sorry. Professor Freeman raised this 

issue, which I alluded to earlier, which is that dues to the ICI are 

paid by mutual fund companies by deducting money from mutual 

fund shareholders, and then the ICI gets all this money and, in effect, your interests are really adverse to mutual fund shareholders’ 

in America, aren’t they? You are a lobbying group that represents 

the managers of mutual funds and the mutual fund companies 

themselves, as opposed to the shareholders. 

Mr. STEVENS. Mr. Chairman, I appreciate the chance to respond 

to this. It is almost a point of personal privilege on behalf of my 

client. 

The ICI was organized in 1940, essentially at the request of the 

SEC, because when the 1940 Act was passed, it needed an interlocutor, an industry representative, in order to begin developing the 

highly complex series of rules that were necessary to implement 

the Act. At that time, the Institute was organized to represent the 

interest of funds and their advisors, and it has continued to do so. 

73

One premise, though, of the critics of the ICI in this regard is—

and I think it has been asserted numerous times today—that advisors’ and funds’ interests are antithetical across the board. 

If you think about it for a moment, I think you would realize 

that is not the case. Certainly they may be antithetical with respect to the price. It is the fund shareholders’ interest to get the 

lowest possible price, and perhaps the manager wants to get a 

higher one, perhaps even the highest possible. But with respect to 

many other areas, I think their interests are common. 

For example, it is obviously in the managers’ interest to get the 

best performance. Why? Not only because it serves the consumers 

best, but it is the best way that we know in this business of getting 

more consumers and attracting more assets. They have a joint interest in good shareholder service as well, for exactly the same reasons. Mutual fund investors are highly demanding in terms of the 

range and quality of the services. And, finally, to a very high degree, there is a common interest with respect to regulatory compliance. Either the fund or the advisor, or both, will pay the consequences if there isn’t such compliance. 

But now let me talk about what the ICI stands for and has stood 

for in that regard, and I speak from my own personal experience, 

but I think we could multiply the examples across a whole range. 

First, for many years, the Institute was up here on behalf of 

funds and their shareholders and their advisors urging the Senate 

and House of Representatives to greatly increase appropriations for 

the Securities and Exchange Commission because of their concern 

that the growth of funds, the growth of advisors, investor dollars, 

and investments was far out-stripping anything that the SEC had 

to bring to bear to inspect, examine, and oversee the industry. 

Those calls are matters of record, and they went largely unheeded 

for a long period of time as funds continue to grow. 

I congratulate the Senate for having appropriated just this week 

over $800 million to the SEC, and we are catching up and we are 

giving the regulators the resources they need. That had been a bedrock of the ICI’s legislative policy for a long time. 

But there are several other examples I can give you. One of the 

things that the SEC and the NASD both are rightly credited for 

and encouraged about is this notion that there should be point-ofsale disclosure of revenue sharing; that is to say, amounts that a 

mutual fund advisor out of its profits pays to a broker-dealer in 

connection with its marketing of the fund. 

What has never been acknowledged by the SEC or the NASD—

or, for that matter, even in the press—is that in 1996, 8 years ago, 

that was a regulatory recommendation that the ICI made to the 

NASD and they never acted on, and I will be happy to provide you 

information in that regard. 

Another example—and, by the way, that was from my tenure as 

general counsel of the ICI. 

Another example: the compliance rule. Many people here today, 

including Jack Bogle, have said what a great idea, we need compliance programs that are consistent throughout funds. And we agree, 

frankly. But the germ of that idea was advanced to the SEC almost 

10 years ago by the ICI in a proposal that I personally worked on 

74

and was transmitted to the SEC, and the SEC did nothing about 

it for a long period of time until the current scandals. 

Now, that is fine. I am not criticizing the SEC, and I am giving 

Chairman Donaldson all the credit for moving in the direction that 

he has. But it was an idea that came from the industry through 

the ICI, and we will provide information in that regard as well. 

And there are other examples, too: simplified disclosure for fund 

shareholders and reforms of the prospectus, new standards for personal investing, support for best practices with respect to the governance of funds. 

These are not proposals that advanced the selfish interests of advisors. They advanced, in fact, the common interests of advisors 

and funds and their shareholders and were all, as a matter of 

record, things that the ICI supported. 

So I reject the notion, frankly—and I kind of resent the ad 

hominem argument that is involved—that the ICI somehow or 

other is nefariously accepting some people’s monies to advance another’s causes. 

With respect to the issue of dues, as a result of the history of the 

Institute, it is indeed true that there are different sources of funding. Some are paid by fund shareholders. Some are paid by fund 

advisors. And those decisions are made at the fund complex level, 

not at the level of the ICI. 

Senator FITZGERALD. Professor Freeman, do you think ICI dues 

should have to be paid out of the advisor’s own money as opposed 

to out of their shareholders’ money? 

Mr. FREEMAN. Yes, I think that that they are a lobbying organization for the advisors, for fund sponsors, and they ought to take 

that money and just be straight up about it, and not pretend that 

they are actually representing the interests of fund shareholders, 

because I don’t see it. 

Senator FITZGERALD. Mr. Plunkett, do you have a thought on 

that? 

Mr. PLUNKETT. To the best of my knowledge, we don’t have a position on this. I think Mr. Stevens raises an interesting point——

Senator FITZGERALD. I thought you were going to recommend 

that we pass a law imposing a one one-thousandth of a basis point 

fee on all mutual fund shareholders and give it to the Consumer 

Federation of America. 

Mr. PLUNKETT. Oh, it wouldn’t have to go to us. It could go to 

a shareholder directed organization. I think the point that there 

are economic—that interests do diverge at the basic economic level 

means that public policy-wise, the ICI and consumer interests often 

diverge. They don’t always diverge but often do. And I think that 

is an important point to note since we are talking about public policy here. 

Mr. STEVENS. Mr. Chairman, if I could just respond. 

Senator FITZGERALD. Do you have any fund shareholders on your 

board, Mr. Stevens, at the ICI as opposed to fund advisors? 

Mr. STEVENS. We have independent fund directors on the board. 

We do not have fund shareholders who are representatives on the 

board. 

Senator FITZGERALD. OK. 

75

Mr. STEVENS. But, Mr. Chairman, if I could just say, I think in 

order to resolve this issue of what the ICI stands for, you have to 

ask yourself in specific cases: What was the position that they 

took? I have offered to provide you the additional evidence, I suppose, of the public policy positions that the ICI has stood for. 

It is also, I think, fairly clear in this current crisis, post-September 3, 2003, where the ICI has stood with respect to a whole 

range of issues. There has been no blinking there and no trying to 

log roll with respect to protecting advisors, much less ones who 

have fallen afoul of the law. It is the Institute, for example, who 

has recommended the hard 4 o’clock close, for which it has been 

criticized by many other participants in the industry for prescribing 

medicine that is simply too strong. 

We also have recommend—and the SEC, I am pleased, is considering this—that there be a mandatory redemption fee for mutual 

fund investors who come in and out of a fund within a 5-day period 

to make it very clear that this is not a short-term transactional vehicle, it is for longer-term shareholders, and to put a friction cost 

in place that would prevent their being abused. 

We have recommended stronger regulations with respect to the 

investments by fund insiders in their own shares so that there is 

oversight, so there is transparency in that regard. And, most fundamentally, we have said loudly and clearly from the very beginning, if any member, any participant in this industry has violated 

the law, they should have the book thrown at them. We make no 

apologies for that whatsoever and supported General Spitzer and 

Chairman Donaldson in the most aggressive enforcement activities 

that they are undertaking with respect to the industry. 

Senator FITZGERALD. Senator Akaka. 

Senator AKAKA. Thank you very much, Mr. Chairman. Again, I 

want to add my praise to you for holding this hearing. 

Mr. Plunkett, in addition to improving the governance structure 

of mutual fund companies and increasing meaningful, relevant, and 

understandable disclosures, what should be done to improve the financial and economic literacy of investors? I ask this of you because you represent the Consumer Federation of America and what 

we want to do is help the consumers of this country. 

Mr. PLUNKETT. Well, thank you, Senator Akaka, for the question. 

We have spent a lot of time on questions of investor education and 

financial literacy. The key here is to examine the experience of less 

sophisticated investors when developing educational programs. We 

know that a portion of investors are making sound decisions, either 

because they have the sophistication to do it on their own or because they are getting good financial advice from financial professionals. That is fine. 

In looking at how to improve investor education, however, and 

how to improve disclosures in particular, we need to start by looking at the experience of those many investors who are making poor 

decisions. I am thinking here of the investor who winds up in an 

S&P 500 index fund with a 2-percent expense ratio, for example. 

We need to know what sources of information they are relying on 

and how they make decisions before we can educate them to make 

better decisions. And we believe any efforts in this area should 

start from a study of those issues. 

76

Mr. LACKRITZ. Senator Akaka, could I intervene? I would say 

that improving investor education and financial literacy is one of 

the top priorities of our organization. We have a website that provides first-class investor education without selling anything, and 

describes the basic things people should know. It is available free 

to anyone. It is called siainvestor.org. 

We also have a foundation for investor education, and we run a 

program in schools, an exercise in schools, that involves economic 

education that teaches kids from middle school through high school 

about the differences between saving and consumption, about interest rates, about compounding, about the difference between equities and debt, all that kind of thing. Currently, we have 550,000 

kids every year that engage in this program, and we are trying to 

expand it. We have, I think, a program active in Hawaii, too. We 

would be happy to talk to you about that and see if we could help 

you see a demonstration of the program in a school. 

Senator AKAKA. I am glad that you brought this up, and I will 

ask others to comment on this. Let me ask Mr. Stevens the same 

question I asked Mr. Plunkett. You are representing another side. 

What do you believe must be done to improve the financial and economic literacy among investors? 

Mr. STEVENS. Well, It is a daunting challenge, Senator, I grant 

you that, and the Institute has many programs supporting investor 

education initiatives that are similar to those in the Securities Industry Association. And I grant you that in many respects mutual 

funds are complex products, so they are hard to know, hard to understand. 

Our appetite as a government—and I am thinking now of the regime that the SEC administers—has been to devise a disclosure 

document, the prospectus, and as Jack Bogle said, throw everything including the kitchen sink in it and hope that people will 

read it and understand it. 

The challenge is not so much making sure the information is out 

there. I grant you, it should be out there, and it should be accessible. But, beyond that, with respect to a more complex financial 

product, crafting a set of information which covers the key points 

that an investor needs to know, this was one of the things that we 

worked on extensively when I was at the ICI. It was called the profile prospectus. It was eventually adopted in the SEC rules in another way as the front end or summary of existing prospectuses, 

and it tried to select all the key information. 

Much of what we are talking about here, by the way, it seems 

to me, while it is information that ought to be out there, I would 

agree with Mr. Bogle it is not necessarily information that is so key 

that an investor has to know it beforehand. Let me give you one 

example. 

There has been a lot of emphasis on improved disclosure of 

transaction costs, and there is complexity about that, and the issue 

becomes how do you do that, because it is not just commission dollars. It is market impact. It is spreads on debt instruments. And 

so there is a big challenge in getting the information out there. 

But all of the costs that are implicit in funds transaction in portfolio securities are already reflected in the performance information 

77

that an investor gets. It is all net of that because it is built into 

that number. 

Now, ask yourself the question: In order to make a good mutual 

fund investment, do I have to know all of the details with respect 

to the transaction costs? Maybe not. Maybe there is a shorthand 

way of providing it. But if we begin putting hurdles like that in 

front of mutual fund investors, what I am afraid is we make it preternaturally more difficult to make good investing decisions. That 

is the challenge: Getting the information out, but also crafting it 

in a way that it is meaningful and communicates effectively with 

the investor public. 

Senator AKAKA. Mr. Chairman, may I? 

Let me ask Mr. Keil, it is quite clear that investors need to have 

additional information about the transaction costs of their mutual 

funds because the expense ratios fail to include them, and the brokerage commissions are buried in the statement of additional information, which investors are only given upon request. It is a lengthy 

and complicated document that does not easily facilitate comparison among funds. 

Mr. Keil, in your statement you mentioned that trying to fully 

quantify brokerage costs in total, given every trading scenario, is 

‘‘similar to attempting to nail’’—and I wanted to say this—‘‘Jell-O 

to a wall.’’ What do you recommend to improve the disclosure of 

transaction costs in a meaningful, understandable way to investors? 

Mr. KEIL. Well, let me make the point that I still stand behind 

my statement that you cannot quantify every last brokerage scenario to the satisfaction of most academics. But I think that the 

scenario, the way it exists today, is thoroughly inadequate. There 

is no way for an investor to quantify what they are paying in brokerage. There is just no way to do it. 

The aggregate dollars, as you point out, are shown in the SAI, 

but let’s face it, if it is a challenge to get the investors to read the 

prospectus cover to cover, they are going to go nowhere near the 

SAI. It is an ineffective document as far as disclosure is concerned. 

I would make the statement that there are ways to quantify the 

different types of brokerage. Whether you segment them or put 

them in one number is another issue. But I would not recommend 

that once you take those dollars, you put them in the form of a 

ratio so that they are the same basis as an expense ratio. That 

should be included in the total expense ratio. We are really talking 

about apples and orange—total expense ratio, which is focused on 

operating expenses, or brokerage is truly transaction costs. 

So from my perspective, the investor needs to be able to make 

the judgment call whether what they are paying in the brokerage 

costs is reasonable given the returns that they are being given by 

the fund itself. 

Senator AKAKA. Mr. Chairman, my time has expired. 

Senator FITZGERALD. Well, thank you. We are going to have to 

wrap up because I have been informed that a vote began at 2:30, 

and apparently the weather, as bad as it was this morning, I am 

told that it has deteriorated to the point that the Federal Government is going to be shutting down at 3 p.m. today. The Office of 

Personnel Management has put that advisory out. But I did not 

78

want to conclude this hearing without going back to the point on 

the Federal Thrift Savings Plan. 

I have met with the executive director and others of the TSP. 

The back-office expenses for separating people’s accounts and so 

forth, those are all included in the expense ratios for the TSP fund. 

In fact, that is most of the expense. The advisors’ fee, I am not allowed to tell you how low it is because it is a confidential fee that 

was subject to bidding. At least that is my understanding. The fee 

is exceedingly low. Most of the expense ratio is for the cost of paying employees of the Agriculture Department down in Louisiana to 

do all the back-room functions. And I guess there are well over 100 

of those people, and those costs are being paid by the fund shareholders, and they are paying full Federal Government benefits to 

those Agriculture Department employees, including Federal health 

insurance, sick leave, other leave, the TSP expenses for those Agriculture Department employees and so forth, which are probably 

much more expensive than the private sector. 

It may be that the TSP fund could get their expenses even lower 

by not using the Agriculture Department and bidding out those 

back-room operations. The only things that may be taken care of 

internally by the Department—for example, I am a Member of the 

Senate. There is a Senate Financial Office that every year sends 

me a brochure and tells me how to contact the TSP, and they forward a form from the TSP to change your withholding amount. But 

I would think that most companies, if you work at IBM, the personnel office at IBM is going to be giving a similar transmittal to 

their employees, and then the employees will fill out that form, and 

it will actually go to a Hewitt and Associates or some company that 

does the back-room operations for IBM, and then it will be invested. 

And I do think in my opening statement I was careful to make 

the comparison between the expense ratios of the TSP fund, which 

I noted were index funds, and I compared them to the average expense ratios as reported by Lipper for S&P 500 stock index funds. 

And last year, the TSP expense ratio was 11 basis points, and the 

average for all mutual funds was 63 basis points. That is just an 

enormous difference. 

And so I think my point is valid, that we have created two regimes for investing—one for ourselves and one for the whole rest 

of the world—and I am not sure that is right. 

On the 12b–1 fees, I do want to ask a question about that. A lot 

of investors think they need to get into a no-load mutual fund. 

They want to avoid a front-end load and they want to avoid a backend load, and then they go into a fund that advertises no load, but 

that fund may have a 12b–1 fee, which is basically, as I understand 

it, a load paid over time. It is really compensation paid over time 

to the broker who put them into that fund. And I think, Mr. Keil, 

your report showed that 95 percent of 12b–1 fees wind up getting 

paid to the brokers who are distributing the funds. 

Mr. KEIL. Well, let me give credit where credit is due. That actually is an ICI statistic where they did a survey of the fund companies themselves. There is not disclosure sufficient for us to quantify 

exactly how 12b–1 fees are used. It is not a disclosure requirement 

at this time. 

79

Mr. STEVENS. Mr. Chairman, if I could clarify, my understanding 

is that under the NASD’s rules—and the NASD is sort of the keeper of what you can and cannot call a no-load fund. If you have 

asset-based charges not in excess of 25 basis points, even if they 

are adopted under a Rule 12b–1 plan—and there are some advantages to doing so. Even if they are not under a Rule 12b–1 plan, 

you can still describe yourself as a no-load fund. 

The point of the 25 basis points——

Senator FITZGERALD. Isn’t that misleading? Because if you are 

essentially paying a load over time—in fact, you may be paying 

more of a load over time than you would just to pay the 500 bucks, 

or whatever it is, up front. 

Mr. STEVENS. I think the NASD rule got to that point years ago 

because the 25 basis points typically is used to defray the cost of 

shareholder services, often recordkeeping, which would be a cost 

the fund would have to bear in many instances no matter what. It 

is not a classic sales charge, and they cut it off there, and they said 

anything more than that we will regard as a sales charge. And certainly any front-end sales charge, back-end sales charge, or level 

load, as it is called in the business, you could not be a no-load fund. 

But the thinking of the NASD at that time was, as long as that 

asset-based charge is 25 basis points or less, that would be consistent with calling yourself a no-load because that would not be 

regarded as a sales load. 

Mr. PLUNKETT. Mr. Chairman, I would like to say that we do 

think it is a deceptive practice, and as investors have become increasingly reluctant to pay front loads, brokers began looking for 

ways to offer funds that looked like no-load funds. That is how we 

got Class B shares. The broker still got his up-front commission 

paid out of fund company assets, and the fund company got the 

money back over time through 12b–1 fees. That is exactly what is 

happening here. 

Mr. FREEMAN. Mr. Chairman, just very quickly, 12b–1 is a monument to the law of unintended consequences. It came in to try to 

help funds advertise and sell and get the word out. What it became 

in the 1980’s and ever since is a mechanism used to sell Class B 

shares, to sell shares that have a load as if they were no-loads and 

to unfairly compete against no-load shares. That is how it is being 

used to a great extent out in practice, which is deceptive. 

Senator FITZGERALD. And isn’t it true when the SEC promulgated Rule 12b–1 to allow funds to charge a fee to compensate brokers for distributing their funds and to pay for advertising, the theory was that if the funds got bigger, expenses as a percentage of 

the assets would go down. Is there any evidence that fund expenses 

have gone down in the 24 years we have had Rule 12b–1? 

Mr. FREEMAN. There is no proof that you can spend your way to 

economies. All the evidence is that 12b–1 fees, insofar as they are 

supposed to generate savings, are a dead weight cost and don’t do 

it. 

Senator FITZGERALD. Mr. Stevens, do you want to comment? You 

have got to be brief. 

Mr. STEVENS. This is a long tale, but the bottom line is if you 

look at trends in distribution costs since the inception of Rule 12b–

1, it has introduced a degree of flexibility in the way that these 

80

kinds of costs can be paid. That has put downward pressure on 

sales charges. It is true, many funds have adopted 12b–1 fees, but 

if you add the sales charges to the costs under Rule 12b–1, distribution costs experienced by individual shareholders have trended 

downward. 

Now, that is what the ICI research indicates, and I think, Mr. 

Chairman, what may seem counterintuitive to you about this is 

that those costs covered by 12b–1 are going to be paid for some way 

because of the nature of the costs themselves. They represent the 

costs of the broker-dealer in terms of its marketing. They represent 

shareholder services. In many instances, they represent recordkeeping. 

If you were to abolish Rule 12b–1 tomorrow, you would not abolish the expenses; you would not abolish the fees. You would merely 

transfer them to some other place. Now, maybe that is a good idea, 

maybe it isn’t. Mr. Plunkett here has said perhaps all of that 

should be taken out of the fund and put on the distributor, and 

that is certainly one way you could look at the problem. But 12b–

1 pays for things that are going to be paid for no matter what. It 

provides a degree of flexibility in the way that they are paid for 

and transparency—it appears in the fee table, the 12b–1 charges—

and oversight because the fund boards have got to superintend 

those costs under the SEC’s rules. 

Senator FITZGERALD. Professor Freeman, final comment. 

Mr. FREEMAN. Very quickly, we do not have transparency. What we have is revenue sharing to the tune of $2 billion a year to get 

push money to the brokers, and that is coming out of the advisory 

fee, and it is coming out of overcharges. We have got directed brokerage, which is, I believe, illegal because the way to pay for sales 

activity is through a 12b–1 plan. We have a lot of funds that are 

already maxed out on that. Then they are using brokerage commissions to accomplish the same thing, double dipping and I think 

treating shareholders unfairly. 

Senator FITZGERALD. Well, you have been a wonderful panel, and 

we appreciate it. All of you have been very articulate and vigorous 

spokesmen for your point of view. 

That concludes our questions. I want to emphasize that the 

record will be kept open for additional materials until the close of 

business this Friday, January 30. So if you have any further submissions you would like to make available to the Subcommittee, we 

would appreciate it. 

Thank you all very much. This hearing is adjourned. 

[Whereupon, at 2:45 p.m., the Subcommittee was adjourned.] 

(81)

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