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STRATEGIC PLANNING, RESOURCE ALLOCATION

AND CRISIS MANAGEMENT—IS THE SEC READY?

HEARING

BEFORE THE

SUBCOMMITTEE ON GOVERNMENT EFFICIENCY

AND FINANCIAL MANAGEMENT

OF THE

COMMITTEE ON

GOVERNMENT REFORM

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

APRIL 20, 2004

Serial No. 108–177

Printed for the use of the Committee on Government Reform

(

Available via the World Wide Web: http://www.gpo.gov/congress/house

http://www.house.gov/reform

(II)

COMMITTEE ON GOVERNMENT REFORM

TOM DAVIS, Virginia, Chairman

DAN BURTON, Indiana

CHRISTOPHER SHAYS, Connecticut

ILEANA ROS-LEHTINEN, Florida

JOHN M. MCHUGH, New York

JOHN L. MICA, Florida

MARK E. SOUDER, Indiana

STEVEN C. LATOURETTE, Ohio

DOUG OSE, California

RON LEWIS, Kentucky

JO ANN DAVIS, Virginia

TODD RUSSELL PLATTS, Pennsylvania

CHRIS CANNON, Utah

ADAM H. PUTNAM, Florida

EDWARD L. SCHROCK, Virginia

JOHN J. DUNCAN, JR., Tennessee

NATHAN DEAL, Georgia

CANDICE S. MILLER, Michigan

TIM MURPHY, Pennsylvania

MICHAEL R. TURNER, Ohio

JOHN R. CARTER, Texas

MARSHA BLACKBURN, Tennessee

PATRICK J. TIBERI, Ohio

KATHERINE HARRIS, Florida

HENRY A. WAXMAN, California

TOM LANTOS, California

MAJOR R. OWENS, New York

EDOLPHUS TOWNS, New York

PAUL E. KANJORSKI, Pennsylvania

CAROLYN B. MALONEY, New York

ELIJAH E. CUMMINGS, Maryland

DENNIS J. KUCINICH, Ohio

DANNY K. DAVIS, Illinois

JOHN F. TIERNEY, Massachusetts

WM. LACY CLAY, Missouri

DIANE E. WATSON, California

STEPHEN F. LYNCH, Massachusetts

CHRIS VAN HOLLEN, Maryland

LINDA T. SANCHEZ, California

C.A. ‘‘DUTCH’’ RUPPERSBERGER, Maryland

ELEANOR HOLMES NORTON, District of

Columbia

JIM COOPER, Tennessee

——— ———

———

BERNARD SANDERS, Vermont

(Independent)

MELISSA WOJCIAK, Staff Director

DAVID MARIN, Deputy Staff Director

ROB BORDEN, Parliamentarian

TERESA AUSTIN, Chief Clerk

PHIL BARNETT, Minority Chief of Staff/Chief Counsel

SUBCOMMITTEE ON GOVERNMENT EFFICIENCY AND FINANCIAL MANAGEMENT

TODD RUSSELL PLATTS, Pennsylvania, Chairman

MARSHA BLACKBURN, Tennessee

STEVEN C. LATOURETTE, Ohio

CANDICE S. MILLER, Michigan

MICHAEL R. TURNER, Ohio

KATHERINE HARRIS, Florida

EDOLPHUS TOWNS, New York

PAUL E. KANJORSKI, Pennsylvania

MAJOR R. OWENS, New York

CAROLYN B. MALONEY, New York

EX OFFICIO

TOM DAVIS, Virginia HENRY A. WAXMAN, California

MIKE HETTINGER, Staff Director

LARRY BRADY, Professional Staff Member

SARA D’ORSIE, Clerk

MARK STEPHENSON, Minority Professional Staff Member

(III)

C O N T E N T S

Page

Hearing held on April 20, 2004 .............................................................................. 1

Statement of:

Bogle, John, Bogle Financial Markets Research Center, founder Vanguard Mutual Funds ..................................................................................... 21

Hillman, Richard, Director, Financial Markets and Community Investment, U.S. General Accounting Office ........................................................ 65

McConnell, James M., executive director, U.S. Securities and Exchange

Commission ................................................................................................... 47

Morey, Matthew R., Ph.D., associate professor of finance, Lubin School

of Business, Pace University ........................................................................ 35

Spitzer, Eliot, attorney general, New York .................................................... 4

Letters, statements, etc., submitted for the record by:

Bogle, John, Bogle Financial Markets Research Center, founder Vanguard Mutual Funds, prepared statement of ............................................. 26

Hillman, Richard, Director, Financial Markets and Community Investment, U.S. General Accounting Office, prepared statement of ................. 67

McConnell, James M., executive director, U.S. Securities and Exchange

Commission, prepared statement of ............................................................ 51

Spitzer, Eliot, attorney general, New York, prepared statement of ............. 10

(1)

STRATEGIC PLANNING, RESOURCE ALLOCATION AND CRISIS MANAGEMENT—IS THE

SEC READY?

TUESDAY, APRIL 20, 2004

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON GOVERNMENT EFFICIENCY AND

FINANCIAL MANAGEMENT,

COMMITTEE ON GOVERNMENT REFORM,

New York, NY.

The subcommittee met, pursuant to notice, at 10:30 a.m., at the

Michael Schimmel Center for the Arts, Pace University, New York,

NY, Hon. Todd Russell Platts (chairman of the subcommittee) presiding.

Present: Representatives Platts and Towns.

Staff present: Michael Hettinger, staff director; Larry Brady and

Tabetha Mueller, professional staff members; and Adam Bordes

and Andrew Delia, minority professional staff members.

Mr. PLATTS. A quorum being present at this field hearing of the

Subcommittee on Government Efficiency and Financial Management will come to order.

We are pleased to be here in New York City today to conduct an

important oversight hearing into strategic planning and resource

allocation at the Securities and Exchange Commission.

I certainly would like to take this opportunity to thank our subcommittee’s ranking member, Ed Towns, for his active participation in helping to arrange this hearing and helping to ensure that

the SEC is effectively regulating the mutual fund industry, the

focus of our hearing in resource allocation today. So, Ed, thanks for

your assistance.

We appreciate not just Ed’s hospitality in being here today, but

also Pace University. We’re delighted to be here on campus and appreciate you hosting as well.

We are here today because we believe Chairman William Donaldson and his senior staff at the Securities and Exchange Commission have made great strides toward making strategic planning at

the SEC a priority. However, we also believe there is more work

to be done.

The Commission is responding to unprecedented challenges. We

have seen corporate accounting scandals and illegal practices in the

mutual fund industry, both of which have shaken the very foundation of our financial markets and undermined investor confidence.

We have seen technological advances that have given more people

access to investment vehicles and contributed to the globalization

2

of our markets, conditions that have increased the SEC’s workload

exponentially. Further increasing the SEC’s responsibilities, Congress enacted Sarbanes-Oxley, giving the Commission a significantly larger oversight role in corporate finance. Congress also recognized the need to transform the SEC and granted pay parity and

hiring flexibility to the SEC along with significant resources to hire

new staff and update existing technology.

All these changes and challenges, whether good or bad, require

a bold and creative strategic focus. One of the most important challenges today for the SEC will be responding effectively to the mutual fund crisis. The mutual fund industry is critical to the health

of our economy. More than half of all U.S. households, 91 million

investors, are invested in mutual funds to the tune of $7.5 trillion.

If the SEC’s goal is to protect the maximum number of individual

investors, effective regulation and enforcement of the mutual fund

industry should be of the highest priority.

The SEC responded to this most recent crisis with aggressive

rulemaking initiatives. Congress is considering several avenues to

reform the industry. Regardless of which rules and laws are finally

enacted, it is effective regulation and enforcement that will make

the difference. This subcommittee believes that regulation enforcement is accomplished, in part, by effective strategic planning which

directs resources where they will have the greatest impact.

The subcommittee is grateful to Attorney General Eliot Spitzer

for his work in prosecuting perpetrators of the mutual fund scandals, and we are certainly honored to have the Attorney General

here today to discuss his successful enforcement efforts, and we appreciate your being with us.

Of course, prosecuting criminals is only one side of the equation;

effective regulation is the other. The use of statistical modeling and

data mining can greatly enhance regulatory efforts. One example

is a recent study conducted by Dr. Morey, from here at Pace University, who will testify today about a method he developed to detect ‘‘window dressing’’ in bond funds. With the appropriate technology and staff with the right expertise, the SEC can be more

proactive as it polices the mutual fund industry and looks out for

investors large and small every day.

With the right strategic focus as a blueprint, the new resources

for technology and human resources can be put to use in the most

effective manner. Oversight of strategic planning at the Commission has been a high priority for this subcommittee. Our July 2003

hearing was encouraging, and we applaud the continuing joint efforts of Rick Hillman and his team at the General Accounting Office and the Office of the Executive Director at the SEC, Jim

McConnell, who is here with us today. We are eager to see the

fruits of your labor, and this hearing will provide a forum for an

in-depth update on your progress.

We also have the benefit today of hearing from Mr. John Bogle,

the founder of Vanguard Funds and a vocal advocate for improving

the mutual fund industry.

I would like to thank each of our witness who will be testifying

today and for your testimony you submitted in writing prior to today’s hearing. We certainly look forward to your testimony.

3

And I now would like to yield to our ranking member, the gentleman from New York, Mr. Towns for the purposes of an opening

statement.

Mr. TOWNS. Thank you, Chairman Platts.

Let me begin by thanking you for holding this hearing in my

hometown, the financial capital of the world. It is the ideal place

to examine how we can strengthen the oversight of our mutual

fund industry. This is the century for the integrity of the financial

sector in the protection of millions of investors.

I would also like to thank the Provost and Pace University for

graciously hosting this hearing which has great importance to the

New Yorkers, of course, and the Nation.

This hearing of the Securities and Exchange Commission is the

result of a series of breakdowns in the Commission’s regulatory enforcement efforts. As many know, there have been widespread reports of deceptive and fraudulent practices in the mutual fund industry, many uncovered by one of our witnesses here today, Attorney General Eliot Spitzer. For too long the SEC has been reactive

to these scandals and unethical practices. We need to ensure that

the SEC has the resources, tools, expertise, planning to be

proactive so it can identify and prevent abuses before they happen.

Due to the recent rash of corporate scandals and mutual funds

abuses there has never been a greater need for the SEC to fulfil

its mission, which is to protect investors and maintain the integrity

of the securities market. The Congress has attempted to assist the

SEC in restoring confidence through the enactment of the Sarbanes-Oxley Act. However, such laws and regulations will be futile

without effective enforcement. Making matters more challenging,

the SEC’s workload has been growing exponentially. Today more

Americans are invested in stock and other capital markets. According to the General Accounting Office, mutual funds have grown

from a $400 billion industry to one with $7.5 trillion in assets during the past two decades. In fact, more than 95 million Americans

invest in mutual funds. These numbers speak to the importance of

maintaining the integrity of the mutual fund industry.

The Congress significantly increased the SEC’s financial resources. Last fiscal year the SEC received appropriations to hire

842 new employees to help meet the increasing workload. In fact,

over the last 2 years the Commission has had an appropriation increase of 73 percent. Congress has given the SEC special flexibility

to set wages and hire employees so they can compete for the best

and the brightest. However, in spite of these efforts there are still

more than 500 employee vacancies remaining of the newly created

permanent positions.

We need to know why the vacancies continue to exist. If there

is something that we need to do in Congress to help fix this.

I am hopeful that Mr. McConnell will shed some light on this

issue by presenting a detailed information on how the SEC will utilize its resources and what hurdles remain in producing a concise

strategic plan.

I am also anxious to hear from today’s witnesses on the areas

they believe the SEC needs to focus on to improve its oversight.

4

I look forward to the testimony of Attorney General Spitzer, who

has been instrumental in uncovering numerous abuse practices

within the industry.

On that note, Mr. Chairman, I yield back.

Mr. PLATTS. Thank you, Mr. Towns.

We will proceed to the testimony from our panels. Certainly first,

as is evident, the Attorney General we will have your statement

and then questions, and then we will go to our second panel with

Dr. Morey and Mr. Bogle. And then our third panel with Mr.

McConnell and Mr. Hillman.

So, Attorney General Spitzer, if you would like to begin.

Actually, I need to swear you in first. If I could have you stand

and take the oath.

[Witness sworn].

Mr. PLATTS. The clerk will reflect that the witness has answered

the oath in the affirmative.

And Attorney General Spitzer, the floor is yours.

STATEMENT OF ELIOT SPITZER, ATTORNEY GENERAL, NEW

YORK

Mr. SPITZER. Thank you, Mr. Chairman and Congressman

Towns. It’s a pleasure to be here. Thank you for visiting New York

and having this hearing, and thank you also to the other witnesses

and Pace University.

I want to congratulate Mr. Bogle on having made what we call

the Times 100, the 100 most important people in the world, I think

it is, being somewhat akin to the Fortune 500 for individuals. Mr.

Bogle years, perhaps even decades speaking for the issues that we

are dealing about and talking about today and what has been recognized and what we are getting to recognize, and quite rightly so.

I wanted to begin by putting into something of a theoretical

framework many of the issues that have troubled the financial securities industry over the last number of years, and suggest to you

that really two polices that have been intentionally adopted by

Congress by our regulatory framework have collided in the past

number of years to generate the problems that we have encountered, problems that have manifested themselves in research that

was being marketed to individuals that was improper, and I truly

believe problems in the mutual fund context and other problems

that will in due course emerge, perhaps.

And these are two policies are, first, an intentional effort to promote concentration within the financial services sector, and this is

what I call the city group model where Congress over a number of

years, actually it was regulatory agencies initially and then Congress, affirmatively repealing Glass-Stegall, has encouraged our financial services sector to seek additional concentration.

The underlying motivation for this was, first, a sense that the

historical rationale for enacting the Glass-Stegall perhaps was

flawed. And second, a concern that capital concentration overseas

in the European and the Asian banks were getting to the point

where competition in the U.S. banks would get to the point where

U.S. banks, U.S. financial service companies could not compete. So

we were driven by what were, perhaps, wise decisions, perhaps not.

But certainly an agreed upon policy to seek additional concentraVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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tion in the financial services sector. And therefore, we continued to

see larger and larger financial service sector companies that all

wanted opportunities, provide opportunities for one-stop-shopping

for clients whether it be a major company or an individual can obtain any product at that one entity, whether its Citi, Morgan

Chase, Bank One, etc., we obviously have seen and continue to see

this increased concentration.

The other policy that is also unambiguously and affirmative one

as the first one that I suppose some would question. The second

policy is one of encouraging all Americans into the capital markets.

And, Mr. Chairman, you referred to this when you gave the numbers that now capture the enormity of the mutual fund sector, 91

million Americans and over $7 trillion. We have seen what we call

this democratization of the capital markets over the last number

of decades. This has been unambiguously good both for the markets

and for the individual investors. It has encouraged, and we have

encouraged and rightly so, Americans to take their savings to invest them in equities and generate and participate in the growth

that resulted there from.

The problem that we have, unfortunately, is that the interface

between these two policies has been uncomfortable. We have larger

and larger financial service sector companies dealing with more

atomized investors. And rather than seeing these investors and individuals whom you owe fiduciary duty and figuring out how to live

up to that fiduciary duty, we have seen the financial service companies view these investors as fee generators. When they are viewed

as fee generators rather than an individual to whom you will owe

a fiduciary duty, unfortunate things can result. That is, I think,

what binds together the issue of improper research that we were

addressing last year, the issue in the mutual fund context where

we have seen fees spiral out of control, and other contexts where

we see smaller, smaller investors not getting the advice, not getting

the benefits of the fiduciary duty that is owed to them, but rather

the view is they’re taken advantage of to generate fees.

Now, I am not suggesting, obviously, that either one of these

policies necessarily should be reversed. What I am suggesting, I

said the same thing to the CEOs of the companies that have

increasedly dominated our financial services sector, that these companies and of course the regulators who deal with these issues,

need to figure out how to generate an interface between the small

investor and the large financial service sector companies that will

provide proper protection for the fiduciary duties that is owed to

the investor. That is the difficulty, the problem, the issue that has

confronted you on these companies. It is one they have to think

about very deeply because if they don’t answer it, then I think they

will see not only increasingly regulatory response, but also they

will see their customers move away to other entities. And so for

business rationale as well as basic obligations of ethics, these companies need to address this issue. And I hope, certainly, that they

do so down the road.

And I can tell you that the issues that we continue to look at

that are far afield from the issues that have already made their

way into the public area, are issues that go to the fore, issue of is

6

a fiduciary duty being breached. That is the issue that binds together our concerns, at least in my office.

Let me quickly, if I might go through the three distinct chapters

that I have seen emerge in the mutual fund investigation. I remind

you that the entire period of this inquiry, at least from a public

perspective, is hardly 8 months old. This issue as to what was

reached publicly right after September 3rd, right after Labor Day

of 2003 and over the succeeding 8 months we have succeeded in returning close to $2 billion to investors. I think it is amazing and

even addressing some of the fundamental structural problems that

the industry has to confront. And so we have made good progress,

I think, considering the speed and the timeframe that this issue

has been in the public arena.

Chapter one simply dealt with the trading violations that were

diagnosed and laid out in the Narry affidavit last September 3rd,

those related to the late trading and the timing issues. Late trading, obviously, being in our view almost a per se or indeed a per

se violation where trades were put in after the NAB had been determined after the 4 p.m. deadline. Timing being a slightly more

subtle issue and the legality or illegalities of timing is contingent

to time with respect to statements of the individual mutual fund.

But those two issues frame the first aspect of the debate.

I think the good news is that these are issues that merely by

being exposed got resolved. It is increasingly difficult to have to believe for traders now to put in their trades after the NAB has been

set, not only because the individuals are more weary of being

caught but because there is an enormous and exponentially greater

degree of scrutiny to that potential abuse. And so that practice certainly has diminished, if not been eliminated.

In addition the SEC has proposed certain rules with respect to

the 4 p.m. deadline that would make it at a regulatory level that

much easier to prosecute those cases.

The issue of timing, as well, has been diminished. We have seen

diminution in the volume of money that has been sloshing around

these various hedge funds dedicated to time abuses. We have seen,

again, an exponentially greater effort on the part of the mutual

funds to crack down on timing. And I have believe, although it is

hard to statistically measure, that we have seen a dramatic reduction in the quid pro quo arrangements that have been struck where

people would give so called sticky assets to mutual funds in return

for the opportunity to take advantage in that capacity.

So I think that with respect to chapter one, the old saying, if

sunlight is the best disinfectant, by exposing these problems, we

have to a certain extent remedied them, which is not to say a more

defined regulatory and/or legislative response is not appropriate.

But I think chapter one by revealing the problems we also began

to solve the problems.

Chapter two in my analysis, at least, is the issue of fees. And

here numerically we are dealing with an issue that is greater in

terms of measuring harm, if more harm is imposed or inflicted

upon ordinary investors by the what I consider to be exorbitant fee

structure that the mutual funds industry has managed to impose

upon investors than the magnitude of harm imposed by late trading and time. Even though billions of dollars of harm have been imVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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posed by late trading and timing, we think we tend to donate the

dollars of harm have been imposed upon investors every year by

virtue of improper fee structure.

It is not merely an issue of disclosure, although I think every

committee in front of which I have testified from both sides of the

aisle there has been nearly unanimous agreement that the disclosures that have been made by the fund companies have been woefully inadequate and it is impossible for most people to parse the

mutual fund prospectuses and have any real sense of what fees

they are paying and what the impact of those fees is upon their

annualized return. And it is in this context that I refer to, you

know, one of my favorite cliches, but compound interest is the

eighth wonder of the world. When you look at the impact of the 1

or 2 percent differential between fees that are being charged or a

30 or 40 basis point differential between fees that are being

charged and fees that should be charged, you say to people 30 basis

points they either do not understand what basis points are, it

sounds so de minimus, they say well big deal. But when you run

the numbers and compound that differential over the long term, it

essentially eliminates whatever upside might have existed by virtue of the performance of the mutual fund or in fact accentuates

the lack of performance and drives investors into the issue where

compared to having an index fund, they end up in a negative position.

Therefore, the fees that are charged by mutual fund companies

must be addressed by this committee, by the SEC, by other regulatory entities. In the settlements in my office struck with mutual

fund companies, we have obligated them to discount their fees for

a period of 5 years by a significant number, hundreds of millions

of dollars of benefits have accrued to investors by virtue of our settlements. There was a response to that, which a skeptical response

by some who said are you involved in price fixing by virtue of what

you are doing. And the answer I will give you is a resounding no.

And here is why.

We have not said we have not arbitrarily or unilaterally taken

a fee and said this is what you will charge and this is what you

must charge. What we have said to mutual fund companies is in

every instance is we conclude a differential between what you were

charging the individual investors and what you were charging institutional investors for identical services. Where there is that gap,

that delta, it cannot be justified because if they do an apples-to-apples comparison you are charging one group of investors who actually negotiate for the fees that are charged a certain fee. And you

charge others who are relying upon a board to negotiate for them,

you charge them a higher fee. Then this reflects to me a failure of

negotiation, a failure to live up to the fiduciary duty that’s owed

to the small investor. And consequently a pawn that has been imposed upon the small investor that should not have been imposed

on them. And we have said to the fund companies therefore we

think that in order to remedy you improper behavior here, you

could give a discount that would begin a process of moving your

fees back to where the market would bring them if you would have

behaved in the marketplace the way you should have. That is why

we have delved into this fee issue. It is an issue that has imposed,

8

as I said, tens of billions of dollars of harm upon investors, and we

will continue to do this.

Let me say that there has been a bit of back and forth between

my office and the SEC on this issue. It is an area where we have

agreed to disagree, and I think the record is clear that we are able,

in fact are very successfully moving forward with settlements even

though we disagree on this issue. I believe deeply the fees should

be diminished and that the market has failed because the board

did not act properly and that we have to push for us to behave

more appropriately, that the SEC is moving forward with us to settle with the companies on issues A and B, reform and restitution

while we also get settlements with the fund companies on fees. So

we are managing to overcome our difference there, which takes me

to issue three. Issue one was late trading timing issue, issue two

was fees, issue three in board behavior.

As in so many instances that have emerged over the last couple

of years where we have seen violations in the corporate arena, ultimately it comes down to a board that was not paying attention.

What we have seen in the mutual fund context, unfortunately, is

that the board of the fund companies have not been living up their

mandate to protect the small investors. They have been all too

often, and I wold refer you to Warren Buffet’s shareholder letter

from this year and the Berkshire Hathaway letter that is probably

one of the most read investment documents every year in which he

goes after, as he has for some period of time now, the mutual fund

boards of directors and really is partially critical of them for not

being sufficiently or indeed at all intuitive to their obligations to

protect investors. Those boards, frankly, were asleep at the switch.

And what we have to do is re-invigorate them and say to them live

up to your duties and if you fail to do so, we will seek to have you

removed. And, indeed, in the settlement that we entered with the

Bank of America a couple of weeks ago now, I think the aggregate

number was $675 million in restitution and fee discounts. Perhaps

the most important aspect of it to me was that eight of the board

members of the mutual fund board are going to be forced to cycle

off the boards in reasonably short order. The reason for that is that

we felt that there was a record that they failed to be properly inquisitive, failed to respond to information that should have indicated that there was ongoing timing and that there was an abuse

of the investors, and their passive response to the violation of a

duty that they should have, and therefore in order to reinvigorate

the protection we need for investors those board members should

cycle off. That is ultimately where we need to get reform. I think

that is the area where legislative action is important, in the area

where defining these standards of fiduciary duty is owed to investors is critically important. And as much as the SEC is doing, and

I have been partially critical at various times over the last several

years, to applaud them for really rolling out a sequence of rulemaking proposals that beings to address these issues, nonetheless

I think legislative response is appropriate here and important in

order to ensure that we have a bulwark of statutory framework

that is appropriate.

One final word, and I thank you for your indulgence and I didn’t

mean to go on this long. And that final word relates to the reguVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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latory structure in which we live. I don’t want to focus on the SEC

here. I want to focus on self-regulatory organizations.

The SROs over the last number of years, unfortunately, have

failed our investment community. And we are seeing new leadership, very wise new leadership in New York Stock Exchange, we

have seen in the NASV and other SROs as well. But I think the

SROs that are supposed to be the primary and first line of defense

in the investment world were not attentive to the changing dynamics and the changing structures that should have been paid attention to. I think we need to question in a very serious way whether

the SROs can reform themselves, if they will live up to their critical mandate. I hope the answer is yes, but it is an issue we have

to raise.

Finally, we have to ask ourselves whether the voices of industry,

the ICI, the SIA, the AICPA, have not been too powerful; whether

their capacity to almost define the terms of debate to Washington

has unfortunately reminded the Congress and the regulatory agencies the need is immediate to examine the critical issues.

And I think the story of the AICPA after they stopped the SEC

from dividing, auditing and consulting several years back is an instructive story and it tells the all too frequently told story of an industry voice that stopped a reform measure that had it been in

place, probably could have prevented some of the most egregious

accounting frauds that ultimately brought down some of our major

companies.

So I think we need to ask ourselves whether the ICI, the AICPA,

the SIA have not been woven too much into the fabric of our Washington environment to whether we need to relieve skepticism about

their counsel and their perspectives as we move forward.

And thank you for the opportunity to appear before you, and certainly will try to answer your questions.

[The prepared statement of Mr Spitzer follows:]

10

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12

13

14

Mr. PLATTS. Well, thank you, Mr. Attorney General. And, again,

both the written testimony provided and your thoughts today are

very helpful, which we appreciate.

A place I would like to start in the questioning is in laying out

the three different chapters; the trading practices that were wrongful and that you have been a great leader in addressing both in the

disclosure of those practices, which as you said, is in and of itself

had a great impact and in your enforcement efforts and prosecutions in pursuing those wrongfully practices, but also the fee issue

and the fiduciary duty or the lack of fulfillment of that duty to especially the small investors by some of the fund managers.

I am not sure if you will be able to hear the testimony of Mr.

Bogle after you, but one of his recommendations that he has been

promoting, I believe, from his testimony, for 8 years is kind of a

comprehensive economic study of the mutual fund industry. He

suggests that as part of the SEC’s strategic plan and vision, that

we really get an in-depth understanding of the industry and the

fees associated, how the managers are actually conducting themselves, that’s critical to going forward to effectively managing and

overseeing and regulating this industry. And from your testimony

it sounds like that is something you think would be a very wise approach for the SEC to embrace?

Mr. SPITZER. Absolutely. The SEC does have a division that is

dedicated to oversight of the mutual fund sector. Having said that,

I think it is critical that we step back and say what has happened

in the sector, what returns are people actually garnering, how were

those returns presented to the investing public, what the people

know, what variables do they rely upon, what variables should

they reply upon?

And let me make it perfectly clear, it is not government’s job and

never should be our job to make the investment decision for the individual investor. What we do have to make clear, however, what

we do have to do is provide to the individual investor the tools so

that he or she could make the individualized determination based

upon full disclosure and the important variables that a wise investor would want to have at his or her fingertips to make those decisions.

Mr. PLATTS. Yes.

Mr. SPITZER. And all too frequently when you read a prospectus

it is impossible to determine whether or not this is a good or bad

investment because the fee structure is not there, the informant’s

numbers are not given in a format that is meaningful.

You know, I have analogized to the disclosure on the side of any

food item when you go to the supermarket. You know, you could

look at a little grid and it tells how much fat, what——

Mr. PLATTS. I try not read those, because you know they make

me feel like I am eating too unhealthy.

Mr. SPITZER. Well, I am with you. I read them all too often after

my kids have already eaten them.

Mr. PLATTS. Exactly.

Mr. SPITZER. You get 800 percent of your daily allotment of sugar

when you have one bite of the cereal. But if we were to have that

sort of disclosure with respect to fees on a monthly statement or

quarterly statement, however often they come, the impact on fees

15

over the past 10 years or the next 3 years of the fee structures depending upon certain rates of return or the actual return, or a hypothetical $1,000 investment, how that investment would have

fared over the last 10 years based upon the actual return, its return net of fees. There is so many ways to present this in a way

that would be more meaningful to investors. And I think Mr.

Bogle’s idea of studying the industry to understand these factors

and then come up with a way to present it to the public is critically

important.

Mr. PLATTS. And I do appreciate your analogy to that label on

the food box. And as a parent of a 5 year old and a 7 year old, they

want that high sugar just as I did when I was their age. But a good

analogy; more transparency, more knowledge for investors to make

their decisions on.

You know, our focus for our subcommittee is the management efforts of the SEC. And whatever the rules are, the regulations, the

law, how are they meeting the charge that they have with their resources, and especially their human capital resources.

In the three areas, again, the three chapters, which is I think a

good way of looking at the mutual fund issue, what is your view

on the SEC’s response from that resource allocation aspect? They

have done a good job on the trading practices and the regs they’ve

proposed and have been more aggressive since your efforts since

last September, but not as aggressive, and you agree to disagree

I guess is your statement on the fees—on the three chapters. How

would you——

Mr. SPITZER. It goes without saying, and Mr. Chairman I am trying very hard these days not to gratuitously scratch at a wound or

at a relationship that has had ups and downs, obviously. But certainly the SEC is doing everything it can do these days to address

these issues and we are probably going to be working together. So

I just want that a predicate to anything I say.

Mr. PLATTS. Yes.

Mr. SPITZER. And Steve Cutler, who is Chief of Enforcement, is

someone I speak to on a regular basis so we are on the same page

in what we are doing. As Chairman Donaldson and I would also

speak on a regular basis. So I do not want this to be interrupted

or have gratuitous criticism.

I think the SEC has done a better job with respect to the trading

abuses than it has done with respect to fees. I think that there is

a bit of schizophrenia at the SEC with respect to the fee issue because it has been hesitant, as I said, to get involved in what it

thinks should be a market determination with respect to fees. And

we all agree, it should be a market determination. However, the

market will determine fees properly only if the participants in that

negotiation are sufficiently and properly aggressive in playing the

role it’s supposed to play. And hence, my discomfort at not pushing

toward what’s supposedly the voice for the small investors more aggressively in saying to them you must act in a particular way, get

competitive data, ask the management companies what the comparative fee structure is for other types of investors, determine

what the profit margins and revenue have been for the management companies. In other words, amass the very information that

you would amiss if you were in a traditional negotiating contract.

16

The ICI did a report several months ago now, I think it was December of last year, in which it tried to rebut my allegation that

fees that were being garnered for an individual investor were higher than fees that were being garnered for institutional investors.

And they rolled this out and they said, ha,ha, see there is only 3

basis point differential, they figured 18 to 21 basis points in those

two pools of money.

I said wait a minute, you have proven my point. Not because it

is a 3 basis point differential, but because the comparison they did,

and my recollection as I do not have it in front of, 18 basis points

for institutional investors at fees, 21 basis points for individual investors when they had a subadvisor that had competed to get the

advisory services for the individual investor. For subadvisors is the

wrong comparison. That itself is only a small piece of the mutual

fund pool of money. And it is the only piece of it where there is

actual competition.

If you were to compare the institutional 18 basic points to the

probably 30, 40 basic points that is being charged elsewhere in the

industry, then you have that enormous gap that is generating what

I spoke of earlier, which is the tens of billions of dollars that is improperly flowing to the mutual funds from companies which, in my

view, they are not properly getting their hands on.

Mr. PLATTS. In kind of following along with allocation, whether

it be not on the fee setting but on how fees are disclosed and,

again, the allocation of the resources, you touched a lot on the important fiduciary duty to that typical Joe on the street, you know

that smaller investor, and that they especially need that. And as

your fee issue highlights, the need for involvement of the SEC.

In your opinion, especially in light of the SEC’s request for a significant funding increase regarding the regulation of hedge funds

versus mutual funds, is that something that we should be worried

about that it is again focusing too disproportionate an amount of

their resources on a select few of large investors as opposed to the

90 plus million small investors?

Mr. SPITZER. This goes back to my very opening comment about

breach of the fiduciary duties being my primary concern. I am a little skeptical of the effort to focus so much attention on hedge funds

right now, and let me be very clear. There are clearly hedge funds

that abuse trading practices and trade in a way that is violate to

the law. They have a poor position, they disseminate false research,

they play market manipulation cases that should and will be prosecuted when they exist. However, hedge funds are designed to be

nimble capital that moves quickly through the market, and that’s

what the law has always contemplated. Hedge fund managers are

doing what they are supposed to do for their investors who are sophisticated investors and defined so statutorily through regulations. And, therefore, I am a little less worried about hedge funds

abusing their relationship to their investors and when hedge funds

individually act improperly in the market place, hopefully they’ll be

caught. So I do not think the notion of regulating hedge funds as

a general area should be getting quite as much attention as it has

been.

I am more focused on the theoretical and actual breach of fiduciary duties we have seen toward mutual funds and their small inVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
17

vestors the 90 million investors you are talking about. That is

where there is an issue of your concern that I think we should be

focusing on.

In terms of resources, let me say this and again I do not say this

to be gratuitously sharp with respect to the SEC. As important as

resources are, I think that it is case selection that is more important. Cases have to be brought based on a strategic determination

that they will have an impact in the marketplace. One case on

market timing for late trading can be brought, as it opens an entire

arena of impropriety and you then can solve a problem. And not

to pat ourselves on the back, but everything we have done in the

last 20 years is with about 15 lawyers total, which is a tiny percent

of what the SEC has. And I do not say that to say look how good

we are. Not at all. But I think it is case selection and making

triage decisions that will lead you to the cases that will reveal

structural problems that is most important.

Mr. PLATTS. I would like to yield to the ranking member, Mr.

Towns.

Mr. TOWNS. Thank you.

Let me just pick up on that point. You have been able to do all

this with 15 lawyers. Are you saying then that it is the mind set

of the SEC is the reason why they have not been able to do even

more with the limited resources?

Mr. SPITZER. Let me, Congressman, let me turn this and state

it affirmatively.

Mr. TOWNS. OK.

Mr. SPITZER. Just so it is not to sort of re-inflame our relationship.

I think that recently we have seen a much more properly, a

much more aggressive attitude on the part of the SEC with respect

to examining structural issues that deserve to be examined. I think

what the SEC is now doing, and very wisely so, is stepping back

from the marketplace and asking itself where have there been

shifts and new dynamics that have emerged such as with research

so that you want to say wait a minute, is research being disseminated because it is believed in or because research is being used

as bait for investment banking clients, and if it is the latter how

do you need to respond in a regulatory level. So the SEC is beginning to ask the appropriate questions that will bring to the fore the

cases that should be brought.

Mr. TOWNS. All right. Thank you.

You talked about in terms of fiduciary responsibility and, of

course, protecting the small investors. And you said that it might

require a legislative response. Do you have any specific ideas, some

things that we might be able to do legislatively to boost this?

Mr. SPITZER. Well, I will bootstrap on Mr. Bogle’s idea, which

again he has been pushing for quite a while, which has very legislatively defined the fiduciary obligation that is owed by a mutual

fund or to the small investor. I mean, that is something that should

be done, I think.

You will hear, no doubt, from the industry, so you have already

heard it or you will get submissions from them in which they claim

well the fiduciary duty has been a little ambiguous and there have

been some case law that makes it unclear what it is. Fortunately

18

here in New York I think we can make the case that we have the

State law that is pretty good and we can use that, and have been

using that. But I think the notation that there is just a very rigorous fiduciary obligation explosion has been—unambiguous fiduciary

obligation explosion is something that should be enshrined statutorily. And Mr. Bogle has been pushing that notion for a while, and

I think he’s right.

Mr. TOWNS. You are very sensitive to the comment about the relationship between the SEC and your office, and I understand that.

Mr. SPITZER. Yes.

Mr. TOWNS. You do not want to distort at all, you are trying to

help, and I understand that. And I recognize that. But have they

discussed a strategic plan with you at all?

Mr. SPITZER. Oh, sure. Well, they did not discuss the particulars

of stepping back and looking at the mutual fund industry, as has

been suggested. But let me make it clear, I speak to Steve Cutler

on a regular basis, the lawyers in my office speak to the lawyers

in the Enforcement Bureau on a regular basis. We are reviewing

the entire litany of enforcement actions that are pending. How we

could think about these cases. I speak to Chairman Donaldson

about these issues.

Yes, there is appropriate integration of thinking and discussion

at this point. And that is progress. That has not always been the

case, but perhaps there was not always the need for that to be the

case. But certainly now we are working well together and are discussing these issues as they surface.

And let me make another point. It is important not only in terms

of getting the maximum utility from the enforcement dollars that

are allocated by Congress to the SEC and by the State to my office

and other States to their enforcement entities, but also to prevent

the risk of incoherence or inconsistency. And one of the things that

I noticed in a topic of discussion on Capitol Hill, and rightly so, is

the need for coherence and the need for eliminating any chance involved in evasion of enforcement that would lead to the incongruities of how we interpret the law and how we enforce it so that this

effort to speak with the SEC and work together is driven by both

of those motivations.

Mr. TOWNS. Right. Let me ask this, I want to deal with the SEC.

I think that if there is anything that you feel we need to do

through Congress to make—I guess more in terms of reassuring

people, you know, and I think that the integrity is there. And I

think that is something that we have to be concerned about, you

know, as we move forward is the integrity. And what can we do

in the Congress to come up with rules and regulations and legislation in particular that might give people that reassurance?

Mr. SPITZER. Here is what I would say, and I have absolutely no

reason to think or suspect when you use the word ‘‘integrity,’’ that

it is inferred a failure of integrity in terms of somebody intentionally overlooking an issue. So I want to put that aside.

I think that something that Congress, and perhaps this subcommittee could wisely spend a bit of time on would be an examination of what—and I don’t say this with any disrespect to Paul

Royce who is the head of the Legal Fund Division of the SEC, but

examination of what that division had besides for 2 or 3 years ago

19

set as its regulatory priorities. In other words, it would be a fair

question what were you examining when in your oversight capacity

with respect to the mutual funds, I mean had you foreseen this. Of

course, with the 9/11 Commission sometimes, you know, retrospective examinations can get a little partisan but I think in a moment

of quiet it would be useful to say were you looking at the issue of

fees, were you looking at the issue of fiduciary obligations and how

those would be fulfilled. Did you have any evidence that there were

issues related to timing and late trading, and if so what was done

with respect to that effort. And I think it would be a good case

study of regulatory, what we now can say I think would be regulatory failure. And it would be a useful exercise to go through

again, not in an effort that sort of points fingers and says ahah,

I caught you. But I think there will be lessons there that could

guide us prospectively so that 10 years from now we do not say in

other sectors that, gee, we should have thought of that.

Mr. TOWNS. Right. You testified before the House Financial Services Committee that there must be fundamental change in the

mind set at the SEC.

Mr. SPITZER. Right.

Mr. TOWNS. So I guess you now feel that change has started taking place?

Mr. SPITZER. Well, I am trying to be kinder and gentler but it

certainly—yes. It certainly happened. And I did say that, and as

I said I have been pretty critical of the SEC at different points in

time, and I am not going to take back any of those words.

Mr. TOWNS. No.

Mr. SPITZER. But I think that there has been a real change in

that perspective in an effort to really rachet up or down in perspective the degree of intensity of examination, and that is very much

to the SEC’s credit. I think it was needed. And I think that there

was certain complacency, perhaps, several years back when the

markets were booming, people were happy. Those things happen.

And so I think that is, however, perhaps when one needs to be

most diligent and attentive. And I think now we have turned that

corner and I think that is good for the investor.

Mr. TOWNS. I yield to the chairman.

Thank you.

Mr. PLATTS. Thanks, Mr. Towns.

I think that is an important point in that is that just because the

market is booming and numbers are going in the direction you

want, does not mean that there are no problems out there. Because

the market was doing so well we were not looking maybe as close

as we should have been at some of these issues. And I appreciate

that you are seeking to be kinder and gentler today than maybe

in the past.

And the followup, and it is not to point fingers but to get a true

understanding, and one of the things that you bring is an outside

perspective, you know, at the State level and in the Attorney General’s office versus the regulatory side. Once you got into the issue,

the mutual fund issue, was it just not enough resources being put

into this area by the SEC that they were not catching these trading

practices?

20

Mr. SPITZER. I think that there was perhaps too great a willingness to accept sometimes what was being said by the industry. I

mean, you think about the mutual fund industry, I have said repeatedly that my office found abuses not because we are so smart,

and I think we are but I really do not think we are any better or

any smarter or any more diligent than anybody else. It is just that

we saw what should have been obvious to everybody because it was

known by everybody on the street. That was the case of fraud research. It was the case of fees that were too high. The late trading

perhaps was a little more subtle. But the timing, I will tell you,

there were hedge fund prospectuses that were floating around

there, anybody who had seen them, and certainly the SEC and others had seen them, you knew that there were billions of dollars

that had been raised and allocated by hedge funds to the timing

of mutual funds.

Now, as I have said, there is nothing wrong, illegal on the hedge

fund side of that equation if you can do it depending upon where

you are on the mutual fund side. But certainly if you were a mutual fund regulator and you were aware that there is this new pool

of money sloshing around the mutual fund world dedicated to timing of funds, you would want somebody to say where is it going,

how does that effect. Everybody knew that had a negative impact

on the individual investor. So certainly I think some of those questions should have been asked. And the mutual fund industry has

maintained for years and gotten away with that, and they say

every year they will cure.

And so I think there has been an acceptance of that without a

sufficiently inquisitive challenge to some of these practices.

Mr. PLATTS. With the strategic plan that we are pushing and

looking forward to hopefully here in the near future, to see from

the SEC, our committee when we had a hearing last summer and

we talked about strategic plan, we think it is critical if we are

going to talk about a 12 percent funding increase for one segment

of the enforcement regulatory efforts, that if you do not have the

big picture what are you taking those funds from and is it mutual

funds, is it other important priorities? And in getting to that point

that we have a strategic plan, if I understood your answer to Mr.

Towns’ question you have a regular dialog with the SEC and your

staff do, but there has been no specific request for your input on

this strategic plan and their focus to the allocation of manpower

and resources regarding enforcement?

Mr. SPITZER. No, no. There has not been. And, frankly, I would

not expect them to ask my perspective on that. You know, I would

not ask them to tell me how to allocate the budget within my organization. I would not expect them to say, hey what do you think.

Mr. PLATTS. I think that’s kinder, as you say. But I also think

it is relevant in the fact that you have mentioned you have 15 attorneys, and the success and efforts you have undertaken and important efforts for those typical investors out there, given the size

of the SEC and that you are obviously being fairly efficient with

your resources and your allocations and prioritization. And that is

something we will get into with the SEC as far as who are they

asking for feedback from regarding their strategic plan.

21

In your approach I assume that technology is an important part

of your efforts to maximize your manpower. Do you use data mining and that type practice or is it more manpower?

Mr. SPITZER. Yes. But I would say that the cases—and I wish I

could tell you otherwise, but the cases do not emerge from data

runs that lead us to irregularities for trading patterns that we then

say we have to look at this. Part of it is that we do not have that

capacity nor the data at our fingertips.

We certainly use enormous data runs once we have a theory that

we either begin with, just somebody creates it or somebody brings

it to us. We then test that theory. And one minor example of that

is, perhaps, in our efforts to calculate dilution effects from the impact of timing of mutual funds, we do enormous quantitative analyses and you have spectacular economists at my office who is involved in running these numbers and comes up with models to figure out how we could quantify. So we do not do it data in theory,

we do it theory can we turn it into and try to do that.

Mr. PLATTS. Right.

Mr. Towns, did you have other questions.

Mr. TOWNS. No. Thank you very much, Mr. Chairman. I would

like to thank the Attorney General for coming and the work that

he is doing in this area. He has 15 lawyers, I mean you would have

to be impressed with that.

Mr. SPITZER. I think they are very good lawyers.

Mr. TOWNS. Evidently so. Thank you so much.

Mr. SPITZER. Thank you.

Mr. PLATTS. OK. And I would like to add my thanks again for

your time today and the great efforts of you and your staff in doing

right by that typical investor out there. We appreciate your work,

and wish you well.

Mr. SPITZER. Thank you very much, Mr. Chairman.

Mr. PLATTS. Thank you.

Mr. SPITZER. Thank you.

Mr. PLATTS. We will take a quick 2 minute break as we get our

second panel with Mr. Bogle and Dr. Morey and reconvene here

shortly.

[Recess].

Mr. PLATTS. We are ready to reconvene this hearing.

Thank you, Mr. Bogle and Mr. Morey for your statements. Will

your raise your right hands and answer the following?

[Witnesses sworn].

Mr. Bogle, we will hear your testimony first.

STATEMENT OF JOHN BOGLE, BOGLE FINANCIAL MARKETS

RESEARCH CENTER, FOUNDER VANGUARD MUTUAL FUNDS

Mr. BOGLE. Thank you for inviting me to speak with you today.

I hope that my experience in the mutual fund industry will be

helpful in considering the issues before you regarding resource allocation and strategic planning at the Securities and Exchange Commission.

I have been involved in this business since I began to write my

Princeton senior thesis which I began in 1949. In 1951, I went to

work for industry pioneer Wellington Management Co., and ran

that company from 1965 to 1974. In 1974, after being fired from

22

Wellington Management Co., I founded a new mutual fund organization, called the Vanguard Group of Investment Companies. Vanguard, surprisingly enough, represented my attempt to create a

firm that would measure up to the goals I set forth for the fund

industry in my Princeton senior thesis, all those years ago:

No. 1: To place the interests of fund shareholders as the highest

priority; No. 2: To reduce management fees and sales charges; No.

3: To make no claim to performance superiority over the stock market indexes; No. 4: To manage mutual funds, ‘‘in the most honest,

efficient, and economical way possible.’’

These goals, of course, were clearly aligned, not only with what

I regarded as the ‘‘spirit’’ of the Investment Company Act, but with

its ‘‘letter’’: to insure that mutual funds are ‘‘organized, operated,

and managed’’ in the interest of shareowners, rather than in the

interest of managers and distributors.

We’ve done our best at Vanguard, to achieve those goals, and we

are now the lowest cost provider of mutual funds in the world. And

we are also one of the two largest firms.

After relinquishing my position as Vanguard’s senior chairman

in 1999, I have been engaged in researching, writing, and speaking

about investing in the mutual fund industry. I have also written

a half-dozen op-ed pieces for the New York Times and the Wall

Street Journal, and four books, all with strong views about this industry’s need to better serve its shareholders. But I am sorry to tell

you gentlemen, the fund industry has yet to measure up to those

idealistic, yet wholly realistic, goals I urged upon it way back in

1951.

Disgusting as they are to someone like me who has made fund

management his life’s work, the recent market timing scandals

have a good side. They call attention to the profound conflicts of

interest that exist between mutual fund managers and mutual

fund shareholders, conflicts that arise from an inherently flawed

governance structure in which fund owners, in practice, have very

little if any voice. The trading scandals are but the small tip of a

very large iceberg, with the cost of time zone trading estimated to

be $5 billion a year. By contrast, in 2003 alone, the total cost of

managing the industry’s $7 trillion of assets came to more than

$100 billion counting turnover costs. An amount that is, of course,

largely if not entirely responsible for the shortfall that mutual

funds demonstrate in being able to keep with the returns on the

markets themselves. If the management portion of those costs were

subject to arms-length negotiation, tens of billions of dollars would

be saved year after year after year.

The same kind of stewardship that demands that fund directors

effectively represent the shareholders who elect them and to whom

they are responsible under the law is rarely found in this industry.

Rather, managers have focused not on salesmanship but on salesmanship. Their agenda is inarguably dominated by the desire to

bring in assets under management. That marketing agenda led us

to create 496 new ‘‘new economy‘‘ funds during the stock market

bubble, not because they were prudent investments, but simply because we saw that the public was eager to buy them. And in the

ensuing market crash, these very funds cost the public quite literally hundreds of billions of dollars. The conflicts of interest that

23

engendered these unhappy and costly outcomes for fund shareholders must be resolved in favor of fund owners, not fund managers.

And the recent scandals give us the opportunity to at last build a

fund industry that is worthy of its early heritage, one that does

what I have long—sometimes, I think forever suggested: To give

this industry’s 95 million investors a fair shake.

Achieving this goal, make no mistake about it, must come from

the industry itself, from within the industry and from investors.

But it cannot be accomplished without an active, energetic, dedicated, fully staffed Securities and Exchange Commission. During

my long career, both before and after the market bubble and the

corporate and mutual fund scandals, I have had frequent occasions

to work with members of the Commission and its staff. And it is

absolutely without hesitation that I report to you on the subcommittee that, virtually without exception, I have found these individuals to measure up to the very highest possible standards of

public service, integrity, expertise, education, intellectual curiosity,

and willingness to listen and make reasoned decisions. And I would

like to take this opportunity to salute the Commission and its staff.

The scope of their oversight of tens of thousands of corporations,

and exchanges, and accounting firms, broker-dealers, advisers, mutual funds is enormous. And as these activities exploded during the

bubble, the Commission’s workload soared accordingly. So, as you

know, did the SEC fees paid by these entities, from $750 million

in 1996 to $2.3 billion three or four times as much—in 2000. If only

those fees had flowed directly to the Commission, it might have

had a fighting chance to hire and retain and motivate a staff sufficient in number and talent not only to deal with that cascading

flow of paperwork, but to increase its investigation and overview

and probe much more deeply into the emerging issues of the era.

However, the SEC fees collected do not represent the funds appropriated for SEC operations, as you and the Congress know. In fact,

the Commission’s appropriation for 2000 was just $370, 16 percent,

one-sixth, of the SEC fees paid. It is hard to imagine that the Commission would not have been far more able to handle the added

regulatory responsibilities engendered by the bubble had its funding grown apace with its responsibilities. I’m pleased they are finally starting to get much more funding. For a Commission starved

in resources and plagued by high staff turnover, is a Commission

unable to fulfill its mission of overseeing our Nation’s vital system

of financial markets. That said, I do not want to appear to excuse,

solely on the basis of limited resources, the Commission’s failures

in its oversight of issues, markets, and funds. Economics, after all,

is all about the allocation of limited resources in a world where

needs are always unlimited. Neither private enterprise nor public

agency ever succeeds in getting its resource allocation exactly right.

And if I may say so, I can assure you that in running two different

mutual fund management companies, I certainly never got the resource allocation exactly right. But I think we have to acknowledge

our mistakes, as I try and do, learn from them, as the SEC is

doing, and use that wisdom to do a better job in the future.

I believe the Commission is doing that. I am impressed, and always have been, with the leaders of both the Division of Enforcement and the Division of Investment Management as they respond

24

to the clear evidence that we’ve been discussing today, illegal behavior among firms that were once considered industry leaders.

I am also impressed with Chairman Donaldson’s willingness to

tackle how the Commission operates, and particularly his new Office of Risk Assessment and Strategic Planning which is positively

responsive, of course, to the subject of your hearing today.

As I am most familiar with the Commission’s Division of Investment Management, my written testimony lists 7 issues that either

need additional attention or should be upon the SEC’s planning

agenda. I will not go through them.

In the time available to me, just let me say a couple of works

about each.

No. 1: Mutual fund market timing. You should know, as my testimony points out, it has been going on for at least a decade and we

all knew it.

No. 2: Hedge funds. They have played a major role in the mutual

fund scandals, as Attorney General Spitzer mentioned. An article

that was published in the Financial Analysts Journal in 2002 identified 30 hedge funds that were doing this and nobody did anything. So for these reasons and others, I do endorse Chairman

Donaldson’s view that hedge funds must—must—be drawn under

the Commission’s purview.

No. 3: Compensation of portfolio management disclosure. Right

now we have proposed rules that would describe how portfolio managers are compensated, but not how much they are compensated.

That is notably the same as no disclosure at all. I believe we need

disclosure of the dollar amount of compensation not only of portfolio managers, but of the five highest paid executives of the company. Why should the mutual fund industry be exempt from the

disclosure required of other corporate executives.

No. 4: Fees paid by pension accounts that are managed by fund

managers. Why are the fees funds pay often from 100 to 150 times

as large, as for example, the fees that California’s personal retirement plan, (CALPERS), pays those same managers, presumably

the same portfolio of essentially the same securities.

No. 5: 401-k plans. Recent press reports have detailed clandestine payments from fund managers to pension clients, often in the

form of rebates. The SEC investigation of this area simply has to

be a high priority.

No. 6: The role of financial conglomerates is almost never discussed. When I came into this business, fund management companies were privately owned organizations owned largely by the fund

managers themselves. Today public ownership and ownership by

giant financial conglomerates have gradually become the industry’s

modus operandi. Of the 50 largest fund management groups, 36 are

owned by huge financial conglomerates.

Why do conglomerates buy mutual fund management companies?

They do it to earn a return on their capital, the conglomerate’s capital. Yet the 1940 Act makes earning a return on the fund’s shareholder’s capital the overriding priority. This rarely acknowledged

conflict of interest cries out for study.

No. 7: Yes, an economic study of the mutual fund industry.

A few minutes ago, Attorney General Spitzer mentioned the need

for an economic study.

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Now to conclude just very briefly having laid out the litany of

priorities of a strategic study by an SEC whose resources are already stretched, I fully recognize the job before the Commission is

large and its resources, while large are still limited. These tasks,

however, are not only worthwhile, but essential for the protection

of investors. However, I want to offer now a final recommendation

in more detail in my written testimony that could in the long run

actually reduce the Commission’s regulatory responsibility. Just

think about this: One of the principle reasons for existing regulation and the existing additional regulation, and the areas of study

I’ve noted above, is the need to deal with the profound and obvious

conflict of interest that exists between mutual funds and their

shareholders on the one hand and management companies and

their shareholders on the other. The timing and trading scandals,

the setting of appropriate fees, the focus on asset gathering are all

issues that reflect this conflict, and the costs they impose are deducted from returns of the financial markets, and trickle down, if

you will, to fund shareholders. Those things must be addressed.

The Investment Company Act of 1940, our Constitution, the law

of the land, puts the fund in the driver seat and the management

company in the rumble seat. A narrow reading of the act would not

even allow the management company into the car. Read the act

and see if you don’t agree with me. The fact is, however, that it

is the management company that’s driving the darn car. If funds

were truly organized, operated and managed solely in the interest

of fund shareholders, most of today’s regulatory problems would

vanish. The funds would protect their own shareholders. That is

what they are supposed to do. How to get to that goal is a good

question for the highest use of SEC’s strategic resources.

That concludes my testimony. And I thank you for your attention.

[The prepared statement of Mr. Bogle follows:]

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Mr. PLATTS. Thank you, Mr. Bogle. And we’ll save questions until

we have Morey’s statement and then have questions for both of

you.

Dr. Morey.

STATEMENT OF MATTHEW R. MOREY, Ph.D., ASSOCIATE PROFESSOR OF FINANCE, LUBIN SCHOOL OF BUSINESS, PACE

UNIVERSITY

Dr. MOREY. Thank you very much. I wanted to thank the Committee for inviting me here to attend the meeting and also to thank

you for coming to Pace. It is wonderful when we get the opportunity to have you all here. And I hope you consider having other

meetings here in the future.

With this testimony I wanted to give my thoughts on two particular issues concerning the regulations of the mutual fund industry.

First, I wanted to relate that the SEC recently has been making

impressive strides to improve the institution’s ability to regulate

the fund industry; however I think more should be done given the

increased importance of mutual funds in the United States.

And second, I believe that disclosure is the most important issue

to focus on with regards to regulating the fund industry. And I

wanted to sort of be up front and say that it is my belief that I

think investors are in fact intelligent. If they are informed of the

basic operations of mutual funds in a clear, concise and accurate

way, investors can understand the differences between funds and

I believe make better investment decisions. And I say this because

I think many of the problems that we are talking about in the last

couple of years and so on relating to the fund industry are associated with this lack of disclosure.

Now in terms of the SEC’s role in regulating mutual funds, I believe that Chairman Donaldson is moving the regulatory institution

in the right direction. The much needed, recent increases in the

SEC’s budget have allowed it to hire many more people, pay them

more competitive salaries, and so on. And this, combined with the

SEC’s fresh interest in investigating many of the most important

mutual fund abuses such as disclosure, fees and market timing, are

all major improvements. However, I would encourage the committee to push for even more funding and support of the SEC with regards to the mutual fund industry.

Consider for a moment that the size of the SEC’s budget, and

now using what we’re basically considering the SEC’s budget for

the future, the best SEC’s budget has gone from $166 million in

1990 to a proposed $913 million for 2005. And this constitutes an

increase of 5.5, 6 times, if you will. From 1990 to 2002, mutual

fund asset—of course in 2002 they much lower at that time because the market had gone down—mutual funds assets have increased about six times during that time. So, on the surface, it does

look like the funding now with the recent increases is keeping up

with the growth of the industry. But if you look more deeply at mutual funds themselves, these figures do not illustrate the entire picture. For example, in 1990 only 6.7 percent of total financial assets

held in U.S. households were in mutual funds, only 6.7 percent.

Twelve years later at the end of 2002, the percentage was almost

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18 percent, 17.8 percent to be exact. So almost a threefold increase.

And hence, while the SEC funding may be close to matching the

growth of the industry if you look at those numbers I was giving

you before, it does not take into consideration the importance of

this industry. It really has grown dramatically. And in fact, I can

quote some studies that have basically found that the amount of

money in mutual funds today is more than are in private U.S.

banks. And it is a major financial institution that deserves to have

some type of regulation that these other financial institutions have.

Furthermore, I would encourage the committee to push for more

support of the SEC during the times that it needs it most: bull

markets. Paradoxically, the very moments when the SEC needs the

largest increases in funding are, I believe, when markets seem to

be behaving well. It is during these times that many scandals arise

as support for regulation declines considerably. Congress, like the

SEC, must be farsighted enough to know that bull markets do not

necessarily mean the fund industry is functioning well.

The second issue I wanted to talk about is disclosure. And this

has been talked a lot about by our previous witnesses.

As I said before, I believe that many of the problems that we

have in the fund industry today are associated with the lack of disclosure and that forcing the industry to be more up-front about

fund practices would greatly help the industry in the future.

First, consider expenses or fees, which have been widely talked

about already. As is well known, mutual funds do not clearly state

or describe their expenses to investors. While the expense ratio

does give information on the cost of running many of the aspects

of the fund, brokerage fees are not included in this calculation. And

what this means is it is difficult, if not impossible, for investors to

discern the true expenses of a fund. Now this is vital information

for the following reason: In almost all the academic research on

mutual fund performance, the one consistent factor that is shown

to be of help in terms of predicting future mutual fund performance

is of the expenses. That is, low expense funds, on average, out-perform high expense funds. However, because not all expenses are

disclosed to investors, they are left without the key information to

help them invest wisely. If the SEC were to require full and complete disclosure of fees and expenses, it would greatly help investors in selecting funds and, I believe, it would help restore trust in

mutual funds.

Second, another problem with mutual funds that is related to

disclosure is window dressing. Until recently the SEC required

funds to disclose their actual portfolio holdings only twice a year.

And recent academic research—some of this by myself—however,

indicates that since disclosure is so infrequent or has been so infrequent, some funds practice a behavior known as window dressing,

whereby they cosmetically alter their portfolios right before disclosure in an effort to make the portfolio look better than it actually

is.

For example, a bond fund manager may attempt to hold slightly

higher quality bonds right at the time of disclosure in an effort to

show a safer portfolio. However, immediately after disclosure, the

manager dismantles these cosmetic positions. For investors, the

detrimental effects of window dressing are two-fold.

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First, investors can be misled about the sources of fund performance. Taken to the extreme, this deception could conceal investing

behavior inconsistent with the fund prospectus.

Second, additional explicit transactions costs are borne by investors to build and dismantle cosmetic positions. It is my belief that

window dressing can and probably will be mitigated with more regular disclosure. If funds have to disclose their holding more often,

more frequently, say on a quarterly basis which is the new change

that the SEC has implemented I believe last 2 months ago, it

would be more difficult for a fund to hide what it is actually holding and more expensive to practice window dressing, as funds

would have to build and unwind these cosmetic positions more

often. And although this more frequent disclosure does increase administrative costs, I believe that the gains of more frequent disclosure, i.e., less window dressing and just more information to the

public, to the investor, outweighs these additional costs.

The last issue I wanted to discuss with the SEC is making mutual fund information easier to understand for the average investor. Indeed, I feel that some recent developments in the mutual

fund industry to sell funds via brokers have actually made it more

difficult for an average investor to understand mutual funds and

that actually have hurt the industry.

For example, consider the issue of multiple share classes. About

12 years ago, almost all funds in the United States, there were

some exceptions but most of the vast majority of funds in the

United States were either load or noload mutual funds. However

around the mid-1990’s, just as investors were beginning to understand the difference between a load and a no-load fund, many

funds moved to multiple share classes as a result of the adoption

of rule 18f–3 by the SEC in 1995. Just like other mutual funds,

multiple-share-class funds represent a portfolio of underlying assets. However, unlike other funds, they have different share classes

differentiated only by how investors pay fees. For example, a single-class fund only has one fee structure whereas a multiple-shareclass fund can have two, three, even four different fee structures

on the same underlying portfolio.

Now, I don’t think the impact of these multiple-share-classes is

well understood by a lot of people in the industry. To understand

the impact of the multiple-share-classes consider that at the end of

1991, the Morningstar mutual funds data base indicated that there

were 2,373 funds. By the end of December 2000, the same data

base indicated that there were 12,029 funds; a more than fivefold

increase in 9 years. However, since each share of a multiple-shareclass fund is counted separately by Morningstar, these numbers are

completely overstated. Indeed, when multiple share classes are adjusted for, these numbers drop to 2,322 funds, again at the end of

December 1991 and only 5,349 funds. Hence, the rise of multipleshare-classes is responsible for about 69 percent of the increase in

the reported number of funds over this period.

And although the stated intentions of this rule 18f–3 seem quite

positive for investors, i.e., investors would now be able to choose

the best fee structure that suits them without the funds having to

pay the costs of creating several funds, many of the effects of this

rule change have actually been quite negative for investors.

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For example, one of the most obvious problems with multipleshare-class funds is that mutual fund fees have become more complicated for investors. And we have been talking about how important fees are in terms of terms. Again, indeed, just as investors

were getting used to the distinction between load and no-load

funds, the industry adopted an alphabet soup of fund share classes

that investors now have to sift through. So after they pick a fund,

they now have to pick the share class that they are actually going

to undertake.

Moreover, and maybe the most negative consequence of multiple

share classes, a colleague of mine, Edward O’Neal and some other

people have well, have found that the introduction of multiple

share classes has given rise to broker compensation arrangements

that can be quite different across share classes. For example, brokers may receive more compensation for selling a deferred-load

class, particularly known as a B share class, rather than a front

load class share. And O’Neal documents that such incentives have

lead to clear conflicts of interest as brokers try to sell a share class

that is the best for them and not necessarily best for the investor.

So to conclude, I would encourage the committee to more fully

support the SEC with regards to mutual fund regulation. The industry has seen its importance increase dramatically and this fact

alone, just alone merits more funding for the industry’s chief

watchdog.

In terms of the focus of the SEC’s regulation efforts, I believe

that fuller disclosure with an emphasis on relatively easy-to-understand statements of fees, expenses and portfolio holdings is the way

to go. At some point, mutual funds have to be self-regulating, but

it is my belief that the SEC should allow investors to make more

informed decisions by requiring funds to disclose much more information to the public.

Thank you.

Mr. PLATTS. Thank you, Dr. Morey. And, again, my thanks to

both of you for your testimony and we will proceed into the questions.

Mr. Bogle, again, certainly your many years in the industry and

your perspective of having been regulated by the SEC brings a

unique perspective to our hearing today. And I wanted to say your

standard that you set in that 1949 thesis statement and the high

ethical standards I commend. And as I say in the political arena

in my approach to politicking and person-to-person that some of my

views are deemed idealistic. I say, well, idealism and realism combine; you can be an idealistic realistic or a realistic idealist. But either one I think is a worthy goal.

Mr. BOGLE. Absolutely, sir.

Mr. PLATTS. And I think that is something that is important,

that your perspectives are idealistic but realistically achievable

goals is important for all of us to understand.

Some of what has transpired in the mutual fund industry and

with the Attorney General, and efforts on the market timing and

late trading, seem to be kind of just fully known and just accepted

practices, although within the ethical and legal standards that

really should have been pursued. And it gets into our focus today

on that strategic planning process of the SEC, its resource allocaVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00042 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
39

tion. Given how pervasive the knowledge was of these practices,

what is your view of what went wrong that the SEC was not

proactive in identifying these practices that were hurting that average investor if it was so openly known?

Mr. BOGLE. I think, first of all, the Investment Company Institute, the trade association for the industry, has always had a heavy

influence on the SEC staff. And the people that run this industry,

the chief executives of the management companies, are persons of

very high ethics but they are involved in a business that has a

whole lot of things that we take for granted that we should not.

You know, Mr. Chairman, there is a wonderful quote from Upton

Sinclair that says it is amazing how difficult it is for a man to understand something if he is paid a small fortune not to understand.

And this is an enormously economically attractive industry. So I

think they were sort of persuaded by their own rhetoric and more

able to persuade to the SEC that things were not serious, they

were not problems. And the ethic in our business was kind of everybody else is accepting these timers. Now our marketing department says if we do not allow market timing by a brokerage firm,

they will take us off their preferred list; all that kind of thing and

all the shelf space and point of sales stuff that affects this industry.

And I think we did not realize how bad it was. I do not think we

thought through that it was actually damaging the existing shareholders. But I have to say, and it will sound self-serving, and in

a lot of ways it is self-serving, but when we started Vanguard it

was to be run for the shareholders. And believe me, we have been

dealing from almost the day we converted from a load system to

a no-load system in 1977 with people trying to break through the

doors and do market timing. And I hate to tell you, I would not

dare tell you, how many of them I have almost personally thrown

out. You do not like that and you know it is not good for the fund

shareholders, but many felt that if it is depriving the management

company of the revenues, you kind of think well it is not too bad.

Certainly some of the stuff that was criminal is an exception. But

very few people thought they were behaving unethically because

the system under which the industry runs and the industry ethic,

if you will, we are all competing and our competitors are doing it,

our peers are doing it and we do not think that there is anything

too bad. I do not think the SEC really knew as much as was going

on as the industry itself it did, even though that Financial Analysts

Journal article was out there for anybody to read. Maybe nobody

in the SEC reads the Financial Analysts Journal. I will bet they

are reading them now.

Mr. PLATTS. We hope so. And, you know, as a dad I put a lot of

things in perspective and I maybe better understand how my dad

always commented to put things in perspective as his dad did himself when he talked about us kids. And it is almost—you know, my

kids will say why can I not do that? Well, all the other kids are

able to do it.

Mr. BOGLE. Yes.

Mr. PLATTS. You know, and if they can do it, why can I not? And

it is just kind of unfortunate, that mentally. But certainly given the

very import fiduciary duty the SEC has, just because it is accepted,

certainly is it within the balance of the law. And a lot of what your

40

testimony brings forward is a big part of what our committee is focused on. Certainly there is certain statutory changes that are

needed to account for the change in the marketplace and to keep

up with those changes. But what I took from your testimony is a

better enforcement in regulation of the marketplace under existing

laws is really going to go a long way to protecting that investment.

Your analogy to the rumble seat and under the law they should not

be in the car and yet they are driving the car; that is not a change

in law, it is enforcing the law. And what our hearing’s focus is from

the strategic allocation of resources to better enforce the law.

You certainly well highlight the challenge that the SEC had as

we—you know. I was not in Congress in the 1990’s, but it looked

like the Federal Treasury was looking to the SEC as kind of the

rainmaker for the Federal Treasury. Just generating more and

more money and we are going to give you a smaller and smaller

percentage of what you are generating. And instead of reinvesting

that we were going the opposite direction. And manpower certainly

was a prominent issue and we are seeking to address that.

Mr. BOGLE. A lot of these things did not need to have happened,

sir.

Mr. PLATTS. Yes.

As we are now trying to give them manpower, give additional authority to SEC and the SEC is actively engaged thanks to the leadership of Chairman Donaldson and his staff of having a more comprehensive approach, is there one or two items that we as a subcommittee should especially be looking for in their strategic plan

that they might coming forward here in the near future to us and

to the general public, to investors and to the community, that we

really should be especially focused on in their strategic plan?

Mr. BOGLE. Yes. I tried to list a fairly large number. I would put

quite high on the list the economic study of the mutual fund industry.

Mr. PLATTS. Of those seven, that would be——

Mr. BOGLE. That would probably be my highest. And the second

is one that is literally not discussed. I do not know anybody who

said a word about it except you know who seems to be getting in

trouble all the time with his fellows in the industry. And that is

the conglomerate takeover of the industry. Is that good? What does

it mean when the whole idea, their idea is to gather assets? Just

the gathering the staggering amounts of assets. Now the largest

mutual fund manager happens, thank God, to be an indexer. Runs

$1 trillion worth of assets. Those are huge amounts of money, but

when you get trying to manage them, can money be managed at

that level effectively? Is there any thought about saying that a certain size of mutual fund can no longer carry out the objectives that

it has in the prospectus?

Size is one. Buffet tells us that a fat wallet is the enemy of superior returns and there is not a money manager in America that

does not know that, and yet we keep looking for more assets in the

industry. And so that would be probably my second one.

Mr. PLATTS. Those are your top two? And those are insights. And

I did appreciate, as I read the Attorney General’s testimony ahead

of today’s hearing and as you reflected in your opening statement,

how closely aligned as he talked about his three chapters, it really

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is almost like you know, he had a copy of your testimony on that

economic study.

Mr. BOGLE. Let me make the record clear, Mr. Chairman, that

we did not share. I know you know we did not.

Mr. PLATTS. I know you did not, but certainly you dove tailed

well with each other from him on the enforcement side as Attorney

General and you coming from the regulated side in the industry.

It really made a great joint message.

And I want to go to our ranking member and then we will come

back some additional questions.

Mr. Towns.

Mr. TOWNS. Thank you very much, Mr. Chairman.

As a former industry leader, Mr. Bogle, let me say to you, I am

really impressed with your testimony (inaudible).

What must the SEC do to ensure that the financial community

take these regulations seriously? They may have regulations, but

they are not taken seriously.

Mr. BOGLE. Well, they are not taken seriously for a couple of reasons. First, the SEC has no criminal, as I understand it, no ability

to prosecute under the law. They have to refer that over to the Justice Department. One of the great advantages Attorney General

Spitzer has is he can do that. He can put people in jail. And believe

me, when people start to go to jail, and we have one mutual fund

executive, he happened to be named mutual fund executive the

year in the year 2002, who is now in the slammer. And that is the

bigger they are, the harder they fall.

So the Attorney General has something quite strong going for

him. Because white collar criminals have quite a different life there

when they find themselves in jail. And then we cannot expect the

SEC to do that.

But I think it is strong enforcement. I think the Commission is

reticent, and more reticent than they should be in making fee reductions a part of their settlements with these various mutual fund

companies. There is sort of a philosophical divide between Attorney

General Spitzer’s approach and the Commission’s approach. But I

would use, you know when you get a struggle like this, a fight like

this is you will, I think the SEC should use every weapon at its

command. And I would say fee reduction would be an important

part of that.

I would also hope that the chairman would use the bully pulpit

that the chairman of the SEC has to stand up and talk much more

boldly and bluntly about these abuses and about the industry in

which they have occurred.

He is a terrific chairman, but I do not think he realizes the

power of the bully pulpit as much as he might.

Mr. TOWNS. Right. Thank you.

Since approximately 20 percent of all pension funds are invested

in mutual funds today, should that be a specific focus on how particular investments in mutual funds are regulated, that is the

stake from the individual investors?

Mr. BOGLE. You raise a very, very good question, Ranking Member Towns. A really good question. Let me just give you an interesting fact.

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Of the 100 largest financial institutions in America, which happen to control 56 percent of all the stock in America, the 13 are

State pension funds and 87 are private firms; 78 of those 87 firms,

the overwhelming majority, actually run both mutual funds and

private pension accounts. The mix, in other words, it is very hard.

I think we have to change our mind set and maybe even our vocabulary a little bit to talk about money managers because the issues

in both classes are not very different. When you are marketing to

individuals, which is the mutual fund side by and large, particularly the 401k area, you know you are marketing to a huge number

of people. But you are still marketing to the institutional side and

then you got salesmen out there trying to say well I am better than

everybody else and all those kind of things that they do, but they

are both afflicted by very much the same things.

I am not sure you need heavy regulation. The advisors of the

pension plans are registered separately and are usually affiliated

companies that register separately under the Investment Advisors

Act. But that is, by and large, at least by my standards kind of a

reporting statute. But I think there should be considerable attention given to the conflicts, I would say, in those two areas, fee setting.

Another good example is these advisors, the same advisors mind

you now with different corporations in the same company, but the

same organizations who will offer very low fees to State pension

plans and also offer them incentive fees that say we will not take

anymore fee than this unless we give you good returns. Why, one

might ask, is not the same deal offered to their mutual fund clients? It seems sort of amazing, does it not? But it is not. Incentive

fees in the mutual fund area are virtually nonexistent. I think 1

percent or 2 percent of all mutual funds use them, which, I think

Vanguard makes up half. We like incentive fees because the adviser gets paid if he does well and pays a penalty if he does not.

So, I think you are right, that there should be some—without

having a regulation that is all encompassing, certainly a parallel

regulation in which there is a recognition that these two businesses

are one in the same and becoming increasingly associated.

Mr. TOWNS. Let me thank you. And I thank you for all your work

you are doing, and re-thank you for your testimony today. Thank

you.

Mr. BOGLE. Thank you.

Mr. PLATTS. Thank you, Mr. Towns.

Dr. Morey, your study on the window dressing issue and the kind

of gaming system for that investor looking at a prospective investment.

Dr. MOREY. Yes.

Mr. PLATTS. Is that something in your assessment that the SEC

should have been able to identify long before your study. It seems

that once you did it, and identifying the practice, it should have

been something that you know was more quickly identified by

those laboring in the industry. What is your assessment?

Dr. MOREY. Yes, it is something I think that they could have investigated a lot earlier. I mean, there have been evidence of window dressing in many different areas. And, you know, the economic

significance of window dressing maybe is not of the level of market

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timing, things of that sort. I do not know if I would put it up at

that high of level. But it is something that has been an issue and

anecdotally talked about, and it has been talked about in a number

of research papers for many years in the recent decade.

So as I think I relayed in the paper, if you have read in the

paper, so the SEC has not brought up one single investigation of

window dressing. So I really think it is something that they could

have looked at. And part of the reason they have not looked at it

is they are just under staffed, under paid. A lot of those things that

have been kind of been talked about before. So I do think it is

something that they certainly looked into more. And the movement

of going to more frequent disclosure, quarterly disclosure I think

really does indicate that the SEC is moving in the direction of trying to, you know, be concerned about window dressing.

Mr. PLATTS. I would agree in the sense of, as we have heard from

the Attorney General as well, disclosure in and of itself helps address some of these. That self regulation——

Dr. MOREY. Right.

Mr. PLATTS [continuing]. Ultimately is going to come from within

the industry as we get better disclosure, whether it is on issues of

window dressing or related issues; that the sunshine will help to

force the industry to better regulate itself as self. But the point

being made, you know, that an aggressive proactive SEC—also that

I use the analogy with your student and you have a homework assignment and the teacher is actually going to call on you in class,

you are more likely to pay attention to it. So if you are in industry

you know that the regulators are more likely to actually look into

what you are doing, you are more likely to be a little more diligent

in fulfilling your duties to the investigators.

Mr. BOGLE. And if you knew your directors were going to take

you to task, if you knew your fund directors were going to take you

to task, which there has not been nearly of.

Mr. PLATTS. Yes, from within the industry itself, right?

Mr. BOGLE. Yes.

Dr. MOREY. I mean, the No. 1 role of the regulatory institutes is

it always be bending over backward for the small investor, I really

believe. And I do not think it has been doing that for the last 10

years or in many ways.

Mr. PLATTS. Well, that was actually a question I wanted for both

of you, because I know Mr. Bogle you have a train to catch.

Mr. BOGLE. That is all right. I am at your service.

Mr. PLATTS. So we want to make sure—as we work with the SEC

and they are coming forward with the strategic plan and where are

they going to focus? And I appreciate in your talk and you are

agreeing with Chairman Donaldson, the importance of the SEC

being involved in the regulation of hedge funds, but how with limited resources, even though they have more, there are still ever

going to be enough in any one’s view, is their strategic plan. What

is the right balance between large investors, a small number of

them and the smaller investors but a huge number? What should

we be looking for in their strategic plan? How do they truly go

about their resource allocation in that regard?

Mr. BOGLE. Well, I certainly agree with Dr. Morey that the small

investor needs a lot more protection than the large investor does,

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and there cannot be any question about that. And sooner or later

we have to try and educate the small investor about how to protect

him or herself. We have gone through an era of great human greed,

a great market bubble and if everything looked easy, we had for

20 years 18 percent annual returns in the stock market. Even a

poor performing mutual fund probably doubled your money. And

that is probably only a 5-percent return or something like that. But

all those things kind of came together. You could even argue it was

kind of a perfect storm.

And it is a little hard to say where the SEC should put its resources. But, you know, one thing which actually Dr. Morey inspired in my mind as I was listening to him here is that the SEC—

the work that comes out of the academic community in the financial area is staggering.

You know, the personal computer has made every academic able

to explore thousands of academics for every single aspect of everything that goes on in the financial fields and the work just pours

out; there are three, four, five, six, seven academic journals. Some

of them are written in English, some of them are written in a language with which I am not familiar. But the SEC, honestly and I

am not kidding about this, should have one or two people; one who

can speak the English and translate all these formulas into English

and see what is worthwhile. A lot of it is not worthwhile. Some of

it just priceless. But just capitalizing on the work that is done out

there does not require using the research others. Using the work

of others would be a very useful thing to do.

I would try and convene groups of people in the industry. I am

not sure how you get them to talk. I have been lucky enough to

be in a position where I can talk to Commission division, and I

have talked informally actually this year to the Director of the Division of Enforcement, Steve Cutler, for whom I have the highest

regard for and his whole division. And I will be talking with Paul

Royee (phonetic) in Division of Investment Management.

But we ought to have people from the industry come and talk to

them about, you know, about the reality as it is in the industry.

Not all the double talk, not all the public relations, not all the veneer. What is really going on and are there economic issues and

management issues and conflict issues that go on in this industry.

And I think those things should not demand too much of SEC resources.

Once we get to the areas you could really focus on, then put the

resources on them.

Dr. MOREY. Yes, I would say the same sort of thing. I mean, I

really do believe that the smaller investor really most of the attention should be put in terms of regulation. Yo know, again, it comes

back to the disclosure. I really do feel that, you now, individuals

should be responsible to some extent about where they are investing their money, but we should be able to give them as much information in as clear a way as possible. And, you know, just multipleshare-class stuff. I can understand why the mutual fund industry

wanted this, because most mutual funds are not bought, they are

sold. That is literally how the industry people, they are sold to

other people. But still, I mean, trying to basically protect investors

by keeping it as clear, as easy to understand as possible is really

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imperative. And that is what I would really stess in terms of the

SEC and (inaudible) share.

Mr. PLATTS. One final question. I want to yield to Mr. Towns to

wrap up this portion, but Mr Bogle, you addressed in the sense of

your meeting with the Enforcement Division and sharing some of

your great wealth and knowledge with them to get that kind of

how things really work on the street. And I was going to ask you,

I am glad to hear that type dialog is happening.

The second half of that is, Dr. Morey, based on your study and

when addressing issues, has there been any effort by the SEC to

reach out to you and to your fellow professors working so that you

are aware of to do as Mr. Bogle has said——

Dr. MOREY. Right.

Mr. PLATTS [continuing]. Kind of just pull in your knowledge as

a source of some additional information?

Dr. MOREY. Yes, there has been. We, in fact, presented this

paper at the SEC not too long ago. One of my colleagues used to

work at the SEC, actually, in that direction.

Mr. PLATTS. Great.

Dr. MOREY. So, yes, I do think there is some, but not enough. Not

nearly enough. And I will give you one example that has worked

pretty well, which is ICI, Investment Company Institute, every 2

years has put together a conference where they bring in academic,

mutual fund academics and with practitioners. And although some

of the practitioners are a little guarded about what the are saying,

and so still there has been an incredible useful thing. Because we

can ask them the questions that we are interested in, they can ask

the questions.

At the last one we were really trying to talk a lot about like compensation, the stuff that Mr. Bogle was talking about. Why isn’t

the mutual fund manager’s compensation disclosed. You could even

disclose it in anonymous ways that we could do studies on it. But,

you know, those kinds of issues. So that was very helpful and

maybe if the SEC could do something like that in a broader way

with a conference or something of that sort, it would be very helpful.

Mr. PLATTS. Thank you.

I yield to Mr. Towns.

Mr. TOWNS. Right. Thank you very much.

And let me thank you also, Dr. Morey for your testimony. And,

of course, I also appreciate the fact that you have given us another

invitation to the University as well. We certainly appreciate that.

Are you saying that the SEC should have a mandate for educating investors? Are you saying that should be their responsibility to

spend more time in terms of making certain that investors are educated?

Dr. MOREY. I guess education——

Mr. TOWNS. Are there responsibilities in the law, I should say?

Dr. MOREY. Yes. I think they have responsibility to make sure

that user funds disclose fees completely and accurately, and also

clearly. Now, if that is educating, I would say yes to that. But I

think it can be done very clearly and so on in the ways that you

really do not have to basically, you know, put a tremendous

amount of energy into educating investors. I think if you put it

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down in pretty simple language and a very concise statement, I

think that the education of investors really is not needed as much.

It is almost really just disclosing things in a clear way.

So if that is education, yes. But I do not really see it as that. I

see it as basically putting things down in a very clear easy to understand sort of method and full disclosure of those things.

Mr. TOWNS. What impact can you discern from your research in

terms of the mutual funds scandals had on investors’ confidence in

the industry? Was that affected in any way?

Dr. MOREY. Yes, I think it initially affected it a lot. I did effect

it. But, I mean, the problem is that, you know, most people when

they are investing money, you know, they are doing through their

pension plans and so on, they do not have that many other options

and they are still investing money back into mutual funds. So, yes,

I think it had a big impact initially and I think people are more

weary of funds. And we have seen basically more movement toward

index funds and things like that because of the fee structures and

so on. But I guess just because of the very fact that this is what

everybody basically invests in now or whatever does for the most

part with their retirement money.

You know, there is going to be a tremendous amount of money

still invested regardless of the scandal. So I mean, I think it has

been sort of short term to some extent and then over the longer

term, if you will, a lot of that sort of has became a—I will not say

it has fallen into memory or fallen away, but it is not as prevalent

as it was. OK.

Mr. TOWNS. Consistent with in terms of this morning, every witness has indicated the fact that the small investors need to be protected.

Dr. MOREY. Yes.

Mr. TOWNS. What do we do as members of the U.S. Congress to

assist in that, making certain that they are protected?

Dr. MOREY. Well, I think, you know again given the resources of

the SEC that, you know, they are in budget constraints and everything, I think what is most important again is disclosure. I really

do think it comes down to that. And that since a certain amount

of the burden has to be put on the investors, but investors have a

right, the actual right to have full information about what these

funds are doing. And I cannot emphasize enough that almost the

academic research—I mean some research has found certain things

to predict mutual fund performance better than others, but the one

single thing that really comes across is expenses. Expenses clearly

are the issue. If you are trying to figure out, you know, a high performing fund and once you figure out the right style that you want

to be in and so on, go to a low expense fund.

And, again, when investors do not have that kind of information,

when they do not really know what the actual expenses are, it

makes it a very hard case to say that, you know, we are regulating

industry correctly.

So I really do believe that given the resource constraints that

what the SEC could be doing is really focusing on complete, easy

to understand disclosure of fees and, you know, we can talk about

some of these other issues. But that would be the main, main thing

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I would do. But the burden, to some extent, in the investor’s hands.

But still with all——

Mr. TOWNS. OK.

Mr. Chairman, I am going to yield but I just am going to make

this comment. I do not know whose idea it was to put them first

and then allow the SEC to come last. But I tell you, that did make

a lot of sense.

Mr. PLATTS. I’m not sure if Commissioner Donaldson would

agree.

Mr. Bogle and Dr. Morey, we greatly appreciate your time with

us today and your efforts in making sure that average investor is

in the driver’s seat and not in the rumble seat. And we are grateful

for the knowledge you have shared with us, and look forward to

perhaps having a chance to work with you again in the future.

Thank you so much.

Mr. BOGLE. Thank you very much.

Dr. MOREY. Thank you.

Mr. PLATTS. You are welcome.

We will take a minute or two break while we get to the final

panel, and get started here shortly.

[Recess.]

Mr. PLATTS. OK. I think we are ready to get started with our

third and final panel. Saved the best for last, right?

If I could ask our two witnesses to stand and I will administer

the oath.

[Witnesses sworn.]

Mr. PLATTS. The clerk will reflect that both witnesses responded

in the affirmative.

And, Mr. McConnell we will begin with you and then, Mr.

Hillman your opening statement and then save questions for both

of you.

If you would like to begin, Mr. McConnell.

STATEMENT OF JAMES M. MCCONNELL, EXECUTIVE

DIRECTOR, U.S. SECURITIES AND EXCHANGE COMMISSION

Mr. MCCONNELL. Chairman Platts, Ranking Member Towns,

thank you for the opportunity to testify on behalf of Chairman William Donaldson regarding strategic planning and the allocation of

our recent funding increases.

The SEC experienced unprecedented staffing and budgetary

growth over the last 3 years. And the Nation’s investors and in the

industry we oversee need to be assured that we have a thorough,

thoughtful plan employed at this moment. Our 2005 request of

$913 million is nearly twice the size of our 2002 budget and demonstrates the strong commitment by this administration to addressing the many challenges confronting the agency.

Before I begin, and perhaps a bit uncharacteristically for a Federal agency, I would like to thank the GAO staff and Rick Hillman

for the work that they have done over the past 2 years in working

with the SEC. Their work and recommendations have been an

asset to the commission and has improved the agency’s operations.

Also, I would respectfully request that in addition to my complete

written statement, a copy of Chairman Donaldson’s recent CongresVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00051 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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sional testimony on the Commission’s efforts to reform the mutual

fund industry be a part of the record.

Mr. PLATTS. Without objection.

Mr. MCCONNELL. Thank you.

Since last February, the SEC has spent considerable energy examining and reforming our organizational structure, operations

and our work flow processes. Our goal is to become more proactive

and to better anticipate risk. We need to be able to respond quickly

to our changing environment by seeing around corners and over

hills. Having this ability is vital to the success of the agency and

developing this capacity has been one of Chairman Donaldson’s

highest priorities. Right now I would like to highlight a few of our

initiatives in this area.

When the Commission first received its funding increases in fiscal 2003, we began a comprehensive planning initiative to determine how best to allocate these funds. Throughout the process, the

chairman’s primary concern was that resources be deployed as effectively and efficiently as possible to maximize the value to taxpayers and investors alike. To achieve this objective, the chairman

held a rigorous series of meetings with the heads of the divisions

and major offices to review their mission, environment, goals and

strategies. The chairman’s office then initiated top to bottom reviews of the new organizational structure proposed by the divisions

and offices to incorporate their new staff. These reviews have examined whether positions are being deployed effectively, are fully

consistent with agency priories and are accompanied by the appropriate level of supervision.

Now that the initial round of reviews is complete we intend to

use the process as the model for analyzing future division and office reorganizations, as staff increases.

Risk assessment. As we highlighted in the hearing last July we

have initiated a new risk management program and laid the

groundwork for the Office of Risk Management and Strategic Planning, the first of its kind at the Commission. Fundamentally this

initiative is instilling a new spirit into our everyday activities so

that we constantly are searching for new and emerging risks to investors and U.S. financial markets. We are focusing on anticipatory

risk, the most difficult to assess but the most important type to try

and understand.

The first stage of this new effort has been to organize internal

risk teams made up of representatives from each major program

area. When fully staffed, the new office will then work in coordination with the internal risk team to then apply new or resurgent

forms of fraudulent, illegal or questionable activities.

In addition to fostering better communication and coordination

with the Commission, the risk assessment initiative will help us

proactively identify existing and emerging problem areas within

our industry and adjust operations and resources accordingly.

Performance dashboards. As we discussed also during last year’s

hearing, the performance dashboards are management reports designed to present regular snapshots of the divisions’ and offices’

progress when we do budget, staffing and performance objectives.

We have been generating dashboards for the last 7 months and

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they continue to evolve as divisions and offices refine their performance measures.

Our dashboards are helping us identify emerging problems. They

reinforce each executive’s accountability for their staff, performance

of this initiatives and proactively adjust operations and resources

as necessary.

Strategic planning. The chairman feels strongly that completing

our 5 year strategic plan is critical, not just because it is required,

but also because it embodies our comprehensive strategy for the

next several years. Though the plan is being completed later than

we originally anticipated, we have taken the time necessary to

make sure it is useful for the agency in a critical time in its history.

In particular, the strategic plan has been substantially enhanced

due to the work I have just outlined in the areas of organizational

review, risk assessment, and performance dashboards. The draft of

the SEC’s strategic plan is being reviewed by the chairman’s office.

It will soon be voted upon by the committee.

It was written by a team of senior managers and staff throughout the agency who actively conferred to their office or division

leadership and interacted with external stakeholders.

You will receive a copy as soon as it is improved, and we look

forward to your feedback.

GAO has stressed the importance of having a strategic plan upon

which to base agency wide resource decisions, and we strongly concur. While we would have preferred to have a strategic plan prior

to deployment of additional resources and staff, the environment in

which we are operating did not permit us that luxury. As you can

see from my testimony, it has been necessary for the staff to undertake multiple tasks concurrently. While our plan has been completed later than anticipated, the vision, mission and values have

guided our activities for quite some time.

I now want to spend a moment to discuss the SEC’s human capital. Thanks to significant budgetary help from the President and

Congress, the agency received appropriations in February 2003 for

resources needed to hire 842 new employees.

Our accepted service hiring authority, which would not have become law without the instrumental support of this subcommittee,

was especially important because it allowed us to put critical staff

in place much more quickly than would have otherwise been possible. Since 2002 we have hired about 770 new staff, 39 percent attorneys, 22 percent accountants, 22 percent examiners, and the remaining 15 percent in other positions. Approximately 107 more will

begin working at the SEC by the end of June. We will then have

403 vacancies remaining, that is compared to our normal vacancy

level of about 150. Of the 403 vacancies, 38 percent are attorneys,

28 percent accountants, 15 percent are examiners and 23 percent

represent other positions.

We have refused to hire employees simply to fill chairs, but rather to focus on hiring the best and most appropriate people to fulfil

our mission and are deployed where each staff can do the most

good. By the end of the year we fully expect that our hiring efforts

will achieve targeted staffing levels.

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As GAO has previously identified, we would be better served by

not just focusing on paying more attention to hiring but also creating a comprehensive work force planning effort to assure that we

reach our human capital goals and objectives. We have begun to

make progress in this area on a variety of fronts.

For example, the SEC launched the SEC University, an initiative

to redesign and enhance our training and orientation programs to

help staffing managers to better perform their responsibilities and

to keep abreast of industry trends. We have begun to review the

Commission’s succession. Our preliminary findings demonstrate

that we are unlikely to face in significant waves of coming retirements as is the case for much of the rest of the Federal Government.

We have implemented a new pay-for-performance system designed to reward job performance based upon employee’s contributions to the Commission’s overall mission.

These and other efforts have helped the SEC think and act

proactively in recruiting and retaining the right staff, our most important asset.

Investments in the SEC’s information technology are critical to

help us delve deeper in our investigations and inspections, improve

investors’ access to company disclosures, and otherwise support the

Commission’s efforts to protect investors.

The Commission has made progress on a variety of fronts. Early

this year, we hired a new Chief Information Officer to guide the

agency’s information technology program. In the short time since

his arrival, our CIO has begun adding staff to manage a broad

range of IT projects and has started to reshape our capital planning process and he will soon begin building a new IT strategic

plan. This plan will guide the various IT initiatives we have or will

soon have underway including a new document management system that streamlines case management, infrastructure architecture, information security enhancements, and a new design of our

disclosure and review process.

For the last 2 years the subcommittee and GAO have raised important concerns regarding SEC’s lack of an updated strategic plan.

We agree with those concerns and that the SEC must deploy resources efficiency and effectively and respond quickly to the fast

paced environment.

With the initiatives I have mentioned today we have confidence

that we are proceeding down the correct path.

We once again would like to thank the subcommittee for inviting

to me testimony today. These are very important issues for the

Congress and for the Commission.

I look forward to addressing your questions.

[The prepared statement of Mr. McConnell follows:]

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Mr. PLATTS. Thank you, Mr. McConnell.

Mr. Hillman?.

STATEMENT OF RICHARD HILLMAN, DIRECTOR, FINANCIAL

MARKETS AND COMMUNITY INVESTMENT, U.S. GENERAL ACCOUNTING OFFICE

Mr. HILLMAN. Thank you very much. I am pleased to be here

today to discuss the Securities and Exchange Commission’s ongoing

strategic planning effort and the challenges that it faces in

proactively overseeing the Nation’s mutual fund industry.

As has been discussed in the last 20 years, mutual funds have

grown from under $400 billion to over $7.5 trillion in assets, and

that becomes vital components of a financial security of more than

95 million American investors estimated to own them. However, as

you know, various allegation of misconduct and abusive practices

involving mutual funds have recently come to light. As a result insuring that SEC has the necessary resources and strategic focus to

adequately oversee our nation’s mutual fund industry has never

been more important.

My testimony today discusses how the abusive practices involving mutual funds came to light and SEC’s subsequent responses,

SEC’s plans for increasing its staffing in the divisions and offices

responsible for overseeing mutual funds and the progress it has

made in developing a strategic plan. And also challenges that may

be affecting SEC’s ability to effectively oversee the industry.

Regarding our first objective and abusive practices in the mutual

fund industry came to light, we found that in late 2003 state authorities were the first to act against various abusive practices in

the mutual fund industry, but since then SEC has taken swift and

vigorous action designed to punish wrongdoers and better prevent

a detected use of practices in the future. SEC did not identify these

abusive practices involving mutual funds for various reasons.

According to SEC staff many of the cases involving fraud and collusion among personnel in such activities is very hard to detect in

routine examinations. Also, according to testimony by the head of

SEC office that conducts mutual fund examinations, SEC examiners did not reveal these practices because their examinations focused primarily on the operations of the mutual fund and trading

of the funds portfolio security practices, which are areas we have

acknowledged potential for abuse. As a result, their examinations

did not generally address the trading in the funds own shares.

SEC also faced resource challenges for years that have affected

its ability to conduct oversight in the mutual fund industry and in

other areas. For example, we reported on SEC’s difficulties during

the 1990’s to keep pace with the growth in the industry and its inability to examine funds and investment advisers frequently. In

prior testimony the Director of the SEC’s office that conducts examinations noted that prior to 1998 SEC’s examinations of mutual

fund firms have been as infrequent as once every 12 to 24 years.

However, since these abuses have come to light, SEC and the National Association of Security Dealers which oversees the broker

dealers that sell fund shares have acted vigorously to address inappropriate practices in the mutual fund industry.

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For example, SEC has already taken 15 enforcement actions that

involve late trading and inappropriate market timing. SEC and the

National Association of Security Dealers also have issued at least

9 proposed rules to address abusive practices in the mutual fund

industry. SEC has also taken some actions that address longstanding concerns over mutual fund practices, including the lack of

transparency of some fund fees and costs and the potential for conflict of interest in fund distribution and sales practices.

Regarding our second objective on SEC’s staffing decisions and

progress on developing a strategic plan we report that after experiencing an extended period in which increases in SEC’s workload

grew faster than its staffing and other resources, SEC has received

recent budget increases that have begun to allow it to increase its

staffing, including positions in the divisions and offices with responsibility for mutual fund regulation oversight and enforcement.

However, SEC has taken these actions without the benefit of an

updated strategic plan to guide their staff deployment and the divisions and offices with responsibility for mutual funds followed various steps for determining their staffing needs. In the absence of

a complete and updated strategic plan that identifies its key mission related goals, we were unable to determine whether SEC’s recent allocation decisions made the best possible use of its resources.

In making these decisions, SEC has obviously increased staffing in

key areas, including providing additional resources to develop

rules, examine participants and pursue enforcement actions

against abusive practices in the mutual fund industry. However,

without a complete and current strategic plan that outlines the

agency’s priorities, the agency lacks a key guide for ensuring that

it is deploying its resources across these areas in the most efficient

way to achieve the most effective outcomes.

Regarding our final objective, we outlined four agency wide challenges that may be affecting SEC’s ability to oversee the mutual

fund industry. These challenges include improving its ability to

head off major problems before they occur by better anticipating

and detecting abuses in the securities industry. SEC also faces

challenges in hiring and retaining all the staff that it needs to

achieve its mission as demands on staff continue to grow. Moreover, SEC has experienced difficulties in obtaining the information

technology it needs to effectively oversee the mutual fund industry.

Finally, SEC faces challenges in overcoming impediments and

ability to gather information, cooperate with other law enforcement

authorities and collect moneys owed. Overall, SEC must effectively

address these challenges and each of these are on their plate to address if they are to successfully restore and in the long run maintain investor confidence in our securities markets.

This concludes my prepared statement. I would be pleased to address any questions.

[The prepared statement of Mr. Hillman follows:]

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Mr. PLATTS. Thank you, Mr. Hillman. And again thanks for not

just being here today, but your work week in and week out in your

job at GAO especially as it relates to this subcommittee’s focus on

the SEC and strategic planning.

Mr. McConnell, I would like to know on the strategic plan, where

we are? Soon to be approved and current, what timeframe are we

talking about? A week or two or a month, and obviously we are interested to see the plan and have an idea of the Commission’s

strategy going forward?

Mr. MCCONNELL. Well, we’re nearly finished, and we appreciate

the indulgence of the subcommittee during this process. We talked

with you about it last summer and we have discussed with you

throughout the process, and it has been a long process and we appreciate that.

The plan right now is in the chairman’s office for final review before going to the Commission. Then it must go through a vote. It

must be voted on by the five members. That will be done seriatim,

which takes several weeks. So I’m hoping that next month is what

we are looking at to get it to you. And then we will hope to get

your feedback, because no one has really seen it.

And this process was not simply just updating our previous strategic plan. As Chairman Donaldson said when he viewed the first

plan, ‘‘This is a nice job but it is not my job.‘‘ His strategic planning

ideas were substantially different. So we essentially went back to

scratch in developing this plan. And the process we used was actually, it’s a major institutional change and that institutional change

is on going and it is tied up with the risk assessment, the organizational reviews. So all of that was being done at the same time. And

I think the synergy that was created has helped all of those efforts.

So, hopefully in a month.

Mr. PLATTS. We are hoping, too.

Mr. MCCONNELL. Yes, sir.

Mr. PLATTS. As we did talk last summer, and then we were talking in the fall, by the end of the year. We are now in April, and

we are talking May. And it is not just kind of an issue over and

over, but as chairman and Mr. Towns, and both sides’ staff share

the view of GAO, every month’s delay just means more decisions

that you need to make. And we acknowledge that you cannot sit

back and not anything while you are putting this together.

Mr. MCCONNELL. Right.

Mr. PLATTS. But the delay in that strategic plan being finalized,

means you are having to make daily decisions and allocations of resources and hiring decisions that are not fully based on the big picture but on a more piecemeal approach.

Mr. MCCONNELL. Yes.

Mr. PLATTS. And we need to get to that big picture. So we certainly hope—and I say that recognizing I always believe it is better

to do a thorough and deliberate job and have a good product than

to rush something and have a product that you really don’t use. So

by your being thorough and deliberate, hopefully that means all

the more embraced the final will be and the better it will guide the

Commission and all the staff.

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In your comment you said one thing that relates to my followup

questions, you said you are anxious to share with us and GAO, and

I believe that because no one has really seen it.

Mr. MCCONNELL. That is correct.

Mr. PLATTS. What type of outreach has the Commission engaged

in to GAO, to individuals in the industry, to academia to generate

feedback in the drafting of it?

Mr. MCCONNELL. Right.

Mr. PLATTS. I understand that there has been extensive dialog

within the Commission, with the staff, but how about outside the

SEC?

Mr. MCCONNELL. There has a major outreach effort. And it has

been associated also with our risk assessment effort. We have

called in people with everything from a brown bag lunch to sort of

talking about what is keeping you awake at night——

Mr. PLATTS. People from outside the agency?

Mr. MCCONNELL. From outside the agency, yes.

Mr. PLATTS. OK.

Mr. MCCONNELL. And Mr. Bogle has been one of them.

Mr. PLATTS. Right.

Mr. MCCONNELL. And we will continue to do that to going to the

industry, and to the groups that represent major portions of the industry. We have had a lot of interactions with the industry.

It has been in the mode of really gathering information at this

point. Of course, in the dialog that occurs they understand the directions we’re proceeding, so you get that kind of interaction; that

is good. And we are, frankly, we are eager to see what your

coments are, we want a lot of comments coming back because this

is a new document. It has not been seen before. And we are eager

for the comments from this subcommittee and from our stakeholders as to how it has all been put together. And we think the process has been good. We think what we put together is quite good,

but let’s get the very hard reaction.

Mr. PLATTS. And I appreciate you wanting that feedback, but I

want to make sure what you are going to release and vote on is

the final strategic plan?

Mr. MCCONNELL. That is correct. It is final.

Mr. PLATTS. And so in a sense it seems that at that point you

will get feedback but on a final plan as opposed to a draft. And I

am glad to hear Mr. Bogle and others have been included.

How close are you with GAO? I know there is a good interaction

there, and I appreciate your comment up front that you are grateful for that interaction, but on the specifics of the plan what efforts

have been taken by SEC with GAO?

Mr. MCCONNELL. Well, I will let Rick speak for himself, but we

have shared a good bit with GAO in the process in all of these efforts. And I think he has seen some draft executive summaries, as

I recall.

Mr. HILLMAN. Yes. We have been given a draft outline of their

strategic plan which tends to outline the broad goals of the organization and all the relevant information about how they intend to

achieve them. And that is consistent with the activity that we have

had with the departments and agencies across the Federal Government in that regard.

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Mr. MCCONNELL. OK. One thing I would like to add is that the

chairman does not view this at all as a 5-year plan, to drop it run.

I mean, he thinks this is going to be updated and it is a year-toyear process. And, of course, we report on it yearly and there is a

rigorous requirement associated with how you follow through on

these plans.

Mr. PLATTS. Hand-in-hand with the strategic plan is the resource

management. Your strategic plan is going to help allocate where

you put the resources including your human capital, but it is also

that you need to have it there.

Mr. MCCONNELL. Correct.

Mr. PLATTS. You mentioned in your testimony another 107 by the

end of June. Those are people in the pipeline?

Mr. MCCONNELL. We actually have names associated with people

who have agreed, who have made commitments to come on. So

those are hard numbers.

Mr. PLATTS. And then about 403, about almost three times the

norm that will still be vacant?

Mr. MCCONNELL. That is correct.

Mr. PLATTS. Is there a timeframe for when you think you would

get to that 150 benchmark, you know——

Mr. MCCONNELL. The end of the fiscal year is when we intend

to achieve that target level. And you are right, there will be 150

vacancies probably at the end of the year. That is right. We build

that into our plans, that is part of our budgeting, our FTE costs

are associated with that kind of a vancany rate.

Mr. PLATTS. Is there a concern with another 250 by September

30th, roughly, so in the final 3 months of the fiscal year? You said

some feedback of—I mean that might be wishful thinking just because we appreciate your being thorough and wanting not to just

fill seats but to get good people in those slots.

Mr. MCCONNELL. Yes.

Mr. PLATTS. And that there is such competition because of Sarbanes-Oxley and what the industry is demanding to be——

Mr. MCCONNELL. Right.

Mr. PLATTS. Are you pretty certain or is it, you know, what your

goal is but how realistic a goal?

Mr. MCCONNELL. We think it is realistic. We have actually—the

competition you are talking about mainly deals with accountants

and that is where the Sarbanes-Oxley competition occurs and

where the competition with the PCAOB and with ever major public

accounting firm in the country. You are all hiring accountants and

many are the same ones that we are hiring. But we have, I think

there are about 27 percent left, to hear.

We have been using the services of an outside selection firm for

that. The pipeline has gotten pretty good. We have a good size

pipeline now of quality applications, and we have instituted procedures in place where we are bringing on 30, 40, 50 a month. So

I think we will make it.

Attorneys, we have had the competition. That has been more of

an accommodation on our part; how quickly and how effective we

can bring them in, bring them in to new places, into new areas and

how to build the organization properly.

Mr. PLATTS. Right.

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Mr. MCCONNELL. And we have never really had problems with

attracting attorneys.

Examiners, similarly. We have not had problems attracting examiners. We are pretty well fully staffed up in that area. And there

we are just dealing with sort of normal attrition.

Mr. PLATTS. Well, and I do appreciate and I am sure Chairman

Davis appreciates the way you have embraced the additional flexibility in the human capital side to retain and recruit and using the

resources being given to you effectively. You’re probably making a

case for that type of flexibility elsewhere in the Federal Government as well. I am sure we and others will be watching that process.

Mr. MCCONNELL. We have lots of attention. Lots of attention.

Mr. PLATTS. I yield to Mr. Towns.

Mr. TOWNS. Thank you very much, Mr. Chairman.

Mr. Hillman, the SEC seems to be having difficulty attracting, as

we just finished talking about, talented and adequately skilled individuals for professional staff. And, of course, Congress as we have

talked about here, we increased the agency flexibility in hiring and

setting pay. Is this enough to attract the necessary qualified staff

do you believe? Do you think this is adequate?

Mr. HILLMAN. One of the major impediments, as Mr. McConnell

just described, is their inability to really bring on topnotch accountants into the organization. And Congress has provided relief to the

SEC last summer to better position themselves to complete their

recruitment process in a more expeditious fashion so that they can

attract and obtain quality accountants. And that is a problem the

SEC will continue to face because really, in the Washington, DC,

area with the Public Company Accounting Oversight Board also attempting to attract accountants to fill their ranks, and with these

major big four CPA firms changing over as a result of the financial

scandals, doing more detailed audits of new clients, they’re clamoring for additional accountants as well. It is just a vicious market

out there right and SEC is trying to complete the best that they

can.

Mr. TOWNS. Right. But is it not also a problem of retaining as

well? They say if you recruit one, you hire one and another leaves;

and then at the end of the day you are at the same level. So I am

thinking that maybe you might want to become creative by saying

that after 3 years, after 5 years of being employed by this agency,

a bonus of some sort would be given.

I mean, you cannot continue to do business as usual expecting

a different result.

Mr. HILLMAN. Very interesting insight.

Mr. MCCONNELL. You are absolutely right. And creativity is

needed in a lot of front, and we are adding benefits and we are

looking at various ways to maximize the authorities that we have

been given. And we are also looking at a different way to deal with

the work force.

Perhaps all of these accountants do not need to be in Washington. There is lots of technology that’s on the cusp or already here

that would allow us to have, perhaps, remote locations where there

probably is not this cutthroat competition for accountants.

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So we appreciate that concern. It is on our minds a lot, and you

are right there are creative things that have to be done, and this

chairman is prepared to do them.

Mr. TOWNS. Right. I thank you.

Mr. Hillman, can you cite for us any specific area that SEC is

lacking legal authority to adequately pursue mutual fund industry

investigations or general oversight? Is there any area that you feel

that the Congress should look at to see in terms of what changes

to be made in order to make it possible for them to carry out their

mission?

Mr. HILLMAN. We have looked at this issue, and our Comptroller

General has testified before the Senate Banking Committee on

March 10th that many of the actions that need to be addressed to

cover the abuses that have occurred in the mutual fund industry

SEC is well positioned to do. But there are a couple of areas. In

particular looking at an issue referred to as ‘‘soft dollars’’ in the

mutual fund industries where commissions that investors pay to

buy and sell their shares, more visibility associated with what

those commissions are paying for we think are needed.

The soft dollar issue refers to a practice where these commissions

not only pay for the trades that occur, according to investors’ wishes, but also research and other services are being provided to the

fund. We in the General Accounting Office believe that there is not

adequate disclosure of those additional costs associated with research and other services that are being provided, and in some instances that is going to require Congress to step in and evaluate

what is referred to as a safe harbor that Congress established in

ensuring that the commissions and these research services are

being provided.

Mr. TOWNS. All right. Thank you.

Let me just make certain, Mr. McConnell, that I understand how

this process works in terms of the plan. Are you saying that you

send the plan out, you know, to the various Commissioners and

then they look at it and vote on it? I mean, is that——

Mr. MCCONNELL. That is correct. They have to vote on it. It’s a

Commission vote.

Mr. TOWNS. I understand that, but I mean it is not a situation

where there is a meeting and that each member votes at a time,

rather then you send it to Chicago, you send it—I mean, I want

to make sure that I understand that process.

Mr. MCCONNELL. Yes, sir.

All the Commissioners, it’s just the five Commissioners that have

to vote. They are all in Washington.

Mr. TOWNS. I understand that.

Mr. MCCONNELL. So we will probably not convene a meeting

where the plan is presented and they vote at one time. It is a process we use quite frequently for reports, official Commission documents and rulemakings where each Commissioner’s office is provided the entire document and background, are giving briefings as

they want for the process. They deliberate and then they vote by

just signing a document saying my vote is in the affirmative or this

release.

There are two basic processes for making SEC actions. One is an

open meeting where they all sit at a dias and actually vote there,

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or this other more deliberative—it is a slower process, frankly, but

it is our seriatim process.

Mr. TOWNS. It would seem to me—I mean here again I guess this

is on another subject. But it would seem to me something as important as this that they would all come together in the same room

and vote and make a decision, you know. I just sort of problems

in terms of my own mind——

Mr. MCCONNELL. Yes.

Mr. TOWNS [continuing]. That it would be done, you know, and

I hate to use the word ‘‘haphazard’’ but I must say that I just have

problems with them not coming and doing this and having dialog

and then fashion their vote on an issue as important, and one that

we waited so long to receive.

Mr. MCCONNELL. I do not want to give the subcommittee the

opinion that the one process is any less deliberative or important

than the other. I mean, clearly the seriatim process is used for

some of the most important actions the Commission takes. It just

really depends on the way the chairman wants to do it, schedules

of the other Commissioners and it is the process that they want to

choose.

Any Commissioner, at anytime can call for a meeting if they do

not choose to use the seriatim process. But they generally like to

do it this way. It allows them more time for review, it is going to

be over 70 pages, plus a lot of background and they will go through

it, their staffs will go through it, I will get called into their office,

Peter Derby will get called into their office to explain things. So it

allows for a lot of iterations.

Mr. TOWNS. Yes.

Mr. MCCONNELL. And explanation.

Mr. TOWNS. Yes. I understand all that, but I just think that

something of this magnitude, you know—but anyway, I mean that

is——

Mr. MCCONNELL. I will let them know that.

Mr. TOWNS. Yes, please do.

Mr. MCCONNELL. I will certainly express your concerns with

Chairman Donaldson.

Mr. TOWNS. Yes, especially I mean it would seem to me it would

be a situation where you would come together.

Mr. MCCONNELL. Right.

Mr. TOWNS. And there would be dialog and then you pass it on.

I think the question was raised earlier in terms of who did you

talk to sort of outside to be able to work, get information input for

the plan. I asked the Attorney General did you talk to him, and

of course he sort of did not quite give me a straight answer on that

one. But I want to know who did you talk to on the outside world,

you know, people that were former Commissioners or actually in

terms of—even chief of staffs did you talk to. I mean, in terms of

putting together this plan?

Mr. MCCONNELL. Well, there has been—I mean, I could probably

give you the actual lists at some point, but I will give you a general

idea.

Mr. TOWNS. Just a general idea. You do not have to——

Mr. MCCONNELL. There has been a lot of interaction, and it has

included the former staff members, former members of the ComVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00100 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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mission, and then those groups; the ABA, you know, those groups

that you traditionally go to that either represent segments of the

industry or segments of the bar. And then we have called in people

on sort of an informal basis where it is off the record; let us have

lunch, sit around with four or five people and talk about things like

just what is on your mind, what is troubling you, what keeps you

awake at night with respect to the industry. And trying to get as

much of that in a really non-threatening environment.

We always have to appreciate that everybody has an agenda at

times, but gathering that kind of information and having open discussions. And that way sort of get an idea as to where we are going

and we get an idea as to what they see are problems we should

be addressing. And that is a lot of people from all across, and that

is an ongoing effort. And we are building that into our risk assessment, the strategic planning office will keep undertaking that.

And academics. I mean, we have a strong academic program in

our office of economic analyses. And they call in academic and review papers. We need to do more of it. And our notion is we have

to do better at anticipating, at being proactive. We do not really

disagree, I do not think, with almost anything that has been said

during this hearing in terms of that need.

Mr. TOWNS. Do you have the technology to address these issues?

Mr. MCCONNELL. We are getting the technology. As you know,

we have had a major increase in our technology budget. It went

from $40 million to over $100 dollars.

Talk about a tough time hiring somebody, we had a really hard

time getting a CIO. That person came on board in January. He is

putting together the strategic plan review. We have a number of

major efforts already underway however. With document management, we have an initiative to enhance substantially our disclosure

program, to take advantage of technology, data tagging to make it

easier for both our staff and mainly investors to understand what

is in these documents that are filed with the SEC.

Our enterprise architecture is being examined and our security.

Our security program.

Mr. TOWNS. I yield back to the chairman.

Thank you.

Mr. PLATTS. Thank you, Mr. Towns.

I want to followup on the plan approval process. And while it is

a requirement under GPRA not just for SEC, but other departments and agencies also. It is a little different here because you’re

a regulatory agency.

Mr. MCCONNELL. Right.

Mr. PLATTS. And with a board of five that do actually vote on approval of this. This is different than a department, where there is

not that formal public vote and approval.

Given that, and this is kind of expanding on Mr. Towns’ and my

questioning—in some ways it seems that this should be a different

process where while you have had a lot of input from outside the

Commission, it is from those who you have invited input from as

opposed to, perhaps, some who would like to provide input but

were not invited. It seems like analogous to a local municipal authority or a local municipality having a plan that we are going to

take a formal vote on and we are going to have a public hearing

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on it so it is out there publicly before the vote so that all who want

to have input in writing, you know, or in person can have some

input, not just those who you invited. Was that something that was

considered by the Commissio—to actually share this in a public

sense prior to the vote to generate feedback?

Mr. MCCONNELL. Not to my—no, it has not been.

Mr. PLATTS. And on the one hand I would like to urge that, but

I know that if I urge it it also would delay it longer. And at this

point I am not sure what is the best approach. I think getting done

and then we can always—but, you know, it is something that given

that is a 5-year with doing an annual approach——

Mr. MCCONNELL. Right.

Mr. PLATTS. And it is a work in progress that hopefully will always be a work in progress to adjust to the mark that is different

challenges. I think that is something that is considered perhaps in

the future.

I also, though, as far as approving it, a simple majority; three out

of the five approves the plan?

Mr. MCCONNELL. Yes. Right.

Mr. PLATTS. OK. It is just a different setting than a typical agency.

Mr. MCCONNELL. It is.

Mr. PLATTS. In the fact that there is a public vote. And coming

out of the State house, under State law you would be required to

have a hearing and allow public input before you could vote.

Mr. MCCONNELL. I will certainly take your concerns back to the

chairman.

Mr. PLATTS. Yes. Because I appreciate you seeking the input, but

sometimes human nature is we seek input from those who have

close relationship with.

Mr. MCCONNELL. Right.

Mr. PLATTS. And not get input from others who maybe we do not

have a close relationship with, but would bring some valuable

knowledge to the table.

Mr. MCCONNELL. Understand. Sunshine and full disclosure is

what we are about.

Mr. PLATTS. Yes.

One of the recommendations of Mr. Bogle is the kind of comprehensive economic study of mutual funds. And the mutual fund,

while it is not the focus of this hearing, it is kind of a case study

of——

Mr. MCCONNELL. Right.

Mr. PLATTS [continuing]. The importance of resource management and why we kind of push for the strategic plan and that big

picture approach.

What would be your thoughts on the approach Mr. Bogle suggested?

Mr. MCCONNELL. Well, I cannot comment on that specific approach as something that maybe the Commission would adopt or

not adopt. But we are certainly envisioning that type of activity as

part of this office of risk assessment and strategic planning.

The office itself will be constructed or consist of five people; a director and four or five key staff, some of whom may be academics

come in on loan. They will also have the resources available to unVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00102 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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dertake major studies. That could be one of them. I cannot speak

for the Commissioners as to whether it would be or not. But it certainly that type of activity is envisioned in this approach.

Mr. PLATTS. And I think it helpful with your hearing not just

from Mr. Bogle and his push——

Mr. MCCONNELL. Right.

Mr. PLATTS [continuing]. But hearing from the other side, the Attorney General, somebody who has been regulated as well as law

enforcement. I would hope that it is something that is given close

scrutiny——

Mr. MCCONNELL. As a private citizen it sounds like a pretty good

idea. Again, that is——

Mr. PLATTS. And continuing on the allocation issue regarding

mutual funds and, Mr. Hillman, you certainly have watched this

closely and with the reorganization, although we have seen reorganizations prior to the strategic plan being completed based on the

necessity of a new board and put more manpower into the mutual

fund oversight, what is GAO’s assessment at this point of resources

that have been allocated? Do you believe they are sufficient and

you are going to be able to meet the challenge that come forward

through the Attorney General and other efforts?

Mr. HILLMAN. We think that the allocations the SEC has made

are certainly consistent with what the Sarbanes-Oxley Act required

it to do in ratching up the oversight attention to filings that come

in from corporation to make sure there are not continuation of

scandals and corporate accounting problems. And the ratching up

of the enforcement division and their office of examination are all

certainly components that they need to provide attention to.

I guess from the General Accounting Office’s standpoint, what we

are looking for and hoping to see is some assurances from the strategic planning process and a human capital planning process that

SEC indeed does have all the resources that it believes it needs in

order to effectively oversee the securities industry. What we have

seen so far to date is that resources that Congress has been able

to provide it equated to about 842 positions. They are asking in

their recent request for fiscal year 2005 an additional 106 positions.

What we are hoping to see is that there is some sort of an analysis to say with these resources we feel we are going to be able to

be out in front as to what these issues are expecting to be over the

next 5 years, and effective would be able to be proactive as opposed

to reactive.

Over the years SEC has not had the resources it has needed to

oversee the industry, and as a result has had to perhaps call back

upon some of its goals it has had out there. For example, in the

recent issue with Sarbanes-Oxley, SEC has not been able to review

all the filings that it needs to review on a timely basis and as a

result, it had not reviewed the filings that had come in from Enron

and Global Crossing to be able to detect and deter these types of

activities.

And with these additional resources now Congress made it in law

a requirement that they review all filings over a 3-year period of

time. Well, 5 years hence that was an SEC goal, but they were not

able to achieve that because of resource limitations.

100

Bringing it back up to date here in the mutual fund industry,

you are looking at the Office of Examinations. They have come up

with what we believe seems to be a very realistic target of looking

at the top mutual fund complexes or on a more frequent level, perhaps every couple of years and ensuring that all complexes overall

get looked at over a 4-year basis.

With this mutual fund industry crises and the scandals that

have occurred, though, however there are now additional examination steps that must be performed in order to ensure that the industry is safe. The director of that office is concerned at the moment as to whether or not they have enough resources to do all

that they need to do to oversee these fund complexes with these

now additional responsibilities that are being placed on them and

each of their routine examinations.

We would like the SEC to be able to say OK, in order to do what

it needs to do, these are the resources that it needs and to let Congress decide if they cannot fund those because of other competing

priorities in the Nation, to make that known. But at this moment

without a strategic plan, without an analyses review and capital

planning standpoint of their expertise and resource levels, it is difficult to say to what extent they are able to achieve their goals.

Mr. PLATTS. We are kind of assuming from us outside the Commission that request for 100 plus more in the 2005 budget request

fits in to what the Commission envisioned approving its strategic

plan. We have not seen it, we do not know that. I assume once we

see it, it will maybe jive, you know, that we need additional positions and here is why. I mean, that is kind of what you are getting

at this point we are making that assumption and thinking as a

given that additional requests are going to match up with their vision in that strategic plan, but we really do not know that.

It really goes to—what you touched on—that the SEC actually

envisioned doing those regular reviews, but did not have the resources. And I do not have a base knowledge myself in the 1990’s

coming into office in 2001, what was the message coming from this.

Publicly, Congress at large, you know we kind of looked at the SEC

as a rainmaker because it was generating billions of fees and getting a smaller and smaller percentage. Were the SEC Commissioners, the chairman, you know, crying uncle and saying hey, you

know, we are getting overwhelmed and Congress was ignoring it or

was it just an acceptance and hey, this is what we do and this is

the way to do it.

Mr. MCCONNELL. Well, I think we certainly are bringing the attention to whomever we could that the mutual fund industry was

growing dramatically and needed fundamental changes. Some fundamental changes did occur. I mean, we changed the whole regulatory scheme back in the 1990’s so that the small investment advisers that were not holding assets were no longer under our review. I mean, we knew we simply could not do it, so we changed

the population and changed the regulatory scheme by which—so

that was one major effort. We thought by doing that we would be

able to get back to a more—and at that time we had, I think as

Mr. Hillman indicated, a review cycle of 20 or 30 years if you just

divided it up and the number staff we had. And we have always

wanted to get back to somewhere a 2 or 4 or 5 year process, deVerDate 11-MAY-2000 13:00 Aug 19, 2004 Jkt 000000 PO 00000 Frm 00104 Fmt 6633 Sfmt 6633 D:\DOCS\95221.TXT HGOVREF1 PsN: HGOVREF1
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pending on risk associated with that. So we thought we had that

worked out, but things continued to grow and it is just that we are

constantly playing catch up.

The last few years——

Mr. PLATTS. The worry is that you are playing catch up.

Mr. MCCONNELL. Right.

Mr. PLATTS. Is that now we are playing catch up to the mutual

fund issue. You know, Sarbanes-Oxley has been enforced. We already play catch up on a corporate governance, on disclosure. Two

years from now I am hoping that we are not going to be saying now

we are playing catch up on something else that came forward because we were not proactive.

Mr. MCCONNELL. Right.

Mr. PLATTS. We are continuing to be reactive.

Mr. MCCONNELL. I cannot judge that we will have the resources,

but this chairman is guaranteeing that he is going to let people

know what we need. And that is what this is all about.

Mr. PLATTS. And that is exactly what I mean. It is important

that——

Mr. MCCONNELL. That is right. That is what this all about.

Mr. PLATTS. And, you know, soft peddling.

Mr. MCCONNELL. And if we do not get the resources, everybody

knows it and it is the decision that has been made.

Mr. PLATTS. Here is what we need to do and here is what we

need to be able to do that.

Mr. MCCONNELL. Exactly.

Mr. PLATTS. And then if Congress does not deliver, the onus is

on us.

Mr. MCCONNELL. Congress has to make the choices.

Mr. PLATTS. Yes. Correct.

Actually, Mr. Towns, do you have any questions?

Mr. TOWNS. No. I am fine.

Mr. PLATTS. OK. On the office of risk assessment program, you

made the accommodation and come to the internal themes. Again,

what type timeframe are you envisioning there? Again, in the next

month or two? Is that in the next fiscal year?

Mr. MCCONNELL. The whole risk assessment program that we

are putting in place has three major components, one of which are

these risk assessment teams that are basically—we started those.

Mr. PLATTS. Right.

Mr. MCCONNELL. They are in operation.

Mr. PLATTS. And so they are doing risk—now.

Mr. MCCONNELL. They are risk mapping through the entire

agency on a program-by-program basis.

Mr. PLATTS. OK.

Mr. MCCONNELL. Building through the raw data.

We also have part of it as embedded risk assessment staff in

each of the divisions and major offices. That is underway. Those

people are being hired. They will be in the division but have a dual

reporting capacity. The key is to get this final five person office set

up and then it all comes together. That we are still struggling with

finding the right person to be the director. That has been a challenge.

102

We have been close a few times with some people. The kind of

people we are looking at for that job make a lot of money. And they

are highly sought out by lots of people, lots of organizations. And

we think we have a very attractive——

Mr. PLATTS. Did you mention it to Bogle today that you have

that—he seems like he would be a pretty good match.

Mr. MCCONNELL. Maybe so. We will talk to him afterward. But

those are the kinds of people——

Mr. PLATTS. Yes. And you made it through that. Is the use of

that more than doubling the technology, can you tell us how you

are looking at using data mining, you know technology to compliment the human capital, to really stretch the human capital farther through technology?

Mr. MCCONNELL. We are really excited about those possibilities.

Because, I mean, that is the way in which you make your resources

that you have work, especially in an information rich industry like

we have. I mean, there is just lots and lots of available information.

We are starting some initiatives. We are starting two underway

now, one of which deals with mutual funds, not surprisingly, we

want to start getting a handle on that. And the other is on full disclosure data, some more information on data ragging.

But we have brought in a whole new data base search engine,

autonomy, that we hope to be able to maximize so that we have

data from all different sources; from enforcement cases, from you

know appropriate dealers and investment advisers have data on

people and firms that we could mind, so we want to be there. I

think we see the promise and the future of that.

Mr. PLATTS. And your comment on the risk assessment office, the

idea of bringing academics in and Dr. Morey is not here to defend

himself, but——

Mr. MCCONNELL. He can sign up, too, is that what you are saying?

Mr. PLATTS. Well, but I was going to say also because sometimes

in the outside academic world because you are focused on the dayto-day, just keeping everything in place—you do not have the time

to sit back and take anymore analytical assessment.

Mr. MCCONNELL. That is right.

Mr. PLATTS. And the academic communities can do that. His

study on the window dressing issues for instance——

Mr. MCCONNELL. Right.

Mr. PLATTS [continuing]. It is kind of like the type of thing the

SEC should be doing.

Mr. MCCONNELL. Yes.

Mr. PLATTS. And you mentioned that you are looking including

some of the academic community, perhaps visiting members of that

office on loan or something——

Mr. MCCONNELL. That is correct.

Mr. PLATTS. I think it could be helpful.

What type of outreach and specifically using the example of the

window dressing, you know he referenced there has not been one

formal investigation done. Given what he is showing, it seems that

there would be a natural reaction that this is not a scandal but

something that has been put on our plate, our radar that we need

103

to look at. But unless I am not aware of it, there has not been any

followup by the Commission on that specific issue.

Mr. MCCONNELL. I am not aware of any either. I will certainly

check with the enforcement division. But whether they do it or

not——

Mr. PLATTS. And again when I to talk to the reporter about today’s hearing it comes back around to the importance of the strategic plan because——

Mr. MCCONNELL. That is right.

Mr. PLATTS [continuing]. To do that it has to be not a piecemeal

decision again, but what are our total resources.

Mr. MCCONNELL. Exactly.

Mr. PLATTS. So what can we put on that type of administration.

And it really goes back to the importance of that big picture being

enclosed.

Mr. MCCONNELL. That is one of the risks that you put on the

table with all the other risks.

Mr. PLATTS. Right.

Mr. MCCONNELL. And then you look at which ones are the ones

you need to go after. You make a decision as to why you do not

go after this one, and you go after this one. And everybody knows.

Mr. PLATTS. And it is a question at a future hearing. I will probably say where are we today on that window dressing investigation. Have we done that, and if not was it because an evaluation

was made? I will understand. But a likely followup.

Mr. MCCONNELL. Right. When would that be?

Mr. PLATTS. The following week. You know, I say that joking, but

seriously it is—you know, you are partnering in your opening comment about GAO and that partnership and our subcommittee and

our efforts is to, not to play gotcha, but to keep pushing everybody.

Mr. MCCONNELL. We appreciate that. We really do.

Mr. PLATTS. OK.

Mr. MCCONNELL. And that is the way we have operated with

your staff in a constructive——

Mr. PLATTS. And I say, for example, including us. Because if you

lay out here is the challenge for SEC in today’s market environment and here is what we need and here is what we do not have

to meet that need, then if Congress does not deliver, that it is

pushing up. And that is why you need to be outspoken and be

vocal. Those 91, 95 million investors out there, it is critical to their

long term economic security that we are proactive, all of us.

Mr. MCCONNELL. I agree.

Mr. TOWNS. Yes. I just want to add that, you know, the fact that

there is no plan and the fact that you have all these vacancies and

you have to realize that at some point people begin to question.

And I think that—and that if you have the slots and you do not

fill them—you know in Washington if you do not use them, you lose

them. I mean, that has been a longstanding concept. So I do not

know in terms of what you need to do, but I think that being there

is this need, you need to try to find a way to begin to go out and

get people. And you might have to do some things within your own

shop to be able to get them and to train them, whatever it needs

to be done, you know, you need to just reach out and do that. Because, you know, to have the money and to say that we do not have

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the resources which means in terms of the people, I mean at some

point people begin to question that.

So I want you to know, I will be honest with you, as close as I

have been to this issue I have problems, you know, understanding

that part. Knowing that I know it is a difficult time to get accountants because I know all that kind of stuff.

Mr. MCCONNELL. Right.

Mr. TOWNS. But the point is that there must be a way that you

can bring them in, because they are out there in some form or fashion.

Mr. MCCONNELL. Right. I agree.

Mr. TOWNS. I give back.

Mr. PLATTS. Thank you, Commissioner Towns.

Mr. Hillman and Mr. McConnell, we again appreciate your participation here today as you try to partner and go forward and

push for all of us to in the end look out for the investors. And I

use my mom who today, keeps a close eye on her retirement investments.

Mr. MCCONNELL. Right.

Mr. PLATTS. And how those mutual funds are doing. And, that

is just a dramatic change in the Nation today versus the 5, 10, 15

years ago. And so the work you are doing is critically important.

And I certainly do echo Mr. Bogle’s comments. We salute you and

all of the SEC for your diligence. While we are going to keep pushing you, we also respect your hard work and efforts you have put

forth for all our investors—I had better stop talking.

So, Mr. Hillman, you as well and GAO and the partnering.

And with regard to committee staff I wanted to commend both

staff on both sides for assistance in putting today’s field hearing.

And again, for arranging for us to be here at Pace University, to

Pace University for hosting us. It worked out great.

We will keep the record open for 2 weeks for any additional submissions, otherwise this hearing stands adjourned.

Thank you.

[Whereupon, at 1:37 p.m., the subcommittee was adjourned.]

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